##### Table of Contents









UNITED STATES SECURITIES AND EXCHANGE
COMMISSION

Washington, D.C. 20549




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Form 10-K

|           |  |                                                                                                 
|---------- |  | ------------------------------------------------------------------------------------------------
|(Mark One) |  |                                                                                                 
|þ          |  | ANNUAL REPORT PURSUANT TO SECTION 13 OR
    15(d)
    OF THE SECURITIES EXCHANGE ACT OF 1934    
|          
|           |  | For the fiscal year ended December 31,
    2003                                                 
|          
|or        
|          
|o          |  | TRANSITION REPORT PURSUANT TO SECTION 13
    OR 15(d)
    OF THE SECURITIES EXCHANGE ACT OF 1934
|          
|           |  | For the transition period
    from           to           .                                     

Commission file number 000-21949



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PACIFICARE HEALTH SYSTEMS, INC.

(Exact name of registrant as specified in its
charter)


|                                                                   |  |                                         
|------------------------------------------------------------------ |  | ----------------------------------------
|Delaware                                                           |  | 95-4591529                              
|(State or other jurisdiction of
    incorporation or organization) |  | (IRS Employer
    Identification Number)

5995 Plaza Drive, Cypress, California
90630

(Address of principal executive offices,
including zip code)


(714) 952-1121

(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:


Common Stock, par value $0.01




---

Indicate by check mark whether the Registrant
(1) has filed all reports required to be filed by §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 þ         No o

Indicate by check mark if disclosure of
delinquent filers pursuant to Item 405 of
Regulation S-K (§229.405 of this chapter) is not
contained herein, and will not be contained, to the best of
Registrants knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this
Form 10-K or any amendment to this
Form 10-K. o

Indicate by check mark whether the Registrant is
an accelerated filer (as defined in Exchange Act
Rule 12b-2)    Yes þ         No o

Non-affiliates of the Registrant held
approximately $1,833,500,000 of the aggregate market value of
common stock on June 30, 2003.

There were approximately 85,682,000 shares of
common stock outstanding on February 27, 2004.



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##### Table of Contents



The following sections of the definitive Proxy
Statement for the 2004 Annual Meeting of Stockholders are
incorporated by reference under Parts II and III of this
Form 10-K:

| |  |     |  |                                                                                           
| |  | --- |  | ------------------------------------------------------------------------------------------
| |  | 1.  |  | Board of Directors                                                                        
| |  | 2.  |  | Director Compensation                                                                     
| |  | 3.  |  | Executive Officers                                                                        
| |  | 4.  |  | Section 16(a) Beneficial Ownership Reporting
    Compliance                               
| |  | 5.  |  | Activities of the Board of Directors and its
    Committees                               
| |  | 6.  |  | Audit Committee Report                                                                    
| |  | 7.  |  | Code of Ethics                                                                            
| |  | 8.  |  | Procedures for Stockholder Recommendations of
    Board Nominees and Stockholder Proposals
| |  | 9.  |  | Executive Compensation                                                                    
| |  | 10. |  | Principal Stockholders                                                                    
| |  | 11. |  | Equity-Based Instruments Held by Management                                               
| |  | 12. |  | Equity Compensation Plan Information                                                      
| |  | 13. |  | Certain Relationships and Related Transactions                                            
| |  | 14. |  | Independent Auditor Fees                                                                  

With the exception of the portions of the
definitive Proxy Statement that are incorporated by reference
under Parts II and III of this Form 10-K, the
definitive Proxy Statement is not deemed filed as part of this
Form 10-K.



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---










PACIFICARE HEALTH SYSTEMS, INC.

INDEX TO ANNUAL REPORT ON FORM 10-K

For the Year Ended December 31,
2003


|              |  |                                                                                                    |  |      |    | 
|------------- |  | -------------------------------------------------------------------------------------------------- |  | ---- | -- | 
|              |  |                                                                                                    |  | Page
|              |  |                                                                                                    |  |     
|PART I       
|Item 1.       |  | Business                                                                                           |  |      | 1  | 
|Item 2.       |  | Properties                                                                                         |  |      | 11 | 
|Item 3.       |  | Legal Proceedings                                                                                  |  |      | 11 | 
|Item 4.       |  | Submission of Matters to a
    Vote of Security Holders                                            |  |      | 11 | 
|PART II      
|Item 5.       |  | Market for the
    Companys Common Equity and Related Stockholder Matters                         |  |      | 12 | 
|Item 6.       |  | Selected Financial Data                                                                            |  |      | 14 | 
|Item 7.       |  | Managements Discussion
    and Analysis of Financial Condition and Results of Operations          |  |      | 16 | 
|Item 7A.      |  | Quantitative and Qualitative
    Disclosures About Market Risk                                     |  |      | 46 | 
|Item 8.       |  | Consolidated Financial
    Statements and Supplementary Data                                       |  |      | 47 | 
|Item 9.       |  | Changes in and Disagreements
    with Accountants and Accounting and Financial Disclosure          |  |      | 47 | 
|Item 9A.      |  | Controls and Procedures                                                                            |  |      | 48 | 
|PART III     
|Item 10.      |  | Directors and Executive
    Officers of the Registrant                                             |  |      | 49 | 
|Item 11.      |  | Executive Compensation                                                                             |  |      | 49 | 
|Item 12.      |  | Security Ownership of
    Certain Beneficial Owners and Management Related Stockholder
    Matters |  |      | 49 | 
|Item 13.      |  | Certain Relationships and
    Related Transactions                                                 |  |      | 49 | 
|Item 14.      |  | Principal Accounting Fees
    and Services                                                         |  |      | 49 | 
|PART IV      
|Item 15.      |  | Exhibits, Financial
    Statement Schedules and Reports on Form 8-K                                |  |      | 50 | 
|EXHIBIT 3.04 
|EXHIBIT 4.06 
|EXHIBIT 10.10
|EXHIBIT 21   
|EXHIBIT 10.30
|EXHIBIT 10.35
|EXHIBIT 10.36
|EXHIBIT 14.1 
|EXHIBIT 21   
|EXHIBIT 23   
|EXHIBIT 31.1 
|EXHIBIT 31.2 
|EXHIBIT 32.01
|EXHIBIT 32.02



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PART I




ITEM
1.     BUSINESS

Introduction

We offer managed care and other health insurance
products to employer groups and Medicare beneficiaries primarily
in eight Western states and Guam. Our commercial and senior
plans are designed to deliver quality health care and customer
service to members cost-effectively. These programs include
health maintenance organizations, or HMOs, preferred provider
organizations, or PPOs, and Medicare Supplement products. We
also offer a variety of specialty managed care products and
services that employees can purchase as a supplement to our
basic commercial and senior medical plans or as stand-alone
products. These products include pharmacy benefit management, or
PBM, services, behavioral health services, group life and health
insurance and dental and vision benefit plans. As of
December 31, 2003, we had approximately 2.9 million
HMO and other commercial and senior product members and
approximately 9.4 million members in our PBM, dental and
behavioral plans, including both members covered by our
commercial or senior HMOs, and members who are unaffiliated with
our HMOs.

We were formed in 1996 as a Delaware corporation
and are the successor to a California corporation that was
formed in 1983 and reincorporated as a Delaware corporation in
1985. Our principal executive offices are located at 5995 Plaza
Drive, Cypress, California 90630, and our telephone number is
(714) 952-1121.

Our Annual Reports on Form 10-K, Quarterly
Reports on Form 10-Q, Current Reports on Form 8-K and
all amendments to those reports that we file with the Securities
and Exchange Commission, or SEC, are currently available free of
charge to the general public through our website at
www.pacificare.com. These reports are accessible on our
website after being filed with the SEC. These reports are also
available at the SECs public reference room at 450 Fifth
Street, N.W., Washington, D.C. 20549. The public may obtain
information on the operation of the public reference room by
calling the SEC at 1-800-SEC-0330. The SEC also maintains a
website at www.sec.gov that contains reports, proxy and
information statements and other information regarding issuers
that file electronically with the SEC.

This Annual Report on Form 10-K contains
both historical and forward-looking information. See
Managements Discussion and Analysis of Financial
Condition and Results of Operations and Cautionary
Statements for a description of a number of factors that
could adversely affect our results.

Business Strategy

Our mission is to create long-term stockholder
value as a consumer health organization committed to making
peoples lives healthier and more secure. Our strategy to
achieve this mission is to continue the innovative expansion of
our health care services portfolio, increase membership in our
commercial and specialty businesses, and maintain and grow our
Medicare+Choice business. We intend to accomplish this by taking
advantage of opportunities in some markets to compete with the
standard government Medicare program for new members, and by
aligning our organization to meet the financial, health and
wellness needs of our members.

We believe that employers and consumers desire
innovative health care products that provide flexible network
benefit design and financing components. We are continuing to
design and offer new products such as our self-directed health
plan product, a low cost plan which offers incentives to
consumers to help contain costs through a broad based PPO
network, as well as tiered network products and value network
products that allow consumers to make trade-offs based upon
breadth of network, quality measures and costs.

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We operate one of the largest Medicare+Choice
programs in the United States and we have used our long
experience in working with seniors to operate our program
cost-effectively in what was a declining Medicare funding
environment. On December 8, 2003, the President signed the
new Medicare Prescription Drug, Improvement, and Modernization
Act of 2003, or DIMA, into law. This law increases the
Medicare+Choice reimbursement payment formula, creates a
prescription drug discount card program in 2004-2005 and
establishes a new Part D Medicare prescription drug benefit
beginning in 2006. With the changes in Medicare funding, we
expect to be able to improve our competitive position in
Medicare+Choice beginning in 2004 for the following reasons:



|  |                                                                                                                                                                                                                                                                                                                                    
|- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Increased government funding under the newly
    enacted DIMA legislation allows us to improve previously reduced
    benefits and reduce member premiums, co-payments and deductibles;                                                                                                                                            
| 
| | Enhanced benefits, such as prescription drugs and
    lower out-of-pocket payments, should also make our
    Medicare+Choice HMO more competitive with the governments
    traditional Medicare program. We already offer prescription drug
    coverage that will not be available under traditional Medicare
    until 2006; and
| 
| | We are well positioned to establish a greater
    market presence due to our long standing commitment to the
    Medicare+Choice market even during times when adequate funding
    may not have been available.                                                                                                                   

Products

We have developed products and services in order
to meet the needs of our commercial and senior customers. In
developing our products and marketing plans, we take into
account the differing needs of our customers and believe that we
create cost-effective, quality health care service options.

Commercial Products

Our commercial HMO and PPO products may be
offered on a stand-alone basis or may be bundled with our
specialty products and services, including PBM, behavioral
health services, group life and health insurance products, and
dental and vision services, providing employer groups and
individuals with more benefit options from a single source and
the ability to design tailored benefit programs. We also sell
our specialty products and services on a stand-alone basis to
unaffiliated health plans and employer groups.

Our HMO plans provide health care benefits to
commercial members through a defined provider network in which
members typically pay a fixed copayment for services accessed.
We have a broad network that as of December 31, 2003
included approximately 700 hospitals and 63,000 primary care and
specialty physicians.

Our PPO network supplements our existing HMO
network with additional health care providers and generally
provides members with a broad selection of providers in any
given geographic area. Additionally, access is extended to
health care providers located outside of a given geographic area
through out-of-network benefits that allow choice beyond the
organized PPO network in exchange for reduced coverage or higher
coinsurance or copayments. Our PPO products provide members open
access to network providers, with no primary care physician
coordinating care and simplified medical management practices.

We target a variety of plan sponsors including
employer groups and other purchasing coalitions, as well as
state and federal government agencies. We offer both HMO and PPO
products in a broad spectrum of customer segments ranging from
individuals and small groups to large employers. We also have
contracts with the United States Office of Personnel Management,
or OPM, to provide HMO services to members under the Federal
Employee Health Benefit Program, or FEHBP, for federal
employees, annuitants and their dependents.

2



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As of December 31, 2003, we had
approximately 2 million commercial HMO numbers and over
182,000 enrollees in our PPO products.

Specialty Products

We use our existing employer group and senior
relationships to offer our specialty products and services in
conjunction with our commercial and senior products. These
specialty products and services include PBM, behavioral health
services, group life and health insurance products, and dental
and vision services. In addition, we sell our specialty products
and services to unaffiliated health plans, union trusts, third
party administrators and employer groups.

Prescription
Solutions®. Prescription
Solutions offered integrated PBM services (including mail order
pharmacy services) to approximately 5 million people,
including approximately 682,000 seniors, as of December 31,
2003. Prescription Solutions offers a broad range of innovative
programs, products and services designed to enhance clinical
outcomes with appropriate financial results for employers and
members.

We believe Prescription Solutions strength
lies in its ability to influence medical outcomes and reduce
overall health care costs by focusing on appropriate
prescription drug use. For example, through its formulary
management program, Prescription Solutions uses lists of
physician-recommended drugs in different therapeutic classes
that have been reviewed for safety, efficacy and value to ensure
that drugs prescribed are the lowest cost option among equally
effective alternatives. Prescription Solutions operates
independently of pharmaceutical or retail drug organizations,
which allows it to focus primarily on improving clinical
outcomes.

We believe that Prescription Solutions mail
order capabilities also differentiate us from our health
insurance competitors who do not have captive PBMs. Prescription
Solutions operates an 84,000 square foot, fully automated
facility in Carlsbad, California, which we believe can support
our projected internal growth for the foreseeable future.
Prescription Solutions aggressively promotes mail order pharmacy
services as a convenient and cost-effective service for our
members.

Behavioral Health Services.We provide behavioral health care
services including managed mental health, employee assistance,
care management and chemical dependency benefit programs. As of
December 31, 2003, we provided these behavioral health care
services to approximately 3.7 million affiliated and
unaffiliated members through our provider network. Managed
mental health and chemical dependency services are offered as a
standard part of most of our commercial health plans and are
sold in conjunction with our other commercial and Medicare
products, and are sold on a stand-alone basis to unaffiliated
health plans and employer groups.

Dental and Vision Services.We provide a broad range of dental and
vision insurance and discount services. Plans include HMO, PPO
and indemnity fee-for-service dental, and PPO vision benefits to
individuals and employer groups. We also provide dental services
to seniors through Secure Horizons. We provide a complete range
of dental and vision product offerings for small, mid-size and
large employers, regardless of their existing medical plan
offering. As of December 31, 2003, we provided these dental
and vision services to approximately 720,000 affiliated and
unaffiliated members.

Group Life and Health Insurance.We are licensed to issue life and
health care insurance in 40 states, including each of the
states where our HMOs operate, the District of Columbia and
Guam. By marketing our commercial health care product line in
conjunction with supplemental insurance products, we are able to
offer multi-option health and financial benefit programs. Other
supplementary benefits offered to employer groups include basic
life insurance, group term life insurance, indemnity dental and
indemnity behavioral health benefits. We also offer life,
accidental death and dismemberment and short-term and long-term
disability products to our commercial

3



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employer groups under a private label arrangement
with Continental Assurance Company, Continental Casualty Company
and CNA Group Life Assurance Company.


Senior Products

We offer eligible Medicare beneficiaries access
to Medicare+Choice and Medicare Supplement products through our
Secure Horizons programs.

Medicare+Choice HMO.We are one of the largest
Medicare+Choice HMOs in the United States as measured by
membership with approximately 682,000 members as of
December 31, 2003. Medicare is a federal program that
provides persons age 65 and over and some disabled persons under
the age of 65 a variety of hospital and medical insurance
benefits. Most individuals eligible for Medicare are entitled to
receive inpatient hospital care under Part A without the payment
of any premium, but are required to pay a premium to the federal
government, which is adjusted annually, to be eligible for
physician care and other services under Part B. Even though
they participate in both Part A and Part B of the
traditional Medicare program, beneficiaries are still required
to pay out-of-pocket deductibles and coinsurance.

We contract with the Centers for Medicare and
Medicaid Services, or CMS, under the Medicare+Choice program to
provide health insurance coverage in exchange for a fixed
monthly payment per member that varies based on the geographic
areas in which the members reside. Individuals who elect to
participate in the Medicare+Choice program are relieved of the
obligation to pay some or all of the deductible or coinsurance
amounts and may receive benefits greater than the government
program such as pharmacy drug coverage, but are generally
required to use the services provided by the HMO exclusively and
are required to pay a Part B premium to the Medicare
program. These individuals also may be required to pay a monthly
premium to the HMO.

Medicare Supplement Products.We are licensed in 22 states to offer
group and individual senior supplement products and have
licenses pending in ten states. These products are designed to
fill gaps left by traditional Medicare coverage. For example,
the Individual Supplement products pay for hospital deductibles,
physician copayments and coinsurance for which an individual
enrolled in the traditional Medicare program would otherwise be
responsible. The Senior Supplement product provides employer
groups with similar coverage options for their Medicare eligible
retirees. The Secure Horizons Prescription Advantages Plan has
no annual deductible, no annual maximums, and provides unlimited
coverage for approximately 400 generic medications covering many
chronic conditions and ailments. This plan offers discounts on
most other drugs depending on how the drugs are purchased.

Physician and Hospital Relationships

Contracting Arrangements with Physicians
and Hospitals

We maintain a network of qualified physicians,
hospitals and other health care providers in every geographic
area where we offer managed care products and services. Our
contracting strategy is to base the type of contract utilized on
our assessment of the underlying structure and strengths of the
medical communities within the applicable geographic markets. In
HMO markets with physicians and hospitals that we believe have
the necessary infrastructure and financial strength to accept
delegation for certain administrative services and prepayment
for health care services, we may elect to use delegation and
capitation contracts. In other circumstances, we may elect to
use fee-for-service or other shared risk arrangements. Most of
our physician and hospital contracts have a one-year term,
however, we may also enter into multiple-year contracts with
physician groups and hospitals to enhance network stability or
provide greater predictability of future health care costs.
Contracts for our PPO products are all fee-for-service.

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Our provider contracting processes include
analysis and modeling of underlying cost and utilization
assumptions. Through these processes, we continually seek to
identify strategies to better manage health care costs. We also
focus on provider consultation and management tools, including
thorough data reporting and financial analysis of expected
performance of our contracts.

Underwriting

In establishing premium rates for our health care
plans, we use underwriting criteria based upon our accumulated
actuarial data, with adjustments for factors such as the
physicians and hospitals utilized, claims experience, member
demographic mix and industry differences. Predictive models
using pharmacy data and health status are also used to identify
health care costs that are likely to emerge. Our underwriting
practices are filed and approved in states requiring those
actions and in all states in which we operate in the individual,
small group and Medicare Supplement markets. Because our members
are in multiple states, our underwriting practices, especially
in the individual, small group and Medicare Supplement markets,
are subject to a variety of legislative and regulatory
requirements and restrictions unique to the state in which a
member resides.

Medical Management

Our profitability depends, in part, on our
ability to control health care costs while providing quality
care. Our medical management staff consists of doctors and
nurses who monitor the medical treatment of our members in need
of hospital and specialist care. In some cases, our medical
managers are located on-site at some of our key hospitals.

Our medical management programs include:



|  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Chronic Disease Management.We have created a wide range of
    disease management programs designed to provide specialized
    services to members with chronic disease states including among
    others, congestive heart failure, end-stage renal disease,
    chronic obstructive pulmonary disease and cancer. These programs
    focus on prevention, member education, and evidence-based care
    to improve our members lifestyle and reduce unnecessary or
    preventable hospitalization costs. These programs may be
    developed and managed internally or we may contract with third
    parties who have specialized expertise or technology within a
    specific diagnostic category;                                                                                                                                                                                                        
| 
| | Precertification of Admission.In the precertification stage, our
    medical managers verify that requests for hospitalization and
    specified health care procedures meet specific clinical criteria
    and are approved in advance;                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
| 
| | Concurrent Review.Once our member has been admitted to
    the hospital for care, our on-site or telephonic medical
    managers provide administrative oversight of the hospitalization
    process. Our medical managers also monitor the discharge process
    and coordinate any outpatient services needed by the patient,
    including skilled nursing facility, home nursing care and
    rehabilitation therapy. We also contract with hospitalists to
    assist us in managing the care of hospitalized patients.
    Hospitalists are physicians who specialize in coordinating the
    care of patients during their stay in a hospital, including
    oversight of patients in the emergency room, coordinating
    appropriate admissions and level of care (including intensive
    care when appropriate), coordinating consultations with
    subspecialists and ordering tests and procedures;
| 
| | Retrospective Review.Our retrospective review process
    involves confirming our certifications of services provided to
    our members when our medical management staff has not been
    concurrently involved in the hospitalization of our members.
    This process can also occur when our members receive emergency
    care at an out-of-area hospital or when medical claims may be
    disputed; and                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
| 
| | Case Management.Our
    case management department provides multi-disciplinary
    coordination of personalized care for patients with complex
    medical conditions, including arranging access to                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             

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| |                                                                                                                                                                                                                                                                      
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | appropriate medical and social services, to
    improve the health status and manage health care costs for these
    patients; in addition, specific case management programs have
    been implemented for the frail member and those with
    terminal illnesses.

Marketing

Our commercial products are marketed under the
PacifiCare brand, which we believe has a reputation for quality
and value. Our senior products are marketed under the Secure
Horizons name, which we believe is one of the premier service
marks in health care services among seniors in our markets in
the western United States. We market our specialty products
under the PacifiCare brand and our third-party unaffiliated PBM
services under our Prescription Solutions service mark.

Marketing to our large group commercial customers
is typically a two-step process in which we first market to the
employer, then market directly to employees, primarily during
their open enrollment periods, once the employer has selected
our plan. For many of our larger commercial accounts the open
enrollment periods typically occur during the fourth quarter of
the calendar year. For some employer groups, we are the
exclusive provider of health care products for their employees
on a full-replacement basis. We also offer individual commercial
products directly to consumers.

We use various techniques to attract commercial
members, including work site presentations, direct mail, medical
group tours and local advertising. We also use television,
radio, billboard and print media to market our programs to
potential commercial members. Further, we utilize multiple
distribution channels such as general agents, an on-line price
quoting service, and insurance brokers and consultants who
represent many employer groups. These brokers and consultants
work directly with employers to recommend or design employee
benefits packages and select carriers to provide these services.

We believe that our understanding of the senior
population and our attention to customer service differentiates
our Secure Horizons program from competing products. We market
our Secure Horizons programs to Medicare beneficiaries and
caregivers for Medicare beneficiaries primarily through direct
mail, telemarketing, our website, television, radio and
community-based events with participating physician groups. Most
Secure Horizons members enroll directly in a plan, generally
without the involvement of insurance brokers, except when
enrolling as part of an employer group retiree offering. We also
have a national broker channel for some of our individual
Medicare Supplement and Prescription Advantages products.

Management Information Systems and Claims
Processing

We use computer-based information systems for
various purposes, including e-commerce, marketing and sales
tracking, underwriting, billing, claims processing, medical
management, medical cost and utilization trending, financial and
management accounting, reporting, planning and analysis. These
systems also support on-line customer service functions,
provider and member administration functions, and support our
tracking and extensive analyses of health care costs and outcome
data.

We have established corporate goals to have our
information technology, or IT, systems operate under one
business platform and improve operational efficiency.
Simplification and integration of the systems servicing our
business are important components of controlling health care and
administrative expenses and improving member satisfaction. To
accomplish these goals, we have outsourced data processing
operations and maintenance of older software applications so we
can focus internally on new technologies. Additionally, we are
opportunistically insourcing data center operations and software
development as part of our long-term sourcing strategy.

We use these computer-based information systems
as an important component of claims processing. We receive
medical claims from physicians and hospitals for services to our
members. Claims are

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reviewed to determine member eligibility, the
quantity and kind of services performed and whether services
were authorized, then adjudicated against pricing, claims rules
and benefits. To help ensure timely and accurate payments, we
regularly review reports on inventory levels and claims
statistics that focus on claims turn-around time and accuracy of
payment processing. We also perform a variety of claim audits
and cost containment programs. We have significantly increased
the number and percentage of claims processed electronically to
improve claims turnaround times and accuracy.


Government Regulation

General HMO and Indemnity
Regulation

We are subject to extensive federal and state
regulations that govern the scope of benefits provided to our
members. These regulations can vary significantly from
jurisdiction to jurisdiction. Broad latitude is given to the
agencies administering these regulations. Changes in applicable
laws and regulations are continually being considered, and the
interpretation of existing laws and rules also may change
periodically. Existing and future laws and rules could force to
change how we do business, restrict revenue and enrollment
growth, increase our health care and administrative costs and
capital requirements and increase our liability in federal and
state courts for coverage determinations, contract
interpretation and other actions. We must obtain and maintain
regulatory approvals to market many of our products, to increase
prices for certain regulated products and to consummate
acquisitions and dispositions of health plans.

We participate in federal, state and local
government health care coverage programs. These programs
generally are subject to frequent change, including changes that
may reduce the number of persons enrolled or eligible, reduce
the amount of reimbursement or payment levels, or increase our
administrative or health care costs under such programs. Such
changes have adversely affected our financial results and
willingness to participate in such programs in the past and may
do so in the future.

State legislatures and Congress continue to focus
on health care issues. Bills and regulations at state and
federal levels may affect certain aspects of our business,
including:



|  |                                                                                                                                                                                                                            
|- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | increasing minimum capital or risk-based capital,
    or RBC, requirements;                                                                                                                                                
| 
| | mandating benefits and products;                                                                                                                                                                                           
| 
| | restricting a health plans ability to limit
    coverage to medically necessary care;                                                                                                                                     
| 
| | reducing the reimbursement or payment levels for
    government funded programs;                                                                                                                                           
| 
| | imposing guidelines for pharmaceutical
    manufacturers that would cause pharmaceutical companies to
    restructure the financial terms of their business arrangements
    with PBMs, HMOs or other health plans;        
| 
| | patients bill of rights legislation at the
    state and federal level that would hold HMOs liable for medical
    malpractice;                                                                                           
| 
| | limiting a health plans ability to capitate
    physicians and hospitals or delegate financial risk, utilization
    review, quality assurance or other medical decisions to our
    contracting physicians and hospitals;
| 
| | restricting a health plans ability to
    select and terminate providers in our networks;                                                                                                                                 
| 
| | allowing independent physicians to collectively
    bargain with health plans on a number of issues, including
    financial compensation;                                                                                 
| 
| | adding further restrictions and administrative
    requirements on the use, retention, transmission, processing,
    protection and disclosure of personally identifiable health
    information; and                      

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|  |                                                                                                                                                               
|- | --------------------------------------------------------------------------------------------------------------------------------------------------------------
| | tightening time periods for the timely payment
    and administration of health care claims and imposing financial
    and other penalties for non-compliance.

Office of Personnel
Management

We have commercial contracts with OPM to provide
managed health care services to federal employees, annuitants
and their dependents under FEHBP. Rather than negotiating rates
with us, OPM requires us to provide the FEHBP with rates
comparable to the rates charged to the two employer groups with
enrollment closest in size to the FEHBP in the applicable
community after making required adjustments. OPM further
requires us to certify each year that its rates meet these
requirements. Periodically, the Office of the Inspector General,
or OIG, audits us to verify that the premiums charged are
calculated and charged in compliance with these regulations and
guidelines. OPM has the right to audit the premiums charged
during any period for up to five years following the end of that
contract year. The final resolution and settlement of audits
have historically taken more than three years and as many as
seven years. We have a formal compliance program to specifically
address potential issues that may arise from the FEHBP rating
process, to work with OPM to understand its interpretation of
the rules and guidelines prior to completion of the rating
process, to standardize the FEHBP rating process among all of
our HMOs, and to help reduce the likelihood that future
government audits will result in any significant findings.

Required Statutory Capital

By law, regulation and governmental policy, our
HMO, indemnity and regulated specialty product subsidiaries,
which we refer to as our regulated subsidiaries, are required to
maintain minimum levels of statutory net worth. The minimum
statutory net worth requirements differ by state and are
generally based on a percentage of annualized premium revenue, a
percentage of annualized health care costs or RBC requirements.
The RBC requirements are based on guidelines established by the
National Association of Insurance Commissioners, or NAIC. If
adopted, the RBC requirements may be modified as each state
legislature deems appropriate for that state. The RBC formula,
based on asset risk, underwriting risk, credit risk, business
risk and other factors, generates the authorized control level,
or ACL, which represents the minimum amount of net worth
believed to be required to support the regulated entitys
business. For states in which the RBC requirements have been
adopted, the regulated entity typically must maintain the
greater of the required ACL or the minimum statutory net worth
requirement calculated pursuant to pre-RBC guidelines. As of
December 31, 2003, the aggregate net worth of our regulated
subsidiaries exceeded 300% of the aggregate ACL calculated under
NAIC RBC guidelines. The amount of statutory capital in excess
of state regulatory requirements was approximately
$614 million as of December 31, 2003. In addition to
the foregoing requirements, our regulated subsidiaries are
subject to restrictions on their ability to make dividend
payments, loans and other transfers of cash to the parent
company.

The statutory framework for our regulated
subsidiaries statutory net worth requirements may change
over time. These subsidiaries are also subject to their state
regulators overall oversight powers. Those regulators
could require our subsidiaries to maintain minimum levels of
statutory net worth in excess of the amount required under the
applicable state laws if the regulators determine that
maintaining such additional statutory net worth is in the best
interest of our members.

Pharmacy Regulations

Our PBM business is subject to state and federal
statutes and regulations governing the operation of pharmacies,
labeling, packaging and repackaging of drug products, dispensing
of controlled substances, disposal, advertising, security,
recordkeeping and inventory control.

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Many states have laws and regulations that
require out-of-state internet and mail-service pharmacies to
register with, or be licensed by, the board of pharmacy or a
similar regulatory body in the state. Other states generally
permit the dispensing pharmacy to follow the laws of the state
within which the dispensing pharmacy is located. Various other
states, however, have enacted laws requiring, among other
things, the hiring of a pharmacist licensed by that state or
compliance with all laws of the states into which the
out-of-state pharmacy dispenses medications, whether or not
those laws conflict with the laws of the state in which the
pharmacy is located. If these laws are applicable to us, they
could restrict or prevent us from providing prescription
internet or mail order in those states.

Other specific laws or regulations that may
affect our PBM business include those that address any willing
provider, contract limitations, benefit mandates, pharmacy
management restrictions, limitations on price negotiations,
changes in Medicaid best price rules, and the
conduct of clinical trials.

Privacy Regulations

The use of individually identifiable data by our
businesses is regulated at international, federal, state and
local levels. These laws and rules are changed frequently by
legislation or administrative interpretation. Various state laws
address the use and maintenance of individually identifiable
health data. Most are derived from the privacy provisions in the
federal Gramm-Leach-Bliley Act and the Health Insurance
Portability and Accountability Act of 1996, or HIPAA. HIPAA also
imposes guidelines on our business associates (as this term is
defined in the HIPAA regulations). Even though we provide for
appropriate protections through our contracts with our business
associates, we still have limited control over their actions and
practices. Compliance with these proposals and new regulations
may result in cost increases due to necessary systems changes,
the development of new administrative processes, and the effects
of potential noncompliance by our business associates. They also
may impose further restrictions on our use of patient
identifiable data that is housed in one or more of our
administrative databases.

Risk Management

We maintain general liability, property,
directors and officers liability and managed care
errors and omissions, which includes medical malpractice,
insurance coverage. Policies typically include varying and
increasing levels of self-insured retention or deductibles that
increase our risk of loss. We operate a wholly owned captive
insurance company designed to assist us primarily in managing
the risk of loss associated with our retained risk on errors and
omissions claims and catastrophic medical claims. We require
contracting physicians, physician groups and hospitals to
maintain individual malpractice insurance coverage.

Competition

In offering HMOs, PPOs and related products, we
compete with CIGNA Corporation, Aetna Inc., Health Net, Inc.,
WellPoint Health Networks Inc. and Anthem Inc., who are
combining, other Blue Cross and Blue Shield plans and
UnitedHealth Group Incorporated for membership from national
employers. We also compete with regional HMOs and small group
employers, which vary depending on the geographic market.
Regional competitors include Kaiser Foundation Health Plan Inc.,
Health Net, Inc., WellPoint Health Networks Inc., Humana Inc.,
and the member companies of the Blue Cross and Blue Shield
Association. We also offer a regional alternative for national
employers who are willing to support multiple health plans to
maintain plans that best suit the needs of employees within a
specific region.

We are one of the largest Medicare+Choice health
plans measured in terms of membership in the nation, both in
absolute terms and as a percentage of overall membership,
offering competitive advantages and economies of scale in the
Medicare+Choice market. In 2002 and 2003, we reduced

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our benefits, raised member copays and
deductibles, and replaced coverage of brand name prescription
drugs with generic drugs in most of the counties where we
participate in Medicare+Choice. This was in response to the
rising health care costs of treating the senior population and
the inadequate rate of increase in levels of Medicare
reimbursement from the government. These changes caused members
to leave our plans for competing plans or traditional Medicare
coverage. Many competing HMO health plans also reduced their
participation in the Medicare+Choice program and reduced
benefits coverage.


Beginning in 2004, we expect to be able to
improve our competitive position in Medicare+Choice for the
following reasons:



|  |                                                                                                                                                                                                                                                                                                                                    
|- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Increased government funding under the newly
    enacted DIMA legislation allows us to improve previously reduced
    benefits and reduce member premiums, co-payments and deductibles;                                                                                                                                            
| 
| | Enhanced benefits, such as prescription drugs and
    lower out-of-pocket payments, should also make our
    Medicare+Choice HMO more competitive with the governments
    traditional Medicare program. We already offer prescription drug
    coverage that will not be available under traditional Medicare
    until 2006; and
| 
| | We are well positioned to establish a greater
    market presence due to our long standing commitment to the
    Medicare+Choice market even during times when adequate funding
    may not have been available.                                                                                                                   

Beginning in 2005, there is a greater risk that
competition among private health plans for Medicare+Choice
members could increase.

The Medicare Supplement product market is highly
fragmented with few large competitors. Our primary competition
in this market is the Medicare Supplement product marketed by
the American Association of Retired Persons, or AARP, and
underwritten by UnitedHealth Group Incorporated. We believe that
our product offerings and distribution channels differentiate
our Medicare Supplement products from competing products.

Prescription Solutions PBM services are
sold as part of our commercial and Medicare products and on a
stand-alone basis to unaffiliated health plans and employer
groups. We believe our competitors include Medco Health
Solutions Inc., MedImpact Healthcare Systems, Inc., Caremark Rx,
Inc., Express Scripts Inc. and AdvancePCS. We believe because it
is aligned with a managed care organization, Prescription
Solutions differentiates itself from other pharmacy benefit
organizations by managing prescription costs and outcomes for
managed care organization members. Our mail order prescription
drug service competes with national, regional and local
pharmacies and other mail order prescription drug companies.
Prescription Solutions also competes with firms offering
prescription discount cards, such as large drugstore chains.

The managed behavioral health care industry is
dominated by a few large companies, principally Magellan Health
Services, Inc. and ValueOptions, Inc., as well as the behavioral
health divisions of health insurers such as UnitedHealth Group
Incorporated and CIGNA Corporation. Our ability to compete is
affected by a limited national supply of providers, particularly
psychiatrists and psychiatric hospital units. Our behavioral
health subsidiary has a core competency in managing at-risk
contracts, which we believe differentiates us competitively in
states with mental health parity laws that mandate equal
coverage for mental health benefits.

We believe that to retain our health plans
competitive advantages we should continue to focus on developing
additional products and services and eliminate or limit growth
of unprofitable products. We believe that consumers want
products and services that go beyond basic necessity, extending
to

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areas such as lifestyle and wellness enhancing
products. The factors that we believe give us competitive
advantages are:




|  |                                                                                                                 
|- | ----------------------------------------------------------------------------------------------------------------
| | our existing market position in our geographic
    areas of operation;                                          
| 
| | our long-term operating experience in managed
    care;                                                         
| 
| | our marketplace reputation with physicians,
    hospitals, members and employers;                               
| 
| | a strong brand identity for PacifiCare, Secure
    Horizons and Prescription Solutions;                         
| 
| | our benefit design and flexibility of features
    for employers;                                               
| 
| | our QUALITY INDEX® profile, which provides
    customers with certain provider performance quality measures; and
| 
| | our emphasis on providing high quality customer
    service.                                                    

Intellectual Property

We own various federally registered trademarks,
service marks and other trade names. Some of the more material
marks we own include PacifiCare®, SecureHorizons®,
Prescription Solutions® and QUALITY INDEX®. There is
also a patent pending for certain methods used in creating our
QUALITY INDEX®.

Employees

At February 27, 2004, we had approximately
7,700 full and part-time employees. None of our employees is
presently covered by a collective bargaining agreement. We
consider relations with our employees to be good and have never
experienced any work stoppage.




ITEM
2.     PROPERTIES

As of December 31, 2003, we leased
approximately 184,000 aggregate square feet of space for our
principal corporate headquarters and executive offices in
Cypress and Santa Ana, California. In connection with our
operations, as of December 31, 2003, we leased
approximately 1.7 million aggregate square feet for office
space, subsidiary operations, customer service centers and space
for computer facilities. Such space corresponds to areas in
which our HMOs or specialty managed care products and services
operate, or where we have satellite administrative offices. Our
leases expire at various dates from 2004 through 2012.

In California and Guam, we own two buildings
encompassing approximately 225,000 aggregate square feet of
space primarily used for administrative operations. All of our
facilities are in good working condition, are well maintained
and are adequate for our present and currently anticipated
needs. We believe that we can rent additional space at
competitive rates when current leases expire, or if we need
additional space.




ITEM 3.     LEGAL
PROCEEDINGS

For information regarding our legal proceedings,
see Note 13 of the Notes to Consolidated Financial Statements.




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

No matter was submitted to a vote of security
holders during the three months ended December 31, 2003.

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PART II






|        |                                                                           
|------- | --------------------------------------------------------------------------
|ITEM 5. | MARKET FOR THE COMPANYS COMMON EQUITY
    AND RELATED STOCKHOLDER MATTERS

On June 6, 2003, our common stock listing
was transferred from the NASDAQ National Market under the symbol
PHSY to the New York Stock Exchange (NYSE) under the symbol PHS.

On January 20, 2004, we effected a
two-for-one stock split in the form of a stock dividend of one
share of our common stock for every share of common stock
outstanding to stockholders of record as of the close of
business on January 7, 2004. All share price and per share
data and numbers of common shares have been retroactively
adjusted to reflect the stock split. See Note 6 of the Notes to
Consolidated Financial Statements.

