<PAGE>
 
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                      SECURITIES AND EXCHANGE COMMISSION
                            WASHINGTON, D.C. 20549
 
                               ----------------
                                 
                              FORM 10-K/A-2     
 
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE
    ACT OF 1934
 
    FOR THE FISCAL YEAR ENDED DECEMBER 31, 1996
 
                                      OR
 
[_] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES
    EXCHANGE ACT OF 1934
 
  FOR THE TRANSITION PERIOD FROM       TO
 
                        COMMISSION FILE NUMBER 0-21098
 
                       PHYSICIANS HEALTH SERVICES, INC.
                (EXACT NAME OF COMPANY AS SPECIFIED IN CHARTER)
 
                                                           06-1116976
               DELAWARE                                  (IRS EMPLOYER
    (STATE OR OTHER JURISDICTION OF                  IDENTIFICATION NUMBER)
    INCORPORATION OR ORGANIZATION)
 
        ONE FAR MILL CROSSING                                 06484
        SHELTON, CONNECTICUT                               (ZIP CODE)
        (ADDRESS OF PRINCIPAL
          EXECUTIVE OFFICES)
 
        COMPANY'S TELEPHONE NUMBER, INCLUDING AREA CODE (203) 381-6400
 
       SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT: NONE
 
          SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT:
 
                CLASS A COMMON STOCK, PAR VALUE $.01 PER SHARE
                               (TITLE OF CLASS)
 
  Indicate by check mark whether the Company: (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
Company was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes [X] No [_]
 
  Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to
the best of Company's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to
this Form 10-K [X]
 
  Aggregate market value of the voting stock held by non-affiliates at March
25, 1997 amounted to $114,394,815 (assuming for purposes of this calculation
only, that all directors and executive officers are affiliates). (Class B
Common Stock is assumed to have a market value of $19.875 per share)
 
  Indicate the number of shares of each of the Company's classes of Common
Stock, as of the latest practicable date.
 
  Shares of Common Stock outstanding as of March 25, 1997:
 
                   5,763,905 SHARES OF CLASS A COMMON STOCK
                   3,546,212 SHARES OF CLASS B COMMON STOCK
 
                     DOCUMENTS INCORPORATED BY REFERENCE:
                                      
                                   NONE     
 
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<PAGE>
 
  This amendment to the Annual Report on Form 10-K of Physicians Health
Services, Inc. (the "Company") for the fiscal year ended December 31, 1996, as
amended by Amendment No. 1 thereto (as so amended, the "Original Form 10-K"),
amends and modifies the Original Form 10-K as follows, in response to comments
from the Securities and Exchange Commission:
 
    (1) The fifth and seventh paragraphs under "Item 7. Management's
  Discussion and Analysis of Financial Condition and Results of Operations"
  have been revised to refer to the impact of arrangements between the
  Company and The Guardian Life Insurance Company, Inc. (the "Guardian").
 
    (2) "Note 2. Significant Accounting Policies," which is part of the Notes to
  the Consolidated Financial Statements submitted with the Original Form 10-K in
  response to Item 8, has been revised to add a paragraph entitled "Impairment
  of long-lived assets."
 
    (3) "Note 10. Arrangement with the Guardian Life Insurance Company of
  America," which is part of the Notes to the Consolidated Financial Statements
  submitted with the Original Form 10-K in response to Item 8, has been revised
  to explain what indemnity costs that appear on the Statements of Operations
  represent (fifth paragraph), to describe "Guardian joint marketing expenses,
  net" (tenth paragraph), to clarify how the Company reports the effects of the
  profit sharing arrangement with the Guardian (second paragraph) and to clarify
  what revenues and costs generated under the "jointly marketed products"
  represent (seventh and eighth paragraphs).
 
    (4) Exhibit 23.1 is filed herewith.

In addition, a correction has been made to the cover page of the Original
Form 10-K to include a check mark to indicate that disclosure of delinquent
filers pursuant to Item 405 of Regulation S-K is not contained therein.

                                       2
<PAGE>
 
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
        RESULTS OF OPERATIONS
 
  The following table shows certain income statement data expressed as a
percentage of total revenues for the years indicated:
 
<TABLE>
<CAPTION>
                                                     YEAR ENDED DECEMBER 31
                                                     --------------------------
                                                      1996      1995     1994
                                                     -------   -------  -------
<S>                                                  <C>       <C>      <C>
Revenues:
  Premiums..........................................    98.7%     98.0%    98.6%
  Investment and other income.......................     1.3       2.0      1.4
                                                     -------   -------  -------
    Total revenues..................................   100.0     100.0    100.0
                                                     -------   -------  -------
Health care expenses:
  Hospital services.................................    36.5      32.0     32.3
  Physicians and related health care services.......    40.7      37.5     39.9
  Other health care services........................     8.7       5.3      4.4
  Indemnity costs...................................     1.4       0.6
                                                     -------   -------  -------
    Total health care expenses......................    87.3      75.4     76.6
                                                     -------   -------  -------
Selling, general and administrative expenses........    17.8      16.7     15.0
Guardian joint marketing (income) expense, net......    (0.2)      0.7      0.0
Proxy defense costs.................................     --        0.2      --
Interest............................................     0.1       0.0      0.0
                                                     -------   -------  -------
    Total expenses..................................   105.0      93.0     91.6
                                                     -------   -------  -------
Income (loss) before taxes..........................    (5.0)      7.0      8.4
Income tax expense (benefit)........................    (2.3)      2.4      3.6
                                                     -------   -------  -------
Net income (loss)...................................    (2.7)%     4.6%     4.8%
                                                     =======   =======  =======
</TABLE>
 
  The Company's subsidiaries, PHS/CT, PHS/NY, PHS/NJ and Bermuda, have entered
into several marketing and reinsurance agreements with The Guardian. Under
these agreements, jointly developed managed care and indemnity products are
offered to existing Guardian insureds as well as to new prospects. The Company
and The Guardian have implemented different ways to share profits and losses
under these agreements which vary among the particular states and time periods
as described below.
 
  In Connecticut, PHS/CT wrote 100% of the managed care business and The
Guardian wrote 100% of the indemnity business. The parties shared profits and
losses through September 30, 1996 pursuant to a "selection adjustment payment"
mechanism. Under this arrangement, each party calculated its quarterly profit
or loss (net premiums earned, minus claims payments, capitation payments and
withholds paid with respect to managed care plans, reserve increases or
decreases, administrative charges, commissions and premium taxes, plus
investment income). The selection adjustment payment, which was designed to
mitigate the effect of potential adverse selection in groups which selected
Healthcare Solutions products and enable the parties to share in any long-term
profits or loses, then provided that if both parties had losses, no adjustment
would be made from one to the other, and each would retain its respective
loss. If both parties had profits, the amounts were combined, and the party
with the greater profit would make a selection adjustment payment to the
other, in an amount equal to half of the profit differential. If only one
party had a profit, the profitable party made a selection adjustment payment
equal to that party's reported profit, thereby partially or fully reimbursing
the other party's loss. If the result was a combined profit, the profitable
party would make a selection adjustment payment equal to the other party's
loss, increased by half of the combined profit. Selection adjustment
calculations were done on a cumulative basis, and accordingly, losses are
carried forward to offset against future profits. Because both PHS and The
Guardian incurred losses in Connecticut in 1996, no selection adjustment
payment was made, and the Company reported 100% of the cumulative losses on
the managed care products sold under the Healthcare Solutions product line.
 
                                       3
<PAGE>
 
  The parties entered into new agreements with respect to the Connecticut
Healthcare Solutions business that were effective as of October 1, 1996. The
selection adjustment methodology was replaced with a reinsurance agreement
pursuant to which the Company cedes 50% of the risk on the managed care
portion of the Healthcare Solutions products to The Guardian. In connection
with the conversion to reinsurance, the parties agreed that 50% of the
cumulative losses in Connecticut would be offset from amounts otherwise due to
The Guardian under the reinsurance agreement when profits, if any, are
generated.
 
  In New York, The Guardian cedes 50% of its risk for the out-of-network
portion of the POS Healthcare Solutions products to Bermuda and the Company
cedes 50% of its risk for HMO products and the in-network portion of the POS
Healthcare Solutions products to The Guardian. In New Jersey, the Company
cedes 100% of the risk of the out-of-network portion of the POS Healthcare
Solutions products and 50% of the risk on the other HMO Healthcare Solutions
products to The Guardian and The Guardian retrocedes 50% of the risk for the
out-of-network portion of the POS Healthcare Solutions products back to
Bermuda. The reinsurance agreements were amended in 1996 to reduce the
Company's risk for indemnity Healthcare Solutions products. In New York, the
Company was responsible for 10% of the associated losses on the indemnity
business between January 1 and June 30, 1996 and did not share risk with
respect to the indemnity portion of the Healthcare Solutions business after
June 30, 1996. In Connecticut, the agreements were amended effective October
1, 1996 so that the Company will not share risk with respect to the indemnity
business in those states following September 30, 1996.
 
  As a result of its arrangements with The Guardian, the Company's percentage
growth in its aggregate premium revenue has lagged its percentage growth in
enrollment, since a portion of the Healthcare Solutions revenues and expenses
that were ceded to The Guardian are omitted from the Company's Statement of
Operations. The Company expects that this trend will continue if its
Healthcare Solutions products continue to be successful and the enrollment mix
between its proprietory products and the Healthcare Solutions products shifts
to a greater percentage in Healthcare Solutions. The aggregate revenue is
impacted by this mix due to the fact that for its proprietary products the
Company retains 100% of the revenue and related health care expenses while
under the Healthcare Solutions product, 50% of the revenue and related health
care expenses are ceded to The Guardian, therefore impacting the aggregate
revenue growth compared to aggregate membership growth. Per member, per month
("PMPM") amounts are similarly impacted by this mix due to the fact Healthcare
Solutions membership is reflected at 100% and revenue and related health care
expenses are reflected at 50%.
 
  The marketing and reinsurance agreements with the Guardian have had a
significant impact on the Company's results of operations. In 1996, the
arrangements with the Guardian resulted in approximately $14.6 million of
pretax losses while in 1995, the arrangements resulted in approximately $1.3
million of pretax income.
 
RESULTS OF OPERATIONS
 
YEAR ENDED DECEMBER 31, 1996 COMPARED TO YEAR ENDED DECEMBER 31, 1995
 
  Premium revenue increased 40.4% to $481.5 million in 1996 from $343.0
million in 1995, while enrollment at December 31, 1996 increased 49.8% over
1995 to 400,021. As of December 31, 1996, fully-insured enrollees increased
59.9% to 332,363 members up from 207,856 as of December 31, 1995, while self-
funded enrollees increased 14.2% to 67,658 members as of December 31, 1996, up
from 59,260 at December 31, 1995. The aggregate premium revenue increase
lagged the membership growth due primarily to the growth of membership in the
Healthcare Solutions product where 50% of the premium revenue and related
healthcare costs are ceded to The Guardian pursuant to the agreement and a
membership shift in the fully insured product mix to lower benefit, lower PMPM
revenue products. Also, enrollee statistics include 100% of the approximately
112,000 members enrolled in Healthcare Solution products at December 31, 1996,
while premium revenue includes only the Company's 50% share of the Healthcare
Solutions revenues derived from the New York arrangements which became
effective July 1, 1995, the New Jersey arrangements effective January 1, 1996,
and the Connecticut arrangements effective October 1, 1996.
 
                                       4
<PAGE>
 
  Investment and other income declined 5.6% in 1996 from $7.0 million for the
year ended December 31, 1995 to $6.6 million for the year ended December 31,
1996. The decline in investment income is due primarily to a decline in
invested assets and lower investment yields due to lower interest rates.
 
