**UNITEDSTATESSECURITIES AND EXCHANGE COMMISSIONWashington, D.C. 20549**

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**FORM 10-K**

| **(Mark One)**                                                                                                        |       |                                                                                                         |
|-----------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------------------------------------------------|
| x                                                                                                                     | ** ** | **ANNUAL REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**     |
| **For the fiscal year ended December 31, 2005**                                                                  |
| **OR**                                                                                                                |
| o                                                                                                                     | ** ** | **TRANSITION REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
| **For the  transition period from               to** |

 

**Commissionfile Number: 0-11321**

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**UNIVERSAL AMERICAN FINANCIAL CORP.**(Exact name ofregistrant as specified in its charter)

| **New York**                     |   | **11-2580136**       |
|----------------------------------|--------|----------------------|
| (State or other  jurisdiction of |   | (I.R.S. Employer     |
| incorporation or  organization)  |   | Identification  No.) |

 

**Six International Drive,Suite 190, Rye Brook, New York 10573**

(Address of principal executiveoffices and zip code)

**(914) 934-5200**

(Registrant’s telephonenumber, including area code)

**Securitiesregistered pursuant to Section 12(b) of the Act:**

| **Title of Each Class**                 |   | **Name of Each Exchange On Which Registered** |
|-----------------------------------------|--------|-----------------------------------------------|
| Common Stock, par  value $.01 per share |   | NASDAQ                                        |

 

**Securities registered pursuant to Section 12(g) of the Act:None**

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Indicate by checkmark ifthe registrant is a wellknown seasoned issuer, as defined in Rule 405 ofthe Securities Act. Yes xNo o

Indicate by checkmark ifthe registrant is not required to file reports pursuant to Section 13 or15(d) of the Act. Yes o   No x

Indicate by checkmarkwhether the registrant (1) has filed all reports required to be filed by Section 13or 15 (d) of the Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period that the registrant was required tofile such reports), and (2) has been subject to such filing requirementsfor the past 90 days. Yes x   No o

Indicate by checkmark ifdisclosure of delinquent filers pursuant to Item 405 of Regulation S-K isnot contained herein, and will not be contained, to the best of registrant’sknowledge, in definitive proxy or information statements incorporated byreference in Part III of this Form 10-K or any amendment tothis Form 10-K. o

Indicateby check mark whether the registrant is a large accelerated filer, anaccelerated filer, or a non-accelerated filer. See definition of “acceleratedfiler and large accelerated filer” in Rule 12b-2 of the Exchange Act.(Check one):

| Large accelerated filer  x | Accelerated filer  o | Non-accelerated filer  o |
|--------------------------------------|--------------------------------|------------------------------------|

 

Indicate by check markwhether the registrant is a shell company (as defined in Rule 12b-2of the Exchange Act). Yes o   No x

The aggregate market value of the registrant’s votingand non-voting common stock held by non-affiliates of the registrant on June 30,2005, the last business day of the registrant’s most recently completed secondfiscal quarter, was approximately $760 million (based on the closing salesprice of the registrant’s common stock on that date). As of February 15,2006, 58,303,131 shares of the registrant’s common stock were issued andoutstanding.

**DOCUMENTS INCORPORATED BYREFERENCE**

Portionsof the registrant’s definitive proxy statement in connection with its 2006Annual Meeting of Stockholders (the “Proxy Statement”), scheduled to be held onMay 25, 2006, are incorporated by reference into Part III hereof. Exceptwith respect to information specifically incorporated by reference in this Form 10-K,the Proxy Statement is not deemed to be filed as part hereof. 

 

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**TABLE OF CONTENTS**

|               | ** ** | **Item** | ** ** |                                                                                                                        | **Description** | ** ** | ** ** | **Page** | ** ** |
|---------------|------------|----------|------------|------------------------------------------------------------------------------------------------------------------------|-----------------|------------|------------|----------|------------|
| PART 1   |       | 1        |       | Business                                                                                                               |            | 4          |       |
|          |       | 1A       |       | Risk Factors                                                                                                           |            | 32         |       |
|          |       | 1B       |       | Unresolved Staff  Comments                                                                                             |            | 51         |       |
|          |       | 2        |       | Properties                                                                                                             |            | 51         |       |
|          |       | 3        |       | Legal Proceedings                                                                                                      |            | 51         |       |
|          |       | 4        |       | Submission of  Matters to a Vote of Security Holders                                                                   |            | 52         |       |
| PART II  |       | 5        |       | Market for the Registrant’s Common Equity, Related Stockholder Matters  and Issuer Purchases of Equity Securities |            | 53         |       |
|          |       | 6        |       | Selected Financial  Data                                                                                               |            | 55         |       |
|          |       | 7        |       | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                            |            | 56         |       |
|          |       | 7A       |       | Quantitative  and Qualitative Disclosures about Market Risk                                                            |            | 86         |       |
|          |       | 8        |       | Financial  Statements and Supplementary Data                                                                           |            | 88         |       |
|          |       | 9        |       | Changes in and  Disagreements with Accountants on Accounting and Financial Disclosure                                  |            | 88         |       |
|          |       | 9A       |       | Controls and  Procedures                                                                                               |            | 88         |       |
|          |       | 9B       |       | Other Information                                                                                                      |            | 90         |       |
| PART III |       | 10       |       | Directors and Executive Officers of the  Registrant                                                                    |            | 90         |       |
|          |       | 11       |       | Executive  Compensation                                                                                                |            | 90         |       |
|          |       | 12       |       | Security  Ownership of Certain Beneficial Owners and Management and Related Stockholder  Matters                       |            | 90         |       |
|          |       | 13       |       | Certain  Relationships and Related Transactions                                                                        |            | 90         |       |
|          |       | 14       |       | Principal  Accountant Fees and Services                                                                                |            | 90         |       |
| Part IV  |       | 15       |       | Exhibits and Financial Statement Schedules                                                                             |            | 91         |       |
|          |       |     |       | Signatures                                                                                                             |            | 94         |       |

 

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As used in this Annual Report on Form 10-K,“Universal American,” “we,” “our,” and “us” refer to Universal AmericanFinancial Corp. and its subsidiaries, except where the context otherwiserequires or as otherwise indicated.

**DISCLOSUREREGARDING FORWARD LOOKING STATEMENTS**

Portions of theinformation in this Annual Report on Form 10-K and certain oralstatements made from time to time by representatives of the Company may beconsidered “forward-looking statements” within the meaning of Section 21Eof the Securities Exchange Act of 1934, as amended, and the Private SecuritiesLitigation Reform Act of 1995. The Company intends such forward-lookingstatements to be covered by the safe harbor provisions for forward-lookingstatements contained in Section 21E of the Exchange Act and the PrivateSecurities Litigation Reform Act of 1995. Such forward-looking statementsrelate to, without limitation, the Company’s future economic performance, plansand objectives for future operations and projections of revenue and otherfinancial items. Forward-looking statements can be identified by the use ofwords such as “prospects,” “outlook,” “believes,” “estimates,” “intends,” “may,”“will,” “should,” “anticipates,” “expects” or “plans,” or the negative or othervariation of these or similar words, or by discussion of trends and conditions,strategy or risks and uncertainties. Forward-looking statements are inherentlysubject to risks, trends and uncertainties, many of which are beyond theCompany’s ability to control or predict with accuracy and some of which theCompany might not even anticipate. Although the Company believes that theexpectations reflected in such forward-looking statements are based uponreasonable assumptions at the time made, it can give no assurance that itsexpectations will be achieved. Future events and actual results, financial andotherwise, may differ materially from the results discussed in theforward-looking statements. Readers are cautioned not to place undue relianceon these forward-looking statements.

Important factorsthat may cause actual results to differ materially from forward-lookingstatements include, but are not limited to, the risks and uncertainties setforth in this report in Item 1 “Business”, Item 1A “Risk Factors” and Item 7 “Management’sDiscussion and Analysis of Financial Condition and Results of Operations”. TheCompany assumes no obligation to update and supplement any forward-lookingstatements that may become untrue because of subsequent events, whether as aresult of new information, future events or otherwise.

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**PART I**

**ITEM 1—BUSINESS**

Universal American Financial Corp. (the “Company” or “UniversalAmerican”) is a specialty health and life insurance holding company, with anemphasis on providing a broad array of health insurance and managed careproducts and services to the growing senior population. In 2005, our principalhealth insurance products for the senior market were Medicare Advantage andMedicare Supplement. Beginning in January 2006, we began to cover membersin insured stand-alone prescription drug benefit plans (“PDP’s”) pursuant toMedicare Part D (“Part D”) through a strategic alliance withPharmaCare Management Services, Inc. (“PharmaCare”), a wholly ownedsubsidiary of CVS Corporation (“CVS”). In addition, we sell specialty healthinsurance to self-employed individuals in the United States and Canada, as wellas life insurance and fixed annuities. We also provide administrative servicesfor senior market insurance and non-insurance programs to both affiliated andunaffiliated insurance companies.

Collectively, our insurance subsidiaries are licensedto sell health insurance, life insurance and annuities in all 50 states, theDistrict of Columbia, Puerto Rico and all the provinces of Canada. Our managedcare subsidiary operates Medicare Advantage coordinated care plans in Texas,Florida and Oklahoma and private fee-for-service (“PFFS”) plans in 15 states.

We were incorporated underthe laws of the State of New York on August 31, 1981. Our corporateheadquarters are located at Six International Drive, Rye Brook, New York 10573and our telephone number is (914) 934-5200. We make available free ofcharge on our Internet website (http://www.uafc.com) our annual reports on Form 10-K,quarterly reports on Form 10-Q, current reports on Form 8-K,and amendments to these reports filed or furnished pursuant to Section 13(a) or15(d) of the Securities Exchange Act of 1934 as soon as reasonablypracticable after we electronically file such material with, or furnish it to,the Securities and Exchange Commission. Copies of any materials we file withthe SEC can be read or copied at the SEC’s Public Reference Room at 450Fifth Street, NW, Washington, DC 20549. You can obtain information on theoperation of the Public Reference Room by calling the SEC at 1-800-SEC-0330.The SEC also maintains an Internet site that contains reports, proxy andinformation statements, and other information regarding issuers that fileelectronically with the SEC. Copies of any materials we have filedelectronically with the SEC may be accessed at the SEC’s website:  http://www.sec.gov.

**Medicare Opportunity**

We believe that attractivegrowth opportunities exist in providing a range of products, particularlyhealth insurance, to the growing senior market. At present, more than44 million Americans are eligible for Medicare, the Federal program thatoffers basic hospital and medical insurance to people over 65 years old andcertain disabled people under the age of 65. Standard Medicare coverage doesnot cover prescription drugs except as required in the course of a coveredhospital stay. According to the U.S. Census Bureau, more than 2 millionAmericans turn 65 in the United States each year, and this number is expectedto grow as the so-called baby boomers begin to turn 65. In addition, manylarge employers who traditionally provided medical and prescription drugcoverage to their retirees have begun to curtail these benefits. Finally, thepassage of the Medicare Modernization Act of 2003 (the “MMA”) demonstrated theFederal government’s commitment to increase the healthcare options available toMedicare beneficiaries through the expansion of Medicare managed care plans (“MedicareAdvantage”) and the authorization of a subsidized prescription drug insurancebenefit pursuant to Part D. Taken together, these conditions presentsignificant opportunities for us to increase the sale of our products.

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**Our Strategy**

The principalcomponents of our business strategy are to:

·       Buildour senior health insurance business by offering a broad array of products, including:

**·****      **MedicareAdvantage;

·        MedicareSupplement and Medicare Select; and

·        MedicarePart D Drug Benefit;

·       Builddistribution with an emphasis on expanding our Senior Solutions® brand;

·       Sellcomplementary senior market and specialty health products through ourdistribution networks;

·       Buildour senior market administrative services business; and

·       Continue to complement ourinternal growth through opportunistic acquisitions.

***Medicare Advantage***

As a result of the increased reimbursement rates fromthe Centers for Medicare and Medicaid Services (“CMS”), the Federal agency thatadministers the Medicare Advantage program, Medicare Advantage plans are ableto offer more attractive benefits including enhanced prescription drug coveragepursuant to Part D. Consequently, we believe that enrollment in MedicareAdvantage programs is likely to increase in the coming years.

We entered the MedicareAdvantage business in 2004 with the acquisition of Heritage Health Systems, Inc.which operates Medicare Advantage coordinated care plans in Southeastern Texas.Heritage has expanded its service area to include 8 counties in Texas, and, in2006, has begun to offer an HMO product in three counties in Florida (Brevard,Broward and Miami-Dade). In 2004, we began to offer Medicare Advantage PFFSplans in New York and Pennsylvania. As of January 2006, we are marketingPFFS plans in a total of 15 states.

***Medicare Supplement***

Medicare Supplementinsurance reimburses the policyholder for certain expenses, such as deductiblesand co-pays, that are not covered by standard Medicare coverage  This coverage is designed for people who wantthe freedom to choose providers who participate in the standard Medicareprogram, as opposed to the more restrictive networks that exist in MedicareAdvantage products. In the past ten years, we have become a successful providerof Medicare Supplement coverage. We believe that the market for MedicareSupplement products will continue to be attractive, especially because many seniorsmay lose similar coverage that had previously been offered to them as a retireebenefit by their former employers.

***Medicare Part D***

Effective January 1, 2006, private insurers werepermitted to sponsor insured stand-alone prescription drug benefit plans (“PDP’s”)pursuant to Part D, which was established by the MMA. A portion of thepremium for this insurance is paid by the Federal government, and the balance,if any, is paid by the individuals who enroll. The Federal government will alsoprovide additional subsidies in the form of premium support and coverage of thecost-sharing elements of the plan for certain low income Medicare beneficiaries.We have been approved to offer these programs in 32 of the 34 regions that havebeen established for this program.

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**Our Operating Segments**

Our business consists offive principal business segments:  SeniorManaged Care - Medicare Advantage, Senior Market Health Insurance, SpecialtyHealth Insurance, Life Insurance and Annuity, and Senior Administrative Services.We also report the corporate activities of our holding company in a separatesegment. Information regarding each segment’s revenue, income or loss beforetaxes for each of the last three fiscal years and total assets as of the end ofeach of the last two fiscal years is included in “Note 21—Business SegmentInformation” in our consolidated financial statements included in this Form 10-K.Information regarding our foreign operations in Canada (included in ourSpecialty Health Insurance segment) is included in “Note 22—Foreign Operations”in our consolidated financial statements included in this Form 10-K.

***Senior Managed Care—Medicare Advantage***

We operate Medicare Advantage coordinated care plansin 8 counties in Southeastern Texas, 10 counties in Oklahoma and 3 counties inFlorida, and Medicare Advantage PFFS plans in 15 states.

Medicare Advantage: Coordinated Care Plans (“HMO Plans”).*  *SelectCare of Texas, the health plan operated byHeritage, offers coordinated care plans in 8 counties in Houston andsoutheastern Texas. The plan provides all basic Medicare covered benefits withreduced member cost-sharing as well as additional supplemental benefits,including a defined prescription drug benefit. This coordinated care product isbuilt around contracted networks of providers who, in connection with thehealth plan, coordinate an active medical management program. In addition to amonthly payment per member from CMS, for certain products, the plan may collecta monthly premium from its members.

This plan is distributed by Heritage’s direct salesforce, and our career agents through Senior Solutions® Centers in the coverage areas. As of December 31,2005, SelectCare of Texas had approximately 24,800 members enrolled,representing $236 million of annualized premium in force.

Through SelectCare of Oklahoma, Heritage offers aspecial needs plan with benefits focused on Medicare beneficiaries who areinstitutionalized.

In addition, we began to offer a coordinated care planin three counties in Florida (Brevard, Broward and Miami-Dade) in 2006.

Medicare Advantage: Private Fee-for-Service Plans.*  *PFFS plans provide enhanced health care benefitscompared to traditional Medicare, subject to cost sharing and otherlimitations. There are limited provider network restrictions, which allow themembers to have more flexibility in the delivery of their health care servicesthan other Medicare Advantage plans. In addition to a fixed monthly payment permember from CMS, individuals in these plans pay a monthly premium.

In June 2004, we began enrolling members in PFFSplans in certain counties of New York and Pennsylvania. The PFFS products aredistributed by our independent agents in the coverage areas. As of December 31,2005, approximately 5,100 members were enrolled in the program generatingapproximately $36.2 million of annualized revenue. As of January 2006, weare offering PFFS in a total of 15 states through our career and independentagents.

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*Membership and Annualized Premium In Force.*

| ** **                        | ** ** | **Membership**   | ** ** | **Annualized Premiums** | ** ** |
|-----------------------------------|------------|------------------|------------|------------------------------|------------|
| ** **                        | ** ** | **May 28,** | ** ** | **December 31,**        | ** ** | **May 28,** | ** ** | **December 31,** | ** ** |
| **Senior Managed Care** | ** ** | **2004**         | ** ** | **2004**                     | ** ** | **2005** | ** ** | **2004** | ** ** | **2004** | ** ** | **2005** | ** ** |
| ** **                        | ** ** | ** **       | ** ** | ** **                   | ** ** | ** ** | ** ** | **(in thousands)** | ** ** |
| HMO plans (1)                |       | 16,075           |       | 18,822                       |       | 24,932 |   | $ | 140,700 |   | $ | 162,800 |   | $ | 236,900 |   |
| Private  Fee-for-Service (2)      |       | —           |       | 1,405                        |       | 5,078 |   | — |   | 9,600 |   | 36,200 |   |
| **Total**                         |       | 16,075           |       | 20,227                       |       | 30,010 |   | $ | 140,700 |   | $ | 172,400 |   | $ | 273,100 |   |

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(1)          We acquired Heritage on May 28,2004.

(2)          Webegan enrolling members in our PFFS plans in June, 2004.

***Senior Market Health Insurance***

Our Senior Market Health Insurance segment focuses onselling health insurance products designed for the senior market through ourSenior Solutions® career agency force and through our network of independentgeneral agencies. Our primary products are Medicare Supplement and MedicareSelect. Beginning in 2006, we will also offer a stand-alone prescription drugbenefit, which will be reported in this segment. As of December 31, 2005,we had $572 million of gross premiums in force in this segment.

Medicare Supplement.*  *UnderFederal and National Association of Insurance Commissioners (“NAIC”) modelregulations adopted in nearly all states, there are 14 standard MedicareSupplement plans (Plans A through L and High Deductible Plans F and J). Thesepolicies provide supplemental coverage for many of the medical expenses thatthe basic Medicare program does not cover, such as deductibles, coinsurance andspecified losses that exceed the Federal program’s maximum benefits. Plan Aprovides the least extensive coverage, while Plan J provides the most extensivecoverage. In some areas, we also sell Medicare Select policies in conjunctionwith hospitals that contract with us to waive the Medicare Part Adeductible.

These products are guaranteed renewable for thelifetime of the policyholder, which means that we cannot cancel the policy butwe can seek to increase premium rates on existing and future policies issuedbased upon our actual claims experience. We monitor the claims experience and,when necessary, apply for rate increases in the states in which we sell theproducts. These rate increases are subject to state regulatory approval andFederal and state loss-ratio requirements.

Medicare Part D.   Part D, which wasestablished by the MMA, created a structure in which private insurancecompanies and Medicare Advantage plans will offer Medicare-sponsoredprescription drug insurance plans to Medicare beneficiaries. The Federalgovernment will support Part D through a combination of direct subsidiesof premium, risk adjustors, stop-loss reinsurance and risk corridors. Further,the Federal government will provide additional subsidies to Medicarebeneficiaries who also qualify for Medicaid (“dual eligible”) and other lowincome subsidy (“LIS”) beneficiaries.

In March 2005,we entered into a strategic alliance with PharmaCare, a pharmacy benefitsmanager (“PBM”) that is a wholly owned subsidiary of CVS. PharmaCare is thefourth largest PBM in the nation, covering more than 30 million lives. Theessential elements of the strategic alliance are:

·       Threeof our insurance subsidiaries applied to and were approved by CMS to become aPrescription Drug Plan sponsor (“PDP’s”) in 32 of the 34 regions designated byCMS, thereby becoming eligible to offer the Medicare-approved plans in thoseregions.

·       ThePDP’s have contracted with PharmaCare to provide the full range of PBM servicesrequired to operate the PDP’s.

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·       Asubsidiary of PharmaCare has agreed to reinsure approximately half of the riskassumed by our PDP’s.

·       CVS/pharmacy stores haveassisted in the marketing of our PDP’s on a non-exclusive basis, subject to therules established by CMS.

*Dual Eligibles*

Dual eligiblebeneficiaries who did not enroll themselves in a PDP were automaticallyassigned on a pro rata basis by CMS among the PDP’s which submitted bids belowthe applicable regional benchmarks for standard plans. The standard bids of ourPDP’s were below the applicable regional benchmark in 26 regions thus making useligible to receive auto-assignment of the dual eligibles in those regions.Dual eligible beneficiaries can change their PDP each month, and some of thesebeneficiaries have already changed plans. As a result, there can be noassurance that the dual eligible beneficiaries who are automatically assignedto us will stay in our PDP’s.

*Low Income Subsidy*

Medicare beneficiaries whoqualify for the LIS can choose to enroll in the PDP of their choice. In May 2006,those beneficiaries who qualify for this subsidy but do not so enroll will beautomatically assigned by CMS to one of the PDP’s whose bids for the standardproduct fall below the applicable regional benchmark.

*Marketing*

Our efforts to market ourproducts under thetrademarked brand name, Prescription Pathway(sm),have several components including marketing to our current MedicareSupplement policyholders, marketing through our distribution force andmarketing through pharmacies, including CVS.

*Alliance withArkansas Blue Cross/Blue Shield*

We have entered into an alliance with a PDP sponsoredby Arkansas Blue Cross and Blue Shield, the largest health insurer in Arkansas.Pursuant to this alliance, CHCS Services, Inc., our senior administrativeservices company, provides all administrative services for this PDP’s entranceinto the Part D program in the Arkansas region. PharmaCare provides allPBM services. One of our insurance subsidiaries will provide 33.3% reinsuranceto this PDP.

Other Senior Health Products.*  *Ourother senior health products include acute recovery care (“Acute Care”), seniordental and hospital indemnity products marketed to seniors. We added Acute Careand senior dental products to our portfolio in 2004. Our Acute Care productprovides benefits for confined care and home health care for short term periodsfor individuals recovering from accident or serious illness. Senior dental is ascheduled benefit indemnity product for seniors that allows them to use theirown dentists.

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*NewBusiness Production*.*  *Thefollowing tables show the total new sales (issued annualized premiums) of oursenior market health insurance products produced by our independent and careeragency systems on a gross basis (before reinsurance) and a net basis (afterreinsurance): 

| ** **                         | ** ** | **Gross**                                  | ** ** | **Net**                                    | ** ** |
|------------------------------------|------------|--------------------------------------------|------------|--------------------------------------------|------------|
| ** **                         | ** ** | **Year ended December 31,** | ** ** | **Year ended December 31,** | ** ** |
| **Production**                     | ** ** | **2003**                                   | ** ** | **2004**                                   | ** ** | **2005** | ** ** | **2003** | ** ** | **2004** | ** ** | **2005** | ** ** |
| ** **                         | ** ** | **(In thousands)**                    | ** ** |
| **Senior Market Health Insurance** |       |                                       |       |                                       |       |   |   |   |   |   |   |   |   |
| Medicare Supplement                |       | $                                          | 86,130     |                                       | $          | 83,469 |   | $ | 61,386 |   | $ | 74,116 |   | $ | 83,469 |   | $ | 61,386 |   |
| Other Senior Health                |       | —                                     |       | 1,283                                      |       | 1,309 |   | — |   | 758 |   | 781 |   |
| **Total**                          |       | $                                          | 86,130     |                                       | $          | 84,752 |   | $ | 62,695 |   | $ | 74,116 |   | $ | 84,227 |   | $ | 62,167 |   |
| Percentage  retained               |       |                                       |       |                                       |       |   |   | 86 | % | 99 | % | 99 | % |

 

*Annualized Premium In Force.  *Totalsenior market insurance product annualized premium in force on a gross basis(before reinsurance) and the net amount we retained after reinsurance, is asfollows:  

| ** **                         | ** ** | **Gross**                                  | ** ** | **Net**                                    | ** ** |
|------------------------------------|------------|--------------------------------------------|------------|--------------------------------------------|------------|
| ** **                         | ** ** | **Year ended December 31,** | ** ** | **Year ended December 31,** | ** ** |
| **In Force**                       | ** ** | **2003**                                   | ** ** | **2004**                                   | ** ** | **2005** | ** ** | **2003** | ** ** | **2004** | ** ** | **2005** | ** ** |
| ** **                         | ** ** | **(In thousands)**                    | ** ** |
| **Senior Market Health Insurance** |       |                                       |       |                                       |       |   |   |   |   |   |   |   |   |
| Medicare  Supplement               |       | $                                          | 561,800    |                                       | $          | 573,600 |   | $ | 569,700 |   | $ | 319,000 |   | $ | 368,800 |   | $ | 395,100 |   |
| Other Senior  Health               |       | 1,100                                      |       | 1,800                                      |       | 2,500 |   | 900 |   | 1,300 |   | 1,600 |   |
| **Total**                          |       | $                                          | 562,900    |                                       | $          | 575,400 |   | $ | 572,200 |   | $ | 319,900 |   | $ | 370,100 |   | $ | 396,700 |   |
| Percentage retained                |       |                                       |       |                                       |       |   |   | 57 | % | 64 | % | 69 | % |

 

***Specialty Health Insurance***

Products in our Specialty Health Insurance segmentinclude fixed benefit accident and sickness disability and other healthinsurance products sold to the self-employed market in the United States andCanada. This segment’s products are distributed primarily by our career agents.Traditionally, ourcareer agency segment concentrated on selling specialty health insurance products,primarily fixed benefit accident and sickness disability insurance, to themiddle-income, self-employed market in the United States and Canada. Eventhough the primary focus of this field force in the United States has shiftedto the senior market, a significant number of our United States career agentsand all of the Canadian career agents continue to actively market theseproducts. This segment also includes certain products that we no longer sell,such as long term care and major medical insurance. As of December 31,2005, we had $164 million of gross premiums in force in this segment.

*Fixed Benefit Accident and Sickness*.   Fixedbenefit accident and health products provide three principal types ofbenefits:  disability (fixed periodicpayments to an insured who becomes disabled and unable to work due to anaccident or sickness), hospital (fixed periodic payments to an insured whobecomes hospitalized), and surgical (fixed single payments that vary in amountfor specified surgical or diagnostic procedures). Because the benefits weprovide are fixed in amount at the time of policy issuance and are not intendedto provide full reimbursement for medical and hospital expenses, paymentamounts are not generally affected by inflation or the rising cost of healthcare services.

*Connecticut State Employees.  *Duringthe third quarter of 2005, the Company commenced a new reinsurance arrangementwith PharmaCare Captive Re, Ltd. (“PharmaCare Re”). Under the terms of theagreement, the Company provides an insured drug benefit for the employees ofthe State of Connecticut. The agreement is renewable annually by the State ofConnecticut. The risk is reinsured to PharmaCare Re 

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under a 100% quota sharecontract. The Company receives an underwriting fee of two percent of premium. Annualizedpremium for this program is approximately $260 million. 

*Long Term Care*.*  *As of the end of 2004, we no longer distributed newlong term care products. Previously, we had offered several long term careplans consisting of fully integrated plans and nursing home, and home healthcare plans, which remain in force. These products typically are guaranteedrenewable for the lifetime of the policyholder, which means that we cannotcancel the policy but can seek to increase premium rates on existing policiesbased upon our actual claims experience, subject to state regulatory approval andloss-ratio requirements.

*NewBusiness Production.  *The following tables show ourtotal new sales (issued annualized premiums) of specialty health insuranceproducts produced by primarily by our career agency systems on a gross basis(before reinsurance) and a net basis (after reinsurance): 

| ** **                                               | ** ** | **Gross(1)**                          | ** ** | **Net(1)**                            | ** ** |
|----------------------------------------------------------|------------|---------------------------------------|------------|---------------------------------------|------------|
| ** **                                               | ** ** | **Year ended December 31,** | ** ** | **Year ended December 31,** | ** ** |
| **Production**                                           | ** ** | **2003**                              | ** ** | **2004**                              | ** ** | **2005** | ** ** | **2003** | ** ** | **2004** | ** ** | **2005** | ** ** |
| ** **                                               | ** ** | **(In thousands)**               | ** ** |
| **Specialty Health Insurance**                           |       |                                  |       |                                  |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Accident & Sickness and Other Specialty  Health |       |                                  | $          | 8,338                                 |       |   |   | $ | 7,494 |   |   | $ | 5,159 |   | $ | 8,338 |   | $ | 7,494 |   | $ | 5,159 |   |
| Canadian Products                                        |       |                                  | 6,334      |                                  |       |   | 6,438 |   |   | 7,095 |   | 6,334 |   | 6,438 |   | 7,095 |   |
| Long Term Care                                           |       |                                  | 5,164      |                                  |       |   | 1,691 |   |   | — |   | 2,707 |   | 947 |   | — |   |
| **Total**                                                |       |                                  | $          | 19,836                                |       |   |   | $ | 15,623 |   |   | $ | 12,254 |   | $ | 17,379 |   | $ | 14,879 |   | $ | 12,254 |   |
| Percentage retained                                      |       |                                  |       |                                  |       |   |   |   |   |   |   | 88 | % | 95 | % | 100 | % |

 

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(1)          Excludes annualizedpremiums in force for the State of Connecticut Employee business, as it is 100%ceded to PharmaCare Re.

*AnnualizedPremium In Force.  *Total specialty health insuranceproduct annualized premium in force on a gross basis (before reinsurance) andthe net amount we retained after reinsurance, is as follows:  

| ** **                                               | ** ** | **Gross(1)**                               | ** ** | **Net(1)**                                 | ** ** |
|----------------------------------------------------------|------------|--------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                               | ** ** | **Year ended December 31,** | ** ** | **Year ended December 31,** | ** ** |
| **In Force**                                        | ** ** | **2003**                                   | ** ** | **2004**                                   | ** ** | **2005** | ** ** | **2003** | ** ** | **2004** | ** ** | **2005** | ** ** |
| ** **                                               | ** ** | **(In thousands)**                    | ** ** |
| **Specialty Health Insurance**                           |       |                                       |       |                                       |       |   |   |   |   |   |   |   |   |
| Accident & Sickness and Other Specialty  Health |       | $                                          | 70,600     |                                       | $          | 63,300 |   | $ | 59,100 |   | $ | 64,300 |   | $ | 61,200 |   | $ | 57,300 |   |
| Canadian Products                                        |       | 57,000                                     |       | 61,300                                     |       | 66,400 |   | 57,000 |   | 61,300 |   | 66,400 |   |
| Long Term Care                                           |       | 43,900                                     |       | 41,900                                     |       | 38,900 |   | 27,200 |   | 27,100 |   | 27,200 |   |
| **Total**                                                |       | $                                          | 171,500    |                                       | $          | 166,500 |   | $ | 164,400 |   | $ | 148,500 |   | $ | 149,600 |   | $ | 150,900 |   |
| Percentage retained                                      |       |                                       |       |                                       |       |   |   | 87 | % | 90 | % | 92 | % |

 

----

(1)          Excludesannualized premiums in force for the State of Connecticut Employee business, asit is 100% ceded to PharmaCare Re.

***Life Insurance and Annuity***

*This segment includes all of thelife insurance and annuity business that we sell in the United States. The lifeinsurance products that we currently sell are designed primarily for the seniormarket. These include “final expense” life insurance and asset accumulationlife insurance. In addition, we sell single and*

10

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*flexiblepremium fixed annuities. These products are distributed through bothindependent general agents and our career agency distribution systems. Thissegment also includes previously produced or acquired term, universal life, andwhole life insurance products that are no longer sold.*As of December 31,2005, we had $62 million of gross premiums in force for this segment and policyholder account balances for our annuity and interest-sensitive life insuranceproducts of $498 million.

*Senior Life.  *We offer aline of low-face amount, simplified issue whole life products that are sold byour senior market independent agency and our career agency systems.

*Asset Enhancer Life Insurance.  *Wemarket a line of interest sensitive whole life products that are designed forefficient asset transfer to beneficiaries. These products also offeracceleration of death benefit features that cover certain long term careexpenses.

*NewBusiness Production.  *The following tables show ourtotal new sales (issued annualized premiums) of our life insurance productsproduced by our independent agency and career agency systems on a gross basis(before reinsurance) and a net basis (after reinsurance): 

| ** **          | ** ** | **Gross**                                  | ** ** | **Net**                                    | ** ** |
|---------------------|------------|--------------------------------------------|------------|--------------------------------------------|------------|
| ** **          | ** ** | **Year ended December 31,** | ** ** | **Year ended December 31,** | ** ** |
| **Production**      | ** ** | **2003**                                   | ** ** | **2004**                                   | ** ** | **2005** | ** ** | **2003** | ** ** | **2004** | ** ** | **2005** | ** ** |
| ** **          | ** ** | **(In thousands)**                    | ** ** |
| **Life  Insurance** |       | $                                          | 25,264     |                                       | $          | 38,469 |   | $ | 24,521 |   | $ | 16,109 |   | $ | 23,951 |   | $ | 16,056 |   |
| Percentage retained |       |                                       |       |                                       |       |   |   | 64 | % | 62 | % | 66 | % |
|                     |            |                                            |            |                                            |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

*Annuities.  *We market singleand flexible premium deferred annuities primarily focusing on the senior andretirement markets. The base rate on the annuity products currently marketed byus is 3%. We offer sales inducements in the form of first year only bonusinterest rates, which range from 1% to 4%, on certain of our annuity products. Includingthe bonus interest rates, our current credited rates on our annuity productsrange from 2.5% to 7.8%. Our currently marketed annuity products have minimumguaranteed interest rates ranging from 1.5% to 3%. We have the right to changethe crediting rates at any time, subject to the minimums, and generally adjustthem quarterly.

Annuitydeposits are not reported as revenue in accordance with generally acceptedaccounting principles. The following table shows our annuity deposits bydistribution channel: 

| ** **                        | ** ** | **Year ended December 31,** | ** ** |
|-----------------------------------|------------|--------------------------------------------|------------|
| ** **                        | ** ** | **2003**                                   | ** ** | **2004** | ** ** | **2005** | ** ** |
| ** **                        | ** ** | **(In thousands)**                    | ** ** |
| Senior Market  Independent Agents |       | $                                          | 62,294     |   | $ | 19,495 |   | $ | 11,309 |   |
| Career Agency                     |       | 63,564                                     |       | 56,944 |   | 39,212 |   |
| **Total  Annuity Deposits**       |       | $                                          | 125,858    |   | $ | 76,439 |   | $ | 50,521 |   |

 

The decline in annuitydeposits reflects our desire to de-emphasize this business and is also a resultof a reduction in the current interest rates that we credit and the minimuminterest rates that we guarantee on our annuity products.

***Senior Administrative Services***

We have built our administrative services capabilitiesthrough internal development and acquisition. Through our wholly ownedsubsidiary, CHCS Services, Inc., we provide outsourcing services thatsupport insurance and non-insurance products, primarily for the senior market. Currently,we provide services to over 50 companies including our own insurance companysubsidiaries. Our Senior Administrative Services segment generated revenues of$59 million for the year ended December 31, 2005.

11

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We perform a full range of administrative services forsenior market insurance products, primarily Medicare Supplement and Select,senior life and long term care, for both affiliated and unaffiliated companies.The services include policy underwriting and issuance, policy billing andcollection, telephone verification, policyholder services, claims adjudicationand payment, clinical case management, care assessment and referral to healthcare facilities. During 2005, we developed the administrative capacity toservice Medicare Part D and certain Medicare Advantage programs. Our fullservice capabilities include enrollment and policy issuance, billing andreconciliation, agent commission administration and payment, comprehensivemember services and CMS reporting.

We also perform similar services, particularly in thelong term care area, for non-insurance products offered both by insurance andnon-insurance companies, including our Nurse Navigator(sm) product, a non-insurance elder care serviceproduct that includes health related information and referrals and access tonationwide networks of geriatric care nurses and long term care providersavailable on a discounted basis.

We utilize multiple technologies and a nationalnetwork of highly trained health care professionals to provide theadministrative platforms for these products and services. These technologiesinclude electronic claims processing, imaging and workflow processes to ensuremaximum efficiency in policy issue, policy administration and claims processing.Our proprietary network of registered nurses and social workers providespersonalized support and care for our senior programs nationwide. In addition,our proprietary network of discount providers is an integral part of ourgeriatric care management services. We have a customer contact center thatprovides 24/7 access to our nurses on staff and can handle calls in severaldifferent languages.

Thefollowing table shows the sources of our Senior Administrative Services revenueby type of product: 

| ** **                             | ** ** | **Year ended December 31,** | ** ** |
|----------------------------------------|------------|---------------------------------------|------------|
| ** **                             | ** ** | **2003**                              | ** ** | **2004** | ** ** | **2005** | ** ** |
| ** **                             | ** ** | **(In thousands)**               | ** ** |
| Affiliated Revenue                     |       |                                  |       |   |   |   |   |   |   |
| Medicare Supplement                    |       |                                  | $          | 22,478 |   |   | $ | 29,376 |   | $ | 30,602 |   |
| Long term care                         |       |                                  | 2,589      |   |   | 2,752 |   | 2,641 |   |
| Life Insurance                         |       |                                  | 2,480      |   |   | 3,942 |   | 3,005 |   |
| Other                                  |       |                                  | 1,797      |   |   | 2,819 |   | 3,101 |   |
| Total Affiliated Revenue               |       |                                  | 29,344     |   |   | 38,889 |   | 39,349 |   |
| Unaffiliated Revenue                   |       |                                  |       |   |   |   |   |   |   |
| Medicare Supplement                    |       |                                  | 9,469      |   |   | 8,557 |   | 8,192 |   |
| Long term care                         |       |                                  | 7,065      |   |   | 6,331 |   | 8,204 |   |
| Non-insurance products                 |       |                                  | 1,563      |   |   | 1,552 |   | 1,461 |   |
| Other                                  |       |                                  | 1,090      |   |   | 1,339 |   | 1,918 |   |
| Total Unaffiliated Revenue             |       |                                  | 19,187     |   |   | 17,779 |   | 19,775 |   |
| Total Administrative  Services Revenue |       |                                  | $          | 48,531 |   |   | $ | 56,668 |   | $ | 59,124 |   |

 

Included in unaffiliatedrevenue are fees received to administer certain business of our insurancesubsidiaries that is 100% reinsured to an unaffiliated reinsurer which amountedto $4.1 million for the year ended December 31, 2005, $5.3 million for2004 and $7.4 million for 2003. These fees, together with the affiliatedrevenue, were eliminated in consolidation.

12

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***Corporate***

Our corporate segmentreflects the activities of our holding company including debt service, certainsenior executive compensation and compliance with regulatory requirementsresulting from our status as a public company.

**Marketing and Distribution**

We distribute our insurance and managed care productsthrough our career agency system, a traditional independent general agencysystem and a direct sales force for our Medicare Advantage products.

Wemeasure new sales of our products based on issued annualized premiums,representing the total annual premium expected to be received by us on policiesthat were issued during the year. The following tables show our new sales byour independent and career agents, excluding annuity deposits, by distributionchannel and by major product line on a gross basis (before reinsurance) and anet basis (after reinsurance):

| **Product**                        | ** ** | **Senior  Market  Health** | ** ** | **Senior  Managed  Care** | ** ** | **Specialty  Health** | ** ** | **Life  Insurance/  Annuity** | ** ** | **Total** | ** ** |
|------------------------------------|------------|----------------------------|------------|---------------------------|------------|-----------------------|------------|-------------------------------|------------|-----------|------------|
| ** **                         | ** ** | **(In thousands)**    | ** ** |
| **Total  Distribution—Gross** |       |                       |       |                      |       |                  |       |                          |       |      |       |   |   |
| 2005                               |       | $                          | 62,695     |                      | $          | 86,725                |       | $                             | 12,254     |      |       | $ | 24,521 |   |   | $ | 186,195 |   |
| 2004                               |       | 84,752                     |       | 21,574                    |       | 15,623                |       |                          | 38,469     |      |       | 160,418 |   |
| 2003                               |       | 86,130                     |       | —                    |       | 19,836                |       |                          | 25,264     |      |       | 131,230 |   |
| **Total  Distribution—Net**   |       |                       |       |                      |       |                  |       |                          |       |      |       |   |   |
| 2005                               |       | $                          | 62,167     |                      | $          | 86,725                |       | $                             | 12,254     |      |       | $ | 16,056 |   |   | $ | 177,202 |   |
| 2004                               |       | 84,227                     |       | 21,574                    |       | 14,879                |       |                          | 23,951     |      |       | 144,631 |   |
| 2003                               |       | 74,116                     |       | —                    |       | 17,379                |       |                          | 16,109     |      |       | 107,604 |   |

 

We have continued to expand geographically, and wehave increased our recruiting efforts to augment our production. Additionally,based on the increased financial strength of our Company, we have increased ourretention on new Medicare Supplement business issued to 100%, in order tocontinue growing our net premium.

One marketing organization produced 7.4% of our totalannualized new sales, primarily Medicare Supplement and PFFS plans. Onemarketing organization produced 8.5% in 2004 and 7.6% in 2003 of our totalannualized new sales, primarily senior life business. No other marketingorganization or single agent produced more than 5.0% of our total annualizednew sales in 2005, 2004 or 2003.

13

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***Career Agency***

In order to maximize production from our career agencysales force, we focus on the sale of senior market insured and non-insuredproducts through our SeniorSolutions® program. SeniorSolutions® is our trademarked brand for our portfolio of supplementalhealth and life insurance, asset protection and senior care service products weoffer the senior market, primarily through our career companies of PennsylvaniaLife and Pyramid Life. As of December 31, 2005, our career field force had120 Senior Solutions® branchoffices throughout the United States with approximately 2,200 agents. Incontrast to independent agents, career agents have an exclusive arrangementwith us, and only sell products that we provide or authorize.

Immediately after we acquired Heritage in 2004, our Senior Solutions® offices inSoutheastern Texas began to sell our Medicare Advantage product. Sales by our Senior Solutions® agents representedapproximately 40% of the new sales of this product for 2005. As of January 2006,we are marketing our Medicare Advantage PFFS products in 13 states where wehave Senior Solutions® branchoffices.

In addition, our career agency sales force distributesspecialty health insurance products, primarily fixed benefit accident and sicknessdisability insurance, to the self-employed market in the United States andCanada. We have 13 branch offices in Canada, with 219 agents that focusprimarily on this market.

Thefollowing tables show our new sales, excluding annuity deposits (issued annualizedpremiums), by our career agency systems by major product line on a gross basis(before reinsurance) and a net basis (after reinsurance):

| **Product**                  | ** ** | ** **              | ** ** | **Senior  Market  Health** | ** ** | **Senior  Managed  Care** | ** ** | **Specialty  Health** | ** ** | **Life  Insurance/  Annuity** | ** ** | **Total** | ** ** |
|------------------------------|------------|-------------------------|------------|----------------------------|------------|---------------------------|------------|-----------------------|------------|-------------------------------|------------|-----------|------------|
| ** **                   | ** ** | **(In thousands)** | ** ** |
| **Career Agency—Gross** |       |                    |       |                       |       |                      |       |                  |       |                          |       |      |       |
| 2005                         |       | $                       | 21,292     |                       | $          | 50,180                    |       | $                     | 12,254     |                          |       | $         | 3,523      |   |   | $ | 87,249 |   |
| 2004                         |       | 26,614                  |       | 11,284                     |       | 15,408                    |       |                  | 5,466      |                          |       | 58,772    |       |
| 2003                         |       | 20,242                  |       | —                     |       | 17,588                    |       |                  | 5,014      |                          |       | 42,844    |       |
| **Career  Agency—Net**  |       |                    |       |                       |       |                      |       |                  |       |                          |       |      |       |
| 2005                         |       | $                       | 20,905     |                       | $          | 50,180                    |       | $                     | 12,254     |                          |       | $         | 3,523      |   |   | $ | 86,862 |   |
| 2004                         |       | 26,277                  |       | 11,284                     |       | 14,771                    |       |                  | 5,466      |                          |       | 57,798    |       |
| 2003                         |       | 19,658                  |       | —                     |       | 16,255                    |       |                  | 5,014      |                          |       | 40,927    |       |

 

***Senior Market Independent Agents***

This field force focuses on the sale of senior marketproducts, including Medicare Supplement, senior life insurance, Acute Care andsenior dental products. These marketing organizations and general agenciestypically recruit and train their own agents, bearing all of the costs incurredin connection with developing their organization. We now sell our productsthrough approximately 25,000 independent licensed agents in 35 states and haveplans to recruit more agents and expand into additional states.

In 2004, we began offering our Medicare Advantage PFFSproducts in New York and Pennsylvania through our senior market independentagents. As of January 2006, we offer this program in a total of 15 states.

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Thefollowing tables show our new sales, excluding annuity deposits (issuedannualized premiums), by our independent general agency system by major productline on a gross basis (before reinsurance) and a net basis (after reinsurance):

| **Product**                                      | ** ** | ** **              | ** ** | **Senior  Market  Health** | ** ** | **Senior  Managed  Care** | ** ** | **Specialty  Health** | ** ** | **Life  Insurance/  Annuities** | ** ** | **Total** | ** ** |
|--------------------------------------------------|------------|-------------------------|------------|----------------------------|------------|---------------------------|------------|-----------------------|------------|---------------------------------|------------|-----------|------------|
| ** **                                       | ** ** | **(In thousands)** | ** ** |
| **Senior  Market Independent Agents—Gross** |       |                    |       |                       |       |                      |       |                  |       |                            |       |      |       |   |   |
| 2005                                             |       | $                       | 41,404     |                       | $          | 36,544                    |       |                  | $          | —                          |       |      |       | $ | 20,998 |   |   | $ | 98,946 |   |
| 2004                                             |       | 58,137                  |       | 10,291                     |       |                      | 215        |                  |       |                            | 33,003     |      |       | 101,646 |   |
| 2003                                             |       | 65,889                  |       | —                     |       |                      | 2,247      |                  |       |                            | 20,250     |      |       | 88,386 |   |
| **Senior Market Independent Agents—Net**    |       |                    |       |                       |       |                      |       |                  |       |                            |       |      |       |   |   |
| 2005                                             |       | $                       | 41,263     |                       | $          | 36,544                    |       |                  | $          | —                          |       |      |       | $ | 12,533 |   |   | $ | 90,340 |   |
| 2004                                             |       | 57,950                  |       | 10,291                     |       |                      | 107        |                  |       |                            | 18,485     |      |       | 86,833 |   |
| 2003                                             |       | 54,458                  |       | —                     |       |                      | 1,124      |                  |       |                            | 11,095     |      |       | 66,677 |   |

 

***Direct Distribution***

The Medicare Advantagecoordinated care plan products offered by Heritage in the Texas, Florida andOklahoma markets are also distributed directly to consumers through a full-timeemployee sales force. If we expand the geographical areas in which we marketMedicare Advantage coordinated care plans, we intend to enhance this aspect ofour distribution.

**GeographicalDistribution of Premium**

Throughour insurance subsidiaries, we are licensed to market our products in all fiftystates, the District of Columbia, Puerto Rico and in all the provinces ofCanada. Our managed care subsidiary operates Medicare Advantage coordinatedcare plans in Texas, Florida and Oklahoma and PFFS plans in 15 states. Thefollowing table shows the geographical distribution of the direct cash premiumand annuity deposits collected (in thousands), as reported on a statutory basisto the regulatory authorities for the full year of 2005: 
| State/Region | ** ** | ** ** | ** ** | **Total (1)** | ** ** | **% of  Total** | ** ** | **Repetitive  Direct Cash  Premium(1)** | ** ** | **% of  Premium** | ** ** | **Annuity  Deposits** | ** ** | **% of  Annuity** | ** ** |
|--------------|------------|------------|------------|--------------------|------------|----------------------|------------|----------------------------------------------|------------|------------------------|------------|-----------------------|------------|------------------------|------------|
| Texas        |       | $          | 300,387    |               | 28.0       | %                    | $          | 296,020                                      |       |                   | 28.8       | %                     |       | $                      | 4,367      |   |   | 9.8 | % |   |
| Florida      |       | 123,764    |       | 11.5               | %          | 121,572              |       |                                         | 11.8       | %                      |       | 2,192                 |       |                   | 4.9        | % |   |
| Canada       |       | 65,504     |       | 6.1                | %          | 65,504               |       |                                         | 6.4        | %                      |       | —                |       |                   | —     | % |   |
| New York     |       | 62,372     |       | 5.8                | %          | 59,510               |       |                                         | 5.8        | %                      |       | 2,862                 |       |                   | 6.4        | % |   |
| Pennsylvania |       | 53,397     |       | 5.0                | %          | 51,940               |       |                                         | 5.1        | %                      |       | 1,457                 |       |                   | 3.3        | % |   |
| Indiana      |       | 47,421     |       | 4.4                | %          | 42,993               |       |                                         | 4.2        | %                      |       | 4,428                 |       |                   | 9.9        | % |   |
| Virginia     |       | 37,395     |       | 3.5                | %          | 36,697               |       |                                         | 3.6        | %                      |       | 698                   |       |                   | 1.6        | % |   |
| Subtotal     |       | 690,241    |       | 64.4               | %          | 674,236              |       |                                         | 65.6       | %                      |       | 16,004                |       |                   | 35.9       | % |   |
| All other    |       | 381,901    |       | 35.6               | %          | 353,279              |       |                                         | 34.4       | %                      |       | 28,621                |       |                   | 64.1       | % |   |
| Total        |       | $          | 1,072,142  |               | 100.0      | %                    | $          | 1,027,515                                    |       |                   | 100.0      | %                     |       | $                      | 44,625     |   |   | 100.0 | % |   |
|              |            |            |            |                    |            |                      |            |                                              |            |                        |            |                       |            |                        |            |  |  |  |  |  |  |  |  |  |

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(1)          Excludespremiums of $132 million for the State of Connecticut Employee business, as itis 100% ceded to PharmaCare Re.

15

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**Total Business In Force**

Ourdirect, acquired and assumed annualized premium in force (including only the portionof premiums on interest-sensitive products that is applied to the cost ofinsurance) and related policy counts are shown in the following tables:

| ** **                                       | ** ** | **Gross Annualized Premium in Force(1)  December 31, 2005** | ** ** |
|--------------------------------------------------|------------|-------------------------------------------------------------------------------------------|------------|
| ** **                                       | ** ** | **Senior Market**                                                                    | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                       | ** ** | **Independent Agents**                                                               | ** ** | **Career Agency** | ** ** | **Direct** | ** ** | **Total** | ** ** |
| ** **                                       | ** ** | **     $     **                         | ** ** | **    %    ** | ** ** | **     $     ** | ** ** | **    %    ** | ** ** | **$** | ** ** | **%** | ** ** | **$** | ** ** | **%** | ** ** | **Policies** | ** ** |
| ** **                                       | ** ** | **(in millions, Policies in thousands)**                              | ** ** |
| **Senior Market Health Insurance**               |       |                                                                                      |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Medicare  Supplement                             |       |                                                                                      | 441.5      |   |   |   | 81.0 | % |   |   | 128.2 |   |   |   | 39.9 | % |   | — |   | — | % | 569.7 |   | 53.2 | % |   | 289.1 |   |   |
| Other Senior  Health                             |       |                                                                                      | 1.4        |   |   |   | 0.2 | % |   |   | 1.1 |   |   |   | 0.3 | % |   | — |   | — | % | 2.5 |   | 0.2 | % |   | 5.9 |   |   |
| **Sub  total**                                   |       |                                                                                      | 442.9      |   |   |   | 81.2 | % |   |   | 129.3 |   |   |   | 40.2 | % |   | — |   | — | % | 572.2 |   | 53.4 | % |   | 295.0 |   |   |
| **Senior  Managed Care—Medicare Advantage** |       |                                                                                      |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Health Plans                                     |       |                                                                                      | —     |   |   |   | — | % |   |   | 31.9 |   |   |   | 9.9 | % |   | 205.1 |   | 100.0 | % | 237.0 |   | 22.1 | % |   | 24.9 |   |   |
| Private  Fee-for-Service                         |       |                                                                                      | 32.5       |   |   |   | 6.0 | % |   |   | 3.7 |   |   |   | 1.2 | % |   | - |   | — | % | 36.2 |   | 3.4 | % |   | 5.1 |   |   |
| **Sub  total**                                   |       |                                                                                      | 32.5       |   |   |   | 6.0 | % |   |   | 35.6 |   |   |   | 11.1 | % |   | 205.1 |   | 100.0 | % | 273.2 |   | 25.5 | % |   | 30.0 |   |   |
| **Specialty  Health Insurance**                  |       |                                                                                      |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Accident &  Sickness and Other          |       |                                                                                      | 4.0        |   |   |   | 0.7 | % |   |   | 55.1 |   |   |   | 17.2 | % |   | — |   | — | % | 59.1 |   | 5.5 | % |   | 182.0 |   |   |
| Canadian Products                                |       |                                                                                      | —     |   |   |   | — | % |   |   | 66.4 |   |   |   | 20.7 | % |   | — |   | — | % | 66.4 |   | 6.2 | % |   | 125.9 |   |   |
| Long Term Care                                   |       |                                                                                      | 22.2       |   |   |   | 4.1 | % |   |   | 16.7 |   |   |   | 5.2 | % |   | — |   | — | % | 38.9 |   | 3.6 | % |   | 22.1 |   |   |
| **Sub  total**                                   |       |                                                                                      | 26.2       |   |   |   | 4.8 | % |   |   | 138.2 |   |   |   | 43.1 | % |   | — |   | — | % | 164.4 |   | 15.3 | % |   | 330.0 |   |   |
| **Life  Insurance and Annuity**                  |       |                                                                                      | 43.7       |   |   |   | 8.0 | % |   |   | 18.0 |   |   |   | 5.6 | % |   | — |   | — | % | 61.7 |   | 5.8 | % |   | 166.6 |   |   |
| **Total**                                        |       |                                                                                      | 545.3      |   |   |   | 100.0 | % |   |   | 321.1 |   |   |   | 100.0 | % |   | 205.1 |   | 100.0 | % | 1,071.5 |   | 100.0 | % |   | 821.6 |   |   |

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(1)          Excludesannualized premiums in force for the State of Connecticut Employee business, asit is 100% ceded to PharmaCare Re.
|                                                  | ** ** | **Gross Annualized Premium in Force  December 31, 2004** | ** ** |
|--------------------------------------------------|------------|----------------------------------------------------------------------------------------|------------|
| ** **                                       | ** ** | **Senior Market  Independent Agents**                                             | ** ** | **Career Agency** | ** ** | **Direct** | ** ** | **Total** | ** ** |
| ** **                                       | ** ** | **     $     **                      | ** ** | **    %    ** | ** ** | **     $     ** | ** ** | **    %    ** | ** ** | **$** | ** ** | **%** | ** ** | **$** | ** ** | **%** | ** ** | **Policies** | ** ** |
| ** **                                       | ** ** | **(In millions, Policies in thousands)**                           | ** ** |
| **Senior Market Health Insurance**               |       |                                                                                   |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Medicare Supplement                              |       |                                                                                   | 447.4      |   |   |   | 85.3 | % |   |   | 126.2 |   |   |   | 43.5 | % |   | — |   | — | % | 573.6 |   | 59.2 | % |   | 310.1 |   |   |
| Other Senior Health                              |       |                                                                                   | 1.2        |   |   |   | 0.2 | % |   |   | 0.6 |   |   |   | 0.2 | % |   | — |   | — | % | 1.8 |   | 0.2 | % |   | 4.3 |   |   |
| **Sub total**                                    |       |                                                                                   | 448.6      |   |   |   | 85.5 | % |   |   | 126.8 |   |   |   | 43.7 | % |   | — |   | — | % | 575.4 |   | 59.4 | % |   | 314.4 |   |   |
| **Senior  Managed Care—Medicare Advantage** |       |                                                                                   |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Health Plans                                     |       |                                                                                   | —     |   |   |   | — | % |   |   | 8.7 |   |   |   | 3.0 | % |   | 154.1 |   | 100.0 | % | 162.8 |   | 16.8 | % |   | 18.8 |   |   |
| Private Fee-for-Service                          |       |                                                                                   | 9.6        |   |   |   | 1.8 | % |   |   | — |   |   |   | — | % |   | — |   | — | % | 9.6 |   | 1.0 | % |   | 1.4 |   |   |
| **Sub total**                                    |       |                                                                                   | 9.6        |   |   |   | 1.8 | % |   |   | 8.7 |   |   |   | 3.0 | % |   | 154.1 |   | 100.0 | % | 172.4 |   | 17.8 | % |   | 20.2 |   |   |
| **Specialty  Health Insurance**                  |       |                                                                                   |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Accident &  Sickness and Other     |       |                                                                                   | 4.4        |   |   |   | 0.8 | % |   |   | 58.9 |   |   |   | 20.3 | % |   | — |   | — | % | 63.3 |   | 6.5 | % |   | 200.5 |   |   |
| Canadian Products                                |       |                                                                                   | —     |   |   |   | — | % |   |   | 61.3 |   |   |   | 21.1 | % |   | — |   | — | % | 61.3 |   | 6.3 | % |   | 131.9 |   |   |
| Long Term Care                                   |       |                                                                                   | 24.0       |   |   |   | 4.6 | % |   |   | 17.9 |   |   |   | 6.2 | % |   | — |   | — | % | 41.9 |   | 4.3 | % |   | 24.7 |   |   |
| **Sub total**                                    |       |                                                                                   | 28.4       |   |   |   | 5.4 | % |   |   | 138.1 |   |   |   | 47.6 | % |   | — |   | — | % | 166.5 |   | 17.2 | % |   | 357.1 |   |   |
| **Life  Insurance and Annuity**                  |       |                                                                                   | 38.0       |   |   |   | 7.2 | % |   |   | 16.5 |   |   |   | 5.7 | % |   | — |   | — | % | 54.5 |   | 5.6 | % |   | 161.9 |   |   |
| **Total**                                        |       |                                                                                   | 524.6      |   |   |   | 100.0 | % |   |   | 290.1 |   |   |   | 100.0 | % |   | 154.1 |   | 100.0 | % | 968.8 |   | 100.0 | % |   | 853.6 |   |   |

 

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**AccountValues on Interest-Sensitive Products**

Thefollowing table shows the account values and policy counts for ourinterest-sensitive products before reinsurance. For these products, we earnincome on the difference between investment income that we earn on our investedassets and interest credited to these account balances. 

| ** **               | ** ** | **As of December 31,** | ** ** |
|--------------------------|------------|---------------------------------------|------------|
| ** **               | ** ** | **2003**                              | ** ** | **2004** | ** ** | **2005** | ** ** |
| ** **               | ** ** | **(In thousands)**               | ** ** |
| Annuities                |       | $                                     | 256,521    |   | $ | 317,085 |   | $ | 335,908 |   |
| Interest-sensitive  Life |       | 163,164                               |       | 161,288 |   | 162,513 |   |
| Total                    |       | $                                     | 419,685    |   | $ | 478,373 |   | $ | 498,421 |   |
| Policies                 |       | 46.1                                  |       | 46.1 |   | 45.7 |   |

 

**Investments**

Our investment policy is to attempt to balance theportfolio duration to achieve investment returns consistent with thepreservation of capital and maintenance of liquidity adequate to meet paymentof policy benefits and claims. We invest in assets permitted under theinsurance laws of the various states in which we operate. Such laws generallyprescribe the nature, quality of and limitations on various types ofinvestments that may be made. However, we do not currently have investments inpartnerships, special purpose entities, real estate, commodity contracts, orother derivative securities.

Thefollowing table summarizes the composition of our investment portfolio bycarrying value (which represents fair value): 

| ** **                      | ** ** | **December 31, 2004**        | ** ** | **December 31, 2005**             | ** ** |
|---------------------------------|------------|----------------------------------------|------------|---------------------------------------------|------------|
| ** **                      | ** ** | **Carrying  Value  (Fair Value)** | ** ** | **Percent of  Total  Carrying  Value** | ** ** | **Carrying  Value  (Fair Value)** | ** ** | **Percent of  Total  Carrying  Value** | ** ** |
| ** **                      | ** ** | **(In thousands)**                | ** ** |
| Fixed Maturity  Securities:     |       |                                   |       |                                        |       |   |   |   |   |   |   |   |   |
| U.S. Government  and            |       |                                   |       |                                        |       |   |   |   |   |   |   |   |   |
| Government agencies(1)          |       | $                                      | 287,539    |                                        |       | 20.9 | % |   | $ | 316,268 |   |   | 20.9 | % |   |
| Mortgage-backed(1)              |       | 45,629                                 |       |                                        | 3.3        | % |   | 56,401 |   |   | 3.7 | % |   |
| Asset-backed                    |       | 87,529                                 |       |                                        | 6.4        | % |   | 247,129 |   |   | 16.4 | % |   |
| Foreign securities(2)           |       | 238,347                                |       |                                        | 17.2       | % |   | 266,168 |   |   | 17.6 | % |   |
| Investment grade corporates     |       | 504,775                                |       |                                        | 36.6       | % |   | 443,509 |   |   | 29.4 | % |   |
| Non-investment grade corporates |       | 7,003                                  |       |                                        | 0.5        | % |   | 15,300 |   |   | 1.0 | % |   |
| Total fixed maturity securities |       | 1,170,822                              |       |                                        | 84.9       | % |   | 1,344,775 |   |   | 89.0 | % |   |
| Cash and cash equivalents       |       | 181,257                                |       |                                        | 13.1       | % |   | 138,899 |   |   | 9.2 | % |   |
| Other  Investments:             |       |                                   |       |                                        |       |   |   |   |   |   |   |   |   |
| Policy loans                    |       | 24,318                                 |       |                                        | 1.8        | % |   | 23,601 |   |   | 1.6 | % |   |
| Equity securities               |       | 755                                    |       |                                        | 0.1        | % |   | 1,279 |   |   | 0.1 | % |   |
| Other invested assets           |       | 1,187                                  |       |                                        | 0.1        | % |   | 896 |   |   | 0.1 | % |   |
| Total cash and invested  assets |       | $                                      | 1,378,339  |                                        |       | 100.0 | % |   | $ | 1,509,450 |   |   | 100.0 | % |   |

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(1)          U.S. Government andgovernment agencies include GNMA and FMNA mortgage-backed securities.

(2)          Primarily Canadiandollar denominated bonds supporting our Canadian insurance reserves.