The following table indicates the high and low
reported sale prices per share as furnished by the NYSE and
NASDAQ.

|                             |  |      |       |     |  |   |       | 
|---------------------------- |  | ---- | ----- | --- |  | - | ----- | 
|                             |  | High |       | Low
|                             |  |      |       |    
|Year ended December 31, 2002 |  |      |       |     |  |   |       | 
|First Quarter                |  | $    | 11.67 |     |  | $ | 7.30  | 
|Second Quarter               |  | $    | 16.31 |     |  | $ | 8.48  | 
|Third Quarter                |  | $    | 13.33 |     |  | $ | 9.85  | 
|Fourth Quarter               |  | $    | 16.83 |     |  | $ | 10.65 | 
|Year ended December 31, 2003 |  |      |       |     |  |   |       | 
|First Quarter                |  | $    | 14.87 |     |  | $ | 10.47 | 
|Second Quarter               |  | $    | 25.99 |     |  | $ | 11.38 | 
|Third Quarter                |  | $    | 29.63 |     |  | $ | 23.35 | 
|Fourth Quarter               |  | $    | 34.20 |     |  | $ | 24.17 | 

We have never paid cash dividends on our common
stock. We do not expect to declare cash dividends on our common
stock in the future, retaining all earnings for business
development. Any possible future dividends will depend on our
earnings, financial condition, and regulatory requirements. If
we decide to declare dividends on our common stock in the
future, such dividends may only be made in compliance with our
senior credit facility and our 10 3/4% senior notes.

As of February 27, 2004 there were
293 stockholders of record of our common stock.

We have $135 million in aggregate principal
amount of 3% convertible subordinated debentures due in 2032
outstanding. The debentures are convertible into 6,428,566
shares of common stock under certain conditions, including
satisfaction of a market price condition for our common stock,
satisfaction of a trading price condition relating to the
debentures, upon notice of redemption, or upon specified
corporate transactions. Each $1,000 of the debentures is
convertible into 47.619 shares of our common stock. The
market price condition for conversion of the debentures is
satisfied if the closing sale price of our common stock exceeds
110% of the conversion price (which is calculated at
$23.10 per share) for the debentures for at least
20 trading days in the 30 consecutive trading days
ending on the last trading day of any fiscal quarter. In the
event that the market price condition is satisfied during any
fiscal quarter, the debentures are convertible, at the option of
the holder, during the following fiscal quarter. The market
price condition is evaluated each quarter to determine whether
the debentures will be convertible at the option of the holder
during the following fiscal quarter. During the fiscal year
ended December 31, 2003, the market price condition
described above was satisfied for the quarters ended
September 30, 2003 and December 31, 2003. As a result,
the debentures were convertible during the quarter ended
December 31, 2003 and remain convertible at the option of
the holder at any time during the quarter ended March 31,
2004. While no debentures

12



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were converted as of December 31, 2003, they
are considered common stock equivalents and are included in the
calculation of weighted average shares outstanding on a diluted
basis for the fourth quarter and fiscal year ended
December 31, 2003.


Beginning in October 2007, we may redeem for cash
all or any portion of the debentures, at a purchase price of
100% of the principal amount plus accrued interest, upon not
less than 30 nor more than 60 days written notice to the
holders. Beginning in October 2007, and in successive 5-year
increments, our holders may require us to repurchase the
debentures for cash at a repurchase price of 100% of the
principal amount plus accrued interest. Our payment obligations
under the debentures are subordinated to our senior
indebtedness, and effectively subordinated to all indebtedness
and other liabilities of our subsidiaries.

In November 2003, we issued 7.6 million
shares of our common stock in a public offering. The net
proceeds from the offering, approximately $200 million
after underwriting fees, were used to redeem $175 million
in principal of the companys outstanding 10 3/4%
senior notes. See Note 5 of the Notes to Consolidated Financial
Statements.

With respect to information regarding our
securities authorized for issuance under equity incentive plans,
the information contained in the section entitled Equity
Compensation Plan Information of our definitive Proxy
Statement for the 2004 Annual Meeting of Stockholders is
incorporated herein by reference.

13



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ITEM 6.     SELECTED
FINANCIAL DATA

The following selected financial and operating
data are derived from our audited consolidated financial
statements. The selected financial and operating data should be
read in conjunction with Item 7. Managements
Discussion and Analysis of Financial Condition and Results of
Operations, and also with Item 15. Exhibits,
Financial Statement Schedules and Reports on Form 8-K.

Income Statement Data

|                                                                                                                        |                                                                                                             |                                               |            |           |   |         |            |           |   |         |            |            |   |   |            |           |   |   |            |           |  
|----------------------------------------------------------------------------------------------------------------------- | ----------------------------------------------------------------------------------------------------------- | --------------------------------------------- | ---------- | --------- | - | ------- | ---------- | --------- | - | ------- | ---------- | ---------- | - | - | ---------- | --------- | - | - | ---------- | --------- | -
|                                                                                                                        |                                                                                                             |                                              
|                                                                                                                        |                                                                                                             | Year Ended December 31,                      
|                                                                                                                        |                                                                                                             |                                              
|                                                                                                                        |                                                                                                             | 2003                                          |            | 2002(2)   |   | 2001(3) |            | 2000(4)   |   | 1999(5)
|                                                                                                                        |                                                                                                             |                                               |            |           |   |         |            |           |   |        
|                                                                                                                        |                                                                                                             |                                              
|                                                                                                                        |                                                                                                             | (Amounts in thousands, except per-share data)
|Operating revenue                                                                                                       |                                                                                                             | $                                             | 11,008,511 |           |   | $       | 11,156,502 |           |   | $       | 11,843,972 |            |   | $ | 11,576,298 |           |   | $ | 10,073,140 |          
|                                                                                                                        |                                                                                                             |                                               |            |           |   |         |            |           |   |         |            |            |   |   |            |           |   |   |            |          
|Expenses:                                                                                                               |                                                                                                             |                                               |            |           |   |         |            |           |   |         |            |            |   |   |            |           |   |   |            |          
|                                                                                                                        | Health care services and other                                                                              |                                               |            | 9,065,794 |   |         |            | 9,485,701 |   |         |            | 10,367,657 |   |   |            | 9,913,657 |   |   |            | 8,368,690 |  
|                                                                                                                        | Selling, general and administrative expenses                                                                |                                               |            | 1,452,542 |   |         |            | 1,370,160 |   |         |            | 1,288,374  |   |   |            | 1,286,790 |   |   |            | 1,181,773 |  
|                                                                                                                        | Impairment, disposition, restructuring, Office of
    Personnel Management and other charges (credits), net |                                               |            |          |   |         |            | 3,774     |   |         |            | 61,157     |   |   |            | 8,766     |   |   |            | (2,233    | )
|                                                                                                                        |                                                                                                             |                                               |            |           |   |         |            |           |   |         |            |            |   |   |            |           |   |   |            |          
|Operating income                                                                                                        |                                                                                                             |                                               | 490,175    |           |   |         | 296,867    |           |   |         | 126,784    |            |   |   | 367,085    |           |   |   | 524,910    |          
|Interest expense, net                                                                                                   |                                                                                                             |                                               | (100,531   | )         |   |         | (74,904    | )         |   |         | (70,282    | )          |   |   | (79,636    | )         |   |   | (43,001    | )        
|Minority interest in consolidated subsidiary                                                                            |                                                                                                             |                                               |           |           |   |         |           |           |   |         |           |            |   |   | 637        |           |   |   |           |          
|                                                                                                                        |                                                                                                             |                                               |            |           |   |         |            |           |   |         |            |            |   |   |            |           |   |   |            |          
|Income before income taxes                                                                                              |                                                                                                             |                                               | 389,644    |           |   |         | 221,963    |           |   |         | 56,502     |            |   |   | 288,086    |           |   |   | 481,909    |          
|Provision for income taxes                                                                                              |                                                                                                             |                                               | 146,896    |           |   |         | 82,792     |           |   |         | 38,371     |            |   |   | 127,046    |           |   |   | 203,365    |          
|                                                                                                                        |                                                                                                             |                                               |            |           |   |         |            |           |   |         |            |            |   |   |            |           |   |   |            |          
|Income before cumulative effect of a change in
    accounting principle and extraordinary gain                          |                                                                                                             |                                               | 242,748    |           |   |         | 139,171    |           |   |         | 18,131     |            |   |   | 161,040    |           |   |   | 278,544    |          
|Cumulative effect of a change in accounting
    principle(1)                                                            |                                                                                                             |                                               |           |           |   |         | (897,000   | )         |   |         |           |            |   |   |           |           |   |   |           |          
|Extraordinary gain on early retirement of debt
    (less income taxes of $0.9 million)                                  |                                                                                                             |                                               |           |           |   |         |           |           |   |         | 875        |            |   |   |           |           |   |   |           |          
|                                                                                                                        |                                                                                                             |                                               |            |           |   |         |            |           |   |         |            |            |   |   |            |           |   |   |            |          
|Net income (loss)                                                                                                       |                                                                                                             | $                                             | 242,748    |           |   | $       | (757,829   | )         |   | $       | 19,006     |            |   | $ | 161,040    |           |   | $ | 278,544    |          
|                                                                                                                        |                                                                                                             |                                               |            |           |   |         |            |           |   |         |            |            |   |   |            |           |   |   |            |          
|Basic earnings (loss) per share (1):                                                                                    |                                                                                                             |                                               |            |           |   |         |            |           |   |         |            |            |   |   |            |           |   |   |            |          
|                                                                                                                        | Income before cumulative effect of a change in
    accounting principle and extraordinary gain              |                                               | $          | 3.26      |   |         | $          | 1.98      |   |         | $          | 0.27       |   |   | $          | 2.29      |   |   | $          | 3.13      |  
|                                                                                                                        | Cumulative effect of a change in accounting
    principle                                                   |                                               |            |          |   |         |            | (12.73    | ) |         |            |           |   |   |            |          |   |   |            |          |  
|                                                                                                                        | Extraordinary gain, net                                                                                     |                                               |            |          |   |         |            |          |   |         |            | 0.01       |   |   |            |          |   |   |            |          |  
|                                                                                                                        |                                                                                                             |                                               |            |           |   |         |            |           |   |         |            |            |   |   |            |           |   |   |            |          
|                                                                                                                        | Basic earnings (loss)per share                                                                              |                                               | $          | 3.26      |   |         | $          | (10.75    | ) |         | $          | 0.28       |   |   | $          | 2.29      |   |   | $          | 3.13      |  
|                                                                                                                        |                                                                                                             |                                               |            |           |   |         |            |           |   |         |            |            |   |   |            |           |   |   |            |          
|Diluted earnings (loss) per share (1):                                                                                  |                                                                                                             |                                               |            |           |   |         |            |           |   |         |            |            |   |   |            |           |   |   |            |          
|                                                                                                                        | Income before cumulative effect of a change in
    accounting principle and extraordinary gain              |                                               | $          | 3.04      |   |         | $          | 1.98      |   |         | $          | 0.26       |   |   | $          | 2.29      |   |   | $          | 3.11      |  
|                                                                                                                        | Cumulative effect of a change in accounting
    principle                                                   |                                               |            |          |   |         |            | (12.73    | ) |         |            |           |   |   |            |          |   |   |            |          |  
|                                                                                                                        | Extraordinary gain, net                                                                                     |                                               |            |          |   |         |            |          |   |         |            | 0.01       |   |   |            |          |   |   |            |          |  
|                                                                                                                        |                                                                                                             |                                               |            |           |   |         |            |           |   |         |            |            |   |   |            |           |   |   |            |          
|                                                                                                                        | Diluted earnings (loss) per share                                                                           |                                               | $          | 3.04      |   |         | $          | (10.75    | ) |         | $          | 0.27       |   |   | $          | 2.29      |   |   | $          | 3.11      |  
|                                                                                                                        |                                                                                                             |                                               |            |           |   |         |            |           |   |         |            |            |   |   |            |           |   |   |            |          
|Operating Statistics                                                                                                    |                                                                                                             |                                               |            |           |   |         |            |           |   |         |            |            |   |   |            |           |   |   |            |          
|Fully-insured risk medical loss ratios:                                                                                 |                                                                                                             |                                               |            |           |   |         |            |           |   |         |            |            |   |   |            |           |   |   |            |          
|                                                                                                                        | Consolidated                                                                                                |                                               |            | 84.0      | % |         |            | 86.8      | % |         |            | 89.7       | % |   |            | 87.5      | % |   |            | 84.8      | %
|                                                                                                                        | Private  Commercial                                                                                        |                                               |            | 84.0      | % |         |            | 87.1      | % |         |            | 89.3       | % |   |            | 85.1      | % |   |            | 81.7      | %
|                                                                                                                        | Private  Senior                                                                                            |                                               |            | 63.4      | % |         |            | 53.5      | % |         |            | 79.7       | % |   |            |          |   |   |            |          |  
|                                                                                                                        | Private  Consolidated                                                                                      |                                               |            | 83.7      | % |         |            | 86.7      | % |         |            | 89.2       | % |   |            | 85.1      | % |   |            | 81.7      | %
|                                                                                                                        | Government  Senior                                                                                         |                                               |            | 84.2      | % |         |            | 86.9      | % |         |            | 90.1       | % |   |            | 89.4      | % |   |            | 86.9      | %
|                                                                                                                        | Government  Consolidated                                                                                   |                                               |            | 84.2      | % |         |            | 86.9      | % |         |            | 90.1       | % |   |            | 89.4      | % |   |            | 86.9      | %
|Selling, general and administrative expenses as a
    percentage of operating revenue (excluding net investment income) |                                                                                                             |                                               | 13.3       | %         |   |         | 12.4       | %         |   |         | 11.0       | %          |   |   | 11.2       | %         |   |   | 11.8       | %        
|Operating income as a percentage of operating
    revenue                                                               |                                                                                                             |                                               | 4.5        | %         |   |         | 2.7        | %         |   |         | 1.1        | %          |   |   | 3.2        | %         |   |   | 5.2        | %        
|Effective tax rate(6)                                                                                                   |                                                                                                             |                                               | 37.7       | %         |   |         | 37.3       | %         |   |         | 67.9       | %          |   |   | 44.1       | %         |   |   | 42.2       | %        

See footnotes following Balance Sheet
Data.

Continued on next page


14



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##### Table of Contents



Other Financial and Operating Data

|                                                              |  |                        |           |      |  |      |           |      |  |      |           |   |  |   |           |   |  |   |           |  
|------------------------------------------------------------- |  | ---------------------- | --------- | ---- |  | ---- | --------- | ---- |  | ---- | --------- | - |  | - | --------- | - |  | - | --------- | -
|                                                              |  |                       
|                                                              |  | December 31,          
|                                                              |  |                       
|                                                              |  | 2003                   |           | 2002 |  | 2001 |           | 2000 |  | 1999
|                                                              |  |                        |           |      |  |      |           |      |  |     
|                                                              |  |                       
|                                                              |  | (Dollars in thousands)
|Depreciation and amortization                                 |  | $                      | 66,621    |      |  | $    | 73,884    |      |  | $    | 148,704   |   |  | $ | 130,563   |   |  | $ | 118,097   |  
|Capital expenditures                                          |  | $                      | 52,271    |      |  | $    | 59,274    |      |  | $    | 77,301    |   |  | $ | 105,256   |   |  | $ | 66,211    |  
|Net cash flows provided by operating activities               |  | $                      | 414,130   |      |  | $    | 242,379   |      |  | $    | 38,923    |   |  | $ | 631,236   |   |  | $ | 569,698   |  
|Net cash flows (used in) provided by investing
    activities |  | $                      | (201,700  | )    |  | $    | (278,137  | )    |  | $    | (260,828  | ) |  | $ | 72,376    |   |  | $ | (250,859  | )
|Net cash flows provided by (used in) financing
    activities |  | $                      | 34,303    |      |  | $    | 9,688     |      |  | $    | (51,971   | ) |  | $ | (301,041  | ) |  | $ | (194,411  | )
|Membership Data                                               |  |                        |           |      |  |      |           |      |  |      |           |   |  |   |           |   |  |   |           |  
|Commercial                                                    |  |                        | 2,202,900 |      |  |      | 2,361,900 |      |  |      | 2,520,400 |   |  |   | 3,061,200 |   |  |   | 2,728,300 |  
|Senior                                                        |  |                        | 709,200   |      |  |      | 776,100   |      |  |      | 959,500   |   |  |   | 1,057,200 |   |  |   | 1,014,600 |  
|                                                              |  |                        |           |      |  |      |           |      |  |      |           |   |  |   |           |   |  |   |           |  
|Total HMO and other membership                                |  |                        | 2,912,100 |      |  |      | 3,138,000 |      |  |      | 3,479,900 |   |  |   | 4,118,400 |   |  |   | 3,742,900 |  
|                                                              |  |                        |           |      |  |      |           |      |  |      |           |   |  |   |           |   |  |   |           |  
|Balance Sheet Data                                            |  |                        |           |      |  |      |           |      |  |      |           |   |  |   |           |   |  |   |           |  
|Cash and equivalents                                          |  | $                      | 1,198,422 |      |  | $    | 951,689   |      |  | $    | 977,759   |   |  | $ | 1,251,635 |   |  | $ | 849,064   |  
|Marketable securities                                         |  |                        | 1,359,720 |      |  |      | 1,195,517 |      |  |      | 1,062,353 |   |  |   | 864,013   |   |  |   | 999,194   |  
|Total assets                                                  |  |                        | 4,619,304 |      |  |      | 4,251,133 |      |  |      | 5,096,046 |   |  |   | 5,323,436 |   |  |   | 4,884,021 |  
|Medical claims and benefits payable                           |  |                        | 1,027,500 |      |  |      | 1,044,500 |      |  |      | 1,095,900 |   |  |   | 1,270,800 |   |  |   | 795,200   |  
|Long-term debt, due after one year                            |  |                        | 612,700   |      |  |      | 731,961   |      |  |      | 794,309   |   |  |   | 836,556   |   |  |   | 975,000   |  
|Stockholders equity                                          |  |                        | 1,851,537 |      |  |      | 1,328,305 |      |  |      | 2,033,785 |   |  |   | 2,003,560 |   |  |   | 1,977,719 |  



---



|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | All applicable per-share amounts reflect the
    retroactive effects of the two-for-one common stock split in the
    form of a stock dividend that was effective January 20,
    2004. See Note 6 of the Notes to Consolidated Financial
    Statements.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|   
|(2) | The 2002 results include impairment, disposition,
    restructuring, OPM and other net pretax charges totaling
    $3.8 million ($2.4 million or $0.03 diluted loss per
    share, net of tax). See Note 10 of the Notes to
    Consolidated Financial Statements. Operating income before net
    pretax charges as a percentage of operating revenue was 2.7%.
    
     The 2002 results include a cumulative effect of a change in
    accounting principle in connection with the goodwill impairment
    recognized upon the adoption of Statement of Financial
    Accounting Standards (SFAS) No. 142, Goodwill and
    Other Intangible Assets, totaling $929 million
    ($897 million or $12.73 diluted loss per share, net of
    tax). See Note 7 of the Notes to Consolidated Financial
    Statements.
|   
|(3) | The 2001 results include impairment, disposition,
    restructuring, OPM and other net pretax charges totaling
    $61 million ($39 million or $0.56 diluted loss per
    share, net of tax). See Note 10 of the Notes to
    Consolidated Financial Statements. Operating income before net
    pretax charges as a percentage of operating revenue was 1.6%.                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|   
|(4) | The 2000 results include impairment, disposition,
    restructuring, OPM and other net pretax charges totaling
    $9 million ($5 million or $0.07 diluted loss per
    share, net of tax). See Note 10 of the Notes to
    Consolidated Financial Statements. Operating income before net
    pretax charges as a percentage of operating revenue was 3.2%.                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|   
|(5) | The 1999 results include impairment, disposition,
    restructuring and other net pretax credits totaling
    $2 million ($2 million or $0.02 diluted loss per
    share, net of tax). The after tax and per share amounts were
    losses because the goodwill impairment was not deductible for
    income tax                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     

15



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##### Table of Contents



|    |                                                                                                                                                                           
|--- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|    | purposes. Operating income before net pretax
    credits as a percentage of operating revenue was 5.2%.                                                                   
|   
|(6) | Effective income tax rate includes the effect of
    nondeductible pretax charges, primarily goodwill amortization
    for the years ended December 31, 1999 through 2001.






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

Results of Operations

In this Annual Report on Form 10-K, we refer
to PacifiCare Health Systems, Inc. as PacifiCare,
the Company, we, us, or
our. Statements that are not historical facts are
forward-looking statements within the meaning of the Federal
Securities laws, and may involve a number of risks and
uncertainties which could cause actual results to differ
materially from those anticipated as of the date of this report.
In addition, past financial and/or operating performance is not
necessarily a reliable indicator of future performance and you
should not use our historical performance to anticipate results
or future period trends. In evaluating these forward-looking
statements, you should specifically consider the risks described
below under Cautionary Statements which follows our
discussion on Critical Accounting Policies and Estimates and in
other parts of this report.

Overview.We
offer managed care and other health insurance products to
employer groups and Medicare beneficiaries in eight western
states and Guam. Our commercial and senior plans are designed to
deliver quality health care and customer service to members
cost-effectively. These programs include health maintenance
organizations, or HMOs, preferred provider organizations, or
PPOs, and Medicare Supplement products. We also offer a variety
of specialty managed care products and services that employees
can purchase as a supplement to our basic commercial and senior
medical plans or as stand-alone products. These products include
pharmacy benefit management, or PBM, services, behavioral health
services, group life and health insurance, dental and vision
benefit plans.

Premium revenues are earned from products where
we bear insured risk. Non-premium revenues are earned from all
other sources, including revenues from our PBM mail order
business, administrative fees and other income. Commencing with
the first quarter of 2003, we reformatted our statement of
operations to show total revenues (premium revenues and
non-premium revenues) and health care services and other
expenses by the following categories: commercial, senior and
specialty and other. These changes are summarized below:



|  |                                                                                                                                                                                                                                                                                                                                                                                                               
|- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | For our behavioral health and dental and vision
    subsidiaries, we previously included premium revenues in the
    commercial revenue line and non-premium revenues in the other
    income line. In 2003, all revenues (premium and non-premium)
    derived from our specialty companies (behavioral health, dental
    and vision and PBM) are now reported in the specialty and other
    revenues line.
| 
| | All health care services and other expenses for
    our specialty companies were previously included within
    commercial health care costs. In 2003, all health care services
    and other expenses for our specialty companies are now reported
    in the specialty and other health care services and other
    expenses line.                                                                          
| 
| | Non-premium revenues earned by, and non-premium
    related fees charged by, our health plans or subsidiaries were
    previously included in the other income line. In 2003, these
    amounts are now included in the commercial, senior or specialty
    revenue and health care services and other expenses lines, as
    appropriate.                                                                    

All intercompany transactions and accounts are
eliminated in consolidation.

16



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##### Table of Contents



Revenue

Commercial and Senior.Our commercial and senior revenues
include all premium revenue we receive from our health plans,
indemnity insurance subsidiary and Medicare Supplement and
Senior Supplement products, as well as fee revenue we receive
from administrative services we offer through our commercial and
senior health plans and related subsidiaries. We receive a
monthly payment on behalf of each subscriber enrolled in our
commercial HMOs and our indemnity insurance service plans.
Generally, our Medicare+Choice contracts entitle us to per
member per month payments from the Centers for Medicare and
Medicaid Services, or CMS, on behalf of each enrolled Medicare
beneficiary. We report prepaid health care premiums received
from our commercial plans enrolled groups, CMS, and our
Medicare plans members as revenue in the month that
members are entitled to receive health care. We record premiums
received in advance as unearned premium revenue.

Premiums for our commercial products and
Medicare+Choice products are generally fixed in advance of the
periods covered. Of our commercial business, more than 50% of
our membership renews on January 1 of each year, with
premiums that are generally fixed for a period of one year. In
addition, each of our subsidiaries that offers Medicare+Choice
products must submit adjusted community rate proposals,
generally by county or service area, to CMS, in early September
for each Medicare+Choice product that will be offered in the
subsequent year. As a result, increases in the costs of health
care services in excess of the estimated future health care
services expense reflected in the premiums or the adjusted
community rate proposals generally cannot be recovered in the
applicable contract year through higher premiums or changes in
benefit designs.

Specialty and Other.Our specialty and other revenues
include all premium revenues we receive from our behavioral
health and dental and vision service plans and fee revenue we
receive from administrative services we offer though our
specialty companies, primarily from our PBM subsidiary. Our PBM
subsidiary generates mail order revenue where we, rather than
network retail pharmacies, collect the member copayments for
both affiliated and unaffiliated members. Additionally, we
record revenues for prescription drug costs and administrative
fees charged on prescriptions dispensed by our mail order
pharmacy when the prescription is filled. For prescription drugs
dispensed through retail pharmacies, we record administrative
services fees when a prescription claim is reviewed and
approved, and the prescription is filled. For prescription drugs
dispensed through retail pharmacies, we do not record revenues
for drugs dispensed or the network pharmacies dispensing
fees; nor do we record revenues for copayments our members make
to the retail pharmacies.

Net Investment Income.Net investment income consists of
interest income, gross realized gains and losses experienced on
cash invested over each period.

Expenses

Commercial and Senior Health Care Services and
Other.Health care services and other
expenses for our commercial plans and our senior plans primarily
comprise payments to physicians, hospitals and other health care
providers under capitated or risk-based contracts for services
provided to our commercial and senior health plan members and
indemnity insurance plan members.

Our risk-based health care services expenses
consist mostly of four cost of care components: outpatient care,
inpatient care, professional services (primarily physician care)
and pharmacy benefit costs. All four components are affected by
both unit costs and utilization rates. Unit costs, for example,
are the cost of outpatient medical procedures, inpatient
hospital stays, physician fees for office visits and
prescription drug prices. Utilization rates represent the volume
of consumption of health services and vary with the age and
health of our members and broader social and lifestyle patterns
of the population as a whole.

17



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##### Table of Contents



The cost of health care provided is accrued in
the month services are provided to members, based in part on
estimates of claims for hospital services and other health care
costs that have been incurred but not yet reported (including
those claims received but not yet paid), or IBNR, under our
risk-based provider contracts as well as some services under our
capitation contracts for which we retain financial liability, or
carve-outs, primarily using standard actuarial methodologies
based on historical data. These standard actuarial methodologies
include, among other factors, contractual requirements,
historical utilization trends, the interval between the date
services are rendered and the date claims are paid, denied
claims activity, disputed claims activity, benefit changes,
expected health care cost inflation, seasonality patterns and
changes in membership. These estimates are adjusted in future
periods as we receive actual paid claims data, and can either
increase or reduce our accrued health care costs. Included in
health care services and other expenses for the year ended
December 31, 2003 were net favorable adjustments of 2002
and prior period medical cost estimates of approximately
$54 million of which the commercial and senior net
favorable adjustments were $22 million and
$32 million, respectively. For both commercial and senior,
the net favorable adjustments were mainly from our Texas and
California markets and were the result of lower than anticipated
health care costs that materialized primarily in senior markets
that we exited and recoveries of claims overpayments at rates
higher than historic recovery patterns. The cost of prescription
drugs covered under our commercial and senior plans is expensed
when the prescription drugs are dispensed. Our commercial and
senior plans also provide incentives, through a variety of
programs, for health care providers that participate in those
plans to control health care costs while providing quality
health care. Expenses related to these programs, which are based
in part on estimates, are recorded in the period in which the
related services are provided. Historically, we have primarily
arranged health care services for our members by contracting
with health care providers on a capitated basis, regardless of
the services provided to each member. Under our risk-based
contracts, we generally bear or partially share the risk of
excess health care expenses with health care providers, meaning
that if member utilization of health care services exceeds
agreed-upon amounts, we bear or partially share the excess
expenses with the applicable health care provider.

Specialty and Other Health Care Services and
Other.Health care services and other
expenses for our specialty companies primarily comprise payments
to physicians, hospitals and other health care providers under
capitated or risk-based contracts for services provided to our
behavioral health and dental and vision members and the cost of
acquiring drugs for our mail order pharmacy benefit management
subsidiary. Health care services and other expenses also include
expenses for administrative services performed by our specialty
companies.

18



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##### Table of Contents



2003 Compared with 2002

Membership.Total HMO and other membership
decreased 7% to approximately 2.9 million members at
December 31, 2003 from approximately 3.1 million
members at December 31, 2002.

|                       |                      |                                |  |                   |           |       |  |            |         |        |  |           |           |  |  |           |           |  |  |         |         |  |  |           |           | 
|---------------------- | -------------------- | ------------------------------ |  | ----------------- | --------- | ----- |  | ---------- | ------- | ------ |  | --------- | --------- |  |  | --------- | --------- |  |  | ------- | ------- |  |  | --------- | --------- | 
|                       |                      |                                |  |                  
|                       |                      | December 31, 2003              |  | December 31, 2002
|                       |                      |                                |  |                  
|                       |                      | Commercial                     |  | Senior            |           | Total |  | Commercial |         | Senior |  | Total    
|                       |                      |                                |  |                   |           |       |  |            |         |        |  |          
|HMO Membership Data:   |                      |                                |  |                   |           |       |  |            |         |        |  |           |           |  |  |           |           |  |  |         |         |  |  |          
|                       | Arizona              |                                |  | 148,500           |           |       |  | 86,600     |         |        |  | 235,100   |           |  |  | 141,300   |           |  |  | 88,400  |         |  |  | 229,700   |          
|                       | California           |                                |  | 1,333,000         |           |       |  | 348,400    |         |        |  | 1,681,400 |           |  |  | 1,543,000 |           |  |  | 386,100 |         |  |  | 1,929,100 |          
|                       | Colorado             |                                |  | 173,700           |           |       |  | 52,600     |         |        |  | 226,300   |           |  |  | 178,300   |           |  |  | 57,600  |         |  |  | 235,900   |          
|                       | Guam                 |                                |  | 26,400            |           |       |  |           |         |        |  | 26,400    |           |  |  | 32,200    |           |  |  |        |         |  |  | 32,200    |          
|                       | Nevada               |                                |  | 25,800            |           |       |  | 25,300     |         |        |  | 51,100    |           |  |  | 24,300    |           |  |  | 27,400  |         |  |  | 51,700    |          
|                       | Oklahoma             |                                |  | 87,200            |           |       |  | 18,400     |         |        |  | 105,600   |           |  |  | 101,100   |           |  |  | 19,800  |         |  |  | 120,900   |          
|                       | Oregon               |                                |  | 58,200            |           |       |  | 24,000     |         |        |  | 82,200    |           |  |  | 68,000    |           |  |  | 25,300  |         |  |  | 93,300    |          
|                       | Texas                |                                |  | 76,500            |           |       |  | 74,500     |         |        |  | 151,000   |           |  |  | 101,100   |           |  |  | 100,400 |         |  |  | 201,500   |          
|                       | Washington           |                                |  | 65,500            |           |       |  | 52,500     |         |        |  | 118,000   |           |  |  | 62,700    |           |  |  | 55,500  |         |  |  | 118,200   |          
|                       |                      |                                |  |                   |           |       |  |            |         |        |  |           |           |  |  |           |           |  |  |         |         |  |  |          
|                       |                      | Total HMO membership           |  |                   | 1,994,800 |       |  |            | 682,300 |        |  |           | 2,677,100 |  |  |           | 2,252,000 |  |  |         | 760,500 |  |  |           | 3,012,500 | 
|                       |                      |                                |  |                   |           |       |  |            |         |        |  |           |           |  |  |           |           |  |  |         |         |  |  |          
|Other Membership Data: |                      |                                |  |                   |           |       |  |            |         |        |  |           |           |  |  |           |           |  |  |         |         |  |  |          
|                       | PPO and indemnity    |                                |  | 183,500           |           |       |  |           |         |        |  | 183,500   |           |  |  | 75,100    |           |  |  |        |         |  |  | 75,100    |          
|                       | Employer self-funded |                                |  | 24,600            |           |       |  |           |         |        |  | 24,600    |           |  |  | 34,800    |           |  |  |        |         |  |  | 34,800    |          
|                       | Medicare Supplement  |                                |  |                  |           |       |  | 26,900     |         |        |  | 26,900    |           |  |  |          |           |  |  | 15,600  |         |  |  | 15,600    |          
|                       |                      |                                |  |                   |           |       |  |            |         |        |  |           |           |  |  |           |           |  |  |         |         |  |  |          
|                       |                      | Total other membership         |  |                   | 208,100   |       |  |            | 26,900  |        |  |           | 235,000   |  |  |           | 109,900   |  |  |         | 15,600  |  |  |           | 125,500   | 
|                       |                      |                                |  |                   |           |       |  |            |         |        |  |           |           |  |  |           |           |  |  |         |         |  |  |          
|                       |                      | Total HMO and other membership |  |                   | 2,202,900 |       |  |            | 709,200 |        |  |           | 2,912,100 |  |  |           | 2,361,900 |  |  |         | 776,100 |  |  |           | 3,138,000 | 
|                       |                      |                                |  |                   |           |       |  |            |         |        |  |           |           |  |  |           |           |  |  |         |         |  |  |          

|                      |                                |                   |  |                      |  |       |  |            |  |              |  |           |  |  |  |           |  |  |  |           |  |  |  |           | 
|--------------------- | ------------------------------ | ----------------- |  | -------------------- |  | ----- |  | ---------- |  | ------------ |  | --------- |  |  |  | --------- |  |  |  | --------- |  |  |  | --------- | 
|                      |                                |                   |  |                     
|                      |                                | December 31, 2003 |  | As December 31, 2002
|                      |                                |                   |  |                     
|                      |                                | PacifiCare        |  | Unaffiliated         |  | Total |  | PacifiCare |  | Unaffiliated |  | Total    
|                      |                                |                   |  |                      |  |       |  |            |  |              |  |          
|Specialty Membership: |                                |                   |  |                      |  |       |  |            |  |              |  |           |  |  |  |           |  |  |  |           |  |  |  |          
|                      | Pharmacy benefit management(1) |                   |  | 2,912,100            |  |       |  | 2,071,400  |  |              |  | 4,983,500 |  |  |  | 3,138,000 |  |  |  | 1,635,100 |  |  |  | 4,773,100 | 
|                      | Behavioral health(2)           |                   |  | 2,013,400            |  |       |  | 1,646,700  |  |              |  | 3,660,100 |  |  |  | 2,194,700 |  |  |  | 1,681,300 |  |  |  | 3,876,000 | 
|                      | Dental and vision(2)           |                   |  | 485,000              |  |       |  | 234,600    |  |              |  | 719,600   |  |  |  | 442,500   |  |  |  | 244,800   |  |  |  | 687,300   | 



---



|    |                                                                                                                                                                                                                                                                                                                                                     
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | PBM PacifiCare membership represents members that
    are in our commercial or senior HMO, PPO and indemnity, employer
    self-funded and Medicare Supplement plans. All of these members
    either have a prescription drug benefit or are able to purchase
    their prescriptions utilizing our retail network contracts or
    our mail order.
|   
|(2) | Behavioral health and dental and vision
    PacifiCare membership represents members that are in our
    commercial and senior HMO that are also enrolled in our
    behavioral health or dental and vision plans.                                                                                                                                  

Commercial HMO membership decreased approximately
11%, or 257,200 members, at December 31, 2003 compared
to the prior year. The decreases were primarily due to
elimination of unprofitable commercial business and the
termination of contracts with network providers. As previously
announced, our contract with the California Public Employee
Retirement System, or

19



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##### Table of Contents



CalPERS, was not renewed for 2003, resulting in
the loss of approximately 180,100 commercial
HMO members in California effective January 1, 2003.


PPO and indemnity membership increased
approximately 144% at December 31, 2003 compared to the
prior year primarily due to enhanced marketing and the addition
of approximately 14,900 members from new product
initiatives primarily in California and Colorado.

Senior HMO membership decreased approximately
10%, or 78,200 members, at December 31, 2003 compared to
the prior year. This decrease primarily resulted from county
exits and member disenrollments attributable to reduced benefits
and increased premiums effective January 1, 2003. As
previously announced, we exited five counties in California and
Texas resulting in the loss of approximately 63,000 senior
HMO members effective January 1, 2003.

We anticipate that commercial and senior
membership will increase in 2004.

Pharmacy benefit management unaffiliated
membership at December 31, 2003 increased approximately
27%, or 436,300 members, compared to the prior year
primarily due to an increase of approximately 400,000 from one
group and the net addition of 20 clients. Pharmacy benefit
management HMO membership at December 31, 2003
decreased approximately 7% compared to the prior year as a
result of county exits and member disenrollments attributable to
reduced benefits and increased premiums effective
January 1, 2003 and the loss of our contract with CalPERS
as discussed above.

PacifiCare behavioral health membership at
December 31, 2003 decreased approximately 8% compared to
the prior year primarily due to the loss of our contract with
CalPERS as discussed above in commercial HMO membership.
Behavioral health unaffiliated membership at December 31,
2003 decreased approximately 2%, or 34,600 members,
compared to the prior year due to member disenrollments.

PacifiCare dental and vision membership at
December 31, 2003 increased approximately 10%, or
42,500 members, compared to the prior year primarily due to
increased cross-selling of these products in conjunction with
our commercial products. Dental and vision unaffiliated
membership at December 31, 2003 was comparable to the prior
year.

We anticipate that total specialty membership
will increase in 2004.

Commercial Revenue.Commercial revenue increased 5%,
or $260 million, to $5 billion for the year ended
December 31, 2003 compared to the prior year as follows:

|                                                                                                                            |  |                       |      |  
|--------------------------------------------------------------------------------------------------------------------------- |  | --------------------- | ---- | -
|                                                                                                                            |  | Year Ended           
|                                                                                                                            |  | December 31, 2003    
|                                                                                                                            |  |                      
|                                                                                                                            |  | (Amounts in millions)
|Revenue increases primarily due to premium rate
    increases of approximately 18% for the year ended
    December 31, 2003 |  | $                     | 743  |  
|Net membership decreases, primarily in California
    and Texas                                                             |  |                       | (489 | )
|Other                                                                                                                       |  |                       | 6    |  
|                                                                                                                            |  |                       |      |  
|Increase over prior year                                                                                                    |  | $                     | 260  |  
|                                                                                                                            |  |                       |      |  

We anticipate revenue increases in 2004 primarily
due to membership and rate increases. However, we do not expect
the same percentage premium rate increases in 2004 that we
experienced in 2003.

