##### Table of Contents









UNITED STATES

SECURITIES AND EXCHANGE COMMISSION


Washington, D.C. 20549


FORM 10-K



---

x

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934 FOR THE FISCAL YEAR ENDED
DECEMBER 31, 2004


OR

o

TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)


OF THE SECURITIES EXCHANGE ACT OF 1934


Commission File Numbers 333-97293; 333-116927

EXTENDICARE HEALTH SERVICES, INC.

(Exact Name of Registrant as Specified in its
Charter)


|                                                                                                                   |  |                                                                           
|------------------------------------------------------------------------------------------------------------------ |  | --------------------------------------------------------------------------
|Delaware                                                                                                           |  | 98-0066268                                                                
|(State or other Jurisdiction of
    Incorporation or Organization)                                                 |  | (I.R.S. Employer
    Identification Number)                               
|111 West Michigan Street
    Milwaukee, WI 53203(Address of principal executive
    office
    Including zip code) |  | (414) 908-8000(Registrants telephone
    number,
    including area code)

Securities Registered Pursuant to
Section 12(b) of the Act: None

Securities Registered Pursuant to
Section 12(g) of the Act: None

Indicate
by check mark whether the registrant (1) has filed all
reports required to be filed by Section 13 or 15(d) of the
Securities Exchange Act of 1934 during the preceding
12 months (or for such shorter period that the registrant
was required to file such reports), and (2) has been
subject to such filing requirements for the past 90 days.

Yes
x          No

Indicate
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 the registrants
knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this
Form 10-K or any amendment to the
Form 10-K.  x

Indicate
by check mark whether the registrant is an accelerated filer (as
defined by Rule 12b-2 of the Act)

Yes
     No
x

Common
Stock  authorized 1,000 shares, $1.00 par
value; issued and outstanding 947 shares as of
March 15, 2005. All issued and outstanding shares of Common
Stock were held on June 30, 2004 and continue to be held
indirectly by Extendicare Inc., a publicly traded Canadian
company.



---






---










TABLE OF CONTENTS

|                                                              |  |                                                                                                                        |                                           |      |     |    | 
|------------------------------------------------------------- |  | ---------------------------------------------------------------------------------------------------------------------- | ----------------------------------------- | ---- | --- | -- | 
|                                                              |  |                                                                                                                        |                                           | Page
|                                                              |  |                                                                                                                        |                                           |     
|PART I                                                       
|                                                             
|Cautionary Statement
    Regarding Forward Looking Statements |  |                                                                                                                        | 1                                         |     
|                                                             
|ITEM 1.                                                       |  | BUSINESS                                                                                                               |                                           |      | 2   |   
|                                                              |  | General                                                                                                                |                                           |      | 2   |   
|                                                              |  | The Long-term Care
    Industry                                                                                        |                                           |      | 3   |   
|                                                              |  | Competitive Strengths                                                                                                  |                                           |      | 4   |   
|                                                              |  | Business Strategy                                                                                                      |                                           |      | 7   |   
|                                                              |  | Risk Factors                                                                                                           |                                           |      | 8   |   
|                                                              |  | Operations                                                                                                             |                                           |      | 16  |   
|                                                              |  |                                                                                                                        | Overview of Business                      |      |     | 16 | 
|                                                              |  |                                                                                                                        | Sources of Revenue                        |      |     | 17 | 
|                                                              |  |                                                                                                                        | Quality of Care and Employee
    Training |      |     | 19 | 
|                                                              |  |                                                                                                                        | Employees                                 |      |     | 20 | 
|                                                              |  |                                                                                                                        | Marketing                                 |      |     | 21 | 
|                                                              |  |                                                                                                                        | Competition                               |      |     | 21 | 
|                                                              |  |                                                                                                                        | Government Regulation                     |      |     | 21 | 
|                                                              |  | Insurance                                                                                                              |                                           |      | 27  |   
|                                                              |  | Legal Proceedings                                                                                                      |                                           |      | 27  |   
|                                                              |  | Website                                                                                                                |                                           |      | 27  |   
|                                                             
|ITEM 2.                                                       |  | PROPERTIES                                                                                                             |                                           |      | 28  |   
|                                                             
|ITEM 3.                                                       |  | LEGAL PROCEEDINGS                                                                                                      |                                           |      | 30  |   
|                                                             
|ITEM 4.                                                       |  | SUBMISSION OF MATTERS TO A
    VOTE OF SECURITY HOLDERS                                                                |                                           |      | 30  |   
|                                                             
|PART II                                                      
|                                                             
|ITEM 5.                                                       |  | MARKET FOR REGISTRANTS
    COMMON STOCK AND RELATED STOCKHOLDER MATTERS AND ISSUER
    PURCHASES OF EQUITY SECURITIES |                                           |      | 31  |   
|                                                             
|ITEM 6.                                                       |  | SELECTED FINANCIAL DATA                                                                                                |                                           |      | 32  |   
|                                                             
|ITEM 7.                                                       |  | MANAGEMENTS DISCUSSION
    AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION                               |                                           |      | 33  |   
|                                                             
|ITEM 7A.                                                      |  | QUANTITATIVE AND QUALITATIVE
    DISCLOSURES ABOUT MARKET RISK                                                         |                                           |      | 65  |   
|                                                             
|ITEM 8.                                                       |  | FINANCIAL STATEMENTS AND
    SUPPLEMENTARY DATA                                                                        |                                           |      | 67  |   
|                                                             
|ITEM 9.                                                       |  | CHANGES IN AND DISAGREEMENTS
    WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE                               |                                           |      | 109 |   
|                                                             
|ITEM 9A.                                                      |  | CONTROLS AND PROCEDURES                                                                                                |                                           |      | 109 |   
|                                                             
|ITEM 9B                                                       |  | OTHER INFORMATION                                                                                                      |                                           |      | 109 |   
|PART III                                                     
|                                                             
|ITEM 10.                                                      |  | DIRECTORS AND EXECUTIVE
    OFFICERS OF THE REGISTRANT                                                                 |                                           |      | 110 |   
|                                                             
|ITEM 11.                                                      |  | EXECUTIVE COMPENSATION                                                                                                 |                                           |      | 112 |   
|                                                             
|ITEM 12.                                                      |  | SECURITY OWNERSHIP OF
    CERTAIN BENEFICIAL OWNERS AND MANAGEMENT                                                     |                                           |      | 116 |   
|                                                             
|ITEM 13.                                                      |  | CERTAIN RELATIONSHIPS AND
    RELATED TRANSACTIONS                                                                     |                                           |      | 116 |   
|                                                             
|ITEM 14.                                                      |  | PRINCIPAL ACCOUNTANT FEES
    AND SERVICES                                                                             |                                           |      | 117 |   
|                                                             
|PART IV                                                      
|                                                             
|ITEM 15.                                                      |  | EXHIBITS AND FINANCIAL
    STATEMENT SCHEDULES                                                                         |                                           |      | 119 |   
|                                                             
|                                                              |  | SIGNATURES                                                                                                             |                                           |      | 120 |   
|                                                             
|                                                              |  | EXHIBIT INDEX                                                                                                          |                                           |      | 122 |   
|Subsidiaries                                                 
|Certification                                                
|Certification                                                
|Certification                                                
|Schedule II                                                  



i



---



##### Table of Contents






Cautionary Statement Regarding Forward Looking
Statements

This Annual Report on Form 10-K contains
forward-looking statements that are intended to qualify for the
safe harbors from liability established by the Private
Securities Litigation Reform Act of 1995. All statements other
than statements of historical fact, including statements
regarding anticipated financial performance, business strategy
and goals for future operations, are forward-looking statements.
These forward-looking statements can be identified as such
because the statements generally include words such as
expect, intend, believe,
anticipate, estimate, plan
or objective or other similar expressions. These
forward-looking statements reflect our beliefs and assumptions,
and are based on information currently available to us.
Forward-looking statements are subject to risks, uncertainties
and other factors that could cause actual results, performance
or achievements or industry results to be materially different
from those expressed in, or implied by, these statements. Some,
but not all, of the risks and uncertainties include those
described in the Risk Factors section of this
Form 10-K and the following:



| |   |                                                                                                                                                                                                 
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | Medicare and Medicaid payment levels and
    reimbursement methodologies and the application of such
    methodologies and policies adopted by the government and its
    fiscal intermediaries;
|
| |  | liabilities and claims asserted against us, such
    as resident care litigation, including our exposure for punitive
    damage claims and increased insurance costs;                          
|
| |  | national and local economic conditions, including
    their effect on the ability to hire and retain qualified staff
    and employees and the associated costs;                                
|
| |  | federal and state regulation of our business and
    change in such regulations, as well as our compliance with such
    regulations;                                                           
|
| |  | actions by our competitors; and                                                                                                                                                                 
|
| |  | our ability to maintain and increase census
    levels.                                                                                                                                         

All forward-looking statements contained in this
Annual Report on Form  10-K are expressly qualified in
their entirety by the cautionary statements set forth or
referred to above. We assume no obligation to update any
forward-looking statement.

1



---



##### Table of Contents






PART I






|        |         
|------- | --------
|ITEM 1. | BUSINESS




General

Extendicare Health Services, Inc. was
incorporated in Delaware in 1984 and is an indirect, wholly
owned subsidiary of Extendicare Inc. (hereafter referred to as
Extendicare), a Canadian publicly traded company. As
used herein, unless the context otherwise specifies or requires,
the Company, we, or us
refers to Extendicare Health Services, Inc. and its subsidiaries
on a combined basis. We are subject to certain of the reporting
requirements of the Securities Exchange Act of 1934, as amended,
due to our public offerings of 9.5% Senior Notes Due 2010,
and 6.875% Senior Subordinated Notes Due 2014, which have
been registered under the Securities Act of 1933, as amended.

Based upon number of beds, we are one of the
largest providers of long-term care and related services in the
United States. Through our network of geographically clustered
facilities, we offer a continuum of healthcare services,
including skilled nursing care, assisted living and related
medical specialty services, such as subacute care and
rehabilitative therapy. As of December 31, 2004, we
operated or managed 185 long-term care facilities with 16,642
beds in 12 states, of which 148 were skilled nursing
facilities with 14,882 beds and 37 were assisted living and
retirement facilities with 1,760 units. We also provided
consulting services to 77 facilities with 9,446 beds in five
states. In addition, we operated 21 outpatient rehabilitation
clinics in four states. We receive payment for our services from
Medicare, Medicaid, private insurance, self-pay residents and
other third-party payors.

On January 31, 2005, we completed our
acquisition of Assisted Living Concepts, Inc., or ALC, for a
total of approximately $285 million, including the
assumption of $141 million of ALCs existing debt. ALC
has a portfolio of 177 assisted living facilities, including 122
owned and 55 leased facilities representing 6,838 units
located in 14 states, many in markets where we currently
operate. Reflecting the impact of the acquisition, as of
February 1, 2005 we operated or managed 362 long-term care
facilities with 23,480 beds in 19 states, of which 148 were
skilled nursing facilities with 14,882 beds and 214 were
assisted living and retirement facilities with 8,598 units.

We focus on our core skilled nursing and assisted
living facility operations, while continuing to grow our
complementary long-term care services. By emphasizing quality
care of patients and by clustering several long-term care
facilities together within the geographic areas we serve, our
goal is to build upon our reputation as a leading provider of a
full range of long-term care services in our communities.

The principal elements of our business strategy
are to:



| |   |                                                                                                                                                                                                                         
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | provide quality, clinically based services;                                                                                                                                                                             
|
| |  | increase our total and Medicare census through
    strategies such as focused marketing efforts, standardized
    admissions protocols and streamlined admitting procedures.                                            
|
| |  | expand non-government based revenue sources,
    thereby decreasing the risk and reliance on government funding;                                                                                                        
|
| |  | leverage presence in small urban markets to
    improve operating efficiencies and to offer our customers a
    broad range of long-term care services, including assisted
    living and related health services;      
|
| |  | expand asset portfolio through acquisition and
    internal growth;                                                                                                                                                     
|
| |  | actively manage our asset portfolio so that we
    upgrade our facilities to meet the demands of the local market
    and customer base, or exit markets or sell facilities which do
    not meet our performance goals.
|
| |  | diversify within long-term care industry through
    growth of facilities under full management and selected
    consulting services agreements and rehabilitation
    clinics; and                                     
|
| |  | increase our operating efficiency.                                                                                                                                                                                      

2



---



##### Table of Contents






The Long-term Care Industry

According to the Centers for Medicare and
Medicaid Services, or CMS, total healthcare spending is expected
to grow at an annual rate of 7.1% from 2003 through 2014. Based
on these estimates, healthcare expenditures will account for
$3.6 trillion, or 18.7% of the gross domestic product by 2014.
Nursing facility expenditures were approximately
$110.8 billion in 2003, or 6.6% of total healthcare
spending, representing one of the largest components of national
healthcare spending. The spending related to nursing facilities
is expected to grow at an annual rate of 8.4% through 2014.

The long-term care industry is changing as a
result of several fundamental factors, on which we believe we
can capitalize. These factors include:

Aging Population.The aging of the U.S. population is a leading driver of
demand for long-term care services. According to the 2000 census
conducted by the U.S. Census Bureau, there were
approximately 34.4 million Americans aged 65 or older. The
U.S. Census Bureau has forecasted that the population of
Americans aged 65 or older will increase to 37.7 million in
2005, 40.2 million in 2010, 54.6 million by 2020, and
86.7 million in 2050. As a result, the percentage of
Americans aged 65 or older will increase from 12.4% in 2000 to
16.3% in 2020 and 20.7% by 2050. Based upon these projections,
while the overall U.S. population growth rate is projected
at approximately 4% every five years from 2005 to 2030, the
65 year and older segment of the U.S. population is
expected to increase by approximately 10% to 17% during each of
the same five-year periods. The following table indicates the
expected growth rates within the elderly U.S. populations.

|          |  |             |      |       |  |       |       |     |  |         |       |  |  |  |       |  |  |  |       | 
|--------- |  | ----------- | ---- | ----- |  | ----- | ----- | --- |  | ------- | ----- |  |  |  | ----- |  |  |  | ----- | 
|          |  | Total U.S.  |      |       |  |       |       |     |  | Total  
|          |  | Population  |      |       |  |       |       |     |  | Elderly
|          |  | Growth Rate |      | 65-74 |  | 75-84 |       | 85+ |  | (65+)  
|          |  |             |      |       |  |       |       |     |  |        
|2005-2010 |  |             | 4.5% |       |  |       | 14.2% |     |  |         | -0.8% |  |  |  | 19.6% |  |  |  | 9.7%  | 
|2010-2015 |  |             | 4.3% |       |  |       | 25.1% |     |  |         | 4.0%  |  |  |  | 11.4% |  |  |  | 16.3% | 
|2015-2020 |  |             | 4.2% |       |  |       | 19.4% |     |  |         | 16.6% |  |  |  | 6.5%  |  |  |  | 16.8% | 
|2020-2025 |  |             | 4.1% |       |  |       | 12.3% |     |  |         | 27.2% |  |  |  | 10.2% |  |  |  | 16.3% | 
|2025-2030 |  |             | 4.1% |       |  |       | 6.3%  |     |  |         | 20.6% |  |  |  | 19.9% |  |  |  | 12.5% | 

Source: U.S. Census Bureau, International
Data Base, published October 10, 2002

According to the MetLife Market Survey of Nursing
Home report in August 2003 (MetLife Report), whereas
in 2000, approximately 1.6 million or 4.5% of all persons
aged 65 and over were living in a nursing facility, this number
will increase to approximately 6.6 million, or 8.4% of all
persons aged 65 by the year 2050.

Supply/ Demand
Imbalance.Acquisition and
construction of additional nursing and assisted living
facilities are subject to certain restrictions on supply,
including government legislated moratoriums for nursing
facilities on new capacity or licensing restrictions limiting
the growth of services. Such restrictions on supply, coupled
with an aging population, are causing a decline in the
availability of long-term beds per person 85 years of age
or older. Additionally, advances in medical technology are
enabling the treatment of certain medical conditions outside the
hospital setting. As a result, patients requiring a higher
degree of monitoring, more intensive and specialized medical
care, 24-hour per day nursing, and a comprehensive array of
rehabilitative therapies are increasing, resulting in a need for
long-term care. We believe that such specialty care can be
provided in nursing homes at a significantly lower cost than in
traditional acute care and rehabilitation hospitals. In
addition, for an aging population seeking a higher quality
living alternative, assisted living facilities offer an array of
accommodations and selective long-term care and services on a
more cost effective basis for the individual. According to
American Senior Housing Association, or ASHA, the percentage of
American seniors aged 65 or older that need assistance with at
least one activity of daily living has been approximately 19%
for each of the years 1998 to 2001.

Cost Containment
Pressures.According to the MetLife
Report, the remaining life expectancy of a male age 65 has
increased to 16.3 years in 2002 from 12.7 years in
1942; and the remaining life expectancy of a female age 65
has increased to 19.2 years in 2002 from 14.7 years in
1942. As the number of people over age 65 continues to grow
and as advances in medicine and technology continue to increase
life expectancies,

3



---



##### Table of Contents



the likelihood of chronic conditions requiring
treatment, and the resulting healthcare costs, are expected to
rise faster than the availability of resources from
government-sponsored healthcare programs. As federal and state
governments face increasing challenges to fund healthcare, they
have initiated steps to limit the growth of healthcare funding.
In response to such rising costs, governmental and private pay
sources in the United States have adopted cost containment
measures that encourage reduced lengths of stay in acute care
hospitals. As a result, average acute care hospital stays have
been shortened, and many patients are discharged despite a
continuing need for nursing or specialty healthcare services,
including therapy. An increasing number of patients require a
high degree of monitoring, intensive and specialized medical
care, 24-hour per day nursing services and a comprehensive array
of rehabilitative therapies. This trend has increased demand for
long-term care, home healthcare, outpatient facilities, hospices
and assisted living facilities. We believe that long-term care
companies with information systems to process clinical and
financial data, and an integrated network and a broad range of
services will be in a good position to contract with managed
care or other payers.


Changing Family Dynamics and
Economics.Changing family dynamics
play an important role in the need of seniors to live in a
long-term care facility. As a result of the growing number of
two-income families, we believe the immediate family has become
less of a primary source of care-giving for the elderly. Our
opinion is based upon a number of facts, including
(1) according to the U.S. Department of Labor, women,
who under more traditional roles were viewed as the primary
caretakers of the family, have moved back into the workforce in
increasing numbers as evidenced through their labor
participation rates increasing from 38% in 1963 to 60% in 1998
and forecasted to reach 62% in 2015; and (2) according to
the U.S. Census Bureau, the parent support ratio (the ratio
of individuals over 85 to those 45 to 64 years of age) has
increased from 3 to 100 in 1950 to 7 to 100 in 2000 and is
expected to reach 22 to 100 by the year 2050. The expected
increase is partly due to the fact that by 1990 approximately
26% of the baby boom generation was childless. At the same time,
an increasing number of two-income families are better able to
provide financial support for elderly parents to receive the
care they need in a nursing or assisted living facility. In
addition, we believe, there is an increasing number of seniors
who are able to afford to live in an assisted living facility.
According to a 2000 study by the Joint Center for Housing
Studies of Harvard University, almost 20% of U.S. seniors
have a net worth between $100,000 and $200,000, while another
18% have a net worth between $200,000 and $500,000. In our
opinion, this study underestimated seniors wealth because
it excluded social security and pension plans. In 1962, the mean
net worth of Americans aged 65 to 74 was $165,000 (based on the
value of the U.S. dollar in 1995), whereas in 1995 the net
worth was $346,000.




Competitive Strengths

The long-term care industry is highly fragmented
with numerous local and regional operators and a select group of
larger operators. According to information published by ASHA, as
of June 2004, there were approximately 20,920 long-term care
facilities in the U.S. containing approximately
2.3 million beds. As of December 31, 2003, fifty of
the largest operators in the U.S. operated approximately
2,922 long-term care facilities, representing 14% of the total
number of properties. Approximately 7,270 or 35% of the
facilities are assisted living facilities, representing
approximately 544,000 or 24% of the total number of long-term
care beds, while the remaining consist of nursing facilities.

According to the CMS Healthcare Industry Market
Update report published in May 2003, the nursing facility
portion of the long-term care industry is fragmented, with the
10 largest nursing facility companies accounting for 15.5% of
the total facility beds as of April 2003. There are
approximately 16,500 nursing facilities certified under the
Medicare and/or Medicaid program with approximately
1.8 million available beds, and during 2002, approximately
3.5 million individuals lived in nursing facilities.
Approximately 65% of nursing facilities are operated by
for-profit companies, 28% are operated by non-profit
organizations and 7% are operated by local government.

Our major competitive strengths are:

Leading Provider of Long-term Care
Services.We are among the largest
providers of long-term care services in the United States. As of
December 31, 2004, we operated or managed 185 long-term
care facilities with 16,642 beds. Effective February 1,
2005 reflecting the impact of the acquisition of ALC, we
operated or

4



---



##### Table of Contents



managed 362 long-term care facilities with 14,882
nursing beds and 8,598 assisted living units. Our scope of
operations allows us to achieve economies of scale in purchasing
and contracting with suppliers and customers. For example,
through our subsidiary, Extendicare Health Network, Inc., we
purchase for nursing facilities in numerous states in addition
to the facilities we operate or manage. Through our affiliate,
Virtual Care Provider, Inc., we also provide technology support
services to unaffiliated long-term care facilities.


Focus on Core
Business.In the past, we have
successfully identified and disposed of portions of our business
that did not fit within our core business or facilities located
in states with unacceptable litigation risks. From 1998 through
2001, in response to the implementation of the Medicare
Prospective Payment System, or PPS, increased litigation and
insurance costs in certain states, and increased operational
costs resulting from changes in legislation and regulatory
scrutiny, we divested under-performing nursing and assisted
living facilities and non-core healthcare assets. These asset
divestitures primarily included the sale of our pharmacy to
Omnicare, Inc., and the sales of facilities and/or the transfer
of all operations in the states of Florida and Texas in 1999,
2000 and 2001 and Arkansas in 2004. We have more recently
commenced a strategy to grow our business through selective
acquisition and internal growth involving development projects,
or undertake full management or selective consulting contracts
to grow in states that are attractive and offer opportunities
for us to expand our present base of operations. In 2004, we
completed four construction projects which included a new
free-standing assisted living facility (40 units), two
additions to existing assisted living facilities (46 units)
and an addition to an existing nursing facility (20 beds). We
have eleven additional construction projects in progress which
will expand or add to our nursing facilities (18 beds) and
assisted living facilities (376 units). In December 2003,
we acquired one nursing facility in Wisconsin (99 beds); in
January 2004, we acquired a previously leased nursing facility
and in June 2004 we acquired four nursing facilities (321 beds)
in Indiana. On January 31, 2005, we acquired ALC, which
operates 177 assisted living facilities (6,838 units). We
intend to continue to focus on operating and managing long-term
care facilities. In addition, we plan to continue to review the
performance of our current facilities and exit markets or sell
facilities that do not meet our performance goals. At the
present time, we have no significant divestiture plans.

Significant Facility
Ownership.We own rather than lease a
majority of our properties, unlike a number of other long-term
care providers. As of December 31, 2004, we owned 163
facilities, or 94.2% of the total number of facilities we
operated. We believe that owning properties increases our
operating flexibility by allowing us to:



| |   |                                                                                              
| | - | ---------------------------------------------------------------------------------------------
| |  | refurbish facilities to meet changing consumer
    demands;                                  
|
| |  | add assisted living and retirement facilities
    adjacent to our skilled nursing facilities;
|
| |  | adjust licensed capacity to avoid occupancy-based
    rate penalties;                        
|
| |  | divest facilities and exit markets at our
    discretion; and                                
|
| |  | more directly control our occupancy costs.                                                   

We maintained this strategy with the acquisition
of ALC. Effective February 1, 2005, with the inclusion of
ALC facilities we owned 285 facilities, or 81.4%, of the total
number of facilities we operated.

Dual Medicare and Medicaid
Certification.We have certified
substantially all of our beds for the provision of care to both
Medicare and Medicaid patients. We believe that dual
certification in nursing facilities increases the likelihood of
higher occupancy rates by increasing the availability of beds to
patients who require a specific bed certification. In addition,
dual certification allows our facilities to easily shift
patients from one level of care and reimbursement to another
without physically moving the patient.

Experienced and Proven Management
Team.Our management team has
demonstrated competency in dealing with significant changes in
the reimbursement environment resulting from the shift to PPS,
and identifying the significant exposures and risks of operating
in the extremely litigious environments in Florida and Texas. We
executed a planned divestiture program that reduced our level of
debt, and reduced our exposure to liability claims and increased
insurance costs. In 2002 and 2004, we refinanced a significant
portion of our debt to reduce the leverage ratio from 71.0% in
2000 to 53.8% in 2004. We have been successful

5



---



##### Table of Contents



in recruiting experienced management staff from
our competitors to further strengthen our existing experienced
executive and operating management team.


Geographic
Diversity.As of December 31,
2004, we operated or managed facilities located in specific
markets across 12 states primarily throughout the
Northeast, Midwest and Northwest regions of the United States.
No state contains more than 20% of our facilities or 20% of our
beds. With the addition of ALC, which has operations in
14 states, seven of which are new states for us, our
operations continue to be primarily in the above mentioned
regions. However we now also have a significant operation in the
southern states of Texas and Arizona. Effective February 1,
2005, we operated or managed facilities located in specific
markets across 19 states, with no state containing more
than 14% of our facilities or 17% of our beds. Each state is
unique in terms of its competitive dynamics as well as its
political and regulatory environment. Each state administers its
own Medicaid program, which constitutes a significant portion of
our revenue. Our diversified market scope limits our exposure to
events or trends that may occur in any individual state,
including changes in any states Medicaid reimbursement
program and in regional and local economic conditions and
demographics.

Diversify within the Long-term Care
Industry.We continue to explore
opportunities to expand in states where we currently operate to
provide either full management, consulting or accounting
services. We also plan to explore opportunities for new
rehabilitation clinics in states where we currently operate. In
2004, we opened one new rehabilitation clinic. However due to
changing demands in the local markets, we closed four other
rehabilitation clinics during 2004. As of December 31,
2004, we operated 21 clinics, compared to 24 in 2003 and 22 in
2002.

Management Focus on Key Performance
Drivers.We believe that our senior
management, as well as our field personnel, are proficient at
focusing on the key areas that drive revenues, profits and cash
flows. Our senior management has identified four critical
drivers of operating and financial performance:



| |   |                                                                                                                                                                               
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | improving census, particularly increasing our
    Medicare census in our nursing facilities;                                                                                  
|
| |  | increasing cash flow from operations, through
    expedited billing and collections and other initiatives;                                                                    
|
| |  | improving income from operations, through control
    of labor and other costs; and                                                                                           
|
| |  | diversifying within the long-term care industry
    through expansion of facilities under management and consulting
    agreements and expansion of our rehabilitation clinics

Every level of management, starting with our
Chief Executive Officer, devotes a significant portion of their
time to improving these key performance drivers. We believe that
this focused attention and commitment, along with hard work by
our employees has resulted in substantial improvement in several
of our key performance drivers.

For 2004, total average daily census, or ADC, for
our nursing facilities increased to 12,607, which is 0.9% higher
than the 12,490 reported for 2003, and 2.3% higher than the
12,319 reported for 2002. The occupancy rate for 2004 was 92.1%
compared to 91.4% in 2003 and 90.1% in 2002. For 2004, Medicare
ADC increased to 2,100, which is 8.5% higher than the 1,935
reported for 2003, and 28.0% higher than the 1,639 reported for
2002. The occupancy of our assisted living facilities was 84.6%
in 2004, compared to 85.8% in 2003 and 83.0% in 2002. All of the
data presented in this paragraph is on a same facility basis.

Cash flow from operations was $81.4 million
in 2004, as compared to $56.0 million in 2003 and
$38.8 million in 2002. Through consistent emphasis on
admissions protocols, attention to older and larger account
balances and proactive collection efforts at regional and head
offices, we have improved our accounts receivable management.
Days of revenues outstanding have dropped to approximately
36.5 days as of December 31, 2004, compared to
40.0 days in 2003 and 43.0 days in 2002.

As discussed in our description of key
performance drivers in the Managements Discussion
and Analysis section of this Annual Report on
Form 10-K, we monitor income from operations by focusing on
earnings before interest, taxes, depreciation and amortization,
or EBITDA, and EBITDA expressed as a percentage of revenues.
EBITDA increased to $133.0 million in 2004, compared to
$99.3 million in 2003 and $80.4 million in 2002; and
EBITDA as a percentage of revenues increased to 14.0% in 2004,
compared to

6



---



##### Table of Contents



11.4% in 2003 and 9.9% in 2002. The improvement
in earnings involved the implementation of a variety of
strategies to control labor costs and minimize the use of
temporary staff. Regular wages as a percent of revenues have
declined to 43.8% for 2004 from 45.4% for 2003 and 46.7% in
2002, while temporary wages as a percent of revenues in the same
periods decreased to 0.3% in 2004, from 0.4% in 2003 and 1.2% in
2002. We also improved our level of Part B Medicare
revenues and increased Medicaid and Medicare rates through the
admission of residents with higher levels of acuity.





Business Strategy

The principal elements of our business strategy
are to:

Provide Quality, Clinically Based
Services.Our corporate clinical
services group monitors quality of care indicators, survey
results and drives continuous quality improvement processes at
the facility and regional levels. Focused review meetings are
held on a regular basis to monitor trends in facilities and to
communicate new protocols and issues within the industry. The
corporate clinical services group directs an internal team of
field-based quality validation specialists who are responsible
for mirroring the regulatory survey process and regularly
communicating with our clinical service specialists in our
corporate office. On-site data is integrated with clinical
indicators, facility human resource data and state regulatory
outcomes to provide a detailed picture of problems, challenges
and successes in achieving performance at all levels of our
organization. This information pool allows us to determine best
practices for duplication in similarly situated facilities. We
emphasize these programs when marketing our services to acute
care providers, community organizations and physicians in the
communities we serve.

Increase Medicare
Census.We continue to develop and
implement strategies and capabilities to attract residents, with
a focus on increasing Medicare census in our nursing facilities.
In 2004, Medicare payments represented approximately 30% of our
total net revenues, up from 24% in 2000. Senior management
continually works with our regional and local management teams
to develop strategies to continue to increase this percentage.
Strategies, such as focused marketing efforts, standardized
admissions protocols, streamlined admitting procedures, the dual
certification of beds and improved management communication have
driven this improvement. In addition to increasing the
profitability of our nursing facilities, the increased Medicare
census expands the market for our service related businesses as
Medicare patients utilize significant ancillary services.

Expand Non-government Based Revenue
Sources.By increasing the level of
non-government based revenue sources, we reduce our risk and
reliance on government funding that in the future may be
constrained. In addition, future generations will have increased
wealth and an increased choice of long-term care alternatives.
One of our goals is to target these markets. Through both our
internal growth program involving the construction of assisted
living facilities, and our recent acquisition of ALC we intend
to increase the level of non-government based revenue sources.
Based upon the ALCs annual revenues for December 31,
2004, our percentage of non-government based revenue sources
will increase from 23% to 31%.

Leverage Presence in Small Urban
Markets.We geographically cluster our
long-term care facilities and services in small urban markets in
order to improve operating efficiencies and to offer our
customers a broad range of long-term care and related health
services, including assisted living services. Future expansion
of our owned nursing facility operations is anticipated to be
through the selective acquisition and construction of new
facilities in areas that are in close proximity to existing
facilities, where management is experienced in dealing with the
regulatory and reimbursement environments, where the facility
can participate as an active member of the nursing facility
association and where the facilitys reputation is
established.

Expand Asset
Portfolio.We seek to expand our
portfolio of nursing and assisted living facilities in states
where we currently operate or that offer attractive
reimbursement systems. We plan to expand through both
acquisitions and internal growth. Opportunities exist to add-on
to existing facilities and to develop new assisted living
facilities in locations close to existing nursing facilities. We
currently employ an internal design and development team that is
well experienced in the design and construction of new
facilities.

7



---



##### Table of Contents



Actively Manage Our Asset
Portfolio.We continually review our
asset portfolio in terms of its physical condition, the facility
meeting the needs of the marketplace, its financial performance
and long-term outlook. When facilities do not meet our
performance criteria, risks within the marketplace increase or
litigation risk increases beyond acceptable limits, we exit the
marketplace or sell facilities. Over the past five years, we
have disposed of a number of facilities and exited three states,
being Florida, Texas and Arkansas, while improving the
performance of the balance of our asset portfolio.

Increase Facilities under Management and
Consulting Services Agreements and Rehabilitation
Clinics.We seek to increase the
number of our management and consulting contracts with third
party operators. We have knowledge and expertise in both the
operational and administrative aspects of the long-term care
sector. We believe that the increasingly complex and
administratively burdensome nature of the long-term care sector,
coupled with our commitment and reputation as a leading,
high-quality operator, will drive demand for new contracts. We
believe this strategy is a logical extension of our business
model and competencies and will drive growth without requiring
substantial capital expenditures. In 2004, we had 89 facilities
under management or consulting service agreements, compared to
33 in 2000.

Increase Operating
Efficiency.We are focused on reducing
operating costs by improving our communications systems,
streamlining documentation and strengthening the formalization
of procedures to approve expenditures. We have reduced the
duplication of roles at the corporate and regional levels and
continue to seek to improve our utilization of regional
resources by adding management and consulting contracts to our
existing regions, thereby enabling us to spread the overhead
costs of our regional structure over a wider base of operations.




Risk Factors

The risk factors and uncertainties facing us and
our industry include:

We depend upon reimbursement for our services
by third-party payors, and changes in their reimbursement levels
could adversely affect our revenues, results of operations and
financial position.Approximately 77%
of our revenues are derived from governmental third-party payors
with the remainder being derived from commercial insurers,
managed care plans, the Department of Veteran Affairs, private
individuals, and third parties for whom we provide management or
consulting services. In 2004, approximately 30% of our revenues
were derived from Medicare and 47% from Medicaid. There are
ongoing pressures from many payors to control healthcare costs
and to reduce or limit increases in reimbursement rates for
medical services. Governmental payment programs are subject to
statutory and regulatory changes, retroactive rate adjustments,
administrative or executive orders and government funding
restrictions, all of which may materially change the amount of
payments to us for our services.

Our revenues may be adversely affected by
changes or elimination of temporary Medicare funding provisions
or reductions in Medicare rates through new rules introduced by
CMS.In 1999 the industry experienced
a decline in revenues primarily attributable to declines in
government reimbursement as a result of the Balanced Budget Act
of 1997, or BBA. The revenue rate reductions from the BBA were
partially offset by $2.7 billion in temporary relief
funding enhancements received through the Balanced Budget
Refinement Act of 1999, or BBRA, and the Benefits Improvement
Protection Act of 2000, or BIPA. The funding enhancements
implemented by the BBRA and BIPA fall into two categories. The
first category is Legislative Add-ons which included
a 16.66% add-on to the nursing component of the Resource
Utilization Groupings, or RUGs rate and a 4% base adjustment.
Despite intensive lobbying by the long-term care industry,
Congress did not extend these Medicare funding enhancements. On
September 30, 2002, the temporary relief funding
enhancements, referred to as the Legislative Add-ons, expired
(referred to as the Medicare Cliff), resulting in a
reduction in Medicare rates for all long-term care providers.
Based upon the Medicare case mix and census for the twelve
months period October 1, 2002 to September 30, 2003,
we estimate that the net impact of the Medicare Cliff and the
market basket increase received on October 1, 2002 was a
reduction in revenues of approximately $16.7 million.

The second category is RUGs
Refinements which involves an initial 20% add-on for 15
RUGs categories identified as having high intensity, non-therapy
ancillary services. The 20% add-ons from three

8



---



##### Table of Contents



RUGs categories were later redistributed to 14
rehabilitation categories at an add-on rate of 6.7% each. CMS
has extended the funding enhancements beyond the previously
announced sunset dates. However, based upon the July 2004 CMS
announcement, the RUGs Refinements extend only until
October 1, 2005. Congress has enacted legislation directing
CMS to conduct a study on the RUGs classification system and
report its recommendations prior to the implementation of a RUGs
Refinement change whereby all or part of the enhancement is
discontinued. In February 2005, the Presidents Proposed
Budget provides for the discontinuance of the RUGs Refinements
effective October 1, 2005. The Presidents Proposed
Budget is subject to legislative review and the budget being
passed by the United States Government. Based upon the Medicare
case mix and census for the year ended December 31, 2004,
we estimate that we receive an average $25.50 per resident
day, which on an annualized basis amounts to $20.1 million
related to the RUGs Refinements. The implementation of a RUGs
Refinement change whereby all or part of the enhancement is
discontinued could have a significant impact on us.


In February 2003, CMS announced its plan to
reduce its level of reimbursement for uncollectible Part A
co-insurance. Under the plan announced by CMS, the reimbursement
level would be reduced to 70% over a three year period as
follows: 90% effective for the government fiscal year commencing
October 1, 2003; 80% effective for the government fiscal
year commencing October 1, 2004; and 70% effective for
government fiscal years commencing on or after October 1,
2005. This plan is consistent with the Part A co-insurance
reimbursement plan applicable to hospitals. CMS did not
implement the rule change effective October 1, 2003, and
continues to review the proposed plan. In February 2005, the
Presidents Proposed Budget provides for the implementation
of the reduced reimbursement plan over a three year period
commencing October 1, 2005. The Presidents Proposed
Budget is subject to legislative review and the budget being
passed by the United States Government. Should that occur, we
estimate that the negative impact to our pre-tax net income
would be $0.4 million in 2005, $1.7 million in 2006,
$2.9 million in 2007, and $3.8 million in 2008.

In January 2003, CMS announced that the
moratorium on implementing payment caps for outpatient
Part B therapy services, which was scheduled to take effect
on January 1, 2003, would be extended. CMS subsequently
extended the moratorium until September 1, 2003. The
therapy caps were made effective from September 1, 2003
until December 8, 2003. On December 8, 2003, as a
result of the Medicare Prescription Drug, Improvement and
Modernization Act of 2003, the moratorium was re-instated for an
additional two-year period until December 2005. The impact of a
payment cap cannot be reasonably estimated based on the
information available to us at this time, however, we believe
that such a cap would reduce therapy revenues.

We cannot assure you that Medicare payments will
remain at levels comparable to present levels or will, in the
future, be sufficient to cover the costs allocable to patients
eligible for reimbursement pursuant to such programs.

Financial pressures on state budgets will
directly impact the level of available Medicaid funding and
hence the level of available funding for inflationary increases.
A majority of states were faced with serious financial budgetary
constraints in 2002, 2003 and 2004 as a result of a reduction in
state revenues from the slowdown in the economy. In response,
budgetary constraints were placed on Medicaid programs, which
represent a significant portion of state budgets. A study issued
by the Kaiser Commission on Medicaid and the Uninsured in
October 2004, indicated that all of the states had made, or
planned to make, Medicaid cuts in fiscal year 2004 and plan new
actions for fiscal year 2005. A number of states did implement
reductions or freezes in Medicaid rates, or limited their
increases to below inflationary levels in 2004. With respect to
the states in which we operate, Ohio and Minnesota did not
provide any Medicaid rate increases, and revenues only increased
in response to the higher acuity of residents we admitted.

In an effort to counter reduced state revenues, a
number of states have submitted proposed state plan amendments
and waivers to seek an increase in the level of federal funding
for their Medicaid programs, and result in providing nursing
facilities with a revenue rate increase to offset new or
increased provider taxes or state assessment fees. Such programs
have been approved in the past, however CMS announced in
December 2003 that all such plans were to be reviewed in detail
and in January 2004, the General Accounting Office was contacted
to review all such programs being introduced. As a result,
during 2004 a number of states had to retract and resubmit their
proposed plans to CMS and Medicaid rate increases were delayed.
In June 2004,

9



---



##### Table of Contents



CMS approved the state plan amendment and waiver
submitted by the State of Oregon pertaining to the fiscal year
commencing July 1, 2003, which resulted in a net favorable
impact of $0.3 million that was recorded in the second
quarter of 2004. In July 2004, the State of Kentucky received
approval from CMS of a state plan amendment and waiver, which
became effective July 1, 2004. The Kentucky plan amendment
and waivers increased our earnings by approximately
$2.3 million for the six months ended December 31,
2004.


In January 2005, the States of Pennsylvania and
Washington received approval from CMS of their submitted state
plan amendments and waivers. The Washington approval will have
no impact on our earnings. As a result of the Pennsylvania
approval, we anticipate that we will receive, subject to
finalization, retroactive revenues of approximately
$11.3 million in 2005 and be required to pay provider taxes
of approximately $8.7 million pertaining to the period
July 1, 2003 to June 30, 2004. As a result, the impact
on income before income taxes is estimated to be
$2.6 million. In addition, subject to state budgetary
approval and certain other actions, we anticipate receiving
retroactive revenues to fund provider taxes for the period
July 1, 2004 to December 31, 2004. These amounts are
subject to finalization, however, current estimates indicate
that the impact on income before income taxes of the
July 1, 2004 to December 31, 2004 settlement will be
approximately $0.5 million. We will record the above
settlements when the plans are finalized in 2005.

The State of Indiana has submitted a proposed
state plan amendment and waiver pertaining to the fiscal year
commencing July 1, 2003, which is awaiting review and
approval by CMS. Since the plan amendment and waiver has not
been approved, we have recorded revenues based upon amounts
received. Approval of the retrospective amendment and waiver as
submitted could result in the recording of incremental income
before income taxes of $4.6 million in 2005 pertaining to
the 18-month period ended December 31, 2004. There would be
no impact to us if the plan were not approved. We anticipate
that amendments will be made to the original plan submitted to
CMS and cannot, therefore, predict the outcome of this plan
submission or its impact on us and our results of operation.
Based upon the final CMS approved state plan amendment and
waiver, changes in Medicaid rates and any associated provider
taxes could result in adjustments to income for the period from
July 1, 2003 to December 31, 2004.

Legislative and regulatory actions have
resulted in continuing changes to Medicare and Medicaid
reimbursement programs.Medicare and
Medicaid reimbursement programs are complicated and constantly
changing as CMS continues to refine its programs. There are
considerable administrative costs incurred in monitoring the
changes made within the programs, determining the appropriate
actions to be taken to respond to those changes, and
implementing the required actions to meet the new requirements
and minimize the repercussions of the changes to our
organization, reimbursement rates and costs. Examples of changes
adopted by either CMS or certain states, which have impacted our
industry, include:



| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                          
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | the repeal of the Boren Amendment federal payment
    standard for Medicaid payments, which required states to provide
    skilled nursing facilities with reasonable and adequate
    reimbursement rates to cover the costs of efficiently and
    economically operated healthcare facilities. As a result, budget
    constraints may cause states to reduce Medicaid reimbursement to
    skilled nursing facilities or delay payments to providers;
|
| |  | the limitation of costs being reimbursed under
    Medicaid reimbursement programs when operators use a certain
    level of agency staffing, or incur leasing costs, which have an
    imputed lease interest cost greater than the current market rate;                                                                                                                                                                                                
|
| |  | the establishment of a minimum occupancy
    requirement in certain Medicaid programs, which effectively
    reduces the eligible Medicaid reimbursement rate that a skilled
    nursing facility can receive; and                                                                                                                                                                                                                                       
|
| |  | an increasing number of states have adopted
    policies to discontinue the reimbursement of Part A
    co-insurance payments for dually eligible residents.                                                                                                                                                                                                                                                                                             

The Medicare Prescription Drug, Improvement and
Modernization Act of 2003 created Part D, a new drug
benefit for Medicare beneficiaries, which will be implemented
January 1, 2006. Although optional for individuals entitled
to or enrolled in Medicare benefits under Part A or
Part B, CMS will auto-enroll individuals who qualify for
both Medicare and Medicaid, or dual-eligible individuals, into
privately run

10



---



##### Table of Contents



Prescription Drug Plans, or PDPs, authorized by
CMS to provide the Part D benefit in 34 regions within the
U.S. Unlike state Medicaid programs currently administering
drug benefits for dual-eligible individuals, PDPs will develop
extensive formularies with the objective of minimizing
prescription drug costs of the Part D benefit. This
legislation could increase our cost of drugs and the
administration associated with drug costs. To prevent and reduce
the potential financial liability when non-formulary drugs are
prescribed for dual-eligible residents, nursing staff at the
facility will be required to communicate with the physician to
assure compliance with PDP formulary.


The cost of general and professional liability
claims are significant and escalating in certain states,
resulting in significant increases in insurance or the
availability of insurance.The
industry has experienced an increasing trend in the number and
severity of litigation claims and punitive settlements. We
believe that this trend is endemic to the long-term care
industry and is a result of the increasing number of large
judgments, including large punitive damage awards, against
long-term care providers in recent years resulting in an
increased awareness by plaintiffs lawyers of potentially
large recoveries. According to a report issued by AON Risk
Consultants in June 2004 on long-term care operators
general liability and professional liability costs, such costs
are seven times higher in 2003, as compared to the early
1990s. The average cost per bed for general liability and
professional liability costs has increased from $310 in 1992, to
$2,290 per bed in 2003. The average general and
professional liability claim has more than doubled from $65,000
in 1992 to $149,000 in 2003, whereas the average number of
claims per 1,000 beds has increased at an average annual rate of
13% from 4.8 in 1992 to 15.3 in 2003 in the long-term care
industry. As a result, general and professional claim costs have
absorbed a significant percentage of the average Medicaid
reimbursement rate increase for the period 1992 through 2003.
The States of Florida and Texas are the leaders where general
and professional liability claims are being incurred; however,
the States of Arkansas, California, Mississippi, Tennessee and
Alabama are showing similar signs. Industry sources report the
average cost of a claim in Florida in 2000 was three times
higher than most of the rest of the United States. Florida
healthcare providers experienced three times the number of
claims that were experienced by providers in most other states.
As a result of the litigious environment, insurance premiums for
general and professional liability claims have increased, and in
certain states coverage is unavailable to skilled nursing
facility operators, since insurance companies have refrained
from providing insurance.

As a result of the adverse development of claims
experienced by us and the industry in the states of Florida and
Texas, we divested all of our nursing facility operations in
these states by the end of December 2000 and September 2001,
respectively. Exclusive of claims pertaining to our past
operations in Florida and Texas, we are experiencing an
increasing trend in the number and severity of litigation claims
against us, but this has been within our projections and accrued
accordingly. We continually review requests for medical records
and claims by facility and by state, and use that information,
along with operational performance measures, to assess whether
we should dispose of additional facilities. At the present time,
we have no significant divestiture plans.

As of December 31, 2004, we have provided
for $37.0 million in accruals for known or potential
general and professional liability claims based on claims
experience and an independent actuarial review; however, we may
need to increase our accruals in excess of the amounts we have
accrued as a result of future actuarial reviews and claims that
may develop. An adverse determination in legal proceedings,
whether currently asserted or arising in the future, could have
a material adverse effect on our business. See the
Business  Insurance section in this
Annual Report on Form 10-K.

The shortage of qualified registered nursing
staff and other healthcare workers could adversely affect our
ability to attract, train and retain qualified personnel and
could increase operating costs.A
national shortage of nurses and other trained personnel, and
general inflationary pressures have forced us to enhance our
wage and benefits packages in order to compete for qualified
personnel. According to a survey by the American Healthcare
Association, or AHCA, issued in February 2003, there were over
96,000 vacant positions in the long-term care sector, of which
39,000 were professional nursing staff and the remainder
certified nursing assistants, or CNAs. The survey reported that
average turnover within the industry was 50% with a 36% turnover
rate for professional staff, and 71% turnover rate for CNAs.
However, the report sited that these turnover and vacancy levels
varied by state and location of the facility. Looking into the
future, the shortage of

11



---



##### Table of Contents



nurses is documented by the U.S. Labor
Department, which reports that there will be a 1.0 million
shortfall of professional nurses by 2010. In some of the markets
where we operate, there are shortages of healthcare workers.
This is supported by a report by the North Carolina Medical
Journal in March/ April 2002, which reported that between 2000
and 2010 there will be 874,000 more nursing workers needed in
the long-term care industry.


As a result of the shortage of nursing and
healthcare workers, our average wage rate has increased above
inflationary levels during the past few years. Wages increased
by approximately 4.8% in 2004 over 2003, and 3.8% in 2003 over
2002. However overall wage costs, as a percentage of revenues,
have been reduced due to the wage strategies that we have
implemented particularly in 2003. In order to supplement
staffing levels, we periodically are forced to utilize costly
temporary help from staffing agencies, which results in wage
premiums of 25% to 60%. We attempt to limit the use of temporary
help from staffing agencies to maintain a higher quality of
care. In 2004, we incurred temporary agency costs of
$2.9 million compared to $3.4 million in 2003 and
$10.2 million in 2002.

We conduct our business in a heavily regulated
industry and our failure to comply with laws and government
regulation could lead to fines and
penalties.We must comply with complex
laws and regulations at the federal, state and local government
levels relating to, among other things:



| |   |                                                                                      
| | - | -------------------------------------------------------------------------------------
| |  | licensure and certification;                                                         
|
| |  | qualifications of healthcare and support
    personnel;                              
|
| |  | maintenance of physical plant and equipment;                                         
|
| |  | staffing levels and quality of healthcare
    services;                              
|
| |  | maintenance, confidentiality and security issues
    associated with medical records;
|
| |  | relationships with physicians and referral
    sources;                              
|
| |  | billing for services;                                                                
|
| |  | operating policies and procedures; and                                               
|
| |  | additions or changes to facilities and services.                                     

There are ongoing initiatives at the federal and
state levels for comprehensive reforms affecting the payment for
and availability of healthcare services. In addition,
regulations and policies of regulatory agencies are subject to
change. Aspects of some of these healthcare initiatives, such as
the termination of Medicare funding improvements and limitations
on Medicare coverage, other pressures to contain healthcare
costs by Medicare, Medicaid and other payors, as well as
increased operational requirements in the administration of
Medicaid, could adversely affect our financial condition or our
results of operations. Revisions to regulatory requirements,
changes in scope and quality of care to residents and revisions
to licensure and certification standards also could potentially
have a material impact on us. In the future, different
interpretations or enforcement of existing, new or amended laws
and regulations could result in allegations of impropriety or
illegality or could result in changes requiring capital
expenditure programs and higher operating expenses.

If we do not comply with applicable laws and
regulations, then we could be subject to liabilities, including
criminal penalties and civil penalties and exclusion of one or
more of our facilities from participation in Medicare, Medicaid
and other federal and state healthcare programs. If one of our
facilities lost its certification under either the Medicare or
Medicaid program, then it would have to cease future admissions
and displace residents funded by the programs from the facility.
In order to become re-certified, a facility must rectify all
identified deficiencies and, over a specified period of time,
pass a survey conducted by representatives of the respective
program through demonstrated care and operations for residents
in the facility. Until the appropriate agency has verified
through the reasonable assurance process that the
facility can achieve and maintain substantial compliance with
all applicable participation requirements, the facility will not
be admitted back into either the Medicare or Medicaid programs.
Medicare and Medicaid re-certification processes, while similar,
are conducted separately. Re-certification requires considerable
staff resources. The

12



---



##### Table of Contents



loss of certification from either program can
have potentially significant financial consequences. Over the
past years, we have operated a number of facilities that have
lost their certification under the Medicare and Medicaid
programs but have since been re-certified under both programs.


In August 2004, we transferred the operations of
a nursing facility (336 beds) in Chippewa Falls, Wisconsin to
Lakeside Health L.L.C., or Lakeside Health, a subsidiary of
Benedictine Health Dimensions, Inc., or Benedictine, for a term
of three years. The transfer of operations was in response to
facility citations for survey deficiencies and an agreement with
the State of Wisconsin to transfer the operations to a new
licensee.

If we do not achieve and maintain competitive
quality of care ratings from CMS our business may be negatively
affected.CMS provides comparative
data available to the public on its website rating every nursing
facility operating in each state based upon nine quality of care
indicators. These quality of care indicators include such
measures as percentages of patients with infections, bedsores
and unplanned weight loss. We currently monitor the comparative
data posted on the website to respond to potential consumers
should questions arise. If we are unable to achieve quality of
care ratings that are comparable or superior to those of our
competitors, our ability to attract and retain patients could be
affected and, as a result, our occupancy levels could decline.

Changes in the case mix of residents, the mix
of residents by payor type and payment methodologies may
significantly affect our
profitability.The sources and amounts
of our resident revenues will be determined by a number of
factors, including licensed bed capacity and occupancy rates of
our nursing facilities, average length of stay of our residents,
the mix of residents by payor type (for example, Medicare versus
Medicaid or private), and, within the Medicare and certain
Medicaid programs, the distribution of residents assessed within
the RUGs. Changes that increase the percentage of Medicaid
residents within our facilities can have a material adverse
effect on our financial operations, especially in states whose
reimbursement levels are below the cost of providing care.

If we fail to cultivate new or maintain
existing relationships with the physicians in the communities in
which we operate, our patient base may
decrease.Our success depends in part
upon the admissions and referral practices of the physicians in
the communities in which we operate and our ability to cultivate
and maintain relationships with these physicians. Physicians
referring patients to our facilities are not our employees and
are free to refer their patients to other providers. If we are
unable to successfully cultivate and maintain strong
relationships with these physicians, our patient population may
decline.

We face national, regional and local
competition.Our nursing and assisted
living facilities compete on a local and regional basis with
other long-term care providers. The number of competing centers
in the local market, the types of services available, quality of
care, reputation, age and appearance of each center and the cost
of care in each locality all affect our ability to compete
successfully. The availability and quality of competing
facilities significantly influence occupancy levels in assisted
living facilities. There are relatively few barriers to entry in
the assisted living industry and, therefore, future development
of assisted living facilities in the markets we serve could
limit our ability to attract and retain residents, to maintain
or increase resident service fees or to expand our business. See
the Business  Competition section in this
Annual Report on Form 10-K.

State efforts to regulate the construction or
expansion of healthcare providers could impair our ability to
expand through construction and
redevelopment.Most of the states in
which we currently operate have adopted laws to regulate
expansion of nursing facilities. Certificate of need laws
generally require that a state agency approve certain
acquisitions or physical plant changes and determine that a need
exists prior to the addition of beds or services, the
implementation of the physical plant changes or the incurrence
of capital expenditures exceeding a prescribed amount. Some
states also prohibit, restrict or delay the issuance of
certificates of need. Many states have established similar
certificate of need processes to regulate the expansion of
assisted living facilities.

If certificates of need or other similar
approvals are required in order to expand our operations, our
failure or inability to obtain the necessary approvals, changes
in the standards applicable to such approvals and

13



---



##### Table of Contents



possible delays and expenses associated with
obtaining such approvals could adversely affect our ability to
expand and, accordingly, to increase our revenues and earnings.
We cannot assure you that we will be able to obtain a
certificate of need or other regulatory approval for all future
projects requiring such approval.


Many states in which we operate have implemented
moratoriums on the granting of licenses for any additional
nursing facility beds. In these states we may only expand by
acquiring existing operations and licensure rights from other
nursing care providers. We cannot guarantee that we will be able
to find acceptable acquisition targets in these states and, as a
result, we may not be able to expand in these states.

We face periodic reviews, audits and
investigations under our contracts with federal and state
government agencies, and these audits could have adverse
findings that may negatively impact our
business.As a result of our
participation in the Medicare and Medicaid programs, we are
subject to various governmental reviews, audits and
investigations to verify our compliance with these programs and
applicable laws and regulations. Private pay sources also
reserve the right to conduct audits. An adverse review, audit or
investigation could result in:



| |   |                                                                                                                        
| | - | -----------------------------------------------------------------------------------------------------------------------
| |  | refunding amounts we have been paid pursuant to
    the Medicare or Medicaid programs or from private payors;          
|
| |  | state or federal agencies imposing fines,
    penalties and other sanctions on us;                                     
|
| |  | loss of our right to participate in the Medicare
    or Medicaid programs or one or more private payor
    networks; or
|
| |  | damages to our reputation in various markets.                                                                          

Both federal and state government agencies have
heightened and coordinated civil and criminal enforcement
efforts as part of numerous ongoing investigations of healthcare
companies and, in particular, skilled nursing facilities. The
focus of these investigations includes:



| |   |                                                       
| | - | ------------------------------------------------------
| |  | cost reporting and billing practices;                 
|
| |  | quality of care;                                      
|
| |  | financial relationships with referral
    sources; and
|
| |  | medical necessity of services provided.               

We also are subject to potential lawsuits under a
federal whistleblower statute designed to combat fraud and abuse
in the healthcare industry. These lawsuits can involve
significant monetary and award bounties to private plaintiffs
who successfully bring these suits.

We are required to comply with laws governing
the transmission and privacy of health
information.The Health Insurance
Portability and Accountability Act of 1996, or HIPAA, requires
us to comply with standards relating to the privacy of protected
health information, the exchange of health information within
our company and with third parties and protect the
confidentiality and security of electronic protected health
information. The privacy standards became effective in April
2003, and we believe we are currently in compliance with these
standards. The standards for electronic data transactions and
code sets became effective in October 2003. We have implemented
the new transaction and code sets with all fiscal intermediaries
and the states that are currently ready to accept them. We
believe we are in compliance with the transaction and code sets
standards. Compliance for the standard governing the security of
health information is required by April 21, 2005.

We established a HIPAA task force consisting of
clinical, legal, financial and information services
professionals to monitor our implementation of and compliance
with the HIPAA standards. At this time, we believe we comply
with the HIPAA privacy and transactions and code set standards
and continue to implement procedures to comply with the security
standards. Our ability to comply with the transactions standards
and security standards are in part, dependent upon other third
parties, including the fiscal intermediaries and state program
providers also complying with the HIPAA requirements and
timetables. Should it be determined that we have not complied
with the new standards, we could be subject to criminal

14



---



##### Table of Contents



penalties and civil sanctions. We do not believe
our on-going implementation to comply with the HIPAA standards
will have a material impact on our consolidated financial
statements.


We may make acquisitions and undertake
management and consulting contracts that could subject us to a
number of operating risks.We
anticipate that we may continue to make acquisitions of,
investments in, and strategic alliances with, complementary
businesses which will enable us to provide additional services
for our customer base and for adjacent markets, and to expand
each of our businesses geographically. In addition, we may
undertake management and consulting service arrangements with
other organizations. Implementation of these strategies entails
a number of risks including:



| |   |                                                                                                                        
| | - | -----------------------------------------------------------------------------------------------------------------------
| |  | inaccurate assessment of undisclosed liabilities;                                                                      
|
| |  | entry into markets in which we may have limited
    or no experience;                                                  
|
| |  | diversion of managements attention from our
    existing core business;                                               
|
| |  | difficulties in assimilating the acquired
    business or in realizing projected efficiencies and cost
    savings; and
|
| |  | increasing our indebtedness and limiting our
    ability to access additional capital when needed.                     

Additionally, certain changes to our existing
operation may be necessary to integrate the acquired businesses,
to assimilate new employees and to implement reporting,
monitoring, compliance and forecasting procedures.

On January 31, 2005, we completed our
acquisition of ALC for a total of approximately
$285 million, including the assumption of ALCs
existing debt of $141 million. Prior to the completion of
the acquisition, we conducted a due diligence review to
ascertain the risks associated in the acquisition. Though we
believe these due diligence efforts identified and correctly
quantified those risks, by virtue of this acquisition we assume
all current and former financial, legal, regulatory and
environmental risks associated with ALC by virtue of this
acquisition. In addition, there are risks associated with the
integration of ALC within our company. During the integration
process, there will be considerable resources deployed which may
divert our attention from other portions of our operations. The
integration may result in changes in senior and middle
management personnel at ALC, and changes or modifications to the
accounting systems, information software and hardware, and other
business processes. Those risks can not be quantified nor
estimated at this time.

We are required to comply with Sarbanes Oxley
Act of 2002, Section 404, or SOX, that involves an in-depth
evaluation of our internal controls and compliance with the
reporting requirements mandated for non-accelerated filers by
December 31, 2006.To comply with
Section 404, we are required to conduct a thorough
assessment of the effectiveness of our internal control
structure and procedures for financial reporting to ascertain
whether those controls are sufficient to prevent a material
misstatement of our financial statements. The requirements of
SOX are extensive and will involve considerable internal
resources and the use of external consultants. At the date of
this Annual Report on Form 10-K, we are on schedule with
the assessment, however there can be no assurance that we will
not uncover internal control weaknesses that will require
disclosure in our SEC filings, nor additional resources to
rectify the deficiencies identified.

If we are unable to control operating costs
and generate sufficient cash flow to meet operational and
financial requirements, including servicing our indebtedness,
our business operations may be adversely
affected.Cost containment and lower
reimbursement levels by third party payors, including federal
and state governments, have had a significant impact on the
healthcare industry as a whole and on our cash flows. Our
operating margins continue to be under pressure because of
continuing regulatory scrutiny and growth in operating expenses,
such as labor costs and insurance premiums. In addition, as a
result of competitive pressures, our ability to maintain
operating margins through price increases to private residents
is limited. If we are unable to generate sufficient cash flow to
service our indebtedness, our business operations will be
materially adversely affected. As of December 31, 2004, we
were in compliance with the financial covenants of our credit
facility, Subordinated Notes and Senior Notes, and management
has a strategy to remain in compliance. However, there can be no
assurance that we will comply with our debt covenant
requirements in the future. If we are unable to do so, our
business operations may be materially adversely affected.