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The following table showsthe distribution of the contractual maturities of our portfolio of fixedmaturity securities by carrying value as of December 31, 2005. Expectedmaturities will differ from contractual maturities because borrowers may havethe right to call or prepay obligations with or without call or prepaymentpenalties: 

| **Available for Sale**    | ** ** | ** **              | ** ** | **Carrying Value** | ** ** | **Percent of Total  Fixed Maturities** | ** ** |
|-------------------------------------|------------|-------------------------|------------|-------------------------|------------|-------------------------------------------------------|------------|
| ** **                          | ** ** | **(In thousands)** | ** ** | ** **              | ** ** |
| Due in 1 year or  less              |       |                    | $          | 48,360                  |       |                                                  |       | 3.6 | % |   |
| Due after 1 year  through 5 years   |       |                    | 243,044    |                    |       |                                                  | 18.1       | % |   |
| Due after 5 years  through 10 years |       |                    | 315,448    |                    |       |                                                  | 23.5       | % |   |
| Due after 10  years                 |       |                    | 229,987    |                    |       |                                                  | 17.1       | % |   |
| Asset-backed  securities            |       |                    | 247,128    |                    |       |                                                  | 18.4       | % |   |
| Mortgage-backed  securities         |       |                    | 260,808    |                    |       |                                                  | 19.3       | % |   |
| Total                               |       |                    | $          | 1,344,775               |       |                                                  |       | 100.0 | % |   |

 

Thefollowing table shows the distribution of the ratings assigned by Standard &Poor’s Corporation to the securities in our portfolio of fixed maturitysecurities:

| ** **                                           | ** ** | **December 31, 2004** | ** ** | **December 31, 2005**                       | ** ** |
|------------------------------------------------------|------------|---------------------------------|------------|-------------------------------------------------------|------------|
| **Standard & Poor’s Rating** | ** ** | ** **                      | ** ** | **Carrying Value  (Estimated Fair  Value)** | ** ** | **% of Total Fixed  Investment** | ** ** | **Carrying Value  (Estimated Fair  Value)** | ** ** | **% of Total Fixed  Investment** | ** ** |
| ** **                                           | ** ** | **(In thousands)**         | ** ** |
| AAA                                                  |       |                            | $          | 425,504                                               |       |   |   | 36.3 | % |   |   | $ | 451,813 |   |   |   | 33.6 | % |   |
| AA                                                   |       |                            | 136,396    |                                                  |       |   | 11.7 | % |   |   | 384,526 |   |   |   | 28.6 | % |   |
| A                                               |       |                            | 434,710    |                                                  |       |   | 37.1 | % |   |   | 386,684 |   |   |   | 28.8 | % |   |
| BBB                                                  |       |                            | 167,209    |                                                  |       |   | 14.3 | % |   |   | 106,452 |   |   |   | 7.9 | % |   |
| BB                                                   |       |                            | 7,003      |                                                  |       |   | 0.6 | % |   |   | 15,300 |   |   |   | 1.1 | % |   |
| B                                               |       |                            | —     |                                                  |       |   | — | % |   |   | — |   |   |   | — | % |   |
| Total                                                |       |                            | $          | 1,170,822                                             |       |   |   | 100.0 | % |   |   | $ | 1,344,775 |   |   |   | 100.0 | % |   |
|                                                      |            |                                 |            |                                                       |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

At December 31, 2005 and 2004, approximately 99%of our fixed maturity investments were rated “investment grade.”  “Investment grade” securities are those rated“BBB-” or higher by Standard & Poor’s Corporation or “Baa3” or higherby Moody’s Investors Service. We owned approximately $507.9 million ofcollateralized mortgage obligations secured by residential mortgages andasset-backed securities, as of December 31, 2005 compared to $332.8million, as of December 31, 2004, representing approximately 37.8% of ourfixed maturity portfolio as of December 31, 2005 and 28.4% of our fixedmaturity portfolio as of December 31, 2004. Some classes of mortgagebacked securities are subject to significant prepayment risk, because inperiods of declining interest rates, mortgages may be repaid more rapidly thanscheduled, as individuals refinance higher rate mortgages to take advantage ofthe lower rates. As a result, holders of mortgage backed securities may receivehigher prepayments on their investments, which they may not be able to reinvestat an interest rate comparable to the rate paid on such mortgage backedsecurities.

Fixed maturity securitieswith less than investment grade ratings had aggregate carrying values of $15.3million as of December 31, 2005 and $7.0 million as of December 31,2004, amounting to 1.1% of total investments as of December 31, 2005 and0.6% of total investments as of December 31, 2004. These securitiesrepresented approximately 0.7% of total assets as of December 31, 2005 and0.4% of total assets as of December 31, 2004. Our holdings of less thaninvestment grade fixed maturity securities are diversified and the largestinvestment in any one such security as of December 31, 2005 was $7.0million, which was approximately 0.3% of total assets. During the years ended December 31,2005 and 2004, we did not write down the value of any fixed maturity securities.

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***Investment Income***

Investmentincome is an important part of our total revenues and profitability. We cannotpredict the impact that changes in future interest rates will have on ourfinancial statements. The following table presents the investment results ofour total invested asset portfolio: 

| ** **                                                                                                         | ** ** | **Years ended December 31,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                                                         | ** ** | **2003**                                    | ** ** | **2004** | ** ** | **2005** | ** ** |
| ** **                                                                                                         | ** ** | **(In thousands)**                     | ** ** |
| Total cash and invested  assets, end of period                                                                     |       | $                                           | 1,286,508  |   | $ | 1,378,339 |   | $ | 1,509,450 |   |
| Net investment income                                                                                              |       | $                                           | 61,075     |   | $ | 65,191 |   | $ | 71,612 |   |
| Yield on average cash  and investments                                                                             |       | 5.3                                         | %          | 4.9 | % | 5.0 | % |
| Net realized investment gains on the sale of  securities (including other-than-temporary declines in market value) |       | $                                           | 2,057      |   | $ | 10,647 |   | $ | 5,773 |   |

 

**Reinsurance**

In the normal course of business, we reinsure portionsof certain policies that we underwrite. We enter into reinsurance arrangementswith unaffiliated reinsurance companies to limit our exposure on individualclaims and to limit or eliminate risk on our non-core or under-performing blocksof business. Accordingly, we are party to several reinsurance agreements on ourlife and accident & health insurance risks. Our senior market accident &health insurance products are generally reinsured under quota share coinsurancetreaties, while our life insurance risks are generally reinsured under eitherquota share coinsurance or yearly-renewable term treaties. Under quota sharecoinsurance treaties, we pay the reinsurer an agreed upon percentage of allpremiums and the reinsurer reimburses us that same percentage of any losses. Inaddition, the reinsurer pays us allowances to cover commissions, cost ofadministering the policies and premium taxes. Under yearly-renewable termtreaties, the reinsurer receives premiums at an agreed upon rate for its shareof the risk on a yearly-renewable term basis. We also use excess of lossreinsurance agreements for certain policies whereby we limit our loss in excessof specified thresholds.

Thetable below details our gross annualized premium in force, the portion that weceded to reinsurers and the net amount that we retained:

| ** **                              | ** ** | **December 31, 2004** | ** ** | **December 31, 2005**(1) | ** ** |
|-----------------------------------------|------------|---------------------------------|------------|------------------------------------|------------|
| ** **                              | ** ** | **Gross**                       | ** ** | **Ceded**                          | ** ** | **Net** | ** ** | **Retained** | ** ** | **Gross** | ** ** | **Ceded** | ** ** | **Net** | ** ** | **Retained** | ** ** |
| ** **                              | ** ** | **(In millions)**          | ** ** |
| **Senior Market Health Insurance**      |       |                            |       |                               |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Medicare Supplement                     |       | $                               | 573.6      |                               | $          | 204.8 |   | $ | 368.8 |   |   | 64 | % |   | $ | 569.7 |   | $ | 174.6 |   | $ | 395.1 |   |   | 69 | % |   |
| Other Senior Health                     |       | 1.8                             |       | 0.5                                |       | 1.3 |   |   | 72 | % |   | 2.5 |   | 0.8 |   | 1.7 |   |   | 66 | % |   |
| **Sub total**                           |       | 575.4                           |       | 205.3                              |       | 370.1 |   |   | 64 | % |   | 572.2 |   | 175.4 |   | 396.8 |   |   | 69 | % |   |
| **Specialty  Health Insurance**         |       |                            |       |                               |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Accident &  Sickness and other |       | 63.3                            |       | 2.1                                |       | 61.2 |   |   | 97 | % |   | 59.1 |   | 1.9 |   | 57.2 |   |   | 97 | % |   |
| Canadian Products                       |       | 61.3                            |       | —                             |       | 61.3 |   |   | 100 | % |   | 66.4 |   | — |   | 66.4 |   |   | 100 | % |   |
| Long Term Care                          |       | 41.9                            |       | 14.8                               |       | 27.1 |   |   | 65 | % |   | 38.9 |   | 11.7 |   | 27.2 |   |   | 70 | % |   |
| **Sub total**                           |       | 166.5                           |       | 16.9                               |       | 149.6 |   |   | 90 | % |   | 164.4 |   | 13.6 |   | 150.8 |   |   | 92 | % |   |
| **Life  Insurance and Annuity**         |       | 54.5                            |       | 13.1                               |       | 41.4 |   |   | 76 | % |   | 61.7 |   | 16.1 |   | 45.6 |   |   | 74 | % |   |
| **Total**                               |       | $                               | 796.4      |                               | $          | 235.3 |   | $ | 561.1 |   |   | 71 | % |   | $ | 798.3 |   | $ | 205.1 |   | $ | 593.2 |   |   | 74 | % |   |

----

(1)          Excludesannualized premiums in force for the State of Connecticut Employee business, asit is 100% ceded to PharmaCare Re.

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We have several quota share coinsurance agreements (asdescribed above) in place with General Re Life Corporation (“General Re”) andHannover Life Re of America (“Hannover”). General Re is rated “A+” and Hannoveris rated “A” by A.M. Best. These agreements cover various accident &health insurance products, primarily Medicare Supplement and long term carepolicies, written or acquired by us and contain ceding percentages ranging from25% to 100%. As of January 1, 2004, our retention on all new MedicareSupplement sales was 100%. During 2005, we ceded premiums of $132.3 million toPharmaCare Re, $96.2 million to General Re and $90.6 million to Hannover,representing approximately 11%, 8% and 8%, respectively, of our total directand assumed premiums. During 2004, we ceded premiums of $109.0 million toGeneral Re and $105.3 million to Hannover, each representing approximately 12%of our total direct and assumed premiums. During 2003, we ceded premiums of$123.5 million to General Re and $116.3 million to Hannover, representing 17%and 16%, respectively, of our total direct and assumed premiums.

Our quota share coinsurance agreements are generallysubject to cancellation on 90 days notice as to future business, but policiesreinsured prior to such cancellation remain reinsured as long as they remain inforce. There is no assurance that if any of our reinsurance agreements werecanceled we would be able to obtain other reinsurance arrangements on satisfactoryterms.

We evaluate the financialcondition of our reinsurers and monitor concentrations of credit risk tominimize our exposure to significant losses from reinsurer insolvencies. We areobligated to pay claims in the event that a reinsurer to whom we have ceded aninsured claim fails to meet its obligations under the reinsurance agreement. Asof December 31, 2005, all of our primary reinsurers were rated “A” orbetter by A.M. Best, except for PharmaCare Re, which is unrated. We do notknow of any instances where any of our reinsurers have been unable to pay anypolicy claims on any reinsured business.

***Administration of Reinsured Blocks of Business***

We retain theadministration for reinsured blocks of business, including underwriting, issue,policy maintenance, rate management and claims adjudication and payment. Inaddition to reimbursement for commissions and premium taxes on the reinsuredbusiness, we also receive allowances from the reinsurers as compensation forour administration.

***Reinsurance of Senior Managed Care—Medicare Advantage***

We reinsure our MedicareAdvantage coordinated care and PFFS products on an excess of loss basis, whichlimits our per member risk to amounts ranging from $100,000 to $190,000.

***Reinsurance of Senior Market Health Insurance***

Historically, we reinsured much of our Senior MarketHealth Insurance business to unaffiliated reinsurers under quota sharecoinsurance agreements. In 2001, we began reducing the amount of premium thatwe ceded to reinsurers on new business, and all new Medicare Supplementbusiness written after January 1, 2004 has been 100% retained by theCompany. Under the existing coinsurance agreements, which remain in effect forthe life of each policy reinsured, we reinsure a portion of the premiums,claims and commissions on a pro rata basis and receive additional expenseallowances for policy issue and administration and premium taxes. The amountsreinsured under these agreements range from 25% to 100%. As older, reinsuredbusiness lapses and new business that has no reinsurance is written, theoverall percentage of business we retain will increase. As of December 31,2005, the percentage of Medicare Supplement business we retained increased to69%, as compared to 64% at the end of 2004.

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***Reinsurance ofSpecialty Health Insurance***

We retain 100% of thefixed benefit accident & sickness disability and hospital businessissued in our Specialty Health Insurance segment. Long term care business isreinsured on a 50% quota share basis, except for the acquired long term carebusiness written in Pennsylvania Life, Penncorp Life (Canada) and Union Bankerswhich is 100% retained. We have excess of loss reinsurance agreements to reduceour liability on individual risks for home health care policies to $250,000. Forother long term care policies issued in the U.S. we have reinsurance agreementswhich cover 90% of the benefits on claims after two years and 100% of thebenefits on claims after the third or fourth years depending upon the plan. Wealso have excess of loss reinsurance agreements with unaffiliated reinsurancecompanies on most of our major medical insurance policies to reduce theliability on individual risks to $325,000 per year.

***Reinsurance—ConnecticutState Employees***

During the third quarterof 2005, the Company commenced a new reinsurance arrangement with PharmaCare Re.Under the terms of the agreement, the Company provides an insured drug benefitfor the employees of the State of Connecticut. The agreement is renewableannually by the State of Connecticut. The risk is reinsured to PharmaCare Reunder a 100% quota share contract. The Company receives an underwriting fee oftwo percent of premium. Annualized premium in force on this block of businessis approximately $260 million. Amounts recoverable from PharmaCare Re aresupported by a letter of credit equal to the total unpaid claims and claimreserves for this business, but no less than $35 million.

***Reinsurance of LifeInsurance and Annuity***

Senior life insuranceproducts currently being issued are reinsured under 50% quota share coinsuranceagreements, except for certain states where our retention is 100%. Our wholelife products currently being issued are reinsured on a yearly renewable termbasis for amounts in excess of $100,000.

**UnderwritingProcedures**

Premiums charged oninsurance products are based, in part, on assumptions about expected mortalityand morbidity experience. We have adopted and follow detailed uniformunderwriting procedures designed to assess and quantify various insurance risksbefore issuing individual life insurance, health insurance policies and annuitypolicies to individuals. These procedures are generally based on industrypractices, reinsurer underwriting manuals and our prior underwriting experience.To implement these procedures, our insurance company subsidiaries employ anexperienced professional underwriting staff.

Applications for insuranceare reviewed on the basis of the answers that the customer provides to theapplication questions. Where appropriate to the type and amount of insuranceapplied for and the applicant’s age and medical history, additional informationis required, such as medical examinations, statements from doctors who havetreated the applicant in the past and, where indicated, special medical tests. Ifdeemed necessary, we use investigative services to supplement and substantiateinformation. For certain coverages, we may verify information with theapplicant by telephone. After reviewing the information collected, we eitherissue the policy as applied for on a standard basis, issue the policy with anextra premium charge due to unfavorable factors, issue the policy excludingbenefits for certain conditions, either permanently or for a period of time, orreject the application. For some of our coverages, we have adopted simplifiedpolicy issue procedures in which the applicant submits an application forcoverage typically containing only a few health-related questions instead of acomplete medical history. Under regulations promulgated by the NAIC and adoptedas a result of the Omnibus Budget Reconciliation Act of 1990, we are prohibitedfrom using medical underwriting criteria for our Medicare Supplement policiesfor certain first-time purchasers and for dis-enrollees from health maintenanceorganizations (HMOs). If a person applies for insurance within six months afterbecoming eligible by reason of age, or disability in 

21

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somecircumstances, the application may not be rejected due to medical conditions. Forother prospective Medicare Supplement policyholders, such as senior citizenswho are purchasing our products, the underwriting procedures are limited basedupon standard industry practices.

In New York and someother states, some of our products, including Medicare Supplement, are subjectto guaranteed issue “Community Rating” laws that severely limit or preventunderwriting of individual applications. See “Regulation” section of thisdocument. Additionally, we are not permitted to underwrite for new members forour Medicare Advantage HMO Plan or our PFFS plans.

**Reserves**

In accordance withapplicable insurance regulations, we have established, and carry as liabilitiesin our statutory financial statements, actuarially determined reserves that arecalculated to satisfy our policy and contract obligations. Reserves, togetherwith premiums to be received on outstanding policies and contracts and interestat assumed rates on such amounts, are calculated to be sufficient to satisfypolicy and contract obligations. The actuarial factors used in determiningreserves for life insurance policies are based on statutorily prescribedmortality tables and interest rates. In addition, reserves for accident andhealth insurance policies use prescribed or permitted morbidity tables. Reservesare also maintained for unearned premiums, for premium deposits, for claimsthat have been reported and are in the process of being paid or contested andfor our estimate for claims that have been incurred but have not yet beenreported.

The reserves reflected inour consolidated financial statements are calculated in accordance withgenerally accepted accounting principles (“GAAP”). These reserves aredetermined based on our best estimates of mortality and morbidity, persistency,expenses and investment income. We use the net level premium method for allnon-interest-sensitive products and the retrospective deposit method forinterest-sensitive products. GAAP reserves differ from statutory reserves dueto the use of different assumptions regarding mortality and morbidity, interestrates and the introduction of lapse assumptions into the GAAP reservecalculation.

When we acquire blocks ofinsurance policies or insurers owning blocks of policies, our assessment of theadequacy of the transferred policy liabilities is subject to risks anduncertainties. With acquired and existing businesses, we may from time to timeneed to increase our claims reserves significantly in excess of those estimated.An inadequate estimate in reserves could have a material adverse impact on ourresults of operations or financial condition.

**ProviderArrangements**

We provide health careservices to members enrolled in our Medicare Advantage coordinated care plansthrough a network of contracted providers, including physicians, other clinicalproviders, hospitals, a variety of outpatient facilities and the full range ofancillary provider services. These ancillary services and facilities includeambulance services, medical equipment services, home health agencies, mentalhealth providers, rehabilitation facilities, skilled nursing facilities,optical services, and pharmacies.

We use a wide range ofsystems and processes to organize and deliver needed health care services toour members. The key steps in this process include:  the careful selection of primary carephysicians to provide overall care management and care coordination of members,the selection of specialists by the primary care physicians, contracting forthe balance of needed services based on the preference and experience of thelocal physicians, and the full range of medical management systems required tosupport the primary care and specialist physicians. We employ qualityassessment and recredentialing programs to ensure that target goals relating tothe provision of quality patient care are met. The medical management systemsinclude: an inpatient hospitalist program, selected authorization of targetservices, case management, prescription drug management and disease management.Our hospitalist programs use 

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specially-trainedphysicians to manage the entire range of our members’ medical care during hospitaladmissions and to coordinate the members’ discharge and post-discharge care. Thesevarious medical management systems are integrated through a care coordinationinformation system to provide clinical and administrative information tosupport the medical management process. Our disease management programs relateto specific medical conditions such as congestive heart failure, coronaryartery disease, asthma related illness, end stage renal disease, diabetes,cancer, and certain other conditions.

Our health plans usuallycontract with hospitals based on Medicare’s Diagnosis-Related Group (“DRG”)methodology, which is an all-inclusive rate per admission. Outpatientfacilities generally are contracted on Medicare’s Ambulatory PaymentClassification (“APC”) methodology, or a percentage of billed charges whichapproximates APC reimbursement. Physicians and other providers are contractedon a capitation or fee-for-service basis, utilizing Medicare’s Resource BasedRelative Value Scale (“RBRVS”) methodology. Under a capitation arrangement,physicians receive a monthly fixed fee for each member, regardless of themedical services provided to the member. Our provider contracts with networkprimary care physicians and specialists generally have terms of one year, withautomatic renewal for successive one-year terms. We may terminate thesecontracts for cause, based on provider conduct or other appropriate reasons,subject to laws giving providers due process rights. The contracts generallymay be cancelled by either party without cause upon 60 or 90 days prior writtennotice. Our contracts with hospitals generally have terms of one to two years,with automatic renewal for successive one-year terms. We may terminate thesecontracts for cause, based on provider misconduct or other appropriate reasons.Our hospital contracts generally may be cancelled by either party without causeupon 120 days prior written notice.

**Competition**

The life and accident andhealth insurance and managed care industries in North America are highlycompetitive. There are approximately 2,000 life and accident and healthinsurance companies and approximately 400 managed care organizations operatingin the United States. We compete with numerous other insurance and managed carecompanies on a national basis plus other regional insurance companies andfinancial services companies, including health maintenance organizations,preferred provider organizations, and other health care-related institutionswhich provide medical benefits based on contractual agreements. We may be at adisadvantage because many of these organizations have been in business for alonger period of time and have substantially greater capital, larger and morediversified portfolios of life and health insurance policies, larger agencysales operations and higher ratings than we do. In addition, it has becomeincreasingly difficult for smaller and mid-size companies to competeeffectively with these larger competitors for insurance product sales in partas a result of heightened consumer and agent awareness of the ratings andfinancial size of companies.

We believe we can meetthese competitive pressures by offering a high level of service andaccessibility to our field force and by developing specialized products andmarketing approaches. We also believe that our policies and premium rates, aswell as the commissions paid to our sales agents, are generally competitivewith those offered by other companies selling similar types of products in thesame jurisdictions. In addition, our insurance subsidiaries operate at lowerpolicy acquisition and administrative expense levels than some other insurancecompanies, allowing us to offer competitive rates while maintaining underwritingmargins. In the case of our Medicare Supplement business, low expense levelsare necessary in order to meet state mandated loss ratios and achieve thedesired underwriting margins. Also, we believe our disciplined underwritingprocedures, pricing practices, effective rate management and related staff, ourquality customer service, our significant market position in certain geographicareas, the quality of our distribution network and our appropriate financialstrength, provide additional strength to compete effectively.

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In addition, we competewith other managed care organizations for government healthcare programcontracts, renewals of those government contracts, members and providers. Manyof our competitors are large companies that have greater financial,technological and marketing resources than we do. In the Medicare managed caremarket, our primary competitors for contracts, members and providers arenational and regional commercial managed care organizations that serve Medicarerecipients and provider-sponsored organizations.

Beginning in 2006, a newregional Medicare Preferred Provider Organization, or Medicare PPO, program hasbeen implemented pursuant to the MMA. Medicare PPO’s allow their members moreflexibility to select physicians than other Medicare Advantage plans, such asHMOs, which often require members to coordinate with a primary care physician. RegionalMedicare PPO plans will compete with local Medicare Advantage HMO plans,including the plans we offer, and with our Medicare Supplement business. Inaddition, several of our competitors have introduced highly competitive PFFSplans that compete with our Medicare Advantage and Medicare Supplementproducts.

Recently, the increasedcompetition from other Medicare Supplement carriers, as well as from MedicareAdvantage plans, has affected our production of Medicare Supplement businessand has caused more lapsation of in-force business than we had anticipated.

**Ratings**

Increased public andregulatory concerns regarding the financial stability of insurance companieshave resulted in policyholders placing greater emphasis upon company ratingsand have created some measure of competitive advantage for insurance carrierswith higher ratings. A.M. Best is considered to be a leading insurancecompany rating agency. In evaluating a company’s financial and operatingperformance, A.M. Best reviews profitability, leverage and liquidity aswell as the quality of the book of business, the adequacy and soundness ofreinsurance programs, the quality and estimated market value of assets, reserveadequacy and the experience and competence of management. A.M. Best’sratings are based upon factors relevant to policyholders, agents, insurancebrokers and intermediaries and are not directed to the protection of investors.Currently, A.M. Best maintains ratings of “B++” on American Pioneer,American Progressive, Constitution Life, Penncorp Life (Canada), PennsylvaniaLife, and Pyramid Life and B+ on Union Bankers and SelectCare of Texas. TheseB++ and B+ ratings mean that, in A.M. Best’s opinion, these companies havedemonstrated “very good” overall performance when compared to standards it hasestablished and have a “good” ability to meet their obligations topolicyholders and are in the “Secure” category of all companies rated by A.M.Best. A.M. Best does not rate our other insurance company subsidiaries.

Standard & Poor’sRatings Service currently assigns its “BBB+” counterparty credit and financialstrength ratings to our American Pioneer, American Progressive, PennsylvaniaLife and Penncorp Life (Canada) subsidiaries. This rating means that inStandard & Poor’s opinion, these companies have good financialsecurity characteristics, but are more likely to be affected by adversebusiness conditions than are insurers that are rated higher by Standard &Poor’s. A plus (+) or minus (-) shows Standard & Poor’s opinion of therelative standing of the insurer within a rating category. Standard &Poor’s Rating Service currently assigns its “BBB-”counterparty credit rating onour Amended Credit Facility. This investment grade rating means the obligationexhibits adequate protection parameters. In February, 2006, Standard &Poor’s Ratings Service revised the outlook to negative from stable on theinsurer financial strength rating and counterparty credit ratings as well asthe counterparty credit rating on our Amended Credit Facility. The outlookrevision reflected earnings for the Company for 2005 that were belowexpectations.

Our insurance companysubsidiaries are not currently rated by Moody’s Investors Service or FitchRatings. Although a higher rating by A.M. Best, Standard & Poor’sor another insurance rating organization could have a favorable effect on ourbusiness, we believe that our competitive pricing, 

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effectiverate management, quality customer service and effective marketing has enabled,and will continue to enable, our insurance company subsidiaries to competeeffectively.

**Regulation**

***General***

Our insurance companysubsidiaries and health plan affiliates are subject to the laws, regulationsand supervision of the jurisdictions in which they are domiciled, as well ascertain Federal laws. The purpose of those laws and regulations is primarily toprovide safeguards for policyholders rather than to protect the interest of shareholders.Government regulation of insurance and health care products and services is achanging area of law that varies from jurisdiction to jurisdiction. Regulatoryagencies generally have broad discretion to issue regulations and to interpretand enforce laws and rules. The passing of the Medicare Modernization Act of2003, or MMA, represents the most sweeping changes to Medicare since theBalanced Budget Act of 1997. Changes in applicable laws and regulations arecontinually being considered, and the interpretation of existing laws and rules alsomay change periodically. These regulatory revisions could affect our operationsand financial results. Also, it may become increasingly difficult to controlmedical costs if Federal and state bodies continue to consider and enactsignificant and sometimes onerous managed care laws and regulations.

***Federal Regulation***

***Medicare***

Medicare is a Federalprogram that provides eligible persons age 65 and over and some disabledpersons a variety of hospital and medical insurance benefits. Medicarebeneficiaries have the option to enroll in a Medicare Advantage plan as an HMObenefit in areas where such a plan is offered. Under Medicare Advantage,managed care plans contract with CMS to provide comparable Medicare benefits asa traditional fee-for-service Medicare program in exchange for a fixed monthlypayment per member that varies based on the county in which a member resides.

The MMA made manysignificant changes to the Medicare fee-for-service and Medicare Advantage programs,as well as other changes to the commercial health insurance marketplace. Mostsignificantly, the MMA created a voluntary prescription drug benefit, called “Part D”benefit, for Medicare beneficiaries that began in 2006, established a newMedicare Advantage program to replace the Medicare+Choice program, and enactedtax-advantaged health savings accounts, or HSA’s, for non-Medicare eligibleindividuals and groups.

The Part D benefitenables Medicare beneficiaries to pay a monthly premium for the coveredoutpatient drug benefit offered through a private drug plan. The drug benefitis subject to certain cost sharing. Under the standard drug coverage, for 2006the cost sharing is a $250 deductible, 25% coinsurance for annual drug costsreimbursed by Medicare up to a maximum of $2,250, and no reimbursement for drugcosts above $2,250, until the beneficiary has paid $3,600. After that, the MMAprovides catastrophic stop loss coverage for annual incurred drug costs inexcess of $3,600, subject to nominal cost-sharing. Plans are not required tomirror these limits; instead, Part D drug plans are required to providecoverage that is at least actuarially equivalent to the standard drug coveragedelineated in the MMA. These numbers are adjusted on an annual basis. The MMAprovides subsidies and the reduction or elimination of cost sharing for certainlow-income beneficiaries, including dual-eligible individuals who receivebenefits under both Medicare and Medicaid. The Part D benefit is offeredby new regional prescription drug plans. Medicare Advantage organizations mustoffer a plan with the Part D benefit. In addition, Medicare Advantageplans may bid to offer a stand-alone prescription drug plan that beneficiarieswho have fee-for-service Medicare may elect.

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The MMA also revisedpayment methodologies for Medicare Advantage organizations beginning in 2004,and in 2006 the MMA expanded the Medicare Advantage program to include newregional plans which provide out-of-network benefits in addition to in-networkbenefits, in addition to the traditional HMO and fee-for-service plansestablished by county. The Secretary of Health and Human Services, or HHS,created 26 regions, each of which may include more than one state or portionsof a particular state. The MMA created a new competitive bidding process thatbegan in 2006 for both the local HMO plans and the new regional plans forsetting the payment to the Medicare Advantage plans and the beneficiary premiumand benefits. The bidding process does not limit the number of plans that mayparticipate in the Medicare Advantage program.

CMS conducts audits ofplans qualified under its Medicare program at least biannually and may performother reviews more frequently to determine compliance with Federal regulationsand contractual obligations. These audits include review of the plans’administration and management, including management information and datacollection systems, fiscal stability, utilization management and physicianincentive arrangements, health services delivery, quality assurance, marketing,enrollment and dis-enrollment activity, claims processing, and complaintsystems.

CMS regulations requiresubmission of quarterly and annual financial statements. In addition, CMSrequires that certain disclosures be made to them and to Medicare beneficiariesconcerning operations of a health plan contracted under the Medicare program. CMS’srules require disclosure, upon request, to members of informationconcerning financial arrangements and incentive plans between the plan andphysicians in the plan’s networks. These rules also require certain levelsof stop loss coverage to protect contracted physicians against major lossesrelating to patient care, depending on the amount of financial risk theyassume.

***Fraud and abuse laws***

Enforcement of health carefraud and abuse laws has become a top priority for the nation’s law enforcemententities. The funding of such law enforcement efforts has increaseddramatically in the past few years and is expected to continue. The focus of theseefforts has been directed at participants in Federal government health careprograms such as Medicare. We participate extensively in these programs andhave continued our stringent regulatory compliance efforts for these programs. Theprograms are subject to very technical rules. When combined with lawenforcement intolerance for any level of noncompliance, these rules meanthat compliance efforts in this area continue to be challenging.

***Privacy regulations***

The use of individuallyidentifiable data by our business is regulated at Federal and state levels. Theselaws and rules are changed frequently by legislation or administrativeinterpretation. Various state laws address the use and maintenance ofindividually identifiable health data. Most are derived from the privacyprovisions in the Federal Gramm-Leach-Bliley Act and the Health InsurancePortability and Accountability Act of 1996 (“HIPAA”).

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HIPAA mandates guaranteed availability andrenewability of health insurance for certain employees and individuals; limitson termination options and on the use of preexisting condition exclusions;prohibitions against discriminating on the basis of health status; andrequirements which make it easier to continue coverage in cases where anemployee is terminated or changes employers. HIPAA also calls for the adoptionof standards for the exchange of electronic health information and privacyrequirements that govern the handling, use and disclosure of protected customerhealth information. We believe that we met the HIPAA Security Rule changesthat became effective on April 21, 2005; however HIPAA is far-reaching andcomplex and proper interpretation and practice under the law continue to evolve.Consequently, our efforts to measure, monitor and adjust our business practicesto comply with HIPAA are ongoing. We do not believe that compliance with HIPAAwill have a material adverse effect on our financial condition or results ofoperations.

Insurance companies alsoare required to comply with Federal “Do Not Call” regulations. Insurancecompanies are required to develop their own “Do Not Call” lists and referencestate and Federal Do Not Call Registries, before making calls to marketinsurance products. It is estimated that approximately two thirds of thecountry’s residential telephone numbers are on the Federal registry, whichcould limit the marketing calls made and potentially could negatively impactsales.

***USA Patriot Act***

A portion of the USAPATRIOT Act applying to insurance companies became effective in mid 2004.Insurance companies have to impose tighter processes and procedures to morethoroughly verify its agents, applicants, insureds, claimants and premiumpayers in an effort to prevent money laundering. Our insurance companies haveimplemented measures to comply with the Office of Federal Asset Controlrequirements, whereby the names of customers and potential customers must bereviewed against a listing of known terrorists and money launderers. Theidentification verification requirement of the USA PATRIOT Act was finalized inlate 2005. In May 2006, insurance companies will be required to verify theidentity of their applicants, insureds, and beneficiaries. We are establishinginternal procedures, securing software and training our home office staff andproducers in an effort to comply.

***State and local regulation***

Each of our insurance company subsidiaries and ourhealth plan affiliates are also subject to the regulations and supervision bythe insurance department of each of the jurisdictions in which they areadmitted and authorized to transact business. Such regulations cover, amongother things, the declaration and payment of dividends by our insurance companysubsidiaries, the setting of rates to be charged for some types of insurance,the granting and revocation of licenses to transact business, the licensing ofagents, the regulation and monitoring of market conduct and claims practices,the approval of forms, the establishment of reserve requirements, investmentrestrictions, the regulation of maximum allowable commission rates, themandating of some insurance benefits, minimum capital and surplus levels, andthe form and accounting practices used to prepare financial statements requiredby statute. A failure to comply with legal or regulatory restrictions maysubject the insurance company subsidiary to a loss of a right to engage in someor all business in a state or states or an obligation to pay fines or makerestitution, which may affect our profitability.

American Pioneer Life Insurance Company (“AmericanPioneer”) and Peninsular Life Insurance Company (“Peninsular”) are Floridadomiciled insurance companies. American Progressive Life & HealthInsurance Company of New York (“American Progressive”) is a New Yorkdomiciled insurance company. The Pyramid Life Insurance Company (“Pyramid Life”)is a Kansas domiciled insurance company. Pennsylvania Life Insurance Company (“PennsylvaniaLife”) is a Pennsylvania domiciled insurance company. American Exchange LifeInsurance Company (“American Exchange”), Constitution Life Insurance Company (“Constitution”),Marquette National Life Insurance Company (“Marquette”) and 

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Union Bankers InsuranceCompany (“Union Bankers”) are Texas domiciled insurance companies. PenncorpLife Insurance Company (“Penncorp Life (Canada)”) is a Canadian insuranceCompany. SelectCare of Texas, LLC (“SelectCare”) is licensed in Texas as aProvider Sponsored Organization (“PSO”). SelectCare Health Plans, Inc. andSelectCare of Oklahoma, Inc. are licensed as HMO’s in Texas and Oklahoma,respectively. Collectively, our insurance subsidiaries are licensed to sellhealth insurance, life insurance and annuities in all 50 states, the Districtof Columbia, Puerto Rico and all the provinces of Canada. Our managed caresubsidiary operates Medicare Advantage coordinated care plans in Texas, Floridaand Oklahoma and PFFS plans in 15 states.

Most jurisdictions mandate minimum benefit standardsand loss ratios for accident and health insurance policies. Generally we arerequired to maintain, with respect to our individual long term care policies,minimum anticipated loss ratios over the entire period of coverage. Withrespect to our Medicare Supplement policies, we are generally required toattain and maintain an actual loss ratio, after three years, of not less than65 percent of earned premium. We provide, to the insurance departments of allstates in which we conduct business, annual calculations that demonstratecompliance with required loss ratio standards for both long term care andMedicare Supplement insurance. We prepare these calculations utilizingstatutory lapse and interest rate assumptions. In the event we fail to maintainminimum mandated loss ratios, our insurance company subsidiaries could berequired to provide retrospective premium refunds or prospective premium ratereductions. We believe that our insurance company subsidiaries currently complywith all applicable mandated minimum loss ratios. In addition, we activelyreview the loss ratio experience of our products and request approval for rateincreases from the respective insurance departments when we determine they areneeded. We cannot guarantee that we will receive the rate increases we request.

Under Federal and NAIC model regulations, adopted insubstantially all states, there are 14 standard Medicare Supplement plans(Plans A through L and High Deductible Plans F and J). Plan A provides theleast extensive coverage, while Plan J provides the most extensive coverage. UnderNAIC regulations, Medicare Supplement insurers must offer Plan A, but may offerany of the other plans at their option. The Medicare Prescription Drug,Improvement and Modernization Act of 2003 (“MMA”) prohibits the sale of theformer H, I and J plans and authorizes two additional plans after December 2005(Plans K and L).

Every insurance company that is a member of an “insuranceholding company system” generally is required to register with the insuranceregulatory authorities in its domicile state and file periodic reportsconcerning its relationships with its insurance holding company and with itsaffiliates. Material transactions between registered insurance companies andmembers of the holding company system are required to be “fair and reasonable”and in some cases are subject to administrative approval. The books, accountsand records of each party are required to be maintained so as to clearly andaccurately disclose the precise nature and details of any such transactions.

Each of our U.S. insurance company subsidiaries isrequired to file detailed reports with the insurance department of eachjurisdiction in which it is licensed to conduct business and its books andrecords are subject to examination by each such insurance department. Inaccordance with the insurance codes of their domiciliary states and the rules andpractices of the NAIC, our insurance company subsidiaries are examinedperiodically by examiners of each company’s domiciliary state with electiveparticipation by representatives of the other states in which they are licensedto do business. Regularly scheduled regulatory financial examinations have beenannounced for American Pioneer, American Exchange, Constitution, Marquette,Union Bankers and Pyramid and has commenced for Pennsylvania Life as of and forthe period ended December 31, 2005. We have not been informed of anysignificant findings or adjustments to statutory surplus from theseexaminations. During 2005, a regularly scheduled examination of SelectCare ofTexas was completed as of and for the period ended December 31, 2004, withno significant findings noted. The final report on the examination of AmericanProgressive for the three years ended December 31, 2003 was released in January 2006.This report included several findings of regulatory 

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violations andrecommendations relating to sales practices and administrative matters. AmericanProgressive was fined $300,000, which was accrued by American Progressive as ofDecember 31, 2005, and has either taken, or is taking, steps to correctthe violations and comply with the recommendations.

During 2004 the Pennsylvania Insurance Department (“PADOI”) conducted an on-site Market Conduct examination of Constitution. The examfocused on claims processes, policy forms and agent appointments. The PA DOIprovided its final report in 2005, which included a $10,000 fine, primarily asa result of late claims payments, due to a processing error which has beencorrected. During 2005 the Ohio Department of Insurance conducted a limitedMarket Conduct exam of the life insurance claims processes of Pennsylvania Lifeand provided a report of its findings which indicated that all reviewed lifeinsurance claims processes were in compliance. In 2005, the Wisconsin Office ofthe Commissioner of Insurance (“WI OCI”) initiated an investigation into thesales practices of the Pennsylvania Life sales agents in the state. Companymanagement has met with WI OCI on several occasions to discuss WI OCI’sconcerns and to propose Company action. The discussions will continue in aneffort to reach a satisfactory agreement.

Many states require deposits of assets by insurancecompanies for the protection of policyholders either in those states or for allpolicyholders. These deposited assets remain part of the total assets of thecompany. As of December 31, 2005, securities totaling $42.6 million,representing approximately 3.0% of the carrying value of our total investments,were on deposit with various state treasurers or custodians. As of December 31,2004 securities totaling $41.8 million, representing approximately 3.5% oftotal investments, were on deposit. These deposits must consist of securitiesthat comply with the standards established by the particular state.

Penncorp Life (Canada), our Canadian domiciledsubsidiary, is subject to provincial regulation and supervision in each of theprovinces of Canada in which it conducts business. Provincial insuranceregulation is concerned primarily with the form of insurance contracts and thesale and marketing of insurance and annuity products, including the licensingand supervision of insurance marketing personnel.

CHCS Services Inc., oursenior administrative entity, is subject to regulation as a third partyadministrator in those states where it services policyholders. The primaryintention of the regulation is to ensure adequate financial strength to meetthe policyholder obligations.

***Dividend Restrictions***

New York State insurance law provides that the declarationor payment of a dividend by American Progressive requires the approval of theNew York Superintendent of Insurance. Management expects that no dividendwould be approved until American Progressive had generated sufficient statutoryprofits to offset its negative unassigned surplus.

Pennsylvania, Kansas and Texas insurance laws providethat a life insurer may pay dividends or make distributions from accumulatedearnings without the prior approval of the Insurance Department, provided theydo not exceed the greater of (i) 10% of the insurer’s surplus as topolicyholders as of the preceding December 31; or (ii) the insurer’snet gain from operations for the immediately preceding calendar year with 30days advance notification to the insurance department. Accordingly,Pennsylvania Life would be able to pay ordinary dividends of up to $9.8 millionto American Exchange (its direct parent) without the prior approval from thePennsylvania Insurance Department in 2006.

Texas insurance companies also are required to havepositive “earned surplus” as defined by Texas regulations, which differs fromstatutory unassigned surplus, in order to pay dividends without priorregulatory approval. American Exchange, Constitution, Marquette and UnionBankers had negative earned surplus at December 31, 2005 and would not beable to pay dividends in 2006 without special approval. SelectCare is licensedin Texas as a Provider Sponsored Organization (“PSO”) would also not be able topay dividends in 2006 without special approval.

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Florida insurance law provides that a life insurer maypay a dividend or make a distribution without the prior written approval of thedepartment when certain conditions are met. American Pioneer had negativeunassigned surplus at December 31, 2005 and would not be able to paydividends in 2006 without special approval.

Canadian law provides thata life insurer may pay a dividend after such dividend declaration has beenapproved by its board of directors and upon at least 10 days prior notificationto the Superintendent of Financial Institutions. Such a dividend is limited toretained net income (based on Canadian GAAP) for the preceding two years, plusnet income earned for the current year. In considering approval of a dividend,the board of directors must consider whether the payment of such dividend wouldbe in contravention of the Insurance Companies Act of Canada. During 2005,Penncorp Life (Canada) paid dividends of C$6.4 million (approximately US$5.4million) to Universal American. During 2005, Penncorp Life (Canada) becamesubject to a 5% withholding tax on dividends paid to Universal American. Thewithholding tax paid on the dividends from Penncorp Life (Canada) in 2005 wasC$0.2 million (approximately US$0.2 million). Due to limitations resulting fromthe timing of prior dividend payments by Penncorp Life (Canada), we do notanticipate that Penncorp Life (Canada) will be able to pay dividends in 2006,without prior approval.

***Risk-Based Capital and Minimum Capital Requirements***

Risk-based capital requirementspromulgated in each state take into account asset risks, interest rate risks,mortality and morbidity risks and other relevant risks with respect to theinsurer’s business and specify varying degrees of regulatory action to occur tothe extent that an insurer does not meet the specified risk-based capitalthresholds, with increasing degrees of regulatory scrutiny or interventionprovided for companies in categories of lesser risk-based capital compliance. PenncorpLife (Canada), is subject to minimum continuing capital and surplusrequirements, which Canadian regulators use to assess financial strength and todetermine when regulatory intervention is needed. As of December 31, 2005all of our U.S. insurance company subsidiaries and managed care affiliatesmaintained ratios of total adjusted capital to risk-based capital in excess ofthe authorized control level and Penncorp Life (Canada) maintained minimumcontinuing capital and surplus requirement ratios in excess of minimumrequirements. However, should our insurance company subsidiaries’ and managedcare affiliates’ risk-based capital position decline in the future, theirability to pay dividends, required capital contributions from UniversalAmerican and the degree of regulatory supervision or control to which they aresubjected might be affected.

***Guaranty Association Assessments***

Our insurance companysubsidiaries can be required, under solvency or guaranty laws of mostjurisdictions in which they do business, to pay assessments to fund policyholderlosses or liabilities of unaffiliated insurance companies that become insolvent.These assessments may be deferred or forgiven under most solvency or guarantylaws if they would threaten an insurer’s financial strength and, in mostinstances, may be offset against future premium taxes. The insurance companysubsidiaries provide for known and expected insolvency assessments based oninformation provided by the National Organization of Life & HealthGuaranty Associations. Our insurance company subsidiaries have not incurred anysignificant costs of this nature. The likelihood and amount of any futureassessments is unknown and is beyond our control.

***Producer Compensation Disclosure***

State regulators and attorney generals have initiatedinvestigations into producer compensation and product pricing. While theinitial investigations have focused on commercial lines insurers and brokers,it remains to be seen whether the investigations will broaden and potentiallychange how our products are 

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sold. We have responded toinquiries regarding our sales practices, and we do not anticipate that ourresponses will require any change in our compensation practices or any otheradverse result. The NAIC, at the end of 2004, adopted an amendment to theProducer Licensing Model Act (the “PLMA”) which provides that when compensationis received by one of our producers from both the customer and an insurancecompany, the producer must receive the customer’s documented acknowledgementthat compensation will be received from the insurance company and must disclosethe amount of such compensation to the customer. Such disclosures, however,will not be necessary if the producer does not receive a fee from the customerfor the placement of insurance and discloses to the customer that he/she isacting on behalf of the insurance company and may provide services to thecustomer on behalf of the insurance company.

In 2005, Arizona,Connecticut, Georgia, Nevada, Oregon, Rhode Island and Texas passed producercompensation disclosure legislation or regulations. Some other states may beconsidering legislation or regulations dealing with producer commissiondisclosure in 2006. It is possible that some states will adopt laws that arebroader than the NAIC model amendment.

***Annuity Suitability***

In September 2003,the NAIC adopted the Senior Protection in Annuity Transaction Model Regulation.States are adopting the Model or similar suitable regulations. The modelregulation imposes additional obligations on insurance producers, theirsupervisors and insurance carriers relating to annuity sales to customers age65 and over. The burden of demonstrating suitability of the recommended annuityis that of the producer with oversight responsibilities imposed on the producer’ssupervisor and the insurer. We have developed and distributed guidelines to oursales forces to assist in complying with the regulations. The NAIC is in theprocess of revising the Model to require producers to demonstrate annuitysuitability for all customers. Such regulatory change will have minimal impacton our annuity business since the processes and procedures are in place and ourmarketing efforts focus on seniors.

**Outsourcing Arrangements**

***MainframeProcessing—Data Center Outsourcing.******  ***We outsource our mainframeprocessing to Alicomp (“Alicomp”), a division of Alicare, Inc. The datacenter is located in Leonia, New Jersey. Our core application softwareprograms are run in Alicomp’s data center facility to obtain the necessarymainframe computer capacity and other computer support services without makingthe substantial capital and infrastructure investments that would be necessaryfor us to provide these services internally.

Our current agreement with Alicomp obligates Alicompto provide us with comprehensive data processing services and obligates us toutilize Alicomp’s services for substantially all of our mainframe dataprocessing requirements. We are billed monthly for these services on an as-usedbasis in accordance with a predetermined pricing schedule for specific services.Our agreement with Alicomp, as amended, expires on December 31, 2008, andis terminable by us with or without cause. Our current agreement with Alicompis renewable automatically for consecutive one year terms unless and untileither party has provided the other with six months prior written notice ofnonrenewal. In the event we elect to terminate the contract, we would besubject to termination fees equal to four months of current fees should weterminate the contract in 2006, two months of current fees should we terminatethe contract in 2007 and one month of current fees should we terminate thecontract in 2008. Alicomp also provides us with mainframe disaster recoveryservices. During 2005, we paid an average of $0.3 million per month under thiscontract.

***Medicare Part D—Administration.******  ***We outsource theadministrative information technology platform necessary to support the Part Dbusiness to the Trizetto Group (“Trizetto”). We have entered into an annualsupport and license agreement, a master hosting services agreement and aconsulting services agreement with Trizetto. These agreements collectivelysupport the basic infrastructure surrounding the 

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membership information ofour Part D business. The initial term for each of the agreements is oneyear, with automatic renewal from year to year provided that written notice notto renew is given with at least six months prior notice. During 2005, we paid$3.2 million to Trizetto under this contract.

***Medicare Advantage Administration.******  ***We also outsource certainadministrative services for our Medicare Advantage business, including memberservices and billing and enrollment to an unaffiliated heath care servicescompany, pursuant to an agreement which expires in December 2010. Underthis agreement, we pay a percentage of monthly revenues, based on a tieredscale, for the contracted services. During 2005, we paid an average of $0.5million per month, under this contract.

**Employees**

As of February 15,2006, we employed approximately 1,300 employees, none of whom is represented bya labor union in such employment. We consider our relations with our employeesto be good.

**Certain Material Weaknesses**

Management has identifieda material weakness in the Company’s internal control over financial reporting.A discussion of this material weakness can be found in Item 9A of Part IIof this Annual Report on Form 10-K. Management believes that theCompany has effectively remediated this weakness.

**ITEM   1A—Risk Factors**

You should carefully consider each of the followingrisks and all of the other information set forth elsewhere in this Form 10-K.These risks and other factors may affect forward-looking statements, includingthose contained in this 10-K or made by the Company elsewhere, such as ininvestor calls or conference presentations. The risks and uncertaintiesdescribed below are not the only ones facing our Company. Additional risks anduncertainties not presently known to us or that we currently believe to beimmaterial may also adversely affect our business.

If any of the followingrisks or uncertainties develops into actual events, this could significantlyand adversely affect our business, prospects, financial condition and operatingresults. In that case, the trading price of our common stock could declinematerially.

**Risks Related To Our Overall Business**

***We have asignificant amount of debt outstanding that contains restrictive covenants andwe may be unable to service and repay our debt obligations if our subsidiariescannot pay sufficient dividends or make other cash payments to us.***

As of December 31, 2005, we had $96 million of debtoutstanding under our amended credit agreement and $75 million in trustpreferred securities. We have available borrowing capacity under our seniorsecured revolving credit facility of approximately $15 million. Substantiallyall of the capital stock of our operating subsidiaries is pledged to our banklenders. Because our principal outstanding indebtedness has been incurred byour parent company, our ability to make interest and principal payments on ouroutstanding debt is dependent upon the ability of our subsidiaries to pay cashdividends or make other cash payments to our parent company. Our subsidiarieswill be able to pay dividends to our parent company only if they earnsufficient profits and, in the case of our insurance company and health plansubsidiaries, they satisfy the requirements of the state insurance lawsrelating to dividend payments and the maintenance of required surplus, to whichthey are subject.

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Ourdebt service obligations will require us to use a portion of our operating cashflow to pay interest and principal on indebtedness instead of for othercorporate purposes, including funding future expansion of our business andongoing capital expenditures. If our operating cash flow and capital resourcesare insufficient to service our debt obligations, we may be forced to sellassets, seek additional equity or debt capital or restructure our debt.However, these measures might be unsuccessful or inadequate in permitting us tomeet scheduled debt service obligations.We may also incur additionalindebtedness in the future. Our substantial indebtedness could have adverseconsequences, including:

·       increasingour vulnerability to adverse economic, regulatory and industry conditions, andplacing us at a disadvantage compared to our competitors that are lessleveraged;

·       limitingour ability to compete and our flexibility in planning for, or reacting to,changes in our business and the industry in which we operate;

·       limitingour ability to borrow additional funds for working capital, capitalexpenditures, acquisitions and general corporate or other purposes; and

·       exposingus to greater interest rate risk since the interest rate on borrowings underour senior credit facilities is variable.

***Capital constraintscould restrict our ability to support our premium growth.***

Our continued growth isdependent upon our ability to support premium revenue growth through theexpansion of our markets and our network of agents while at the same timemaintaining sufficient levels of capital and surplus to support that growth. Ournew business growth typically results in reduced income caused by investmentexpenses in new market expansion and, on certain insurance products, net lossesduring the early years of a policy (statutory surplus strain). The resultingreduction in capital and surplus can limit our ability to generate new businessdue to statutory restrictions on premium to surplus ratios and other requiredstatutory surplus parameters. In addition, some states, such as Florida andTexas, limit an insurer’s ability to write certain lines of business if grossand/or net premiums written would exceed a specified percentage of capital andsurplus. In addition, we are required to maintain adequate risk based capitalratios as prescribed by each state. Moreover, substantially more capital thanthe statutory minimums are needed to support our level of premium growth and tofinance acquisitions. If we cannot generate sufficient capital and statutorysurplus to maintain minimum statutory requirements and support our growth, wecould be restricted in our ability to generate new premium revenue.

***If we are required to maintain higher statutorycapital levels for our existing operations or if we are subject to additionalcapital reserve requirements as we pursue new business opportunities, our cashflows and liquidity may be adversely affected.***

Our insurance and healthplans operations are conducted through subsidiaries in various states. Thesesubsidiaries are subject to state regulations that, among other things, requirethe maintenance of minimum levels of statutory capital, or net worth, asdefined by each state. One or more of these states may raise the statutorycapital level from time to time. Other states have adopted risk-based capitalrequirements based on guidelines adopted by the National Association ofInsurance Commissioners, which tend to be, although are not necessarily, higherthan existing statutory capital requirements. Regardless of whether the otherstates in which we operate adopt risk-based capital requirements, the statedepartments of insurance can require our subsidiaries to maintain minimumlevels of statutory capital in excess of amounts required under the applicablestate laws if they determine that maintaining additional statutory capital isin the best interests of our members. Any increases in these requirements couldmaterially increase our reserve requirements. In addition, as we continue toexpand our plan offerings in new states or pursue new business opportunities,including our recent offerings of PDP’s and expansion of private fee forservice products and health plans in new markets, we may be required tomaintain additional statutory capital 

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reserves.In either case, our available funds could be materially reduced, which couldharm our ability to implement our business strategy.

***If state regulators do not approve payments, includingdividends and other distributions, by our subsidiaries to us, our business andgrowth strategy could be materially impaired or we could be required to incuradditional indebtedness to fund these strategies.***

Our health plan andinsurance company subsidiaries are subject to laws and regulations that limitthe amount of dividends and distributions they can pay to us for purposes otherthan to pay income taxes related to their earnings. These laws and regulationsalso limit the amount of management fees our subsidiaries may pay to theiraffiliates, including our management subsidiaries, without prior approval of,or notification to, state regulators. The pre-approval and notice requirementsvary from state to state with some states, such as Texas, generally allowing,subject to advance notice requirements, dividends to be declared, provided thesubsidiary meets or exceeds the applicable deposit, net worth, and risk-basedcapital requirements. The discretion of the state regulators, if any, inapproving or disapproving a dividend is not always clearly defined.Subsidiaries that declare non-extraordinary dividends must usually providenotice to the regulators in advance of the intended distribution date. If theregulators were to deny or significantly restrict our subsidiaries’ requests topay dividends to us or to pay management and other fees to the affiliates ofour subsidiaries, the funds available to us would be limited, which couldimpair our ability to implement our business and growth strategy and satisfyour debt obligations or we could be required to incur additional indebtednessto fund these strategies.

***We hold reserves for expected claims, which areestimated, and these estimates involve an extensive degree of judgment; ifactual claims exceed reserve estimates, our results could be materiallyadversely affected.***

Our benefits incurredexpense includes estimates of claims incurred but not reported, or IBNR. We,together with our internal and consulting actuaries, estimate our claimliabilities using actuarial methods based on historical data adjusted forpayment patterns, cost trends, product mix, seasonality, utilization ofhealthcare services and other relevant factors. Actual conditions, however,could differ from those assumed in the estimation process. Due to theuncertainties associated with the factors used in these assumptions, the actualamount of benefit expense that we incur may be materially more or less than theamount of IBNR originally estimated, and materially different amounts could bereported in our financial statements for a particular period under different conditionsor using different assumptions. Adjustments, if necessary, are made to benefitsincurred expense when the criteria used to determine IBNR change and whenactual claim costs are ultimately determined. If our estimates of IBNR areinadequate in the future, our reported results of operations will be negativelyimpacted. Further, our inability to estimate IBNR accurately may also affectour ability to take timely corrective actions or otherwise establishappropriate premium pricing, further exacerbating the extent of any adverseeffect on our results.

***Our financial strength rating is lower than severaldistributors’ minimum acceptable rating and could affect our competitivenessand results of operations.***

Increased public andregulatory concerns regarding the financial stability of insurance companiesand health plans have resulted in consumers placing greater emphasis uponfinancial strength ratings and have created some measure of competitiveadvantage for insurance companies and health plans with higher ratings. Ourability to expand and to attract new business is affected by the financialstrength ratings assigned to our subsidiaries by independent industry ratingagencies, such as A.M. Best Company, Inc. Some distributors such asfinancial institutions, unions, associations and affinity groups may not sellour products to these groups unless the rating of our subsidiary writing thebusiness improves to at least an “A-” from their current “B++.”  The lack of higher A.M. Best ratings forour subsidiaries could adversely affect sales of our products. In addition, anyfuture downgrade in our ratings may cause our policyholders and members tolapse. Increased lapse rates would reduce our premium revenue and net income. Any

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futuredowngrade in our ratings could also cause some of our agents to sell less ofour products or to cease selling our policies altogether.

***Failure to maintainour information systems could adversely affect our business.***

Our business dependssignificantly on efficient, effective and secure information systems. We havevarious information systems which support our operating segments. Theinformation gathered and processed by our management information systemsassists us in, among other things, marketing and sales tracking, underwriting,billing, claims processing, medical management, medical care cost andutilization trending, financial and management accounting, reporting, planningand analysis and e-commerce. These systems also support on-line customerservice functions, provider and member administrative functions and supporttracking and extensive analyses of medical expenses and outcome data. Theseinformation systems and applications require continual maintenance, upgradingand enhancement to meet our operational needs and handle our expansion andgrowth. Any inability or failure to properly maintain management informationsystems, successfully update or expand processing capability or develop newcapabilities to meet our business needs in a timely manner, could result inoperational disruptions, loss of existing customers, difficulty in attractingnew customers or in implementing our growth strategies, disputes with customersand providers, regulatory problems, increases in administrative expenses, lossof our ability to produce timely and accurate reports and other adverseconsequences. To the extent a failure in maintaining effective informationsystems occurs, we may need to contract for these services with third-partymanagement companies, which may be on less favorable terms to us andsignificantly disrupt our operations and information flow.

Furthermore, our businessrequires the secure transmission of confidential information over publicnetworks. Because of the confidential health information we store and transmit,security breaches could expose us to a risk of regulatory action, litigation,possible liability and loss. Our security measures may be inadequate to preventsecurity breaches, and our business operations and profitability would beadversely affected by cancellation of contracts, loss of members and potentialcriminal and civil sanctions if they are not prevented.

We have outsourced theoperation of our data center to independent third parties and may from time totime obtain additional services or facilities from other independent thirdparties. Dependence on third parties for these services and facilities may makeour operations vulnerable to their failure to perform as agreed.

***We may not be ableto find suitable acquisition candidates.***

Part of our businessstrategy is to make acquisitions that will be accretive to income and willadvance our strategic mission. We continue to evaluate possible acquisitiontransactions on an ongoing basis, and at any given time, we may be engaged indiscussions with respect to possible acquisitions. We cannot be sure that wewill be able to find suitable acquisition candidates and close the transactions.Factors that might preclude closing transactions include the inability to reacha definitive agreement with the seller, the inability to obtain financing onacceptable terms, and the discovery of material issues with the acquisitioncandidate as a result of our due diligence investigation. If we cannot findsuitable acquisition candidates or are not successful in completingacquisitions, we may not be able to sustain our recent historical growth rates.

***There is no assurance that we will continue to besuccessful in managing our growing operations or in integrating acquiredcompanies into our operations.***

The rapid growth in thesize and complexity of our operations has placed, and will continue to place,significant demands on our management, operations systems, accounting systems,internal controls systems and financial resources.

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*Acquisition risk*

As part of our strategy,we have experienced, and expect to continue to experience, considerable growththrough acquisitions.

Acquisitionsinvolve numerous additional risks, some of which we have experienced in thepast, including:

·       difficultiesin integrating operations, technologies, products, systems and personnel of theacquired company;

·       diversionof financial and management resources from existing operations;

·       potentialincreases in policy lapses;

·       potentiallosses from unanticipated litigation or levels of claims; and

·       inabilityto generate sufficient revenue to offset acquisition costs.

In addition, we generallyare required to obtain regulatory approval from one or more state agencies whenmaking acquisitions, which may require a public hearing, regardless of whetherwe already operate a plan in the state in which the business to be acquired islocated. We may be unable to comply with these regulatory requirements for anacquisition in a timely manner, or at all. Moreover, some sellers may insist onselling assets that we may not want, including commercial lines of business, ortransferring their liabilities to us as part of the sale of their companies orassets. Even if we identify suitable acquisition targets, we may be unable tocomplete acquisitions or obtain the necessary financing for these acquisitionson terms favorable to us, or at all.

To the extent we completean acquisition, we may be unable to realize the anticipated benefits from itbecause of operational factors or difficulties in integrating the acquisitionswith our existing businesses. This may include the integration of: (1) additionalemployees who are not familiar with our operations; (2) new providernetworks, which may operate on terms different from our existing networks; (3) additionalmembers, who may decide to transfer to other healthcare providers or healthplans; (4) disparate information technology, claims processing, and recordkeeping systems; and (5) accounting policies, including those that requirea high degree of judgment or complex estimation processes, including estimatesof IBNR claims, valuation and accounting for goodwill and intangible assets,stock-based compensation, and income tax matters.

For all of the abovereasons, we may not be able to successfully implement our acquisition strategy.Furthermore, in the event of an acquisition or investment, you should be awarethat we may issue stock that would dilute stock ownership, incur debt thatwould restrict our cash flow, assume liabilities, incur large and immediatewrite-offs, incur unanticipated costs, divert management’s attention from ourexisting business, experience risks associated with entering markets in whichwe have no or limited prior experience, or lose key employees from the acquiredentities.

*Internal growth and expansion risk*

Additionally,we are likely to incur additional costs if we develop new product offerings orenter new service areas or states where we do not currently operate, which maylimit our ability to expand to, or further expand in, those areas. Our rate ofexpansion into new geographic areas may also be limited by:

·       thetime and costs associated with designing and filing new product forms andrecruiting related sales forces to offer in the new area;

·       thetime and costs associated with obtaining an HMO license to operate in the newarea or expanding our licensed service area, as the case may be;

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·       ourinability to develop a network of physicians, hospitals, and other healthcareproviders that meets our requirements and those of the applicable regulators;

·       competition,which could increase the costs of recruiting members, reduce the pool ofavailable members, or increase the cost of attracting and maintaining ourproviders;

·       thecost of providing healthcare services in those areas; and

·       demographicsand population density.

Our ability to manage ourgrowth and compete effectively will depend, in part, on our success inaddressing these demands and risks. Any failure by us to effectively manage ourgrowth could have a material adverse effect on our business, financialcondition or results of operations.

***Most of our assetsare invested in fixed income securities and are subject to market fluctuations.***

Our investment portfolioconsists almost entirely of fixed income securities. The fair market value ofthese assets and the investment income from these assets fluctuate depending ongeneral economic and market conditions. The fair market value of ourinvestments in fixed income securities generally increases or decreases in aninverse relationship with fluctuations in interest rates, while net investmentincome realized by us from future investments in fixed income securities willgenerally increase or decrease with interest rates. In addition, actual netinvestment income and/or cash flows from investments that carry prepayment risk(such as mortgage-backed and other asset-backed securities) may differ fromthose anticipated at the time of investment as a result of interest ratefluctuations. Because substantially all of our fixed income securities areclassified as available for sale, changes in the market value of our securitiesare reflected in our balance sheet. Similar treatment is not available forliabilities. Therefore, interest rate fluctuations could adversely affect ourresults of operations and financial condition.