20



---



##### Table of Contents



Senior Revenue.Senior revenue decreased 8%, or
$492 million, to $5.4 billion for the year ended
December 31, 2003 compared to the prior year as follows:

|                                                                                                                           |  |                       |      |  
|-------------------------------------------------------------------------------------------------------------------------- |  | --------------------- | ---- | -
|                                                                                                                           |  | Year Ended           
|                                                                                                                           |  | December 31, 2003    
|                                                                                                                           |  |                      
|                                                                                                                           |  | (Amounts in millions)
|Revenue increases primarily due to premium rate
    increases of approximately 4% for the year ended
    December 31, 2003 |  | $                     | 260  |  
|Net membership decreases, primarily in California
    and Texas                                                            |  |                       | (752 | )
|                                                                                                                           |  |                       |      |  
|Decrease over prior year                                                                                                   |  | $                     | (492 | )
|                                                                                                                           |  |                       |      |  

We anticipate revenue increases in 2004 primarily
due to membership and rate increases, and from changes as a
result of the newly enacted DIMA legislation.

Specialty and Other Revenue.Specialty and other revenue of
$499 million for the year ended December 31, 2003
increased 18%, or $77 million, compared to the same period
in the prior year. The increase was primarily due to increased
mail order revenues and unaffiliated membership from our
pharmacy benefit management subsidiary.

Net Investment Income.Net investment income increased
11%, or $7 million, to $71 million for the year ended
December 31, 2003, from $64 million for the year ended
December 31, 2002. The increase was primarily due to the
following:



|  |                                                                                                                                                                                                        
|- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | write-off of a decline in the value of our
    investment in MedUnite, Inc. of $11 million during 2002,
    with no comparable activity in 2003;                                                       
| 
| | write-down of certain telecommunication
    investments to market value resulting in a charge of
    approximately $2 million during 2002, with no comparable
    activity in 2003; partially offset by
| 
| | lower pre-tax rates of return due to Federal
    Reserve rate reductions in 2003.                                                                                                                      

Commercial Margin.Our commercial margin increased
34%, or $195 million, to $773 million for the year
ended December 31, 2003, compared to $578 million for
the same period in the prior year as follows:

|                                                                                                                                                    |  |                       |      |  
|--------------------------------------------------------------------------------------------------------------------------------------------------- |  | --------------------- | ---- | -
|                                                                                                                                                    |  | Year Ended           
|                                                                                                                                                    |  | December 31, 2003    
|                                                                                                                                                    |  |                      
|                                                                                                                                                    |  | (Amounts in millions)
|Commercial revenue increases (as noted above)                                                                                                       |  | $                     | 260  |  
|Decreases in health care services and other
    expenses as a result of net HMO and PPO membership decreases,
    primarily in California and Texas |  |                       | 432  |  
|Increases in health care services and other
    expenses as a result of health care cost trends and increases in
    capitation expense             |  |                       | (481 | )
|Other                                                                                                                                               |  |                       | (16  | )
|                                                                                                                                                    |  |                       |      |  
|Increase over the comparable period of the prior
    year                                                                                           |  | $                     | 195  |  
|                                                                                                                                                    |  |                       |      |  

We anticipate our commercial margin in 2004 will
be slightly higher than 2003.

21



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##### Table of Contents



Senior Margin.Our senior margin increased 9%, or
$72 million, to $855 million for the year ended
December 31, 2003, compared to $783 million the same
period in the prior year as follows:

|                                                                                                                                            |  |                       |      |  
|------------------------------------------------------------------------------------------------------------------------------------------- |  | --------------------- | ---- | -
|                                                                                                                                            |  | Year Ended           
|                                                                                                                                            |  | December 31, 2003    
|                                                                                                                                            |  |                      
|                                                                                                                                            |  | (Amounts in millions)
|Senior revenue decreases (as noted above)                                                                                                   |  | $                     | (492 | )
|Decreases in health care services and other
    expenses as a result of HMO membership decreases, primarily in
    California and Texas     |  |                       | 614  |  
|Increases in health care services and other
    expenses as a result of health care cost trends partially offset
    by benefit adjustments |  |                       | (43  | )
|Other                                                                                                                                       |  |                       | (7   | )
|                                                                                                                                            |  |                       |      |  
|Increase over the comparable period of the prior
    year                                                                                   |  | $                     | 72   |  
|                                                                                                                                            |  |                       |      |  

We anticipate our senior margin in 2004 will be
lower than in 2003 primarily due to expected enhancement of
benefits offered to our Medicare+Choice beneficiaries.

Specialty and Other Margin.Our specialty and other margin
decreased 1%, or $2 million, to $244 million for the year
ended December 31, 2003. The decrease was primarily driven
by the loss of higher margin business, partially offset by an
increase in unaffiliated membership in our behavioral health and
PBM businesses.

Medical Loss Ratio.Our medical loss ratios, or MLRs,
are calculated using premium revenue and related health care
services and other expenses and cannot be directly calculated
from the line items in the Consolidated Statement of Operations.
Our MLRs are calculated using the following categories of
revenue and expenses:



|  |                                                                                                                                                                                                                                                                                                                                            
|- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Private 
    Commercial:includes premium revenue
    and related health care services and other expenses for our
    commercial HMO products (including Federal Employees Health
    Benefit Program, or FEHBP, and state and local government
    contracts), PPO products, and other indemnity, behavioral,
    dental and vision plans;
| 
| | Private 
    Senior:includes premium revenue and
    related health care services and other expenses for our Medicare
    Supplement and Senior Supplement products where premiums are
    paid in full by the employer or the consumer;                                                                                                  
| 
| | Government 
    Senior:includes premium revenue and
    related health care services and other expenses for our
    Medicare+ Choice, HMO and PPO products and other senior products
    where premiums are paid principally through government programs.                                                                                 

All non-premium revenues and related health care
services and other expenses are excluded from the calculation of
our MLR.

In 2002, we calculated our MLR for our commercial
and senior products based on total premiums and total health
care services expenses as reported on our statement of
operations. This resulted in the inclusion of certain health
care costs related to the cost of acquiring drugs for our mail
order business of our PBM subsidiary within our commercial MLR
calculation for which there was no corresponding revenues (the
related revenues were included in the other income line). Since
this inadvertently had the effect of slightly increasing the MLR
of our commercial product, we changed this presentation in order
to provide more transparency on the trends affecting the
profitability of our insured products. Under our new format,
only premium revenues and the related health care and other
services expenses are included in the MLR calculations. The 2002
MLR calculations have been recalculated to conform to the 2003
presentation.

22



---



##### Table of Contents



The consolidated MLR and its components,
unadjusted for any prior period changes in healthcare cost
estimates, for the year ended December 31, 2003 and 2002
are as follows:

|                    |                           |              |  |      |   |  |  |      |  
|------------------- | ------------------------- | ------------ |  | ---- | - |  |  | ---- | -
|                    |                           |             
|                    |                           | Year Ended  
|                    |                           | December 31,
|                    |                           |             
|                    |                           | 2003         |  | 2002
|                    |                           |              |  |     
|Medical loss ratio: |                           |              |  |      |   |  |  |     
|                    | Consolidated              |              |  | 84.0 | % |  |  | 86.8 | %
|                    | Private  Commercial      |              |  | 84.0 | % |  |  | 87.1 | %
|                    | Private  Senior          |              |  | 63.4 | % |  |  | 53.5 | %
|                    | Private  Consolidated    |              |  | 83.7 | % |  |  | 86.7 | %
|                    | Government  Senior       |              |  | 84.2 | % |  |  | 86.9 | %
|                    | Government  Consolidated |              |  | 84.2 | % |  |  | 86.9 | %

Private  Commercial Medical Loss
Ratio.Our private 
commercial medical loss ratio decreased to 84.0% for the year
ended December 31, 2003 compared to 87.1% for the prior
year. The decrease was driven by premium rate increases that
outpaced an increase in health care services and other expenses
on both an absolute dollar and per member per month basis.

Private  Senior Medical Loss
Ratio.Our private 
senior medical loss ratio increased to 63.4% for the year ended
December 31, 2003 compared to 53.5% for the prior year. The
increase was primarily driven by health care services and other
expenses increases that outpaced premium revenue increases on a
per member per month basis.

Government  Senior Medical Loss
Ratio.Our government 
senior medical loss ratio decreased to 84.2% for the year ended
December 31, 2003 compared to 86.9% for the prior year. The
decrease was driven by rate increases, benefit reductions and
decreased utilization attributable to our medical management
programs that outpaced an increase in health care services and
other expenses on a per member per month basis.

Selling, General and Administrative
Expenses.Selling, general and
administrative expenses increased $82 million to
$1.5 billion for the year ended December 31, 2003,
from $1.4 billion in the prior year. Selling, general and
administrative expenses increased primarily due to increased
spending for new product development and marketing costs, our
expensing of stock-based compensation and increased write-off of
certain property and equipment.

Selling, general and administrative expenses as a
percentage of operating revenue (excluding net investment
income) increased compared to the prior year primarily due to
declines in operating revenue (excluding net investment income)
totaling $155 million for the year ended December 31,
2003.

|                                                                                                                        |  |              |      |      |  |  |      |  
|----------------------------------------------------------------------------------------------------------------------- |  | ------------ | ---- | ---- |  |  | ---- | -
|                                                                                                                        |  |             
|                                                                                                                        |  | Year Ended  
|                                                                                                                        |  | December 31,
|                                                                                                                        |  |             
|                                                                                                                        |  | 2003         |      | 2002
|                                                                                                                        |  |              |      |     
|Selling, general and administrative expenses as a
    percentage of operating revenue (excluding net investment income) |  |              | 13.3 | %    |  |  | 12.4 | %

Interest Expense.Interest expense increased 34%, or
$26 million, to $101 million for the year ended
December 31, 2003, from $75 million compared to the
prior year. The increase was due to the following:



|  |                                                                                                                                                                                                                                
|- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | $28 million for the redemption premium and
    other write-offs associated with our redemption of
    $175 million in principal of our 10 3/4% senior notes
    in December 2003 with no comparable activity in the prior year,

23



---



##### Table of Contents





|  |                                                                                                                                                                                                                                                      
|- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | approximately $3 million for the write-off
    of unamortized loan fees in the second quarter of 2003 in
    connection with the replacement of our senior credit facility
    with no comparable activity in the prior year, partially offset
    by
| 
| | $5 million of favorable effect of the
    interest rate swap on $300 million of our 10 3/4% senior
    notes with no comparable activity in the prior year, and                                                                                      
| 
| | lower interest rate from our term loan under the
    senior credit facility which was effective June 2003.                                                                                                                                           

Provision for Income Taxes.The effective income tax rate was
37.7% for the year ended December 31, 2003, compared with
37.3% in 2002. The increase in the effective tax rate from the
prior year is primarily due to higher 2003 earnings resulting in
a higher state tax expense while reducing the benefit that
tax-exempt income had on our effective tax rate.

Our effective tax rate is based on statutory tax
rates, reported income, certain permanent tax differences, and
tax planning opportunities available to us in the various
jurisdictions in which we operate. Significant judgment is
required in determining our effective tax rate and in evaluating
our tax positions. Despite our belief that our tax return
positions are fully supportable, we may establish reserves when
we believe that certain tax positions are likely to be
challenged and we may not fully prevail in overcoming these
challenges. We may adjust these reserves as relevant
circumstances evolve, such as the progress of a tax audit. Our
effective tax rate includes the impact of reserve provisions and
changes to reserves that we consider appropriate, as well as
related interest. In the event that there is a significant
unusual or one-time item recognized in our operating results,
the tax attributable to that item would be separately calculated
and recorded at the same time as the usual or one-time item.

24



---



##### Table of Contents



2002 Compared with 2001

Membership.Total HMO and other membership
decreased 10% to approximately 3.1 million members at
December 31, 2002 from approximately 3.5 million
members at December 31, 2001.

|                       |                      |                                |  |                   |           |       |  |            |         |        |  |           |           |  |  |           |           |  |  |         |         |  |  |           |           | 
|---------------------- | -------------------- | ------------------------------ |  | ----------------- | --------- | ----- |  | ---------- | ------- | ------ |  | --------- | --------- |  |  | --------- | --------- |  |  | ------- | ------- |  |  | --------- | --------- | 
|                       |                      |                                |  |                  
|                       |                      | December 31, 2002              |  | December 31, 2001
|                       |                      |                                |  |                  
|                       |                      | Commercial                     |  | Senior            |           | Total |  | Commercial |         | Senior |  | Total    
|                       |                      |                                |  |                   |           |       |  |            |         |        |  |          
|HMO Membership Data:   |                      |                                |  |                   |           |       |  |            |         |        |  |           |           |  |  |           |           |  |  |         |         |  |  |          
|                       | Arizona              |                                |  | 141,300           |           |       |  | 88,400     |         |        |  | 229,700   |           |  |  | 144,000   |           |  |  | 104,600 |         |  |  | 248,600   |          
|                       | California           |                                |  | 1,543,000         |           |       |  | 386,100    |         |        |  | 1,929,100 |           |  |  | 1,579,000 |           |  |  | 487,000 |         |  |  | 2,066,000 |          
|                       | Colorado             |                                |  | 178,300           |           |       |  | 57,600     |         |        |  | 235,900   |           |  |  | 202,300   |           |  |  | 60,300  |         |  |  | 262,600   |          
|                       | Guam                 |                                |  | 32,200            |           |       |  |           |         |        |  | 32,200    |           |  |  | 36,400    |           |  |  |        |         |  |  | 36,400    |          
|                       | Nevada               |                                |  | 24,300            |           |       |  | 27,400     |         |        |  | 51,700    |           |  |  | 36,100    |           |  |  | 30,900  |         |  |  | 67,000    |          
|                       | Oklahoma             |                                |  | 101,100           |           |       |  | 19,800     |         |        |  | 120,900   |           |  |  | 91,300    |           |  |  | 30,200  |         |  |  | 121,500   |          
|                       | Oregon               |                                |  | 68,000            |           |       |  | 25,300     |         |        |  | 93,300    |           |  |  | 93,200    |           |  |  | 26,800  |         |  |  | 120,000   |          
|                       | Texas                |                                |  | 101,100           |           |       |  | 100,400    |         |        |  | 201,500   |           |  |  | 180,400   |           |  |  | 149,600 |         |  |  | 330,000   |          
|                       | Washington           |                                |  | 62,700            |           |       |  | 55,500     |         |        |  | 118,200   |           |  |  | 76,900    |           |  |  | 59,100  |         |  |  | 136,000   |          
|                       |                      |                                |  |                   |           |       |  |            |         |        |  |           |           |  |  |           |           |  |  |         |         |  |  |          
|                       |                      | Total HMO membership           |  |                   | 2,252,000 |       |  |            | 760,500 |        |  |           | 3,012,500 |  |  |           | 2,439,600 |  |  |         | 948,500 |  |  |           | 3,388,100 | 
|                       |                      |                                |  |                   |           |       |  |            |         |        |  |           |           |  |  |           |           |  |  |         |         |  |  |          
|Other Membership Data: |                      |                                |  |                   |           |       |  |            |         |        |  |           |           |  |  |           |           |  |  |         |         |  |  |          
|                       | PPO and indemnity    |                                |  | 75,100            |           |       |  |           |         |        |  | 75,100    |           |  |  | 38,400    |           |  |  |        |         |  |  | 38,400    |          
|                       | Employer self-funded |                                |  | 34,800            |           |       |  |           |         |        |  | 34,800    |           |  |  | 42,400    |           |  |  |        |         |  |  | 42,400    |          
|                       | Medicare Supplement  |                                |  |                  |           |       |  | 15,600     |         |        |  | 15,600    |           |  |  |          |           |  |  | 11,000  |         |  |  | 11,000    |          
|                       |                      |                                |  |                   |           |       |  |            |         |        |  |           |           |  |  |           |           |  |  |         |         |  |  |          
|                       |                      | Total other membership         |  |                   | 109,900   |       |  |            | 15,600  |        |  |           | 125,500   |  |  |           | 80,800    |  |  |         | 11,000  |  |  |           | 91,800    | 
|                       |                      |                                |  |                   |           |       |  |            |         |        |  |           |           |  |  |           |           |  |  |         |         |  |  |          
|                       |                      | Total HMO and other membership |  |                   | 2,361,900 |       |  |            | 776,100 |        |  |           | 3,138,000 |  |  |           | 2,520,400 |  |  |         | 959,500 |  |  |           | 3,479,900 | 
|                       |                      |                                |  |                   |           |       |  |            |         |        |  |           |           |  |  |           |           |  |  |         |         |  |  |          

|                      |                                |                   |  |                      |  |       |  |            |  |              |  |           |  |  |  |           |  |  |  |           |  |  |  |           | 
|--------------------- | ------------------------------ | ----------------- |  | -------------------- |  | ----- |  | ---------- |  | ------------ |  | --------- |  |  |  | --------- |  |  |  | --------- |  |  |  | --------- | 
|                      |                                |                   |  |                     
|                      |                                | December 31, 2002 |  | As December 31, 2001
|                      |                                |                   |  |                     
|                      |                                | PacifiCare        |  | Unaffiliated         |  | Total |  | PacifiCare |  | Unaffiliated |  | Total    
|                      |                                |                   |  |                      |  |       |  |            |  |              |  |          
|Specialty Membership: |                                |                   |  |                      |  |       |  |            |  |              |  |           |  |  |  |           |  |  |  |           |  |  |  |          
|                      | Pharmacy benefit management(1) |                   |  | 3,138,000            |  |       |  | 1,635,100  |  |              |  | 4,773,100 |  |  |  | 3,479,900 |  |  |  | 1,129,000 |  |  |  | 4,608,900 | 
|                      | Behavioral health(2)           |                   |  | 2,194,700            |  |       |  | 1,681,300  |  |              |  | 3,876,000 |  |  |  | 2,337,200 |  |  |  | 1,373,400 |  |  |  | 3,710,600 | 
|                      | Dental and vision(2)           |                   |  | 442,500              |  |       |  | 244,800    |  |              |  | 687,300   |  |  |  | 685,300   |  |  |  | 222,800   |  |  |  | 908,100   | 



---



|    |                                                                                                                                                                                                                                                                                                                                                     
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | PBM PacifiCare membership represents members that
    are in our commercial or senior HMO, PPO and indemnity, employer
    self-funded and Medicare Supplement plans. All of these members
    either have a prescription drug benefit or are able to purchase
    their prescriptions utilizing our retail network contracts or
    our mail order.
|   
|(2) | Behavioral health and dental and vision
    PacifiCare membership represents members that are in our
    commercial and senior HMO that are also enrolled in our
    behavioral health or dental and vision plans.                                                                                                                                  

Commercial HMO membership decreased approximately
8% at December 31, 2002 compared to the prior year due to
decreases of 79,300 members in Texas, 36,000 members in
California, 25,200 members in Oregon and 24,000 members in
Colorado. These decreases were primarily due to

25



---



##### Table of Contents



elimination of unprofitable commercial business
and the termination of contracts with network providers.


Senior HMO membership decreased approximately 20%
at December 31, 2002 compared to the prior year due to a
decrease of 150,100 members in California and Texas. This
decrease primarily resulted from county exits and member
disenrollments attributable to reduced benefits and increased
premiums effective January 1, 2002.

PPO and indemnity membership increased
approximately 96% at December 31, 2002 compared to the
prior year due to enhanced marketing and new product initiatives
primarily in California and Texas.

Pharmacy benefit management unaffiliated
membership at December 31, 2002 increased approximately 45%
compared to the prior year due to increased marketing efforts.
PacifiCare pharmacy benefit management membership at
December 31, 2002 decreased approximately 10% compared to
the prior year as a result of county exits and member
disenrollments attributable to reduced benefits and increased
premiums effective January 1, 2002.

PacifiCare behavioral health membership at
December 31, 2002 decreased approximately 6% compared to
the prior year due to declines in commercial HMO membership
resulting from renewal premium rate increases primarily in
Texas. Behavioral health unaffiliated membership at
December 31, 2002 increased approximately 22% compared to
the prior year due to the addition of one large employer group
in the eastern United States.

PacifiCare dental and vision membership at
December 31, 2002 decreased approximately 35% compared to
the prior year primarily due to senior membership losses in
California, attributable to dental benefit changes effective
January 1, 2002. Dental and vision unaffiliated membership
at December 31, 2002 increased approximately 10% compared
to the prior year due to membership from new PPO product
offerings.

Commercial Revenue.Commercial revenue increased 5%,
or $229 million, for the year ended December 31, 2002
compared to the prior year as follows:

|                                                                                                 |  |                       |      |  
|------------------------------------------------------------------------------------------------ |  | --------------------- | ---- | -
|                                                                                                 |  | Year Ended           
|                                                                                                 |  | December 31, 2002    
|                                                                                                 |  |                      
|                                                                                                 |  | (Amounts in millions)
|Premium yield increases that averaged
    approximately 15% for the year ended December 31, 2002 |  | $                     | 634  |  
|Net membership decreases, primarily in
    California, Colorado and Texas                        |  |                       | (420 | )
|Other                                                                                            |  |                       | 15   |  
|                                                                                                 |  |                       |      |  
|Increase over prior year                                                                         |  | $                     | 229  |  
|                                                                                                 |  |                       |      |  

Senior Revenue.Senior revenue decreased 13%, or
$911 million, for the year ended December 31, 2002
compared to the prior year as follows:

|                                                                                                                                |  |                       |        |  
|------------------------------------------------------------------------------------------------------------------------------- |  | --------------------- | ------ | -
|                                                                                                                                |  | Year Ended           
|                                                                                                                                |  | December 31, 2002    
|                                                                                                                                |  |                      
|                                                                                                                                |  | (Amounts in millions)
|Premium yield increases, including member
    premiums, that averaged approximately 8% for the year ended
    December 31, 2002 |  | $                     | 390    |  
|Membership decreases, primarily in California and
    Texas                                                                     |  |                       | (1,270 | )
|Other                                                                                                                           |  |                       | (31    | )
|                                                                                                                                |  |                       |        |  
|Decrease over prior year                                                                                                        |  | $                     | (911   | )
|                                                                                                                                |  |                       |        |  

26



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##### Table of Contents



Specialty and Other Revenue.Specialty and other revenue
increased 11%, or $41 million, for the year ended
December 31, 2002, compared to the same period in the prior
year. The increase was primarily due to increased unaffiliated
membership and mail order revenues of our pharmacy benefit
management subsidiary.

Net Investment Income.Net investment income decreased
42%, or $47 million, to $64 million for the year ended
December 31, 2002, from $111 million for the year
ended December 31, 2001.

During 2002, we wrote off our entire
$11 million investment in MedUnite Inc. In late 2002,
MedUnite was acquired by ProxyMed Inc. Additionally, during
2002, we wrote down certain telecommunications investments to
market value resulting in a charge of approximately
$2 million during the second quarter of 2002. In total, we
recorded a charge of $13 million ($8 million, or $0.11
diluted loss per share, net of tax) for other than temporary
impairments to the value of these investments which is included
in net investment income. In addition to the impairment of these
investments, we experienced lower pretax rates of return on our
portfolio as a result of lower investable balances and interest
rates that have been declining since 2001.

Commercial Margin.Our commercial margin increased
28%, or $126 million, to $578 million for the year
ended December 31, 2002, compared to $452 million for
the same period in the prior year as follows:

|                                                                                                                                                    |  |                       |      |  
|--------------------------------------------------------------------------------------------------------------------------------------------------- |  | --------------------- | ---- | -
|                                                                                                                                                    |  | Year Ended           
|                                                                                                                                                    |  | December 31, 2002    
|                                                                                                                                                    |  |                      
|                                                                                                                                                    |  | (Amounts in millions)
|Commercial revenue increases (as noted above)                                                                                                       |  | $                     | 229  |  
|Decreases in health care services and other
    expenses as a result of net HMO and PPO membership decreases,
    primarily in California and Texas |  |                       | 366  |  
|Increases in health care services and other
    expenses as a result of health care cost trends and increases in
    capitation expense             |  |                       | (469 | )
|                                                                                                                                                    |  |                       |      |  
|Increase over the comparable period of the prior
    year                                                                                           |  | $                     | 126  |  
|                                                                                                                                                    |  |                       |      |  

Senior Margin.Our senior margin increased 18%,
or $118 million, to $783 million for the year ended
December 31, 2002, compared to $665 million the same
period in the prior year as follows:

|                                                                                                                                            |  |                       |       |  
|------------------------------------------------------------------------------------------------------------------------------------------- |  | --------------------- | ----- | -
|                                                                                                                                            |  | Year Ended           
|                                                                                                                                            |  | December 31, 2002    
|                                                                                                                                            |  |                      
|                                                                                                                                            |  | (Amounts in millions)
|Senior revenue decreases (as noted above)                                                                                                   |  | $                     | (911  | )
|Decreases in health care services and other
    expenses as a result of HMO membership decreases, primarily in
    California and Texas     |  |                       | 1,192 |  
|Increases in health care services and other
    expenses as a result of health care cost trends partially offset
    by benefit adjustments |  |                       | (163  | )
|                                                                                                                                            |  |                       |       |  
|Increase over the comparable period of the prior
    year                                                                                   |  | $                     | 118   |  
|                                                                                                                                            |  |                       |       |  

Specialty and Other Margin.Our specialty and other margin
decreased 1%, or $3 million, to $245 million for the
year ended December 31, 2002. The decrease was primarily
driven by the loss of PacifiCare senior dental and vision
members attributable to dental benefit changes effective
January 1, 2002.

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Medical Loss Ratio.The consolidated MLR and its
components, unadjusted for any prior period changes in
healthcare cost estimates, for the year ended December 31,
2002 and the prior year are as follows:

|                    |                           |              |  |      |   |  |  |      |  
|------------------- | ------------------------- | ------------ |  | ---- | - |  |  | ---- | -
|                    |                           |             
|                    |                           | Year Ended  
|                    |                           | December 31,
|                    |                           |             
|                    |                           | 2002         |  | 2001
|                    |                           |              |  |     
|Medical loss ratio: |                           |              |  |      |   |  |  |     
|                    | Consolidated              |              |  | 86.8 | % |  |  | 89.7 | %
|                    | Private  Commercial      |              |  | 87.1 | % |  |  | 89.3 | %
|                    | Private  Senior          |              |  | 53.5 | % |  |  | 79.7 | %
|                    | Private  Consolidated    |              |  | 86.7 | % |  |  | 89.2 | %
|                    | Government  Senior       |              |  | 86.9 | % |  |  | 90.1 | %
|                    | Government  Consolidated |              |  | 86.9 | % |  |  | 90.1 | %

Private  Commercial Medical Loss
Ratio.Our private 
commercial medical loss ratio decreased to 87.1% for the year
ended December 31, 2002 compared to 89.3% in the prior
year. The decrease was driven by significant premium rate
increases that outpaced an increase in health care services and
other expenses on both an absolute dollar and per member per
month basis.

Private  Senior Medical Loss
Ratio.Our private 
senior medical loss ratio decreased to 53.5% for year ended
December 31, 2002 compared to 79.7% in the prior year. The
decrease was driven by rate increases, benefit reductions
primarily of prescription drugs, effective January 1, 2002
and decreased utilization attributable to our medical management
programs that outpaced an increase in health care services and
other expenses on a per member per month basis.

Government  Senior Medical Loss
Ratio.Our government 
senior medical loss ratio decreased to 86.9% for the year ended
December 31, 2002 compared to 90.1% in the prior year. The
decrease was driven by a 8% increase in premium revenue, offset
partially by a 4% decrease in health care services and other
expenses.

Selling, General and Administrative
Expenses.Selling, general and
administrative expenses increased $82 million to
$1.4 billion for the year ended December 31, 2002,
from $1.3 billion in the prior year. Selling, general and
administrative expenses increased primarily due to increased
spending for information technology, or IT, initiatives, our
PacifiCare and Secure Horizons brand building campaign and
incentive compensation costs. These costs were partially offset
by lower labor costs as a result of our 2001 corporate
restructuring and no goodwill amortization in 2002 due to the
adoption of SFAS No. 142, Goodwill and Other Intangible
Assets. See Note 7 of the Notes to Consolidated
Financial Statements.

Selling, general and administrative expenses as a
percentage of operating revenue (excluding net investment
income) increased compared to the prior year primarily due to
declines in operating revenue (excluding net investment income)
totaling $641 million for the year ended December 31,
2002.

|                                                                                                                        |  |              |      |      |  |  |      |  
|----------------------------------------------------------------------------------------------------------------------- |  | ------------ | ---- | ---- |  |  | ---- | -
|                                                                                                                        |  |             
|                                                                                                                        |  | Year Ended  
|                                                                                                                        |  | December 31,
|                                                                                                                        |  |             
|                                                                                                                        |  | 2002         |      | 2001
|                                                                                                                        |  |              |      |     
|Selling, general and administrative expenses as a
    percentage of operating revenue (excluding net investment income) |  |              | 12.4 | %    |  |  | 11.0 | %

Impairment, Disposition, Restructuring,
Office of Personnel Management, or OPM, and Other
Charges.We recognized net pretax
charges of approximately $3.7 million ($2.2 million or
$0.04

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diluted loss per share, net of tax) for the year
ended December 31, 2002. See Note 10 of the Notes to
Consolidated Financial Statements.


Interest Expense.Interest expense increased 7%, or
$5 million, to $75 million for the year ended
December 31, 2002, from $70 million in the prior year
due to our sale of $500 million in aggregate principal
amount of 10 3/4% senior notes in May 2002, which carried a
higher annual interest rate than the debt we repaid using the
proceeds of that offering. The increase was partially offset by
cash redemptions of a portion of our outstanding 7% FHP senior
notes and our sale of $135 million in aggregate principal
amount of 3% convertible subordinated debentures in the fourth
quarter of 2002, which carried a lower annual interest rate than
the debt we repaid using a portion of the proceeds of that
offering. See Note 5 of the Notes to Consolidated Financial
Statements.

Provision for Income Taxes.The effective income tax rate was
37.3% for the year ended December 31, 2002, compared with
67.9% in 2001. The decrease was primarily attributable to our
adoption of Statement of Financial Accounting Standards (SFAS)
No. 142, Goodwill and Other Intangible Assets,
effective January 1, 2002. Under SFAS No. 142,
beginning with the first quarter of 2002, goodwill is no longer
being amortized. Because a significant portion of our goodwill
amortization was nondeductible, this accounting change caused a
significant reduction to our effective tax rate.

Liquidity and Capital Resources

Operating Cash Flows.Our consolidated cash, equivalents
and marketable securities increased $411 million, or 19%,
to $2.6 billion at December 31, 2003, from
$2.1 billion at December 31, 2002.

Cash flows provided by operations were
$414 million (or $397 million, excluding the impact of
unearned premium revenue) for the year ended December 31,
2003 compared to cash flows provided by operations of
$242 million (or $312 million, excluding the impact of
unearned premium revenue) for the year ended December 31,
2002. The increase was primarily related to our increased net
income for the year ended December 31, 2003 and the changes
in assets and liabilities as discussed below in Other
Balance Sheet Change Explanations.

Investing Activities.For the year ended
December 31, 2003, investing activities used
$202 million of cash, compared to $278 million used
during the year ended December 31, 2002. The change was
primarily related to decreased purchases of restricted
marketable securities, partially offset by an increase in
purchases of unrestricted marketable securities.

Financing Activities.For the year ended
December 31, 2003, financing activities provided
$34 million of cash, compared to $10 million provided
during the year ended December 31, 2002. During the year
ended December 31, 2003, the significant changes were as
follows:



|  |                                                                                                                                                                                                                                                                                                                                                                       
|- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | We redeemed $175 million in principal of our
    10  3/4% senior notes, paid a redemption premium of
    $19 million and received approximately $200 million of
    net proceeds from our public offering of 7.6 million shares
    of common stock in 2003, after adjusting the number of shares
    for the two-for-one stock split in the form of a stock dividend.
| 
| | We paid $151 million on our previous senior
    credit facility and received $150 million of proceeds from
    our new syndicated senior credit facility in 2003.                                                                                                                                                                                                     
| 
| | We paid $43 million on the remaining
    principal balance from the FHP senior notes by liquidating the
    restricted cash collateral which was established for this
    purpose, with no comparable activity during 2002.                                                                                                                                           
| 
| | We received $41 million from the issuance of
    common stock for year ended December 31, 2003 in connection
    with our Employee Stock Purchase Plan and exercises of employee
    stock options compared to $5 million during the same period
    in 2002.                                                                                                         

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|  |                                                                                                                                                                                                                                                                                                                                                                                                                                              
|- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | We paid $7 million in loan fees in
    connection with the replacement of our senior credit facility in
    June 2003. In 2002, we paid $38 million in loan fees,
    including $20 million in connection with the 10 3/4%
    senior notes offering, $13 million in connection with the
    amendment to the previous senior credit facility, and
    $5 million in connection with the 3% convertible
    subordinated debentures offering.
| 
| | We received $135 million from the
    3% convertible subordinated debentures offering in 2002,
    with no comparable activity during 2003.                                                                                                                                                                                                                                                                                                  
| 
| | We paid $554 million under our senior credit
    facility, including $499 million under the term loan
    facility and $55 million under the revolving credit
    facility, and received $497 million of proceeds from the
    10 3/4 senior notes offering in 2002.                                                                                                                                                                         
| 
| | We received $9 million in proceeds from a
    draw down on an equity commitment arrangement in 2002, with no
    comparable activity during 2003.                                                                                                                                                                                                                                                                                            

We have $135 million in aggregate principal
amount of 3% convertible subordinated debentures due in
2032. The debentures are convertible into 6,428,566 shares of
common stock under certain conditions, including satisfaction of
a market price condition for our common stock, satisfaction of a
trading price condition relating to the debentures, upon notice
of redemption, or upon specified corporate transactions. Each
$1,000 of the debentures is convertible into 47.619 shares
of our common stock. The market price condition for conversion
of the debentures is satisfied if the closing sale price of our
common stock exceeds 110% of the conversion price (which is
calculated at $23.10 per share) for the debentures for at
least 20 trading days in the 30 consecutive trading
days ending on the last trading day of any fiscal quarter. In
the event that the market price condition is satisfied during
any fiscal quarter, the debentures are convertible, at the
option of the holder, during the following fiscal quarter. The
market price condition is evaluated each quarter to determine
whether the debentures will be convertible at the option of the
holder during the following fiscal quarter. During the fiscal
year ended December 31, 2003, the market price condition
described above was satisfied for the quarters ended
September 30, 2003 and December 31, 2003. As a result,
the debentures were convertible during the quarter ended
December 31, 2003 and remain convertible at the option of
the holder at any time during the quarter ended March 31,
2004. While no debentures were converted as of December 31,
2003, they are considered common stock equivalents and are
included in the calculation of weighted average shares
outstanding on a diluted basis for the fourth quarter and fiscal
year ended December 31, 2003.

Beginning in October 2007, we may redeem for
cash all or any portion of the debentures, at a purchase price
of 100% of the principal amount plus accrued interest, upon not
less than 30 nor more than 60 days written notice to
the holders. Beginning in October 2007, and in successive
5-year increments, our holders may require us to repurchase the
debentures for cash at a repurchase price of 100% of the
principal amount plus accrued interest. Our payment obligations
under the debentures are subordinated to our senior
indebtedness, and effectively subordinated to all indebtedness
and other liabilities of our subsidiaries.

We have $325 million in aggregate principal
amount of 10 3/4% senior notes due in 2009 outstanding. The
10 3/4% senior notes were issued in May 2002 at
99.389% of the aggregate principal amount representing a
discount of $3 million that is being amortized over the
term of the notes. In December 2003, in accordance with the
applicable provisions of the indenture, we redeemed
$175 million in principal of the senior notes at a
redemption price equal to 110.750%, plus accrued and unpaid
interest on the notes as of the redemption date. We expensed
approximately $28 million in connection with the
redemption, including the pro-rata write-off of the initial
discount, the redemption premium and other fees and expenses
associated with the transaction. We may redeem the remaining
10 3/4% senior notes at any time on or after
June 1, 2006 at an initial redemption price equal to
105.375% of their principal amount plus accrued and unpaid
interest. The redemption price

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will thereafter decline annually. Additionally,
at any time on or prior to June 1, 2006, we may redeem the
10 3/4% senior notes upon a change of control, as
defined in the indenture for the notes, at 100% of their
principal amount plus accrued and unpaid interest and a
make-whole premium.


Certain of our domestic, unregulated subsidiaries
fully and unconditionally guarantee the 10 3/4% senior
notes. Prior to September 15, 2003, some of our domestic,
unregulated subsidiaries were restricted from guaranteeing the
10 3/4% senior notes by the terms of the
FHP senior notes. As the FHP senior notes were repaid
in full on September 15, 2003, these subsidiaries now fully
and unconditionally guarantee the 10 3/4% senior
notes. See Note 15 of the Notes to Consolidated Financial
Statements.

In April 2003, we entered into an interest rate
swap on $300 million of our 10 3/4% senior notes
for the purpose of hedging the fair value of our indebtedness.
This fair value hedge is accounted for using the short-cut
method under SFAS No. 133, Accounting for Derivative
Instruments and Hedging Activities, whereby the hedge is
reported in our balance sheets at fair value, and the carrying
value of the long-term debt is adjusted for an offsetting amount
representing changes in fair value attributable to the hedged
risk. Under the terms of the agreement, we make interest
payments based on the three-month London Interbank Offered Rate
(LIBOR) plus 692 basis points and receive interest
payments based on the 10 3/4% fixed rate. Our rate
under the swap agreement was 8.09%, at December 31, 2003
which is based on a 90-day LIBOR of 1.17% plus
692 basis points. The three-month LIBOR rate we use to
determine our interest payments under the swap agreement was
first established on June 2, 2003 and resets every three
months thereafter, until expiration in June 2009.

In June 2003, we replaced our senior credit
facility with a new syndicated facility with JPMorgan Chase Bank
serving as the Administrative Agent. The new facility consists
of a $150 million term loan, which matures on June 3,
2008, and a $150 million revolving line of credit, which
matures on June 3, 2006. We used the proceeds from the term
loan to repay the $131 million outstanding under the prior
facility. The remaining $19 million was used to pay fees
and expenses relating to the new facility and for general
corporate purposes. As of December 31, 2003, we had
$149 million outstanding on the term loan and no balance
outstanding on the revolving line of credit. We borrowed and
repaid $3 million under the revolving line of credit during the
year ended December 31, 2003.