15



---



##### Table of Contents






Operations



Overview of Business

Organizational Structure of
Operations

We have centralized various functions, which are
provided from our corporate office, and direct our operations
from five regional offices in close proximity to our facilities.
The regional office staff is responsible for overseeing all
operational aspects of our facilities, including resident care,
rehabilitative services, recruitment and personnel matters,
compliance with state regulatory requirements, marketing and
sales activities, internal control and accounting support, and
participation in state associations. At our corporate offices,
staff members are responsible for the development and
implementation of corporate-wide policies pertaining to resident
care, employee hiring, training and retention, marketing
initiatives and strategies; accounting and finance functions
including billing and collection, accounts payable, payroll,
general finance and accounting, tax planning and compliance; and
providing overall strategic direction.

Our operations are organized into a number of
different direct and indirect wholly owned subsidiaries
primarily for legal purposes. We manage our operations as a
single unit. Operating policies and procedures are substantially
the same in each subsidiary. Several of our subsidiaries own and
operate a significant number of our total portfolio of
facilities. No single facility generates more than 2% of total
revenues. Our nursing home operations represent the largest
portion of our business, comprising approximately 93% of our
revenues. Below is a summary of each of our business operations.

Nursing Care

We provide a broad range of long-term nursing
care, including nursing services, subacute care and
rehabilitative therapy services, to assist patients in the
recovery from acute illness or injury. We provide nursing care
and therapy services to persons who do not require the more
extensive and specialized services of a hospital. Our nursing
facilities employ registered nurses, licensed practical nurses,
therapists, certified nursing assistants and qualified
healthcare aides who provide care as prescribed by each
residents attending physician. All of our nursing
facilities provide daily dietary services, social services and
recreational activities, as well as basic services such as
housekeeping and laundry.

Assisted Living and Retirement
Facilities

In our assisted living facilities, we provide
residential accommodations, activities, meals, security,
housekeeping and assistance in the activities of daily living to
seniors who require some support, but not the level of nursing
care provided in a nursing facility. Our retirement communities
provide activities, security, transportation, special amenities,
comfortable apartments, housekeeping services and meals. Our
assisted living facilities enhance the value of an existing
nursing facility in situations where the two facilities operate
side by side. This allows us to better serve the communities in
which we operate by providing a broader continuum of services.
Most of our assisted living facilities are within close
proximity to our nursing facilities.

The term assisted living facility
encompasses a broad spectrum of senior living services and care
options, which include independent living, assisted living and
different levels of skilled nursing care. Independent living is
designed to meet the needs of seniors who choose to live in an
environment surrounded by their peers where they receive
services such as housekeeping, meals and activities, but are not
reliant on assistance with activities of daily living (for
example, bathing, eating and dressing). Assisted living meets
the needs of seniors who seek housing with supportive care and
services or who are receiving rehabilitative services. We offer
both independent living and assisted living services in our
assisted living facilities.

Management and Selected Consulting
Services

We apply our operating expertise and knowledge in
long-term care by providing either full management services or
selected consulting services to third parties.

16



---



##### Table of Contents



Through our wholly owned subsidiary, Partners
Health Group, LLC, we provide full management services utilizing
our experienced professionals who have considerable knowledge
and expertise in both the operational and administrative aspects
of the long-term care industry. Under our full management
contracts, we consult on all aspects of operating a long-term
care facility, including the areas of nursing, dietary, laundry
and housekeeping. Contracts are generally structured on a
fee-for-service basis and generally have terms ranging from one
to five years.

Through our wholly owned subsidiary, Fiscal
Services Group, LLC, we provide selected consulting services,
which include selected accounting or cost reimbursement
services. Accounting services can include billing, accounts
receivable tracking, payroll, invoice processing, financial
reporting, tax and cost reimbursement services. Contracts are
generally structured on a fee-for-service basis and generally
have terms ranging from one to five years.

In addition, Virtual Care Provider, Inc., a
wholly owned subsidiary of our Canadian parent, Extendicare,
provides information technology services to us and unrelated
third parties on a fee-for-services basis.

Group Purchasing

Through Extendicare Health Network, Inc., one of
our wholly owned subsidiaries, we provide purchasing services
for nursing facilities in numerous states, as well as to the
facilities we own or manage. We offer substantial cost
reductions for members of the purchasing groups through the
contractual volume-based arrangements made with a variety of
industry suppliers of food, supplies and capital equipment. As
of December 31, 2004, our group purchasing operations
provided purchasing services for 4,899 facilities in
48 states.

Rehabilitative Therapy  Outpatient
and Inpatient Services

We operate rehabilitative therapy clinics within
three wholly owned subsidiaries being The Progressive Step
Corporation, Health Poconos, Inc. and Adult Services Unlimited,
Inc. As of December 31, 2004, we operated 21 clinics:
eleven in Pennsylvania, one in Ohio, two in Texas and seven in
Wisconsin. These clinics provide services to outpatients
requiring physical, occupational and/or speech-language therapy.
In addition, our Pennsylvania clinics provide respiratory and
psychological and social services.

We provide rehabilitative therapy services on
both an inpatient and outpatient basis. We have developed
therapy programs to provide patient-centered, outcome-oriented
subacute and rehabilitative care. At the majority of our
facilities, we employ physical, occupational and/or
speech-language therapists who provide rehabilitative therapy
services to both inpatient and outpatient clients.

Expansion

Plans for expanding our operations are developed
from sources such as:



| |   |                                                                                                                                     
| | - | ------------------------------------------------------------------------------------------------------------------------------------
| |  | personal contacts that we have in the long-term
    care industry;                                                                  
|
| |  | information made available to us, and that we
    make available to others, through state and nationally based
    associations; and
|
| |  | investment and financing firms and brokers.                                                                                         

All acquisitions and undertakings of new
contracts for management and consulting services involve a
process of due diligence in which the operational, building and
financial aspects of the transactions are investigated.




Sources of Revenue

Nursing Facilities

We estimate that, for our nursing facilities
only, Medicare and Medicaid accounted for approximately 32% and
51% of our revenues, respectively, in 2004, compared to 29% and
52% of our revenues in 2003, and

17



---



##### Table of Contents



27% and 54% of our revenues in 2002. These payors
have set maximum reimbursement levels for payments for nursing
services and products. The healthcare policies and programs of
these agencies have been subject to changes in payment
methodologies during the past several years. There can be no
assurance that future changes will not reduce reimbursements for
nursing services from these payors. Below is a description of
each of the major payors.


Medicaid

Medicaid is a state-administered program financed
by state funds and matching federal funds, providing health
insurance coverage for certain persons in financial need,
regardless of age, and which may supplement Medicare benefits
for financially needy persons aged 65 or older. Medicaid
reimbursement formulas are established by each state with the
approval of the federal government in accordance with federal
guidelines. Generally, 50% of the funds available under these
programs are provided by the federal government under a matching
program. Medicaid programs currently exist in all of the states
in which we operate nursing facilities. These programs vary in
certain respects from state to state.

In August 1997, the BBA was signed into law and
broadened the authority of states to develop their own standards
for the establishment of rates. The BBA repealed the federal
payment standard that required state Medicaid programs to pay
rates that were reasonable and adequate to meet the costs
necessary to efficiently and economically operate skilled
nursing facilities. As a result, states have considerable
flexibility in establishing payment rates for Medicaid services
provided after October 1, 1997. The law requires each state
to use a public process for establishing proposed rates whereby
the methodology and justification of rates used are available
for public review and comment. Due to the economic slowdown and
costs attributable to September 11, 2001, many states have
had to restrain their budgets of which Medicaid represents a
significant portion.

The states in which we operate currently use
cost-based or price-based reimbursement systems. Under
cost-based reimbursement systems, the facility is reimbursed for
the reasonable direct and indirect allowable costs it incurs in
providing routine resident care services as defined by the
program. In certain states, efficiency incentives are provided
and facilities may be subject to cost ceilings. Reasonable costs
normally include certain allowances for administrative and
general costs, as well as the cost of capital or investment in
the facility, which may be transformed into a fair rental or
cost of capital charge for property and equipment. The
price-based or modified price-based systems pay a provider at a
certain payment rate irrespective of the providers cost to
deliver the care. Price-based or modified price-based systems
may use various methods, such as state averages from a specific
base year, to determine the base cost, which could be subject to
inflationary increases.

The reimbursement formulas employed by the state
may be categorized as prospective or retrospective in nature.
Under a prospective cost-based system, per diem rates are
established based upon the historical cost of providing services
during a prior year, adjusted to reflect factors such as
inflation and any additional service required to be performed.
Many of the prospective payment systems under which we operate
contain an acuity measurement system, which adjusts rates based
on the care needs of the resident. Retrospective systems operate
similar to the pre-PPS Medicare program where nursing facilities
are paid on an interim basis for services provided, subject to
adjustments based on allowable costs, which are generally
submitted on an annual basis.

Medicare  Part A and
Part B

Medicare is a federally funded health-insurance
program providing health insurance coverage for persons aged 65
or older, who have been disabled for at least two consecutive
years or who have end-stage renal disease. Medicare provides
health insurance benefits in two parts:



| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | Part A  Hospital insurance, which
    provides reimbursement for inpatient services for hospitals,
    skilled nursing facilities and certain other healthcare
    providers and patients requiring daily professional skilled
    nursing and other rehabilitative care. Coverage in a skilled
    nursing facility is limited for a period up to 100 days, if
    medically necessary, after a qualifying hospital stay. Medicare
    pays for the first 20 days of

18



---



##### Table of Contents



| |   |                                                                                                                                                                                                                                                                                                                                                                     
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |   | stay in a skilled nursing facility in full and
    the next 80 days above a daily coinsurance amount, after
    the individual has qualified for Medicare coverage by a
    three-day hospital stay.                                                                                                                                                                
|
| |  | Part B  Supplemental Medicare
    insurance, which requires the beneficiary to pay monthly
    premiums will cover physician services and other outpatient
    services, such as physical, occupational, and speech therapy
    services, enteral nutrition, certain medical items, and X-ray
    services received outside of a Part A covered inpatient
    stay.

Under Medicare  Part A, the
nursing facility is reimbursed based upon the acuity level of
the Medicare resident. Acuity is determined by classifying the
resident into one of 44 RUGs categories based upon the nature of
the residents condition and services needed. CMS adjusts
the Medicare rates for the 44 RUGs categories on an annual basis
on October 1st each year, and inflates the RUGs rates
based upon an inflation factor referred to as the market
basket. Under Medicare  Part B, the
nursing facility is reimbursed based upon defined fee
screen rates established by CMS.

Private Pay and Other

Private pay and other sources consist of
individuals or parties with contractual obligations to the
residents such as private insurance companies, HMOs, PPOs, other
charge-based payment sources, HMO Medicare risk plans, Blue
Cross and the Department of Veterans Affairs.

Assisted Living Facilities

Assisted living facility revenue is primarily
derived from private pay residents at rates we establish based
upon the services we provide and market conditions in the area
of operation. Approximately 40 states provide or have
approval to provide Medicaid reimbursement for board and care
services provided in assisted living facilities. For the year
end December 31, 2004, our assisted living facility revenue
was $38.3 million, of which $35.1 million, or 91.6%,
was from private pay residents and the balance from Medicaid.
With our acquisition of ALC on January 31, 2005, we expect
our future revenues from assisted living facilities to increase.
ALCs unaudited revenues for the year ended
December 31, 2004 were approximately $176.0 million,
of which $133.1 million or 75.6% were from private pay
residents, and the balance from Medicaid.

Rehabilitation Therapy and Other
Revenues

We derive outpatient therapy revenues by
providing rehabilitation therapy services to outside third
parties at our clinics. The revenue sources are primarily
HMOs and commercial insurance (46%), workers
compensation (23%), Medicare (22%), Medicaid (4%) and other
sources, including self-pay clients (5%).

Management and consulting fees are paid directly
from the long-term care organizations with which we contract to
provide services.




Quality of Care and Employee
Training

Quality of Care

Our Commitment to Residents
emphasizes our corporate-wide philosophy of treating residents
with dignity and respect, a philosophy that we implement and
monitor through rigorous standards that we periodically assess
and update.

We have established a Medical Advisory Board,
which is comprised of a medical director representing each of
our regions. The purpose of the Medical Advisory Board is to
review and attest to our key clinical protocols, to review and
clarify roles and responsibilities of medical directors at our
facilities and to improve communication between medical
directors and our facilities.

Our corporate clinical services department
establishes corporate nursing and quality of life standards,
monitors issues and trends in the industry and implements our
policies and procedures. Training programs are developed at the
corporate level and implemented throughout the company as
required. In addition, the corporate clinical services
department conducts, as required, periodic pre-survey and
post-survey reviews.

19



---



##### Table of Contents



At a regional level, our area directors of care
management lead a department that is primarily responsible for
establishing care and service standards, policies and procedures
and auditing care and service delivery systems. They also
provide direction and training for all levels of the staff
within the nursing facilities and assisted living facilities.
Our area directors of care management develop programs and
standards for all professional disciplines and services provided
to our customers, including nursing, dietary, social services,
activities, ethical practices, mental health services, behavior
management, quality validation and continuous quality
improvement.

We participate on a national level in the Quality
First Initiative, which is voluntary national program whose
members include major long-term care providers. The objectives
of the Quality First Initiative are to discuss and promote
awareness to assist members adhere to current regulations,
promote clinical outcomes and improve consumer satisfaction and
publicly demonstrate our commitment to quality care.

Employee Training

Employee training at all levels is an integral
part of our ongoing efforts to improve and maintain our service
quality. Each new nursing facility administrator and assisted
living facility manager or director of nursing is required to
attend a week of company-provided training to ensure that he or
she understands all aspects of nursing facility operations,
including clinical, management and business operations. We
conduct additional training for these individuals and all other
staff on a regional or local basis. For department heads and
senior professional nursing staff, we provide a modular based
supervisory training program, which is taken over a twelve-month
period and is conducted within each of our facilities.




Employees

As of December 31, 2004, we employed
approximately 18,100 people, including approximately 3,600
registered and licensed practical nurses, 7,100 nursing
assistants, 1,900 therapists, 4,100 dietary, domestic,
maintenance and other staff and 1,400 administrative employees
who work at our corporate offices and facilities.

As one of the largest employers within the
long-term care industry, we have been subject to the
organizational efforts of certain unions. For several months
starting in September 2004, we were subject to organizational
efforts by the Service Employees International Union, or SEIU,
at seven of our nursing facilities. However SEIU was not
successful in achieving a union at any of these owned
facilities. As of December 31, 2004, approximately 12% of
our employees located in 32 of our nursing and assisted living
facilities are represented by various labor unions. We have
approximately 35 collective bargaining agreements, 23 of which
expire within 12 months of March 31, 2005, among six
unions covering approximately 2,100 employees. As of
December 31, 2004 we were in the process of negotiating
seven of these collective bargaining agreements. As of the date
of filing this Annual Report on Form 10-K, we have
completed negotiations relating to six of these collective
bargaining agreements. To date, our facilities have never
experienced any material work stoppage and we believe that we
have a good relationship with all of our employees. However, we
cannot predict the effect continued union representation or
organization activities will have on our future operations.

The national shortage of nurses and other trained
personnel have required us to adjust our wage and benefits
packages to compete in the healthcare marketplace. We compete
for such employees with other healthcare providers within the
long-term care industry and the broader healthcare sector. We
also compete with various industries for certified nursing
assistants and other lower-wage employees. We have been
successful in reducing the level of temporary staff, for which
we have to pay a premium and may reduce the quality of care.
However, we continue to face challenges in recruiting and
retaining qualified personnel. We also are subject to increasing
levels of reference checks and criminal background checks on our
hired staff to ensure that they are suitable for the functions
they will perform within our facilities. Our inability to
control labor availability and costs could have a material
adverse effect on our future operating results.

20



---



##### Table of Contents






Marketing

Most of our long-term care facilities are located
in smaller urban communities. We focus our marketing efforts
predominantly at the local level. We believe that residents
selecting a long-term care facility are strongly influenced by
word-of-mouth and referrals from physicians, hospital discharge
planners, community leaders, neighbors and family members. The
administrator of each long-term care facility is, therefore, a
key element of our marketing strategy. Each administrator is
responsible for developing relationships with potential referral
sources. Administrators are supported by a regional team of
marketing personnel, who establish the overall marketing
strategy, develop relationships with HMO and PPO organizations
and provide marketing direction with training and community
specific promotional materials. Our goal is to be the provider
of choice in the communities we serve.




Competition

The long-term care industry in the United States
is highly competitive with companies offering a variety of
similar services. We face local and regional competition from
other healthcare providers, including for-profit and
not-for-profit organizations, hospital-based nursing units,
rehabilitation hospitals, home health agencies, medical supplies
and services agencies and rehabilitative therapy providers.
Newer assisted living facilities may attract potential and
existing residents. Significant competitive factors affecting
the placement of residents in nursing and assisted living
facilities include quality of care, services offered,
reputation, physical appearance, location and, in the case of
private pay residents, cost of the services.

Our group purchasing and management and
consulting services groups compete with similar operations in
the long-term care industry.

We also compete with other providers in the
acquisition and development of additional facilities. Other
competitors may accept a lower rate of return, and therefore,
present significant price competition. Also, tax-exempt
not-for-profit organizations may finance acquisitions and
capital expenditures on a tax-exempt basis or receive charitable
contributions unavailable to us.




Government Regulation

Various federal, state and local governmental
authorities in the United States regulate the provision of
institutional care and healthcare services. Though we believe
our operations comply with the laws governing our industry, we
cannot guarantee that we will be in absolute compliance with all
regulations at all times. Failure to comply may result in
significant penalties, including exclusion from the Medicare and
Medicaid programs, which could have a material adverse effect on
our business. We cannot assure you that governmental authorities
will not impose additional restrictions on our activities that
might adversely affect our business. In addition to the
information presented below, please see the Risk
Factors section in this Annual Report on Form 10-K.

General Regulatory
Requirements

Nursing facilities, assisted living facilities
and other healthcare businesses are subject to licensure and
other state and local regulatory requirements. In addition, in
order for a nursing facility to be approved for payment under
the Medicare and Medicaid reimbursement programs, it must meet
the participation requirements of the Social Security Act and
related regulations. The regulatory requirements for nursing
facility licensure and participation in Medicare and Medicaid
generally prescribe standards relating to provision of services,
resident rights, staffing, employee training, physical
environment and administration. Nursing and assisted living
facilities are generally subject to unannounced annual
inspections by state or local authorities for purposes of
licensure, and in the case of nursing facilities, for purposes
of certification under Medicare and Medicaid. These surveys will
also confirm whether a nursing facility continues to meet
Medicare and Medicaid participation standards. As of
December 31, 2004, all of our nursing facilities are
licensed under applicable state laws and all of our nursing
facilities are certified to participate in either the Medicare
program, the Medicaid program, or both.

21



---



##### Table of Contents



Nursing Facility Regulation

CMS has established regulations to implement
survey, certification and enforcement procedures. The survey
process is intended to review the actual provision of care and
services, with an emphasis on resident outcomes, to determine
whether the care provided meets the assessed needs of the
individual residents. Surveys are generally conducted on an
unannounced annual basis by state survey agencies. Remedies are
assessed for cited deficiencies based upon the scope and
severity of the cited deficiencies. The regulations specify that
the remedies are intended to motivate facilities to return to
compliance and to facilitate the removal of chronically poor
performing facilities from the Medicare or Medicaid programs.
Remedies range from:



| |   |                                                                                                                                                                                                                                      
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | directed plans of correction, directed in-service
    training and state monitoring for minor deficiencies;                                                                                                                          
|
| |  | denial of Medicare or Medicaid reimbursement for
    existing residents or new admissions, and civil money penalties
    up to $3,000 per day for deficiencies that do not
    immediately jeopardize resident health and safety; and
|
| |  | appointment of temporary management, termination
    from the program and civil money penalties of up to $10,000 for
    one or more deficiencies that immediately jeopardize resident
    health or safety.                         

The regulations allow state survey agencies to
identify alternative remedies that must be approved by CMS prior
to implementation.

Facilities with acceptable regulatory histories
generally are given an opportunity to correct deficiencies by a
date certain, usually within six months. CMS will continue
payments and refrain from imposing sanctions within the
correction period, unless the facility does not return to
compliance within the specified time period. Facilities with
deficiencies that immediately jeopardize resident health and
safety and those that are classified as poor performing
facilities are not given an opportunity to correct their
deficiencies prior to the assessment of remedies. From time to
time, we receive notices from federal and state regulatory
agencies alleging deficiencies for failing to comply with
components of the regulations. While we do not always agree with
the positions taken by the agencies, we review all such notices
and take corrective action when appropriate. Due to the fact
that the regulatory process provides us with limited appeal
rights, many alleged deficiencies are not challenged even if we
do not agree with the allegation.

While we try to comply with all applicable
regulatory requirements, from time to time some of our nursing
facilities have been sanctioned as a result of deficiencies
cited by CMS or state survey agencies. We cannot assure you that
we will not be sanctioned in the future.

Federal law requires each state to have a
Medicaid Fraud Control Unit, which is responsible for
investigating provider fraud and resident abuse in Medicaid
funded facilities. We are aware of an investigation by this unit
in Kentucky, but this investigation has been inactive for a
substantial period of time. During 2004, we had an investigation
concerning resident care and funds received for Certified Nurse
Assistant training at the Lakeside facility before the
operations were transferred to Lakeside Health under a lease
arrangement. As of December 31, 2004, we were in the final
negotiations with the State to settle all of these issues and
have accrued for known and estimated fines and penalties to be
assessed. In March 2005, we reached settlement with the state
for the $2.3 million we accrued.

The CMS Nursing Home Quality
Initiative

CMS launched in April 2002 a Nursing Home Quality
Initiative to provide consumers with comparative information
about nursing home quality measures, which rates every nursing
facility on nine quality of care indicators. These quality of
care indicators include such measures as percentages of patients
with infections, bedsores and unplanned weight loss and this
comparative data is available to the public on the CMS website.
We believe that, though the information is important to share
with the public and may drive improvements in quality of care in
the long-term care industry, the data can be influenced by the
level of care and nature of admissions at a particular facility,
in addition to the quality of care.

22



---



##### Table of Contents



Restrictions on Acquisitions and
Construction

Acquisition and construction of additional
nursing facilities, changes in licensed bed capacity, or
facility closure are subject to state regulation. Most of the
states in which we currently operate have adopted laws to
regulate ownership transfer and expansion of nursing facilities.
Approvals must be obtained prior to a change of ownership, or
CHOW. Certificate of need laws generally require that a state
agency approve certain acquisitions or physical plant changes
and determine that a need exists prior to the addition of beds
or services, the implementation of the physical plant changes or
the incurrence of capital expenditures exceeding a prescribed
amount. Some states also prohibit, restrict or delay the
issuance of certificates of need, or have moratoriums on the
addition of licensed bed capacity. In addition, in most states
the reduction of beds or the closure of a facility requires the
approval of the appropriate state regulatory agency. Our nursing
facility expansions comply with all state regulations regarding
expansion. Prior to engaging in any regulated expansion project,
we obtain certificates of need, if required by law. If we decide
to reduce beds or close a facility, we could be adversely
affected by a failure to obtain or a delay in obtaining required
regulatory approval. To the extent that a certificate of need or
other similar approvals are required for expansion of our
operations, either through facility acquisitions, construction
of new facilities or additions to existing facilities, or
expansion or provision of new services or other changes, or to
the extent expansion in licensed bed capacity is otherwise
restricted, our expansion proposals could be adversely affected
by an inability to obtain the necessary approvals, changes in
the standards applicable to such approvals and possible delays
and expenses associated with obtaining such approvals.

Acquisition, construction and operation of
assisted living facilities are subject to less stringent
regulation than nursing facilities and, in the absence of
uniform federal regulations, states have developed their own
regulations. The majority of states have implemented regulations
regarding the acquisition, construction and operation of
assisted living facilities. Virtually every state has a
licensure process, registration process or some other form of
regulation that may apply to assisted living providers.
Depending on the level of services that an assisted living
provider supplies, the provider may be required to obtain a
license. Licensure regulations may be based on admission and
discharge criteria and the variety and type of services
provided. Many states require that potential operators submit
building plans and receive state approval prior to construction
of an assisted living facility. The approval process when
certificates of need are involved is more of a clearance
process, however, assisted living facilities must meet a
stringent set of building construction and design regulations
including the Life Safety Code (NFPA101). State regulators
conduct inspections of assisted living facilities on a periodic
basis that are similar to their inspections of nursing
facilities in most cases. As of December 31, 2004, we
believe all of our assisted living facilities were compliant in
all material respects with applicable state licensure, building
construction and design regulations.

Regulation of Fraud and Related
Matters

Because we participate in federal and state
healthcare programs, we are subject to a variety of federal and
state laws that are intended to prevent healthcare fraud and
abuse. These laws are punishable by criminal and/or civil
sanctions, including, in some instances, exclusion from
participation in federal health programs, including Medicare,
Medicaid and Department of Veterans Affairs health programs.
These laws, which include, but are not limited to, anti-kickback
laws, false claims laws, physician self-referral laws and
federal criminal healthcare fraud laws, are discussed in further
detail below. Management believes that we have been and continue
to be in substantial compliance with all of these laws as they
apply to us.

We believe our billing practices, operations and
compensation and financial arrangements with referral sources
and others materially comply with applicable federal and state
requirements. However, we cannot assure you that a governmental
authority will not interpret such requirements in a manner
inconsistent with our interpretation and application. If we fail
to comply, even inadvertently, with any of these requirements,
we could be required to alter our operations and/or refund
payments to the government. In addition, we could be subject to
significant penalties. Even if we successfully defend against
any action against us for violating these laws or regulations,
we would likely be forced to incur significant legal expenses
and divert our managements attention from the operation of
our business. Any of these actions, individually or in the
aggregate, could have a material adverse effect on our business
and financial results. We cannot reasonably predict whether

23



---



##### Table of Contents



enforcement activities will increase at the
federal or state level or the effect of any such increase on our
business.


The illegal remuneration provisions of the Social
Security Act make it a felony to solicit, receive, offer to pay
or pay any kickback, bribe or rebate in return for referring a
resident for any item or service or in return for purchasing,
leasing, ordering, recommending or arranging for any good,
facility, service or item, for which payment may be made under
the federal healthcare programs. A violation of the illegal
remuneration statute may result in the imposition of criminal
penalties, including imprisonment for up to five years, the
imposition of a fine of up to $25,000, civil penalties and
exclusion from participating in federal health programs.

Recognizing that the law is broad and may
technically prohibit beneficial arrangements, the Office of
Inspector General of the Department of Health and Human Services
developed regulations addressing those types of business
arrangements that will not be subject to scrutiny under the law.
These safe harbors describe activities that may technically
violate the act, but which are not to be considered illegal when
carried on in conformance with the regulations. For example, the
safe harbors cover activities such as contracting with
physicians or other individuals that have the potential to refer
business to us that would ultimately be billed to a federal
health program. Failure to qualify for safe harbor protection
does not mean that an arrangement is illegal. Rather, the
arrangement must be analyzed under the anti-kickback statute to
determine whether there is intent to pay or receive remuneration
in return for referrals. Conduct and business arrangements that
do not fully satisfy one of the safe harbors may result in
increased scrutiny by government enforcement authorities. In
addition, some states have anti-kickback laws that may apply
regardless of whether a federal healthcare program is involved.
Although our business arrangements may not always satisfy all of
the criteria of a safe harbor, we believe that as of
December 31, 2004, our operations were in material
compliance with federal and state anti-kickback laws.

Under the federal Stark II law,
physicians are prohibited from making a referral to an entity
for the furnishing of designated health services, including
therapy services for which Medicare or Medicaid may pay, if the
physician, or an immediate family member of the physician, has a
financial relationship, including ownership interests and
compensation arrangements, with that entity and the relationship
fails to meet a statutory or regulatory exception to the rule.
The penalties for violating this act include denial of payment,
additional financial penalties and exclusion from participating
in federal health programs. In addition, a number of states have
enacted their own versions of self-referral laws.

The Federal False Claims Act and similar state
statutes prohibit presenting a false or misleading claim for
payment under a federal program. Violations can result in
significant civil penalties, treble damages and exclusion from
participation in federal programs. Liability arises, primarily,
when an entity knowingly submits a false claim for reimbursement
to the federal government. However, enforcement over the past
few years has expanded the traditional scope of this act to
cover quality of care issues, especially in the skilled nursing
facility industry. In addition to the civil provisions of the
False Claims Act, the federal government may use several other
criminal statutes to prosecute persons who submit false or
fraudulent claims for payment to the federal government.

Federal law provides that practitioners,
providers and related persons may not participate in most
federal healthcare programs, including the Medicare and Medicaid
programs, if the individual or entity has been convicted of a
criminal offense related to the delivery of an item or service
under these programs or if the individual or entity has been
convicted under state or federal law, of a criminal offense
relating to neglect or abuse of residents in connection with the
delivery of a healthcare item or service. Other individuals or
entities may be, but are not required to be, excluded from such
programs under certain circumstances, including the following:



| |   |                                                            
| | - | -----------------------------------------------------------
| |  | conviction related to fraud;                               
|
| |  | conviction relating to obstruction of an
    investigation;
|
| |  | conviction relating to a controlled substance;             
|
| |  | licensure revocation or suspension;                        

24



---



##### Table of Contents





| |   |                                                                                                                                                                                                                                                                              
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | exclusion or suspension from state or other
    federal healthcare programs;                                                                                                                                                                                                 
|
| |  | filing claims for excessive charges or
    unnecessary services or failure to furnish medically necessary
    services;                                                                                                                                                      
|
| |  | ownership or control by an individual who has
    been excluded from the Medicaid and/or Medicare programs,
    against whom a civil monetary penalty related to the Medicaid
    and/or Medicare programs has been assessed or who has been
    convicted of the crimes; and
|
| |  | the transfer of ownership or control interest in
    an entity to an immediate family or household member in
    anticipation of, or following, a conviction, assessment or
    exclusion from the Medicare or Medicaid programs.                                            

Office of the Inspector General

The Office of Inspector General, or OIG, amongst
other priorities, identifies and eliminates fraud, abuse and
waste in certain federal healthcare programs. The OIG has
implemented a nationwide program of audits, inspections and
investigations and from time to time issues fraud
alerts to segments of the healthcare industry on
particular practices that are vulnerable to abuse. The fraud
alerts inform healthcare providers of potentially abusive
practices or transactions that are subject to criminal activity
and reportable to the OIG.

An increasing level of resources have been
devoted to investigation of allegations of fraud and abuse in
the Medicare and Medicaid programs, and federal and state
regulatory authorities are taking an increasingly strict view of
the requirements imposed on healthcare providers by the Social
Security Act and Medicare and Medicaid programs.

CrossDecertification and
De-Licensure

In some circumstances, if one facility is
convicted of abusive or fraudulent behavior, then other
facilities under common control or ownership may be decertified
from participating in Medicaid or Medicare programs. Executive
Order 12549 prohibits any corporation or facility from
participating in federal contracts if it or its principals have
been barred, suspended, ineligible, or have been voluntarily
excluded from participating in federal contracts. In addition,
some state regulations provide that all facilities under common
control or ownership licensed within a state may be de-licensed
if any one or more of the facilities are de-licensed. To date,
neither we nor our subsidiaries have experienced any
cross-decertifications and none of our subsidiaries
facilities have been de-licensed.

New Initiatives

There are ongoing initiatives at the federal and
state levels for comprehensive reforms affecting the payment for
and availability of healthcare services. Aspects of some of
these healthcare initiatives, such as the termination of
Medicare funding improvements and limitations on Medicare
coverage, other pressures to contain healthcare costs by
Medicare, Medicaid and other payors, as well as increased
operational requirements in the administration of Medicaid,
could adversely affect us. We cannot predict the ultimate
content, timing or effect of any healthcare reform legislation,
nor can we estimate the impact of potential legislation on us.

Environmental Laws and
Regulations

Some federal and state laws govern the handling
and disposal of medical, infectious and hazardous waste. If an
entity fails to comply with those laws or the related
regulations, the entity could be subject to fines, criminal
penalties and other enforcement actions. Federal regulations
established by the Occupational Safety and Health Administration
impose additional requirements on us with regard to protecting
employees from exposure to blood borne pathogens. We have
developed policies for the handling and disposal of medical,
infectious and hazardous waste to assure that each of our
facilities complies with those laws and regulations. We incur
ongoing operational costs to comply with environmental laws and
regulations. However, we have not had to make any material
capital expenditures to comply with such laws and regulations.
As of December 31,

25



---



##### Table of Contents



2004, we believe that we substantially comply
with applicable laws and regulations governing these
requirements.


As a result of fires in long-term care facilities
in recent years, states are reconsidering the laws governing the
requirement for facilities to have sprinklers systems. In
February 2004 the AHCA reaffirmed its position taken in October
2003 that nursing facilities nationwide be required to implement
sprinkler systems, provided that federal funding and/or low-cost
financing is made available for the installation of such
systems. As of December 31, 2004, we had approximately
24 facilities without sprinkler systems. However, as part
of a renovation plan announced in November 2003, we intend to
install sprinkler systems in the remaining facilities by
December 2006 for an estimated cost of $4.5 million.

Health Insurance Portability and
Accountability Act

The Health Insurance Portability and
Accountability Act of 1996, or HIPAA, requires us to comply with
standards for the exchange of health information within our
company and with third parties and protect the confidentiality
and security of health data. More specifically, HIPAA calls for:



| |   |                                                                                                                     
| | - | --------------------------------------------------------------------------------------------------------------------
| |  | standardization of electronic patient health,
    administrative and financial data;                                
|
| |  | unique health identifiers for individuals,
    employers, health plans and healthcare providers;                    
|
| |  | privacy standards protecting the privacy of
    individually identifiable health information; and                   
|
| |  | security standards protecting the confidentiality
    and integrity of individually identifiable health information.

The Department of Health and Human Services has
released three rules to date mandating the use of new standards
with respect to certain healthcare transactions and health
information.

The first rule established privacy standards,
which were released in December 2000 and then further revised in
August 2002. Most entities covered under HIPAA were required to
implement the privacy standards by April 2003. The privacy
standards are designed to protect the privacy of certain
individually identifiable health information. As a result, we
have updated our policies and procedures, conducted training for
our employees on the new standards and implemented procedures to
report violations of the new policies. We believe we are in
compliance with the privacy standards.

The second rule established standards for
electronic data transactions and code sets, as were outlined in
the final regulations of August 2000. These standards are
designed to allow entities to exchange medical, billing and
other information and to process transactions in a more
effective manner electronically. In compliance with the October
2003 effective date, we have implemented the new electronic
transaction and code sets with all fiscal intermediaries and the
states, which accept the new electronic data transactions and
code sets. We believe we are in compliance with the transaction
and code sets standards.

The third rule, issued in 2003, governs the
security of health information. Compliance with the security
regulations is required by April 21, 2005. The security
regulations apply only to electronic protected health
information, and have four main objectives to:



| |   |                                                                                                                                                                               
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | ensure the confidentiality, integrity and
    availability of protected health information that a covered
    entity creates, receives, maintains or transmits electronically;
|
| |  | protect against any reasonably anticipated
    hazards that might threaten the security or integrity of
    electronic protected health information;                          
|
| |  | protect against any unauthorized use or
    disclosure of electronic protected health information that can
    be reasonably anticipated; and                                 
|
| |  | ensure that the covered entitys workforce
    complies with the full range of security measures.                                                                             

Although HIPAA was intended to ultimately reduce
administrative expenses and burdens faced within the healthcare
industry, it is generally agreed that the implementation of this
law will result in additional costs to all healthcare
organizations in the short term. We established a HIPAA task
force consisting of clinical, legal, financial and information
services professionals to work on the project, and monitor the
implementation and compliance to the standards and procedural
changes within our organization. At this time, we believe we
fully comply with the HIPAA privacy and transactions standards.
Our ability to comply with the transaction

26



---



##### Table of Contents



and security standards is, in part, dependent
upon other third parties. Should it be determined that we have
not complied with the new standards, we could be subject to
criminal penalties and civil sanctions. We do not believe our
on-going implementation to comply with the HIPAA standards will
have a material impact on our consolidated financial statements.


Corporate Compliance Program

Our Corporate Compliance Program was developed to
ensure that we achieve our goal of providing a level of service
in a manner consistent with all applicable state and federal
laws and regulations, and our internal standards of conduct. Our
Corporate Compliance Program incorporates the elements included
in the OIG guidance. As part of our Corporate Compliance
Program, our employees must acknowledge their responsibility to
comply with relevant laws, regulations and policies, including
our Corporate Compliance Program. We have a Corporate Compliance
Officer responsible for administering our Corporate Compliance
Program who reports to the Board of Extendicare and our Chief
Executive Officer.



Insurance

We currently maintain insurance policies for
property coverage, workers compensation and
employers liability insurance in amounts and with such
coverage and deductibles as we believe adequate based on
availability, the nature and risks of our business, historical
experience and industry standards. These policies are obtained
through both affiliated subsidiaries of Extendicare and
third-party insurers. We self-insure for health and dental
claims, workers compensation and employers liability
in certain states. Management believes that, as of
December 31, 2004, our skilled nursing facilities, assisted
living facilities and rehabilitation therapy clinics were
adequately insured.

As a result of limited availability from
third-party insurers or availability at an excessive cost or
deductible, since January 2000, we generally self insure for
comprehensive general and professional liability (including
malpractice insurance for our health providers, assistants and
other staff, as it relates to their respective duties performed
on our behalf) up to a certain amount per incident. In January
2000, our retained risk for general and professional liability
coverage increased significantly resulting in us providing
accruals based upon past claims and actuarial estimates of the
ultimate cost to settle claims. Those risks were significantly
reduced when we ceased operation of all Florida facilities in
2000 and Texas nursing facilities in the fourth quarter of 2001.
As of December 31, 2004, we have provided for
$37.0 million in accruals for known or potential general
and professional liability claims based on claims experience and
an independent actuarial review. Based upon such claims
experience and independent actuarial review, we believe that our
accrual is adequate to cover any losses from general and
professional liability claims. General and professional
liability claims are the most volatile and significant of the
risks that we self-insure.



Legal Proceedings

For information regarding legal proceedings,
please see the Risk Factors, Legal
Proceedings and Management Discussion and Analysis
of Financial Condition and Results of Operations sections
in this Annual Report on Form 10-K.



Website

Our parent company, Extendicare, maintains a
website at www.extendicare.com. Our Annual Report on
Form 10-K, quarterly reports on Form 10-Q, and certain
other of our Securities and Exchange Commission filings are
available free of charge through contact information provided on
the Extendicare website. You can also contact our Communications
Department at the address or phone number on the front of this
Annual Report, for a copy, free of charge, of our Annual Report
on Form 10-K or quarterly reports on Form 10-Q. The
filings are also available as soon as reasonably practicable
after we electronically file such material with or furnish such
material to the Securities and Exchange Commission.

We are not including the information contained
on, or available through, Extendicares website, as part
of, or incorporating such information by reference into, this
Annual Report on Form 10-K.

27



---



##### Table of Contents








|        |           
|------- | ----------
|ITEM 2. | PROPERTIES

At December 31, 2004, we operated 173
long-term care facilities with 15,673 beds in 12 states, of
which 141 were nursing facilities with 14,069 beds and 32 were
assisted living facilities with 1,604 units. We also
managed 12 long-term care facilities with 969 beds, of which 7
were nursing facilities with 813 beds and five were assisted
living facilities with 156 units. In addition, we provided
consulting services for 77 long-term care facilities with 9,446
beds. In addition, we owned long-term care properties of which
11 were nursing properties with 1,310 beds that were leased and
operated by three unrelated long-term care providers. At
December 31, 2004, we also operated 21 rehabilitative
therapy clinics: eleven in Pennsylvania, one in Ohio, two in
Texas and seven in Wisconsin. The following table lists by
state, the nursing and assisted living facilities that we
operated or managed at December 31, 2004:

|                                     |  |                  |     |               |  |                  |        |                    |  |                  |    |          |  |        |       |          |  |        |     |          |  |  |        |  |  |  |    |  |  |  |     |  |  |  |     |  |  |  |        | 
|------------------------------------ |  | ---------------- | --- | ------------- |  | ---------------- | ------ | ------------------ |  | ---------------- | -- | -------- |  | ------ | ----- | -------- |  | ------ | --- | -------- |  |  | ------ |  |  |  | -- |  |  |  | --- |  |  |  | --- |  |  |  | ------ | 
|                                     |  |                  |     |               |  |                  |        |                    |  |                  |    |          |  |       
|                                     |  |                  |     | Leased        |  | Total Facilities |        |                    |  | Total Facilities
|                                     |  | Owned Facilities |     | Facilities(1) |  | Under Operations |        | Managed Facilities |  | Under Management
|                                     |  |                  |     |               |  |                  |        |                    |  |                 
|                                     |  |                  |     | Resident      |  |                  |        | Resident           |  |                  |    | Resident |  |        |       | Resident |  |        |     | Resident
|                                     |  | Number           |     | Capacity      |  | Number           |        | Capacity           |  | Number           |    | Capacity |  | Number |       | Capacity |  | Number |     | Capacity
|                                     |  |                  |     |               |  |                  |        |                    |  |                  |    |          |  |        |       |          |  |        |     |         
|Pennsylvania                         |  |                  | 21  |               |  |                  | 2,224  |                    |  |                  |   |          |  |        |      |          |  |        | 21  |          |  |  | 2,224  |  |  |  | 12 |  |  |  | 969 |  |  |  | 33  |  |  |  | 3,193  | 
|Ohio                                 |  |                  | 24  |               |  |                  | 2,421  |                    |  |                  | 7  |          |  |        | 774   |          |  |        | 31  |          |  |  | 3,195  |  |  |  |   |  |  |  |    |  |  |  | 31  |  |  |  | 3,195  | 
|Wisconsin                            |  |                  | 35  |               |  |                  | 2,536  |                    |  |                  |   |          |  |        |      |          |  |        | 35  |          |  |  | 2,536  |  |  |  |   |  |  |  |    |  |  |  | 35  |  |  |  | 2,536  | 
|Indiana                              |  |                  | 22  |               |  |                  | 2,046  |                    |  |                  |   |          |  |        |      |          |  |        | 22  |          |  |  | 2,046  |  |  |  |   |  |  |  |    |  |  |  | 22  |  |  |  | 2,046  | 
|Washington                           |  |                  | 20  |               |  |                  | 1,611  |                    |  |                  | 3  |          |  |        | 320   |          |  |        | 23  |          |  |  | 1,931  |  |  |  |   |  |  |  |    |  |  |  | 23  |  |  |  | 1,931  | 
|Kentucky                             |  |                  | 19  |               |  |                  | 1,561  |                    |  |                  |   |          |  |        |      |          |  |        | 19  |          |  |  | 1,561  |  |  |  |   |  |  |  |    |  |  |  | 19  |  |  |  | 1,561  | 
|Minnesota                            |  |                  | 11  |               |  |                  | 1,336  |                    |  |                  |   |          |  |        |      |          |  |        | 11  |          |  |  | 1,336  |  |  |  |   |  |  |  |    |  |  |  | 11  |  |  |  | 1,336  | 
|Oregon                               |  |                  | 5   |               |  |                  | 300    |                    |  |                  |   |          |  |        |      |          |  |        | 5   |          |  |  | 300    |  |  |  |   |  |  |  |    |  |  |  | 5   |  |  |  | 300    | 
|Idaho                                |  |                  | 2   |               |  |                  | 194    |                    |  |                  |   |          |  |        |      |          |  |        | 2   |          |  |  | 194    |  |  |  |   |  |  |  |    |  |  |  | 2   |  |  |  | 194    | 
|Delaware                             |  |                  | 1   |               |  |                  | 120    |                    |  |                  |   |          |  |        |      |          |  |        | 1   |          |  |  | 120    |  |  |  |   |  |  |  |    |  |  |  | 1   |  |  |  | 120    | 
|West Virginia                        |  |                  | 1   |               |  |                  | 120    |                    |  |                  |   |          |  |        |      |          |  |        | 1   |          |  |  | 120    |  |  |  |   |  |  |  |    |  |  |  | 1   |  |  |  | 120    | 
|Texas                                |  |                  | 2   |               |  |                  | 110    |                    |  |                  |   |          |  |        |      |          |  |        | 2   |          |  |  | 110    |  |  |  |   |  |  |  |    |  |  |  | 2   |  |  |  | 110    | 
|                                     |  |                  |     |               |  |                  |        |                    |  |                  |    |          |  |        |       |          |  |        |     |          |  |  |        |  |  |  |    |  |  |  |     |  |  |  |     |  |  |  |        | 
|Total                                |  |                  | 163 |               |  |                  | 14,579 |                    |  |                  | 10 |          |  |        | 1,094 |          |  |        | 173 |          |  |  | 15,673 |  |  |  | 12 |  |  |  | 969 |  |  |  | 185 |  |  |  | 16,642 | 
|                                     |  |                  |     |               |  |                  |        |                    |  |                  |    |          |  |        |       |          |  |        |     |          |  |  |        |  |  |  |    |  |  |  |     |  |  |  |     |  |  |  |        | 
|Nursing                              |  |                  | 132 |               |  |                  | 13,038 |                    |  |                  | 9  |          |  |        | 1,031 |          |  |        | 141 |          |  |  | 14,069 |  |  |  | 7  |  |  |  | 813 |  |  |  | 148 |  |  |  | 14,882 | 
|Assisted living                      |  |                  | 31  |               |  |                  | 1,541  |                    |  |                  | 1  |          |  |        | 63    |          |  |        | 32  |          |  |  | 1,604  |  |  |  | 5  |  |  |  | 156 |  |  |  | 37  |  |  |  | 1,760  | 
|Consulting services(2):             
|Florida                              |  |                  | 47  |               |  |                  | 6,016  |                   
|Texas                                |  |                  | 18  |               |  |                  | 1,695  |                   
|Massachusetts                        |  |                  | 5   |               |  |                  | 606    |                   
|Pennsylvania                         |  |                  | 4   |               |  |                  | 564    |                   
|Louisiana                            |  |                  | 3   |               |  |                  | 565    |                   
|                                     |  |                  |     |               |  |                  |        |                   
|Total consulting services            |  |                  | 77  |               |  |                  | 9,446  |                   
|                                     |  |                  |     |               |  |                  |        |                   
|Total, including consulting services |  |                  | 262 |               |  |                  | 26,088 |                   
|                                     |  |                  |     |               |  |                  |        |                   
|Breakdown by type of facility:      
|Nursing                              |  |                  | 220 |               |  |                  | 23,835 |                   
|Assisted living                      |  |                  | 42  |               |  |                  | 2,253  |                   
|                                     |  |                  |     |               |  |                  |        |                   
|Total, including consulting services |  |                  | 262 |               |  |                  | 26,088 |                   
|                                     |  |                  |     |               |  |                  |        |                   
|OTHER PROPERTIES OWNED:             
|Nursing facilities under lease(3)    |  |                  | 11  |               |  |                  | 1,310  |                   
|                                     |  |                  |     |               |  |                  |        |                   



---

|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|--- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | The remaining life of the leases, not including
    renewal options, ranges from one to eight years, the
    average being three years. We retain an option to purchase
    the leased property for four of the 10 leased properties.
    For lease payment information, please see Note 20 to our
    consolidated financial statements.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|   
|(2) | Consulting services provided to the facilities
    listed include billing, accounts receivable tracking, invoice
    processing, payroll, financial reporting and cost reimbursements
    services.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|   
|(3) | We own 11 nursing properties held under lease
    arrangements with three unrelated long-term care operators.
    Senior Health Properties  South, Inc. leases six
    properties whose term matures on December 31, 2006. Senior
    Health Properties  Texas, Inc. leases four properties
    whose term matures on September 30, 2006. In addition,
    Senior Health Properties  Texas, Inc. subleases 12
    leased facilities whose term matures in February 2012. The
    facilities we lease to Senior Health Properties 
    South, Inc. and Senior Health Properties  Texas, Inc.
    are included in the facilities for which we provide consulting
    services. We lease one property in Wisconsin for a term that
    expires in July 2007 to Lakeside Health, L.L.C., a wholly owned
    subsidiary of Benedictine Health Dimensions, Inc.

28



---



##### Table of Contents



Properties Following the Acquisition of
ALC

On January 31, 2005, we completed our
acquisition of ALC. ALC has a portfolio of 177 assisted living
facilities, including 122 owned and 55 leased facilities
representing 6,838 units located in 14 states.
Following our acquisition of ALC, we operated or managed the
following facilities:

|                                     |  |                  |     |               |  |                  |        |                    |  |                  |    |          |  |        |       |          |  |        |     |          |  |  |        |  |  |  |    |  |  |  |     |  |  |  |     |  |  |  |        | 
|------------------------------------ |  | ---------------- | --- | ------------- |  | ---------------- | ------ | ------------------ |  | ---------------- | -- | -------- |  | ------ | ----- | -------- |  | ------ | --- | -------- |  |  | ------ |  |  |  | -- |  |  |  | --- |  |  |  | --- |  |  |  | ------ | 
|                                     |  |                  |     |               |  |                  |        |                    |  |                  |    |          |  |       
|                                     |  |                  |     | Leased        |  | Total Facilities |        |                    |  | Total Facilities
|                                     |  | Owned Facilities |     | Facilities(1) |  | Under Operations |        | Managed Facilities |  | Under Management
|                                     |  |                  |     |               |  |                  |        |                    |  |                 
|                                     |  |                  |     | Resident      |  |                  |        | Resident           |  |                  |    | Resident |  |        |       | Resident |  |        |     | Resident
|                                     |  | Number           |     | Capacity      |  | Number           |        | Capacity           |  | Number           |    | Capacity |  | Number |       | Capacity |  | Number |     | Capacity
|                                     |  |                  |     |               |  |                  |        |                    |  |                  |    |          |  |        |       |          |  |        |     |         
|Pennsylvania                         |  |                  | 29  |               |  |                  | 2,536  |                    |  |                  | 1  |          |  |        | 39    |          |  |        | 30  |          |  |  | 2,575  |  |  |  | 12 |  |  |  | 969 |  |  |  | 42  |  |  |  | 3,544  | 
|Ohio                                 |  |                  | 36  |               |  |                  | 2,873  |                    |  |                  | 12 |          |  |        | 965   |          |  |        | 48  |          |  |  | 3,838  |  |  |  |   |  |  |  |    |  |  |  | 48  |  |  |  | 3,838  | 
|Wisconsin                            |  |                  | 35  |               |  |                  | 2,536  |                    |  |                  |   |          |  |        |      |          |  |        | 35  |          |  |  | 2,536  |  |  |  |   |  |  |  |    |  |  |  | 35  |  |  |  | 2,536  | 
|Indiana                              |  |                  | 40  |               |  |                  | 2,748  |                    |  |                  | 2  |          |  |        | 78    |          |  |        | 42  |          |  |  | 2,826  |  |  |  |   |  |  |  |    |  |  |  | 42  |  |  |  | 2,826  | 
|Washington                           |  |                  | 28  |               |  |                  | 1,942  |                    |  |                  | 11 |          |  |        | 628   |          |  |        | 39  |          |  |  | 2,570  |  |  |  |   |  |  |  |    |  |  |  | 39  |  |  |  | 2,570  | 
|Texas                                |  |                  | 28  |               |  |                  | 1,125  |                    |  |                  | 14 |          |  |        | 563   |          |  |        | 42  |          |  |  | 1,688  |  |  |  |   |  |  |  |    |  |  |  | 42  |  |  |  | 1,688  | 
|Kentucky                             |  |                  | 19  |               |  |                  | 1,561  |                    |  |                  |   |          |  |        |      |          |  |        | 19  |          |  |  | 1,561  |  |  |  |   |  |  |  |    |  |  |  | 19  |  |  |  | 1,561  | 
|Minnesota                            |  |                  | 11  |               |  |                  | 1,336  |                    |  |                  |   |          |  |        |      |          |  |        | 11  |          |  |  | 1,336  |  |  |  |   |  |  |  |    |  |  |  | 11  |  |  |  | 1,336  | 
|Oregon                               |  |                  | 15  |               |  |                  | 626    |                    |  |                  | 8  |          |  |        | 276   |          |  |        | 23  |          |  |  | 902    |  |  |  |   |  |  |  |    |  |  |  | 23  |  |  |  | 902    | 
|Arizona                              |  |                  | 7   |               |  |                  | 324    |                    |  |                  | 2  |          |  |        | 76    |          |  |        | 9   |          |  |  | 400    |  |  |  |   |  |  |  |    |  |  |  | 9   |  |  |  | 400    | 
|Idaho                                |  |                  | 7   |               |  |                  | 390    |                    |  |                  | 4  |          |  |        | 148   |          |  |        | 11  |          |  |  | 538    |  |  |  |   |  |  |  |    |  |  |  | 11  |  |  |  | 538    | 
|South Carolina                       |  |                  | 6   |               |  |                  | 234    |                    |  |                  | 3  |          |  |        | 117   |          |  |        | 9   |          |  |  | 351    |  |  |  |   |  |  |  |    |  |  |  | 9   |  |  |  | 351    | 
|Nebraska                             |  |                  | 5   |               |  |                  | 168    |                    |  |                  | 4  |          |  |        | 156   |          |  |        | 9   |          |  |  | 324    |  |  |  |   |  |  |  |    |  |  |  | 9   |  |  |  | 324    | 
|New Jersey                           |  |                  | 5   |               |  |                  | 195    |                    |  |                  | 3  |          |  |        | 117   |          |  |        | 8   |          |  |  | 312    |  |  |  |   |  |  |  |    |  |  |  | 8   |  |  |  | 312    | 
|Iowa                                 |  |                  | 5   |               |  |                  | 189    |                    |  |                  | 1  |          |  |        | 35    |          |  |        | 6   |          |  |  | 224    |  |  |  |   |  |  |  |    |  |  |  | 6   |  |  |  | 224    | 
|Louisiana                            |  |                  | 4   |               |  |                  | 173    |                    |  |                  |   |          |  |        |      |          |  |        | 4   |          |  |  | 173    |  |  |  |   |  |  |  |    |  |  |  | 4   |  |  |  | 173    | 
|Delaware                             |  |                  | 1   |               |  |                  | 120    |                    |  |                  |   |          |  |        |      |          |  |        | 1   |          |  |  | 120    |  |  |  |   |  |  |  |    |  |  |  | 1   |  |  |  | 120    | 
|West Virginia                        |  |                  | 1   |               |  |                  | 120    |                    |  |                  |   |          |  |        |      |          |  |        | 1   |          |  |  | 120    |  |  |  |   |  |  |  |    |  |  |  | 1   |  |  |  | 120    | 
|Michigan                             |  |                  | 3   |               |  |                  | 117    |                    |  |                  |   |          |  |        |      |          |  |        | 3   |          |  |  | 117    |  |  |  |   |  |  |  |    |  |  |  | 3   |  |  |  | 117    | 
|                                     |  |                  |     |               |  |                  |        |                    |  |                  |    |          |  |        |       |          |  |        |     |          |  |  |        |  |  |  |    |  |  |  |     |  |  |  |     |  |  |  |        | 
|Total                                |  |                  | 285 |               |  |                  | 19,313 |                    |  |                  | 65 |          |  |        | 3,198 |          |  |        | 350 |          |  |  | 22,511 |  |  |  | 12 |  |  |  | 969 |  |  |  | 362 |  |  |  | 23,480 | 
|                                     |  |                  |     |               |  |                  |        |                    |  |                  |    |          |  |        |       |          |  |        |     |          |  |  |        |  |  |  |    |  |  |  |     |  |  |  |     |  |  |  |        | 
|Nursing                              |  |                  | 132 |               |  |                  | 13,038 |                    |  |                  | 9  |          |  |        | 1,031 |          |  |        | 141 |          |  |  | 14,069 |  |  |  | 7  |  |  |  | 813 |  |  |  | 148 |  |  |  | 14,882 | 
|Assisted living                      |  |                  | 153 |               |  |                  | 6,275  |                    |  |                  | 56 |          |  |        | 2,167 |          |  |        | 209 |          |  |  | 8,442  |  |  |  | 5  |  |  |  | 156 |  |  |  | 214 |  |  |  | 8,598  | 
|Consulting services(2):             
|Florida                              |  |                  | 47  |               |  |                  | 6,016  |                   
|Texas                                |  |                  | 18  |               |  |                  | 1,695  |                   
|Massachusetts                        |  |                  | 5   |               |  |                  | 606    |                   
|Pennsylvania                         |  |                  | 4   |               |  |                  | 564    |                   
|Louisiana                            |  |                  | 3   |               |  |                  | 565    |                   
|                                     |  |                  |     |               |  |                  |        |                   
|Total consulting services            |  |                  | 77  |               |  |                  | 9,446  |                   
|                                     |  |                  |     |               |  |                  |        |                   
|Total, including consulting services |  |                  | 439 |               |  |                  | 32,926 |                   
|                                     |  |                  |     |               |  |                  |        |                   
|Breakdown by type of facility:       |  |                  |     |               |  |                  |        |                   
|Nursing                              |  |                  | 220 |               |  |                  | 23,835 |                   
|Assisted living                      |  |                  | 219 |               |  |                  | 9,091  |                   
|                                     |  |                  |     |               |  |                  |        |                   
|Total, including consulting services |  |                  | 439 |               |  |                  | 32,926 |                   
|                                     |  |                  |     |               |  |                  |        |                   
|OTHER PROPERTIES OWNED:              |  |                  |     |               |  |                  |        |                   
|Nursing facilities under lease(3)    |  |                  | 11  |               |  |                  | 1,310  |                   
|                                     |  |                  |     |               |  |                  |        |                   



---

|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|--- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | The remaining life of the leases, not including
    renewal options exercisable solely by us, ranges from one to ten
    years, the average being about four years. We retain an option
    to purchase the leased property for four of the 65 leased
    properties. For lease payment information, please see
    Note 20 to our consolidated financial statements. For
    information in respect of two of the significant lessors in
    respect of ALC, refer to Note 19 of our consolidated
    financial statements.                                                                                                                                                                                                                                                                                                                                  
|   
|(2) | Consulting services provided to the facilities
    listed include billing, accounts receivable tracking, invoice
    processing, payroll, financial reporting and cost reimbursements
    services.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|   
|(3) | We own 11 nursing properties held under lease
    arrangements with three unrelated long-term care operators.
    Senior Health Properties  South, Inc. leases six
    properties whose term matures on December 31, 2006. Senior
    Health Properties  Texas, Inc. leases four properties
    whose term matures on September 30, 2006. In addition,
    Senior Health Properties  Texas, Inc. subleases 12
    leased facilities whose term matures in February 2012. The
    facilities we lease to Senior Health Properties 
    South, Inc. and Senior Health Properties  Texas, Inc.
    are included in the facilities for which we provide consulting
    services. We lease one property in Wisconsin for a term that
    expires in July 2007 to Lakeside Health, L.L.C., a wholly owned
    subsidiary of Benedictine Health Dimensions, Inc.

29



---



##### Table of Contents



The number of nursing beds and assisted living
units identified in the above tables and throughout this Annual
Report on Form 10-K represents the approximate number of
operational beds and units that we currently use. The number of
operational beds and units is subject to periodic changes and
can be less than the licensed number of beds approved by the
state due to market and other factors.






|        |                  
|------- | -----------------
|ITEM 3. | LEGAL PROCEEDINGS

We are defendants in actions against us from time
to time in connection with our operations and due to the nature
of our business. These actions may include civil or criminal
actions from personal injury and wrongful death suits arising
out of allegation of professional malpractice brought against
us, one or more of our facilities, or the individuals who work
at particular facilities. We are unable to predict the ultimate
outcome of pending litigation and other investigations. We
cannot assure you that claims will not arise that are in excess
of our insurance coverage, are not covered by our insurance
coverage or result in punitive damage being assessed against us.
In addition, we cannot assure you that the United States
Department of Justice, CMS or other regulatory agencies will not
initiate investigations related to our businesses in the future.
A successful claim against us that is not covered by, or is in
excess of, our insurance could have a material adverse effect on
our financial condition and results of operation. Claims against
us, regardless of their merit or eventual outcome, would require
management to devote time to matters unrelated to the operation
of our business and, due to publicity, may also have a material
adverse effect on our ability to attract residents or expand our
operations.