***Compliance withrecently enacted laws and regulations is complex and expensive.***

Several laws andregulations adopted by the Federal government including Sarbanes-Oxley, theGramm-Leach-Bliley Act, HIPAA, the USA PATRIOT Act, and “Do Not Call”regulations, have created additional administrative and compliance requirementson us. The requirements of these laws and regulations are still evolving, andthe cost of compliance may have an adverse effect on our profitability. Inaddition, if we do not comply adequately, we may be faced with administrativepenalties.

***We are required to comply with laws governing thetransmission, security and privacy of health information that requiresignificant compliance costs, and any failure to comply with these laws couldresult in material criminal and civil penalties.***

Regulations under HIPAArequire us to comply with standards regarding the exchange of healthinformation within our company and with third parties, including healthcareproviders, business associates and our members. These regulations includestandards for common healthcare transactions, including claims information,plan eligibility, and payment information; unique identifiers for providers andemployers; security; privacy; and enforcement. HIPAA also provides that to theextent that state laws impose stricter privacy standards than HIPAA privacyregulations, such state standards and laws are not preempted by HIPAA.

We will conduct ouroperations in an attempt to comply with all applicable HIPAA requirements.Given the complexity of the HIPAA regulations, the possibility that theregulations may change, and the fact that the regulations are subject tochanging and, at times, conflicting interpretation, our ongoing ability tocomply with the HIPAA requirements is uncertain. Furthermore, a state’s abilityto promulgate stricter laws, and uncertainty regarding many aspects of suchstate requirements, make compliance more difficult. To the extent that wesubmit electronic healthcare claims and payment transactions that do not complywith the electronic data transmission standards established under HIPAA,payments to us may be delayed or denied. Additionally, the costs of complyingwith any changes to the HIPAA regulations may 

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have anegative impact on our operations. Sanctions for failing to comply with theHIPAA health information provisions include criminal penalties and civilsanctions, including significant monetary penalties. In addition, our failureto comply with state health information laws that may be more restrictive thanthe regulations issued under HIPAA could result in additional penalties.

***We are subject to extensive government regulation, andany violation of the laws and regulations applicable to us could reduce ourrevenues and profitability and otherwise adversely affect our operatingresults.***

Ourhealth plans and insurance companies are extensively regulated by the Federalgovernment and the states in which we operate. The laws and regulationsgoverning our operations are generally intended to benefit and protectpolicyholders, health plan members and providers rather than stockholders. Thegovernment agencies administering these laws and regulations have broadlatitude to enforce them. These laws and regulations, along with the terms ofour government contracts, regulate how we do business, what services we offer,and how we interact with our policyholders, members, providers and the public. Healthcarelaws and regulations are subject to frequent change and differinginterpretations. Changes in existing laws or regulations, or theirinterpretations, or the enactment of new laws or the issuance of newregulations could adversely affect our business by, among other things:

·       imposingadditional license, registration, or capital reserve requirements;

·       increasingour administrative and other costs;

·       forcingus to undergo a corporate restructuring;

·       increasingmandated benefits without corresponding premium increases;

·       limitingour ability to engage in inter-company transactions with our affiliates andsubsidiaries;

·       effectingour ability to operate under the Medicare program and to continue to serve ourmembers and attract new members;

·       forcingus to restructure our relationships with providers and agents; or

·       requiringus to implement additional or different programs and systems.

Inaddition, we are subject, on an ongoing basis, to various governmental reviews,audits and investigations to verify our compliance with our contracts andapplicable laws and regulations. Any adverse review, audit or investigationcould result in:

·       forfeitureof amounts we have been paid pursuant to our government contracts;

·       impositionof civil or criminal penalties, fines or other sanctions on us;

·       lossof our right to participate in government-sponsored programs, including Medicare;

·       damageto our reputation in various markets;

·       increaseddifficulty in marketing our products and services; and

·       lossof one or more of our licenses to act as an insurer or health maintenanceorganization or to otherwise provide a service.

Any of these events couldreduce our revenues and profitability and otherwise adversely affect ouroperating results.

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***The Medicare Prescription Drug, Improvement andModernization Act of 2003 made changes to the Medicare program that willmaterially impact our operations and could reduce our profitability andincrease competition for existing and prospective members.***

The MMA substantiallychanged the Medicare program and will modify how we operate our business.Although many of these changes are designed to benefit Medicare Advantage plansgenerally, certain provisions of the MMA may increase competition, createchallenges for us with respect to educating our existing and potential membersabout the changes, and create other risks and substantial and potentially adverseuncertainties, including the following:

*Increased competition could adversely affect ourenrollment and results of operations:*

·        TheMMA increased reimbursement rates for Medicare Advantage plans. Higherreimbursement rates may increase the number of plans that participate in theMedicare program, creating new competition that could adversely affect ourprofitability and cause increased lapsation in our Medicare Supplement in forceas policyholders choose to enroll in a competitors plan.

·        Asof 2006, a new regional Medicare Preferred Provider Organization, or MedicarePPO, program and private fee-for-service plans were implemented pursuant to theMMA. Medicare PPO’s and private fee-for-service plans allow their members moreflexibility to select physicians than the current plans, which are HMOs thatrequire members to coordinate with a primary care physician. The regionalMedicare PPO program and private fee-for-service plans will compete with localMedicare Advantage programs and may affect our Medicare Advantage business. Wedo not know how the creation of the regional Medicare PPO program and privatefee-for-service plans, which are intended to provide further choice tobeneficiaries, will affect our Medicare Advantage HMO business.

*The new competitive bidding process may adverselyaffect our profitability:*

·        Asof January 1, 2006, the payments for the local Medicare Advantage HMO andregional Medicare Advantage PPO programs are based on a competitive biddingprocess that may decrease the amount of premiums paid to us or cause us toincrease the benefits we offer.

*The newlimited annual enrollment process may adversely affect our growth and abilityto market our products:*

·        Beginningin 2006, Medicare beneficiaries generally have a more limited annual enrollmentperiod during which they can choose to participate in a Medicare Advantage planor receive benefits under the traditional fee-for-service Medicare program. Afterthe annual enrollment period, most Medicare beneficiaries will not be permittedto change their Medicare benefits. The new annual enrollment process andsubsequent “lock-in” provisions of the MMA may adversely affect our growth asit will limit our ability to enter new service areas and market to or enrollnew members in our established service areas outside of the annual enrollmentperiod.

*The limited annual enrollment period may make itdifficult to retain an adequate sales force:*

·        Asa result of the limited annual enrollment period and the subsequent “lock-in”provisions of the MMA, our sales force, including our independent sales brokersand agents, may be limited in their ability to market our products year-round.Our agents rely substantially on sales commissions for their income. Given thelimited annual sales window, it may become more difficult to find agents tomarket and promote our products.

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***We may be unable to provide the new Medicare Part Dbenefit profitably (See also “Risks Related To Our Prescription Drug PlanBusiness”):***

·       Beginningin 2006, organizations that offer Medicare Advantage plans of the type wecurrently offer are required to offer a prescription drug benefit, as definedby Medicare, and Medicare Advantage enrollees will be required to obtain theirdrug benefit from their Medicare Advantage plan. Such combined managed careplans offering drug benefits are, under the new law, called MA-PD’s. It is notknown at this time whether the governmental payments will be adequate to coverthe actual costs for this benefit. Current enrollees may prefer a stand-alonedrug plan and may dis-enroll from the Medicare Advantage plan altogether inorder to participate in another drug plan. Accordingly, the new prescriptiondrug benefit could reduce our profitability and membership enrollment.

·       Someenrollees may have chosen our Medicare Advantage plan in the past rather than aMedicare fee-for-service program because of the added drug benefit that weoffer with our Medicare Advantage plans. As of January 1, 2006, Medicarebeneficiaries have the opportunity to obtain a drug benefit without joining amanaged care plan. We do not know at this time whether our PDP or MA-PDbenefits will be as or more attractive than those of our competitors.Additionally, Medicare beneficiaries that participate in a Medicare Advantageplan that enroll in a PDP will be automatically dis-enrolled from theirMedicare Advantage plan. Accordingly, the existence of new PDP’s in our serviceareas could result in our members intentionally or inadvertently dis-enrollingfrom our plans and reduce our membership and profitability.

·       Webegan marketing our MA-PD’s and PDP’s in October 2005 and began enrollingmembers, effective as of January 1, 2006, on November 15, 2005. Ourability to profitably operate our MA-PD’s and PDP’s will depend on a number offactors, including our ability to attract members, to develop the necessarycore systems and processes and to manage our medical expense related to theseplans. Because required prescription drug benefits are new to Medicare and tothe health insurance market generally, there is significant uncertainty of theultimate market size, consumer demand, and related medical loss ratio.Accordingly, we do not know whether we will be able to operate our MA-PD’s orPDP’s profitably or competitively, and our failure to do so could have anadverse effect on our results of operations.

·       The MMA provides for “riskcorridors” that are expected to limit to some extent the losses MA-PD’s or PDP’swould incur if their costs turned out to be higher than those in the per memberper month, or pmpm, bids submitted to CMS in excess of certain specified ranges.For example, for 2006 and 2007 drug plans will bear all gains and losses up to2.5% of their expected costs, but will be reimbursed for 75% of the lossesbetween 2.5% and 5%, and 80% of losses in excess of 5%. It is anticipated thatthe initial risk corridors in 2006 and 2007 will provide more protectionagainst excess losses than will be available beginning in 2008 and future yearsas the thresholds increase and the reimbursement percentages decrease. Inaddition, we expect there will be a delay in obtaining reimbursement from CMSfor reimbursable losses pursuant to the risk corridors. For example, if weincur reimbursable losses in 2006, we would not be reimbursed by CMS until2007. In that event, we expect there would be a negative impact on our cash flowsand financial condition as a result of being required to finance excess lossesuntil we are reimbursed. In addition, as the risk corridors are designed to besymmetrical, a plan whose actual costs fall below their expected costs would berequired to reimburse CMS based on a similar methodology as set forth above.Furthermore, reconciliation payments for estimated upfront Federal reinsurancepayments, or, in some cases, the entire amount of the reinsurance payments, forMedicare beneficiaries who reach the drug benefit’s catastrophic threshold aremade retroactively on an annual basis, which could expose plans to upfrontcosts in providing the benefit. Accordingly, it may be difficult to accuratelypredict or report the operating results associated with our drug benefits.

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***We have identified a material weakness in our internalcontrol over financial reporting, and our business and stock price may beadversely affected if we have not adequately addressed the weakness or if wehave other material weaknesses or significant deficiencies in our internalcontrol over financial reporting.***

We have identified amaterial weakness in our internal control over financial reporting as ofDecember 31, 2005, relating to the accounting for our Medicare Supplementclaim reserves and amounts recoverable from reinsurers.  Specifically, our analysis and reviewcontrols were not sufficient to ensure that our estimated claims reserves,amounts recoverable from reinsurers and net incurred claims for our MedicareSupplement business were appropriately stated. As a result of this weakness, our internal controls did not detect theneed for adjustments to the amounts initially recorded for these items. Basedon additional analysis and procedures performed, management made adjustments inthe fourth quarter of 2005 to our claim reserves and amounts recoverable fromreinsurers as of December 31, 2005 and the related incurred claims expense forthe year ended December 31, 2005 for our Medicare Supplement business prior tothe issuance of the consolidated financial statements as of December 31, 2005. Theexistence of one or more material weaknesses or significant deficiencies couldresult in errors in our consolidated financial statements, and substantialcosts and resources may be required to rectify any internal controldeficiencies. If we cannot produce reliable financial reports, investors couldlose confidence in our reported financial information, the market price of ourstock could decline significantly, we may be unable to obtain additionalfinancing to operate and expand our business, and our business and financialcondition could be harmed.

***Restrictions on ourability to market would adversely affect our revenue.***

We rely on our marketingand sales efforts for a significant portion of our premium revenue growth. TheFederal and state governments in which we currently operate permit marketingbut impose strict requirements and limitations as to the types of marketingactivities that are permitted. If our marketing efforts were to be prohibitedor curtailed, our ability to increase or sustain membership would besignificantly harmed, which would adversely affect our revenue.

***We may beresponsible for the actions of our independent and career agents.***

In litigation against oursubsidiaries, claims are sometimes made that agents failed to comply withapplicable laws, regulations and rules, or acted improperly in other ways andthat we are responsible for such failure. Although we require our agents to complywith applicable laws, regulations, and our rules and standards, andmaintain monitoring and supervisory procedures to enforce this requirement, wemay be held liable for contractual or extra-contractual damages on such claims.We cannot assure you that any future claim will not result in materialliability in the future.

***Legal and regulatory investigations and actions areincreasingly common in the insurance and managed care business and may resultin financial losses and harm our reputation.***

We face a significant riskof litigation and regulatory investigations and actions in the ordinary courseof operating our businesses, including the risk of class action lawsuits. Ourpending legal and regulatory actions include proceedings specific to us and othersgenerally applicable to business practices in the industries in which weoperate. In our insurance and health plan operations, we are or may becomesubject to class actions and individual suits alleging, among other things,issues relating to sales or underwriting practices, alleged agent misconduct,discrimination, claims payments and procedures, product design, disclosure,administration, additional premium charges for premiums paid on a periodicbasis, denial or delay of benefits and breaches of fiduciary or other duties tocustomers. Plaintiffs in class action and other lawsuits against us may seekvery large or indeterminate amounts, including punitive and treble damages,which may remain unknown for substantial periods of time. We are also subject tovarious regulatory 

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inquiries,such as information requests, subpoenas and books and record examinations, fromstate, Federal and international regulators and other authorities. Asubstantial legal liability or a significant regulatory action against us couldhave an adverse effect on our business, financial condition and results ofoperations.

We, and certain of ourofficers and directors, currently are party to a number of lawsuits, includingpurported class actions and derivative claims. These actions generally relateto allegedly false statements about our medical loss ratio and allege variousviolations of law. These cases currently seek unspecified damages. We also maybe subject to additional litigation in the future. Litigation could materiallyadversely affect our business or results of operations because of the costs ofdefending these cases, the costs of settlement or judgments against us, or thechanges in our operations that could result from litigation. The defense of anysuch actions may be time-consuming and costly, and may distract our management’sattention. In addition, we could suffer significant harm to our reputation,which could have an adverse effect on our business, financial condition andresults of operations. As a result, we may incur significant expenses and maybe unable to effectively operate our business. Please see “Item 3—LegalProceedings” for more information about litigation against us.

We maintain errors andomissions insurance and other insurance coverage that we believe are adequatebased on industry standards. Potential liabilities may not be covered byinsurance or indemnity, our insurers or indemnifying parties may disputecoverage or may be unable to meet their obligations or the amount of ourinsurance or indemnification coverage may be inadequate. We cannot assure youthat we will be able to obtain insurance coverage in the future, or thatinsurance will continue to be available on a cost-effective basis, if at all.

***The occurrence of natural or man-made disasters couldadversely affect our financial condition and results of operation.***

We are exposed to variousrisks arising out of natural disasters, including earthquakes, hurricanes,floods and tornadoes, and pandemic health events such as avian influenza, aswell as man-made disasters, including acts of terrorism and military actions.For example, a natural or man-made disaster could lead to unexpected changes inpersistency rates as policyholders and contractholders who are affected by thedisaster may be unable to meet their contractual obligations, such as paymentof premiums on our insurance policies. The continued threat of terrorism andongoing military actions may cause significant volatility in global financialmarkets, and a natural or man-made disaster could trigger an economic downturnin the areas directly or indirectly affected by the disaster. Theseconsequences could, among other things, result in a decline in business andincreased claims from those areas. Disasters also could disrupt public andprivate infrastructure, including communications and financial services, whichcould disrupt our normal business operations.

A natural or man-madedisaster also could disrupt the operations of our counterparties or result inincreased prices for the products and services they provide to us. In addition,a disaster could adversely affect the value of the assets in our investmentportfolio if it affects companies’ ability to pay principal or interest ontheir securities.

***Our business may suffer if we are not able to hire andretain sufficient qualified personnel or if we lose our key personnel.***

Our future success dependspartly on the continued contribution of our senior management and other keyemployees. While we currently have employment agreements with certain keyexecutives. these do not guarantee that the services of these executives willcontinue to be available to us. The loss of the services of any of our seniormanagement, or other key employees, could harm our business. In addition,recruiting 

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andretaining the personnel we require to effectively compete in our markets may bedifficult. If we fail to hire and retain qualified employees, we may not beable to maintain and expand our business.

**RisksRelated To Our Medicare Advantage Business**

***If our government contractsare not renewed or are terminated, our business could be substantiallyimpaired.***

We provide our Medicareand other services through a limited number of contracts with Federalgovernment agencies. These contracts generally have terms of one or two yearsand are subject to nonrenewal by the applicable agency. All of our governmentcontracts are terminable for cause if we breach a material provision of thecontract or violate relevant laws or regulations. In addition, our right to addnew members may be suspended by a government agency if it finds deficiencies inour provider network or operations. If we are unable to renew, or tosuccessfully rebid or compete for any of our government contracts, or if any ofour contracts are terminated, our business could be substantially impaired. Ifany of those circumstances were to occur, we would likely pursue one or morealternatives, including seeking to enter into contracts in other geographicmarkets, seeking to enter into contracts for other services in our existingmarkets, or seeking to acquire other businesses with existing governmentcontracts. If we were unable to do so, we could be forced to cease conductingbusiness. In any such event, our revenues and profits would decreasematerially.

***Because our Medicare Advantage premiums, whichgenerate most of our Medicare Advantage revenues, are fixed by contract, we areunable to increase our Medicare Advantage premiums during the contract term ifour corresponding medical benefits expense exceeds our estimates.***

Most of our MedicareAdvantage revenues are generated by premiums consisting of fixed monthlypayments per member. These payments are fixed on an annual basis by contract,and we are obligated during the contract period, which is generally one or twoyears, to provide or arrange for the provision of healthcare services asestablished by the Federal government. If our medical expenses exceed ourestimates, except in very limited circumstances or as a result of risk scoreadjustments for member acuity, we will be unable to increase the premiums wereceive under these contracts during the then-current terms. As a result, ourprofitability depends, to a significant degree, on our ability to adequatelypredict and effectively manage our medical expenses related to the provision ofhealthcare services. Relatively small changes in our medical loss ratio, orMLR, can create significant changes in our financial results. Accordingly, thefailure to adequately predict and control medical expenses and to make reasonableestimates and maintain adequate accruals for incurred but not reported, orIBNR, claims, may have a material adverse effect on our financial condition,results of operations, or cash flows.

Historically,our medical expenses as a percentage of premium revenue have fluctuated.Factors that may cause medical expenses to exceed our estimates include:

·       anincrease in the cost of healthcare services and supplies, includingpharmaceuticals, whether as a result of inflation or otherwise;

·       higherthan expected utilization of healthcare services;

·       periodicrenegotiation of hospital, physician, and other provider contracts;

·       changesin the demographics of our members and medical trends affecting them;

·       newmandated benefits or other changes in healthcare laws, regulations, andpractices;

·       newtreatments and technologies;

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·       consolidationof physician, hospital, and other provider groups;

·       contractualdisputes with providers, hospitals, or other service providers; and

·       theoccurrence of catastrophes, major epidemics, or acts of terrorism.

Because of the relativelyhigh average age of the Medicare population, medical expenses for our MedicareAdvantage plans may be particularly difficult to control. We attempt to controlthese costs through a variety of techniques, including capitation and otherrisk-sharing payment methods, collaborative relationships with primary carephysicians and other providers, advance approval for hospital services andreferral requirements, case and disease management and quality assuranceprograms, information systems and reinsurance. Despite our efforts and programsto manage our medical expenses, we may not be able to continue to manage theseexpenses effectively in the future. If our medical expenses increase, ourprofits could be reduced or we may not remain profitable.

***We derive a substantial portion of our MedicareAdvantage revenues and profits from Medicare Advantage operations in Texas, andlegislative actions, economic conditions or other factors that adversely affectthose operations could materially reduce our revenues and profits.***

If we are unable tocontinue to operate in Texas, or if our current operations in any portion ofTexas are significantly curtailed, our revenues will decrease materially. Ourreliance on our operations in Texas could cause our revenues and profitabilityto change suddenly and unexpectedly, depending on legislative actions, economicconditions and similar factors. In addition, our market share in Texas may makeit more difficult for us to expand our membership in existing markets in Texas.Our inability to continue to operate in Texas, or a decrease in the revenues ofour Texas operations, would harm our overall operating results.

***CMS’s risk adjustment payment system and budgetneutrality factors make our revenue and profitability difficult to predict andcould result in material retroactive adjustments to our results of operations.***

All of the MedicareAdvantage programs we offer are through Medicare. As a result, ourprofitability is dependent, in large part, on continued funding for governmenthealthcare programs at or above current levels. The premium rates paid tohealth plans like ours by the Federal government are established by contract,although the rates differ depending on a combination of factors such as amember’s health status, age, gender, county or region, benefit mix, membereligibility categories, and the plans’ risk scores. CMS has implemented a riskadjustment payment system for Medicare health plans to improve the accuracy ofpayments and establish incentives for Medicare plans to enroll and treat lesshealthy Medicare beneficiaries. CMS is phasing-in this payment methodology witha risk adjustment model that bases a portion of the total CMS reimbursementpayments on various clinical and demographic factors including hospitalinpatient diagnoses, diagnosis data from ambulatory treatment settings,including hospital outpatient facilities and physician visits, gender, age, andMedicaid eligibility. CMS requires that all managed care companies capture,collect, and submit the necessary diagnosis code information to CMS twice ayear for reconciliation with CMS’s internal database. As part of the phase-in,during 2005, risk adjusted payments accounted for 50% of Medicare health planpayments, with the remaining 50% being reimbursed in accordance with thetraditional CMS demographic rate books. The portion of risk adjusted paymentswas increased to 75% in 2006, and will increase to 100% in 2007. As a result ofthis process, it is difficult to predict with certainty our future revenue orprofitability. In addition, our own risk scores for any period may result infavorable or unfavorable adjustments to the payments we receive from CMS andour Medicare premium revenue. There can be no assurance that our contractingphysicians and hospitals will be successful in improving the accuracy ofrecording diagnosis code information and thereby enhancing our risk scores.

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Payments to MedicareAdvantage plans are also adjusted by a “budget neutrality” to prevent healthplan payments from being reduced overall while, at the same time, directinghigher risk adjusted payments to those plans with more chronically illenrollees. In general, this adjustment has favorably impacted payments to allMedicare Advantage plans. The President’s budget issued in February 2005assumed a phase-out of the budget neutrality adjustments over a five yearperiod from 2007 through 2011. On February 8, 2006, the President signedthe Deficit Reduction Act of 2005, which is estimated to reduce the growth inMedicare Advantage spending by more than $6 billion over the next five years. Amongother changes, the legislation provided for a phase-out of budget neutralityfor risk adjustment of payments made to Medicare Advantage plans. These legislativechanges will have the effect of reducing payments to Medicare Advantage plansin general. Consequently, our plans’ premiums will be reduced unless our riskscores increase. We cannot assure you that our risk scores will increase in thefuture or, if they do, that they will be large enough to offset the eliminationof this adjustment.

***If we are unable to maintain satisfactoryrelationships with our providers, our profitability could decline and we may beprecluded from operating in some markets.***

Our operations andprofitability depend, in large part, upon our ability to enter intocost-effective contracts with hospitals, physicians and other healthcareproviders in appropriate numbers in our geographic markets and at convenientlocations for our members. In any particular market, however, providers couldrefuse to contract with us, demand higher payments or take other actions thatcould result in higher healthcare costs, disruption of benefits to our members,or difficulty in meeting our regulatory or accreditation requirements. In somemarkets, certain providers, particularly hospitals, physician/hospitalorganizations or multi-specialty physician groups, may have significant marketpositions or near monopolies. If such a provider or any of our other providersrefuse to contract with us, use their market position to negotiate contractsthat might not be cost-effective or otherwise place us at a competitivedisadvantage, then our ability to market products or to be profitable in thoseservice areas could be materially adversely affected. Our provider networkscould also be materially disrupted by the financial insolvency of a largeprovider group. Any disruption in our provider network could result in a lossof membership or higher healthcare costs. In the long term, our ability tocontract successfully with a sufficiently large number of providers in aparticular geographic market will affect the relative attractiveness of ourmanaged care products in that market and could preclude us from renewing our Medicarecontracts in those markets or from entering into new markets. We will berequired to establish acceptable provider networks prior to entering newmarkets. Although we have established long-term relationships with many of ournetwork providers, we may be unable to maintain those relationships or enterinto agreements with providers in new markets on a timely basis or underfavorable terms. If we are unable to retain our current provider contracts orto enter into new provider contracts timely or on favorable terms, ourprofitability could decline.

***We may not have adequate intellectual property rightsin our brand names for our health plans, and we may be unable to adequatelyenforce such rights.***

Our success depends, inpart, upon our ability to market our health plans under our brand names,including our “Texan Plus” family of products. While we hold Federal trademarkregistrations for the “Texan Plus” trademark, we have not taken enforcementaction to prevent infringement of our Federal trademark and have not securedregistrations of our other marks. Other businesses may have prior rights in thebrand names that we market under or in similar names, which could limit orprevent our ability to use these marks, or to prevent others from using similarmarks. If we are unable to prevent others from using our brand names, or ifothers prohibit us from using them, our revenues could be adversely affected.Even if we are able to protect our intellectual property rights in such brands,we could incur significant costs in doing so.

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***We are subject tocompetition that may limit our ability to increase or maintain membership inthe markets we serve.***

We operate in a highlycompetitive environment and in an industry that is currently subject tosignificant changes due to business consolidations, new strategic alliances andaggressive marketing practices by other managed care organizations. We competefor members principally on the basis of size, location and quality of providernetwork, benefits provided, quality of service and reputation. A number ofthese competitive elements are partially dependent upon and can be positivelyaffected by financial resources available to a health plan. Many otherorganizations with which we compete have substantially greater financial andother resources than we do. Our failure to maintain or attract members to ourhealth plans could adversely affect our results of operations. In addition,changes resulting from the MMA may bring additional competitors into our marketarea. As a result, we may be unable to increase or maintain our membership.

***Claims relating tomedical malpractice and other litigation could cause us to incur significantexpenses.***

Our providers involved inmedical care decisions may be exposed to the risk of medical malpractice claims.A small percentage of these providers do not have malpractice insurance. As aresult of increased costs or inability to secure malpractice insurance, thepercentage of physicians who do not have malpractice insurance may increase. Althoughour network providers are independent contractors, claimants sometimes allegethat a managed care organization should be held responsible for allegedprovider malpractice, particularly where the provider does not have malpracticeinsurance, and some courts have permitted that theory of liability. Inaddition, managed care organizations may be sued directly for allegednegligence, such as in connection with the credentialing of network providersor for improper denials or delay of care. In addition, Congress and severalstates are considering legislation that would expressly permit managed careorganizations to be held liable for negligent treatment decisions or benefitscoverage determinations.

***Negative publicity regarding the managed care industrygenerally or us in particular may harm our business and operating results.***

Negativepublicity regarding the managed healthcare industry generally or us inparticular may result in increased regulation and legislative review ofindustry practices that further increase our costs of doing business andadversely affect our results of operations by:

·       requiringus to change our products and services;

·       increasingthe regulatory burdens under which we operate;

·       adverselyaffecting our ability to market our products or services; or

·       adversely affecting ourability to attract and retain members.

**Risks Related To Our Insurance Business**

***Our net income may decline if our premium rates arenot adequate.***

We set the premium rateson our insurance policies based on facts and circumstances known at the time weissue the policies and on assumptions about numerous variables, including theactuarial probability of a policyholder incurring a claim, the severity andduration of the claim, the mortality rate of our policyholder base, thepersistency or renewal rate of our policies in force, our commission and policyadministration expenses, and the interest rate earned on our investment ofpremiums. In setting premium rates, we consider historical claims information,industry statistics and other factors. If our actual claims experience provesto be less favorable than we assumed and we are unable to raise our premiumrates, our net income may decrease. We generally cannot raise our premiums inany state unless we first obtain the 

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approvalof the insurance regulator in that state. We review the adequacy of ouraccident & health premium rates regularly and file rate increases onour products when we believe permitted premium rates are too low. Whendetermining whether to approve or disapprove our rate increase filings, thevarious state insurance departments take into consideration our actual claimsexperience compared to expected claims experience, policy persistency (whichmeans the percentage of policies that are in-force at certain intervals fromthe issue date compared to the total amount originally issued), investmentincome and medical cost inflation. If the regulators do not believe thesefactors warrant a rate increase, it is possible that we will not be able toobtain approval for premium rate increases from currently pending requests orrequests filed in the future. If we are unable to raise our premium ratesbecause we fail to obtain approval for rate increases in one or more states,our net income may decrease. If we are successful in obtaining regulatoryapproval to raise premium rates, the increased premium rates may reduce thevolume of our new sales and cause existing policyholders to let their policieslapse. This would reduce our premium income in future periods. Increased lapserates also could require us to expense all or a portion of the deferred policycosts relating to lapsed policies in the period in which those policies lapse,reducing our net income in that period.

***Our reserves forfuture policy benefits and claims may prove to be inadequate, requiring us toincrease liabilities and resulting in reduced net income and shareholders’equity.***

We calculate and maintainreserves for the estimated future payment of claims to our policyholders usingthe same actuarial assumptions that we use to set our premiums. For ouraccident and health insurance business, we establish active life reserves forexpected future policy benefits (including for certain of our policies,provisions for return of premiums (“ROP”)), plus a liability for due and unpaidclaims, claims in the course of settlement, and incurred but not reportedclaims. Many factors can affect these reserves and liabilities, such aseconomic and social conditions, taxability of ROP benefits, inflation, hospitaland medical costs, changes in doctrines of legal liability andextra-contractual damage awards. Therefore, the reserves and liabilities weestablish are necessarily based on extensive estimates, assumptions and prioryears’ statistics. When we acquire other insurance companies or blocks ofinsurance, our assessment of the adequacy of acquired policy liabilities issubject to similar estimates and assumptions. Establishing reserves involvesinherent uncertainties, and it is possible that actual claims could materiallyexceed our reserves and have a material adverse effect on our results ofoperations and financial condition. Our net income depends significantly uponthe extent to which our actual claims experience is consistent with theassumptions we used in setting our reserves and pricing our policies. If ourassumptions with respect to future claims are incorrect, and our reserves areinsufficient to cover our actual losses and expenses, we would be required toincrease our liabilities resulting in reduced net income, statutory surplus andshareholders’ equity.

***The availability ofreinsurance on acceptable terms and the financial stability of our reinsurerscould impact our ability to manage risk and increase the volume of insurancethat we sell.***

We utilize reinsuranceagreements with larger, financially sound reinsurers to mitigate insurancerisks that we underwrite. We enter into reinsurance arrangements withunaffiliated reinsurance companies to limit our exposure on individual claimsand to limit or eliminate risk on our non-core or under-performing blocks ofbusiness. As of December 31, 2005, we ceded to reinsurers approximately26% of our gross annualized insurance premium in force. Reinsurancearrangements leave us exposed to two risks: credit risk and replacement risk. Credit risk exists because reinsurancedoes not relieve us of our liability to our insureds for the portion of therisks ceded to reinsurers. We are exposed to the risk of a reinsurer’s failureto pay in full and in a timely manner the claims we make against them in accordancewith the terms of our reinsurance agreements, which could expose our insurancecompany subsidiaries to liabilities in excess of their reserves and surplus andcould expose them to insolvency proceedings. The failure of a reinsurer to makeclaims payments to us could materially and adversely affect our results ofoperations and financial 

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conditionand our ability to make payments to our policyholders. Replacement risk existsbecause a reinsurer may cancel its participation on new business issued on advancenotice. As a result, we would need to find reinsurance from another source tosupport our level of new business. The amount and cost of reinsurance availableto us is subject, in large part, to prevailing market conditions beyond ourcontrol. Because our current reinsurance agreements are non-cancelable forbusiness in force, non-renewal or cancellation of a reinsurance arrangementaffects only new business and the reinsurer remains liable on businessreinsured prior to non-renewal or cancellation. In the event that currentreinsurers cancel their participation on new business, we would seek to replacethem, possibly at higher rates. If we are not able to reinsure our lifeinsurance products on acceptable terms, we would consider limiting the amount ofsuch new business issued. A failure to obtain reinsurance on acceptable termswould allow us to underwrite new business only to the extent that we arewilling and able to bear the exposure to the new business on our own.

***Changes in the exchange rate between the U.S. dollarand the Canadian dollar may impact our results.***

We publish ourconsolidated financial statements in U.S. dollars. However, portions of ouroperations are transacted using the Canadian dollar as the functional currency.As of and for the year ended December 31, 2005, approximately 13% of ourassets, 8% of our revenues, excluding realized gains, and 19% of our incomebefore realized gains and taxes were derived from our Canadian operations. Accordingly,our earnings and shareholders’ equity are affected by fluctuations in the valueof the U.S. dollar as compared to the Canadian dollar. Although this risk issomewhat mitigated by the fact that both the assets and liabilities for ourCanadian operations are denominated in Canadian dollars, we are still subjectto losses resulting from currency translation that will impact our reportedconsolidated financial condition, results of operations and cash flows fromyear to year.

***We may experience future lapsation in our MedicareSupplement business.***

We experienced higher thanexpected lapsation in our Medicare Supplement business beginning in the thirdquarter of 2005  We believe that thereare a number of factors contributing to the lapsation, including competitivepressure from other Medicare Supplement companies and Medicare Advantageproducts, as well as the departure of certain of our sales managers. Thisexcess lapsation required us to accelerate the amortization of the deferredacquisition cost and present value of future profits assets associated with thebusiness that lapsed. We cannot give assurances that lapsation of our MedicareSupplement business will decline from the 2005 level, requiring fasteramortization of the deferred costs.

***We may experience higher than expected loss ratios inour Medicare Supplement business.***

During 2005, weexperienced a higher than expected loss ratio on our Medicare Supplementbusiness. As a result of higher than anticipated Part B costs (outpatientdoctor costs) and skilled nursing facility incidence, we did not see ourhistorical pattern of seasonal reduction in loss ratios in the latter part ofthe year. We are actively obtaining appropriate rate action in an effort toreverse the trend in these numbers, however, we can make no assurances thatfuture rate increases will be obtained, or if obtained, will be sufficient. Wealso cannot give assurance that our Medicare Supplement loss ratio will notcontinue to increase beyond what we currently anticipate.

***We may not be able to compete successfully if wecannot recruit and retain insurance agents.***

We distribute our productsprincipally through career agents and independent agents who we recruit andtrain to market and sell our products. We also engage managing general agentsfrom time to time to recruit agents and develop networks of agents in variousstates. We compete with other insurance companies for productive agents,primarily on the basis of our financial position, support services,compensation and product features. It can be difficult to successfully competewith larger insurance 

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companiesthat have higher financial strength ratings than we do for productive agents. Ourbusiness and ability to compete will suffer if we are unable to recruit andretain insurance agents or if we lose the services provided by our managinggeneral agents.

***We may be required to refund or reduce premiums if ourpremium rates are determined to be too high.***

Insurance regulatorsrequire that we maintain minimum statutory loss ratios on some of the insuranceproducts that we sell. We must therefore pay out, on average, a specifiedminimum percentage of premiums as benefits to policyholders. State regulationsalso mandate the manner in which insurance companies may compute loss ratiosand the manner in which compliance is measured and enforced. If our insuranceproducts are not in compliance with state mandated minimum loss ratios, stateregulators may require us to refund or reduce premiums.

***We have stoppedselling new long term care insurance and the premiums that we charge for thepolicies that remain in force may not be adequate to cover the claims expensesthat we incur.***

We have concluded that thesale of long term care insurance does not fit within our strategic or financialgoals. We began to curtail the sale of new business in 2003, and stopped allnew sales at the end of 2004. Approximately, $39 million of premium remains inforce, of which we retain approximately $27 million. The overall block ofbusiness continues to generate losses; however we have incurred substantiallosses from a specific block of Florida home health care business that westopped selling in 1999. There can be no assurance that current premiums wecharge will be adequate to cover the claims expenses that we will incur in thefuture. There is also no assurance that rate increases that we may seek will beapproved by the applicable state regulators or, if approved, will be adequateto fully mitigate adverse loss experience.

**Risks Related To Our Prescription Drug Plan Business**

***We have incurredand may continue to incur significant expenses in connection with implementingour new prescription drug benefits, which may have an adverse effect on ournear-term operating results.***

We receivedapproval from CMS to provide prescription drug benefits, as a stand-alone PDP,under Medicare Part D. We have incurred expenses to upgrade and improveour infrastructure, technology, and systems to manage our new prescription drugbenefits. We incurred significant expenses in 2005 as we prepared to providethese prescription drug benefits as of January 1, 2006 and will continueto incur additional expenses. In particular, our expenses incurred inconnection with the implementation of our prescription drug benefits related tothe following:

·       hiringand training of personnel to establish and manage systems, operations,regulatory relationships, and materials;

·       systemsdevelopment and upgrade costs, including hardware, software, and developmentresources;

·       marketingand sales;

·       enrollingnew members and verifying eligibility with CMS;

·       developingand distributing member materials such as ID cards and member welcome kits; and

·       handling sales inquiry andcustomer service calls.

***Recent challengesfaced by CMS and our plans’ information and reporting systems related toimplementation of Part D may temporarily disrupt or adversely affect ourplans’ relationships with our members.***

Partially in anticipationof the implementation of Part D, CMS transitioned to new information andreporting systems, which have recently generated confusing and, we believe insome cases, erroneous 

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membershipand payment reports concerning our and others’ Medicare eligibility andenrollment, most of which we believe reflects inadvertently dis-enrolleddual-eligible and other beneficiaries who were already members of one of ourplans. In addition, recent media reports are prevalent concerning the confusioncaused by failures in systems and reporting for Part D, particularly asthese failures adversely affect the access of dual-eligibles and low incomebeneficiaries to obtain their prescription drugs. These developments havecaused our plans to experience short-term disruptions in their operations andchallenged our information and communications systems. Although we believe thecurrent conditions are temporary, there can be no assurance that the currentconfusion, systems failures, and erroneous payment reports will not temporarilydisrupt or adversely affect our plans’ relationships with our members, whichcould result in a reduction of our membership and adversely affect our resultsof operations.

***There are significant risks associated with ourparticipation in the Medicare Part D program.***

Our participationin the Medicare Part D program involves a number of risks, including thefollowing:

·       CMScontinues to release regulations on Part D, including importantrequirements related to the implementation and marketing of the Part Dprescription drug benefit plan. This will create challenges for planning andimplementation of our Part D program, and there is no assurance thatCongress or CMS will not alter the program in a manner that will be detrimentalto us.

·       Wewill incur significant expenditures of time and resources in developing thisprogram, and we may need to divert human resources from other areas of theCompany. Although we believe that we have the capability to meet our staffingneeds, it is possible that the fulfillment of our administrative duties inother areas may suffer.

·       Wecannot be certain that our products will be competitive, as compared to otherPDP’s.

·       Weare making actuarial assumptions about the utilization of benefits in our PDP’s.Because Part D is a newly created program, there is no historical basisfor these assumptions, and we cannot be assured that these assumptions willprove to be correct and that premiums will be sufficient to cover benefits.

·       Wecannot be assured that potential members will accept and acquire insurance fromour PDPs, and therefore our anticipated sales under the program may generatesignificantly less revenue than our current expectations.

·       Asof December 31, 2005, CMS had automatically assigned dual eligibles to ourPDP plans in regions where our price is under the regional benchmarks. Wecannot guarantee that all of these dual eligibles assigned to us will enroll inour PDP’s. In addition, because dual eligible beneficiaries can change theirPDP each month, we can not assure that the dual eligible beneficiaries who areautomatically assigned to our PDP’s will remain in our PDP’s.

·       Part Dis a new program and the competitive landscape is uncertain. We expect toencounter competition from other PDP sponsors, some of whom may havesignificantly greater resources and brand recognition than we do. Our marketingarrangement with CVS is non-exclusive, and CVS has entered into marketingarrangements with our competitors. We cannot predict whether we will be able toeffectively compete in this new market.

·       Thecosts of developing and marketing our PDP’s will vary based upon the size ofmembership in our PDP’s. Given the uncertainties and risks described above, thecost of developing PDP’s that will allow us to effectively compete in this newmarket could exceed our current expectations.

·       Companiesthat offer Medicare Advantage plans, including us, will be required to offerprescription drug benefits in 2006 as part of the Medicare Advantage plans.Such combined managed care plans 

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offering drug benefitsare, under the new law, called MA-PD’s. It is not known at this time whetherthe governmental payments will be adequate to cover our actual costs for thesenew MA-PD benefits or, in light of our inexperience with this program, whetherwe will be able to profitably or competitively manage our MA-PD’s.

·       Someenrollees may have chosen our Medicare Advantage plan in the past rather thanthose of our competitors or traditional Medicare fee-for-service because of thedrug benefit that we offer with our Medicare Advantage plans. We do not know atthis time whether our PDP or MA-PD benefits will be as or more attractive thanthose of our competitors. Additionally, Medicare beneficiaries that participatein a Medicare Advantage plan that enroll in a PDP will be automaticallydis-enrolled from their Medicare Advantage plan. Accordingly, the existence ofnew PDP’s in our service areas could result in our members intentionally orinadvertently dis-enrolling from our plans and reduce our membership andprofitability.

·       Thereis uncertainty as to whether the dual eligibles auto-assigned to us for 2006will be re-assigned to our PDP’s in 2007.

·       Wecan not be certain that our bids for 2007 will be competitive to those bidssubmitted by other PDP’s.

·       If our current providers,including our PBM, terminate their contracts, we will have to contract withother providers to take their place.

**ITEM 1B—UNRESOLVED STAFF COMMENTS**

There are no unresolvedcomments from the Securities and Exchange Commission staff regarding theregistrant’s periodic or current reports under the Act.

**ITEM 2—PROPERTIES**

Our executive offices arelocated in Rye Brook, New York. Marketing and professional staff for ourU.S. insurance subsidiaries occupy space in Lake Mary, Florida. Our Canadianoperations are located in Mississauga, Ontario, Canada. Our AdministrativeServices operations occupy office space in Pensacola and Weston, Florida. OurMedicare Advantage operations occupy office space in Houston and Beaumont,Texas. We lease all of the approximately 295,000 square feet of office spacethat we occupy. Management considers its office facilities suitable andadequate for the current level of operations. In addition to the above,Pennsylvania Life or Penncorp Life (Canada) is the named lessee onapproximately 69 properties occupied by career agents for use as field offices.Rent for these field offices is reimbursed by the agents. Additional information regarding our lease obligationsis included in Note 16—Commitments and Contingencies in our consolidatedfinancial statements included in this Form 10-K.

**ITEM 3—LEGAL PROCEEDINGS**

***Securities Class Action and Derivative Litigation***

Five actions containing related factual allegationswere filed against the Company and certain of its officers and directorsbetween November 22, 2005 and February 2, 2006. One of these actionswas voluntarily withdrawn by plaintiffs, and four actions are now pending.

In the first action, Robert Kemp filed a purportedclass action complaint (the “Kemp Action”) on November 22, 2005, in theUnited States District Court for the Southern District of New York. The KempAction is a purported class action asserted on behalf of those shareholders ofthe Company who acquired the Company’s common stock between February 16,2005 and October 28, 2005. Plaintiffs in the Kemp Action seek unspecifieddamages under Section 10(b) and 20(a) of the Securities ExchangeAct of 1934 

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based upon allegedly falsestatements by the Company and Richard A. Barasch, Robert A. Waegelein and GaryW. Bryant (hereinafter, the “Officer Defendants”) in press releases, financialstatements and analyst conferences during the class period.

Another purported class action was recently filed byWestern Trust Laborers-Employers Pension Trust (the “Western Trust Action”), aputative class member in the Kemp Action who had filed a motion to be named aslead plaintiff in that action, on February 2, 2006, in the United StatesDistrict Court for the Southern District of New York. The factual and legalallegations in the Western Trust Action, which also purports to be a classaction, are similar to those in the Kemp Action.

Two additional actions have been brought derivatively byshareholders purporting to act on behalf of the Company, and not as classactions. One of these was filed by Green Meadows Partners LLP (the “GreenMeadows Action”) on December 13, 2005, in the United States District Courtfor the Southern District of New York. In the Green Meadows Action, plaintiffsseek contribution under Section 10(b) and 21D of the Exchange Act onthe ground that if the Company is found liable to have violated the securitieslaws in the Kemp Action, then the Officer Defendants are liable forcontribution. The Green Meadows Action also asserts three claims under statelaw for breach of fiduciary duty against the Officer Defendants.

The second derivative action was filed by plaintiffArthur Tsutsui (the “Tsutsui Action”) on December 30, 2005, in The SupremeCourt for New York State, Westchester County. The defendants in the TsutsuiAction are the three Officer Defendants named in the other actions, as well asall of the directors sitting on the Company’s Board of Directors as of the timethe complaint was filed. The Tsutsui Action alleges that the same allegedmisstatements that are the subject of the Kemp Action constituted a breach offiduciary duty by the Officer Defendants and the directors that caused the Companyto sustain damages. The Tsutsui Action also seeks recovery of any proceedsderived by the Officer Defendants from the sale of Company stock that was inbreach of their fiduciary duties.

All of the cases are at apreliminary stage. In the class actions, motions concerning the appointment oflead plaintiff are pending before the Court. The defendants were not requiredto respond to these motions, and did not do so. The time for the defendantsinitially to respond to the class actions will not expire until at least 45days after the Court enters an order concerning the appointment of lead plaintiff.In the derivative actions, the time for defendants initially to respond to bothcomplaints was extended to April 28, 2006. Each of the OfficerDefendants  denies the allegations and hasindicated that he intends to vigorously defend against the allegations. Managementbelieves that after liability insurance recoveries, none of these actions willhave a material adverse effect on us.

***Other Litigation***

We have litigation in theordinary course of our business, including claims for medical, disability andlife insurance benefits, and in some cases, seeking punitive damages. Managementbelieves that after liability insurance recoveries, none of these actions willhave a material adverse effect on us.

**ITEM 4—SUBMISSION OF MATTERS TO A VOTE OF SECURITYHOLDERS**

There were no matters submitted by us to a vote ofstockholders, through the solicitation of proxies or otherwise, during thefourth quarter of 2005.

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**Part II**

**ITEM5—market for registrant’s common equity,related stockholder matters and Issuer purchases of EQUITY securities**

**Market information**

Our common stock is traded in the over-the-countermarket and quoted on the Nasdaq National Market tier of The Nasdaq Stock Market(“Nasdaq”) under the symbol “UHCO”. The following table sets forth the high andlow sales prices for our common stock on the Nasdaq National Market, asreported by Nasdaq for the periods indicated. 

| **Period**                                      | ** ** | **Common Stock** | ** ** |
|-------------------------------------------------|------------|-----------------------|------------|
| ** **                                      | ** ** | **High**              | ** ** | **Low** | ** ** |
| Year Ended  December 31, 2004              |       |                  |       |   |   |
| First Quarter                                   |       | $                     | 12.82      |   | $ | 9.36 |   |
| Second Quarter                                  |       | 12.50                 |       | 10.00 |   |
| Third Quarter                                   |       | 12.95                 |       | 10.29 |   |
| Fourth Quarter                                  |       | 16.01                 |       | 11.07 |   |
| Year Ended  December 31, 2005              |       |                  |       |   |   |
| First Quarter                                   |       | 18.48                 |       | 14.16 |   |
| Second Quarter                                  |       | 24.11                 |       | 16.26 |   |
| Third Quarter                                   |       | 25.08                 |       | 21.19 |   |
| Fourth Quarter                                  |       | 23.90                 |       | 13.68 |   |
| Year Ending  December 31, 2006             |       |                  |       |   |   |
| First Quarter (through  February 15, 2006) |       | 18.74                 |       | 14.88 |   |
|                                                 |            |                       |            |  |  |  |  |

 

The closing sale price ofour common stock on February 15, 2006, as reported by Nasdaq, was $15.00per share.

**Stockholders**

As of the close ofbusiness on February 15, 2006, there were approximately 1,100 holders ofrecord of our common stock. We estimate that there are approximately 8,700beneficial owners of our common stock.

**Dividends**

We have never declaredcash dividends on our common stock, and have no present intention to declareany cash dividends in the foreseeable future.

**Issuerpurchases of Equity securities**

| **Period**                                               | ** ** | **Total Number  of Shares  Purchased (1)** | ** ** | **Average  Price Paid**

**Per Share** | ** ** | **Total Number of   Shares Purchased as  Part of Publicly  Announced Plans or  Programs** | ** ** | **Maximum Number  of Shares That May  Yet Be Purchased  Under the Plans or  Programs** | ** ** |
|----------------------------------------------------------|------------|-----------------------------------------------------------|------------|--------------------------------------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------------------------------------------------------------|------------|
| October 1,  2005—October 31, 2005         |       |                                                      | 244,312    |                                             |       |                                                                                                                                   | $          | 14.69                                                                                                                               |       |   |   | 244,312 |   |   |   | 462,292 |   |   |
| November 1,  2005—November 30, 2005  |       |                                                      | 461,524    |                                             |       |                                                                                                                                   | $          | 15.87                                                                                                                               |       |   |   | 461,524 |   |   |   | 1,000,768 |   |   |
| December 1,  2005—December 31, 2005       |       |                                                      | —     |                                             |       |                                                                                                                                   | —     |                                                                                                                                |       |   | — |   |   |   | 1,000,768 |   |   |
| Total                                                    |       |                                                      | 705,836    |                                             |       |                                                                                                                                   |       |                                                                                                                                |       |   | 705,836 |   |   |   |   |   |   |

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(1)          Between October 28,2005 and November 9, 2005, the Company purchased 705,036 shares in openmarket transactions at an average price per share of $15.46 in accordance with Rule 10b-18of the Securities Exchange Act of 1934. All remaining shares were purchased inprivate transactions.

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During 2000, our Board of Directors approved a planfor us to purchase up to 0.5 million shares of our common stock in the openmarket. Our Board approved an amendment to the plan to increase the totalshares authorized for purchase to 1.0 million in March 2002, and during December 2003approved a second amendment to increase the shares authorized for purchase to1.5 million. Pursuant to the plan, purchases may be made from time to time atprevailing prices, subject to restrictions on volume and timing.

Between October 28, 2005 and November 9,2005, the Company purchased 705,036 shares in open market transactions at anaverage price per share of $15.46 in accordance with Rule 10b-18 ofthe Securities Exchange Act of 1934. All remaining shares were purchased inprivate transactions.

On November 11, 2005,our Board of Directors approved a share repurchase program (the “2005 ShareRepurchase Program”) that authorized the Company to repurchase up to 1.0million shares of our Common Stock. The 2005 Share Repurchase Program has noexpiration date, and purchases may be made under the 2005 Share RepurchaseProgram in the open market or in privately negotiated transactions from time totime at management’s discretion, as approved by a committee of the Board. As ofDecember 31, 2005, we have not engaged in any repurchases under the 2005Share Repurchase Program.

**RecentSales of Unregistered Securities**

None.

**SecuritiesAuthorized for Issuance Under Equity Compensation Plans**

The information regardingsecurities authorized for issuance under our equity compensation plans isdisclosed in Item 12 “Security Ownership of Certain Beneficial Owners andManagement and Related Stockholder Matters.”

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**ITEM 6—**SELECTED FINANCIAL DATA

Thetable below provides selected financial data and other operating information asof and for the five fiscal years ended December 31, 2005. We derived theselected financial data presented below for the five fiscal years ended December 31,2005 from our audited financial statements, which were audited by Ernst &Young LLP, our independent auditors. We have prepared the following data, otherthan statutory data, in conformity with generally accepted accountingprinciples. You should read this selected financial data together with ourfinancial statements and the notes to those financial statements as well as thediscussion under the caption “Management’s Discussion and Analysis of FinancialCondition and Results of Operations.”  

| ** **                                   | ** ** | **As of or for the Year Ended December 31,**   | ** ** |
|----------------------------------------------|------------|----------------------------------------------------------------------------------------|------------|
| ** **                                   | ** ** | **2001**                                                                               | ** ** | **2002** | ** ** | **2003(1)** | ** ** | **2004(2)** | ** ** | **2005** | ** ** |
| ** **                                   | ** ** | **(in thousands, except per share and other data)** | ** ** |
| **Income Statement Data:**                   |       |                                                                                   |       |   |   |   |   |   |   |   |   |
| Direct  premium and policyholder fees        |       | $                                                                                      | 513,575    |   | $ | 586,686 |   | $ | 700,415 |   | $ | 854,146 |   | $ | 1,154,367 |   |
| Reinsurance  premium assumed                 |       | 2,549                                                                                  |       | 5,075 |   | 27,042 |   | 35,682 |   | 32,108 |   |
| Reinsurance  premium ceded                   |       | (286,918                                                                               | )          | (325,184 | ) | (280,489 | ) | (244,883 | ) | (350,416 | ) |
| Net  premium and other policyholder fees     |       | 229,206                                                                                |       | 266,577 |   | 446,968 |   | 644,945 |   | 836,059 |   |
| Net  investment income                       |       | 57,812                                                                                 |       | 57,716 |   | 61,075 |   | 65,191 |   | 71,612 |   |
| Realized  gains                              |       | 3,078                                                                                  |       | (5,083 | ) | 2,057 |   | 10,647 |   | 5,773 |   |
| Fee  and other income                        |       | 10,847                                                                                 |       | 12,313 |   | 12,648 |   | 14,680 |   | 18,479 |   |
| Total  revenues                              |       | 300,943                                                                                |       | 331,523 |   | 522,748 |   | 735,463 |   | 931,923 |   |
| Total  benefits, claims and other deductions |       | 257,580                                                                                |       | 287,493 |   | 456,269 |   | 638,995 |   | 849,957 |   |
| Income  before taxes                         |       | 43,363                                                                                 |       | 44,030 |   | 66,479 |   | 96,468 |   | 81,966 |   |
| Net  income                                  |       | 28,925                                                                                 |       | 30,127 |   | 43,052 |   | 63,871 |   | 53,876 |   |
| **Per Share  Data:**                         |       |                                                                                   |       |   |   |   |   |   |   |   |   |
| Earnings  per share:                         |       |                                                                                   |       |   |   |   |   |   |   |   |   |
| Basic                                        |       | 0.58                                                                                   |       | 0.57 |   | 0.80 |   | 1.17 |   | 0.94 |   |
| Diluted                                      |       | 0.57                                                                                   |       | 0.56 |   | 0.78 |   | 1.13 |   | 0.91 |   |
| Book  value per share:                       |       |                                                                                   |       |   |   |   |   |   |   |   |   |
| Basic                                        |       | $                                                                                      | 4.38       |   | $ | 5.42 |   | $ | 6.41 |   | $ | 7.60 |   | $ | 9.13 |   |

 

| ** **                          | ** ** | **As at**              | ** ** |
|-------------------------------------|------------|-----------------------------|------------|
| ** **                          | ** ** | **December 31,  2004** | ** ** | **December 31,  2005** | ** ** |
| **Balance Sheet Data:**             | ** ** |                        | ** ** | ** ** |   |   | ** ** | ** ** |   |
| Total  cash and investments         |       |                        | $          | 1,378,339 | ** ** |   |   | $ | 1,509,450 | ** ** |   |
| Total  assets                       |       |                        | 2,017,088  | ** ** |   |   | 2,227,979 | ** ** |   |
| Policyholder  related liabilities   |       |                        | 1,343,026  | ** ** |   |   | 1,428,384 | ** ** |   |
| Outstanding  bank debt              |       |                        | 101,063    | ** ** |   |   | 95,813 | ** ** |   |
| Trust  preferred securities         |       |                        | 75,000     | ** ** |   |   | 75,000 | ** ** |   |
| Shareholders’  equity          |       |                        | 419,421    | ** ** |   |   | 531,884 | ** ** |   |
| **Data Reported to Regulators(3):** |       |                        |       | ** ** |   |   |   | ** ** |   |
| Statutory  capital and surplus      |       |                        | $          | 183,136 | ** ** |   |   | $ | 231,810 | ** ** |   |
| Asset  valuation reserve            |       |                        | 2,423      | ** ** |   |   | 3,182 | ** ** |   |
| Adjusted capital and surplus        |       |                        | 185,559    | ** ** |   |   | 234,992 | ** ** |   |

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(1) Includes theresults of Pyramid Life since its acquisition on March 31, 2003.

(2) Includes theresults of Heritage Health Systems, Inc. since its acquisition on May 28,2004.

(3) Includes capital andsurplus of Penncorp Life (Canada) as reported to the Office of theSuperintendent of Financial Institutions Canada of C$57,398 as of December 31,2004, converted at the related exchange rate of C$0.8320 per U.S. $1.00 andC$62,307 as of December 31, 2005, converted at the related exchange rate of C$0.8606 per U.S. $1.00.

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**ITEM7—**Management’sDiscussion and Analysis of Financial Condition and Results of Operations

**Introduction**

The following analysis of our consolidated results ofoperations and financial condition should be read in conjunction with theconsolidated financial statements and related consolidated footnotes includedin this Annual Report on Form 10-K.

The following discussionand analysis presents a review of the Company as of December 31, 2005 andits results of operations for the fiscal years ended December 31, 2005,2004 and 2003.

**Overview**

Our principal business segments are based on ourproducts and include:  Senior ManagedCare—Medicare Advantage, Senior Market Health Insurance, Specialty HealthInsurance, Life Insurance and Annuity and Senior Administrative Services. Wealso report the activities of our holding company in a separate segment. Reclassificationshave been made to conform prior year amounts to the current year presentation. See“Note 21—Business Segment Information” in our consolidated financial statementsincluded in this Annual Report on Form 10-K for a description of oursegments.

Inter-segment revenues andexpenses are reported on a gross basis in each of the operating segments buteliminated in the consolidated results. These inter-segment revenues andexpenses affect the amounts reported on the individual financial statement lineitems, but are eliminated in consolidation and do not change income beforetaxes. The significant items eliminated include inter-segment revenue andexpense relating to services performed by the Senior Administrative Servicessegment for our other segments and interest on notes payable or receivablebetween the Corporate segment and the other operating segments.

**Critical Accounting Policies**

Our consolidated financialstatements have been prepared in accordance with accounting principlesgenerally accepted in the United States (“GAAP”). The preparation of ourfinancial statements in conformity with GAAP requires us to make estimates andassumptions that affect the amounts of assets and liabilities and disclosuresof assets and liabilities reported by us at the date of the financialstatements and the revenues and expenses reported during the reporting period. Asadditional information becomes available or actual amounts become determinable,the recorded estimates may be revised and reflected in operating results. Actualresults could differ from those estimates. Accounts that, in our judgment, aremost critical to the preparation of our financial statements include policyrelated liabilities, deferred policy acquisition costs, intangible assets,valuation of certain investments and deferred income taxes. There have been nochanges in our critical accounting policies during the current quarter.

***Policy related liabilities***

We calculate and maintainreserves for the estimated future payment of claims to our policyholders usingthe same actuarial assumptions that we use in the pricing of our products. Forour accident and health insurance business, we establish an active life reservefor expected future policy benefits, plus a liability for due and unpaidclaims, claims in the course of settlement and incurred but not reported claims.Many factors can affect these reserves and liabilities, such as economic andsocial conditions, inflation, hospital and pharmaceutical costs, changes indoctrines of legal liability, premium rate increases and extra contractualdamage awards. Therefore, the reserves and liabilities we establish are basedon extensive estimates, assumptions and prior years’ statistics. When weacquire other insurance companies or blocks of insurance, our assessment of theadequacy of acquired policy liabilities is subject to similar estimates andassumptions. Establishing reserves involves inherent uncertainties, and it ispossible that actual claims 

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couldmaterially exceed our reserves and have a material adverse effect on ourresults of operations and financial condition. Our net income dependssignificantly upon the extent to which our actual claims experience isconsistent with the assumptions we used in setting our reserves and pricing ourpolicies. If our assumptions with respect to future claims are incorrect, andour reserves are insufficient to cover our actual losses and expenses, we wouldbe required to increase our liabilities resulting in reduced net income andshareholders’ equity.

***Deferred policy acquisition costs***

The cost of acquiring new business, principallynon-level commissions, agency production, policy underwriting, policy issuance,and associated costs, all of which vary with, and are primarily related to theproduction of new and renewal business, are deferred. For interest-sensitivelife and annuity products, these costs are amortized in relation to the presentvalue of expected gross profits on the policies arising principally frominvestment, mortality and expense margins in accordance with FAS No. 97, “Accountingand Reporting by Insurance Enterprises for Certain Long-Duration Contracts andfor Realized Gains and Losses from the Sale of Investments”. For other life andhealth products, these costs are amortized in proportion to premium revenueusing the same assumptions used in estimating the liabilities for future policybenefits in accordance with FAS No. 60, “Accounting and Reporting byInsurance Enterprises.”  Amortization ofdeferred acquisition costs for Medicare Supplement policies is periodicallyadjusted for significant changes in benefit structures and differences inassumed premium rates on a prospective basis, consistent with assumptions usedin the related reserves for future policy benefits. During 2005, the Companydetermined that the historical actual approved rate increases and persistencywere higher than assumed levels. The prospective unlocking of these assumptionsresulted in a slower amortization of Medicare Supplement deferred acquisitioncosts.

The determination ofexpected gross profits for interest-sensitive products is an inherentlyuncertain process that relies on assumptions including projected interestrates, the persistency of the policies issued as well as anticipated benefits,commissions and expenses. It is possible that the actual profits from thebusiness may vary materially from the assumptions used in the determination andamortization of deferred acquisition costs. Deferred policy acquisition costsare written off to the extent that it is determined that future policy premiumsand investment income or expected gross profits would not be adequate torecover the unamortized costs.

***Present value of future profits and other intangibles***

Business combinations accounted for as a purchaseresult in the allocation of the purchase consideration to the fair values ofthe assets and liabilities acquired, including the present value of futureprofits, establishing such fair values as the new accounting basis. The presentvalue of future profits is based on an estimate of the cash flows of thein-force business acquired, discounted to reflect the present value of thosecash flows. The discount rate selected depends upon the general marketconditions at the time of the acquisition and the inherent risk in thetransaction. Purchase consideration in excess of the fair value of net assetsacquired, including the present value of future profits and other identifiedintangibles, for a specific acquisition, is allocated to goodwill. Allocationof purchase price is performed in the period in which the purchase is consummated.Adjustments, if any, in subsequent periods relate to resolution ofpre-acquisition contingencies and refinements made to estimates of fair valuein connection with the preliminary allocation.

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Amortization of present value of future profits isbased upon the pattern of the projected cash flows of the in-force businessacquired, over weighted average lives ranging from six to forty years. Otheridentified intangibles are amortized over their estimated lives.

On a periodic basis,management reviews the unamortized balances of present value of future profits,goodwill and other identified intangibles to determine whether events orcircumstances indicate the carrying value of such assets is not recoverable, inwhich case an impairment charge would be recognized. Management believes thatno impairments of present value of future profits, goodwill or other identifiedintangibles existed as of December 31, 2005.

***Investment valuation***

Fair value of investments is based upon quoted marketprices, where available, or on values obtained from independent pricingservices. For certain mortgage-backed and asset-backed securities, thedetermination of fair value is based primarily upon the amount and timing ofexpected future cash flows of the security. Estimates of these cash flows arebased upon current economic conditions, past credit loss experience and othercircumstances.