On December 17, 2003, our senior credit
facility was amended to provide for reduced interest rates per
annum applicable to term loan borrowings, with the amount of
margin spread for the borrowing being determined by our current
debt ratings. The amended applicable rates are, at our option,
either JPMorgan Chase Banks prime rate (or, if greater,
the Federal Funds Rate plus 0.5%) which we refer to as the
alternative base rate, plus a margin spread of 1.25% to
1.75% per annum, or the LIBOR for the applicable interest
period, plus a margin spread of 2.25% to 2.75% per annum.
All of our borrowings under the term loan are currently LIBOR
borrowings, and the current margin spread on our term loan
borrowings is 2.50%. As of December 31, 2003, our term loan
rate was 3.68% per annum, which is based on a 90-day LIBOR of
1.18% plus the applicable margin spread of 2.50%. The
interest rates per annum under the senior credit facility
applicable to revolving credit borrowings are, at our option,
either the alternate base rate plus a margin spread of between
1.5% to 2.75% per annum, or the LIBOR for the applicable
interest period plus a margin spread of between 2.5% to
3.75% per annum, with the amount of the margin for any
borrowing being determined based on current credit ratings for
the debt under the senior credit facility. Our current margins
for revolving credit borrowings are 2.25% per annum for
alternate base rate borrowings and 3.25% per annum for
LIBOR borrowings.

The terms of the senior credit facility contain
various covenants customary for financings of this type which
place restrictions on our and/or our subsidiaries ability
to incur debt, pay dividends, create liens, make investments,
optionally repay, redeem or repurchase our securities, and enter
into

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mergers, dispositions and transactions with
affiliates. The senior credit facility also requires us to meet
various financial ratios, including a minimum net worth
requirement, a minimum fixed-charge coverage requirement and a
maximum leverage ratio. At December 31, 2003, we were in
compliance with all of these covenants. See Note 5 of the
Notes to Consolidated Financial Statements.


Certain of our domestic, unregulated subsidiaries
provide guarantees and have granted security interests to the
lenders in substantially all of their personal property in order
to secure our obligations under the senior credit facility. We
have also pledged the equity of certain of our subsidiaries to
the lenders. Prior to September 15, 2003, some of our
domestic, unregulated subsidiaries were restricted from
guaranteeing the senior credit facility by the terms of the FHP
senior notes. As the FHP senior notes were repaid in full on
September 15, 2003, these subsidiaries now fully and
unconditionally guarantee the senior credit facility.

|                                                                         |  |                       |      |           |  |       |     |   |  |   |      |  
|------------------------------------------------------------------------ |  | --------------------- | ---- | --------- |  | ----- | --- | - |  | - | ---- | -
|                                                                         |  |                       |      | Revolving |  |      
|                                                                         |  | Term Loan             |      | Credit    |  |      
|                                                                         |  | Facility              |      | Facility  |  | Total
|                                                                         |  |                       |      |           |  |      
|                                                                         |  |                      
|                                                                         |  | (Amounts in millions)
|Balance at December 31, 2001                                             |  | $                     | 650  |           |  | $     | 55  |   |  | $ | 705  |  
|Proceeds applied from funding of
    10 3/4% senior notes                |  |                       | (315 | )         |  |       | (54 | ) |  |   | (369 | )
|Scheduled payments                                                       |  |                       | (60  | )         |  |       |    |   |  |   | (60  | )
|Proceeds applied from funding of convertible
    subordinated debentures |  |                       | (53  | )         |  |       |    |   |  |   | (53  | )
|Proceeds applied from sales of property                                  |  |                       | (35  | )         |  |       |    |   |  |   | (35  | )
|Payments under amendment to senior credit facility                       |  |                       | (32  | )         |  |       |    |   |  |   | (32  | )
|Proceeds applied from equity commitment
    arrangement                  |  |                       | (4   | )         |  |       | (1  | ) |  |   | (5   | )
|                                                                         |  |                       |      |           |  |       |     |   |  |   |      |  
|Balance at December 31, 2002                                             |  |                       | 151  |           |  |       |    |   |  |   | 151  |  
|                                                                         |  |                       |      |           |  |       |     |   |  |   |      |  
|Scheduled payments under prior senior credit
    facility                |  |                       | (20  | )         |  |       |    |   |  |   | (20  | )
|Repayment of outstanding balance under prior
    senior credit facility  |  |                       | (131 | )         |  |       |    |   |  |   | (131 | )
|Proceeds from borrowing under new senior credit
    facility             |  |                       | 150  |           |  |       | 3   |   |  |   | 153  |  
|Scheduled payments under new senior credit
    facility                  |  |                       | (1   | )         |  |       | (3  | ) |  |   | (4   | )
|                                                                         |  |                       |      |           |  |       |     |   |  |   |      |  
|Balance at December 31, 2003                                             |  | $                     | 149  |           |  | $     |    |   |  | $ | 149  |  
|                                                                         |  |                       |      |           |  |       |     |   |  |   |      |  

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Our contractual cash obligations as of
December 31, 2003, including long-term debt and other
commitments, were as follows:

|                                                                          |                                       |                                                                    |       |           |       |             |     |             |     |         |     |    |     |   |     |     |     |   |     |     |     | 
|------------------------------------------------------------------------- | ------------------------------------- | ------------------------------------------------------------------ | ----- | --------- | ----- | ----------- | --- | ----------- | --- | ------- | --- | -- | --- | - | --- | --- | --- | - | --- | --- | --- | 
|                                                                          |                                       |                                                                   
|                                                                          |                                       | Payments Due by Period                                            
|                                                                          |                                       |                                                                   
|                                                                          |                                       |                                                                    |       | Less than |       |             |     | More than  
|                                                                          |                                       | Total                                                              |       | 1 year    |       | 1  3 years |     | 3  5 years |     | 5 years
|                                                                          |                                       |                                                                    |       |           |       |             |     |             |     |        
|                                                                          |                                       |                                                                   
|                                                                          |                                       | (Amounts in millions)                                             
|Long-term debt:                                                           |                                       |                                                                    |       |           |       |             |     |             |     |         |     |    |     |   |     |     |     |   |     |    
|                                                                          | 10 3/4% senior notes, net of discount |                                                                    | $     | 323       |       |             | $   |            |     |         | $   |   |     |   | $   |    |     |   | $   | 323 |    
|                                                                          | Senior term loan                      |                                                                    |       | 149       |       |             |     | 2           |     |         |     | 24 |     |   |     | 123 |     |   |     |    |    
|                                                                          | Convertible subordinated debentures   |                                                                    |       | 135       |       |             |     |            |     |         |     |   |     |   |     |    |     |   |     | 135 |    
|                                                                          | Database financing agreement          |                                                                    |       | 9         |       |             |     | 5           |     |         |     | 4  |     |   |     |    |     |   |     |    |    
|                                                                          | Other                                 |                                                                    |       | 4         |       |             |     |            |     |         |     | 2  |     |   |     | 1   |     |   |     | 1   |    
|                                                                          |                                       |                                                                    |       |           |       |             |     |             |     |         |     |    |     |   |     |     |     |   |     |    
|                                                                          |                                       | Total long-term debt commitments, including
    current maturities |       |           | 620   |             |     |             | 7   |         |     |    | 30  |   |     |     | 124 |   |     |     | 459 | 
|                                                                          |                                       |                                                                    |       |           |       |             |     |             |     |         |     |    |     |   |     |     |     |   |     |    
|Other commitments:                                                        |                                       |                                                                    |       |           |       |             |     |             |     |         |     |    |     |   |     |     |     |   |     |    
|Information technology outsourcing contracts(1)                           |                                       |                                                                    | 1,118 |           |       |             | 175 |             |     |         | 306 |    |     |   | 263 |     |     |   | 374 |    
|Operating leases                                                          |                                       |                                                                    | 107   |           |       |             | 27  |             |     |         | 44  |    |     |   | 25  |     |     |   | 11  |    
|Purchase obligations(2)                                                   |                                       |                                                                    | 51    |           |       |             | 27  |             |     |         | 14  |    |     |   | 6   |     |     |   | 4   |    
|Interest on long-term debt, including current
    maturities(3)           |                                       |                                                                    | 288   |           |       |             | 37  |             |     |         | 74  |    |     |   | 68  |     |     |   | 109 |    
|Other long-term liabilities reflected on our
    balance sheet under GAAP |                                       |                                                                    | 28    |           |       |             |    |             |     |         |    |    |     |   |    |     |     |   | 28  |    
|                                                                          |                                       |                                                                    |       |           |       |             |     |             |     |         |     |    |     |   |     |     |     |   |     |    
|                                                                          |                                       | Total other commitments                                            |       |           | 1,592 |             |     |             | 266 |         |     |    | 438 |   |     |     | 362 |   |     |     | 526 | 
|                                                                          |                                       |                                                                    |       |           |       |             |     |             |     |         |     |    |     |   |     |     |     |   |     |    
|Total contractual cash obligations                                        |                                       | $                                                                  | 2,212 |           |       | $           | 273 |             |     | $       | 468 |    |     | $ | 486 |     |     | $ | 985 |    
|                                                                          |                                       |                                                                    |       |           |       |             |     |             |     |         |     |    |     |   |     |     |     |   |     |    



---



|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | Amounts under information technology outsourcing
    contracts reflect our payment obligations for the resource
    baselines specified in the applicable outsourcing contracts and
    do not take into consideration any rights we may have under
    these contracts to reduce or eliminate resource usage or
    baselines.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|   
|(2) | Purchase obligations include agreements to
    purchase goods or services that are enforceable and legally
    binding on us and that specify all significant terms, including:
    fixed or minimum quantities to be purchased; fixed, minimum or
    variable price provisions; and the approximate timing of the
    transaction. This includes contracts which are cancelable with
    notice and the payment of an early termination penalty. Purchase
    obligations exclude agreements that are cancelable without
    penalty and also exclude liabilities to the extent presented on
    the balance sheet as of December 31, 2003. 
     We are subject to various contracts with certain health care
    providers and facilities for the provision of health care
    services to its members. Such contracts involve payments from
    us, generally on a monthly basis, in the ordinary course of
    business and are not included in the above table because we are
    not required to make minimum payments under these contracts.
|   
|(3) | Interest on long-term debt is calculated using
    the stated rates per the financing agreements. For debt with
    variable rates, such as the swap on $300 million of our
    10 3/4% senior notes and the senior term loan, the
    rate in place as of December 31, 2003 was used to estimate
    all remaining payments.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        

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As of December 31, 2003 we did not have any
off-balance sheet arrangements that are required to be disclosed
under Item 303(a)(4)(ii) of SEC Regulation S-K.

In February 2004, our debt was rated below
investment grade by the major credit rating agencies as follows:

|                  |  |          |  |          |     |         |  |              |     |  |  |  |    | 
|----------------- |  | -------- |  | -------- | --- | ------- |  | ------------ | --- |  |  |  | -- | 
|                  |  |          |  | Senior   |     | 10 3/4% |  | Convertible 
|                  |  |          |  | Credit   |     | Senior  |  | Subordinated
|Agency            |  | Outlook  |  | Facility |     | Notes   |  | Debentures  
|                  |  |          |  |          |     |         |  |             
|Moodys           |  | Positive |  |          | Ba3 |         |  |              | B1  |  |  |  | B2 | 
|Standard & Poors |  | Stable   |  |          | BB+ |         |  |              | BB+ |  |  |  | B  | 
|Fitch IBCA        |  | Positive |  |          | BB  |         |  |              | BB  |  |  |  | B+ | 

Consequently, if we seek to raise funds in
capital markets transactions, our ability to do so will be
limited to issuing additional non-investment grade debt or
issuing equity and/or equity-linked instruments.

We expect to fund our working capital
requirements and capital expenditures during the next twelve
months from our cash flow from operations or from capital market
transactions. We have taken a number of steps to increase our
internally generated cash flow, including increasing premiums,
increasing our marketing of specialty product lines, introducing
new products to generate new revenue sources and reducing our
health care expenses by, among other things, exiting from
unprofitable markets and cost savings initiatives. If our cash
flow is less than we expect due to one or more of the risk
factors described in Cautionary Statements, or our
cash flow requirements increase for reasons we do not currently
foresee or we make any acquisitions as part of our growth
strategy, then we may need to draw down available funds on our
revolving line of credit which matures in June 2006 or issue
additional debt or equity securities. A failure to comply with
any covenant in the senior credit facility could make funds
under our revolving line of credit unavailable. We also may be
required to take additional actions to reduce our cash flow
requirements, including the deferral of planned investments
aimed at reducing our selling, general and administrative
expenses. The deferral or cancellation of any investments could
have a material adverse impact on our ability to meet our
short-term business objectives. We regularly evaluate cash
requirements for current operations and commitments, and for
capital acquisitions and other strategic transactions. We may
elect to raise additional funds for these purposes either
through additional debt or equity, the sale of investment
securities or otherwise as appropriate. We have an effective
shelf registration statement on file with the Securities and
Exchange Commission under which we may sell common stock,
preferred stock, depositary shares, debt securities, warrants,
stock purchase contracts and stock purchase units in one or more
offerings from time to time up to a total dollar amount of
$600 million. As of December 31, 2003, we have
approximately $400 million available under the shelf
registration after our common stock offering in November 2003.
The actual amount of any securities issued, the terms of those
securities and the intended use of the proceeds from any sale,
will be determined at the time of sale, if any such sale occurs.

Other Balance Sheet Change
Explanations

Receivables, Net.Receivables, net as of
December 31, 2003, decreased $24 million from
December 31, 2002 due to the decrease in provider
receivables from collections and settlements primarily in
California and Washington.

Medical Claims and Benefits Payable.The majority of our medical
claims and benefits payable represents liabilities related to
our risk-based contracts. Under risk-based contracts, claims are
payable once incurred and cash disbursements are made to health
care providers for services provided to members after the
related claim has been submitted and adjudicated. Under
capitated contracts, health care providers are prepaid on a
fixed-fee per member per month basis, regardless of the

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services provided to members. The liabilities
that arise for capitated contracts relate to timing issues
primarily due to membership changes that may occur. As of
December 31, 2003, approximately 85% of medical claims
and benefits payable was attributable to risk-based contracts.


The following table presents the breakdown of our
medical claims and benefits payable:

|                                                                 |  |                       |       |              |  |   |       | 
|---------------------------------------------------------------- |  | --------------------- | ----- | ------------ |  | - | ----- | 
|                                                                 |  | December 31,          |       | December 31,
|                                                                 |  | 2003                  |       | 2002        
|                                                                 |  |                       |       |             
|                                                                 |  |                      
|                                                                 |  | (Amounts in millions)
|Incurred But Not Reported (IBNR)                                 |  | $                     | 826   |              |  | $ | 753   | 
|Capitation and All Other Medical Claims and
    Benefits Payable |  |                       | 202   |              |  |   | 292   | 
|                                                                 |  |                       |       |              |  |   |       | 
|Medical Claims and Benefits Payable                              |  | $                     | 1,028 |              |  | $ | 1,045 | 
|                                                                 |  |                       |       |              |  |   |       | 

Medical claims and benefits payable as of
December 31, 2003 decreased $17 million from the
balance as of December 31, 2002, primarily due to a
$90 million reduction in capitation and all other medical
claims and benefits payable due primarily to annual settlements
of provider risk sharing programs through payouts or by
offsetting of risk program receivables against risk program
liabilities. IBNR increased $73 million as a result of an
increase in commercial risk membership and commercial health
care costs per member, partially offset by a decrease in the
elapsed time between the date health care services were provided
and payment of the related claims liabilities as compared to
December 31, 2002.

Accounts Payable and Accrued Liabilities.Accounts payable and accrued
liabilities, including accrued compensation and employee
benefits, increased $52 million from December 31,
2002, primarily due to an increase of $39 million related
to increases in liabilities for reinsurance and legal expenses
and the timing of payments of trade accounts payable and other
accruals, an increase of $16 million in accrued
compensation and an increase of $10 million in accrued
taxes, partially offset by a decrease of $13 million in OPM
reserves.

Stockholders Equity.The decrease in treasury stock and
additional paid-in capital from December 31, 2002 were
primarily due to the retirement of all 23 million shares of
outstanding treasury stock, partially offset by the issuance of
7.6 million shares in connection with the public common
stock offering and 1.5 million shares of restricted common
stock that we granted as part of an employee recognition and
retention program during the year ended December 31, 2003.
All share data have been adjusted for the effect of the
two-for-one stock split in the form of a stock dividend that was
effective January 20, 2004. See Note 6 of the Notes to
Consolidated Financial Statements.

Adoption of New Accounting Policy 
Stock-Based Compensation

For the year ended December 31, 2003, we
recognized approximately $8 million, net of tax, of
compensation expense related to stock-based compensation for
employees and directors related to stock options and shares
under the Employee Stock Purchase Plan. Prior to 2003, we
accounted for our stock-based employee and director compensation
plans under the recognition and measurement provisions of APB
Opinion No. 25, Accounting for Stock Issued to
Employees, and related Interpretations. Stock-based employee
and director compensation cost was not reflected in the net loss
for the year ended December 31, 2002, because all options
granted under our plans had exercise prices equal to the market
value of the underlying common stock on the date of grant.
Effective January 1, 2003, we adopted the fair value
recognition provisions of FASB Statement No. 123,
Accounting for Stock-Based Compensation, on a prospective
basis for all employee and director awards granted, modified, or
settled after January 1, 2003. Awards to employees
typically vest over four years. Therefore, the cost related to
stock-based employee and director compensation included in the
determination of net income for 2003 is less than that which
would have been recognized if the

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fair value based method had been applied to all
awards granted, modified or settled since October 1, 1995.
See Note 2 of the Notes to Consolidated Financial
Statements.


Critical Accounting Policies and
Estimates

When we prepare our consolidated financial
statements, we use estimates and assumptions that may affect
reported amounts and disclosures. The accounting estimates that
we believe involve the most complex judgments, and are the most
critical to the accurate reporting of our financial condition
and results of operations include the following:

Incurred But Not Reported or Paid Claims
Reserves.We estimate the amount
of our reserves for claims incurred but not reported (including
those received but not yet paid), or IBNR, under our risk-based
provider contracts and our fee-for service carve-outs from our
capitated provider contracts, primarily using standard actuarial
methodologies based on historical data. These standard actuarial
methodologies include, among other factors, contractual
requirements, historical utilization trends, the interval
between the date services are rendered and the date claims are
paid, denied claims activity, disputed claims activity, benefit
changes, expected health care cost inflation, seasonality
patterns and changes in membership. In developing the IBNR
estimate, we apply different estimation methods depending on the
month for which incurred claims are being estimated. For
example, we actuarially calculate completion factors using our
analysis of claims payment patterns over the most recent
36-month period. The completion factor is an actuarial estimate,
based upon historical experience, of the percentage of claims
incurred during a given period that has been adjudicated by us
as of the date of estimation. We then apply these completion
factors to the actual claims paid to-date for each incurral
month, except for the most recent months, to estimate the
expected amount of ultimate incurred claims for each of these
months. We do not believe that completion factors are a reliable
basis for estimating claims incurred for the most recent two to
four months, because claims likely have not had enough time to
achieve a trendable level of completion. Therefore, for the more
recent months, we estimate our claims incurred by applying
observed trend factors to the per member per month (PMPM) costs
for prior months, which costs have been estimated using
completion factors, in order to estimate the PMPMs for the most
recent months. We validate our estimates of the most recent
PMPMs by comparing the most recent months utilization
levels to the utilization levels in older months. This approach
is consistently applied from period to period.

The completion factors and claims PMPM trend
factors are the most significant factors we use in estimating
our IBNR. The following table illustrates the sensitivity of
these factors and the estimated potential impact on the
Companys operating results caused by these factors:

|                              |    |                        |  |   |     |  
|----------------------------- | -- | ---------------------- |  | - | --- | -
|Completion Factor(a)          |    | Increase (Decrease) in
|Increase (Decrease) in Factor |    | Medical Claims Payable
|                              |    |                       
|                              |    | (Amounts in millions) 
|                              | (3 | )%                     |  | $ | 41  |  
|                              | (2 | )%                     |  |   | 27  |  
|                              | (1 | )%                     |  |   | 13  |  
|                              | 1  | %                      |  |   | (13 | )
|                              | 2  | %                      |  |   | (26 | )
|                              | 3  | %                      |  |   | (39 | )

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|                              |    |                        |  |   |    |  
|----------------------------- | -- | ---------------------- |  | - | -- | -
|Claims Trend Factor(b)        |    | Increase (Decrease) in
|Increase (Decrease) in Factor |    | Medical Claims Payable
|                              |    |                       
|                              |    | (Amounts in millions) 
|                              | (3 | )%                     |  | $ | (2 | )
|                              | (2 | )%                     |  |   | (1 | )
|                              | (1 | )%                     |  |   | (1 | )
|                              | 1  | %                      |  |   | 1  |  
|                              | 2  | %                      |  |   | 1  |  
|                              | 3  | %                      |  |   | 2  |  



---



|    |                                                                                                                                                                                                                
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(a) | Reflects estimated potential changes in medical
    claims payable caused by changes in completion factors in each
    of the most recent four months.                                                         
|   
|(b) | Reflects estimated potential changes in medical
    claims payable caused by changes in annualized claims trend used
    for the estimation of per member per month claims for the most
    recent four months.

In addition, assuming a hypothetical 1%
difference between our December 31, 2003 estimated claims
liability and the actual claims incurred run-out, net income for
the year ended December 31, 2003 would increase or decrease
by approximately $8.3 million, while diluted net income per
share would increase or decrease by $0.06 per share, net of tax,
after adjusting for the two-for-one stock split in the form of a
stock dividend that was effective January 20, 2004.

The estimates for submitted claims and IBNR
claims liabilities are made on an accrual basis and adjusted,
based on actual claims data, in future periods as required.
Adjustments to prior period estimates, if any, are included in
the current period. We also consider exceptional situations that
might require judgmental adjustments in establishing our best
estimate, such as system conversions, processing interruptions,
or environmental changes. None of these factors had a material
impact on the development of our claims payable estimates during
any of the periods reflected in this filing.

For new products, such as our PPO products,
estimates are initially based on health care cost data provided
by third parties. This data includes assumptions for member age,
gender and geography. The models that we use to prepare
estimates for each product are adjusted to be in line with the
approach discussed above as we accumulate actual claims data.
Such estimates could materially understate or overstate our
actual liability for medical claims and benefits payable.

Provider Insolvency Reserves.We maintain insolvency reserves
for our capitated contracts with providers that include
estimates for potentially insolvent providers, where conditions
indicate claims are not being paid or have slowed considerably,
and we have determined that it is probable that we will be
required to make the providers claim payments. These
insolvency reserves include the estimated cost of unpaid health
care claims that were previously the responsibility of the
capitated provider. Depending on states laws, we may be
held liable for unpaid health care claims that were previously
the responsibility of the capitated provider and for which we
have already paid capitation. These estimates could materially
understate or overstate our actual liability for medical claims
and benefits payable.

Ordinary Course Legal Proceedings.From time to time, we are involved
in legal proceedings that involve claims for coverage and tort
liability encountered in the ordinary course of business. The
loss of even one of these claims, if it results in a significant
punitive damage award, could have a material adverse effect on
our business. In addition, our exposure to potential liability
under punitive damage theories may significantly decrease our
ability to settle these claims on reasonable terms.

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CAUTIONARY STATEMENTS

In connection with the safe harbor
provisions of the Private Securities Litigation Reform Act of
1995, we are hereby filing cautionary statements identifying
important risk factors that could cause our actual results to
differ materially from those projected in forward looking
statements of the Company made by or on behalf of the
Company (in this report or otherwise), within the meaning of
Section 21E of the Securities Exchange Act of 1934, as
amended, and Section 27A of the Securities Act of 1933, as
amended. These forward looking statements relate to future
events or our future financial and/or operating performance and
can generally be identified as such because the context of the
statement will include words such as may,
will, intends, plans,
believes, anticipates,
expects, estimates,
predicts, potential,
continue, or opportunity, the negative
of these words or words of similar import. Similarly, statements
that describe our reserves and our future plans, strategies,
intentions, expectations, objectives, goals or prospects are
also forward looking statements. These forward looking
statements are based largely on our expectations and projections
about future events and future trends affecting our business,
and so are subject to risks and uncertainties, including the
risks and uncertainties set forth below, that could cause actual
results to differ materially from those anticipated as of the
date of this report. In addition, past financial and/or
operating performance is not necessarily a reliable indicator of
future performance and you should not use our historical
performance to anticipate results or future period trends. In
evaluating these statements, you should specifically consider
the risks described below and in other parts of this report.
Except as required by law, we undertake no obligation to
publicly revise these forward-looking statements to reflect
events or circumstances that arise after the date of this report.

Risks Relating to Us and Our
Industry

Our profitability will depend in part on
accurately pricing our products and predicting health care costs
and on our ability to control future health care
costs.

Our profitability depends in part on our ability
to price our products accurately, predict our health care costs
and control future health care costs through underwriting
criteria, medical and disease management programs, product
design and negotiation of favorable provider and hospital
contracts. We use our underwriting systems to establish and
assess premium rates based on accumulated actuarial data, with
adjustments for factors such as claims experience and hospital
and physician contract changes. We may be less able to
accurately price our new products than our other products
because of our relative lack of experience and accumulated data
for our new products. Premiums on our commercial products are
generally fixed for one-year periods. Each of our subsidiaries
that offers Medicare+Choice products must submit adjusted
community rate proposals, generally by county or service area,
to CMS in early September for each Medicare+Choice product that
will be offered in a subsequent year. As a result, increases in
the costs of health care services in excess of the estimated
future health care costs reflected in the premiums or the
adjusted community rate proposals generally cannot be recovered
in the applicable contract year through higher premiums or
benefit designs.

Our actual health care costs may exceed our
estimates reflected in premiums and adjusted community rates due
to various factors, including increased utilization of medical
facilities and services, including prescription drugs, changes
in demographic characteristics, the regulatory environment,
changes in health care practices, medical cost inflation, new
treatment and technologies, continued consolidation of
physician, hospital and other provider groups, termination of
capitation arrangements resulting in transfer of membership to
risk based arrangements and contractual disputes with providers.
Our failure to adequately price our products or predict and
control health care costs may result in a material adverse
effect on our financial condition, results of operations or cash
flows.

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If we fail to implement successfully our
strategic initiatives, our revenues could decline and our
results of operations could be adversely affected.

Our performance depends in part upon our ability
to implement our business strategy of expanding our product
portfolio and increasing our commercial and specialty
memberships, managing our participation in the Medicare+Choice
program in light of the new Medicare legislation and growth
opportunity, and ultimately evolving into a consumer health
organization. In 2002 and 2003, we experienced a decline in
revenue from our reduced participation in Medicare+Choice and a
loss of unprofitable commercial membership. We are seeking to
replace revenue and increase our commercial business through a
number of new product initiatives. Our revenues could decline if
we lose membership, fail to increase membership in targeted
markets or fail to gain market acceptance for new products for
any reason, including:



|  |                                                                                                                                                                                      
|- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | the effect of premium increases, benefit changes
    and member-paid supplemental premiums and copayments on the
    retention of existing members and the enrollment of new members;
| 
| | the members assessment of our benefits,
    quality of service, our ease of use and our network stability
    for members in comparison to competing health plans;                  
| 
| | reductions in work force by existing customers
    and/or reductions in benefits purchased by existing customers;
    and                                                            
| 
| | negative publicity and news coverage about us or
    litigation or threats of litigation against us.                                                                                 

Our operating results could be adversely
affected if our actual health care claims exceed our reserves or
our liability for unpaid claims of insolvent providers under
capitation agreements exceeds our insolvency reserves.

We estimate the amount of our reserves for
submitted claims and claims that have been incurred but not yet
reported or IBNR claims primarily using standard actuarial
methodologies based upon historical data. The estimates for
submitted claims and IBNR claims liabilities are made on an
accrual basis, are continually reviewed and are adjusted in
current operations as required. Given the uncertainties inherent
in such estimates, the reserves could materially understate or
overstate our actual liability for claims and benefits payable.
Any increases to these prior estimates could adversely affect
our results of operations in future periods.

Our capitated providers could become insolvent
and expose us to unanticipated expenses. We maintain insolvency
reserves that include estimates for potentially insolvent
providers, where conditions indicate claims are not being paid
or have slowed considerably. Depending on states laws, we
may be held liable for unpaid health care claims that were
previously the responsibility of the capitated provider and for
which we have already paid capitation. We may also incur
additional health care costs in the event of provider
instability that causes us to replace a provider at less
cost-effective rates to continue providing health care services
to our members.

To reduce insolvency risk, we have developed
contingency plans that include shifting members to other
providers and reviewing operational and financial plans to
monitor and maximize financial and network stability. As
capitation contracts are renewed for providers we have also
taken steps, where feasible, to have security reserves
established for insolvency issues. Security reserves are most
frequently in the forms of letters of credit or segregated funds
that are held in the providers name in a third party
financial institution. The reserves may be used to pay claims
that are the financial responsibility of the provider. These
security reserves may not be adequate to cover claims that are
the financial responsibility of the provider.

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A disruption in our health care provider
network could have an adverse effect on our ability to market
our products and our profitability.

Our profitability is dependent in part upon our
ability to contract with health care providers on favorable
terms. In any particular market, health care providers could
refuse to contract with us, demand higher payments or take other
actions that could result in higher health care costs or our
difficulty in meeting regulatory or accreditation requirements.
In some markets, health care providers may have significant
market positions or may be the only available health care
provider. If health care providers refuse to contract with us,
use their market position to negotiate favorable contracts, or
place us at a competitive disadvantage, then our ability to
market products or to be profitable in those markets could be
adversely affected. Our provider networks could also be
disrupted by the financial insolvency of large provider groups.
Any disruption in our provider network could result in a loss of
membership or higher health care costs.

We may be exposed to liability or fail to
estimate IBNR accurately if we cannot process our increased
volume of claims accurately and timely.

We have regulatory risk for the timely processing
and payment of claims. If we, or any entities with whom we
subcontract to process or pay claims, are unable to handle
continued increased claims volume, or if we are unable to pay
claims timely we may be subject to regulatory censure and
penalties, which could have a material adverse effect on our
operations and results of operations. In addition, if our claims
processing system is unable to process claims accurately, the
data we use for our IBNR estimates could be incomplete and our
ability to estimate claims liabilities and establish adequate
reserves could be adversely affected.

Our profitability may be adversely affected if
we are unable to adequately control our prescription drug
costs.

Overall, prescription drug costs have been rising
for the past few years. The increases are due to the
introduction of new drugs that treat new conditions or have
fewer side effects, new medications costing significantly more
than existing drugs, direct consumer advertising by the
pharmaceutical industry creating consumer demand for particular
brand drugs, patients seeking medications to address lifestyle
changes, higher prescribed doses of medications and enhanced
pharmacy benefits for members such as reduced copayments and
higher benefit maximums. We may be unable to predict these costs
when establishing our premiums or completely manage these costs,
which could adversely impact our profitability.

Increases in our selling, general and
administrative expenses could harm our profitability.

Our selling, general and administrative expenses
have been rising due in part to our continued investment in
strategic initiatives and could increase more than we anticipate
as a result of a number of factors, which could adversely impact
our profitability. These factors include:



|  |                                                                                                                                                                                                                                                                    
|- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | our need for additional investments in PBM
    expansion, branding and advertising campaigns, medical
    management, underwriting and actuarial resources and technology;                                                                                         
| 
| | our need for additional investments in
    information technology projects, including consolidation of our
    existing systems that manage membership, eligibility,
    capitation, claims processing and payment information and other
    important information;
| 
| | our need for increased claims administration,
    personnel and systems;                                                                                                                                                                                           
| 
| | our greater emphasis on small group and
    individual health insurance products, which may result in an
    increase in the broker commissions we pay;                                                                                                            

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|  |                                                                                                                                                   
|- | --------------------------------------------------------------------------------------------------------------------------------------------------
| | the necessity to comply with regulatory
    requirements;                                                                                         
| 
| | the success or lack of success of our marketing
    and sales plans to attract new customers, and create customer
    acceptance for new products;
| 
| | our ability to estimate costs for our
    self-insured retention for medical malpractice claims; and                                              
| 
| | our ability to estimate legal expenses and
    settlements associated with litigation that has been or could be
    brought against us.           

In addition, our selling, general and
administrative expenses as a percentage of our revenue could
increase due to changes in our product mix among commercial,
senior and specialty products and unexpected declines in our
membership and related revenue. If we do not generate expected
cash flow from operations, we could be forced to postpone or
cancel some of these planned investments, which would adversely
affect our ability to meet our short-term strategic plan.

The inability or failure to properly maintain
management information systems, or any inability or failure to
successfully update or expand processing capability or develop
new capabilities to meet our business needs could result in
operational disruptions and other adverse
consequences.

Our business depends significantly on effective
information systems. The information gathered and processed by
our management information systems assists us in among other
things, marketing and sales tracking, underwriting, billing,
claims processing, capitation processing, medical management,
medical cost and utilization trending, financial and management
accounting, reporting, planning and analysis and e-commerce.
These systems also support our on-line customer service
functions, provider and member administrative functions and
support our tracking and extensive analyses of health care costs
and outcome data. Any inability or failure to properly maintain
management information systems, or any inability or failure to
successfully update or expand processing capability or develop
new capabilities to meet our business needs, could result in
operational disruptions, loss of existing customers, difficulty
in attracting new customers, disputes with customers and
providers, regulatory problems, increases in administrative
expenses and other adverse consequences.

We are subject to class action lawsuits that
could result in material liabilities to us or cause us to incur
material costs, to change our operating procedures or comply
with increased regulatory requirements.

Health care providers and members are currently
attacking practices of the HMO industry through a number of
lawsuits brought against us and other HMOs, including In re
Managed Care. The class action lawsuits brought by health
care providers allege that HMOs claims processing systems
automatically and impermissibly alter codes included on
providers reimbursement/ claims forms to reduce the amount
of reimbursement, and that HMOs impose unfair contracting terms
on health care providers, impermissibly delay making capitated
payments under their capitated contracts, and negotiate
capitation payments that are inadequate to cover the costs of
health care services provided.

These lawsuits, including those filed to date
against us, may take years to resolve and cause us to incur
substantial litigation expenses. Depending upon the outcomes of
these cases, these lawsuits may cause or force changes in
practices of the HMO industry. These cases also may cause
additional regulation of the industry through new federal or
state laws. These actions and actions brought by state attorney
generals ultimately could adversely affect the HMO industry and,
whether due to damage awards, required changes to our operating
procedures, increased regulatory requirements or otherwise, have
a material adverse effect on our financial position, results of
operations or cash flows and prospects.

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We are subject to other litigation in the
ordinary course of business that may result in material
liabilities to us, including liabilities for which we may not be
insured.

We are, in the ordinary course of business,
subject to the claims of our members arising out of decisions to
deny or restrict reimbursement for services, including medical
malpractice claims related to our taking a more active role in
managing the cost of medical care. The loss of even one of these
claims, if it results in a significant punitive damage award,
could have a material adverse effect on our business. In
addition, our exposure to potential liability under punitive
damage theories may significantly decrease our ability to settle
these claims on reasonable terms. We maintain general liability,
property, excess managed care errors and omissions and medical
malpractice insurance coverage. We are at risk for our
self-insured retention on these claims, and are substantially
self-insured for errors and omissions and medical malpractice
claims through a combination of retention and through premiums
we pay to a captive insurance carrier. Coverages typically
include varying and increasing levels of self-insured retention
or deductibles that increase our risk of loss.

As a government contractor, we are exposed to
risks that could materially affect our revenue or profitability
from our Medicare+Choice products or our willingness to
participate in the Medicare program.

The Medicare program has accounted for 49% of our
total revenue in 2003 and more than 50% of our total revenue in
each of the prior five years. CMS regulates the benefits
provided, premiums paid, quality assurance procedures, marketing
and advertising for our Medicare+Choice products. CMS may
terminate our Medicare+Choice contracts or elect not to renew
those contracts when those contracts come up for renewal every
12 months. Although we expect to receive increased
government funding under the newly enacted DIMA legislation, we
may still face the risk of reduced or insufficient government
reimbursement and the need to continue to exit unprofitable
markets. The loss of Medicare contracts or changes in the
regulatory requirements governing the Medicare+Choice program or
the program itself could have a material adverse effect on our
financial position, results of operations or cash flows.

We compete in highly competitive markets and
our inability to compete effectively for any reason in any of
those markets could adversely affect our
profitability.

We operate in highly competitive markets.
Consolidation of acute care hospitals and continuing
consolidation of insurance carriers, other HMOs, employer
self-funded programs and PPOs, some of which have substantially
larger enrollments or greater financial resources than ours, has
created competition for hospitals, physicians and members,
impacting profitability and the ability to influence medical
management. The cost of providing benefits is in many instances
the controlling factor in obtaining and retaining employer
groups as clients and some of our competitors have set premium
rates at levels below our rates for comparable products. We
anticipate that premium pricing will continue to be highly
competitive. In addition, PBM companies have continued to
consolidate, competing with our PBM, Prescription Solutions.
Some PBMs possess greater financial, marketing and other
resources than we possess. If we are unable to compete
effectively in any of our markets, our business may be adversely
affected.

Our business activities are highly regulated
and new and proposed government regulation or legislative
reforms could increase our cost of doing business, reduce our
membership or subject us to additional litigation.

Our health plans are subject to substantial
federal and state government regulations, including those
relating to:



|  |                                                            
|- | -----------------------------------------------------------
| | maintenance of minimum net worth or risk based
    capital;

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|  |                                                                                                                                                         
|- | --------------------------------------------------------------------------------------------------------------------------------------------------------
| | licensing requirements;                                                                                                                                 
| 
| | approval of policy language and benefits;                                                                                                               
| 
| | mandated benefits and administrative processes;                                                                                                         
| 
| | Employment Retirement Income Security Act of
    1974, or ERISA, claims and appeals review procedures for
    employer-sponsored and self-insured plans;
| 
| | provider compensation arrangements;                                                                                                                     
| 
| | member disclosure;                                                                                                                                      
| 
| | periodic audits and investigations by state and
    federal agencies;                                                                                   
| 
| | restrictions on some investment activities; and                                                                                                         
| 
| | restrictions on our subsidiaries ability to
    make dividend payments, loans, loan repayments or other payments
    to us.                            