We have experienced an increasing trend in the
number and severity of litigation claims asserted against us. We
believe that this trend is endemic to the long-term care
industry and is a result of the increasing number of large
judgments, including large punitive damage awards, against
long-term care providers in recent years resulting in an
increased awareness by plaintiffs lawyers of potentially
large recoveries. This has been particularly the case in the
States of Florida and Texas where we formerly operated nursing
facilities. Over the past two years, certain states have
implemented limited tort reform changes. For example, Texas has
placed a punitive damage award limit of $250,000. However, as a
result of the litigious environment, insurance coverage for
general and professional liability claims has increased and in
certain states become unavailable to operators where insurance
companies have refrained from providing insurance. There can be
no assurance that we will not be liable for claims in excess of
the amounts provided or for punitive damages awarded in such
litigation cases. We also believe that there has been, and will
continue to be, an increase in governmental investigations of
long-term care providers and in enforcement actions resulting
from these investigations. Adverse determinations in legal
proceedings or governmental investigations, whether currently
asserted or arising in the future, could have a material adverse
effect on us.

As referred to in the Managements
Discussion and Analysis of Financial Condition and Results of
Operation section of this Annual Report on Form 10-K,
pursuant to the disposition of our pharmacy operations in 1998,
we entered into a Preferred Provider Agreement with Omnicare,
Inc., or Omnicare. The terms of the Preferred Provider Agreement
enabled Omnicare to execute Pharmacy Service Agreements and
Consulting Service Agreements with all of our skilled nursing
facilities. In 2001, we and Omnicare brought a matter to
arbitration involving per diem pricing rates billed
for managed care residents. This matter was subsequently settled
and amounts reflected within the financial results. We are
currently negotiating the pricing of drugs for Medicare
residents and should this matter not be settled, the matter will
be taken to arbitration. In addition, in connection with its
agreements to provide pharmacy services, Omnicare has requested
arbitration for an alleged lost profits claim related to our
disposition of assets, primarily in Florida. Damage amounts, if
any, cannot be reasonably estimated based on information
available to us at this time. We and Omnicare continue to
discuss the claim and should we fail to resolve the matter, the
claim will be taken to an arbitration hearing. An arbitration
hearing has not been scheduled. We believe that we have
interpreted correctly and complied with the terms of the
agreement, however, there can be no assurance that we will
prevail at any arbitration hearing, or that other claims will
not be made with respect to the agreement.






|        |                                                        
|------- | -------------------------------------------------------
|ITEM 4. | SUBMISSION OF MATTERS TO A VOTE OF SECURITY
    HOLDERS

Not applicable.

30



---



##### Table of Contents






PART II






|        |                                                                                                                       
|------- | ----------------------------------------------------------------------------------------------------------------------
|ITEM 5. | MARKET FOR REGISTRANTS COMMON STOCK AND
    RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY
    SECURITIES

As of the date of this Annual Report on
Form 10-K, Extendicare Holdings Inc., or EHI, a
wholly-owned subsidiary of Extendicare Inc., owns all of our
outstanding common stock and therefore there is no external
market for our shares. We have not paid dividends to EHI in
2004, 2003 and 2002. However, we have received federal tax
refunds from EHI and made federal tax-related payments to EHI in
settlement of federal taxes amounts due to or from EHI
throughout this period. We are restricted from making payments
or paying dividends to EHI, except to: (1) reimburse EHI
for up to $5.0 million of corporate overhead expenses
incurred in the ordinary course of business, and (2) pay
any taxes which are due and payable by EHI.

31



---



##### Table of Contents








|        |                        
|------- | -----------------------
|ITEM 6. | SELECTED FINANCIAL DATA

The following table summarizes our selected
consolidated financial data, which has been derived from our
consolidated financial statements as audited by KPMG LLP, our
registered public accounting firm. You should read the following
information in conjunction with our consolidated financial
statements and related notes included within Item 8 and the
Managements Discussion and Analysis of Financial
Condition and Results of Operation section, being
Item 7, of this Annual Report on Form 10-K.

|                                                |                                                                                                          |                                               |                        |         |        |         |         |         |        |         |         |         |        |         |         |         |        |         |         |         |        |         | 
|----------------------------------------------- | -------------------------------------------------------------------------------------------------------- | --------------------------------------------- | ---------------------- | ------- | ------ | ------- | ------- | ------- | ------ | ------- | ------- | ------- | ------ | ------- | ------- | ------- | ------ | ------- | ------- | ------- | ------ | ------- | 
|                                                |                                                                                                          |                                              
|                                                |                                                                                                          | Year Ended December 31,                      
|                                                |                                                                                                          |                                              
|                                                |                                                                                                          | 2004                                          |                        | 2003    |        | 2002    |         | 2001    |        | 2000   
|                                                |                                                                                                          |                                               |                        |         |        |         |         |         |        |        
|                                                |                                                                                                          |                                              
|                                                |                                                                                                          | (thousands of dollars unless otherwise noted)
|Income Statement Data:                          |                                                                                                          |                                               |                        |         |        |         |         |         |        |         |         |         |        |         |         |         |        |         |         |        
|Revenues:                                       |                                                                                                          |                                               |                        |         |        |         |         |         |        |         |         |         |        |         |         |         |        |         |         |        
|                                                | Nursing and assisted living facilities                                                                   |                                               | $                      | 918,867 |        |         | $       | 843,414 |        |         | $       | 787,419 |        |         | $       | 766,952 |        |         | $       | 904,847 |       
|                                                | Outpatient therapy and medical supplies                                                                  |                                               |                        | 10,987  |        |         |         | 11,524  |        |         |         | 10,280  |        |         |         | 9,515   |        |         |         | 9,716   |       
|                                                | Other                                                                                                    |                                               |                        | 17,998  |        |         |         | 15,494  |        |         |         | 17,352  |        |         |         | 17,640  |        |         |         | 8,506   |       
|                                                |                                                                                                          |                                               |                        |         |        |         |         |         |        |         |         |         |        |         |         |         |        |         |         |        
|                                                |                                                                                                          |                                               | Total revenues         |         |        | 947,852 |         |         |        | 870,432 |         |         |        | 815,051 |         |         |        | 794,107 |         |         |        | 923,069 | 
|Costs and expenses:                             |                                                                                                          |                                               |                        |         |        |         |         |         |        |         |         |         |        |         |         |         |        |         |         |        
|                                                | Operating                                                                                                |                                               |                        | 776,730 |        |         |         | 731,134 |        |         |         | 691,094 |        |         |         | 684,814 |        |         |         | 825,172 |       
|                                                | General and administrative                                                                               |                                               |                        | 29,722  |        |         |         | 30,871  |        |         |         | 32,947  |        |         |         | 32,387  |        |         |         | 46,507  |       
|                                                | Lease costs                                                                                              |                                               |                        | 9,049   |        |         |         | 9,113   |        |         |         | 10,642  |        |         |         | 14,575  |        |         |         | 15,731  |       
|                                                | Depreciation and amortization                                                                            |                                               |                        | 35,200  |        |         |         | 37,448  |        |         |         | 37,575  |        |         |         | 40,772  |        |         |         | 45,434  |       
|                                                | Interest expense, net                                                                                    |                                               |                        | 17,183  |        |         |         | 29,946  |        |         |         | 31,529  |        |         |         | 35,560  |        |         |         | 45,155  |       
|                                                | Valuation adjustment on interest rate caps                                                               |                                               |                        | 7,983   |        |         |         | (131    | )      |         |         | 746     |        |         |         |        |        |         |         |        |       
|                                                | Loss on disposal of assets, provision for closure
    and exit costs and impairment of long-lived assets |                                               |                        | 8,541   |        |         |         |        |        |         |         | 1,332   |        |         |         | 25,931  |        |         |         | 27,416  |       
|                                                | Loss on refinancing and retirement of debt                                                               |                                               |                        | 6,484   |        |         |         |        |        |         |         | 2,849   |        |         |         | 75      |        |         |         | 699     |       
|                                                |                                                                                                          |                                               |                        |         |        |         |         |         |        |         |         |         |        |         |         |         |        |         |         |        
|Income (loss) before income taxes               |                                                                                                          |                                               | 56,960                 |         |        |         | 32,051  |         |        |         | 6,337   |         |        |         | (40,007 | )       |        |         | (83,045 | )      
|                                                |                                                                                                          |                                               |                        |         |        |         |         |         |        |         |         |         |        |         |         |         |        |         |         |        
|Net income (loss)                               |                                                                                                          | $                                             | 67,738                 |         |        | $       | 20,086  |         |        | $       | 3,220   |         |        | $       | (27,495 | )       |        | $       | (55,121 | )      
|                                                |                                                                                                          |                                               |                        |         |        |         |         |         |        |         |         |         |        |         |         |         |        |         |         |        
|Operating Data:                                 |                                                                                                          |                                               |                        |         |        |         |         |         |        |         |         |         |        |         |         |         |        |         |         |        
|Number of facilities at end of period:          |                                                                                                          |                                               |                        |         |        |         |         |         |        |         |         |         |        |         |         |         |        |         |         |        
|                                                |                                                                                                          | Owned and leased:                             |                        |         |        |         |         |         |        |         |         |         |        |         |         |         |        |         |         |         |        |        
|                                                |                                                                                                          |                                               | Nursing                |         |        | 141     |         |         |        | 140     |         |         |        | 139     |         |         |        | 139     |         |         |        | 155     | 
|                                                |                                                                                                          |                                               | Assisted living        |         |        | 32      |         |         |        | 34      |         |         |        | 36      |         |         |        | 36      |         |         |        | 36      | 
|                                                |                                                                                                          |                                               |                        |         |        |         |         |         |        |         |         |         |        |         |         |         |        |         |         |        
|                                                |                                                                                                          |                                               | Total owned and leased |         |        | 173     |         |         |        | 174     |         |         |        | 175     |         |         |        | 175     |         |         |        | 191     | 
|                                                |                                                                                                          |                                               |                        |         |        |         |         |         |        |         |         |         |        |         |         |         |        |         |         |        
|                                                |                                                                                                          | Managed                                       |                        |         | 12     |         |         |         | 19     |         |         |         | 22     |         |         |         | 23     |         |         |         | 21     |        
|                                                |                                                                                                          | Consulting services                           |                        |         | 77     |         |         |         | 63     |         |         |         | 39     |         |         |         | 35     |         |         |         | 12     |        
|Average resident census:                        |                                                                                                          |                                               |                        |         |        |         |         |         |        |         |         |         |        |         |         |         |        |         |         |        
|                                                |                                                                                                          | Nursing                                       |                        |         | 13,038 |         |         |         | 12,901 |         |         |         | 12,727 |         |         |         | 13,358 |         |         |         | 16,253 |        
|                                                |                                                                                                          | Assisted living                               |                        |         | 1,434  |         |         |         | 1,496  |         |         |         | 1,472  |         |         |         | 1,463  |         |         |         | 1,600  |        
|Average occupancy rate:                         |                                                                                                          |                                               |                        |         |        |         |         |         |        |         |         |         |        |         |         |         |        |         |         |        
|                                                |                                                                                                          | Nursing                                       |                        |         | 91.8   | %       |         |         | 91.5   | %       |         |         | 90.3   | %       |         |         | 87.5   | %       |         |         | 87.5   | %      
|                                                |                                                                                                          | Assisted living                               |                        |         | 84.4   | %       |         |         | 86.3   | %       |         |         | 83.9   | %       |         |         | 83.1   | %       |         |         | 84.6   | %      
|Payor source as a % of total revenue:           |                                                                                                          |                                               |                        |         |        |         |         |         |        |         |         |         |        |         |         |         |        |         |         |        
|                                                |                                                                                                          | Medicare                                      |                        |         | 30     | %       |         |         | 27     | %       |         |         | 26     | %       |         |         | 24     | %       |         |         | 24     | %      
|                                                |                                                                                                          | Medicaid                                      |                        |         | 47     | %       |         |         | 49     | %       |         |         | 50     | %       |         |         | 51     | %       |         |         | 51     | %      
|                                                |                                                                                                          | Private pay                                   |                        |         | 23     | %       |         |         | 24     | %       |         |         | 24     | %       |         |         | 25     | %       |         |         | 25     | %      
|Balance Sheet Data (end of period):             |                                                                                                          |                                               |                        |         |        |         |         |         |        |         |         |         |        |         |         |         |        |         |         |        
|Cash and cash equivalents                       |                                                                                                          | $                                             | 29,612                 |         |        | $       | 48,855  |         |        | $       | 24,360  |         |        | $       | 407     |         |        | $       | 1,102   |        
|Working capital                                 |                                                                                                          |                                               | 29,570                 |         |        |         | 55,795  |         |        |         | 29,897  |         |        |         | (2,554  | )       |        |         | 44,473  |        
|Property and equipment                          |                                                                                                          |                                               | 446,085                |         |        |         | 448,743 |         |        |         | 453,119 |         |        |         | 477,830 |         |        |         | 507,536 |        
|Total assets                                    |                                                                                                          |                                               | 735,957                |         |        |         | 833,349 |         |        |         | 830,278 |         |        |         | 795,246 |         |        |         | 873,051 |        
|Total debt                                      |                                                                                                          |                                               | 291,932                |         |        |         | 392,918 |         |        |         | 398,150 |         |        |         | 385,347 |         |        |         | 451,147 |        
|Shareholders equity                            |                                                                                                          |                                               | 250,189                |         |        |         | 182,660 |         |        |         | 159,201 |         |        |         | 156,002 |         |        |         | 184,161 |        
|Other Financial Data:                           |                                                                                                          |                                               |                        |         |        |         |         |         |        |         |         |         |        |         |         |         |        |         |         |        
|Capital expenditures for property and equipment |                                                                                                          |                                               | 25,444                 |         |        |         | 21,029  |         |        |         | 18,659  |         |        |         | 16,348  |         |        |         | 14,169  |        
|Capital expenditures for acquisitions           |                                                                                                          |                                               | 6,454                  |         |        |         | 4,124   |         |        |         | 17,930  |         |        |         |        |         |        |         |        |        
|Capital expenditures for new construction       |                                                                                                          |                                               | 14,970                 |         |        |         | 4,304   |         |        |         |        |         |        |         |        |         |        |         |        |        
|Net cash flow provided by operating activities  |                                                                                                          |                                               | 81,400                 |         |        |         | 56,033  |         |        |         | 38,832  |         |        |         | 82,626  |         |        |         | 32,842  |        
|Days of revenue outstanding                     |                                                                                                          |                                               | 37                     |         |        |         | 40      |         |        |         | 43      |         |        |         | 45      |         |        |         | 52      |        

32



---



##### Table of Contents








|        |                                                                                         
|------- | ----------------------------------------------------------------------------------------
|ITEM 7. | MANAGEMENTS DISCUSSION AND ANALYSIS OF
    FINANCIAL CONDITION AND RESULTS OF OPERATION

Executive Overview

Our operations and net earnings improved for the
fifth consecutive year and through the collection of a number of
significant notes and receivables, and our refinancing, we
improved the strength of our balance sheet. Improvement in total
average daily census (1.1%) and Medicare average daily census
(7.9%), along with a focus on operating costs, resulted in an
increase of revenues of $77.4 million and a
$24.9 million improvement in income before income taxes.
Through the acquisition of Assisted Living Concepts, Inc., or
ALC, we have emerged from the restructuring strategy that was
largely completed by the end of 2002, and are now in a growth
mode. However, we continue to be cautious of future potential
actions by the Centers of Medicare and Medicaid Services, or
CMS, which could result in the discontinuance of temporary
enhancements through the implementation of a RUGs refinement
change.

Our business strategy and competitive strengths
are outlined in detail in Item 1 in this Annual Report on
Form 10-K. Our key business goals are to:



| |   |                                                                                                                                                                                                                   
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | strengthen both Medicare and total average daily
    census;                                                                                                                                                      
|
| |  | improve operating cash flow;                                                                                                                                                                                      
|
| |  | expand our asset portfolio through acquisition or
    internal growth, and actively manage our asset portfolio,
    including where appropriate, divesting facilities that fail to
    meet our performance goals;
|
| |  | expand non-government based revenue sources,
    thereby decreasing the level of risk and reliance on government
    funding;                                                                                     
|
| |  | diversify within the long-term care industry
    through growth of facilities under full management or selected
    consulting, agreements and rehabilitation clinics; and                                        
|
| |  | increase our operating efficiency.                                                                                                                                                                                

Total census on a same facility basis in our
nursing facilities increased 0.9% to 12,607 in 2004 compared to
12,490 in 2003. Medicare census on a same facility basis
increased 8.5% to 2,100 in 2004 compared to 1,935 in 2003.

In June 2004, we acquired four nursing facilities
(321 beds) in Indiana for $5.0 million in cash. We
completed four construction projects during 2004 that increased
operational capacity at one nursing facility and two assisted
living facilities and added one new free-standing assisted
living facility. We currently have 11 additional construction
projects in progress that will add 18 nursing beds and 376
assisted living facility units. We expect nine of the
construction projects will be completed in 2005 and the
remaining are scheduled to be completed in 2006. In 2004, we
also divested all of our nursing and assisted living facilities
in Arkansas for $6.1 million and transferred operations of
one nursing facility in Wisconsin to another long-term care
provider.

On November 4, 2004, we entered into a
definitive merger and acquisition agreement with ALC of Dallas,
Texas (OTC. BB: ASLC) providing for the acquisition of all of
the outstanding shares and stock options of ALC for
$18.50 per share. The completion of the acquisition was
subject to certain conditions, including approval by ALCs
shareholders and certain customary regulatory approvals. On
January 31, 2005, the shareholders of ALC approved the
transaction and we completed the acquisition for a total of
approximately $285 million, including the assumption of
ALCs existing debt of approximately $141 million. We
financed the acquisition by using approximately $29 million
in cash on hand, a $55 million 6% Term Loan from
Extendicare Holdings, Inc. and drawing down $60 million
from our credit facility. ALC has a portfolio of 177 assisted
living facilities, including 122 owned and 55 leased facilities
representing 6,838 units located in 14 states, many in
markets where we currently operate.

We initiated and completed in the second quarter
of 2004 several transactions that reduced our level of debt and,
as a result, improved our operating cash flow and cash
resources. In April 2004, we sold and issued $125.0 million
aggregate principal amount of 6.875% Senior Subordinated
Notes due 2014, or 2014 Notes.

33



---



##### Table of Contents



The net proceeds from the sale and issuance of
the 2014 Notes were approximately $117.4 million, net of a
$3.1 million discount and fees and expenses of
$4.5 million. We used these net proceeds, together with
borrowings under our amended and restated credit facility, to
purchase for cash approximately $104.9 million aggregate
principal amount of our 9.35% Senior Subordinated Notes due
2007, or 2007 Notes, validly tendered in the tender offer that
we commenced in April 2004 and to redeem the remaining
$95.1 million of 2007 Notes not tendered in the tender
offer or cancelled. In addition, in April 2004, coterminous with
the redemption of the 2007 Notes, we terminated our related
interest rate swap and cap agreements for an aggregate gain of
$3.3 million. In addition, to hedge our exposure to
fluctuations in market value, we entered into two new interest
rate swap agreements and two new interest rate cap agreements
relating to the 9.50% Senior Notes due 2010, or the 2010
Senior Notes, and the 2014 Notes. As a result of our debt
refinancing, we lowered our long-term debt and debt to equity
ratio from $392.9 million and 2.2 to 1, respectively,
as of December 31, 2003 to $291.9 million and 1.2 to 1
as of December 31, 2004, and we also reduced our weighted
average interest rate from 7.5% as of December 31, 2003 to
approximately 6.3% as of December 31, 2004.


We also monetized $30.6 million in notes
that were formerly outstanding from our Florida divestiture
program and reduced our balance of Medicare settlement
receivables. We accepted and received in February and June 2004,
a total of $20.6 million in cash prepayments for all
outstanding notes receivable from Tandem Health Care, Inc., or
Tandem, and as a result recorded a loss in the second quarter of
$1.3 million. In June 2004, we concluded the September 2000
deferred sales transaction with Greystone Tribeca Acquisition,
L.L.C., or Greystone, by receipt of the final consideration of
$10.0 million on the Vendor Take Back Note plus
$2.6 million in interest. As a result, we recognized a gain
on the sale of assets of $4.9 million and related interest
income of $1.7 million.

During 2004, we reached negotiated settlements
with our Fiscal Intermediaries, or FIs, of all significant
outstanding Medicare settlement issues pertaining to revenues
earned prior to the implementation of the Prospective Payment
System, or PPS. In January 2004, we negotiated and subsequently
received a cash settlement of $5.6 million for all
remaining years of a Medicare settlement receivable involving a
staffing cost matter. In April 2004, we reached a negotiated
settlement on an allocation of overhead cost settlement
receivable issue that resulted in the receipt of
$6.6 million in cash in May 2004. In August 2004, we
reached a negotiated settlement, which resulted in the payment
of $1.8 million in December 2004, with respect to various
issues relating to facilities purchased in the Arbor Health Care
Company, or Arbor, acquisition in 1997. In September 2004, we
reached a negotiated settlement with respect to the Director of
Nursing staff cost issue that resulted in the collection of
$2.8 million in October 2004. As a result of these
settlements, Medicare and Medicaid settlement receivables
declined $20.2 million from a balance of $37.2 million
as of December 31, 2003 to $17.0 million as of
December 31, 2004. The settlement of the Arbor issues
resulted in a charge of $6.9 million to previously accrued
liability balances, however, the remainder of the settlements
did not result in any significant adjustment to the recorded
receivable balance.

We operate in a competitive marketplace and
depend substantially on revenues derived from governmental
third-party payors, with the remainder of our revenues derived
from commercial insurers, managed care plans, and private
individuals. The on-going pressures from the Medicare and
Medicaid programs, along with other payors seeking to control
costs and/or limit reimbursement rates for medical services, are
but one of the business risks that we face. We also operate in a
heavily regulated industry, subject to the scrutiny of federal
and state regulators. Each of our facilities must comply with
regulations regarding staffing levels, resident care standards,
occupational health and safety, resident confidentiality,
billing and reimbursement, environmental and biological and
other standards.

Government agencies have steadily increased their
enforcement activity over the past several years. As a result,
we are continually allocating increased resources to ensure
compliance with applicable regulations and to respond to
inspections, investigations and/or enforcement actions. In July
2004, as a result of facility citations for survey deficiencies
in the Lakeside nursing facility in Chippewa Falls, Wisconsin,
we reached an agreement with the State of Wisconsin to transfer
the operations of the nursing facility under a lease
arrangement. On August 1, 2004, we transferred the
operations to Lakeside Health L.L.C., or Lakeside Health, a
subsidiary of Benedictine Health Dimensions, Inc., or
Benedictine, another long-term care provider.

34



---



##### Table of Contents



As a result of the financial and operating
performance of Lakeside Health in the fourth quarter, in
December 2004 we recorded an asset impairment provision of
$6.8 million to reduce the carrying value of the Lakeside
leased property from $13.0 million to $6.2 million. We
determined the reduced property value based upon our estimate of
the current market value of the facility, which assumes the
facility attains a suitable Medicare occupancy level. There
cannot be assurance that a future reduction in the carrying
value will not be required if these estimates change. Federal
law requires each state to have a Medicaid Fraud Control Unit,
which is responsible for investigating provider fraud and
resident abuse. We are aware of an investigation by this unit in
Kentucky, but this investigation has been inactive for a
substantial period of time. During 2004, we were under
investigation concerning resident care and funds received for
Certified Nurse Assistant training at the Lakeside facility
before the operations were transferred to Lakeside Health. As of
December 31, 2004, we accrued for known and estimated fines
and penalties to be assessed, based upon our negotiations with
the State. In March 2005, we reached a settlement with the state
for the $2.3 million we accrued.


In December 2004, we recorded a tax benefit of
$33.6 million relating to additional losses claimed from
the December 1999 sale of Arbor, our former subsidiary, to
Tandem and the settlement of an Internal Revenue Service, or
IRS, audit.

Revenues

We derive revenues by providing routine and
ancillary healthcare services to residents in our network of
facilities. Long-term healthcare services provided to our
residents include services such as nursing care, assisted living
and related medical services, such as subacute care. We also
derive revenues by providing rehabilitative therapy to outside
third parties at our rehabilitation clinics, and earn management
and consulting revenues from other long-term care organizations.

Nursing facilities

Within our nursing facilities, we generate our
revenue from Medicare, Medicaid and private pay sources.
Medicaid rates are generally lower than rates earned from
Medicare, private, commercial insurance and other sources, and
therefore, an important performance measurement is Quality
Mix, which is defined as revenues or census earned from
payor sources other than from Medicaid programs. The following
table sets forth our Medicare, Medicaid and private pay sources
of revenue of our nursing facilities by percentage of total
revenue and the level of Quality Mix:

|                  |             |                                      |      |       |   |      |      |       |   |  |      |       |  
|----------------- | ----------- | ------------------------------------ | ---- | ----- | - | ---- | ---- | ----- | - |  | ---- | ----- | -
|                  |             |                                     
|                  |             | Percentage of Total Nursing Revenues
|                  |             | Year Ended December 31              
|                  |             |                                     
|                  |             | 2004                                 |      | 2003  |   | 2002
|                  |             |                                      |      |       |   |     
|Medicare          |             |                                      | 32.1 | %     |   |      | 29.2 | %     |   |  | 27.3 | %    
|Private and other |             |                                      | 17.3 | %     |   |      | 18.5 | %     |   |  | 19.0 | %    
|                  |             |                                      |      |       |   |      |      |       |   |  |      |      
|                  | Quality Mix |                                      |      | 49.4  | % |      |      | 47.7  | % |  |      | 46.3  | %
|Medicaid          |             |                                      | 50.6 | %     |   |      | 52.3 | %     |   |  | 53.7 | %    
|                  |             |                                      |      |       |   |      |      |       |   |  |      |      
|                  | Total       |                                      |      | 100.0 | % |      |      | 100.0 | % |  |      | 100.0 | %
|                  |             |                                      |      |       |   |      |      |       |   |  |      |      

35



---



##### Table of Contents



Nursing and Assisted Living
Facilities

Within our assisted living facilities, we
generate our revenue from primarily private pay sources, with a
small portion earned from Medicaid where states offer such
programs. The following table sets forth our Medicare, Medicaid
and private pay sources of revenues for all nursing and assisted
living facilities by percentage of total revenue and the level
of Quality Mix:

|                  |             |                                 |      |       |   |      |      |       |   |  |      |       |  
|----------------- | ----------- | ------------------------------- | ---- | ----- | - | ---- | ---- | ----- | - |  | ---- | ----- | -
|                  |             |                                
|                  |             | Percentage of Total Nursing and
|                  |             | Assisted Living Revenues       
|                  |             | Year Ended December 31         
|                  |             |                                
|                  |             | 2004                            |      | 2003  |   | 2002
|                  |             |                                 |      |       |   |     
|Medicare          |             |                                 | 30.7 | %     |   |      | 27.9 | %     |   |  | 26.1 | %    
|Private and other |             |                                 | 20.5 | %     |   |      | 21.8 | %     |   |  | 22.4 | %    
|                  |             |                                 |      |       |   |      |      |       |   |  |      |      
|                  | Quality Mix |                                 |      | 51.2  | % |      |      | 49.7  | % |  |      | 48.5  | %
|Medicaid          |             |                                 | 48.8 | %     |   |      | 50.3 | %     |   |  | 51.5 | %    
|                  |             |                                 |      |       |   |      |      |       |   |  |      |      
|                  | Total       |                                 |      | 100.0 | % |      |      | 100.0 | % |  |      | 100.0 | %
|                  |             |                                 |      |       |   |      |      |       |   |  |      |      

Other Revenues

We derive outpatient therapy revenues by
providing rehabilitation therapy services to outside third
parties at our clinics. The revenue sources are primarily
HMOs and commercial insurance (46%), workers
compensation (23%), Medicare (22%), Medicaid (4%) and other
sources, including self-pay clients (5%). Management and
consulting fees are paid directly from the long-term care
organizations that we are contracted to provide services with.

Legislative Actions Affecting
Revenues

Legislative Actions Affecting Medicare
Revenues

Prior to October 1, 2002, the incremental
Medicare relief packages received from the Balanced Budget
Refinement Act, or BBRA, and Benefits Improvement and Protection
Act, or BIPA, provided a total of $2.7 billion in temporary
Medicare funding enhancements to the long-term care industry.
The funding enhancements implemented by BBRA and BIPA fall into
two categories. The first category is Legislative
Add-ons, which included a 16.66% add-on to the nursing
component of the Resource Utilization Groups, or RUGs, rate and
a 4% base adjustment. The Legislative Add-ons expired on
September 30, 2002, hereafter referred to as the
Medicare Cliff. Based upon the Medicare case mix and
census for the 12 month period from October 1, 2002 to
September 30, 2003, the net impact of the Medicare Cliff
and the market basket increase reduced our revenues by
$16.7 million. The second category is RUGs Refinements,
which involved an initial 20% add-on for 15 RUGs categories
identified as having high intensity, non-therapy ancillary
services. The 20% add-ons from three RUGs categories were later
redistributed to 14 rehabilitation categories at an add-on rate
of 6.7% each. As discussed below, the RUGs Refinements funding
enhancements are currently scheduled to sunset on
September 30, 2005.

Effective October 1, 2003, CMS increased
Medicare rates by 6.26% reflecting (1) a cumulative
forecast correction, or Administrative Fix, to
correct past years under-funded rate increases, which increased
the federal base payment rates by 3.26% and (2) the annual
market basket increase of 3.0%. Based on the Medicare case mix
and census for the twelve months ended September 30, 2004,
the impact of the 6.26% Medicare rate increase increased our
revenues by $14.4 million ($18.45 per Medicare day),
which was offset by higher labor and other operating costs. In
order to maintain their commitment to Senator Grassley and CMS
in providing the Administrative Fix, in October 2003 the
Alliance for Quality Nursing Home Care (which is a membership of
large long-term care providers) and the American Health Care
Association announced their support to spend the Administrative
Fix over the next fiscal period on direct care and services for
residents. In October 2003, CMS published notice to nursing
facilities that future cost reports will require confirmation
that the Administrative Fix funding was spent on direct patient
care and related expenses.

36



---



##### Table of Contents



Future Medicare Changes

With respect to the RUGs Refinements, CMS has
extended the funding enhancements beyond the previously
announced sunset dates. However, based upon the July 2004 CMS
announcement, the RUGs Refinements extend only until
September 30, 2005. Congress has enacted legislation
directing CMS to conduct a study on the RUGs classification
system and report its recommendations prior to the
implementation of a RUGs Refinement change whereby all or part
of the enhancement is discontinued. In February 2005, the
Presidents Proposed Budget provides for the discontinuance
of the RUGs Refinements effective October 1, 2005. The
Presidents Proposed Budget is subject to legislative
review and the budget being passed by the United States
Government. Based upon the Medicare case mix and census for the
year ended December 31, 2004, we estimate that we receive
an average $25.50 per resident day, which on an annualized
basis amounts to $20.1 million related to the RUGs
Refinements. The implementation of a RUGs Refinement change
whereby all or part of the enhancement is discontinued could
have a significant impact on us.

In February 2003, CMS announced its plan to
reduce its level of reimbursement for uncollectible Part A
co-insurance. Under the plan announced by CMS, the reimbursement
level would be reduced to 70% over a three year period as
follows: 90% effective for the government fiscal year commencing
October 1, 2003; 80% effective for the government fiscal
year commencing October 1, 2004; and 70% effective for
government fiscal years commencing on or after October 1,
2005. This plan is consistent with the Part A co-insurance
reimbursement plan applicable to hospitals. CMS did not
implement the rule change effective October 1, 2003, and
continues to review the proposed plan. In February 2005, the
Presidents Proposed Budget provides for the implementation
of the reduced reimbursement plan over a three year period
commencing October 1, 2005. The Presidents Proposed
Budget is subject to legislative review and the budget being
passed by the United States Government. Should that occur, we
estimate that the negative impact to our pre-tax net income
would be $0.4 million in 2005, $1.7 million in 2006,
$2.9 million in 2007, and $3.8 million in 2008.

State Plan Amendments that Affected Medicaid
Rates

Several states in which we operate have submitted
plan amendments and waivers to CMS, which seek to increase the
level of federal funding for the states Medicaid programs.
If approved, these plan amendments and waivers would result in
providing nursing facilities with revenue rate increases to
offset new or increased provider taxes. In June 2004, CMS
approved the state plan amendment and waiver submitted by the
State of Oregon pertaining to the fiscal year commencing
July 1, 2003, which resulted in a net favorable impact of
$0.3 million that was recorded in the second quarter of
2004. In July 2004, the State of Kentucky received approval from
CMS of a state plan amendment and waiver, which became effective
July 1, 2004. The Kentucky plan amendment and waivers
increased our income before income taxes by approximately
$2.3 million for the six months ended December 31,
2004.

Future State Plan Amendment Changes

In January 2005, the States of Pennsylvania and
Washington received approval from CMS for their submitted state
plan amendments and waivers. The Washington approval will have
no impact on our earnings. As a result of the Pennsylvania
approval, we anticipate that we will receive, subject to
finalization, retroactive revenues of approximately
$11.3 million in 2005 and be required to pay provider taxes
of approximately $8.7 million pertaining to the period
July 1, 2003 to June 30, 2004. As a result, the impact
on income before income taxes is estimated to be approximately
$2.6 million. In addition, subject to state budgetary
approval and certain other actions, we anticipate that we will
receive retroactive revenues to fund provider taxes for the
period July 1, 2004 to December 31, 2004. These
amounts are subject to finalization, however current estimates
indicate that the impact on income before income taxes of the
July 1, 2004 to December 31, 2004 settlement will be
approximately $0.5 million. We will record the above
settlements when the plans are finalized in 2005.

The State of Indiana has submitted a proposed
state plan amendment and waiver pertaining to the fiscal year
commencing July 1, 2003, which is awaiting review and
approval by CMS. Since the plan amendment and waiver has not
been approved, we have recorded revenues based upon amounts
received. Approval of the

37



---



##### Table of Contents



retrospective amendment and waiver submitted
could result in the recording of incremental income before
income taxes of $4.6 million in 2005 pertaining to the
18-month period ended December 31, 2004. There would be no
impact to us if the plan were not approved. We anticipate that
amendments will be made to the original plan submitted to CMS
and cannot, therefore, predict the outcome of this plan
submission or its impact on us and our results of operation.
Based upon the final CMS approved state plan amendment and
waiver, changes in Medicaid rates and any associated provider
taxes could result in adjustments to income for the period from
July 1, 2003 to December 31, 2004.


Significant Events and Developments

Events of 2004

Improvement in Medicare and Total
Census.Medicare Average Daily Census,
or ADC, increased 8.5% to 2,100 for 2004 from 1,935 for 2003 on
a same facility basis. Total ADC increased 0.9% to 12,607 for
2004 from 12,490 for 2003 on a same facility basis. The
improvement in Medicare census was the direct result of a number
of our initiatives, including the implementation of consistent
admission practices, the Medicare certification of all our
nursing facility beds and senior managements focus on
census.

Acquisitions of Nursing
Facilities.On February 12, 2004,
we acquired a nursing facility in Washington, which we had
previously leased, for $1.4 million. On June 1, 2004,
we acquired four nursing facilities (321 beds) in Indiana
for cash of approximately $5.0 million. Our 2004 financial
results also include the operations of a nursing facility in
Wisconsin (99 beds) that was acquired on December 31,
2003 for cash of $4.1 million.

Construction
Projects.During 2004, we completed
four construction projects for a total cost of
$10.0 million, which included a new free-standing assisted
living facility with 40 units, two additions to existing
assisted living facilities adding 46 units and an addition
of 20 nursing beds to an existing nursing facility. We
currently have 11 additional construction projects in progress,
that will add 18 nursing beds and 376 assisted living
units. Nine of the projects are expected to be completed in 2005
and the remaining in 2006. The total estimated cost of the
uncompleted projects is $42.0 million, of which
approximately $9.4 million has been spent through
December 31, 2004.

Definitive Merger and Acquisition Agreement
with ALC.On November 4, 2004, we
entered into a definitive merger and acquisition agreement with
ALC providing for the acquisition of all of the outstanding
shares and stock options of ALC at $18.50 per share. The
acquisition was subsequently completed on January 31, 2005.
The completion of the acquisition was subject to certain
conditions, including approval by ALCs shareholders and
certain customary regulatory approvals. ALC has a portfolio of
177 assisted living facilities, including 122 owned and 55
leased facilities representing 6,838 units located in
14 states, many in markets where we currently operate.

Tender Offer/ Redemption of 2007 Notes and
Sale and Issuance of 2014 Notes.On
April 5, 2004, we commenced a tender offer to purchase any
and all of our outstanding $200.0 million 2007 Notes.
Approximately $104.9 million aggregate principal amount of
outstanding 2007 Notes were validly tendered in the tender
offer, which we purchased for cash. All of the outstanding 2007
Notes that were not tendered in the tender offer were either
cancelled or redeemed for cash and cancelled as of May 24,
2004.

On April 22, 2004, we sold and issued
$125 million aggregate principal amount of 2014 Notes
pursuant to Rule 144A and Regulation S under the
Securities Act of 1933, as amended, or the Securities Act. The
2014 Notes were issued at a price of 97.5001% of par to yield
7.23%. The net proceeds from the sale and issuance of the 2014
Notes were approximately $117.4 million, net of a
$3.1 million discount and fees and expenses of
$4.5 million. We used these net proceeds, together with
cash on hand and borrowings under our amended and restated
credit facility, to purchase for cash approximately
$104.9 million aggregate principal amount of 2007 Notes
validly tendered in the tender offer and to redeem any 2007
Notes not tendered in the tender offer or cancelled prior to
May 24, 2004. See Liquidity and Capital
Resources for more information regarding the 2014 Notes.
In August 2004, we completed our offer to exchange new
6.875% Senior Subordinated Notes due

38



---



##### Table of Contents



2014 that have been registered under the
Securities Act for the 2014 Notes issued in April 2004. The
terms of the new 2014 Notes are identical to the terms of the
2014 Notes issued in April 2004.


As a result of the tender offer, redemption and
repayment of the 2007 Notes, in the second quarter of 2004 we
wrote off deferred finance charges of approximately
$2.4 million related to the 2007 Notes and incurred legal
costs of $0.3 million. In addition, pursuant to the
termination of our related interest rate swap and cap agreements
(discussed below), we recorded a gain of approximately
$3.3 million recognized in the second quarter of 2004. The
net impact to income was a loss of approximately
$6.0 million. Below is a summary of the loss recognized in
the second quarter of 2004 relating to these transactions.

|                                                                 |  |                        |        |  
|---------------------------------------------------------------- |  | ---------------------- | ------ | -
|                                                                 |  | (Dollars in thousands)
|                                                                 |  |                       
|Tender premium and call premium                                  |  | $                      | (6,636 | )
|Write-off of deferred finance charges                            |  |                        | (2,359 | )
|Legal expenses                                                   |  |                        | (285   | )
|                                                                 |  |                        |        |  
|                                                                 |  |                        | (9,280 | )
|Gain on termination of interest rate swap and cap
    Agreements |  |                        | 3,302  |  
|                                                                 |  |                        |        |  
|                                                                 |  | $                      | (5,978 | )
|                                                                 |  |                        |        |  

Amendment and Restatement of Credit Facility.In connection with the April 22,
2004 closing of the sale and issuance of the 2014 Notes, we
amended and restated our credit facility. The terms of our
amended and restated credit facility include the following
changes, among other things:



| |   |                                                                                                                                                                                                                                                      
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | a two year maturity extension to June 28,
    2009;                                                                                                                                                                                                  
|
| |  | an additional $50.0 million of senior
    secured financing on a revolving basis, resulting in total
    borrowing capacity of $155.0 million;                                                                                                       
|
| |  | an interest rate spread which ranges from the
    Eurodollar rate plus 2.50% per annum to 3.25% per annum or the
    base rate plus 1.50% per annum to 2.25% per annum, subject, in
    each case, to adjustments based on our senior leverage ratio;
|
| |  | a commitment fee of 0.50% per annum on the
    undrawn capacity regardless of utilization;                                                                                                                                                           
|
| |  | changes to the collateral securing the facility
    to permit us to substitute certain assets with other assets.                                                                                                                                     

See Liquidity and Capital Resources
for more information regarding our credit facility.

Interest Rate Swap and Cap Agreements.In April 2004, coterminous with the
redemption of the 2007 Notes, we terminated our related interest
rate swap and cap agreements for an aggregate gain of
$3.3 million. In addition, to hedge our exposure to
fluctuations in market value, we entered into two new interest
rate swap agreements and two new interest rate cap agreements
relating to the 2010 Senior Notes and the 2014 Notes. See
Liquidity and Capital Resources for more information
regarding our interest rate swap and cap agreements.

Redemption of 2007 Notes Held by
Extendicare and Advances to and from Extendicare.Extendicare held $27.9 million of
the 2007 Notes prior to the refinancing of those Notes. Pursuant
to the tender offer, in May 2004 the 2007 Notes held by
Extendicare were redeemed for approximately $28.8 million
in cash. In May 2004, subsequent to the redemption, Extendicare
advanced through our direct parent company $22.9 million,
of which $14.0 million was advanced through an affiliate to
us. In December 2004, we advanced $7.7 million to
Extendicare, which was subsequently repaid in January 2005.

Omnicare Shares and Warrants Held for
Investment.In May 2004, Extendicare
purchased for market value all of our investment of 125,000
common shares in Omnicare for $4.9 million in cash, which
resulted in a pre-tax gain of $0.9 million. At
December 31, 2004, we held a warrant to purchase up to
1.5 million shares of Omnicare common stock, which had an
original attributed carrying value of $4.0 million pursuant
to the sale of our pharmacy to Omnicare in 1998. The warrant has
an exercise price of $48.00 per share and expires in September
2005. The book value of the warrant is based on the estimated
market value that is computed using the Black-Scholes model. The
book value of the warrant as of December 31, 2003 was
$4.4 million. However,

39



---



##### Table of Contents



during the third quarter of 2004 the share price
of Omnicare common stock declined significantly, resulting in
the value of the warrant declining to $0.3 million. Prior
to the third quarter of 2004, the change in book value had been
recorded through a charge to Accumulated Other Comprehensive
Income, or AOCI. In the third quarter of 2004, we wrote off our
$4.0 million investment because the likelihood of the
warrant being in-the-money before it expires had significantly
declined as a result of the decrease in Omnicares share
price. The market value of an Omnicare share as of
December 31, 2004 was $34.62.


Other Loan Repayments and Refinancing.In February and August 2004, we
prepaid three Industrial Development Revenue Bonds in full which
in aggregate reduced our borrowing by $22.5 million and
resulted in a charge to income of $0.6 million to write off
deferred financing costs. In October 2002, we completed a
transaction in which we exercised our right to acquire seven
previously leased nursing facilities in the states of Ohio and
Indiana for $17.9 million. The purchase price included cash
of $7.4 million and a $10.5 million interest bearing
10-year note. The interest rate on the note was subject to
negotiation and failing an agreement would have been settled
through arbitration. In the latter part of 2003, we prepaid
$4.5 million against the note. In April 2004, we refinanced
the facilities with mortgages whose interest rates vary with
LIBOR above a minimum level, and repaid the remaining balance of
the note due to the seller.

Prepayment of Tandem Notes Receivable.In February 2004, Tandem refinanced
two of its nursing facilities and we subsequently received
prepayment in full of $4.4 million of notes receivable held
in respect of certain properties. In June 2004, we accepted and
received a cash prepayment of $16.2 million for the
remaining $17.0 million of notes receivable due from
Tandem. After payment of the associated selling expenses of
$0.5 million, we recognized a loss of $1.3 million on
this transaction.

Completion of Greystone Divestiture Agreement.In June 2004, we concluded a deferred
sales transaction with Greystone by receipt of the final
consideration of $10.0 million on the Vendor Take Back Note
plus $2.6 million of interest. Finalizing this transaction
resulted in the recognition of a gain on the sale of assets of
$4.9 million and interest income of $1.7 million. The
initial transaction in 2000 was treated as a deferred sale since
a significant portion of the proceeds was contingent and we held
an option to repurchase the facilities.

In September 2000, we disposed of eleven Florida
nursing facilities (1,435 beds) and four Florida assisted
living facilities (135 units) to Greystone and received
initial cash proceeds of $30.0 million and contingent
consideration in the form of a $10.0 million Vendor Take
Back Note and two other contingent and interest-bearing notes.
For the period from September 2000 through March 2004, we
retained the right of first refusal to repurchase the
facilities. We also retained an option to repurchase the
facilities until March 2003; however, we elected not to place an
offer to repurchase the facilities. The option to repurchase
along with the significant portion of the sales price being
contingent, resulted in the disposition being accounted for as a
deferred sale in accordance with Statement of Financial
Accounting Standards, or SFAS, No. 66 and, accordingly,
there was no gain or loss recorded on the initial transaction.
Prior to the finalization of the agreement, the fixed assets had
been classified as Assets held under Divestiture
Agreement and had a net book value of $33.7 million.
As of December 31, 2003, we anticipated the final
consideration to be received in 2004, and, therefore, the
Assets held under Divestiture Agreement were
classified as a current asset and we ceased depreciating these
assets as of January 1, 2004.

Settlement of Medicare Receivable Issues.During 2004, we reached negotiated
settlements with our FIs of all significant outstanding Medicare
settlement issues pertaining to revenues earned prior to the
implementation of PPS. As a result of the settlements discussed
below, settlement receivables decreased by $20.2 million,
from a balance of $37.2 million as of December 31,
2003 to $17.0 million as of December 31, 2004. In
January 2004, we negotiated and subsequently received a cash
settlement of $5.6 million for a specific staffing cost
issue involving six specific claims years. The settlement did
not result in any significant adjustment from the recorded
receivable balance. In April 2004, we reached a negotiated
settlement with a FI in respect of the remaining two claim years
regarding an allocation of overhead cost settlement receivable
issue. The settlement will result in the receipt of
approximately $7.7 million, $6.6 million of which was
received in May 2004. We will receive the balance of the payment
upon resolution of other matters concerning the cost report
years under appeal. In August 2004, prior to the Provider
Reimbursement Review Board, or PRRB, hearing date, we reached a
negotiated settlement with a FI with respect to various issues
relating to

40



---



##### Table of Contents



facilities purchased in the Arbor acquisition in
1997. The settlement will result in the payment to us of
$2.1 million, $1.8 million of which was received in
the fourth quarter of 2004. The balance of the settlement will
be received in 2005. The settlement receivables had been
reserved for upon the 1999 divestiture of Arbor to Tandem and
further within the provision for divested operations. Upon the
sale of Arbor to Tandem, a long-term liability of
$3.7 million was accrued for outstanding tax, Medicare and
other claims against Arbor. Upon settlement of these Medicare
matters, we believe that there are no outstanding claims in
respect of Arbor, however, there can be no assurance that other
claims will not be made until the expiration of the warranty
period with Tandem in 2007. As a result of the Arbor issue
settlement, the $6.9 million difference between the net
settlement balance and proceeds to be received was charged
against the $3.7 million Arbor long-term liability balance,
and $3.2 million against the liability for divested
operations. In September 2004, prior to the PRRB hearing date,
we reached a negotiated settlement with a FI with respect to the
Director of Nursing staff cost issue amounting to
$3.2 million, of which $2.8 million was received in
the fourth quarter of 2004. The balance of the settlement will
be received in 2005. No gain or loss resulted on settlement of
this issue.


Consolidation of Two
Facilities.In March 2004, we
concluded the evaluation of two nursing facilities that operate
adjacent to one another in Indiana, both of which require
capital renovations. After evaluation of the respective
operations, we made a decision, subject to State of Indiana
approval, to consolidate the two operations into one renovated
facility, that upon completion, will accommodate all residents
from both facilities; however, decrease the total available
nursing beds by 46. We expect consolidation of the two
operations to be completed by April 2005. As a result of the
decision to close one facility, we have recorded a provision of
$1.6 million for impairment of long-lived assets.

Divestitures.In
August 2004, we sold all of our Arkansas facilities, consisting
of one nursing (96 beds) and three assisted living facilities
(181 units), for $6.1 million. Proceeds consisted of
cash of $5.2 million and a five-year interest-bearing note
of $0.9 million. The sale resulted in a pre-tax loss of
$0.6 million. For 2004 and 2003, respectively, the Arkansas
facilities had revenues of $5.3 million and
$7.4 million and income before interest, depreciation and
income taxes of $0.7 million and $0.6 million.

Transfer of Operations of Nursing Facility in
Chippewa Falls, Wisconsin.In August
2004, we transferred the operations of the Lakeside nursing
facility (336 beds) in Chippewa Falls, Wisconsin to
Lakeside Health L.L.C., or Lakeside Health, a subsidiary of
Benedictine Health Dimensions, Inc., or Benedictine, under a
three-year lease arrangement. The transfer of operations was in
response to facility citations for survey deficiencies and an
agreement with the State of Wisconsin to transfer the operations
to a new licensee. Under the terms of the agreement, Lakeside
Health is responsible for all operating costs, including rent
payable to us and management fees payable to Benedictine. We
will receive rental income of $0.5 million per annum,
however, we are responsible for funding Lakeside Healths
operating losses from the nursing facility, as defined in the
agreement, and to provide to Lakeside Health working capital
advances sufficient to maintain an operating cash account of
$1.5 million. As of December 31, 2004, we have
advanced $4.4 million to Lakeside Health, which is secured
by a first security interest in Lakeside Healths accounts
receivable and is repayable from the assets and future cash flow
of Lakeside Health, if any. Effective the date of the license
transfer, the State of Wisconsin reduced the Lakeside nursing
facility licensed bed capacity from 336 to 245. In September
2004, Benedictine completed its plan of correction at Lakeside
and passed its survey with the State of Wisconsin bringing the
facility into regulatory compliance. In the five months
Benedictine operated the facility in 2004, considerable
resources were employed to bring the facility into compliance,
resulting in Lakeside Health reporting a $1.8 million net
loss. We recorded a provision of $2.0 million against the
working capital advances made to Lakeside Health, and therefore,
as of December 31, 2004, the net carrying value of advances
made to Lakeside Health was $2.4 million. During 2004, we
were under investigation concerning resident care and funds
received for Certified Nurse Assistant training at the Lakeside
facility before the operations were transferred to Lakeside
Health. As of December 31, 2004, we accrued for known and
estimated fines and penalties to be assessed, based upon our
negotiations with the State. In March 2005, we reached a
settlement with the state for the $2.3 million we accrued.

Impairment Provision for Lakeside Property.As a result of the financial and
operating performance of Lakeside Health in the fourth quarter
of 2004, we recorded an asset impairment provision of
$6.8 million to reduce the carrying value of the Lakeside
property from $13.0 million to $6.2 million. We
determined the

41



---



##### Table of Contents



reduced property value based upon our estimate of
the current market value of the facility, which assumes the
facility attains a suitable Medicare occupancy level. There
cannot be assurance that a future reduction in carrying value
will not be required if these estimates change. We will continue
to monitor the facilitys performance in respect of
determination of a potential asset impairment charge. Prior to
the transfer of operations, we incurred a loss before lease
costs, depreciation, interest and income taxes of
$1.2 million for the seven months ended July 31, 2004
as compared to income before these items of $0.5 million
for the year ended December 31, 2003.


State Plan Amendments affecting Medicaid
Revenues.In July 2004, the State of
Kentucky received approval from CMS of a state plan amendment
and waiver, which became effective July 1, 2004. The
Kentucky plan amendment and waiver contributed approximately
$2.3 million in incremental income before income taxes for
the six month period ended December 31, 2004.

Management and Consulting Services.We commenced managing two new nursing
facilities and providing consulting services to five new nursing
and assisted living facilities. We also transferred management
responsibilities for nine nursing facilities to another
long-term care provider while retaining consulting services for
these nursing facilities. We also assumed full management
responsibilities for two facilities and new consulting service
responsibilities for six facilities in 2004.

Income Tax Benefits.In December 2004, we recorded an
aggregate $33.6 million of income tax benefits that
resulted primarily from two events. We recorded a tax benefit of
$31.9 million for an additional loss claimed from the
December 1999 sale of our former subsidiary Arbor to Tandem.
This additional loss was primarily due to the issuance of
additional guidance by the IRS regarding the method to calculate
the loss on the sale of subsidiary stock and partially due to
the settlement of an IRS audit for the tax years ending December
1997 through December 2002. In addition, we recorded a tax
benefit of $1.7 million relating to this IRS audit and
other issues.

42



---



##### Table of Contents



Events Subsequent to 2004

Acquisition of ALC.On January 31, 2005, the
shareholders of ALC approved the merger and acquisition
agreement with us and we completed the acquisition for cash of
approximately $144 million. We financed the acquisition by
using approximately $29 million in cash on hand, a
$55 million 6% Term Loan from Extendicare Holdings, Inc.,
or EHI, and $60 million from our credit facility. The
estimated impact of the acquisition on each asset and liability
category in the Companys balance sheet as of
January 31, 2005 is as follows:

|                                                             |                                                                                       |                |         |         | 
|------------------------------------------------------------ | ------------------------------------------------------------------------------------- | -------------- | ------- | ------- | 
|                                                             |                                                                                       | (in thousands)
|ASSETS:                                                      |                                                                                       |                |         |        
|Cash, net of $29 million used to finance the
    acquisition |                                                                                       | $              | (22,652 | )      
|Accounts receivable                                          |                                                                                       |                | 3,003   |        
|Other current assets                                         |                                                                                       |                | 8,308   |        
|                                                             |                                                                                       |                |         |        
|Total current assets                                         |                                                                                       |                | (11,341 | )      
|Property, plant and equipment                                |                                                                                       |                | 290,761 |        
|Goodwill                                                     |                                                                                       |                |        |        
|Other long-term assets                                       |                                                                                       |                | 4,497   |        
|                                                             |                                                                                       |                |         |        
|Total assets                                                 |                                                                                       | $              | 283,917 |        
|                                                             |                                                                                       |                |         |        
|LIABILITIES:                                                 |                                                                                       |                |         |        
|Current maturities of long-term debt                         |                                                                                       | $              | 3,418   |        
|Other current liabilities                                    |                                                                                       |                | 19,733  |        
|                                                             |                                                                                       |                |         |        
|Total current liabilities                                    |                                                                                       |                | 23,151  |        
|Long term debt:                                              |                                                                                       |                |         |        
|                                                             | Long-term debt of ALC assumed                                                         |                |         | 141,011 | 
|                                                             | Proceeds from 6% Term Loan from Extendicare
    Holdings, Inc. to finance acquisition |                |         | 55,000  | 
|                                                             | Draw on credit facility to finance acquisition                                        |                |         | 60,000  | 
|                                                             |                                                                                       |                |         |        
|                                                             | Total long-term debt                                                                  |                |         | 256,011 | 
|Other long term liabilities                                  |                                                                                       |                | 4,755   |        
|                                                             |                                                                                       |                |         |        
|Total liabilities                                            |                                                                                       | $              | 283,917 |        
|                                                             |                                                                                       |                |         |        

In January 2005, we amended our credit facility
to permit the loan from EHI and accommodate the ALC acquisition.
The ALC debt we assumed in the acquisition, is non-recourse to
us and the debt and earnings of ALC are excluded from existing
financial covenants under our credit facility. We are restricted
from borrowing further under our credit facility and under the
ALC credit facility to finance any ALC operating deficiencies,
and all cash flow from ALC will be retained within the ALC
operations. Any cash flow deficiencies within ALC will be
financed by way of advances from Extendicare directly to ALC and
we believe Extendicare has the financial capacity to meet any
such deficiency.

In January 2005, Extendicare Inc. advanced
$55.0 million to EHI, who in turn advanced
$55.0 million as a Term Loan to us, as part of the
financing of the ALC acquisition. This Term Loan has a term of
five years, can be repaid at any time by us and bears interest
at 6%.

In January 2005, we entered into a Memorandum of
Understanding, or MOU, with LTC Properties, Inc., or LTC, in
respect of the 37 facilities leased by ALC from LTC. Under the
terms of the MOU, which became effective January 1, 2005,
we agreed to increase the annual rent paid to LTC by $250,000
per annum for each of the successive four years, commencing on
January 1, 2005, and amended the terms relating to
inflationary increases. Formerly, the 37 leases had expiration
dates ranging from 2007 through to 2015. Under the terms of the
MOU, the amended lease provides for an initial 10 year
lease commencing on January 1, 2005, and three successive
10 year lease terms at our option. The aggregate minimum
rent payments for the Leases for the

43



---



##### Table of Contents



calendar years 2005 through 2008 will be
$9.4 million, $9.8 million and $10.2 million and
$10.7 million, respectively. The minimum rent will increase
by 2% over the prior years minimum rent for each of the
calendar years 2009 through 2014. Annual minimum rent during any
extended term will increase a minimum of 2% over the minimum
rent of the immediately preceding year. The MOU provides that
LTC will not assert certain events of default against ALC under
the original leases.


Potential Legislative Changes affecting
Medicare Revenues.In February 2005,
the Presidents Proposed Budget provides for the
discontinuance of the RUGs Refinements and reductions in the
level of reimbursement for uncollectible Part A
co-insurance commencing October 1, 2005. The
Presidents Proposed Budget is subject to legislative
review and the budget being passed by the United States
Government. With respect to the RUGs Refinement, by legislation
the RUGs Refinement extends only until October 1, 2005.
However, Congress has enacted legislation directing CMS to
conduct a study on the RUGs classification system and report its
recommendations prior to the implementation of a RUGs Refinement
change whereby all or part of the enhancement is discontinued.
Based upon the Medicare case mix and census for the year ended
December 31, 2004, we estimate that we received an average
$25.50 per resident day, which on an annualized basis amounts to
$20.1 million related to the RUGs Refinements. With respect
to the reduction in reimbursement for uncollectible Part A
co-insurance, should the plan previously announced by CMS, be
implemented, reimbursement of Part A co-insurance would be
reduced to 70% over a three-year period as follows: 90%
effective for the government fiscal year commencing
October 1, 2005; 80% effective for the government fiscal
year commencing October 1, 2006; and 70% effective for
government fiscal years commencing on or after October 1,
2007. This plan is consistent with the Part A co-insurance
reimbursement plan applicable to hospitals. Should that occur,
we estimate that, based on our Medicare case mix and census for
the 12-months ended December 31, 2004, the negative impact
to income before income taxes would be $0.4 million in
2005, $1.7 million in 2006, $2.9 million in 2007, and
$3.8 million in 2008. The reduction in the level of
reimbursement for uncollectible Part A co-insurance and
discontinuance of all or part of the RUGs Refinement enhancement
could have a significant impact on us.

State Plan Amendments affecting Medicaid
Revenues.In January 2005, the States
of Pennsylvania and Washington received approval from CMS for
their submitted state plan amendments and waivers. The
Washington approval will have no impact on our earnings. As a
result of the Pennsylvania approval, we anticipate that we will
receive, subject to finalization, retroactive revenues of
approximately $11.3 million in 2005 and be required to pay
provider taxes of approximately $8.7 million pertaining to
the period July 1, 2003 to June 30, 2004. As a result,
the impact on income before income taxes will be approximately
$2.6 million. In addition, subject to state budgetary
approval and certain other actions, we anticipate that we will
receive retroactive revenues to fund provider taxes for the
period July 1, 2004 to December 31, 2004. These
amounts are subject to finalization, however current estimates
indicate that the impact on income before income taxes of the
July 1, 2004 to December 31, 2004 settlement will be
$0.5 million. We will record the above settlements when the
plans are finalized in 2005.

Loan Repayments.In
January 2005, we prepaid the remaining Industrial Development
Revenue Bond totaling $9.5 million, which will result in a
charge to income of $0.1 million to write off deferred
financing costs. In February, we prepaid a mortgage totaling
$5.3 million, which will result in a pre-tax charge to
income of $0.2 million to write off deferred financing
costs.

Divestitures.In
January 2005, we sold for $1.9 million in cash a property
in Maryland that formerly was a nursing facility but was closed
in 1998. The pre-tax gain on the disposition was
$0.4 million.

Events prior to 2004

The most significant event in 2003 was the
continued improvement in total census, particularly Medicare
census. Total average daily census increased to 12,901 in 2003
from 12,727 in 2002, representing a 1.4% increase over 2002.
Medicare average daily census increased to 1,997 in 2003 from
1,699 in 2002 representing a 17.5% increase over 2002.

The October 2003, Medicare rate increase, which
included an Administrative Fix of 3.26% in addition to the
market basket increase of 3%, was partial recognition by CMS of
past under-funding of the industry.

44



---



##### Table of Contents



On December 31, 2003, we acquired one
nursing facility (99 beds) in Wisconsin. During 2003, we
commenced seven new developments involving additions to two
nursing facilities (38 beds), additions to four assisted living
facilities (88 units) and the construction of one new
free-standing assisted living facility (40 units). Four of
the developments, with 86 assisted living units and 20 nursing
beds, opened in 2004. The remaining three developments are
expected to be completed in 2005.