We regularly evaluate theamortized cost of our investments compared to the fair value of thoseinvestments. Impairments of securities generally are recognized when a declinein fair value below the amortized cost basis is considered to beother-than-temporary. Generally, we consider a decline in fair value to beother-than-temporary when the fair value of an individual security is belowamortized cost for an extended period and we do not believe that recovery infair value is probable. Impairment losses for certain mortgage-backed andasset-backed securities are recognized when an adverse change in the amount ortiming of estimated cash flows occurs, unless the adverse change is solely aresult of changes in estimated market interest rates and we intend to hold thesecurity until maturity. The cost basis for securities determined to be impairedare reduced to their fair value, with the excess of the cost basis over thefair value recognized as a realized investment loss.

***Income taxes***

We use the liability method to account for deferredincome taxes. Under the liability method, deferred tax assets and liabilitiesare recognized for the future tax consequences attributable to differencesbetween the financial statement carrying amounts of existing assets andliabilities and their respective tax bases. Deferred tax assets and liabi­litiesare measured using enacted tax rates expected to apply to taxable income in theyears in which those temporary differences are expected to be recovered orsettled. The effect on deferred tax assets and liabilities of a change in taxrates is recognized in income in the period that includes the enactment date ofa change in tax rates.

We establish valuation allowances on our deferred taxassets for amounts that we determine will not be recoverable based upon ouranalysis of projected taxable income and our ability to implement prudent andfeasible tax planning strategies. Increases in these valuation allowances arerecognized as deferred tax expense. Subsequent determinations that portions ofthe valuation allowances are no longer necessary are reflected as deferred taxbenefits. To the extent that valuation allowances were established inconjunction with acquisitions, changes in those allowances are first applied toincreasing or decreasing the goodwill (but not below zero) or other intangiblesrelated to the acquisition and then applied as an increase or decrease inincome tax expense.

During the year ended December 31,2005, we released approximately $1.6 million of valuation allowances on taxcapital loss carryforwards as a result of investments gains taken during thatperiod. As of December 31, 2005 we have $2.1 million of valuationallowances on tax capital loss carryforwards remaining.

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**SignificantTransactions and Initiatives**

***Medicare Opportunity***

We believe that attractivegrowth opportunities exist in providing a range of products, particularlyhealth insurance, to the growing senior market. At present, more than 44 millionAmericans are eligible for Medicare, the Federal program that offers basichospital and medical insurance to people over 65 years old plus certaindisabled people under the age of 65. The standard Medicare coverage does notcover prescription drugs except as required in the course of a covered hospitalstay. According to the U.S. Census Bureau, more than 2 million Americansturn 65 in the United States each year, and this number is expected to grow asthe so-called baby boomers begin to turn 65. In addition, many largeemployers who traditionally provided medical and prescription drug coverage totheir retirees have begun to curtail these benefits. Finally, the passage ofthe Medicare Modernization Act of 2003 (the “MMA”) demonstrated the Federalgovernment’s commitment to expand the healthcare options available to Medicarebeneficiaries through the expansion of Medicare managed care plans (“MedicareAdvantage”) and the authorization of a subsidized prescription drug insurancebenefit pursuant to Part D (“Part D”). Taken together, theseconditions present significant opportunities for us to increase the sale of ourproducts.

***Medicare Advantage***

As a result of the increased reimbursement rates fromthe Centers for Medicare and Medicaid Services, the Federal agency thatadministers the Medicare Advantage program (“CMS”), Medicare Advantage plansare able to offer more attractive benefits including enhanced prescription drugcoverage pursuant to Part D. Consequently, we believe that enrollment inMedicare Advantage programs is likely to increase in the coming years.

We entered the MedicareAdvantage business in 2004 with the acquisition of Heritage Health Systems, Inc.which operates Medicare Advantage coordinated care plans in Southeastern Texas.Since 2005, Heritage has expanded its service area to include 8 counties inTexas, and has begun to offer an HMO product in three counties in Florida(Brevard, Broward and Miami-Dade) in 2006. In 2004, we began to offer MedicareAdvantage PFFS plans in New York and Pennsylvania. As of January 2006, weare marketing PFFS plans in a total of 15 states.

***Medicare Supplement***

Medicare Supplement insurance reimburses thepolicyholder for certain expenses that are not covered by standard Medicarecoverage such as deductibles and co-pays. This coverage is designed for peoplewho want the freedom to choose providers who participate in the standardMedicare program, as opposed to the more restrictive networks that exist inMedicare Advantage products. In the past ten years, we have become a successfulprovider of Medicare Supplement coverage as well as other products designed forthe senior market. We believe that the market for Medicare Supplement productswill continue to be attractive, especially because many seniors may losesimilar coverage that had previously been offered to them as a retiree benefitby their former employers.

Recently, there has been increased competition fromother Medicare Supplement carriers, as well as from Medicare Advantage plans,which has affected our production of Medicare Supplement business.

During the third and fourth quarters of 2005, weexperienced Medicare Supplement claim costs that were higher than thecomparable quarters of the prior year, and higher than we had anticipated. Duringthe fourth quarter of 2005, the Company recorded a pre-tax adjustment thatincreased incurred claims by $9.9 million, or $0.11 per diluted share after tax.Two factors caused this action. First, incurred claims increased by $4.4million as a result of a change in the estimate of the Company’s MedicareSupplement claim reserves of $6.8 million, offset by an increase in amountsrecoverable from reinsurers of $2.4 million. 

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Second, the Companydetermined that, over a four year period, it had overstated the amountsrecoverable from reinsurers for ceded Medicare Supplement claim reserves. Duringthe fourth quarter of 2005, the Company decreased its recoverable from reinsurersfor ceded Medicare Supplement claim reserves by $5.5 million. Approximately$1.1 million of the decrease was determined to relate to the first threequarters of 2005 and $3.1 million of the decrease was determined to relate tothe years 2002 through 2004. When the effect of the reserve adjustmentsrelating to prior periods is eliminated, the estimated pro-forma MedicareSupplement loss ratio for the full year 2005 was 73.4%. The increase in ourMedicare Supplement loss ratio was primarily as a result ofhigher-than-anticipated outpatient doctor (Part B) and skilled nursingfacility utilization.

We also experienced higherthan expected lapsation in our Medicare Supplement business. We believe thatthere are a number of factors contributing to the lapsation, includingcompetitive pressure from other Medicare Supplement companies and MedicareAdvantage products, as well as the departure of certain of our sales managers. Thisexcess lapsation required us to accelerate the amortization of the deferred acquisitioncost and present value of future profits assets associated with the businessthat lapsed. We cannot give assurances that lapsation of our MedicareSupplement business will decline from the 2005 level, requiring fasteramortization of the deferred costs.

***Medicare Part D***

Effective January 1,2006, private insurers were permitted to sponsor insured stand-aloneprescription drug benefit plans (“PDP’s”) pursuant to Part D, which wasestablished by the MMA. A portion of the premium for this insurance is paid bythe Federal government, and the balance, if any, is paid by the individuals whoenroll. The Federal government will also provide additional subsidies in theform of premium support and coverage of the cost-sharing elements of the planto certain low income Medicare beneficiaries. We have been approved to offerthese programs in 32 of the 34 regions that have been established for thisprogram.

***Reinsurance—Connecticut State Employees***

During the third quarterof 2005, we commenced a new reinsurance arrangement with PharmaCare Captive Re,Ltd. Under the terms of the agreement, we provide an insured drug benefit forthe employees of the State of Connecticut. The agreement is renewable annuallyby the State of Connecticut. The risk is reinsured to PharmaCare’s reinsurancesubsidiary under a 100% quota share contract. We receive an underwriting fee oftwo percent of premium. Annualized premium for this program is approximately$260 million. As a result of this arrangement, both direct and ceded premiumincreased by approximately $132 million for the year, with no impact on netpremium.

***Equity Offering***

On June 22, 2005, weissued 2.0 million shares of our common stock at a price of $23.61 per share,in a public offering pursuant to a shelf registration. The issuance of theseshares generated proceeds to us of $44.2 million, net of underwriters discountand other issuance costs. Additionally, 5.0 million shares were sold under thesame shelf registration by Capital Z Financial Services Fund II, L.P. and itsaffiliates (“Capital Z”), our largest shareholder. On July 20, 2005, theunderwriters exercised their over-allotment option and we issued an additional660,000 shares of our common stock at $23.61 per share, generating additionalnet proceeds of $14.8 million. Following the offering, Capital Z owned 20.2million shares, or 34.5% of our outstanding common stock. See “ShelfRegistration and Equity Offering” in the Liquidity section of this Management’sDiscussion and Analysis of Financial Condition and Results of Operations.

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***Acquisition of Heritage Health Systems, Inc.***

On May 28, 2004, weacquired Heritage, a privately owned managed care company that operatesMedicare Advantage plans in Houston and Beaumont Texas, for $98 million in cashplus transaction costs of $1.6 million. The acquisition was financed with $66.5million of net proceeds derived from the amendment of our credit facility and$33.1 million of cash on hand. As of the date of acquisition, Heritage hadapproximately 16,000 Medicare members and annualized revenues of approximately$140 million. Operating results generated by Heritage prior to the date ofacquisition are not included in our consolidated financial statements.

***Acquisition of Guarantee Reserve MarketingOrganization***

Effective July 1,2003, we entered into an agreement with Swiss Re and its newly acquiredsubsidiary, Guarantee Reserve Life Insurance Company (“Guarantee Reserve”), toacquire Guarantee Reserve’s marketing organization, including all rights to dobusiness with its field force. The primary product sold by this marketingorganization is low face amount whole life insurance, primarily for seniors. BeginningJuly 1, 2003, the Guarantee Reserve field force continued to write thisbusiness in Guarantee Reserve, with us administering all new business andassuming 50% of the risk through a quota share reinsurance arrangement. Newbusiness has been written by our subsidiaries with 50% of the risk ceded toSwiss Re beginning in the second quarter of 2004 as the products were approvedfor sale in each state.

***Recapture of Reinsurance Ceded***

Effective April 1,2003, we entered into agreements to recapture approximately $48 million ofMedicare Supplement business that had previously been reinsured to TransamericaOccidental Life Insurance Company, Reinsurance Division under two quota sharecontracts. No ceding allowance was paid in the recapture and we currentlyretain 100% of the risks on the $48 million of Medicare Supplement business. Therewas no gain or loss reported on these recapture agreements.

***Acquisition of Pyramid Life***

On March 31, 2003, weacquired all of the outstanding common stock of Pyramid Life Insurance Company(“Pyramid Life”). Pyramid Life specializes in selling health and life insuranceproducts to the senior market, including Medicare Supplement, long term care,life insurance, and annuities. With this acquisition, we acquired a $120million block of in-force business, as well as a career sales force that isskilled in selling senior market insurance products. As of the date ofacquisition, Pyramid Life marketed its products in 30 states through a careeragency sales force of over 1,000 agents operating out of 39 Senior Solutions® Sales Centers. Operatingresults generated by Pyramid Life prior to the date of acquisition are notincluded in our consolidated financial statements.

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**Resultsof Operations—Consolidated Overview**

Thefollowing table reflects income from each of our segments (1) and contains areconciliation to reported net income:

| ** **                                          | ** ** | **For the year ended December 31,** | ** ** |
|-----------------------------------------------------|------------|--------------------------------------------------------------|------------|
| ** **                                          | ** ** | **2003**                                                     | ** ** | **2004** | ** ** | **2005** | ** ** |
| ** **                                          | ** ** | **(In thousands)**                                      | ** ** |
| Senior Managed  Care-Medicare Advantage(1)          |       | $                                                            | —     |   | $ | 10,136 |   | $ | 27,829 |   |
| Senior Market  Health Insurance(1)                  |       | 27,734                                                       |       | 35,407 |   | 10,181 |   |
| Specialty Health  Insurance(1)                      |       | 24,435                                                       |       | 26,316 |   | 26,948 |   |
| Life Insurance  and Annuity(1)                      |       | 11,981                                                       |       | 13,370 |   | 15,723 |   |
| Senior  Administrative Services(1)                  |       | 11,018                                                       |       | 13,090 |   | 9,449 |   |
| Corporate(1)                                        |       | (10,746                                                      | )          | (12,498 | ) | (13,937 | ) |
| Realized gains                                      |       | 2,057                                                        |       | 10,647 |   | 5,773 |   |
| Income before  income taxes(1)                      |       | 66,479                                                       |       | 96,468 |   | 81,966 |   |
| Income taxes,  excluding capital gains              |       | 23,325                                                       |       | 28,871 |   | 27,734 |   |
| Income taxes on  capital gains                      |       | 720                                                          |       | 3,726 |   | 356 |   |
| Income tax  benefit on early extinguishment of debt |       | (618                                                         | )          | — |   | — |   |
| Total income taxes                                  |       | 23,427                                                       |       | 32,597 |   | 28,090 |   |
| Net income                                          |       | $                                                            | 43,052     |   | $ | 63,871 |   | $ | 53,876 |   |
| Per Share Data  (Diluted):                          |       |                                                         |       |   |   |   |   |
| Net income                                          |       | $                                                            | 0.78       |   | $ | 1.13 |   | $ | 0.91 |   |

 

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(1)          Weevaluate the results of operations of our segments based on income beforerealized gains and income taxes. Management believes that realized gains andlosses are not indicative of overall operating trends. This differs fromgenerally accepted accounting principles, which includes the effect of realizedgains in the determination of net income. The schedule above reconciles oursegment income to net income in accordance with generally accepted accountingprinciples.

***Years ended December 31, 2005 and 2004***

Net income for 2005 declined 16% to $53.9 million, or$0.91 per diluted share, compared to $63.9 million, or $1.13 per diluted sharein 2004. Net income for 2005 was affected by higher claim costs and reserveadjustments in our Medicare Supplement business, which reduced net income by$6.3 million, or $0.11 per diluted share, and increased lapsation of ourMedicare Supplement in force business, which resulted in an acceleration of theamortization of deferred acquisition costs and present value of future profitswhich reduced net income by $1.7 million, or $0.03 per diluted share.Additionally, net income for 2005 was reduced by after-tax expenses of $8.1million, or $0.14 per diluted share, relating to the implementation of our Part Dprogram and Medicare Advantage growth initiatives. These items are offset, inpart, by the growth in our Senior Managed Care business, which added $11.5million, or $0.21 per diluted share, in 2005.

Net income for 2005 includes realized investmentgains, net of tax, of $5.4 million, or $0.09 per diluted share, which reflectsthe benefit from a $1.6 million release of a tax valuation allowance relatingto capital loss carryforwards. The realized investment gains during 2005 weregenerated as we took advantage of the tightening of the yield curve and soldlonger duration investments. Net income for 2004 includes realized investmentgains, net of tax, of $6.9 million, or $0.12 per diluted share.

Our overall effective tax rate was 34.3% for 2005,reflecting the release of the valuation allowance noted above, and 33.8% for2004.

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Our Senior Managed Care—Medicare Advantage segmentgenerated segment income of $27.8 million during 2005, an increase of $17.7million, compared to $10.1 million in 2004, primarily due to the inclusion ofthe results of Heritage for the full year in 2005 compared to only seven monthsin 2004 and the continued growth in membership in our Medicare Advantage plans.This segment includes the results of Heritage and our other initiatives inMedicare managed care, including our Medicare Advantage private fee-for-serviceplans, since our acquisition or inception during the second quarter of 2004.

Our Senior Market Health Insurance segment generatedsegment income of $10.2 million during 2005, a 71% decline compared to segmentincome of $35.4 million in 2004. Segment income for 2005 was affected by higherclaim costs and reserve adjustments in our Medicare Supplement lines andincreased lapsation of our Medicare Supplement in force business, whichresulted in an acceleration of the amortization of deferred acquisition costsand present value of future profits. Additionally, segment income for 2005 wasreduced by expenses of $4.8 million relating to the implementation of our Part Dprogram.

Our Specialty Health Insurance segment income of $26.9million for 2005 improved by 2% compared to $26.3 million for 2004, primarilyas a result of the underwriting fees earned on the new reinsurance arrangementwith PharmaCare Re and the strengthening of the Canadian dollar, partiallyoffset by higher claim costs.

Results for our Life Insurance and Annuity segmentimproved by $2.4 million, or 18%, to $15.7 million compared to 2004, primarilyas a result of an increase in renewal business and lower claim costs.

Segment income for our Senior Administrative Servicessegment decreased by $3.6 million, or 28%, to $9.4 million compared to 2004,primarily as a result of the $5.9 million of expenses incurred in this segmentrelating to our implementation of Part D, offset in part by growth inpremiums managed.

The loss from ourCorporate segment increased by $1.4 million, or 12%, compared to 2004. Theincrease was due primarily to higher interest cost as a result of an increasein the amount of the debt outstanding during the year, relating to theamendment of our credit facility in connection with our acquisition ofHeritage, and an increase in the weighted average interest rates, as comparedto 2004.

***Years ended December 31, 2004 and 2003***

Net income for 2004 increased 48% to $63.9 million, or$1.13 per share, compared to $43.1 million, or $0.78 per share in 2003. During2004, we recognized realized gains, net of tax, of $6.9 million, or $0.12 pershare, compared to realized gains, net of tax, of $1.3 million, or $0.02 pershare in 2003. The realized gains in 2004 were generated at Penncorp Life(Canada) as a result of the sale of investments to fund the dividend ofapproximately $19.9 million paid to the parent company during the first quarterof 2004 and the tax payments made during the first quarter of 2004 relating to2003 taxable income. See “Liquidity and Capital Resources—Obligations of theParent Company to Affiliates” for additional information regarding the dividend.Additionally, during the third quarter of 2004, we took the opportunity torealize investment gains as interest rates dropped during the year to makeefficient use of our tax capital loss carryforwards. We believe that furtheropportunity for generating realized investment gains is limited. Our overalleffective tax rate was 33.8% for 2004 and 35.2% for 2003.

Our Senior Managed Care—Medicare Advantage segmentincludes the results of Heritage and our other initiatives in Medicare managedcare, including our Medicare Advantage private fee for service plans, for theseven months since acquisition or inception.

Our Senior Market Health Insurance segment resultsimproved by $7.7 million, or 28%, to $35.4 million in 2004 compared to 2003,primarily as a result of the Pyramid Life business being included for a fullyear in 2004 compared to nine months in 2003 and increased retention of theMedicare Supplement 

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business. We haveincreased our retention to 100% for all Medicare Supplement business soldbeginning January 1, 2004.

Our Specialty Health Insurance segment resultsimproved by $1.9 million, or 8%, to $26.3 million in 2004 compared to 2003,primarily as a result of improvement in loss ratios, as well as thestrengthening of the Canadian dollar, relative to the U.S. dollar.

Results for our Life Insurance and Annuity segmentimproved by $1.4 million, or 12%, to $13.4 million in 2004 compared to 2003,primarily as a result of an increase in business and more favorable morbidity.

Our Senior Administrative Services segment incomeimproved by $2.1 million, or 19%, compared to 2003. This improvement wasprimarily a result of the growth in premiums managed.

The loss from ourCorporate segment increased by $1.8 million, or 16%, compared to the 2003. Theincrease was due to higher interest cost as a result of an increase in theamount of the debt outstanding during the year, relating to the amendment ofour credit facility in connection with our acquisition of Heritage, offset inpart, by a reduction in the weighted average interest rates, as compared to thesame period of 2003.

**SegmentResults—Senior Managed Care—Medicare Advantage**

| ** **                                                                              | ** ** | **For the year ended December 31,** | ** ** |
|-----------------------------------------------------------------------------------------|------------|--------------------------------------------------------------|------------|
| ** **                                                                              | ** ** | **2003**                                                     | ** ** | **2004(2)** | ** ** | **2005** | ** ** |
| ** **                                                                              | ** ** | **(In thousands)**                                      | ** ** |
| Net premiums                                                                            |       |                                                         | $          | — |   |   | $ | 93,011 |   | $ | 237,891 |   |
| Net and other  investment income                                                        |       |                                                         | —     |   |   | 517 |   | 2,859 |   |
| Total revenue                                                                           |       |                                                         | —     |   |   | 93,528 |   | 240,750 |   |
| Medical expenses                                                                        |       |                                                         | —     |   |   | 66,449 |   | 170,900 |   |
| Amortization of  intangible assets                                                      |       |                                                         | —     |   |   | 1,901 |   | 2,292 |   |
| Commissions and  general expenses                                                       |       |                                                         | —     |   |   | 15,042 |   | 39,729 |   |
| Total benefits, claims and other deductions                                             |       |                                                         | —     |   |   | 83,392 |   | 212,921 |   |
| Segment income                                                                          |       |                                                         | —     |   |   | 10,136 |   | 27,829 |   |
| Depreciation,  amortization and interest                                                |       |                                                         | —     |   |   | 2,185 |   | 2,961 |   |
| Earnings before  interest, taxes, depreciation and amortization (“EBITDA”)(1) |       |                                                         | $          | — |   |   | $ | 12,321 |   | $ | 30,790 |   |

 

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(1)          In addition to segmentincome, we also evaluate the results of our Medicare Advantage segment based onearnings before interest, taxes, depreciation and amortization (“EBITDA”). EBITDAis a common alternative measure of performance used by investors, financialanalysts and rating agencies. It is also a measure that is included in thefixed charge ratio required by the covenants for our outstanding bank debt. Accordingly,these groups use EBITDA, along with other measures, to estimate the value of acompany and evaluate the Company’s ability to meet its debt servicerequirements. While we consider EBITDA to be an important measure ofcomparative operating performance, it should not be construed as an alternativeto segment income or cash flows from operating activities (as determined inaccordance with generally accepted accounting principles).

(2)          Includes results for theseven months since acquisition or inception.

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Our Senior Managed Care - Medicare Advantage segmentincludes the operations of Heritage and our other initiatives in Medicaremanaged care, including our Medicare Advantage private fee-for-service plansand special needs plan. Heritage generates its revenues and profits from threesources. First, Heritage owns an interest in SelectCare of Texas (“SCOT”), ahealth plan that offers coverage to Medicare beneficiaries in Houston andBeaumont, Texas, under a contract with CMS. Next, Heritage operates three separateManagement Service Organizations (“MSO’s”) that manage the business ofSelectCare and two affiliated Independent Physician Associations (“IPA’s”).Lastly, Heritage participates in the profits derived from these IPA’s.

Starting in June 2004, American Progressive, aninsurance subsidiary of Universal American, began enrolling members in itsprivate fee-for-service (“PFFS”) product, a Medicare Advantage program thatallows its members to have more flexibility in the delivery of their healthcare services than other Medicare Advantage plans. In addition to premiumreceived from CMS, we receive modest premium payments from the members. BeginningSeptember 1, 2005, we have expanded our PFFS product offering to Medicareeligibles in 258 counties in seven new states. As part of this expansionPyramid Life, an insurance subsidiary of Universal American, began enrollingmembers in its PFFS product. As of January 1, 2006, we expanded the PFFSproduct to an additional 152 counties in six states.

In August 2005, SelectCare of Oklahoma (“SCOK”),a wholly owned subsidiary of Heritage, began enrolling members in a MedicareAdvantage special needs program that provides health care management servicesto Medicare eligible seniors in nursing home facilities in ten counties inOklahoma.

The components ofthe revenues and results within the segment are as follows:

| ** **                | ** ** | **For the years ended December 31,** | ** ** |
|---------------------------|------------|---------------------------------------------------------------|------------|
| ** **                | ** ** | **2004**                                                      | ** ** | **2005** | ** ** |
| ** **                | ** ** | **Revenue**                                                   | ** ** | **Segment Income** | ** ** | **Revenue** | ** ** | **Segment Income** | ** ** |
| ** **                | ** ** | **(In thousands)**                                       | ** ** |
| Health Plans              |       | $                                                             | 90,497     |   |   | $ | 3,722 |   |   | $ | 217,319 |   |   | $ | 9,590 |   |   |
| Affiliated IPA’s     |       | 58,517                                                        |       |   | 5,619 |   |   | 118,245 |   |   | 12,023 |   |   |
| MSO’s and  Corporate |       | 15,843                                                        |       |   | 1,124 |   |   | 35,991 |   |   | 3,764 |   |   |
| Private Fee-for  Service  |       | 3,333                                                         |       |   | (329 | ) |   | 22,157 |   |   | 2,452 |   |   |
| Eliminations              |       | (74,662                                                       | )          |   | — |   |   | (152,962 | ) |   | — |   |   |
| Total                     |       | $                                                             | 93,528     |   |   | $ | 10,136 |   |   | $ | 240,750 |   |   | $ | 27,829 |   |   |

 

Intra-segment revenues are reported on a gross basisin each of the above components of the Medicare Advantage segment. Theseintra-segment revenues are eliminated in the consolidation for the segmenttotals. The eliminations include premiums received by the IPA’s from the HealthPlan amounting to $117.7 million for 2005 and $59.1 million for the sevenmonths since the acquisition of Heritage in 2004 and management fees receivedby the MSO’s from the Health Plan and the IPA’s amounting to $35.2 million for2005 and $15.6 million for the seven months since the acquisition of Heritagein 2004.

Heritage operates a health plan through SCOT, aprovider sponsored organization (“PSO”). SCOT offers Medicare Advantagecoordinated care plans operating in Southeastern Texas, including Beaumont andHouston, and receives its premiums primarily from CMS. SCOT makes capitatedrisk payments to IPA’s or other medical groups in the Houston and Beaumontregions, two of which are affiliated IPA’s. In addition, SCOT retains the riskfor certain other types of care, primarily out of area emergency andtransplants. As of December 31, 2005, SCOT had 24,834 members enrolled. Asof December 31, 2005, SCOK had 98 members enrolled in its special needsplan. During 2005, the health plans had revenues of $217.3 million and reporteda medical loss ratio of 82.3%. For the seven months since the acquisition ofHeritage in 2004, the health plans had revenues of $90.5 million and reported amedical loss ratio of 83.3%.

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Heritage participates in the profits from the twoaffiliated IPA’s that receive capitated payments from SCOT. As of December 31,2005, the affiliated IPA’s managed the care for approximately 15,795 SCOTmembers. During 2005, the IPA’s earned $12.0 million on $118.2 million inrevenues received from SCOT. For the seven months since the acquisition ofHeritage in 2004, the IPA’s earned $5.6 million on $58.5 million in revenuesreceived from SCOT.

Heritage owns three MSO’s that provide comprehensivemanagement services to SCOT and its affiliated IPA’s as part of long-termmanagement agreements. Services provided include strategic planning, providernetwork services, marketing, finance and accounting, enrollment, claimsprocessing, information systems, utilization review, credentialing and qualitymanagement. For 2005, these MSO’s earned $3.8 million of income on $36.0million of fees collected. For the seven months since the acquisition ofHeritage in 2004, these MSO’s earned $1.1 million of income on $15.8 million offees collected.

As of December 31,2005, American Progressive and Pyramid Life had 5,078 members enrolled in theirPFFS plans. During 2005, American Progressive and Pyramid Life collected $22.2million of premium from CMS and the members, and reported a medical loss ratioof 67.2%. For the seven months since inception in 2004, American Progressiveand Pyramid Life collected $3.3 million of premium from CMS and the members,and reported a medical loss ratio of 75.4%.

**SegmentResults—Senior Market Health Insurance**

| ** **                                           | ** ** | **For the year ended December 31,** | ** ** |
|------------------------------------------------------|------------|--------------------------------------------------------------|------------|
| ** **                                           | ** ** | **2003**                                                     | ** ** | **2004** | ** ** | **2005** | ** ** |
| ** **                                           | ** ** | **(In thousands)**                                      | ** ** |
| **Premiums:**                                        |       |                                                         |       |   |   |   |   |
| Direct and assumed                                   |       | $                                                            | 511,272    |   | $ | 567,445 |   | $ | 571,486 |   |
| Ceded                                                |       | (243,215                                                     | )          | (212,122 | ) | (180,966 | ) |
| Net premiums                                         |       | 268,057                                                      |       | 355,323 |   | 390,520 |   |
| Net investment  income                               |       | 3,341                                                        |       | 4,167 |   | 4,783 |   |
| Other income                                         |       | 221                                                          |       | 859 |   | 1,001 |   |
| Total revenue                                        |       | 271,619                                                      |       | 360,349 |   | 396,304 |   |
| Policyholder  benefits                               |       | 184,493                                                      |       | 246,019 |   | 291,696 |   |
| Change in  deferred acquisition costs                |       | (21,914                                                      | )          | (32,878 | ) | (31,035 | ) |
| Amortization of  intangible assets                   |       | 1,823                                                        |       | 1,973 |   | 3,858 |   |
| Commissions and  general expenses, net of allowances |       | 79,483                                                       |       | 109,828 |   | 121,604 |   |
| Total benefits, claims and other deductions          |       | 243,885                                                      |       | 324,942 |   | 386,123 |   |
| Segment income                                       |       | $                                                            | 27,734     |   | $ | 35,407 |   | $ | 10,181 |   |

 

***Years ended December 31, 2005 and 2004***

Our Senior Market Health Insurance segment generatedsegment income of $10.2 million during 2005, a 71% decline compared to segmentincome of $35.4 million in 2004. Segment income for 2005 was affected by higherclaim costs and reserve adjustments in our Medicare Supplement lines andincreased lapsation of our Medicare Supplement in force business, whichresulted in an acceleration of the amortization of deferred acquisition costsand present value of future profits. Additionally, segment income for 2005 wasreduced by expenses of $4.8 million relating to the implementation of our Part Dprogram.

*Revenues.**  *Net premiums for the Senior Market Health Insurancesegment increased by $35.2 million, or 10%, compared to 2004, due to increasedretention of our Medicare Supplement business, rate increases and new sales.

*Benefits,Claims and Expenses.**  *Policyholderbenefits incurred increased by $45.7 million, or 19%, compared to 2004. Overallloss ratios for the segment increased 550 basis points to 74.7% for 2005 

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compared to 69.2% for 2004.During the fourth quarter of 2005, the Company recorded a pre-tax adjustmentthat increased incurred claims by $9.9 million. Two factors caused this action.First, incurred claims increased by $4.4 million as a result of a change in theestimate of the Company’s Medicare Supplement claim reserves of $6.8 million,offset by an increase in amounts recoverable from reinsurers of $2.4 million. Second,the Company determined that, over a four year period, it had overstated theamounts recoverable from reinsurers for ceded Medicare Supplement claimreserves. During the fourth quarter of 2005, the Company decreased itsrecoverable from reinsurers for ceded Medicare Supplement claim reserves by$5.5 million. Approximately $1.1 million of the decrease was determined torelate to the first three quarters of 2005 and $3.1 million of the decrease wasdetermined to relate to the years 2002 through 2004. When the effect of thereserve adjustments relating to prior periods is eliminated, the estimatedpro-forma Medicare Supplement loss ratio for the full year 2005 was 73.4%. Theincrease in our Medicare Supplement loss ratio was primarily as a result ofhigher-than-anticipated outpatient doctor (Part B) and skilled nursingfacility utilization. Approximately $10.0 million of the increase related tothe increase in the loss ratio, exclusive of the reserve adjustment noted above.Additionally, higher net premiums added approximately $25.8 million topolicyholder benefits.

The increase in deferred acquisition costs was $1.8million less for 2005, than the increase for 2004. We experienced higher thanexpected lapsation in our Medicare Supplement business beginning in the thirdquarter of 2005. We believe that there are a number of factors contributing tothe lapsation, including competitive pressure from other Medicare Supplementcompanies and Medicare Advantage products, as well as the departure of certainof our sales managers. This excess lapsation required us to accelerate theamortization of the deferred acquisition cost and present value of futureprofits assets associated with the business that lapsed. The excess lapsationof our Medicare supplement in force resulted in the acceleration ofapproximately $4.6 million in the amortization of deferred acquisition costs. Excludingthe effect of the excess lapsation, the increase in deferred acquisition costswas $2.7 million more for 2005, than for 2004, primarily as a result of higherretained premium and the effect of prospective unlocking resulting from higherthan anticipated rate increases and better than anticipated persistency(excluding the lapses incurred from the departure of the sales managersdiscussed above). As a percentage of premium, the increase in deferredacquisition costs, excluding the effect of the excess lapsation, was 9.1% for2005 compared to 9.3% for 2004.

The amortization of intangibles relates primarily tointangibles recorded from the acquisition of Pyramid Life, and increased by$1.9 million compared to 2004, due to the excess lapsation of in force businessnoted above.

Commissions andgeneral expenses increased by $11.8 million, or 11%, compared to 2004. Thefollowing table details the components of commission and other operatingexpenses:

| ** **                                           | ** ** | **2004**                | ** ** | **2005** | ** ** |
|------------------------------------------------------|------------|-------------------------|------------|----------|------------|
| ** **                                           | ** ** | **(In thousands)** | ** ** |
| Commissions                                          |       | $                       | 84,977     |     | $          | 81,470 |   |
| Other operating  costs                               |       | 72,269                  |       | 77,335   |       |
| Reinsurance  allowances                              |       | (47,418                 | )          | (37,201  | )          |
| Commissions and general  expenses, net of allowances |       | $                       | 109,828    |     | $          | 121,604 |   |

 

The ratio of commissionsto gross premiums decreased to 14.3% for 2005, from 15.0% for 2004, as a resultof lower overall commission rates associated with the continued growth of ourin force renewal premium. Other operating costs as a percentage of grosspremiums were 13.5% for 2005, compared to 12.7% for 2004. The increase relatesprimarily to the $4.8 million of expenses related to the implementation of our Part Dprogram. Commission and expense allowances received from reinsurers as apercentage of the premiums ceded decreased to 20.6% for 2005 from 22.4% for2004, primarily due to the reduction in new business ceded and the effects ofnormal lower commission allowances on our aging base of ceded renewal business.

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***Years ended December 31, 2004 and 2003***

Our Senior Market Health Insurance segment resultsimproved by $7.7 million, or 28%, to $35.4 million in 2004 compared to 2003,primarily as a result of the inclusion of the results of operations of thePyramid Life business for a full year in 2004 compared to only nine months in 2003and increased retention of the Medicare Supplement business. We have increasedour retention to 100% for all Medicare Supplement business sold as of January 1,2004.

*Revenues.**  *Net premiums for the Senior Market Health Insurancesegment increased by $87.3 million, or 33%, compared to 2003. Approximately$28.2 million, or 11%, relates to additional premiums from the Pyramid Lifebusiness as a result of the inclusion of the results of operations of thePyramid Life business for a full year in 2004 compared to only nine months in2003. $59.1 million, or 22%, is due to growth and increased retention of theMedicare Supplement business

Net investment income increased by approximately $0.8million, or 25%, compared to 2003. The increase is due primarily to growth ininvested assets due to growth in business.

*Benefits,Claims and Expenses.**  *Policyholderbenefits, including the change in reserves, increased by $61.5 million, or 33%,during 2004 compared to 2003, primarily as a result of the increased retentionof the Medicare Supplement business noted above, the effect of a full year ofthe Pyramid Life operations and a modest increase in loss ratios. Overall lossratios for the segment increased to 69.2% in 2004 compared to 68.8% in 2003,which accounted for $1.3 million of the increase in benefits. The additionalquarter of the Pyramid Life business contributed $19.6 million and the growthand increased retention rate added the balance of $40.6 million to theincrease.

The change in deferred acquisition costs was $11.0million more in 2004, compared to the amount in 2003. $3.7 million of thischange is due to the Pyramid Life business being included for a full year in2004 compared to nine months in 2003. The balance of $7.3 million is a resultof growth and the increased retention of the Medicare Supplement business.

The amortization of intangibles relates primarily tointangibles relating to the acquisition of Pyramid Life.

Commissions andgeneral expenses increased by $30.3 million, or 38%, in 2004 compared to 2003. $7.8million of this increase is due to the inclusion of an additional quarter ofthe results of operations of the Pyramid Life business and the balance of $22.5million is due to higher net commission expense due to the growth and increasedretention of the Medicare Supplement business. The following table details thecomponents of commission and other operating expenses:

| ** **                                           | ** ** | **2003**                | ** ** | **2004** | ** ** |
|------------------------------------------------------|------------|-------------------------|------------|----------|------------|
| ** **                                           | ** ** | **(In thousands)** | ** ** |
| Commissions                                          |       | $                       | 78,014     |     | $          | 84,977 |   |
| Other operating  costs                               |       | 61,236                  |       | 72,269   |       |
| Reinsurance  allowances                              |       | (59,767                 | )          | (47,418  | )          |
| Commissions and general  expenses, net of allowances |       | $                       | 79,483     |     | $          | 109,828 |   |

 

The ratio of commissionsto gross premiums decreased to 15.0% during 2004, from 15.3% in 2003, as aresult of the growth in the in force renewal premium from better persistencyand rate increases. Other operating costs as a percentage of gross premiumsincreased to 12.7% during 2004 from 12.0% in 2003. Commission and expenseallowances received from reinsurers as a percentage of the premiums ceded alsodecreased to 22.4% during 2004 from 24.6% in 2003, primarily due to thereduction in new business ceded and the affects of normal lower commissionallowances on an aging base of renewal ceded business.

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**SegmentResults—Specialty Health Insurance**

| ** **                                           | ** ** | **For the year ended December 31,** | ** ** |
|------------------------------------------------------|------------|--------------------------------------------------------------|------------|
| ** **                                           | ** ** | **2003**                                                     | ** ** | **2004** | ** ** | **2005** | ** ** |
| ** **                                           | ** ** | **(In thousands)**                                      | ** ** |
| **Premiums:**                                        |       |                                                         |       |   |   |   |   |
| Direct and assumed                                   |       | $                                                            | 173,746    |   | $ | 171,959 |   | $ | 301,058 |   |
| Ceded                                                |       | (29,131                                                      | )          | (24,416 | ) | (153,227 | ) |
| Net premiums                                         |       | 144,615                                                      |       | 147,543 |   | 147,831 |   |
| Net investment  income                               |       | 26,970                                                       |       | 26,351 |   | 27,152 |   |
| Other income                                         |       | 546                                                          |       | 874 |   | 1,264 |   |
| Total revenue                                        |       | 172,131                                                      |       | 174,768 |   | 176,247 |   |
| Policyholder  benefits                               |       | 97,204                                                       |       | 96,932 |   | 102,276 |   |
| Change in  deferred acquisition costs                |       | (10,553                                                      | )          | (8,292 | ) | (8,799 | ) |
| Commissions and  general expenses, net of allowances |       | 61,045                                                       |       | 59,812 |   | 55,822 |   |
| Total benefits, claims and other deductions          |       | 147,696                                                      |       | 148,452 |   | 149,299 |   |
| Segment income                                       |       | $                                                            | 24,435     |   | $ | 26,316 |   | $ | 26,948 |   |

 

***Years ended December 31, 2005 and 2004***

Our Specialty Health Insurance segment income improvedby 2%, to $26.9 million for 2005, compared to $26.3 million for 2004, primarilyas a result of the underwriting fees earned on the new reinsurance arrangementwith PharmaCare Re and the strengthening of the Canadian dollar, partiallyoffset by higher claim costs. The operations of Penncorp Life (Canada), whichare included in our Specialty Health segment results, are transacted using theCanadian dollar as the functional currency. The Canadian dollar strengthenedrelative to the U.S. dollar in 2005. The average conversion rate increased 7%,to C$0.8256 per U.S.$1.00 for 2005, from C$0.7689 per U.S.$1.00 for 2004. Thisstrengthening added approximately $1.0 million of pre-tax income to theSpecialty Health segment results compared to 2004. See discussion below underthe heading “Quantitative and Qualitative Disclosures about Market Risk” foradditional information.

*Revenues.**  *Both direct and ceded premium for the SpecialtyHealth Insurance segment increased approximately $132.2 million in connectionwith the PharmaCare Re reinsurance agreement discussed above. Net premiumsincreased by $0.3 million, or less than 1%, compared to 2004. Canadian businessaccounted for approximately 43% of the net premiums of this segment for 2005and 40% of the net premiums for 2004. The stronger Canadian dollar andincreased sales in Canada generated an increase in premiums of approximately$5.0 million, which was offset by reductions of $3.1 million in our U.S. fixedbenefit accident and sickness line, $1.0 million in our long term care line and$0.5 million in our major medical and other lines.

Net investment income increased by approximately $0.8million, or 3%, compared to 2004. The increase is due primarily to investingcash that we had been accumulating in anticipation of rising interest rates.

*Benefits,Claims and Expenses.**  *Policyholderbenefits incurred increased by $5.3 million, or 6%, compared to 2004, primarilyas a result of higher loss ratios for our U.S. fixed benefit accident andsickness line, our Canadian business and our long term care line. Overall lossratios for the segment increased to 69.2% for 2005 compared to 65.7% for 2004.

The increase in deferred acquisition costs was $0.5million more in 2005 than the increase in 2004, primarily as a result of theincrease in commissions and acquisition costs for our Canadian business.

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Commissions and generalexpenses decreased by $4.0 million, or 7%, in 2005 compared to 2004, primarilyas a result of an increase in reinsurance allowances of $2.6 million due to theunderwriting fees earned on the new reinsurance arrangement with PharmaCare Re.Commissions for our U.S. fixed benefit accident and sickness line decreased by$2.3 million and commissions for our long term care line decreased by $0.9million as a result of the decline in premiums for those lines. Commissions forour Canadian business increased by $1.7 million, consistent with the increasedsales.

***Years ended December 31, 2004 and 2003***

Our Specialty Health Insurance segment resultsimproved by $1.9 million, or 8%, to $26.3 million in 2004 compared to 2003,primarily as a result of improvement in loss ratios, as well as thestrengthening of the Canadian dollar. The operations of Penncorp Life (Canada),which are included in our Specialty Health segment results, are transactedusing the Canadian dollar as the functional currency. The Canadian dollarstrengthened relative to the U.S. dollar in 2004. The average conversion rateincreased 8%, to C$0.7689 per U.S.$1.00 for 2004, from C$0.7141 per U.S.$1.00for 2003. This strengthening added approximately $1.0 million of pre-tax incometo the Specialty Health segment results for 2004, compared to 2003. Seediscussion below under the heading “Quantitative and Qualitative Disclosuresabout Market Risk” for additional information.

*Revenues.  *Net premiums for the Specialty Health Insurancesegment increased by $2.9 million, or 2%, compared to 2003. Approximately, $1.9million of the increase relates to additional long term care and major medicalpremiums from the inclusion of the results of operations of Pyramid Lifebusiness for a full year in 2004 compared to only nine months in 2003. Thebalance of the increase is due to rate increases, offset by a reduction in longterm care premium as a result of our decision to discontinue marketing that product,beginning in late 2003. Canadian business accounted for approximately 40% ofthe net premiums of this segment in 2004 and 38% of the net premiums in 2003,the increase attributed to the stronger Canadian dollar.

Net investment income decreased by approximately $0.6million, or 2%, compared to 2003. The decrease is due primarily to acombination of lower yields and a decrease in invested assets, due to thedividend paid by Penncorp Life (Canada) to our parent holding company in early2004.

*Benefits, Claims and Expenses.*   Policyholderbenefits, including the change in reserves, decreased by $0.3 million, or lessthan 1%, during 2004 compared to 2003, primarily as a result of improved lossratios. Overall loss ratios for the segment declined to 65.5% in 2004 comparedto 67.2% in 2003. During 2004 we recorded a non-recurring reduction in reservesin the amount of U.S. $1.3 million (C$1.8 million) which was identified duringa review in connection with a conversion of the actuarial system used todetermine reserves on our Canadian policies. Additionally, during 2004, weincreased reserves on the runoff block of Florida home healthcare business by$1.4 million as a result of an actuarial study performed on this block.

The increase in deferred acquisition costs was $2.3million less in 2004, compared to the increase in 2003. This was a result of alower level of new business being written relative to the amortization ofamounts previously capitalized.

Commissions and generalexpenses decreased by $1.2 million, or 2%, in 2004 compared to 2003. Approximately$0.6 million of the decrease relates to reductions in general expenses and thebalance relates to lower commission expense as a result of the reduction in newbusiness sold.

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**SegmentResults—Life Insurance and Annuity**

| ** **                                           | ** ** | **For the year ended December 31,** | ** ** |
|------------------------------------------------------|------------|--------------------------------------------------------------|------------|
| ** **                                           | ** ** | **2003**                                                     | ** ** | **2004** | ** ** | **2005** | ** ** |
| ** **                                           | ** ** | **(In thousands)**                                      | ** ** |
| **Premiums  :**                                      |       |                                                         |       |   |   |   |   |
| Direct and assumed                                   |       | $                                                            | 43,933     |   | $ | 61,543 |   | $ | 76,565 |   |
| Ceded                                                |       | (7,793                                                       | )          | (11,506 | ) | (16,825 | ) |
| Net premiums                                         |       | 36,140                                                       |       | 50,037 |   | 59,740 |   |
| Net investment  income                               |       | 30,742                                                       |       | 34,207 |   | 36,299 |   |
| Other income                                         |       | 208                                                          |       | 279 |   | 129 |   |
| Total revenue                                        |       | 67,090                                                       |       | 84,523 |   | 96,168 |   |
| Policyholder  benefits                               |       | 26,411                                                       |       | 34,844 |   | 37,523 |   |
| Interest credited  to policyholders                  |       | 14,900                                                       |       | 18,617 |   | 19,069 |   |
| Change in  deferred acquisition costs                |       | (18,637                                                      | )          | (24,337 | ) | (16,906 | ) |
| Amortization of  intangible assets                   |       | 817                                                          |       | 925 |   | 269 |   |
| Commissions and  general expenses, net of allowances |       | 31,618                                                       |       | 41,104 |   | 40,490 |   |
| Total benefits, claims and other deductions          |       | 55,109                                                       |       | 71,153 |   | 80,445 |   |
| Segment income                                       |       | $                                                            | 11,981     |   | $ | 13,370 |   | $ | 15,723 |   |

 

**Years ended December 3**1, 2005 and 2004

Results for our Life Insurance and Annuity segmentimproved by $2.4 million, or 18%, to $15.7 million compared to 2004, primarilyas a result of an increase in renewal business and lower claim costs.

Revenues.   Net premiums forthe segment increased by $9.7 million, or 19%, compared to 2004. Approximately$9.3 million of the increase relates to the growth in renewal premiums for oursenior life product. Ceded premiums increased by approximately $5.3 million,primarily as a result of the increase in our senior life premiums.

Our agents sold $44.8 million of fixed annuitiesduring 2005 and $72.0 million during 2004. Annuity deposits are not consideredpremiums for reporting in accordance with generally accepted accountingprinciples. The reduction in annuity sales was the result of lower interestcrediting rates offered and our reduced emphasis on this business as wecontinue our focus more on providing health insurance alternatives to thegrowing senior market.

Net investment income increased by approximately $2.1million, or 6%, compared to the 2004, primarily as a result of the increase inpolicyholder account balances as a result of the additional deposits receivedas noted above, offset by a decline in yields on the portfolio.

*Benefits, Claims and Expenses.  *Policyholderbenefits incurred increased by $2.7 million, or 8%, compared to 2004. Theincrease in business and related reserves added approximately $6.9 million topolicyholder benefits during 2005, however this was offset by approximately$4.1 million as a result of favorable mortality, including a larger amount ofreinsurance to offset claims, as compared to 2004. Interest credited increasedby $0.5 million, due to the increase in policyholder account balances as aresult of continued annuity sales, offset by a reduction in our overallcredited rates. The increase in deferred acquisition costs was $7.4 millionless during 2005, as compared to the increase in 2004. This was primarily dueto lower production of new senior life insurance and annuity business during2005, resulting in a lower level of acquisition costs to capitalize, as well asincreased levels of amortization corresponding to the increased level ofinsurance in force. Commissions and general expenses decreased by $0.6 million,or 2%, compared to 2004, due to the lower levels of new senior life insurancean annuity business, as noted above.

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***Years ended December 31, 2004 and 2003***

Results for our Life Insurance and Annuity segmentimproved by $1.4 million, or 12%, to $13.4 million in 2004 compared to 2003,primarily as a result of an increase in business and more favorable morbidity.

*Revenues.  *Net premiums forthe segment increased by $13.9 million, or 39%, compared to 2003. Approximately,$7.1 million of the increase relates to the net business produced by the formerGuarantee Reserve field force acquired in mid 2003. Approximately $2.5 millionof the increase relates to additional premiums from the Pyramid Life businessas a result of inclusion of the results of operations of the Pyramid businessfor a full year in 2004 compared to only nine months in 2003. The balancerelates to increased sales of our senior life product and an increase in policyfees on our interest sensitive life and annuity business as a result of thegrowth in the level of deposits for those products. Ceded premiums increased byapproximately $2.3 million as a result of the Guarantee Reserve business. During2003, prior to receiving approval to write the business through the insurancesubsidiaries of Universal American, 50% of the business was assumed from SwissRe. As we received the regulatory approvals, we wrote the business through ourinsurance subsidiaries and ceded 50% back to Swiss Re. The balance of theincrease in the ceded premiums relates to the increase in our senior lifebusiness.

Our agents sold $72.0 million of fixed annuitiesduring 2004 and $120.7 million in 2003. Annuity deposits are not consideredpremiums for reporting in accordance with generally accepted accountingprinciples. The reduction in annuity sales was the result of lower interestcrediting rates on policy account balances and a decrease in minimum guaranteedcrediting rates on our policies from the rates existing in 2003.

Net investment income increased by approximately $3.5million, or 11%, compared to 2003. Approximately $4.9 million relates to theincrease in policyholder account balances as a result of the additionaldeposits received as noted above. This was offset by a decline in yields on theportfolio.

*Benefits, Claims and Expenses.  *Policyholderbenefits, including the change in reserves, increased by $8.4 million, or 32%,during 2004 compared to 2003, consistent with the increase in premiums. Claimsbenefits incurred for the segment declined in 2004 compared to 2003, as aresult of more favorable mortality. Interest credited increased by $3.7million, due to the increase in policyholder account balances as a result ofcontinued annuity sales, offset by a reduction in credited rates. In addition,during the fourth quarter of 2004, we recorded approximately $0.3 million inadditional benefits on certain replacement annuity policies that we determinedcontained inappropriate disclosure information to the insured. There is noadditional liability to these policyholders.

The increase in deferred acquisitioncosts was approximately $5.7 million more in 2004, compared to the increase in2003. This is directly related to the increase in commissions and otheracquisition costs related to the new life and annuity business produced duringthe year. The amortization of intangible assets relates to the present value ofthe future profits of the life business acquired with Pyramid Life. Commissionsand general expenses increased by $9.5 million, or 30%, in 2004 compared to2003, consistent with the increase in premium.

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**SegmentResults—Senior Administrative Services**

| ** **                                                                              | ** ** | **For the year ended December 31,** | ** ** |
|-----------------------------------------------------------------------------------------|------------|--------------------------------------------------------------|------------|
| ** **                                                                              | ** ** | **2003**                                                     | ** ** | **2004** | ** ** | **2005** | ** ** |
| ** **                                                                              | ** ** | **(In thousands)**                                      | ** ** |
| Affiliated Fee  Revenue                                                                 |       |                                                         |       |   |   |   |   |
| Medicare Supplement                                                                     |       | $                                                            | 22,478     |   | $ | 29,376 |   | $ | 30,602 |   |
| Long term care                                                                          |       | 2,589                                                        |       | 2,752 |   | 2,641 |   |
| Life insurance                                                                          |       | 2,480                                                        |       | 3,942 |   | 3,005 |   |
| Other                                                                                   |       | 1,797                                                        |       | 2,819 |   | 3,101 |   |
| Total Affiliated Revenue                                                                |       | 29,344                                                       |       | 38,889 |   | 39,349 |   |
| Unaffiliated Fee  Revenue                                                               |       |                                                         |       |   |   |   |   |
| Medicare Supplement                                                                     |       | 9,469                                                        |       | 8,557 |   | 8,192 |   |
| Long term care                                                                          |       | 7,065                                                        |       | 6,331 |   | 8,204 |   |
| Non-insurance products                                                                  |       | 1,563                                                        |       | 1,552 |   | 1,461 |   |
| Other                                                                                   |       | 1,042                                                        |       | 1,330 |   | 1,918 |   |
| Total Unaffiliated Revenue                                                              |       | 19,139                                                       |       | 17,770 |   | 19,775 |   |
| Service fee and  other income                                                           |       | 48,483                                                       |       | 56,659 |   | 59,124 |   |
| Net investment  income                                                                  |       | 48                                                           |       | 9 |   | — |   |
| Total revenue                                                                           |       | 48,531                                                       |       | 56,668 |   | 59,124 |   |
| Amortization of  present value of future profits                                        |       | 370                                                          |       | 418 |   | 478 |   |
| General expenses                                                                        |       | 37,143                                                       |       | 43,160 |   | 49,197 |   |
| Total expenses                                                                          |       | 37,513                                                       |       | 43,578 |   | 49,675 |   |
| Segment income                                                                          |       | 11,018                                                       |       | 13,090 |   | 9,449 |   |
| Depreciation,  amortization and interest                                                |       | 2,038                                                        |       | 2,199 |   | 2,285 |   |
| Earnings before  interest, taxes, depreciation and amortization (“EBITDA”)(1) |       | $                                                            | 13,056     |   | $ | 15,289 |   | $ | 11,734 |   |

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(1)          In addition to segmentincome, we also evaluate the results of our Senior Administrative Servicessegment based on earnings before interest, taxes, depreciation and amortization(“EBITDA”). EBITDA is a common alternative measure of performance used byinvestors, financial analysts and rating agencies. It is also a measure that isincluded in the fixed charge ratio required by the covenants for our outstandingbank debt. Accordingly, these groups use EBITDA, along with other measures, toestimate the value of a company and evaluate the Company’s ability to meet itsdebt service requirements. While we consider EBITDA to be an important measureof comparative operating performance, it should not be construed as analternative to segment income or cash flows from operating activities (asdetermined in accordance with generally accepted accounting principles).

Included in unaffiliatedrevenue are fees received to administer certain business of our insurancesubsidiaries that is 100% reinsured to an unaffiliated reinsurer, whichamounted to $4.1 million in the year ended December 31, 2005,$5.3 million for 2004 and $7.4 million for 2003. These fees, togetherwith the affiliated revenue, were eliminated in consolidation.

***Years ended December 31, 2005 and 2004***

Segment income for our Senior Administrative Servicessegment decreased by $3.6 million, or 28%, to $9.4 million compared to 2004,primarily as a result of the $5.9 million of expenses incurred in this segmentrelating to our implementation of Part D, offset in part by growth inpremiums managed.

Service fee revenueincreased by $2.5 million, or 4%, compared to 2004. Affiliated service feerevenue increased by $0.5 million compared to 2004 as a result of the increasein Medicare Supplement business in force at our insurance subsidiaries offset,in part by a decline in revenues for administration of affiliated 

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lifeinsurance business. Unaffiliated service fee revenue increased by $2.0 millioncompared to 2004, due primarily to an increase of $1.9 million, or 30%, forservices for long term care products. General expenses for the segmentincreased by $6.1 million, or 14%, due to the Part D implementation costs,as well as an increase in business.

***Years ended December 31, 2004 and 2003***

Our Senior Administrative Services segment incomeimproved by $2.1 million, or 19%, compared to 2003. This improvement wasprimarily a result of the growth in premiums managed. EBITDA for this segmentincreased $2.2 million, or 17%, compared to 2003.

Service fee revenueincreased by $8.2 million, or 17%, compared to 2003. Affiliated service feerevenue increased by $9.5 million compared to 2003 as a result of the increasein Medicare Supplement business in force at our insurance subsidiaries,including Pyramid, for which CHCS Services began providing service effective January 1,2004, and fees from the administration of the life insurance products sold bythe Guarantee Reserve marketing organization that was acquired in July 2003.Unaffiliated service fee revenue decreased by approximately $1.4 millionprimarily due to the reduction in the fees from the underwriting work weperformed for the consortium that is offering long term care to employees ofthe Federal government and their families. The initial enrollment period forthis program, for which we performed underwriting, began in the third quarterof 2002 and ended during the first quarter of 2003. General expenses for thesegment increased by $6.0 million, or 16%, due primarily to the increase inbusiness.

**Segment Results—Corporate**

Thefollowing table presents the primary components comprising the loss from thesegment:

| ** **                                         | ** ** | **For the year ended December 31,** | ** ** |
|----------------------------------------------------|------------|--------------------------------------------------------------|------------|
| ** **                                         | ** ** | **2003**                                                     | ** ** | **2004** | ** ** | **2005** | ** ** |
| ** **                                         | ** ** | **(In thousands)**                                      | ** ** |
| Interest                                           |       | $                                                            | 4,894      |   | $ | 7,903 |   | $ | 10,983 |   |
| Early  extinguishment of debt                      |       | 1,766                                                        |       | — |   | — |   |
| Amortization of  capitalized loan origination fees |       | 492                                                          |       | 727 |   | 897 |   |
| Stock-based  compensation expense                  |       | 367                                                          |       | 92 |   | (18 | ) |
| Other parent  company expenses, net                |       | 3,227                                                        |       | 3,776 |   | 2,075 |   |
| Segment loss                                       |       | $                                                            | 10,746     |   | $ | 12,498 |   | $ | 13,937 |   |

 

***Years ended December 31, 2005 and 2004***

The loss from our Corporate segment increased by $1.4million, or 12%, in 2005 compared to 2004. The increase was due primarily tohigher interest cost as a result of an increase in the amount of the debtoutstanding during the year, relating to the amendment of our credit facilityin connection with our acquisition of Heritage, and an increase in the weightedaverage interest rates, as compared to 2004. Our combined outstanding debt was$170.8 million at December 31, 2005 compared to $176.1 million at December 31,2004. The weighted average interest rate on our loan payable increased to 5.5%for 2005 from 4.1% for 2004. The weighted average interest rate on our otherlong term debt increased to 7.2% for 2005 from 6.3% for 2004. See “Liquidityand Capital Resources” for additional information regarding our loan payableand other long term debt. The increase in interest cost was offset partially byinterest income earned on the proceeds from our equity offering in June 2005.

Additionally, certain ofthe companies acquired in July 1999 had post-retirement benefit plans inplace prior to their acquisition and Universal American maintained theliability for the expected cost of such plans. In October 2000,participants were notified of the termination of the plans in accordance with 

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theirterms. The liability has been reduced as, and to the extent that, it becomescertain that we will incur no liabilities for the plans as a result of thetermination. During the fourth quarter of 2005, $1.8 million of the liabilitywas released, compared to a release of $0.6 million in 2004.

***Years Ended December 31, 2004 and 2003***

The loss from our Corporate segment increased by $1.8million, or 16%, compared to the 2003. The increase was due to higher interestcost as a result of an increase in the amount of the debt outstanding duringthe year, relating to the amendment of our credit facility in connection withour acquisition of Heritage, offset in part, by a reduction in the weightedaverage interest rates, as compared to the same period of 2003. Our combinedoutstanding debt was $176.1 million at December 31, 2004 compared to$113.2 million at December 31, 2003. The weighted average interest rate onour loan payable decreased to 4.1% for 2004 from 4.5% for 2003. The weightedaverage interest rate on our other long term debt increased slightly to 6.3%for 2004 from 5.9% for 2003. See “Liquidity and Capital Resources” for additionalinformation regarding our loan payable and other long term debt. In 2003, wereported a $1.8 million charge relating to the early extinguishment of debtthat was incurred during the first quarter of 2003 that did not recur in 2004. Otherparent company expenses increased as a result of additional expenses from anincrease in corporate governance related activities, as well as managementbonuses. Additionally, during the fourth quarter of 2004, $0.6 million of theretiree plan termination liability was released compared to a release of $0.4million in 2003.

**ContractualObligations and Commercial Commitments**

Ourcontractual obligations as of December 31, 2005, are shown below.

| ** **                          | ** ** | ** **              | ** ** | **Payments Due by Period** | ** ** |
|-------------------------------------|------------|-------------------------|------------|-------------------------------------------|------------|
| **Contractual Obligations**    | ** ** | ** **              | ** ** | **Total**                                 | ** ** | **Less than  1 Year** | ** ** | **1-3 Years** | ** ** | **3-5 Years** | ** ** | **More than  5 Years** | ** ** |
| ** **                          | ** ** | **(In thousands)** | ** ** |
| Long Term Debt  Obligations(1):     |       |                    |       |                                      |       |   |   |   |   |   |   |   |   |
| Trust preferred securities(2)       |       |                    | $          | 248,769                                   |       |   | $ | 5,667 |   | $ | 11,809 |   | $ | 12,745 |   | $ | 218,549 |   |
| Loan payable(3)                     |       |                    | 115,044    |                                      |       | 11,566 |   | 22,087 |   | 81,391 |   | — |   |
| Capital Lease  Obligations          |       |                    | —     |                                      |       | — |   | — |   | — |   | — |   |
| Operating Lease  Obligations        |       |                    | 26,191     |                                      |       | 4,189 |   | 8,162 |   | 7,085 |   | 6,754 |   |
| Purchase  Obligations(4)            |       |                    | 44,042     |                                      |       | 11,734 |   | 19,708 |   | 12,600 |   | — |   |
| Policy Related  Liabilities(5)      |       |                    |       |                                      |       |   |   |   |   |   |   |   |   |
| Policyholder account balances       |       |                    | 702,501    |                                      |       | 49,842 |   | 90,964 |   | 80,461 |   | 481,234 |   |
| Reserves for future policy benefits |       |                    | 1,136,141  |                                      |       | 61,974 |   | 116,501 |   | 107,233 |   | 850,433 |   |
| Policy and contract claims          |       |                    | 130,886    |                                      |       | 117,274 |   | 13,465 |   | 148 |   | — |   |
| Other Long—Term  Liabilities   |       |                    | —     |                                      |       | — |   | — |   | — |   | — |   |
| Total                               |       |                    | $          | 2,403,574                                 |       |   | $ | 262,246 |   | $ | 282,696 |   | $ | 301,663 |   | $ | 1,556,970 |   |
|                                     |            |                         |            |                                           |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

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(1)          These obligationsinclude contractual interest and the table reflects scheduled maturities forcontractual obligations existing as of December 31, 2005 and does notinclude any obligations arising as a result of our shelf registration.

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(2)          Trustpreferred securities all have scheduled maturities of 30 years from the datesof issue; however they are all callable by us five years from the date ofissuance. For the purpose of this schedule, we have assumed that the securitieswill be redeemed at their scheduled maturities, not the call date. Accordingly,the obligation for repayment of principal relating to these is included in themore than 5 Years column. The trust preferred securities all have floating ratecoupons, except for $15 million which has a fixed rate through its no callperiod and then converts to a floating rate. Additionally, we have entered intoseparate swap agreements whereby we pay fixed rates on $35 million of the trustpreferred securities through the no call period. We did not project futurechanges in the base interest rates. For the purpose of this schedule, weapplied the base rate in effect at December 31, 2005 to all future periods.Additionally, we assumed that, upon the expiration of the swap agreements andthe fixed rate, the rate for the respective trust preferred securities adjustedto a variable rate using the current base rate.

(3)          Includesscheduled amortization through final maturity in 2009. The loan payable isfloating rate debt. We did not project future changes in the base interestrates. For the purpose of this schedule, we applied the rate in effect at December 31,2005 to all future periods.