The laws and regulations governing our business
and interpretations of these laws and regulations are subject to
frequent change. In recent years, significant federal and state
laws have been enacted that have increased our cost of doing
business, exposed us to increased liability and had other
adverse effects on our business. State and federal governments
are continually considering changes to the laws and regulations
regulating our industry, and are currently considering laws and
regulations relating to:



|  |                                                                                                                                                                                                                            
|- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | increasing minimum capital or risk based capital
    requirements;                                                                                                                                                         
| 
| | mandating benefits and products;                                                                                                                                                                                           
| 
| | restricting a health plans ability to limit
    coverage to medically necessary care;                                                                                                                                     
| 
| | reducing the reimbursement or payment levels for
    government funded programs;                                                                                                                                           
| 
| | imposing guidelines for pharmaceutical
    manufacturers that would cause pharmaceutical companies to
    restructure the financial terms of their business arrangements
    with PBMs, HMOs or other health plans;        
| 
| | patients bill of rights legislation at the
    state and federal level that would hold HMOs liable for medical
    malpractice;                                                                                           
| 
| | limiting a health plans ability to capitate
    physicians and hospitals or delegate financial risk, utilization
    review, quality assurance or other medical decisions to our
    contracting physicians and hospitals;
| 
| | restricting a health plans ability to
    select and terminate providers in our networks;                                                                                                                                 
| 
| | allowing independent physicians to collectively
    bargain with health plans on a number of issues, including
    financial compensation;                                                                                 
| 
| | adding further restrictions and administrative
    requirements on the use, retention, transmission, processing,
    protection and disclosure of personally identifiable health
    information; and                      
| 
| | tightening time periods for the timely payment
    and administration of health care claims and imposing financial
    and other penalties for non-compliance.                                                             

All of these proposals could apply to us and
could increase our health care costs, decrease our membership or
otherwise adversely affect our revenue and our profitability.

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Our investment portfolio is subject to
economic and market conditions as well as regulation that may
adversely affect the performance of the portfolio.

The market value of our investments fluctuates
depending upon economic and market conditions. The investment
income we earn has been negatively impacted by the lower
interest rates prevailing in United States financial markets. In
periods of declining interest rates, bond calls and mortgage
loan prepayments generally increase, resulting in the
reinvestment of these funds at the then lower market rates. Our
regulated subsidiaries are also subject to state laws and
regulations that require diversification of our investment
portfolio and limit the amount of investments we can make in
riskier investments that could generate higher returns. In some
cases, these laws could require the sale of investments in our
portfolio. We cannot be certain that our investment portfolio
will produce total positive returns in future periods or that we
will not sell investments at prices that are less than the
carrying value of these investments.

We have a significant amount of indebtedness
and may incur additional indebtedness in the future, which could
adversely affect our operations.

We have substantial indebtedness outstanding and
have available borrowing capacity under our senior credit
facility of up to $150 million. We may also incur
additional indebtedness in the future.

Our significant indebtedness poses risks to our
business, including the risks that:



|  |                                                                                                                                                                                                                                                 
|- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | we could use a substantial portion of our
    consolidated cash flow from operations to pay principal and
    interest on our debt, thereby reducing the funds available to
    fund our strategic initiatives and working capital requirements;
| 
| | insufficient cash flow from operations may force
    us to sell assets, or seek additional capital, which we may be
    unable to do at all or on terms favorable to us;                                                                        
| 
| | our level of indebtedness may make us more
    vulnerable to economic or industry downturns; and                                                                                                                                                
| 
| | our debt service obligations increase our
    vulnerabilities to competitive pressures, because many of our
    competitors are less leveraged than we are.                                                                                     

Our ability to repay debt depends in part on
dividends and cash transfers from our subsidiaries.

Nearly all of our subsidiaries are subject to HMO
regulations or insurance regulations and may be subject to
substantial supervision by one or more HMO or insurance
regulators. Subsidiaries subject to regulation must meet or
exceed various capital standards imposed by HMO or insurance
regulations, which may from time to time impact the amount of
funds the subsidiaries can pay to us. Our subsidiaries are not
obligated to make funds available to us. Additionally, from time
to time, we advance funds in the form of a loan or capital
contribution to our subsidiaries to assist them in satisfying
state financial requirements. We may provide additional funding
to a subsidiary if a state regulator imposes additional
financial requirements due to concerns about the financial
position of the subsidiary or if there is an adverse effect
resulting from changes to the risk-based capital requirements.
This may in turn affect the subsidiarys ability to pay
state-regulated dividends or make other cash transfers.

Our senior credit facility and our
10 3/4% senior notes contain restrictive covenants that may
limit our ability to expand or pursue our business
strategy.

Our senior credit facility and our 10 3/4%
senior notes limit, and in some circumstances prohibit, our
ability to incur additional indebtedness, pay dividends, make
investments or other restricted payments, sell or otherwise
dispose of assets, effect a consolidation or merger and engage
in other activities.

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We are required under the senior credit facility
to maintain compliance with certain financial ratios. We may not
be able to maintain these ratios. Covenants in the senior credit
facility and our 10 3/4% senior notes may impair our
ability to expand or pursue our business strategies. Our ability
to comply with these covenants and other provisions of the
senior credit facility and our 10 3/4% senior notes may be
affected by our operating and financial performance, changes in
business conditions or results of operations, adverse regulatory
developments or other events beyond our control. In addition, if
we do not comply with these covenants, the lenders under the
senior credit facility and our 10 3/4% senior notes may
accelerate our debt repayment under the senior credit facility
and our 10 3/4% senior notes. If the indebtedness under the
senior credit facility or our 10 3/4% senior notes is
accelerated, we could not assure you that our assets would be
sufficient to repay all outstanding indebtedness in full.

The concentration of our commercial and
government senior business in eight western states and Guam
subjects us to risks from economic downturns in this
region.

We offer managed care and other health insurance
products to employer groups and Medicare beneficiaries primarily
in eight western states and Guam. Due to this concentration of
business in a small number of states, we are exposed to
potential losses resulting from the risk of an economic downturn
in these states and region of the country. If economic
conditions deteriorate in any of these states, particularly in
California where we have our largest membership, our membership
and our margins may decline, which could have a material adverse
effect on our business, financial conditions and results of
operations.

We could incur unexpected health care and
other costs as a result of terrorism or natural
disasters.

We cannot predict or prevent the occurrence of
bioterrorism or other acts of terrorism or natural disasters,
such as earthquakes, which could cause increased and unexpected
utilization of health care services. These events could also
have adverse effects on general economic conditions in the
states where we offer products, the price and availability of
products and services we purchase, the availability and morale
of our employees, our operations and facilities or the demand
for our products. We maintain disaster recovery plans intended
to enable us to continue to operate without major disruptions in
service following disasters. However, a disaster could severely
impair or delay service to our members, cause us to incur
significant cost of recovery and cause a loss of members.

Our PBM subsidiary, Prescription Solutions,
faces regulatory and other risks associated with the pharmacy
benefits management industry that differ from the risks of
providing managed care and health insurance products.

Our PBM is also subject to federal and state
anti-remuneration laws that govern its relationships with
pharmaceutical manufacturers. Federal and state legislatures are
considering new regulations for the industry that could
adversely affect current industry practices, including the
receipt of rebates from pharmaceutical companies. In addition,
if a court were to determine that our PBM acts as a fiduciary
under ERISA, we could be subject to claims for alleged breaches
of fiduciary obligations in implementation of formularies,
preferred drug listings and therapeutic intervention programs
and other transactions. We also conduct business as a mail-order
pharmacy, which subjects us to extensive federal, state and
local regulation, as well as risks inherent in the packaging and
distribution of pharmaceuticals and other health care products.
The failure to adhere to these regulations could expose our PBM
subsidiary to civil and criminal penalties. We also face
potential claims in connection with claimed errors by our
mail-order pharmacy.

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Our forecasts and other forward looking
statements are based upon various assumptions that are subject
to significant uncertainties that may result in our failure to
achieve our forecasted results.

From time to time in press releases, conference
calls and otherwise, we may publish or make forecasts or other
forward looking statements regarding our future results,
including estimated earnings per share and other operating and
financial metrics. Our forecasts are based upon various
assumptions that are subject to significant uncertainties and
any number of them may prove incorrect. Our estimated earnings
per share are based in part upon a forecast of our weighted
average shares outstanding at the time of our estimate. Our
convertible subordinated debentures include a contingent
conversion feature that may materially affect our weighted
average shares outstanding in any quarter. If the conditions to
conversion are satisfied during a quarter, then the debentures
are convertible during the next quarter and the underlying
shares of common stock into which they are convertible are
included in the calculation of our weighted average shares
outstanding. If the conditions to conversion are not met, then
the underlying shares are excluded from the calculation.

Our achievement of any forecasts depends upon
numerous factors, many of which are beyond our control.
Consequently, we cannot assure you that our performance will be
consistent with management forecasts. Variations from forecasts
and other forward-looking statements may be material and adverse.




ITEM
7A.     QUANTITATIVE AND QUALITATIVE
DISCLOSURES ABOUT MARKET RISK

Market Risk

The principal objective of our asset/ liability
management activities is to maximize net investment income,
while maintaining acceptable levels of interest rate risk and
facilitating our funding needs. Our net investment income and
interest expense are subject to the risk of interest rate
fluctuations. To mitigate the impact of fluctuations in interest
rates, we manage the structure of the maturity of debt and
investments and may use derivative financial instruments,
primarily interest rate swaps.

In April 2003, we entered into an interest rate
swap on $300 million of our 10 3/4% senior notes for
the purpose of hedging the fair value of our indebtedness. This
fair value hedge is accounted for using the short-cut method
under SFAS No. 133, Accounting for Derivative
Instruments and Hedging Activities, whereby the hedge is
reported in our balance sheets at fair value, and the carrying
value of the long-term debt is adjusted for an offsetting amount
representing changes in fair value attributable to the hedged
risk. Under the terms of the agreement, we make interest
payments based on the three-month London Interbank Offered Rate
(LIBOR) plus 692 basis points and receive interest payments
based on the 10 3/4% fixed rate. The three-month LIBOR rate
we use to determine our interest payments under the swap
agreement was first established on June 2, 2003 and resets
every three months thereafter, until expiration in June 2009.

The following table provides information about
our financial instruments that are sensitive to changes in
interest rates as of December 31, 2003 and 2002. For
investment securities and debt obligations, the table presents
principal cash flows and related weighted average interest rates
by expected maturity dates. For debt with variable rates, the
rates in place as of December 31, 2003 are used to
determine average interest rates. Additionally, we have assumed
our marketable securities and restricted marketable securities,
comprised primarily of U.S. government, state, municipal,
and corporate debt securities, are similar enough to aggregate
into fixed rate and variable rate securities for presentation
purposes. For terms relating to our long-term debt, see
Note 5 of the Notes to Consolidated Financial Statements.

46



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As of December 31, 2003:

|                                                        |                       |                        |   |         |   |      |   |        |   |      |   |         |   |       |   |            |   |  |   |         |   |  |   |         |   |  |   |           |   |  |   |           | 
|------------------------------------------------------- | --------------------- | ---------------------- | - | ------- | - | ---- | - | ------ | - | ---- | - | ------- | - | ----- | - | ---------- | - |  | - | ------- | - |  | - | ------- | - |  | - | --------- | - |  | - | --------- | 
|                                                        |                       | 2004                   |   | 2005    |   | 2006 |   | 2007   |   | 2008 |   | Beyond  |   | Total |   | Fair Value
|                                                        |                       |                        |   |         |   |      |   |        |   |      |   |         |   |       |   |           
|                                                        |                       |                       
|                                                        |                       | (Amounts in thousands)
|Assets:                                                 |                       |                        |   |         |   |      |   |        |   |      |   |         |   |       |   |            |   |  |   |         |   |  |   |         |   |  |   |           |   |  |   |          
|Marketable securities:                                  |                       |                        |   |         |   |      |   |        |   |      |   |         |   |       |   |            |   |  |   |         |   |  |   |         |   |  |   |           |   |  |   |          
|                                                        | Fixed rate            |                        | $ | 144,335 |   |      | $ | 79,464 |   |      | $ | 126,485 |   |       | $ | 111,437    |   |  | $ | 148,452 |   |  | $ | 686,113 |   |  | $ | 1,296,286 |   |  | $ | 1,326,317 | 
|                                                        | Average interest rate |                        |   | 2.82    | % |      |   | 5.55   | % |      |   | 4.57    | % |       |   | 5.16       | % |  |   | 4.71    | % |  |   | 5.49    | % |  |   | 4.99      | % |  |   |          | 
|                                                        | Variable rate         |                        | $ | 3,500   |   |      | $ | 2,527  |   |      | $ |        |   |       | $ | 2,506      |   |  | $ |        |   |  | $ | 25,043  |   |  | $ | 33,576    |   |  | $ | 33,403    | 
|                                                        | Average interest rate |                        |   | 1.49    | % |      |   | 1.47   | % |      |   |        |   |       |   | 1.36       | % |  |   |        |   |  |   | 2.06    | % |  |   | 1.91      | % |  |   |          | 
|Marketable securities  restricted:                     |                       |                        |   |         |   |      |   |        |   |      |   |         |   |       |   |            |   |  |   |         |   |  |   |         |   |  |   |           |   |  |   |          
|                                                        | Fixed rate            |                        | $ | 108,383 |   |      | $ | 16,900 |   |      | $ | 14,631  |   |       | $ | 7,017      |   |  | $ | 6,632   |   |  | $ | 12,842  |   |  | $ | 166,405   |   |  | $ | 167,616   | 
|                                                        | Average interest rate |                        |   | 2.78    | % |      |   | 2.78   | % |      |   | 3.32    | % |       |   | 5.42       | % |  |   | 5.16    | % |  |   | 5.79    | % |  |   | 3.22      | % |  |   |          | 
|                                                        | Variable rate         |                        | $ |        |   |      | $ |       |   |      | $ |        |   |       | $ |           |   |  | $ |        |   |  | $ | 141     |   |  | $ | 141       |   |  | $ | 144       | 
|                                                        | Average interest rate |                        |   |        |   |      |   |       |   |      |   |        |   |       |   |           |   |  |   |        |   |  |   | 6.24    | % |  |   | 6.24      | % |  |   |          | 
|Liabilities:                                            |                       |                        |   |         |   |      |   |        |   |      |   |         |   |       |   |            |   |  |   |         |   |  |   |         |   |  |   |           |   |  |   |          
|Long term debt, including debt due within one
    year: |                       |                        |   |         |   |      |   |        |   |      |   |         |   |       |   |            |   |  |   |         |   |  |   |         |   |  |   |           |   |  |   |          
|                                                        | Fixed rate            |                        | $ | 5,996   |   |      | $ | 4,532  |   |      | $ | 905     |   |       | $ | 270        |   |  | $ | 289     |   |  | $ | 458,954 |   |  | $ | 470,946   |   |  | $ | 470,946   | 
|                                                        | Average interest rate |                        |   | 4.36    | % |      |   | 4.51   | % |      |   | 6.17    | % |       |   | 6.77       | % |  |   | 6.77    | % |  |   | 6.73    | % |  |   |          |   |  |   |          | 
|                                                        | Variable rate         |                        | $ | 1,500   |   |      | $ | 1,500  |   |      | $ | 23,250  |   |       | $ | 72,750     |   |  | $ | 50,250  |   |  | $ |        |   |  | $ | 149,250   |   |  | $ | 149,250   | 
|                                                        | Average interest rate |                        |   | 3.68    | % |      |   | 3.68   | % |      |   | 3.68    | % |       |   | 3.68       | % |  |   | 3.68    | % |  |   |        |   |  |   |          |   |  |   |          | 

As of December 31, 2002:

|                                                        |                       |                        |   |        |   |      |   |        |   |      |   |        |   |       |   |            |   |  |   |         |   |  |   |         |   |  |   |           |   |  |   |           | 
|------------------------------------------------------- | --------------------- | ---------------------- | - | ------ | - | ---- | - | ------ | - | ---- | - | ------ | - | ----- | - | ---------- | - |  | - | ------- | - |  | - | ------- | - |  | - | --------- | - |  | - | --------- | 
|                                                        |                       | 2003                   |   | 2004   |   | 2005 |   | 2006   |   | 2007 |   | Beyond |   | Total |   | Fair Value
|                                                        |                       |                        |   |        |   |      |   |        |   |      |   |        |   |       |   |           
|                                                        |                       |                       
|                                                        |                       | (Amounts in thousands)
|Assets:                                                 |                       |                        |   |        |   |      |   |        |   |      |   |        |   |       |   |            |   |  |   |         |   |  |   |         |   |  |   |           |   |  |   |          
|Marketable securities:                                  |                       |                        |   |        |   |      |   |        |   |      |   |        |   |       |   |            |   |  |   |         |   |  |   |         |   |  |   |           |   |  |   |          
|                                                        | Fixed rate            |                        | $ | 89,716 |   |      | $ | 21,947 |   |      | $ | 76,516 |   |       | $ | 107,695    |   |  | $ | 100,005 |   |  | $ | 733,833 |   |  | $ | 1,129,712 |   |  | $ | 1,167,299 | 
|                                                        | Average interest rate |                        |   | 3.14   | % |      |   | 3.71   | % |      |   | 6.49   | % |       |   | 5.43       | % |  |   | 5.35    | % |  |   | 5.74    | % |  |   | 5.48      | % |  |   |          | 
|                                                        | Variable rate         |                        | $ |       |   |      | $ | 3,500  |   |      | $ | 2,527  |   |       | $ |           |   |  | $ |        |   |  | $ | 25,021  |   |  | $ | 31,048    |   |  | $ | 28,218    | 
|                                                        | Average interest rate |                        |   |       |   |      |   | 6.53   | % |      |   | 2.17   | % |       |   |           |   |  |   |        |   |  |   | 2.65    | % |  |   | 3.05      | % |  |   |          | 
|Marketable securities  restricted:                     |                       |                        |   |        |   |      |   |        |   |      |   |        |   |       |   |            |   |  |   |         |   |  |   |         |   |  |   |           |   |  |   |          
|                                                        | Fixed rate            |                        | $ | 56,097 |   |      | $ | 85,105 |   |      | $ | 3,342  |   |       | $ | 7,956      |   |  | $ | 10,596  |   |  | $ | 22,946  |   |  | $ | 186,042   |   |  | $ | 190,172   | 
|                                                        | Average interest rate |                        |   | 1.34   | % |      |   | 3.30   | % |      |   | 6.16   | % |       |   | 5.73       | % |  |   | 5.45    | % |  |   | 5.80    | % |  |   | 3.12      | % |  |   |          | 
|                                                        | Variable rate         |                        | $ |       |   |      | $ |       |   |      | $ |       |   |       | $ |           |   |  | $ |        |   |  | $ | 147     |   |  | $ | 147       |   |  | $ | 149       | 
|                                                        | Average interest rate |                        |   |       |   |      |   |       |   |      |   |       |   |       |   |           |   |  |   |        |   |  |   | 6.24    | % |  |   | 6.24      | % |  |   |          | 
|Liabilities:                                            |                       |                        |   |        |   |      |   |        |   |      |   |        |   |       |   |            |   |  |   |         |   |  |   |         |   |  |   |           |   |  |   |          
|Long term debt, including debt due within one
    year: |                       |                        |   |        |   |      |   |        |   |      |   |        |   |       |   |            |   |  |   |         |   |  |   |         |   |  |   |           |   |  |   |          
|                                                        | Fixed rate            |                        | $ | 46,750 |   |      | $ | 5,123  |   |      | $ | 3,007  |   |       | $ |           |   |  | $ |        |   |  | $ | 633,562 |   |  | $ | 688,442   |   |  | $ | 688,442   | 
|                                                        | Average interest rate |                        |   | 6.83   | % |      |   | 4.65   | % |      |   | 4.65   | % |       |   |           |   |  |   |        |   |  |   | 9.09    | % |  |   |          |   |  |   |          | 
|                                                        | Variable rate         |                        | $ | 60,484 |   |      | $ | 81,103 |   |      | $ | 9,000  |   |       | $ |           |   |  | $ |        |   |  | $ |        |   |  | $ | 150,587   |   |  | $ | 150,587   | 
|                                                        | Average interest rate |                        |   | 6.40   | % |      |   | 6.40   | % |      |   | 6.40   | % |       |   |           |   |  |   |        |   |  |   |        |   |  |   |          |   |  |   |          | 




ITEM 8.     CONSOLIDATED
FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

See Item 15. Exhibits, Financial
Statement Schedules, and Reports on Form 8-K.






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

We have not changed our independent auditors, nor
have we had disagreements with our auditors on accounting
principles, practices or financial statement disclosure.

47



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##### Table of Contents






ITEM 9A.     CONTROLS
AND PROCEDURES

Under the supervision and with the participation
of our management, including our chief executive officer, or
CEO, and chief financial officer, or CFO, an evaluation was
performed on the effectiveness of the design and operation of
our disclosure controls and procedures as of the end of the
period covered by this annual report. Based on that evaluation,
our management, including the CEO and CFO, concluded that our
disclosure controls and procedures were effective as of
December 31, 2003.

An evaluation was also performed under the
supervision and with the participation of our management,
including our CEO and CFO, of any change in our internal
controls over financial reporting that occurred during our last
fiscal year and that has materially affected, or is reasonably
likely to materially affect, our internal controls over
financial reporting. That evaluation did not identify any change
in our internal controls over financial reporting that occurred
during our latest fiscal year and that has materially affected,
or is reasonably likely to materially affect, our internal
controls over financial reporting.

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##### Table of Contents






PART III




ITEM 10.     DIRECTORS
AND EXECUTIVE OFFICERS OF THE REGISTRANT

The information contained in the sections
entitled Board of Directors, Director
Compensation, Executive Officers and
Section 16(a) Beneficial Ownership Reporting
Compliance contained in Registrants definitive Proxy
Statement for its 2004 Annual Meeting of Stockholders is
incorporated herein by reference.

The information regarding the Registrants
audit committee members and audit committee financial experts
set forth in the sections entitled Activities of the Board
of Directors and its Committees and Audit Committee
Report contained in Registrants definitive Proxy
Statement for its 2004 Annual Meeting of Stockholders is
incorporated herein by reference.

The information regarding the Registrants
code of ethics set forth in the section entitled Code of
Ethics contained in Registrants definitive Proxy
Statement for its 2004 Annual Meeting of Stockholders is
incorporated herein by reference.

The information regarding the procedures for
stockholders to recommend board nominees is set forth in the
section entitled Procedures for Stockholder
Recommendations of Board Nominees and Stockholder
Proposals contained in Registrants definitive Proxy
Statement for its 2004 Annual Meeting of Stockholders is
incorporated herein by reference.




ITEM 11.     EXECUTIVE
COMPENSATION

The information contained in the section entitled
Executive Compensation in the Registrants
definitive Proxy Statement for its 2004 Annual Meeting of
Stockholders is incorporated herein by reference.






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

The information contained in the section entitled
Principal Stockholders and Equity-Based
Instruments Held by Management in the Registrants
definitive Proxy Statement for its 2004 Annual Meeting of
Stockholders is incorporated herein by reference.

The information contained in the section entitled
Equity Compensation Plan Information in the
Registrants definitive Proxy Statement for its 2004 Annual
Meeting of Stockholders is also incorporated herein by reference.




ITEM 13.     CERTAIN
RELATIONSHIPS AND RELATED TRANSACTIONS

The information set forth in the section entitled
Certain Relationships and Related Transactions
contained in the Registrants definitive Proxy Statement
for its 2004 Annual Meeting of Stockholders is incorporated
herein by reference.




ITEM 14.     PRINCIPAL
ACCOUNTANTS FEES AND SERVICES

The information contained in the section entitled
Independent Auditor Fees in the Registrants
definitive Proxy Statement for its 2004 Annual Meeting of
Stockholders is incorporated herein by reference.

49



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##### Table of Contents






PART IV






|         |                                                                    
|-------- | -------------------------------------------------------------------
|ITEM 15. | EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND
    REPORTS ON FORM 8-K

The following documents are filed as part of this
report:

|      |  |                                                                                                                                                                                                                                                                                                                                                                                                                                                              |                                                                                                                                                          |           |      |  | 
|----- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ | -------------------------------------------------------------------------------------------------------------------------------------------------------- | --------- | ---- |  | 
|      |  |                                                                                                                                                                                                                                                                                                                                                                                                                                                              |                                                                                                                                                          | Page     
|      |  |                                                                                                                                                                                                                                                                                                                                                                                                                                                              |                                                                                                                                                          | Reference
|      |  |                                                                                                                                                                                                                                                                                                                                                                                                                                                              |                                                                                                                                                          |          
|(a)1. |  | Consolidated Financial Statements:                                                                                                                                                                                                                                                                                                                                                                                                                           |                                                                                                                                                          |           |      | 
|      |  | Consolidated Balance Sheets as of
    December 31, 2003 and 2002                                                                                                                                                                                                                                                                                                                                                                                             |                                                                                                                                                          |           | F-1  | 
|      |  | Consolidated Statements of Operations for the
    years ended December 31, 2003, 2002 and 2001                                                                                                                                                                                                                                                                                                                                                               |                                                                                                                                                          |           | F-2  | 
|      |  | Consolidated Statements of Stockholders
    Equity for the years ended December 31, 2003, 2002 and 2001                                                                                                                                                                                                                                                                                                                                                     |                                                                                                                                                          |           | F-3  | 
|      |  | Consolidated Statements of Cash Flows for the
    years ended December 31, 2003, 2002 and 2001                                                                                                                                                                                                                                                                                                                                                               |                                                                                                                                                          |           | F-4  | 
|      |  | Notes to Consolidated Financial Statements                                                                                                                                                                                                                                                                                                                                                                                                                   |                                                                                                                                                          |           | F-6  | 
|      |  | Report of Ernst & Young LLP, Independent
    Auditors                                                                                                                                                                                                                                                                                                                                                                                                        |                                                                                                                                                          |           | F-42 | 
|      |  | Quarterly Information for 2003 and 2002
    (Unaudited)                                                                                                                                                                                                                                                                                                                                                                                                      |                                                                                                                                                          |           | F-43 | 
|2.    |  | Financial Statement Schedule:                                                                                                                                                                                                                                                                                                                                                                                                                                |                                                                                                                                                          |           |      | 
|      |  | Schedule II  Valuation and
    Qualifying Accounts                                                                                                                                                                                                                                                                                                                                                                                                          |                                                                                                                                                          |           | F-44 | 
|      |  |                                                                                                                                                                                                                                                                                                                                                                                                                                                              | All other schedules are omitted because they are
    not required or the information is included elsewhere in the
    consolidated financial statements. |           |      |  | 
|3.    |  | Exhibits:An
    Exhibit Index is filed as part of this
    Form 10-K beginning on page E-1 and is incorporated by
    reference.                                                                                                                                                                                                                                                                                                                           |                                                                                                                                                          |           |      | 
|(b)   |  | Reports on Form 8-K:                                                                                                                                                                                                                                                                                                                                                                                                                                         |                                                                                                                                                          |           |      | 
|      |  | We filed the following reports on Form 8-K
    during the quarter ended December 31, 2003:                                                                                                                                                                                                                                                                                                                                                                   |                                                                                                                                                          |           |      | 
|      |  | On November 5, 2003, we filed a
    Form 8-K that filed a press release wherein we announced
    our financial results for the quarter ended September 30,
    2003.                                                                                                                                                                                                                                                                                         |                                                                                                                                                          |           |      | 
|      |  | On November 10, 2003, we filed a
    Form 8-K that filed a press release wherein we announced
    the appointment of Aida Alvarez and Linda Rosenstock to the
    Board of Directors.                                                                                                                                                                                                                                                                        |                                                                                                                                                          |           |      | 
|      |  | On November 12, 2003, we filed a
    Form 8-K that filed a press release wherein we announced a
    revision to our earnings per share guidance for the 2003 fourth
    quarter and the full year 2003 to reflect the costs associated
    with the redemption of $175 million in principal
    10 3/4% senior notes and the dilutive effect of the
    7.6 million shares of common stock issued in the public
    offering announced on November 10, 2003. |                                                                                                                                                          |           |      | 
|      |  | On November 13, 2003, we filed a
    Form 8-K that filed a press release wherein we attached the
    Underwriting Agreement, dated as of November 10, 2003,
    between us and Goldman, Sachs & Co. in connection with
    the public offering of 7.6 million shares of our common
    stock.                                                                                                                                                                |                                                                                                                                                          |           |      | 
|      |  | On December 23, 2003, we filed a
    Form 8-K that filed a press release wherein we announced
    that our Board of Directors had approved a two-for-one common
    stock split in the form of a stock dividend, which was
    distributed on January 20, 2004.                                                                                                                                                                                              |                                                                                                                                                          |           |      | 

50



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##### 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.



| |                                
| | -------------------------------
| | PACIFICARE HEALTH SYSTEMS, INC.



| |     |                        
| | --- | -----------------------
| | By: | /s/ HOWARD G. PHANSTIEL

| |                                                      
| | -----------------------------------------------------
| |                                                      
| | Howard G. Phanstiel                                  
| | Chairman of the Board and
    Chief Executive Officer
| | (Principal Executive Officer)                        

Date: March 4, 2004

POWER OF ATTORNEY

We, the undersigned directors and officers of
PacifiCare Health Systems, Inc., do hereby constitute and
appoint Howard G. Phanstiel and Gregory W. Scott, or either of
them, our true and lawful attorneys and agents, to do any and
all acts and things in our name and on our behalf in our
capacities as directors and officers and to execute any and all
instruments for us and in our names in the capacities indicated
below, which said attorneys and agents, or either of them, may
deem necessary or advisable to enable said corporation to comply
with the Securities Exchange Act of 1934, and any rules,
regulations, and requirements of the Securities and Exchange
Commission, in connection with this Report, including
specifically, but without limitation, power and authority to
sign any and all amendments hereto; and we do hereby ratify and
confirm all that said attorneys and agents, or either of them,
shall do or cause to be done by virtue hereof.

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 in the
capacities and on the dates indicated.

|                                           |  |                                                                                            |  |              
|------------------------------------------ |  | ------------------------------------------------------------------------------------------ |  | -------------
|Name                                       |  | Title                                                                                      |  | Date         
|                                           |  |                                                                                            |  |              
|                                          
|/s/ HOWARD G. PHANSTIELHoward G. Phanstiel |  | Chairman of the Board and
    Chief Executive Officer
    (Principal Executive Officer)    |  | March 4, 2004
|                                          
|/s/ GREGORY W. SCOTTGregory W. Scott       |  | Executive Vice President and
    Chief Financial Officer
    (Principal Financial Officer) |  | March 4, 2004
|                                          
|/s/ PETER A. REYNOLDSPeter A. Reynolds     |  | Senior Vice President and
    Corporate Controller
    (Chief Accounting Officer)          |  | March 4, 2004
|                                          
|/s/ DAVID A. REEDDavid A. Reed             |  | Lead Independent Director                                                                  |  | March 4, 2004

51



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|                                                     |  |          |  |              
|---------------------------------------------------- |  | -------- |  | -------------
|Name                                                 |  | Title    |  | Date         
|                                                     |  |          |  |              
|                                                    
|/s/ AIDA ALVAREZAida Alvarez                         |  | Director |  | March 4, 2004
|                                                    
|/s/ BRADLEY C. CALLBradley C. Call                   |  | Director |  | March 4, 2004
|                                                    
|/s/ SHIRLEY S. CHATER, PH.D.Shirley S. Chater, PH.D. |  | Director |  | March 4, 2004
|                                                    
|/s/ TERRY O. HARTSHORNTerry O. Hartshorn             |  | Director |  | March 4, 2004
|                                                    
|/s/ GARY L. LEARYGary L. Leary                       |  | Director |  | March 4, 2004
|                                                    
|/s/ DOMINIC NGDominic Ng                             |  | Director |  | March 4, 2004
|                                                    
|/s/ WARREN E. PINCKERT IIWarren E. Pinckert II       |  | Director |  | March 4, 2004
|                                                    
|/s/ CHARLES R. RINEHARTCharles R. Rinehart           |  | Director |  | March 4, 2004
|                                                    
|/s/ LINDA ROSENSTOCKLinda Rosenstock                 |  | Director |  | March 4, 2004
|                                                    
|/s/ LLOYD E. ROSSLloyd E. Ross                       |  | Director |  | March 4, 2004

52



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##### Table of Contents



PACIFICARE HEALTH SYSTEMS, INC.

CONSOLIDATED BALANCE SHEETS

|                                           |                                                                                                                          |                            |           |              |           |   |           |           |           | 
|------------------------------------------ | ------------------------------------------------------------------------------------------------------------------------ | -------------------------- | --------- | ------------ | --------- | - | --------- | --------- | --------- | 
|                                           |                                                                                                                          | December 31,               |           | December 31,
|                                           |                                                                                                                          | 2003                       |           | 2002        
|                                           |                                                                                                                          |                            |           |             
|                                           |                                                                                                                          |                           
|                                           |                                                                                                                          | (Amounts in thousands,    
|                                           |                                                                                                                          | except per share data)    
|ASSETS                                    
|Current assets:                            |                                                                                                                          |                            |           |              |           |   |           |          
|                                           | Cash and equivalents                                                                                                     |                            | $         | 1,198,422    |           |   | $         | 951,689   |          
|                                           | Marketable securities                                                                                                    |                            |           | 1,359,720    |           |   |           | 1,195,517 |          
|                                           | Receivables, net                                                                                                         |                            |           | 265,943      |           |   |           | 289,900   |          
|                                           | Prepaid expenses and other current assets                                                                                |                            |           | 57,299       |           |   |           | 46,805    |          
|                                           | Restricted cash collateral for FHP senior notes                                                                          |                            |           |             |           |   |           | 43,346    |          
|                                           | Deferred income taxes                                                                                                    |                            |           | 149,817      |           |   |           | 100,758   |          
|                                           |                                                                                                                          |                            |           |              |           |   |           |          
|                                           |                                                                                                                          | Total current assets       |           |              | 3,031,201 |   |           |           | 2,628,015 | 
|                                           |                                                                                                                          |                            |           |              |           |   |           |          
|Property, plant and equipment at cost, net |                                                                                                                          |                            | 149,407   |              |           |   | 161,685   |          
|Marketable securities-restricted           |                                                                                                                          |                            | 166,546   |              |           |   | 186,189   |          
|Goodwill, net                              |                                                                                                                          |                            | 983,104   |              |           |   | 983,104   |          
|Intangible assets, net                     |                                                                                                                          |                            | 221,108   |              |           |   | 243,016   |          
|Other assets                               |                                                                                                                          |                            | 67,938    |              |           |   | 49,124    |          
|                                           |                                                                                                                          |                            |           |              |           |   |           |          
|                                           |                                                                                                                          | $                          | 4,619,304 |              |           | $ | 4,251,133 |          
|                                           |                                                                                                                          |                            |           |              |           |   |           |          
|LIABILITIES AND STOCKHOLDERS
    EQUITY  
|Current liabilities:                       |                                                                                                                          |                            |           |              |           |   |           |          
|                                           | Medical claims and benefits payable                                                                                      |                            | $         | 1,027,500    |           |   | $         | 1,044,500 |          
|                                           | Accounts payable                                                                                                         |                            |           | 65,222       |           |   |           | 69,733    |          
|                                           | Accrued liabilities                                                                                                      |                            |           | 326,051      |           |   |           | 285,438   |          
|                                           | Accrued compensation and employee benefits                                                                               |                            |           | 99,537       |           |   |           | 83,471    |          
|                                           | Unearned premium revenue                                                                                                 |                            |           | 496,480      |           |   |           | 479,552   |          
|                                           | Current portion of long-term debt                                                                                        |                            |           | 7,496        |           |   |           | 107,235   |          
|                                           |                                                                                                                          |                            |           |              |           |   |           |          
|                                           |                                                                                                                          | Total current liabilities  |           |              | 2,022,286 |   |           |           | 2,069,929 | 
|                                           |                                                                                                                          |                            |           |              |           |   |           |          
|Long-term debt                             |                                                                                                                          |                            | 477,700   |              |           |   | 596,961   |          
|Convertible subordinated debentures        |                                                                                                                          |                            | 135,000   |              |           |   | 135,000   |          
|Deferred income taxes                      |                                                                                                                          |                            | 104,777   |              |           |   | 103,790   |          
|Other liabilities                          |                                                                                                                          |                            | 28,004    |              |           |   | 17,148    |          
|Stockholders equity:                      |                                                                                                                          |                            |           |              |           |   |           |          
|                                           | Common stock, $0.01 par value; 200,000 shares
    authorized; issued 84,854 shares in 2003 and 95,418 shares in
    2002 |                            |           | 848          |           |   |           | 954       |          
|                                           | Unearned compensation                                                                                                    |                            |           | (16,843      | )         |   |           | (2,000    | )        
|                                           | Additional paid-in capital                                                                                               |                            |           | 1,458,310    |           |   |           | 1,560,308 |          
|                                           | Accumulated other comprehensive income                                                                                   |                            |           | 18,815       |           |   |           | 21,730    |          
|                                           | Retained earnings                                                                                                        |                            |           | 390,407      |           |   |           | 350,369   |          
|                                           | Treasury stock, at cost; no shares in 2003 and
    23,409 shares in 2002                                                 |                            |           |             |           |   |           | (603,056  | )        
|                                           |                                                                                                                          |                            |           |              |           |   |           |          
|                                           |                                                                                                                          | Total stockholders equity |           |              | 1,851,537 |   |           |           | 1,328,305 | 
|                                           |                                                                                                                          |                            |           |              |           |   |           |          
|                                           |                                                                                                                          | $                          | 4,619,304 |              |           | $ | 4,251,133 |          
|                                           |                                                                                                                          |                            |           |              |           |   |           |          

All applicable share and per-share amounts
reflect the retroactive effects of the two-for-one common stock
split in the form of a stock dividend that was effective
January 20, 2004.

See accompanying notes.

F-1



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##### Table of Contents



PACIFICARE HEALTH SYSTEMS, INC.