Issuance of Senior Notes

On June 28, 2002, we completed a private
placement of $150 million of our 9.5% Senior Notes due
July 1, 2010, which were issued at a discount of 0.25% of
par to yield 9.54%. In January 2003, we completed the offer to
exchange our 9.5% Senior Notes due 2010 that have been
registered under the Securities Act of 1933 for the Notes issued
in June 2002. The terms of the new 2010 Senior Notes are
identical to the terms of the Senior Notes issued in June 2002
and are guaranteed by all of our existing and future active
subsidiaries.

We used the proceeds of $149.6 million to
pay $8.3 million of related fees and expenses, retire
$130.8 million of debt (consisting of $124.5 million
outstanding under the previous credit facility and
$6.3 million of other debt), and the remainder for general
corporate purposes.

We had hedged a portion of our previous
variable-rate long-term debt through an interest rate swap with
a notional amount of $25 million maturing in February 2003.
Upon refinancing of the debt in April 2004, we terminated this
swap with a cash payment of $0.6 million. The retirement of
the previous credit facility resulted in the write-off of
deferred financing charges and a loss from the early retirement
of debt totaling $2.8 million ($1.7 million after tax).

Purchase of Previously-leased
Facilities

In October 2002, we purchased three skilled
nursing facilities in Ohio and four skilled nursing facilities
in Indiana that we previously leased for an aggregate purchase
price of $17.9 million. The purchase price consisted of
$7.4 million in cash and a $10.5 million ten-year
interest-bearing note.

Loss on Disposal of Assets and Provision for
Closure and Exit Costs

In May 2002, Tandem exercised its option to
purchase seven properties in Florida that it leased from us for
gross proceeds of $28.6 million, consisting of cash of
$15.6 million and $13.0 million in 8.5% five-year
notes. We applied $12.4 million of the proceeds to reduce
our bank debt. Until this date, Tandem operated these facilities
under a lease agreement with a purchase option. The carrying
value of the seven facilities was $25.3 million. As a
result, we recorded a gain on the sale of assets of
$4.0 million, inclusive of the deferred gain of
$2.2 million from the sale of two leased facilities in the
April 2001.

In May 2002, we recorded a provision for closure
and exit costs relating to divested Florida operations of
$5.3 million relating to cost report settlement issues, and
the settlement of claims with suppliers and employees.



| |                                       
| | --------------------------------------
| | Significant Assets and
    Liabilities

Assets, Liabilities and Contingencies
Resulting from Divestiture Program.As
a result of the divestiture programs related to Florida (1999
and 2000), and Texas (2001), we received cash proceeds and
notes, and we retained interest in, or ownership of, certain
nursing facility properties and entered into ongoing consulting
service agreements with operators in these two states. However,
during 2004 we accepted and received $30.6 million in cash
in settlement of outstanding notes from Tandem and Greystone. As
a result, the significant portion of assets held in connection
with these divestiture programs have now been crystalized into
cash. As of December 31, 2004, the remaining assets
relating to the divestiture program are:



| |   |                                                                                                                                                                                      
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | $7.0 million in non-current amounts
    receivable from Senior Health  South, Inc., or Senior
    Health  South, and Senior Health  Texas,
    Inc., or Senior Health  Texas; and

45



---



##### Table of Contents





| |   |                                                                                                                                                                                                                       
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | six owned and leased nursing home properties in
    Florida and four owned and leased nursing home properties in
    Texas with a net book value of $14.1 million, and we
    sublease another 12 properties in Texas.

We lease our six Florida properties to Senior
Health  South with lease expiration dates in December
2006. We lease our four Texas properties to Senior
Health  Texas with lease expiration dates in
September 2006 and sublease 12 Texas properties to Senior
Health  Texas with sublease expiration dates in
February 2012. In addition, we provide on-going consulting
services to Senior Health  South and Senior
Health  Texas and earn rental income from the
operators of these facilities. As of December 31, 2004, we
had $7.0 million in non-current accounts receivable due
from Senior Health  Texas and Senior
Health  South. As a result, our income and cash flow
can be influenced by the financial stability of these unrelated
companies.

We have recorded provisions for estimated costs
related to operations that we disposed of and have an accrued
liability balance of $2.5 million for such costs at
December 31, 2004. This reserve may be subject to
revisions, which may impact our future income. On an on going
basis we review the levels of our overall reserves for losses
related to our Florida and Texas operations, which reserves were
initially established when we decided to exit these states.
During 2002, as a result of events that became known to us then,
we concluded that we should increase our overall reserves by
$5.3 million for cost report and other settlements with the
State of Florida and other Medicare fiscal intermediaries,
collection of receivables and settlement of claims with
suppliers and employees. During 2004 and 2003, we settled
certain Medicare and Medicaid claims and charged to the divested
operations liability account approximately $3.2 million and
$1.3 million, respectively.

We entered into a Preferred Provider Agreement
with Omnicare pursuant to the disposition of our pharmacy
operations in 1998. The terms of the Preferred Provider
Agreement enabled Omnicare to execute pharmacy service
agreements and consulting service agreements with all of our
nursing facilities. In connection with its agreements to provide
pharmacy services, Omnicare has requested arbitration for an
alleged lost profits claim related to our disposition of assets,
primarily in Florida. Damage amounts, if any, cannot be
reasonably estimated based on information available at this
time. An arbitration hearing for this matter has not yet been
scheduled. We believe we have interpreted correctly and complied
with the terms of the Preferred Provider Agreement; however, we
cannot assure you that other claims will not be made with
respect to the agreement.

Medicare and Medicaid Settlement Receivables.As of December 31, 2004, we are
pursuing settlement of a number of outstanding Medicare and
Medicaid receivable balances, which, in aggregate, have a net
book value of $17.0 million. For Medicare revenues earned
prior to the implementation of PPS and Medicaid programs with a
retrospective reimbursement system, differences between revenues
that we ultimately expect to be realized from these programs and
amounts received are reflected as accounts receivable, or as
accrued liabilities when payments have exceeded revenues that we
ultimately expect to receive. For Medicare pre-PPS claims,
normally such issues are resolved during the audit process;
however, we record general provisions for disagreements that
require settlement through a formal appeal process. During 2004,
we reached negotiated settlements of all significant outstanding
Medicare settlement issues pertaining to revenues earned prior
to the implementation of PPS with our FIs.

Medicare and Medicaid settlement receivables
declined $20.2 million from a balance of $37.2 million
as of December 31, 2003 to $17.0 million as of
December 31, 2004. Refer to Significant Events and
Developments for details of changes in the settlement
receivables balance. We continue to work on the balance of other
Medicare claims with our FIs and on an on-going basis with each
of the states in respect of Medicaid receivables.

Self-Insured Liabilities.We have $37.7 million in accruals
for self-insured liabilities with respect to general and
professional liability claims as of December 31, 2004. An
actuarial valuation was completed as of December 31, 2004
and it was determined that no adjustment was required to the
accrual for self-insured liability amounts on the balance sheet.
We have estimated that approximately $18.0 million of this
liability will be paid within the next twelve months. The
majority of the liability balance was accrued during the period
that we operated in Florida and Texas.

46



---



##### Table of Contents



Key Performance Indicators

We manage our business through monitoring certain
key performance indicators. The most important key performance
indicators are:

Census

Census is defined as the number of residents
occupying a bed (or unit in the case of an assisted living
facility).

Average Daily Census

Average Daily Census, or ADC, is the number of
residents occupying a bed over a period of time, divided by the
number of days in that period.

Occupancy Percentage

Occupancy is measured as the percentage of census
relative to the total available resident beds. Total operational
resident capacity is the number of beds (or units in the case of
an assisted living facility) available for occupancy multiplied
by the number of days in the period.

Quality Mix

Quality mix is the measure of the level of
non-Medicaid census. In most states, Medicaid is the most
unattractive payor source as rates are the lowest of all payor
types.

Average Revenue Rate by Payor
Source

The average revenue rate by each payor source
influences our focus and marketing efforts to place certain
resident payor types and in certain states varies based on the
acuity of care required by a resident. The change in revenue
rates is largely dictated by CMS and state governments.

EBITDA and EBITDA Percentage

EBITDA is defined as net earnings
(loss) before income taxes, interest expense net of
interest income, valuation adjustment on interest rate caps,
depreciation and amortization, and non-cash, non-recurring gains
and losses, including disposal of assets, provision for closure
and exit costs and impairment of long-lived assets and
retirement of debt. EBITDA is not a measure of performance under
accounting principles generally accepted in the United States of
America, or GAAP. We use EBITDA as a key performance indicator
and EBITDA expressed as a percentage of total revenues as a
measurement of margin. We understand that EBITDA, or derivatives
thereof, are customarily used by lenders, financial and credit
analysts, and many investors as a performance measure in
evaluating healthcare acquisitions. Moreover, substantially all
of our financing agreements, including the indenture governing
our 2010 Senior Notes and our credit facility, contain covenants
in which EBITDA is used as a measure of compliance. Thus, we use
EBITDA to monitor our compliance with these financing
agreements. EBITDA should not be considered in isolation or as a
substitute for net income, cash flows from operating activities
and other income or cash flow statement data prepared in
accordance with GAAP, or as a measure of profitability or
liquidity.

In order to compare our performance between
periods, we assess the key performance indicators for all of our
facilities, as well as the facilities that we operated in all
reported periods, or same facility operations. Set forth below,
we provide an analysis of our key performance indicators in
total, and, where appropriate, on a same facility basis and
discuss the significant trends when comparing 2004 to 2003 and
2002. The same facility basis figures exclude the December 2003
acquisition of a nursing facility in Manitowoc, Wisconsin, the
newly-constructed assisted living facility completed in May
2004, the June 2004 acquisition of four nursing facilities in
Indiana, the August 2004 sale of a nursing facility and three
assisted living facilities located in Arkansas and the August
2004 transfer of a nursing facility in Wisconsin to Lakeside
Health.

47



---



##### Table of Contents



Nursing Facilities  ADC and Quality
Mix

The following table sets forth the ADC, by type
of payor, and the Quality Mix for all of our nursing facilities.

|                  |             |                        |       |        |  |      |       |        |  |  |       |        | 
|----------------- | ----------- | ---------------------- | ----- | ------ |  | ---- | ----- | ------ |  |  | ----- | ------ | 
|                  |             |                       
|                  |             | Year Ended December 31
|                  |             |                       
|                  |             | 2004                   |       | 2003   |  | 2002
|                  |             |                        |       |        |  |     
|Medicare          |             |                        | 2,155 |        |  |      | 1,997 |        |  |  | 1,699 |       
|Private and other |             |                        | 2,184 |        |  |      | 2,222 |        |  |  | 2,291 |       
|                  |             |                        |       |        |  |      |       |        |  |  |       |       
|                  | Quality Mix |                        |       | 4,339  |  |      |       | 4,219  |  |  |       | 3,990  | 
|Medicaid          |             |                        | 8,699 |        |  |      | 8,682 |        |  |  | 8,737 |       
|                  |             |                        |       |        |  |      |       |        |  |  |       |       
|                  | Total       |                        |       | 13,038 |  |      |       | 12,901 |  |  |       | 12,727 | 
|                  |             |                        |       |        |  |      |       |        |  |  |       |       

The following table sets forth the ADC, by type
of payor and percentage of ADC by payor type for all of our
nursing facilities, presented on a same facility basis, and
showing the percentage change in ADC between years.

|                  |       |                        |       |        |  |      |      |            |   |     |       |        |  |         |      |         |   |  |       |        |  |  |      |       |   |  |      |     |   |  |      |     |  
|----------------- | ----- | ---------------------- | ----- | ------ |  | ---- | ---- | ---------- | - | --- | ----- | ------ |  | ------- | ---- | ------- | - |  | ----- | ------ |  |  | ---- | ----- | - |  | ---- | --- | - |  | ---- | --- | -
|                  |       |                        |       |        |  |     
|                  |       | Year Ended December 31 |       |        |  |     
|                  |       |                        |       |       
|                  |       |                        |       |        |  |      |      | Percentage
|                  |       | 2004                   |       | 2003   |  | 2002 |      | Changes   
|                  |       |                        |       |        |  |      |      |           
|                  |       |                        |       | % of   |  |      |      | % of       |   |     |       | % of   |  | 2004 to |      | 2003 to
|                  |       | ADC                    |       | Total  |  | ADC  |      | Total      |   | ADC |       | Total  |  | 2003    |      | 2002   
|                  |       |                        |       |        |  |      |      |            |   |     |       |        |  |         |      |        
|Medicare          |       |                        | 2,100 |        |  |      | 16.6 | %          |   |     | 1,935 |        |  |         | 15.5 | %       |   |  | 1,640 |        |  |  | 13.3 | %     |   |  | 8.5  | %   |   |  | 18.0 | %  
|Private and other |       |                        | 2,103 |        |  |      | 16.7 | %          |   |     | 2,134 |        |  |         | 17.1 | %       |   |  | 2,194 |        |  |  | 17.8 | %     |   |  | (1.5 | )%  |   |  | (2.7 | )% 
|                  |       |                        |       |        |  |      |      |            |   |     |       |        |  |         |      |         |   |  |       |        |  |  |      |       |   |  |      |     |   |  |      |    
|Quality Mix       |       |                        | 4,203 |        |  |      | 33.3 | %          |   |     | 4,069 |        |  |         | 32.6 | %       |   |  | 3,834 |        |  |  | 31.1 | %     |   |  | 3.3  | %   |   |  | 6.1  | %  
|Medicaid          |       |                        | 8,404 |        |  |      | 66.7 | %          |   |     | 8,421 |        |  |         | 67.4 | %       |   |  | 8,485 |        |  |  | 68.9 | %     |   |  | (0.2 | )%  |   |  | (0.7 | )% 
|                  |       |                        |       |        |  |      |      |            |   |     |       |        |  |         |      |         |   |  |       |        |  |  |      |       |   |  |      |     |   |  |      |    
|                  | Total |                        |       | 12,607 |  |      |      | 100.0      | % |     |       | 12,490 |  |         |      | 100.0   | % |  |       | 12,319 |  |  |      | 100.0 | % |  |      | 0.9 | % |  |      | 1.4 | %
|                  |       |                        |       |        |  |      |      |            |   |     |       |        |  |         |      |         |   |  |       |        |  |  |      |       |   |  |      |     |   |  |      |    

On a same facility basis, total ADC increased
0.9% between 2004 and 2003, and 1.4% between 2003 and 2002. On a
same facility basis, Medicare ADC increased 8.5% between 2004
and 2003, and 18.0% between 2003 and 2002. As a result, the
percentage of Medicare ADC to all payor sources increased to
16.6% in 2004, as compared to 15.5% in 2003 and 13.3% in 2002.
The improvement in census was the direct result of a number of
initiatives, including an implementation of consistent admission
practices, the Medicare certification of all nursing facility
beds, and senior managements focus on census.

All Nursing and Assisted Living
Facilities  Occupancy and Number of Facilities In
Operation

Below are tables setting forth occupancy
percentages, ADC and operational resident capacity for the years
ended December 31, 2004, 2003 and 2002.

All Facilities:

The following table is for all of our nursing and
assisted living facilities in total:

|                            |                          |                      |      |      |   |                      |      |      |   |      |      |      |   |      |        |       |  |      |        |       |  |  |        |       |  |  |        |       |  |  |        |       |  |  |        |       | 
|--------------------------- | ------------------------ | -------------------- | ---- | ---- | - | -------------------- | ---- | ---- | - | ---- | ---- | ---- | - | ---- | ------ | ----- |  | ---- | ------ | ----- |  |  | ------ | ----- |  |  | ------ | ----- |  |  | ------ | ----- |  |  | ------ | ----- | 
|                            |                          |                      |      |      |   |                      |      |      |   |      |      |      |   |     
|                            |                          |                      |      |      |   | Operational Resident
|                            |                          | Occupancy Percentage |      | ADC  |   | Capacity            
|                            |                          |                      |      |      |   |                     
|                            |                          | 2004                 |      | 2003 |   | 2002                 |      | 2004 |   | 2003 |      | 2002 |   | 2004 |        | 2003  |  | 2002
|                            |                          |                      |      |      |   |                      |      |      |   |      |      |      |   |      |        |       |  |     
|Nursing                     |                          |                      | 91.8 | %    |   |                      | 91.5 | %    |   |      | 90.3 | %    |   |      | 13,038 |       |  |      | 12,901 |       |  |  | 12,727 |       |  |  | 14,198 |       |  |  | 14,103 |       |  |  | 14,093 |      
|Assisted Living:            |                          |                      |      |      |   |                      |      |      |   |      |      |      |   |      |        |       |  |      |        |       |  |  |        |       |  |  |        |       |  |  |        |       |  |  |        |      
|                            | Mature facilities        |                      |      | 86.1 | % |                      |      | 85.7 | % |      |      | 83.1 | % |      |        | 1,327 |  |      |        | 1,402 |  |  |        | 1,377 |  |  |        | 1,543 |  |  |        | 1,635 |  |  |        | 1,658 | 
|                            | Developmental facilities |                      |      | 67.4 | % |                      |      | 96.3 | % |      |      | 97.4 | % |      |        | 107   |  |      |        | 94    |  |  |        | 95    |  |  |        | 158   |  |  |        | 98    |  |  |        | 98    | 
|                            |                          |                      |      |      |   |                      |      |      |   |      |      |      |   |      |        |       |  |      |        |       |  |  |        |       |  |  |        |       |  |  |        |       |  |  |        |      
|                            | Total                    |                      |      | 84.4 | % |                      |      | 86.3 | % |      |      | 83.9 | % |      |        | 1,434 |  |      |        | 1,496 |  |  |        | 1,472 |  |  |        | 1,701 |  |  |        | 1,733 |  |  |        | 1,756 | 
|                            |                          |                      |      |      |   |                      |      |      |   |      |      |      |   |      |        |       |  |      |        |       |  |  |        |       |  |  |        |       |  |  |        |       |  |  |        |      
|Nursing and Assisted Living |                          |                      | 91.0 | %    |   |                      | 90.9 | %    |   |      | 89.6 | %    |   |      | 14,472 |       |  |      | 14,397 |       |  |  | 14,199 |       |  |  | 15,899 |       |  |  | 15,836 |       |  |  | 15,849 |      
|                            |                          |                      |      |      |   |                      |      |      |   |      |      |      |   |      |        |       |  |      |        |       |  |  |        |       |  |  |        |       |  |  |        |       |  |  |        |      

48



---



##### Table of Contents



Due to our expansion and development plans, which
involve both new assisted living facilities and the expansion of
existing facilities, the occupancy and ADC information is split
between mature and developmental facilities. Mature facilities
are those that have been operational for 12 months; and
developmental facilities include either facilities that have
undergone additions or have opened within the past
12 months.



| |                     
| | --------------------
| | Same Facility Basis:

The following table is for all of our nursing and
assisted living facilities on a same facility basis:

|                            |                          |                      |      |      |   |                      |      |      |   |      |      |      |   |      |        |       |  |      |        |       |  |  |        |       |  |  |        |       |  |  |        |       |  |  |        |       | 
|--------------------------- | ------------------------ | -------------------- | ---- | ---- | - | -------------------- | ---- | ---- | - | ---- | ---- | ---- | - | ---- | ------ | ----- |  | ---- | ------ | ----- |  |  | ------ | ----- |  |  | ------ | ----- |  |  | ------ | ----- |  |  | ------ | ----- | 
|                            |                          |                      |      |      |   |                      |      |      |   |      |      |      |   |     
|                            |                          |                      |      |      |   | Operational Resident
|                            |                          | Occupancy Percentage |      | ADC  |   | Capacity            
|                            |                          |                      |      |      |   |                     
|                            |                          | 2004                 |      | 2003 |   | 2002                 |      | 2004 |   | 2003 |      | 2002 |   | 2004 |        | 2003  |  | 2002
|                            |                          |                      |      |      |   |                      |      |      |   |      |      |      |   |      |        |       |  |     
|Nursing                     |                          |                      | 92.1 | %    |   |                      | 91.4 | %    |   |      | 90.1 | %    |   |      | 12,607 |       |  |      | 12,490 |       |  |  | 12,319 |       |  |  | 13,692 |       |  |  | 13,671 |       |  |  | 13,669 |      
|Assisted Living:            |                          |                      |      |      |   |                      |      |      |   |      |      |      |   |      |        |       |  |      |        |       |  |  |        |       |  |  |        |       |  |  |        |       |  |  |        |      
|                            | Mature facilities        |                      |      | 85.6 | % |                      |      | 85.1 | % |      |      | 82.1 | % |      |        | 1,217 |  |      |        | 1,237 |  |  |        | 1,213 |  |  |        | 1,422 |  |  |        | 1,454 |  |  |        | 1,477 | 
|                            | Developmental facilities |                      |      | 73.7 | % |                      |      | 96.3 | % |      |      | 97.4 | % |      |        | 97    |  |      |        | 94    |  |  |        | 95    |  |  |        | 131   |  |  |        | 98    |  |  |        | 98    | 
|                            |                          |                      |      |      |   |                      |      |      |   |      |      |      |   |      |        |       |  |      |        |       |  |  |        |       |  |  |        |       |  |  |        |       |  |  |        |      
|                            | Total                    |                      |      | 84.6 | % |                      |      | 85.8 | % |      |      | 83.0 | % |      |        | 1,314 |  |      |        | 1,331 |  |  |        | 1,308 |  |  |        | 1,553 |  |  |        | 1,552 |  |  |        | 1,575 | 
|                            |                          |                      |      |      |   |                      |      |      |   |      |      |      |   |      |        |       |  |      |        |       |  |  |        |       |  |  |        |       |  |  |        |       |  |  |        |      
|Nursing and Assisted Living |                          |                      | 91.3 | %    |   |                      | 90.8 | %    |   |      | 89.4 | %    |   |      | 13,921 |       |  |      | 13,821 |       |  |  | 13,627 |       |  |  | 15,245 |       |  |  | 15,223 |       |  |  | 15,244 |      
|                            |                          |                      |      |      |   |                      |      |      |   |      |      |      |   |      |        |       |  |      |        |       |  |  |        |       |  |  |        |       |  |  |        |       |  |  |        |      

On a same facility basis, occupancy percentages
decreased within the assisted living facilities to 84.6% for
2004 from 85.8% for 2003. The decrease in occupancy percentage
within the assisted living facilities was primarily due to the
opening in 2004 of several new wings at certain of the
facilities that were not yet fully occupied during 2004. Mature
facilities had a small increase in occupancy percentage to 85.6%
in 2004 from 85.1% in 2003.

The following table sets forth the number of
facilities under operation.

|                                     |  |                   |      |      |  |      |      |   |  |  |      |  
|------------------------------------ |  | ----------------- | ---- | ---- |  | ---- | ---- | - |  |  | ---- | -
|                                     |  |                  
|                                     |  | As of December 31
|                                     |  |                  
|                                     |  | 2004              |      | 2003 |  | 2002
|                                     |  |                   |      |      |  |     
|Percent of facilities owned          |  |                   | 94.2 | %    |  |      | 93.7 | % |  |  | 93.7 | %
|Number of facilities under operation |  |                   | 173  |      |  |      | 174  |   |  |  | 175  |  



| |                                                                          
| | -------------------------------------------------------------------------
| | Nursing Facilities  Average Revenue
    per Resident Day by Payor Source

The following table sets forth the average
revenue per resident day by payor source, including the impact
of prior year revenue adjustments discussed in Note 14 of
our financial statements included in Item 8 of this Annual
Report on Form 10-K.

|                             |       |                        |        |        |  |      |        |        |  |   |        |        | 
|---------------------------- | ----- | ---------------------- | ------ | ------ |  | ---- | ------ | ------ |  | - | ------ | ------ | 
|                             |       |                       
|                             |       | Year Ended December 31
|                             |       |                       
|                             |       | 2004                   |        | 2003   |  | 2002
|                             |       |                        |        |        |  |     
|Medicare (Part A and Part B) |       | $                      | 357.94 |        |  | $    | 322.64 |        |  | $ | 331.23 |       
|Private and other            |       | $                      | 191.09 |        |  | $    | 183.76 |        |  | $ | 170.86 |       
|Medicaid                     |       | $                      | 139.94 |        |  | $    | 132.99 |        |  | $ | 126.56 |       
|                             |       |                        |        |        |  |      |        |        |  |   |        |       
|                             | Total |                        | $      | 184.54 |  |      | $      | 171.09 |  |   | $      | 161.86 | 
|                             |       |                        |        |        |  |      |        |        |  |   |        |       

During 2004, we recorded favorable Medicaid
revenue adjustments related to prior cost report years of
$3.7 million pursuant to the settlement of state cost
reports and retroactive rate adjustments.

During 2003, we recorded a provision for
$4.0 million pertaining to individual Medicare claims in
dispute with a FI for the cost report years 1996 through 1998.
Of the $4.0 million provision, $1.3 million pertained
to discontinued operations and therefore was applied to the
previously accrued balance. The net adjustment of
$2.7 million resulted in a reduction of revenues during
2003. Offsetting this, we recorded a recovery of
$4.2 million in Medicaid revenues resulting from a
favorable court decision in the State of Ohio relating to the
recovery of alleged government overpayments for adjudicated
Medicaid cost report periods. In 2002, we

49



---



##### Table of Contents



recorded Medicaid revenue adjustments related to
prior cost report years pursuant to the settlement of state cost
reports.


The following table sets forth the average
revenue rate by payor source, excluding the above-mentioned
revenue adjustments, and the percentage changes between years.
In addition, the Medicare  Part A rate is also
reported.

|                             |       |                        |        |                    |  |      |        |              |  |              |        |        |  |  |     |     |   |  |      |     |  
|---------------------------- | ----- | ---------------------- | ------ | ------------------ |  | ---- | ------ | ------------ |  | ------------ | ------ | ------ |  |  | --- | --- | - |  | ---- | --- | -
|                             |       |                        |        |                   
|                             |       | Year Ended December 31 |        | Percentage Changes
|                             |       |                        |        |                   
|                             |       | 2004                   |        | 2003               |  | 2002 |        | 2004 to 2003 |  | 2003 to 2002
|                             |       |                        |        |                    |  |      |        |              |  |             
|Medicare (Part A and Part B) |       | $                      | 357.94 |                    |  | $    | 326.31 |              |  | $            | 331.23 |        |  |  | 9.7 | %   |   |  | (1.5 | )% 
|Private and other            |       | $                      | 191.09 |                    |  | $    | 183.76 |              |  | $            | 170.86 |        |  |  | 4.0 | %   |   |  | 7.6  | %  
|Medicaid                     |       | $                      | 138.76 |                    |  | $    | 131.31 |              |  | $            | 126.03 |        |  |  | 5.7 | %   |   |  | 4.2  | %  
|                             |       |                        |        |                    |  |      |        |              |  |              |        |        |  |  |     |     |   |  |      |    
|                             | Total |                        | $      | 183.76             |  |      | $      | 170.53       |  |              | $      | 161.49 |  |  |     | 7.8 | % |  |      | 5.6 | %
|                             |       |                        |        |                    |  |      |        |              |  |              |        |        |  |  |     |     |   |  |      |    
|Medicare Part A only         |       | $                      | 325.85 |                    |  | $    | 298.81 |              |  | $            | 305.21 |        |  |  | 9.0 | %   |   |  | (2.1 | )% 

In 2002, as a result of the Medicare Cliff, net
of the market basket increase that was effective October 1,
2002, the average Medicare  Part A rate
decreased by $23.64 per Medicare resident day. If the Medicare
Cliff had been effective January 1, 2002, the net impact
for 2002 would have been a decrease of $23.71 per Medicare
resident day.

In 2003, the Medicare Cliff revenue reductions,
net of the market basket increase, estimated at $23.64 per
Medicare resident day, continued through the nine-month period
ended September 30, 2003. On an annualized basis, the net
impact for 2003 compared to 2002 was $17.68 per Medicare day.
However, on October 1, 2003, Medicare rates increased by
6.26%, or $18.45 per Medicare resident day, reflecting the
Administrative Fix and the annual market basket increases. On an
annualized basis, this increased our Medicare rate by $4.65 per
Medicare day. In addition, we improved Medicare rates from the
admission of higher acuity residents (approximately $6.66 per
Medicare day) and increased the level of Part B Medicare
revenues (approximately $1.48 per Medicare day).

On October 1, 2004, Medicare rates increased
by 2.8%, or $9.05, per Medicare day, reflecting the annual
market basket increase. On an annualized basis, the net impact
for 2004 compared to 2003 was $2.30 per Medicare day. In
addition, we improved Medicare rates from the admission of
higher acuity residents (approximately $10.18 per Medicare day)
and increased the level of Part B Medicare revenues
(approximately $4.59 per Medicare day).

For private and other payor sources, we
experienced a 4.0% increase in rates from 2003 to 2004; as
compared to 7.6% increase from 2002 to 2003. The 2003 increase
was unusually high primarily due to the shift of lower paying
private pay residents into Medicare, and increases in rates
received from health maintenance organizations.

Average Medicaid revenue per resident day
increased 5.7% in 2004 relative to 2003; and 4.2% in 2003
relative to 2002. For a number of states, the increase in
average Medicaid revenue per resident day was primarily
attributable to increases in acuity of care levels, and funding
for increased state assessment fees and taxes.

50



---



##### Table of Contents





| |                             
| | ----------------------------
| | EBITDA and EBITDA Percentage

The following table sets forth a reconciliation
of net income before taxes and EBITDA.

|                                      |                                                                                                           |                        |         |        |  |      |        |        |   |   |        |        | 
|------------------------------------- | --------------------------------------------------------------------------------------------------------- | ---------------------- | ------- | ------ |  | ---- | ------ | ------ | - | - | ------ | ------ | 
|                                      |                                                                                                           |                       
|                                      |                                                                                                           | Year Ended December 31
|                                      |                                                                                                           |                       
|                                      |                                                                                                           | 2004                   |         | 2003   |  | 2002
|                                      |                                                                                                           |                        |         |        |  |     
|Net income (loss) before income taxes |                                                                                                           | $                      | 56,960  |        |  | $    | 32,051 |        |   | $ | 6,337  |       
|Add (deduct):                         |                                                                                                           |                        |         |        |  |      |        |        |   |   |        |       
|                                      | Depreciation and amortization                                                                             |                        |         | 35,200 |  |      |        | 37,448 |   |   |        | 37,575 | 
|                                      | Interest expense, net                                                                                     |                        |         | 17,183 |  |      |        | 29,946 |   |   |        | 31,529 | 
|                                      | Valuation adjustment on interest rate caps                                                                |                        |         | 7,983  |  |      |        | (131   | ) |   |        | 746    | 
|                                      | Loss on disposal of assets, provision for closure
    and exit costs, and impairment of long-lived assets |                        |         | 8,541  |  |      |        |       |   |   |        | 1,332  | 
|                                      | Loss on refinancing and retirement of debt                                                                |                        |         | 6,484  |  |      |        |       |   |   |        | 2,849  | 
|                                      |                                                                                                           |                        |         |        |  |      |        |        |   |   |        |       
|EBITDA                                |                                                                                                           | $                      | 132,351 |        |  | $    | 99,314 |        |   | $ | 80,368 |       
|                                      |                                                                                                           |                        |         |        |  |      |        |        |   |   |        |       

The following table sets forth the calculations
of EBITDA percentages:

|                                   |  |                        |         |      |  |      |         |   |  |   |         |  
|---------------------------------- |  | ---------------------- | ------- | ---- |  | ---- | ------- | - |  | - | ------- | -
|                                   |  |                       
|                                   |  | Year Ended December 31
|                                   |  |                       
|                                   |  | 2004                   |         | 2003 |  | 2002
|                                   |  |                        |         |      |  |     
|EBITDA                             |  | $                      | 132,351 |      |  | $    | 99,314  |   |  | $ | 80,368  |  
|Revenues                           |  | $                      | 947,852 |      |  | $    | 870,432 |   |  | $ | 815,051 |  
|EBITDA as percent of total revenue |  |                        | 14.0    | %    |  |      | 11.4    | % |  |   | 9.9     | %

EBITDA, as a percentage of total revenues,
increased to 14.0% in 2004 from 11.4% in 2003 and 9.9% in 2002.
The increase was attributable to the improvement in Medicare
census and reductions in certain operating costs as a percentage
of revenues, primarily wages and benefits.

Results from Operations:

The following table sets forth details of our
revenues and income as a percentage of total revenues:

|                                                                                                         |                                        |                        |       |      |   |      |       |      |   |  |       |      |  
|-------------------------------------------------------------------------------------------------------- | -------------------------------------- | ---------------------- | ----- | ---- | - | ---- | ----- | ---- | - |  | ----- | ---- | -
|                                                                                                         |                                        |                       
|                                                                                                         |                                        | Year Ended December 31
|                                                                                                         |                                        |                       
|                                                                                                         |                                        | 2004                   |       | 2003 |   | 2002
|                                                                                                         |                                        |                        |       |      |   |     
|Revenues                                                                                                 |                                        |                        |       |      |   |      |       |      |   |  |       |     
|                                                                                                         | Nursing and assisted living facilities |                        |       | 96.9 | % |      |       | 96.9 | % |  |       | 96.6 | %
|                                                                                                         | Outpatient therapy                     |                        |       | 1.2  |   |      |       | 1.3  |   |  |       | 1.3  |  
|                                                                                                         | Other                                  |                        |       | 1.9  |   |      |       | 1.8  |   |  |       | 2.1  |  
|                                                                                                         |                                        |                        |       |      |   |      |       |      |   |  |       |     
|                                                                                                         |                                        |                        | 100.0 |      |   |      | 100.0 |      |   |  | 100.0 |     
|Operating and general and administrative costs                                                           |                                        |                        | 85.1  |      |   |      | 87.5  |      |   |  | 88.8  |     
|Lease, depreciation and amortization                                                                     |                                        |                        | 4.7   |      |   |      | 5.4   |      |   |  | 5.9   |     
|Interest expense, net                                                                                    |                                        |                        | 1.8   |      |   |      | 3.4   |      |   |  | 3.9   |     
|Valuation adjustment on interest rate caps                                                               |                                        |                        | 0.8   |      |   |      |      |      |   |  | 0.1   |     
|Loss on disposal of assets, provision for closure
    and exit costs and impairment of long-lived assets |                                        |                        | 0.9   |      |   |      |      |      |   |  | 0.2   |     
|Loss on refinancing and retirement of debt                                                               |                                        |                        | 0.7   |      |   |      |      |      |   |  | 0.3   |     
|                                                                                                         |                                        |                        |       |      |   |      |       |      |   |  |       |     
|Income before income taxes                                                                               |                                        |                        | 6.0   |      |   |      | 3.7   |      |   |  | 0.8   |     
|Income tax (benefit) expense                                                                             |                                        |                        | (1.1  | )    |   |      | 1.4   |      |   |  | 0.4   |     
|                                                                                                         |                                        |                        |       |      |   |      |       |      |   |  |       |     
|Net income                                                                                               |                                        |                        | 7.1   | %    |   |      | 2.3   | %    |   |  | 0.4   | %   
|                                                                                                         |                                        |                        |       |      |   |      |       |      |   |  |       |     

51



---



##### Table of Contents



Year Ended December 31, 2004 Compared
with Year Ended December 31, 2003



| |         
| | --------
| | Revenues

Revenues in 2004 increased $77.5 million, or
8.9%, to $947.9 million from $870.4 million in 2003.
Outpatient therapy and other revenues in 2004 increased
$2.0 million, or 7.4%, to $29.0 million due to
increased lease revenue and management and consulting revenue.

Revenues from nursing and assisted living
facilities increased $75.5 million in 2004 compared to
2003, including $1.7 million as a net result of the
following: (1) the acquisition of a nursing facility in
Wisconsin on December 31, 2003, (2) a
newly-constructed assisted living facility completed in May 2004
in Wisconsin, (3) the acquisition of four nursing
facilities in Indiana in June 2004, (4) sale of the
facilities in Arkansas in August 2004, and (5) the transfer
to a third party of the operations of a nursing facility in
Wisconsin in August 2004. Revenues from nursing and assisted
living facilities, on a same facility basis, increased
$73.8 million, or 9.0%, in 2004. This increase was
attributable to the following:

|                                                                                                                                                                                                                          |  |            |      | 
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ---------- | ---- | 
|                                                                                                                                                                                                                          |  | Dollars in
|                                                                                                                                                                                                                          |  | Millions  
|                                                                                                                                                                                                                          |  |           
| a 5.7% increase (excluding prior year
    adjustments) in the average daily nursing Medicaid rate (which
    included cost-offset funding as a result of increased state
    assessments and bed taxes of $5.7 million) |  | $          | 23.1 | 
| an increase in Medicare revenues due
    to Medicare Part A rate increases of 2.8% and 6.26%
    effective October 1, 2004 and 2003, respectively                                                                       |  |            | 12.6 | 
| an increase in Medicare residents
    from 15.5% of total in 2003 to 16.6% in 2004                                                                                                                                      |  |            | 9.8  | 
| an increase in Medicare revenues due
    to the improvement in RUGs mix and other factors                                                                                                                               |  |            | 7.8  | 
| an increase in nursing ancillary
    revenues                                                                                                                                                                           |  |            | 6.3  | 
| a increase in nursing resident ADC
    census from 12,490 in 2003 to 12,607 in 2004                                                                                                                                     |  |            | 5.5  | 
| increases in other average daily
    nursing rates                                                                                                                                                                      |  |            | 4.5  | 
| increase due to one extra day in 2004                                                                                                                                                                                   |  |            | 2.1  | 
| an increase in assisted living
    revenues due to increased occupancy and higher rates                                                                                                                                 |  |            | 1.1  | 
|                                                                                                                                                                                                                          |  |            |      | 
|                                                                                                                                                                                                                          |  |            | 72.8 | 
|These increases were adjusted by:                                                                                                                                                                                         |  |            |      | 
| favorable prior year revenue
    adjustments recorded in 2004 of $3.7 million compared to
    favorable prior year revenue adjustments of $2.6 million
    recorded in 2003                                             |  |            | 1.0  | 
|                                                                                                                                                                                                                          |  |            |      | 
|Total increase in revenues from same facility
    nursing and assisted living centers                                                                                                                                     |  | $          | 73.8 | 
|                                                                                                                                                                                                                          |  |            |      | 



| |                                                   
| | --------------------------------------------------
| | Operating and General and Administrative
    Costs

Operating and general and administrative costs
increased $44.5 million, or 5.8%, in 2004 compared to 2003,
including $3.1 million as a net result of the following:
(1) the acquisition of a nursing facility in Wisconsin on
December 31, 2003, (2) a newly-constructed assisted
living facility completed in May 2004 in Wisconsin, (3) the
acquisition of four nursing facilities in Indiana in June 2004,
(4) the sale of the facilities in Arkansas in August 2004,
and (5) the transfer to a third party of the operations of
a nursing facility in

52



---



##### Table of Contents



Wisconsin in August 2004. Operating and general
and administrative costs on a same facility basis increased
$41.4 million, or 5.6%. This increase was attributable to
the following:


|                                                                                                    |  |            |      | 
|--------------------------------------------------------------------------------------------------- |  | ---------- | ---- | 
|                                                                                                    |  | Dollars in
|                                                                                                    |  | Millions  
|                                                                                                    |  |           
| wages, benefits and contracted
    staffing, which included an average wage rate increase of 3.0% |  | $          | 26.8 | 
| state assessments and bed taxes                                                                   |  |            | 5.7  | 
| drug expense due to higher resident
    census, Medicare mix and drug prices                      |  |            | 3.1  | 
| equipment expenses                                                                                |  |            | 2.2  | 
| other operating and administrative
    expenses                                                   |  |            | 3.6  | 
|                                                                                                    |  |            |      | 
|Total increase in same facility operating and
    general and administrative costs                  |  | $          | 41.4 | 
|                                                                                                    |  |            |      | 

Lease Costs, Depreciation and
Amortization

Lease costs decreased $0.1 million to
$9.0 million when comparing 2004 to 2003. Depreciation and
amortization decreased $2.2 million to $35.2 million
in 2004 compared to $37.4 million in 2003. Approximately
$2.5 million of this decrease resulted from the
discontinuation of depreciation on assets held for divestiture
as of January 1, 2004, offset by an increase of
$0.3 million from other items.

Interest Expense, Net

Interest expense, net of interest income,
decreased $12.7 million to $17.2 million for 2004
compared to $29.9 million for 2003. The weighted average
interest rate of all long-term debt decreased to approximately
6.88% during 2004 compared to approximately 7.76% during 2003.
Interest income was $4.2 million higher in 2004 than in
2003 primarily due to (1) the receipt in October 2004 of
$2.3 million of interest from the Internal Revenue Service
relating to an income tax refund from carry back of net
operating losses, (2) an increase of $1.4 million in
interest from Greystone relating to the completion of the
Divestiture Agreement and (3) an increase of
$1.4 million in interest related to the loss adjustment on
the 1999 Arbor sale, offset by (4) a decrease of
$0.9 million in interest primarily relating to the receipt
of $20.6 million from Tandem in February and June 2004 for
early repayment of notes receivable. The average debt level
decreased to $332.4 million during 2004 compared to
$397.7 million during 2003.

Valuation Adjustment on Interest Rate
Caps

The valuation adjustment on interest rate caps
was an expense of $8.0 million for 2004 compared to income
of $0.1 million in 2003. The value of the caps decreased in
2004 due to a decrease in the volatility of the projected future
six-month LIBOR. The valuation adjustment on the interest rate
caps, formerly included in interest income, has been
reclassified to a separate line on the income statement because
they do not qualify for hedge accounting.

Loss (Gain) on Disposal of Assets and
Impairment of Long-Lived Assets

Loss on disposal of assets and impairment of
long-lived assets was $8.5 million for 2004. Loss on the
disposal of assets totaled $0.1 million and the loss on
impairment of long-lived assets totaled $8.4 million.

The net loss on disposal of assets included
(1) the write-off of the Omnicare stock warrant in
September 2004 for a loss of $4.0 million, (2) the
prepayment of notes receivable from Tandem at a discount for a
loss of $1.3 million, (3) the sale of the Arkansas
facilities in August 2004 for a loss of $0.6 million,
(4) the completion in June 2004 of the September 2000
Divestiture Agreement with Greystone, that resulted in cash
proceeds of $10.0 million from a Vendor Take Back note and
a gain of $4.9 million, and (5) the sale, at market
value, to Extendicare of our 125,000 shares of Omnicare stock
for $4.9 million in cash for a gain of $0.9 million.

53



---



##### Table of Contents



The loss on impairment of assets was
$8.4 million. A $1.6 million impairment loss was
recorded in March 2004, when we concluded the evaluation of two
nursing facilities in Indiana and made a decision, subject to
State of Indiana approval, and after renovation to one of the
two facilities, to consolidate the two operations into one. As a
result of the decision to close the one facility, we have
recorded a provision of $1.6 million for impairment of
long-lived assets. As a result of the financial and operating
performance of Lakeside Health in the fourth quarter of 2004, in
December 2004, we recorded an asset impairment provision of
$6.8 million to reduce the carrying value of the Lakeside
property from $13.0 million to $6.2 million. We
determined the reduced property value based upon our view of the
current market value of the facility, which assumes that the
facility attains a suitable Medicare occupancy level. There
cannot be assurance that a future reduction in carrying value
will not be required if these estimates change.

Loss on Refinancing and Retirement of
Debt

Loss on refinancing and retirement of debt was
$6.5 million for 2004. This loss included a loss of
$9.3 million on the early retirement of the 2007 Notes and
losses totaling $0.5 million on the early retirement of
Industrial Development Revenue Bonds. Refer to Significant
Events and Developments for the component costs of the
refinancing of the 2007 Notes. These losses were offset by a
$3.3 million gain on termination of the interest rate swap
and cap. The interest rate swap and cap maturing in 2007 were
terminated due to the early retirement of the 2007 Notes.

Income Taxes

Income taxes for 2004 were a benefit of
$10.8 million compared to a provision of $12.0 million
for 2003. Our effective tax rate was a benefit of 18.9% in 2004,
compared to an tax expense provision of 37.3% in 2003. Included
in 2004 income taxes is a tax benefit of $33.6 million
recorded in December 2004 resulting primarily from two events.
We recorded a tax benefit of $31.9 million for an
additional loss claimed from the December 1999 sale of Arbor,
our former subsidiary, to Tandem. This additional loss was
primarily due to the issuance of additional guidance by the IRS,
regarding the method to calculate loss on the sale of subsidiary
stock, and partially due to the settlement of an IRS audit for
the tax years ending December 1997 through December 2002. In
addition, we recorded a tax benefit of $1.7 million
relating to this IRS audit and other issues.

Without the above tax benefits of
$33.6 million, income tax expense for 2004 was
$22.8 million compared to $12.0 million for 2003.
Without these tax benefits, our effective tax rate was 40.0% for
2004 compared to 37.3% for 2003. The increase in the effective
tax rate primarily related to the change in the valuation
allowance for state deferred tax assets between the two years.
When we assess the realizability of deferred tax assets, we
consider whether it is more likely than not that some portion or
all of the deferred tax assets will not be realized and record a
valuation allowance, if required. The ultimate realization of
deferred tax assets depends upon us generating future taxable
income during the periods in which those temporary differences
become deductible. We consider the scheduled reversal of
deferred tax liabilities, projected future taxable income and
tax planning strategies when we make this assessment.

Net Income

Net income for 2004 was $67.7 million
compared to $20.1 million for 2003. The improvement in net
income was due to the reasons described herein.

Related Party Transactions

We insure certain risks, including comprehensive
general liability, excess workers compensation and
employers liability insurance, with Laurier Indemnity
Company and Laurier Indemnity Ltd., affiliated insurance
subsidiaries of Extendicare. We recorded approximately
$10.8 million and $10.7 million of expenses for this
purpose for 2004 and 2003, respectively. Also, for 2004, we
recorded a credit to expense of $1.0 million due to a
refund relating to prior year workers compensation
policies with Laurier Indemnity Company.

We purchase computer hardware and software
support services from Virtual Care Provider, Inc., an affiliated
subsidiary of Extendicare. Expenses related to these services
were $4.8 million and $6.9 million for

54



---



##### Table of Contents



2004 and 2003, respectively. The decrease of
$2.1 million primarily related to the transfer of certain
employees from Virtual Care Provider, Inc. to us as of
January 1, 2004, which increased our compensation and
benefit expense by $2.7 million during 2004.


Extendicare held $27.9 million of the 2007
Notes prior the refinancing. Pursuant to our tender offer, in
May 2004 the 2007 Notes held by Extendicare were redeemed for
approximately $28.8 million in cash. Subsequently in May
2004, Extendicare purchased at market value all of our 125,000
common share investment in Omnicare, for $4.9 million in
cash, which resulted in a gain of $0.9 million.

In addition, Extendicare advanced through our
direct parent company $22.9 million, of which
$14.0 million was through an affiliate. In December 2004,
we advanced $7.7 million to Extendicare, which was
outstanding as of December 31, 2004 but subsequently repaid
in January 2005. As a result, as of December 31, 2004, we
owe $17.8 million to our shareholder and an affiliate,
which includes a $3.5 million non-interest bearing payable
with no specific repayment due date to a subsidiary company of
Extendicare.

Year Ended December 31, 2003 Compared
with Year Ended December 31, 2002

Revenues

Revenues in 2003 increased $55.3 million, or
6.8%, to $870.4 million from $815.1 million in 2002.
Outpatient therapy and other revenues decreased by
$0.7 million in 2003 due to lower rental income resulting
from the sale of facilities in 2002 that we previously leased to
a third party, partially offset by growth of our outpatient
therapy operations.

Revenues from nursing and assisted living
facilities increased $56.0 million in 2003 compared to
2002. This increase was attributable to the following:

|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |  |          |       |  
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ |  | -------- | ----- | -
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |  | Millions
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |  |         
| an increase in Medicare residents
    from 13.4% of total residents in 2002 to 15.5% in 2003                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           |  | $        | 15.5  |  
| a 4.2% increase (excluding prior
    period adjustments) in the average daily nursing Medicaid rate
    (which included cost-offset funding as a result of increased
    state assessments and bed taxes of $4.4 million)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |  |          | 16.0  |  
| a 1.4% increase in nursing resident
    census from an ADC of 12,727 in 2002 to 12,901 in 2003                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |  |          | 11.1  |  
| increases in other average daily
    nursing rates                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     |  |          | 8.2   |  
| an increase in nursing ancillary
    revenues                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |  |          | 6.8   |  
| an increase in Medicare revenues due
    to the improvement in RUGs mix                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                |  |          | 4.5   |  
| an increase in Medicare revenues due
    to the 6.26% increase in the Medicare Part A rate effective
    October 1, 2003; and                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |  |          | 3.5   |  
| an increase in assisted living
    revenues due to increased occupancy and higher rates                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                |  |          | 2.3   |  
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |  |          |       |  
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |  |          | 67.9  |  
|These increases were offset and adjusted by:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             |  |          |       |  
| a decrease due to the Medicare Cliff,
    net of the market basket increase, implemented on
    October 1, 2002                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |  |          | (12.8 | )
| favorable prior year revenue
    adjustments recorded in 2003 consisting of (1) a recovery
    of $4.2 million in Medicaid revenues as the outcome of a
    favorable court decision in the State of Ohio relating to the
    recovery of alleged government overpayments for adjudicated
    Medicaid cost report periods, and (2) revenue adjustments
    totaling $1.1 million for the settlement of prior year
    state cost reports; offset by (a) the recording in 2003 of
    a contractual revenue adjustment totaling $2.7 million for
    prior year Medicare settlement receivables, and further offset
    by (b) $1.7 million in favorable prior year
    adjustments recorded in 2002 primarily for the settlement of
    prior year state cost reports |  |          | 0.9   |  
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |  |          |       |  
|Total increase in revenues from nursing and
    assisted living centers                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |  | $        | 56.0  |  
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |  |          |       |  

55



---



##### Table of Contents



Operating and General and Administrative
Costs

Operating and general and administrative costs
increased $38.0 million, or 5.2%, in 2003 compared to 2002.
This increase was attributable to the following:

|                                                                     |                                                                                                                                                                                                                                                              |          |      |      | 
|-------------------------------------------------------------------- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ | -------- | ---- | ---- | 
|                                                                     |                                                                                                                                                                                                                                                              | Millions
|                                                                     |                                                                                                                                                                                                                                                              |         
|                                                                     |  wages and benefits of
    $18.8 million and contracted staffing for food, laundry and
    therapy services of $4.5 million, totaling
    $23.3 million, or a 4.4% increase, which included an
    average wage rate increase of 3.2% in nursing operations |          | $    | 23.3 | 
|                                                                     |  drug expense due to higher resident
    census, Medicare mix and drug prices                                                                                                                                                                               |          |      | 3.9  | 
|                                                                     |  state assessments and bed taxes                                                                                                                                                                                                                            |          |      | 4.4  | 
|                                                                     |  professional fees expense primarily
    due to legal fees and nursing consulting                                                                                                                                                                           |          |      | 1.9  | 
|                                                                     |  general liability expense primarily
    due to premiums and accruals                                                                                                                                                                                       |          |      | 1.7  | 
|                                                                     |  other operating expenses                                                                                                                                                                                                                                   |          |      | 2.8  | 
|                                                                     |                                                                                                                                                                                                                                                              |          |      |     
|Total increase in operating and general and
    administrative costs |                                                                                                                                                                                                                                                              | $        | 38.0 |     
|                                                                     |                                                                                                                                                                                                                                                              |          |      |     

Lease Costs, Depreciation and
Amortization

Lease costs decreased $1.5 million when
comparing years as a result of the purchase of previously leased
facilities in 2002. Depreciation and amortization decreased
$0.2 million to $37.4 million in 2003 compared to
$37.6 million in 2002.

Interest Expense, Net

Interest expense, net of interest income,
decreased $1.6 million to $29.9 million for 2003
compared to $31.5 million for 2002. The weighted average
interest rate of all long-term debt decreased to 7.76% during
2003 compared to approximately 7.81% during 2002. Interest
income was $1.9 million higher than 2002, primarily due to
$1.3 million in interest income that was previously not
recognized. The average debt level increased to
$397.7 million during 2003 compared to $383.5 million
during 2002.

Valuation Adjustment on Interest Rate
Caps

The valuation adjustment on interest rate caps
was a gain of $0.1 million for 2003 compared to a loss of
$0.8 million in 2002. The change was due to changes in
long-term market interest rates. The valuation adjustment on the
interest rate caps, formerly included in interest income, has
been reclassified to a separate line on the income statement.

Income Taxes

Income tax expense for 2003 was
$12.0 million compared to $3.2 million for 2002. Our
effective tax rate was 37.3% for 2003 as compared to 49.2% for
2002. The decrease in the effective tax rate resulted from the
reversal of current and prior year state deferred income tax
benefits, the non-recognition of tax benefits in certain states
in 2002, and the impact of permanent items between the two
years. When we assess the realizability of deferred tax assets,
we consider whether it is more likely than not that some portion
or all of the deferred tax assets will not be realized and
record a valuation allowance, if required. The ultimate
realization of deferred tax assets depends upon us generating
future taxable income during the periods in which those
temporary differences become deductible. We consider the
scheduled reversal of deferred tax liabilities, projected future
taxable income and tax planning strategies when we make this
assessment.

Net Income

Net income for 2003 was $20.1 million
compared to $3.2 million for 2002. The improvement in net
income was due to the reasons described herein above.

56



---



##### Table of Contents



Related Party Transactions

We insure certain risks, including comprehensive
general liability, excess workers compensation and
employers liability insurance, with Laurier Indemnity
Company and Laurier Indemnity Ltd., affiliated insurance
subsidiaries of Extendicare, our Canadian parent. We recorded
approximately $10.7 million and $9.9 million of
expenses for this purpose for 2003 and 2002, respectively.

We purchase computer hardware and software
support services from Virtual Care Provider, Inc., an affiliated
subsidiary of Extendicare Inc. Expenses related to these
services were $6.9 million and $7.9 million for 2003
and 2002, respectively.

Liquidity and Capital Resources

Sources and Uses of Cash

We had cash and cash equivalents of
$29.6 million at December 31, 2004 and
$48.9 million at December 31, 2003. The table below
sets forth a summary of the significant sources and uses of cash:

|                                                     |  |                        |         |      |  |      |         |   |  |   |         |  
|---------------------------------------------------- |  | ---------------------- | ------- | ---- |  | ---- | ------- | - |  | - | ------- | -
|                                                     |  |                       
|                                                     |  | Year Ended December 31
|                                                     |  |                       
|                                                     |  | 2004                   |         | 2003 |  | 2002
|                                                     |  |                        |         |      |  |     
|                                                     |  |                       
|                                                     |  | (thousand of dollars) 
|Cash provided by operating activities                |  | $                      | 81,400  |      |  | $    | 56,033  |   |  | $ | 38,832  |  
|Cash used in investing activities                    |  |                        | (9,669  | )    |  |      | (26,772 | ) |  |   | (22,415 | )
|Cash (used in) provided by financing activities      |  |                        | (90,974 | )    |  |      | (4,766  | ) |  |   | 7,536   |  
|Increase (decrease) in cash and cash
    equivalents |  |                        | (19,243 | )    |  |      | 24,495  |   |  |   | 23,953  |  

The increase in cash flow from operating
activities of $25.4 million in 2004 compared to 2003 was
primarily due to an improvement in income, an increase of
$13.1 million in collections of Medicare settlement
receivables and a reduction of $2.1 million in payments for
self-insured liabilities, partially offset by a decrease of
$6.2 million in amounts due to shareholder and affiliates.

Our working capital decreased $26.2 million
from $55.8 million at December 31, 2003 to
$29.6 million at December 31, 2004. Working capital
decreased primarily due to the use of cash to reduce long-term
debt by $101.0 million from $392.9 million at
December 31, 2003 to $291.9 million as of
December 31, 2004, which was offset by cash flow from
operating activities.

Accounts receivable at December 31, 2004
were $96.0 million compared with $95.3 million at
December 31, 2003, representing an increase of
$0.7 million. The increase in accounts receivable included
a $1.4 million increase in interest receivable due to the
estimated IRS interest impact of our additional loss claimed
from the December 1999 sale of Arbor, our former subsidiary, to
Tandem, partially offset by an $0.8 million decrease within
the nursing operations and an increase of $0.1 million in
outpatient therapy receivables. Within the nursing operations,
billed patient care and other receivables increased
$3.7 million while third-party payor settlement receivables
decreased $4.5 million.

The decrease in settlement receivables of
$4.5 million from December 31, 2003 to
December 31, 2004 included decreases of $17.2 million
from the collection of Medicare settlements and
$9.4 million from the collection of Medicare co-insurance
amounts. These decreases were partially offset by increases of
$8.5 million from the reclassification of settlement
receivables from other long-term assets to accounts receivables,
$13.1 million relating to revenue in the 2004 period for
anticipated Medicare reimbursement for uncollectible
co-insurance and $0.5 million from Medicaid cost report
settlements and other items.

Property and equipment decreased
$2.6 million from $448.7 million at December 31,
2003 to $446.1 million at December 31, 2004. Property
and equipment decreased due to depreciation expense of
$34.1 million, provisions for impairment of long-lived
assets of $8.4 million, a decrease of $6.1 million
resulting from the sale of the Arkansas facilities and other
decreases of $0.9 million. These decreases were partially
offset by normal capital expenditures of $25.4 million,
$15.0 million from new construction projects,
$1.5 million from the

57



---



##### Table of Contents



February 2004 acquisition of a previously-leased
nursing facility in Washington and $5.0 million from the
June 2004 acquisition of four nursing facilities in Indiana.


Total long-term debt, including both current and
long-term maturities of debt, was $291.9 million at
December 31, 2004. This represents a decrease of
$101.0 million from December 31, 2003, including
(1) a decrease of $200.0 million due to the prepayment
of the 2007 Notes, (2) an increase of $121.9 million
due to the sale and issuance of the 2014 Notes, and (3) a
decrease of $22.5 million due to the prepayment of
Industrial Development Revenue Bonds.

Cash used in investing activities was
$9.7 million for 2004 compared to $26.8 million for
2003. The change of $17.1 million was due to proceeds in
2004 of (1) $10.0 million from the completion of the sale
of nursing facilities to Greystone, (2) $4.9 million from
sale of Omnicare shares to Extendicare, (3) $20.6 million
from collection of note receivables due from Tandem, and (4)
$4.9 million from the sale of the Arkansas facilities.
These items were partially offset by increases in expenditures
in the 2004 period compared to the 2003 period of (1)
$2.4 million for acquisitions, (2) $10.7 million for
new construction projects, (3) $4.4 million in purchases of
property and equipment, and (4) $5.8 million in other
non-current assets.

Cash used in financing activities was
$91.0 million for 2004 compared to $4.8 million for
2003. The change of $86.2 million related primarily to the
long-term debt transactions discussed herein plus the payments
of fees and expenses relating to those transactions, partially
offset by advances from our shareholder and an affiliate of
$22.9 million.

Debt Instruments

Summary of Long-term Debt

Long-term debt consisted of the following at
December 31:

|                                                                                                                                                        |  |                        |         |      |  |   |         | 
|------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ---------------------- | ------- | ---- |  | - | ------- | 
|                                                                                                                                                        |  | 2004                   |         | 2003
|                                                                                                                                                        |  |                        |         |     
|                                                                                                                                                        |  |                       
|                                                                                                                                                        |  | (dollars in thousands)
|9.50% Senior Notes due 2010                                                                                                                             |  | $                      | 149,714 |      |  | $ | 149,676 | 
|6.875% Senior Subordinated Notes due 2014                                                                                                               |  |                        | 122,022 |      |  |   |        | 
|9.35% Senior Subordinated Notes due 2007                                                                                                                |  |                        |        |      |  |   | 200,000 | 
|Industrial Development Revenue Bonds, variable
    interest rates ranging from 2.01% to 6.25%, maturing through
    2014, secured by certain facilities |  |                        | 10,455  |      |  |   | 33,160  | 
|Mortgage notes payable, interest rates ranging
    from 3.0% to 10.0%, maturing through 2009                                                            |  |                        | 9,730   |      |  |   | 10,054  | 
|Other, primarily capital lease obligations                                                                                                              |  |                        | 11      |      |  |   | 28      | 
|                                                                                                                                                        |  |                        |         |      |  |   |         | 
|Long-term debt before current maturities                                                                                                                |  |                        | 291,932 |      |  |   | 392,918 | 
|Less current maturities                                                                                                                                 |  |                        | 1,071   |      |  |   | 1,223   | 
|                                                                                                                                                        |  |                        |         |      |  |   |         | 
|Total long-term debt                                                                                                                                    |  | $                      | 290,861 |      |  | $ | 391,695 | 
|                                                                                                                                                        |  |                        |         |      |  |   |         | 

The weighted average interest rate of all of our
long-term debt (including the effects of the interest rate swap
and cap discussed below) was 6.26% and 7.52% as of
December 31, 2004 and 2003, respectively. Our long-term
debt instruments have maturities ranging from 2005 to 2014.

2010 Senior Notes

On June 28, 2002, we refinanced all
outstanding indebtedness under our then existing credit facility
with the proceeds from the issuance of $150.0 million of
our 2010 Senior Notes.