(4)          Includesminimum obligations on our data center outsourcing contract, as well as ouroutsourced administrative service contracts for certain portions of our Part Dbusiness and our HMO product (See Outsourcing Arrangements above). Our actualmonthly payments are affected by the amount of service provided under thecontract and the levels of business administered and currently the actualpayments exceed the minimums stated in the contracts. Therefore our actualpayments will exceed the amounts presented in the above schedule based uponfuture usage and premium amounts.

(5)          Theobligations on policy related liabilities represent those payments we expect tomake on death, disability and health insurance claims and policy surrenders. Theseprojected values contain assumptions for future policy persistency, mortalityand morbidity comparable with our historical experience. The distribution ofpayments for policy and contract claims includes assumptions as to the timingof policyholders reporting claims for prior periods and the amounts of thoseclaims. Actual amounts and timing of both future policy benefits and policy andcontract claims may differ significantly from the estimates above. Weanticipate that our liabilities for policyholder account balances and reservesfor future policy benefits totaling $1.3 billion, along with future netpremiums,  investment income andrecoveries from our reinsurers, will be sufficient to fund future policybenefit payments. In addition, we anticipate that our policy and contractclaims liability totaling $130.3 million, along with recoveries from ourreinsurers, will be sufficient to fund these claim liability payments.

**Liquidityand Capital Resources**

Our capital is usedprimarily to support the retained risks and growth of our insurance companysubsidiaries and health plan and to support our parent company as an insuranceholding company. In addition, we use capital to fund our growth throughacquisitions of other companies, blocks of insurance or administrative servicebusiness.

We require cash at ourparent company to meet our obligations under our credit facility. We alsorequire cash to pay the operating expenses necessary to function as a holdingcompany (applicable insurance department regulations require us to bear our ownexpenses), and to meet the costs of being a public company.

We believe that ourcurrent cash position, the availability of our $15.0 million revolving creditfacility, the expected cash flows of our administrative service company andmanagement service organizations (acquired in the acquisition of Heritage) andthe surplus note interest and principal payments from American Exchange (asexplained below) can support our parent company obligations for the foreseeable

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future. However,there can be no assurance as to our actual future cash flows or to thecontinued availability of dividends from our insurance company subsidiaries.

*Credit Facility, as Amended in May 2004*

In connection with theacquisition of Heritage on May 28, 2004, the Company amended the CreditAgreement by increasing the facility to $120 million from $80 million (the “AmendedCredit Agreement”), including an increase in the term loan portion to $105million from $36.4 million (the balance outstanding at May 28, 2004) andmaintaining the $15 million revolving loan facility. None of the revolving loanfacility was drawn as of December 31, 2005. Under the Amended CreditAgreement, the spread over LIBOR was reduced to 225 basis points from 275 basispoints. Effective January 1, 2006, the interest rate on the term loan was6.6%. Principal repayments are scheduled at $5.3 million per year over afive-year period with a final payment of $80.1 million due upon maturity on March 31,2009.

The Company incurredadditional loan origination fees of approximately $2.1 million, which werecapitalized and are being amortized on a straight-line basis over the life of theAmended Credit Agreement along with the continued amortization of theorigination fees incurred in connection with the Credit Agreement. The Companypays an annual commitment fee of 50 basis points on the unutilized revolvingloan facility.

The obligations of theCompany under the Amended Credit Facility are guaranteed by our subsidiaries,CHCS Services Inc., WorldNet Services Corp., Quincy Coverage Corporation,Universal American Financial Services, Inc., Heritage, HHS-HPN Network, Inc.,Heritage Health Systems of Texas, Inc., PSO Management of Texas, LLC, HHSTexas Management, Inc. and HHS Texas Management LP (collectively the “Guarantors”)and secured by substantially all of the assets of each of the Guarantors. Inaddition, as security for the performance by the Company of its obligationsunder the Amended Credit Facility, the Company, CHCS Services Inc., WorldNetServices Corp., Heritage and HHS Texas Management, Inc., have each pledgedand assigned substantially all of their respective securities (but not morethan 65% of the issued and outstanding shares of voting stock of any foreignsubsidiary), all of their respective limited liability company and partnershipinterests, all of their respective rights, title and interest under any serviceor management contract entered into between or among any of their respectivesubsidiaries and all proceeds of any and all of the foregoing.

The Amended CreditFacility requires the Company and its subsidiaries to meet certain financialtests, including a minimum fixed charge coverage ratio, a minimum risk basedcapital test and a minimum consolidated net worth test. The Amended CreditFacility also contains covenants, which among other things, limit theincurrence of additional indebtedness, dividends, capital expenditures,transactions with affiliates, asset sales, acquisitions, mergers, prepaymentsof other indebtedness, liens and encumbrances and other matters customarilyrestricted in such agreements. The Amended Credit Facility contains customaryevents of default, including, among other things, payment defaults, breach ofrepresentations and warranties, covenant defaults, cross-acceleration,cross-defaults to certain other indebtedness, certain events of bankruptcy andinsolvency and judgment defaults. During the fourth quarter of 2005, theCompany was in default with a covenant regarding limitations on treasury stockrepurchases. The Company requested and received, from the administrative agentfor the bank group, a waiver of the event of default and an amendment to theAmended Credit Facility to increase the limitation for treasury stock purchasesto $30.0 million in the aggregate after January 1, 2006.

The Company made regularlyscheduled principal payments of $5.3 million during the year ended December 31,2005, $5.7 million during 2004 and $8.7 million during 2003 in connection withits credit facilities. The Company paid interest of $5.5 million during 2005,$3.1 million during 2004 and $2.7 million during 2003 in connection with itscredit facilities. Due to the variable interest rate for this Credit Agreement,the Company would be subject to higher interest costs if short-term interestrates rise.

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Thefollowing table shows the schedule of principal payments (in thousands)remaining on our Amended Credit Agreement, with the final payment in March 2009:

| 2006   |   | $      | 5,250  |   |
|--------|--------|--------|--------|--------|
| 2007   |   | 5,250  |   |
| 2008   |   | 5,250  |   |
| 2009   |   | 80,063 |   |
|   |   | $      | 95,813 |   |

 

*2003 Refinancing of Debt*

On March 31, 2003,the Credit Facility issued in 1999 was repaid from the proceeds of the CreditAgreement obtained in connection with the acquisition of Pyramid Life. Theearly extinguishment of this debt resulted in the immediate amortization of therelated capitalized loan origination fees, resulting in a pre-tax expense ofapproximately $1.8 million.

*Other Long Term Debt*

We formed statutorybusiness trusts, which exist for the exclusive purpose of issuing trustpreferred securities representing undivided beneficial interests in the assetsof the trust, investing the gross proceeds of the trust preferred securities injunior subordinated deferrable interest debentures of our parent holdingcompany (the “Junior Subordinated Debt”) and engaging in only those activitiesnecessary or incidental thereto. In accordance with the adoption of FIN 46R, wehave deconsolidated the trusts.

Separate subsidiarytrusts of our parent holding company (the “Trusts”) have issued a combined$75.0 million in thirty year trust preferred securities (the “CapitalSecurities”) as detailed in the following table:

| **Maturity Date** | ** ** | ** **              | ** ** | **Amount Issued** | ** ** | **Term**                | ** **     | **Spread Over  LIBOR** | ** ** | **Rate as of  December 31, 2005** | ** ** |
|------------------------|------------|-------------------------|------------|------------------------|------------|-------------------------|----------------|-----------------------------|------------|-------------------------------------------------------|------------|
| ** **             | ** ** | **(In thousands)** | ** ** | ** **             | ** ** | **(Basis points)** | ** **     | ** **                  | ** ** |
| December 2032     |       |                    | $          | 15,000                 |       |                    | Fixed/Floating |                        |       | 400                                                   | (1)        |   |   | 6.7 | % |   |
| March 2033        |       |                    | 10,000     |                   |       | Floating                |           |                        | 400        |                                                  |       |   | 8.2 | % |   |
| May 2033          |       |                    | 15,000     |                   |       | Floating                |           |                        | 420        |                                                  |       |   | 8.6 | % |   |
| May 2033          |       |                    | 15,000     |                   |       | Fixed/Floating          |           |                        | 410        | (2)                                                   |       |   | 7.4 | % |   |
| October 2033      |       |                    | 20,000     |                   |       | Fixed/Floating          |           |                        | 395        | (3)                                                   |       |   | 7.0 | % |   |
|                   |       |                    | $75,000    |                   |       |                    |           |                        |       |                                                  |       |   |   |   |   |

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(1)          EffectiveSeptember, 2003, we entered into a swap agreement whereby it will pay a fixedrate of 6.7% in exchange for a floating rate of LIBOR plus 400 basis points. Theswap contract expires in December 2007.

(2)          Therate on this issue is fixed at 7.4% for the first five years. On May 15,2008 it will be converted to a floating rate equal to LIBOR plus 410 basispoints.

(3)          EffectiveApril 29, 2004, we entered into a swap agreement whereby it will pay afixed rate of 6.98% in exchange for a floating rate of LIBOR plus 395 basispoints. The swap contract expires in October 2008.

The Trusts have the rightto call the Capital Securities at par after five years from the date ofissuance (which ranged from December 2002 to October 2003). Theproceeds from the sale of the Capital Securities, together with proceeds fromthe sale by the Trusts of their common securities to our parent holdingcompany, were invested in thirty-year floating rate Junior Subordinated Debt ofour parent holding company. From the proceeds of the trust preferredsecurities, $26.0 million was used to pay down debt during 2003. The balance ofthe proceeds has been used, in part to fund acquisitions, to provide capital toour insurance subsidiaries to support growth and to be held for generalcorporate purposes.

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The Capital Securitiesrepresent an undivided beneficial interest in the Trusts’ assets, which consistsolely of the Junior Subordinated Debt. Holders of the Capital Securities haveno voting rights. Our parent holding company owns all of the common securitiesof the Trusts. Holders of both the Capital Securities and the JuniorSubordinated Debt are entitled to receive cumulative cash distributionsaccruing from the date of issuance, and payable quarterly in arrears at afloating rate equal to the three-month LIBOR plus a spread. The floating rateresets quarterly and is limited to a maximum of 12.5% during the first sixtymonths. Due to the variable interest rate for these securities, we may besubject to higher interest costs if short-term interest rates rise. The CapitalSecurities are subject to mandatory redemption upon repayment of the JuniorSubordinated Debt at maturity or upon earlier redemption. The JuniorSubordinated Debt is unsecured and ranks junior and subordinate in right ofpayment to all present and future senior debt of our parent holding company andis effectively subordinated to all existing and future obligations of theCompany’s subsidiaries. Our parent holding company has the right to redeem theJunior Subordinated Debt after five years from the date of issuance.

Our parent holding companyhas the right at any time, and from time to time, to defer payments of intereston the Junior Subordinated Debt for a period not exceeding 20 consecutivequarters up to each debenture’s maturity date. During any such period, interestwill continue to accrue and our parent holding company may not declare or payany cash dividends or distributions on, or purchase, our common stock nor makeany principal, interest or premium payments on or repurchase any debtsecurities that rank equally with or junior to the Junior Subordinated Debt. Ourparent holding company has the right at any time to dissolve the Trusts andcause the Junior Subordinated Debt to be distributed to the holders of theCapital Securities. We have guaranteed, on a subordinated basis, all of theTrusts’ obligations under the Capital Securities including payment of theredemption price and any accumulated and unpaid distributions to the extent ofavailable funds and upon dissolution, winding up or liquidation but only to theextent the Trusts have funds available to make such payments. The CapitalSecurities have not been and will not be registered under the Securities Act of1933, as amended (the “Securities Act”), and will only be offered and soldunder an applicable exemption from registration requirements under the SecuritiesAct.

We paid $5.3 million ininterest in connection with the Junior Subordinated Debt during the year ended December 31,2005, $4.7 million during 2004 and $2.1 million during 2003.

*Lease Obligations*

We areobligated under certain lease arrangements for our executive and administrativeoffices in New York, Florida, Indiana, Texas, and Ontario, Canada. Rent expensewas $4.2 million for the year ended December 31, 2005, $3.0 million for2004 and $2.4 million for 2003. Annual minimum rental commitments, subject toescalation, under non-cancelable operating leases (in thousands) are asfollows:

| 2006                 |   | $      | 4,189  |   |
|----------------------|--------|--------|--------|--------|
| 2007                 |   | 4,151  |   |
| 2008                 |   | 4,011  |   |
| 2009                 |   | 3,619  |   |
| 2010 and  thereafter |   | 10,220 |   |
| Totals               |   | $      | 26,190 |   |

 

In addition to the above,Pennsylvania Life and Penncorp Life (Canada) are the named lessees on 69properties occupied by Career Agents for use as field offices. The CareerAgents reimburse Pennsylvania Life and Penncorp Life (Canada) the actual rentfor these field offices. The total annual rent paid by the Company andreimbursed by the Career Agents for these field offices during 2005 wasapproximately $1.7 million.

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*Shelf Registration*

On November 3, 2004,we filed a universal shelf registration statement on Form S-3 withthe U.S. Securities and Exchange Commission (“SEC”), pursuant to which we mayissue common stock, warrants and debt securities from time to time, up to anaggregate offering of $140 million. The registration statement also covers fivemillion shares of common stock that may be offered for sale by Capital ZFinancial Services Fund II, L.P. (“Capital Z”), our largest shareholder. Theshelf registration statement was declared effective in December, 2004.

The shelf registrationstatement enables us to raise funds from the offering of any individualsecurity covered by the shelf registration statement, as well as anycombination thereof, through one or more methods of distribution, subject tomarket conditions and our capital needs. The terms of any offering pursuant tothis shelf will be established at the time of the offering. We plan to use theproceeds from any future offering under the registration statement for generalcorporate purposes, including, but not limited to, working capital, capitalexpenditures, investments in subsidiaries, acquisitions and refinancing of debt.A more detailed description of the use of proceeds will be included in anyspecific offering of securities in the prospectus supplement relating to theoffering.

On June 22, 2005, weissued 2.0 million shares of our common stock at a price of $23.61 per share,in connection with a public offering pursuant to the shelf registration. Theissuance of these shares generated proceeds to us of $44.2 million, net ofunderwriters discount and other issuance costs. Additionally, 5.0 millionshares were sold by Capital Z Financial Services Fund II, L.P. and itsaffiliates (“Capital Z”), our largest shareholder, under the same shelfregistration. On July 20, 2005, the underwriters exercised theirover-allotment option and we issued an additional 660,000 shares of our commonstock at $23.61 per share, generating additional net proceeds of $14.8 million.Following the offering, Capital Z owned 20.2 million shares, or 34.5% of ouroutstanding common stock.

Subsequent to the offeringnoted above, the aggregate amount that remains available for offering under theshelf registration statement is $77.2 million.

*Obligations of the Parent Company to Affiliates*

In January 2002, ourparent company issued an $18.5 million, 8.5% debenture to Pennsylvania Life inconnection with the transfer of the business of Pennsylvania Life’s CanadianBranch to Penncorp Life (Canada). The debenture has been repaid in full as of December 31,2005. Our parent company repaid principal of $4.5 million in 2002,$7.1 million in 2003, $3.5 million in 2004 and $3.4 million in 2005. Ourparent holding company paid $0.3 million in interest on these debentures during2005, $0.5 million in 2004 and $1.0 million in 2003. The interest onthese debentures is eliminated in consolidation. Dividends from Penncorp Life(Canada) funded all the interest and principal paid on the debenture.

*Sources of Liquidity to the Parent Company*

Weanticipate funding the obligations of the parent company and the capitalrequired to grow our business from the four distinct and uncorrelated sourcesof cash flow within the organization as follows:

·       theexpected cash flows of our senior administrative services company;

·       theexpected cash flows of our senior managed care company (acquired in theacquisition of Heritage);

·       dividendpayments received from Penncorp Life (Canada); and

·       surplusnote principal and interest payments from American Exchange.

In addition, we haveaccess to the $15.0 million available under the revolving portion of our creditfacility. Finally, we have the ability, from time to time, to access thecapital markets for additional capital. 

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Therecan be no assurance as to our actual future cash flows, from the continuedavailability of dividends from our insurance company subsidiaries or fromaccess to the capital markets.

The issues affecting theprofitability of the Company during the third and fourth quarters of 2005, asdiscussed in the Managements’ Discussion and Analysis, do not materially affectthe sources of liquidity to the Parent Company as discussed below. The increasein the Medicare Supplement loss ratios is confined to insurance companies thatwe do not look to for significant cash flow. The increased amortization ofdeferred acquisition cost and present value of future profits is a non-cashitem.

*Senior AdministrativeServices Company.*   Liquidity for our SeniorAdministrative Services subsidiary is measured by its ability to pay operatingexpenses and pay dividends to our parent company. The primary source ofliquidity is fees collected from clients. We believe that the sources of cashfor our Senior Administrative Services company exceed scheduled uses of cashand results in amounts available to dividend to our parent holding company. Wemeasure the ability of the Senior Administrative Services company to paydividends based on its earnings before interest, taxes, depreciation andamortization (“EBITDA”). EBITDA for our Senior Administrative Services segmentwas $11.7 million for the year ended December 31, 2005, $15.3 million for2004 and $13.1 million for 2003. The reduction in EBITDA from 2004 to 2005was a result of the $5.9 million of expenses incurred in this segment relatingto our implementation of Part D.

*Senior Managed Care Company*.*  *Liquidity for our managed care company is measured byits ability to pay operating expenses and pay dividends to our parent company.The primary source of liquidity is management fees for administration of SCOTand services provided to the IPA’s. Dividend payments by SCOT to Heritage aresubject to the approval of the insurance regulatory authorities of the state ofTexas, SCOT’s state of domicile. SCOT is not able to pay dividends during 2006without prior approval. However, we believe that the sources of cash to ourmanaged care holding company exceed scheduled uses of cash which will result infunds available to dividend to our parent holding company. We measure theability of the senior managed care holding company to pay dividends based onits EBITDA. EBITDA for our senior managed care holding company was $30.8 forthe year ended December 31, 2005 and $12.3 million for the seven monthssince its acquisition on May 28, 2004 through December 31, 2004.

*Penncorp Life (Canada) Dividends*.*  *Penncorp Life (Canada) is a Canadian insurancecompany. Canadian law provides that a life insurer may pay a dividend aftersuch dividend declaration has been approved by its board of directors and uponat least 10 days prior notification to the Superintendent of FinancialInstitutions. Such a dividend is limited to retained net income (based onCanadian GAAP) for the preceding two years, plus net income earned for thecurrent year. In considering approval of a dividend, the board of directorsmust consider whether the payment of such dividend would be in contravention ofthe Insurance Companies Act of Canada. During 2005, Penncorp Life (Canada) paiddividends of C$6.4 million (approximately US$5.4 million) to UniversalAmerican. During 2005, Penncorp Life (Canada) became subject to a 5%withholding tax on dividends paid to Universal American. The withholding taxpaid on the dividends from Penncorp Life (Canada) in 2005 was C$0.2 million(approximately US$0.2 million). During the first quarter of 2004, Penncorp Life(Canada) paid dividends of C$26.7 million (approximately US$20.0 million) toUniversal American, relating to 2003 net income. The amount of the dividend waslarger than normal due to a benefit received by Penncorp Life (Canada) from anactuarial experience study that allowed Penncorp Life (Canada) to reduce itspolicy benefit reserves at December 31, 2003 on a Canadian GAAP basis. Theactuarial experience study did not have an impact on Penncorp Life (Canada)’spolicy benefit reserves on a U.S. GAAP basis. During the remainder of 2004,Penncorp Life (Canada) paid dividends totaling C$7.2 million (US$5.6 million)relating to net income for 2004. Penncorp Life (Canada) paid dividends toUniversal American totaling C$11.2 million (US $8.1 million) during 2003.Due to limitations resulting from the timing of prior dividend payments byPennCorp (Canada), we do not anticipate that Penncorp (Canada) will be able topay dividends in 2006, without prior approval.

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*Insurance Subsidiaries—Surplus Note, Dividends andCapital Contributions.Cash  *generated by our insurancecompany subsidiaries will be made available to our holding company, principallythrough periodic payments of principal and interest on the surplus note owed toour holding company by our subsidiary, American Exchange Life. As of December 31,2005, the principal amount of the surplus note was $40.1 million. The notebears interest to our parent holding company at LIBOR plus 325 basis points. Weanticipate that the surplus note will be primarily serviced by dividends fromPennsylvania Life, a wholly owned subsidiary of American Exchange, and bytax-sharing payments among the insurance companies that are wholly owned byAmerican Exchange and file a consolidated Federal income tax return. AmericanExchange made principal payments totaling $8.4 million during the year ended December 31,2005 and payments totaling $11.6 million during the year ended December 31,2004. No principal payments were made during 2003. American Exchange paidinterest on the surplus note of $2.6 million during the year ended December 31,2005, $2.4 million in 2004, and $2.8 million in 2003.

Our parent holding company made capital contributionsto American Exchange amounting to $37.2 million during 2005. In September 2005,Pennsylvania Life declared and paid a dividend in the amount of $2.5 million toAmerican Exchange. American Exchange made capital contributions of $16.5million to American Pioneer, $7.5 million to American Progressive, $5.0 millionto Pennsylvania Life, $3.4 million to Constitution and $3.0 million to UnionBankers during the year ended December 31, 2005. Additionally, during2005, Pennsylvania Life made a capital contribution of $13.0 million to PyramidLife.

Our parent holding company made capital contributionsto American Exchange amounting to $17.8 million during 2004. In March 2004,Pennsylvania Life declared and paid a dividend in the amount of $10.6 millionto American Exchange. American Exchange made capital contributions of $12.0million to Union Bankers, $8.2 million to American Pioneer and $7.0 million toAmerican Progressive during the year ended December 31, 2004.

During the year ended December 31, 2003, nodividends were declared or paid by the U.S. insurance company subsidiaries toAmerican Exchange. During 2003, American Exchange received capitalcontributions from its parent totaling $35.5 million. American Exchange madecapital contributions of $27.0 million to Pennsylvania Life, primarily relatingto the acquisition of Pyramid Life, $2.5 million to American Pioneer, $3.5million to American Progressive and $2.5 million to Union Bankers. PennsylvaniaLife contributed $1.0 million to Pyramid Life in 2003.

Dividend payments by ourU.S. insurance companies to our holding company or to intermediate subsidiariesare limited by, or subject to the approval of the insurance regulatoryauthorities of each insurance company’s state of domicile. Such dividendrequirements and approval processes vary significantly from state to state. PennsylvaniaLife is able to pay ordinary dividends of up to $9.8 million to AmericanExchange during 2006, without prior approval.

*InsuranceSubsidiaries - Liquidity*

Liquidity for our insurance company subsidiaries ismeasured by their ability to pay scheduled contractual benefits, pay operatingexpenses, fund investment commitments, and pay dividends to their parentcompany. The principal sources of cash for our insurance operations includescheduled and unscheduled principal and interest payments on investments,premium payments, annuity deposits, and the sale or maturity of investments. Boththe sources and uses of cash are reasonably predictable and we believe thatthese sources of cash for our insurance company subsidiaries exceed scheduleduses of cash.

Liquidity is also affected by unscheduled benefitpayments including benefits under accident and health insurance policies, deathbenefits and interest-sensitive policy surrenders and withdrawals.

Our accident and health insurance policies generallyprovide for fixed-benefit amounts and, in the case of Medicare Supplementpolicies, for supplemental payments to Medicare provider rates. Some of 

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these benefits are subjectto medical-cost inflation and we have the capability to file for premium rateincreases to mitigate rising medical costs. Our health insurance business iswidely dispersed in the United States and Canada, which mitigates the risk ofunexpected increases in claim payments due to epidemics and events of acatastrophic nature. These accident and health polices are notinterest-sensitive and therefore are not subject to unexpected policyholderredemptions due to investment yield changes.

Some of our life insurance and annuity policies areinterest-sensitive in nature. The amount of surrenders and withdrawals isaffected by a variety of factors such as credited interest rates for similarproducts, general economic conditions and events in the industry that affectpolicyholders’ confidence. Although the contractual terms of substantially allof our in force life insurance policies and annuities give the holders theright to surrender the policies and annuities, we impose penalties for earlysurrenders. As of December 31, 2005 we held reserves that exceeded theunderlying cash surrender values of our net retained in force life insuranceand annuities by $33.8 million. Our insurance subsidiaries, in our view, havenot experienced any material changes in surrender and withdrawal activity inrecent years.

Changes in interest rates may affect the incidence ofpolicy surrenders and withdrawals. In addition to the potential impact onliquidity, unanticipated surrenders and withdrawals in a changed interest rateenvironment could adversely affect earnings if we were required to sellinvestments at reduced values in order to meet liquidity demands. We manage ourasset and liability portfolios in order to minimize the adverse earnings impactof changing market rates. We have segregated a portion of our investmentportfolio in order to match liabilities that are sensitive to interest ratemovements with fixed income securities containing similar characteristics tothe related liabilities, most notably the expected duration and requiredinterest spread. We believe that this asset/liability management processadequately covers the expected payment of benefits related to theseliabilities.

As of December 31, 2005, our insurance companysubsidiaries held cash and cash equivalents totaling $124.9 million, as well asfixed maturity securities that could readily be converted to cash with carryingvalues (and fair values) of $1.3 billion.

The net yields on our cash and invested assetsdecreased to 5.0% for the year ended December 31, 2005, from 4.9% for 2004and 5.3% for 2003. A portion of these securities are held to support theliabilities for policyholder account balances, which liabilities are subject toperiodic adjustments to their credited interest rates. The credited interestrates of the interest-sensitive policyholder account balances are determined byus based upon factors such as portfolio rates of return and prevailing marketrates and typically follow the pattern of yields on the assets supporting theseliabilities.

Our domestic insurance subsidiaries are required tomaintain minimum amounts of statutory capital and surplus as required byregulatory authorities. However, substantially more than the statutory minimumamounts are needed to meet statutory and administrative requirements ofadequate capital and surplus to support the current level of our insurancesubsidiaries’ operations. Each of our insurance subsidiaries’ statutory capitaland surplus exceeds its respective minimum statutory requirement at levels webelieve are sufficient to support their current levels of operation. Additionally,the National Association of Insurance Commissioners (“NAIC”) imposes regulatoryrisk-based capital (“RBC”) requirements on life insurance enterprises. At December 31, 2005, all of ourinsurance subsidiaries maintained ratios of total adjusted capital to RBC inexcess of the “authorized control level”. The combined statutory capital andsurplus, including asset valuation reserve, of our U.S. insurance subsidiariestotaled $158.4 million at December 31, 2005 and $127.9 million at December 31,2004. For the year ended December 31, 2005, our U.S. insurancesubsidiaries generated a statutory net loss of $1.8 million. Our U.S. insurancecompanies generated statutory net income of $5.4 million for the year ended December 31,2004 and $0.6 million for the year ended December 31, 2003.

Our health plan affiliates are also required tomaintain minimum amounts of capital and surplus, as required by regulatoryauthorities and is also subject to RBC requirements. At December 31, 2005,the 

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statutory capital andsurplus of each of our health plan affiliates exceeds its minimum requirementand its RBC is in excess of the “authorized control level”. The statutorycapital and surplus for our health plan affiliates was $23.0 million at December 31,2005 and $9.9 million at December 31, 2004. Statutory net income for ourhealth plan affiliates was $9.6 million for the year ended December 31,2005 and $5.5 million for the year ended December 31, 2004.

Penncorp Life (Canada)reports to Canadian regulatory authorities based upon Canadian statutoryaccounting principles that vary in some respects from U.S. statutory accountingprinciples. Penncorp Life (Canada)’s net assets based upon Canadian statutoryaccounting principles were C$62.3 million (US$53.6 million) as of December 31,2005 and were C$57.4 million (US$47.8 million) as of December 31, 2004. Netincome based on Canadian generally accepted accounting principles was C$11.3million (US$9.3 million) for the year ended December 31, 2005, C$8.4million (US$6.5 million) for 2004 and C$34.4 million (US$24.6 million) for 2003.Penncorp Life (Canada) maintained a Minimum Continuing Capital and SurplusRequirement Ratio (“MCCSR”) in excess of the minimum requirement at December 31,2005.

*Investments*

Our investment policy is to balance the portfolioduration to achieve investment returns consistent with the preservation ofcapital and maintenance of liquidity adequate to meet payment of policybenefits and claims. We invest in assets permitted under the insurance laws ofthe various states in which we operate. Such laws generally prescribe thenature, quality of and limitations on various types of investments that may bemade. We do not currently have investments in partnerships, special purposeentities, real estate, commodity contracts, or other derivative securities. Wecurrently engage the services of three investment advisors under the directionof the management of our insurance company subsidiaries and in accordance withguidelines adopted by the Investment Committees of their respective boards ofdirectors. Conning Asset Management Company manages the portfolio of all of ourUnited States subsidiaries, except for the portfolio of Pyramid Life, andcertain floating rate portfolios, which are managed by Hyperion Capital. MFCGlobal Investment Management manages our Canadian portfolio. We investprimarily in fixed maturity securities of the U.S. Government and its agenciesand in corporate fixed maturity securities with investment grade ratings of “BBB-”(Standard & Poor’s Corporation), “Baa3” (Moody’s Investor Service) orhigher.

As of December 31,2005, approximately 99% of our fixed maturity investments had investment graderatings from Standard & Poor’s Corporation or Moody’s Investor Service.There were no non-income producing fixed maturities as of December 31,2005. During the years ended December 31, 2005 and 2004, we did not writedown the value of any fixed maturity securities. We wrote down the value ofcertain fixed maturity securities, considered to have been subject to another-than-temporary decline in value, by $1.3 million during 2003. In each case, these write-downsrepresent our estimate of other than temporary declines in value and wereincluded in net realized gains on investments in our consolidated statements ofoperations.

**FederalIncome Taxation of the Company**

We file a consolidated return for Federal income taxpurposes that includes all of the non-life insurance company subsidiaries,including Heritage. American Progressive was included in the consolidatedreturn through March 31, 2002 and American Pioneer was included through June 30,2002. American Exchange and its subsidiaries and Penncorp Life (Canada) are notcurrently included. American Exchange and its subsidiaries, including AmericanProgressive since April 1, 2002 and American Pioneer since July 1,2002, filed a separate consolidated Federal return. Penncorp Life (Canada)files a separate return with the Canada Revenue Agency.

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At December 31, 2005, the Company (exclusive ofAmerican Exchange and its subsidiaries and PennCorp Life) had net operatingloss carryforwards of approximately $3.8 million (including $2.8 million fromHeritage) that expire in 2015 and 2024 and capital loss carryforwards of $0.8million that expire in 2007. At December 31, 2005, the Company also had anAlternative Minimum Tax (AMT) credit carryforward for Federal income taxpurposes of approximately $0.3 million that can be carried forward indefinitely.At December 31, 2005, American Exchange and its subsidiaries had netoperating loss carryforwards, most of which relate to the companies acquired in1999 (and were incurred prior to their acquisition), of approximately $0.5million that expire in 2017. At December 31, 2005, American Exchange andits subsidiaries also had capital loss carryforwards of $5.2 million thatexpire in 2007 and an AMT credit carryforward for Federal income tax purposesof approximately $0.9 million that can be carried forward indefinitely. As aresult of changes in ownership of the Company in July 1999, the use ofmost of the loss carryforwards of the Company are subject to annuallimitations.

The Company establishes valuation allowances basedupon an analysis of projected taxable income and its ability to implementprudent and feasible tax planning strategies. The Company carried valuationallowances on its deferred tax assets of $2.9 million at December 31, 2005and $3.8 million at December 31, 2004. At December 31, 2003, thevaluation allowance on certain of the life tax loss carryforwards no longer wasconsidered necessary and the Company released the valuation allowance of $4.5million which was reported as a deferred income tax benefit. As a result ofuncertainty regarding the ability to generate taxable capital gains to utilizecapital loss carryforwards, the Company established a valuation allowance inthe amount of $3.2 million during 2004 that was reported as a deferred incometax expense. Approximately $1.6 million of the valuation allowance related tothe capital loss carryforward was released during 2005, and reported as adeferred income tax benefit, as capital gains were generated and the Companywas able to realize the benefit from the capital loss carryforwards. During2005, the Company incurred creditable foreign taxes related to dividends fromPenncorp Life, its Canadian subsidiary, generating a foreign tax creditcarryforward, for which a deferred tax asset of approximately $0.8 million wasestablished. A valuation allowance for approximately $0.8 million wasestablished because the Company lacks sufficient foreign source income torealize the benefit for the foreign tax credit. In 2003, the Companyestablished a reserve for pre-acquisition tax years of certain life insurancesubsidiaries that were being examined by the Internal Revenue Service in theamount of $4.4 million. During 2004, the Company released $3.8 million relatingto a portion of reserve amounts established for pre-acquisition tax years ofcertain life insurance subsidiaries that were being examined by the InternalRevenue Service. Management believes it is more likely than not that theCompany will realize the recorded value of its net deferred tax assets.

Our U.S. insurance company subsidiaries, other thanPeninsular Life Insurance Company, are taxed as life insurance companies asprovided in the Internal Revenue Code. The Omnibus Budget Reconciliation Act of1990 amended the Internal Revenue Code to require a portion of the expensesincurred in selling insurance products to be capitalized and amortized over aperiod of years, as opposed to an immediate deduction in the year incurred. Insteadof measuring actual selling expenses, the amount capitalized for tax purposesis based on a percentage of premiums. In general, the capitalized amounts aresubject to amortization over a ten-year period. Since this change only affectsthe timing of the deductions, it does not, assuming stability of rates, affectthe provisions for taxes reflected in our financial statements prepared inaccordance with GAAP. However, by deferring deductions, the change has theeffect of increasing our current tax expense and reducing statutory surplus. Therewas no material increase in our current income tax provision for any of thethree years in the period ended December 31, 2005 due to the existence ofour insurance company subsidiaries’ net operating loss carryforwards.

The Jobs Creation Tax Actof 2004 contains a provision that places a two year moratorium on theimposition of tax on distributions from Policyholder Surplus Accounts (“PSA”). Additionally,the ordering rules were changed to allow for the first dollar of anydistribution to reduce the PSA. Any distribution 

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during2005 and 2006 from an insurance company that has a PSA will be treated as adistribution from its PSA account. However, the distribution will not besubject to Federal income tax. As of December 31, 2005, we had $20.2million of PSA balances and have accrued $7.1 million in deferred taxliabilities corresponding to those balances. The Jobs Creation Tax Act of 2004provides the mechanism to eliminate this potential tax without the impositionof any tax payment. Although, we have received the pre-approval of theInsurance Departments of the respective companies for the transactions requiredto trigger the elimination of the potential tax, such distributions had notbeen made as of December 31, 2005.

*Effectsof Recently Issued and Pending Accounting Pronouncements*

There was no materialimpact on our consolidated financial condition or results of operations as aresult of our adoption of the recently issued accounting pronouncements. We donot anticipate any material impact from the future adoption of the pendingaccounting pronouncements, other than the adoption of Statement of FinancialAccounting Standards No. 123-Revised, “Share-Based Payment” (“FAS 123-R”).FAS 123-R requires all companies to recognize compensation costs forshare-based payments to employees based on the grant-date fair value of theaward for financial statements for annual reporting periods beginning after June 15,2005. Refer to Consolidated Financial Statements Note 2—Recent and PendingAccounting Pronouncements.

**ITEM 7A—Quantitativeand Qualitative Disclosures About Market Risk**

In general, market riskrelates to changes in the value of financial instruments that arise fromadverse movements in interest rates, equity prices and foreign exchange rates. Weare exposed principally to changes in interest rates that affect the marketprices of our fixed income securities as well as the cost of our variable ratedebt. Additionally, we are exposed to changes in the Canadian dollar thataffects the translation of the financial position and the results of operationsof our Canadian subsidiary from Canadian dollars to U.S. dollars.

*Investment InterestRate Sensitivity*

Our profitability could be affected if we wererequired to liquidate fixed income securities during periods of rising and/orvolatile interest rates. However, we attempt to mitigate our exposure toadverse interest rate movements through a combination of active portfoliomanagement and by staggering the maturities of our fixed income investments toassure sufficient liquidity to meet our obligations and to address reinvestmentrisk considerations. Our insurance liabilities generally arise over relativelylong periods of time, which typically permits ample time to prepare for theirsettlement.

Certain classes of mortgage-backed securities aresubject to significant prepayment risk due to the fact that in periods ofdeclining interest rates, individuals may refinance higher rate mortgages totake advantage of the lower rates then available. We monitor and adjust ourinvestment portfolio mix to mitigate this risk.

We regularly conduct various analyses to gauge thefinancial impact of changes in interest rate on our financial condition. Theranges selected in these analyses reflect our assessment as being reasonablypossible over the succeeding twelve-month period. The magnitude of changesmodeled in the accompanying analyses should not be construed as a prediction offuture economic events, but rather, be treated as a simple illustration of thepotential impact of such events on our financial results.

The sensitivity analysisof interest rate risk assumes an instantaneous shift in a parallel fashionacross the yield curve, with scenarios of interest rates increasing anddecreasing 100 and 200 basis points from their levels as of December 31,2005, and with all other variables held constant. A 100 basis point increase inmarket interest rates would result in a pre-tax decrease in the market value ofour fixed income investments of $64.8 million and a 200 basis point increase inmarket interest rates would result in $126.7 

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milliondecrease. Similarly, a 100 basis point decrease in market interest rates wouldresult in a pre-tax increase in the market value of our fixed incomeinvestments of $70.2 million and a 200 basis point decrease in market interestrates would result in a $145.1 million increase.

*Debt*

We pay interest on ourterm loan and a portion of our trust preferred securities based on the LondonInter Bank Offering Rate (“LIBOR”) for one, two or three months. Due to thevariable interest rate, the Company would be subject to higher interest costsif short-term interest rates rise. We have attempted to mitigate our exposureto adverse interest rate movements by fixing the rate on $15.0 million of thetrust preferred securities for a five year period through the contractual termsof the security at inception and an additional $35.0 million through the use ofinterest rate swaps.

We regularly conduct various analyses to gauge thefinancial impact of changes in interest rate on our financial condition. Theranges selected in these analyses reflect our assessment as being reasonablypossible over the succeeding twelve-month period. The magnitude of changesmodeled in the accompanying analyses should not be construed as a prediction offuture economic events, but rather, be treated as a simple illustration of thepotential impact of such events on our financial results.

Thesensitivity analysis of interest rate risk assumes scenarios increases ordecreases in LIBOR of 100 and 200 basis points from their levels as of and forthe year ended December 31, 2005, and with all other variables heldconstant. The following table summarizes the impact of changes in LIBOR.

| ** **                                                | ** ** | ** **             | ** ** | ** **                                | ** ** | Effect of Change in LIBOR on Pre-tax Income  for the year ended December 31, 2005 | ** ** |
|-----------------------------------------------------------|------------|------------------------|------------|-------------------------------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| **Description of Floating Rate Debt** | ** ** | ** **             | ** ** | **Weighted  Average  Interest Rate** | ** ** | **Weighted  Average  Balance  Outstanding**                                                                                                        | ** ** | **200 Basis  Point  Decrease** | ** ** | **100 Basis  Point  Decrease** | ** ** | **100 Basis  Point  Increase** | ** ** | **200 Basis  Point  Increase** | ** ** |
| ** **                                                | ** ** | **(in millions)** | ** ** |
| Loan Payable                                              |       |                   | 5.53       | %                                         |       |                                                                                                                                               | $          | 99.1 |   |   |   | $ | 2.0 |   |   |   | $ | 1.0 |   |   |   | $ | (1.0 | ) |   |   | $ | (2.0 | ) |   |
| Other long term  debt                                     |       |                   | 7.57       | %                                         |       |                                                                                                                                               | $          | 25.0 |   |   |   | 0.5 |   |   |   | 0.3 |   |   |   | (0.3 | ) |   |   | (0.5 | ) |   |
| Total                                                     |       |                   |       |                                      |       |                                                                                                                                               |       |   |   |   | $ | 2.5 |   |   |   | $ | 1.3 |   |   |   | $ | (1.3 | ) |   |   | $ | (2.5 | ) |   |
|                                                           |            |                        |            |                                           |            |                                                                                                                                                    |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

As noted above, we havefixed the interest rate on $50 million of our $171 million of total debtoutstanding, leaving $121 million of the debt exposed to rising interest rates.As of December 31, 2005 we had approximately $139 million of cash and cashequivalents and $145 million in short duration floating rate investmentsecurities. We anticipate that the net investment income on this $284 millionwill be positively impacted by rising interest rates and will mitigate thenegative impact of rising interest rates on our debt.

*Currency Exchange Rate Sensitivity*

Portions of our operations are transacted using theCanadian dollar as the functional currency. As of and for the year ended December 31,2005, approximately 13% of our assets, 8% of our revenues, excluding realizedgains, and 19% of our income before realized gains and taxes were derived fromour Canadian operations. As of and for the year ended December 31, 2004,approximately 12% of our assets, 9% of our revenues, excluding realized gains,and 16% of our income before realized gains and taxes were derived from ourCanadian operations. Accordingly, our earnings and shareholder’s equity areaffected by fluctuations in the value of the U.S. dollar as compared to theCanadian dollar. Although this risk is somewhat mitigated by the fact that boththe assets and liabilities for our foreign operations are denominated inCanadian dollars, we are still subject to translation gains and losses.

We periodically conduct various analyses to gauge thefinancial impact of changes in the foreign currency exchange rate on ourfinancial condition. The ranges selected in these analyses reflect ourassessment of what is reasonably possible over the succeeding twelve-monthperiod.

87

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A 10% strengthening of theU.S. dollar relative to the Canadian dollar, as compared to the actual averageexchange rate for the year ended December 31, 2005, would have resulted ina decrease in our income before realized gains and taxes of approximately $1.3million for the year ended December 31, 2005 and a decrease in ourshareholders’ equity of approximately $5.9 million at December 31, 2005. A10% weakening of the U.S. dollar relative to the Canadian dollar would haveresulted in an increase in our income before realized gains and taxes ofapproximately $1.6 million for the year ended December 31, 2005 and anincrease in shareholders’ equity of approximately $7.3 million at December 31,2005. Our sensitivity analysis of the effects of changes in foreign currencyexchange rates does not factor in any potential change in sales levels, localprices or any other variables.

The magnitude of changesreflected in the above analysis regarding interest rates and foreign currencyexchange rates should, in no manner, be construed as a prediction of futureeconomic events, but rather as a simple illustration of the potential impact ofsuch events on our financial results.

**ITEM8—FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA**

The financial statementsand supplementary schedules are listed in the accompanying Index toConsolidated Financial Statements and Financial Statement Schedules on Page F- 1.

**ITEM 9—CHANGES IN ANDDISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE**

None.

**ITEM9A—Controls and procedures**

***Disclosure Controlsand Procedures***

The Company maintainsdisclosure controls and procedures that are designed to ensure that informationrequired to be disclosed in the reports that we file or submit under theExchange Act, is recorded, processed, summarized and reported within the timeperiods specified in the SEC’s rules and forms, and that such informationis accumulated and communicated to management, including the Company’s ChiefExecutive Officer and Chief Financial Officer, as appropriate, to allow timelydecisions regarding required disclosures.

**Inherent Limitations on Effectiveness of Controls**

Our management, includingour Chief Executive Officer and Chief Financial Officer, does not expect thatour disclosure controls and procedures or our internal controls over financialreporting will prevent or detect all errors and all fraud. A control system, nomatter how well designed and operated, can provide only reasonable, notabsolute, assurance that the objectives of the control system are met. Thedesign of a control system must reflect the fact that there are resourceconstraints, and the benefits of controls must be considered relative to theircosts. Further, because of the inherent limitations in all control systems, noevaluation of controls can provide absolute assurance that misstatements due toerror or fraud will not occur or that all control issues and instances offraud, if any, within Universal American have been detected. These inherentlimitations include the realities that judgments in decision-making can befaulty and that breakdowns can occur because of simple error or mistake. Controlscan also be circumvented by the individual acts of some persons or by collusionof two or more people. The design of any system of controls is based in part oncertain assumptions about the likelihood of future events, and there can be noassurance that any design will succeed in achieving its stated goals under allpotential future conditions. Projections of any evaluation of controlseffectiveness to future periods are subject to risks. Over time, controls maybecome inadequate because of changes in conditions or deterioration in thedegree of compliance with policies or procedures.

88

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**Evaluation of Effectiveness of Controls**

An evaluation was carriedout under the supervision and with the participation of the Company’smanagement, including our Chief Executive Officer and Chief Financial Officer,of the effectiveness of our disclosure controls and procedures (as defined inExchange Act Rules 13a-15(e) and 15d-15(e)) as of December 31,2005. Based on this evaluation, management has concluded that our disclosurecontrols and procedures were not effective as of December 31, 2005, as aresult of a material weakness in internal control over financial reporting setforth below. A material weakness, as defined under standards established by thePublic Company Accounting Oversight Board’s Auditing Standard No. 2, is acontrol deficiency, or combination of control deficiencies, that results inmore than a remote likelihood that a material misstatement of our annual orinterim financial statements would not be prevented or detected.

In light of the materialweakness, the Company performed additional analyses and other post-closingprocedures to ensure that its consolidated financial statements included inthis Annual Report on Form 10-K were prepared in accordance withgenerally accepted accounting principles and presented fairly in all materialrespects its financial position, results of operations and cash flows for theperiods presented.

***Management’s AnnualReport on Internal Control over Financial Reporting***

Our management isresponsible for establishing and maintaining adequate internal control overfinancial reporting (as defined in Rule 13a-15(f) under theExchange Act). A company’s internal control over financial reporting is aprocess designed to provide reasonable assurance regarding the reliability offinancial reporting and the preparation of financial statements for externalpurposes in accordance with accounting principles generally accepted in theUnited States.

Because of its inherentlimitations, internal control over financial reporting may not prevent ordetect misstatements. Also, projections of any evaluation of effectiveness tofuture periods are subject to the risk that controls may become inadequatebecause of changes in conditions, or that the degree of compliance with thepolicies or procedures may deteriorate.

Management assessed ourinternal control over financial reporting as of December 31, 2005, the endof our fiscal year. Management based its assessment on criteria established inInternal Control—Integrated Framework issued by the Committee of SponsoringOrganizations of the Treadway Commission. In performing its assessment ofinternal control over financial reporting, management determined that amaterial weakness existed in the Company’s internal controls relating to theaccounting for our Medicare Supplement claim reserves and the related amountsrecoverable from reinsurers. Specifically, the Company’s analysis and review controlswere not sufficient to ensure that our claim reserves, amounts recoverable fromreinsurers and net incurred claims for our Medicare Supplement business wereappropriately stated. As a result of this weakness, the Company’s internalcontrols did not detect the need for adjustments to the amounts initiallyrecorded for these items. Based on additional analysis and proceduresperformed, management made adjustments in the fourth quarter of 2005 to itsclaim reserves and amounts recoverable from reinsurers as of December 31,2005 and the related incurred claims expense for the year ended December 31,2005 for our Medicare Supplement business prior to the issuance of theconsolidated financial statements as of December 31, 2005.

As a result of thematerial weakness described above, management has concluded that the Company’sinternal control over financial reporting was not effective as of December 31,2005.

Our independent registeredpublic accounting firm, Ernst & Young LLP, audited management’sassessment and independently assessed the effectiveness of the company’sinternal control over financial reporting. Ernst & Young LLP hasissued an attestation report on our internal controls that concurs withmanagement’s assessment. This report is included on page F-3 of ourconsolidated financial statements included in this Form 10-K.

89

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***Remediation ofMaterial Weaknesses***

Management is responsiblefor maintaining effective internal control processes over its financialstatement close and financial reporting processes. Management also is requiredto ensure that its finance and accounting personnel have the competence andtraining necessary for their assigned levels of responsibility, and thatsufficient staff is present to effectively perform all processes necessary tomaintaining a proper internal control environment. The Company believes it hastaken the necessary steps to remediate its material weakness by: (i) addingadditional analytical procedures to ensure the accuracy of claim reservesestimation methods; (ii) retaining independent consulting actuaries toreview the estimation of claim reserves on a regular basis; and (iii) strengtheningthe management review of claim reserves trends and methods used to estimateMedicare Supplement claim reserves and amounts recoverable from reinsurers.

***Changes in InternalControl Over Financial Reporting***

Other than the aboveitems, there were no changes in our internal controls over financial reportingduring the quarter ended December 31, 2005 that have materially affected,or are reasonably likely to materially affect, our internal controls overfinancial reporting.

**ITEM 9B—OTHERINFORMATION**

None

**Part III**

**ITEM10—directors and executive officers ofthe registrant**

The information requiredby Item 10 is incorporated into Part III of this Annual Report on Form 10-Kby reference to our definitive Proxy Statement for the Annual Meeting ofStockholders scheduled to be held on May 25, 2006.

**ITEM11—Executive Compensation**

The information requiredby Item 11 is incorporated into Part III of this Annual Report on Form 10-Kby reference to our definitive Proxy Statement for the Annual Meeting ofStockholders scheduled to be held on May 25, 2006.

**ITEM 12—SECURITY OWNERSHIP OF CERTAINBENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS**

The information requiredby Item 12 is incorporated into Part III of this Annual Report on Form 10-Kby reference to our definitive Proxy Statement for the Annual Meeting ofStockholders scheduled to be held on May 25, 2006.

**ITEM13—CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS**

The information required by Item 13 is incorporatedinto Part III of this Annual Report on Form 10-K by referenceto our definitive Proxy Statement for the Annual Meeting of Stockholdersscheduled to be held on May 25, 2006.

**ITEM14—PRINCIPAL ACCOUNTANT FEES AND SERVICES**

The information required by Item 14 is incorporatedinto Part III of this Annual Report on Form 10-K by referenceto our definitive Proxy Statement for the Annual Meeting of Stockholdersscheduled to be held on May 25, 2006.

90

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**PART IV**

**ITEM15—EXHIBITS AND FINANCIAL STATEMENT SCHEDULES**

**1   FinancialStatements**

See separate index toFinancial Statements and Financial Statement Schedules on Page F-1 of thisForm 10-K.

**2   FinancialStatement Schedules**

See separate index toFinancial Statements and Financial Statement Schedules on Page F-1 of thisForm 10-K.

**3   Exhibits**

|  2.1 |   | Agreement and Plan of Merger, dated as of  March 9, 2004, among Universal American Financial Corp., HHS Acquisition  Corp., Heritage Health Systems, Inc. and Carlyle Venture Partners, L.P.,  as the stockholder representative, incorporated by reference to Form 8-K  dated March 9, 2004.                                                                                  |
|-----------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|  3.1 |   | Restated Certificate of  Incorporation of Universal American Financial Corp. incorporated by reference  to Exhibit 3.1 to the registrant’s Amendment No. 2 to the  Registration Statement (No. 333-62036) on Form S-3  filed on July 11, 2001.                                                                                                                       |
|  3.2 |   | Amendment No. 1 to  the Restated Certificate of Incorporation of Universal American Financial  Corp., incorporated by reference to Exhibit 3 to Form 10-Q  (File No. 0-11321) for the quarter ended June 30, 2004, filed  with the SEC on August 9, 2004.                                                                                                            |
|  3.3 |   | Amended and Restated By-Laws  of Universal American Financial Corp., incorporated by reference to  Exhibit A to Form 8-K (File No. 0-11321) dated  August 13, 1999.                                                                                                                                                                                                            |
|  4.1 |   | Form of Indenture  dated as of December 2004 between Universal American Financial Corp. and  U.S. Bank National Association, as Trustee, incorporated by reference to  Exhibit 4.01 to Amendment No. 1 to the Company’s Registration  Statement on Form S-3 (File No. 333-120190) filed with  the Securities and Exchange Commission on December 10, 2004. |
|  4.2 |   | Form of Indenture  dated as of December 2004 between Universal American Financial Corp. and  U.S. Bank National Association, as Trustee, incorporated by reference to  Exhibit 4.02 to Amendment No. 1 to the Company’s Registration  Statement on Form S-3 (File No. 333-120190) filed with  the Securities and Exchange Commission on December 10, 2004. |
|  4.3 |   | Shareholders Agreement  dated July 30, 1999, among the Company, Capital Z Financial Services  Fund II, L.P., UAFC, L.P., AAM Capital Partners, L.P., Chase Equity  Associates, L.P., Richard A. Barasch and others, incorporated by reference to  Exhibit A of Form 8-K dated August 13, 1999.                                                                                 |
|  4.4 |   | Registration Rights  Agreement, dated July 30, 1999, among the Company, Capital Z Financial  Services Fund II, L.P., Wand/Universal American Investments L.P.I.,  Wand/Universal American Investments L.P. II, Chase Equity Associates, L.P.,  Richard A. Barasch and others, incorporated by reference to Exhibit A to  Form 8-K dated August 13, 1999.                       |
| 10.1      |   | Amended and Restated  Purchase Agreement among the Company, dated December 31, 1999, as  amended and restated on July 2, 1999, between Universal American, PennCorp  Financial Group, Inc. (“PFG”) and several of PFG’s subsidiaries,  incorporated by reference to Annex B of Proxy Statement dated July 12,  1999.                                            |

91

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| 10.2   |   | Share Purchase  Agreement, as of December 31, 1998, between the Company and Capital Z  Financial Services Fund II, L.P. as amended by Amendment, dated as of  July 2, 1999, incorporated by reference to Annex A of Proxy Statement  dated July 12, 1999.                      |
|--------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.3   |   | Credit Agreement dated  as of July 30, 1999, among the Registrant and the Chase Manhattan Bank  as agent, the lender and signatory thereto, incorporated by reference to  Exhibit C to Form 8-K/A dated March 16, 2001.                                                   |
| 10.4   |   | Employment Agreements  dated July 30, 1999, between Registrant and each of Richard A. Barasch,  Robert A. Waegelein, and Gary W. Bryant, incorporated by reference to  Exhibits D and E to Form 8-K/A dated March 14, 2001.                                                    |
| 10.5   |   | Agent Equity Plan for  Agents of Penn Union Companies incorporated by reference to Amendment 1 to  Registration Statement on Form S-2, dated July 13, 2000.                                                                                                                         |
| 10.6   |   | Agent Equity Plan for  Regional Managers and Sub Managers of Penn Union Companies incorporated by  reference to Amendment 1 to Registration Statement on Form S-2,  dated July 13, 2000.                                                                                            |
| 10.7   |   | 1998 Incentive  Compensation Plan, incorporated by reference to Annex A of Definitive Proxy  Statement filed on Form 14A dated April 29, 1998.                                                                                                                                      |
| 10.8   |   | Purchase Agreement dated  as of December 20, 2002, by and among Universal American Financial  Corp., Pennsylvania Life Insurance Company, Ceres Group, Inc. and  Continental General Insurance Company incorporated by reference to  Form 8-K dated December 20, 2002.    |
| 10.9   |   | Credit Agreement dated  March 31, 2003, among the Company, various lending institutions and,  Bank of America, N.A., as the Administrative Agent, the Collateral Agent and  the L/C Issuer incorporated by reference to Form 8-K dated  March 27, 2003.                        |
| 10.10  |   | Agreement dated as of  July 6, 2000, by and between ALICOMP, a division of ALICARE, Inc.  and Universal American Financial Corp. incorporated by reference to  Form 10-Q/A (Amendment No. 1) for the period ended  September 30, 2003, dated December 23, 2003. |
| 10.11  |   | Amended and Restated Credit Agreement dated as of  May 28, 2004, among the Company, various lending institutions and Bank  of America, N.A., as the Administrative Agent, the                                                                                                            |
| 10.12* |   | First Amendment to Amended and Restated Credit  Agreement dated as of June 2, 2005 among the Company, the Banks party to  the Credit Agreement and Bank of America, N.A., as the Administrative Agent.                                                                                   |
| 10.13* |   | Waiver and Second Amendment to Amended and Restated  Credit Agreement dated as of December 30, 2005 among the Company, the  Banks party to the Credit Agreement and Bank of America, N.A., as the  Administrative Agent.                                                                 |
| 10.14  |   | Amendment No. 1 to  Universal American Financial Corp. 1998 Incentive Compensation Plan,  incorporated by reference to Amendment No. 1 to the registrant’s  Registration Statement on Form S-4 (No. 333-120190)  filed on December, 10, 2004.                        |
| 10.15  |   | Addendum II for Item 1A  to agreement dated as of July 6, 2000, by and between ALICOMP, a division  of ALICARE, Inc. and Universal American Financial Corp.                                                                                                                         |

92

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| 10.16  |       | Quota Share Reinsurance  Agreement, dated June 30, 2005, among the Company and PharmaCare Captive  Re, Ltd., incorporated by reference to Exhibit 10.1 to Form 10-Q  for the quarter ended September 30, 2005, filed with the SEC on  November 9, 2005. |
|--------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.17* |       | Employment Letter dated  June 17, 2002, between the Company and Jason Israel.                                                                                                                                                                                               |
| 10.18* |       | Employment Agreement  dated March 9, 2004, by and among the Company, Heritage Health Systems,  Inc. and Theodore M. Carpenter, Jr.                                                                                                                                     |
| 12.1*  |       | Statement re Computation  of Ratios of Earnings to Fixed Charges.                                                                                                                                                                                                                |
| 21.1*  |       | List of Subsidiaries.                                                                                                                                                                                                                                                            |
| 23.1*  |       | Consent of  Ernst & Young LLP                                                                                                                                                                                                                                           |
| 31.1*  | ** ** | Certification of Chief  Executive Officer, as required by Rule 13a-14(a) of the  Securities Exchange Act of 1934.                                                                                                                                                      |
| 31.2*  | ** ** | Certification of Chief  Financial Officer, as required by Rule 13a-14(a) of the  Securities Exchange Act of 1934.                                                                                                                                                      |
| 32.1*  | ** ** | Certification of the  Chief Executive Officer and Chief Financial Officer, as required by  Rule 13a-14(b) of the Securities Exchange Act of 1934 and 18  U.S.C. Section 1350, as adopted pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002.         |
|   |       | * Filed or furnished  herewith.                                                                                                                                                                                                                                                  |

 

93

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**SIGNATURES**

Pursuant to the requirements of Section 13 or 15(d) ofthe Securities Exchange Act of 1934, the Registrant has duly caused this reportto be signed on its behalf by the undersigned, thereunto duly authorized.

|                     |   | **UNIVERSAL AMERICAN FINANCIAL CORP.** |                                 |   |
|---------------------|--------|----------------------------------------|--------------------------------------|--------|
| March 16, 2006 |   |                                   | /s/ Richard A. Barasch               |   |
|                |   |                                   | Richard A. Barasch                   |   |
|                |   |                                   | Chairman of the Board, President and |   |
|                |   |                                   | Chief Executive Officer              |   |
|                     |        |                                        |                                      |        |  |  |

 

Pursuant to therequirements of the Securities Exchange Act of 1934, this report has been signedbelow by the following persons on behalf of the registrant and in the followingcapacities and on the dates indicated.

| Signature and Title                                             | ** ** | **Date**             |
|-----------------------------------------------------------------|------------|----------------------|
| /s/  RICHARD A. BARASCH                                         |       | March 16,  2006 |
| Richard A.  Barasch                                             |       |                 |
| Chairman of the Board,  President,                              |       |                 |
| Chief Executive  Officer and Director                           |       |                 |
| (Principal  Executive Officer)                                  |       |                 |
| /s/  ROBERT A. WAEGELEIN                                        |       | March 16,  2006 |
| Robert A.  Waegelein                                            |       |                 |
| Executive Vice  President and Chief Financial Officer           |       |                 |
| (Principal  Financial Officer and Principal Accounting Officer) |       |                 |
| /s/  BRADLEY E. COOPER                                          |       | March 16,  2006 |
| Bradley E. Cooper                                               |       |                 |
| Director                                                        |       |                 |
| /s/  MARK M. HARMELING                                          |       | March 16,  2006 |
| Mark M. Harmeling                                               |       |                 |
| Director                                                        |       |                 |
| /s/  BERTRAM HARNETT                                            |       | March 16,  2006 |
| Bertram Harnett                                                 |       |                 |
| Director                                                        |       |                 |
| /s/  LINDA LAMEL                                                |       | March 16,  2006 |
| Linda Lamel                                                     |       |                 |
| Director                                                        |       |                 |

94

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| /s/ ERIC LEATHERS          |   | March 16,  2006 |
|----------------------------|--------|----------------------|
| Eric Leathers              |   |                 |
| Director                   |   |                 |
| /s/  PATRICK J. MCLAUGHLIN |   | March 16,  2006 |
| Patrick J.  McLaughlin     |   |                 |
| Director                   |   |                 |
| /s/  ROBERT A. SPASS       |   | March 16,  2006 |
| Robert A. Spass            |   |                 |
| Director                   |   |                 |
| /s/  ROBERT F. WRIGHT      |   | March 16,  2006 |
| Robert F. Wright           |   |                 |
| Director                   |   |                 |

 

 

95

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**UNIVERSALAMERICAN FINANCIAL CORP. AND SUBSIDIARIESINDEX TO CONSOLIDATED FINANCIAL STATEMENTS**

| CONSOLIDATED FINANCIAL  STATEMENTS AND FINANCIAL STATEMENT SCHEDULES OF THE REGISTRANT:                                         |   |   |   |
|---------------------------------------------------------------------------------------------------------------------------------|--------|--------|--------|
| Report of Independent Registered Public Accounting  Firm                                                                        |   | F-2    |   |
| Report of Independent Registered Public Accounting  Firm on Internal Control Over Financial Reporting                           |   | F-3    |   |
| Consolidated Balance Sheets as of December 31,  2005 and 2004                                                              |   | F-5    |   |
| Consolidated Statements of Operations for the Three  Years Ended December 31, 2005                                         |   | F-6    |   |
| Consolidated Statements of Stockholders’ Equity and  Comprehensive Income for the Three Years Ended December 31, 2005 |   | F-7    |   |
| Consolidated Statements of Cash Flows for the Three  Years Ended December 31, 2005                                         |   | F-8    |   |
| Notes to Consolidated Financial Statements                                                                                      |   | F-9    |   |
| Schedule I—Summary of Investments - other than  investments in related parties                                             |   | F-47   |   |
| Schedule II—Condensed Financial Information of  Registrant                                                                 |   | F-48   |   |
| Notes to Condensed Financial Information                                                                                        |   | F-51   |   |
| Schedule III—Supplementary Insurance Information                                                                           |   | F-52   |   |
| Schedule  IV—Reinsurance  (incorporated in Note 12 to the Consolidated Financial Statements)                               |   |   |   |
| Schedule  V—Valuation and Qualifying Accounts  (incorporated in Note 6 to the Consolidated Financial Statements)           |   |   |   |
| Other schedules were omitted because they were not  applicable                                                                  |   |   |   |

 

F-1

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**Reportof Independent Registered Public Accounting Firm**

The Board of Directors and Stockholders ofUniversal AmericanFinancial Corp.

We have audited the accompanying consolidated balancesheets of Universal American Financial Corp. and subsidiaries as of December 31,2005 and 2004, and the related consolidated statements of operations,stockholders’ equity and comprehensive income, and cash flows for each of thethree years in the period ended December 31, 2005. Our audits alsoincluded the financial statement schedules listed in the Index at Item 15(a). Thesefinancial statements and schedules are the responsibility of the Company’smanagement. Our responsibility is to express an opinion on these financialstatements and schedules based on our audits.