CONSOLIDATED STATEMENTS OF
OPERATIONS

|                                                                                                            |                                                                                                |                                               |           |              |            |              |           |           |            |   |           |           |            | 
|----------------------------------------------------------------------------------------------------------- | ---------------------------------------------------------------------------------------------- | --------------------------------------------- | --------- | ------------ | ---------- | ------------ | --------- | --------- | ---------- | - | --------- | --------- | ---------- | 
|                                                                                                            |                                                                                                | Year Ended                                    |           | Year Ended   |            | Year Ended  
|                                                                                                            |                                                                                                | December 31,                                  |           | December 31, |            | December 31,
|                                                                                                            |                                                                                                | 2003                                          |           | 2002         |            | 2001        
|                                                                                                            |                                                                                                |                                               |           |              |            |             
|                                                                                                            |                                                                                                |                                              
|                                                                                                            |                                                                                                | (Amounts in thousands, except per share data)
|Revenue:                                                                                                    |                                                                                                |                                               |           |              |            |              |           |           |            |   |           |          
|                                                                                                            | Commercial                                                                                     |                                               | $         | 5,043,257    |            |              | $         | 4,782,973 |            |   | $         | 4,553,933 |           
|                                                                                                            | Senior                                                                                         |                                               |           | 5,395,265    |            |              |           | 5,887,603 |            |   |           | 6,798,637 |           
|                                                                                                            | Specialty and other                                                                            |                                               |           | 498,668      |            |              |           | 421,439   |            |   |           | 380,139   |           
|                                                                                                            | Net investment income                                                                          |                                               |           | 71,321       |            |              |           | 64,487    |            |   |           | 111,263   |           
|                                                                                                            |                                                                                                |                                               |           |              |            |              |           |           |            |   |           |          
|                                                                                                            |                                                                                                | Total operating revenue                       |           |              | 11,008,511 |              |           |           | 11,156,502 |   |           |           | 11,843,972 | 
|Expenses:                                                                                                   |                                                                                                |                                               |           |              |            |              |           |           |            |   |           |          
|Health care services and other:                                                                             |                                                                                                |                                               |           |              |            |              |           |           |            |   |           |          
|                                                                                                            | Commercial                                                                                     |                                               |           | 4,270,329    |            |              |           | 4,205,376 |            |   |           | 4,101,936 |           
|                                                                                                            | Senior                                                                                         |                                               |           | 4,540,301    |            |              |           | 5,104,275 |            |   |           | 6,133,789 |           
|                                                                                                            | Specialty and other                                                                            |                                               |           | 255,164      |            |              |           | 176,050   |            |   |           | 131,932   |           
|                                                                                                            |                                                                                                |                                               |           |              |            |              |           |           |            |   |           |          
|                                                                                                            |                                                                                                | Total health care services and other          |           |              | 9,065,794  |              |           |           | 9,485,701  |   |           |           | 10,367,657 | 
|Selling, general and administrative expenses                                                                |                                                                                                |                                               | 1,452,542 |              |            |              | 1,370,160 |           |            |   | 1,288,374 |          
|Impairment, disposition, restructuring, Office of
    Personnel Management and other charges (credits), net |                                                                                                |                                               |          |              |            |              | 3,774     |           |            |   | 61,157    |          
|                                                                                                            |                                                                                                |                                               |           |              |            |              |           |           |            |   |           |          
|Operating income                                                                                            |                                                                                                |                                               | 490,175   |              |            |              | 296,867   |           |            |   | 126,784   |          
|Interest expense, net                                                                                       |                                                                                                |                                               | (100,531  | )            |            |              | (74,904   | )         |            |   | (70,282   | )        
|                                                                                                            |                                                                                                |                                               |           |              |            |              |           |           |            |   |           |          
|Income before income taxes                                                                                  |                                                                                                |                                               | 389,644   |              |            |              | 221,963   |           |            |   | 56,502    |          
|Provision for income taxes                                                                                  |                                                                                                |                                               | 146,896   |              |            |              | 82,792    |           |            |   | 38,371    |          
|                                                                                                            |                                                                                                |                                               |           |              |            |              |           |           |            |   |           |          
|Income before cumulative effect of a change in
    accounting principle and extraordinary gain              |                                                                                                |                                               | 242,748   |              |            |              | 139,171   |           |            |   | 18,131    |          
|Cumulative effect of a change in accounting
    principle                                                   |                                                                                                |                                               |          |              |            |              | (897,000  | )         |            |   |          |          
|Extraordinary gain on early retirement of debt,
    net                                                     |                                                                                                |                                               |          |              |            |              |          |           |            |   | 875       |          
|                                                                                                            |                                                                                                |                                               |           |              |            |              |           |           |            |   |           |          
|Net income (loss)                                                                                           |                                                                                                | $                                             | 242,748   |              |            | $            | (757,829  | )         |            | $ | 19,006    |          
|                                                                                                            |                                                                                                |                                               |           |              |            |              |           |           |            |   |           |          
|Basic earnings (loss) per share:                                                                            |                                                                                                |                                               |           |              |            |              |           |           |            |   |           |          
|                                                                                                            | Income before cumulative effect of a change in
    accounting principle and extraordinary gain |                                               | $         | 3.26         |            |              | $         | 1.98      |            |   | $         | 0.27      |           
|                                                                                                            | Cumulative effect of a change in accounting
    principle                                      |                                               |           |             |            |              |           | (12.73    | )          |   |           |          |           
|                                                                                                            | Extraordinary gain, net                                                                        |                                               |           |             |            |              |           |          |            |   |           | 0.01      |           
|                                                                                                            |                                                                                                |                                               |           |              |            |              |           |           |            |   |           |          
|                                                                                                            | Basic earnings (loss) per share                                                                |                                               | $         | 3.26         |            |              | $         | (10.75    | )          |   | $         | 0.28      |           
|                                                                                                            |                                                                                                |                                               |           |              |            |              |           |           |            |   |           |          
|Diluted earnings (loss) per share:                                                                          |                                                                                                |                                               |           |              |            |              |           |           |            |   |           |          
|                                                                                                            | Income before cumulative effect of a change in
    accounting principle and extraordinary gain |                                               | $         | 3.04         |            |              | $         | 1.98      |            |   | $         | 0.26      |           
|                                                                                                            | Cumulative effect of a change in accounting
    principle                                      |                                               |           |             |            |              |           | (12.73    | )          |   |           |          |           
|                                                                                                            | Extraordinary gain, net                                                                        |                                               |           |             |            |              |           |          |            |   |           | 0.01      |           
|                                                                                                            |                                                                                                |                                               |           |              |            |              |           |           |            |   |           |          
|                                                                                                            | Diluted earnings (loss) per share                                                              |                                               | $         | 3.04         |            |              | $         | (10.75    | )          |   | $         | 0.27      |           
|                                                                                                            |                                                                                                |                                               |           |              |            |              |           |           |            |   |           |          

All applicable per-share amounts reflect the
retroactive effects of the two-for-one common stock split in the
form of a stock dividend that was effective January 20,
2004.

See accompanying notes.

F-2



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##### Table of Contents



PACIFICARE HEALTH SYSTEMS, INC.

CONSOLIDATED STATEMENTS OF STOCKHOLDERS
EQUITY

|                                                                       |                                       |                                                                                             |      |              |   |            |         |               |   |          |           |          |   |       |        |   |        |   |           |          |   |   |          |        |   |   |           |          |        |  
|---------------------------------------------------------------------- | ------------------------------------- | ------------------------------------------------------------------------------------------- | ---- | ------------ | - | ---------- | ------- | ------------- | - | -------- | --------- | -------- | - | ----- | ------ | - | ------ | - | --------- | -------- | - | - | -------- | ------ | - | - | --------- | -------- | ------ | -
|                                                                       |                                       |                                                                                             |      |              |   |            |         | Accumulated   |   |          |           |          |   |      
|                                                                       |                                       |                                                                                             |      |              |   |            |         | Other         |   |          |           |          |   |      
|                                                                       |                                       |                                                                                             |      |              |   | Additional |         | Comprehensive |   |          |           |          |   |      
|                                                                       |                                       | Common                                                                                      |      | Unearned     |   | Paid-in    |         | Income        |   | Retained |           | Treasury |   |      
|                                                                       |                                       | Stock                                                                                       |      | Compensation |   | Capital    |         | (Loss)        |   | Earnings |           | Stock    |   | Total
|                                                                       |                                       |                                                                                             |      |              |   |            |         |               |   |          |           |          |   |      
|                                                                       |                                       |                                                                                            
|                                                                       |                                       | (Amounts in thousands)                                                                     
|Balances at December 31, 2000                                          |                                       | $                                                                                           | 940  |              |   | $          |        |               |   | $        | 1,613,474 |          |   | $     | (2,975 | ) |        | $ | 1,089,192 |          |   | $ | (697,071 | )      |   | $ | 2,003,560 |         
|                                                                       |                                       |                                                                                             |      |              |   |            |         |               |   |          |           |          |   |       |        |   |        |   |           |          |   |   |          |        |   |   |           |         
|Comprehensive income:                                                  |                                       |                                                                                             |      |              |   |            |         |               |   |          |           |          |   |       |        |   |        |   |           |          |   |   |          |        |   |   |           |         
|                                                                       | Net income                            |                                                                                             |      |             |   |            |         |              |   |          |           |         |   |       |        |  |        |   |           | 19,006   |   |   |          |       |   |   |           | 19,006   |       
|                                                                       | Other comprehensive gain, net of tax: |                                                                                             |      |              |   |            |         |               |   |          |           |          |   |       |        |   |        |   |           |          |   |   |          |        |   |   |           |          |       
|                                                                       |                                       | Change in unrealized gains on marketable
    securities, net of reclassification adjustment |      |              |  |            |         |               |  |          |           |          |  |       |        |   | 4,926  |   |           |          |  |   |          |        |  |   |           |          | 4,926  |  
|                                                                       |                                       |                                                                                             |      |              |   |            |         |               |   |          |           |          |   |       |        |   |        |   |           |          |   |   |          |        |   |   |           |         
|Comprehensive income                                                   |                                       |                                                                                             |     |              |   |            |        |               |   |          |          |          |   |       | 4,926  |   |        |   | 19,006    |          |   |   |         |        |   |   | 23,932    |         
|                                                                       |                                       |                                                                                             |      |              |   |            |         |               |   |          |           |          |   |       |        |   |        |   |           |          |   |   |          |        |   |   |           |         
|Capital stock activity:                                                |                                       |                                                                                             |      |              |   |            |         |               |   |          |           |          |   |       |        |   |        |   |           |          |   |   |          |        |   |   |           |         
|                                                                       | Employee benefit plans                |                                                                                             |      | 6            |   |            |         | (1,153        | ) |          |           | 4,357    |   |       |        |  |        |   |           |         |   |   |          |       |   |   |           | 3,210    |       
|                                                                       | Reissuance of treasury stock          |                                                                                             |      |             |   |            |         |              |   |          |           | (28,621  | ) |       |        |  |        |   |           |         |   |   |          | 38,821 |   |   |           | 10,200   |       
|Purchase of remaining minority interest in
    consolidated subsidiary |                                       |                                                                                             |     |              |   |            |        |               |   |          | (7,138    | )        |   |       |       |   |        |   |          |          |   |   |         |        |   |   | (7,138    | )       
|Tax benefit associated with exercise of stock
    options              |                                       |                                                                                             |     |              |   |            |        |               |   |          | 21        |          |   |       |       |   |        |   |          |          |   |   |         |        |   |   | 21        |         
|                                                                       |                                       |                                                                                             |      |              |   |            |         |               |   |          |           |          |   |       |        |   |        |   |           |          |   |   |          |        |   |   |           |         
|Balances at December 31, 2001                                          |                                       |                                                                                             | 946  |              |   |            | (1,153  | )             |   |          | 1,582,093 |          |   |       | 1,951  |   |        |   | 1,108,198 |          |   |   | (658,250 | )      |   |   | 2,033,785 |         
|                                                                       |                                       |                                                                                             |      |              |   |            |         |               |   |          |           |          |   |       |        |   |        |   |           |          |   |   |          |        |   |   |           |         
|Comprehensive income (loss):                                           |                                       |                                                                                             |      |              |   |            |         |               |   |          |           |          |   |       |        |   |        |   |           |          |   |   |          |        |   |   |           |         
|                                                                       | Net loss                              |                                                                                             |      |             |   |            |         |              |   |          |           |         |   |       |        |  |        |   |           | (757,829 | ) |   |          |       |   |   |           | (757,829 | )     
|                                                                       | Other comprehensive gain, net of tax: |                                                                                             |      |              |   |            |         |               |   |          |           |          |   |       |        |   |        |   |           |          |   |   |          |        |   |   |           |          |       
|                                                                       |                                       | Change in unrealized gains on marketable
    securities, net of reclassification adjustment |      |              |  |            |         |               |  |          |           |          |  |       |        |   | 19,779 |   |           |          |  |   |          |        |  |   |           |          | 19,779 |  
|                                                                       |                                       |                                                                                             |      |              |   |            |         |               |   |          |           |          |   |       |        |   |        |   |           |          |   |   |          |        |   |   |           |         
|Comprehensive income (loss)                                            |                                       |                                                                                             |     |              |   |            |        |               |   |          |          |          |   |       | 19,779 |   |        |   | (757,829  | )        |   |   |         |        |   |   | (738,050  | )       
|                                                                       |                                       |                                                                                             |      |              |   |            |         |               |   |          |           |          |   |       |        |   |        |   |           |          |   |   |          |        |   |   |           |         
|Capital stock activity:                                                |                                       |                                                                                             |      |              |   |            |         |               |   |          |           |          |   |       |        |   |        |   |           |          |   |   |          |        |   |   |           |         
|                                                                       | Employee benefit plans                |                                                                                             |      | 8            |   |            |         | (847          | ) |          |           | (7,649   | ) |       |        |  |        |   |           |          |   |   |          | 28,301 |   |   |           | 19,813   |       
|                                                                       | Reissuance of treasury stock          |                                                                                             |      |             |   |            |         |              |   |          |           | (15,145  | ) |       |        |  |        |   |           |         |   |   |          | 26,893 |   |   |           | 11,748   |       
|Tax benefit associated with exercise of stock
    options              |                                       |                                                                                             |     |              |   |            |        |               |   |          | 1,009     |          |   |       |       |   |        |   |          |          |   |   |         |        |   |   | 1,009     |         
|                                                                       |                                       |                                                                                             |      |              |   |            |         |               |   |          |           |          |   |       |        |   |        |   |           |          |   |   |          |        |   |   |           |         
|Balances at December 31, 2002                                          |                                       |                                                                                             | 954  |              |   |            | (2,000  | )             |   |          | 1,560,308 |          |   |       | 21,730 |   |        |   | 350,369   |          |   |   | (603,056 | )      |   |   | 1,328,305 |         
|                                                                       |                                       |                                                                                             |      |              |   |            |         |               |   |          |           |          |   |       |        |   |        |   |           |          |   |   |          |        |   |   |           |         
|Comprehensive income (loss):                                           |                                       |                                                                                             |      |              |   |            |         |               |   |          |           |          |   |       |        |   |        |   |           |          |   |   |          |        |   |   |           |         
|                                                                       | Net income                            |                                                                                             |      |             |   |            |         |              |   |          |           |         |   |       |        |  |        |   |           | 242,748  |   |   |          |       |   |   |           | 242,748  |       
|                                                                       | Other comprehensive loss, net of tax: |                                                                                             |      |              |   |            |         |               |   |          |           |          |   |       |        |   |        |   |           |          |   |   |          |        |   |   |           |          |       
|                                                                       |                                       | Change in unrealized gains on marketable
    securities, net of reclassification adjustment |      |              |  |            |         |               |  |          |           |          |  |       |        |   | (2,915 | ) |           |          |  |   |          |        |  |   |           |          | (2,915 | )
|                                                                       |                                       |                                                                                             |      |              |   |            |         |               |   |          |           |          |   |       |        |   |        |   |           |          |   |   |          |        |   |   |           |         
|Comprehensive income (loss)                                            |                                       |                                                                                             |     |              |   |            |        |               |   |          |          |          |   |       | (2,915 | ) |        |   | 242,748   |          |   |   |         |        |   |   | 239,833   |         
|                                                                       |                                       |                                                                                             |      |              |   |            |         |               |   |          |           |          |   |       |        |   |        |   |           |          |   |   |          |        |   |   |           |         
|Capital stock activity:                                                |                                       |                                                                                             |      |              |   |            |         |               |   |          |           |          |   |       |        |   |        |   |           |          |   |   |          |        |   |   |           |         
|                                                                       | Employee benefit plans                |                                                                                             |      | 51           |   |            |         | (14,843       | ) |          |           | 78,974   |   |       |        |  |        |   |           |         |   |   |          | 2,448  |   |   |           | 66,630   |       
|                                                                       | Purchase of treasury stock            |                                                                                             |      |             |   |            |         |              |   |          |           |         |   |       |        |  |        |   |           |         |   |   |          | (493   | ) |   |           | (493     | )     
|Retirement of treasury stock                                           |                                       |                                                                                             | (233 | )            |   |            |        |               |   |          | (398,158  | )        |   |       |       |   |        |   | (202,710  | )        |   |   | 601,101  |        |   |   |          |         
|Proceeds from equity offering                                          |                                       |                                                                                             | 76   |              |   |            |        |               |   |          | 199,348   |          |   |       |       |   |        |   |          |          |   |   |         |        |   |   | 199,424   |         
|Tax benefit associated with exercise of stock
    options              |                                       |                                                                                             |     |              |   |            |        |               |   |          | 17,838    |          |   |       |       |   |        |   |          |          |   |   |         |        |   |   | 17,838    |         
|                                                                       |                                       |                                                                                             |      |              |   |            |         |               |   |          |           |          |   |       |        |   |        |   |           |          |   |   |          |        |   |   |           |         
|Balances at December 31, 2003                                          |                                       | $                                                                                           | 848  |              |   | $          | (16,843 | )             |   | $        | 1,458,310 |          |   | $     | 18,815 |   |        | $ | 390,407   |          |   | $ |         |        |   | $ | 1,851,537 |         
|                                                                       |                                       |                                                                                             |      |              |   |            |         |               |   |          |           |          |   |       |        |   |        |   |           |          |   |   |          |        |   |   |           |         

All applicable dollar amounts reflect the
retroactive effects of the two-for-one common stock split in the
form of a stock dividend that was effective January 20,
2004.

See accompanying notes.

F-3



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##### Table of Contents



PACIFICARE HEALTH SYSTEMS, INC.

CONSOLIDATED STATEMENTS OF CASH
FLOWS

|                                                |                                                                                                    |                                                                                                             |                                           |                                                                                    |         |              |          |          |         |         |           |          |        |          |          |  
|----------------------------------------------- | -------------------------------------------------------------------------------------------------- | ----------------------------------------------------------------------------------------------------------- | ----------------------------------------- | ---------------------------------------------------------------------------------- | ------- | ------------ | -------- | -------- | ------- | ------- | --------- | -------- | ------ | -------- | -------- | -
|                                                |                                                                                                    | Year Ended                                                                                                  |                                           | Year Ended                                                                         |         | Year Ended  
|                                                |                                                                                                    | December 31,                                                                                                |                                           | December 31,                                                                       |         | December 31,
|                                                |                                                                                                    | 2003                                                                                                        |                                           | 2002                                                                               |         | 2001        
|                                                |                                                                                                    |                                                                                                             |                                           |                                                                                    |         |             
|                                                |                                                                                                    |                                                                                                            
|                                                |                                                                                                    | (Amounts in thousands)                                                                                     
|Operating activities:                           |                                                                                                    |                                                                                                             |                                           |                                                                                    |         |              |          |          |         |         |           |         
|                                                | Net income (loss)                                                                                  |                                                                                                             | $                                         | 242,748                                                                            |         |              | $        | (757,829 | )       |         | $         | 19,006   |       
|                                                | Adjustments to reconcile net income
    (loss) to net cash flows provided by operating activities: |                                                                                                             |                                           |                                                                                    |         |              |          |          |         |         |           |          |       
|                                                |                                                                                                    | Deferred income taxes                                                                                       |                                           |                                                                                    | (46,088 | )            |          |          | 18,559  |         |           |          | (3,966 | )       
|                                                |                                                                                                    | Depreciation and amortization                                                                               |                                           |                                                                                    | 44,713  |              |          |          | 50,284  |         |           |          | 65,808 |         
|                                                |                                                                                                    | Expenses related to bond redemption                                                                         |                                           |                                                                                    | 28,155  |              |          |          |        |         |           |          |       |         
|                                                |                                                                                                    | Loss on disposal of property, plant and equipment
    and other                                             |                                           |                                                                                    | 22,328  |              |          |          | 12,793  |         |           |          | 6,053  |         
|                                                |                                                                                                    | Amortization of intangible assets                                                                           |                                           |                                                                                    | 21,908  |              |          |          | 23,600  |         |           |          | 23,781 |         
|                                                |                                                                                                    | Stock-based compensation expense                                                                            |                                           |                                                                                    | 19,092  |              |          |          | 693     |         |           |          | 3,632  |         
|                                                |                                                                                                    | Tax benefit realized for stock option exercises                                                             |                                           |                                                                                    | 17,838  |              |          |          | 1,009   |         |           |          | 21     |         
|                                                |                                                                                                    | Provision for doubtful accounts                                                                             |                                           |                                                                                    | 10,271  |              |          |          | 6,346   |         |           |          | 22,070 |         
|                                                |                                                                                                    | Amortization of capitalized loan fees                                                                       |                                           |                                                                                    | 7,481   |              |          |          | 7,784   |         |           |          | 7,560  |         
|                                                |                                                                                                    | Amortization of notes receivable from sale of
    fixed assets                                              |                                           |                                                                                    | (5,641  | )            |          |          | (3,107  | )       |           |          |       |         
|                                                |                                                                                                    | Employer benefit plan contributions in treasury
    stock                                                   |                                           |                                                                                    | 1,363   |              |          |          | 12,132  |         |           |          |       |         
|                                                |                                                                                                    | Amortization of discount on 10 3/4% senior
    notes                                                        |                                           |                                                                                    | 424     |              |          |          | 266     |         |           |          |       |         
|                                                |                                                                                                    | Cumulative effect of a change in accounting
    principle                                                   |                                           |                                                                                    |        |              |          |          | 897,000 |         |           |          |       |         
|                                                |                                                                                                    | Marketable and other securities impairment for
    other than temporary declines in value                   |                                           |                                                                                    |        |              |          |          | 12,543  |         |           |          |       |         
|                                                |                                                                                                    | Impairment, disposition, restructuring, Office of
    Personnel Management and other charges (credits), net |                                           |                                                                                    |        |              |          |          | 3,774   |         |           |          | 61,157 |         
|                                                |                                                                                                    | Adjustment to cash received in purchase
    transaction                                                     |                                           |                                                                                    |        |              |          |          | 17      |         |           |          |       |         
|                                                |                                                                                                    | Amortization of goodwill                                                                                    |                                           |                                                                                    |        |              |          |          |        |         |           |          | 59,115 |         
|                                                |                                                                                                    | Gain on early retirement of debt                                                                            |                                           |                                                                                    |        |              |          |          |        |         |           |          | (1,800 | )       
|                                                |                                                                                                    | Changes in assets and liabilities:                                                                          |                                           |                                                                                    |         |              |          |          |         |         |           |          |        |         
|                                                |                                                                                                    |                                                                                                             | Receivables, net                          |                                                                                    |         | 19,327       |          |          |         | 82,369  |           |          |        | 16,186   |         
|                                                |                                                                                                    |                                                                                                             | Prepaid expenses and other assets         |                                                                                    |         | (33,748      | )        |          |         | 2,627   |           |          |        | 7,721    |         
|                                                |                                                                                                    |                                                                                                             | Medical claims and benefits payable       |                                                                                    |         | (17,000      | )        |          |         | (52,226 | )         |          |        | (174,900 | )       
|                                                |                                                                                                    |                                                                                                             | Accounts payable and accrued liabilities: |                                                                                    |         |              |          |          |         |         |           |          |        |          |         
|                                                |                                                                                                    |                                                                                                             |                                           | Payment for Office of Personnel Management
    settlement, net of amounts received |         |              | (10,000  | )        |         |         | (65,441   | )        |        |          |         |  
|                                                |                                                                                                    |                                                                                                             |                                           | Other changes in accounts payable and accrued
    liabilities                      |         |              | 74,031   |          |         |         | 59,027    |          |        |          | (25,216  | )
|                                                |                                                                                                    |                                                                                                             | Unearned premium revenue                  |                                                                                    |         | 16,928       |          |          |         | (69,841 | )         |          |        | (47,305  | )       
|                                                |                                                                                                    |                                                                                                             |                                           |                                                                                    |         |              |          |          |         |         |           |         
|                                                |                                                                                                    |                                                                                                             |                                           | Net cash flows provided by operating activities                                    |         |              | 414,130  |          |         |         | 242,379   |          |        |          | 38,923   |  
|                                                |                                                                                                    |                                                                                                             |                                           |                                                                                    |         |              |          |          |         |         |           |         
|Investing activities:                           |                                                                                                    |                                                                                                             |                                           |                                                                                    |         |              |          |          |         |         |           |         
|                                                | Purchase of marketable securities, net                                                             |                                                                                                             |                                           | (169,102                                                                           | )       |              |          | (113,987 | )       |         |           | (190,401 | )     
|                                                | Purchase of property, plant and equipment                                                          |                                                                                                             |                                           | (52,271                                                                            | )       |              |          | (59,274  | )       |         |           | (77,301  | )     
|                                                | Sale (purchase) of marketable
    securities-restricted, net                                       |                                                                                                             |                                           | 19,643                                                                             |         |              |          | (117,368 | )       |         |           | (17,765  | )     
|                                                | Proceeds from the sale of property, plant and
    equipment                                        |                                                                                                             |                                           | 30                                                                                 |         |              |          | 12,492   |         |         |           | 25,139   |       
|                                                | Net cash paid for acquisitions                                                                     |                                                                                                             |                                           |                                                                                   |         |              |          |         |         |         |           | (500     | )     
|                                                |                                                                                                    |                                                                                                             |                                           |                                                                                    |         |              |          |          |         |         |           |         
|                                                |                                                                                                    |                                                                                                             |                                           | Net cash flows used in investing activities                                        |         |              | (201,700 | )        |         |         | (278,137  | )        |        |          | (260,828 | )
|                                                |                                                                                                    |                                                                                                             |                                           |                                                                                    |         |              |          |          |         |         |           |         
|Financing activities:                           |                                                                                                    |                                                                                                             |                                           |                                                                                    |         |              |          |          |         |         |           |         
|                                                | Proceeds from equity offering used for redemption
    of $175 million of senior notes              |                                                                                                             |                                           | 199,424                                                                            |         |              |          |         |         |         |           |         |       
|                                                | Principal payments on senior note redemption                                                       |                                                                                                             |                                           | (175,000                                                                           | )       |              |          |         |         |         |           |         |       
|                                                | Principal payments on long-term debt                                                               |                                                                                                             |                                           | (151,329                                                                           | )       |              |          | (554,308 | )       |         |           | (30,284  | )     
|                                                | Proceeds from borrowings of long-term debt                                                         |                                                                                                             |                                           | 150,000                                                                            |         |              |          | 496,945  |         |         |           |         |       
|                                                | Principal payments on FHP senior notes                                                             |                                                                                                             |                                           | (43,250                                                                            | )       |              |          | (41,750  | )       |         |           |         |       
|                                                | Use of restricted cash collateral for payment of
    FHP senior notes                              |                                                                                                             |                                           | 43,250                                                                             |         |              |          |         |         |         |           |         |       
|                                                | Proceeds from issuance of common and treasury
    stock                                            |                                                                                                             |                                           | 41,146                                                                             |         |              |          | 4,893    |         |         |           | 83       |       
|                                                | Payment of premium to bondholders for senior note
    redemption                                   |                                                                                                             |                                           | (18,813                                                                            | )       |              |          |         |         |         |           |         |       
|                                                | Loan fees                                                                                          |                                                                                                             |                                           | (6,949                                                                             | )       |              |          | (37,789  | )       |         |           | (12,949  | )     
|                                                | Payments on software financing agreement                                                           |                                                                                                             |                                           | (3,683                                                                             | )       |              |          | (2,231   | )       |         |           |         |       
|                                                | Common stock repurchases                                                                           |                                                                                                             |                                           | (493                                                                               | )       |              |          |         |         |         |           |         |       
|                                                | Proceeds from issuance of convertible
    subordinated debentures                                  |                                                                                                             |                                           |                                                                                   |         |              |          | 135,000  |         |         |           |         |       
|                                                | Proceeds from draw down under equity commitment
    arrangement                                    |                                                                                                             |                                           |                                                                                   |         |              |          | 8,928    |         |         |           |         |       
|                                                | Purchase of minority interest in consolidated
    subsidiary                                       |                                                                                                             |                                           |                                                                                   |         |              |          |         |         |         |           | (8,821   | )     
|                                                |                                                                                                    |                                                                                                             |                                           |                                                                                    |         |              |          |          |         |         |           |         
|                                                |                                                                                                    |                                                                                                             |                                           | Net cash flows provided by (used in) financing
    activities                      |         |              | 34,303   |          |         |         | 9,688     |          |        |          | (51,971  | )
|                                                |                                                                                                    |                                                                                                             |                                           |                                                                                    |         |              |          |          |         |         |           |         
|Net increase (decrease) in cash and equivalents |                                                                                                    |                                                                                                             | 246,733                                   |                                                                                    |         |              | (26,070  | )        |         |         | (273,876  | )       
|Beginning cash and equivalents                  |                                                                                                    |                                                                                                             | 951,689                                   |                                                                                    |         |              | 977,759  |          |         |         | 1,251,635 |         
|                                                |                                                                                                    |                                                                                                             |                                           |                                                                                    |         |              |          |          |         |         |           |         
|Ending cash and equivalents                     |                                                                                                    | $                                                                                                           | 1,198,422                                 |                                                                                    |         | $            | 951,689  |          |         | $       | 977,759   |         
|                                                |                                                                                                    |                                                                                                             |                                           |                                                                                    |         |              |          |          |         |         |           |         

See accompanying notes.


Table continued on next page


F-4



---



##### Table of Contents



PACIFICARE HEALTH SYSTEMS, INC.


CONSOLIDATED STATEMENTS OF CASH FLOWS
(Continued)

|                                                                         |                                                                           |                                                         |                              |                                |        |              |   |       |         |         |   |      |         |        |     | 
|------------------------------------------------------------------------ | ------------------------------------------------------------------------- | ------------------------------------------------------- | ---------------------------- | ------------------------------ | ------ | ------------ | - | ----- | ------- | ------- | - | ---- | ------- | ------ | --- | 
|                                                                         |                                                                           | Year Ended                                              |                              | Year Ended                     |        | Year Ended  
|                                                                         |                                                                           | December 31,                                            |                              | December 31,                   |        | December 31,
|                                                                         |                                                                           | 2003                                                    |                              | 2002                           |        | 2001        
|                                                                         |                                                                           |                                                         |                              |                                |        |             
|                                                                         |                                                                           |                                                        
|                                                                         |                                                                           | (Amounts in thousands)                                 
|Supplemental cash flow information:                                      |                                                                           |                                                         |                              |                                |        |              |   |       |         |         |   |     
|                                                                         | Cash paid (received) during the year for:                                 |                                                         |                              |                                |        |              |   |       |         |         |   |      |        
|                                                                         |                                                                           |                                                         | Income taxes, net of refunds |                                | $      | 168,933      |   |       | $       | (68,123 | ) |      | $       | 7,328  |    
|                                                                         |                                                                           |                                                         | Interest                     |                                | $      | 67,363       |   |       | $       | 68,732  |   |      | $       | 73,140 |    
|Supplemental schedule of noncash investing and
    financing activities: |                                                                           |                                                         |                              |                                |        |              |   |       |         |         |   |     
|                                                                         | Details of cumulative effect of a change in
    accounting principle:     |                                                         |                              |                                |        |              |   |       |         |         |   |      |        
|                                                                         |                                                                           | Goodwill impairment                                     |                              | $                              |       |              |   | $     | 929,436 |         |   | $    |        |       
|                                                                         |                                                                           | Less decrease in deferred liability                     |                              |                                |       |              |   |       | (32,436 | )       |   |      |        |       
|                                                                         |                                                                           |                                                         |                              |                                |        |              |   |       |         |         |   |     
|                                                                         |                                                                           | Goodwill impairment, net of tax                         |                              | $                              |       |              |   | $     | 897,000 |         |   | $    |        |       
|                                                                         |                                                                           |                                                         |                              |                                |        |              |   |       |         |         |   |     
|                                                                         | Stock-based compensation                                                  |                                                         | $                            | 5,028                          |        |              | $ | 1,915 |         |         | $ | (506 | )      
|                                                                         |                                                                           |                                                         |                              |                                |        |              |   |       |         |         |   |     
|                                                                         | Treasury stock reissued in exchange for
    retirement of long-term debt: |                                                         |                              |                                |        |              |   |       |         |         |   |      |        
|                                                                         |                                                                           | Treasury stock                                          |                              | $                              |       |              |   | $     | 5,218   |         |   | $    | 38,821  |       
|                                                                         |                                                                           | Additional paid-in capital                              |                              |                                |       |              |   |       | (2,398  | )       |   |      | (28,621 | )     
|                                                                         |                                                                           | Long-term debt retired                                  |                              |                                |       |              |   |       | (3,000  | )       |   |      | (12,000 | )     
|                                                                         |                                                                           |                                                         |                              |                                |        |              |   |       |         |         |   |     
|                                                                         |                                                                           | Extraordinary gain on early retirement of debt          |                              | $                              |       |              |   | $     | (180    | )       |   | $    | (1,800  | )     
|                                                                         |                                                                           |                                                         |                              |                                |        |              |   |       |         |         |   |     
|                                                                         | Details of accumulated other comprehensive income:                        |                                                         |                              |                                |        |              |   |       |         |         |   |      |        
|                                                                         |                                                                           | Change in unrealized gains on marketable
    securities |                              | $                              | (4,899 | )            |   | $     | 31,720  |         |   | $    | 7,939   |       
|                                                                         |                                                                           | Less change in deferred income taxes                    |                              |                                | 1,984  |              |   |       | (11,941 | )       |   |      | (3,013  | )     
|                                                                         |                                                                           |                                                         |                              |                                |        |              |   |       |         |         |   |     
|                                                                         |                                                                           | Change in stockholders equity                          |                              | $                              | (2,915 | )            |   | $     | 19,779  |         |   | $    | 4,926   |       
|                                                                         |                                                                           |                                                         |                              |                                |        |              |   |       |         |         |   |     
|                                                                         | Details of assets sold:                                                   |                                                         |                              |                                |        |              |   |       |         |         |   |      |        
|                                                                         |                                                                           | Net book value of assets sold                           |                              | $                              |       |              |   | $     |        |         |   | $    | (42,000 | )     
|                                                                         |                                                                           | Less cash received                                      |                              |                                |       |              |   |       |        |         |   |      | 25,000  |       
|                                                                         |                                                                           |                                                         |                              |                                |        |              |   |       |         |         |   |     
|                                                                         |                                                                           | Note receivable from sale of assets                     |                              | $                              |       |              |   | $     |        |         |   | $    | (17,000 | )     
|                                                                         |                                                                           |                                                         |                              |                                |        |              |   |       |         |         |   |     
|                                                                         | Details of businesses acquired in purchase
    transactions:              |                                                         |                              |                                |        |              |   |       |         |         |   |      |        
|                                                                         |                                                                           | Fair value of assets acquired                           |                              | $                              |       |              |   | $     |        |         |   | $    | 3,245   |       
|                                                                         |                                                                           | Less liabilities assumed or created                     |                              |                                |       |              |   |       |        |         |   |      | (2,745  | )     
|                                                                         |                                                                           |                                                         |                              |                                |        |              |   |       |         |         |   |     
|                                                                         |                                                                           | Cash paid for fair value of assets acquired             |                              |                                |       |              |   |       |        |         |   |      | 500     |       
|                                                                         |                                                                           | Cash acquired in acquisitions                           |                              |                                |       |              |   |       |        |         |   |      |        |       
|                                                                         |                                                                           |                                                         |                              |                                |        |              |   |       |         |         |   |     
|                                                                         |                                                                           |                                                         |                              | Net cash paid for acquisitions |        | $            |  |       |         | $       |  |      |         | $      | 500 | 
|                                                                         |                                                                           |                                                         |                              |                                |        |              |   |       |         |         |   |     
|                                                                         | Details of discount on 10 3/4% senior notes:                              |                                                         |                              |                                |        |              |   |       |         |         |   |      |        
|                                                                         |                                                                           | Discount                                                |                              | $                              | (2,789 | )            |   | $     | (3,055  | )       |   | $    |        |       
|                                                                         |                                                                           | Discount reduction related to bond redemption           |                              |                                | 836    |              |   |       |        |         |   |      |        |       
|                                                                         |                                                                           | Amortization                                            |                              |                                | 424    |              |   |       | 266     |         |   |      |        |       
|                                                                         |                                                                           |                                                         |                              |                                |        |              |   |       |         |         |   |     
|                                                                         |                                                                           | Net discount on notes payable                           |                              | $                              | (1,529 | )            |   | $     | (2,789  | )       |   | $    |        |       
|                                                                         |                                                                           |                                                         |                              |                                |        |              |   |       |         |         |   |     
|                                                                         | Details of assets acquired:                                               |                                                         |                              |                                |        |              |   |       |         |         |   |      |        
|                                                                         |                                                                           | Net book value of assets acquired                       |                              | $                              | (2,522 | )            |   | $     | (13,674 | )       |   | $    |        |       
|                                                                         |                                                                           | Note payable                                            |                              |                                | 3,002  |              |   |       |        |         |   |      |        |       
|                                                                         |                                                                           | Prepaid software maintenance                            |                              |                                | (480   | )            |   |       | 13,674  |         |   |      |        |       
|                                                                         |                                                                           |                                                         |                              |                                |        |              |   |       |         |         |   |     
|                                                                         |                                                                           | Cash paid for assets acquired                           |                              | $                              |       |              |   | $     |        |         |   | $    |        |       
|                                                                         |                                                                           |                                                         |                              |                                |        |              |   |       |         |         |   |     

See accompanying notes.

F-5



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##### Table of Contents



PACIFICARE HEALTH SYSTEMS, INC.

NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS



|   |                      
|-- | ---------------------
|1. | Basis of Presentation

Organization and Operations.PacifiCare Health Systems, Inc. offers
managed care and other health insurance products to employer
groups and Medicare beneficiaries primarily in eight western
states and Guam. Our commercial and senior medical plans are
designed to deliver quality health care and customer service to
members cost-effectively. These programs include health
maintenance organizations, or HMOs, preferred provider
organizations, or PPOs, and Medicare Supplement products. We
also offer a variety of specialty managed care products and
services that employees can purchase as a supplement to our
basic commercial and senior plans or as stand-alone products.
These products include pharmacy benefit management, or PBM,
services, behavioral health services, group life and health
insurance and dental and vision benefit plans.

Consolidation.Premium revenues are earned from
products where we bear insured risk. Non-premium revenues are
earned from all other sources, including revenues from our PBM
mail order business, administrative fees and other revenue.
Commencing with the first quarter of 2003, we reformatted our
statement of operations to show total revenues (premium revenues
and non-premium revenues) and health care services and other
expenses by the following categories: commercial, senior and
specialty and other. These changes are summarized below:



|  |                                                                                                                                                                                                                                                                                                                                                                                                               
|- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | For our behavioral health and dental and vision
    subsidiaries, we previously included premium revenues in the
    commercial revenue line and non-premium revenues in the other
    income line. In 2003, all revenues (premium and non-premium)
    derived from our specialty companies (behavioral health, dental
    and vision and PBM) are now reported in the specialty and other
    revenues line.
| 
| | All health care services and other expenses for
    our specialty companies were previously included within
    commercial health care costs. In 2003, all health care services
    and other expenses for our specialty companies are now reported
    in the specialty and other health care services and other
    expenses line.                                                                          
| 
| | Non-premium revenues earned by, and non-premium
    related fees charged by, our health plans or subsidiaries were
    previously included in the other income line. In 2003, these
    amounts are now included in the commercial, senior or specialty
    revenue and health care services and other expenses lines, as
    appropriate.                                                                    

The accompanying consolidated financial
statements include the accounts of the parent company and all
significant subsidiaries that are more than 50% owned and
controlled. All significant intercompany transactions and
balances were eliminated in consolidation.

Segment Information.We present segment information
externally the same way management uses financial data
internally to make operating decisions and assess performance.
Because we sell health care packages in the form of bundled
managed care and supplemental managed care products to members
of all ages, we have one reportable operating segment. These
managed care members generally fall within two product lines,
commercial and senior. Revenues from non-Medicare members,
generally employees or early retirees of businesses, are
reported in the commercial product line. Revenues from our
Medicare customers are reported in the senior product line. Our
single largest customer is the federal government. Sources of
federal government revenues include revenues from Medicare
beneficiaries and from federal employees covered by the Federal
Employee Health Benefits Program, or FEHBP, who are included in
our commercial product line. Federal government revenues were
$5.9 billion in 2003, $6.3 billion in 2002, and
$7.1 billion in 2001.

F-6



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##### Table of Contents



PACIFICARE HEALTH SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)

Use of Estimates.In
preparing the consolidated financial statements, we must use
some estimates and assumptions that may affect reported amounts
and disclosures. We use estimates most often when accounting for:



|  |                                                                                   
|- | ----------------------------------------------------------------------------------
| | Allowances for doubtful premiums and accounts
    receivable;                     
| 
| | Provider receivables and reserves;                                                
| 
| | Impairment of long-lived assets;                                                  
| 
| | Medical claims and benefits payable;                                              
| 
| | Professional and general liability; and                                           
| 
| | Reserves relating to the United States Office of
    Personnel Management, or OPM.

We are also subject to risks and uncertainties
that may cause actual results to differ from estimated results,
such as changes in the health care environment, competition and
legislation.

Reclassifications.We reclassified certain prior year
amounts in the accompanying consolidated financial statements to
conform to the reformatted 2003 presentation. The
reclassifications and changes in presentation do not have any
effect on our total consolidated revenues or health care
services and other expenses.



|   |                                
|-- | -------------------------------
|2. | Significant Accounting Policies

Cash and Equivalents.Cash and equivalents include items
such as money market funds and certificates of deposit, with
maturity periods of three months or less when purchased.

Marketable Securities.All marketable securities (which
include municipal bonds, corporate notes, commercial paper and
U.S. government securities), except for certain marketable
securities-restricted, are designated as available-for-sale.
Accordingly, marketable securities are carried at fair value and
unrealized gains or losses, net of applicable income taxes, are
recorded in stockholders equity. Because marketable
securities are available for use in current operations, they are
classified as current assets without regard to the
securities contractual maturity dates.

We are required by state regulatory agencies to
set aside funds to comply with the laws of the various states in
which we operate. These funds are classified as marketable
securities-restricted (which include U.S. government securities
and certificates of deposit held by trustees or state regulatory
agencies). Certain marketable securities-restricted are
designated as held-to-maturity since we have the intent and
ability to hold such securities to maturity. Held-to-maturity
securities are stated at amortized cost, adjusted for
amortization of premiums and accretion of discounts to maturity,
and are classified as noncurrent assets. See Note 3,
Marketable Securities.

Concentrations of Credit Risk.Financial instruments that potentially
subject us to concentrations of credit risk consist primarily of
investments in marketable securities and receivables generated
in the ordinary course of business. Our short-term investments
in marketable securities are managed by professional investment
managers within guidelines established by our board of directors
that, as a matter of policy, limit the amounts that may be
invested in any one issuer. Our receivables include premium
receivables from commercial customers, rebate receivables from
pharmaceutical manufacturers, receivables related to prepayment
of claims on behalf of our self-funded customers, and
receivables owed to us from providers under risk-sharing
arrangements. We had no significant concentrations of credit
risk at December 31, 2003.

F-7



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##### Table of Contents



PACIFICARE HEALTH SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)

Fair Value of Financial Instruments.Our consolidated balance sheets
include the following financial instruments: cash and
equivalents, trade accounts and notes receivable, trade accounts
payable and long-term obligations. We consider the carrying
amounts of current assets and liabilities in the consolidated
financial statements to approximate the fair value for these
financial instruments because of the relatively short period of
time between origination of the instruments and their expected
realization. The carrying value of all long-term obligations
approximates the fair value of such obligations.

Long-Lived Assets.

Property, Plant and Equipment.We record property, plant and
equipment at cost. We capitalize replacements and major
improvements and certain internal and external costs associated
with the purchase or development of internal-use software. We
charge repairs and maintenance to expense as incurred. We
eliminate the costs and related accumulated depreciation when we
sell property, plant and equipment, and any resulting gains or
losses are included in net income. We depreciate property, plant
and equipment, including assets under capital leases, evenly
over the assets useful lives ranging from three to
25 years. We amortize leasehold improvements evenly over
the shorter of the lease term or five years. We amortize
software costs evenly over estimated useful lives ranging from
three to five years. Accumulated depreciation and amortization
on property, plant and equipment totaled $212 million at
December 31, 2003 and $192 million at
December 31, 2002.

Long-lived Asset Impairment.We review long-lived assets, including
identified intangible assets, for impairment when events or
changes in business conditions indicate that their full carrying
value may not be recovered. We consider assets to be impaired
and write them down to fair value if expected associated
undiscounted cash flows are less than the carrying amounts. Fair
value is determined based on the present value of the expected
associated cash flows.

Goodwill and Intangible Assets.When we acquire a business, we
allocate the excess of the purchase price over the fair value of
the net assets acquired to goodwill and identified intangible
assets. Prior to 2002, we amortized goodwill and intangible
assets evenly over periods ranging from three to 40 years.
On January 1, 2002, we adopted Statements of Financial
Accounting Standards, or SFAS, No. 141, Business
Combinations,and SFAS No. 142, Goodwill and Other
Intangible Assets.Under the new rules, goodwill is no
longer amortized, but is subject to impairment tests on an
annual basis or more frequently if impairment indicators exist.
The tests for measuring goodwill impairment under SFAS
No. 142 are more stringent than the previous tests required
by SFAS No. 121. See Note 7, Goodwill and
Intangible Assets.

Premiums and Revenue Recognition.We report prepaid health care premiums
received from our HMOs enrolled groups as revenue in the
month that enrollees are entitled to receive health care
services. We record premiums received in advance as unearned
premium revenue. Funds received under the federal Medicare
program accounted for approximately 50% in 2003, 53% in 2002 and
58% in 2001 as a percentage of total premiums.

Health Care Services.Our HMOs arrange for comprehensive
health care services to their members through capitation or
risk-based arrangements. Capitation is a fixed monthly payment
made without regard to the frequency, extent or nature of the
health care services actually furnished. We provide benefits to
enrolled members generally through our contractual relationships
with physician groups and hospitals. Our capitated physicians
and hospitals may, in turn, contract with specialists or
referral physicians and hospitals for specific services and are
generally responsible for any related payments to those referral
physicians and hospitals. Risk-based arrangements include
shared-risk and fee-for-

F-8



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##### Table of Contents



PACIFICARE HEALTH SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)

service contracts. Under the shared-risk
contracts, we share the risk of health care costs with parties
not covered by our capitation arrangements. Under
fee-for-service contracts, we contract with certain hospitals
and ancillary providers, as well as some individual physicians
or physician organizations, to provide services to our members
based on modified discounted fee schedules for the services
provided. Expenses related to these programs that are based in
part on estimates are recorded in the period in which the
related services are dispensed. The cost of health care provided
is accrued in the period it is dispensed to the enrolled
members, based in part on estimates for hospital services and
other health care costs that have been incurred but not yet
reported, or IBNR. Management develops these estimates using
standard actuarial methods which include, among other factors,
the average interval between the date services are rendered and
the date claims are paid, denied claims activity, disputed
claims activity, expected health care cost inflation,
utilization, seasonality patterns and changes in membership. The
estimates for submitted claims and IBNR claims liabilities are
made on an accrual basis and adjusted based on actual claims
data in future periods as required. For new products, such as
our PPO products, estimates are initially based on health care
cost data provided by third parties. This data includes
assumptions for member age, gender and geography. The models
that we use to prepare estimates for each product are adjusted
as we accumulate actual claims paid data. Such estimates could
materially understate or overstate our actual liability for
medical claims and benefits payable. These estimates are
reviewed by outside parties and state regulatory authorities on
a periodic basis. The estimates for submitted claims and IBNR
claims liabilities are made on an accrual basis and adjusted in
future periods as required. Adjustments to prior period
estimates, if any, are included in current operations. We have
also recorded reserves, based in part on estimates, to indemnify
our members against potential claims made by specialists or
other providers whose fees should have been paid by the
insolvent medical groups. See Note 13,
Contingencies.

Premium Deficiency Reserves on Loss Contracts.We assess the profitability of our
contracts for providing health care services to our members when
current operating results or forecasts indicate probable future
losses. We compare anticipated premiums to health care related
costs, including estimated payments for physicians and
hospitals, commissions and cost of collecting premiums and
processing claims. If the anticipated future costs exceed the
premiums, a loss contract accrual is recognized.

Stock-Based
Compensation.We have stock-based
employee and director compensation plans. See Note 9,
Employee Benefit Plans. Prior to 2003, we accounted
for those plans under the recognition and measurement provisions
of APB Opinion No. 25, Accounting for Stock Issued to
Employees,and related interpretations. No stock-based
employee and director compensation cost was reflected in net
income (loss) for the years ended December 31, 2002
and 2001, as all stock options granted under our plans had an
exercise price equal to the market value of the underlying
common stock on the date of grant. Effective January 1,
2003, we adopted the fair value recognition provisions of FASB
Statement No. 123, Accounting for Stock-Based
Compensation,on a prospective basis for all employee and
director awards granted, modified or settled on or after
January 1, 2003. Awards typically vest over four years.
Therefore, cost related to stock-based employee and director
compensation included in the determination of net income for
2003 is less than that which would have been recognized if the
fair value based method had been applied to all awards granted,
modified or settled since October 1, 1995. The following
table illustrates the effect on net income (loss) and
earnings (loss) per share, after adjusting for the effect
of the two-for-one stock split in the form of a

F-9



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##### Table of Contents



PACIFICARE HEALTH SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)

stock dividend that was effective
January 20, 2004, as if the fair value method had been
applied to all outstanding and unvested awards in each period.

|                                                                                                                                   |                       |                               |         |      |  |      |          |        |   |   |        |      | 
|---------------------------------------------------------------------------------------------------------------------------------- | --------------------- | ----------------------------- | ------- | ---- |  | ---- | -------- | ------ | - | - | ------ | ---- | 
|                                                                                                                                   |                       |                              
|                                                                                                                                   |                       | Year Ended                   
|                                                                                                                                   |                       |                              
|                                                                                                                                   |                       | 2003                          |         | 2002 |  | 2001
|                                                                                                                                   |                       |                               |         |      |  |     
|                                                                                                                                   |                       |                              
|                                                                                                                                   |                       | (Amounts in thousands, except
|                                                                                                                                   |                       | per-share data)              
|Net income (loss), as reported                                                                                                     |                       | $                             | 242,748 |      |  | $    | (757,829 | )      |   | $ | 19,006 |     
|Add stock-based compensation expense included in
    reported net income (loss), net of related tax effect                         |                       |                               | 8,228   |      |  |      |         |        |   |   |       |     
|Deduct total stock-based compensation expense
    determined under fair value method for all awards, net of
    related tax effect |                       |                               | (16,703 | )    |  |      | (18,360  | )      |   |   | (6,427 | )   
|                                                                                                                                   |                       |                               |         |      |  |      |          |        |   |   |        |     
|Pro forma net income (loss)                                                                                                        |                       | $                             | 234,273 |      |  | $    | (776,189 | )      |   | $ | 12,579 |     
|                                                                                                                                   |                       |                               |         |      |  |      |          |        |   |   |        |     
|Earnings (loss) per share:                                                                                                         |                       |                               |         |      |  |      |          |        |   |   |        |     
|                                                                                                                                   | Basic  as reported   |                               | $       | 3.26 |  |      | $        | (10.75 | ) |   | $      | 0.28 | 
|                                                                                                                                   |                       |                               |         |      |  |      |          |        |   |   |        |     
|                                                                                                                                   | Basic  pro forma     |                               | $       | 3.15 |  |      | $        | (11.01 | ) |   | $      | 0.19 | 
|                                                                                                                                   |                       |                               |         |      |  |      |          |        |   |   |        |     
|                                                                                                                                   | Diluted  as reported |                               | $       | 3.04 |  |      | $        | (10.75 | ) |   | $      | 0.27 | 
|                                                                                                                                   |                       |                               |         |      |  |      |          |        |   |   |        |     
|                                                                                                                                   | Diluted  pro forma   |                               | $       | 2.93 |  |      | $        | (11.01 | ) |   | $      | 0.19 | 
|                                                                                                                                   |                       |                               |         |      |  |      |          |        |   |   |        |     

The following table illustrates the components of
our stock-based compensation expense:

|                             |  |                        |        |            |  |         |        |            |  |         |     |            |  |   |     |  |  |   |       |  |  |   |       | 
|---------------------------- |  | ---------------------- | ------ | ---------- |  | ------- | ------ | ---------- |  | ------- | --- | ---------- |  | - | --- |  |  | - | ----- |  |  | - | ----- | 
|                             |  |                       
|                             |  | Year Ended            
|                             |  |                       
|                             |  |                        |        |            |  |        
|                             |  | 2003                   |        | 2002       |  | 2001   
|                             |  |                        |        |            |  |        
|                             |  | Pretax                 |        | Net-of-Tax |  | Pretax  |        | Net-of-Tax |  | Pretax  |     | Net-of-Tax
|                             |  | Charges                |        | Amount     |  | Charges |        | Amount     |  | Charges |     | Amount    
|                             |  |                        |        |            |  |         |        |            |  |         |     |           
|                             |  |                       
|                             |  | (Amounts in thousands)
|Stock options                |  | $                      | 7,545  |            |  | $       | 4,512  |            |  | $       |    |            |  | $ |    |  |  | $ |      |  |  | $ |      | 
|Employee Stock Purchase Plan |  |                        | 6,214  |            |  |         | 3,716  |            |  |         |    |            |  |   |    |  |  |   |      |  |  |   |      | 
|                             |  |                        |        |            |  |         |        |            |  |         |     |            |  |   |     |  |  |   |       |  |  |   |       | 
|                             |  |                        | 13,759 |            |  |         | 8,228  |            |  |         |    |            |  |   |    |  |  |   |      |  |  |   |      | 
|Restricted stock(1)          |  |                        | 5,333  |            |  |         | 3,189  |            |  |         | 693 |            |  |   | 414 |  |  |   | 3,632 |  |  |   | 2,172 | 
|                             |  |                        |        |            |  |         |        |            |  |         |     |            |  |   |     |  |  |   |       |  |  |   |       | 
|Total                        |  | $                      | 19,092 |            |  | $       | 11,417 |            |  | $       | 693 |            |  | $ | 414 |  |  | $ | 3,632 |  |  | $ | 2,172 | 
|                             |  |                        |        |            |  |         |        |            |  |         |     |            |  |   |     |  |  |   |       |  |  |   |       | 



---



|    |                                                                                                                                                                                                                                                                                                                                                                                                                             
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | The recognition and measurement of restricted
    stock is the same under APB Opinion No. 25 and FASB
    Statement No. 123. The related expenses for the fair value
    of restricted stock were charged to selling, general and
    administrative expenses and are included in the net income
    (loss), as reported amounts in the pro forma net income
    (loss) table above. See Note 6, Stockholders
    Equity.

Taxes Based on Premiums.Certain states in which we do business
require the payment of excise, per capita or premium taxes based
on a specified rate for enrolled members or a percentage of
billed premiums. Such taxes may be levied instead of state
income tax. These taxes are recorded in selling, general and
administrative expenses, and totaled $34 million in 2003,
$27 million in 2002 and $26 million in 2001.

F-10



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##### Table of Contents



PACIFICARE HEALTH SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)

Income Taxes.We
recognize deferred income tax assets and liabilities for the
expected future tax consequences of events that have been
included in the consolidated financial statements or tax
returns. Deferred tax assets and liabilities are determined
based on temporary differences between the financial reporting
and tax bases of assets and liabilities. We measure deferred tax
assets and liabilities by applying enacted tax rates and laws to
taxable years in which such differences are expected to reverse.
See Note 8, Income Taxes.

Earnings per Share.The following table includes a
reconciliation of the denominators for the computation of basic
and diluted earnings per share. All share and per share amounts
reflect the retroactive effects of the two-for-one common stock
split in the form of a stock dividend that was effective January
20, 2004. See Note 6 Stockholders Equity.

|                                                                            |                                                              |                        |        |       |  |      |        |       |  |  |        |     | 
|--------------------------------------------------------------------------- | ------------------------------------------------------------ | ---------------------- | ------ | ----- |  | ---- | ------ | ----- |  |  | ------ | --- | 
|                                                                            |                                                              | 2003                   |        | 2002  |  | 2001
|                                                                            |                                                              |                        |        |       |  |     
|                                                                            |                                                              |                       
|                                                                            |                                                              | (Amounts in thousands)
|Shares outstanding at the beginning of the
    period(1)                    |                                                              |                        | 71,782 |       |  |      | 68,894 |       |  |  | 66,908 |    
|Weighted average number of shares issued:                                   |                                                              |                        |        |       |  |      |        |       |  |  |        |    
|                                                                            | Stock options exercised and treasury stock
    reissued, net |                        |        | 1,627 |  |      |        | 1,580 |  |  |        | 642 | 
|                                                                            | Common stock offering(2)                                     |                        |        | 1,000 |  |      |        |      |  |  |        |    | 
|                                                                            |                                                              |                        |        |       |  |      |        |       |  |  |        |    
|Denominator for basic earnings per share                                    |                                                              |                        | 74,409 |       |  |      | 70,474 |       |  |  | 67,550 |    
|Employee stock options and other dilutive
    potential common shares(3)(4) |                                                              |                        | 5,554  |       |  |      |       |       |  |  | 508    |    
|                                                                            |                                                              |                        |        |       |  |      |        |       |  |  |        |    
|Denominator for diluted earnings per share(3)(4)                            |                                                              |                        | 79,963 |       |  |      | 70,474 |       |  |  | 68,058 |    
|                                                                            |                                                              |                        |        |       |  |      |        |       |  |  |        |    



---



|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | Excludes approximately 1,515,000, 226,000 and
    180,000 shares of restricted common stock which have been
    granted but have not fully vested as of December 31, 2003,
    2002 and 2001, respectively.                                                                                                                                                                                                                                                                       
|   
|(2) | In November 2003, we issued 7.6 million
    shares of our common stock in a public offering. See Note 6
    Stockholders Equity.                                                                                                                                                                                                                                                                                                                                               
|   
|(3) | Certain options to purchase common stock were not
    included in the calculation of diluted earnings per share
    because their exercise prices were greater than the average
    market price of our common stock for the periods presented. For
    the years ended December 31, 2003 and 2001, these weighted
    options outstanding totaled 4.6 million shares and
    12.2 million shares, respectively, with exercise prices
    ranging from $12.34 to $57.00 per share.
|   
|(4) | Employee stock options and other dilutive
    potential common shares for the year ended December 31,
    2002 were not included in the calculation of diluted earnings
    per share because they were antidilutive.                                                                                                                                                                                                                                                             

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##### Table of Contents



PACIFICARE HEALTH SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)

3.     Marketable
Securities

The following table summarizes marketable
securities as of the dates indicated:

|                                  |                                             |                                        |           |            |           |            |        |            |        |   |        |        |        |   |           |         |           | 
|--------------------------------- | ------------------------------------------- | -------------------------------------- | --------- | ---------- | --------- | ---------- | ------ | ---------- | ------ | - | ------ | ------ | ------ | - | --------- | ------- | --------- | 
|                                  |                                             |                                        |           | Gross      |           | Gross      |        |           
|                                  |                                             | Amortized                              |           | Unrealized |           | Unrealized |        |           
|                                  |                                             | Cost                                   |           | Gains      |           | Losses     |        | Fair Value
|                                  |                                             |                                        |           |            |           |            |        |           
|                                  |                                             |                                       
|                                  |                                             | (Amounts in thousands)                
|Marketable securities:            |                                             |                                        |           |            |           |            |        |            |        |   |        |        |        |   |           |        
|                                  | U.S. government and agency                  |                                        | $         | 337,323    |           |            | $      | 4,084      |        |   | $      | (3,903 | )      |   | $         | 337,504 |          
|                                  | State, municipal and state and local agency |                                        |           | 537,179    |           |            |        | 20,037     |        |   |        | (1,359 | )      |   |           | 555,857 |          
|                                  | Corporate debt and other securities         |                                        |           | 455,360    |           |            |        | 13,644     |        |   |        | (2,645 | )      |   |           | 466,359 |          
|                                  |                                             |                                        |           |            |           |            |        |            |        |   |        |        |        |   |           |        
|                                  |                                             | Total marketable securities            |           |            | 1,329,862 |            |        |            | 37,765 |   |        |        | (7,907 | ) |           |         | 1,359,720 | 
|                                  |                                             |                                        |           |            |           |            |        |            |        |   |        |        |        |   |           |        
|Marketable securities-restricted: |                                             |                                        |           |            |           |            |        |            |        |   |        |        |        |   |           |        
|                                  | U.S. government and agency                  |                                        |           | 111,442    |           |            |        | 523        |        |   |        | (9     | )      |   |           | 111,956 |          
|                                  | State, municipal and state and local agency |                                        |           | 17,305     |           |            |        | 432        |        |   |        | (39    | )      |   |           | 17,698  |          
|                                  | Corporate debt and other securities         |                                        |           | 37,799     |           |            |        | 320        |        |   |        | (13    | )      |   |           | 38,106  |          
|                                  |                                             |                                        |           |            |           |            |        |            |        |   |        |        |        |   |           |        
|                                  |                                             | Total marketable securities-restricted |           |            | 166,546   |            |        |            | 1,275  |   |        |        | (61    | ) |           |         | 167,760   | 
|                                  |                                             |                                        |           |            |           |            |        |            |        |   |        |        |        |   |           |        
|Balance at December 31, 2003      |                                             | $                                      | 1,496,408 |            |           | $          | 39,040 |            |        | $ | (7,968 | )      |        | $ | 1,527,480 |        
|                                  |                                             |                                        |           |            |           |            |        |            |        |   |        |        |        |   |           |        

|                                  |                                             |                                        |           |            |           |            |        |            |        |   |        |        |        |   |           |         |           | 
|--------------------------------- | ------------------------------------------- | -------------------------------------- | --------- | ---------- | --------- | ---------- | ------ | ---------- | ------ | - | ------ | ------ | ------ | - | --------- | ------- | --------- | 
|                                  |                                             |                                        |           | Gross      |           | Gross      |        |           
|                                  |                                             | Amortized                              |           | Unrealized |           | Unrealized |        |           
|                                  |                                             | Cost                                   |           | Gains      |           | Losses     |        | Fair Value
|                                  |                                             |                                        |           |            |           |            |        |           
|                                  |                                             |                                       
|                                  |                                             | (Amounts in thousands)                
|Marketable securities:            |                                             |                                        |           |            |           |            |        |            |        |   |        |        |        |   |           |        
|                                  | U.S. government and agency                  |                                        | $         | 339,514    |           |            | $      | 9,010      |        |   | $      | (1,696 | )      |   | $         | 346,828 |          
|                                  | State, municipal and state and local agency |                                        |           | 391,370    |           |            |        | 16,057     |        |   |        | (759   | )      |   |           | 406,668 |          
|                                  | Corporate debt and other securities         |                                        |           | 429,876    |           |            |        | 15,726     |        |   |        | (3,581 | )      |   |           | 442,021 |          
|                                  |                                             |                                        |           |            |           |            |        |            |        |   |        |        |        |   |           |        
|                                  |                                             | Total marketable securities            |           |            | 1,160,760 |            |        |            | 40,793 |   |        |        | (6,036 | ) |           |         | 1,195,517 | 
|                                  |                                             |                                        |           |            |           |            |        |            |        |   |        |        |        |   |           |        
|Marketable securities-restricted: |                                             |                                        |           |            |           |            |        |            |        |   |        |        |        |   |           |        
|                                  | U.S. government and agency                  |                                        |           | 103,287    |           |            |        | 2,542      |        |   |        |       |        |   |           | 105,829 |          
|                                  | State, municipal and state and local agency |                                        |           | 25,679     |           |            |        | 736        |        |   |        | (68    | )      |   |           | 26,347  |          
|                                  | Corporate debt and other securities         |                                        |           | 57,223     |           |            |        | 924        |        |   |        | (2     | )      |   |           | 58,145  |          
|                                  |                                             |                                        |           |            |           |            |        |            |        |   |        |        |        |   |           |        
|                                  |                                             | Total marketable securities-restricted |           |            | 186,189   |            |        |            | 4,202  |   |        |        | (70    | ) |           |         | 190,321   | 
|                                  |                                             |                                        |           |            |           |            |        |            |        |   |        |        |        |   |           |        
|Balance at December 31, 2002      |                                             | $                                      | 1,346,949 |            |           | $          | 44,995 |            |        | $ | (6,106 | )      |        | $ | 1,385,838 |        
|                                  |                                             |                                        |           |            |           |            |        |            |        |   |        |        |        |   |           |        

F-12



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##### Table of Contents



PACIFICARE HEALTH SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)

As of December 31, 2003 the contractual
maturities of our marketable securities were as follows:

|                                       |  |                        |           |                         |  |                |           |            |  |   |         |  |  |   |         | 
|-------------------------------------- |  | ---------------------- | --------- | ----------------------- |  | -------------- | --------- | ---------- |  | - | ------- |  |  | - | ------- | 
|                                       |  |                        |           |                         |  |               
|                                       |  |                        |           | Marketable Securities 
|                                       |  | Marketable Securities  |           | Restricted             
|                                       |  |                        |           |                        
|                                       |  | Amortized Cost         |           | Fair Value              |  | Amortized Cost |           | Fair Value
|                                       |  |                        |           |                         |  |                |           |           
|                                       |  |                       
|                                       |  | (Amounts in thousands)
|Due in one year or less                |  | $                      | 147,337   |                         |  | $              | 143,199   |            |  | $ | 108,881 |  |  | $ | 109,273 | 
|Due after one year through five years  |  |                        | 471,369   |                         |  |                | 487,246   |            |  |   | 44,681  |  |  |   | 45,318  | 
|Due after five years through ten years |  |                        | 387,392   |                         |  |                | 401,122   |            |  |   | 6,732   |  |  |   | 6,870   | 
|Due after ten years                    |  |                        | 323,764   |                         |  |                | 328,153   |            |  |   | 6,252   |  |  |   | 6,299   | 
|                                       |  |                        |           |                         |  |                |           |            |  |   |         |  |  |   |         | 
|                                       |  | $                      | 1,329,862 |                         |  | $              | 1,359,720 |            |  | $ | 166,546 |  |  | $ | 167,760 | 
|                                       |  |                        |           |                         |  |                |           |            |  |   |         |  |  |   |         | 

Proceeds from sales and maturities of marketable
securities were $7.4 billion in 2003, $7.7 billion in
2002 and $8.8 billion in 2001. Gross realized gains and
gross realized losses are included in net investment income
under the specific identification method.

4.     Dispositions

2002 Dispositions.In the fourth quarter of 2002, we
entered into an agreement with HEALTHvisionunder which
HEALTHvisionacquired the e-prescribing assets of our
subsidiary MEDeMORPHUS Healthcare Solutions, Inc. in exchange
for assuming certain liabilities. Under this agreement,
HEALTHvisionassumed responsibility for
MEDeMORPHUSs existing contracts with more than 1,600
physicians, including the delivery of MEDeMORPHUSs
handheld devices and wireless functionality. In connection with
the sale of assets, we recognized pretax charges of
$9 million ($6 million or $0.07 diluted loss per
share, net of tax). See Note 10, Impairment,
Disposition, Restructuring, Office of Personnel Management and
Other Charges (Credits).

5.     Long-Term Debt
and Other Commitments

Our contractual cash obligations as of
December 31, 2003, including long-term debt and other
commitments, were as follows:

|                                             |                                       |                                  |       |      |       |      |     |      |     |      |     |      |     |            |     |    |     |   |     |    |     |   |     |    |     |   |     |     |     | 
|-------------------------------------------- | ------------------------------------- | -------------------------------- | ----- | ---- | ----- | ---- | --- | ---- | --- | ---- | --- | ---- | --- | ---------- | --- | -- | --- | - | --- | -- | --- | - | --- | -- | --- | - | --- | --- | --- | 
|                                             |                                       |                                 
|                                             |                                       | Payments Due by Period          
|                                             |                                       |                                 
|                                             |                                       | Total                            |       | 2004 |       | 2005 |     | 2006 |     | 2007 |     | 2008 |     | Thereafter
|                                             |                                       |                                  |       |      |       |      |     |      |     |      |     |      |     |           
|                                             |                                       |                                 
|                                             |                                       | (Amounts in millions)           
|Long-term debt:                              |                                       |                                  |       |      |       |      |     |      |     |      |     |      |     |            |     |    |     |   |     |    |     |   |     |    |     |   |     |    
|                                             | 10 3/4% senior notes, net of discount |                                  | $     | 323  |       |      | $   |     |     |      | $   |     |     |            | $   |   |     |   | $   |   |     |   | $   |   |     |   | $   | 323 |    
|                                             | JPMorgan Chase term loan              |                                  |       | 149  |       |      |     | 2    |     |      |     | 1    |     |            |     | 23 |     |   |     | 73 |     |   |     | 50 |     |   |     |    |    
|                                             | Convertible subordinated debentures   |                                  |       | 135  |       |      |     |     |     |      |     |     |     |            |     |   |     |   |     |   |     |   |     |   |     |   |     | 135 |    
|                                             | Database financing agreement          |                                  |       | 9    |       |      |     | 5    |     |      |     | 4    |     |            |     |   |     |   |     |   |     |   |     |   |     |   |     |    |    
|                                             | Other                                 |                                  |       | 4    |       |      |     |     |     |      |     | 1    |     |            |     | 1  |     |   |     |   |     |   |     | 1  |     |   |     | 1   |    
|                                             |                                       |                                  |       |      |       |      |     |      |     |      |     |      |     |            |     |    |     |   |     |    |     |   |     |    |     |   |     |    
|                                             |                                       | Total long-term debt commitments |       |      | 620   |      |     |      | 7   |      |     |      | 6   |            |     |    | 24  |   |     |    | 73  |   |     |    | 51  |   |     |     | 459 | 
|                                             |                                       |                                  |       |      |       |      |     |      |     |      |     |      |     |            |     |    |     |   |     |    |     |   |     |    |     |   |     |    
|Other commitments:                           |                                       |                                  |       |      |       |      |     |      |     |      |     |      |     |            |     |    |     |   |     |    |     |   |     |    |     |   |     |    
|Information technology outsourcing contracts |                                       |                                  | 1,118 |      |       |      | 175 |      |     |      | 164 |      |     |            | 142 |    |     |   | 133 |    |     |   | 130 |    |     |   | 374 |    
|Operating leases                             |                                       |                                  | 107   |      |       |      | 27  |      |     |      | 23  |      |     |            | 21  |    |     |   | 17  |    |     |   | 8   |    |     |   | 11  |    
|                                             |                                       |                                  |       |      |       |      |     |      |     |      |     |      |     |            |     |    |     |   |     |    |     |   |     |    |     |   |     |    
|                                             |                                       | Total other commitments          |       |      | 1,225 |      |     |      | 202 |      |     |      | 187 |            |     |    | 163 |   |     |    | 150 |   |     |    | 138 |   |     |     | 385 | 
|                                             |                                       |                                  |       |      |       |      |     |      |     |      |     |      |     |            |     |    |     |   |     |    |     |   |     |    |     |   |     |    
|Total contractual cash obligations           |                                       | $                                | 1,845 |      |       | $    | 209 |      |     | $    | 193 |      |     | $          | 187 |    |     | $ | 223 |    |     | $ | 189 |    |     | $ | 844 |    
|                                             |                                       |                                  |       |      |       |      |     |      |     |      |     |      |     |            |     |    |     |   |     |    |     |   |     |    |     |   |     |    

Convertible Subordinated Debentures.We have $135 million in aggregate
principal amount of 3% convertible subordinated debentures due
in 2032. The debentures are convertible into 6,428,566

F-13



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##### Table of Contents



PACIFICARE HEALTH SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)

shares of common stock under certain conditions,
including satisfaction of a market price condition for our
common stock, satisfaction of a trading price condition relating
to the debentures, upon notice of redemption, or upon specified
corporate transactions. Each $1,000 of the debentures is
convertible into 47.619 shares of our common stock. The market
price condition for conversion of the debentures is satisfied if
the closing sale price of our common stock exceeds 110% of the
conversion price (which is calculated at $23.10 per share)
for the debentures for at least 20 trading days in the
30 consecutive trading days ending on the last trading day
of any fiscal quarter. In the event that the market price
condition is satisfied during any fiscal quarter, the debentures
are convertible, at the option of the holder, during the
following fiscal quarter. The market price condition is
evaluated each quarter to determine whether the debentures will
be convertible at the option of the holder during the following
fiscal quarter. During the fiscal year ended December 31,
2003, the market price condition described above was satisfied
for the quarters ended September 30, 2003 and
December 31, 2003. As a result, the debentures were
convertible during the quarter ended December 31, 2003 and
remain convertible at the option of the holder at any time
during the quarter ended March 31, 2004. While no
debentures were converted as of December 31, 2003, they are
considered common stock equivalents and are included in the
calculation of weighted average shares outstanding on a diluted
basis for the fourth quarter and fiscal year ended
December 31, 2003. All share and per share amounts
disclosed above reflect the retroactive effects of the
two-for-one common stock split in the form of a stock dividend
that was effective January 20, 2004. See Note 6
Stockholders Equity.

Beginning in October 2007, we may redeem for cash
all or any portion of the debentures, at a purchase price of
100% of the principal amount plus accrued interest, upon not
less than 30 nor more than 60 days written notice to
the holders. Beginning in October 2007, and in successive 5-year
increments, our holders may require us to repurchase the
debentures for cash at a repurchase price of 100% of the
principal amount plus accrued interest. Our payment obligations
under the debentures are subordinated to our senior
indebtedness, and effectively subordinated to all indebtedness
and other liabilities of our subsidiaries.

10 3/4% Senior Notes.We have $325 million in aggregate
principal amount of 10 3/4% senior notes due in 2009.
The 10 3/4% senior notes were issued in May 2002 at 99.389%
of the aggregate principal amount representing a discount of
$3 million that is being amortized over the term of the
notes. In December 2003, in accordance with the applicable
provisions of the debt agreement, we redeemed $175 million
in principal of the senior notes at a redemption price equal to
110.750%, plus accrued and unpaid interest on the notes as of
the redemption date. We expensed approximately $28 million
in connection with the redemption, including the pro-rata
write-off of the initial discount, the redemption premium and
other fees and expenses associated with the transaction. We may
redeem the remaining 10 3/4% senior notes at any time on or
after June 1, 2006 at an initial redemption price equal to
105.375% of their principal amount plus accrued and unpaid
interest. The redemption price will thereafter decline annually.
Additionally, at any time on or prior to June 1, 2006, we
may redeem the 10 3/4% senior notes upon a change of
control, as defined in the indenture for the notes, at 100% of
their principal amount plus accrued and unpaid interest and a
make-whole premium.

Certain of our domestic, unregulated subsidiaries
fully and unconditionally guarantee the 10 3/4% senior
notes. Prior to September 15, 2003, some of our domestic,
unregulated subsidiaries were restricted from guaranteeing the
10 3/4% senior notes by the terms of the FHP senior
notes. As the FHP senior notes were repaid in full on
September 15, 2003, these subsidiaries now fully and
unconditionally guarantee the 10 3/4% senior notes.
See FHP Senior Notes below and Note 15,
Financial Guarantees.

F-14



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##### Table of Contents



PACIFICARE HEALTH SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)

In April 2003, we entered into an interest rate
swap on $300 million of our 10 3/4% senior notes
for the purpose of hedging the fair value of our indebtedness.
This fair value hedge is accounted for using the short-cut
method under SFAS No. 133, Accounting for Derivative
Instruments and Hedging Activities, whereby the hedge is
reported in our balance sheets at fair value, and the carrying
value of the long-term debt is adjusted for an offsetting amount
representing changes in fair value attributable to the hedged
risk. Under the terms of the agreement, we make interest
payments based on the three-month London Interbank Offered Rate
(LIBOR) plus 692 basis points and receive interest payments
based on the 10 3/4% fixed rate. Our rate under the
swap agreement was 8.09%, at December 31, 2003 which is
based on a 90-day LIBOR of 1.17% plus 692 basis points. The
three-month LIBOR rate we use to determine our interest payments
under the swap agreement was first established on June 2,
2003 and resets every three months thereafter, until expiration
in June 2009.