  Health care expenses as a percentage of premium revenue (medical loss ratio)
increased to 89.8% for 1996 from 78.2% for 1995. The increase in the medical
loss ratio resulted from a 7.4% increase in medical costs on a PMPM basis
(primarily hospital and prescription drug costs as discussed below) and a
decline of 6.5% in the PMPM premium revenue.
 
  Hospital services expenses increased 59.1% to $178.1 million in 1996 from
$111.9 million in 1995. The increase is due primarily to an increase in fully-
insured membership. On a PMPM basis, however, hospital services increased 5.7%
from 1995 to 1996. This increase is attributable primarily to the recent trend
to perform certain lower cost services, which historically had been performed
in an in-patient setting, in an out-patient setting. This results in a higher
average cost for those services which are still performed in an in-patient
setting. Inpatient hospital utilization for fully-insured commercial enrollees
decreased 3.2% to 272 days per thousand members, per year for the year ending
December 31, 1996 from 281 days per thousand members, per year for the same
1995 period. This decrease was primarily due to the continued trend towards
less expensive treatment being provided in the out-patient setting and more
effective medical management techniques.
 
  Physician and related health care expenses increased 51.6% in 1996 from
1995. The increase is primarily due to the 59.9% increase in fully insured
membership as well as increases in non-capitated expenses, including costs for
out-of-network physicians' services.
 
  Other health care expenses increased by $23.7 million from 1995 to 1996 due
primarily to higher prescription drug costs resulting from an increase in the
number of members covered by prescription drug riders. Additionally, there was
a shift in membership to drug riders which offered greater benefits. At the
same time, fewer generic drugs were prescribed resulting in increased pharmacy
costs.
 
  Indemnity costs reflect the medical costs associated with the indemnity
revenue assumed in connection with The Guardian reinsurance arrangement in New
York which began in 1995. The Company's net indemnity costs for 1996 were $7.0
million, up from $2.2 million for 1995. As a result of continuing adverse
experience related to this business, the Company amended the New York
reinsurance agreement to reduce the Company's share of the indemnity business
assumed from 50% to 10%, for the period from January 1, 1996 to June 30, 1996.
The impact of this adjustment reduced the after tax loss associated with the
indemnity business by approximately $900 thousand, which was recorded in the
second quarter of 1996. The amendment also provided that the Company will
assume no further indemnity risk in the New York market for claims incurred
after June 30, 1996. As noted above, after September 30, 1996 the Company did
not share risk in connection with the Healthcare Solutions indemnity business
in the Connecticut market. Selling, general and administrative expenses
increased 48.2% to $86.7 million in 1996 from $58.5 million in 1995. The
increase was principally due to additional staffing, outside services and
other costs needed to support geographic expansion, product diversification
and enrollment growth.
 
  The Company's effective tax benefit rate was 46.5% for the year ended
December 31, 1996, as compared to an effective tax provision rate of 34.6% for
the comparable 1995 period. The 1996 effective tax rate resulted primarily
from the favorable effect of the income from tax exempt securities which
increases the tax benefit when there are losses.
 
  The Company has undertaken a number of actions intended to restore
profitability in 1997. It increased its premiums an average of 4.4% at the end
of 1996 for groups renewing in 1997 and may make further adjustments subject
to competitive conditions. It has moved to introduce enhanced medical
management, which is intended to result in reduced health care expenses on a
PMPM basis in 1997. In addition, its contracts with risk entities shift a
greater amount of the risk of overutilization to the risk entities, which will
provide further protection against rising health care costs. Moreover, the
Company has shifted a portion of the Healthcare Solutions membership to
capitation arrangements with the Physician Groups. Although there can be no
assurance that these changes, among others, will enable the Company to be
profitable in 1997, the Company expects to see significant improvement in its
financial results in 1997. See "Management's Discussion and Analysis of
Financial Condition and Results of Operations--Cautionary Statement."
 
                                       5
<PAGE>
 
YEAR ENDED DECEMBER 31, 1995 COMPARED TO YEAR ENDED DECEMBER 31, 1994
 
  Premium revenue increased 18.4% to $343.0 million in 1995 from $289.8
million in 1994 while enrollment at December 31, 1995 increased 48.8% over
1994 to 267,116. As of December 31, 1995, fully-insured enrollees increased
55.5% to 207,856 members from 133,676 as of December 31, 1994, while self-
funded enrollees increased 29.2% to 59,260 members as of December 31, 1995, up
from 45,874 as of December 31, 1994. The premium revenue increase lagged the
membership growth due to more aggressive pricing and a shift in fully insured
product mix to lower revenue yielding products. Also, enrollee statistics
include 100% of the enrollees in New York, while premium revenue includes only
the Company's 50% share of revenues derived from the New York Guardian
arrangements which become effective July 1, 1995.
 
  Investment and other income was up 67.5% in 1995 from $4.2 million for the
year ended December 31, 1994 to $7.0 million for the year ended December 31,
1995. The increase in investment income was due to improved portfolio yields
and a reduction in realized losses.
 
  Health care expenses as a percentage of premium revenue (medical loss ratio)
decreased to 78.2% for 1995 from 79.0% for 1994. The decrease in the medical
loss ratio resulted from a 7.0% decline in medical costs on a per member per
month basis which was partially offset by a 6.4% decline in the per member per
month premium revenue. Total health care expenses increased 17.1% to $263.8
million in 1995 from $225.3 million for 1994.
 
  Hospital services expenses increased 17.9% to $111.9 million in 1995 from
$94.9 million in 1994. On a PMPM basis, hospital services declined 6.8% from
1994 to 1995. The decline was due primarily to a reduction in in-patient
hospital utilization which was partially offset by higher out-patient
utilization. In-patient hospital utilization for fully-insured enrollees,
excluding Medicare cost contract enrollees, decreased 14.1% to 281 days per
thousand members per year for the year ending December 31, 1995 from 327 days
per thousand members for the same 1994 period.
 
  Physician and related health care expenses increased 11.6% in 1995 from 1994
despite a 55.5% increase in fully insured enrollees. As a result, physician
expense declined 11.8% on a per member per month basis for the year ended
December 31, 1995 as compared to the same 1994 period. The decrease is largely
due to more favorable capitation arrangements with providers and a shift in
membership to lower cost capitated products.
 
  Other health care expenses increased by $5.8 million from 1994 to 1995 due
primarily to higher prescription drug expense resulting from an increase in
prescription drug benefit coverage and increased utilization. Additionally, in
1995, other health care expenses includes the Healthcare Solutions profit
sharing expense which resulted from The Guardian reinsurance arrangement in
Connecticut.
 
  Indemnity costs reflect the medical costs associated with the indemnity
revenue assumed in connection with The Guardian reinsurance arrangement in New
York which began in 1995.
 
  Selling, general and administrative expenses increased 32.7% to $58.5
million in 1995 from $44.1 million in 1994. The increase was principally due
to continuing resource commitments to support enrollment growth and the
expansion into the Connecticut, New York and New Jersey tri-state region.
Additionally, the related administrative infrastructure was also expanded to
accommodate the increased growth.
 
  The Company's effective tax rate declined to 34.6% for the year ended
December 31, 1995 from 42.5% for the comparable 1994 period. The decline in
the effective tax rate resulted primarily from the shift of much of the
Company's investment portfolio into tax exempt municipal bonds and to a slight
decline in the statutory state income tax rates. Additionally, the effective
tax rate for 1995 was favorably affected by the reconciliation of prior
provisions.
 
                                       6
<PAGE>
 
LIQUIDITY AND CAPITAL RESOURCES
 
  PHS has historically financed its operations primarily through internally
generated funds. The Company's primary capital requirements are for working
capital, principally to fund geographic and product expansion, and to maintain
necessary regulatory capital. In addition, the Company's HMO subsidiaries,
PHS/CT, PHS/NY and PHS/NJ, and its insurance subsidiaries, are subject to
statutory regulations that restrict the payment of dividends.
 
  Net cash flows for the year ended December 31, 1996 resulted in an increase
in cash and cash equivalents of $31.7 million. Although operating cash flows
were unfavorably affected by the Company's 1996 loss of $13.0 million, net
cash was provided by operating activities of $24.6 million for the year ended
December 31, 1996. The difference between the net loss and the net cash
provided from operating activities resulted primarily from a $22.3 million
increase in hospital incurred but not reported ("IBNR") claims, which was
generated from the increase in the volume of claims activity due to the rise
in membership and the timing of the related claims payments and from the
collection of outstanding advances to hospitals which totalled $5.5 million.
Additionally, the amounts due to IPAs, physicians and other providers
increased $15.3 million in 1996, reflecting an increase in the amounts payable
to non-capitated providers, such as out of network providers, and the timing
of those related payments. These items were offset in part by the net increase
in receivables of approximately $10.0 million which occurred due to the growth
in enrollment from both the Company's proprietary business and from its
arrangements with The Guardian. Approximately $44.0 million of net cash was
provided by the sales and maturities of marketable securities, of which $34.6
million was used to fund the enhancement of the Company's computer
infrastructure and to purchase the Company's new corporate headquarters .
 
  PHS's net cash used in operations amounted to $9.5 million in 1995. Since
The Guardian holds the funds generated by Healthcare Solutions, on which the
Company earns interest, and since the funds were not released by year end,
operating cash flows in 1995 were unfavorably affected by the arrangements
with The Guardian. In addition, IPA withhold percentages were generally
decreased in 1995, and as a result, the amounts owed to the IPAs tended to be
paid over on a more rapid schedule. Further, accelerated payments related to
income taxes and the Medicare cost contract decreased operating cash flows.
These items were partially offset by the net income of $16.0 million generated
during the year. Cash used for investing activities was $11.7 million for the
year ended December 31, 1995, primarily due to capital expenditures of $15.2
million which represented investments in optical imaging technology and other
improvements in the computer infrastructure needed to support the Company's
expansion.
 
  Net cash flow during 1994 resulted in an increase in cash and investments to
$139.8 million at December 31, 1994 from $112.2 million at December 31, 1993.
Cash provided by operating activities totaled $39.3 million, resulting
primarily from net income of $14.1 million generated during the period, the
timing of the receipt of medical claims and the timing of payments related to
other liabilities.
 
  At December 31, 1994, PHS was no longer required to maintain a restricted
cash reserve to comply with the requirement of the Office of Prepaid
Healthcare in connection with the Medicare cost contract. In New York, the
Company is required to maintain an escrow reserve equal to 5% of estimated
health care expenses for the current year, for the protection of enrollees,
which, as of December 31, 1996 was $9.0 million. In Connecticut, the Company
is required to maintain a statutory minimum unimpaired capital surplus of $1.0
million. The Company is currently in compliance with all applicable statutory
capital requirements. The Company is subject to various laws and regulations
which, at December 31, 1996, caused the aggregate amount of its restricted net
assets to be approximately $38.8 million.
 
  The Company's expenditures for capital equipment, primarily for computers
and related equipment, and in 1996 for the purchase of the Company's new
headquarters, totaled $34.6 million, $15.2 million and $9.7 million for the
years ended December 31, 1996, 1995 and 1994, respectively. The Company
expects to spend additional capital, principally in computer and technology
systems enhancements, over the next several years. The Company expects to
require additional capital over the next several years and, although it can
provide no assurances in this regard, believes that in addition to its current
capital resources and internally generated funds, it will be able to obtain
financing, if necessary, sufficient for its continued operations.
 
                                       7
<PAGE>
 
EFFECT OF INFLATION
 
  Health care industry costs have been rising annually at rates higher than
the Consumer Price Index. To offset this trend, PHS has been able to achieve
premium rate increases for its 1997 business which should help mitigate the
effect of medical cost inflation on its operations. The Company's premiums are
higher than many of its competitors, however, and there can be no assurance
that the Company will be able to increase premiums sufficiently to offset the
rise in health care costs without jeopardizing the Company's competitive
position. In addition, PHS contracts with several major hospitals on a multi-
year basis with fixed annual increases. The Company's risk sharing
arrangements with its Physician Groups and other cost control measures, such
as its utilization review program, also help to mitigate the effects of price
increases on operations. There can be no assurance that the Company's efforts
to reduce the impact of inflation will be successful.
 