We conducted our audits in accordance with thestandards of the Public Company Accounting Oversight Board (United States). Thosestandards require that we plan and perform the audit to obtain reasonableassurance about whether the financial statements are free of materialmisstatement. An audit includes examining, on a test basis, evidence supportingthe amounts and disclosures in the financial statements. An audit also includesassessing the accounting principles used and significant estimates made bymanagement, as well as evaluating the overall financial statement presentation.We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statementsreferred to above present fairly, in all material respects, the consolidatedfinancial position of Universal American Financial Corp. and subsidiaries at December 31,2005 and 2004 and the consolidated results of their operations and their cashflows for each of the three years in the period ended December 31, 2005,in conformity with U.S. generally accepted accounting principles. Also, in ouropinion, the related financial statement schedules, when considered in relationto the basic financial statements taken as a whole, present fairly in allmaterial respects the information set forth therein.

We also have audited, in accordance with the standardsof the Public Company Accounting Oversight Board (United States), theeffectiveness of Universal American Financial Corp.’s internal control overfinancial reporting as of December 31, 2005, based on criteria establishedin Internal Control—Integrated Framework issued by the Committee of SponsoringOrganizations of the Treadway Commission and our report dated March 14,2006 expressed an unqualified opinion on management’s assessment of internalcontrol over financial reporting, and an adverse opinion on the effectivenessof internal control over financial reporting.

/s/ Ernst & Young LLP

New York, New YorkMarch 14, 2006

F-2

----

**Report of Independent Registered Public AccountingFirm**

** **

** **

The Board of Directors and Stockholders ofUniversal American Financial Corp. 

We have audited management’s assessment, included inthe accompanying management’s annual report on internal control over financialreporting, that Universal American Financial Corp. did not maintain effectiveinternal control over financial reporting as of December 31, 2005, becausemanagement determined that a material weakness existed in the Company’sinternal controls relating to the accounting for its Medicare Supplement claimreserves and the related amounts recoverable from reinsurers, based on criteria established in InternalControl—Integrated Framework issued by the Committee of SponsoringOrganizations of the Treadway Commission (the COSO criteria).  Universal American Financial Corp.’smanagement is responsible for maintaining effective internal control overfinancial reporting and for its assessment of the effectiveness of internalcontrol over financial reporting. Our responsibility is to express an opinionon management’s assessment and an opinion on the effectiveness of the company’sinternal control over financial reporting based on our audit. 

We conducted our audit in accordance with thestandards of the Public Company Accounting Oversight Board (United States).Those standards require that we plan and perform the audit to obtain reasonableassurance about whether effective internal control over financial reporting wasmaintained in all material respects. Our audit included obtaining anunderstanding of internal control over financial reporting, evaluatingmanagement’s assessment, testing and evaluating the design and operatingeffectiveness of internal control, and performing such other procedures as weconsidered necessary in the circumstances. We believe that our audit provides areasonable basis for our opinion.

A company’s internal control over financial reportingis a process designed to provide reasonable assurance regarding the reliabilityof financial reporting and the preparation of financial statements for externalpurposes in accordance with generally accepted accounting principles. Acompany’s internal control over financial reporting includes those policies andprocedures that (1) pertain to the maintenance of records that, in reasonabledetail, accurately and fairly reflect the transactions and dispositions of theassets of the company; (2) provide reasonable assurance that transactions arerecorded as necessary to permit preparation of financial statements inaccordance with generally accepted accounting principles, and that receipts andexpenditures of the company are being made only in accordance withauthorizations of management and directors of the company; and (3) providereasonable assurance regarding prevention or timely detection of unauthorizedacquisition, use, or disposition of the company’s assets that could have amaterial effect on the financial statements.

Because of its inherent limitations, internal controlover financial reporting may not prevent or detect misstatements.  Also, projections of any evaluation ofeffectiveness to future periods are subject to the risk that controls maybecome inadequate because of changes in conditions, or that the degree ofcompliance with the policies or procedures may deteriorate.

A material weakness is a control deficiency, orcombination of control deficiencies, that results in more than a remotelikelihood that a material misstatement of the annual or interim financialstatements will not be prevented or detected. The following material weaknesshas been identified and included in management’s assessment.  As of December 31, 2005, the Company’sanalysis and review controls were not sufficient to ensure that its claimreserves, amounts recoverable from reinsurers and net incurred claims for itsMedicare supplement business were appropriately stated. As a result of thisweakness, the Company’s internal controls did not detect the need foradjustments to the amounts initially recorded for these items.  Based on additional analysis and proceduresperformed, management made adjustments in the fourth quarter of 2005 to itsclaim reserves and amounts recoverable from reinsurers as of December 

F-3

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31, 2005 and to the related incurred claims expensefor the year ended December 31, 2005 for its Medicare Supplement business priorto issuance of the consolidated financial statements as of December 31,2005.  The effects on prior quarterly andannual consolidated financial statements of the Company were not material.  This material weakness was considered indetermining the nature, timing, and extent of audit tests applied in our auditof the 2005 consolidated financial statements, and this report does not affectour report dated March 14, 2006 on those financial statements. 

In our opinion, management’s assessment that UniversalAmerican Financial Corp. did not maintain effective internal control overfinancial reporting as of December 31, 2005, is fairly stated, in all materialrespects, based on the COSO control criteria. Also, in our opinion, because ofthe effect of the material weakness described above on the achievement of theobjectives of the control criteria, Universal American Financial Corp. has notmaintained effective internal control over financial reporting as of December31, 2005, based on the COSO control criteria. 

|   | /s/ Ernst & Young LLP |
|--------|---------------------------|

 

New York, New YorkMarch 14, 2006

F-4

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**UNIVERSALAMERICAN FINANCIAL CORP. AND SUBSIDIARIESCONSOLIDATED BALANCE SHEETSDecember 31, 2005 and 2004(In thousands)**

| ** **                                                                                                      | ** ** | **2005**  | ** ** | **2004**  | ** ** |
|-----------------------------------------------------------------------------------------------------------------|------------|-----------|------------|-----------|------------|
| ASSETS                                                                                                          |       |      |       |      |       |
| Investments (Notes 2 and 5):                                                                                    |       |      |       |      |       |
| Fixed maturities  available for sale, at fair value  (amortized cost: 2005, $1,294,124; 2004, $1,109,678)  |       | $    | 1,344,775  |      | $     | 1,170,822 |   |
| Equity securities, at  fair value (cost: 2005, $1,299; 2004, $749)                                              |       | 1,279     |       | 755       |       |
| Policy loans                                                                                                    |       | 23,601    |       | 24,318    |       |
| Other invested assets                                                                                           |       | 896       |       | 1,187     |       |
| Total investments                                                                                               |       | 1,370,551 |       | 1,197,082 |       |
| Cash and cash  equivalents                                                                                      |       | 138,899   |       | 181,257   |       |
| Accrued investment  income                                                                                      |       | 13,067    |       | 13,151    |       |
| Deferred policy  acquisition costs (Notes 2 and 11)                                                             |       | 272,542   |       | 208,281   |       |
| Amounts due from  reinsurers (Note 12)                                                                          |       | 227,392   |       | 212,501   |       |
| Due and unpaid premiums                                                                                         |       | 7,815     |       | 6,474     |       |
| Present value of future  profits and other amortizing intangible assets                                         |       | 50,724    |       | 60,804    |       |
| Goodwill and other  indefinite lived intangible assets (Notes 2 and 4)                                          |       | 73,000    |       | 75,180    |       |
| Income taxes receivable                                                                                         |       | 2,230     |       | 865       |       |
| Other assets                                                                                                    |       | 71,759    |       | 61,493    |       |
| Total assets                                                                                                    |       | $         | 2,227,979  |      | $          | 2,017,088 |   |
| LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                       |       |      |       |      |       |
| LIABILITIES                                                                                                     |       |      |       |      |       |
| Policyholder account  balances (Note 2)                                                                         |       | $         | 498,421    |      | $          | 478,373 |   |
| Reserves for future  policy benefits                                                                            |       | 799,659   |       | 759,325   |       |
| Policy and contract  claims—life                                                                           |       | 14,525    |       | 10,802    |       |
| Policy and contract  claims—health (Note 10)                                                               |       | 115,779   |       | 94,526    |       |
| Loan payable (Note 13)                                                                                          |       | 95,813    |       | 101,063   |       |
| Other long term debt  (Note 14)                                                                                 |       | 75,000    |       | 75,000    |       |
| Amounts due to  reinsurers                                                                                      |       | 6,028     |       | 6,023     |       |
| Deferred income tax  liability (Note 6)                                                                         |       | 20,072    |       | 5,206     |       |
| Other liabilities                                                                                               |       | 70,798    |       | 67,349    |       |
| Total liabilities                                                                                               |       | 1,696,095 |       | 1,597,667 |       |
| Commitments and contingencies (Note 16)                                                                         |       |      |       |      |       |
| STOCKHOLDERS’ EQUITY (Note 7)                                                                              |       |      |       |      |       |
| Common stock  (Authorized: 100 million shares, issued: 2005, 59.0 million shares; 2004,  55.3 million shares)   |       | 590       |       | 553       |       |
| Additional paid-in  capital                                                                                     |       | 242,433   |       | 172,525   |       |
| Accumulated other  comprehensive income (Notes 7 and 20)                                                        |       | 39,896    |       | 40,983    |       |
| Retained earnings                                                                                               |       | 260,205   |       | 206,329   |       |
| Less: Treasury stock  (2005, 0.8 million shares; 2004, 0.1 million shares)                                      |       | (11,240   | )          | (969      | )          |
| Total stockholders’  equity                                                                                |       | 531,884   |       | 419,421   |       |
| Total liabilities and stockholders’ equity                                                                 |       | $         | 2,227,979  |      | $          | 2,017,088 |   |

 

See notes to consolidated financial statements.

F-5

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**UNIVERSALAMERICAN FINANCIAL CORP. AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF OPERATIONSFor the Three Years Ended December 31, 2005(In thousands, per share amounts in dollars)**

| ** **                                          | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|-----------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Revenues:                                           |       |     |       |     |       |     |       |
| Direct premium and policyholder fees earned         |       | $        | 1,154,367  |     | $          | 854,146  |       | $ | 700,415 |   |
| Reinsurance premiums assumed                        |       | 32,108   |       | 35,682   |       | 27,042   |       |
| Reinsurance premiums ceded                          |       | (350,416 | )          | (244,883 | )          | (280,489 | )          |
| Net premiums and policyholder fees earned (Note 12) |       | 836,059  |       | 644,945  |       | 446,968  |       |
| Net investment income (Note 5)                      |       | 71,612   |       | 65,191   |       | 61,075   |       |
| Net realized gains on investments (Note 5)          |       | 5,773    |       | 10,647   |       | 2,057    |       |
| Fee and other income                                |       | 18,479   |       | 14,680   |       | 12,648   |       |
| Total revenues                                      |       | 931,923  |       | 735,463  |       | 522,748  |       |
| Benefits, Claims  and Expenses:                     |       |     |       |     |       |     |       |
| Claims and other benefits                           |       | 579,786  |       | 421,807  |       | 292,211  |       |
| Net increase in reserves for future policy benefits |       | 22,796   |       | 21,275   |       | 14,423   |       |
| Interest credited to policyholders                  |       | 19,069   |       | 18,617   |       | 14,900   |       |
| Increase in deferred acquisition costs (Note 11)    |       | (56,740  | )          | (65,507  | )          | (51,104  | )          |
| Amortization of intangible assets (Note 4)          |       | 6,907    |       | 5,232    |       | 3,023    |       |
| Commissions                                         |       | 150,248  |       | 143,699  |       | 135,937  |       |
| Reinsurance commission and expense allowances       |       | (56,924  | )          | (51,729  | )          | (69,712  | )          |
| Interest expense                                    |       | 10,983   |       | 7,903    |       | 4,894    |       |
| Early extinguishment of debt (Note 13)              |       | —   |       | —   |       | 1,766    |       |
| Other operating costs and expenses                  |       | 173,832  |       | 137,698  |       | 109,931  |       |
| Total benefits, claims and other deductions         |       | 849,957  |       | 638,995  |       | 456,269  |       |
| Income before taxes                                 |       | 81,966   |       | 96,468   |       | 66,479   |       |
| Income tax  expense                                 |       | 28,090   |       | 32,597   |       | 23,427   |       |
| Net income                                          |       | $        | 53,876     |     | $          | 63,871   |       | $ | 43,052 |   |
| Earnings per common  share (Notes 2 and 19):        |       |     |       |     |       |     |       |
| Basic                                               |       | $        | 0.94       |     | $          | 1.17     |       | $ | 0.80 |   |
| Diluted                                             |       | $        | 0.91       |     | $          | 1.13     |       | $ | 0.78 |   |

 

See notes to consolidated financial statements.

F-6

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**UNIVERSALAMERICAN FINANCIAL CORP. AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY AND COMPREHENSIVE INCOMEFor the Three Years Ended December 31, 2005(In thousands)**

| ** **                                           | ** ** | **Common  Stock** | ** ** | **Additional  Paid-In  Capital** | ** ** | **Accumulated  Other  Comprehensive  Income** | ** ** | **Retained  Earnings** | ** ** | **Treasury  Stock** | ** ** | **Total** | ** ** |
|------------------------------------------------------|------------|-------------------|------------|----------------------------------|------------|-----------------------------------------------|------------|------------------------|------------|---------------------|------------|-----------|------------|
| Balance, January 1,  2003                       |       |              | $          | 532                              |       |                                          | $          | 158,264                |       |                | $          | 29,887    |       |   | $ | 99,406 |   | $ | (1,320 | ) | $ | 286,769 |   |
| Net income                                           |       |              | —     |                             |       | —                                        |       |                   | —     |                |       | 43,052    |       | — |   | 43,052 |   |
| Other comprehensive  income (Note 20)           |       |              | —     |                             |       | —                                        |       |                   | 9,887      |                |       | —    |       | — |   | 9,887 |   |
| Comprehensive income                                 |       |              | —     |                             |       | —                                        |       |                   | —     |                |       | —    |       | — |   | 52,939 |   |
| Issuance of common stock  (Note 7)                   |       |              | 9          |                             |       | 4,077                                         |       |                   | —     |                |       | —    |       | — |   | 4,086 |   |
| Stock-based compensation  (Note 8)                   |       |              | —     |                             |       | 1,343                                         |       |                   | —     |                |       | —    |       | — |   | 1,343 |   |
| Repayments of loans to  officers (Note 7)  |       |              | —     |                             |       | 653                                           |       |                   | —     |                |       | —    |       | — |   | 653 |   |
| Treasury shares  purchased, at cost (Note 7)         |       |              | —     |                             |       | —                                        |       |                   | —     |                |       | —    |       | (1,113 | ) | (1,113 | ) |
| Treasury shares reissued  (Note 7)                   |       |              | —     |                             |       | 18                                            |       |                   | —     |                |       | —    |       | 1,043 |   | 1,061 |   |
| Balance,  December 31, 2003                     |       |              | 541        |                             |       | 164,355                                       |       |                   | 39,774     |                |       | 142,458   |       | (1,390 | ) | 345,738 |   |
| Net income                                           |       |              | —     |                             |       | —                                        |       |                   | —     |                |       | 63,871    |       | — |   | 63,871 |   |
| Other comprehensive  income (Note 20)           |       |              | —     |                             |       | —                                        |       |                   | 1,209      |                |       | —    |       | — |   | 1,209 |   |
| Comprehensive income                                 |       |              | —     |                             |       | —                                        |       |                   | —     |                |       | —    |       | — |   | 65,080 |   |
| Issuance of common stock  (Note 7)                   |       |              | 12         |                             |       | 4,779                                         |       |                   | —     |                |       | —    |       | — |   | 4,791 |   |
| Stock-based compensation  (Note 8)                   |       |              | —     |                             |       | 3,010                                         |       |                   | —     |                |       | —    |       | — |   | 3,010 |   |
| Repayments of loans to  officers (Note 7)  |       |              | —     |                             |       | 126                                           |       |                   | —     |                |       | —    |       | — |   | 126 |   |
| Treasury shares  purchased, at cost (Note 7)         |       |              | —     |                             |       | —                                        |       |                   | —     |                |       | —    |       | (325 | ) | (325 | ) |
| Treasury shares reissued  (Note 7)                   |       |              | —     |                             |       | 255                                           |       |                   | —     |                |       | —    |       | 746 |   | 1,001 |   |
| Balance,  December 31, 2004                     |       |              | 553        |                             |       | 172,525                                       |       |                   | 40,983     |                |       | 206,329   |       | (969 | ) | 419,421 |   |
| Net income                                           |       |              | —     |                             |       | —                                        |       |                   | —     |                |       | 53,876    |       | — |   | 53,876 |   |
| Other comprehensive  income (loss) (Note 20)         |       |              | —     |                             |       | —                                        |       |                   | (1,087     | )                   |       | —    |       | — |   | (1,087 | ) |
| Comprehensive income                                 |       |              | —     |                             |       | —                                        |       |                   | —     |                |       | —    |       | — |   | 52,789 |   |
| Issuance of common stock  (Note 7)                   |       |              | 37         |                             |       | 64,804                                        |       |                   | —     |                |       | —    |       | — |   | 64,841 |   |
| Stock-based compensation  (Note 8)                   |       |              | —     |                             |       | 4,486                                         |       |                   | —     |                |       | —    |       | — |   | 4,486 |   |
| Repayments of loans to  officers (Note 7)  |       |              | —     |                             |       | 20                                            |       |                   | —     |                |       | —    |       | — |   | 20 |   |
| Treasury shares  purchased, at cost (Note 7)         |       |              | —     |                             |       | —                                        |       |                   | —     |                |       | —    |       | (10,961 | ) | (10,961 | ) |
| Treasury shares reissued  (Note 7)                   |       |              | —     |                             |       | 598                                           |       |                   | —     |                |       | —    |       | 690 |   | 1,288 |   |
| Balance, December 31, 2005                      |       |              | $          | 590                              |       |                                          | $          | 242,433                |       |                | $          | 39,896    |       |   | $ | 260,205 |   | $ | (11,240 | ) | $ | 531,884 |   |

 

See notes to consolidated financial statements.

F-7

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**UNIVERSALAMERICAN FINANCIAL CORP. AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF CASH FLOWSFor the Three Years Ended December 31, 2005(In thousands)**

| ** **                                                                                                                                            | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Cash flows from operating  activities:                                                                                                                |       |     |       |     |       |     |       |
| Net income                                                                                                                                            |       | $        | 53,876     |     | $          | 63,871   |       | $ | 43,052 |   |
| Adjustments  to reconcile net income to net cash provided by operating activities, net of  balances acquired (see Note 3—Business Combinations): |       |     |       |     |       |     |       |
| Deferred income taxes                                                                                                                                 |       | 16,561   |       | 22,435   |       | 7,839    |       |
| Change in reserves for future policy benefits                                                                                                         |       | 31,327   |       | 27,751   |       | 17,393   |       |
| Change in policy and contract claims                                                                                                                  |       | 27,647   |       | (16,080  | )          | 23       |       |
| Change in reinsurance balances                                                                                                                        |       | (17,056  | )          | 5,825    |       | 18,327   |       |
| Change in deferred policy acquisition costs                                                                                                           |       | (56,740  | )          | (65,507  | )          | (51,104  | )          |
| Amortization of present value of future profits and  other intangibles                                                                                |       | 6,907    |       | 5,232    |       | 3,023    |       |
| Other amortization and depreciation                                                                                                                   |       | 5,481    |       | 4,890    |       | 5,450    |       |
| Net accretion of bond discount                                                                                                                        |       | (4,716   | )          | (3,724   | )          | (3,299   | )          |
| Realized gains on investments                                                                                                                         |       | (5,773   | )          | (10,647  | )          | (2,057   | )          |
| Equity in loss of unconsolidated subsidary                                                                                                            |       | 3,980    |       | —   |       | —   |       |
| Change in income taxes payable                                                                                                                        |       | 1,506    |       | (13,354  | )          | 10,488   |       |
| Change in policy loans                                                                                                                                |       | 718      |       | 1,184    |       | 286      |       |
| Change in accrued investment income                                                                                                                   |       | 84       |       | 1,325    |       | (1,371   | )          |
| Other, net                                                                                                                                            |       | (1,222   | )          | 3,153    |       | (3,750   | )          |
| Net cash provided by operating activities                                                                                                             |       | 62,580   |       | 26,354   |       | 44,300   |       |
| Cash flows from  investing activities:                                                                                                                |       |     |       |     |       |     |       |
| Proceeds from sale or redemption of fixed maturities                                                                                                  |       | 283,154  |       | 304,886  |       | 271,968  |       |
| Cost of fixed maturities purchased                                                                                                                    |       | (450,509 | )          | (304,803 | )          | (335,629 | )          |
| Purchase of business, net of cash acquired (Note 3)                                                                                                   |       | —   |       | (65,961  | )          | (58,940  | )          |
| Other investing activities                                                                                                                            |       | (7,581   | )          | (19,803  | )          | (3,852   | )          |
| Net cash used by investing activities                                                                                                                 |       | (174,936 | )          | (85,681  | )          | (126,453 | )          |
| Cash flows from  financing activities:                                                                                                                |       |     |       |     |       |     |       |
| Net proceeds from issuance of common stock                                                                                                            |       | 64,861   |       | 4,916    |       | 4,741    |       |
| Cost of treasury stock purchases                                                                                                                      |       | (10,961  | )          | (325     | )          | (1,113   | )          |
| Change in policyholder account balances                                                                                                               |       | 20,048   |       | 58,688   |       | 109,870  |       |
| Change in reinsurance on policyholder account  balances                                                                                               |       | 1,300    |       | (35      | )          | 1,028    |       |
| Principal repayment on loan payable                                                                                                                   |       | (5,250   | )          | (5,703   | )          | (8,653   | )          |
| Early extinguishment of debt (Note 13)                                                                                                                |       | —   |       | —   |       | (68,950  | )          |
| Issuance of new debt (Note 13)                                                                                                                        |       | —   |       | 68,594   |       | 65,000   |       |
| Cost of new debt issued                                                                                                                               |       | —   |       | (2,075   | )          | —   |       |
| Issuance of trust preferred securities (Note 14)                                                                                                      |       | —   |       | —   |       | 60,000   |       |
| Net cash provided by financing activities                                                                                                             |       | 69,998   |       | 124,060  |       | 161,923  |       |
| Net increase (decrease) in cash and cash equivalents                                                                                                  |       | (42,358  | )          | 64,733   |       | 79,770   |       |
| Cash and cash equivalents at beginning of year                                                                                                        |       | 181,257  |       | 116,524  |       | 36,754   |       |
| Cash and cash equivalents at end of year                                                                                                              |       | $        | 138,899    |     | $          | 181,257  |       | $ | 116,524 |   |
| Supplemental cash  flow information:                                                                                                                  |       |     |       |     |       |     |       |
| Cash paid for interest                                                                                                                                |       | $        | 10,885     |     | $          | 7,805    |       | $ | 4,804 |   |
| Cash paid for  income taxes                                                                                                                           |       | $        | 8,155      |     | $          | 20,464   |       | $ | 3,199 |   |

 

See notes to consolidated financial statements.

F-8

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**UNIVERSALAMERICAN FINANCIAL CORP. AND SUBSIDIARIESNOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**1.**                 *ORGANIZATION AND COMPANY BACKGROUND*

Universal AmericanFinancial Corp. (the “Company” or “Universal American”) is a specialty healthand life insurance holding company with an emphasis on providing a broad arrayof health insurance and managed care products and services to the growingsenior population. Universal American was incorporated in the State of New Yorkin 1981. Collectively, our insurance company subsidiaries are licensed to selllife and accident & health insurance and annuities in all fiftystates, the District of Columbia, Puerto Rico and all the provinces of Canada. Theprincipal insurance products currently sold by the Company are Medicare Supplementand Select, fixed benefit accident and sickness disability insurance, seniorlife insurance and fixed annuities. The Company distributes these productsthrough an independent general agency system and a career agency system. Thecareer agents focus on sales for Pennsylvania Life Insurance Company (“PennsylvaniaLife”), The Pyramid Life Insurance Company (“Pyramid Life”) and Penncorp LifeInsurance Company, a Canadian company (“Penncorp Life (Canada)”) while theindependent general agents sell for American Pioneer Life Insurance Company (“AmericanPioneer”), American Progressive Life & Health Insurance Company of NewYork (“American Progressive”), Constitution Life Insurance Company (“Constitution”),Marquette National Life Insurance Company (“Marquette”) and Union BankersInsurance Company (“Union Bankers”). Heritage operates Medicare Advantage plansin Houston and Beaumont Texas through SelectCare of Texas, L.L.C., and inOklahoma through SelectCare of Oklahoma, Inc. (formerly Eagle LifeInsurance Company), and our Medicare Advantage private fee-for-service plans. CHCSServices, Inc. (“CHCS”), the Company’s administrative services company, acts asa service provider for both affiliated and unaffiliated insurance companies forsenior market insurance and non-insurance programs. Beginning in 2006, we willoffer prescription drug benefit plans pursuant to Medicare Part D (“Part D”)through a strategic alliance with PharmaCare Management Services, Inc. (“PharmaCare”),a wholly owned subsidiary of CVS Corporation (“CVS”).

**2.**                 *SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES*

***Basis ofPresentation:***   The accompanying consolidatedfinancial statements have been prepared in accordance with accountingprinciples generally accepted in the United States (“GAAP”) and consolidate theaccounts of Universal American Financial Corp. (“Universal American”) and itssubsidiaries (collectively the “Company”), American Progressive, AmericanPioneer, American Exchange Life Insurance Company (“American Exchange”),Pennsylvania Life, Peninsular Life Insurance Company (“Peninsular”), UnionBankers, Constitution, Marquette, Penncorp Life (Canada), Pyramid Life,Heritage Health Systems, Inc (“Heritage”) and CHCS. For the insurancesubsidiaries, GAAP differs from statutory accounting practices prescribed orpermitted by regulatory authorities. All material intercompany transactions andbalances between Universal American and its subsidiaries have been eliminated. PyramidLife was acquired on March 31, 2003 and Heritage was acquired on May 28,2004. Operating results for these entities prior to the date of theirrespective acquisitions are not included in Universal American’s consolidatedresults of operations. The significant accounting policies followed byUniversal American and its subsidiaries are summarized below.

***Use of Estimates:***   Thepreparation of our financial statements in conformity with GAAP requires us tomake estimates and assumptions that affect the amounts of assets andliabilities and disclosures of assets and liabilities reported by us at thedate of the financial statements and the revenues and expenses reported duringthe reporting period. As additional information becomes available or actualamounts become determinable, the recorded estimates may be revised andreflected in operating results. Actual results could differ from thoseestimates. In our judgment, the accounts involving estimates and 

F-9

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assumptions that are mostcritical to the preparation of our financial statements are future policybenefits and claim liabilities, deferred policy acquisition costs, goodwill, presentvalue of future profits and other intangibles, the valuation of certaininvestments and income taxes. There have been no changes in our criticalaccounting policies during the current year.

***Investments:***   TheCompany follows Statement of Financial Accounting Standards (“FAS”) No. 115,“Accounting for Certain Debt and Equity Securities” (“FAS 115”). FAS 115requires that debt and equity securities be classified into one of threecategories and accounted for as follows: Debt securities that the Company has the positive intent and the abilityto hold to maturity are classified as “held to maturity” and reported atamortized cost. Debt and equity securities that are held for current resale areclassified as “trading securities” and reported at fair value, with unrealizedgains and losses included in earnings. Debt and equity securities notclassified as held to maturity or as trading securities are classified as “availablefor sale” and reported at fair value. Unrealized gains and losses on availablefor sale securities are excluded from earnings and reported as accumulatedother comprehensive income, net of tax and deferred policy acquisition costadjustments.

As of December 31, 2005 and 2004, all fixedmaturity securities were classified as available for sale and were carried atfair value, with the unrealized gain or loss, net of tax and deferred policyacquisition cost adjustments, included in accumulated other comprehensiveincome. Equity securities are carried at current fair value. Policy loans arestated at the unpaid principal balance. Short-term investments are carried atcost, which approximates fair value. Other invested assets include mortgageloans and collateral loans. The collateral loans are carried at the underlyingvalue of their collateral, the cash surrender value of life insurance. Mortgageloans are carried at the unpaid principal balance.

The fair value of investments is based upon quotedmarket prices, where available, or on values obtained from independent pricingservices. For certain mortgage-backed and asset-backed securities, thedetermination of fair value is based primarily upon the amount and timing ofexpected future cash flows of the security. Estimates of these cash flows arebased on current economic conditions, past credit loss experience and otherfactors.

The Company regularly evaluates the amortized cost ofits investments compared to the fair value of those investments. Impairments ofsecurities are generally recognized when a decline in fair value below theamortized cost basis is considered to be other-than-temporary. Impairmentlosses for certain mortgage-backed and asset-backed securities are recognizedwhen an adverse change in the amount or timing of estimated cash flows occurs,unless the adverse change is solely a result of changes in estimated marketinterest rates. The cost basis for securities determined to be impaired arereduced to their fair value, with the excess of the cost basis over the fairvalue recognized as a realized investment loss.

Realized investment gains and losses on the sale ofsecurities are based on the specific identification method.

Investment income is generally recorded when earned. Premiumsand discounts arising from the purchase of certain mortgage-backed andasset-backed securities are amortized into investment income over the estimatedremaining term of the securities, adjusted for anticipated prepayments. Theprospective method is used to account for the impact on investment income ofchanges in the estimated future cash for these securities. Premiums anddiscounts on other fixed maturity securities are amortized using the interestmethod over the remaining term of the security.

***Deferred PolicyAcquisition Costs:***   The cost of acquiring newbusiness, principally commissions and certain expenses of the agency, policyissuance and underwriting departments, all of which vary with, and areprimarily related to the production of new and renewal business, have beendeferred. These costs are being amortized in relation to the present value ofexpected gross profits on the policies arising principally from investment,mortality and expense margins in accordance with FAS No. 97, “Accountingand 

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Reporting by InsuranceEnterprises for Certain Long-Duration Contracts and for Realized Gains andLosses from the Sale of Investments” (“FAS 97”), for interest sensitive lifeand annuity products and in proportion to premium revenue using the sameassumptions used in estimating the liabilities for future policy benefits inaccordance with FAS No. 60, “Accounting and Reporting by InsuranceEnterprises” (“FAS 60”), for non-interest sensitive life and all accident &health products. Deferred policy acquisition costs are written off to the extentthat it is determined that future policy premiums and investment income orgross profits would not be adequate to cover related losses and expenses.

The Company has several reinsurance arrangements inplace on its life and accident & health insurance risks. Amountscapitalized for deferred acquisition costs are reported net of the relatedcommissions and expense allowances received from the reinsurer on these costs(see Note 11—Deferred Acquisition Costs).

***Present Value ofFuture Profits and Goodwill:****  *Business combinations accounted for as a purchaseresult in the allocation of the purchase consideration to the fair values ofthe assets and liabilities acquired, including the present value of futureprofits, establishing such fair values as the new accounting basis. The presentvalue of future profits is based on an estimate of the cash flows of the inforce business acquired, discounted to reflect the present value of those cashflows. The discount rate selected depends upon the general market conditions atthe time of the acquisition and the inherent risk in the transaction. Purchaseconsideration in excess of the fair value of net assets acquired, including thepresent value of future profits and other identified intangibles, for aspecific acquisition, is allocated to goodwill. Allocation of purchase price isperformed in the period in which the purchase is consummated. Adjustments, ifany, in subsequent periods relate to resolution of pre-acquisitioncontingencies and refinements made to estimates of fair value in connectionwith the preliminary allocation.

Amortization of present value of future profits isbased upon the pattern of the projected cash flows of the in-force businessacquired, over weighted average lives ranging from six to forty years. Otheridentified intangibles are amortized over their estimated lives.

At least annually, management reviews the unamortizedbalances of present value of future profits, goodwill and other identifiedintangibles to determine whether events or circumstances indicate the carryingvalue of such assets is not recoverable, in which case an impairment chargewould be recognized. Management believes that no impairments of present valueof future profits, goodwill or other identified intangibles existed as of December 31,2005.

***Recognition ofRevenues, Contract Benefits and Expenses for Investment and Universal Life TypePolicies:***   Revenues for Universal Life-typepolicies and investment products consist of mortality charges for the cost ofinsurance and surrender charges assessed against policyholder account balancesduring the period. Amounts received for investment and universal life typeproducts are not reflected as premium revenue; rather such amounts areaccounted for as deposits, with the related liability included in policyholderaccount balances. Benefit claims incurred in excess of policyholder accountbalances are expensed. The liability for policyholder account balances foruniversal life-type policies and investment products under FAS 97 aredetermined following a “retrospective deposit” method. The retrospectivedeposit method establishes a liability for policy benefits at an amountdetermined by the account or contract balance that accrues to the benefit ofthe policyholder, which consists principally of policy account values beforeany applicable surrender charges. The base rate on the annuity productscurrently marketed by us is 3%. We offer sales inducements in the form of firstyear only bonus interest rates, which range from 1% to 4%, on certain of ourannuity products. Including the bonus interest rates, our current creditedrates on our annuity products range from 2.5% to 7.8%. Our currently marketedannuity products have minimum guaranteed interest rates ranging from 1.5% to 3%.For Universal Life products, current credited rates range from 3% to 6%, whichrepresent the minimum guaranteed rates. There is no first year only bonusinterest on our Universal Life policies.

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***Recognition ofPremium Revenues and Policy Benefits for Accident & Health InsuranceProducts:****  *Premiumsare recorded when due and recognized as revenue over the period to which thepremiums relate. Benefits and expenses associated with earned premiums are recognizedas the related premiums are earned so as to result in recognition of profitsover the life of the policies. This association is accomplished by recording aprovision for future policy benefits and amortizing deferred policy acquisitioncosts. The liability for future policy benefits for accident & healthpolicies consists of active life reserves and the estimated present value ofthe remaining ultimate net cost of incurred claims. Active life reservesinclude unearned premiums and additional reserves. The additional reserves arecomputed on the net level premium method using assumptions for futureinvestment yield, mortality and morbidity experience. The assumptions are basedon past experience. Claim reserves are established for future payments not yetdue on incurred claims, primarily relating to individual disability and longterm care insurance and group long-term disability insurance products. Thesereserves are initially established based on past experience, continuouslyreviewed and updated with any related adjustments recorded to currentoperations. Claim liabilities represent policy benefits due but unpaid andprimarily relate to individual health insurance products.

***Recognition ofPremium Revenues and Policy Benefits for Traditional Life and Annuity Products:***   Premiumsfrom traditional life and annuity policies with life contingencies generallyare recognized as revenue when due. Benefits and expenses are matched with suchrevenue so as to result in the recognition of profits over the life of thecontracts. This matching is accomplished by recording a provision for futurepolicy benefits and the deferral and subsequent amortization of policyacquisition costs.

***Recognition ofPremium Revenues and Policy Benefits for Medicare Advantage Policies:***   Premiumsreceived pursuant to Medicare Advantage contracts with the Federal government’sCenters for Medicare & Medicaid Services (“CMS”) for Medicareenrollees are recorded as revenue in the month in which members are entitled toreceive service. Premiums collected in advance are deferred. Accountsreceivable from CMS and healthplan members for coordinating physician servicesand inpatient, outpatient and ancillary care are included in other assets andare recorded net of estimated bad debts. Commissions are deferred and recognizedover the period they are earned. Policies and contract claims include actualclaims reported but not paid and estimates of health care services incurred butnot reported. The estimated claims incurred but not reported are based onhistorical data, current enrollment, health service utilization statistics andother related information. Although considerable variability is inherent insuch estimates, management believes that the liability is adequate. Changes inassumptions for medical costs caused by changes in actual experience couldcause these estimates to change in the near term.

***Recognition ofAdministrative Service Revenue:***   Fees foradministrative services generally are recognized over the period for which theCompany is obligated to provide service.

***Income Taxes:***   TheCompany uses the asset and liability method of accounting for income taxes. Underthis method, deferred tax assets and liabilities are recognized for the futuretax consequences attributable to differences between the financial statementcarrying amounts of existing assets and liabilities and their respective taxbases. Deferred tax assets and liabi­lities are measured using enacted taxrates expected to apply to taxable income in the years in which those temporarydifferences are expected to be recovered or settled. The effect on deferred taxassets and liabilities of a change in tax rates is recognized in income in theperiod that includes the enactment date of a change in tax rates.

The Company establishes valuation allowances on itsdeferred tax assets for amounts that it determines will not be recoverablebased upon an analysis of projected taxable income and its ability to implementprudent and feasible tax planning strategies. Increases in the valuationallowances are recognized as deferred tax expense. Subsequent determinationsthat portions of the valuation allowances are no longer necessary are reflectedas deferred tax benefits. To the extent that valuation allowances were 

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established in conjunctionwith acquisitions, changes in those allowances are first applied to goodwill(but not below zero) or other intangibles related to the acquisition and thenare applied to income tax expense.

***Reinsurance:****  *Amounts recoverable under reinsurancecontracts are included in total assets as amounts due from reinsurers ratherthan net against the related policy asset or liability. The cost of reinsurancerelated to long-duration contracts is accounted for over the life of theunderlying reinsured policies using assumptions consistent with those used toaccount for the underlying policies.

***Foreign CurrencyTranslation:***   The financial statement accounts of the Company’s Canadianoperations, which are denominated in Canadian dollars, are translated into U.S.dollars as follows: (i) assets and liabilities are translated at the ratesof exchange as of the balance sheet dates and the related unrealizedtranslation adjustments are included as a component of accumulated othercomprehensive income, and (ii) revenues, expenses and cash flows aretranslated using a weighted average of exchange rates for each periodpresented.

***DerivativeInstruments—Cash Flow Hedge:***   The Companyuses certain derivative instruments, interest rate swap agreements, to managerisk arising from interest rate volatility. Interest rate swap agreements (“cashflow hedges”) are contracts to exchange interest payments on a specifiedprincipal (notional) amount for a specified period. By using derivatives tomanage risk, the Company exposes itself to credit risk and additional marketrisk. Credit risk is the exposure to loss if a counterparty fails to performunder the terms of the derivative contract. The Company minimizes its creditrisk by entering into transactions with counterparties that maintain highcredit ratings. Market risk is the exposure to changes in the market price ofthe underlying instrument and the related derivative. Such price changes resultfrom movements in interest rates, and as a result, assets and liabilities willappreciate or depreciate in market value. These derivative instruments arerecognized on the balance sheet at their fair value, based on independentpricing sources. The fair value of the derivative instruments are reported asassets or liabilities in other assets or other liabilities.

On the date the interest rate swap contract is enteredinto the Company may designate it as a hedge of a forecasted transaction or ofthe variability of cash flows to be received or paid related to a recognizedasset or liability (“cash flow hedge”), if certain criteria are met. At theinception of the contract, the Company formally documents all relationshipsbetween the hedging instrument and the hedged item, as well as itsrisk-management objective and strategy for undertaking each hedge transaction. TheCompany also formally assesses, both at the hedge’s inception and on an ongoingbasis, whether the derivative used in hedging transactions are highly effectivein offsetting changes in the cash flows of the hedged items.

For a derivative designated as a cash flow hedge, theeffective portion of changes in the fair value of the derivative are recordedin accumulated other comprehensive income and are recognized in the incomestatement when the hedged item affects results of operations. If it is determined that (i) an interestrate swap is not highly effective in offsetting changes in the cash flows of ahedged item, (ii) the derivative expires or is sold, terminated orexercised, or (iii) the derivative is undesignated as a hedge instrumentbecause it unlikely that a forecasted transaction will occur, the Companydiscontinues hedge accounting prospectively.

If hedge accounting is discontinued, the derivativewill continue to be carried at fair value, with change in the fair value of thederivative recognized in the current period results of operations. When hedgeaccounting is discontinued because it is probable that a forecasted transactionwill not occur, the accumulated gains and losses included in other accumulatedother comprehensive income will be recognized immediately in results ofoperations.

***Earnings Per CommonShare:****  *Basicearning per share (“EPS”) excludes dilution and is computed by dividing netincome by the weighted average number of shares outstanding for the period. DilutedEPS gives the dilutive effect of the stock options outstanding during the year.There were 368,224 stock options 

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excluded from thecomputation of diluted EPS at December 31, 2005 because they wereantidilutive. At December 31, 2004, 109,250 were excluded.

***Stock BasedCompensation:***   The Company has variousstock-based incentive plans for its employees, non-employee directors and itsagents. Detailed information for activity in the Company’s stock plans can befound in Note 8—Stock-Based Compensation. The Company follows Statement ofFinancial Accounting Standards (“FAS”) No. 123 “Accounting for Stock BasedCompensation,” (“FAS 123”) for determining the fair value of options issued toagents and others. The fair value of options awarded to agents and others isexpensed over the vesting period of each award. As permitted by FAS 123,the Company measures its stock-based compensation for employees and directorsusing the intrinsic value approach under Accounting Principles Board Opinion No. 25.“Accounting for Stock Issued to Employees” (“APB 25”) and relatedinterpretations. Accordingly, the Company does not recognize compensationexpense upon the issuance of its stock options because the option terms arefixed and the exercise price equaled the market price of the underlying commonstock on the grant date. For options issued to employees with an exercise pricethat is less than market on the date of grant the Company recognizes an expensefor the difference between the exercise price and the value of the options onthe date of grant. The Company complies with the provisions of FAS 123 byproviding pro forma disclosures of net income and related per share data givingconsideration to the fair value method provisions of FAS 123. The Companyuses a modified Black-Scholes option pricing model to estimate fair value. Forpurposes of pro forma disclosures, the estimated fair value of the options isamortized to expense over the options’ vesting periods.

Thefollowing table illustrates the effect on net income and earnings per share ifthe fair value based method had been applied during each period presented.

| ** **                                                                                                   | ** ** | **For the year ended December 31,**      | ** ** |
|--------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------|------------|
| ** **                                                                                                   | ** ** | **2005**                                                          | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                                                                                   | ** ** | **(in thousands, except  per share amounts)** | ** ** |
| Reported net  income                                                                                         |       | $                                                                 | 53,876     |   | $ | 63,871 |   | $ | 43,052 |   |
| Add back:  Stock-based compensation expense included in reported net income, net of tax                      |       | 1,331                                                             |       | 589 |   | 1,527 |   |
| Less: Stock based  compensation expense determined under fair value based method for all awards,  net of tax |       | (3,099                                                            | )          | (2,126 | ) | (2,895 | ) |
| Pro forma net  income                                                                                        |       | $                                                                 | 52,108     |   | $ | 62,334 |   | $ | 41,684 |   |
| Net income per  share:                                                                                       |       |                                                              |       |   |   |   |   |
| Basic, as reported                                                                                           |       | $                                                                 | 0.94       |   | $ | 1.17 |   | $ | 0.80 |   |
| Basic, pro forma                                                                                             |       | $                                                                 | 0.91       |   | $ | 1.14 |   | $ | 0.78 |   |
| Diluted, as reported                                                                                         |       | $                                                                 | 0.91       |   | $ | 1.13 |   | $ | 0.78 |   |
| Diluted, pro  forma                                                                                          |       | $                                                                 | 0.88       |   | $ | 1.10 |   | $ | 0.76 |   |

 

Pro forma compensation expense reflected for priorperiods is not indicative of future compensation expense that would be recordedby the Company if it were to adopt the fair value based recognition provisionsof FAS No. 123-Revised, “Share-Based Payment” (“FAS 123-R”)for stock based compensation for its employees and directors. Future expensemay vary based upon factors such as the number of awards granted by the Companyand the then-current fair market value of such awards.

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Thefair value for these options was estimated at the date of grant using aBlack-Scholes option pricing model with the following range of assumptions:

| Risk free  interest rates             |   | 3.12% - 6.68%   |   |
|---------------------------------------|--------|---------------------------|--------|
| Dividend yields                       |   | 0.0%                      |   |
| Expected  volatility                  |   | 40.00% - 48.64% |   |
| Expected lives of  options (in years) |   | 0 - 9.0         |   |

 

The Black-Scholes option valuation model was developedfor use in estimating the fair value of traded options that have no vestingrestrictions and are fully transferable. In addition, option valuation modelsrequire the input of highly subjective assumptions including the expected stockprice volatility. Because the Company’s employee stock options havecharacteristics significantly different from those of traded options, andbecause changes in the subjective input assumptions can materially affect thefair value estimate, in management’s opinion, the existing models do notnecessarily provide a reliable single measure of the fair value of its employeestock options. Detailed information for activity in the Company’s stock planscan be found in Note 8—Stock-Based Compensation.

***Cash FlowInformation:***   Cash and cash equivalentsinclude cash on deposit, money market funds, and short term investments thathad an original maturity of three months or less from the time of purchase.

***Adoption of NewAccounting Pronouncements:****   ***Other-Than-TemporaryImpairment—****In November, 2005, the FinancialAccounting Standards Board issued FSP 115-1, “The Meaning ofOther-Than-Temporary Impairment and Its Application to Certain Investments” (“FSP115-1”). FSP 115-1 modifies certain existing quidance andestablishes a framework for the evaluation of whether an impairment of aninvestment is other-than-temporary. The evaluation is based on the intent andability to hold the security to maturity, and should be considered on anindividual security basis, not on a portfolio basis. FSP 115-1 alsoclarifies that subsequent to the recognition of an other-than-temporaryimpairment loss for debt securities, an investor shall account for the securityusing the constant effective yield method. FSP 115-1 is effective forreporting periods beginning after December 15, 2005, with earlierapplication permitted. The adoption of FSP 115-1 did not have an effecton the Company’s consolidated financial condition or results of operations. However,the framework provided in FSP 115-1 could potentially result in therecognition of unrealized losses, including those declines in value that areattributable to interest rate movements, as other-than-temporary impairments,except those deemed to be minor in nature. As of December 31, 2005, theCompany had $8.7 million of total gross unrealized losses. The amount ofimpairments to be recognized, if any, will depend on market conditions andmanagement’s intent and ability to hold securities with unrealized losses atthe time of the impairment evaluation.

*Accounting forCertain Nontraditional Long-Duration Contracts—*In July 2003, the Accounting Standards ExecutiveCommittee of the American Institute of Certified Public Accountants issued afinal Statement of Position 03-1, “Accounting and Reporting by InsuranceEnterprises for Certain Nontraditional Long-Duration Contracts and for SeparateAccounts” (“SOP 03-1”). SOP 03-1 addresses a wide variety oftopics, however, the primary provision that applies to the Company relates tocapitalizing sales inducements that meet specified criteria and amortizing suchamounts over the life of the contracts using the same methodology as used foramortizing deferred acquisition costs. The Company adopted SOP 03-1effective January 1, 2004. The Company currently offers enhanced or bonuscrediting rates to contract-holders on certain of its individual annuityproducts. The Company’s policy in this regard was to defer only the portion ofthe bonus interest amount that was offset by a corresponding reduction in thesales commission to the agent. Effective January 1, 2004, all bonusinterest was deferred and amortized. The adoption of SOP 03-1 did nothave a material impact on the consolidated financial position or results ofoperations of the Company.

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***Future Adoption ofAccounting Standards:******  ******Accounting for Stock-Based Compensation—***In December 2004,the Financial Accounting Standards Board FAS 123-R. FAS 123-Rrequires companies to charge the fair value of all share-based payment awards(including stock options) issued to employees and non-employees to expense. Theprovisions of this standard require the fair value to be calculated using avaluation model (such as the Black-Scholes or binomial-lattice models). Theprovisions of this standard are effective for all new share-based arrangementsentered into in the first quarter of 2006, as well as the fair value of theunvested portion of existing arrangements as of January 1, 2006. Theestimated fair value of the unvested portion of existing arrangements as ofJanuary 1, 2006 is expected to be approximately $3.8 million, of whichapproximately $2.4 million will be expensed in 2006 in addition to the fairvalue of any future grants. FAS 123-R also requires the benefits of taxdeductions in excess of recognized compensation cost to be reported as afinancing cash flow, rather than as an operating cash flow as required undercurrent literature. This requirement will reduce net operating cash flows andincrease net financing cash flows in periods after adoption. While the Companycannot estimate what those amounts will be in the future (because they dependon, among other things, when employees exercise stock options), the amount ofoperating cash flows recognized for such excess tax deductions were $2.9million for the year ended December 31, 2005 and $2.3 million for the yearended December 31, 2004, and $0.1 million for the year endedDecember 31, 2003.

*DeferredAcquisition Costs—*InSeptember 2005, the American Institute of Certified Public Accountantsissued Statement of Position 05-1, “Accounting by Insurance Enterprisesfor Deferred Acquisition Costs (“DAC”) in Connection with Modifications orExchanges of Insurance Contracts”, (“SOP 05-1”). SOP 05-1 providesguidance on accounting by insurance enterprises for DAC on internalreplacements of insurance and investment contracts. An internal replacement isa modification in product benefits, features, rights or coverages that occursby the exchange of a contract for a new contract, or by amendment, endorsement,or rider to a contract, or by the election of a feature or coverage within acontract. Modifications that result in a replacement contract that issubstantially changed from the replaced contract should be accounted for as anextinguishment of the replaced contract. Unamortized DAC, unearned revenueliabilities and deferred sales inducements from the replaced contract must bewritten-off. Modifications that result in a contract that is substantiallyunchanged from the replaced contract should be accounted for as a continuationof the replaced contract. SOP 05-1 is effective for internal replacementsoccurring in fiscal years beginning after December 15, 2006, with earlieradoption encouraged. Initial application of SOP 05-1 should be as of thebeginning of the entity’s fiscal year. The Company expects to adopt SOP 05-1effective January 1, 2007. Adoption of this statement is expected to havean effect on the Company’s consolidated financial statements; however, theeffect has not yet been determined.

***Reclassifications:***   Certain reclassifications havebeen made to prior years’ financial statements to conform to current periodpresentation.

**3.**                 BUSINESSCOMBINATIONS

*Acquisition ofHeritage Health Systems, Inc.*

On May 28, 2004, the Company acquired 100% of theoutstanding common stock of Heritage, a privately owned managed care companythat operates Medicare Advantage plans in Houston and Beaumont Texas, for $98.0million in cash plus transaction costs of $2.0 million. Heritage generates itsrevenues and profits from three sources. First, Heritage owns an interest inSelectCare of Texas, L.L.C. (“SelectCare”), a health plan that offers coverageto Medicare beneficiaries under a contract with CMS. Next, Heritage operatesthree separate Management Service Organizations (“MSO’s”) that manage thebusiness of SelectCare and two affiliated Independent Physician Associations (“IPA’s”).Lastly, Heritage participates in the net results derived from these IPA’s. Theacquisition was financed with $66.5 million of net proceeds derived from theamendment of the Company’s credit facility (See Note 13—Loan Payable) 

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and $33.5 million of cashon hand. As of the date of acquisition, Heritage had approximately 16,000Medicare members and annualized revenues of approximately $140.0 million. Operatingresults generated by Heritage prior to May 28, 2004, the date ofacquisition, are not included in the Company’s consolidated financialstatements.

As of May 28,2005, the Company finalized the purchase accounting for the acquisition,resulting in an increase in the fair value of the net tangible assets ofHeritage of $4.8 million as of the date of acquisition, to $28.0 million, as aresult of the resolution of pre-acquisition contingencies. The excess of thepurchase price over the fair value of net tangible assets acquired was $72.0million, which the Company allocated to identifiable intangible assets andgoodwill. Based on this allocation, approximately $12.2 million was assigned toamortizing intangible assets, including $10.0 million (net of deferred incometaxes of $5.4 million), which was assigned to the value of the membership inforce and determined to have a weighted average life of 6 years and $2.2million (net of deferred taxes of $1.2 million), which was assigned to the IPA’s,and determined to have a weighted average lives of between 6 and 13 years. Approximately$5.2 million was allocated to non-amortizing intangible assets, including $4.4million assigned to the value of trademarks and $0.8 million assigned to thevalue of Heritage’s licenses. Each of these items was determined to haveindefinite lives. The balance of $54.3 million was assigned to goodwill. Thecondensed balance sheet of Heritage was as follows on the date of acquisition:

| ** **                                     | ** ** | **May 28, 2004** | ** ** |
|------------------------------------------------|------------|----------------------------|------------|
| ** **                                     | ** ** | **(in thousands)**    | ** ** |
| *Assets*                                       |       |                       |       |   |   |
| Cash and  Investments                          |       |                       | $          | 38,150 |   |   |
| PVFP and other  amortizing intangibles         |       |                       | 18,840     |   |   |
| Goodwill and  other non-amortizing intangibles |       |                       | 59,494     |   |   |
| Other                                          |       |                       | 8,271      |   |   |
| Total Assets                                   |       |                       | $          | 124,755 |   |   |
| *Liabilities*                                  |       |                       |       |   |   |
| Policy related  liabilities                    |       |                       | $          | 9,584 |   |   |
| Other                                          |       |                       | 15,124     |   |   |
| Total Liabilities                              |       |                       | 24,708     |   |   |
| Equity                                         |       |                       | 100,047    |   |   |
| Total Liabilities  and Equity                  |       |                       | $          | 124,755 |   |   |

 

Theconsolidated pro forma results of operations, assuming that Heritage waspurchased on January 1, 2004 is as follows:

| **Year ended December 31,** | ** ** | ** **              | ** ** | **2005** | ** ** | **2004** | ** ** |
|--------------------------------------------|------------|-------------------------|------------|----------|------------|----------|------------|
| ** **                                 | ** ** | **(In thousands)** | ** ** |
| Total revenue                              |       | $                       | 931,923    |     | $          | 792,933  |       |
| Income before  taxes(1)                    |       | $                       | 81,966     |     | $          | 101,731  |       |
| Net income(1)                              |       | $                       | 53,876     |     | $          | 67,293   |       |
| Earnings per  common share:                |       |                    |       |     |       |
| Basic                                      |       | $                       | 0.94       |     | $          | 1.23     |       |
| Diluted(1)                                 |       | $                       | 0.91       |     | $          | 1.19     |       |

 

The pro forma results ofoperations reflect management’s best estimate based upon currently availableinformation. The pro forma adjustments are applied to the historical financialstatements of Universal American and Heritage to account for Heritage under thepurchase method of accounting. In accordance with FAS No. 141, “BusinessCombinations”, the total purchase cost was allocated to the assets 

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andliabilities of Heritage based on their relative fair values. These allocationsare subject to valuations as of the date of the acquisition based uponappraisals and other information at that time. Management has provided its bestestimate of the fair values of assets and liabilities for the purpose of thispro forma information. The pro forma information presented above is fordisclosure purposes only and is not necessarily indicative of the results ofoperations that would have occurred if the acquisition had been consummated onthe dates assumed, nor is the pro forma information intended to be indicativeof Universal American’s future results of operations.

**4.**                 *INTANGIBLE ASSETS*

Thefollowing table shows the Company’s acquired intangible assets that continue tobe subject to amortization and accumulated amortization expense:

| ** **                                         | ** ** | **December 31, 2005** | ** ** | **December 31, 2004** | ** ** |
|----------------------------------------------------|------------|---------------------------------|------------|---------------------------------|------------|
| ** **                                         | ** ** | **Value  Assigned**             | ** ** | **Accumulated  Amortization**   | ** ** | **Value  Assigned** | ** ** | **Accumulated  Amortization** | ** ** |
| ** **                                         | ** ** | **(In thousands)**         | ** ** |
| Senior Health Insurance:                           |       |                            |       |                            |       |   |   |   |   |   |   |   |   |
| Present value of future profits (“PVFP”) |       | $                               | 18,472     |                            |       | $ | 6,761 |   |   | $ | 18,472 |   |   | $ | 3,628 |   |   |
| Distribution Channel                               |       | 22,055                          |       |                            | 2,022      |   |   | 22,055 |   |   | 1,287 |   |   |
| Life  Insurance/Annuity—PVFP                  |       | 4,127                           |       |                            | 1,577      |   |   | 4,127 |   |   | 1,308 |   |   |
| Senior Managed  Care—Medicare Advantage:      |       |                            |       |                            |       |   |   |   |   |   |   |   |   |
| PVFP                                               |       | 15,381                          |       |                            | 3,558      |   |   | 18,554 |   |   | 1,667 |   |   |
| Value of IPA’s                                |       | 3,459                           |       |                            | 635        |   |   | 3,459 |   |   | 234 |   |   |
| Senior Administrative  Services                    |       |                            |       |                            |       |   |   |   |   |   |   |   |   |
| PVFP                                               |       | 7,671                           |       |                            | 7,240      |   |   | 7,671 |   |   | 7,035 |   |   |
| Value of future override fees                      |       | 1,797                           |       |                            | 445        |   |   | 1,797 |   |   | 172 |   |   |
| Total                                              |       | $                               | 72,962     |                            |       | $ | 22,238 |   |   | $ | 76,135 |   |   | $ | 15,331 |   |   |

 

Thefollowing table shows the changes in the present value of future profits andother amortizing intangible assets:

| ** **                                         | ** ** | **2005**                | ** ** | **2004** | ** ** | **2003** | ** ** |
|----------------------------------------------------|------------|-------------------------|------------|----------|------------|----------|------------|
| ** **                                         | ** ** | **(In thousands)** | ** ** |
| Balance,  beginning of year                        |       | $                       | 60,804     |     | $          | 44,047   |       | $ | 2,987 |   |
| Additions and adjustments relating to acquisitions |       | (3,173                  | )          | 21,989   |       | 44,083   |       |
| Amortization, net of interest                      |       | (6,907                  | )          | (5,232   | )          | (3,023   | )          |
| Balance, end of year                               |       | $                       | 50,724     |     | $          | 60,804   |       | $ | 44,047 |   |

 

Estimatedfuture net amortization expense (in thousands) is as follows:

| 2006       |   | $      | 6,922  |   |
|------------|--------|--------|--------|--------|
| 2007       |   | 6,583  |   |
| 2008       |   | 6,217  |   |
| 2009       |   | 4,623  |   |
| 2010       |   | 2,386  |   |
| Thereafter |   | 23,993 |   |
|       |   | $      | 50,724 |   |

 

F-18

----

Thecarrying amounts of goodwill and intangible assets with indefinite lives areshown below:

| ** **                                   | ** ** | **December 31,**   | ** ** |
|----------------------------------------------|------------|-------------------------|------------|
| ** **                                   | ** ** | **2005**                | ** ** | **2004** | ** ** |
| ** **                                   | ** ** | **(In thousands)** | ** ** |
| Senior Market  Health Insurance              |       | $                       | 8,760      |   | $ | 8,760 |   |
| Senior Managed  Care—Medicare Advantage |       | 59,883                  |       | 62,063 |   |
| Senior  Administrative Services              |       | 4,357                   |       | 4,357 |   |
| Total                                        |       | $                       | 73,000     |   | $ | 75,180 |   |

 

**5.**                 *INVESTMENTS*

Theamortized cost and fair value of fixed maturities are as follows:

| ** **                                   | ** ** | **December 31, 2005** | ** ** |
|----------------------------------------------|------------|---------------------------------|------------|
| ** **                                   | ** ** | ** **                      | ** ** | **Gross** | ** ** | **Gross** | ** ** | ** ** | ** ** |
| ** **                                   | ** ** | **Amortized**                   | ** ** | **Unrealized** | ** ** | **Unrealized** | ** ** | **Fair** | ** ** |
| **Classification**                           | ** ** | ** **                      | ** ** | **Cost** | ** ** | **Gains** | ** ** | **Losses** | ** ** | **Value** | ** ** |
| ** **                                   | ** ** | **(In thousands)**         | ** ** |
| U.S. Treasury securities  and                |       |                            |       |   |   |   |   |   |   |   |   |   |   |
| obligations of  U.S. government              |       | $                               | 112,857    |   |   | $ | 262 |   |   |   | $ | (1,258 | ) |   | $ | 111,861 |   |
| Corporate debt  securities                   |       | 449,639                         |       |   | 12,956 |   |   |   | (3,786 | ) |   | 458,809 |   |
| Foreign debt  securities(1)                  |       | 223,428                         |       |   | 42,949 |   |   |   | (209 | ) |   | 266,168 |   |
| Mortgage-backed  and asset-backed securities |       | 508,200                         |       |   | 3,148 |   |   |   | (3,411 | ) |   | 507,937 |   |
|                                         |       | $                               | 1,294,124  |   |   | $ | 59,315 |   |   |   | $ | (8,664 | ) |   | $ | 1,344,775 |   |
|                                              |            |                                 |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

| ** **                                   | ** ** | **December 31, 2004** | ** ** |
|----------------------------------------------|------------|---------------------------------|------------|
| ** **                                   | ** ** | ** **                      | ** ** | **Gross** | ** ** | **Gross** | ** ** | ** ** | ** ** |
| ** **                                   | ** ** | **Amortized**                   | ** ** | **Unrealized** | ** ** | **Unrealized** | ** ** | **Fair** | ** ** |
| **Classification**                           | ** ** | ** **                      | ** ** | **Cost** | ** ** | **Gains** | ** ** | **Losses** | ** ** | **Value** | ** ** |
| ** **                                   | ** ** | **(In thousands)**         | ** ** |
| U.S. Treasury securities  and                |       |                            |       |   |   |   |   |   |   |   |   |   |   |
| obligations of  U.S. government              |       | $                               | 87,552     |   |   | $ | 718 |   |   |   | $ | (327 | ) |   | $ | 87,943 |   |
| Corporate debt  securities                   |       | 486,142                         |       |   | 27,467 |   |   |   | (1,830 | ) |   | 511,779 |   |
| Foreign debt  securities(1)                  |       | 209,583                         |       |   | 28,797 |   |   |   | (33 | ) |   | 238,347 |   |
| Mortgage-backed  and asset-backed securities |       | 326,401                         |       |   | 6,879 |   |   |   | (527 | ) |   | 332,753 |   |
|                                         |       | $                               | 1,109,678  |   |   | $ | 63,861 |   |   |   | $ | (2,717 | ) |   | $ | 1,170,822 |   |
|                                              |            |                                 |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

----

(1)          Primarily Canadiandollar denominated bonds supporting our Canadian insurance reserves.