The subsidiary guarantees of the 2010 Senior
Notes are full and unconditional, and joint and several, and any
of our subsidiaries that do not guarantee the 2010 Senior
Notes are minor. There are no significant restrictions on the
ability of us to obtain funds from our subsidiaries by loan or
dividend.

58



---



##### Table of Contents



The indenture governing the 2010 Senior
Notes contains customary covenants and events of default. Under
this indenture, we are also restricted from incurring
indebtedness if the fixed charge coverage ratio, determined on a
pro forma basis, is less than or equal to 2.0 to 1. Our fixed
charge coverage ratio is currently in excess of this minimum
requirement. The fixed charge coverage ratio is defined under
our indenture governing the 2010 Senior Notes, and is
represented by a ratio of consolidated cash flow to fixed
charges. In general, fixed charges consist of interest expense,
including capitalized interest, amortization of fees related to
debt financing and rent expense deemed to be interest, and
consolidated cash flow consists of net income prior to the
aforementioned fixed charges, and prior to income taxes and
losses on disposal of assets.

In October 2003, the 2010 Senior Notes were
upgraded by Standard & Poors Ratings Services, or
S&P, from B- to B, and the credit
facility was upgraded from BB- to BB. In
April 2004, the 2010 Senior Notes were upgraded by Moodys
Investors Service from B2 to B1.

2014 Notes

On April 22, 2004, we sold and issued
$125 million aggregate principal amount of the 2014 Notes
pursuant to Rule 144A and Regulation S under the
Securities Act. The 2014 Notes were issued at a price of
97.5001% of par to yield 7.23%. The net proceeds from the
issuance of the 2014 Notes were approximately
$117.4 million, net of a discount of $3.1 million and
fees and expenses of $4.5 million. We used these net
proceeds, along with cash-on-hand and borrowings under our
amended and restated credit facility described below, to
purchase for cash the 2007 Notes validly tendered in the
tender offer, to redeem the 2007 Notes not tendered in the
tender offer prior to May 24, 2004 and to pay related fees
and expenses of the tender offer and redemption. In August 2004,
we completed our offer to exchange new 6.875% Senior
Subordinated Notes due 2014 that have been registered under the
Securities Act for the Senior Subordinated Notes issued in
April 2004. The terms of the new 2014 Notes are identical
to the terms of the 2014 Notes issued in April 2004.

The 2014 Notes are fully and unconditionally
guaranteed on a senior subordinated unsecured basis, jointly and
severally, by all of our existing and future domestic
significant subsidiaries, all of our existing and future
domestic subsidiaries that guarantee or incur any indebtedness
and any other existing and future significant subsidiaries or
restricted subsidiaries of ours that guarantee or otherwise
provide direct credit support for our indebtedness or the
indebtedness of any of our domestic subsidiaries. The 2014 Notes
and guarantees are our and our subsidiary guarantors
general unsecured obligations.

On or after May 1, 2009, we may redeem all
or part of the 2014 Notes at the redemption prices (expressed as
percentages of principal amount) listed below, plus accrued and
unpaid interest, if any, to the date of redemption, if redeemed
during the twelve-month period commencing on May 1 of the
years set forth below:

|                    |  |                  |         |  
|------------------- |  | ---------------- | ------- | -
|Year                |  | Redemption Price
|                    |  |                 
|2009                |  |                  | 103.438 | %
|2010                |  |                  | 102.292 | %
|2011                |  |                  | 101.146 | %
|2012 and thereafter |  |                  | 100.000 | %

Before May 1, 2007, we may redeem up to 35%
of the aggregate principal amount of outstanding 2014 Notes
under the indenture with the net cash proceeds of qualified
equity offerings.

In April 2004, S&P assigned a B-
rating to the 2014 Notes.

2007 Notes

On April 22, 2004, we purchased for cash
$104.9 million aggregate principal amount of our 2007 Notes
pursuant to a tender offer to purchase any and all of our
then-outstanding $200 million of 2007 Notes. On
May 24, 2004, we redeemed and cancelled the remaining
$95.1 million of 2007 Notes not tendered in the tender
offer. The holders of the 2007 Notes who tendered their
2007 Notes, or whose 2007 Notes were redeemed by us,
were paid a premium that, in the aggregate, amounted to
approximately $6.6 million.

59



---



##### Table of Contents



Credit Facility

We established a senior secured revolving credit
facility in June 2002. In connection with the April 2004
offering of the 2014 Notes, we amended and restated our
senior secured revolving credit facility to, among other things,
extend the maturity date from June 28, 2007 to
June 28, 2009 and increase the total borrowing capacity
from $105 million to $155 million.

The credit facility is used to back letters of
credit and for general corporate purposes. Borrowings under the
credit facility bear interest, at our option, at the Eurodollar
rate or the base rate, plus applicable margins. Depending upon
our senior leverage ratio, the interest rate is equal to the
Eurodollar rate plus a margin of 2.50% to 3.25% per annum or the
base rate plus a margin of 1.50% to 2.25% per annum. The
commitment fee is 0.50% per annum on the undrawn capacity
regardless of utilization.

As of December 31, 2004 and
December 31, 2003, the Company had no borrowings under the
credit facility. The unused portion of the credit facility that
is available for working capital and corporate purposes, after
reduction for outstanding letters of credit of
$23.9 million, was $131.1 million as of
December 31, 2004.

The credit facility is secured by a perfected,
first priority security interest in certain tangible and
intangible assets and all of our capital stock and the capital
stock of our subsidiary guarantors. The credit facility is also
secured by a pledge of 65% of the voting stock of our foreign
subsidiaries, including our subsidiary guarantors foreign
subsidiaries, if any. The credit facility contains customary
covenants and events of default and is subject to various
mandatory prepayment and commitment reductions. We are permitted
to make voluntary prepayments at any time under the credit
facility.

The credit facility requires that we comply with
various financial covenants, including fixed charge coverage,
debt leverage, and tangible net worth ratios. We are in
compliance in respect of all outstanding debt covenants as of
the date of this Annual Report on Form 10-K, based upon the
financial covenants calculations as of December 31, 2004.

In April 2004, S&P assigned a BB-
rating to the amended and restated credit facility.

Acquisition of ALC and Assumption of
Debt

In January 2005, we amended our credit facility
to permit the loan from EHI and accommodate the ALC acquisition.
On January 31, 2005, the shareholders of ALC approved the
merger and acquisition agreement with us and we completed the
acquisition for a total of approximately $285 million,
including the assumption of ALCs debt of approximately
$141 million. We financed the acquisition by using
available $29 million in cash on hand, a $55 million
6% Term Loan from Extendicare Holdings, Inc., or EHI and
$60 million from our credit facility. The ALC debt we
assumed on the acquisition is non-recourse to us, and the debt
and earnings of ALC are excluded from existing financial
covenants under our credit facility. We are restricted from
borrowing further under our the credit facility and under the
ALC credit facility to finance any ALC operating deficiencies
and all cash flow from ALC will be retained within the ALC
operations. Any cash flow deficiencies within ALC will be
financed by way of advances from Extendicare directly to ALC. We
believe that Extendicare has sufficient cash on hand and a line
of credit to finance any cash flow deficiencies.

Interest Rate Swap and Cap
Agreements

In April 2004, coterminous with the redemption of
the 2007 Notes, we terminated our related interest rate
swap and cap agreements for an aggregate gain of
$3.3 million recognized in the second quarter of 2004. In
addition, to hedge our exposure to fluctuations in market value,
we entered into two new interest rate swap agreements and two
new interest rate cap agreements relating to the
2010 Senior Notes and the 2014 Notes.

With respect to the 2010 Senior Notes, we
entered into an interest rate swap agreement expiring
July 1, 2010, or 2010 Swap, with a notional amount of
$150.0 million. The 2010 Swap effectively converted up
to $150.0 million of fixed interest rate indebtedness into
variable interest rate indebtedness. Under the terms of the
2010 Swap, the counterparty can call the swap at any time
on or after July 1, 2006 with payments as determined under
the agreement. This call option is a mirror image of the
embedded call option in the debt

60



---



##### Table of Contents



instrument. The 2010 Swap was designated as
a highly-effective fair value hedge, and as a result, changes in
market value of the swap are recorded in income but are offset
by changes in market value of the indebtedness so that there is
no net impact on the statement of income unless the swap is
terminated or no longer qualifies as a hedge. We also entered
into an interest rate cap agreement expiring July 1, 2010,
or 2010 Cap, with a notional amount of $150.0 million.
Under the 2010 Cap, we paid an upfront fee of
$3.5 million to the counterparty. We will receive a
variable rate of interest equal to the excess, if any, of the
six-month LIBOR, adjusted semi-annually, over the cap rate of
7%. We use the 2010 Cap to offset possible increases in
interest payments under the 2010 Swap caused by increases
in market interest rates over a certain level. Under the terms
of the 2010 Cap, the counterparty can call the cap if the
2010 Swap is terminated. The 2010 Cap was not
designated as a hedging instrument under SFAS 133 and,
therefore, changes in market value are recorded in the statement
of income.


With respect to the 2014 Notes, we also entered
into an interest rate swap agreement expiring May 1, 2014,
or 2014 Swap, with a notional amount of
$125.0 million. This agreement effectively converted up to
$125.0 million of fixed interest rate indebtedness into
variable interest rate indebtedness. Under the terms of the
2014 Swap, the counterparty can call the swap at any time
on or after May 1, 2009 with payments as determined under
the agreement. This call option is a mirror image of the
embedded call option in the debt instrument. The 2014 Swap
was designated as a highly-effective fair value hedge, and as a
result, changes in market value of the swap are recorded in
income but are offset by changes in market value of the
indebtedness so that there is no net impact on the statement of
income unless the swap is terminated or no longer qualifies as a
hedge. We also entered into an interest rate cap agreement
expiring May 1, 2014, or 2014 Cap, with a notional
amount of $125.0 million. Under the 2014 Cap, we pay a
fixed rate of interest equal to 0.75% to the counterparty and
receive a variable rate of interest equal to the excess, if any,
of the six-month LIBOR, adjusted semi-annually, over the cap
rate of 7%. We use the 2014 Cap to offset possible
increases in interest payments under the 2014 Swap caused by
increases in market interest rates over a certain level. Under
the terms of the 2014 Cap, the counterparty can call the
cap if the 2014 Swap is terminated. The 2014 Cap was
not designated as a hedging instrument under SFAS 133 and,
therefore, changes in market value are recorded in the statement
of income.

Off Balance Sheet Arrangements

We have no significant off balance sheet
arrangements.

Cash Management

As of December 31, 2004, we held cash and
cash equivalents of $29.6 million. The majority of excess
cash is held in overnight investments and Certificate of
Deposits, or CDs, for periods of less than 90 days. We
forecast on a regular basis monthly cash flows to determine the
investment periods of CDs and monitor daily the incoming and
outgoing expenditures to ensure available cash is invested on a
daily basis.

Future Liquidity and Capital
Resources

We believe that our cash from operations and
anticipated growth, together with other available sources of
liquidity, including borrowings available under our credit
facility, will be sufficient for the foreseeable future to fund
anticipated capital expenditures and make required payments of
principal and interest on our debt.

In addition, we believe that our cash from
operations inclusive of our acquisition of ALC, together with
the collective available sources of liquidity including
borrowing available under our credit facility will be sufficient
for the foreseeable future to fund capital expenditures and make
required payments of principal and interest on our debt.

During the 2004 period, we completed four
construction projects for a total cost of $10.0 million. We
have 11 additional construction projects in progress to add
18 nursing beds and 376 assisted living units to be
completed in 2005 and 2006. Total costs incurred, through
December 31, 2004 on these projects was approximately
$9.4 million and purchase commitments of $12.6 million
are outstanding. The total estimated cost of the uncompleted
projects is approximately $42.0 million.

61



---



##### Table of Contents



At December 31, 2004, we had an accrued
liability for settlement of self-insured liabilities of
$37.7 million in respect of general and professional
liability claims. Claim payments in 2004 were $13.9 million
as compared to $16.0 million in 2003 and $20.9 million
in 2002. The accrual for self-insured liabilities includes
estimates of the cost of both reported claims and claims
incurred but not yet reported. We exited the nursing facility
markets of the highly litigious States of Florida and Texas in
2000 and 2001, respectively. As a result, accruals for general
and professional liabilities have declined significantly from
the 2002 level. We estimate that $18.0 million of the total
$37.7 million liability will be paid within the next fiscal
year. The timing of payments is not directly within our control,
and, therefore, estimates are subject to change in the future.
We believe we have provided sufficient provisions as of
December 31, 2004.

Contractual Obligations

Set forth below is a table showing the estimated
timing of payments under our contractual obligations as of
December 31, 2004:

|                            |  |                        |         |           |  |           |       |           |  |         |        |  |  |   |        |  |  |   |         | 
|--------------------------- |  | ---------------------- | ------- | --------- |  | --------- | ----- | --------- |  | ------- | ------ |  |  | - | ------ |  |  | - | ------- | 
|                            |  |                       
|                            |  | Payments Due By Period
|                            |  |                       
|                            |  |                        |         | Less than |  |           |       | More than
|Contractual Obligations     |  | Total                  |         | 1 Year    |  | 1-3 Years |       | 3-5 Years |  | 5 Years
|                            |  |                        |         |           |  |           |       |           |  |        
|                            |  |                       
|                            |  | (dollars in thousands)
|Long-term debt              |  | $                      | 291,932 |           |  | $         | 1,071 |           |  | $       | 4,825  |  |  | $ | 4,800  |  |  | $ | 281,236 | 
|Operating lease commitments |  |                        | 44,844  |           |  |           | 8,455 |           |  |         | 9,343  |  |  |   | 7,293  |  |  |   | 19,753  | 
|                            |  |                        |         |           |  |           |       |           |  |         |        |  |  |   |        |  |  |   |         | 
|Total                       |  | $                      | 336,776 |           |  | $         | 9,526 |           |  | $       | 14,168 |  |  | $ | 12,093 |  |  | $ | 300,989 | 
|                            |  |                        |         |           |  |           |       |           |  |         |        |  |  |   |        |  |  |   |         | 

Critical Accounting Policies

Our consolidated financial statements have been
prepared in conformity with accounting principles generally
accepted in the United States of America, or GAAP. For a full
discussion of our accounting policies as required by GAAP, refer
to the accompanying notes to the consolidated financial
statements. We consider the accounting policies discussed below
to be critical to an understanding of our financial statements
because their application requires significant judgment and
reliance on estimations of matters that are inherently
uncertain. Specific risks related to these critical accounting
policies are described below.

Revenue Recognition and Accounts
Receivable

Revenues and Accounts Receivable

We derive our revenues primarily from providing
long-term healthcare services in the nursing and assisted living
facilities we operate. Nursing facility revenue results from the
payment for services and products from federal and state-funded
cost reimbursement programs as well as private pay residents.
Approximately 83% of our nursing facility revenues are derived
from services provided under various federal or state medical
assistance programs. We derive assisted living facility revenue
primarily from private pay residents in the period in which we
provide services and at rates we establish based upon the
services provided and market conditions in the area of operation.

We recognize nursing home revenues in the period
in which we provide services and/or deliver products at
established rates less contractual adjustments. Contractual
adjustments include differences between our established billing
rates and amounts estimated by management as reimbursable under
various reimbursement formulas or contracts in effect.
Estimation differences between final settlements and amounts
recorded in previous years are reported as adjustments to
revenues in the period such settlements are determined. Due to
the complexity of the laws and regulations governing the federal
and state reimbursement programs, there is a possibility that
recorded estimates may change by a material amount.

We record accounts receivable at the net
realizable value we expect to receive from federal and state
reimbursement programs, other third-party payors or individual
residents. We also estimate which receivables may be collected
within one year and reflect those not expected to be collected
within one year as non-current. We continually monitor and
adjust our allowances associated with these receivables. We
record allowances for

62



---



##### Table of Contents



bad debts from other third-party payors or from
individual patients based upon a specific assessment of an
accounts collection risk and our historical experience by
payor type. If circumstances change, for instance due to
economic downturn, resulting in higher than expected defaults or
denials, our estimates of the recoverability of our receivables
could be reduced by a material amount. Our allowance for
doubtful accounts for current accounts receivable totaled
$10.6 million and $11.7 million at December 31,
2004 and 2003, respectively.


Medicare and Medicaid Settlement
Receivables

For Medicare revenues earned prior to the
implementation of PPS, and Medicaid programs with a
retrospective reimbursement system, differences between revenues
that we ultimately expect to realize and amounts received are
reflected as settlement accounts receivable, or as accrued
liabilities when payments have exceeded revenues that we
ultimately expect to realize.

The Medicare program, prior to January 1,
1999, was a cost-based reimbursement program under which nursing
facilities received interim payments for each facilitys
respective reimbursable costs, which could be subject to
adjustment based upon the submission of a year-end cost report
and certain cost limits. The year-end cost report would be
subject to audit by a FI, and could lead to ongoing discussions
with a FI, which are normally resolved during the audit process,
and therefore, no provisions are required. For unresolved items
involving differences of opinion, such items can be settled
through a formal appeal process, which results in the provider
filing an appeal with the PRRB of the CMS. Should this occur, a
general provision for Medicare receivables may be provided for
disagreements.

Similarly for states that operate under a
retrospective reimbursement system under which interim payments
are subject to audits, we have to evaluate and determine the
amount of potential settlement accounts receivable or payable.

We periodically review the settlement accounts
receivable and the general contractual allowance for settlement
of amounts in dispute, and adjust the balances accordingly based
upon known facts at the time. An adjustment to settlement
receivable amount and recorded revenues would occur upon,
resolution of issues in dispute, or upon issues being settled at
the PRRB. Since certain issues are significant in amounts, the
resolution could have a material impact on our financial
statements. In addition, we estimate the portion of the Medicaid
and Medicare accounts receivable that are collectible within the
next 12 months and classify this amount as a current asset.
Accounts receivable from both Medicare and Medicaid state
programs, net of a general contractual allowance, at
December 31, 2004 totaled $17.0 million
(2003  $37.2 million). Of the total net Medicare
and Medicaid settlement receivable balance, $6.7 million
(2003  $11.3 million) is expected to be
substantially collected within one year and included within
accounts receivable as a current asset. Our contractual
allowance for current and non-current Medicare and Medicaid
settlement accounts receivable totaled $4.4 million and
$14.0 million at December 31, 2004 and 2003,
respectively.

Valuation of Assets and Asset
Impairment

We record property and equipment at cost less
accumulated depreciation and amortization. We depreciate and
amortize these assets using a straight-line method for book
purposes based upon the estimated lives of the assets. Goodwill
represents the cost of the acquired net assets in excess of
their fair market values. Pursuant to SFAS No. 142 we
do not amortize goodwill and intangible assets with indefinite
useful lives. Instead we test for impairment at least annually.
Other intangible assets, consisting of the cost of leasehold
rights, are deferred and amortized over the term of the lease
including renewal options. We periodically assess the
recoverability of long-lived assets, including property and
equipment, goodwill and other intangibles, when there are
indications of potential impairment based upon the estimates of
undiscounted future cash flows. The amount of any impairment is
calculated by comparing the estimated fair market value with the
carrying value of the related asset. We consider such factors as
current results, trends and future prospects, current estimated
market value and other economic and regulatory factors in
performing these analyses.

A substantial change in the estimated future cash
flows for these assets could materially change the estimated
fair values of these assets, possibly resulting in an additional
impairment. Changes which may impact future cash flows include,
but are not limited to, competition in the marketplace, changes
in Medicare

63



---



##### Table of Contents



and Medicaid rates, increases in wages or other
operating costs, increased litigation and insurance costs, and
increased operational costs resulting from changes in
legislation and regulatory scrutiny and changes in interest
rates. As detailed in Note 16 to our consolidated financial
statements, the net loss on disposal of assets, provisions for
closure and exit costs and impairment of long-lived assets
totaled $8.5 million, $0.0 million and
$1.3 million in 2004, 2003 and 2002, respectively.


Self-insured Liabilities

Insurance coverage for patient care liability and
other risks has become increasingly difficult to obtain. We
insure certain risks with affiliated insurance subsidiaries of
Extendicare Inc. and third-party insurers. The insurance
policies cover comprehensive general and professional liability,
workers compensation and employers liability
insurance in amounts and with such coverage and deductibles as
we deem appropriate, based on the nature and risks of our
business, historical experiences, availability and industry
standards. We self-insure for health and dental claims, in
certain states for workers compensation and
employers liability, and since January 2000, for general
and professional liability claims up to deductible amounts as
defined in our insurance policies.

We accrue our self-insured liabilities based upon
past trends and information received from an independent
actuary. We regularly evaluate the appropriateness of the
carrying value of the self-insured liabilities through an
independent actuarial review. Our estimate of the accrual for
general and professional liability costs is significantly
influenced by assumptions, which are limited by the uncertainty
of predicting future events, and assessments regarding
expectations of several factors. Such factors include, but are
not limited to: the frequency and severity of claims, which can
differ materially by jurisdiction; coverage limits of
third-party reinsurance; the effectiveness of the claims
management process; and the outcome of litigation.

Changes in our level of retained risk, and other
significant assumptions that underlie our estimate of
self-insured liabilities, could have a material effect on the
future carrying value of the self-insured liabilities. For
example, in 2000, we experienced an adverse development of
claims. In 2000 our per claim retained risk increased
significantly for general and professional liability coverage
mainly due to the level of risks associated with our Florida and
Texas operations. We no longer operate nursing or assisted
living facilities in Florida or nursing operations in Texas.
However, claims originated from prior years continue to be
adjudicated in these states. Our accrual for self-insured
liabilities totaled $37.7 million and $45.1 million at
December 31, 2004 and 2003, respectively.

Deferred Tax Assets

Our results of operations are included in the
consolidated federal tax return of our U.S. parent company.
Accordingly, federal current and deferred income taxes payables
(or receivables) are determined as if we filed our own income
tax returns. Deferred tax assets and liabilities are recognized
to reflect the expected future tax consequences attributed to
differences between the financial statement carrying amounts of
existing assets and liabilities and their respective tax bases
and operating loss and tax credit carryforwards. We measure
deferred tax assets and liabilities using enacted tax rates
expected to apply to taxable income in the years in which we
expect those temporary differences to be recovered or settled.
We establish a valuation allowance based upon our estimate of
whether it is more likely than not that some portion or all of
the deferred tax assets will not be realized. The ultimate
realization of deferred tax assets depends upon us generating
future taxable income during the periods in which those
temporary differences become deductible. We consider the
scheduled reversal of deferred tax liabilities, projected future
taxable income and tax planning strategies in making this
assessment. Our valuation allowance for net state deferred tax
assets totaled $3.7 million and $19.1 million at
December 31, 2004 and 2003, respectively. The reduction in
valuation allowance in 2004 primarily related to certain capital
loss carryforwards, which had been subject to a complete
valuation allowance that statutorily expired in 2004. The
deferred tax asset and related valuation allowance were written
off as a result of the expiration of the loss carryforwards.

64



---



##### Table of Contents



Principles of Consolidation

Our consolidated financial statements have been
prepared in accordance with accounting principles generally
accepted in the United States of America. The preparation of
financial statements in conformity with generally accepted
accounting principles requires management to make estimates and
assumptions that affect the reported amount of assets and
liabilities and disclosure of contingent assets and liabilities
at the date of the financial statements and the reported amounts
of revenues and expenses during the reporting period. All
significant intercompany accounts and transactions with
subsidiaries have been eliminated from the consolidated
financial statements.




ITEM 7A. QUANTITATIVE AND QUALITATIVE
DISCLOSURES ABOUT MARKET RISK

Qualitative Disclosures

We use interest rate swaps to hedge a significant
portion of the fair value of our debt obligations and interest
rate caps to limit our exposure to increases in interest rates.

For our variable-rate debt, changes in interest
rates generally do not impact the market value of the debt
instruments, but do affect our future income and cash flows. At
December 31, 2004, we had $272 million of fixed-rate
debt outstanding that has been effectively converted to
variable-rate debt using interest rate swaps. Assuming that the
balance of this debt remains constant, each one percentage point
increase in the six-month LIBOR will result in an annual
increase in interest expense, and a corresponding decrease in
cash flows, of approximately $2.7 million. Conversely, each
one percentage point decrease in the six-month LIBOR will result
in an annual decrease in interest expense, and a corresponding
increase in cash flows, of approximately $2.7 million.
Increases in interest expense are limited by interest rate caps
that reimburse us to the extent that the six-month LIBOR exceeds
7%.

We monitor the markets to adequately determine
the appropriate market timing to sell or otherwise act with
respect to our stock and warrant holdings in order to maximize
their value. With the exception of the above holdings, we do not
enter into derivative instruments for any purpose other than
cash flow hedging purposes. That is, we do not speculate using
derivative instruments and do not engage in trading activity of
any kind.

65



---



##### Table of Contents



Quantitative Disclosures

The table below presents principal, or notional,
amounts and related weighted average interest rates by year of
maturity for our debt obligations and interest rate swaps and
caps as of December 31, 2004 (dollars in thousands):

|                                             |                 |      |       |      |  |      |       |      |  |      |       |            |  |       |      |            |  |   |       |   |  |   |         |         |  |   |         |         |  |   |         |       |  
|-------------------------------------------- | --------------- | ---- | ----- | ---- |  | ---- | ----- | ---- |  | ---- | ----- | ---------- |  | ----- | ---- | ---------- |  | - | ----- | - |  | - | ------- | ------- |  | - | ------- | ------- |  | - | ------- | ----- | -
|                                             |                 |      |       |      |  |      |       |      |  |      |       |            |  |       |      | Fair Value
|                                             |                 |      |       |      |  |      |       |      |  |      |       |            |  |       |      | Liability 
|                                             |                 | 2005 |       | 2006 |  | 2007 |       | 2008 |  | 2009 |       | After 2009 |  | Total |      | (Asset)   
|                                             |                 |      |       |      |  |      |       |      |  |      |       |            |  |       |      |           
|LONG-TERM DEBT:                              |                 |      |       |      |  |      |       |      |  |      |       |            |  |       |      |            |  |   |       |   |  |   |         |         |  |   |         |         |  |   |         |      
|Fixed Rate                                   |                 | $    | 1,071 |      |  | $    | 1,026 |      |  | $    | 3,799 |            |  | $     | 583  |            |  | $ | 4,217 |   |  | $ | 271,736 |         |  | $ | 282,432 |         |  | $ | 308,155 |      
|Average Interest Rate                        |                 |      | 5.98  | %    |  |      | 5.79  | %    |  |      | 6.87  | %          |  |       | 6.75 | %          |  |   | 7.00  | % |  |   | 8.48    | %       |  |   | 8.42    | %       |  |   |         |      
|Variable Rate                                |                 |      |      |      |  |      |      |      |  |      |      |            |  |       |     |            |  |   |      |   |  | $ | 9,500   |         |  | $ | 9,500   |         |  | $ | 9,500   |      
|Average Interest Rate                        |                 |      |      |      |  |      |      |      |  |      |      |            |  |       |     |            |  |   |      |   |  |   | 2.01    | %       |  |   | 2.01    | %       |  |   |         |      
|INTEREST RATE SWAPS:
    (fixed to variable) |                 |      |       |      |  |      |       |      |  |      |       |            |  |       |      |            |  |   |       |   |  |   |         |         |  |   |         |         |  |   |         |      
|                                             | Notional Amount |      |       |     |  |      |       |     |  |      |       |           |  |       |      |           |  |   |       |  |  |   | $       | 275,000 |  |   | $       | 275,000 |  |   | $       | (308  | )
|Average Pay Rate (variable rate)             |                 |      |      |      |  |      |      |      |  |      |      |            |  |       |     |            |  |   |      |   |  |   | 6.24    | %       |  |   | 6.24    | %       |  |   |         |      
|Average Receive Rate (fixed rate)            |                 |      |      |      |  |      |      |      |  |      |      |            |  |       |     |            |  |   |      |   |  |   | 8.31    | %       |  |   | 8.31    | %       |  |   |         |      
|INTEREST RATE CAPS:                          |                 |      |       |      |  |      |       |      |  |      |       |            |  |       |      |            |  |   |       |   |  |   |         |         |  |   |         |         |  |   |         |      
|                                             | Notional Amount |      |       |     |  |      |       |     |  |      |       |           |  |       |      |           |  |   |       |  |  |   | $       | 150,000 |  |   | $       | 150,000 |  |   | $       | (984  | )
|                                             | Notional Amount |      |       |     |  |      |       |     |  |      |       |           |  |       |      |           |  |   |       |  |  |   | $       | 125,000 |  |   | $       | 125,000 |  |   | $       | 5,241 |  

The above table incorporates only those exposures
that existed as of December 31, 2004 and does not consider
those exposures or positions which could arise after that date
or future interest rate movements. As a result, the information
presented above has limited predictive value. Our ultimate
results with respect to interest rate fluctuations will depend
upon the exposures that occur, our hedging strategies at the
time and interest rate movements.

66



---



##### Table of Contents








|        |                                                
|------- | -----------------------------------------------
|ITEM 8. | FINANCIAL STATEMENTS AND SUPPLEMENTARY
    DATA




REPORT OF INDEPENDENT REGISTERED PUBLIC
ACCOUNTING FIRM

The Board of Directors

Extendicare Health Services, Inc.:


We have audited the accompanying consolidated
balance sheets of Extendicare Health Services, Inc. and
subsidiaries (the Company) as of December 31, 2004 and
2003, and the related consolidated statements of income,
shareholders equity and comprehensive income, and cash
flows for each of the years in the three-year period ended
December 31, 2004. These consolidated financial statements
are the responsibility of the Companys management. Our
responsibility is to express an opinion on these consolidated
financial statements based on our audits.

We conducted our audits in accordance with the
standards of the Public Company Accounting Oversight Board
(United States). These 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 consolidated financial
statements referred to above present fairly, in all material
respects, the financial position of Extendicare Health Services,
Inc. and subsidiaries as of December 31, 2004 and 2003, and
the results of their operations and their cash flows for each of
the years in the three-year period ended December 31, 2004,
in conformity with U.S. generally accepted accounting principles.

KPMG SIG

Milwaukee, Wisconsin

February 7, 2005


67



---



##### Table of Contents



EXTENDICARE HEALTH SERVICES, INC.



CONSOLIDATED BALANCE SHEETS


December 31, 2004 and 2003


(In thousands except share data)


|                                                             |                                                                                            |                                            |         |         |         |  |         |         |         | 
|------------------------------------------------------------ | ------------------------------------------------------------------------------------------ | ------------------------------------------ | ------- | ------- | ------- |  | ------- | ------- | ------- | 
|                                                             |                                                                                            | 2004                                       |         | 2003   
|                                                             |                                                                                            |                                            |         |        
|ASSETS                                                       |                                                                                            |                                            |         |         |         |  |         |        
|Current Assets:                                              |                                                                                            |                                            |         |         |         |  |         |        
|                                                             | Cash and cash equivalents                                                                  |                                            | $       | 29,612  |         |  | $       | 48,855  |        
|                                                             | Accounts receivable, less allowances of $10,594
    and $11,692, respectively              |                                            |         | 95,973  |         |  |         | 95,338  |        
|                                                             | Assets held under Divestiture Agreement
    (Note 5)                                       |                                            |         |        |         |  |         | 33,723  |        
|                                                             | Supplies, prepaid expenses and other current
    assets (Note 3)                           |                                            |         | 17,751  |         |  |         | 7,436   |        
|                                                             | Income taxes receivable (Note 24)                                                          |                                            |         | 1,654   |         |  |         |        |        
|                                                             | Deferred state income taxes (Note 24)                                                      |                                            |         | 2,664   |         |  |         | 4,260   |        
|                                                             | Due from shareholder and affiliates
    (Notes 13, 23 and 24):                             |                                            |         |         |         |  |         |         |        
|                                                             |                                                                                            | Federal income taxes receivable            |         |         | 5,231   |  |         |         | 8,121   | 
|                                                             |                                                                                            | Deferred federal income taxes              |         |         | 13,258  |  |         |         | 22,584  | 
|                                                             |                                                                                            | Other                                      |         |         | 7,690   |  |         |         | 7,010   | 
|                                                             |                                                                                            |                                            |         |         |         |  |         |        
|                                                             |                                                                                            | Total current assets                       |         |         | 173,833 |  |         |         | 227,327 | 
|Property and equipment (Note 6)                              |                                                                                            |                                            | 446,085 |         |         |  | 448,743 |        
|Goodwill and other intangible assets (Note 7)                |                                                                                            |                                            | 74,554  |         |         |  | 75,193  |        
|Other assets (Note 8)                                        |                                                                                            |                                            | 41,485  |         |         |  | 82,086  |        
|                                                             |                                                                                            |                                            |         |         |         |  |         |        
|                                                             |                                                                                            | Total Assets                               |         | $       | 735,957 |  |         | $       | 833,349 | 
|                                                             |                                                                                            |                                            |         |         |         |  |         |        
|LIABILITIES AND SHAREHOLDERS
    EQUITY                     |                                                                                            |                                            |         |         |         |  |         |        
|Current Liabilities:                                         |                                                                                            |                                            |         |         |         |  |         |        
|                                                             | Current maturities of long-term debt (Note 9)                                              |                                            | $       | 1,071   |         |  | $       | 1,223   |        
|                                                             | Accounts payable                                                                           |                                            |         | 22,297  |         |  |         | 20,672  |        
|                                                             | Accrued liabilities (Note 10)                                                              |                                            |         | 99,920  |         |  |         | 101,614 |        
|                                                             | Deposits held under Divestiture Agreement
    (Note 5)                                     |                                            |         |        |         |  |         | 30,000  |        
|                                                             | Current portion of accrual for self-insured
    liabilities (Note 11)                      |                                            |         | 18,000  |         |  |         | 18,000  |        
|                                                             | Current portion of amounts due from shareholder
    and affiliates (Note 23)               |                                            |         | 2,975   |         |  |         |        |        
|                                                             | Income taxes payable (Note 24)                                                             |                                            |         |        |         |  |         | 23      |        
|                                                             |                                                                                            |                                            |         |         |         |  |         |        
|                                                             |                                                                                            | Total current liabilities                  |         |         | 144,263 |  |         |         | 171,532 | 
|Accrual for self-insured liabilities
    (Note 11)           |                                                                                            |                                            | 19,725  |         |         |  | 27,063  |        
|Long-term debt (Note 9)                                      |                                                                                            |                                            | 290,861 |         |         |  | 391,695 |        
|Deferred state income taxes (Note 24)                        |                                                                                            |                                            | 1,833   |         |         |  | 7,343   |        
|Other long-term liabilities (Note 12)                        |                                                                                            |                                            | 12,448  |         |         |  | 11,082  |        
|Due to shareholder and affiliates (Notes 13,
    23 and 24): |                                                                                            |                                            |         |         |         |  |         |        
|                                                             | Deferred federal income taxes                                                              |                                            |         | 1,853   |         |  |         | 38,490  |        
|                                                             | Other                                                                                      |                                            |         | 14,785  |         |  |         | 3,484   |        
|                                                             |                                                                                            |                                            |         |         |         |  |         |        
|                                                             |                                                                                            | Total liabilities                          |         |         | 485,768 |  |         |         | 650,689 | 
|                                                             |                                                                                            |                                            |         |         |         |  |         |        
|Shareholders Equity:                                        |                                                                                            |                                            |         |         |         |  |         |        
|                                                             | Common stock, $1 par value, 1,000 shares
    authorized, 947 shares issued and outstanding |                                            |         | 1       |         |  |         | 1       |        
|                                                             | Additional paid-in capital                                                                 |                                            |         | 209,221 |         |  |         | 208,787 |        
|                                                             | Accumulated other comprehensive income                                                     |                                            |         | 342     |         |  |         | 985     |        
|                                                             | Retained earnings (accumulated deficit)                                                    |                                            |         | 40,625  |         |  |         | (27,113 | )      
|                                                             |                                                                                            |                                            |         |         |         |  |         |        
|                                                             |                                                                                            | Total Shareholders Equity                 |         |         | 250,189 |  |         |         | 182,660 | 
|                                                             |                                                                                            |                                            |         |         |         |  |         |        
|                                                             |                                                                                            | Total Liabilities and Shareholders Equity |         | $       | 735,957 |  |         | $       | 833,349 | 
|                                                             |                                                                                            |                                            |         |         |         |  |         |        

The accompanying notes are an integral part of
these consolidated financial statements.

68



---



##### Table of Contents



EXTENDICARE HEALTH SERVICES, INC.



CONSOLIDATED STATEMENTS OF INCOME


For the Years Ended December 31, 2004,
2003 and 2002


(In thousands)


|                             |                                                                                                                    |      |         |         |   |      |         |         |   |   |         |         | 
|---------------------------- | ------------------------------------------------------------------------------------------------------------------ | ---- | ------- | ------- | - | ---- | ------- | ------- | - | - | ------- | ------- | 
|                             |                                                                                                                    | 2004 |         | 2003    |   | 2002
|                             |                                                                                                                    |      |         |         |   |     
|REVENUES:                    |                                                                                                                    |      |         |         |   |      |         |         |   |   |         |        
|                             | Nursing and assisted living facilities
    (Note 14)                                                               |      | $       | 918,867 |   |      | $       | 843,414 |   |   | $       | 787,419 | 
|                             | Outpatient therapy                                                                                                 |      |         | 10,987  |   |      |         | 11,524  |   |   |         | 10,280  | 
|                             | Other                                                                                                              |      |         | 17,998  |   |      |         | 15,494  |   |   |         | 17,352  | 
|                             |                                                                                                                    |      |         |         |   |      |         |         |   |   |         |        
|                             |                                                                                                                    |      | 947,852 |         |   |      | 870,432 |         |   |   | 815,051 |        
|                             |                                                                                                                    |      |         |         |   |      |         |         |   |   |         |        
|COSTS AND EXPENSES (INCOME): |                                                                                                                    |      |         |         |   |      |         |         |   |   |         |        
|                             | Operating                                                                                                          |      |         | 776,730 |   |      |         | 731,134 |   |   |         | 691,094 | 
|                             | General and administrative                                                                                         |      |         | 29,722  |   |      |         | 30,871  |   |   |         | 32,947  | 
|                             | Lease costs                                                                                                        |      |         | 9,049   |   |      |         | 9,113   |   |   |         | 10,642  | 
|                             | Depreciation and amortization                                                                                      |      |         | 35,200  |   |      |         | 37,448  |   |   |         | 37,575  | 
|                             | Interest expense, net (Note 15)                                                                                    |      |         | 17,183  |   |      |         | 29,946  |   |   |         | 31,529  | 
|                             | Valuation adjustment on interest rate caps
    (Note 21)                                                           |      |         | 7,983   |   |      |         | (131    | ) |   |         | 746     | 
|                             | Loss on disposal of assets, provision for closure
    and exit costs and impairment of long-lived assets (Note 16) |      |         | 8,541   |   |      |         |        |   |   |         | 1,332   | 
|                             | Loss on refinancing and retirement of debt
    (Note 17)                                                           |      |         | 6,484   |   |      |         |        |   |   |         | 2,849   | 
|                             |                                                                                                                    |      |         |         |   |      |         |         |   |   |         |        
|                             |                                                                                                                    |      | 890,892 |         |   |      | 838,381 |         |   |   | 808,714 |        
|                             |                                                                                                                    |      |         |         |   |      |         |         |   |   |         |        
|INCOME BEFORE INCOME TAXES   |                                                                                                                    |      | 56,960  |         |   |      | 32,051  |         |   |   | 6,337   |        
|                             | Income tax (benefit) expense (Note 24)                                                                             |      |         | (10,778 | ) |      |         | 11,965  |   |   |         | 3,117   | 
|                             |                                                                                                                    |      |         |         |   |      |         |         |   |   |         |        
|NET INCOME                   |                                                                                                                    | $    | 67,738  |         |   | $    | 20,086  |         |   | $ | 3,220   |        
|                             |                                                                                                                    |      |         |         |   |      |         |         |   |   |         |        

The accompanying notes are an integral part of
these consolidated financial statements.

69



---



##### Table of Contents



EXTENDICARE HEALTH SERVICES, INC.



CONSOLIDATED STATEMENTS OF
SHAREHOLDERS


EQUITY AND COMPREHENSIVE INCOME


(In thousands except share data)


|                              |                                                            |                                                              |     |            |   |               |   |               |   |               |         |        |   |   |        |   |       |   |         |   |        |   |         |        |        |  
|----------------------------- | ---------------------------------------------------------- | ------------------------------------------------------------ | --- | ---------- | - | ------------- | - | ------------- | - | ------------- | ------- | ------ | - | - | ------ | - | ----- | - | ------- | - | ------ | - | ------- | ------ | ------ | -
|                              |                                                            |                                                              |     |            |   | Accumulated   |   | Retained      |   |              
|                              |                                                            | Common Stock                                                 |     | Additional |   | Other         |   | Earnings      |   | Total        
|                              |                                                            |                                                              |     | Paid-In    |   | Comprehensive |   | (Accumulated  |   | Shareholders
|                              |                                                            | Shares                                                       |     | Amount     |   | Capital       |   | Income (Loss) |   | Deficit)      |         | Equity
|                              |                                                            |                                                              |     |            |   |               |   |               |   |               |         |       
|BALANCES at DECEMBER 31, 2001 |                                                            |                                                              | 947 |            |   | $             | 1 |               |   | $             | 208,787 |        |   | $ | (2,367 | ) |       | $ | (50,419 | ) |        | $ | 156,002 |       
|                              | Comprehensive income (loss) (Note 25):                     |                                                              |     |            |   |               |   |               |   |               |         |        |   |   |        |   |       |   |         |   |        |   |         |        |       
|                              |                                                            | Unrealized loss on investments, net of income
    taxes      |     |            |  |               |   |               |  |               |         |        |  |   |        |   | (995  | ) |         |   |       |   |         |        | (995   | )
|                              |                                                            | Unrealized gain on cash flow hedges, net of
    income taxes |     |            |  |               |   |               |  |               |         |        |  |   |        |   | 974   |   |         |   |       |   |         |        | 974    |  
|                              |                                                            | Net income                                                   |     |            |  |               |   |               |  |               |         |        |  |   |        |   |      |   |         |   | 3,220  |   |         |        | 3,220  |  
|                              |                                                            |                                                              |     |            |   |               |   |               |   |               |         |        |   |   |        |   |       |   |         |   |        |   |         |       
|                              | Total comprehensive income (loss)                          |                                                              |     |            |   |               |   |               |   |               |         |        |   |   |        |   |       |   |         |   |        |   |         | 3,199  |       
|                              |                                                            |                                                              |     |            |   |               |   |               |   |               |         |        |   |   |        |   |       |   |         |   |        |   |         |       
|BALANCES at DECEMBER 31, 2002 |                                                            |                                                              | 947 |            |   |               | 1 |               |   |               | 208,787 |        |   |   | (2,388 | ) |       |   | (47,199 | ) |        |   | 159,201 |       
|                              | Comprehensive income (Note 25):                            |                                                              |     |            |   |               |   |               |   |               |         |        |   |   |        |   |       |   |         |   |        |   |         |        |       
|                              |                                                            | Unrealized gain on investments, net of income
    taxes      |     |            |  |               |   |               |  |               |         |        |  |   |        |   | 3,341 |   |         |   |       |   |         |        | 3,341  |  
|                              |                                                            | Unrealized gain on cash flow hedges, net of
    income taxes |     |            |  |               |   |               |  |               |         |        |  |   |        |   | 32    |   |         |   |       |   |         |        | 32     |  
|                              |                                                            | Net income                                                   |     |            |  |               |   |               |  |               |         |        |  |   |        |   |      |   |         |   | 20,086 |   |         |        | 20,086 |  
|                              |                                                            |                                                              |     |            |   |               |   |               |   |               |         |        |   |   |        |   |       |   |         |   |        |   |         |       
|                              | Total comprehensive income                                 |                                                              |     |            |   |               |   |               |   |               |         |        |   |   |        |   |       |   |         |   |        |   |         | 23,459 |       
|                              |                                                            |                                                              |     |            |   |               |   |               |   |               |         |        |   |   |        |   |       |   |         |   |        |   |         |       
|BALANCES at DECEMBER 31, 2003 |                                                            |                                                              | 947 |            |   |               | 1 |               |   |               | 208,787 |        |   |   | 985    |   |       |   | (27,113 | ) |        |   | 182,660 |       
|                              | Comprehensive income (loss) (Note 25):                     |                                                              |     |            |   |               |   |               |   |               |         |        |   |   |        |   |       |   |         |   |        |   |         |        |       
|                              |                                                            | Unrealized loss on investments, net of income
    taxes      |     |            |  |               |   |               |  |               |         |        |  |   |        |   | (742  | ) |         |   |       |   |         |        | (742   | )
|                              |                                                            | Unrealized gain on cash flow hedges, net of
    income taxes |     |            |  |               |   |               |  |               |         |        |  |   |        |   | 99    |   |         |   |       |   |         |        | 99     |  
|                              |                                                            | Net income                                                   |     |            |  |               |   |               |  |               |         |        |  |   |        |   |      |   |         |   | 67,738 |   |         |        | 67,738 |  
|                              |                                                            |                                                              |     |            |   |               |   |               |   |               |         |        |   |   |        |   |       |   |         |   |        |   |         |       
|                              | Total comprehensive income                                 |                                                              |     |            |   |               |   |               |   |               |         |        |   |   |        |   |       |   |         |   |        |   |         | 67,095 |       
|                              | Income tax benefit from parent stock options
    exercised |                                                              |     |           |   |               |   |              |   |               |         | 434    |   |   |        |  |       |   |         |  |        |   |         | 434    |       
|                              |                                                            |                                                              |     |            |   |               |   |               |   |               |         |        |   |   |        |   |       |   |         |   |        |   |         |       
|BALANCES at DECEMBER 31, 2004 |                                                            |                                                              | 947 |            |   | $             | 1 |               |   | $             | 209,221 |        |   | $ | 342    |   |       | $ | 40,625  |   |        | $ | 250,189 |       
|                              |                                                            |                                                              |     |            |   |               |   |               |   |               |         |        |   |   |        |   |       |   |         |   |        |   |         |       

The accompanying notes are an integral part of
these consolidated financial statements.

70



---



##### Table of Contents



EXTENDICARE HEALTH SERVICES, INC.



CONSOLIDATED STATEMENTS OF CASH
FLOWS


For the Years Ended December 31, 2004,
2003 and 2002


(In thousands)


|                                                                                      |                                                                                                                         |                                                         |         |          |         |      |        |         |         |   |        |          |         |  
|------------------------------------------------------------------------------------- | ----------------------------------------------------------------------------------------------------------------------- | ------------------------------------------------------- | ------- | -------- | ------- | ---- | ------ | ------- | ------- | - | ------ | -------- | ------- | -
|                                                                                      |                                                                                                                         | 2004                                                    |         | 2003     |         | 2002
|                                                                                      |                                                                                                                         |                                                         |         |          |         |     
|OPERATING ACTIVITIES:                                                                 |                                                                                                                         |                                                         |         |          |         |      |        |         |         |   |        |         
|Net income                                                                            |                                                                                                                         | $                                                       | 67,738  |          |         | $    | 20,086 |         |         | $ | 3,220  |         
|Adjustments to reconcile net income to net cash
    provided by operating activities: |                                                                                                                         |                                                         |         |          |         |      |        |         |         |   |        |         
|                                                                                      | Depreciation and amortization                                                                                           |                                                         |         | 35,200   |         |      |        | 37,448  |         |   |        | 37,575   |        
|                                                                                      | Amortization of deferred financing costs                                                                                |                                                         |         | 1,672    |         |      |        | 1,496   |         |   |        | 1,722    |        
|                                                                                      | Provision for self-insured liabilities
    (Note 11)                                                                    |                                                         |         | 6,600    |         |      |        | 6,000   |         |   |        | 5,250    |        
|                                                                                      | Payments of self-insured liabilities
    (Note 11)                                                                      |                                                         |         | (13,938  | )       |      |        | (16,026 | )       |   |        | (20,877  | )      
|                                                                                      | Provision for bad debts                                                                                                 |                                                         |         | 11,325   |         |      |        | 11,038  |         |   |        | 10,937   |        
|                                                                                      | Deferred income taxes                                                                                                   |                                                         |         | (30,794  | )       |      |        | 1,820   |         |   |        | 11,351   |        
|                                                                                      | Valuation adjustment on interest rate caps
    (Note 21)                                                                |                                                         |         | 7,983    |         |      |        | (131    | )       |   |        | 746      |        
|                                                                                      | Loss on disposal of assets, provision for closure
    and exit costs, and impairment of long-lived assets
    (Note 16) |                                                         |         | 8,541    |         |      |        |        |         |   |        | 1,332    |        
|                                                                                      | Loss on refinancing and retirement of debt
    (Note 17)                                                                |                                                         |         | 6,484    |         |      |        |        |         |   |        | 2,849    |        
|                                                                                      | Changes in assets and liabilities:                                                                                      |                                                         |         |          |         |      |        |         |         |   |        |          |        
|                                                                                      |                                                                                                                         | Accounts receivable                                     |         |          | (18,812 | )    |        |         | (10,551 | ) |        |          | (11,515 | )
|                                                                                      |                                                                                                                         | Other assets                                            |         |          | 15,723  |      |        |         | 3,793   |   |        |          | 6,680   |  
|                                                                                      |                                                                                                                         | Supplies, prepaid expenses and other current
    assets |         |          | (10,673 | )    |        |         | (211    | ) |        |          | (638    | )
|                                                                                      |                                                                                                                         | Accounts payable                                        |         |          | 1,625   |      |        |         | (178    | ) |        |          | (2,322  | )
|                                                                                      |                                                                                                                         | Accrued liabilities                                     |         |          | 381     |      |        |         | 735     |   |        |          | 13,823  |  
|                                                                                      |                                                                                                                         | Income taxes payable/receivable                         |         |          | (1,622  | )    |        |         | 526     |   |        |          | (80     | )
|                                                                                      |                                                                                                                         | Current due to shareholder and affiliates               |         |          | (6,033  | )    |        |         | 188     |   |        |          | (21,221 | )
|                                                                                      |                                                                                                                         |                                                         |         |          |         |      |        |         |         |   |        |         
|                                                                                      |                                                                                                                         | Cash provided by operating activities                   |         |          | 81,400  |      |        |         | 56,033  |   |        |          | 38,832  |  
|                                                                                      |                                                                                                                         |                                                         |         |          |         |      |        |         |         |   |        |         
|INVESTING ACTIVITIES:                                                                 |                                                                                                                         |                                                         |         |          |         |      |        |         |         |   |        |         
|                                                                                      | Proceeds from repayment of notes receivable                                                                             |                                                         |         | 20,552   |         |      |        |        |         |   |        |         |        
|                                                                                      | Proceeds from completion of divestiture agreement                                                                       |                                                         |         | 10,000   |         |      |        |        |         |   |        |         |        
|                                                                                      | Proceeds from sale of investments                                                                                       |                                                         |         | 4,894    |         |      |        |        |         |   |        |         |        
|                                                                                      | Proceeds from sale of property and equipment
    (Note 16)                                                              |                                                         |         | 4,850    |         |      |        |        |         |   |        | 14,315   |        
|                                                                                      | Payments for acquisitions (Note 4)                                                                                      |                                                         |         | (6,454   | )       |      |        | (4,124  | )       |   |        | (17,930  | )      
|                                                                                      | Payments for new construction projects                                                                                  |                                                         |         | (14,970  | )       |      |        | (4,304  | )       |   |        |         |        
|                                                                                      | Payments for purchases of property and equipment                                                                        |                                                         |         | (25,444  | )       |      |        | (21,029 | )       |   |        | (18,659  | )      
|                                                                                      | Changes in other non-current assets                                                                                     |                                                         |         | (3,097   | )       |      |        | 2,685   |         |   |        | (141     | )      
|                                                                                      |                                                                                                                         |                                                         |         |          |         |      |        |         |         |   |        |         
|                                                                                      |                                                                                                                         | Cash used in investing activities                       |         |          | (9,669  | )    |        |         | (26,772 | ) |        |          | (22,415 | )
|                                                                                      |                                                                                                                         |                                                         |         |          |         |      |        |         |         |   |        |         
|FINANCING ACTIVITIES:                                                                 |                                                                                                                         |                                                         |         |          |         |      |        |         |         |   |        |         
|                                                                                      | Proceeds from issuance of long-term debt
    (Note 9)                                                                   |                                                         |         | 128,082  |         |      |        |        |         |   |        | 171,122  |        
|                                                                                      | Payments of deferred financing costs (Note 9)                                                                           |                                                         |         | (5,506   | )       |      |        |        |         |   |        | (7,090   | )      
|                                                                                      | Payments of long-term debt (Note 9)                                                                                     |                                                         |         | (229,253 | )       |      |        | (5,267  | )       |   |        | (158,335 | )      
|                                                                                      | Payments of interest rate cap fee (Note 21)                                                                             |                                                         |         | (3,495   | )       |      |        |        |         |   |        |         |        
|                                                                                      | Payments of tender and call premium and legal
    expenses                                                              |                                                         |         | (6,921   | )       |      |        |        |         |   |        |         |        
|                                                                                      | Proceeds from termination of interest rate swap
    and cap                                                             |                                                         |         | 2,615    |         |      |        |        |         |   |        |         |        
|                                                                                      | Advances from shareholder and an affiliate                                                                              |                                                         |         | 22,900   |         |      |        |        |         |   |        |         |        
|                                                                                      | Other long-term liabilities                                                                                             |                                                         |         | 604      |         |      |        | 501     |         |   |        | 1,839    |        
|                                                                                      |                                                                                                                         |                                                         |         |          |         |      |        |         |         |   |        |         
|                                                                                      |                                                                                                                         | Cash (used in) provided by financing activities         |         |          | (90,974 | )    |        |         | (4,766  | ) |        |          | 7,536   |  
|                                                                                      |                                                                                                                         |                                                         |         |          |         |      |        |         |         |   |        |         
|Increase (decrease) in cash and cash
    equivalents                                  |                                                                                                                         |                                                         | (19,243 | )        |         |      | 24,495 |         |         |   | 23,953 |         
|Cash and cash equivalents, beginning of year                                          |                                                                                                                         |                                                         | 48,855  |          |         |      | 24,360 |         |         |   | 407    |         
|                                                                                      |                                                                                                                         |                                                         |         |          |         |      |        |         |         |   |        |         
|Cash and cash equivalents, end of year                                                |                                                                                                                         | $                                                       | 29,612  |          |         | $    | 48,855 |         |         | $ | 24,360 |         
|                                                                                      |                                                                                                                         |                                                         |         |          |         |      |        |         |         |   |        |         

The accompanying notes are an integral part of
these consolidated financial statements.

71



---



##### Table of Contents



EXTENDICARE HEALTH SERVICES, INC.



NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS


1.     BUSINESS

Extendicare Health Services, Inc. and its
subsidiaries (hereafter referred to as the Company)
operates in one reporting segment, nursing and assisted living
facilities, throughout the United States. The Company is an
indirect wholly owned subsidiary of Extendicare Inc.
(Extendicare), a Canadian publicly traded company.

At December 31, 2004, the Company operated
or managed 148 nursing facilities with capacity for 14,882 beds
and 37 assisted living facilities with 1,760 units. Through its
nursing centers, the Company provides nursing, rehabilitative
and other specialized medical services and, in the assisted
living facilities, the Company provides varying levels of
assistance with daily living activities to residents. The
Company also provides consulting services to 72 nursing
facilities (8,953 beds) and five assisted living facilities (493
units).

In addition, at December 31, 2004, the
Company owned 11 nursing facilities (1,310 beds), which were
leased to and operated by three unrelated nursing home providers.



|   |                                               
|-- | ----------------------------------------------
|2. | SUMMARY OF SIGNIFICANT ACCOUNTING
    POLICIES

a)Principles of Consolidation

The consolidated financial statements of the
Company have been prepared in accordance with accounting
principles generally accepted in the United States of America.
The preparation of financial statements in conformity with
generally accepted accounting principles requires management to
make estimates and assumptions that affect the reported amount
of assets and liabilities and disclosure of contingent assets
and liabilities at the date of the financial statements and the
reported amounts of revenues and expenses during the reporting
period. Managements most significant estimates include
provision for bad debts, provision for Medicaid and Medicare
revenue rate settlements, valuation of assets and asset
impairment, self-insured liabilities for general and
professional liability, workers compensation and health
and dental claims, and valuation of deferred tax assets. Actual
results could differ from those estimates.

The consolidated financial statements include
those of the Company and its subsidiaries. All significant
intercompany accounts and transactions with subsidiaries have
been eliminated from the consolidated financial statements.

b)Cash and Cash Equivalents

Cash and cash equivalents include unrestricted
cash and short-term investments less bank overdrafts and
outstanding checks. Short-term investments, comprised of money
market instruments, have a maturity of 90 days or less from
their date of purchase and are stated at cost, which
approximates net realizable value. For purposes of the
Consolidated Statements of Cash Flows, the Company considers all
cash and highly liquid investments that have a maturity of
90 days or less to be cash equivalents.

c)Accounts Receivable

Accounts receivable are recorded at the net
realizable value expected to be received from federal and state
assistance programs, other third-party payors or from individual
residents. Receivables from government agencies represent the
only concentrated group of accounts receivable for the Company.

The Company had approximately 25%, 23% and 24% as
of December 31, 2004, 2003 and 2002, respectively, in
accounts receivable derived from services provided under various
federal (Medicare) programs and 41%, 40% and 41% as of the same
dates derived from services provided under various state medical
assistance programs (Medicaid). Management does not believe
there are any credit risks associated with these government
agencies other than possible funding delays. Accounts receivable
other than from government

72



---



##### Table of Contents



|   |                                                           
|-- | ----------------------------------------------------------
|2. | SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
    (Continued)

agencies consist of receivables from various
payors that are subject to differing economic conditions and do
not represent any concentrated credit risks to the Company.

The Company periodically evaluates the adequacy
of its allowance for doubtful accounts by conducting a specific
account review of amounts in excess of predefined target amounts
and aging thresholds, which vary by payor type. Provisions are
considered based upon the evaluation of the circumstances for
each of these specific accounts. In addition, the Company has
established internally-determined percentages for allowance for
doubtful accounts, which is based upon historical collection
trends for each payor type and age of these receivables.
Accounts receivable that the Company specifically estimates to
be uncollectible, based upon the above process, are fully
reserved for in the allowance for doubtful accounts until they
are written off or collected.

d)Property and Equipment

Property and equipment are stated at cost less
accumulated depreciation and amortization. Provisions for
depreciation and amortization are computed using the
straight-line method for book purposes (accelerated methods for
tax purposes) at rates based upon the following estimated useful
lives:

|                        |  |                                                                                          
|----------------------- |  | -----------------------------------------------------------------------------------------
|Land improvements       |  | 10 to 25 years                                                                           
|Buildings               |  | 30 to 40 years                                                                           
|Building improvements   |  | 5 to 30 years                                                                            
|Furniture and equipment |  | Varying periods not exceeding 15 years                                                   
|Leasehold improvements  |  | The shorter of the term of the applicable lease
    or the useful life of the improvement

Construction in progress includes pre-acquisition
costs and other direct costs related to acquisition, development
and construction of properties, including interest, which are
capitalized until the facility is opened. Depreciation of the
facility, including interest capitalized, is commenced the month
after the facility is opened and based upon the useful life of
the asset, as outlined above. Leased nursing facility assets are
stated at cost less accumulated depreciation. Provisions for
depreciation of leased facilities are computed as outlined above.

Computer software is included within furniture
and equipment and amortized over a five-year period.
Approximately $111,000, $118,000 and $739,000 of costs included
in furniture and equipment associated with developing or
obtaining internal-use software were capitalized during the
years ended December 31, 2004, 2003 and 2002, respectively,
and are being amortized over three years.

Maintenance and repairs are charged to expense as
incurred. When property or equipment is retired or disposed, the
cost and related accumulated depreciation and amortization are
removed from the accounts and the resulting gain or loss is
included in the results of operations.

e)Leases

Leases that substantially transfer all of the
benefits and risks of ownership of property to the Company, or
otherwise meet the criteria for capitalizing a lease under
accounting principles generally accepted in the United States of
America, are accounted for as capital leases. An asset is
recorded at the time a capital lease is entered into together
with its related long-term obligation to reflect its purchase
and financing. Property and equipment recorded under capital
leases are depreciated on the same basis as previously
described. Rental payments under operating leases are expensed
as incurred.

Leases that are operating leases with defined
scheduled rent increases are accounted for in accordance with
FASB Technical Bulletin 85-3. The effect of scheduled rent
increases, which are included in minimum lease payments under
SFAS Statement 13, Accounting for Leases, are recognized on
a straight-line basis over the lease term.