CAUTIONARY STATEMENT
 
  In connection with the "safe harbor" provisions of the Private Securities
Litigation Reform Act of 1995, the Company is hereby making cautionary
statements identifying important risk factors that could cause the Company's
actual results to differ materially from those projected in forward-looking
statements made by or on behalf of the Company.
 
  The Company wishes to caution readers that the following important factors,
among others, could cause the Company's actual financial or enrollment results
to differ materially from those expressed in any projected, estimated or
forward-looking statements relating to the Company.
 
  Premium Structure; Unpredictability of Medical Costs. A substantial amount
of the Company's revenues are generated by premiums which represent fixed
monthly payments for each person enrolled in the Company's plans. If the
Company is unable to obtain adequate premiums because of competitive or
regulatory considerations, the Company could incur decreased margins or
significant losses. The Company believes that commercial premium pricing will
continue to be highly competitive. The Company's revenues from its Medicare
and Medicaid programs could be adversely affected if reimbursement rates do
not keep pace with rising medical costs. Historically, these rates have been
subject to wide variations from year to year. In the event reimbursement were
to decline from projected amounts, the Company would attempt to renegotiate
its contracts with its health care providers. There can be no assurance that
it could successfully renegotiate these financial arrangements and failure to
reduce the health care costs associated with such programs could have a
material adverse effect upon the Company's business.
 
  The Company's profitability is also dependent, in large part, upon its
ability to accurately project and manage health care costs, including without
limitation, appropriate benefit design, utilization review and case management
programs, and its risk sharing arrangements with providers, while providing
members with quality health care. Health care costs are affected by a variety
of factors that are difficult to predict and are not entirely within the
Company's control, including the severity and frequency of claims. Medical
cost inflation, mandated benefits and other regulatory changes, new
technologies, natural disasters, epidemics and other external factors relating
to the delivery of health care services, inability to establish acceptable
risk sharing arrangements with providers and other factors may adversely
affect the Company's ability to manage the costs of providing health care
services. In addition, the Company experienced high out-of-network utilization
in connection with its POS products in 1996 in New York, which resulted in
medical costs for the POS products exceeding budgeted amounts. The Company is
seeking to expand its network in New York and institute other measures to
limit the risk of high out-of-network utilization. The Company is implementing
a variety of measures to help it manage health care costs better. However,
there can be no assurance that the Company will be able to continue to reduce
its medical costs sufficiently to restore profitability in all its product
lines. In light of the expected continuing growth of the POS products, failure
to reduce out-of-network utilization could adversely affect the Company's
profitability.
 
  Accrued health care expenses payable in the Company's financial statements
include reserves for incurred but not reported claims ("IBNR"), the amount of
which is estimated by the Company. The Company estimates the amount of such
reserves using standard actuarial methodologies based upon historical data
including the
 
                                       8
<PAGE>
 
average interval between the date services are rendered and the date claims
are paid, expected medical cost inflation, seasonality patterns and increases
in membership. The Company believes that its reserves for IBNR are adequate in
order to satisfy its ultimate claims liability. However, there can be no
assurances as to the ultimate accuracy or completeness of such estimates or
that adjustments to reserves will not cause volatility in the Company's
results of operations.
 
  Dependence upon Key Employer Agreements. The Company's ability to obtain and
maintain favorable group benefit agreements with employer groups affects the
Company's profitability. Currently, 17% of its total commercial enrollment
(those groups which are fully insured, which includes 332,363 enrollees) is
derived from its largest five fully insured accounts. Fully insured groups
produce the highest PMPM revenues for the Company. Although during the
Company's most recent fiscal year, no employer group accounted for more than
7.5% of total revenues, the loss of one or more of the larger employer group
accounts could have a material adverse effect upon the Company's business.
Although only 8% of the Company's total membership in 1996 was enrolled in
Medicare and Medicaid programs, that percentage is expected to increase in the
future. Loss of one or more of the contracts the Company currently has or
expects to have to serve Medicaid or Medicare participants could have a
material adverse effect upon the Company's business. Finally, the Company has
agreed to certain performance guarantees for certain of the large employer
groups with which it contracts. Failure to satisfy such guarantees could
result in financial penalties.
 
  Key Partnership. The Company's contracts with The Guardian are expected to
represent a significant percentage of the Company's revenue and enrollment in
future years. See "Business--Joint Marketing Arrangement with The Guardian."
The loss of this relationship could have a material adverse effect on the
Company's business.
 
  Competition. Managed care companies and HMOs operate in a highly competitive
environment. The Company has numerous types of competitors, both local and
national, including, among others, HMOs, PPOs, self-insured employer plans and
traditional indemnity carriers, many of which have substantially larger total
enrollments, greater financial resources and other characteristics that give
them an advantage in competing with the Company. Additional competitors with
needs or desires for immediate market share or those with greater financial
resources than the Company have entered or may enter the Company's market. The
Company also believes that the addition of new competitors can occur
relatively easily. In addition, certain of the Company's customers may decide
to perform for themselves certain administrative services currently provided
by the Company, which could adversely affect the Company's revenues.
Significant merger and acquisition activity has occurred in the managed care
industry as well as in industries which are suppliers to the Company. This
activity may result in stronger competitors or increased health care costs.
Increased competitive pressures may limit the Company's ability to increase,
or in some instances, maintain premiums, reduce membership levels or decrease
profit margins, and there can be no assurance that the Company will not incur
increased pricing and enrollment pressure from local and national competitors.
Any such pressures could materially affect the Company's results of
operations.
 
  Government Regulation. The Company's business is subject to extensive
federal and state laws and regulations, including, but not limited to,
financial requirements, licensing requirements, enrollment requirements and
periodic examinations by governmental agencies. The laws and regulations
governing the Company's business and the interpretation of those laws and
regulations are subject to frequent change. Existing or future laws or
regulations could force the Company to change the way it does business and may
restrict the Company's revenue or enrollment growth or increase its health
care and/or administrative costs. In particular, the Company's HMO and
insurance subsidiaries are subject to regulations relating to cash reserves,
minimum net worth, premium rates and approval of policy language and benefits.
Although such regulations have not significantly impeded the growth of the
Company's business to date, there can be no assurance that the Company will be
able to continue to obtain or maintain required governmental approvals or
licenses or that regulatory changes will not have a material adverse effect on
the Company's business. In addition, delays in obtaining regulatory approvals
or moratoriums imposed by regulatory authorities could adversely effect the
Company's ability to bring new products to market as forecasted. The Company
is also subject to various governmental audits and investigations.
 
                                       9
<PAGE>
 
Such activities could result in the loss of required licenses or the right to
participate in certain programs, or the imposition of penalties and/or other
sanctions. In addition, disclosure of any adverse investigation or audit
results or sanctions could negatively affect the Company's reputation in
various markets and make it more difficult for the Company to sell its
products and services.
 
  Management Information System. The Company's management information system
is critical to its current and future operations. The information gathered and
processed by the Company's management information system assists the Company
in, among other things, pricing its services, monitoring utilization and other
cost factors, processing provider claims, providing bills on a timely basis
and identifying accounts for collection. Any difficulty associated with or
failure to successfully implement the current conversion of its management
information system, or any inability to expand processing capability in the
future in accordance with its business needs, could result in a loss of
existing customers and difficulty in attracting new customers, customer and
provider disputes, regulatory problems, increases in administrative expenses
or other adverse consequences.
 
  New Service Areas and Products. The Company recently undertook a significant
expansion of its geographic market area. In addition, it recently introduced
several new products, including Medicare risk and Medicaid products. The
success of its geographic and product expansion efforts depends in large part
on its ability to develop market share in a highly competitive market and to
develop the infrastructure necessary to support the forecasted enrollment
growth. The Company believes that it has budgeted sufficient amounts to meet
its growth expectations; however, there can be no assurance that it will not
require greater resources than expected or that it will be successful in its
marketing efforts. Furthermore, although it believes it has introduced
programs to effectively manage its new products, there can be no assurance
that the health care and other costs associated with such programs will not be
greater than revenues. Medicare risk contracts provide revenues which are
generally higher per member than those for non-Medicare members, and thus
provide an opportunity for increased profits and cash flow. Such risk
contracts, however, also carry certain risks such as higher comparative
medical costs, government regulatory and reporting requirements, the
possibility of reduced or insufficient government reimbursement in the future,
and higher marketing and advertising costs per member as the result of
marketing to individuals as opposed to groups.
 
  Possible Volatility of Common Stock Price. Recently, there has been
significant volatility in the market prices of securities of companies in the
health care industry, including the price of the Company's Common Stock. Many
factors, including medical cost increases, analysts' comments, speculation
about a possible merger or acquisition, announcements of new legislative
proposals or laws relating to health care reform, the performance of, and
investor expectations for, the Company, the trading volume of the Company's
Common Stock and general economic and market conditions, may influence the
trading price of the Company's Common Stock. Accordingly, there can be no
assurance as to the price at which the Company's Common Stock will trade in
the future.
 
  Negative Publicity. The managed care industry has recently received a
significant amount of negative publicity. Such general publicity, or any
negative publicity regarding the Company in particular, could adversely affect
the Company's ability to sell its products or services or could create
regulatory problems for the Company. Recently, the managed care industry has
experienced significant merger and acquisition activity. Speculation or
uncertainty about the Company's future could adversely affect the ability of
the Company to market its products.
 
  Accreditation. Certain of the Company's customers or potential customers
consider rating, accreditation or certification of the Company by various
private or governmental bodies or rating agencies as necessary and/or
important. The Company currently has three year accreditation from the
National Committee on Quality Assurance ("NCQA") which will expire in May,
1997. NCQA visited the Company's offices in connection with its
reaccreditation in late March 1997. Should the Company fail to maintain three-
year NCQA accreditation, or obtain any other certification or accreditation as
may be deemed to be necessary and/or important by customers, it may adversely
affect the Company's ability to obtain or retain the business of such
customers.
 
  Administrative Expense. The level of administrative expense is a partial
determinant of the Company's profitability. While the Company attempts to
effectively manage such expenses, increases in staff-related and
 
                                      10
<PAGE>
 
other administrative expenses may occur as a result of business or product
expansion, changes in business, acquisitions, regulatory requirements or other
reasons. Such expense increases are not clearly predictable and increases in
administrative expenses may adversely affect financial results.
 
  The Company currently believes that it has a relatively experienced, capable
management staff. Loss of certain managers or a number of such managers could
adversely affect the Company's ability to administer and manage its business.
 
  Litigation and Insurance. The Company is subject to a variety of legal
actions to which any corporation may be subject. In addition, because of the
nature of its business, the Company incurs and likely will continue to incur
potential liability for claims related to its business, such as failure to pay
for or provide health care, poor outcomes for care delivered or arranged,
provider disputes and claims related to self-funded business. It is possible
that punitive or substantial non-economic damages may be sought in cases of
this nature. While the Company currently has insurance coverage for some of
these potential liabilities, others may not be covered by insurance, the
insurers may dispute coverage or the amount of insurance may not be enough to
cover the damages awarded. In addition, certain types of damages, such as
punitive damages, may not be covered by insurance and insurance coverage for
all or certain forms of liability may become unavailable or prohibitively
expensive in the future.
 
  Provider Relations. One of the significant techniques that the Company uses
to manage health care costs and utilization is contracting with physicians,
hospitals and other providers. Because of the large number of providers with
which the Company contracts, the Company currently believes that it has a
limited exposure to provider relations issues. In any particular market,
however, providers could refuse to contract with the Company, demand higher
payments or take other actions which could result in higher health care costs,
less desirable products for customers and members or difficulty in meeting
regulatory or accreditation requirements. In some markets, certain providers,
particularly hospitals, physician/hospital organization or multi-speciality
physician groups, may have significant market positions. Such groups may also
compete directly with the Company. If such providers refuse to contract with
the Company or utilize their market position to negotiate favorable contacts
or place the Company at a competitive disadvantage, the Company's ability to
market products or to be profitable in those areas could be adversely
affected.
 