Theamortized cost and fair value of fixed maturities at December 31, 2005 bycontractual maturity are shown below. Expected maturities will differ fromcontractual maturities because borrowers may have the right to call or prepayobligations with or without call or prepayment penalties.

| ** **                            | ** ** | **Amortized**           | ** ** | **Fair**  | ** ** |
|---------------------------------------|------------|-------------------------|------------|-----------|------------|
| ** **                            | ** ** | **Cost**                | ** ** | **Value** | ** ** |
| ** **                            | ** ** | **(In thousands)** | ** ** |
| Due in 1 year or  less                |       | $                       | 47,727     |      | $          | 48,360 |   |
| Due after 1 year  through 5 years     |       | 240,180                 |       | 243,044   |       |
| Due after 5 years  through 10 years   |       | 303,230                 |       | 315,448   |       |
| Due after 10  years                   |       | 194,788                 |       | 229,987   |       |
| Mortgage and  asset-backed securities |       | 508,199                 |       | 507,936   |       |
|                                  |       | $                       | 1,294,124  |      | $          | 1,344,775 |   |

 

F-19

----

Thefair value and unrealized loss as of December 31, 2005 for fixed maturityand equity securities, aggregated by investment category and length of timethat individual securities have been in a continuous unrealized loss position,are shown below:

| ** **                                                   | ** ** | **Less than 12 Months** | ** ** | **12 Months or Longer** | ** ** | **Total** | ** ** |
|--------------------------------------------------------------|------------|----------------------------------------|------------|----------------------------------------|------------|-----------|------------|
| ** **                                                   | ** ** | **Fair**                               | ** ** | **Unrealized**                         | ** ** | **Fair**  | ** ** | **Unrealized** | ** ** | **Fair** | ** ** | **Unrealized** | ** ** |
| **Classification**                                           | ** ** | ** **                             | ** ** | **Value**                              | ** ** | **Loss**  | ** ** | **Value** | ** ** | **Loss** | ** ** | **Value** | ** ** | **Loss** | ** ** |
| ** **                                                   | ** ** | **(In thousands)**                | ** ** |
| U.S. Treasury  securities and obligations of U.S. Government |       | $                                      | 75,939     |                                   |       | $         | 765        |   |   | $ | 31,155 |   |   | $ | 560 |   |   | $ | 107,094 |   |   | $ | 1,325 |   |   |
| government                                                   |       |                                   |       |                                   |       |      |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Corporate debt                                               |       | 129,176                                |       |                                   | 3,278      |      |       | 13,223 |   |   | 471 |   |   | 142,399 |   |   | 3,749 |   |   |
| Foreign debt  securities                                     |       | 12,438                                 |       |                                   | 179        |      |       | 995 |   |   | 30 |   |   | 13,433 |   |   | 209 |   |   |
| Mortgage-backed  and asset-backed securities                 |       | 270,117                                |       |                                   | 2,975      |      |       | 15,721 |   |   | 406 |   |   | 285,838 |   |   | 3,381 |   |   |
| Total fixed  maturities                                      |       | 487,670                                |       |                                   | 7,197      |      |       | 61,094 |   |   | 1,467 |   |   | 548,764 |   |   | 8,664 |   |   |
| Equity securities                                            |       | 531                                    |       |                                   | 24         |      |       | — |   |   | — |   |   | 531 |   |   | 24 |   |   |
| Total                                                        |       | $                                      | 488,201    |                                   |       | $         | 7,221      |   |   | $ | 61,094 |   |   | $ | 1,467 |   |   | $ | 549,295 |   |   | $ | 8,688 |   |   |
|                                                              |            |                                        |            |                                        |            |           |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Fixed maturity and equity securities in an unrealizedloss position were diversified, representing 216 different securities as of December 31,2005. Collectively, the unrealized loss for these securities was less than 2%of their amortized cost. The fair value for these securities was 101% of theirpar value. Individually, the amortized cost for approximately 99% of thesesecurities was greater than 90% of its respective market value.

The majority of the securities in an unrealized lossposition for less than twelve months are depressed due to the rise in long-terminterest rates. This group of securities was comprised of 178 securities. Collectively,the unrealized loss for the securities in this group was less than 2% of theiramortized cost. The fair value for the securities in this group was 101% oftheir par value. Approximately 97%, of the less than twelve months totalunrealized loss amount was comprised of securities with fair value that isgreater than 90% of amortized cost.

The group of securities depressed for twelve months ormore was comprised of 37 securities. Collectively, the unrealized loss for thesecurities in this group was approximately 2% of their amortized cost. The fairvalue for the securities in this group was 104% of their par value. Individually,the amortized cost for approximately 99% of these securities was greater than90% of its respective market value. U.S. Treasury securities and obligations ofU.S. Government represent more than 50% and mortgage and asset-backed securities,which is comprised primarily of obligations of federal agencies, representsapproximately 26% of the total fair value for the more than twelve month group.Corporate debt securities represent approximately 22% of the total fair valueof the more than twelve month group. There was only one security with a marketvalue less than 94% of amortized cost with an unrealized loss of less than $0.1 million.A description of the events contributing to the security’s unrealized lossposition and the factors considered in determining that recording another-than-temporary impairment was not warranted are outlined below.

As part of the Company’s ongoing security monitoringprocess by a committee of investment and accounting professionals, the Companyhas reviewed its investment portfolio and concluded that there were noadditional other-than-temporary impairments as of December 31, 2005 and2004. Due to the issuers’ continued satisfaction of the securities’ obligationsin accordance with their contractual terms and the expectation that they willcontinue to do so, management’s intent and ability to hold these securities, aswell as the evaluation of the fundamentals of the issuers’ financial conditionand other objective evidence 

F-20

----

(including evaluation ofthe underlying collateral of a security), the Company believes that the pricesof the securities in the sectors identified above were temporarily depressed.

The evaluation for other-than-temporary impairments isa quantitative and qualitative process, which is subject to risks anduncertainties in the determination of whether declines in the fair value ofinvestments are other-than-temporary. The risks and uncertainties includechanges in general economic conditions, the issuer’s financial condition ornear term recovery prospects and the effects of changes in interest rates.

Grossunrealized gains and gross unrealized losses of equity securities as of December 31,are as follows:

| ** **               | ** ** | **2005**                | ** ** | **2004** | ** ** |
|--------------------------|------------|-------------------------|------------|----------|------------|
| ** **               | ** ** | **(In thousands)** | ** ** |
| Gross unrealized  gains  |       | $                       | 4          |     |       | $ | 7 |   |   |
| Gross unrealized  losses |       | (24                     | )          |     | (1         | ) |   |
| Net unrealized gains     |       | $                       | (20        | )        |       | $ | 6 |   |   |

 

Thecomponents of the change in unrealized gains and losses included in theconsolidated statements of stockholders’ equity are as follows:

| ** **                                                | ** ** | **2005**                | ** ** | **2004** | ** ** | **2003** | ** ** |
|-----------------------------------------------------------|------------|-------------------------|------------|----------|------------|----------|------------|
| ** **                                                | ** ** | **(In thousands)** | ** ** |
| Change in net  unrealized gains (losses):                 |       |                    |       |     |       |     |       |
| Fixed maturities                                          |       | $                       | ($10,493   | )        | $          | 1,706    |       | $ | 8,542 |   |
| Equity securities                                         |       | (26                     | )          | (20      | )          | 42       |       |
| Foreign currency                                          |       | 1,624                   |       | 2,329    |       | 9,090    |       |
| Fair value of cash flow swap                              |       | 712                     |       | 636      |       | 196      |       |
| Adjustment relating to deferred policy acquisition  costs |       | 6,511                   |       | (2,791   | )          | (2,665   | )          |
| Change in net  unrealized gains before income tax         |       | (1,672                  | )          | 1,860    |       | 15,205   |       |
| Income tax  (expense)                                     |       | 585                     |       | (651     | )          | (5,318   | )          |
| Change in net unrealized  gains                           |       | $                       | (1,087     | )        | $          | 1,209    |       | $ | 9,887 |   |

 

Thedetails of net investment income are as follows:

| ** **                | ** ** | **2005**                | ** ** | **2004** | ** ** | **2003** | ** ** |
|---------------------------|------------|-------------------------|------------|----------|------------|----------|------------|
| ** **                | ** ** | **(In thousands)** | ** ** |
| Investment Income:        |       |                    |       |     |       |     |       |
| Fixed maturities          |       | $                       | 65,330     |     | $          | 62,342   |       | $ | 59,528 |   |
| Cash and cash equivalents |       | 5,497                   |       | 2,155    |       | 882      |       |
| Policy loans              |       | 1,612                   |       | 1,678    |       | 1,652    |       |
| Other                     |       | 1,555                   |       | 1,020    |       | 899      |       |
| Gross investment  income  |       | 73,994                  |       | 67,195   |       | 62,961   |       |
| Investment  expenses      |       | (2,382                  | )          | (2,004   | )          | (1,886   | )          |
| Net investment income     |       | $                       | 71,612     |     | $          | 65,191   |       | $ | 61,075 |   |

 

There were no non-income producing fixed maturitysecurities for the years ended December 31, 2005, 2004 or 2003.

F-21

----

Grossrealized gains and gross realized losses included in the consolidatedstatements of operations are as follows:

| ** **                                  | ** ** | **2005**                | ** ** | **2004** | ** ** | **2003** | ** ** |
|---------------------------------------------|------------|-------------------------|------------|----------|------------|----------|------------|
| ** **                                  | ** ** | **(In thousands)** | ** ** |
| Realized gains:                             |       |                    |       |     |       |     |       |
| Fixed maturities                            |       | $                       | 6,883      |     | $          | 12,400   |       | $ | 3,497 |   |
| Equity securities and other invested assets |       | 505                     |       | 32       |       | 476      |       |
| Total realized  gains                       |       | 7,388                   |       | 12,432   |       | 3,973    |       |
| Realized losses:                            |       |                    |       |     |       |     |       |
| Fixed maturities                            |       | (1,587                  | )          | (1,344   | )          | (1,811   | )          |
| Equity securities and other invested assets |       | (28                     | )          | (441     | )          | (105     | )          |
| Total realized  losses                      |       | (1,615                  | )          | (1,785   | )          | (1,916   | )          |
| Net realized  gains                         |       | $                       | 5,773      |     | $          | 10,647   |       | $ | 2,057 |   |

 

The Company did not write down the value of any fixedmaturity securities during 2005 or 2004. The Company wrote down the value ofcertain fixed maturity securities by $1.3 million during 2003. These writedowns represent management’s estimate of other-than-temporary declines in valueand were included in net realized gains on investments.

At December 31,2005 and 2004, the Company held unrated or less-than-investment grade corporatedebt securities as follows:

| ** **                             | ** ** | **2005**                | ** ** | **2004** | ** ** |
|----------------------------------------|------------|-------------------------|------------|----------|------------|
| ** **                             | ** ** | **(In thousands)** | ** ** |
| Carrying value  (estimated fair value) |       | $                       | 15,300     |     | $          | 7,003 |   |
| Percentage of total  assets            |       | 0.7                     | %          | 0.3      | %          |
|                                        |            |                         |            |          |            |  |  |

 

The holdings of less-than-investment grade securitiesare diversified and the largest investment in any one such security was $7.0million, or 0.03% of total assets at December 31, 2005, and $3.0 million,or 0.02% of total assets at December 31, 2004.

Included in fixedmaturities were investments held by various states as security for thepolicyholders of the Company within such states with carrying values of $42.6million at December 31, 2005 and $41.8 million at December 31,2004.

**6.**                 *INCOME TAXES*

The parent holding company files a consolidated returnfor federal income tax purposes that includes all of the non-life insurancecompany subsidiaries, including Heritage. American Exchange and itssubsidiaries and Penncorp Life (Canada) are not currently included. AmericanExchange and its subsidiaries file a separate consolidated federal income taxreturn. Penncorp Life (Canada) files a separate return with Revenue Canada.

Incomebefore taxes by geographic distribution is as follows:

| ** **                 | ** ** | **2005**                | ** ** | **2004** | ** ** | **2003** | ** ** |
|----------------------------|------------|-------------------------|------------|----------|------------|----------|------------|
| ** **                 | ** ** | **(In thousands)** | ** ** |
| United States              |       | $                       | 66,383     |     | $          | 77,457   |       | $ | 51,597 |   |
| Canada                     |       | 15,583                  |       | 19,011   |       | 14,882   |       |
| Total income before  taxes |       | $                       | 81,966     |     | $          | 96,468   |       | $ | 66,479 |   |

 

F-22

----

TheCompany’s federal and state income tax expense (benefit) is as follows:

| ** **                  | ** ** | **2005**                | ** ** | **2004** | ** ** | **2003** | ** ** |
|-----------------------------|------------|-------------------------|------------|----------|------------|----------|------------|
| ** **                  | ** ** | **(In thousands)** | ** ** |
| Current—United  States |       | $                       | 5,521      |     | $          | (825     | )          | $ | 303 |   |
| Current—Canada         |       | 5,017                   |       | 3,173    |       | 15,285   |       |
| Sub total current           |       | 10,538                  |       | 2,348    |       | 15,588   |       |
| Deferred—United States |       | 16,885                  |       | 27,148   |       | 17,821   |       |
| Deferred—Canada        |       | 667                     |       | 3,101    |       | (9,982   | )          |
| Sub total deferred          |       | 17,552                  |       | 30,249   |       | 7,839    |       |
| Total tax expense           |       | $                       | 28,090     |     | $          | 32,597   |       | $ | 23,427 |   |

 

Areconciliation of the “expected” tax expense at 35% with the Company’s actualtax expense applicable to operating income before taxes reported in theConsolidated Statements of Operations is as follows:

| ** **                                         | ** ** | **2005**                | ** ** | **2004** | ** ** | **2003** | ** ** |
|----------------------------------------------------|------------|-------------------------|------------|----------|------------|----------|------------|
| ** **                                         | ** ** | **(In thousands)** | ** ** |
| Expected tax  expense                              |       | $                       | 28,688     |     | $          | 33,764   |       | $ | 23,268 |   |
| Change in  valuation allowance                     |       | (807                    | )          | 3,163    |       | (4,507   | )          |
| Reserve for prior  year taxes of acquired entities |       | —                  |       | (3,805   | )          | 4,439    |       |
| Other                                              |       | 209                     |       | (525     | )          | 227      |       |
| Actual tax expense                                 |       | $                       | 28,090     |     | $          | 32,597   |       | $ | 23,427 |   |

 

In addition to federal and state income tax, theCompany is subject to state premium taxes, which taxes are included in otheroperating costs and expenses in the accompanying statements of operations.

Deferred income taxes reflect the net tax effects oftemporary differences between the carrying value of assets and liabilities forfinancial reporting purposes and the amount used for income tax purposes. Thetax effects of temporary differences that give rise to significant portions ofthe deferred tax assets and deferred tax liabilities are as follows:

| ** **                           | ** ** | **2005**                | ** ** | **2004** | ** ** |
|--------------------------------------|------------|-------------------------|------------|----------|------------|
| ** **                           | ** ** | **(In thousands)** | ** ** |
| Deferred tax assets:                 |       |                    |       |     |       |
| Reserves for  future policy benefits |       | $                       | 43,269     |     | $          | 43,733 |   |
| Loss  carryforwards                  |       | 2,879                   |       | 5,218    |       |
| Asset valuation  differences         |       | 4,329                   |       | 4,403    |       |
| Deferred revenues                    |       | 610                     |       | 1,113    |       |
| Tax credit  carryforwards            |       | 2,114                   |       | 1,234    |       |
| Total gross deferred tax assets      |       | 53,201                  |       | 55,701   |       |
| Less valuation allowance             |       | (2,949                  | )          | (3,756   | )          |
| Net deferred tax assets              |       | 50,252                  |       | 51,945   |       |
| Deferred tax  liabilities:           |       |                    |       |     |       |
| Deferred policy  acquisition costs   |       | (23,485                 | )          | (6,998   | )          |
| Present value of  future profits     |       | (21,480                 | )          | (25,641  | )          |
| Unrealized gains  on investments     |       | (21,483                 | )          | (22,068  | )          |
| Other                                |       | (3,876                  | )          | (2,444   | )          |
| Total gross deferred tax liabilities |       | (70,324                 | )          | (57,151  | )          |
| Net deferred tax  liability          |       | $                       | (20,072    | )        | $          | (5,206 | ) |

 

F-23

----

At December 31, 2005, the Company (exclusive ofAmerican Exchange and its subsidiaries and PennCorp Life) had net operatingloss carryforwards of approximately $3.8 million (including $2.8 million fromHeritage) that expire in 2015 and 2024 and capital loss carryforwards of $0.8million that expire in 2007. At December 31, 2005, the Company also had anAlternative Minimum Tax (AMT) credit carryforward for federal income taxpurposes of approximately $0.3 million that can be carried forward indefinitely.At December 31, 2005, American Exchange and its subsidiaries had netoperating loss carryforwards, most of which relate to the companies acquired in1999 (and were incurred prior to their acquisition), of approximately $0.5million that expire in 2017. At December 31, 2005, American Exchange andits subsidiaries also had capital loss carryforwards of $5.2 million thatexpire in 2007 and an AMT credit carryforward for federal income tax purposesof approximately $0.9 million that can be carried forward indefinitely. As aresult of changes in ownership of the Company in July 1999, the use ofmost of the loss carryforwards of the Company are subject to annuallimitations.

The Company establishesvaluation allowances based upon an analysis of projected taxable income and itsability to implement prudent and feasible tax planning strategies. The Companycarried valuation allowances on its deferred tax assets of $2.9 million at December 31,2005 and $3.8 million at December 31, 2004. At December 31, 2003, thevaluation allowance on certain of the life tax loss carryforwards no longer wasconsidered necessary and the Company released the valuation allowance of $4.5million which was reported as a deferred income tax benefit. As a result ofuncertainty regarding the ability to generate taxable capital gains to utilizecapital loss carryforwards, the Company established a valuation allowance inthe amount of $3.2 million during 2004 that was reported as a deferred incometax expense. Approximately $1.6 million of the valuation allowance related tothe capital loss carryforward was released during 2005, and reported as adeferred income tax benefit, as capital gains were generated and the Companywas able to realize the benefit from the capital loss carryforwards. During2005, the Company incurred creditable foreign taxes related to dividends from itssubsidiary Penncorp Life (Canada) generating a foreign tax credit carryforward,for which a deferred tax asset of approximately $0.8 million was established. Avaluation allowance for approximately $0.8 million was established because theCompany lacks sufficient foreign source income to realize the benefit for theforeign tax credit. In 2003, the Company established a reserve forpre-acquisition tax years of certain life insurance subsidiaries that werebeing examined by the Internal Revenue Service in the amount of $4.4 million. During2004, the Company released $3.8 million relating to a portion of reserveamounts established for pre-acquisition tax years of certain life insurancesubsidiaries that were being examined by the Internal Revenue Service. Managementbelieves it is more likely than not that the Company will realize the recordedvalue of its net deferred tax assets.

**7.**                 *STOCKHOLDERS’ EQUITY*

*Preferred Stock*

The Company has 2.0 millionauthorized shares of preferred stock with no such shares issued or outstandingat December 31, 2005 or at December 31, 2004.

*Common Stock*

The par value of common stock is $0.01 per share with100 million shares authorized for issuance. The shareholders approved aproposal to amend the Company’s Restated Certificate of Incorporation toincrease the number of authorized shares of common stock, par value $0.01 pershare, from 80 million shares to 100 million shares at the Annual Meeting on May 26,2004.

F-24

----

Changesin the number of shares of common stock issued were as follows:

| **Years ended December 31,**                                              | ** ** | ** ** | ** ** | **2005**   | ** ** | **2004**   | ** ** | **2003** | ** ** |
|------------------------------------------------------------------------------------------|------------|------------|------------|------------|------------|------------|------------|----------|------------|
| Common stock  issued, beginning of year                                                  |       | 55,326,092 |       | 54,111,923 |       | 53,184,381 |       |
| Equity offering                                                                          |       | 2,660,000  |       | —     |       | —     |       |
| Stock options  exercised                                                                 |       | 954,684    |       | 1,190,018  |       | 389,412    |       |
| Stock issued in  connection with acquisition                                             |       | —     |       | —     |       | 147,711    |       |
| Agent stock award                                                                        |       | 73,512     |       | —     |       | 41,872     |       |
| Stock purchases  pursuant to agents’ stock purchase and deferred compensation plans |       | 28,397     |       | 24,151     |       | 348,547    |       |
| Common stock issued, end  of period                                                      |       | 59,042,685 |       | 55,326,092 |       | 54,111,923 |       |

 

On June 22, 2005, theCompany issued 2.0 million shares of its common stock at a price of $23.61 pershare, in connection with a public offering pursuant to a shelf registration. Theissuance of these shares generated proceeds to the Company of $44.2 million,net of underwriters discount and other issuance costs. Additionally, 5.0million shares were sold by Capital Z Financial Services Fund II, L.P. and itsaffiliates (“Capital Z”), the Company’s largest shareholder, under the sameshelf registration. On July 20, 2005, the underwriters exercised theirover-allotment option and the Company issued an additional 660,000 shares ofits common stock at $23.61 per share, generating additional net proceeds of$14.8 million. Following the offering, Capital Z owned 20.2 millionshares, or 34.5% of Universal American’s outstanding common stock.

*Treasury Stock*

During 2000, our Board of Directors approved a planfor us to purchase up to 0.5 million shares of our common stock in the openmarket. Our Board approved an amendment to the plan to increase the totalshares authorized for purchase to 1.0 million in March 2002 and during December 2003approved a second amendment to increase the shares authorized for purchase to1.5 million. Pursuant to the plan, purchases may be made from time to time atprevailing prices, subject to restrictions on volume and timing.

BetweenOctober 28, 2005 and November 9, 2005, the Company purchased 705,036shares in open market transactions at an average price per share of $15.46 inaccordance with Rule 10b-18 of the Securities Exchange Act of 1934. Allremaining shares were purchased in private transactions.

| ** **                                          | ** ** | **For the year ended December 31,** | ** ** |
|-----------------------------------------------------|------------|--------------------------------------------------------------|------------|
| ** **                                          | ** ** | **2005**                                                     | ** ** | **2004** | ** ** |
| ** **                                          | ** ** | **Shares**                                                   | ** ** | **Amount** | ** ** | **Weighted  Average  Cost Per  Share** | ** ** | **Shares** | ** ** | **Amount** | ** ** | **Weighted  Average  Cost Per  Share** | ** ** |
| ** **                                          | ** ** | **(In thousands)**                                      | ** ** | **(In thousands)** | ** ** |
| Treasury stock  beginning of year                   |       | 124,941                                                      |       | $ | 969 |   |   | $ | 7.75 |   |   | 192,863 |   |   | $ | 1,390 |   |   |   | $ | 7.21 |   |   |
| Shares  repurchased                                 |       | 708,113                                                      |       | 10,961 |   |   | 15.48 |   |   | 30,929 |   |   | 325 |   |   |   | 10.52 |   |   |
| Shares  distributed in the form of employee bonuses |       | (81,581                                                      | )          | (690 | ) |   | 15.79 |   |   | (98,851 | ) |   | (746 | ) |   |   | 10.12 |   |   |
| Treasury stock, end of  period                      |       | 751,473                                                      |       | $ | 11,240 |   |   | $ | 14.96 |   |   | 124,941 |   |   | $ | 969 |   |   |   | $ | 7.75 |   |   |

 

On November 11, 2005,our Board of Directors approved a share repurchase program (the “2005 ShareRepurchase Program”) that authorized the Company to repurchase up to 1,000,000shares of our Common Stock. The 2005 Share Repurchase Program has no expirationdate, and purchases may be made under the 2005 Share Repurchase Program in theopen market or in privately negotiated transactions from time to time atmanagement’s discretion, as approved by a committee of the Board. As of December 31,2005, we have not engaged in any repurchases under the 2005 Share RepurchaseProgram.

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*Additional Paid InCapital*

In connection with the1999 acquisition the Company provided loans to certain members of management topurchase shares of common stock. The loans totaled $1.0 million at inceptionand were accounted for as a reduction of additional paid in capital in thefinancial statements. Through December 31, 2005, $0.9 million has beenrepaid. Repayments are reported as an increase to additional paid in capital. Asof December 31, 2005, the outstanding balance of these loans was $0.1million.

*Accumulated OtherComprehensive Income*

Thecomponents of accumulated other comprehensive income are as follows:

| ** **                                        | ** ** | **December 31,**   | ** ** |
|---------------------------------------------------|------------|-------------------------|------------|
| ** **                                        | ** ** | **2005**                | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                        | ** ** | **(In thousands)** | ** ** |
| Net unrealized appreciation  on  investments |       | $                       | 50,631     |   | $ | 61,150 |   | $ | 59,464 |   |
| Deferred  acquisition cost adjustment             |       | (1,265                  | )          | (7,776 | ) | (4,985 | ) |
| Foreign currency  translation gains               |       | 10,469                  |       | 8,845 |   | 6,516 |   |
| Fair value of  cash flow swap                     |       | 1,544                   |       | 832 |   | 196 |   |
| Deferred tax on  the above                        |       | (21,483                 | )          | (22,068 | ) | (21,417 | ) |
| Accumulated other  comprehensive income           |       | $                       | 39,896     |   | $ | 40,983 |   | $ | 39,774 |   |

 

**8.**                 *STOCK BASED COMPENSATION*

*1998 IncentiveCompensation Plan*

On May 28, 1998, the Company’s shareholdersapproved the 1998 Incentive Compensation Plan (the “1998 ICP”). The 1998 ICPsuperceded the Company’s 1993 Incentive Stock Option Plan. Options previouslygranted under the Company’s Incentive Stock Option Plan will remain outstandingin accordance with their terms and the terms of the respective plans. The 1998ICP provides for grants of stock options, stock appreciation rights (“SARs”),restricted stock, deferred stock, other stock-related awards, and performanceor annual incentive awards that may be settled in cash, stock, or otherproperty (“Awards”).

The total number of shares of the Company’s CommonStock reserved and available for delivery to participants in connection withAwards under the 1998 ICP is (i) 1.5 million, plus (ii) the number ofshares of Common Stock subject to awards under Preexisting Plans that becomeavailable (generally due to cancellation or forfeiture) after the effectivedate of the 1998 ICP, plus (iii) 13% of the number of shares of CommonStock issued or delivered by the Corporation during the term of the 1998 ICP(excluding any issuance or delivery in connection with Awards, or any othercompensation or benefit plan of the Corporation), provided, however, that thetotal number of shares of Common Stock with respect to which incentive stockoptions (“ISOs”) may be granted shall not exceed 1.5 million. On May 26,2004, the Company’s shareholders approved an amendment to increase the numberof shares of common stock authorized for issuance under the 1998 ICP by 2.5million shares. As of December 31, 2005, a total of 10.2 millionshares were eligible for grant under the plan of which 4.7 million shares werereserved for delivery under outstanding options awarded under the 1998 ICP, 3.7million shares had been issued pursuant to previous awards and 1.8 millionshares were reserved for issuance under future Awards at December 31,2005.

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Executive officers,directors, and other officers and employees of the Corporation or anysubsidiary, as well as other persons who provide services to the Company or anysubsidiary, are eligible to be granted Awards under the 1998 ICP, which isadministered by the Board or a Committee established pursuant to the Plan. TheCommittee, may, in its discretion, accelerate the exercisability, the lapsingof restrictions, or the expiration of deferral or vesting periods of any Award,and such accelerated exercisability, lapse, expiration and vesting shall occurautomatically in the case of a “change in control” of the Company, except tothe extent otherwise determined by the Committee at the date of grant orthereafter. The Committee has not yet exercised any of its discretions notedabove.

*Employee StockAwards*

In accordance with the1998 ICP, the Company grants restricted stock to its officers and non-officeremployees. These grants vest upon issue. The non-officer grants are expensedand awarded in the same year. The Company granted awards to non-officeremployees of 1,156 shares with a fair value of $15.08 per share during 2005,1,661 shares with a fair value of $15.47 per share during 2004, and 5,219shares with a fair value of $9.71 per share during 2003. Executive officers aregranted restricted stock in connection with the bonuses. This restricted stockvests ratably over four years. The award for 2005 performance has not yet beendetermined. Executive officers were awarded 72,420 shares with a fair value of$15.88 per share for 2004 performance and 79,132 shares with a fair value of$10.11 per share for 2003 performance. The expense for these awards isrecognized over the vesting period. For 2002 and prior, other officers werealso granted stock awards in connection with their bonuses. These awards vestedimmediately. Officer grants were accrued for during the year for which theywere earned and awarded the following year. The Company granted awards toofficers of 130,847 shares with a fair value of $5.57 per share during 2003 for2002. The Company recognized compensation expense of $0.2 million for the yearended December 31, 2003.

*Agent’s StockPurchase Plan*

The Company offers sharesof its common stock for sale to qualifying agents of the Insurance Subsidiariespursuant to the Company’s Agents Stock Purchase Plan (“ASPP”). Shares are soldat market price and, accordingly, no expense is recognized. Pursuant to theASPP, agents purchased 3,200 shares at a weighted average price of $17.67 pershare in 2005, 5,100 shares at a weighted average price of $10.73 per share in2004, and 183,286 shares at a weighted average price of $6.20 per share in2003.

*Agent’s DeferredCompensation Plan*

The Company also offersshares of Common Stock for sale to its agents pursuant to the Company’sDeferred Compensation Plan for Agents (“DCP”). Under the DCP, agents may electto defer receipt between 5% and 100% of their first year commission, whichdeferral will be matched by a contribution by the Company, initially set at 25%of the amount of the deferral, up to a maximum of 5% of the agent’s commissions.Both the agent’s participation in the DCP and the Company’s obligation to matchthe agent’s deferral are subject to the agent satisfying and continuing tosatisfy minimum earning, production and persistency standards. Shares are soldunder the plan at market price and, accordingly, no expense is recognized,except for the fair value of the shares representing the Company match on thedate of the contribution to the DCP. Agents deferred commissions amounted to$0.5 million in 2005, $0.3 million in 2004, and $0.3 million in 2003.

F-27

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*Option Awards*

Asummary of the status of the Company’s stock option plans during the threeyears ended December 31, 2005 and changes during the years ending on thosedates is presented below:

| ** **                          | ** ** | **2005**                | ** ** | **2004**                               | ** ** | **2003**                | ** ** |
|-------------------------------------|------------|-------------------------|------------|----------------------------------------|------------|-------------------------|------------|
| ** **                          | ** ** | **Options**             | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Options**             | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Options** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
| ** **                          | ** ** | **(In thousands)** | ** ** | ** **                             | ** ** | **(In thousands)** | ** ** | ** ** | ** ** | **(In thousands)** | ** ** | ** ** | ** ** |
| Outstanding—beginning  of year |       |                    | 5,180      |                                   |       |                    | $          | 5.19 |   |   |   | 5,659 |   |   |   | $ | 4.17 |   |   |   | 5,513 |   |   |   | $ | 3.87 |   |   |
| Granted                             |       |                    | 732        |                                   |       |                    | 16.90      |   |   |   | 832 |   |   |   | 10.69 |   |   |   | 745 |   |   |   | 6.28 |   |   |
| Exercised                           |       |                    | (955       | )                                      |       |                    | 5.78       |   |   |   | (1,190 | ) |   |   | 3.99 |   |   |   | (389 | ) |   |   | 3.63 |   |   |
| Terminated                          |       |                    | (134       | )                                      |       |                    | 6.56       |   |   |   | (121 | ) |   |   | 7.12 |   |   |   | (210 | ) |   |   | 4.77 |   |   |
| Outstanding—end  of year       |       |                    | 4,823      |                                   |       |                    | $          | 6.81 |   |   |   | 5,180 |   |   |   | $ | 5.19 |   |   |   | 5,659 |   |   |   | $ | 4.17 |   |   |
| Options exercisable at  end of Year |       |                    | 3,369      |                                   |       |                    | $          | 5.33 |   |   |   | 3,560 |   |   |   | $ | 4.46 |   |   |   | 4,019 |   |   |   | $ | 3.78 |   |   |

 

Asummary of the weighted average fair value of options granted during the threeyears ended December 31, 2005 is presented below:

| ** **    | ** ** | **2005**                | ** ** | **2004**                                | ** ** | **2003**                | ** ** |                                    |
|---------------|------------|-------------------------|------------|-----------------------------------------|------------|-------------------------|------------|-----------------------------------------|
| ** **    | ** ** | **Options**             | ** ** | **Weighted-  Average  Fair Value** | ** ** | **Options**             | ** ** | **Weighted-  Average  Fair Value** | ** ** | **Options** | ** ** | **Weighted-  Average  Fair Value** | ** ** |   |
| ** **    | ** ** | **(In thousands)** | ** ** | ** **                              | ** ** | **(In thousands)** | ** ** | ** **                              | ** ** | **(In thousands)** | ** ** | ** ** | ** ** |   |
| Above market  |       |                    | 298        |                                    |       |                    | $          | 4.94                                    |   |   |   | 173 |   |   |   | $ | 3.10 |   |   |   | 306 |   |   |   | $ | 1.85 |   |   |
| At market     |       |                    | 434        |                                    |       |                    | 7.50       |                                    |   |   | 659 |   |   |   | 5.84 |   |   |   | 439 |   |   |   | 2.84 |   |   |
| Below market  |       |                    | —     |                                    |       |                    | —     |                                    |   |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |
| Total granted |       |                    | 732        |                                    |       |                    | $          | 6.46                                    |   |   |   | 832 |   |   |   | $ | 5.27 |   |   |   | 745 |   |   |   | $ | 2.43 |   |   |

 

Thefollowing table summarizes information about stock options outstanding at December 31,2005:

| **Range of  Exercise Prices** | ** ** | **Number  Outstanding at  December 31, 2005** | ** ** | **Weighted-Average  Remaining  Contractual Life** | ** ** | **Weighted-Average  Exercise Price** | ** ** | **Number  Exercisable at  December 31, 2005** | ** ** | **Weighted-Average  Exercise Price** | ** ** |
|-----------------------------------------|------------|--------------------------------------------------------------|------------|--------------------------------------------------------|------------|-------------------------------------------|------------|--------------------------------------------------------------|------------|-------------------------------------------|------------|
| ** **                              | ** ** | **(In thousands)**                                      | ** ** | ** **                                             | ** ** | ** **                                | ** ** | **(In thousands)**                                      | ** ** | ** **                                | ** ** |
| $  1.88 - 3.12      |       |                                                         | 594        |                                                   |       |                                      | 2.3 years  |                                                         |       |                                      | $          | 2.50 |   |   |   | 594 |   |   |   | $ | 2.50 |   |   |
| 3.15                                    |       |                                                         | 1,450      |                                                   |       |                                      | 3.6 years  |                                                         |       |                                      | 3.15       |   |   |   | 1,024 |   |   |   | 3.15 |   |   |
| 3.25 - 4.79                   |       |                                                         | 520        |                                                   |       |                                      | 4.5 years  |                                                         |       |                                      | 4.01       |   |   |   | 470 |   |   |   | 4.02 |   |   |
| 5.00 - 8.42                   |       |                                                         | 873        |                                                   |       |                                      | 5.6 years  |                                                         |       |                                      | 6.35       |   |   |   | 795 |   |   |   | 6.40 |   |   |
| 10.11 - 12.32                 |       |                                                         | 713        |                                                   |       |                                      | 7.4 years  |                                                         |       |                                      | 10.73      |   |   |   | 308 |   |   |   | 10.69 |   |   |
| 15.61 - 22.92                 |       |                                                         | 673        |                                                   |       |                                      | 9.0 years  |                                                         |       |                                      | 17.12      |   |   |   | 178 |   |   |   | 16.67 |   |   |
| $ 1.88 - 22.92           |       |                                                         | 4,823      |                                                   |       |                                      | 5.2 years  |                                                         |       |                                      | $          | 6.81 |   |   |   | 3,369 |   |   |   | $ | 5.33 |   |   |

 

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Asummary of the activity relating to the options awarded by the Company foremployees, directors and agents is as follows:

| ** **                       | ** ** | **Employees**           | ** ** | **Directors** | ** ** | **Agents &  Others** | ** ** | **Total** | ** ** | **Range of  Exercise Prices** | ** ** |
|----------------------------------|------------|-------------------------|------------|---------------|------------|-------------------------------|------------|-----------|------------|-----------------------------------------|------------|
| ** **                       | ** ** | **(In thousands)** | ** ** |
| Balance,  January 1, 2003   |       |                    | 4,004      |          |       |                          | 242        |      |       |                                    | 1,267      |   |   | 5,513 |   |   |   |
| Granted                          |       |                    | 391        |          |       |                          | 48         |      |       |                                    | 306        |   |   | 745 |   | $ | 5.57 - $10.56 |   |
| Exercised                        |       |                    | (162       | )             |       |                          | (2         | )         |       |                                    | (225       | ) |   | (389 | ) | $ | 2.00 - $  8.42 |   |
| Terminated                       |       |                    | (122       | )             |       |                          | (9         | )         |       |                                    | (79        | ) |   | (210 | ) | $ | 2.62 - $  8.42 |   |
| Balance,  December 31, 2003 |       |                    | 4,111      |          |       |                          | 279        |      |       |                                    | 1,269      |   |   | 5,659 |   |   |   |
| Granted                          |       |                    | 610        |          |       |                          | 48         |      |       |                                    | 174        |   |   | 832 |   | $ | 10.11 - $12.32 |   |
| Exercised                        |       |                    | (420       | )             |       |                          | (14        | )         |       |                                    | (756       | ) |   | (1,190 | ) | $ | 1.01 - $10.11 |   |
| Terminated                       |       |                    | (35        | )             |       |                          | —     |      |       |                                    | (86        | ) |   | (121 | ) | $ | 3.15 - $10.56 |   |
| Balance,  December 31, 2004 |       |                    | 4,266      |          |       |                          | 313        |      |       |                                    | 601        |   |   | 5,180 |   |   |   |
| Granted                          |       |                    | 383        |          |       |                          | 51         |      |       |                                    | 298        |   |   | 732 |   | $ | 15.61 - $24.85 |   |
| Exercised                        |       |                    | (569       | )             |       |                          | (17        | )         |       |                                    | (369       | ) |   | (955 | ) | $ | 2.00 - $19.21 |   |
| Terminated                       |       |                    | (112       | )             |       |                          | —     |      |       |                                    | (22        | ) |   | (134 | ) | $ | 3.15 - $15.88 |   |
| Balance,  December 31, 2005 |       |                    | 3,968      |          |       |                          | 347        |      |       |                                    | 508        |   |   | 4,823 |   |   |   |
| Vested,  December 31, 2005  |       |                    | 2,868      |          |       |                          | 248        |      |       |                                    | 253        |   |   | 3,369 |   |   |   |

 

*Options Granted toEmployees*

Options are generally granted to eligible employees ata price not less than the market price of the Company’s common stock on thedate of the grant. Option shares may be exercised subject to the termsprescribed by the individual grant agreement. During 2005, there wereapproximately 296,000 options issued to management in connection with themanagement bonus and 87,000 issued for new employees. During 2004, there wereapproximately 245,000 options issued to management in connection with themanagement bonus, 25,000 issued for new employees and 340,000 issued toHeritage employees in connection with the acquisition. During 2003, there were301,000 options issued in connection with the management bonus and 90,000 fornew employees. Vested options must be exercised not later than the expirationdate of the option, or earlier, following termination of employment. Prior to September 2005,options issued to employees had a term of ten years. Options issued toemployees after August 2005 have a term of five years. These awards aremade at a price equal to or greater than market on the date of grant,therefore, no compensation cost is recognized for such awards.

On August 1, 1999,the Company issued 2.3 million below market stock options with an exerciseprice of $3.15 per share to certain employees and members of management. During2000, the Company issued an additional 0.2 million below market stock optionswith an exercise price of $3.15 per share to certain relocated employees andmembers of management on July 31, 2000. As of December 31, 2005, thenumber of these options outstanding decreased to 1.4 million, through employeeterminations and exercises. These options are fully vested, except for 0.5million which will become vested after seven years. These options must beexercised not later than ten years after the date of the grant or followingearlier termination of employment. The Company recorded an expense for thedifference between the exercise price of $3.15 per share and the value of theoptions on the date of grant of $(0.1) million for the year ended December 31,2005, $0.1 million for 2004, and $0.4 million for 2003.

*Stock OptionsIssued to Directors*

Directors of the Companyare eligible for options under the 1998 ICP. The 1998 ICP provides that unlessotherwise determined by the Board, each non-employee director would be grantedan option to 

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purchase4,500 shares of Common Stock upon approval of the 1998 ICP by shareholders or,as to directors thereafter elected, his or her initial election to the Board,and at each annual meeting of shareholders starting in 1999 at which he or shequalifies as a non-employee director. Effective October 1, 2005, theannual grant of stock options to non-employee directors of the Board wasincreased to 5,000. A pro-rata award of 333 options was granted to eachnon-employee director on October 1, 2005. The 1998 ICP also provides thatthe non-employee directors for American Progressive and Penncorp Life (Canada)would be granted an option to purchase 1,500 shares of Common Stock at eachannual meeting. Unless otherwise determined by the Board, such options willhave an exercise price equal to 100% of the fair market value per share on thedate of grant and will become exercisable in three equal installments aftereach of the first, second and third anniversaries of the date of grant based oncontinued service as a director. These are made at a price equal to market,therefore, no compensation expense is recognized for such awards.

*Stock Option andStock Award Plans for Agents*

Both career agents and independent general agents areeligible for options under the 1998 ICP. Options are awarded to agents based onproduction. These options vest in equal installments over a two year period andexpire five years from the date of grant. The exercise prices are set atbetween 110% and 125% of the fair market value of Universal American commonstock on the date of the award. During 2005, career agents were awarded a totalof approximately 244,000 options and independent agents were awardedapproximately 54,000 options with a weighted average exercise price of $17.44per share for 2004 performance. During 2004, career agents were awarded a totalof approximately 75,000 options and independent general agents were awardedapproximately 99,000 options with a weighted average exercise price of $11.45per share for 2003 sales performance. During 2003 career agents were awarded atotal of approximately 167,000 options and independent general agents wereawarded approximately 139,000 options with a weighted average exerciseprice of $7.03 per share for 2002 sales performance. The fair values of theseoptions are expensed over the vesting period of each award.

The Company also granted awards of common stock toqualifying career agents for performance through 2004. These shares vest aftertwo years. During 2005, career agents were awarded stock grants ofapproximately 25,000 shares with a fair value of $15.37 for 2004 performance. During2004, career agents were awarded stock grants of approximately 36,000 shareswith a fair value of $9.71 per share for 2003 sales performance. During 2003, careeragents were awarded stock grants of approximately 49,000 shares with a fairvalue of $5.92 per share for 2002 sales performance.

Beginning in 2005, the Company began granting awardsof common stock to certain other qualifying agents. These awards vest over fiveyears. During 2005, the qualifying agents were awarded stock grants ofapproximately 18,000 shares with a fair value of $23.17 per share for 2004performance.

Total expense relating tothe above plans was $1.7 million for the year ended December 31, 2005,$0.6 million for 2004, and $0.9 million for 2003.

**9.**                 *STATUTORY FINANCIAL DATA*

The insurance subsidiaries are required to maintainminimum amounts of statutory capital and surplus as required by regulatoryauthorities. However, substantially more than such minimum amounts are neededto meet statutory and administrative requirements of adequate capital andsurplus to support the current level of our insurance subsidiaries’ operations.Each of the life insurance subsidiaries’ statutory capital and surplus exceedsits respective minimum statutory requirement at levels we believe are sufficientto support their current levels of operation. Additionally, the NationalAssociation of Insurance Commissioners (“NAIC”) imposes regulatory risk-basedcapital (“RBC”) requirements on life insurance enterprises. At December 31,2005, all of our life insurance subsidiaries maintained ratios of totaladjusted capital to RBC in excess of the “authorized control level”. Thecombined statutory capital and surplus, 

F-30

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including asset valuationreserve, of the U.S. life insurance subsidiaries totaled $158.4 million at December 31,2005 and $127.9 million at December 31, 2004. For the year ended December 31,2005, the insurance subsidiaries generated a statutory net loss of $1.8 million.The insurance subsidiaries generated statutory net income of $5.4 million forthe year ended December 31, 2004 and $0.6 million for the year ended December 31,2003.

Our health plan affiliates are also required tomaintain minimum amounts of capital and surplus, as required by regulatoryauthorities and are also subject to RBC requirements. At December 31,2005, the statutory capital and surplus of each of our health plan affiliatesexceeds its minimum requirement and its RBC is in excess of the “authorizedcontrol level”. The statutory capital and surplus for our health plan affiliateswas $23.0 million at December 31, 2005 and $9.9 million at December 31,2004. Statutory net income for our health plan affiliates was $9.6 million forthe year ended December 31, 2005 and $5.5 million for the year ended December 31,2004.

Penncorp Life (Canada)reports to Canadian regulatory authorities based upon Canadian statutoryaccounting principles that vary in some respects from U.S. statutory accountingprinciples. Penncorp Life (Canada)’s net assets based upon Canadian statutoryaccounting principles were C$62.3 million (US$53.6 million) as ofDecember 31, 2005 and were C$57.4 million (US$47.8 million) as ofDecember 31, 2004. Penncorp Life (Canada) maintained a Minimum ContinuingCapital and Surplus Requirement Ratio (“MCCSR”) in excess of the minimumrequirement at December 31, 2005. Net income for Penncorp Life (Canada)based on Canadian generally accepted accounting principles was C$11.3 million(US$9.3 million) for the year ended December 31, 2005, C$8.4 million(US$6.5 million) for 2004 and C$34.4 million (US$24.6 million) for 2003.

**10.**          *ACCIDENT AND HEALTH POLICY AND CONTRACT CLAIM LIABILITIES*

Activityin the accident & health policy and contract claim liability is asfollows:

| ** **                        | ** ** | **2005**                | ** ** | **2004** | ** ** | **2003** | ** ** |
|-----------------------------------|------------|-------------------------|------------|----------|------------|----------|------------|
| ** **                        | ** ** | **(In thousands)** | ** ** |
| Balance at  beginning of year     |       | $                       | 94,526     |     | $          | 100,232  |       | $ | 88,216 |   |
| Less reinsurance recoverables     |       | (27,789                 | )          | (39,014  | )          | (48,925  | )          |
| Net balance at  beginning of year |       | 66,737                  |       | 61,218   |       | 39,291   |       |
| Balances acquired                 |       | —                  |       | 9,265    |       | 18,744   |       |
| Incurred related  to:             |       |                    |       |     |       |     |       |
| Current year                      |       | 540,810                 |       | 394,053  |       | 249,862  |       |
| Prior years                       |       | 3,515                   |       | (2,141   | )          | (1,949   | )          |
| Total incurred                    |       | 544,325                 |       | 391,912  |       | 247,913  |       |
| Paid related to:                  |       |                    |       |     |       |     |       |
| Current year                      |       | 465,818                 |       | 348,887  |       | 220,602  |       |
| Prior years                       |       | 59,198                  |       | 47,401   |       | 25,302   |       |
| Total paid                        |       | 525,016                 |       | 396,288  |       | 245,904  |       |
| Foreign currency adjustment       |       | 282                     |       | 630      |       | 1,174    |       |
| Net balance at end of year        |       | 86,328                  |       | 66,737   |       | 61,218   |       |
| Plus reinsurance  recoverables    |       | 29,451                  |       | 27,789   |       | 39,014   |       |
| Balance at end of  year           |       | $                       | 115,779    |     | $          | 94,526   |       | $ | 100,232 |   |

 

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During 2005, theunfavorable development related primarily to higher than anticipated claims forthe Medicare Supplement business in the Senior Market Health Insurance Segment.During 2004, the favorable development related primarily to the Medicare Supplementbusiness in the Senior Market Health Insurance Segment. During 2003, thefavorable development on the accident and health claims reserves resulted fromthe improvement in claims management processes in the Specialty HealthInsurance Segment.

During the fourth quarterof 2005, the Company recorded a pre-tax adjustment that increased incurredclaims by $9.9 million. Two factors caused this action. First, incurred claimsincreased by $4.4 million as a result of a change in the estimate of theCompany’s Medicare Supplement claim reserves of $6.8 million, offset by anincrease in amounts recoverable from reinsurers of $2.4 million. Second, theCompany determined that, over a four year period, it had overstated the amountsrecoverable from reinsurers for ceded Medicare Supplement claim reserves. Duringthe fourth quarter of 2005, the Company decreased its recoverable fromreinsurers for ceded Medicare Supplement claim reserves by $5.5 million. Approximately$1.1 million of the decrease was determined to relate to the first threequarters of 2005 and $3.1 million of the decrease was determined to relate tothe years 2002 through 2004.

In 2004, the Companyacquired Heritage. In 2003, the Company acquired Pyramid Life and recaptured ablock of Medicare Supplement business previously ceded to Transamerica. Thebalances acquired represent the accident and health claim liabilities acquiredin these transactions.

**11.**          *DEFERRED POLICY ACQUISITION COSTS*

Detailswith respect to deferred policy acquisition costs are as follows:

| ** **                                                        | ** ** | **2005**                | ** ** | **2004** | ** ** | **2003** | ** ** |
|-------------------------------------------------------------------|------------|-------------------------|------------|----------|------------|----------|------------|
| ** **                                                        | ** ** | **(In thousands)** | ** ** |
| Balance,  beginning of year                                       |       | $                       | 208,281    |     | $          | 143,711  |       | $ | 92,093 |   |
| Capitalized costs, net of reinsurance commissions  and allowances |       | 110,291                 |       | 114,411  |       | 88,505   |       |
| Adjustment relating to unrealized gains on fixed  maturities      |       | 6,511                   |       | (2,791   | )          | (2,665   | )          |
| Adjustment relating to recapture of reinsurance                   |       | —                  |       | —   |       | 275      |       |
| Foreign currency adjustment                                       |       | 1,010                   |       | 1,854    |       | 2,904    |       |
| Amortization                                                      |       | (53,551                 | )          | (48,904  | )          | (37,401  | )          |
| Balance, end of year                                              |       | $                       | 272,542    |     | $          | 208,281  |       | $ | 143,711 |   |

 

The increase inamortization during 2005 is primarily due to a combination of higher amounts ofdeferred policy acquisition costs at the beginning of the year and an increasein lapsation of Medicare Supplement policies. The increase in the amount ofacquisition costs capitalized during 2003 and the corresponding increase inamortization is directly related to the increase in new business as a result ofthe acquisitions of Pyramid Life and the Guarantee Reserve marketingorganization, the recapture of the Transamerica reinsurance and the increase inretention on new business, as well as the increase in annuities written duringthe year. The increase in the amount capitalized during 2004 is primarily theresult of the full year impact of the above transactions along with an increasein new business in existing companies.

**12.**          *REINSURANCE*

In the normal course ofbusiness, the Company reinsures portions of certain policies that itunderwrites. The Company enters into reinsurance arrangements with unaffiliatedreinsurance companies to limit our exposure on individual claims and to limitor eliminate risk on our non-core or underperforming blocks of business. Accordingly,the Company is party to several reinsurance agreements on its life and accidentand health insurance risks. The Company’s senior market accident and healthinsurance products are generally reinsured under quota share coinsurancetreaties with unaffiliated 

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insurers,while the life insurance risks are reinsured under either quota share coinsuranceor yearly-renewable term treaties with unaffiliated insurers. Under quota sharecoinsurance treaties, the Company pays the reinsurer an agreed upon percentageof all premiums and the reinsurer reimburses the Company that same percentageof any losses. In addition, the reinsurer pays the Company certain allowancesto cover commissions, cost of administering the policies and premium taxes. Underyearly-renewable term treaties, the reinsurer receives premiums at an agreedupon rate for its share of the risk on a yearly-renewable term basis. TheCompany also uses excess of loss reinsurance agreements for certain policieswhereby the Company limits its loss in excess of specified thresholds. TheCompany’s quota share coinsurance agreements are generally subject tocancellation on 90 days notice as to future business, but policies reinsuredprior to such cancellation remain reinsured as long as they remain in force.

The Company evaluates thefinancial condition of its reinsurers and monitors concentrations of creditrisk to minimize its exposure to significant losses from reinsurer insolvencies.The Company is obligated to pay claims in the event that any reinsurer to whomwe have ceded an insured claim fails to meet its obligations under thereinsurance agreement.

The Company has severalquota share reinsurance agreements in place with General Re Life Corporation (“GeneralRe”), Hannover Life Re of America (“Hannover”) and Swiss Re Life &Health America (“Swiss Re”), (collectively, the “Reinsurers”), which Reinsurersare rated A or better by A.M. Best. These agreements cover variousinsurance products, primarily Medicare Supplement, long term care and seniorlife policies, written or acquired by the Company and contain cedingpercentages ranging between 15% and 100%. Effective January 1, 2004, theCompany’s retention on all new Medicare Supplement business was 100%. Therefore,the Company no longer reinsures new Medicare Supplement business.

During the third quarterof 2005, the Company commenced a new reinsurance arrangement with PharmaCareCaptive Re, Ltd. (“PharmaCare Re”). Under the terms of the agreement, theCompany provides an insured drug benefit for the employees of the State ofConnecticut. The agreement is renewable annually by the State of Connecticut. Therisk is reinsured to PharmaCare Re under a 100% quota share contract. Amountsrecoverable from PharmaCare Re are supported by a letter of credit equal to thetotal unpaid claims and claim reserves for this business, but no less than$35.0 million. The Company receives an underwriting fee of two percent ofpremium. Annualized premium in force on this block of business is approximately$260.0 million. During 2005, both direct and ceded premium increased byapproximately $132.3 million as a result of this agreement.

During2005, we ceded premiums of $132.3 million to PharmaCare Re, $96.2 million toGeneral Re, $90.6 million to Hannover and $12.0 million to Swiss Re,representing 11%, 8%, 8% and 1% respectively of our total direct and assumedpremiums. During 2004, we ceded premiums of $109.0 million to General Re,$105.3 million to Hannover, and $7.7 million to Swiss Re, representing 12%, 12%and 1%, respectively, of our total direct and assumed premiums. During 2003, weceded premiums of $123.5 million to General Re, $116.3 million to Hannover and$4.9 million to Swiss Re, representing 17%, 16% and 1%, respectively, of ourtotal direct and assumed premiums. Amounts recoverable from all our reinsurerswere as follows:

| ** **    | ** ** | **2005**                | ** ** | **2004**   | ** ** |
|---------------|------------|-------------------------|------------|------------|------------|
| ** **    | ** ** | **(In thousands)** | ** ** |
| *Reinsurer*   | ** ** | ** **              | ** ** | ** ** | ** ** |
| General Re    |       | $                       | 86,864     |       | $          | 83,696 |   |
| Hannover      |       | 64,885                  |       | 68,463     |       |
| PharmaCare Re |       | 21,423                  |       | —     |       |
| Swiss Re      |       | 17,947                  |       | 14,583     |       |
| Other         |       | 36,273                  |       | 45,759     |       |
| Total         |       | $                       | 227,392    |       | $          | 212,501 |   |

 

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At December 31,2005, the total amount recoverable from reinsurers included $217.8 millionrecoverable on future policy benefits and unpaid claims and $9.6 million foramounts due from reinsurers on paid claims, commissions and expense allowancesnet of premiums reinsured. At December 31, 2004, the total amountrecoverable from reinsurers included $208.3 million recoverable on futurepolicy benefits and unpaid claims and $4.2 million for amounts due fromreinsurers on paid claims, commissions and expense allowances net of premiumsreinsured. A summary of reinsurance is presented below:

| ** **                           | ** ** | **Year Ended December 31,** | ** ** |
|--------------------------------------|------------|--------------------------------------------|------------|
| ** **                           | ** ** | **2005**                                   | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                           | ** ** | **(In thousands)**                    | ** ** |
| Premiums                             |       |                                       |       |   |   |   |   |
| Life insurance                       |       | $                                          | 75,701     |   | $ | 58,059 |   | $ | 44,268 |   |
| Accident and health                  |       | 1,078,666                                  |       | 796,087 |   | 656,147 |   |
| Total gross premiums                 |       | 1,154,367                                  |       | 854,146 |   | 700,415 |   |
| Ceded to other companies             |       |                                       |       |   |   |   |   |
| Life insurance                       |       | (18,713                                    | )          | (12,375 | ) | (8,142 | ) |
| Accident and health                  |       | (331,703                                   | )          | (232,508 | ) | (272,347 | ) |
| Total ceded premiums                 |       | (350,416                                   | )          | (244,883 | ) | (280,489 | ) |
| Assumed from other companies         |       |                                       |       |   |   |   |   |
| Life insurance                       |       | 5,628                                      |       | 7,376 |   | 3,339 |   |
| Accident and health                  |       | 26,480                                     |       | 28,306 |   | 23,703 |   |
| Total assumed premium                |       | 32,108                                     |       | 35,682 |   | 27,042 |   |
| Net amount                           |       |                                       |       |   |   |   |   |
| Life insurance                       |       | 62,617                                     |       | 53,060 |   | 39,465 |   |
| Accident and health                  |       | 773,442                                    |       | 591,885 |   | 407,503 |   |
| Total net premium                    |       | $                                          | 836,059    |   | $ | 644,945 |   | $ | 446,968 |   |
| Percentage of assumed to net premium |       |                                       |       |   |   |   |   |
| Life insurance                       |       | 9                                          | %          | 14 | % | 8 | % |
| Accident and health                  |       | 3                                          | %          | 5 | % | 6 | % |
| Total assumed to total net           |       | 4                                          | %          | 6 | % | 6 | % |
| Claims recovered                     |       | $                                          | 321,525    |   | $ | 192,856 |   | $ | 189,626 |   |

 

| ** **                             | ** ** | **As of December 31,** | ** ** |
|----------------------------------------|------------|---------------------------------------|------------|
| ** **                             | ** ** | **2005**                              | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                             | ** ** | **(In thousands)**               | ** ** |
| Life insurance in force                |       |                                  |       |   |   |   |   |
| Gross amount                           |       | $                                     | 4,013,595  |   | $ | 3,932,446 |   | $ | 3,757,618 |   |
| Ceded to other companies               |       | (835,724                              | )          | (833,452 | ) | (788,761 | ) |
| Assumed from other companies           |       | 109,353                               |       | 138,849 |   | 145,028 |   |
| Net amount                             |       | $                                     | 3,287,224  |   | $ | 3,237,843 |   | $ | 3,113,885 |   |
| Percentage of  assumed to net in force |       | 3                                     | %          | 4 | % | 5 | % |

 

**13.**          *LOAN PAYABLE*

*Credit Facility, asAmended in May 2004*

In connection with the acquisition of Heritage on May 28,2004 (see Note 3—Business Combinations), the Company amended the CreditAgreement by increasing the facility to $120.0 million from $80.0 million (the “AmendedCredit Agreement”), including an increase in the term loan portion to $105.0million from 

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$36.4 million (the balanceoutstanding at May 28, 2004) and maintaining the $15.0 million revolvingloan facility. None of the revolving loan facility has been drawn as of December 31,2005. Under the Amended Credit Agreement, the spread over LIBOR was reduced to225 basis points. Effective January 1, 2006, the interest rate on the termloan is 6.6%. Principal repayments are scheduled at $5.3 million per year overa five-year period with a final payment of $80.1 million due upon maturity on March 31,2009.

The Company incurred additional loan origination feesof approximately $2.1 million, which were capitalized and are being amortizedon a straight-line basis over the life of the Amended Credit Agreement alongwith the continued amortization of the origination fees incurred in connectionwith the Credit Agreement. The Company pays an annual commitment fee of 50basis points on the unutilized revolving loan facility. The obligations of theCompany under the Amended Credit Facility are guaranteed by CHCS Services Inc.,WorldNet Services Corp., Quincy Coverage Corporation, Universal AmericanFinancial Services, Inc., Heritage, HHS-HPN Network, Inc., HeritageHealth Systems of Texas, Inc., PSO Management of Texas, LLC, HHS TexasManagement, Inc. and HHS Texas Management LP (collectively the “Guarantors”)and secured by substantially all of the assets of each of the Guarantors. Inaddition, as security for the performance by the Company of its obligationsunder the Amended Credit Facility, the Company, CHCS Services Inc., WorldNetServices Corp., Heritage and HHS Texas Management, Inc. have each pledgedand assigned substantially all of their respective securities (but not morethan 65% of the issued and outstanding shares of voting stock of any foreignsubsidiary), all of their respective limited liability company and partnershipinterests, all of their respective rights, title and interest under any serviceor management contract entered into between or among any of their respectivesubsidiaries and all proceeds of any and all of the foregoing.

The Amended Credit Facility requires the Company andits subsidiaries to meet certain financial tests, including a minimum fixedcharge coverage ratio, a minimum risk based capital test and a minimumconsolidated net worth test. The Amended Credit Facility also containscovenants, which among other things, limit the incurrence of additionalindebtedness, dividends, capital expenditures, transactions with affiliates,asset sales, acquisitions, mergers, prepayments of other indebtedness, liensand encumbrances and other matters customarily restricted in such agreements. TheAmended Credit Facility contains customary events of default, including, amongother things, payment defaults, breach of representations and warranties,covenant defaults, cross-acceleration, cross-defaults to certain otherindebtedness, certain events of bankruptcy and insolvency and judgmentdefaults. During the fourth quarter of 2005, the Company was in default with acovenant regarding limitations on treasury stock repurchases. The Companyrequested and received, from the administrative agent for the bank group, awaiver of the event of default and an amendment to the Amended Credit Facilityto increase the limitation for treasury stock purchases to $30.0 million in theaggregate after January 1, 2006.

The Company made regularly scheduled principalpayments of $5.3 million during the year ended December 31, 2005, $5.7million during 2004 and $8.7 million during 2003 in connection with its creditfacilities. The Company paid interest of $5.5 million during 2005, $3.1 millionduring 2004 and $2.7 million during 2003 in connection with its creditfacilities.

Thefollowing table shows the schedule of principal payments (in thousands)remaining on the Amended Credit Agreement, with the final payment inMarch 2009:

| 2006   |   | $      | 5,250  |   |
|--------|--------|--------|--------|--------|
| 2007   |   | 5,250  |   |
| 2008   |   | 5,250  |   |
| 2009   |   | 80,063 |   |
|   |   | $      | 95,813 |   |

 

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The following tablesets forth certain summary information with respect to total borrowings of theCompany:

| ** ** | ** ** | **As of December 31,** | ** ** | **Year Ended December 31,** | ** ** |
|------------|------------|---------------------------------------|------------|--------------------------------------------|------------|
| ** ** | ** ** | ** **                            | ** ** | ** **                                 | ** ** | ** ** | ** ** | **Weighted** | ** ** | ** ** | ** ** |
| ** ** | ** ** | ** **                            | ** ** | ** **                                 | ** ** | **Maximum** | ** ** | **Average** | ** ** | **Average** | ** ** |
| ** ** | ** ** | **Amount**                            | ** ** | **Interest**                               | ** ** | **Amount** | ** ** | **Amount** | ** ** | **Interest** | ** ** |
| ** ** | ** ** | **Outstanding**                       | ** ** | **Rate**                                   | ** ** | **Outstanding** | ** ** | **Outstanding**(1) | ** ** | **Rate**(2) | ** ** |
| ** ** | ** ** | **(In thousands)**               | ** ** | ** **                                 | ** ** | **(In thousands)** | ** ** | **(In thousands)** | ** ** | ** ** | ** ** |
| 2005       |       |                                  | $          | 95,813                                     |       |   |   | 6.64 | % |   |   | $ | 101,063 |   |   |   | $ | 99,081 |   |   |   | 5.53 | % |   |
| 2004       |       |                                  | $          | 101,063                                    |       |   |   | 4.29 | % |   |   | $ | 105,000 |   |   |   | $ | 75,775 |   |   |   | 4.06 | % |   |
| 2003       |       |                                  | $          | 38,172                                     |       |   |   | 4.14 | % |   |   | $ | 65,000 |   |   |   | $ | 49,889 |   |   |   | 4.50 | % |   |

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(1)                Theaverage amounts of borrowings outstanding were computed by determining thearithmetic average of the months’ average outstanding in borrowings.

(2)                Theweighted-average interest rates were determined by dividing interest expenserelated to total borrowings by the average amounts outstanding of suchborrowings.

*2003 Refinancing of Debt*

On March 31, 2003,the Credit Facility issued in 1999 was repaid from the proceeds of the CreditAgreement obtained in connection with the acquisition of Pyramid Life. Theearly extinguishment of this debt resulted in the immediate amortization of therelated capitalized loan origination fees, resulting in a pre-tax expense ofapproximately $1.8 million.