73



---



##### Table of Contents



|   |                                                           
|-- | ----------------------------------------------------------
|2. | SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
    (Continued)

f)Goodwill and Other Intangible
Assets

Goodwill represents the cost of acquired net
assets in excess of their fair market values. As of
January 1, 2002, the Company adopted the Statement of
Financial Accounting Standards (SFAS) issued by the
Financial Accounting Standards Board (FASB)
No. 142, Goodwill and Other Intangible Assets
which requires that goodwill and intangible assets with
indefinite useful lives are no longer amortized but instead
tested for impairment at least annually in accordance with the
provisions of SFAS No. 142. As a result, the
amortization of goodwill and intangible assets with an
indefinite life ceased upon adoption of the Statement.
SFAS No. 142 also requires that intangible assets with
estimable useful lives be amortized over their respective
estimated useful lives to their estimated residual values, and
reviewed for impairment. In accordance with
SFAS No. 142, goodwill and intangible assets are
assessed for impairment at least annually (refer to
paragraph (g) below). The Company performs its annual
assessment as of September 30th, and has not recorded an
impairment of goodwill in 2004, 2003 or 2002.

Other intangible assets, consisting of the costs
of acquiring leasehold rights are deferred and amortized over
the term of the lease including renewal options.

g)Long-lived Assets

The Company periodically assesses the
recoverability of long-lived assets, including property and
equipment, in accordance with the provisions of
SFAS No. 144, Accounting for the Impairment or
Disposal of Long-Lived Assets. This statement requires
that all long-lived assets be reviewed for impairment whenever
events or changes in circumstances indicate the carrying amount
of an asset may not be recoverable. Recoverability of assets to
be held and used is measured by comparison of the carrying value
of an asset to the undiscounted future cash flows expected to be
generated by the asset. If the carrying value of an asset
exceeds its estimated undiscounted future cash flows, an
impairment is recognized to the extent the book value of the
asset exceeds estimated fair value. Assets to be disposed of are
reported at the lower of the carrying amount or the fair value
of the asset, less all associated costs of disposition. In
addition, SFAS No. 144 requires companies to
separately report discontinued operations and extends that
reporting to a component of an entity that either has been
disposed of (by sale, abandonment, or in a distribution to
owners) or is classified as held for sale. Management considers
such factors as current results, trends and future prospects,
current market value, and other economic and regulatory factors,
in performing these analyses.

h)Other Assets and Assets under
Divestiture Agreement

Assets held under Divestiture Agreement (see
Note 5) are stated at cost less accumulated depreciation.
Provisions for depreciation are computed as outlined above in
Note 2(d).

The Company has settlement accounts receivable
due from the federal Medicare program, and certain state
Medicaid programs with retrospective reimbursement systems. The
Medicare program, prior to the implementation of the Prospective
Payment System (PPS) on January 1, 1999, was a
cost-based reimbursement program under which nursing facilities
received interim payments for each facilitys respective
reimbursable costs, which could be subject to adjustment based
upon the submission of a year-end cost report and certain cost
limits. The year-end cost report would be subject to audit by a
Companys Fiscal Intermediary (FI) and could
lead to ongoing discussions with the FI regarding the treatment
of various items related to prior years cost reports.
Normally items are resolved during the audit process and no
provisions are required. For items involving differences of
opinion between the Company and a FI regarding cost report
methods, such items can be settled through a formal appeal
process. Should this occur, a general provision or contractual
allowance for Medicare receivables may be provided for
disagreements, which result in the provider filing an appeal
with the Provider Reimbursement Review Board (PRRB)
of the Centers for Medicare and Medicaid Services
(CMS). Similarly, for states that operate under a
retrospective reimbursement system under which interim payments
are subject to audits, the Company evaluates and determines the
amount of potential settlement accounts receivable or payable.
The Company periodically reviews the accounts receivable and the
general contractual allowance for settlement of amounts in
dispute, and adjusts its balances

74



---



##### Table of Contents



|   |                                                           
|-- | ----------------------------------------------------------
|2. | SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
    (Continued)

accordingly based upon known facts at the time.
An adjustment to settlement receivable amount and recorded
revenues would occur upon resolution of issues in dispute or
upon issues being settled at the PRRB. In addition, the Company
estimates the portion of the Medicaid and Medicare settlement
accounts receivable to be collectible within the next
12 months and classifies this amount as a current asset.

Notes receivables are stated at the face value of
the note. Advances are stated at the amount of the receivable,
net of any allowance for non-collection. The Company monitors
the payment of interest due on the notes or advances and, where
provided within the terms of the notes, reviews the financial
statements of the company owing the amount to assess the
ultimate collectibility of the notes. Should circumstances arise
that the collectibility of the note is doubtful, an allowance
will be reflected against the note receivable.

Direct loan origination costs are recorded as
deferred financing costs and amortized over the life of the
related debt using the effective interest method.

Debt service and capital expenditure trust funds
and other investment holdings, which are comprised of fixed
interest securities, equity securities, and liquid money market
investments, are considered to be available-for-sale and
accordingly, are reported at fair value. Fair values are based
on quoted market prices. Unrealized gains and losses, net of
related tax effects, are reported within Accumulated Other
Comprehensive Income (AOCI) as a separate component
of shareholders equity. A decline in the market value of
any security below cost that is deemed other than temporary is
charged to income, resulting in the establishment of a new cost
basis for the security. The cost basis of the debt service trust
funds approximates fair value. Realized gains and losses for
securities classified as available-for-sale are included in the
results of operations and are derived using the specific
identification method for determining the cost of securities
sold. Interest income is recognized when earned.

i)Revenue Recognition

Nursing facility revenue results from the payment
for services and products from federal and state-funded
reimbursement programs as well as private pay residents.
Revenues are recorded in the period in which services and
products are provided at established rates less contractual
adjustments. Contractual adjustments include differences between
the Companys established billing rates and amounts
estimated by management as reimbursable under various
reimbursement formulas or contracts in effect. Estimation
differences between final settlements and amounts recorded in
previous years are reported as adjustments to revenues in the
period such settlements are determined. Refer to Note 14
for a specific description of legislative changes that impact
revenues.

Assisted living facility revenue is primarily
derived from private pay residents in the period in which the
services are provided and at rates established by the Company
based upon the services provided and market conditions in the
area of operation.



|   |                                                            
|-- | -----------------------------------------------------------
|j) | Provision for Divested Operations and Facility
    Closures

The Company continually assesses the performance
of its asset portfolio, and for those assets that fail to meet
operating and financial standards, a decision may be made to
dispose of the asset. Assets to be disposed of are recorded at
the lower of the carrying value or estimated fair market value
after disposal costs. Effective January 1, 2003 the Company
adopted SFAS Statement No. 146
(SFAS No. 146) Accounting for
Restructuring Costs Associated with Exit or Disposal
Activities which limits the Company from recording exit
costs until the event is incurred or obligates the Company to
the liability. Prior to the adoption of SFAS No. 146,
upon the divestiture of operations, the Company identified and
accrued for future known operating costs, commitments and
obligations, and thereafter continually assessed the adequacy of
the liability.

75



---



##### Table of Contents



|   |                                                           
|-- | ----------------------------------------------------------
|2. | SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
    (Continued)

k)Derivative Instruments and Hedging
Activities

All derivative instruments are recorded on the
balance sheet at their respective fair values. On the date the
derivative contract is entered into, the Company designates the
derivative as either a hedge of the fair value of a recognized
asset or liability (fair value hedge) or a hedge of
the variability of cash flows to be received or paid related to
a recognized asset or liability (cash flow hedge).
The Company assesses, both at the hedges inception and on
an ongoing basis, whether the derivatives that are used in
hedging transactions are highly effective in offsetting changes
in fair values or cash flows of hedge items. When it is
determined that a derivative is not highly effective as a hedge
or that it has ceased to be a highly effective hedge, the
Company discontinues the hedge accounting prospectively.

Changes in the fair value of a derivative that is
highly effective and that is designated and qualifies as a
fair-value hedge, along with the loss or gain on the hedged
asset or liability of the hedged item that is attributable to
the hedged risk are recorded in income. Changes in the fair
value of a derivative that is highly effective and that is
designated and qualifies as a cash-flow hedge are recorded in
other comprehensive income, until income is affected by the
variability in cash flows of the designated hedged item.

The Company discontinues hedge accounting
prospectively when it is determined that the derivative is no
longer effective in offsetting changes in the fair value or cash
flows of the hedged item, the derivative expires or is sold,
terminated, or exercised, or because management determines that
designation of the derivative as a hedging instrument is no
longer appropriate. When hedge accounting is discontinued
because it is determined that the derivative no longer qualifies
as an effective fair-value hedge, the Company continues to carry
the derivative on the balance sheet at its fair value, and
changes in fair value are reported in the statement of income.
In all other situations in which hedge accounting is
discontinued, the Company continues to carry the derivative at
its fair value on the balance sheet, and recognizes any changes
in its fair value in income.

l)Income Taxes

The Companys results of operations are
included in the consolidated federal tax return of the
Companys U.S. parent company. Accordingly, federal current
and deferred income taxes payable (or receivable), are
determined as if the Company had filed our own income tax
returns. Income taxes are accounted for under the asset and
liability method. Deferred tax assets and liabilities are
recognized for the expected future tax consequences attributable
to differences between the financial statement carrying amounts
of existing assets and liabilities and their respective tax
bases and operating loss and tax credit carryforwards. Deferred
tax assets and liabilities are measured using enacted tax rates
expected to apply to taxable income in the years in which those
temporary differences are expected to be recovered or settled.
The effect on deferred tax assets and liabilities of a change in
tax rates is recognized in income in the period that includes
the enactment date.

m)Reclassifications

Certain reclassifications have been made to the
2003 and 2002 consolidated financial statements to conform to
the presentation for 2004.



|   |                                                        
|-- | -------------------------------------------------------
|3. | SUPPLIES, PREPAID EXPENSES AND OTHER CURRENT
    ASSETS

|                     |  |                |        |      |  |   |       | 
|-------------------- |  | -------------- | ------ | ---- |  | - | ----- | 
|                     |  | 2004           |        | 2003
|                     |  |                |        |     
|                     |  |               
|                     |  | (in thousands)
|Prepaid expenses     |  | $              | 11,477 |      |  | $ | 932   | 
|Supplies             |  |                | 4,278  |      |  |   | 4,581 | 
|Other current assets |  |                | 1,996  |      |  |   | 1,923 | 
|                     |  |                |        |      |  |   |       | 
|                     |  | $              | 17,751 |      |  | $ | 7,436 | 
|                     |  |                |        |      |  |   |       | 

As of December 31, 2004, prepaid expenses
include a $9.5 million prepayment to Laurier Indemnity
Ltd., an affiliated insurance subsidiary of Extendicare Inc.,
for general liability and umbrella insurance premiums

76



---



##### Table of Contents



|   |                                                                    
|-- | -------------------------------------------------------------------
|3. | SUPPLIES, PREPAID EXPENSES AND OTHER CURRENT
    ASSETS (Continued)

for 2005. The Company changed the renewal period
for its 2004 and 2005 insurance that resulted in the prepaid
insurance balance as of December 31, 2004.



|   |                                  
|-- | ---------------------------------
|4. | ACQUISITIONS AND NEW CONSTRUCTION

On June 1, 2004, the Company acquired four
nursing facilities (321 beds) in Indiana for $5.0 million
in cash. On February 12, 2004, the Company acquired a
nursing facility in Washington, which was previously leased, for
$1.4 million in cash.

During 2004, the Company completed four
construction projects for a total cost of $10.0 million.
The Company added the following beds or units to existing
facilities: 16 units to an assisted living facility in Kentucky
in February 2004, 20 nursing beds to a nursing facility in
Wisconsin in March 2004, and 30 units to an assisted living
facility in Wisconsin in May 2004. In addition, the Company
opened a new assisted living facility with 40 units in Wisconsin
in May 2004.

On December 31, 2003, the Company acquired
one nursing facility (99 beds) in Wisconsin for
$4.1 million in cash.



|   |                                                           
|-- | ----------------------------------------------------------
|5. | ASSETS (AND DEPOSITS HELD) UNDER DIVESTITURE
    AGREEMENT

Assets Held Under Divestiture
Agreement

In June 2004, the Company concluded a deferred
sales transaction (described below) with Greystone Tribeca
Acquisition, L.L.C. (Greystone), by receipt of the
final consideration of $10.0 million on the Vendor Take
Back Note plus $2.6 million of interest, which completed
the September 2000 Divestiture Agreement. Finalizing this
transaction resulted in a gain of $4.9 million and interest
income of $1.7 million.

In September 2000, the Company disposed of eleven
Florida nursing facilities (1,435 beds) and four Florida
assisted living facilities (135 units) to Greystone and received
initial cash proceeds of $30.0 million and contingent
consideration in the form of a $10.0 million Vendor Take
Back Note and two other contingent and interest-bearing notes.
For the period from September 2000 through March 2004, the
Company retained the right of first refusal to repurchase the
facilities. The Company also retained an option to repurchase
the facilities until March 2003; however, the Company elected
not to place an offer to repurchase the facilities. The option
to repurchase along with the significant portion of the sales
price being contingent, resulted in the disposition being
accounted for as a deferred sale in accordance with
SFAS No. 66 and, accordingly, there was no gain or
loss recorded on the initial transaction. Prior to the
finalization of the agreement, the fixed assets had been
classified as Assets held under Divestiture
Agreement and had a net book value of $33.7 million.
As of December 31, 2003, the Company anticipated the final
consideration to be received in 2004, and, therefore, the
Assets held under Divestiture Agreement were
classified as a current asset and the Company ceased
depreciating these assets as of January 1, 2004.

Deposits Held Under Divestiture
Agreement

Prior to finalization of the Divestiture
Agreement, the initial cash proceeds of $30.0 million were
classified in the balance sheet as Deposits held under
Divestiture Agreement. Consistent with the classification
of the Assets Held under Divestiture Agreement, the Deposits
held under Divestiture Agreement were classified as a current
liability as of December 31, 2003 and until the transaction
was completed in June 2004.

77



---



##### Table of Contents





|   |                       
|-- | ----------------------
|6. | PROPERTY AND EQUIPMENT

Property and equipment and related accumulated
depreciation and amortization as of December 31 is as follows:

|                                                               |  |                |         |      |  |   |         | 
|-------------------------------------------------------------- |  | -------------- | ------- | ---- |  | - | ------- | 
|                                                               |  | 2004           |         | 2003
|                                                               |  |                |         |     
|                                                               |  |               
|                                                               |  | (in thousands)
|Land and land improvements                                     |  | $              | 40,220  |      |  | $ | 40,576  | 
|Buildings and improvements                                     |  |                | 585,757 |      |  |   | 578,531 | 
|Furniture and equipment                                        |  |                | 70,927  |      |  |   | 68,432  | 
|Leasehold improvements                                         |  |                | 12,209  |      |  |   | 11,393  | 
|Construction in progress (Note 22)                             |  |                | 11,485  |      |  |   | 5,952   | 
|                                                               |  |                |         |      |  |   |         | 
|                                                               |  |                | 720,598 |      |  |   | 704,884 | 
|Less accumulated depreciation and amortization
    (Note 2(d)) |  |                | 274,513 |      |  |   | 256,141 | 
|                                                               |  |                |         |      |  |   |         | 
|                                                               |  | $              | 446,085 |      |  | $ | 448,743 | 
|                                                               |  |                |         |      |  |   |         | 

Included within property and equipment are
properties leased to unrelated operators (refer to Note 20).



|   |                                     
|-- | ------------------------------------
|7. | GOODWILL AND OTHER INTANGIBLE ASSETS

Goodwill and other intangible assets consisted of
the following at December 31:

|                                          |  |                |        |      |  |   |        | 
|----------------------------------------- |  | -------------- | ------ | ---- |  | - | ------ | 
|                                          |  | 2004           |        | 2003
|                                          |  |                |        |     
|                                          |  |               
|                                          |  | (in thousands)
|Goodwill                                  |  | $              | 82,414 |      |  | $ | 81,916 | 
|Leasehold rights                          |  |                | 10,016 |      |  |   | 10,016 | 
|                                          |  |                |        |      |  |   |        | 
|                                          |  |                | 92,430 |      |  |   | 91,932 | 
|Less accumulated amortization (Note 2(f)) |  |                | 17,876 |      |  |   | 16,739 | 
|                                          |  |                |        |      |  |   |        | 
|                                          |  | $              | 74,554 |      |  | $ | 75,193 | 
|                                          |  |                |        |      |  |   |        | 

Aggregate amortization expense for leasehold
rights for the years ended December 31, 2004 and 2003 was
$1.1 million and $1.1 million, respectively. Estimated
amortization expense for the next five years is
$1.1 million in 2005, $0.6 million in 2006,
$0.2 million in 2007, and nil thereafter based on leasehold
rights owned as at December 31, 2004.

78



---



##### Table of Contents





|   |             
|-- | ------------
|8. | OTHER ASSETS

Other assets consisted of the following at
December 31:

|                                                                                                                                                            |  |                |        |      |  |   |        | 
|----------------------------------------------------------------------------------------------------------------------------------------------------------- |  | -------------- | ------ | ---- |  | - | ------ | 
|                                                                                                                                                            |  | 2004           |        | 2003
|                                                                                                                                                            |  |                |        |     
|                                                                                                                                                            |  |               
|                                                                                                                                                            |  | (in thousands)
|Deferred financing costs, net                                                                                                                               |  | $              | 11,828 |      |  | $ | 10,562 | 
|Non-current accounts receivable from Medicare and
    Medicaid programs, less contractual allowance of $2,994 and
    $8,470 in 2004 and 2003, respectively |  |                | 10,214 |      |  |   | 25,938 | 
|Non-current accounts receivable from
    non-affiliated long-term care operators                                                                            |  |                | 7,024  |      |  |   | 6,901  | 
|Indemnification escrow                                                                                                                                      |  |                | 3,700  |      |  |   | 3,700  | 
|Non-current advances to Lakeside Health, LLC                                                                                                                |  |                | 2,445  |      |  |   |       | 
|Funds held under deferred compensation plan
    (Note 12)                                                                                                   |  |                | 2,001  |      |  |   | 1,551  | 
|Notes receivable                                                                                                                                            |  |                | 1,000  |      |  |   |       | 
|Prepaid interest rate cap fee                                                                                                                               |  |                | 984    |      |  |   |       | 
|Other investments                                                                                                                                           |  |                | 916    |      |  |   | 762    | 
|Security deposits                                                                                                                                           |  |                | 361    |      |  |   | 363    | 
|Debt service and capital expenditure trust funds                                                                                                            |  |                | 309    |      |  |   | 308    | 
|Notes receivable from Tandem                                                                                                                                |  |                |       |      |  |   | 21,402 | 
|Omnicare shares held for investment                                                                                                                         |  |                |       |      |  |   | 5,048  | 
|Omnicare warrants held for investment                                                                                                                       |  |                |       |      |  |   | 4,375  | 
|Other                                                                                                                                                       |  |                | 703    |      |  |   | 1,176  | 
|                                                                                                                                                            |  |                |        |      |  |   |        | 
|                                                                                                                                                            |  | $              | 41,485 |      |  | $ | 82,086 | 
|                                                                                                                                                            |  |                |        |      |  |   |        | 

Medicare and Medicaid Settlement
Receivables

For Medicare revenues earned prior to the
implementation of Medicare PPS on January 1, 1999 and for
Medicaid programs with a retrospective reimbursement system,
differences between revenues that the Company ultimately expects
to realize from these programs and amounts received are
reflected as accounts receivable, or as accrued liabilities when
payments have exceeded revenues that the Company ultimately
expects to realize.

As of December 31, 2003, the balance of
Medicare and Medicaid settlement receivables totaled
$37.2 million. As a result of the settlements discussed
below, settlement receivables decreased by $20.2 million to
$17.0 million as of December 31, 2004. Though there
remain certain issues to be resolved with the FIs, the
significant Medicare settlement receivable issues in respect of
revenues earned prior to the implementation of PPS have been
resolved as of December 31, 2004. The remaining Medicare
settlement receivables primarily relate to reimbursable
Part A co-insurance receivables, which amounted to
$10.6 million and $8.5 million as of December 31,
2004 and 2003, respectively. Below is a summary of non-current
and current settlement receivables balance:

|                                                                                                                                            |  |                |        |      |  |   |        | 
|------------------------------------------------------------------------------------------------------------------------------------------- |  | -------------- | ------ | ---- |  | - | ------ | 
|                                                                                                                                            |  | 2004           |        | 2003
|                                                                                                                                            |  |                |        |     
|                                                                                                                                            |  |               
|                                                                                                                                            |  | (in thousands)
|Total Settlement Receivables from Medicare and
    Medicaid programs, less contractual allowance of $4,370 and
    $14,019 in 2004 and 2003 |  | $              | 16,954 |      |  | $ | 37,213 | 
|Less: Current portion of Medicare and Medicaid
    settlement receivables (included in accounts receivable)                                 |  |                | 6,740  |      |  |   | 11,275 | 
|                                                                                                                                            |  |                |        |      |  |   |        | 
|Non-current portion of Settlement Accounts
    Receivable                                                                                   |  | $              | 10,214 |      |  | $ | 25,938 | 
|                                                                                                                                            |  |                |        |      |  |   |        | 

79



---



##### Table of Contents



|   |                         
|-- | ------------------------
|8. | OTHER ASSETS (Continued)



For a specific staffing cost issue, a settlement
of the first year of seven specific claim years was reached
prior to the January 2003 Provider Reimbursement Review Board
(PRRB) hearing, and during 2003 the Company
continued to negotiate the remaining years in dispute with a FI.
In January 2004, the Company negotiated and subsequently
received a cash settlement of $5.6 million. The settlement
did not result in a significant adjustment from the recorded
receivable balance.

For another specific Medicare receivable issue
involving the allocation of overhead costs, the first of three
specific claim years was presented to the PRRB at a hearing in
January 2003. The hearing procedures were discontinued after the
parties negotiated a methodology for resolution of the claim for
one of the years in dispute. The negotiated settlement for this
and other issues relating to the 1996 cost report year resulted
in no adjustment to the recorded receivable balance, and the
Company subsequently collected in September 2003
$3.0 million from a FI. In April 2004, the Company reached
a negotiated settlement with a FI in respect of the remaining
two claim years regarding overhead costs. The settlement will
result in the receipt of approximately $7.7 million,
$6.6 million of which was received in May 2004. The Company
will receive the balance of the payment upon resolution of other
matters concerning the cost report years under appeal. Upon
resolution of these matters, the financial impact of the related
settlement, if any, will be determined.

In August 2004, prior to the PRRB hearing date,
the Company reached a negotiated settlement with a FI with
respect to various issues related to facilities purchased in the
Arbor Health Care Company (Arbor) acquisition in
1997. The settlement reached will result in the payment of
$2.1 million, $1.8 million of which was received in
the fourth quarter of 2004. The balance of the settlement will
be received in 2005. The settlement receivables had been
reserved for upon the 1999 divestiture of Arbor to Tandem Health
Care, Inc. (Tandem) and further within the provision
for divested operations (refer to Note 10). Upon the sale
of Arbor to Tandem, a long-term liability of $3.7 million
(refer to Note 12) was accrued for outstanding tax,
Medicare and other claims against Arbor as part of the sale, as
a offset to the Indemnification Escrow funds, identified above,
that were deposited with a trustee. Upon settlement of these
Medicare matters, the Company is confident that there are no
outstanding claims in respect of Arbor; however, there can be no
assurance that other claims will not be made against the
Indemnification Escrow until the expiration of the warranty
period with Tandem in 2007. As a result of the settlement, the
$6.9 million difference between the net settlement balance
and proceeds to be received was charged against the
$3.7 million Arbor long-term liability balance, and
$3.2 million against the reserve for divested operations
(refer to Note 10).

In September 2004, prior to the PRRB hearing
date, the Company reached a negotiated settlement with a FI with
respect to the Director of Nursing staff cost issue. The
settlement will result in the receipt of $3.2 million, of
which $2.8 million was received in the fourth quarter of
2004. The balance of the settlement will be received in 2005. No
gain or loss was recognized on settlement of this issue.

In 2003, the Company wrote-off $4.0 million
pertaining to individual claims in dispute with a FI for the
cost report years 1996 through 1998. Of the $4.0 million
write-off, $1.3 million pertains to discontinued
operations, and therefore, was applied to the previously accrued
reserve for divested operations (refer to Note 10). The net
adjustment of $2.7 million resulted in a reduction of
revenues during 2003.

Notes Receivable from Tandem

As of December 31, 2003, the Company held
$21.4 million in notes receivable due from Tandem. In
February 2004, Tandem refinanced two of its nursing facilities
and the Company subsequently received prepayment in full of
$4.4 million of the notes receivable held in respect of
these properties. In June 2004, the Company accepted and
received a cash prepayment of $16.2 million for the
remaining $17.0 million of notes receivable due from
Tandem. After payment of the associated selling expenses of
$0.5 million, the Company recognized a loss of
$1.3 million, which is recognized in loss on disposal of
assets on the statement of income.

80



---



##### Table of Contents



|   |                         
|-- | ------------------------
|8. | OTHER ASSETS (Continued)



Omnicare Shares and Warrants Held for
Investment

In May 2004, Extendicare purchased for market
value all of the Companys investment of 125,000 common
shares in Omnicare for $4.9 million in cash, which resulted
in a gain of $0.9 million.

As of December 31, 2004, the Company held a
warrant to purchase up to 1.5 million shares of Omnicare
Inc. (Omnicare) common stock, which had an original
attributed carrying value of $4.0 million pursuant to the
sale of the Companys pharmacy to Omnicare in 1998. The
warrant has an exercise price of $48.00 per share and expires in
September 2005. The book value of the warrant is based on the
estimated market value, which is computed using the
Black-Scholes model. The book value of the warrant as of
December 31, 2003 was $4.4 million and
$3.2 million as of June 30, 2004. However, during the
third quarter of 2004, the share price of Omnicare common stock
declined resulting in the value of the warrant declining to
$0.3 million. Prior to third quarter of 2004, the change in
fair value had been recorded through Accumulated Other
Comprehensive Income (AOCI). In the third quarter of
2004, the Company wrote off its $4.0 million investment as
the likelihood of the warrant being in-the-money before it
expires had significantly declined as a result of the recent
decrease in Omnicares share price. The market value of an
Omnicare share as of December 31, 2004 was $34.62.

Advances and Amounts Due from
Non-Affiliated Long-term Care Operators

The Company has provided working capital advances
to non-affiliated long-term care operators of $9.4 million,
of which $7.0 million are to long-term care operators that
the Company provides consulting services to, and
$2.4 million (net of allowance) is to Lakeside
Health L.L.C. (Lakeside Health) as outlined
below.

In August 2004, the Company transferred the
operations of the Lakeside nursing facility (336 beds) in
Chippewa Falls, Wisconsin to Lakeside Health, a subsidiary of
Benedictine Health Dimensions, Inc. (Benedictine)
under a three-year lease arrangement. The transfer of operations
was in response to facility citations for survey deficiencies
and an agreement with the State of Wisconsin to transfer the
operations to a new licensee. Under the terms of the agreement,
Lakeside Health is responsible for all operating costs,
including rent payable to the Company and management fees
payable to Benedictine. The Company will receive rental income
of $0.5 million per annum, however, is responsible for
funding Lakeside Healths operating losses from the nursing
facility, as defined in the agreement, and to provide working
capital advances sufficient to maintain an operating cash
account of $1.5 million. As of December 31, 2004, the
Company has advanced $4.4 million to Lakeside Health. These
advances are secured by a first security interest in Lakeside
Healths accounts receivable and are repayable from the
assets and future cash flow of Lakeside Health, if any.
Effective the date of the license transfer, the State of
Wisconsin reduced the Lakeside nursing facility licensed bed
capacity from 336 to 245. In September 2004, Benedictine
completed its plan of correction at Lakeside and passed its
survey with the State of Wisconsin, bringing the facility into
regulatory compliance. In the five months that Benedictine
operated the facility, considerable resources were employed to
bring the facility into compliance, resulting in Lakeside Health
reporting a net loss of $1.8 million. The Company recorded
a provision of $2.0 million against the working capital
advances made to Lakeside Health. As of December 31, 2004,
the net carrying value of advances made to Lakeside Health is
$2.4 million.

As a result of the financial and operating
performance of Lakeside Health in the fourth quarter of 2004,
the Company recorded an asset impairment provision of
$6.8 million to reduce the carrying value of the Lakeside
property from $13.0 million to $6.2 million. The
Company determined the reduced property value based upon its
estimate of the current market value of the facility which
assumes the facility attains a suitable Medicare occupancy
level. There cannot be any assurance that a future reduction in
carry value will not be required if these estimates change. The
Company will continue to monitor the facilitys performance
in respect of determination of a potential asset impairment
charge. Prior to the transfer of operations, the Company
incurred a loss before lease costs, depreciation, interest and
income taxes of $1.2 million for the seven months ended
July 31, 2004 as compared to net earnings before these
items of $0.5 million for the year ended December 31,
2003.

81



---



##### Table of Contents



|   |                         
|-- | ------------------------
|8. | OTHER ASSETS (Continued)



Other Assets

During 2004, the Company made payments of
deferred financing costs of $5.5 million relating to the
issuance of new debt and the amendment of its credit facility
(refer to Note 9). The Company wrote off deferred financing
costs of $2.9 million, net of accumulated amortization
expense of $4.7 million, relating to early retirement of
debt (refer to Note 9). Accumulated amortization of
deferred financing costs as of December 31, 2004 and 2003
was $2.7 million and $5.9 million, respectively.

9.     LINE OF CREDIT
AND LONG-TERM DEBT

Long-term debt, net of discount, consisted of the
following at December 31:

|                                                                                                                                                        |  |                        |         |      |  |   |         | 
|------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ---------------------- | ------- | ---- |  | - | ------- | 
|                                                                                                                                                        |  | 2004                   |         | 2003
|                                                                                                                                                        |  |                        |         |     
|                                                                                                                                                        |  |                       
|                                                                                                                                                        |  | (dollars in thousands)
|9.50% Senior Notes due 2010                                                                                                                             |  | $                      | 149,714 |      |  | $ | 149,676 | 
|6.875% Senior Subordinated Notes due 2014                                                                                                               |  |                        | 122,022 |      |  |   |        | 
|9.35% Senior Subordinated Notes due 2007                                                                                                                |  |                        |        |      |  |   | 200,000 | 
|Industrial Development Revenue Bonds, variable
    interest rates ranging from 2.01% to 6.25%, maturing through
    2014, secured by certain facilities |  |                        | 10,455  |      |  |   | 33,160  | 
|Mortgage notes payable, interest rates ranging
    from 3.0% to 10.0%, maturing through 2009                                                            |  |                        | 9,730   |      |  |   | 10,054  | 
|Other, primarily capital lease obligations                                                                                                              |  |                        | 11      |      |  |   | 28      | 
|                                                                                                                                                        |  |                        |         |      |  |   |         | 
|Long-term debt before current maturities                                                                                                                |  |                        | 291,932 |      |  |   | 392,918 | 
|Less current maturities                                                                                                                                 |  |                        | 1,071   |      |  |   | 1,223   | 
|                                                                                                                                                        |  |                        |         |      |  |   |         | 
|                                                                                                                                                        |  | $                      | 290,861 |      |  | $ | 391,695 | 
|                                                                                                                                                        |  |                        |         |      |  |   |         | 

2010 Senior Notes

On June 28, 2002, the Company completed a
private placement of $150 million of its 9.5% Senior Notes
due July 1, 2010 (the 2010 Senior Notes),
which were issued at a discount of 0.25% of par to yield 9.54%.
In January 2003, the Company completed its offer to exchange new
9.5% Senior Notes due 2010 that have been registered under the
Securities Act for the Notes issued in June 2002. The terms of
the new 2010 Senior Notes are identical to the terms of the
2010 Senior Notes issued in June 2002 and are guaranteed by
all existing and future active subsidiaries of the Company.

The Company used the proceeds of
$149.6 million from the Senior Notes to pay related fees
and expenses of $8.3 million, to retire $124.5 million
of indebtedness outstanding under its previous credit facility
and Term Loans, to refinance $6.3 million of other debt,
and for general corporate purposes. The retirement of the
previous credit facility resulted in a loss on early retirement
of debt of $2.8 million. Also on June 28, 2002, the
Company entered into an interest rate swap agreement and an
interest rate cap agreement. The Company terminated these
agreements in April 2004 in connection with the sale and
issuance of the 2014 Notes. See Note 21 for more
information on the swap and cap agreements.

The indenture governing the 2010 Senior
Notes contains customary covenants and events of default. Under
this indenture, the Company is restricted from incurring
indebtedness if the fixed charge coverage ratio, determined on a
pro forma basis, is less than or equal to 2.0 to 1. The
Companys fixed charge coverage ratio is currently in
excess of this minimum requirement. The fixed charge coverage
ratio is defined in the indenture governing the 2010 Senior
Notes, and is represented by a ratio of consolidated cash flow
to fixed charges. In general, fixed charges consist of interest
expense, including capitalized interest, amortization of fees
related to debt financing and rent expense deemed to be
interest, and consolidated cash flow consists of net income
prior to the aforementioned fixed charges, and prior to income
taxes and losses on disposal of assets.

82



---



##### Table of Contents



|   |                                                  
|-- | -------------------------------------------------
|9. | LINE OF CREDIT AND LONG-TERM DEBT
    (Continued)

The Company is required to make mandatory
prepayments of principal upon the occurrence of certain events,
such as certain asset sales and certain issuances of securities.
The 2010 Senior Notes are redeemable at the option of the
Company starting on July 1, 2006. The redemption prices, if
redeemed during the 12-month period beginning on July 1 of the
year indicated, are as follows:

|                    |  |                  |          | 
|------------------- |  | ---------------- | -------- | 
|Year                |  | Redemption Price
|                    |  |                 
|2006                |  |                  | 104.750% | 
|2007                |  |                  | 102.375% | 
|2008 and thereafter |  |                  | 100.000% | 

The Company has no independent assets or
operations and the guarantees of the 2010 Senior Notes are
full and unconditional, and joint and several, and any of the
Companys subsidiaries that do not guarantee the 2010
Senior Notes are minor. There are no significant
restrictions on the ability of the Company to obtain funds from
its subsidiaries by loan or dividend.

2014 Notes

On April 22, 2004, the Company sold and
issued $125 million aggregate principal amount of 6.875%
Senior Subordinated Notes due May 1, 2014 (the 2014
Notes) pursuant to Rule 144A and Regulation S
under the Securities Act of 1933, as amended (the
Securities Act). The 2014 Notes were issued at a
price of 97.5001% of par to yield 7.23%. The net proceeds from
the issuance of the 2014 Notes were approximately
$117.4 million, net of a discount of $3.1 million and
fees and expenses of $4.5 million. The Company used these
net proceeds, along with cash on hand and borrowings under its
amended and restated credit facility described below, to
purchase for cash the 9.35% Senior Subordinated Notes due 2007
(the 2007 Notes), tendered in the tender offer
described below, to redeem the 2007 Notes not tendered in
the tender offer prior to May 24, 2004 and to pay related
fees and expenses of the tender offer and redemption. Also on
April 22, 2004, the Company entered into two interest rate
swap agreements and two interest rate cap agreements. See
Note 21 for the terms of the interest rate swap and cap
agreements. In August 2004, the Company completed its offer to
exchange new 6.875% Senior Subordinated Notes due 2014 that have
been registered under the Securities Act for the Senior
Subordinated Notes issued in April 2004. The terms of the new
2014 Notes are identical to the terms of the 2014 Notes
issued in April 2004 and are guaranteed by all of the
Companys existing and future domestic significant
subsidiaries, existing and future domestic subsidiaries that
guarantee or incur any indebtedness and any other existing and
future significant subsidiaries or restricted subsidiaries that
guarantee or otherwise provide direct credit support for
indebtedness of the Company or any of the Companys
domestic subsidiaries.

The 2014 Notes are fully and unconditionally
guaranteed on a senior subordinated unsecured basis, jointly and
severally, by all of the Companys existing and future
domestic significant subsidiaries, all of the Companys
existing and future domestic subsidiaries that guarantee or
incur any indebtedness and any other existing and future
significant subsidiaries or restricted subsidiaries that
guarantee or otherwise provide direct credit support for
indebtedness of the Company or any of its domestic subsidiaries.
The 2014 Notes and guarantees are general unsecured obligations
of the Company and the Companys subsidiaries.

On or after May 1, 2009, the Company may
redeem all or part of the 2014 Notes, at the redemption prices
(expressed as percentages of principal amount) listed below,
plus accrued and unpaid interest, if any, to the date of
redemption, if redeemed during the twelve-month period
commencing on May 1 of the years set forth below:

|                    |  |                  |          | 
|------------------- |  | ---------------- | -------- | 
|Year                |  | Redemption Price
|                    |  |                 
|2009                |  |                  | 103.438% | 
|2010                |  |                  | 102.292% | 
|2011                |  |                  | 101.146% | 
|2012 and thereafter |  |                  | 100.000% | 

83



---



##### Table of Contents



|   |                                                  
|-- | -------------------------------------------------
|9. | LINE OF CREDIT AND LONG-TERM DEBT
    (Continued)

2007 Notes

On April 22, 2004, the Company purchased for
cash $104.9 million aggregate principal amount of its 2007
Notes pursuant to a tender offer to purchase any and all of its
then-outstanding $200 million of 2007 Notes. On
May 24, 2004, the Company redeemed and cancelled the
remaining $95.1 million of 2007 Notes not tendered in the
tender offer. The holders of the 2007 Notes who tendered their
2007 Notes or whose 2007 Notes were redeemed by the Company were
paid a premium that, in the aggregate, amounted to approximately
$6.6 million. As a result of the tender offer, redemption
and repayment of the 2007 Notes, the Company wrote off deferred
finance charges of approximately $2.4 million related to
the 2007 Notes and incurred legal costs estimated at
$0.3 million. In addition, pursuant to the termination of
the related interest rate swap and cap agreements (refer to
Note 21), the Company recorded a gain of approximately
$3.3 million in the second quarter of 2004. Below is a
summary of the loss reported relating to these transactions:

|                                                                 |  |             |        |  
|---------------------------------------------------------------- |  | ----------- | ------ | -
|                                                                 |  | (dollars in
|                                                                 |  | thousands) 
|                                                                 |  |            
|Tender premium and call premium                                  |  | $           | (6,636 | )
|Write-off of deferred finance charges                            |  |             | (2,359 | )
|Legal expenses                                                   |  |             | (285   | )
|                                                                 |  |             |        |  
|                                                                 |  |             | (9,280 | )
|Gain on termination of interest rate swap and cap
    Agreements |  |             | 3,302  |  
|                                                                 |  |             |        |  
|                                                                 |  | $           | (5,978 | )
|                                                                 |  |             |        |  

The Company issued the 2007 Notes in December
1997. The 2007 Notes were unsecured senior subordinated
obligations of the Company subordinated in right of payment to
all existing and future senior indebtedness of the Company,
which included all borrowings under the credit facility as well
as all indebtedness not refinanced by the credit facility. The
2007 Notes were to mature on December 15, 2007.

Credit Facility

The Company established a senior secured
revolving credit facility in June 2002. In connection with the
April 2004 offering of the 2014 Notes, the Company amended and
restated its credit facility (the Credit Facility)
to, among other things, extend the maturity date from
June 28, 2007 to June 28, 2009 and increase the total
borrowing capacity from $105 million to $155 million.

The Credit Facility is used to back letters of
credit and for general corporate purposes. Borrowings under the
Credit Facility bear interest, at the Companys option, at
the Eurodollar rate or the base rate, plus applicable margins.
Depending upon the Companys senior leverage ratio, the
interest rate is equal to the Eurodollar rate plus a margin of
2.50% to 3.25% per annum or the base rate plus a margin of
1.50% to 2.25% per annum. The commitment fee is 0.50%
per annum on the undrawn capacity regardless of utilization.

The Credit Facility is secured by a perfected,
first priority security interest in certain tangible and
intangible assets and all of the Companys capital stock
and the capital stock of the Companys subsidiary
guarantors. The Credit Facility is also secured by a pledge of
65% of the voting stock of the Companys foreign
subsidiaries, including the Company subsidiary guarantors
foreign subsidiaries, if any. The Credit Facility contains
customary covenants and events of default and is subject to
various mandatory prepayment and commitment reductions. The
Company is permitted to make voluntary prepayments at any time
under the Credit Facility.

As of December 31, 2004 and
December 31, 2003, the Company had no borrowings under the
Credit Facility. The unused portion of the Credit Facility that
is available for working capital and corporate purposes, after
reduction for outstanding letters of credit of
$23.9 million, was $131.1 million as of
December 31, 2004.

84



---



##### Table of Contents



|   |                                                  
|-- | -------------------------------------------------
|9. | LINE OF CREDIT AND LONG-TERM DEBT
    (Continued)

The Credit Facility requires that the Company
comply with various financial covenants, including fixed charge
coverage, debt leverage, and tangible net worth ratios. In
January 2005, the Company amended its Credit Facility to
accommodate the ALC acquisition. Refer to Subsequent Events
(refer to Note 19).



| |                     
| | --------------------
| | Other Long-term Debt

In February 2004, the Company prepaid in full two
Industrial Development Revenue Bonds totaling
$13.0 million, which resulted in a charge to income of
$0.3 million to write off deferred financing costs. In
August 2004 the Company prepaid in full a $9.5 million
Industrial Development Revenue bond that resulted in a charge to
income of $0.2 million to write off deferred financing
costs.

On October 2002, the Company completed a
transaction in which it exercised its right to acquire seven
previously-leased nursing facilities in the states of Ohio and
Indiana for $17.9 million. The purchase price included cash
of $7.4 million and a $10.5 million interest bearing
10-year note. The interest rate on the note was subject to
negotiation and failing an agreement would have been settled
through arbitration. In the latter part of 2003, the Company
prepaid $4.5 million against the note and in April 2004 the
Company refinanced the facilities with mortgages whose interest
rates vary with LIBOR above a minimum level, and repaid the
remaining balance of the note due to the seller.



| |                             
| | ----------------------------
| | Principle Repayment Schedule

Principal payments on long-term debt, net of
discount, due within the next five years and thereafter are as
follows (dollars in thousands):

|           |  |   |         | 
|---------- |  | - | ------- | 
|2005       |  | $ | 1,071   | 
|2006       |  |   | 1,026   | 
|2007       |  |   | 3,799   | 
|2008       |  |   | 583     | 
|2009       |  |   | 4,217   | 
|After 2009 |  |   | 281,236 | 
|           |  |   |         | 
|           |  | $ | 291,932 | 
|           |  |   |         | 

Interest paid in 2004, 2003 and 2002 was
$24.6 million, $32.7 million and $26.2 million,
respectively.

10.     ACCRUED
LIABILITIES

Accrued liabilities consisted of the following at
December 31:

|                                                           |  |                |        |      |  |   |         | 
|---------------------------------------------------------- |  | -------------- | ------ | ---- |  | - | ------- | 
|                                                           |  | 2004           |        | 2003
|                                                           |  |                |        |     
|                                                           |  |               
|                                                           |  | (in thousands)
|Salaries and wages, fringe benefits and payroll
    taxes  |  | $              | 45,325 |      |  | $ | 41,620  | 
|Workers compensation                                      |  |                | 16,155 |      |  |   | 18,957  | 
|Other claims                                               |  |                | 12,614 |      |  |   | 11,245  | 
|Interest and financing                                     |  |                | 7,174  |      |  |   | 7,970   | 
|Real estate, utilities and other taxes                     |  |                | 5,825  |      |  |   | 6,702   | 
|State bed fees and other assessments                       |  |                | 4,277  |      |  |   | 1,865   | 
|Other operating expense                                    |  |                | 4,145  |      |  |   | 4,219   | 
|Reserves for divested operations and facility
    closures |  |                | 2,523  |      |  |   | 7,291   | 
|Medicaid accrued liabilities                               |  |                | 1,882  |      |  |   | 1,745   | 
|                                                           |  |                |        |      |  |   |         | 
|                                                           |  | $              | 99,920 |      |  | $ | 101,614 | 
|                                                           |  |                |        |      |  |   |         | 

Reserves for divested operations and facility
closures primarily relate to provisions for the settlement of
Medicare and Medicaid claims and other amounts with third
parties. The settlement of such amounts are

85



---



##### Table of Contents



10.     ACCRUED
LIABILITIES (Continued)




dependent on actions by those third parties and
negotiations by the Company, and therefore may not be resolved
within the next several years.

Below is a summary of activity of the accrued
liabilities balance relating to divested operations and facility
closures:

|                          |               |                    |       |              |   |       |       |        |   |   |       |        |   |   |       |        |  
|------------------------- | ------------- | ------------------ | ----- | ------------ | - | ----- | ----- | ------ | - | - | ----- | ------ | - | - | ----- | ------ | -
|                          |               | Medicare, Medicaid |       | Resident and |   |       |       |       
|                          |               | and Supplier       |       | Employee     |   |       |       |       
|                          |               | Claims             |       | Claims       |   | Other |       | Total 
|                          |               |                    |       |              |   |       |       |       
|                          |               |                   
|                          |               | (in thousands)    
|Balance December 31, 2001 |               |                    | 1,896 |              |   |       | 2,305 |        |   |   | 3,801 |        |   |   | 8,002 |       
|                          | Cash Payments |                    |       | (863         | ) |       |       | (1,051 | ) |   |       | (2,777 | ) |   |       | (4,691 | )
|                          | Provisions(1) |                    |       | 7,066        |   |       |       | 64     |   |   |       | (723   | ) |   |       | 6,407  |  
|                          |               |                    |       |              |   |       |       |        |   |   |       |        |   |   |       |       
|Balance December 31, 2002 |               |                    | 8,099 |              |   |       | 1,318 |        |   |   | 301   |        |   |   | 9,718 |       
|                          | Cash Payments |                    |       | (565         | ) |       |       | (824   | ) |   |       | (141   | ) |   |       | (1,530 | )
|                          | Provisions(2) |                    |       | (897         | ) |       |       |       |   |   |       |       |   |   |       | (897   | )
|                          |               |                    |       |              |   |       |       |        |   |   |       |        |   |   |       |       
|Balance December 31, 2003 |               |                    | 6,637 |              |   |       | 494   |        |   |   | 160   |        |   |   | 7,291 |       
|                          | Cash Payments |                    |       | (1,410       | ) |       |       |       |   |   |       | (160   | ) |   |       | (1,570 | )
|                          | Provisions(3) |                    |       | (3,198       | ) |       |       |       |   |   |       |       |   |   |       | (3,198 | )
|                          |               |                    |       |              |   |       |       |        |   |   |       |        |   |   |       |       
|Balance December 31, 2004 |               | $                  | 2,029 |              |   | $     | 494   |        |   | $ |      |        |   | $ | 2,523 |       
|                          |               |                    |       |              |   |       |       |        |   |   |       |        |   |   |       |       



---



|    |                                                                                                                                                                                                                                                                           
|--- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | In 2002, provisions include a provision for
    closure and exit costs of $5.3 million and selling expenses
    of $1.2 million relating to the sale of assets to Tandem.                                                                                                 
|   
|(2) | In 2003, provisions include the write-off of
    $1.3 million of previously accrued Medicare claims
    receivable relating to discontinued operations (refer to
    Note 14). Provisions for 2003 were net of refunds of
    $0.4 million from various Medicaid programs.
|   
|(3) | In 2004, provisions include the write-off of
    $3.2 million of net Medicare settlement receivables
    pertaining to facilities acquired from Arbor, which were accrued
    as part of the divestiture of Arbor to Tandem in 1999 (refer to
    Note 8).                

11.     ACCRUAL FOR
SELF-INSURED LIABILITIES

The Company insures certain risks with affiliated
insurance subsidiaries of Extendicare and third-party insurers.
The insurance policies cover comprehensive general and
professional liability (including malpractice insurance) for the
Companys health providers, assistants and other staff as
it relates to their respective duties performed on the
Companys behalf, workers compensation and
employers liability in amounts and with such coverage and
deductibles as determined by the Company, based on the nature
and risk of its businesses, historical experiences, availability
and industry standards. The Company also self insures for health
and dental claims, in certain states for workers
compensation and employers liability and for general and
professional liability claims. Self-insured liabilities with
respect to general and professional liability claims are
included within the accrual for self-insured liabilities. The
Companys accrual for self-insured health and dental
claims, and workers compensation are included in accrued
liabilities (refer to Note 10).

Management regularly evaluates the
appropriateness of the carrying value of the self-insured
liability through an independent actuarial review. General and
professional liability claims are the most volatile and
significant of the risks for which the Company self insures.
Managements estimate of the accrual for general and
professional liability costs is significantly influenced by
assumptions, which are limited by the uncertainty of predicting
future events, and assessments regarding expectations of several
factors. Such factors include, but are not limited to: the
frequency and severity of claims, which can differ materially by
jurisdiction; coverage limits of third-party reinsurance; the
effectiveness of the claims management process; and the

86



---



##### Table of Contents



11.     ACCRUAL FOR
SELF-INSURED LIABILITIES (Continued)


outcome of litigation. In addition, the Company
estimates the amount of general and professional liability
claims it will pay in the subsequent year and classifies this
amount as a current liability.

In 2000, the Company experienced an adverse
development of claims resulting in the per claim retained risk
to increase significantly for general and professional liability
coverage. This escalation was primarily due to the level of risk
associated with Florida and Texas operations. As of
January 1, 2001, the Company no longer operated nursing and
assisted living facilities in Florida and, as of October 1,
2001, ceased nursing operations in Texas, thereby reducing the
level of exposure to future litigation in these litigious
states. Changes in the Companys level of retained risk,
and other significant assumptions that underlie
managements estimates of self-insured liabilities, could
have a material effect on the future carrying value of the
self-insured liabilities as well as the Companys operating
results and liquidity.

Following is a summary of activity in the accrual
for self-insured liabilities:

|                              |  |                |         |      |  |   |         |  
|----------------------------- |  | -------------- | ------- | ---- |  | - | ------- | -
|                              |  | 2004           |         | 2003
|                              |  |                |         |     
|                              |  |               
|                              |  | (in thousands)
|Balances at beginning of year |  | $              | 45,063  |      |  | $ | 55,089  |  
|Cash payments                 |  |                | (13,938 | )    |  |   | (16,026 | )
|Provisions                    |  |                | 6,600   |      |  |   | 6,000   |  
|                              |  |                |         |      |  |   |         |  
|Balances at end of year       |  | $              | 37,725  |      |  | $ | 45,063  |  
|                              |  |                |         |      |  |   |         |  
|Current portion               |  | $              | 18,000  |      |  | $ | 18,000  |  
|Long-term portion             |  |                | 19,725  |      |  |   | 27,063  |  
|                              |  |                |         |      |  |   |         |  
|Balances at end of year       |  | $              | 37,725  |      |  | $ | 45,063  |  
|                              |  |                |         |      |  |   |         |  

12.     OTHER
LONG-TERM LIABILITIES

Other long-term liabilities consisted of the
following at December 31:

|                                                                    |  |                |        |      |  |   |        | 
|------------------------------------------------------------------- |  | -------------- | ------ | ---- |  | - | ------ | 
|                                                                    |  | 2004           |        | 2003
|                                                                    |  |                |        |     
|                                                                    |  |               
|                                                                    |  | (in thousands)
|Deferred compensation                                               |  | $              | 7,207  |      |  | $ | 6,391  | 
|Market value of interest rate caps                                  |  |                | 5,241  |      |  |   | 781    | 
|Indemnification escrow relating to sold
    facilities (see Note 8) |  |                |       |      |  |   | 3,700  | 
|Other                                                               |  |                |       |      |  |   | 210    | 
|                                                                    |  |                |        |      |  |   |        | 
|                                                                    |  | $              | 12,448 |      |  | $ | 11,082 | 
|                                                                    |  |                |        |      |  |   |        | 

The Company maintains an unfunded deferred
compensation plan offered to all corporate employees defined as
highly compensated by the Internal Revenue Service Code in which
participants may defer up to 10% of their base salary. The
Company will match up to 50% of the amount deferred. The Company
also maintains non-qualified deferred compensation plans
covering certain executive employees. Expense incurred for
Company contributions under such plans were $604,000, $609,000
and $361,000 in 2004, 2003 and 2002, respectively.

The Company maintains defined contribution
retirement 401(k) savings plans, which are made available to
substantially all of the Companys employees. The Company
pays a matching contribution of 25% of every qualifying dollar
contributed by plan participants, net of any forfeitures.
Expenses incurred by the Company related to the 401(k) savings
plans were $1.3 million, $0.8 million and
$1.3 million in 2004, 2003 and 2002, respectively. The
Company also maintains a money purchase plan for two facilities
in which the Company pays amounts based upon the plan
participants worked hours and an agreed fixed hourly rate.
Expenses incurred by the Company related to the money purchase
plan were $32,000, $90,000 and $96,000 in 2004, 2003 and 2002,
respectively.

87



---



##### Table of Contents



12.     OTHER
LONG-TERM LIABILITIES (Continued)


Effective April 2003, the Company participates in
a multi-employer defined-benefit pension plan for its employees
in three facilities. The Company made contributions of $64,000
and $32,000 to this plan in 2004 and 2003, respectively.

13.     DUE TO
SHAREHOLDER

In May 2004, subsequent to the redemption of
$27.9 million of the 2007 Notes held by Extendicare, an
advance of $22.9 million was made was by Extendicare to the
Company, of which $14.0 million was advanced through an
affiliate of the Company. In December 2004, the Company advanced
$7.7 million to Extendicare for short term purposes, and
that was repaid in January 2005. As of December 31, 2004,
the Company has a current advance due from Extendicare of
$7.7 million and has an advance due to Extendicare and its
affiliates of $17.8 million, of which $3.0 million has
been classified as a current payable, and the remainder is
classified as a long-term payable. As of December 31, 2003,
the Company had a current receivable from shareholder and an
affiliate of $7.0 million and a long-term payable of
$3.5 million.

14.     REVENUES

The Company derived approximately 30%, 27% and
26% of its revenues from services provided under various federal
(Medicare) programs and approximately 47%, 49% and 50% of its
revenues from services provided under various state medical
assistance programs (Medicaid) in 2004, 2003 and 2002,
respectively. The Medicare program and most state Medicaid
programs pay each participating facility on a prospectively-set
per diem rate for each resident, which is based on the
residents acuity. Most Medicaid programs fund
participating facilities using a case-mix system, paying
prospectively set rates.

Legislation Actions Affecting Medicare
Revenues

The Balanced Budget Act (BBA) that
was signed into law in August 1997 resulted in the
implementation of a Prospective Payment System (PPS)
for skilled nursing facility funding certified under the
Medicare program effective January 1, 1999. The PPS
establishes a federal per diem rate for virtually all covered
services. The provisions of the BBA provided that for skilled
nursing facilities in operation prior to 1996, the federal per
diem rate would be phased in over a four-year period ending
January 1, 2002. In November 1999, the Balanced Budget
Relief Act (BBRA) was passed to allow each skilled
nursing facility to apply to adopt the full federal rate
effective January 1, 2000 or to continue to phase in to the
federal rate over the next three years. Effective January 2002,
all skilled nursing facilities are reimbursed at the full
federal rate.

As a result of the industry coming under
financial pressure due to the implementation of PPS and other
BBA of 1997 provisions, Congress passed two acts to provide some
relief to the industry, namely the BBRA of 1999 and the BIPA of
2000. These laws contained additional funding provisions to
assist providers as they adjusted to PPS for an interim period.
The BBRA of 1999 increased the rate by 20% for 15 Resource
Utilization Groups III (RUGs) categories identified
as having intensity non-therapy ancillary services deemed to be
underfunded. The BBRA of 1999 also provided for a 4% increase to
all RUGs categories on October 1, 2000. The BIPA of 2000
increased the nursing component of the federal rate by 16.66%
and replaced the 20% add-on to the three RUGs categories with a
6.7% add-on for all 14 rehabilitative RUGs categories.

The funding enhancements implemented by the BBRA
and BIPA fall into two categories. The first category is
Legislative Add-ons which included a 16.66% add-on
to the nursing component of the RUGs rate and a 4% base
adjustment. The second category is RUGs Refinements
which involves an initial 20% add-on for 15 RUGs categories
identified as having high intensity, non-therapy ancillary
services. The 20% add-ons from three RUGs categories were later
redistributed to 14 rehabilitation categories at an add-on rate
of 6.7% each.

88



---



##### Table of Contents



14.     REVENUES
(Continued)


On September 30, 2002, the Legislative
Add-ons expired, hereafter referred to as the Medicare
Cliff, resulting in a reduction in Medicare funding for
all skilled nursing facilities. The Company estimates that based
upon the Medicare case mix and census for the nine months ended
September 30, 2002, it received an average rate of $31.22
per resident day related to the Legislative Add-ons. This
decline in Medicare rates was partially offset by a 2.6% market
basket increase received on October 1, 2002. Based upon the
Medicare case mix and census for the twelve months ended
October 1, 2002 to September 30, 2003 the net impact
of the Medicare Cliff and market basket increase was a reduction
of revenues of $16.7 million.

Effective October 1, 2003, the Centers for
Medicare and Medicaid Services (CMS) increased
Medicare rates by 6.26% reflecting (1) a cumulative
forecast correction (Administrative Fix), to correct
past years under-funded rate increases, which increased the
Federal base payment rates by 3.26%, and (2) the annual
market basket increase of 3.0%. The Company estimated that based
on the Medicare case mix for the nine month period ended
September 30, 2003, this Medicare rate increase would add
approximately $18.45 per Medicare day. Based upon the
Medicare case mix and census in the fourth quarter of 2003, the
impact of the 6.26% Medicare rate increase resulted in
$3.5 million in increased revenues. Based on the Medicare
case mix and census for the year ended December 31, 2004,
this Medicare rate increase amounted to additional annualized
revenue of approximately $14.6 million, which was tempered
by higher labor and other operating costs. In order to maintain
their commitment to Senator Grassley and CMS in providing the
Administrative Fix, in October 2003 the Alliance for Quality
Nursing Home Care (which is a membership of large long-term care
providers) and the American Health Care Association
(AHCA) announced their support to spend the
Administrative Fix over the next fiscal period on direct care
and services for its residents. In October 2003 CMS published
notice to skilled nursing facilities that within future cost
reports, it will require confirmation that the Administrative
Fix funding was spent on direct patient care and related
expenses. Effective October 1, 2004, CMS increased Medicare
rates based upon the annual basket increase of 2.8%.

With respect to the RUGs Refinements, CMS has
extended the funding enhancements beyond the previously
announced sunset dates. However, based upon the July 2004 CMS
announcement, the RUGs Refinements extend only until
October 1, 2005. The Congress has enacted legislation
directing CMS to conduct a study on the RUGs classification
system and report its recommendations prior to the
implementation of a RUGs Refinement change whereby all or part
of the enhancement is discontinued.



| |                                                      
| | -----------------------------------------------------
| | State Plan Amendments affecting Medicaid
    Revenues

In July 2004, the State of Kentucky received
approval from CMS of a state plan amendment and waiver,
effective July 1, 2004. The Kentucky plan amendment and
waiver contributed approximately $2.3 million in
incremental income before income taxes for the six month period
ended December 31, 2004.

As of December 31, 2004, the State of
Indiana has submitted a proposed state plan amendment and
waiver, which is awaiting review and approval by CMS pertaining
to the fiscal year commencing July 1, 2003. The
retrospective plan amendment and waiver seeks an increase in the
level of federal funding for the Medicaid programs, and would
result in providing nursing facilities with revenue rate
increases to offset new or increased provider taxes. As the plan
amendment and waiver have not been approved, the Company has
recorded revenues based upon amounts received. Based upon the
final and CMS approved plan amendment and waiver, changes in the
Medicaid rates and any associated provider taxes could result in
adjustments to income for the period July 1, 2003 to
December 31, 2004.

In January 2005, the States of Pennsylvania and
Washington received approval from CMS for their submitted state
plan amendments and waivers. Refer to Subsequent Events (refer
to Note 18).



| |                                                                                                        
| | -------------------------------------------------------------------------------------------------------
| | Revenue Adjustments and Provisions
    (Recovery) for Outstanding Medicare and Medicaid
    Receivables

In respect of Medicare cost reporting periods
prior to the implementation of PPS, the Company has ongoing
discussions with its FI regarding the treatment of various items
related to prior years cost reports. Normally items are
resolved during the audit process and no provisions are
required. For items involving

89



---



##### Table of Contents



14.     REVENUES
(Continued)


differences of opinion between the Company and a
FI regarding cost report methods, such items can be settled
through a formal appeal process. Should this occur, a general
provision for Medicare receivables may be provided for
disagreements, which result in the provider filing an appeal
with the PRRB of the CMS. Estimated differences between the
final settlement and amounts recorded in previous years are
reported as adjustments to revenues in the period.

In respect of Medicaid in states that utilize
retrospective reimbursement systems, nursing facilities are paid
on an interim basis for services provided, subject to
adjustments based upon allowable costs, which are generally
submitted in cost reports on an annual basis. In these states,
revenues are subject to adjustments as a result of cost report
settlements with the state.