  In addition, the Company has recently entered into a number of contracts
with physician/hospital organizations and other physician groups that place a
significant percentage of the risk of overutilization on those groups.
Although this technique is believed to be advantageous to the Company insofar
as it limits the Company's risk, failure of one or more of the
physician/hospital or other physician groups to successfully manage the risk
could have a material adverse effect on the Company's business and results of
operations.

ITEM 8.  FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

  The response to this Item is submitted in Item 14 of this Report.



                                      11
<PAGE>
 
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K.

  (a)  1.  All financial statements -- see Index to Consolidated Financial 
           Statements and Schedules attached hereto.

       2.  Financial statement schedules -- see Index to Consolidated Financial 
           Statements and Schedules attached hereto.

       3.  Exhibits -- see Exhibit Index on page E-1.

  (b)  Reports on Form 8-K

       None


                                      12
<PAGE>
 
               PHYSICIANS HEALTH SERVICES, INC. AND SUBSIDIARIES

           INDEX TO CONSOLIDATED FINANCIAL STATEMENTS AND SCHEDULES


                                                                      Page
                                                                      ----


Report of Independent Auditors.......................................  F-1

Consolidated Balance Sheets as of December 31, 1996 and 1995.........  F-2

Consolidated Statements of Operations for the years ended
  December 31, 1996, 1995 and 1994...................................  F-3

Consolidated Statements of Shareholders' Equity for the
  years ended December 31, 1996, 1995 and 1994.......................  F-4

Consolidated Statements of Cash Flows for the years ended
  December 31, 1996, 1995 and 1994...................................  F-5

Notes to Consolidated Financial Statements...........................  F-6

Schedule I -- Condensed Financial Information of Registrant..........  F-17

Schedule II -- Valuation and Qualifying Accounts.....................  F-20


                                      13

<PAGE>
 
                        REPORT OF INDEPENDENT AUDITORS
 
Board of Directors
Physicians Health Services, Inc.
 
  We have audited the consolidated balance sheets of Physicians Health
Services, Inc. and subsidiaries as of December 31, 1996 and 1995, and the
related consolidated statements of operations, stockholders' equity, and cash
flows for the three years in the period ended December 31, 1996. Our audits
also included the financial statement schedules listed in the Index at Item
14(a). These financial statements are the responsibility of the Company's
management. Our responsibility is to express an opinion on these financial
statements based on our audits.
 
  We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to
obtain reasonable assurance about whether the financial statements are free of
material misstatement. An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements. An audit
also includes assessing the accounting principles used and significant
estimates made by management, 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 financial statements referred to above present fairly,
in all material respects, the consolidated financial position of Physicians
Health Services, Inc. and subsidiaries at December 31, 1996 and 1995, and the
consolidated results of their operations and their cash flows for each of the
three years in the period ended December 31, 1996, in conformity with
generally accepted accounting principles. Also, in our opinion, the related
financial statement schedules, when considered in relation to the basic
financial statements taken as a whole, present fairly, in all material
respects, the information set forth therein.
 
  As discussed in Note 2 to the consolidated financial statements, in 1994 the
Company changed its method of accounting for certain investments in debt and
equity securities.
 
                                          Ernst & Young LLP
 
Stamford, Connecticut
March 14, 1997
 
                                      F-1
<PAGE>
 
                        PHYSICIANS HEALTH SERVICES, INC.
 
                          CONSOLIDATED BALANCE SHEETS
 
<TABLE>
<CAPTION>
                                                              DECEMBER 31,
                                                         -----------------------
                                                            1996        1995
                                                         ----------- -----------
                                                         (DOLLARS IN THOUSANDS)
<S>                                                      <C>         <C>
ASSETS
Current assets:
 Cash and cash equivalents.............................  $    39,213 $     7,536
 Investments available for sale, at fair value:
 Fixed maturity securities.............................       59,115     102,130
 Equity securities.....................................          --        1,355
 Accounts receivable, less allowances (1996-$1,781 and
  1995-$1,050).........................................       38,028      31,548
 Other receivables.....................................       19,696      14,815
 Advances to participating hospitals...................          400       5,903
 Prepaid expenses and other............................        1,154         204
                                                         ----------- -----------
  Total Current Assets.................................      157,606     163,491
Property, plant and equipment:
 Land..................................................        8,822       3,322
 Building and improvements.............................       26,938      14,645
 Furniture and equipment...............................       46,559      29,817
                                                         ----------- -----------
                                                              82,319      47,784
Less accumulated depreciation and amortization.........       15,273      11,028
                                                         ----------- -----------
                                                              67,046      36,756
Other assets (including restricted investments)........       13,658      10,821
                                                         ----------- -----------
  Total Assets.........................................  $   238,310 $   211,068
                                                         =========== ===========
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
 Accrued hospital and other health care expenses.......  $    46,153 $    23,878
 Unearned premiums.....................................       27,757      25,022
 Amounts due to IPAs, physicians and other providers...       53,103      37,806
 Accounts payable and accrued expenses.................       13,849      14,199
                                                         ----------- -----------
  Total Current Liabilities............................      140,862     100,905
Excess of net assets over cost of company acquired.....        1,162       1,282
                                                         ----------- -----------
  Total Liabilities....................................      142,024     102,187
Stockholders' equity:
 Preferred Stock, par value $0.01 per share--authorized
  500 shares, none issued..............................          --          --
 Class A Common Stock, par value $0.01 per share--
  authorized 13,000,000 shares; issued and outstanding
  1996--5,566,023 shares; 1995--5,310,347 shares;
  voting rights--1 per share...........................           56          53
 Class B Common Stock, par value $0.01 per share; non-
  transferable; authorized and issued 1996--3,829,880
  shares; 1995--4,052,974 shares; voting rights--10 per
  share................................................           38          41
Additional paid-in capital.............................       41,360      40,760
Net unrealized gains on marketable securities, net of
 tax...................................................          279         510
Retained earnings......................................       54,554      67,518
                                                         ----------- -----------
                                                              96,287     108,882
Less cost of Class B Common Stock (86,400 shares) in
 Treasury..............................................            1           1
                                                         ----------- -----------
  Total Stockholders' Equity...........................       96,286     108,881
                                                         ----------- -----------
 Total Liabilities and Stockholders' Equity............  $   238,310 $   211,068
                                                         =========== ===========
</TABLE>
 
                See notes to consolidated financial statements.
 
                                      F-2
<PAGE>
 
                        PHYSICIANS HEALTH SERVICES, INC.
 
                     CONSOLIDATED STATEMENTS OF OPERATIONS
 
<TABLE>
<CAPTION>
                                                     YEAR ENDED DECEMBER 31,
                                                    ---------------------------
                                                      1996      1995     1994
                                                    --------  -------- --------
                                                      (DOLLARS IN THOUSANDS,
                                                              EXCEPT
                                                         PER SHARE DATA)
<S>                                                 <C>       <C>      <C>
REVENUES:
  Premiums......................................... $481,534  $342,975 $289,784
  Investment and other income......................    6,574     6,968    4,160
                                                    --------  -------- --------
                                                     488,108   349,943  293,944
Costs and expenses:
  Hospital services................................  178,059   111,947   94,934
  Physicians and related health care services......  198,591   131,019  117,393
  Other health care services.......................   42,382    18,707   12,943
  Indemnity costs..................................    7,008     2,157      --
  Selling, general and administrative expenses.....   86,728    58,504   44,089
  Guardian joint marketing expense (income), net...     (809)    2,298      --
  Proxy defense costs..............................      --        892      --
  Interest expense.................................      388       --       --
                                                    --------  -------- --------
                                                     512,347   325,524  269,359
Income (loss) before income taxes..................  (24,239)   24,419   24,585
Income tax expense (benefit).......................  (11,275)    8,449   10,451
                                                    --------  -------- --------
Net income (loss).................................. $(12,964) $ 15,970 $ 14,134
                                                    ========  ======== ========
Net income (loss) per common share................. $  (1.39) $   1.70 $   1.52
                                                    ========  ======== ========
Weighted average number of common and common
 equivalent shares outstanding.....................    9,301     9,403    9,307
                                                    ========  ======== ========
</TABLE>
 
                See notes to consolidated financial statements.
 
                                      F-3
<PAGE>
 
                        PHYSICIANS HEALTH SERVICES, INC.
 
                CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
 
<TABLE>
<CAPTION>
                                                      YEAR ENDED DECEMBER 31,
                                                     ---------------------------
                                                       1996      1995     1994
                                                     --------  --------  -------
                                                      (DOLLARS IN THOUDANDS)
<S>                                                  <C>       <C>       <C>
CLASS A COMMON STOCK
Balance at beginning of period.....................  $     53  $     49  $    45
Conversion of Class B Common Stock into Class A
 Common Stock:
 1996--223,094 shares, 1995--437,537 shares, 1994--
  435,228 shares...................................         3         4        4
Options exercised:
 1996--32,582 shares, 1995--14,974 shares, 1994--
  3,558 shares.....................................
                                                     --------  --------  -------
Balance at end of period...........................  $     56  $     53  $    49
                                                     ========  ========  =======
CLASS B COMMON STOCK
Balance at beginning of period.....................  $     41  $     45  $    49
Conversion of Class B Common Stock into Class A
 Common Stock:
 1996--223,094 shares, 1995--437,537 shares, 1994--
  435,228 shares...................................        (3)       (4)      (4)
                                                     --------  --------  -------
Balance at end of period...........................  $     38  $     41  $    45
                                                     ========  ========  =======
ADDITIONAL PAID-IN CAPITAL
Balance at beginning of period.....................  $ 40,760  $ 40,514  $40,461
Exercise of stock options..........................       600       246       53
                                                     --------  --------  -------
Balance at end of period...........................  $ 41,360  $ 40,760  $40,514
                                                     ========  ========  =======
NET UNREALIZED GAINS (LOSSES) ON MARKETABLE SECURI-
 TIES, NET OF TAX
Balance at beginning of period.....................  $    510  $   (949) $   --
Net unrealized gain at date of adoption of SFAS
 115, net of tax...................................       --        --       184
Net unrealized gain (loss).........................      (231)    1,459   (1,133)
                                                     --------  --------  -------
Balance at end of period...........................  $    279  $    510  $  (949)
                                                     ========  ========  =======
RETAINED EARNINGS
Balance at beginning of period.....................  $ 67,518  $ 51,548  $37,414
Net income (loss)..................................   (12,964)   15,970   14,134
                                                     --------  --------  -------
Balance at end of period...........................  $ 54,554  $ 67,518  $51,548
                                                     ========  ========  =======
TREASURY STOCK
Balance at beginning and end of period.............  $     (1) $     (1) $    (1)
TOTAL STOCKHOLDERS' EQUITY
Balance at beginning of period.....................  $108,881  $ 91,206  $77,968
Exercise of stock options..........................       600       246       53
Net income (loss)..................................   (12,964)   15,970   14,134
Net unrealized gain (loss) on marketable
 securities, net of tax............................      (231)    1,459     (949)
                                                     --------  --------  -------
Balance at end of period...........................  $ 96,286  $108,881  $91,206
                                                     ========  ========  =======
</TABLE>
 
                See notes to consolidated financial statements.
 
                                      F-4
<PAGE>
 
                        PHYSICIANS HEALTH SERVICES, INC.
 