**14.**          *OTHER LONG TERM DEBT*

The Company has formedseparate statutory business trusts (the “Trusts”), which exist for theexclusive purpose of issuing trust preferred securities representing undividedbeneficial interests in the assets of the trust, investing the gross proceedsof the trust preferred securities in junior subordinated deferrable interestdebentures of the Company (the “Junior Subordinated Debt”) and engaging in onlythose activities necessary or incidental thereto. In accordance with theadoption of FASB Interpretation No. 46(R), “Consolidation of VariableInterest Entities,” the Company does not consolidate the trusts.

The Trusts haveissued a combined $75.0 million in thirty year trust preferred securities (the “CapitalSecurities”) as detailed in the following table:

| **Maturity Date** | ** ** | ** **              | ** ** | **Amount  Issued** | ** ** | **Term**                | ** **     | **Spread  Over LIBOR** | ** ** | **Rate as of  December 31, 2005** | ** ** |
|------------------------|------------|-------------------------|------------|--------------------|------------|-------------------------|----------------|-----------------------------|------------|-------------------------------------------------------|------------|
| ** **             | ** ** | **(In thousands)** | ** ** | ** **         | ** ** | **(Basis points)** | ** **     | ** **                  | ** ** |
| December 2032     |       |                    | $          | 15,000             |       |                    | Fixed/Floating |                        |       | 400                                                   | (1)        |   |   | 6.7 | % |   |
| March 2033        |       |                    | 10,000     |               |       | Floating                |           |                        | 400        |                                                  |       |   | 8.2 | % |   |
| May 2033          |       |                    | 15,000     |               |       | Floating                |           |                        | 420        |                                                  |       |   | 8.6 | % |   |
| May 2033          |       |                    | 15,000     |               |       | Fixed/Floating          |           |                        | 410        | (2)                                                   |       |   | 7.4 | % |   |
| October 2033      |       |                    | 20,000     |               |       | Fixed/Floating          |           |                        | 395        | (3)                                                   |       |   | 7.0 | % |   |
|                   |       |                    | $          | 75,000             |       |                    |           |                        |       |                                                  |       |   |   |   |   |   |

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(1)                EffectiveSeptember 2003, the Company entered into a swap agreement whereby it willpay a fixed rate of 6.7% in exchange for a floating rate of LIBOR plus 400basis points. The swap contract expires in December 2007.

(2)                Therate on this issue is fixed at 7.4% for the first five years. On May 15,2008, it will be converted to a floating rate equal to LIBOR plus 410 basispoints.

(3)                Effective April 29,2004, the Company entered into a swap agreement whereby it will pay a fixedrate of 6.98% in exchange for a floating rate of LIBOR plus 395 basis points. Theswap contract expires in October 2008.

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The Trusts have the right to call the CapitalSecurities at par after five years from the date of issuance (which ranged fromDecember 2002 to October 2003). The proceeds from the sale of theCapital Securities, together with proceeds from the sale by the Trusts of theircommon securities to the Company, were invested in thirty-year floating rateJunior Subordinated Debt of the Company. From the proceeds of the trustpreferred securities, $26.0 million was used to pay down debt during 2003. Thebalance of the proceeds has been used, in part to fund acquisitions, to providecapital to the Company’s insurance subsidiaries to support growth and to beheld for general corporate purposes.

The Capital Securities represent an undivided beneficialinterest in the Trusts’ assets, which consist solely of the Junior SubordinatedDebt. Holders of the Capital Securities have no voting rights. The Company ownsall of the common securities of the Trusts. Holders of both the CapitalSecurities and the Junior Subordinated Debt are entitled to receive cumulativecash distributions accruing from the date of issuance, and payable quarterly inarrears at a floating rate equal to the three-month LIBOR plus a spread. Thefloating rate resets quarterly and is limited to a maximum of 12.5% during thefirst sixty months. Due to the variable interest rate for these securities, theCompany would be subject to higher interest costs if short-term interest ratesrise. The Capital Securities are subject to mandatory redemption upon repaymentof the Junior Subordinated Debt at maturity or upon earlier redemption. TheJunior Subordinated Debt is unsecured and ranks junior and subordinate in rightof payment to all present and future senior debt of the Company and is effectivelysubordinated to all existing and future obligations of the Company’ssubsidiaries. The Company has the right to redeem the Junior Subordinated Debtafter five years from the date of issuance.

The Company has the right at any time, and from time totime, to defer payments of interest on the Junior Subordinated Debt for aperiod not exceeding 20 consecutive quarters up to each debenture’s maturitydate. During any such period, interest will continue to accrue and the Companymay not declare or pay any cash dividends or distributions on, or purchase, theCompany’s common stock nor make any principal, interest or premium payments onor repurchase any debt securities that rank equally with or junior to theJunior Subordinated Debt. The Company has the right at any time to dissolve theTrusts and cause the Junior Subordinated Debt to be distributed to the holdersof the Capital Securities. The Company has guaranteed, on a subordinated basis,all of the Trusts’ obligations under the Capital Securities including paymentof the redemption price and any accumulated and unpaid distributions to theextent of available funds and upon dissolution, winding up or liquidation butonly to the extent the Trusts have funds available to make such payments.

The Company paid $5.3million in interest in connection with the Junior Subordinated Debt during theyear ended December 31, 2005, $4.7 million during 2004, and $ 2.1 millionduring 2003.

**15.**          *DERIVATIVE INSTRUMENTS—CASH FLOW HEDGE*

Effective September 4, 2003, the Company enteredinto a swap agreement whereby it pays a fixed rate of 6.7% on a $15.0 millionnotional amount relating to the December 2002 trust preferred securitiesissuance, in exchange for a floating rate of LIBOR plus 400 basis points,capped at 12.5%. The swap contract expires in December 2007. Effective April 29,2004, the Company entered into a second swap agreement whereby it pays a fixedrate of 6.98% on a $20.0 million notional amount relating to the October 2003trust preferred securities issuance, in exchange for a floating rate of LIBORplus 395 basis points, capped at 12.45%. The swap contract expires in October 2008.The swaps are designated and qualify as cash flow hedges, and changes in theirfair value are recorded in accumulated other comprehensive income. The combinedfair value of the swaps was $1.5 million at December 31, 2005 and $0.8million at December 31, 2004 and is included in other assets.

During the third quarter of 2005, the Company began toconsider alternatives to refinance its debt. As the likelihood of suchrefinancing grew, the Company entered into two separate forward treasury ratelock 

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agreement transactions. Eachsuch transaction locked in the rates on separate $25.0 million pieces of theanticipated $125.0 million refinancing. The Company designated the hedgingtransactions as cash flow hedges of a series of forecasted interest paymentswith a variability attributable to changes in the benchmark interest rate riskassociated with a borrowing program over the life of the agreements. At thetime the treasury rate lock agreements were entered into, the Companydetermined that it was likely that the forecasted transaction (the refinancing)would occur. Rates continued to rise subsequent to the dates the rate lockswere entered into, and as a result, the value of the rate locks to the Companywas positive.

In December 2005, theCompany determined that it was no longer probable that the forecastedtransaction (the refinancing) would occur, and the Company terminated both ofthe treasury rate lock agreements. The Company received a total of $0.5million, the fair value of the treasury rate locks, as consideration upon thetermination of the contracts. As the hedges were no longer effective, the totalamount of the consideration was recognized as a realized gain.

**16.**          *COMMITMENTS AND CONTINGENCIES*

*Securities Class Actionand Derivative Litigation*

Five actions containing related factual allegationswere filed against the Company and certain of its officers and directorsbetween November 22, 2005 and February 2, 2006. One of these actionswas voluntarily withdrawn by plaintiffs, and four actions are now pending.

In the first action, Robert Kemp filed a purportedclass action complaint (the “Kemp Action”) on November 22, 2005, in theUnited States District Court for the Southern District of New York. The KempAction is a purported class action asserted on behalf of those shareholders ofthe Company who acquired the Company’s common stock between February 16,2005 and October 28, 2005. Plaintiffs in the Kemp Action seek unspecifieddamages under Section 10(b) and 20(a) of the Securities ExchangeAct of 1934 based upon allegedly false statements by the Company and Richard A.Barasch, Robert A. Waegelein and Gary W. Bryant (hereinafter, the “OfficerDefendants”) in press releases, financial statements and analyst conferencesduring the class period.

Another purported class action was recently filed byWestern Trust Laborers-Employers Pension Trust (the “Western Trust Action”), aputative class member in the Kemp Action who had filed a motion to be named aslead plaintiff in that action, on February 2, 2006, in the United StatesDistrict Court for the Southern District of New York. The factual and legalallegations in the Western Trust Action are similar to those in the KempAction.

Two additional actions have been brought derivativelyby shareholders purporting to act on behalf of the Company, and not as classactions. One of these was filed by Green Meadows Partners LLP (the “GreenMeadows Action”) on December 13, 2005, in the United States District Courtfor the Southern District of New York. In the Green Meadows Action, plaintiffsseek contribution under Section 10(b) and 21D of the Exchange Act onthe ground that if the Company is found liable to have violated the securitieslaws in the Kemp Action, then the Officer Defendants are liable forcontribution. The Green Meadows Action also asserts three claims under statelaw for breach of fiduciary duty against the Officer Defendants.

The second derivative action was filed by plaintiffArthur Tsutsui (the “Tsutsui Action”) on December 30, 2005, in The SupremeCourt for New York State, Westchester County. The defendants in the TsutsuiAction are the three Officer Defendants named in the other actions, as well asall of the directors sitting on the Company’s Board of Directors as of the timethe complaint was filed. The Tsutsui Action alleges that the same allegedmisstatements that are the subject of the Kemp Action constituted a breach offiduciary duty by the Officer Defendants and the directors that caused theCompany to sustain 

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damages . The TsutsuiAction also seeks recovery of any proceeds derived by the Officer Defendantsfrom the sale of Company stock that was in breach of their fiduciary duties.

All of the cases are at apreliminary stage. In the class actions, motions concerning the appointment oflead plaintiff are pending before the Court. The defendants were not requiredto respond to these motions, and did not do so. The time for the defendantsinitially to respond to the class actions will not expire until at least 45days after the Court enters an order concerning the appointment of leadplaintiff. In the derivative actions, the time for defendants initially torespond to both complaints was extened to April 28, 2006. Each of the OfficerDefendants denies the allegations and has indicated that he intends tovigorously defend against the allegations. Management believes that afterliability insurance recoveries, none of these actions will have a materialadverse effect on the Company.

*Other Litigation*

The Company has litigationin the ordinary course of business, including claims for medical, disabilityand life insurance benefits, and in some cases, seeking punitive damages. Managementbelieves that after liability insurance recoveries, none of these actions willhave a material adverse effect on the Company.

*Lease Obligations*

We areobligated under certain lease arrangements for our executive and administrativeoffices in New York, Florida, Indiana, Tennessee, Texas, and Ontario, Canada. Rentexpense was $4.2 million for the year ended December 31, 2005, $3.0million for 2004 and $2.4 million for 2003. Annual minimum rental commitments,subject to escalation, under non-cancelable operating leases (in thousands) areas follows: 

| 2006                 |   | $      | 4,189  |   |
|----------------------|--------|--------|--------|--------|
| 2007                 |   | 4,151  |   |
| 2008                 |   | 4,011  |   |
| 2009                 |   | 3,619  |   |
| 2010 and  thereafter |   | 10,220 |   |
| Total                |   | $      | 26,190 |   |

 

In addition to the above, Pennsylvania Life andPenncorp Life (Canada) are the named lessees on 69 properties occupied by careeragents for use as field offices. The career agents reimburse Pennsylvania Lifeand Penncorp Life (Canada) the actual rent for these field offices. The totalannual rent paid by the Company and reimbursed by the career agents for thesefield offices during 2005 was approximately $1.7 million.

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**17.**          *UNIVERSAL AMERICAN FINANCIAL CORP. 401(K) SAVINGS PLAN*

Effective April 1,1992, the Company adopted the Universal American Financial Corp. 401(k) SavingsPlan (“Savings Plan”). The Savings Plan is a voluntary contributory plan underwhich employees may elect to defer compensation for federal income tax purposesunder Section 401(k) of the Internal Revenue Code of 1986. Theemployee is entitled to participate in the Savings Plan by contributing throughpayroll deductions up to 100% of the employee’s compensation. The participatingemployee is not taxed on these contributions until they are distributed. Moreover,the employer’s contributions vest at the rate of 25% per plan year, starting atthe end of the second year. Amounts credited to employee’s accounts under theSavings Plan are invested by the employer-appointed investment committee. Currently,the Company matches employee contributions with Company common stock in amountsequal to 100% of the employee’s first 1% of contributions and 50% of the employee’snext 4% of contributions to a maximum matching contribution of 3% of theemployee’s eligible compensation. The Company made matching contributions underthe Savings Plan of $0.7 million in 2005, $0.6 million in 2004 and $0.4 millionin 2003. Employees are required to hold the employer contribution in Companycommon stock until vested, at which point the employee has the option totransfer the amount to any of the other investments available under the SavingsPlan. The Savings Plan held 610,132 shares of the Company’s common stock at December 31,2005, which represented 44.3% of total plan assets and 565,034 shares at December 31,2004, which represented 47% of total plan assets. Generally, a participatingemployee is entitled to distributions from the Savings Plan upon termination ofemployment, retirement, death or disability. Savings Plan participants whoqualify for distributions may receive a single lump sum, have the assetstransferred to another qualified plan or individual retirement account, or receivea series of specified installment payments.

**18.**          *DISCLOSURES ABOUT FAIR VALUES OF FINANCIAL INSTRUMENTS*

The following methods and assumptions were used toestimate the fair value of each class of financial instruments for which it ispracticable to estimate that value:

*Fixed maturities available for sale:  *Fairvalue of fixed maturities is based upon quoted market prices, where available,or on values obtained from independent pricing services. For certainmortgage-backed and asset-backed securities, the determination of fair value isbased primarily upon the amount and timing of expected future cash flows of thesecurity. Estimates of these cash flows are based current economic conditions,past credit loss experience and other circumstances.

*Equity securities:  *Forequity securities carried at fair value, based on quoted market price.

*Other invested assets:  *Otherinvested assets consists of collateralized loans which are carried at theunderlying collateral value, cash value of life insurance and mortgage loanswhich are carried at the aggregate unpaid balance. The determination of fairvalue for these invested assets is not practical because there is no activetrading market for such invested assets and therefore, the carrying value is areasonable estimate of fair value.

*Cash and cash equivalents and policy loans:  *Forcash and cash equivalents and policy loans, the carrying amount is a reasonableestimate of fair value.

*Cash flow swap:  *The cashflow swap is carried at fair value, obtained from a pricing service.

*Investment contract liabilities:  *Forannuity and universal life type contracts, the carrying amount is thepolicyholder account value; estimated fair value equals the policyholderaccount value less surrender charges.

*Loan payable and trust preferred securities  *Fair value for the loan payable and trust preferred securities is equal to thecarrying amount.

F-40

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Theestimated fair values of the Company’s financial instruments are as follows:

| ** **                           | ** ** | **2005**                | ** ** | **2004**                | ** ** |
|--------------------------------------|------------|-------------------------|------------|-------------------------|------------|
| ** **                           | ** ** | **Carrying**            | ** ** | ** **              | ** ** | **Carrying** | ** ** | ** ** | ** ** |
| ** **                           | ** ** | **Amount**              | ** ** | **Fair Value**     | ** ** | **Amount** | ** ** | **Fair Value** | ** ** |
| ** **                           | ** ** | **(In thousands)** | ** ** | **(In thousands)** | ** ** |
| Financial assets:                    |       |                    |       |                    |       |   |   |   |   |
| Fixed maturities  available for sale |       | $                       | 1,344,775  |                    | $          | 1,344,775 |   | $ | 1,170,822 |   | $ | 1,170,822 |   |
| Equity securities                    |       | 1,279                   |       | 1,279                   |       | 755 |   | 755 |   |
| Policy loans                         |       | 23,601                  |       | 23,601                  |       | 24,318 |   | 24,318 |   |
| Other invested  assets               |       | 896                     |       | 896                     |       | 1,187 |   | 1,187 |   |
| Cash and cash  equivalents           |       | 138,899                 |       | 138,899                 |       | 181,257 |   | 181,257 |   |
| Cash flow swap                       |       | 1,544                   |       | 1,544                   |       | 832 |   | 832 |   |
| Financial  liabilities:              |       |                    |       |                    |       |   |   |   |   |
| Investment contract liabilities      |       | 498,421                 |       | 464,609                 |       | 478,373 |   | 444,068 |   |
| Loan payable                         |       | 95,813                  |       | 95,813                  |       | 101,063 |   | 101,063 |   |
| Trust preferred  securities          |       | 75,000                  |       | 75,000                  |       | 75,000 |   | 75,000 |   |
|                                      |            |                         |            |                         |            |  |  |  |  |  |  |  |  |

 

**19.**          *EARNINGS PER SHARE*

Thereconciliation of the numerators and the denominators for the computation ofbasic and diluted EPS is as follows: 

| ** **                                 | ** ** | **For the Year Ended December 31, 2005**         | ** ** |
|--------------------------------------------|------------|--------------------------------------------------------------------------------|------------|
| ** **                                 | ** ** | **Income**                                                                     | ** ** | **Shares** | ** ** | **Per Share** | ** ** |
| ** **                                 | ** ** | **(Numerator)**                                                                | ** ** | **(Denominator)** | ** ** | **Amount** | ** ** |
| ** **                                 | ** ** | **(In thousands, per share amounts in dollars)** | ** ** |
| Weighted average  common stock outstanding |       |                                                                           |       |   |   |   | 57,254 |   |   |   |   |   |   |
| Less: Weighted  average treasury shares    |       |                                                                           |       |   |   |   | (175 | ) |   |   |   |   |   |
| Basic earnings per share                   |       |                                                                           | $          | 53,876 |   |   |   | 57,079 |   |   |   | $ | 0.94 |   |   |
| Effect of dilutive securities              |       |                                                                           |       |   |   |   | 1,986 |   |   |   |   |   |   |
| Diluted EPS                                |       |                                                                           | $          | 53,876 |   |   |   | 59,065 |   |   |   | $ | 0.91 |   |   |

 

| ** **                                 | ** ** | **For the Year Ended December 31, 2004**         | ** ** |
|--------------------------------------------|------------|--------------------------------------------------------------------------------|------------|
| ** **                                 | ** ** | **Income**                                                                     | ** ** | **Shares** | ** ** | **Per Share** | ** ** |
| ** **                                 | ** ** | **(Numerator)**                                                                | ** ** | **(Denominator)** | ** ** | **Amount** | ** ** |
| ** **                                 | ** ** | **(In thousands, per share amounts in dollars)** | ** ** |
| Weighted average  common stock outstanding |       |                                                                           |       |   |   |   | 54,780 |   |   |   |   |   |   |
| Less: Weighted  average treasury shares    |       |                                                                           |       |   |   |   | (153 | ) |   |   |   |   |   |
| Basic earnings per share                   |       |                                                                           | $          | 63,871 |   |   |   | 54,627 |   |   |   | $ | 1.17 |   |   |
| Effect of dilutive securities              |       |                                                                           |       |   |   |   | 2,005 |   |   |   |   |   |   |
| Diluted EPS                                |       |                                                                           | $          | 63,871 |   |   |   | 56,632 |   |   |   | $ | 1.13 |   |   |

 

F-41

----

 

| ** **                                 | ** ** | **For the Year Ended December 31, 2003**         | ** ** |
|--------------------------------------------|------------|--------------------------------------------------------------------------------|------------|
| ** **                                 | ** ** | **Income**                                                                     | ** ** | **Shares** | ** ** | **Per Share** | ** ** |
| ** **                                 | ** ** | **(Numerator)**                                                                | ** ** | **(Denominator)** | ** ** | **Amount** | ** ** |
| ** **                                 | ** ** | **(In thousands, per share amounts in dollars)** | ** ** |
| Weighted average  common stock outstanding |       |                                                                           |       |   |   |   | 53,670 |   |   |   |   |   |   |
| Less: Weighted  average treasury shares    |       |                                                                           |       |   |   |   | (148 | ) |   |   |   |   |   |
| Basic earnings per share                   |       |                                                                           | $          | 43,052 |   |   |   | 53,522 |   |   |   | $ | 0.80 |   |   |
| Effect of dilutive securities              |       |                                                                           |       |   |   |   | 1,508 |   |   |   |   |   |   |
| Diluted EPS                                |       |                                                                           | $          | 43,052 |   |   |   | 55,030 |   |   |   | $ | 0.78 |   |   |

 

**20.**          *OTHER COMPREHENSIVE INCOME*

Thecomponents of other comprehensive income, and the related tax effects for eachcomponent, are as follows:

| ** **                                                                            | ** ** | **Before Tax  Amount** | ** ** | **Tax Expense  (Benefit)** | ** ** | **Net of Tax  Amount** | ** ** |
|---------------------------------------------------------------------------------------|------------|-----------------------------|------------|---------------------------------|------------|----------------------------------|------------|
| ** **                                                                            | ** ** | **(In thousands)**     | ** ** |
| For the year ended  December 31, 2005                                            |       |                        |       |                            |       |                             |       |   |   |   |   |   |   |
| Net unrealized gain arising during  the year (net of deferred acquisition costs) |       |                        | $          | 1,765                           |       |                             |       | $ | 619 |   |   |   | $ | 1,146 |   |   |
| Reclassification adjustment for gains  included in net income                    |       |                        | (5,773     | )                               |       |                             | (2,021     | ) |   |   | (3,752 | ) |   |
| Net unrealized loss                                                                   |       |                        | (4,008     | )                               |       |                             | (1,402     | ) |   |   | (2,606 | ) |   |
| Cash Flow Hedge                                                                       |       |                        | 712        |                            |       |                             | 249        |   |   |   | 463 |   |   |
| Foreign currency translation adjustment                                               |       |                        | 1,624      |                            |       |                             | 568        |   |   |   | 1,056 |   |   |
| Other  comprehensive loss                                                             |       |                        | $          | (1,672                          | )          |                             |       | $ | (585 | ) |   |   | $ | (1,087 | ) |   |

 

| ** **                                                                            | ** ** | **Before Tax  Amount** | ** ** | **Tax Expense  (Benefit)** | ** ** | **Net of Tax  Amount** | ** ** |
|---------------------------------------------------------------------------------------|------------|-----------------------------|------------|---------------------------------|------------|----------------------------------|------------|
| ** **                                                                            | ** ** | **(In thousands)**     | ** ** |
| For the year ended  December 31, 2004                                            |       |                        |       |                            |       |                             |       |   |   |   |   |   |   |
| Net unrealized gain arising during  the year (net of deferred acquisition costs) |       |                        | $          | 9,542                           |       |                             |       | $ | 3,339 |   |   |   | $ | 6,203 |   |   |
| Reclassification adjustment for gains  included in net income                    |       |                        | (10,647    | )                               |       |                             | (3,726     | ) |   |   | (6,921 | ) |   |
| Net unrealized loss                                                                   |       |                        | (1,105     | )                               |       |                             | (387       | ) |   |   | (718 | ) |   |
| Cash flow hedge                                                                       |       |                        | 636        |                            |       |                             | 223        |   |   |   | 413 |   |   |
| Foreign currency translation adjustment                                               |       |                        | 2,329      |                            |       |                             | 815        |   |   |   | 1,514 |   |   |
| Other  comprehensive income                                                           |       |                        | $          | 1,860                           |       |                             |       | $ | 651 |   |   |   | $ | 1,209 |   |   |

 

| ** **                                                                            | ** ** | **Before Tax  Amount** | ** ** | **Tax Expense  (Benefit)** | ** ** | **Net of Tax  Amount** | ** ** |
|---------------------------------------------------------------------------------------|------------|-----------------------------|------------|---------------------------------|------------|----------------------------------|------------|
| ** **                                                                            | ** ** | **(In thousands)**     | ** ** |
| For the year ended  December 31, 2003                                            |       |                        |       |                            |       |                             |       |   |   |   |   |   |   |
| Net unrealized gain arising during  the year (net of deferred acquisition costs) |       |                        | $          | 7,976                           |       |                             |       | $ | 2,791 |   |   |   | $ | 5,185 |   |   |
| Reclassification adjustment for gains  included in net income                    |       |                        | (2,057     | )                               |       |                             | (720       | ) |   |   | (1,337 | ) |   |
| Net unrealized gain                                                                   |       |                        | 5,919      |                            |       |                             | 2,071      |   |   |   | 3,848 |   |   |
| Cash flow hedge                                                                       |       |                        | 196        |                            |       |                             | 69         |   |   |   | 127 |   |   |
| Foreign currency translation adjustment                                               |       |                        | 9,090      |                            |       |                             | 3,178      |   |   |   | 5,912 |   |   |
| Other  comprehensive income                                                           |       |                        | $          | 15,205                          |       |                             |       | $ | 5,318 |   |   |   | $ | 9,887 |   |   |

 

F-42

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**21.**          *BUSINESSSEGMENT INFORMATION:*

The Company’s principal business segments are based onproduct and include:  Senior Managed Care—MedicareAdvantage, Senior Market Health Insurance, Specialty Health Insurance, LifeInsurance and Annuity and Senior Administrative Services. The Company alsoreports the activities of our holding company in a separate segment. Reclassificationshave been made to conform prior year amounts to the current year presentation. Adescription of these segments follows:

**Senior Managed Care**—**Medicare Advantage**—The Senior Managed Care—MedicareAdvantage segment includes the operations of Heritage and our other initiativesin managed care for seniors. Heritage operates Medicare Advantage plans inHouston and Beaumont Texas, and our Medicare Advantage private fee-for-serviceplans. Heritage generates its revenues and profits from three sources. First,Heritage owns an interest in SelectCare, a health plan that offers coverage toMedicare beneficiaries under a contract with CMS. Next, Heritage operates threeseparate Management Service Organizations (“MSO’s”) that manage the business ofSelectCare and two affiliated Independent Physician Associations (“IPA’s”). Lastly,Heritage participates in the net results derived from these IPA’s. Heritage’sMedicare Advantage plans are sold by our career agency sales force and directlyby employee representatives. Our Medicare Advantage private fee-for-serviceplans were introduced during the second quarter of 2004 and are sold byindependent agents.

**Senior Market Health Insurance**—Thissegment consists primarily of our Medicare Supplement business and other seniormarket health products distributed through our career agency sales force andthrough our network of independent general agencies.

**Specialty Health Insurance**—TheSpecialty Health Insurance segment includes specialty health insuranceproducts, primarily fixed benefit accident and sickness disability insurancesold to the middle income self-employed market in the United States and Canada.This segment also includes certain products that we no longer sell such as longterm care and major medical. This segment’s products are distributed primarilyby our career agents.

**Life Insurance and Annuity**—This segmentincludes all of the life insurance and annuity business sold in the UnitedStates. This segment’s products include senior, traditional and universal lifeinsurance and fixed annuities and are distributed through both independent general agents and our career agencydistribution systems.

**Senior Administrative Services**—Oursenior administrative services subsidiary acts as a third party administratorand service provider of senior market insurance products and geriatric caremanagement for both affiliated and unaffiliated insurance companies. Theservices provided include policy underwriting and issuance, telephone andface-to-face verification, policyholder services, claims adjudication, casemanagement, care assessment and referral to health care facilities.

**Corporate**—This segment reflectsthe activities of Universal American, including debt service, certain seniorexecutive compensation, and compliance with requirements resulting from ourstatus as a public company.

Intersegment revenues and expenses are reported on agross basis in each of the operating segments but eliminated in theconsolidated results. These intersegment revenues and expenses affect theamounts reported on the individual financial statement line items, but areeliminated in consolidation and do not change income before taxes. Thesignificant items eliminated include intersegment revenue and expense relatingto services performed by the Senior Administrative Services segment for ourother segments and interest on notes payable or receivable between theCorporate segment and the operating segments.

F-43

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Financialdata by segment, including a reconciliation of segment revenues and segmentincome (loss) before income taxes to total revenue and net income in accordancewith generally accepted accounting principles is as follows:

| ** **                                   | ** ** | **2005**                | ** ** | **2004**                                  | ** ** | **2003**    | ** ** |
|----------------------------------------------|------------|-------------------------|------------|-------------------------------------------|------------|-------------|------------|
| ** **                                   | ** ** | **Revenue**             | ** ** | **Income  (Loss)  Before  Income  Taxes** | ** ** | **Revenue** | ** ** | **Income  (Loss)  Before  Income  Taxes** | ** ** | **Revenue** | ** ** | **Income  (Loss)  Before  Income  Taxes** | ** ** |
| ** **                                   | ** ** | **(In thousands)** | ** ** |
| Senior Managed  Care—Medicare Advantage |       | $                       | 240,750    |                                      | $          | 27,829      |       | $ | 93,528 |   | $ | 10,136 |   | $ | — |   | $ | — |   |   |
| Senior Market Health  Insurance              |       | 396,304                 |       | 10,181                                    |       | 360,349     |       | 35,407 |   | 271,619 |   | 27,734 |   |   |
| Specialty Health  Insurance                  |       | 176,246                 |       | 26,948                                    |       | 174,768     |       | 26,316 |   | 172,131 |   | 24,435 |   |   |
| Life Insurance  and Annuity                  |       | 96,168                  |       | 15,723                                    |       | 84,523      |       | 13,370 |   | 67,090 |   | 11,981 |   |   |
| Senior  Administrative Services              |       | 59,124                  |       | 9,449                                     |       | 56,668      |       | 13,090 |   | 48,531 |   | 11,018 |   |   |
| Corporate                                    |       | 1,017                   |       | (13,937                                   | )          | 289         |       | (12,498 | ) | 232 |   | (10,746 | ) |   |
| Intersegment  revenues                       |       | (43,795                 | )          | —                                    |       | (44,340     | )          | — |   | (37,068 | ) | — |   |   |
| Adjustments to segment  amounts:             |       |                    |       |                                      |       |        |       |   |   |   |   |   |   |   |
| Net realized gains(1)                        |       | 5,773                   |       | 5,773                                     |       | 10,647      |       | 10,647 |   | 2,057 |   | 2,057 |   |   |
| Premium revenue adjustment(2)           |       | 336                     |       | —                                    |       | (969        | )          | — |   | (1,844 | ) | — |   |   |
| Total                                        |       | $                       | 931,923    |                                      | $          | 81,966      |       | $ | 735,463 |   | $ | 96,468 |   | $ | 522,748 |   | $ | 66,479 |   |   |

----

(1)          We evaluate the resultsof operations of our segments based on income before realized gains and lossesand income taxes. Management believes that realized gains and losses are notindicative of overall operating trends.

(2)          We evaluate the resultsof our insurance segments based on incurred premium net of the change inunearned premium. The change in unearned premium is reported as part of the netincrease in future policy benefits in the consolidated statements of operations.Management believes that including the change in unearned premium in revenueprovides more indicative trends for the purpose of evaluating loss ratios.

Identifiableassets by segment are as follows:

| ** **                                   | ** ** | **As of December 31,** | ** ** |
|----------------------------------------------|------------|---------------------------------------|------------|
| ** **                                   | ** ** | **2005**                              | ** ** | **2004** | ** ** |
| ** **                                   | ** ** | **(In thousands)**               | ** ** |
| Senior Managed  Care—Medicare Advantage |       | $                                     | 167,664    |   | $ | 136,349 |   |
| Senior Market  Health Insurance              |       | 440,661                               |       | 385,487 |   |
| Specialty Health  Insurance                  |       | 795,768                               |       | 732,680 |   |
| Life Insurance  and Annuity                  |       | 764,160                               |       | 723,343 |   |
| Senior  Administrative Services              |       | 26,149                                |       | 19,401 |   |
| Corporate                                    |       | 705,409                               |       | 608,722 |   |
| Intersegment  assets(1)                      |       | (671,832                              | )          | (588,894 | ) |
| Total Assets                                 |       | $                                     | 2,227,979  |   | $ | 2,017,088 |   |

----

(1)          Intersegmentassets include the elimination of the parent holding company’s investment inits subsidiaries as well as the elimination of other intercompany balances.

F-44

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**22.**          *FOREIGNOPERATIONS*

Aportion of the Company’s operations is conducted in Canada through PenncorpLife (Canada). These assets and liabilities are located in Canada where theinsurance risks are written. Revenues, excluding capital gains and losses, ofthe Company by geographic distribution by country are as follows:

| ** **    | ** ** | **For the year ended December 31,** | ** ** |
|---------------|------------|--------------------------------------------------------------|------------|
| ** **    | ** ** | **2005**                                                     | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **    | ** ** | **(In thousands)**                                      | ** ** |
| United States |       | $                                                            | 851,936    |   | $ | 655,842 |   | $ | 456,631 |   |
| Canada        |       | 74,214                                                       |       | 68,974 |   | 64,060 |   |
| Total         |       | $                                                            | 926,150    |   | $ | 724,816 |   | $ | 520,691 |   |

 

Totalassets and liabilities of Penncorp Life (Canada), located entirely in Canada,are as follows:

| ** **  | ** ** | **December 31,**   | ** ** |
|-------------|------------|-------------------------|------------|
| ** **  | ** ** | **2005**                | ** ** | **2004** | ** ** |
| ** **  | ** ** | **(In thousands)** | ** ** |
| Assets      |       | $                       | 277,695    |   | $ | 233,741 |   |
| Liabilities |       | $                       | 212,270    |   | $ | 188,125 |   |

 

**23.**          *CONDENSED QUARTERLY RESULTS OF OPERATIONS (UNAUDITED)*

Thequarterly results of operations are presented below. Due to the use of weightedaverage shares outstanding when determining the denominator for earnings pershare, the sum of the quarterly per common share amounts may not equal the percommon share amounts.

| ** **                                 | ** ** | **Three Months Ended** | ** ** |
|--------------------------------------------|------------|----------------------------------|------------|
| **2005**                                   | ** ** | ** **                       | ** ** | **March 31,** | ** ** | **June 30,** | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
| ** **                                 | ** ** | **(In thousands)**          | ** ** |
| Total revenue                              |       | $                                | 224,202    |   | $ | 229,797 |   |   | $ | 237,152 |   |   |   | $ | 240,772 |   |   |
| Total benefits,  claims and other expenses |       | 199,545                          |       | 202,119 |   |   | 213,103 |   |   |   | 235,190 |   |   |
| Income before  income taxes                |       | 24,657                           |       | 27,678 |   |   | 24,049 |   |   |   | 5,582 |   |   |
| Income tax  expense                        |       | 8,585                            |       | 9,030 |   |   | 8,761 |   |   |   | 1,714 |   |   |
| Net income                                 |       | $                                | 16,072     |   | $ | 18,648 |   |   | $ | 15,288 |   |   |   | $ | 3,868 |   |   |
| Basic earnings  per share                  |       | $                                | 0.29       |   | $ | 0.33 |   |   | $ | 0.26 |   |   |   | $ | 0.07 |   |   |
| Diluted earnings per  share                |       | $                                | 0.28       |   | $ | 0.32 |   |   | $ | 0.25 |   |   |   | $ | 0.06 |   |   |
|                                            |            |                                  |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

| ** **                                 | ** ** | **Three Months Ended** | ** ** |
|--------------------------------------------|------------|----------------------------------|------------|
| **2004**                                   | ** ** | ** **                       | ** ** | **March 31,** | ** ** | **June 30,** | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
| ** **                                 | ** ** | **(In thousands)**          | ** ** |
| Total revenue                              |       | $                                | 158,538    |   | $ | 166,507 |   |   | $ | 203,721 |   |   |   | $ | 206,579 |   |   |
| Total benefits,  claims and other expenses |       | 137,353                          |       | 146,582 |   |   | 174,403 |   |   |   | 180,539 |   |   |
| Income before  income taxes                |       | 21,185                           |       | 19,925 |   |   | 29,318 |   |   |   | 26,040 |   |   |
| Income tax  expense                        |       | 7,309                            |       | 6,874 |   |   | 9,776 |   |   |   | 8,638 |   |   |
| Net income                                 |       | $                                | 13,876     |   | $ | 13,051 |   |   | $ | 19,542 |   |   |   | $ | 17,402 |   |   |
| Basic earnings  per share                  |       | $                                | 0.26       |   | $ | 0.24 |   |   | $ | 0.36 |   |   |   | $ | 0.32 |   |   |
| Diluted earnings per  share                |       | $                                | 0.25       |   | $ | 0.23 |   |   | $ | 0.34 |   |   |   | $ | 0.30 |   |   |
|                                            |            |                                  |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

F-45

----

 

| ** **                                 | ** ** | **Three Months Ended** | ** ** |
|--------------------------------------------|------------|----------------------------------|------------|
| **2003**                                   | ** ** | ** **                       | ** ** | **March 31,** | ** ** | **June 30,** | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
| ** **                                 | ** ** | **(In thousands)**          | ** ** |
| Total revenue                              |       |                             | $          | 97,913 |   |   | $ | 138,109 |   |   | $ | 139,803 |   |   |   | $ | 146,923 |   |   |
| Total benefits,  claims and other expenses |       |                             | 86,262     |   |   | 121,464 |   |   | 122,106 |   |   |   | 126,438 |   |   |
| Income before  income taxes                |       |                             | 11,651     |   |   | 16,645 |   |   | 17,697 |   |   |   | 20,485 |   |   |
| Income tax  expense                        |       |                             | 4,103      |   |   | 5,645 |   |   | 6,281 |   |   |   | 7,398 |   |   |
| Net income                                 |       |                             | $          | 7,548 |   |   | $ | 11,000 |   |   | $ | 11,416 |   |   |   | $ | 13,087 |   |   |
| Basic earnings  per share                  |       |                             | $          | 0.14 |   |   | $ | 0.21 |   |   | $ | 0.21 |   |   |   | $ | 0.24 |   |   |
| Diluted earnings per  share                |       |                             | $          | 0.14 |   |   | $ | 0.20 |   |   | $ | 0.21 |   |   |   | $ | 0.23 |   |   |
|                                            |            |                                  |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

*Significant FourthQuarter Adjustments*

During the fourth quarter of 2005, the Companyrecorded a pre-tax adjustment that increased incurred claims by $9.9 million,or $0.11 per diluted share after tax. Two factors caused this action. First,incurred claims increased by $4.4 million as a result of a change in theestimate of the Company’s Medicare Supplement claim reserves of $6.8 million,offset by an increase in amounts recoverable from reinsurers of $2.4 million. Second,the Company determined that, over a four year period, it had overstated theamounts recoverable from reinsurers for ceded Medicare Supplement claimreserves. During the fourth quarter of 2005, the Company decreased itsrecoverable from reinsurers for ceded Medicare Supplement claim reserves by$5.5 million. Approximately $1.1 million of the decrease was determined torelate to the first three quarters of 2005 and $3.1 million of the decrease wasdetermined to relate to the years 2002 through 2004.

Also during the fourth quarter of 2005, the Companyincurred pre-tax expenses of $10.6 million, or $0.11 per diluted share aftertax, to implement our Part D and Medicare Advantage expansion initiatives.

Certain of the companies acquired in July 1999had post-retirement benefit plans in place prior to their acquisition andUniversal American maintained the liability for the expected cost of such plans.In October 2000, participants were notified of the termination of theplans in accordance with their terms. The liability will be reduced as, and tothe extent, it becomes certain that we will incur no liabilities for the plansas a result of the termination. During the fourth quarter of 2005, $1.8 millionof the liability was released, approximately $0.02 per diluted share after tax.

There were no significant fourth quarter adjustmentsduring 2004 or 2003.

F-46

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**Schedule I—Summary of Investments Other ThanInvestments in Related Parties**

**UNIVERSALAMERICAN FINANCIAL CORP.December 31, 2005 and 2004**

| ** **                                                   | ** ** | **December 31, 2005** | ** ** |
|--------------------------------------------------------------|------------|---------------------------------|------------|
| **Classification**                                           | ** ** | ** **                      | ** ** | **Face  Value** | ** ** | **Amortized  Cost** | ** ** | **Fair  Value** | ** ** | **Carrying  Value** | ** ** |
| ** **                                                   | ** ** | **(In thousands)**         | ** ** |
| U.S. Treasury  securities and obligations of U.S. Government |       | $                               | 114,089    |   | $ | 112,857 |   | $ | 111,861 |   | $ | 111,861 |   |
| Corporate bonds                                              |       | 439,544                         |       | 449,639 |   | 458,809 |   | 458,809 |   |
| Foreign bonds(1)                                             |       | 453,678                         |       | 223,428 |   | 266,168 |   | 266,168 |   |
| Mortgage-backed  and asset-backed securities                 |       | 506,456                         |       | 508,200 |   | 507,937 |   | 507,937 |   |
| Equity securities                                            |       |                            |       | 1,299 |   | 1,279 |   | 1,279 |   |
| Sub-total                                                    |       |                            |       | 1,295,423 |   | $ | 1,346,054 |   | 1,346,054 |   |
| Policy loans                                                 |       |                            |       | 23,601 |   |   |   | 23,601 |   |
| Other invested  assets                                       |       |                            |       | 896 |   |   |   | 896 |   |
| Total investments                                            |       |                            |       | $ | 1,319,920 |   |   |   | $ | 1,370,551 |   |
|                                                              |            |                                 |            |  |  |  |  |  |  |  |  |  |  |  |  |

 

| ** **                                                   | ** ** | **December 31, 2004** | ** ** |
|--------------------------------------------------------------|------------|---------------------------------|------------|
| ** **                                                   | ** ** | **Face**                        | ** ** | **Amortized** | ** ** | **Fair** | ** ** | **Carrying** | ** ** |
| **Classification**                                           | ** ** | ** **                      | ** ** | **Value** | ** ** | **Cost** | ** ** | **Value** | ** ** | **Value** | ** ** |
| ** **                                                   | ** ** | **(In thousands)**         | ** ** |
| U.S. Treasury  securities and obligations of U.S. Government |       | $                               | 85,547     |   | $ | 87,552 |   | $ | 87,943 |   | $ | 87,943 |   |
| Corporate bonds                                              |       | 474,322                         |       | 486,142 |   | 511,779 |   | 511,779 |   |
| Foreign bonds (1)                                            |       | 424,613                         |       | 209,583 |   | 238,347 |   | 238,347 |   |
| Mortgage-backed  and asset-backed securities                 |       | 358,466                         |       | 326,401 |   | 332,753 |   | 332,753 |   |
| Equity securities                                            |       |                            |       | 748 |   | 755 |   | 755 |   |
| Sub-total                                                    |       |                            |       | 1,110,426 |   | $ | 1,171,577 |   | 1,171,577 |   |
| Policy loans                                                 |       |                            |       | 24,318 |   |   |   | 24,318 |   |
| Other invested  assets                                       |       |                            |       | 1,187 |   |   |   | 1,187 |   |
| Total investments                                            |       |                            |       | $ | 1,135,931 |   |   |   | $ | 1,197,082 |   |
|                                                              |            |                                 |            |  |  |  |  |  |  |  |  |  |  |  |  |

----

(1)          Primarily Canadian dollar denominated bonds supporting our Canadianinsurance reserves.

F-47

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**Schedule II**—Condensed Financial Information ofRegistrant

**UNIVERSAL AMERICANFINANCIAL CORP.(Parent Company)CONDENSED BALANCE SHEETSDecember 31, 2005 and 2004**

| ** **                                        | ** ** | **2005**                | ** ** | **2004** | ** ** |
|---------------------------------------------------|------------|-------------------------|------------|----------|------------|
| ** **                                        | ** ** | **(In thousands)** | ** ** |
| ASSETS                                            |       |                    |       |     |       |
| Cash and cash equivalents                         |       | $                       | 12,455     |     | $          | 3,020 |   |
| Investments in  subsidiaries, at equity           |       | 632,449                 |       | 535,277  |       |
| Surplus note  receivable from affiliate           |       | 40,050                  |       | 48,450   |       |
| Due from  affiliates—agent balance financing |       | 8,436                   |       | 8,894    |       |
| Due from  affiliates                              |       | 964                     |       | 821      |       |
| Deferred loan  origination fees                   |       | 4,656                   |       | 5,331    |       |
| Deferred tax  asset                               |       | 1,124                   |       | 1,537    |       |
| Other assets                                      |       | 5,275                   |       | 5,392    |       |
| Total assets                                      |       | $                       | 705,409    |     | $          | 608,722 |   |
| LIABILITIES AND  STOCKHOLDERS’ EQUITY        |       |                    |       |     |       |
| Loan payable                                      |       | $                       | 95,813     |     | $          | 101,063 |   |
| Other long term  debt                             |       | 75,000                  |       | 75,000   |       |
| Note payable to  affiliate                        |       | —                  |       | 3,407    |       |
| Due to affiliate                                  |       | —                  |       | 3,870    |       |
| Retiree plan  termination liability               |       | 772                     |       | 2,681    |       |
| Accounts payable  and other liabilities           |       | 1,939                   |       | 3,280    |       |
| Total liabilities                                 |       | 173,524                 |       | 189,301  |       |
| Total stockholders’ equity                   |       | 531,885                 |       | 419,421  |       |
| Total liabilities  and stockholders’ equity  |       | $                       | 705,409    |     | $          | 608,722 |   |

 

See notes to condensed financial statements.

F-48

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**UNIVERSAL AMERICANFINANCIAL CORP.(Parent Company)CONDENSED STATEMENTS OF OPERATIONSFor the Three Years Ended December 31, 2005**

| ** **                                                     | ** ** | **2005**                | ** ** | **2004** | ** ** | **2003** | ** ** |
|----------------------------------------------------------------|------------|-------------------------|------------|----------|------------|----------|------------|
| ** **                                                     | ** ** | **(In thousands)** | ** ** |
| REVENUES:                                                      |       |                    |       |     |       |     |       |
| Surplus note investment income—affiliated                 |       | $                       | 2,587      |     | $          | 2,389    |       | $ | 2,845 |   |
| Realized gain                                                  |       | 498                     |       | —   |       | —   |       |
| Other income                                                   |       | 1,013                   |       | 298      |       | 230      |       |
| Total revenues                                                 |       | 4,098                   |       | 2,687    |       | 3,075    |       |
| EXPENSES:                                                      |       |                    |       |     |       |     |       |
| Selling, general and administrative expenses                   |       | 5,553                   |       | 6,347    |       | 4,701    |       |
| Release of  retiree plan termination liability                 |       | (1,815                  | )          | (604     | )          | (393     | )          |
| Equity in loss of  unconsolidated subsidiary                   |       | 3,980                   |       | —   |       | —   |       |
| Early  extinguishment of debt                                  |       | —                  |       | —   |       | 1,766    |       |
| Interest  expense—loan payable                            |       | 5,557                   |       | 3,074    |       | 2,245    |       |
| Interest  expense—other long term debt                    |       | 5,426                   |       | 4,829    |       | 2,649    |       |
| Interest  expense—affiliated                              |       | 231                     |       | 502      |       | 991      |       |
| Total expenses                                                 |       | 18,932                  |       | 14,148   |       | 11,959   |       |
| Loss before income taxes and equity in income of  subsidiaries |       | (14,834                 | )          | (11,461  | )          | (8,884   | )          |
| Income tax  benefit                                            |       | 5,706                   |       | 4,680    |       | 3,635    |       |
| Loss before  equity in income of subsidiaries                  |       | (9,128                  | )          | (6,781   | )          | (5,249   | )          |
| Equity in income of subsidiaries                               |       | 63,004                  |       | 70,652   |       | 48,301   |       |
| Net income                                                     |       | $                       | 53,876     |     | $          | 63,871   |       | $ | 43,052 |   |

 

See notes to condensed financial statements.

F-49

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**UNIVERSAL AMERICANFINANCIAL CORP.(Parent Company)CONDENSED STATEMENTS OF CASH FLOWSFor the Three Years Ended December 31, 2005**

| ** **                                                                     | ** ** | **2005**                | ** ** | **2004** | ** ** | **2003** | ** ** |
|--------------------------------------------------------------------------------|------------|-------------------------|------------|----------|------------|----------|------------|
| ** **                                                                     | ** ** | **(In thousands)** | ** ** |
| Cash flows from operating activities:                                          |       |                    |       |     |       |     |       |
| Net income                                                                     |       | $                       | 53,876     |     | $          | 63,871   |       | $ | 43,052 |   |
| Adjustments to reconcile  net income to net cash used by operating activities: |       |                    |       |     |       |     |       |
| Realized gain                                                                  |       | (498                    | )          | —   |       | —   |       |
| Equity in income  of subsidiaries                                              |       | (63,004                 | )          | (70,652  | )          | (48,903  | )          |
| Equity in loss of  unconsolidated subsidiary                                   |       | 3,980                   |       | —   |       | —   |       |
| Change in amounts  due to/from subsidiaries                                    |       | (4,405                  | )          | (560     | )          | (223     | )          |
| Amortization of  deferred loan origination fees                                |       | 675                     |       | 727      |       | 2,206    |       |
| Deferred income  taxes                                                         |       | 413                     |       | (164     | )          | (1,177   | )          |
| Change in other  assets and liabilities                                        |       | (3,802                  | )          | 2,354    |       | 506      |       |
| Net cash used by  operating activities                                         |       | (12,765                 | )          | (4,424   | )          | (4,539   | )          |
| Cash flows from investing activities:                                          |       |                    |       |     |       |     |       |
| Proceeds from sale  of fixed maturities                                        |       | 23,253                  |       | —   |       | —   |       |
| Purchase of fixed  maturities                                                  |       | (23,253                 | )          | —   |       | —   |       |
| Redemption of  surplus note due from affiliate                                 |       | 8,400                   |       | 11,550   |       | —   |       |
| Capital  contributions to subsidiaries                                         |       | (37,150                 | )          | (17,800  | )          | (36,500  | )          |
| Purchase of  business                                                          |       | —                  |       | (100,149 | )          | —   |       |
| Loans to  subsidiaries                                                         |       | —                  |       | —   |       | (3,500   | )          |
| Repayments of  loans to subsidiaries                                           |       | —                  |       | 2,397    |       | 1,102    |       |
| Purchase of agent  balances from subsidiaries, net of collections              |       | 458                     |       | (1,263   | )          | (5,840   | )          |
| Other investing  activities                                                    |       | (2,618                  | )          | —   |       | (1,966   | )          |
| Net cash used by  investing activities                                         |       | (30,910                 | )          | (105,265 | )          | (46,704  | )          |
| Cash flows from financing activities:                                          |       |                    |       |     |       |     |       |
| Net proceeds from  issuance of common stock                                    |       | 64,843                  |       | 4,791    |       | 4,086    |       |
| Purchase of  treasury stock                                                    |       | (10,961                 | )          | (325     | )          | (1,113   | )          |
| Repayment of stock  loans                                                      |       | 20                      |       | 125      |       | 653      |       |
| Repayments of debt  to subsidiaries                                            |       | (3,407                  | )          | (3,518   | )          | (9,111   | )          |
| Issuance of trust  preferred securities                                        |       | —                  |       | —   |       | 60,000   |       |
| Issuance of new  debt                                                          |       | —                  |       | 68,594   |       | 65,000   |       |
| Early  extinguishment of debt                                                  |       | —                  |       | —   |       | (68,950  | )          |
| Principal  repayment on debt                                                   |       | (5,250                  | )          | (5,704   | )          | (8,653   | )          |
| Dividends received  from subsidiaries                                          |       | 6,975                   |       | 34,582   |       | 16,568   |       |
| Other financing  activities                                                    |       | 890                     |       | (2,075   | )          | (3,860   | )          |
| Net cash provided  from financing activities                                   |       | 53,110                  |       | 96,470   |       | 54,620   |       |
| Net increase  (decrease) in cash and cash equivalents                          |       | 9,435                   |       | (13,219  | )          | 3,377    |       |
| Cash and cash equivalents:                                                     |       |                    |       |     |       |     |       |
| At beginning of  year                                                          |       | 3,020                   |       | 16,239   |       | 12,862   |       |
| At end of year                                                                 |       | 12,455                  |       | $        | 3,020      |     | $          | 16,239 |   |
| Supplemental disclosure of cash flow information:                              |       |                    |       |     |       |     |       |
| Cash paid during the year  for:                                                |       |                    |       |     |       |     |       |
| Interest                                                                       |       | $                       | 11,116     |     | $          | 8,307    |       | $ | 5,863 |   |
| Income taxes                                                                   |       | $                       | 3,300      |     | $          | (4,717   | )          | $ | (3,525 | ) |

 

See notes to condensed financial statements

F-50

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**UNIVERSALAMERICAN FINANCIAL CORP.(Parent Company)NOTES TO CONDENSED FINANCIAL STATEMENTS**

**1.**                 *BASIS OF PRESENTATION*

In the parent-company-onlyfinancial statements, the parent company’s investment in subsidiaries is statedat cost plus equity in undistributed earnings of subsidiaries since date ofacquisition. The parent company’s share of net income of its wholly ownedunconsolidated subsidiaries is included in its net income using the equitymethod. Parent-company-only financial statements should be read in conjunctionwith the Company’s consolidated financial statements. Certain reclassificationshave been made to prior years’ financial statements to conform to currentperiod presentation.

**2.**                 *RETIREE PLAN TERMINATION LIABILITY*

Certain of the companiesacquired in July 1999 had post-retirement benefit plans in place prior totheir acquisition and Universal American maintained the liability for theexpected cost of such plans. In October 2000, participants were notifiedof the termination of the plans in accordance with their terms. The liabilitywill be reduced as, and to the extent, it becomes certain that we will incur noliabilities for the plans as a result of the termination. During the fourthquarter of 2005, $1.8 million of the liability was released. The liabilityreleased during the fourth quarter of 2004 was $ 0.6 million and the liabilityreleased during the fourth quarter of 2003 was $0.4 million. The futureprojected releases of the liability are $0.7 million in 2006 and $0.1million in 2007.

**3.**                 *UNCONSOLIDATED SUBSIDIARY*

In the second quarter of2005, Universal American entered into a joint venture with PharmaCare andcreated PDMS, Inc., which is 50% owned by each Universal American andPharmaCare. The net deficit of the entity of $1.0 million is included in otherassets. The Company and PharmaCare each made additional contributions of $1.3million to PDMS, Inc. in January 2006.

**4.**                 *EARLY EXTINGUISHMENT OF DEBT*

On March 31, 2003, the company repaid the balanceof its existing credit facility from the proceeds of the new loan obtained inconnection with the acquisition of Pyramid Life Insurance Company. The earlyextinguishment of debt resulted in the immediate amortization of the relatedcapitalized loan origination fees, resulting in a pre-tax expense ofapproximately $1.8 million.

F-51

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**ScheduleIII—SUPPLEMENTAL INSURANCE INFORMATIONUNIVERSAL AMERICAN FINANCIAL CORP.(In thousands)**

| ** **                                        | ** ** | **Deferred  Acquisition  Costs** | ** **                                              | **Reserves for  Future Policy  Benefits** | ** ** | **Unearned  Premiums** | ** **                                                                | **Policy and  Contract  Claims** | ** ** | **Net  Premium  Earned** | ** **    | **Net  Investment  Income** | ** ** | **Policyholder  Benefits** | ** **     | **Net Change  in DAC** | ** ** | **Other  Operating  Expense** | ** ** |
|---------------------------------------------------|------------|----------------------------------|---------------------------------------------------------|-----------------------------------------------------|------------|------------------------|---------------------------------------------------------------------------|---------------------------------------|------------|--------------------------|---------------|-----------------------------|------------|----------------------------|----------------|----------------------------------|------------|-------------------------------|------------|
| **2005**                                          |       |                             |                                                    |                                                |       |                   |                                                                      |                                  |       |                     |          |                        |       |                       |           |                             |       |                          |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Senior Managed Care—Medicare Advantage  |       |                             | $        — |                                                |       |                   | $           — |                                  |       |                     | —        |                        |       |                       | $ 27,692  |                             |       | $ 237,891                |       |   | $ 2,685 |   |   |   | $ 170,900 |   |   |   | $        — |   |   |   | $ 39,729 |   |   |
| Senior Market Health Insurance                    |       |                             | 112,800                                                 |                                                |       |                   | 113,029                                                                   |                                  |       |                     | —        |                        |       |                       | 51,780         |                             |       | 390,520                       |       |   | 4,783 |   |   |   | 291,696 |   |   |   | (31,035 | ) |   |   | 121,604 |   |   |
| Specialty Health Insurance                        |       |                             | 76,083                                                  |                                                |       |                   | 507,634                                                                   |                                  |       |                     | —        |                        |       |                       | 36,751         |                             |       | 147,831                       |       |   | 27,152 |   |   |   | 102,276 |   |   |   | (8,799 | ) |   |   | 55,822 |   |   |
| Life Insurance/Annuities                          |       |                             | 83,659                                                  |                                                |       |                   | 677,417                                                                   |                                  |       |                     | —        |                        |       |                       | 14,081         |                             |       | 59,740                        |       |   | 36,299 |   |   |   | 56,592 |   |   |   | (16,906 | ) |   |   | 40,491 |   |   |
| Senior Administrative Services                    |       |                             | —                                                  |                                                |       |                   | —                                                                    |                                  |       |                     | —        |                        |       |                       | —         |                             |       | —                        |       |   | — |   |   |   | — |   |   |   | — |   |   |   | 49,197 |   |   |
| Corporate                                         |       |                             | —                                                  |                                                |       |                   | —                                                                    |                                  |       |                     | —        |                        |       |                       | —         |                             |       | —                        |       |   | 815 |   |   |   | — |   |   |   | — |   |   |   | 15,164 |   |   |
| Intersegment and other adjustments                |       |                             | —                                                  |                                                |       |                   | —                                                                    |                                  |       |                     | —        |                        |       |                       | —         |                             |       | 77                            |       |   | (122 | ) |   |   | 187 |   |   |   | — |   |   |   | (43,868 | ) |   |
| Segment Total                                     |       |                             | $ 272,542                                          |                                                |       |                   | $ 1,298,080                                                          |                                  |       |                     | —        |                        |       |                       | $ 130,304 |                             |       | $ 836,059                |       |   | $ 71,612 |   |   |   | $ 621,651 |   |   |   | $ (56,740 | ) |   |   | $ 278,139 |   |   |
| **2004**                                          |       |                             |                                                    |                                                |       |                   |                                                                      |                                  |       |                     |          |                        |       |                       |           |                             |       |                          |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Senior Managed Care—Medicare Advantage  |       |                             | $        — |                                                |       |                   | $           — |                                  |       |                     | —        |                        |       |                       | $ 14,448  |                             |       | $ 93,011                 |       |   | $    333 |   |   |   | $ 66,449 |   |   |   | $        — |   |   |   | $ 15,042 |   |   |
| Senior Market Health Insurance                    |       |                             | 81,889                                                  |                                                |       |                   | 118,892                                                                   |                                  |       |                     | —        |                        |       |                       | 53,981         |                             |       | 355,323                       |       |   | 4,167 |   |   |   | 246,019 |   |   |   | (32,878 | ) |   |   | 109,828 |   |   |
| Specialty Health Insurance                        |       |                             | 66,310                                                  |                                                |       |                   | 472,716                                                                   |                                  |       |                     | —        |                        |       |                       | 26,276         |                             |       | 147,543                       |       |   | 26,351 |   |   |   | 96,932 |   |   |   | (8,292 | ) |   |   | 59,812 |   |   |
| Life Insurance/Annuities                          |       |                             | 60,082                                                  |                                                |       |                   | 646,090                                                                   |                                  |       |                     | —        |                        |       |                       | 10,623         |                             |       | 50,037                        |       |   | 34,207 |   |   |   | 53,461 |   |   |   | (24,337 | ) |   |   | 41,104 |   |   |
| Senior Administrative Services                    |       |                             | —                                                  |                                                |       |                   | —                                                                    |                                  |       |                     | —        |                        |       |                       | —         |                             |       | —                        |       |   | 9 |   |   |   | — |   |   |   | — |   |   |   | 43,160 |   |   |
| Corporate                                         |       |                             | —                                                  |                                                |       |                   | —                                                                    |                                  |       |                     | —        |                        |       |                       | —         |                             |       | —                        |       |   | 247 |   |   |   | — |   |   |   | — |   |   |   | 13,398 |   |   |
| Intersegment and other adjustments                |       |                             | —                                                  |                                                |       |                   | —                                                                    |                                  |       |                     | —        |                        |       |                       | —         |                             |       | (969                          | )          |   | (123 | ) |   |   | (1,162 | ) |   |   | — |   |   |   | (44,773 | ) |   |
| Segment Total                                     |       |                             | $ 208,281                                          |                                                |       |                   | $ 1,237,698                                                          |                                  |       |                     | $ — |                        |       |                       | $ 105.328 |                             |       | $ 644,945                |       |   | $ 65,191 |   |   |   | $ 461,699 |   |   |   | $ (65,507 | ) |   |   | $ 237,571 |   |   |
| **2003**                                          |       |                             |                                                    |                                                |       |                   |                                                                      |                                  |       |                     |          |                        |       |                       |           |                             |       |                          |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Senior Market Health Insurance                    |       |                             | $ 48,909                                           |                                                |       |                   | $  117,637                                                      |                                  |       |                     | $ — |                        |       |                       | $ 73,325  |                             |       | $ 268,057                |       |   | $ 3,341 |   |   |   | $ 184,493 |   |   |   | $ (21,914 | ) |   |   | $ 79,482 |   |   |
| Specialty Health Insurance                        |       |                             | 56,150                                                  |                                                |       |                   | 444,419                                                                   |                                  |       |                     | —        |                        |       |                       | 27,058         |                             |       | 144,615                       |       |   | 26,970 |   |   |   | 97,204 |   |   |   | (10,553 | ) |   |   | 61,033 |   |   |
| Life Insurance/Annuities                          |       |                             | 38,652                                                  |                                                |       |                   | 580,095                                                                   |                                  |       |                     | —        |                        |       |                       | 8,521          |                             |       | 36,140                        |       |   | 30,742 |   |   |   | 41,311 |   |   |   | (18,637 | ) |   |   | 31,617 |   |   |
| Senior Administrative Services                    |       |                             | —                                                  |                                                |       |                   | —                                                                    |                                  |       |                     | —        |                        |       |                       | —         |                             |       | —                        |       |   | 48 |   |   |   | — |   |   |   | — |   |   |   | 37,143 |   |   |
| Corporate                                         |       |                             | —                                                  |                                                |       |                   | —                                                                    |                                  |       |                     | —        |                        |       |                       | —         |                             |       | —                        |       |   | 190 |   |   |   | — |   |   |   | — |   |   |   | 11,959 |   |   |
| Intersegment and other adjustments                |       |                             | —                                                  |                                                |       |                   | —                                                                    |                                  |       |                     | —        |                        |       |                       | —         |                             |       | (1,844                        | )          |   | (216 | ) |   |   | (1,474 | ) |   |   | — |   |   |   | (38,418 | ) |   |
| Segment Total                                     |       |                             | $ 143,711                                          |                                                |       |                   | $ 1,142,151                                                          |                                  |       |                     | $ — |                        |       |                       | $ 108,904 |                             |       | $ 446,968                |       |   | $ 61,075 |   |   |   | $ 321,534 |   |   |   | $ (51,104 | ) |   |   | $ 182,816 |   |   |

 

F-52

 

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