During 2003, the Company wrote off
$4.0 million, pertaining to individual Medicare claims in
dispute with a FI for the cost report years 1996 through 1998
(refer to Note 8). Of the $4.0 million write off,
$1.3 million pertains to discontinued operations, and
therefore, was applied to the previously accrued divested
operations liability balance (refer to Note 10). The net
adjustment of $2.7 million resulted in a reduction of
revenues during 2003. Offsetting this, the Company recorded a
recovery of $4.2 million in Medicaid revenues resulting
from a favorable court decision in the State of Ohio relating to
the recovery of alleged government overpayments for adjudicated
Medicaid cost report periods.

15.     INTEREST
EXPENSE, NET

The following summarizes the components of
interest expense, net:

|                 |  |                        |        |      |  |      |        |   |  |   |        |  
|---------------- |  | ---------------------- | ------ | ---- |  | ---- | ------ | - |  | - | ------ | -
|                 |  | 2004                   |        | 2003 |  | 2002
|                 |  |                        |        |      |  |     
|                 |  |                       
|                 |  | (dollars in thousands)
|Interest expense |  | $                      | 25,390 |      |  | $    | 33,981 |   |  | $ | 33,654 |  
|Interest income  |  |                        | (8,207 | )    |  |      | (4,035 | ) |  |   | (2,125 | )
|                 |  |                        |        |      |  |      |        |   |  |   |        |  
|                 |  | $                      | 17,183 |      |  | $    | 29,946 |   |  | $ | 31,529 |  
|                 |  |                        |        |      |  |      |        |   |  |   |        |  

The valuation adjustment expense on the interest
rate caps is reflected separately on the consolidated statements
of income. (refer to Note 21).



|    |                                                                                                              
|--- | -------------------------------------------------------------------------------------------------------------
|16. | LOSS ON DISPOSAL OF ASSETS, PROVISION FOR
    CLOSURE AND EXIT COSTS, AND IMPAIRMENT OF LONG-LIVED
    ASSETS

|                                                                                                            |                                                          |      |       |        |   |      |   |   |  |   |        |        |  
|----------------------------------------------------------------------------------------------------------- | -------------------------------------------------------- | ---- | ----- | ------ | - | ---- | - | - |  | - | ------ | ------ | -
|                                                                                                            |                                                          | 2004 |       | 2003   |   | 2002
|                                                                                                            |                                                          |      |       |        |   |     
|Loss (gain) on disposal of assets:                                                                          |                                                          |      |       |        |   |      |   |   |  |   |        |       
|                                                                                                            | Completion of Divestiture Agreement with Greystone       |      | $     | (4,873 | ) |      |   |  |  |   |        |       |  
|                                                                                                            | Write-off of Omnicare warrant                            |      |       | 4,000  |   |      |   |  |  |   |        |       |  
|                                                                                                            | Payoff of notes receivable from Tandem at a
    discount |      |       | 1,266  |   |      |   |  |  |   |        |       |  
|                                                                                                            | Sale of Omnicare common stock                            |      |       | (863   | ) |      |   |  |  |   |        |       |  
|                                                                                                            | Sale of Arkansas facilities                              |      |       | 574    |   |      |   |  |  |   |        |       |  
|                                                                                                            | Sale of seven Florida nursing facilities to Tandem       |      |       |       |   |      |   |  |  |   |        | (3,961 | )
|                                                                                                            |                                                          |      |       |        |   |      |   |   |  |   |        |       
|                                                                                                            |                                                          |      | 104   |        |   |      |  |   |  |   | (3,961 | )     
|Provision for closure and exit costs and other
    items for Florida nursing and assisted living facilities |                                                          |      |      |        |   |      |  |   |  |   | 5,293  |       
|Loss on impairment of long-lived assets:                                                                    |                                                          |      |       |        |   |      |   |   |  |   |        |       
|                                                                                                            | Impairment of skilled nursing facility in
    Wisconsin  |      |       | 6,825  |   |      |   |  |  |   |        |       |  
|                                                                                                            | Impairment of skilled nursing facility in Indiana        |      |       | 1,612  |   |      |   |  |  |   |        |       |  
|                                                                                                            |                                                          |      |       |        |   |      |   |   |  |   |        |       
|                                                                                                            |                                                          | $    | 8,541 |        |   | $    |  |   |  | $ | 1,332  |       
|                                                                                                            |                                                          |      |       |        |   |      |   |   |  |   |        |       

90



---



##### Table of Contents



|    |                                                                                                                          
|--- | -------------------------------------------------------------------------------------------------------------------------
|16. | LOSS ON DISPOSAL OF ASSETS, PROVISION FOR
    CLOSURE AND EXIT COSTS, AND IMPAIRMENT OF LONG-LIVED ASSETS
    (Continued)



| |                                      
| | -------------------------------------
| | Loss (gain) on disposal of
    assets

Below is a summary of the transactions that
resulted in the above gains and losses.

In June 2004, the Company concluded a deferred
sales transaction (refer to Note 5) with Greystone Tribeca
Acquisition, L.L.C. (Greystone), by receipt of the
final consideration of $10.0 million on the Vendor Take
Back Note plus $2.6 million of interest, which completed
the September 2000 Divestiture Agreement. Finalizing this
transaction resulted in recognition in 2004 of a gain of
$4.9 million and interest income of $1.7 million.

At December 31, 2004, the Company held a
warrant to purchase up to 1.5 million shares of Omnicare
common stock, which had an original attributed carrying value of
$4.0 million pursuant to the sale of the Companys
pharmacy to Omnicare in 1998. The warrant has an exercise price
of $48.00 per share and expires in September 2005. During the
third quarter of 2004, the share price of Omnicare common stock
declined, resulting in the value of the warrant declining to
$0.3 million. In the third quarter of 2004, the Company
wrote off its $4.0 million investment (refer to
Note 8) as the likelihood of the warrant being in-the-money
before it expires had significantly declined as a result of the
decrease in Omnicares share price.

In June 2004, the Company accepted and received a
cash prepayment of $16.2 million for the remaining
$17.0 million of notes receivable due from Tandem (refer to
Note 8). After payment of the associated selling expenses
of $0.5 million, the Company recognized a loss of
$1.3 million.

In May 2004, Extendicare purchased at market
value all of the Companys investment of 125,000 common
shares of Omnicare Inc., or Omnicare, for $4.9 million,
which resulted in a gain of $0.9 million (refer to
Note 8). This stock was acquired pursuant to the sale of
the Companys pharmacy to Omnicare in 1998.

In August 2004, the Company sold its Arkansas
facilities, consisting of one nursing (96 beds) and three
assisted living facilities (181 units), for $6.1 million.
Proceeds consisted of cash of $5.2 million and a five-year
interest-bearing note of $0.9 million. The sale resulted in
a pre-tax loss of $0.6 million.

In May 2002, Tandem exercised its option to
purchase seven properties in Florida that it leased from us for
gross proceeds of $28.6 million, consisting of cash of
$15.6 million and $13.0 million in 8.5% five-year
notes. The Company applied $12.4 million of the proceeds to
reduce bank debt. Until this date, Tandem operated these
facilities under a lease agreement with a purchase option. The
carrying value of the seven facilities was $25.3 million.
As a result, the Company recorded a gain on the sale of assets
of $4.0 million, inclusive of the deferred gain of
$2.2 million from the sale of two leased facilities in the
April 2001.



| |                                         
| | ----------------------------------------
| | Provision for closure and exit
    costs

In May 2002, the Company recorded a provision for
closure and exit costs relating to divested Florida operations
of $5.3 million relating to cost report settlement issues,
and the settlement of claims with suppliers and employees.



| |                                            
| | -------------------------------------------
| | Loss on impairment of long-lived
    assets

In March 2004, the Company concluded the
evaluation of two nursing facilities that operate adjacent to
one another in Indiana, both of which require capital
renovations. After evaluation of the respective operations, the
Company made a decision, subject to State of Indiana approval,
to consolidate the two operations into one renovated facility,
which upon completion will accommodate all residents from both
facilities; however, the total available nursing beds will
decrease by 46. The consolidation of the two operations is
expected to be completed by April 2005. As a result of the
decision to close the one facility, the Company recorded a
provision of $1.6 million for impairment of long-lived
assets.

In August 2004, the Company transferred the
operations of a nursing facility (336 beds) in Chippewa Falls,
Wisconsin to Lakeside Health, a subsidiary of Benedictine for a
term of three years (refer to Note 8).

91



---



##### Table of Contents



|    |                                                                                                                          
|--- | -------------------------------------------------------------------------------------------------------------------------
|16. | LOSS ON DISPOSAL OF ASSETS, PROVISION FOR
    CLOSURE AND EXIT COSTS, AND IMPAIRMENT OF LONG-LIVED ASSETS
    (Continued)

There was no loss incurred in respect of the
transfer. As a result of the financial and operating performance
of Lakeside Health in the fourth quarter of 2004, in December
2004, the Company recorded an asset impairment provision of
$6.8 million to reduce the carrying value of the Lakeside
property from $13.0 million to $6.2 million. The
Company determined the reduced property value based upon its
estimate of the current market value of the facility, which
assumes the facility attains a suitable Medicare occupancy
level. There cannot be any assurance that a future charge will
not be required if these estimates change.

Reconciliation of proceeds

The following reconciles total proceeds from
dispositions to proceeds from sale of property and equipment
reported in the Consolidated Statements of Cash Flow:

|                                                   |                                                                             |                |   |       |   |      |   |   |  |  |   |         |  
|-------------------------------------------------- | --------------------------------------------------------------------------- | -------------- | - | ----- | - | ---- | - | - |  |  | - | ------- | -
|                                                   |                                                                             | 2004           |   | 2003  |   | 2002
|                                                   |                                                                             |                |   |       |   |     
|                                                   |                                                                             |               
|                                                   |                                                                             | (in thousands)
|Reconciliation of cash proceeds from dispositions: |                                                                             |                |   |       |   |      |   |   |  |  |   |        
|                                                   | Total proceeds, net of selling costs                                        |                | $ | 5,750 |   |      | $ |  |  |  | $ | 27,315  |  
|                                                   | Notes receivable                                                            |                |   | (900  | ) |      |   |  |  |  |   | (13,000 | )
|                                                   |                                                                             |                |   |       |   |      |   |   |  |  |   |        
|                                                   | Proceeds from sale of property and equipment in
    Statements of Cash Flow |                | $ | 4,850 |   |      | $ |  |  |  | $ | 14,315  |  
|                                                   |                                                                             |                |   |       |   |      |   |   |  |  |   |        

17.     LOSS ON
REFINANCING AND RETIREMENT OF DEBT

The following summarizes the components of the
loss on refinancing and retirement of debt:

|                                                                              |  |                        |        |      |  |      |   |  |  |   |       | 
|----------------------------------------------------------------------------- |  | ---------------------- | ------ | ---- |  | ---- | - |  |  | - | ----- | 
|                                                                              |  | 2004                   |        | 2003 |  | 2002
|                                                                              |  |                        |        |      |  |     
|                                                                              |  |                       
|                                                                              |  | (dollars in thousands)
|Loss on early retirement of credit facility
    (Note 9)                      |  | $                      |       |      |  | $    |  |  |  | $ | 2,849 | 
|Loss on early retirement of 2007 Notes
    (Note 9)                           |  |                        | 9,280  |      |  |      |  |  |  |   |      | 
|Loss on early retirement of Industrial
    Development Revenue Bonds (Note 9) |  |                        | 506    |      |  |      |  |  |  |   |      | 
|                                                                              |  |                        |        |      |  |      |   |  |  |   |       | 
|                                                                              |  |                        | 9,786  |      |  |      |  |  |  |   | 2,849 | 
|Gain on termination of interest rate swap and cap
    (Note 21)               |  |                        | (3,302 | )    |  |      |  |  |  |   |      | 
|                                                                              |  |                        |        |      |  |      |   |  |  |   |       | 
|                                                                              |  | $                      | 6,484  |      |  | $    |  |  |  | $ | 2,849 | 
|                                                                              |  |                        |        |      |  |      |   |  |  |   |       | 

18.     SUBSEQUENT
EVENTS

Legislation Actions Affecting Medicaid and
Medicare Revenues

In January 2005, the States of Pennsylvania and
Washington received approval from CMS for their submitted state
plan amendments and waivers. The Washington approval will have
no impact on earnings. As a result of the Pennsylvania approval,
the Company anticipates that it will receive, subject to
finalization, retroactive revenues of approximately
$11.3 million (unaudited) in 2005 and be required to
pay provider taxes of approximately $8.7 million
(unaudited) pertaining to the period July 1, 2003 to
June 30, 2004. As a result, the Company anticipates that
the impact on net income before income taxes will be
approximately $2.6 million (unaudited). In addition,
subject to state budgetary approval and certain other actions,
the Company anticipates that it will in addition receive
retroactive revenues to fund provider taxes for the period
July 1, 2004 to December 2004. These amounts are subject to
finalization, however current estimates indicate that the impact
on net income before income taxes of the July 1, 2004 to
December 31, 2004 settlement will be approximately
$0.5 million (unaudited). The Company will record the above
settlements when the plans are finalized in 2005.

92



---



##### Table of Contents



|    |                              
|--- | -----------------------------
|18. | SUBSEQUENT EVENTS (Continued)



Acquisitions and Divestitures

In January 2005, the Company completed the
acquisition of Assisted Living Concepts, Inc. Refer to
Note 19.

In January 2005, the Company sold for
$1.9 million in cash a property in Maryland that formerly
was a nursing facility but was closed in 1998. The pre-tax gain
on the disposition was $0.4 million.

Loan Repayments

In January 2005, the Company prepaid the
remaining Industrial Development Revenue Bond totaling
$9.5 million, which will result in a charge to income of
$0.1 million to write off deferred financing costs. In
February 2005, the Company prepaid a mortgage totaling
$5.3 million, which will result in a charge to income of
$0.1 million to write off deferred financing costs.



|    |                                                  
|--- | -------------------------------------------------
|19. | ACQUISITION OF ASSISTED LIVING CONCEPTS,
    INC.

On November 4, 2004, the Company entered
into a definitive merger and acquisition agreement with Assisted
Living Concepts, Inc. (ALC) of Dallas, Texas
(OTC. BB: ASLC) providing for the acquisition of all
of the outstanding shares and stock options of ALC at $18.50 per
share. The completion of the acquisition was subject to certain
conditions, including approval by ALCs shareholders and
certain customary regulatory approvals. ALC has a portfolio of
177 assisted living facilities, comprised of 122 owned
properties and 55 leased facilities representing 6,838 units,
located in 14 states, many in markets where we currently
operate.

On January 31, 2005, the shareholders of ALC
approved the merger and acquisition agreement and the Company
completed the acquisition for cash of approximately
$144 million. The Company financed the acquisition by using
approximately $29 million of cash on hand, a
$55 million 6% Term Loan from Extendicare Holdings, Inc.
(EHI), the Companys U.S. parent company, and
$60 million from the Credit

93



---



##### Table of Contents



|    |                                                              
|--- | -------------------------------------------------------------
|19. | ACQUISITION OF ASSISTED LIVING CONCEPTS, INC.
    (Continued)



Facility. The estimated impact of the acquisition
on each asset and liability category in the Companys
consolidated balance sheet is as follows as of January 31,
2005:

|                                                             |                                                                                       |                        |         |         | 
|------------------------------------------------------------ | ------------------------------------------------------------------------------------- | ---------------------- | ------- | ------- | 
|                                                             |                                                                                       | (dollars in thousands)
|ASSETS:                                                      |                                                                                       |                        |         |        
|Cash, net of $29 million used to finance the
    acquisition |                                                                                       | $                      | (22,652 | )      
|Accounts receivable                                          |                                                                                       |                        | 3,003   |        
|Other current assets                                         |                                                                                       |                        | 8,308   |        
|                                                             |                                                                                       |                        |         |        
|Total current assets                                         |                                                                                       |                        | (11,341 | )      
|Property, plant and equipment                                |                                                                                       |                        | 290,761 |        
|Goodwill                                                     |                                                                                       |                        |        |        
|Other long-term assets                                       |                                                                                       |                        | 4,497   |        
|                                                             |                                                                                       |                        |         |        
|Total assets                                                 |                                                                                       | $                      | 283,917 |        
|                                                             |                                                                                       |                        |         |        
|LIABILITIES:                                                 |                                                                                       |                        |         |        
|Current maturities of long-term debt                         |                                                                                       | $                      | 3,418   |        
|Other current liabilities                                    |                                                                                       |                        | 19,733  |        
|                                                             |                                                                                       |                        |         |        
|Total current liabilities                                    |                                                                                       |                        | 23,151  |        
|Long term debt:                                              |                                                                                       |                        |         |        
|                                                             | Long-term debt of ALC assumed                                                         |                        |         | 141,011 | 
|                                                             | Proceeds from 6% Term Loan from Extendicare
    Holdings, Inc. to finance acquisition |                        |         | 55,000  | 
|                                                             | Proceeds from revolving Credit Facility to
    finance acquisition                    |                        |         | 60,000  | 
|                                                             |                                                                                       |                        |         |        
|                                                             | Total long-term debt                                                                  |                        |         | 256,011 | 
|Other long-term liabilities                                  |                                                                                       |                        | 4,755   |        
|                                                             |                                                                                       |                        |         |        
|Total liabilities                                            |                                                                                       | $                      | 283,917 |        
|                                                             |                                                                                       |                        |         |        

The preliminary purchase price allocation
reflected above shows goodwill of zero and the allocation will
be finalized in 2005 after the final tangible and intangible
asset valuations are complete.

In January 2005, the Company amended its Credit
Facility to permit the loan from EHI to accommodate the ALC
acquisition. ALCs debt will be non-recourse to the Company
and ALCs debt and earnings will be excluded from existing
financial covenants under the Companys Credit Facility.

In January 2005, Extendicare Inc. advanced
$55 million to EHI, who in turn advanced $55 million
as a Term Loan to the Company to accommodate the ALC
acquisition. This Term Loan, has a term of five years, can be
repaid at any time by the Company and bears interest at 6%.

In January 2005, the Company entered into a
Memorandum of Understanding (MOU) with LTC
Properties, Inc. (LTC) in respect of 37 facilities
leased to ALC by LTC. Under the terms of the MOU which become
effective January 1, 2005, the Company agreed to increase
the annual rent paid to LTC by $250,000 per annum for each of
the successive four years, commencing on January 1, 2005,
and amended the terms relating to inflationary increases.
Formerly, the 37 leases had expiration dates ranging from 2007
through to 2015. Under the terms of the MOU, the amended lease
provides for an initial 10 year lease term commencing on
January 1, 2005, and three successive 10 year lease
terms at the option of the Company. The aggregate minimum rent
payments for the leases for the calendar years 2005 through 2008
will be $9.4 million, $9.8 million and
$10.2 million and $10.7 million, respectively. The
minimum rent will increase by 2% over the prior years
minimum rent for each of the calendar years 2009 through 2014.
Annual minimum rent during any extended term will increase a
minimum of 2% over the minimum rent of the immediately preceding
year. The MOU provides that LTC will not assert certain events
of default against ALC under the original leases.

94



---



##### Table of Contents



20.     LEASE
COMMITMENTS

As at December 31, 2004, as a lessee, the
Company was committed under non-cancelable operating leases
requiring future minimum rentals as follows:

|                       |  |                |        | 
|---------------------- |  | -------------- | ------ | 
|                       |  | (in thousands)
|2005                   |  | $              | 8,455  | 
|2006                   |  |                | 5,514  | 
|2007                   |  |                | 3,829  | 
|2008                   |  |                | 3,785  | 
|2009                   |  |                | 3,508  | 
|After 2009             |  |                | 19,753 | 
|                       |  |                |        | 
|Total minimum payments |  | $              | 44,844 | 
|                       |  |                |        | 

The above commitments do not include commitments
assumed as a result of the January 2005 ALC acquisition. These
leases expire on various dates extending to the year 2015 and in
many cases contain renewal options. Operating lease costs were
$9.0 million, $9.1 million and $10.6 million in
2004, 2003 and 2002, respectively. Refer to terms of MOU in
respect of ALC lease with LTC in Subsequent Events
(Note 19).

As at December 31, 2004, as a lessor, the
Company leases 11 nursing properties (1,310 beds) to three
unrelated long-term care operators in Florida, Texas and
Wisconsin. All of the leases are accounted for as operating
leases. Senior Health-South leases six nursing properties in
Florida for a term that expires in December 2006. The Company
earns rental income (based upon the net operating cash flow of
the properties), which on average cannot exceed
$2.0 million per annum. Rental income earned during 2004
totaled $1.2 million (2003  $0.3 million;
2002  $0.5 million) under this lease. Senior
Health-South has an option to purchase the nursing properties
during the term of the lease. Senior Health-Texas leases four
nursing properties in Texas for a term that expires in September
2006, and subleases another 12 properties until February 2012,
all in Texas. The annual rental income during 2004 totaled
$3.9 million (2003  $3.9 million;
2002  $3.8 million) or $1.8 million in
excess of the Companys annual lease cost. Senior
Health-Texas has the right of first refusal to purchase the four
nursing properties over the term of the lease. Lakeside Health
(refer to Note 8) leases one nursing property in Wisconsin
for a term that expires in July 2007. The annual rent is
$0.5 million and during 2004 the Company earned
approximately $0.2 million. The cost and accumulated
depreciation of facilities under operating lease arrangements
included in Property and Equipment (refer to Note 6) as of
December 31, 2004 and December 31, 2003 are as follows:

|                                               |  |                |        |      |  |   |        | 
|---------------------------------------------- |  | -------------- | ------ | ---- |  | - | ------ | 
|                                               |  | 2004           |        | 2003
|                                               |  |                |        |     
|                                               |  |               
|                                               |  | (in thousands)
|Land and land improvements                     |  | $              | 3,496  |      |  | $ | 2,147  | 
|Buildings and improvements                     |  |                | 42,108 |      |  |   | 33,172 | 
|Furniture and equipment                        |  |                | 8,131  |      |  |   | 6,894  | 
|                                               |  |                |        |      |  |   |        | 
|                                               |  |                | 53,735 |      |  |   | 42,213 | 
|Less accumulated depreciation and amortization |  |                | 33,473 |      |  |   | 26,440 | 
|                                               |  |                |        |      |  |   |        | 
|Property and equipment                         |  | $              | 20,262 |      |  | $ | 15,773 | 
|                                               |  |                |        |      |  |   |        | 

21.     DERIVATIVE
INSTRUMENTS AND HEDGING ACTIVITIES

Objectives and Strategies

As of December 31, 2004, all but
$9.5 million of the Companys outstanding debt
obligations have fixed interest rates. To hedge the fair value
of fixed-rate debt obligations, the Company has entered into
interest rate swap agreements under which it pays a variable
rate of interest and receives a fixed rate of interest. These
interest rate swaps are designated as fair value hedges under
SFAS 133 and changes in the market value of the interest
rate swaps have no impact on the statement of income unless they
are terminated or are no longer

95



---



##### Table of Contents



|    |                                                              
|--- | -------------------------------------------------------------
|21. | DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES
    (Continued)



designated as hedges. In addition, the Company
has entered into interest rate cap agreements to limit its
exposure to increases in interest rates.

The Company does not speculate using derivative
instruments.

Interest Rate Swap and Cap Agreements
Entered into in April 2004 and Maturing in 2010 and
2014

On April 22, 2004, the Company entered into
two interest rate swap agreements and two interest rate cap
agreements relating to the 2010 Senior Notes and the 2014 Notes.

With respect to the 2010 Senior Notes, the
Company entered into an interest rate swap agreement expiring
July 1, 2010 (the 2010 Swap) with a notional
amount of $150 million. The 2010 Swap effectively converted
up to $150 million of fixed-rate indebtedness into
variable-rate indebtedness. Under the terms of the 2010 Swap,
the counterparty can call the swap at any time on or after
July 1, 2006 with payments as determined under the
agreement. This call option is a mirror image of the embedded
call option in the debt instrument. The swap was designated as a
highly-effective fair value hedge, and as a result, changes in
market value of the swap are recorded in income but are offset
by changes in market value of the indebtedness so that there is
no net impact on the statement of income unless the swap is
terminated or no longer qualifies as a hedge. The Company also
entered into an interest rate cap agreement expiring
July 1, 2010 (the 2010 Cap) with a notional
amount of $150 million. Under the 2010 Cap, the
Company paid on April 22, 2004 an upfront fee of
$3.5 million to the counterparty. The Company will receive
a variable rate of interest equal to the excess, if any, of the
six-month LIBOR, adjusted semi-annually, over the cap rate of
7%. The Company uses the 2010 Cap to offset possible
increases in interest payments under the 2010 Swap caused by
increases in market interest rates over a certain level. Under
the terms of the 2010 Cap, the counterparty can call the
cap if the 2010 Swap is terminated. The 2010 Cap was not
designated as a hedging instrument under SFAS 133 and,
therefore, changes in market value are recorded in the statement
of income.

With respect to the 2014 Notes, the Company
entered into an interest rate swap agreement expiring
May 1, 2014 (the 2014 Swap) with a notional
amount of $125 million. The 2014 Swap effectively converted
up to $125 million of fixed-rate indebtedness into
variable-rate indebtedness. Under the terms of the 2014 Swap,
the counterparty can call the 2014 Swap at any time on or after
May 1, 2009 with payments as determined under the
agreement. This call option is a mirror image of the embedded
call option in the debt instrument. The 2014 Swap was designated
as a highly-effective fair value hedge and, as a result, changes
in market value of the swap are recorded in income but are
offset by changes in market value of the indebtedness so that
there is no net impact on the statement of income unless the
swap is terminated or no longer qualifies as a hedge. The
Company also entered into an interest rate cap agreement
expiring May 1, 2014 (2014 Cap) with a notional
amount of $125 million. Under the 2014 Cap, the Company
pays a fixed rate of interest equal to 0.75% to the counterparty
and receives a variable rate of interest equal to the excess, if
any, of the six-month LIBOR, adjusted semi-annually, over the
cap rate of 7%. The Company uses the 2014 Cap to offset possible
increases in interest payments under the 2014 Swap caused by
increases in market interest rates over a certain level. Under
the terms of the 2014 Cap, the counterparty can call the cap if
the 2014 Swap is terminated. The 2014 Cap was not designated as
a hedging instrument under SFAS 133 and, therefore, changes
in market value are recorded in the statement of income.

Interest Rate Swap and Cap Agreements Prior
to April 2004

In June 2002, the Company entered into an
interest rate swap agreement maturing in 2007 (the 2007
Swap) with a notional amount of $150 million to hedge
the fair value of the fixed-rate 2007 Notes that were repaid
during the second quarter of 2004 (refer to Note 9). The
2007 Swap effectively converted up to $150 million of
fixed-rate indebtedness into variable-rate indebtedness. The
2007 Swap was designated as a highly-effective fair value hedge
and, as a result, changes in market value of the swap were
recorded in income but were offset by changes in the market
value of the indebtedness so there was no impact on the
statement of income.

96



---



##### Table of Contents



|    |                                                              
|--- | -------------------------------------------------------------
|21. | DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES
    (Continued)



Also in June 2002, the Company entered into an
interest rate cap agreement maturing in 2007 (the 2007
Cap) with a notional amount of $150 million. Under
the 2007 Cap, the Company paid a fixed rate of interest equal to
0.24% and received a variable rate of interest equal to the
excess, if any, of the one-month LIBOR, adjusted monthly, over
the cap rate of 7%. A portion of the 2007 Cap with a notional
amount of $19 million was designated as a hedging
instrument (cash-flow hedge) to effectively limit possible
increases in interest payments under variable-rate debt
obligations. The remainder of the 2007 Cap with a notional
amount of $131 million was used to offset increases in
variable-rate interest payments under the 2007 Swap to the
extent the one-month LIBOR exceeded 7%. This portion of the 2007
Cap was not designated as a hedging instrument under
SFAS 133 and, therefore, changes in market value were
recorded in the statement of income.

In April 2004, coterminous with the redemption of
the 2007 Notes, the Company terminated its 2007 Swap and its
2007 Cap for $2.6 million in cash and an aggregate gain of
approximately $3.3 million.

Risk Management Policies

The Company assesses interest rate cash flow risk
by continually identifying and monitoring changes in interest
rate exposures that may adversely impact expected future cash
flows and by evaluating hedging opportunities. The Company
maintains risk management control systems to monitor interest
rate cash flow risk attributable to both of the Companys
outstanding or forecasted debt obligations as well as the
Companys offsetting hedge positions. The risk management
control systems involve the use of analytical techniques,
including cash flow sensitivity analysis, to estimate the
expected impact of changes in interest rates on the
Companys future cash flows.

Quantitative Disclosures

Changes in the fair value of a derivative that is
highly effective and that is designated and qualifies as a fair
value hedge, along with the loss or gain on the hedged asset or
liability of the hedged item that is attributable to the hedged
risk, are recorded in income. Changes in the fair value of cash
flow hedges are reported as Accumulated Other Comprehensive
Income (AOCI) as a component of Shareholders
Equity. There were no cash flow hedges after the termination of
the 2007 Cap in April 2004. Changes in the fair value of
interest rate caps not designated as a hedging instrument are
reported in the statement of income.

As of December 31, 2004, the fair value of
the interest rate swaps designated as fair value hedges is an
asset of $0.3 million and is offset by a liability of
$0.3 million relating to the changes in market value of the
hedged items (long-term debt obligations). A gain of
$0.1 million (net of income tax effect) was credited to
AOCI during 2004 relating to the 2007 Cap. As of
December 31, 2004, the fair value of the 2010 Cap is an
asset of $1.0 million recorded in other long-term assets
and the fair value of the 2014 Cap is a liability of
$5.2 million recorded in other long-term liabilities.

The fair values of the Companys interest
rate caps are dependent on the projected six-month LIBOR that
are influenced by long-term rates and the volatility of these
rates. As a result of a decline in the volatility of rates in
2004, the value of the Companys interest rate caps
declined and resulted in valuation adjustment expense of
$8.0 million. For 2003 and 2002, the Company reported
valuation adjustment income of $0.1 million and valuation
adjustment expense of $0.7 million, respectively. Valuation
adjustment expense on the interest rate caps is reflected on a
separate line on the statements of income.

Valuation Adjustment for Interest Rate
Caps

The valuation adjustment on interest rate caps
was $8.0 million, a credit of $0.1 million, and
$0.7 million for the years ended December 31, 2004,
2003 and 2002, respectively.

97



---



##### Table of Contents



22.     COMMITMENTS
AND CONTINGENCIES

Capital Expenditures

As of December 31, 2004, the Company had
capital expenditure purchase commitments outstanding of
approximately $8.2 million, not including the construction
projects discussed in the next paragraph.

During 2004, the Company completed four
construction projects for a total cost of $10.0 million. As
of December 31, 2004, the Company has 11 new construction
projects in progress, which are expected to be completed in 2005
and 2006 and add 18 nursing units and 374 assisted living units.
The total estimated cost of the uncompleted projects is
$42.0 million. Total costs incurred through
December 31, 2004 on these projects were approximately
$9.4 million and purchase commitments of $12.6 million
are outstanding.

Insurance and Self-insured
Liabilities

The Company insures certain risks with affiliated
insurance subsidiaries of Extendicare and third-party insurers.
The insurance policies cover comprehensive general and
professional liability (including malpractice insurance) for the
Companys health providers, assistants and other staff as
it relates to their respective duties performed on the
Companys behalf, workers compensation and
employers liability in amounts and with such coverage and
deductibles as determined by the Company, based on the nature
and risk of its businesses, historical experiences, availability
and industry standards. The Company also self insures for health
and dental claims, in certain states for workers
compensation and employers liability and for general and
professional liability claims up to a certain amount per
incident. Self-insured liabilities with respect to general and
professional liability claims are included within the accrual
for self-insured liabilities.

Litigation

The Company and its subsidiaries are defendants
in actions brought against them from time to time in connection
with their operations. While it is not possible to estimate the
final outcome of the various proceedings at this time, such
actions generally are resolved within amounts provided.

The U.S. Department of Justice and other federal
agencies are increasing resources dedicated to regulatory
investigations and compliance audits of healthcare providers.
The Company is diligent to address these regulatory efforts.

Regulatory Risks

All providers are subject to surveys and
inspections by state and federal authorities to ensure
compliance with applicable laws and licensure requirements of
the Medicare and Medicaid programs. The survey process is
intended to review the actual provision of care and services,
and remedies for assessed deficiencies can be levied based upon
the scope and severity of the cited deficiencies. Remedies range
from the assessment of fines to the withdrawal of payments under
the Medicare and Medicaid programs. Should a deficiency not be
addressed through a plan of correction, a facility can be
decertified from the Medicare and Medicaid program.

As of December 31, 2004, the Company has
certain facilities under plans of correction. While it is not
possible to estimate the final outcome of the required
corrective action, the Company has accrued for known costs. In
addition, Federal law requires each state to have a Medicaid
Fraud Control Unit, which is responsible for investigating
provider fraud and resident abuse. The Company is aware of an
investigation by this unit in Kentucky, but this investigation
has been inactive for a substantial period of time.

Cash Flow Commitment to Lakeside
Health

Under the terms of the agreement with Lakeside
Health (refer to Note 8), the Company is responsible for
funding operating losses of the Lakeside nursing facility during
the term of the agreement. After the facility clears all
regulatory deficiencies, the Company has the right to terminate
the contract should funded operating losses exceed
$3.0 million and for various other reasons. The facility
cleared all regulatory

98



---



##### Table of Contents



|    |                                              
|--- | ---------------------------------------------
|22. | COMMITMENTS AND CONTINGENCIES
    (Continued)



deficiencies in September 2004 and for the five
months ended December 31, 2004 incurred net losses of
$1.8 million. The Company has advanced to date
$4.4 million to fund operating losses of the facility.

Omnicare Preferred Provider
Agreement

In 1998, the Company disposed of its pharmacy
operations to Omnicare, Inc. Subsequently, the Company entered
into a Preferred Provider Agreement, the terms of which enabled
Omnicare to execute Pharmacy Service Agreements and Consulting
Service Agreements with all of the Companys skilled
nursing facilities. Under the terms of the agreement, the
Company secured per diem pricing arrangements for
pharmacy supplies for the first four years of the Agreement,
which period expired December 2002. The Preferred Provider
Agreement contains a number of provisions that involve
sophisticated calculations to determine the per diem
pricing during this first four-year period. Under the per
diem pricing arrangement, pharmacy costs fluctuate based
upon occupancy levels in the facilities. The per
diem rates were established assuming a declining per
diem value over the initial four years of the contract to
coincide with the phase-in of the Medicare PPS rates. Omnicare
has subsequently asserted that per diem rates for
managed care and Medicare beneficiaries are subject to an upward
adjustment based upon a comparison of per diem rates to pricing
models based on Medicaid rates.

In 2001, the Company and Omnicare brought a
matter to arbitration, involving a per diem pricing
rate billed for managed care residents. This matter was
subsequently settled and amounts reflected in the financial
results. The parties are currently negotiating the pricing of
drugs for Medicare residents for the years 2001 and 2002, and
should this matter not be settled, the matter will be taken to
arbitration. Provisions for settlement of this claim are
included within the financial statements.

In 2002, in connection with its agreements to
provide pharmacy services to the Company, Omnicare, Inc. has
requested arbitration for an alleged lost profits claim related
to the Companys disposition of assets, primarily in
Florida. Damage amounts, if any, cannot be reasonably estimated
based on information available at this time. An arbitration
hearing has not yet been scheduled. The Company believes it has
interpreted correctly and has complied with the terms of the
Preferred Provider Agreement; however, there can be no assurance
that other claims will not be made with respect to the Agreement.

23.     TRANSACTIONS
WITH SHAREHOLDER AND AFFILIATES

The following is a summary of the Companys
transactions with Extendicare and its affiliates in 2004, 2003
and 2002:

Transactions pertaining to Refinancing of
2007 Notes in May 2004

Extendicare held $27.9 million of the 2007
Notes prior to the May 2004 refinancing. Pursuant to the tender
offer, in May 2004, the 2007 Notes held by Extendicare were
redeemed for approximately $28.8 million in cash.
Subsequently in May 2004, Extendicare purchased for market value
all of the Companys investment of 125,000 common shares in
Omnicare for $4.9 million in cash, which resulted in a gain
of $0.9 million. In addition, Extendicare advanced
$22.9 million to the Company, of which $14.0 million
was advanced through Virtual Care Provider, Inc.
(VCPI), an affiliate of the Company. The latter two
transactions provided funds used in the refinancing.

Insurance

The Company insures certain risks with affiliated
insurance subsidiaries of Extendicare. The cost of general and
professional liability premiums was the most significant
insurance expense charged to the Company by the affiliates. The
consolidated statements of income for 2004, 2003 and 2002
include intercompany insurance premium expenses of
$9.8 million, $10.7 million and $9.9 million,
respectively. The 2004 figure is net of favorable actuarial
adjustments for prior years under its retroactively-rated
workers compensation coverage in the amount of
$1.0 million.

99



---



##### Table of Contents



|    |                                                             
|--- | ------------------------------------------------------------
|23. | TRANSACTIONS WITH SHAREHOLDER AND AFFILIATES
    (Continued)



Computer Services

In January 2001, the Company established an
agreement for computer hardware and software support services
with VCPI, an affiliated subsidiary of Extendicare. The annual
cost of services was $4.8 million for 2004
(2003  $6.9 million; 2002 
$6.8 million). The decrease of $2.1 million primarily
related to the transfer of certain employees from Virtual Care
Provider, Inc. to the Company as of January 1, 2004, which
increased compensation and benefit expense by $2.7 million
during 2004.

Due to Shareholders and
Affiliates

Transactions affecting the balances due to
Shareholders and Affiliates include payments for general and
professional liability insurance premiums and claims, computer
services, working capital advances and tax charges and payments.
EHI, the Companys U.S. parent company, is responsible for
all federal tax return filings and therefore the Company incurs
charges (payments) from (to) shareholder for income
taxes and the Company has balances due to EHI in each of the
three years 2004, 2003 and 2002.

As of December 31, 2004, the Company had a
non-interest bearing advance due from Extendicare of
$7.7 million pursuant to an advance made in December 2004
that was repaid in January 2005.

As of December 31, 2004, the Company had
non-interest bearing advances due to Extendicare and its
affiliates of $17.8 million, of which $3.0 million has
been classified as a current payable, and the remainder is
classified as a long-term payable. As of December 31, 2003,
the Company had a non-interest bearing current receivable from
shareholder and an affiliate of $7.0 million and a
non-interest bearing long-term payable of $3.5 million.

At December 31, 2004, 2003 and 2002 the
Company had a $3.5 million non-interest bearing payable
with no specific due date to a subsidiary company of Extendicare.

24.     INCOME
TAXES

The Companys results of operations are
included in the consolidated federal tax return of its U.S.
parent company. Accordingly, federal current and deferred income
taxes payable are transferred to the Companys parent
company. The provisions for income taxes have been calculated as
if the Company was a separately taxed entity for each of the
periods presented in the accompanying consolidated financial
statements.

Total income taxes for the years ended
December 31, 2004, 2003 and 2002 were allocated as follows:

|                                                                        |  |                |         |      |  |      |        |  |  |   |       |  
|----------------------------------------------------------------------- |  | -------------- | ------- | ---- |  | ---- | ------ |  |  | - | ----- | -
|                                                                        |  | 2004           |         | 2003 |  | 2002
|                                                                        |  |                |         |      |  |     
|                                                                        |  |               
|                                                                        |  | (in thousands)
|Income tax expense (benefit)                                            |  | $              | (10,778 | )    |  | $    | 11,965 |  |  | $ | 3,117 |  
|Shareholders equity for unrealized gain or
    (loss) on investments   |  |                | (496    | )    |  |      | 2,227  |  |  |   | (663  | )
|Shareholders equity for unrealized gain
    (loss) on cash flow hedges |  |                | 67      |      |  |      | 4      |  |  |   | 525   |  
|Shareholders equity for disqualifying stock
    option dispositions    |  |                | (434    | )    |  |      |       |  |  |   |      |  
|                                                                        |  |                |         |      |  |      |        |  |  |   |       |  
|                                                                        |  | $              | (11,641 | )    |  | $    | 14,196 |  |  | $ | 2,979 |  
|                                                                        |  |                |         |      |  |      |        |  |  |   |       |  

100



---



##### Table of Contents



24.     INCOME TAXES
(Continued)


The income tax expense (benefit) consists of
the following for the years ended December 31:

|                                   |          |                |         |         |   |      |        |       |  |   |       |        |  
|---------------------------------- | -------- | -------------- | ------- | ------- | - | ---- | ------ | ----- |  | - | ----- | ------ | -
|                                   |          | 2004           |         | 2003    |   | 2002
|                                   |          |                |         |         |   |     
|                                   |          |               
|                                   |          | (in thousands)
|Federal:                           |          |                |         |         |   |      |        |       |  |   |       |       
|                                   | Current  |                | $       | 15,787  |   |      | $      | 9,079 |  |   | $     | (8,690 | )
|                                   | Deferred |                |         | (26,932 | ) |      |        | 1,666 |  |   |       | 10,582 |  
|                                   |          |                |         |         |   |      |        |       |  |   |       |       
|Total Federal                      |          |                | (11,145 | )       |   |      | 10,745 |       |  |   | 1,892 |       
|State:                             |          |                |         |         |   |      |        |       |  |   |       |       
|                                   | Current  |                |         | 4,229   |   |      |        | 1,066 |  |   |       | 456    |  
|                                   | Deferred |                |         | (3,862  | ) |      |        | 154   |  |   |       | 769    |  
|                                   |          |                |         |         |   |      |        |       |  |   |       |       
|Total State                        |          |                | 367     |         |   |      | 1,220  |       |  |   | 1,225 |       
|                                   |          |                |         |         |   |      |        |       |  |   |       |       
|Total income tax expense (benefit) |          | $              | (10,778 | )       |   | $    | 11,965 |       |  | $ | 3,117 |       
|                                   |          |                |         |         |   |      |        |       |  |   |       |       

Income taxes for 2004 included a tax benefit of
$33.6 million recorded in December 2004 resulting from two
events. The Company recorded a tax benefit of $31.9 million
for an additional loss claimed from the December 1999 sale of
our former subsidiary Arbor to Tandem. This additional loss was
primarily due to the issuance of additional guidance by the IRS,
regarding the method to calculate loss on the sale of subsidiary
stock, and partially due to the settlement of an IRS audit for
the tax years ending December 1997 through December 2002. In
addition, the Company recorded a tax benefit of
$1.7 million relating to this IRS audit and other issues.

During 2002, the Company reported a
reclassification of $5.9 million from deferred to current
income tax benefit, reflecting a new federal tax law enacted in
March 2002 retroactive to 2001, which extended the net operating
loss carryback period to five years from two years.

The differences between the effective tax rates
on income before income taxes and the United States federal
income tax rate are as follows:

|                                                     |                                                                          |      |       |       |   |      |      |      |   |  |      |      |  
|---------------------------------------------------- | ------------------------------------------------------------------------ | ---- | ----- | ----- | - | ---- | ---- | ---- | - |  | ---- | ---- | -
|                                                     |                                                                          | 2004 |       | 2003  |   | 2002
|                                                     |                                                                          |      |       |       |   |     
|Statutory federal income tax rate                    |                                                                          |      | 35.0  | %     |   |      | 35.0 | %    |   |  | 35.0 | %   
|Increase (reduction) in tax rate resulting
    from: |                                                                          |      |       |       |   |      |      |      |   |  |      |     
|                                                     | State income taxes, net of Federal income tax
    benefit                |      |       | 7.0   |   |      |      | 8.6  |   |  |      | 12.6 |  
|                                                     | Recovery of prior year taxes due to loss on sale
    of subsidiary stock |      |       | (56.0 | ) |      |      |     |   |  |      |     |  
|                                                     | Other permanent items                                                    |      |       | 2.3   |   |      |      | 1.9  |   |  |      | 6.3  |  
|                                                     | IRS audit settlement and other items                                     |      |       | (3.0  | ) |      |      |     |   |  |      |     |  
|                                                     | Change in valuation allowance                                            |      |       | (3.2  | ) |      |      | (6.1 | ) |  |      |     |  
|                                                     | Work opportunity credit                                                  |      |       | (1.0  | ) |      |      | (2.0 | ) |  |      | (7.9 | )
|                                                     | Other, net                                                               |      |       | (0.0  | ) |      |      | (0.1 | ) |  |      | 3.2  |  
|                                                     |                                                                          |      |       |       |   |      |      |      |   |  |      |     
|Effective tax rate (benefit)                         |                                                                          |      | (18.9 | )%    |   |      | 37.3 | %    |   |  | 49.2 | %   
|                                                     |                                                                          |      |       |       |   |      |      |      |   |  |      |     

The Company received payments of
$7.0 million, $1.4 million and $0.7 million for
federal income taxes from its U.S. parent in 2004, 2003 and
2002, respectively and made payments of $19.5 million and
$7.7 million in 2004 and 2003, respectively to its U.S.
parent for federal income taxes.

101



---



##### Table of Contents



24.     INCOME TAXES
(Continued)


The components of the net state deferred tax
assets and liabilities as of December 31 are as follows:

|                                            |                              |                                      |     |        |       |   |        |        |       | 
|------------------------------------------- | ---------------------------- | ------------------------------------ | --- | ------ | ----- | - | ------ | ------ | ----- | 
|                                            |                              | 2004                                 |     | 2003  
|                                            |                              |                                      |     |       
|                                            |                              |                                     
|                                            |                              | (in thousands)                      
|State Deferred tax assets:                  |                              |                                      |     |        |       |   |        |       
|                                            | Employee benefit accruals    |                                      | $   | 2,891  |       |   | $      | 1,898  |      
|                                            | Accrued liabilities          |                                      |     | 2,906  |       |   |        | 2,494  |      
|                                            | Accounts receivable reserves |                                      |     | 567    |       |   |        | 184    |      
|                                            | Capital loss carryforwards   |                                      |     |       |       |   |        | 13,530 |      
|                                            | Operating loss carryforwards |                                      |     | 4,473  |       |   |        | 5,296  |      
|                                            | Goodwill                     |                                      |     | 110    |       |   |        |       |      
|                                            | Other assets                 |                                      |     | 1,329  |       |   |        | 1,241  |      
|                                            |                              |                                      |     |        |       |   |        |       
|                                            | Subtotal                     |                                      |     | 12,276 |       |   |        | 24,643 |      
|                                            | Valuation allowance          |                                      |     | 3,690  |       |   |        | 19,057 |      
|                                            |                              |                                      |     |        |       |   |        |       
|                                            |                              | Total state deferred tax assets      |     |        | 8,586 |   |        |        | 5,586 | 
|State Deferred tax liabilities:             |                              |                                      |     |        |       |   |        |       
|                                            | Depreciation                 |                                      |     | 6,279  |       |   |        | 5,609  |      
|                                            | Goodwill                     |                                      |     |       |       |   |        | 504    |      
|                                            | Leasehold rights             |                                      |     | 119    |       |   |        | 194    |      
|                                            | Miscellaneous                |                                      |     | 1,357  |       |   |        | 2,362  |      
|                                            |                              |                                      |     |        |       |   |        |       
|                                            |                              | Total state deferred tax liabilities |     |        | 7,755 |   |        |        | 8,669 | 
|                                            |                              |                                      |     |        |       |   |        |       
|Net state deferred tax assets (liabilities) |                              | $                                    | 831 |        |       | $ | (3,083 | )     
|                                            |                              |                                      |     |        |       |   |        |       

The Company paid state income taxes of
$5.8 million, $0.5 million and $0.7 million in
2004, 2003 and 2002, respectively. As of December 31, 2004
the Company had $61.8 million of total net operating loss
carryforwards available for state income tax purposes, which
expire from 2005 to 2023. Where the realizability of these
losses is uncertain, a valuation allowance has been established.

The valuation allowance for state deferred tax
assets as of December 31, 2004 and 2003 was
$3.7 million and $19.1 million, respectively. The net
change in the total valuation allowance for the years ended
December 31, 2004, 2003 and 2002 was a decrease of
$15.4 million, a decrease of $1.9 million and an
increase of $0.8 million, respectively. In 2004, capital
loss carryforwards with a related gross deferred tax asset
balance of $13.5 million, which had been subject to a
complete valuation allowance, statutorily expired and the
deferred tax asset and related valuation allowance were written
off. In assessing the realizability of deferred tax assets,
management considers whether it is more likely than not that
some portion or all of the deferred tax assets will not be
realized. The ultimate realization of deferred tax assets is
dependent upon the generation of future taxable income during
the periods in which those temporary differences become
deductible. Management considers the scheduled reversal of
deferred tax liabilities, projected future taxable income, and
tax planning strategies in making this assessment. Management
believes it is more likely than not the Company will realize the
benefits of these deductible differences, net of the valuation
allowances.

102



---



##### Table of Contents



25.     COMPREHENSIVE
INCOME

The accumulated balances for each classification
of comprehensive income are as follows:

|                                                         |  |             |        |             |  |               |        |   |  |   |        |  
|-------------------------------------------------------- |  | ----------- | ------ | ----------- |  | ------------- | ------ | - |  | - | ------ | -
|                                                         |  |             |        | Unrealized  |  |              
|                                                         |  | Unrealized  |        | Gains       |  | Accumulated  
|                                                         |  | Gains       |        | (Losses) on |  | Other        
|                                                         |  | (Losses) on |        | Cash Flow   |  | Comprehensive
|                                                         |  | Investments |        | Hedges      |  | Income       
|                                                         |  |             |        |             |  |              
|Balance at December 31, 2001                             |  | $           | (1,262 | )           |  | $             | (1,105 | ) |  | $ | (2,367 | )
|Reclassification to loss on early retirement of
    debt |  |             |       |             |  |               | 635    |   |  |   | 635    |  
|Net current period change                                |  |             | (995   | )           |  |               | 339    |   |  |   | (656   | )
|                                                         |  |             |        |             |  |               |        |   |  |   |        |  
|Balance at December 31, 2002                             |  |             | (2,257 | )           |  |               | (131   | ) |  |   | (2,388 | )
|Net current period change                                |  |             | 3,341  |             |  |               | 32     |   |  |   | 3,373  |  
|                                                         |  |             |        |             |  |               |        |   |  |   |        |  
|Balance at December 31, 2003                             |  |             | 1,084  |             |  |               | (99    | ) |  |   | 985    |  
|Net current period change                                |  |             | (742   | )           |  |               | 99     |   |  |   | (643   | )
|                                                         |  |             |        |             |  |               |        |   |  |   |        |  
|Balance at December 31, 2004                             |  | $           | 342    |             |  | $             |       |   |  | $ | 342    |  
|                                                         |  |             |        |             |  |               |        |   |  |   |        |  

The related tax effects allocated to each
component of other comprehensive income are as follows:

|                                         |                                                                 |            |        |            |   |            |        |        |   |   |       |       |  
|---------------------------------------- | --------------------------------------------------------------- | ---------- | ------ | ---------- | - | ---------- | ------ | ------ | - | - | ----- | ----- | -
|                                         |                                                                 |            |        | Tax        |   |           
|                                         |                                                                 | Before-Tax |        | (Expense)  |   | Net-of-Tax
|                                         |                                                                 | Amount     |        | or Benefit |   | Amount    
|                                         |                                                                 |            |        |            |   |           
|Year Ended December 31, 2004:            |                                                                 |            |        |            |   |            |        |        |   |   |       |      
|Unrealized gains (losses) on securities: |                                                                 |            |        |            |   |            |        |        |   |   |       |      
|                                         | Unrealized holding gains (losses) arising
    during the period |            | $      | (1,238     | ) |            | $      | 496    |   |   | $     | (742  | )
|Cash flow hedges:                        |                                                                 |            |        |            |   |            |        |        |   |   |       |      
|                                         | Net derivative gains arising during the period                  |            |        | 166        |   |            |        | (67    | ) |   |       | 99    |  
|                                         |                                                                 |            |        |            |   |            |        |        |   |   |       |      
|Other comprehensive income (loss)        |                                                                 | $          | (1,072 | )          |   | $          | 429    |        |   | $ | (643  | )    
|                                         |                                                                 |            |        |            |   |            |        |        |   |   |       |      
|Year Ended December 31, 2003:            |                                                                 |            |        |            |   |            |        |        |   |   |       |      
|Unrealized gains on securities:          |                                                                 |            |        |            |   |            |        |        |   |   |       |      
|                                         | Unrealized holding gains arising during the period              |            | $      | 5,568      |   |            | $      | (2,227 | ) |   | $     | 3,341 |  
|Cash flow hedges:                        |                                                                 |            |        |            |   |            |        |        |   |   |       |      
|                                         | Net derivative gains arising during the period                  |            |        | 36         |   |            |        | (4     | ) |   |       | 32    |  
|                                         |                                                                 |            |        |            |   |            |        |        |   |   |       |      
|Other comprehensive income               |                                                                 | $          | 5,604  |            |   | $          | (2,231 | )      |   | $ | 3,373 |      
|                                         |                                                                 |            |        |            |   |            |        |        |   |   |       |      
|Year Ended December 31, 2002:            |                                                                 |            |        |            |   |            |        |        |   |   |       |      
|Unrealized gains (losses) on securities: |                                                                 |            |        |            |   |            |        |        |   |   |       |      
|                                         | Unrealized holding gains (losses) arising
    during the period |            | $      | (1,658     | ) |            | $      | 663    |   |   | $     | (995  | )
|Cash flow hedges:                        |                                                                 |            |        |            |   |            |        |        |   |   |       |      
|                                         | Net derivative gains arising during the period                  |            |        | 1,499      |   |            |        | (525   | ) |   |       | 974   |  
|                                         |                                                                 |            |        |            |   |            |        |        |   |   |       |      
|Other comprehensive income (loss)        |                                                                 | $          | (159   | )          |   | $          | 138    |        |   | $ | (21   | )    
|                                         |                                                                 |            |        |            |   |            |        |        |   |   |       |      



|    |                                                
|--- | -----------------------------------------------
|26. | UNCERTAINTIES AND CERTAIN SIGNIFICANT
    RISKS

Revenues

The Companys income is highly dependent on
Medicare and Medicaid funding rates, and the effective
management of staffing and other costs of operations that are
strictly monitored through state and federal regulatory
authorities. The Company is unable to accurately predict whether
the federal or any state government will adopt changes in their
reimbursement systems, or if adopted and implemented, what effect

103



---



##### Table of Contents



|    |                                                            
|--- | -----------------------------------------------------------
|26. | UNCERTAINTIES AND CERTAIN SIGNIFICANT RISKS
    (Continued)



such initiatives would have on the Company.
Limitations on Medicare and Medicaid reimbursement for
healthcare services are continually proposed. Changes in
applicable laws and regulations could have an adverse effect on
the levels of reimbursement from governmental, private and other
sources.

Prior to October 1, 2002, the incremental
Medicare relief packages received from the Balanced Budget
Refinement Act (BBRA) and the Benefits Improvement
and Protection Act (BIPA) provided a total of
$2.7 billion in temporary Medicare funding enhancements to
the long-term care industry. The funding enhancements
implemented by the BBRA and BIPA fall into two categories. The
first category is Legislative Add-ons which included
a 16.66% add-on to the nursing component of the Resource
Utilization Groupings (RUGs) rate and the 4% base
adjustment. On September 30, 2002, the Legislative Add-ons
expired, or Medicare Cliff, resulting in a reduction
in Medicare rates for all long-term care providers and a
reduction of approximately $16.7 million per annum in
Medicare funding for the Company.

The second category is RUGs
Refinements which involves an initial 20% add-on for 15
RUGs categories identified as having high intensity, non-therapy
ancillary services. The 20% add-ons from three RUGs categories
were later redistributed to 14 rehabilitation categories at an
add-on rate of 6.7% each. CMS has extended the funding
enhancements beyond the previously announced sunset dates.
However, based upon the July 2004 CMS announcement, the RUGs
Refinements extend only until October 1, 2005. The Congress
has enacted legislation directing CMS to conduct a study on the
RUGs classification system and report its recommendations prior
to the implementation of a RUGs Refinement change whereby all or
part of the enhancement is discontinued will be delayed. In
February 2005, the Presidents Proposed Budget provides for
the discontinuance of the RUGs Refinements effective
October 1, 2005. The Presidents Proposed Budget is
subject to legislative review and the budget being passed by the
United States Government. The implementation of a RUGs
refinement change, where all or part of the enhancement is
discontinued, could have a significant impact on the Company.

In February 2003, CMS announced its plan to
reduce its level of reimbursement for uncollectible Part A
co-insurance. Under current law, skilled nursing facilities are
reimbursed 100% for any bad debts incurred. Under the plan
announced by CMS, the reimbursement level would have been
reduced to 70% over a three year period as follows: 90%
effective for the government fiscal year commencing
October 1, 2003; 80% for the government fiscal year
commencing October 1, 2004; and 70% for the government
fiscal year commencing October 1, 2005 and thereafter. This
plan is consistent with the Part A co-insurance
reimbursement plan applicable to hospitals. CMS has not yet
implemented the rule change continues to review the proposed
plan. In February 2005, the Presidents Proposed Budget
provides for this 3-year phase-in plan be implemented commencing
October 1, 2005. The Presidents Proposed Budget is
subject to legislative review and the budget being passed by the
United States Government. Should the 3-year phase-in plan be
implemented, the plan could have a significant impact on the
Company.

As of December 31, 2004, the State of
Indiana has a proposed state plan amendment and waiver
pertaining to the fiscal year commencing July 1, 2003 that
are awaiting review and approval by CMS. As the state plan
amendment and waiver have not been approved, the Company has
recorded revenues based upon amounts received. Based upon the
final and CMS approved state plan amendment and waiver, changes
in Medicaid rates and any associated provider taxes could result
in adjustments to income for the period from July 1, 2003
to December 31, 2004.

Interests in Unrelated Long-Term Care
Providers

Through the divestiture program in Texas and
Florida, the Company has retained ownership of certain nursing
facility properties, which the Company leases to other unrelated
long-term care providers (refer to Notes 8 and 20). The
Company also has an obligation to fund operating losses of a
nursing facility operated by an unrelated long-term care
provider in Wisconsin (refer to Note 8). In addition, due
to the divestiture agreements and on-going consulting
agreements, the Company has amounts due from other unrelated
long-term providers. In aggregate, as of December 31, 2004,
the Company owns $20.3 million in nursing home properties
in Florida, Texas and Wisconsin, and has $9.4 million in
amounts receivable due from unrelated

104



---



##### Table of Contents



|    |                                                            
|--- | -----------------------------------------------------------
|26. | UNCERTAINTIES AND CERTAIN SIGNIFICANT RISKS
    (Continued)



long-term care providers in Florida, Texas and
Wisconsin. For 2004, 2003 and 2002, the Company earned
$3.2 million, $2.1 million and $3.7 million,
respectively, in rental revenue from unrelated long-term care
operators that were operating in properties owned by the Company
and earned $6.3 million, $5.7 million and
$5.7 million, respectively, in consulting fees from all
unrelated long-term care operators. As a result, the income and
cash flow of the Company can be influenced by the financial
stability of unrelated long-term operators.



| |                                      
| | -------------------------------------
| | Medicare and Medicaid
    Receivables

The Company is attempting to settle a number of
outstanding Medicare and Medicaid receivables. Normally such
items are resolved during an annual audit process and no
provision is required. However, where differences exist between
the Company and a FI, the Company may record a general
provision. The Company continues to negotiate on the remaining
issues and when appropriate seek resolution from the PRRB. No
adjustment to the receivable amount can be determined until
negotiations are concluded on a majority of issues that are
involved in the cost reporting years under appeal. Though the
Company remains confident that it will successfully settle the
issues, an unsuccessful conclusion could negatively impact the
Companys income and cash flow. As of December 31,
2004 and 2003 the Company had $21.3 million and
$51.2 million, respectively, of gross Medicare and Medicaid
settlement receivables with a related contractual allowance of
$4.4 million and $14.0 million, respectively. The net
amount receivable represents the Companys estimate of the
amount collectible on Medicare and Medicaid prior period cost
reports.



| |                                         
| | ----------------------------------------
| | Accrual for Self-Insured
    Liabilities

The Company had $37.7 million and
$45.1 million in accruals for self-insured liabilities as
of December 31, 2004 and 2003, respectively. An actuarial
valuation was completed as of December 31, 2004 and it was
determined that no adjustment was required to the accrual for
self-insured liability amounts on the balance sheet. Though the
Company has been successful in exiting from the states of Texas
and Florida and limiting future exposure to general liability
claims, the timing and eventual settlement costs for these
claims cannot be precisely defined.



| |                         
| | ------------------------
| | Claims and Contingencies

The Company entered into a Preferred Provider
Agreement with Omnicare, Inc. pursuant to the divestiture of its
pharmacy operation in 1998. In connection with its agreement to
provide pharmacy services, Omnicare has requested arbitration
for an alleged lost profits claim relating to the Companys
disposition of assets, primarily in Florida. Damage amounts, if
any cannot be reasonably estimated based on information
available at this time. An arbitration hearing for this matter
has not been scheduled. The Company believes that it has
interpreted correctly and complied with the terms of the
Preferred Provider Agreement; however there can be no assurances
that this claim will not be successful or other claims arise.