                            STATEMENTS OF CASH FLOWS
 
<TABLE>
<CAPTION>
                                                  YEAR ENDED DECEMBER 31,
                                                 ----------------------------
                                                   1996      1995      1994
                                                 --------  --------  --------
                                                   (DOLLARS IN THOUSANDS)
<S>                                              <C>       <C>       <C>
OPERATING ACTIVITIES
Net income (loss)............................... $(12,964) $ 15,970  $ 14,134
Adjustments to reconcile net income (loss) to
 net cash provided by (used for) operating
 activities:
 Depreciation and amortization..................    4,302     3,064     2,364
 Provision for doubtful accounts................    1,485       103     1,423
 Amortization of excess of net assets over cost
  of company acquired...........................     (120)     (120)     (120)
 Deferred income tax expense (benefit)..........      690     1,421      (233)
 Changes in assets and liabilities:
  Accounts receivable...........................   (7,965)   (4,453)   (3,273)
  Other receivables.............................   (4,881)  (13,043)   (1,217)
  Advances to participating hospitals...........    5,503     1,619     3,794
  Prepaid expenses and other....................     (950)      708      (114)
  Accrued health care expenses..................   22,275    (1,232)   (4,028)
  Unearned premiums.............................    2,735       631     2,233
  Due to IPAS, Physicians and other providers...   15,297    (5,793)    8,076
  Accounts payable and accrued expenses.........     (856)   (8,367)   16,292
                                                 --------  --------  --------
Net cash provided by (used for) operating
 activities.....................................   24,551    (9,492)   39,331
INVESTING ACTIVITIES
Purchases of property, plant and equipment......  (34,633)  (15,168)   (9,711)
Disposals of property, plant and equipment......       41        14       226
Net increase in other assets....................   (2,837)   (6,916)     (674)
Purchases of marketable securities.............. (242,451) (324,877) (340,176)
Proceeds from sales of marketable securities....  286,406   335,262   332,629
                                                 --------  --------  --------
Net cash provided from (used for) investing
 activities.....................................    6,526   (11,685)  (17,706)
FINANCING ACTIVITIES
Proceeds from revolving credit line.............   18,000       --        --
Repayment of revolving credit line..............  (18,000)      --        --
Exercise of stock options.......................      600       246        53
                                                 --------  --------  --------
Net cash provided by financing activities.......      600       246        53
                                                 --------  --------  --------
Increase (decrease) in cash and cash
 equivalents....................................   31,677   (20,931)   21,678
Cash and cash equivalents at beginning of year..    7,536    28,467     6,789
                                                 --------  --------  --------
Cash and cash equivalents at end of year........ $ 39,213  $  7,536  $ 28,467
                                                 ========  ========  ========
</TABLE>
 
                See notes to consolidated financial statements.
 
                                      F-5
<PAGE>
 
                       PHYSICIANS HEALTH SERVICES, INC.
 
                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 
                               DECEMBER 31, 1996
 
1. ORGANIZATION AND BUSINESS
 
  Physicians Health Services, Inc. (the "Company" or "PHS") is a holding
company which owns nine subsidiary corporations: Physicians Health Services of
Connecticut, Inc. (PHS/CT), Physicians Health Services of New York, Inc.
(PHS/NY), Physicians Health Insurance Services, Inc. (PHIS), PHS Investments,
Inc., Physicians Health Services (Bermuda), Ltd. (PHS/Bermuda), Physicians
Health Services of New Jersey, Inc. (PHS/NJ), (which was licensed in January
1996), PHS Insurance of Connecticut, Inc. (PHS Insurance CT), Physicians
Health Services Insurance of New York, Inc. (PHS Insurance NY), and PHS Real
Estate, Inc. (PHS RE). PHS/CT and PHS/NY have been designated by the
Department of Health and Human Services (DHHS) as federally qualified Health
Maintenance Organizations (HMOs).
 
  PHS/CT, PHS/NY and PHS/NJ operate as health maintenance organizations in
Connecticut, New York and New Jersey, respectively, and are regulated by their
respective state insurance departments. PHS/NY and PHS/NJ are also regulated
by the Department of Health and Human Services and New Jersey Department of
Health and Senior Services, respectively. State regulations include reserve
and cash flow requirements and restrictions on the ability to pay dividends.
Subscribers pay monthly premiums which entitle them to comprehensive health
services as needed, according to the terms of their contracts.
 
  PHIS, which is licensed as an insurance broker, was formed to market
insurance products to enrollees. The operations of PHIS for all years
presented were not significant.
 
  PHS Insurance CT and PHS Insurance NY operate in and are regulated by the
Insurance Departments of Connecticut and New York, respectively. These
companies are licensed to write accident and health indemnity insurance
although no business has yet been written.
 
  PHS/Bermuda is an offshore property and casualty reinsurer that was formed
to support the business needs of the Company. This includes an agreement to
reinsure certain business with The Guardian Life Insurance Company of America
(see Note 10).
 
  PHS/CT operates throughout most of Connecticut with a significant portion of
its enrollees currently located in Fairfield County. PHS/NY operates only in
New York's Westchester, Putnam, Dutchess, Rockland and Orange Counties, and
the metropolitan New York City and Long Island regions. PHS/NJ operates
throughout New Jersey. The Company's membership consists of commercial,
government and self-funded members.
 
  PHS RE has a wholly owned subsidiary, PHS Real Estate II, Inc. (PHS RE II),
which owns the Company's new corporate headquarters. The operations of PHS RE
and PHS RE II were not significant.
 
  The Company's managed care products include traditional HMO products, in
both open access and gatekeeper models, point of service ("POS") products,
administrative services only ("ASO") plans and Medicare and Medicaid plans.
 
  The Company contracts with physician groups, such as IPAs, PHOs, and multi-
specialty groups (collectively, "Physician Groups"), individual physicians and
other health care providers for a defined range of health services, including
primary and specialty care. The Company's contracts with providers include
discounted fee for service arrangements as well as capitated group
arrangements in which the contracting Physician Group assumes a significant
amount of the risk of overutilization. The Company currently has contracts
with four IPAs, three PHOs and one large physician group ("Group") that
provide for most of its physician services in its Connecticut service area. In
New York and New Jersey, the Company generally
 
                                      F-6
<PAGE>
 
                       PHYSICIANS HEALTH SERVICES, INC.
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
contracts directly with physicians and other health care providers. Under the
typical Physician Group arrangements, the Physician Group receives a fixed
monthly capitation payment for each member selecting a primary care physician
from that Physician Group. Capitation rates and any increases thereto are
negotiated for the term of the contract. The capitation payment is designed to
cover not only the professional medical services (including ancillary tests
and services) rendered by the physicians and other providers associated with
that Physician Group but also includes payments for certain other services
rendered to the enrollee by providers who are not members of the Physician
Group. Services covered by the capitation payment include, among other things,
virtually all physician claims (whether inpatient or outpatient, including
authorized out-of-plan care) and care rendered by other professionals such as
physical therapists and psychologists. In certain of the contracts, the
Physician Groups also are at risk for hospital, pharmacy and other facility
expenses. The Company does not capitate physicians directly.
 
  The capitation payments to Physician Groups other than the PHOs typically do
not cover hospital and other facility expenses, although the Physician Groups
are partially at risk for non-Medicare and non-Medicaid hospital utilization.
The Company establishes an annual per member, per month target for hospital
expenses. The amount varies by benefit plan and Physician Group, and
encompasses both inpatient and outpatient costs. If total hospital expenses
generated by the Physician Group exceed the applicable hospital expense
target, the Company withholds from amounts owed by it to the Physician Group
all or a portion of the excess over budget, in most cases one-half of the
excess over budget. If actual costs are less than budgeted targets, the
Physician Group receives from the Company an incentive credit typically equal
to forty to fifty percent of the amount by which actual costs are less than
budgeted targets.
 
  In its New York and New Jersey expansion areas and in areas in Connecticut
not served through Physician Group contracts, the Company contracts for
services principally through direct contracts with individual physicians and
other health care providers. In addition, the Company contracts with two IPAs
in the northern counties of its New York service area. The Company withholds a
percentage of reimbursement for services rendered pursuant to its direct
physician contracts against budgeted amounts to manage excessive utilization.
 
  The Company generally negotiates contracts with hospitals that include
compensation on a per diem basis (at a daily rate, without regard to the scope
of services actually provided). Other compensation arrangements with hospitals
include charged-based discounts (negotiated discounts from the hospital's
billed charges) and all inclusive case rates. In the case of non-participating
hospitals, the Company pays either hospital billed charges or negotiated
discounted charges. Additionally, some hospital contracts include per case,
all-inclusive payment arrangements for select procedures such as maternity
care.
 
  At December 31, 1996, three of the IPA's own common stock of the Company
aggregating approximately 32% (which entitle them to 68% of the vote on
matters submitted to the Stockholders), with one IPA (Greater Bridgeport
Individual Practice Association) owning approximately 27% (58% of the vote).
Capitation expenses incurred relating to these three IPA's which are included
in physician and related healthcare expenses in the accompanying statements of
operations amounted to $55,019,000, $68,523,000 and $65,091,000 for the years
ended December 31, 1996, 1995 and 1994 respectively. At December 31, 1996 and
1995 amounts payable to these IPA's were $21,622,000 and $10,388,000,
respectively.
 
2. SIGNIFICANT ACCOUNTING POLICIES
 
PRINCIPLES OF CONSOLIDATION
 
  The consolidated financial statements include the accounts of the Company
and its subsidiaries, all of which are wholly-owned except for PHS/NJ which is
80% owned by the Company with a 20% minority interest owned
 
                                      F-7
<PAGE>
 
                       PHYSICIANS HEALTH SERVICES, INC.
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
by Mastercare Companies, Inc. (See Note 11). Such minority interest was not
material to the accompanying consolidated financial statements. Significant
intercompany accounts and transactions have been eliminated in consolidation.
 
USE OF ESTIMATES
 
  The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the amounts reported in the financial statements and
accompanying notes. Actual results could differ from those estimates.
 
REVENUE RECOGNITION
 
  Premiums from subscribers and assumed or ceded under reinsurance agreements
are reflected in operations as earned on a pro-rata basis over the period of
coverage. Premiums for periods extending beyond year-end are classified as
unearned premiums. The Company maintains an allowance for doubtful accounts at
a level management believes is sufficient to cover potentially uncollectible
amounts.
 
PHYSICIANS AND RELATED HEALTH CARE SERVICES
 
  The costs of physicians and related health care services are accrued for in
the period they are provided to enrollees. For the services provided for by
individually contracted physicians, the accrual for the incurred but not
reported claims represent the estimated liability on outstanding claims, based
upon an evaluation of reported claims. Such estimates are continually
monitored and, as estimates are adjusted, they are reflected in current
operations. The amounts accrued under capitation arrangements with IPA's are
increased or decreased based on a comparison of the HMO's hospitalization
costs to contractual targets.
 
HOSPITAL AND OTHER HEALTH CARE SERVICES
 
  The cost of health care services is accrued in the period they are provided
to enrollees. The amounts accrued for hospital and other health care expenses
represent the estimated liabilities for reported and unreported claims. The
reserves for incurred but not reported claims represent the estimated
liability on outstanding claims, based on an evaluation of reported claims.
The estimates are continually monitored and reviewed and, as settlements are
made or estimates adjusted, the resulting differences are reflected in current
operations. Although considerable variability is inherent in such estimates,
management believes that reported reserves are adequate in the aggregate to
cover the ultimate resolution of incurred claims.
 
CONTRACTS WITH HEALTH CARE FINANCING ADMINISTRATION
 
  Prior to 1996, the Company had entered into a "cost based" contract with the
Health Care Financing Administration ("HCFA"). Under this contract, HCFA pays
the Company a fixed per member per month amount for physician services, while
HCFA pays the costs for inpatient and outpatient services. During 1996, the
Company entered into a "risk based" contract with HCFA. Under the risk-based
contract the Company is paid a fixed per member, per month amount by HCFA for
all services provided. The Company bears the risk that the actual costs of
health care services may exceed the per member, per month amount. The risk
based contract is intended to replace the cost based contract for new
enrollees.
 
PROPERTY, PLANT AND EQUIPKMENT
 
  Property, plant and equipment are stated at cost, less accumulated
depreciation and amortization. Provisions for depreciation and amortization
are computed using the straight-line method over the estimated useful lives of
 
                                      F-8
<PAGE>
 
                       PHYSICIANS HEALTH SERVICES, INC.
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
the assets or the terms of the leases, if shorter. Included in property, plant
and equipment are the costs related to the development of a new managed care
information system, approximately $18,600,000 at December 31, 1996. This new
system is expected to be implemented in late 1997. Amortization of the cost of
the new system will begin upon its implementation and continue on a straight-
line basis over its estimated useful life.
 
EXCESS OF NET ASSETS OVER COST OF COMPANY ACQUIRED
 
  The excess of net assets over the cost of company acquired is being
amortized by the straight-line method over a 20 year period ending August 31,
2006. Accumulated amortization was $1,240,000 and $1,120,000 at December 31,
1996 and 1995, respectively.
 
PER SHARE DATA
 
  Per share data are based on the weighted average number of common and common
equivalent shares outstanding during the period. Common stock equivalents
consist of stock options. Fully diluted per share data are not presented as
they are not materially different from primary earnings per share data.
 
STOCK BASED COMPENSATION
 
  In 1996, the Company implemented the supplemental pro forma provisions of
Statement of Financial Accounting Standards ("SFAS") No. 123, "Accounting for
Stock-Based Compensation" ("SFAS 123"). SFAS 123, if adopted, requires
companies to recognize compensation expense for grants of restricted stock,
stock options and similar equity instruments to employees and directors based
on their respective fair values at the date of grant. However, the provisions
of Accounting Principles Board ("APB") Opinion No. 25, "Accounting for Stock
Issued to Employees" ("APB 25") may still be utilized with supplemental pro
forma disclosures of net income and earnings per share being made in the
footnotes as if the accounting provisions of SFAS 123 had been adopted. SFAS
123 is effective for fiscal years beginning after December 15, 1995. The
Company continues to apply the requirements of APB 25 in the accompanying
financial statements with supplemental pro forma disclosures provided in the
notes to the consolidated financial statements (See note 8).
 
CASH AND CASH EQUIVALENTS
 
  Cash and cash equivalents consist of highly liquid investments with a
maturity of three months or less at the time of purchase.
 
FAIR VALUE OF FINANCIAL INSTRUMENTS
 
  Cash and cash equivalents, accounts receivable, other receivables, advances
to participating hospitals and all current liabilities have fair values that
approximate their carrying amounts.
 
INVESTMENTS
 
  In May 1993, the Financial Accounting Standards Board issued SFAS 115,
"Accounting for Certain Investments in Debt and Equity Securities." The
Company adopted the provisions of the new standard as of January 1, 1994, and
categorizes its investments in fixed maturity and equity securities as
"available for sale." Accordingly, such investments are reported at fair value
with changes in unrealized gains and losses disclosed separately, net of
taxes, in stockholders' equity. Fair values are based primarily on quoted
market prices.
 
  Investment income includes realized investment gains and losses on the sale
or maturity of investments, determined by the specific identification method,
and dividends and interest, which are recognized when earned. The amortization
of premium and accretion of discount for fixed maturities is computed
utilizing the interest method.
 
INCOME TAXES
 
  Income taxes have been provided using the liability method in accordance
with SFAS 109, "Accounting for Income Taxes."
 
                                      F-9
<PAGE>
 
                       PHYSICIANS HEALTH SERVICES, INC.
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
 
IMPAIRMENT OF LONG-LIVED ASSETS
 
  In March 1995 the FASB issued Statement of Financial Accounting Standards
("SFAS") No. 121, "Accounting for the Impairment of Long-Lived Assets and for
Long-Lived Assets to be Disposed Of." At December 31, 1996, the Company had no
long-lived assets held for disposal. In accordance with SFAS No. 121, the
Company monitors its long-lived assets for any indicators of impairment. To
the extent such indicators are present, a comparison is made of the asset's
carrying value to the estimated undiscounted cash flows related to the asset.
If the undiscounted cash flows of the asset are less than its carrying value,
the Company would recognize an impairment loss equal to the amount by which
the asset's carrying value exceeds its fair value. At December 31, 1996, the
Company noted no indicators of impairment related to its long-lived assets.
 
RECLASSIFICATIONS
 
  Certain reclassifications were made to conform prior year amounts to current
year presentation.
 
3. EXCESS OF LOSS REINSURANCE AGREEMENT
 
  During 1996 the Company limited the amount of its risk on eligible hospital
claims for any one member in a contract year by acquiring reinsurance coverage
for claims in excess of $600,000 per member, per year for PHS/CT, PHS/NY and
PHS/NJ. The reinsurance contracts allow the Company to transfer to the
reinsurer 80% of the next $400,000 of claims per member per year. The contract
limits covered claims to $2 million per member per lifetime (including the
deductible). During 1995 and 1994, the Company acquired reinsurance coverage
for claims in excess of $250,000 per member, per year for PHS/CT and $100,000
per member, per year for PHS/NY. Those reinsurance policies allowed the
Company to transfer to the reinsurer 80% of the next $750,000 (PHS/CT) and
$900,000 (PHS/NY) of the amount of claims in excess of the aforementioned
annual retentions. Reinsurance expense and recoveries are included in other
health care services.
 
  Reinsurance expense was $910,000, $1,300,000, and $636,000, for 1996, 1995
and 1994, respectively. Recoveries were $311,000, $60,000, and $106,000 for
1996, 1995, and 1994, respectively.
 
4. INVESTMENTS AND OTHER INCOME
 
  The amortized cost, gross unrealized gains and losses, and estimated fair
values of investments are as follows (in thousands):
 
<TABLE>
<CAPTION>
                                                   DECEMBER 31, 1996
                                        ----------------------------------------
                                                    GROSS      GROSS
                                        AMORTIZED UNREALIZED UNREALIZED   FAIR
                                          COST      GAINS      LOSSES    VALUE
                                        --------- ---------- ---------- --------
<S>                                     <C>       <C>        <C>        <C>
U.S. Government and its agencies....... $  5,598     $--        $ 15    $  5,583
Corporate securities...................   12,803        5         20      12,788
Municipals.............................   40,242      503          1      40,744
                                        --------     ----       ----    --------
Total fixed securities................. $ 58,643     $508       $ 36    $ 59,115
                                        ========     ====       ====    ========
<CAPTION>
                                                   DECEMBER 31, 1995
                                        ----------------------------------------
                                                    GROSS      GROSS
                                        AMORTIZED UNREALIZED UNREALIZED   FAIR
                                          COST      GAINS      LOSSES    VALUE
                                        --------- ---------- ---------- --------
<S>                                     <C>       <C>        <C>        <C>
U.S. Government and its agencies....... $ 10,629     $ 22       $--     $ 10,651
Corporate securities...................    1,535       14        --        1,549
Municipals.............................   89,017      936         23      89,930
                                        --------     ----       ----    --------
  Fixed securities.....................  101,181      972         23     102,130
Equity securities......................    1,417      --          62       1,355
                                        --------     ----       ----    --------
  Total................................ $102,598     $972       $ 85    $103,485
                                        ========     ====       ====    ========
</TABLE>
 
                                     F-10
<PAGE>
 
                       PHYSICIANS HEALTH SERVICES, INC.
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
 
  At December 31, 1996, the contractual maturities of investments in fixed
maturities are as follows (in thousands):
 
<TABLE>
<CAPTION>
                                                              AMORTIZED  FAIR
                                                                COST     VALUE
                                                              --------- -------
   <S>                                                        <C>       <C>
   Due in one year or less...................................  $25,037  $25,131
   Due after one year through five years.....................   33,106   33,485
   Due after ten years.......................................      500      499
                                                               -------  -------
                                                               $58,643  $59,115
                                                               =======  =======
</TABLE>
 
  Major sources of and related amounts of net investment and other income are
as follows (in thousands):
 
<TABLE>
<CAPTION>
                                YEAR ENDED DECEMBER 31
                               --------------------------
                                 1996     1995     1994
                               --------  -------  -------
   <S>                         <C>       <C>      <C>
   Dividends and interest
    income from investments..  $  5,444  $ 7,099  $ 5,091
   Realized gains............       139      385      290
   Realized losses...........       (99)    (366)  (1,170)
   Investment expenses.......      (132)    (193)    (258)
                               --------  -------  -------
   Net investment income.....     5,352    6,925    3,953
   Interest on Guardian
    Receivable...............       866      --       --
   Other income..............       356       43      207
                               --------  -------  -------
   Net investment and other
    income...................  $  6,574  $ 6,968  $ 4,160
                               ========  =======  =======
 
5. INCOME TAXES
 
  Significant components of income tax expense (benefit) were as follows (in
thousands):
 
<CAPTION>
                                YEAR ENDED DECEMBER 31
                               --------------------------
                                 1996     1995     1994
                               --------  -------  -------
   <S>                         <C>       <C>      <C>
   Current income tax expense
    (benefit):
     Federal.................  $(10,004) $ 5,428  $ 7,720
     State...................    (1,961)   1,600    2,964
                               --------  -------  -------
                                (11,965)   7,028   10,684
   Deferred income tax
    expense (benefit)........       690    1,421     (233)
                               --------  -------  -------
   Income tax expense
    (benefit)................  $(11,275) $ 8,449  $10,451
                               ========  =======  =======
 
  The following is a reconciliation of federal income tax expense computed at
statutory rates to the amount of income tax expense reflected in the
consolidated statements of operations (in thousands):
 
<CAPTION>
                                YEAR ENDED DECEMBER 31
                               --------------------------
                                 1996     1995     1994
                               --------  -------  -------
   <S>                         <C>       <C>      <C>
   Federal income tax
    (benefit) at statutory
    rates....................  $ (8,484) $ 8,547  $ 8,605
   State income taxes (net of
    federal tax benefit).....    (1,750)   1,773    1,938
   Tax exempt interest.......    (1,239)  (1,790)     --
   Other.....................       198      (81)     (92)
                               --------  -------  -------
   Income tax expense
    (benefit)................  $(11,275) $ 8,449  $10,451
                               ========  =======  =======
</TABLE>
 
                                     F-11
<PAGE>
 
                       PHYSICIANS HEALTH SERVICES, INC.
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
 
  Net deferred tax liabilities, which are included in accounts payable and
accrued expenses, reflect the tax effect of temporary differences between the
carrying amounts of assets and liabilities for financial reporting and income
tax purposes. Significant components of the Company's net deferred tax
liabilities as of December 31 are as follows (in thousands):
 
<TABLE>
<CAPTION>
                                                                   1996   1995
                                                                  ------ ------
<S>                                                               <C>    <C>
Deferred tax assets:
  Provision for bad debts........................................ $  748 $  444
  Nondeductible hospitalization accruals.........................    968    643
  Accrued vacation...............................................    611    428
  State net operating loss carryforward..........................  1,864    --
  Other..........................................................    370    --
                                                                  ------ ------
Total deferred tax assets........................................  4,561  1,515
Deferred tax liabilities:
  Unrealized gains on investments................................    193    377
  Depreciation...................................................  1,075  1,090
  Tax credit for research activities.............................  4,242    751
  Prepaid expenses...............................................    240    --
  Accrued market discount on bonds held..........................    443    423
                                                                  ------ ------
Total deferred tax liabilities...................................  6,193  2,641
                                                                  ------ ------
Net deferred tax liability....................................... $1,632 $1,126
                                                                  ====== ======
</TABLE>
 
  As a result of current year losses, approximately $27.0 million of state tax
loss carryforwards will be available for use to offset future state taxable
income through 2001.
 
  The Company paid income taxes of $904,000 in 1996, $10,754,000 in 1995, and
$7,059,000 in 1994.
 