The Company is subject to surveys and inspections
by state and federal authorities to ensure compliance with
applicable laws and licensure requirements of the Medicare and
Medicaid programs. The survey process is intended to review the
actual provision of care and services, and remedies for assessed
deficiencies can be levied based upon the scope and severity of
the cited deficiencies. Remedies range from the assessment of
fines to the withdrawal of payments under the Medicare and
Medicaid programs. Should a deficiency not be addressed through
the plan of correction, a facility can be decertified from the
Medicare and Medicaid program. As of December 31, 2004, the
Company has certain facilities under a plan of correction. While
it is not possible to estimate the final outcome of the required
corrective action, the Company has accrued for known costs. In
addition, Federal law requires each state to have a Medicaid
Fraud Control Unit, which is responsible for investigating
provider fraud and resident abuse. The Company is aware of an
investigation by this unit in Kentucky, but this investigation
has been inactive for a substantial period of time.

105



---



##### Table of Contents



|    |                                                            
|--- | -----------------------------------------------------------
|26. | UNCERTAINTIES AND CERTAIN SIGNIFICANT RISKS
    (Continued)



Acquisition of ALC

On February 1, 2005, the Company completed
merger and acquisition agreement with ALC of Dallas, Texas for a
total of approximately $285 million, including the
assumption of ALCs debt of $141 million. Prior to the
completion the Company completed due diligence in respect of the
acquisition to ascertain risks associated in respect of the
acquisition. Though the Company believes these due diligence
efforts identified and correctly quantified those risks, the
Company by virtue of this acquisition is assuming all current
and former financial, legal, regulatory and environmental risks
associated with ALC by virtue of this acquisition. Those risks
can not be quantified nor estimated at this time.

Debt Obligations

The Company has a high level of indebtedness with
debt service obligations totaling $291.9 million in
borrowings at December 31, 2004 representing 50.2% of total
capitalization (defined as total long-term liabilities plus
total equity), compared to a similar ratio of 62.5% at
December 31, 2003. As a result, the degree to which the
Company is leveraged could have important consequences,
including, but not limited to the following:



| |   |                                                                                                                                                                                                                                 
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | a substantial portion of the Companys cash
    flow from operations would be dedicated to the payment of
    principal and interest on the Companys indebtedness,
    thereby reducing the funds available for other purposes;
|
| |  | the Companys ability to obtain additional
    financing within its current Credit Facility for working
    capital, capital expenditures, acquisitions or other purposes
    may be limited; and                               
|
| |  | certain of the Companys borrowings are at
    variable rates of interest, which exposes the Company to the
    risk of higher interest rates.                                                                                  

The Company expects to satisfy the required
payments of principal and interest on indebtedness from cash
flow from operations. However, the Companys ability to
generate sufficient cash flow from operations depends on a
number of internal and external factors, including factors
beyond the Companys control such as prevailing industry
conditions. There can be no assurance that cash flow from
operations will be sufficient to enable the Company to service
its debt and meet other obligations.

While management has a strategy to remain in
compliance, there can be no assurance that the Company will meet
future covenant requirements. The Companys available bank
lines can be affected by its ability to remain in compliance, or
if not, would depend upon managements ability to amend the
covenant or refinance the debt.

106



---



##### Table of Contents



27.     DISCLOSURES
ABOUT FAIR VALUES OF FINANCIAL INSTRUMENTS

The estimated fair values of the Companys
financial instruments at December 31 are as follows:

|                                |  |                |         |            |  |          |         |            |  |   |         |   |  |   |         |  
|------------------------------- |  | -------------- | ------- | ---------- |  | -------- | ------- | ---------- |  | - | ------- | - |  | - | ------- | -
|                                |  |                |         |           
|                                |  | 2004           |         | 2003      
|                                |  |                |         |           
|                                |  | Carrying       |         | Estimated  |  | Carrying |         | Estimated 
|                                |  | Value          |         | Fair Value |  | Value    |         | Fair Value
|                                |  |                |         |            |  |          |         |           
|                                |  |               
|                                |  | (in thousands)
|Cash and cash equivalents       |  | $              | 29,612  |            |  | $        | 29,612  |            |  | $ | 48,855  |   |  | $ | 48,855  |  
|Non-current accounts receivable |  |                | 10,214  |            |  |          | 9,540   |            |  |   | 25,938  |   |  |   | 22,370  |  
|Prepaid interest rate cap fee   |  |                | 984     |            |  |          | 984     |            |  |   |        |   |  |   |        |  
|Other assets                    |  |                | 17,855  |            |  |          | 17,649  |            |  |   | 44,184  |   |  |   | 43,517  |  
|Long-term debt                  |  |                | 291,932 |            |  |          | 317,655 |            |  |   | 392,918 |   |  |   | 419,239 |  
|Interest rate swaps (asset)     |  |                | (308    | )          |  |          | (308    | )          |  |   | (4,190  | ) |  |   | (4,190  | )
|Interest rate caps              |  |                | 5,241   |            |  |          | 5,241   |            |  |   | 781     |   |  |   | 781     |  
|Deferred compensation           |  |                | 7,207   |            |  |          | 7,207   |            |  |   | 6,391   |   |  |   | 6,391   |  
|Other long-term liabilities     |  |                |        |            |  |          |        |            |  |   | 991     |   |  |   | 991     |  
|Long-term due to affiliates     |  |                | 14,875  |            |  |          | 14,875  |            |  |   | 3,484   |   |  |   | 3,484   |  

The fair value of non-current accounts
receivable, which are anticipated to be collected beyond one
year, are estimated based on discounted cash flows at estimated
current borrowing rates.

Other assets consist of non-current accounts
receivable from facilities under consulting agreements, debt
service and capital expenditure trust funds and other financial
instruments, the fair values of which are estimated based on
market prices from the same or similar issues of the underlying
investments.

The fair value of long-term debt is estimated
based on approximate borrowing rates currently available to the
Company for debt equal to the existing debt maturities.

The fair values of the interest rate swaps and
caps are based on the quoted market prices as provided by the
financial institution which is the counterparty to the
arrangements.

The fair value of deferred compensation, other
long-term liabilities and long-term due to affiliates are
estimated to be equal to their carrying value.

28.     SUPPLEMENTARY
QUARTERLY FINANCIAL DATA (UNAUDITED)

The following is a summary of the quarterly
results of operations for the years ended December 31, 2004
and 2003 (in thousands):

|                                                                          |  |      |         |     |  |     |         |     |  |       |         |   |  |   |         |   |  |   |         |  
|------------------------------------------------------------------------- |  | ---- | ------- | --- |  | --- | ------- | --- |  | ----- | ------- | - |  | - | ------- | - |  | - | ------- | -
|                                                                          |  |     
|                                                                          |  | 2004
|                                                                          |  |     
|                                                                          |  | 1st  |         | 2nd |  | 3rd |         | 4th |  | Total
|                                                                          |  |      |         |     |  |     |         |     |  |      
|Total revenues                                                            |  | $    | 231,501 |     |  | $   | 233,328 |     |  | $     | 242,429 |   |  | $ | 240,594 |   |  | $ | 947,852 |  
|                                                                          |  |      |         |     |  |     |         |     |  |       |         |   |  |   |         |   |  |   |         |  
|Valuation adjustment on interest rate caps                                |  |      | (73     | )   |  |     | (4,320  | )   |  |       | (2,030  | ) |  |   | (1,560  | ) |  |   | (7,983  | )
|Gain (loss) on disposal of assets and
    impairment of long-lived assets |  |      | (1,612  | )   |  |     | 4,469   |     |  |       | (4,573  | ) |  |   | (6,825  | ) |  |   | (8,541  | )
|Loss on refinancing and retirement of debt                                |  |      | (354    | )   |  |     | (5,978  | )   |  |       | (152    | ) |  |   |        |   |  |   | (6,484  | )
|Income before provision for income taxes                                  |  |      | 14,986  |     |  |     | 14,123  |     |  |       | 16,749  |   |  |   | 11,102  |   |  |   | 56,960  |  
|Provision for income taxes                                                |  |      | 5,639   |     |  |     | 5,297   |     |  |       | 6,289   |   |  |   | (28,003 | ) |  |   | (10,778 | )
|                                                                          |  |      |         |     |  |     |         |     |  |       |         |   |  |   |         |   |  |   |         |  
|Net income                                                                |  | $    | 9,347   |     |  | $   | 8,826   |     |  | $     | 10,460  |   |  | $ | 39,105  |   |  | $ | 67,738  |  
|                                                                          |  |      |         |     |  |     |         |     |  |       |         |   |  |   |         |   |  |   |         |  

107



---



##### Table of Contents



28.     SUPPLEMENTARY
QUARTERLY FINANCIAL DATA (UNAUDITED) (Continued)


|                                         |  |      |         |     |  |     |         |     |  |       |         |  |  |   |         |  |  |   |         | 
|---------------------------------------- |  | ---- | ------- | --- |  | --- | ------- | --- |  | ----- | ------- |  |  | - | ------- |  |  | - | ------- | 
|                                         |  |     
|                                         |  | 2003
|                                         |  |     
|                                         |  | 1st  |         | 2nd |  | 3rd |         | 4th |  | Total
|                                         |  |      |         |     |  |     |         |     |  |      
|Total revenues                           |  | $    | 211,426 |     |  | $   | 213,258 |     |  | $     | 220,030 |  |  | $ | 225,718 |  |  | $ | 870,432 | 
|                                         |  |      |         |     |  |     |         |     |  |       |         |  |  |   |         |  |  |   |         | 
|Income before provision for Income taxes |  |      | 3,828   |     |  |     | 6,974   |     |  |       | 8,999   |  |  |   | 12,250  |  |  |   | 32,051  | 
|Provision for income taxes               |  |      | 1,540   |     |  |     | 2,793   |     |  |       | 3,598   |  |  |   | 4,034   |  |  |   | 11,965  | 
|                                         |  |      |         |     |  |     |         |     |  |       |         |  |  |   |         |  |  |   |         | 
|Net income                               |  | $    | 2,288   |     |  | $   | 4,181   |     |  | $     | 5,401   |  |  | $ | 8,216   |  |  | $ | 20,086  | 
|                                         |  |      |         |     |  |     |         |     |  |       |         |  |  |   |         |  |  |   |         | 

108



---



##### Table of Contents








|        |                                                                                         
|------- | ----------------------------------------------------------------------------------------
|ITEM 9. | CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS
    ON ACCOUNTING AND FINANCIAL DISCLOSURE

None






|         |                        
|-------- | -----------------------
|ITEM 9A. | CONTROLS AND PROCEDURES

Evaluation of Disclosure Control and
Procedures

In accordance with Rule 15 (d)  15
(b) of the Securities Exchange Act of 1934, our management
has evaluated, with the participation of our Chairman of the
Board and Chief Executive Officer and our Senior Vice President,
Chief Financial Officer and Treasurer, the effectiveness of the
design and operation of our disclosure controls and procedures
as of the end of the year ended December 31, 2004. Based
upon their evaluation of these disclosure controls and
procedures, our Chairman of the Board and Chief Executive
Officer and our Senior Vice President, Chief Financial Officer
and Treasurer concluded that the disclosure controls and
procedures were effective as of the end of the year ended
December 31, 2004 to ensure that material information
relating to us (including our consolidated subsidiaries) was
made known to them by others within those entities, particularly
during the period in which this Annual Report on Form 10-K
was being prepared.

Changes in Internal Controls Over Financial
Reporting

There were no changes in our internal control
over financial reporting that occurred during the quarter ended
December 31, 2004 that have materially affected, or are
reasonably likely to materially affect, our internal control
over financial reporting.






|         |                  
|-------- | -----------------
|ITEM 9B. | OTHER INFORMATION

None

109



---



##### Table of Contents






PART III






|         |                                                       
|-------- | ------------------------------------------------------
|ITEM 10. | DIRECTORS AND EXECUTIVE OFFICERS OF THE
    REGISTRANT

Directors and Executive Officers

The following table sets forth information
with respect to our executive directors and executive
officers:

|                    |  |     |    |          |  |                                                                           
|------------------- |  | --- | -- | -------- |  | --------------------------------------------------------------------------
|Name                |  | Age |    | Position
|                    |  |     |    |         
|Mel Rhinelander     |  |     | 54 |          |  | Chairman of the Board and Chief Executive Officer
    and Director        
|Philip W. Small     |  |     | 48 |          |  | Executive Vice President, Chief Operating Officer
    and Director        
|Richard L. Bertrand |  |     | 56 |          |  | Senior Vice President, Chief Financial Officer,
    Treasurer and Director
|Roch Carter         |  |     | 65 |          |  | Vice President, General Counsel and Assistant
    Secretary               
|Douglas J. Harris   |  |     | 49 |          |  | Vice President and Controller                                             
|L. William Wagner   |  |     | 56 |          |  | Vice President, Human Resources                                           

Mel Rhinelanderis
our Chairman and Chief Executive Officer and one of our
directors. He has been with us and our affiliated companies
since 1977 and has served in a number of senior management
positions. Mr. Rhinelander has been President of
Extendicare Inc. since August 1999, a director since May 2000
and its Chief Executive Officer since August 2000. He has been
an officer of our company since 1989 and a director since 1998.
He has been our Chief Executive Officer since December 1999 and
Chairman of our Board of Directors since August 2000.

Philip W. Smallwas
appointed Executive Vice President and Chief Operating Officer
on February 19, 2004. He joined us, and Extendicare, in
June 2001 as our Senior Vice President, Strategic Planning. He
was appointed to our Board of Directors on December 31,
2001. Prior to joining us, Mr. Small served 15 years
at Beverly Enterprises Corporation, Fort Smith, Arkansas,
in various financial capacities, the most recent being Executive
Vice President, Strategic Planning and Operations Support and
acting Chief Financial Officer. His prior experience includes
serving as Director, Reimbursement for HCA Management Company of
Atlanta, Georgia. Mr. Small has over 23 years of
experience in the healthcare industry.

Richard L. Bertrandis our Senior Vice President, Chief
Financial Officer and Treasurer. Mr. Bertrand was appointed
to his current position in September 2004, prior to that he was
the Senior Vice President of Development. Mr. Bertrand
joined us in 1983 as our Vice President of Finance and has over
28 years of experience in the healthcare industry. From
1983 to 1995 he served as our Vice President of Finance and
later as our Senior Vice President of Finance and Chief
Financial Officer. Beginning in 1995, Mr. Bertrand served
as our Senior Vice President, Reimbursement and later as our
Senior Vice President, Development. Prior to joining us,
Mr. Bertrand served as Vice President and Controller of
Extendicare from 1977 to 1983. Prior to that, he was a staff
accountant and supervisor with the accounting firm of Thorne
Riddell from 1972 to 1976.

Roch Carterwas
appointed our Vice President, General Counsel and Assistant
Secretary in January 1998. He joined us in 1974 as Legal Counsel
and he was subsequently appointed as our General Counsel in
1985. Prior to joining us, Mr. Carter was an attorney with
the United States Attorneys office in Milwaukee.
Mr. Carter was also an attorney with the City of Milwaukee
and was in practice with Young and McManus, S.C. Mr. Carter
has over 30 years of experience in healthcare law and
practice.

Douglas J. Harrisjoined us in December 1999 as our Vice
President and Controller, and has over 24 years of
experience in the healthcare industry. From 1994 through 1999,
Mr. Harris was the Managing Director of Extendicare (U.K.)
Limited. Mr. Harris has been with us and Extendicares
affiliated companies since 1981 and has held positions in
various financial capacities. Prior to joining us,
Mr. Harris was an audit supervisor with KPMG.

L. William Wagnerjoined us in 1987 as Vice President of
Human Resources. Prior to joining us, Mr. Wagner was Vice
President of Human Resources for ARA Living Centers and Director
of Personnel for

110



---



##### Table of Contents



General Foods Corp. Mr. Wagner has
21 years of experience in the healthcare industry and over
27 years of human resources experience.


Corporate Governance Matters

We are an indirect wholly owned subsidiary of
Extendicare Inc., a Canadian publicly traded company.
Consequently, our Board of Directors is comprised solely of
certain of our executive officers. We have no committees of our
Board of Directors. Since we have no audit committee, our Board
of Directors has not determined whether we have an audit
committee financial expert as defined by the regulations
of the United States Securities and Exchange Commission.

Extendicare Inc. has adopted a Business Conduct
Policy (that also serves as a code of ethics), which applies to
all of its subsidiaries, including us. Extendicare Inc.s
Business Conduct Policy applies to all of our directors,
officers and employees, including the Chief Executive Officer,
Chief Financial Officer and any other persons performing similar
functions. The Business Conduct Policy is available on
Extendicares website at www.extendicare.com under
the Governance tab, and within this tab, the
Corporate Governance tab. Any amendments to, or
waivers from, the Business Conduct Policy will be disclosed on
Extendicares website within the prescribed time period.

111



---



##### Table of Contents






ITEM
11.     EXECUTIVE
COMPENSATION

Compensation of Named Executive
Officers

The following summary compensation table details
compensation information for the three fiscal years ended
December 31, 2004, 2003 and 2002 for each of our Chief
Executive Officer and the four other most highly compensated
executive officers (collectively, the named executive
officers).

Summary Compensation Table

|                                           |  |      |      |                     |  |              |         |              |  |              |         |              |  |  |        |  |  |  |         |  |  |  |        | 
|------------------------------------------ |  | ---- | ---- | ------------------- |  | ------------ | ------- | ------------ |  | ------------ | ------- | ------------ |  |  | ------ |  |  |  | ------- |  |  |  | ------ | 
|                                           |  |      |      |                     |  | Long-Term    |         |             
|                                           |  |      |      | Annual Compensation |  | Compensation |         |             
|                                           |  |      |      |                     |  |              |         |             
|                                           |  |      |      |                     |  | Other        |         | Securities   |  |             
|                                           |  |      |      |                     |  | Annual       |         | Underlying   |  | All Other   
|Name and Principal Position                |  |      |      | Salary              |  | Bonus        |         | Compensation |  | Options/SARs |         | Compensation
|with the Corporation                       |  | Year |      | ($)                 |  | ($)          |         | (1)($)       |  | (#)          |         | (2)($)      
|                                           |  |      |      |                     |  |              |         |              |  |              |         |             
|M.A. Rhinelander                           |  |      | 2004 |                     |  |              | 800,000 |              |  |              | 950,000 |              |  |  | 85,512 |  |  |  | 100,000 |  |  |  | 10,834 | 
|President and Chief Executive              |  |      | 2003 |                     |  |              | 650,000 |              |  |              | 950,000 |              |  |  | 44,512 |  |  |  | 100,000 |  |  |  | 11,632 | 
|Officer of Extendicare Inc.; Chairman      |  |      | 2002 |                     |  |              | 500,000 |              |  |              | 500,000 |              |  |  | 34,585 |  |  |  | 100,000 |  |  |  | 8,447  | 
|and Chief Executive Officer of             |  |      |      |                     |  |              |         |              |  |              |         |              |  |  |        |  |  |  |         |  |  |  |        | 
|Extendicare Health Services, Inc.          |  |      |      |                     |  |              |         |              |  |              |         |              |  |  |        |  |  |  |         |  |  |  |        | 
|                                          
|R.L. Bertrand(3)                           |  |      | 2004 |                     |  |              | 258,667 |              |  |              | 140,000 |              |  |  |       |  |  |  | 30,000  |  |  |  | 30,303 | 
|Senior Vice President, Chief Financial     |  |      | 2003 |                     |  |              | 240,000 |              |  |              | 120,000 |              |  |  |       |  |  |  | 30,000  |  |  |  | 36,768 | 
|Officer, and Treasurer of Extendicare Inc. |  |      | 2002 |                     |  |              | 230,000 |              |  |              | 92,000  |              |  |  |       |  |  |  | 30,000  |  |  |  | 37,663 | 
|and Extendicare Health Services, Inc.      |  |      |      |                     |  |              |         |              |  |              |         |              |  |  |        |  |  |  |         |  |  |  |        | 
|                                          
|P.W. Small                                 |  |      | 2004 |                     |  |              | 375,000 |              |  |              | 168,750 |              |  |  |       |  |  |  | 40,000  |  |  |  | 40,711 | 
|Executive Vice President and               |  |      | 2003 |                     |  |              | 310,000 |              |  |              | 174,500 |              |  |  |       |  |  |  | 30,000  |  |  |  | 40,381 | 
|Chief Operating Officer of                 |  |      | 2002 |                     |  |              | 275,500 |              |  |              | 115,000 |              |  |  |       |  |  |  | 30,000  |  |  |  | 33,228 | 
|Extendicare Health Services, Inc.          |  |      |      |                     |  |              |         |              |  |              |         |              |  |  |        |  |  |  |         |  |  |  |        | 
|                                          
|M.W. Durishan(4)                           |  |      | 2004 |                     |  |              | 280,000 |              |  |              | 157,000 |              |  |  |       |  |  |  |        |  |  |  | 48,668 | 
|Vice-President                             |  |      | 2003 |                     |  |              | 265,000 |              |  |              | 150,000 |              |  |  |       |  |  |  | 30,000  |  |  |  | 41,750 | 
|                                           |  |      | 2002 |                     |  |              | 258,000 |              |  |              | 116,100 |              |  |  |       |  |  |  | 30,000  |  |  |  | 47,212 | 
|                                          
|D.K. Howe                                  |  |      | 2004 |                     |  |              | 237,000 |              |  |              | 82,950  |              |  |  |       |  |  |  | 25,000  |  |  |  | 39,798 | 
|Senior Area Vice President,                |  |      | 2003 |                     |  |              | 227,000 |              |  |              | 100,000 |              |  |  |       |  |  |  | 15,000  |  |  |  | 38,824 | 
|Extendicare Health Services, Inc.          |  |      | 2002 |                     |  |              | 200,000 |              |  |              | 70,000  |              |  |  |       |  |  |  | 10,000  |  |  |  | 35,977 | 



---

Notes:


|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | The aggregate amount of perquisites and other
    benefits for each named executive officer is less than the
    lesser of $50,000 or 10% of total annual salary and bonus. In
    the case of M.A. Rhinelander, the amount is comprised of car
    allowance and flexible account.                                                                                                                                                                                                                                                                                                                                                                                
|   
|(2) | For M.A. Rhinelander these amounts reflect
    premiums paid by the Company for term life insurance and
    long-term disability. All other compensation, in the case of
    R.L. Bertrand, P.W. Small, M.W. Durishan and D.K. Howe, includes
    payments for life insurance and long-term disability premiums
    and contributions to a deferred compensation plan and a defined
    contribution retirement plan. The amount of salary and/or bonus
    deferred by the named executive officer is included within the
    figures set forth in the Salary and/or
    Bonus columns in the above table. EHSIs
    contribution is included within the All

112



---



##### Table of Contents



| |                                                                                                                                                                  
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Other Compensation column. The amounts
    contributed by the officer and our matching portion contributed
    to the deferred compensation plan are as follows:

|                        |  |      |        |      |  |      |        |  |  |   |        | 
|----------------------- |  | ---- | ------ | ---- |  | ---- | ------ |  |  | - | ------ | 
|Named Executive Officer |  | 2004 |        | 2003 |  | 2002
|                        |  |      |        |      |  |     
|R.L. Bertrand           |  |      |        |      |  |      |        |  |  |   |        | 
|Officer contribution    |  |      |       |      |  |      |       |  |  | $ | 3,833  | 
|Officer interest        |  | $    | 8,660  |      |  | $    | 7,922  |  |  |   | 8,576  | 
|EHSI contribution       |  |      |       |      |  |      |       |  |  |   | 1,916  | 
|EHSI interest           |  |      | 4,330  |      |  |      | 3,961  |  |  |   | 4,288  | 
|P.W. Small              |  |      |        |      |  |      |        |  |  |   |        | 
|Officer contribution    |  |      | 30,000 |      |  |      |       |  |  |   |       | 
|Officer interest        |  |      | 127    |      |  |      |       |  |  |   |       | 
|EHSI contribution       |  |      |       |      |  |      |       |  |  |   |       | 
|EHSI interest           |  |      |       |      |  |      |       |  |  |   |       | 
|M.W. Durishan           |  |      |        |      |  |      |        |  |  |   |        | 
|Officer contribution    |  |      | 27,750 |      |  |      | 26,500 |  |  |   | 25,800 | 
|Officer interest        |  |      | 5,959  |      |  |      | 4,325  |  |  |   | 3,502  | 
|EHSI contribution       |  |      | 13,875 |      |  |      | 13,250 |  |  |   | 12,900 | 
|EHSI interest           |  |      | 2,980  |      |  |      | 2,163  |  |  |   | 1,751  | 



|    |                                                                                                                                                                                                       
|--- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(3) | R.L. Bertrand, formerly the Senior
    Vice-President, Development, was appointed to the position of
    Senior Vice President, Chief Financial Officer and Treasurer
    effective September 1, 2004.
|   
|(4) | M.W. Durishan was the Companys Chief
    Financial Officer for the 2002 and 2003 fiscal years, and until
    September 1, 2004. Mr. Durishan is planning to retire
    in 2005.                      

Stock Option Plan

Extendicare Inc.s stock option plan
provides for the grant, from time to time, at the discretion of
Extendicare Inc.s board of directors, to certain
directors, officers and employees of the Extendicare Inc. group
of companies, of options to purchase subordinate voting shares
of Extendicare Inc. for cash. In May 2004, Extendicare
Inc.s board of directors, with the approval of the Toronto
Stock Exchange, amended the stock option plan to add tandem
share appreciation rights (SARs) with option grants. Extendicare
Inc. has not increased the number subordinate voting shares
reserved for issuance under its stock option plan, and to the
extent that awards granted pursuant to its stock option plan
result in the exercise of SARs, the equivalent number of
subordinate voting shares will be reduced from the number
reserved and available under the stock option plan for future
grants.

The plan provides that the exercise price of any
options granted not be less than the closing price (or, if there
is no closing price, the simple average of the bid and ask
price) for the subordinate voting shares as quoted on the
Toronto Stock Exchange on the trading day prior to the date of
grant. It also permits options to be exercised for a period not
to exceed ten years from the date of grant, as determined by the
Extendicare Inc. board of directors at the time the option is
granted. The options vest equally over the first four years and
the plan contains provisions for appropriate adjustments in the
event of corporate reorganizations of Extendicare Inc.

At December 31, 2004, a total of 3,815,000
subordinate voting shares of Extendicare Inc. were reserved for
issuance under the plan, of which 2,122,775 subordinate voting
shares were subject to outstanding options and 1,692,225 were
available for grant.

113



---



##### Table of Contents



The following table summarizes stock options/
SARs granted during 2004 to our named executive officers under
the Extendicare Inc. stock option plan:

OPTION/ SAR GRANTS IN FISCAL YEAR
2004

|                 |  |              |         |              |  |            |       |                             |  |     |       |                 |  |   |         |  |  |   |           |  |  |  |                | 
|---------------- |  | ------------ | ------- | ------------ |  | ---------- | ----- | --------------------------- |  | --- | ----- | --------------- |  | - | ------- |  |  | - | --------- |  |  |  | -------------- | 
|                 |  |              |         |              |  |            |       |                             |  |    
|                 |  |              |         |              |  |            |       | Potential Realizable Value  |  |    
|                 |  |              |         | Percent of   |  |            |       | at Assumed Annual Rates     |  |    
|                 |  | Number of    |         | Total        |  | Exercise   |       | of Stock Price Appreciation |  |    
|                 |  | Securities   |         | Options/SARs |  | or Base    |       | for Option Term             |  |    
|                 |  | Underlying   |         | Granted to   |  | Price      |       | (C$)                        |  |    
|                 |  | Options/SARs |         | Employees in |  | (C$)       |       |                             |  |    
|Name             |  | Granted      |         | Fiscal Year  |  | Per Share) |       | 5%                          |  | 10% |       | Expiration Date
|                 |  |              |         |              |  |            |       |                             |  |     |       |                
|M.A. Rhinelander |  |              | 100,000 |              |  |            | 22.73 | %                           |  |     | 14.50 |                 |  | $ | 911,897 |  |  | $ | 2,310,927 |  |  |  | August 3, 2014 | 
|R.L. Bertrand    |  |              | 30,000  |              |  |            | 6.82  |                             |  |     | 14.50 |                 |  |   | 273,569 |  |  |   | 693,278   |  |  |  | August 3, 2014 | 
|P.W. Small       |  |              | 40,000  |              |  |            | 9.09  |                             |  |     | 14.50 |                 |  |   | 364,759 |  |  |   | 924,371   |  |  |  | August 3, 2014 | 
|D.K. Howe        |  |              | 25,000  |              |  |            | 5.68  |                             |  |     | 14.50 |                 |  |   | 227,974 |  |  |   | 577,732   |  |  |  | August 3, 2014 | 
|M. W. Durishan   |  |              | Nil     |              |  |            | Nil   |                             |  |     | Nil   |                 |  |   | Nil     |  |  |   | Nil       |  |  |  | Not applicable | 

These amounts do not represent the present value
of the options. All amounts are stated in Canadian dollars (C$).
The amounts shown represent what would be received upon exercise
ten years after the date of grant, assuming certain rates of
stock price appreciation during the entire period. Actual gains,
if any, on stock option exercises are dependent on future
performance of the Extendicare Inc. common stock and overall
market conditions. In addition, actual gains depend upon
whether, and the extent to which, the options actually vest.

The following table summarizes options exercised
during 2004 and option values at December 31, 2004 for our
named executive officers.

AGGREGATED OPTION/ SAR EXERCISED IN FISCAL
YEAR 2004

AND FISCAL YEAR-END OPTION/ SAR
VALUES


|                 |  |             |        |          |  |                        |         |                           |  |             |         |               |  |  |         |  |  |  |           |  |  |  |           | 
|---------------- |  | ----------- | ------ | -------- |  | ---------------------- | ------- | ------------------------- |  | ----------- | ------- | ------------- |  |  | ------- |  |  |  | --------- |  |  |  | --------- | 
|                 |  |             |        |          |  |                        |         |                           |  |            
|                 |  |             |        |          |  | Number of Securities   |         |                          
|                 |  |             |        |          |  | Underlying Unexercised |         | Value of Unexercised     
|                 |  |             |        |          |  | Options/SARs at        |         | in-the-money Options/SARs
|                 |  | Shares      |        |          |  | Fiscal Year-end        |         | at Fiscal Year-end       
|                 |  | Acquired    |        | Value    |  | (#)                    |         | (C$)                     
|                 |  | on Exercise |        | Realized |  |                        |         |                          
|Name             |  | (#)         |        | (C$)     |  | Exercisable            |         | Unexercisable             |  | Exercisable |         | Unexercisable
|                 |  |             |        |          |  |                        |         |                           |  |             |         |              
|M.A. Rhinelander |  |             | 50,000 |          |  |                        | 530,000 |                           |  |             | 225,000 |               |  |  | 250,000 |  |  |  | 2,699,500 |  |  |  | 1,843,250 | 
|R.L. Bertrand    |  |             | 27,500 |          |  |                        | 310,650 |                           |  |             | 26,250  |               |  |  | 71,250  |  |  |  | 304,538   |  |  |  | 508,913   | 
|P.W. Small       |  |             | 32,500 |          |  |                        | 265,175 |                           |  |             | 27,500  |               |  |  | 90,000  |  |  |  | 295,050   |  |  |  | 596,225   | 
|M.W. Durishan    |  |             | 25,000 |          |  |                        | 289,925 |                           |  |             |        |               |  |  | 42,500  |  |  |  |          |  |  |  | 495,100   | 
|D.K. Howe        |  |             | 7,500  |          |  |                        | 92,575  |                           |  |             |        |               |  |  | 55,000  |  |  |  |          |  |  |  | 378,375   | 



---

|      |                                                                                                                                                                                                                                               
|----- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Note: | The value of the unexercised options is based on
    C$15.45, the closing price of the Extendicare Inc. subordinate
    voting shares on the Toronto Stock Exchange on December 31,
    2004. All amounts are stated in Canadian dollars (C$).

Effective 2003, the fair value of the options
granted to our executives for subordinate voting shares of
Extendicare Inc. to our executives, which do not include tandem
SARs, are expensed as a payroll cost on our records. In 2004,
the amount of the payroll costs associated with the options
granted was $57,000 (2003  $48,000). In addition,
option grants that include tandem SARs are expensed as a payroll
cost on a graded vesting basis, in an amount by which the quoted
market value of the subordinate voting shares of Extendicare
Inc. exceed the option price. In 2004, the amount of the payroll
costs associated with the tandem SARs granted was $23,000.

114



---



##### Table of Contents



Retirement Arrangements

M.A. Rhinelander and R.L. Bertrand have an
arrangement with Extendicare Inc. providing them with a benefit
guarantee upon retirement. Mr. Rhinelander has
27 years of credited service at the end of 2004.
Mr. Rhinelander has the Companys consent to retire at
age 55, and he is guaranteed to receive 70% of the best three
consecutive years of basic salary upon retirement.
Mr. Bertrand has 28 years of credited service at the
end of 2004, and he is guaranteed to receive a fixed retirement
benefit of C$173,000 (Canadian dollars) per annum upon
retirement. Mr. Bertrands plan allows for normal
retirement at age 60. Retirement benefits are not subject to any
deduction for social security or Canada Pension, and are payable
as an annuity over the lifetime of the executive with a portion
continuing to be paid to the executives spouse after the
death of the executive. Mr. Bertrand is also a participant
in money purchase, 401(k), and deferred compensation plans
established for the Companys executives.

P.W. Small, M.W. Durishan and D.K. Howe are
participants in money purchase, 401(k), and deferred
compensation plans established for executives. The Company
maintains a non-qualified deferred compensation plan and
executive retirement plan for certain of its highly compensated
employees and executives, as described below. The Companys
liabilities under these plans are unfunded and unsecured.

Deferred Compensation Plan

We maintain a non-qualified, deferred
compensation plan (consisting of individual agreements), which
is offered to all highly compensated employees as prescribed by
the Internal Revenue Service. The maximum amount of annual
compensation that may be deferred is 10% of the employees
base salary, excluding any bonus. We match up to 50% of the
amount deferred, and the combined amount earns interest at the
prime rate. Our matching payment, plus interest, vests to the
employee over eight years. Amounts deferred and vested matching
amounts are payable upon the death, disability or termination of
the employee. Amounts deferred are not guaranteed, are at
risk and are subject to our ability to make the scheduled
payments.

Executive Retirement Plan

We provide an executive retirement program for
certain of our key officers and executives. Under the program we
contribute 10% of the participants base salary into an
account to be invested in certain mutual funds at the
participants discretion. The amounts in the executive
retirement program vest upon certain events which are specified
in the participants executive retirement program plan, and
by discretionary actions by the Board of Directors of
Extendicare Inc. A graduated vesting schedule applies for some
program participants if we terminate the participant. Any funds
that we invest or assets that we acquire pursuant to the program
continue to be a part of our general funds. No party, other than
EHSI, has any interest in such funds. To the extent that any
participant acquires a right to receive payment from us under
the executive retirement program, such right shall be no greater
than the right of any unsecured general creditor of ours. We
expense the amounts we fund into the executive retirement
program on a monthly basis. Amounts held within this executive
retirement program accounts are not guaranteed, are at
risk and are subject to our ability to make the scheduled
payments.

Termination of Employment
Arrangements

M.A. Rhinelander has a termination of employment
agreement with Extendicare Inc. that provides for a lump sum
cash payment equivalent to 24 months of his annual total
compensation, less applicable deductions required by law, in the
event of termination by the company other than for just cause;
or in the event of resignation with six months notice in
the case of a change of control or material reduction in
responsibilities.

Compensation Committee Interlocks and Insider
Participation

Our Board of Directors is comprised solely of
certain of our executive officers. The Human Resources Committee
of the Extendicare Inc. Board of Directors performs the
functions of a compensation committee for Extendicare Inc. and
its subsidiaries, including us. The following six outside and
unrelated directors served as members of the Committee: Derek
H.L. Buntain, Sir Graham Day, David M. Dunlap,
Michael J.L. Kirby,

115



---



##### Table of Contents



Frederick B. Ladly and J. Thomas
MacQuarrie, Q.C. None of these committee members are our
directors or officers, or directors or officers of any of our
subsidiaries.







|         |                                                                   
|-------- | ------------------------------------------------------------------
|ITEM 12. | SECURITY OWNERSHIP OF CERTAIN BENEFICIAL
    OWNERS AND MANAGEMENT

We are an indirect wholly owned subsidiary of
Extendicare. Extendicares principal executive offices are
located at 3000 Steeles Avenue East, Markham, Ontario, Canada
L3R 9W2.

There are no equity compensation plans under
which our common stock is issued.






|         |                                                   
|-------- | --------------------------------------------------
|ITEM 13. | CERTAIN RELATIONSHIPS AND RELATED
    TRANSACTIONS

We are an indirect wholly owned subsidiary of
Extendicare Inc. Certain operating expenses are allocated
between Extendicare Inc. and its subsidiaries. We insure certain
risks, including comprehensive general liability, and excess
workers compensation/employers liability insurance,
with Laurier Indemnity Company and Laurier Indemnity Ltd.,
affiliated insurance subsidiaries of Extendicare Inc. We
recorded approximately $9.8 million, $10.7 million,
and $9.9 million of expenses for this purpose in the fiscal
years ended December 31, 2004, 2003 and 2002, respectively.
The 2004 amount is net of favorable actuarial adjustments for
prior years under our retroactively-rated workers
compensation coverage in the amount of $1.0 million.

In January 2001, we established an arrangement
for computer hardware and software support services with Virtual
Care Provider, Inc., an affiliated subsidiary of Extendicare
Inc. The annual cost of services was $4.8 million,
$6.9 million and $7.9 million in 2004, 2003 and 2002
respectively.

For federal tax purposes we file as part of a
consolidated group of companies, of which Extendicare Holdings
Inc. is the parent. Extendicare Holdings (a subsidiary of
Extendicare Inc.) holds all of Extendicare Inc.s U.S.
operations, including EHSI. We have a tax sharing arrangement
with Extendicare Holdings pursuant to which we had a receivable
of $16.6 million as of December 31, 2004 and a payable
of $7.8 million as of December 31, 2003. Under this
tax sharing arrangement, a U.S. consolidated income tax return
is filed by Extendicare Holdings and, for purposes of
determining each members share of the tax liability in
such return, each member of the affiliated group computes its
separate U.S. income tax liability for regular income tax
purposes (but not for alternative minimum tax purposes) as if it
had filed a separate U.S. income tax return. Such amount is
reflected as a federal income tax expense and as an intercompany
payable to Extendicare Holdings on each members separate
financial statements. If a member incurs a net operating loss,
such net operating loss is tax benefited (for regular tax
purposes only) in the year the net operating loss is incurred.
Such amount is reflected as a reduction in federal income tax
expense and as an intercompany receivable from Extendicare
Holdings on each members separate financial statements.
Similarly, the federal income tax receivable and payable is
recorded on the separate financial statement of Extendicare
Holdings. Each members separate intercompany balances are
transferred to Extendicare Holdings through the intercompany
payable and receivable account.

116



---



##### Table of Contents



In addition to the income tax amounts discussed
in the preceding paragraph, we had non-interest bearing amounts
due from (to) affiliates as follows:

|                             |  |                                 |  |                        |         |      |  |      |        |   |  |   |        |  
|---------------------------- |  | ------------------------------- |  | ---------------------- | ------- | ---- |  | ---- | ------ | - |  | - | ------ | -
|                             |  |                                 |  |                       
|                             |  |                                 |  | December 31,          
|                             |  |                                 |  |                       
|Affiliate                    |  | Purpose                         |  | 2004                   |         | 2003 |  | 2002
|                             |  |                                 |  |                        |         |      |  |     
|                             |  |                                 |  |                       
|                             |  |                                 |  | (dollars in thousands)
|Current asset (liability):   |  |                                 |  |                        |         |      |  |      |        |   |  |   |        |  
|Extendicare Inc.             |  | Working capital advances        |  | $                      | 7,690   |      |  | $    | (47    | ) |  | $ |       |  
|Virtual Care Provider, Inc.  |  | Working capital advances        |  |                        | (3,000  | )    |  |      | 6,970  |   |  |   | 6,436  |  
|The Northern Group, Inc.     |  | Intercompany operating expenses |  |                        | 19      |      |  |      | 84     |   |  |   |       |  
|Laurier Indemnity Company    |  | Intercompany insurance premium  |  |                        | 2       |      |  |      |       |   |  |   |       |  
|Extendicare Holdings, Inc.   |  | Working capital advances        |  |                        | 4       |      |  |      | 3      |   |  |   |       |  
|                             |  |                                 |  |                        |         |      |  |      |        |   |  |   |        |  
|                             |  |                                 |  | $                      | 4,715   |      |  | $    | 7,010  |   |  | $ | 6,436  |  
|                             |  |                                 |  |                        |         |      |  |      |        |   |  |   |        |  
|Long-term asset (liability): |  |                                 |  |                        |         |      |  |      |        |   |  |   |        |  
|Extendicare Inc.             |  | Working capital advances        |  | $                      | (8,900  | )    |  | $    |       |   |  | $ |       |  
|Extendicare Inc.             |  | Intercompany operating expenses |  |                        | 1,218   |      |  |      |       |   |  |   |       |  
|Extendicare Holdings, Inc.   |  | Working capital advances        |  |                        | (3,483  | )    |  |      | (3,484 | ) |  |   | (3,484 | )
|Virtual Care Provider, Inc.  |  | Working capital advances        |  |                        | (3,620  | )    |  |      |       |   |  |   |       |  
|                             |  |                                 |  |                        |         |      |  |      |        |   |  |   |        |  
|                             |  |                                 |  | $                      | (14,785 | )    |  | $    | (3,484 | ) |  | $ | (3,484 | )
|                             |  |                                 |  |                        |         |      |  |      |        |   |  |   |        |  

In January 2005, we amended our credit facility
to permit the loan from EHI and accommodate the ALC acquisition.
In January 2005, Extendicare Inc. advanced $55.0 million to
EHI, who in turn advanced $55.0 million as a Term Loan to
us, as part of the financing of the ALC acquisition. This Term
Loan has a term of five years, can be repaid at any time by us
and bears interest at 6%. The ALC debt we assumed on the
acquisition is non-recourse to us and the debt and earnings of
ALC will be excluded from existing financial covenants under our
credit facility. We are restricted from borrowing further under
our credit facility and under the ALC credit facility to finance
any ALC operating deficiencies and all cash flow from ALC will
be retained within the ALC operations. Any cash flow
deficiencies within ALC will be financed by way of advances from
Extendicare directly to ALC and we believe Extendicare has the
financial capacity to meet any such deficiency.






|         |                                           
|-------- | ------------------------------------------
|ITEM 14. | PRINCIPAL ACCOUNTANT FEES AND
    SERVICES

The following table sets forth information with
respect to services provided to us by KPMG LLP, our independent
certified public accountants, for the years ended
December 31, 2004 and 2003.

|                               |  |                |     |      |  |   |     | 
|------------------------------ |  | -------------- | --- | ---- |  | - | --- | 
|                               |  | 2004           |     | 2003
|                               |  |                |     |     
|                               |  |               
|                               |  | (in thousands)
|Audit fees billed for the year |  | $              | 453 |      |  | $ | 426 | 
|Audit-related fees             |  |                |    |      |  |   |    | 
|Tax fees                       |  |                | 43  |      |  |   |    | 
|All other fees                 |  |                | 48  |      |  |   | 19  | 
|                               |  |                |     |      |  |   |     | 
|                               |  | $              | 544 |      |  | $ | 445 | 
|                               |  |                |     |      |  |   |     | 

(1) Audit Fees.This consists of
aggregate fees billed to us by KPMG LLP for professional
services rendered for the audit of our annual financial
statements, reviews of our interim financial statements, and
services that are normally provided in connection with statutory
or regulatory filings or engagements, including consents and
other services related to Securities and Exchange Commission
matters.

(2) Audit-Related Fees.This consists
of fees billed to us by KPMG LLP for assurance and related
services that are reasonably related to the performance of the
audit or review of our financial statements and are not reported
under Audit Fees. These services include
consultations in connection with potential transactions, and
consultations concerning financial accounting and reporting
standards.

117



---



##### Table of Contents



(3) Tax Fees.This consists of fees
billed to us by KPMG LLP for professional services for tax
compliance, tax advice and tax planning. These services include
assistance regarding federal and state tax compliance, tax audit
issues, mergers and acquisitions, and tax planning.

(4) All Other Fees.This consists of
other fees billed to us by KPMG LLP for products and services
other than the services reported above. All other fees are for
support and learning services, which have been deemed to be
permissible non-attest services.

Pre-Approval Policies and Procedures

Extendicare Inc. has adopted the pre-approval
policies and procedures set forth below regarding the engagement
of external auditors, which apply to it and all of its
subsidiaries, including us.

1.     Pre-approval is
required for all auditing services prior to the start of the
engagement, unless the audit services are within the scope of
the approved engagement.

2.     With respect to
other accounting, financial or taxation services conducted by
our external auditors, pre-approval is required for all
engagements.

3.     Our external
auditors may not provide the following services:
(1) bookkeeping or other services related to the accounting
records or financial statements, (2) financial system
design, (3) implementation, appraisal or valuation services
or those involving the preparation of fairness opinions or
contribution-in-kind reports, (4) actuarial services,
(5) internal audit outsourcing services,
(6) management services, (7) human resource services,
(8) investment advisory or banking services, (9) legal
services and (10) expert services unrelated to the audit.

These pre-approval policies do not permit
delegation of the audit committees responsibilities to
management.

Since January 1, 2004, we have approved 100%
of the services described in the table above under
Audit-Related Fees, Tax Fees, and
All Other Fees in accordance with our pre-approval
policy.

118



---



##### Table of Contents






PART IV






|         |                                               
|-------- | ----------------------------------------------
|ITEM 15. | EXHIBITS AND FINANCIAL STATEMENT
    SCHEDULES



|    |                                            
|--- | -------------------------------------------
|(a) | Documents filed as part of this
    report:

1. Financial Statements

The following financial statements and report of
the independent auditors are contained in Item 8 of this
Annual Report on Form 10-K on the pages indicated.

|                                                                                                               |  |       |    | 
|-------------------------------------------------------------------------------------------------------------- |  | ----- | -- | 
|                                                                                                               |  | Pages
|                                                                                                               |  |      
|Report of the Independent
    Registered Public Accounting Firm                                                |  |       | 67 | 
|Consolidated Balance Sheets
    at December 31, 2004 and 2003                                                  |  |       | 68 | 
|Consolidated Statements of
    Income for Years 2004, 2003, and 2002                                           |  |       | 69 | 
|Consolidated Statements of
    Shareholders Equity and Comprehensive Income for Years
    2004, 2003 and 2002 |  |       | 70 | 
|Consolidated Statements of
    Cash Flows for Years 2004, 2003 and 2002                                        |  |       | 71 | 
|Notes to Consolidated
    Financial Statements                                                                 |  |       | 72 | 



|   |                             
|-- | ----------------------------
|2. | Financial Statement Schedule

Schedule II  Valuation and
Qualifying Accounts is filed as part of this Annual Report on
Form 10-K.



|   |         
|-- | --------
|3. | Exhibits

The exhibits listed in the accompanying
Exhibit Index are filed as part of this Annual Report on
Form 10-K.



|    |         
|--- | --------
|(b) | Exhibits

The exhibits listed in the accompanying
Exhibit Index are filed (except where otherwise indicated)
as part of this Annual Report on Form 10-K.



|    |                                                                      
|--- | ---------------------------------------------------------------------
|(c) | Financial Statements Excluded from Annual
    Report to Shareholders:

Not applicable.

119



---



##### Table of Contents






SIGNATURES

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



| |                                  
| | ---------------------------------
| | EXTENDICARE HEALTH SERVICES, INC.



| |     |                        
| | --- | -----------------------
| | By: | /s/ RICHARD L. BERTRAND

| |                                               
| | ----------------------------------------------
| |                                               
| | Richard L. Bertrand                           
| | Senior Vice President, Chief Financial Officer
| | and Treasurer and Director                    
| | (Principal Financial and Accounting Officer)  

Date: March 30, 2005

Pursuant to the requirements of the Securities
Exchange Act of 1934, this report has been signed below by the
following persons on behalf of the Registrant and on the date
indicated.

|                                           |  |                                                                                                                                |  |               
|------------------------------------------ |  | ------------------------------------------------------------------------------------------------------------------------------ |  | --------------
|Name                                       |  | Title                                                                                                                          |  | Date          
|                                           |  |                                                                                                                                |  |               
|                                          
|/s/ MEL RHINELANDERMel Rhinelander         |  | Chairman of the Board, and
    Chief Executive Officer
    (Principal Executive Officer)                                       |  | March 30, 2005
|                                          
|/s/ RICHARD L. BERTRANDRichard L. Bertrand |  | Senior Vice President,
    Chief Financial Officer
    Treasurer and Director
    (Principal Financial and Accounting Officer) |  | March 30, 2005
|                                          
|/s/ PHILIP W. SMALLPhilip W. Small         |  | Executive Vice President, Chief Operating Officer
    and Director                                                             |  | March 30, 2005

120



---



##### Table of Contents



SUPPLEMENTAL INFORMATION TO BE FURNISHED WITH
REPORTS FILED PURSUANT TO SECTION 15(D) OF THE ACT BY
REGISTRANTS WHICH HAVE NOT REGISTERED SECURITIES PURSUANT TO
SECTION 12 OF THE ACT.

We have not sent to security holders any annual
report covering our last fiscal year or any proxy soliciting
material with respect to any annual or other meeting of security
holders and we do not intend to do so.

121



---



##### Table of Contents






EXHIBIT INDEX

|       |   |             |  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|------ | - | ----------- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Number |   | Description
|       |   |            
|       | 2 | .1          |  | Form of Operations Transfer Agreement, dated as
    of October 1, 2001, by and among Extendicare Homes, Inc.,
    Extendicare Health Facilities, Inc., Senior Health
    Properties  Texas, Inc. and certain affiliates of
    Senior Health Properties  Texas, Inc. (Certain
    exhibits of the Operations Transfer Agreement and certain
    exhibits of the exhibits have been omitted based on
    Item 601(b)(2) of Regulation S-K. Such exhibits are
    described in the Operations Transfer Agreement and the exhibits
    thereto. The Company agrees to furnish to the Commission, upon
    its request, any or all of such omitted exhibits. (Incorporated
    by reference to the Companys Form 8-K filed on
    January 4, 2002).
|      
|       | 2 | .2          |  | Plan of Merger and Acquisition Agreement, dated
    as of November 4, 2004, By and Among Extendicare Health
    Services, Inc., Alpha Acquisition, Inc., and Assisted Living
    Concepts, Inc. (Incorporated by reference to Exhibit 2.1 to
    the Companys Current Report on Form 8-K filed on
    November 9, 2004).                                                                                                                                                                                                                                                                                                                                                                                                                         
|      
|       | 3 | .1          |  | Restated Certificate of Incorporation of
    Extendicare Health Services, Inc. (Incorporated by reference to
    the Companys Registration Statement on Form S-4
    (Registration No. 333-43549)).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|      
|       | 3 | .2          |  | By-Laws of Extendicare Health Services, Inc.
    (Incorporated by reference to the Companys Registration
    Statement on Form S-4 (Registration No. 333-43549)).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|      
|       | 4 | .1          |  | Purchase Agreement, dated as of June 20,
    2002, among Extendicare Health Services, Inc., the Guarantors
    named therein, Lehman Brothers, Inc., ABN AMRO Incorporated and
    U.S. Bancorp Piper Jaffrey Inc. (Incorporated by reference
    to Exhibit 4.2 to the Companys Registration Statement
    on Form S-4 (Registration No. 333-97293)).                                                                                                                                                                                                                                                                                                                                                                                           
|      
|       | 4 | .2          |  | Indenture, dated as of June 28, 2002, among
    Extendicare Health Services, Inc., the Guarantors named therein,
    as Guarantors, and U.S. Bank, N.A., as Trustee. (Incorporated by
    reference to the Companys Registration Statement on
    Form S-4 (Registration No. 333-97293)).                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|      
|       | 4 | .3          |  | Exchange and Registration Rights Agreement, dated
    as of June 28, 2002, among Extendicare Health Services,
    Inc., the Guarantors named therein, Lehman Brothers Inc., ABN
    AMRO Incorporated and U.S. Bancorp Piper Jaffrey Inc.
    (Incorporated by reference to Exhibit 4.4 to the
    Companys Registration Statement on Form S-4
    (Registration No. 333-97293)).                                                                                                                                                                                                                                                                                                                                                                
|      
|       | 4 | .4          |  | Second Amended and Restated Credit Agreement,
    dated as of April 22, 2004, among Extendicare Holdings,
    Inc., Extendicare Health Services, Inc., Lehman Brothers Inc.,
    as Arranger, Lehman Commercial Paper Inc., as Administrative
    Agent, U.S. Bank National Association, as Syndication Agent, GE
    Capital Corporation, Residential Funding Corporation and LaSalle
    Bank National Association, as Co-Documentation Agents and other
    lenders thereto (Incorporated by reference to Exhibit 4.4
    to the Companys Registration Statement on Form S-4
    (Registration No. 333-116927).                                                                                                                               
|      
|       | 4 | .5          |  | First Amendment, dated as of November 2,
    2004, to the Second Amended and Restated Credit Agreement, dated
    as of April 22, 2004 among Extendicare Holdings, Inc.,
    Extendicare Health Services, Inc., the several banks and other
    financial institutions or entities from time to time parties to
    the Credit Agreement, US Bank, National Association, as
    syndication agent, General Electric Capital Corporation,
    Residential Funding Corporation and LaSalle Bank National
    Association, as co-documentation agents, and Lehman Commercial
    Paper Inc., as administrative agent (Incorporated by reference
    to Exhibit 4.1 to the Companys Current Report on
    Form 8-K filed on January 31, 2005).       
|      
|       | 4 | .6          |  | Purchase Agreement, dated as of April 15,
    2004, among Extendicare Health Services, Inc., the Guarantors
    named therein, Lehman Brothers, Inc., ABN AMRO Incorporated and
    U.S. Bancorp Piper Jaffrey Inc. (Incorporated by reference to
    Exhibit 4.5 to the Companys Registration Statement on
    Form S-4 (Registration No. 333-116927).                                                                                                                                                                                                                                                                                                                                                                                          
|      
|       | 4 | .7          |  | Indenture, dated as of April 22, 2004, among
    Extendicare Health Services, Inc., the Guarantors named therein,
    as Guarantors, and U.S. Bank, N.A., as Trustee.
    (Incorporated by reference to Exhibit 4.6 to the
    Companys Registration Statement on Form S-4
    (Registration No. 333-116927).                                                                                                                                                                                                                                                                                                                                                                                                                                    



---



##### Table of Contents



|       |    |             |  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|------ | -- | ----------- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Number |    | Description
|       |    |            
|       | 4  | .8          |  | Exchange and Registration Rights Agreement, dated
    as of April 22, 2004, among Extendicare Health Services,
    Inc., the Guarantors named therein, Lehman Brothers, Inc., ABN
    AMRO Incorporated and U.S. Bancorp Piper Jaffrey Inc.
    (Incorporated by reference to Exhibit 4.7 to the
    Companys Registration Statement on Form S-4
    (Registration No. 333-116927).                                                                                                                                                                                                                                                                                                                                                                                                              
|      
|       |    |             |  | Pursuant to Item 601(b)(4) (iii) of
    Regulation S-K, the Registrants agree to furnish to the
    Securities and Exchange Commission, upon request, any instrument
    defining the rights of holders of long-term debt not being
    registered that is not filed as an exhibit to this Annual Report
    on Form 10-K.                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|      
|       | 4  | .9          |  | Second Amendment, dated as of January 28,
    2005, to the Second Amended and Restated Credit Agreement, dated
    as of April 22, 2004 (as amended, supplemented or otherwise
    modified, among Extendicare Holdings, Inc., Extendicare Health
    Services, Inc., the several banks and other financial
    institutions or entities from time to time parties to the Credit
    Agreement, US BANK, NATIONAL ASSOCIATION, as syndication agent,
    GENERAL ELECTRIC CAPITAL CORPORATION, RESIDENTIAL FUNDING
    CORPORATION and LASALLE BANK NATIONAL ASSOCIATION, as
    co-documentation agents, and LEHMAN COMMERCIAL PAPER INC., as
    administrative agent (Incorporated by referenced to
    Exhibit 4.2 to the Companys Current Report on
    Form 8-K filed on January 31, 2005).
|      
|       | 4  | .10         |  | Senior Unsubordinated and Unsecured $55 Million
    Note between Extendicare Health Services, Inc. and Extendicare
    Holdings, Inc. dated January 27, 2005 (Incorporated by
    referenced to Exhibit 4.3 to the Companys Current
    Report on Form 8-K filed on January 31, 2005).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|      
|       | 10 | .1          |  | Asset Purchase Agreement, dated as of
    July 29, 1998, between Extendicare Health Service, Inc. and
    certain affiliate and Omnicare, Inc. and its affiliates
    (Incorporated by reference to the Companys Form 10-K
    for the year ended December 31, 1998).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|      
|       | 10 | .2          |  | Preferred Provider Agreement dated as of
    July 29, 1998 between the Company and Omnicare, Inc.
    (Incorporated by reference to the Companys Form 10-K
    for the year ended December 31, 2001).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|      
|       | 10 | .3          |  | Amended and Restated Subordinate Voting Share
    Option Plan (Incorporated by reference to the Companys
    Registration Statement on Form S-4 (Registration
    No. 333-97293)).*                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|      
|       | 10 | .4          |  | Executive Retirement Program (Incorporated by
    reference to the Companys Registration Statement on
    Form S-4 (Registration No. 333-97293)).*                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|      
|       | 10 | .5          |  | Form of Deferred Compensation Agreement (which
    collectively constitutes the deferred compensation plan)
    available to all highly compensated employees of the Company as
    prescribed by the Internal Revenue Service, which form of
    agreement has been executed by Mark W. Durishan,
    Douglas J. Harris, L. William Wagner, Roch Carter and
    Richard L. Bertrand. (Incorporated by reference to the
    Companys Registration Statement on Form S-4
    (Registration No. 333-97293)).*                                                                                                                                                                                                                                                                                      
|      
|       | 10 | .6          |  | Termination of Employment Arrangement for Mel
    Rhinelander (Incorporated by reference to the Companys
    Registration Statement on Form S-4 (Registration
    No. 333-97293)).*                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|      
|       | 10 | .7          |  | Form of Executive Retiring Allowance Agreement
    entered into by Mel Rhinelander and Richard L. Bertrand
    (Incorporated by reference to the Companys Registration
    Statement on Form S-4 (Registration No. 333-97293)).*                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|      
|       | 10 | .8          |  | Form of Addendum to Executive Retiring Allowance
    Agreement entered into by Mel Rhinelander (Incorporated by
    reference to the Companys Registration Statement on
    Form S-4 (Registration No. 333-97293)).*                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|      
|       | 10 | .9          |  | ISDA Master Agreement, dated as of April 16,
    2004, between U.S. Bank National Association and Extendicare
    Health Services, Inc. (Incorporated by reference to
    Exhibit 10.8 to the Companys Registration Statement
    on Form S-4 (Registration No. 333-116927).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     



---



##### Table of Contents



|       |    |             |  |                                                                                                                                                                                                                                                                                                                                                                                                              
|------ | -- | ----------- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Number |    | Description
|       |    |            
|       | 10 | .10         |  | Memorandum of Understanding dated
    January 31, 2005, by and among LTC Properties, Inc. and
    Texas-LTC Limited Partnership; and Extendicare Health Services,
    Inc., Alpha Acquisition, Inc., Assisted Living Concepts, Inc.,
    and Carriage House Assisted Living, Inc. (Incorporated by
    referenced to Exhibit 10.1 to the Companys Current
    Report on Form 8-K filed on January 31, 2005).
|      
|       | 21 |             |  | Subsidiaries of the Registrant.                                                                                                                                                                                                                                                                                                                                                                              
|      
|       | 31 | .1          |  | Certifications of Chairman of the Board and Chief
    Executive Officer.                                                                                                                                                                                                                                                                                                                                     
|      
|       | 31 | .2          |  | Certifications of Senior Vice President, Chief
    Financial Officer and Treasurer.                                                                                                                                                                                                                                                                                                                          
|      
|       | 32 |             |  | Written Statement of Chairman of the Board and
    Chief Executive Officer and Senior Vice President, Chief
    Financial Officer and Treasurer pursuant to 18 U.S.C.
    Section 1350.                                                                                                                                                                                                                      
|      
|       | 99 | .1          |  | Schedule II  Valuation and
    Qualifying Accounts and related Report of Independent Registered
    Public Accounting Firm                                                                                                                                                                                                                                                                                  



---

|  |                                                                          
|- | -------------------------------------------------------------------------
|* | Represents a management contract or compensatory
    plan or arrangement.