6. LEASES
 
  The Company leases office space for ten branch locations.
 
  Future minimum lease payments under noncancelable operating leases with
remaining terms of one year or more consisted of the following at December 31,
1996 (in thousands):
 
<TABLE>
   <S>                                                                   <C>
   1997................................................................. $ 2,530
   1998.................................................................   2,573
   1999.................................................................   2,465
   2000.................................................................   2,264
   2001.................................................................   1,779
   2002 and thereafter..................................................   5,094
                                                                         -------
                                                                         $16,705
                                                                         =======
</TABLE>
 
  Total rent expense was $2,784,000 in 1996, $1,423,000 in 1995, and $420,000
in 1994.
 
7. COMMITMENTS AND CONTINGENCIES
 
  The Company is involved in various litigation and claims arising in the
normal course of business which management believes, based upon discussions
with legal counsel, will not have a material adverse effect on the
accompanying financial statements.
 
                                     F-12
<PAGE>
 
                       PHYSICIANS HEALTH SERVICES, INC.
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
 
  During 1996, the Company entered into a revolving credit agreement under
which it borrowed $18 million to provide short-term financing for the purchase
of the Company's new headquarters. In the fourth quarter the Company repaid
amounts due under the credit agreement and terminated the credit line. Total
interest expense paid in connection with this agreement was approximately
$388,000.
 
  The Health Reinsurance Association ("HRA") provides for otherwise
unavailable health insurance coverage to uninsured or underinsured Connecticut
residents. All health insurers, including HMOs, licensed in Connecticut are
subject to assessment by the HRA to the extent the HRA incurs net losses.
Assessments are based on premiums written and amounted to $1,018,000,
$692,000, and $800,000 in 1996, 1995 and 1994, respectively.
 
  PHS/NY is subject to a community rating law which establishes a pooling
mechanism providing for payments to insurers writing policies for a
disproportionate share of individuals with certain demographic characteristics
and catastrophic medical expenses. Depending on the age and sex
characteristics of an insurer's members, an insurer will either make payments
to or receive payments from the state pooled fund. Expenses related to the
demographic pool were $3,180,000 in 1996, $1,483,000 in 1995 and $1,152,000 in
1994.
 
  For further commitments, refer to Note 11.
 
8. EMPLOYEE BENEFIT AND STOCK OPTION PLANS
 
  The Company sponsors a defined contribution pension plan covering all full-
time eligible employees (as defined). Contributions are based on a percentage
of eligible salaries as determined by the Board of Directors. This plan also
allows for additional voluntary contributions by covered full-time employees.
Pension cost was approximately $1,061,000 in 1996, $853,000 in 1995 and
$696,000 in 1994. The Company also has a 401(k) plan which covers
substantially all eligible employees (as defined). This plan allows for
voluntary employee contributions and a corporate match of 75% up to 4% of each
employee's compensation. In addition, the Company contributes 1% of each
eligible employee's compensation (as defined) to the plan. Expense related to
the 401(k) plan was $858,000 in 1996, $654,000 in 1995, and $519,000 in 1994.
 
  The Company's Board of Directors, on November 17, 1992, and subsequently on
November 21, 1995, adopted two Stock Option Plans (the "Plans") under which
the Company may grant to certain officers and key employees (and, under the
1995 Plan, directors) incentive and nonqualified stock options for up to an
aggregate maximum of 1,400,000 shares of Class A Common Stock. Under the
Plans, the Board or Compensation Committee sets the exercise price for such
options, but for incentive stock options, the exercise price shall not be less
than the fair market value of the stock at the date of grant. Under the Plans,
options may be exercised only at such times and under such conditions as
determined by the Board or the Compensation Committee, but in no event more
than ten years after the date of grant. The options that have been granted to
date become exerciseable in equal installments over a period of three years
and expire after ten years except for ten percent shareholders for which such
options expire five years after the grant dates and certain performance based
options granted in 1996, whose vesting may be accelerated based upon
achievement of certain earnings targets.
 
                                     F-13
<PAGE>
 
                       PHYSICIANS HEALTH SERVICES, INC.
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
 
  Information relating to stock options during 1996, 1995, and 1994 is as
follows:
 
<TABLE>
<CAPTION>
                                 1996                1995               1994
                          ------------------- ------------------ ------------------
                                     WEIGHTED           WEIGHTED           WEIGHTED
                                     AVERAGE            AVERAGE            AVERAGE
                           NUMBER    EXERCISE  NUMBER   EXERCISE  NUMBER   EXERCISE
                          OF SHARES   PRICE   OF SHARES  PRICE   OF SHARES  PRICE
                          ---------  -------- --------- -------- --------- --------
<S>                       <C>        <C>      <C>       <C>      <C>       <C>
Outstanding at beginning
 of year................    574,478   $24.78   187,514   $18.40    86,848   $15.00
Granted.................    565,040    22.09   413,098    27.45   111,950    20.86
Exercised...............    (32,582)   18.43   (14,974)   16.73    (3,558)   15.00
Canceled................    (37,153)   29.29   (11,160)   27.05    (7,726)   17.36
                          ---------   ------   -------   ------   -------   ------
Outstanding at end of
 year...................  1,069,783   $23.40   574,478   $24.78   187,514   $18.40
                          =========   ======   =======   ======   =======   ======
Exercisable at end of
 year...................    317,478   $22.90    73,364   $17.55    25,318   $15.00
Available for grant, at
 end of year............    279,103      --    506,990      --    408,928      --
</TABLE>
 
  Supplemental and Pro Forma Disclosure:
 
  The following pro forma information regarding net income (loss) and net
income (loss) per share, required by SFAS 123, has been determined as if the
Company had accounted for its stock-based compensation plans under the fair
value methods described in that statement. The fair value of options granted
under the Company's stock-based compensation plans was estimated at the date
of grant using a Black-Scholes option pricing model. The Black-Scholes option
pricing model was developed for use in estimating the fair value of traded
options which have no vesting restrictions and are fully transferable. In
addition, option pricing models require the input of highly subjective
assumptions including the expected dividend yield, the expected life of the
options, the expected price volatility and the risk free interest rate. The
weighted averages of the assumptions used are set forth in the following
paragraph.
 
  The weighted average dividend yield for stock option grants during 1996 and
1995 was 0%. The weighted average expected life for 1996 and 1995 was 5 years.
The weighted average volatility for 1996 and 1995 was .46%. The weighted
average risk-free interest rate for 1996 and 1995 was 5.87% and 6.99%,
respectively.
 
  For purposes of pro forma disclosure, the estimated fair values of the
options awarded are amortized to expense over the options' vesting period and
do not include grants prior to January 1, 1995. As such, the pro forma
information is not indicative of future years. The Company's pro forma
information was as follows (in thousands, except per share data):
 
<TABLE>
<CAPTION>
                                                                1996     1995
                                                              --------  -------
<S>                                                           <C>       <C>
Net income (loss):
  As reported................................................ $(12,964) $15,970
  Pro forma..................................................  (14,379)  15,535
Net income (loss) per common share:
  As reported................................................ $  (1.39) $  1.70
  Pro forma..................................................    (1.54)    1.65
</TABLE>
 
9. DIVIDEND AND INVESTMENT RESTRICTIONS OF SUBSIDIARIES
 
  The Company's HMO and insurance subsidiaries are subject to statutory
regulations that restrict the payment of dividends. Based on laws currently in
effect, PHS/CT generally may not pay dividends in excess of the greater of (1)
the net gain from operations for the preceding calendar year, or (2) 10% of
capital and surplus as of the preceding year end, both as determined in
accordance with statutory accounting practices, without
 
                                     F-14
<PAGE>
 
                       PHYSICIANS HEALTH SERVICES, INC.
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
receiving approval of the Connecticut Insurance Commissioner. The maximum
amount of cash dividends that PHS/CT could pay in 1997 without regulatory
approval is approximately $2,800,000.
 
  The Company is required by the State of New York to maintain an escrow
reserve, currently held in U.S. government obligations, equal to 5% of
PHS/NY's estimated health care expenses for the upcoming year. The escrow
reserve was approximately $9,113,000 and $7,087,000 at December 31, 1996 and
1995, respectively.
 
  The Company is required by the New Jersey State Insurance Department to
maintain an escrow reserve of $300,000 in the event of insolvency. The escrow
reserve was approximately $322,000 at December 31, 1996.
 
  Based on statutory rules and restrictions, the amount of restricted net
assets of consolidated subsidiaries at December 31, 1996 was approximately
$38.8 million.
 
10. ARRANGEMENT WITH THE GUARDIAN LIFE INSURANCE COMPANY OF AMERICA
 
  In 1995, the Company's subsidiaries, PHS/CT, PHS/NY and PHS/Bermuda, entered
into several marketing and reinsurance agreements with The Guardian Life
Insurance Company of America ("Guardian") and, together, the "companies".
Under these agreements, jointly developed managed care and indemnity products
are marketed to existing insureds of Guardian. In addition, the companies
distributed these products through the brokerage community and an integrated
marketing effort by the companies under the trade name "Healthcare Solutions."
 
  In 1995 and for the first nine months of 1996, PHS/CT, under the terms of
the marketing agreement, wrote 100% of the HMO/POS business and Guardian wrote
100% of the indemnity business in Connecticut. Under the terms of the profit
sharing agreement, a profit or loss was determined for each line of business.
If both lines were profitable, profits, after provisions for related expenses,
as defined, were shared equally. If neither line were profitable, each company
retained losses, after provisions for related expenses, for its line of
business written. If one line was profitable and the other unprofitable,
payments, as defined, were to be made by the company writing the profitable
line to the company with the unprofitable line, before net profits, if any,
were shared. The Company reported the profits, if any, which inure to Guardian
under this agreement as a component of Guardian joint marketing expenses net.
In connection with this agreement, PHS/CT reported income of $574,000 in 1995,
which represented 50% of the net income in accordance with the terms of the
agreement. In 1996, PHS/CT reported losses after operating expenses of $7.6
million for the HMO/POS business, which represented 100% of the losses in
accordance with the terms of the agreement.
 
  As of October 1, 1996, PHS/CT writes 100% of the HMO/POS business and, under
the terms of a quota share reinsurance agreement, cedes 50% of it to Guardian.
Accordingly, profits and losses, after provisions for related expenses, as
defined, are shared equally. Additionally, 50% of losses previously reported
under the agreement discussed in the preceeding paragraph are recoverable from
future profits, if any, under the reinsurance agreement. Since there is no
assurance that there will be future profits under this agreement, the Company
has not recorded a receivable from Guardian or recognized income for any
future profits. After September 30, 1996, PHS/CT no longer participates in the
indemnity business.
 
  In 1995, PHS/NY wrote the HMO/POS In-Network business and, under the terms
of a quota share reinsurance agreement, ceded 50% of it to Guardian, while
Guardian wrote 100% of the Indemnity/POS Out-of-Network business and, under
the terms of a quota share reinsurance agreement with PHS/Bermuda, ceded 50%
of it to PHS/Bermuda. As such, profits and losses, after provisions for
related expenses, as defined, were shared equally.
 
  From January 1, 1996 to June 30, 1996, PHS/NY's participation in the
Indemnity business was reduced from 50% to 10%. Indemnity costs that appear on
the Statements of Operations represent the Company's
 
                                     F-15
<PAGE>
 
                       PHYSICIANS HEALTH SERVICES, INC.
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
proportionate share of medical costs assumed from Guardian associated with the
New York indemnity business. After June 30, 1996, PHS/NY no longer
participates in the Indemnity business.
 
  In 1996, PHS/NJ entered into marketing and reinsurance agreements with
Guardian. PHS/NJ writes the HMO/POS In-Network business and, under the terms
of the quota share reinsurance agreement, cedes 50% of it to Guardian PHS/NJ
writes the HMO/POS out-of-network business and under the terms of a quota
share reinsurance agreement, ceded 100% of it to Guardian, who retrocedes 50%
of it back to PHS. As such, profits and losses, after provisions for related
expenses, as defined, are shared equally.
 
  In 1996, approximately $114.5 million of total revenues and $129.1 million
of medical costs and other expenses for PHS were generated under the various
marketing and reinsurance arrangements with Guardian described above.
 
  In 1995, approximately $21.5 million of total revenues and $20.2 million of
medical costs and other expenses for PHS were generated under the various
marketing and reinsurance arrangements with Guardian described above.
 
  Other receivables at December 31, 1996 and 1995 includes amounts due from
Guardian under profit sharing and reinsurance agreements of approximately
$18.4 million and $11.8 million, respectively.
 
  As part of the arrangements, the Company recovers from Guardian, a specified
portion of the administrative expenses related to the Healthcare Solutions
activity. Additionally, the direct costs for marketing the Healthcare
Solutions products are shared equally. Both of these expenses as well as the
profits, if any, that inure to Guardian under the profit sharing arrangement
with PHS/CT as described above are included in Guardian joint marketing
expense, net. The components of this line item are as follows:
 
<TABLE>
<CAPTION>
                                                       YEAR ENDED DECEMBER 31
                                                       ----------------------
                                                          1996         1995
                                                       -----------  -----------
      <S>                                              <C>          <C>
      Administrative recovery......................... ($    1,998) ($     542)
      Direct marketing expense........................       1,189       1,494
      Profit sharing expense..........................          --       1,346
                                                       -----------  ----------
                                                       ($      809) $    2,298
                                                       ===========  ==========
</TABLE>
 
  In October 1996, Guardian canceled its warrant that was issued by the
Company in 1995, which originally provided for the purchase of one million
shares of the Company's Class A common stock, once certain operating
conditions had been met. Based upon a subsequent agreement with Guardian, the
number of shares available for purchase under the warrant at the time it was
canceled had been substantially reduced as a result of the Guardian's purchase
of shares of the Company's Class A common stock on the open market. The
Company had not recognized any expense related to the warrant as the
conditions to its exercisability had not been met, nor was it deemed probable
that they would be met up to the date of cancellation.
 
11. SALE OF TEC AND INVESTMENT IN MASTERCARE COMPANIES, INC.
 
  In September 1995, the Company sold 81% of its wholly-owned subsidiary Total
Employee Care, Inc. to Mastercare Companies, Inc. (Mastercare) for 625,000
voting shares of Mastercare common stock. There was no gain or loss recognized
on the transaction since the estimated fair value of the Mastercare stock
received approximated the book value of the TEC stock sold. In addition, the
Company purchased additional shares of Mastercare voting stock in the amount
of 1,250,000 shares at $1.20 per share. The Company owns less than 20% of the
voting stock and does not have the ability to exercise significant influence
over the operating and financial policies of Mastercare and, accordingly has
reported this investment at cost which approximates fair value.
 
                                     F-16
<PAGE>
 
12. QUARTERLY RESULTS OF OPERATIONS (UNAUDITED)
 
  Selected unaudited data reflecting the Company's results of operations for
each of the last eight fiscal quarters are shown in the following table
(dollars in millions):
 
<TABLE>
<CAPTION>
                                                             1996
                                                  -----------------------------
                                                   1ST    2ND     3RD     4TH
                                                  ------ ------  ------  ------
<S>                                               <C>    <C>     <C>     <C>
Premium revenues................................. $111.8 $118.4  $123.2  $128.1
Total health care expenses.......................   92.9  108.9   109.6   114.6
Selling general and administrative expenses......   19.4   20.0    23.4    23.2
Net income (loss)................................     .9   (5.0)   (4.5)   (4.4)
Net income (loss) per share......................   0.09  (0.54)  (0.49)  (0.46)
</TABLE>
 
<TABLE>
<CAPTION>
                                                                 1995
                                                        -----------------------
                                                         1ST   2ND   3RD   4TH
                                                        ----- ----- ----- -----
<S>                                                     <C>   <C>   <C>   <C>
Premium revenues....................................... $79.6 $78.7 $85.7 $99.0
Total health care expenses.............................  62.5  60.8  63.7  76.8
Selling general and administrative expenses............  12.6  14.0  15.4  18.8
Net income.............................................   3.1   3.7   5.2   4.0
Net income per share...................................  0.33  0.39  0.55  0.42
</TABLE>
 
  Note: The sum of the quarters' net income (loss) per share does not equal
the full year per share amount due to rounding.
 
 
                                     F-17
<PAGE>
 
                                                                      SCHEDULE I
 
                        PHYSICIANS HEALTH SERVICES, INC.
 
                 CONDENSED FINANCIAL INFORMATION OF REGISTRANT
                             (DOLLARS IN THOUSANDS)
 
                                 BALANCE SHEETS
 
                                (PARENT COMPANY)
 
<TABLE>
<CAPTION>
                                                               DECEMBER 31
                                                            ------------------
                                                              1996      1995
                                                            --------  --------
<S>                                                         <C>       <C>
                          ASSETS
Cash....................................................... $ 15,572  $    187
Other receivables..........................................      219       192
Prepaid expenses and other.................................    1,128        99
                                                            --------  --------
    TOTAL CURRENT ASSETS...................................   16,919       478
                                                            --------  --------
Property, plant and equipment..............................      408       250
Other assets...............................................    2,319     2,306
Investment in and advances to wholly-owned subsidiaries....   86,603   106,206
                                                            --------  --------
    TOTAL ASSETS........................................... $106,249  $109,240
                                                            ========  ========
           LIABILITIES AND STOCKHOLDERS' EQUITY
Accounts payable and accrued expenses...................... $  9,963  $    359
                                                            --------  --------
    TOTAL CURRENT LIABILITIES..............................    9,963       359
                                                            --------  --------
Stockholders' equity
  Common Stock.............................................       94        94
  Additional paid-in capital...............................   41,360    40,760
  Net unrealized gains on marketable securities of
   subsidiaries, net of tax................................      279       510
  Retained earnings........................................   54,554    67,518
                                                            --------  --------
                                                              96,287   108,882
Less treasury stock........................................       (1)       (1)
                                                            --------  --------
    TOTAL STOCKHOLDERS' EQUITY.............................   96,286   108,881
                                                            --------  --------
  TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY............... $106,249  $109,240
                                                            ========  ========
</TABLE>
 
   The condensed financial information should be read in conjunction with the
     consolidated financial information and the accompanying notes thereto.
 
                                      F-18
<PAGE>
 
                                                                      SCHEDULE I
 
                        PHYSICIANS HEALTH SERVICES, INC.
 
                 CONDENSED FINANCIAL INFORMATION OF REGISTRANT
                             (DOLLARS IN THOUSANDS)
 
                            STATEMENTS OF OPERATIONS
 
                                (PARENT COMPANY)
 
<TABLE>
<CAPTION>
                                                     YEAR ENDED DECEMBER 31
                                                    --------------------------
                                                      1996     1995     1994
                                                    --------  -------  -------
<S>                                                 <C>       <C>      <C>
Revenue:
  Investment income................................ $     92  $     8  $   --
                                                    --------  -------  -------
Costs and expenses:
  General and administrative expenses..............      --     2,188    1,243
  Interest expense.................................      381      --       --
                                                    --------  -------  -------
                                                         381    2,188    1,243
                                                    --------  -------  -------
LOSS BEFORE INCOME TAXES...........................     (289)  (2,180)  (1,243)
Income tax expense (benefit).......................      249      505     (154)
                                                    --------  -------  -------
Loss before equity in net income (loss) of wholly-
 owned subsidiaries................................     (538)  (2,685)  (1,089)
Equity in net income (loss) of wholly-owned
 subsidiaries, net of taxes........................  (12,426)  18,655   15,223
                                                    --------  -------  -------
NET INCOME (LOSS).................................. $(12,964) $15,970  $14,134
                                                    ========  =======  =======
</TABLE>
 
 
   The condensed financial information should be read in conjunction with the
     consolidated financial information and the accompanying notes thereto.
 
                                      F-19
<PAGE>
 
                                                                      SCHEDULE I
 
                        PHYSICIANS HEALTH SERVICES, INC.
 
                 CONDENSED FINANCIAL INFORMATION OF REGISTRANT
                             (DOLLARS IN THOUSANDS)
 
                            STATEMENTS OF CASH FLOWS
 
                                (PARENT COMPANY)
 
<TABLE>
<CAPTION>
                                                     YEAR ENDED DECEMBER 31
                                                   ----------------------------
                                                     1996      1995      1994
                                                   --------  --------  --------
<S>                                                <C>       <C>       <C>
OPERATING ACTIVITIES
Net income (loss)................................  $(12,964)   15,970  $ 14,134
Plus equity in net loss (income) of subsidiaries.    12,426   (18,655)  (15,223)
Adjustments to reconcile net income (loss) to
 cash provided by (used for) operating
 activities......................................     8,377     2,382     1,271
                                                   --------  --------  --------
Net cash provided by (used for) operating
 activities......................................     7,839      (303)      182
FINANCING ACTIVITIES
Advances to subsidiaries.........................   (40,198)   (9,000)  (10,000)
Dividends and return of capital from
 subsidiaries....................................    47,144     9,000    10,000
Exercise of stock options........................       600       246        53
                                                   --------  --------  --------
Net cash provided by financing activities........     7,546       246        53
Increase (decrease) in cash......................    15,385       (57)      235
Cash at beginning of year........................       187       244         9
                                                   --------  --------  --------
Cash at end of year..............................  $ 15,572  $    187  $    244
                                                   ========  ========  ========
</TABLE>
 
 
 
   The condensed financial information should be read in conjunction with the
     consolidated financial information and the accompanying notes thereto.
 
                                      F-20
<PAGE>
 
                                                                     SCHEDULE II
 
               PHYSICIANS HEALTH SERVICES, INC. AND SUBSIDIARIES
 
                               DECEMBER 31, 1996
 
                       VALUATION AND QUALIFYING ACCOUNTS
                             (DOLLARS IN THOUSANDS)
 
<TABLE>
<CAPTION>
                                      BALANCE AT CHARGE TO            BALANCE AT
                                      BEGINNING  COST AND               END OF
                                      OF PERIOD  EXPENSES  DEDUCTIONS   PERIOD
                                      ---------- --------- ---------- ----------
<S>                                   <C>        <C>       <C>        <C>
Year ended December 31, 1994
  Allowance for doubtful accounts....   $  926    $1,423     $(549)     $1,800
                                        ======    ======     =====      ======
Year ended December 31, 1995
  Allowance for doubtful accounts....   $1,800    $  103     $(853)     $1,050
                                        ======    ======     =====      ======
Year ended December 31, 1996
  Allowance for doubtful accounts....   $1,050    $1,485     $(754)     $1,781
                                        ======    ======     =====      ======
</TABLE>
 
                                      F-21
<PAGE>
 
 
                                   SIGNATURES
 
  PURSUANT TO THE REQUIREMENTS OF SECTION 13 OR 15(D) OF THE SECURITIES
EXCHANGE ACT OF 1934, THE COMPANY HAS DULY CAUSED THIS REPORT TO BE SIGNED ON
ITS BEHALF BY THE UNDERSIGNED, THEREUNTO DULY AUTHORIZED, IN THE TOWN OF
SHELTON AND STATE OF CONNECTICUT ON THE 24TH DAY OF JULY, 1997.
 
                                          Physicians Health Services, Inc.
 
                                                   /s/ Robert L. Natt
                                          By: _________________________________
                                            PRESIDENT AND CO-CHIEF EXECUTIVE
                                                         OFFICER


                                      S-1
<PAGE>

                                 Exhibit Index


Exhibit No.             Description of Document
-----------             -----------------------

    23                  Consent of Independent Auditors (filed herewith).