Senior Credit Facility.In June 2003, we replaced our senior
credit facility with a new syndicated facility with JPMorgan
Chase Bank serving as the Administrative Agent. The new facility
consists of a $150 million term loan, which matures on
June 3, 2008, and a $150 million revolving line of
credit, which matures on June 3, 2006. We used the proceeds
from the term loan to repay the $131 million outstanding
under the prior facility. The remaining $19 million was used to
pay fees and expenses relating to the new facility and for
general corporate purposes. As of December 31, 2003, we had
$149 million outstanding on the term loan and no balance
outstanding on the revolving line of credit. We borrowed and
repaid $3 million under the revolving line of credit during
the year ended December 31, 2003.

On December 17, 2003 our senior credit
facility was amended to provide for reduced interest rates per
annum applicable to term loan borrowings, with the amount of
margin spread for the borrowing being determined by our current
debt ratings. The amended applicable rates are, at our option,
either JPMorgan Chase Banks prime rate (or, if greater,
the Federal Funds Rate plus 0.5%) which we refer to as the
alternative base rate, plus a margin spread of 1.25% to
1.75% per annum, or the LIBOR for the applicable interest
period, plus a margin spread of 2.25% to 2.75% per annum.
All of our borrowings under the term loan are currently LIBOR
borrowings, and the current margin spread on our term loan
borrowings is 2.50%. As of December 31, 2003, our term loan
rate was 3.68% per annum, which is based on a 90-day LIBOR of
1.18% plus the applicable margin spread of 2.50%. The interest
rates per annum under the senior credit facility applicable to
revolving credit borrowings are, at our option, either the
alternate base rate plus a margin spread of between 1.5% to
2.75% per annum, or the LIBOR for the applicable interest
period plus a margin spread of between 2.5% to 3.75% per
annum, with the amount of the margin for any borrowing being
determined based on current credit ratings for the debt under
the senior credit facility. Our current margins for revolving
credit borrowings are 2.25% per annum for alternate base
rate borrowings and 3.25% per annum for LIBOR borrowings.

The terms of the senior credit facility contain
various covenants customary for financings of this type which
place restrictions on our and/or our subsidiaries ability
to incur debt, pay dividends, create liens, make investments,
optionally repay, redeem or repurchase our securities, and enter
into mergers, dispositions and transactions with affiliates. The
senior credit facility also requires us to meet various
financial ratios, including a minimum net worth requirement, a
minimum fixed-charge coverage requirement and a maximum leverage
ratio. At December 31, 2003, we were in compliance with all
of these covenants. See FHP Senior Notes below and
Note 15, Financial Guarantees.

Certain of our domestic, unregulated subsidiaries
provide guarantees and have granted security interests to the
lenders in substantially all of their personal property in order
to secure our obligations

F-15



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##### Table of Contents



PACIFICARE HEALTH SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)

under the senior credit facility. We have also
pledged the equity of certain of our subsidiaries to the
lenders. Prior to September 15, 2003, some of our domestic,
unregulated subsidiaries were restricted from guaranteeing the
senior credit facility by the terms of the FHP senior notes. As
the FHP senior notes were repaid in full on September 15,
2003, these subsidiaries now fully and unconditionally guarantee
the senior credit facility.

|                                                                         |  |                       |      |           |  |       |     |   |  |   |      |  
|------------------------------------------------------------------------ |  | --------------------- | ---- | --------- |  | ----- | --- | - |  | - | ---- | -
|                                                                         |  |                       |      | Revolving |  |      
|                                                                         |  | Term Loan             |      | Credit    |  |      
|                                                                         |  | Facility              |      | Facility  |  | Total
|                                                                         |  |                       |      |           |  |      
|                                                                         |  |                      
|                                                                         |  | (Amounts in millions)
|Balance at December 31, 2001                                             |  | $                     | 650  |           |  | $     | 55  |   |  | $ | 705  |  
|Proceeds applied from funding of 10 3/4%
    senior notes                |  |                       | (315 | )         |  |       | (54 | ) |  |   | (369 | )
|Scheduled payments                                                       |  |                       | (60  | )         |  |       |    |   |  |   | (60  | )
|Proceeds applied from funding of convertible
    subordinated debentures |  |                       | (53  | )         |  |       |    |   |  |   | (53  | )
|Proceeds applied from sales of property                                  |  |                       | (35  | )         |  |       |    |   |  |   | (35  | )
|Payments under amendment to senior credit facility                       |  |                       | (32  | )         |  |       |    |   |  |   | (32  | )
|Proceeds applied from equity commitment
    arrangement                  |  |                       | (4   | )         |  |       | (1  | ) |  |   | (5   | )
|                                                                         |  |                       |      |           |  |       |     |   |  |   |      |  
|Balance at December 31, 2002                                             |  |                       | 151  |           |  |       |    |   |  |   | 151  |  
|                                                                         |  |                       |      |           |  |       |     |   |  |   |      |  
|Scheduled payments under prior senior credit
    facility                |  |                       | (20  | )         |  |       |    |   |  |   | (20  | )
|Repayment of outstanding balance under prior
    senior credit facility  |  |                       | (131 | )         |  |       |    |   |  |   | (131 | )
|Proceeds from borrowing under new senior credit
    facility             |  |                       | 150  |           |  |       | 3   |   |  |   | 153  |  
|Scheduled payments under new senior credit
    facility                  |  |                       | (1   | )         |  |       | (3  | ) |  |   | (4   | )
|                                                                         |  |                       |      |           |  |       |     |   |  |   |      |  
|Balance at December 31, 2003                                             |  | $                     | 149  |           |  | $     |    |   |  | $ | 149  |  
|                                                                         |  |                       |      |           |  |       |     |   |  |   |      |  

FHP Senior Notes.In
September 2003, we paid in full the senior notes that we assumed
when we acquired FHP International Corporation, or FHP, in 1997.
As a result, some of our domestic, unregulated subsidiaries
which were previously restricted from guaranteeing our
10 3/4% senior notes and our senior credit facility by
the provisions of the FHP senior notes, now fully and
unconditionally guarantee the 10 3/4% senior notes and
the senior credit facility. See Note 15, Financial
Guarantees.

Database Financing Agreements.As of December 31, 2003, we had
$9 million outstanding under various financing agreements
related to the purchase of database licenses, financial
accounting system software and related maintenance in connection
with the implementation of our information technology, or IT,
initiatives. Payments under the financing agreements are due
quarterly through July 2005. The interest imputed on the payment
plan agreement ranges from 4% to 5.3%.

Letters of Credit.Letters of credit are purchased
guarantees that assure our performance or payment to third
parties in connection with professional liability insurance
policies, lease commitments and other potential obligations.
Letters of credit commitments totaled $19 million at
December 31, 2003 and 2002. As of December 31, 2003,
our letters of credit commitments were backed by funds deposited
in restricted cash accounts.

Information Technology Outsourcing Contracts.In December 2001, we entered into a
10-year contract to outsource our IT operations to International
Business Machines Corporation, or IBM. Under the contract, IBM
is the coordinator of our IT outsourcing arrangement, and will
provide IT services and day-to-day management of our IT
infrastructure, including data center operations, support
services and information distribution. In January 2002, we
entered into a 10-year contract to

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PACIFICARE HEALTH SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)

outsource our IT software applications
maintenance and enhancement services to Keane, Inc., or Keane.
Our remaining cash obligations for base fees under these
contracts over the initial 10-year terms is $1.1 billion,
assuming our actual use of services equals the baselines
specified in the contracts. However, because we have the ability
to reduce services from the vendors under the contracts, our
ultimate cash commitment may be less than the stated contract
amounts. The contracts also provide for variable fees, based on
services provided above certain contractual baselines. During
2002, we entered into additional services contracts with IBM
totaling $127 million over the remaining term of the
original contract. Additionally, in the event of contract
termination, we would be responsible to pay termination fees to
IBM and Keane. These termination fees decline as each successive
year of the contract term is completed. In connection with these
outsourcing agreements, we transitioned approximately 550
employee positions to IBM and Keane in March 2002.

In connection with the IBM outsourcing contract,
we sold IBM computer equipment with a net book value of
$42 million in December 2001. The consideration we received
from IBM for the sale included $25 million in cash, and a
note receivable for the $17 million balance. We will
collect the note receivable, which bears interest at
approximately 7% per annum, in the form of credits against
our future base fee payments from 2002 through 2005. We used the
$25 million we received from IBM to repay indebtedness
under the term loan facility of our senior credit facility in
January 2002.

Operating Leases.We
lease office space and equipment under various non-cancelable
operating leases. Rent expense totaled $46 million in 2003,
$76 million in 2002 and $57 million in 2001.

6.     Stockholders
Equity

Stockholder Rights Agreement.In November 1999, our board of
directors adopted a stockholder rights agreement to protect
stockholder rights in the event of a proposed takeover. The
board of directors declared a dividend of one right for each
share of our common stock outstanding as of November 19,
1999. The right entitles the registered holder to purchase from
PacifiCare 1/100th of a share of Series A junior
participating preferred stock at a price of $180 per
1/100th of a preferred share. Similar rights will generally be
issued in respect of common stock issued after November 19,
1999.

Stock Split.On
December 19, 2003, our board of directors approved a
two-for-one split of our common stock in the form of a stock
dividend. On January 20, 2004, we distributed one
additional share of common stock for every share of common stock
outstanding to stockholders of record as of the close of
business on January 7, 2004. We had a sufficient number of
authorized but unissued shares of common stock to effect this
stock split. The par value of our common stock after the split
remained at $0.01 per share, and additional paid-in capital was
reduced by the par value of the additional common shares issued.
The rights of the holders of these securities were not otherwise
modified. In accordance with SFAS 128, Earnings per
Share,which requires retroactive adjustment of per share
computation of stock split that occurs after the close of the
period but before issuance of the financial statements, all
shares, per-share and market price data related to our common
shares outstanding and under employee stock plans reflect the
retroactive effects of this two-for-one stock split in the form
of a dividend.

Common Stock Offering.In November 2003, we issued
7.6 million shares of our common stock in a public
offering. The net proceeds from the offering, approximately
$200 million after underwriting fees, were used to redeem
$175 million in principal of the companys outstanding
10 3/4% senior notes. See Note 5, Long-Term
Debt and Other Commitments.

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##### Table of Contents



PACIFICARE HEALTH SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)

Restricted Stock Awards.We granted approximately 1,489,000 and
106,000 shares of restricted common stock, including stock
deferred into restricted stock units, as part of an employee
recognition and retention program during the years ended
December 31, 2003 and 2002, respectively. Restrictions on
these shares will expire and related charges are being amortized
as earned over the vesting period, not to exceed four years. A
total of approximately 108,000 shares were forfeited for the
year ended December 31, 2003. No shares were forfeited
during the year ended December 31, 2002.

All shares of restricted stock were issued from
our 1996 Officer and Key Employee Stock Option Plan, as amended.
See Note 9, Employee Benefits. The amount of
unearned compensation recorded is based on the market value of
the shares on the date of issuance and is included as a separate
component of stockholders equity, which was approximately
$17 million and $2 million as of December 31,
2003 and 2002, respectively. Expenses related to the vesting of
restricted stock (charged to selling, general and administrative
expenses) were $5.3 million and $1.0 million for the year
ended December 31, 2003 and 2002, respectively.

Acqua Wellington Arrangement.In December 2001, we entered into an
equity commitment arrangement with Acqua Wellington North
American Equities Fund Ltd., or Acqua Wellington, an
institutional investor, for the purchase by Acqua Wellington of
up to 13.8 million shares, or $150 million in our
common stock. This equity commitment arrangement expired in June
2003.

Treasury Stock.In
December 2003, our board of directors approved a resolution to
retire all outstanding shares of the Companys treasury
stock. As a result of this resolution, approximately
23 million shares were permanently retired and have been
added back to our shares authorized for future issuance.

7.     Goodwill and
Intangible Assets.

In the first quarter of 2002, we recognized
$897 million (net of $32 million of deferred tax
liability reversals) of goodwill impairment as the cumulative
effect of a change in accounting principle upon adopting FASB
Statement No. 142, Goodwill and Other Intangible
Assets. Under the new rules, goodwill is no longer
amortized, but is subject to impairment tests on an annual basis
or more frequently if impairment indicators exist. Under the
guidance of FASB Statement No. 142, we used a discounted
cash flow methodology to assess the fair values of our reporting
units as of January 1, 2002. For reporting units with book
equity values that exceeded the fair values, we performed a
hypothetical purchase price allocation. Impairment was measured
by comparing the goodwill derived from the hypothetical purchase
price allocation to the carrying value of the goodwill balance.
The same methodology was used for the years ended
December 31, 2003 and 2002. Based on the results of our
impairment testing, no additional adjustments were required.

The following table reflects consolidated results
adjusted as though the adoption of the SFAS No. 142
non-amortization of goodwill provisions occurred for the year
ended December 31, 2001,

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##### Table of Contents



PACIFICARE HEALTH SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)

after adjusting for the effect of the two-for-one
stock split in the form of a stock dividend that was effective
January 20, 2004 as discussed in Note 6
Stockholders Equity:

|                           |  |                              |        |             |  |             |        |  |  |   |        | 
|-------------------------- |  | ---------------------------- | ------ | ----------- |  | ----------- | ------ |  |  | - | ------ | 
|                           |  |                             
|                           |  | Year Ended December 31, 2001
|                           |  |                             
|                           |  | As Reported                  |        | Adjustments |  | As Adjusted
|                           |  |                              |        |             |  |            
|                           |  |                             
|                           |  | (Amounts in thousands,      
|                           |  | except per-share data)      
|Net income                 |  | $                            | 19,006 |             |  | $           | 57,411 |  |  | $ | 76,417 | 
|Basic earnings per share   |  | $                            | 0.28   |             |  | $           | 0.85   |  |  | $ | 1.13   | 
|Diluted earnings per share |  | $                            | 0.27   |             |  | $           | 0.84   |  |  | $ | 1.12   | 

Other intangible assets will continue to be
amortized over their useful lives. We estimate our intangible
asset amortization will be $20 million in 2004,
$16 million in 2005, $15 million in 2006,
$15 million in 2007 and $14 million in 2008. The
following table sets forth balances of identified intangible
assets, by major class, for the periods indicated:

|                   |                   |                              |   |              |         |             |   |         |         |  |   |         |         | 
|------------------ | ----------------- | ---------------------------- | - | ------------ | ------- | ----------- | - | ------- | ------- |  | - | ------- | ------- | 
|                   |                   |                              |   | Accumulated  |         |            
|                   |                   | Cost                         |   | Amortization |         | Net Balance
|                   |                   |                              |   |              |         |            
|                   |                   |                             
|                   |                   | (Amounts in thousands)      
|Intangible assets: |                   |                              |   |              |         |             |   |         |         |  |   |        
|                   | Employer groups   |                              | $ | 243,820      |         |             | $ | 124,170 |         |  | $ | 119,650 |        
|                   | Provider networks |                              |   | 121,051      |         |             |   | 21,080  |         |  |   | 99,971  |        
|                   | Other             |                              |   | 10,729       |         |             |   | 9,242   |         |  |   | 1,487   |        
|                   |                   |                              |   |              |         |             |   |         |         |  |   |        
|                   |                   | Balance at December 31, 2003 |   | $            | 375,600 |             |   | $       | 154,492 |  |   | $       | 221,108 | 
|                   |                   |                              |   |              |         |             |   |         |         |  |   |        
|Intangible assets: |                   |                              |   |              |         |             |   |         |         |  |   |        
|                   | Employer groups   |                              | $ | 243,820      |         |             | $ | 105,406 |         |  | $ | 138,414 |        
|                   | Provider networks |                              |   | 121,051      |         |             |   | 17,986  |         |  |   | 103,065 |        
|                   | Other             |                              |   | 10,729       |         |             |   | 9,192   |         |  |   | 1,537   |        
|                   |                   |                              |   |              |         |             |   |         |         |  |   |        
|                   |                   | Balance at December 31, 2002 |   | $            | 375,600 |             |   | $       | 132,584 |  |   | $       | 243,016 | 
|                   |                   |                              |   |              |         |             |   |         |         |  |   |        

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##### Table of Contents



PACIFICARE HEALTH SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)

8.     Income
Taxes

The tax effects of the major items recorded as
deferred tax assets and liabilities were as follows:

|                                                   |                                           |                        |          |         |   |   |          |         |  
|-------------------------------------------------- | ----------------------------------------- | ---------------------- | -------- | ------- | - | - | -------- | ------- | -
|                                                   |                                           | 2003                   |          | 2002   
|                                                   |                                           |                        |          |        
|                                                   |                                           |                       
|                                                   |                                           | (Amounts in thousands)
|Current deferred tax assets (liabilities):         |                                           |                        |          |         |   |   |          |        
|                                                   | Accrued expenses                          |                        | $        | 44,243  |   |   | $        | 48,632  |  
|                                                   | Medical claims and benefits payable       |                        |          | 63,295  |   |   |          | 28,453  |  
|                                                   | Restructuring                             |                        |          | 7,325   |   |   |          | 11,275  |  
|                                                   | Accrued compensation                      |                        |          | 21,389  |   |   |          | 16,588  |  
|                                                   | Stock-based compensation                  |                        |          | 4,903   |   |   |          |        |  
|                                                   | Provider receivables                      |                        |          | 20,702  |   |   |          | 14,204  |  
|                                                   | Prepaid expenses                          |                        |          | (12,673 | ) |   |          | (10,130 | )
|                                                   | State franchise taxes                     |                        |          | 6,963   |   |   |          | 2,039   |  
|                                                   | Unrealized gains on marketable securities |                        |          | (11,043 | ) |   |          | (13,027 | )
|                                                   | Other                                     |                        |          | 4,713   |   |   |          | 2,724   |  
|                                                   |                                           |                        |          |         |   |   |          |        
|                                                   |                                           | $                      | 149,817  |         |   | $ | 100,758  |        
|                                                   |                                           |                        |          |         |   |   |          |        
|Non-current deferred tax
    (liabilities) assets: |                                           |                        |          |         |   |   |          |        
|                                                   | Identifiable intangibles                  |                        | $        | (84,816 | ) |   | $        | (91,402 | )
|                                                   | Goodwill amortization(1)                  |                        |          | 7,347   |   |   |          | 6,860   |  
|                                                   | Depreciation and software amortization    |                        |          | (27,308 | ) |   |          | (21,131 | )
|                                                   | Other                                     |                        |          |        |   |   |          | 1,883   |  
|                                                   |                                           |                        |          |         |   |   |          |        
|                                                   |                                           | $                      | (104,777 | )       |   | $ | (103,790 | )      
|                                                   |                                           |                        |          |         |   |   |          |        



---



|    |                                                                                                                                                                                                                          
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | Non-current deferred tax liabilities for 2002
    reflect a $32 million adjustment for the tax impact of the
    cumulative effect of a change in accounting principle. See
    Note 7, Goodwill and Intangible Assets.

The provision for income taxes consisted of the
following:

|          |                            |                        |   |         |         |      |   |        |        |  |   |        |        |  
|--------- | -------------------------- | ---------------------- | - | ------- | ------- | ---- | - | ------ | ------ |  | - | ------ | ------ | -
|          |                            | 2003                   |   | 2002    |         | 2001
|          |                            |                        |   |         |         |     
|          |                            |                       
|          |                            | (Amounts in thousands)
|Current:  |                            |                        |   |         |         |      |   |        |        |  |   |       
|          | Federal                    |                        | $ | 165,009 |         |      | $ | 60,063 |        |  | $ | 34,286 |       
|          | State                      |                        |   | 27,975  |         |      |   | 4,170  |        |  |   | 8,051  |       
|          |                            |                        |   |         |         |      |   |        |        |  |   |       
|          |                            | Total current          |   |         | 192,984 |      |   |        | 64,233 |  |   |        | 42,337 |  
|          |                            |                        |   |         |         |      |   |        |        |  |   |       
|Deferred: |                            |                        |   |         |         |      |   |        |        |  |   |       
|          | Federal                    |                        |   | (39,148 | )       |      |   | 15,321 |        |  |   | 959    |       
|          | State                      |                        |   | (6,940  | )       |      |   | 3,238  |        |  |   | (4,925 | )     
|          |                            |                        |   |         |         |      |   |        |        |  |   |       
|          |                            | Total deferred         |   |         | (46,088 | )    |   |        | 18,559 |  |   |        | (3,966 | )
|          |                            |                        |   |         |         |      |   |        |        |  |   |       
|          | Provision for income taxes |                        | $ | 146,896 |         |      | $ | 82,792 |        |  | $ | 38,371 |       
|          |                            |                        |   |         |         |      |   |        |        |  |   |       

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##### Table of Contents



PACIFICARE HEALTH SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)

Reconciliation of the U.S. statutory income tax
rate to our effective tax rate is as follows:

|                                    |  |      |      |      |  |      |      |   |  |  |      |  
|----------------------------------- |  | ---- | ---- | ---- |  | ---- | ---- | - |  |  | ---- | -
|                                    |  | 2003 |      | 2002 |  | 2001
|                                    |  |      |      |      |  |     
|Computed expected provision         |  |      | 35.0 | %    |  |      | 35.0 | % |  |  | 35.0 | %
|Amortization of intangibles         |  |      |     |      |  |      |     |   |  |  | 32.3 |  
|Tax-exempt interest                 |  |      | (1.6 | )    |  |      | (2.1 | ) |  |  | (8.6 | )
|State taxes, net of federal benefit |  |      | 3.7  |      |  |      | 3.2  |   |  |  | 3.6  |  
|Nondeductible expenses              |  |      | 0.3  |      |  |      | 0.9  |   |  |  | 3.2  |  
|Other, net                          |  |      | 0.3  |      |  |      | 0.3  |   |  |  | 2.4  |  
|                                    |  |      |      |      |  |      |      |   |  |  |      |  
|Provision for income taxes          |  |      | 37.7 | %    |  |      | 37.3 | % |  |  | 67.9 | %
|                                    |  |      |      |      |  |      |      |   |  |  |      |  

9.     Employee
Benefit Plans

Savings and profit-sharing plans.Most of our employees may participate
in our savings and profit-sharing plan. Features of the plan in
2003 were as follows:



|  |                                                                                                                        
|- | -----------------------------------------------------------------------------------------------------------------------
| | Participants could defer up to 15% of annual
    compensation;                                                         
| 
| | We matched one-half of the deferral, up to 3% of
    annual compensation per employee; and                             
| 
| | We automatically contributed 3% of annual
    compensation per employee to all employees participating in the
    plan.

The plan authorizes us to contribute a
discretionary amount to each employees account, generally
based on a percentage of pretax income. We did not contribute a
discretionary amount in 2003, 2002 or 2001. Charges to income
for the plan were $21 million in 2003, $18 million in
2002 and $19 million in 2001.

Our Statutory Restoration Plan allows executive
officers to defer the portion of their pay that due to statutory
limitations are not available for deferral, and also to receive
excess matching contributions, profit-sharing contributions and
discretionary contributions in the same percentages as those
provided by the 401(k) plan.

Supplemental Executive Retirement Plan.We maintain an unfunded, nonqualified
executive pension plan covering certain senior executives. This
plan provides defined benefits based on years of service and
final average compensation. The accumulated benefit obligation
for the Supplemental Executive Retirement Plan at the end of
2003 and 2002 was $10,043,000 and $1,715,000 respectively, of
which $2,838,000 and $1,136,000 respectively, were the net
amounts recognized (excludes unrecognized prior service costs
which offsets the accumulated benefit obligation).

Employee Stock Purchase Plan.In September 2001, our board of
directors adopted a non-compensatory employee stock purchase
plan, or ESPP. The ESPP provides that up to 2,200,000 shares of
our common stock can be sold to our employees, after adjusting
for the effect of the two-for-one stock split in the form of a
stock dividend that was effective January 20, 2004.
Features of the plan in 2003 were as follows:



|  |                                                                                                                                                                                         
|- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Participants could have up to 15% of their
    after-tax earnings withheld and applied to the purchase of these
    shares;                                                             
| 
| | The purchase price was 85% of the lower of the
    market price of our common stock on the offering date (generally
    the first day of each offering period), or on the purchase date;

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PACIFICARE HEALTH SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)



|  |                                                                                                            
|- | -----------------------------------------------------------------------------------------------------------
| | Each offering period was two years, and there
    were four purchase dates within each offering period; and
| 
| | Purchase dates were the last day of each
    six-month purchase period within the offering period.         

Approximately 1,500 employees are currently
participating in this plan.

Equity Incentive Plans.

Employee Plans.As
of December 31, 2003, under the 2000 and 1996 Employee
Plans, we could award officers and employees the following
equity incentives:



|  |                                                                                                                                 
|- | --------------------------------------------------------------------------------------------------------------------------------
| | Options to purchase shares of common stock at no
    less than 100% of the market price on the date the options are
    granted;
| 
| | Shares of restricted stock that could be deferred
    into restricted stock units; and                                          
| 
| | Stock appreciation rights.                                                                                                      

Stock options typically vest over four years in
equal increments, and expire 10 years after the grant date. In
late 2001, we granted approximately four million options that
vested over two years. Awards under the Employee Plans are
generally subject to continuous employment. As of
December 31, 2003, approximately 5.8 million shares
were available for awards under the Employee Plans. All
applicable share amounts reflect the two-for-one stock split in
the form of a stock dividend that was effective January 20,
2004.

In 2003, we began to award restricted stock and
stock units as part of the annual performance cycle to enhance
stock ownership, assist in retaining key talent and to reduce
the use of our shares. These awards typically vest over four
years. For our executive officers, the awards were subject to a
mandatory minimum four-year deferral into restricted stock
units. Upon expiration of the deferral period, executive
officers receive shares of common stock equal to the number of
vested shares underlying the restricted stock units. The
deferral provisions promote stock retention and significant
career share holdings. Vesting of the restricted stock and stock
units accelerates upon the occurrence of certain events.

Restricted stock units are deferred under our
Stock Unit Deferred Compensation Plan, or Stock Unit Plan. Under
the Stock Unit Plan, executive officers may also defer all or a
portion of their annual bonus and signing bonus. The chief
executive officer could also defer all or a portion of his
salary. Salary and bonus deferrals are converted into units of
our common stock. The number of stock units converted is equal
to the amount of bonus or salary deferred, multiplied by a risk
premium, then divided by the price of our common stock on a
predetermined date selected by the Compensation Committee.
Distributions are made in shares of common stock.

Premium Plan.As of
December 31, 2003, 0.4 million of the vested premium
options were outstanding and will expire in 2007. The balance of
the premium options expired because the closing market price of
our common stock did not reach $57.00 prior to October 6,
2002. There are no shares available for future awards under the
Premium Plan. All applicable share and per share amounts reflect
the two-for-one stock split in the form of a stock dividend that
was effective January 20, 2004.

F-22



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##### Table of Contents



PACIFICARE HEALTH SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)

Director Plans.As
of December 31, 2003 under the 2000 and 1996 Director
Plans, we could grant non-employee directors the following stock
incentives, after adjusting for the effect of the two-for-one
stock split in the form of a stock dividend that was effective
January 20, 2004:



|  |                                                                                                                                                                                                                                                                             
|- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Options to purchase 10,000 shares of common stock
    are automatically granted annually to all non-employee members
    of the board other than the Chairman of the Board on
    June 30, at no less than 100% of the market price on the
    date the options are granted;
| 
| | Options to purchase 20,000 shares of common stock
    are automatically granted annually to the non-employee Chairman
    of the Board on June 30, at no less than 100% of the market
    price on the date the options are granted;                                        
| 
| | Options to purchase up to 30,000 shares of common
    stock are awarded when new members are elected or appointed to
    the board of directors;                                                                                                                            
| 
| | Options to purchase shares of common stock may be
    granted on a discretionary basis; and                                                                                                                                                                                 
| 
| | Stock units issued as a deferral of up to 50% of
    directors annual retainer, until directors reach targeted
    stock ownership levels.                                                                                                                                 

All stock options, except for initial grants to
new board members, vest immediately on the grant date, but the
associated common stock may not be sold within six months after
the grant date. Effective October 23, 2003, the initial
grants to new board members vest one-third on the date of grant
and one-third on the first and second anniversary of the date of
grant. As of December 31, 2003, approximately
0.2 million shares were available for awards under the
Director Plans.

Our stock incentive plans provide for accelerated
exercisability of plan awards if certain events relating to a
change of control, merger, sale of assets or liquidation of
PacifiCare were to occur.

Prior to 2003, we accounted for our stock option
plans under Accounting Principles Board Opinion No. 25,
Accounting for Stock Issued to Employees, and related
interpretations. Effective January 1, 2003, we adopted the
fair value recognition provisions of FASB Statement
No. 123, Accounting for Stock-Based Compensation, or
FAS 123, on a prospective basis. Under the prospective
method provisions of FASB Statement No. 148, Accounting
for Stock-Based Compensation  Transition and
Disclosure, or FAS 148, the recognition provisions will
be applied to all employee awards granted, modified or settled
after January 1, 2003.

Pro forma information regarding net income
(loss) and earnings (loss) per share, as presented in
Note 2, Significant Accounting Policies, is
required by FAS 123, as amended by FAS 148, and has
been determined as if we had accounted for our employee stock
options and ESPP under the fair value method of that Statement
upon its initial effective date. The fair value for these
options was

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##### Table of Contents



PACIFICARE HEALTH SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)

estimated at the date of grant using a
Black-Scholes option-pricing model with the following
weighted-average assumptions for 2003, 2002 and 2001:

|                                                          |                          |                        |    |      |  |      |    |      |  |      |     |      |  |  |     |       |  |  |     |      |  |  |    |    | 
|--------------------------------------------------------- | ------------------------ | ---------------------- | -- | ---- |  | ---- | -- | ---- |  | ---- | --- | ---- |  |  | --- | ----- |  |  | --- | ---- |  |  | -- | -- | 
|                                                          |                          |                        |    |     
|                                                          |                          | Employee Stock Options |    | ESPP
|                                                          |                          |                        |    |     
|                                                          |                          | 2003                   |    | 2002 |  | 2001 |    | 2003 |  | 2002 |     | 2001
|                                                          |                          |                        |    |      |  |      |    |      |  |      |     |     
|Expected dividend yield                                   |                          |                        | 0  | %    |  |      | 0  | %    |  |      | 0   | %    |  |  | 0   | %     |  |  | 0   | %    |  |  | NA |   
|Risk-free interest rate                                   |                          |                        | 4  | %    |  |      | 3  | %    |  |      | 3   | %    |  |  | 1   | %     |  |  | 2   | %    |  |  | NA |   
|Expected stock price volatility                           |                          |                        | 80 | %    |  |      | 83 | %    |  |      | 110 | %    |  |  | 59  | %     |  |  | 67  | %    |  |  | NA |   
|Expected term until exercise upon vesting (years)         |                          |                        | 2  |      |  |      | 2  |      |  |      | 2   |      |  |  | 0.5 |       |  |  | 0.5 |      |  |  | NA |   
|Weighted average fair value of options on grant
    date: |                          |                        |    |      |  |      |    |      |  |      |     |      |  |  |     |       |  |  |     |      |  |  |    |   
|                                                          | Granted at market prices |                        | $  | 9.11 |  |      | $  | 6.75 |  |      | $   | 6.30 |  |  | $   | 11.49 |  |  | $   | 5.04 |  |  |    | NA | 

Nonqualified stock option activity for all plans
was as follows, after adjusting for the effect of the
two-for-one stock split in the form of a stock dividend that was
effective January 20, 2004:

|                                     |  |         |            |                  |  |             |       |                  |  |  |           |  |  |   |       | 
|------------------------------------ |  | ------- | ---------- | ---------------- |  | ----------- | ----- | ---------------- |  |  | --------- |  |  | - | ----- | 
|                                     |  |         |            | Weighted Average |  | Options     |       | Weighted Average
|                                     |  | Options |            | Exercise Price   |  | Exercisable |       | Exercise Price  
|                                     |  |         |            |                  |  |             |       |                 
|Outstanding at December 31,
    2000 |  |         | 17,829,176 |                  |  | $           | 32.94 |                  |  |  | 7,614,956 |  |  | $ | 36.27 | 
|Granted at market price              |  |         | 5,524,324  |                  |  | $           | 8.88  |                  |  |  |          |  |  | $ |      | 
|Exercised                            |  |         | (9,600     | )                |  | $           | 8.63  |                  |  |  |          |  |  | $ |      | 
|Canceled                             |  |         | (7,359,198 | )                |  | $           | 36.08 |                  |  |  |          |  |  | $ |      | 
|                                     |  |         |            |                  |  |             |       |                  |  |  |           |  |  |   |       | 
|Outstanding at December 31,
    2001 |  |         | 15,984,702 |                  |  | $           | 23.20 |                  |  |  | 7,195,034 |  |  | $ | 31.91 | 
|Granted at market price              |  |         | 3,782,344  |                  |  | $           | 9.73  |                  |  |  |          |  |  | $ |      | 
|Exercised                            |  |         | (413,126   | )                |  | $           | 7.61  |                  |  |  |          |  |  | $ |      | 
|Canceled                             |  |         | (5,826,284 | )                |  | $           | 30.39 |                  |  |  |          |  |  | $ |      | 
|                                     |  |         |            |                  |  |             |       |                  |  |  |           |  |  |   |       | 
|Outstanding at December 31,
    2002 |  |         | 13,527,636 |                  |  | $           | 16.81 |                  |  |  | 6,628,204 |  |  | $ | 22.34 | 
|Granted at market price              |  |         | 1,712,400  |                  |  | $           | 15.51 |                  |  |  |          |  |  | $ |      | 
|Exercised                            |  |         | (3,205,864 | )                |  | $           | 11.16 |                  |  |  |          |  |  | $ |      | 
|Canceled                             |  |         | (966,420   | )                |  | $           | 23.48 |                  |  |  |          |  |  | $ |      | 
|                                     |  |         |            |                  |  |             |       |                  |  |  |           |  |  |   |       | 
|Outstanding at December 31,
    2003 |  |         | 11,067,752 |                  |  | $           | 17.66 |                  |  |  | 6,383,252 |  |  | $ | 21.55 | 
|                                     |  |         |            |                  |  |             |       |                  |  |  |           |  |  |   |       | 

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##### Table of Contents



PACIFICARE HEALTH SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)

The following is a summary of information about
options outstanding and options exercisable at December 31,
2003:

|                         |  |                     |            |                     |  |                |   |             |  |                |       |  |  |  |           |  |  |   |       | 
|------------------------ |  | ------------------- | ---------- | ------------------- |  | -------------- | - | ----------- |  | -------------- | ----- |  |  |  | --------- |  |  | - | ----- | 
|                         |  |                     |            |                    
|                         |  | Options Outstanding |            | Options Exercisable
|                         |  |                     |            |                    
|                         |  |                     |            | Weighted            |  | Weighted       |   |             |  | Weighted      
|                         |  | Number              |            | Average             |  | Average        |   | Number      |  | Average       
|Range of Exercise Prices |  | Outstanding         |            | Life(1)             |  | Exercise Price |   | Exercisable |  | Exercise Price
|                         |  |                     |            |                     |  |                |   |             |  |               
|$6.03 - $9.73            |  |                     | 4,817,690  |                     |  |                | 8 |             |  | $              | 8.28  |  |  |  | 2,473,190 |  |  | $ | 7.98  | 
|$11.09 - $19.25          |  |                     | 2,280,576  |                     |  |                | 9 |             |  | $              | 13.76 |  |  |  | 346,326   |  |  | $ | 13.67 | 
|$22.66 - $30.88          |  |                     | 2,293,832  |                     |  |                | 7 |             |  | $              | 25.87 |  |  |  | 1,888,082 |  |  | $ | 25.56 | 
|$32.78 - $46.25          |  |                     | 1,675,654  |                     |  |                | 4 |             |  | $              | 38.69 |  |  |  | 1,675,654 |  |  | $ | 38.69 | 
|                         |  |                     |            |                     |  |                |   |             |  |                |       |  |  |  |           |  |  |   |       | 
|                         |  |                     | 11,067,752 |                     |  |                |   |             |  |                |       |  |  |  | 6,383,252 |  |  |   |       | 
|                         |  |                     |            |                     |  |                |   |             |  |                |       |  |  |  |           |  |  |   |       | 



---



|    |                                                          
|--- | ---------------------------------------------------------
|(1) | Weighted average contractual life remaining in
    years.



|    |                                                                                                       
|--- | ------------------------------------------------------------------------------------------------------
|10. | Impairment, Disposition, Restructuring, Office
    of Personnel Management and Other Charges (Credits)

We recognized net pretax (credits) charges in
2003, 2002 and 2001 as follows:

|                                                                                |                                                                                   |                                                                                            |              |           |       |            |     |              |      |      |     |   |       |       |      | 
|------------------------------------------------------------------------------- | --------------------------------------------------------------------------------- | ------------------------------------------------------------------------------------------ | ------------ | --------- | ----- | ---------- | --- | ------------ | ---- | ---- | --- | - | ----- | ----- | ---- | 
|                                                                                |                                                                                   |                                                                                            |              | Pretax    |       |            |     | Diluted Loss
|                                                                                |                                                                                   | Quarter                                                                                    |              | (Credits) |       | Net-of-Tax |     | (Earnings)  
|                                                                                |                                                                                   | Recognized                                                                                 |              | Charges   |       | Amount     |     | per Share(1)
|                                                                                |                                                                                   |                                                                                            |              |           |       |            |     |             
|                                                                                |                                                                                   |                                                                                           
|                                                                                |                                                                                   | (Amounts in millions, except per share data)                                              
|2003                                                                            |                                                                                   |                                                                                            |              |           |       |            |     |              |      |      |     |   |       |      
|Restructuring change in estimate                                                |                                                                                   | Total Fourth                                                                               |              | $         | (1.9  | )          |     | $            | (1.2 | )    |     | $ | (0.01 | )    
|                                                                                |                                                                                   |                                                                                            |              |           |       |            |     |              |      |      |     |   |       |      
|2002                                                                            |                                                                                   |                                                                                            |              |           |       |            |     |              |      |      |     |   |       |      
|OPM credits                                                                     |                                                                                   | Total First                                                                                |              | $         | (12.9 | )          |     | $            | (8.1 | )    |     | $ | (0.11 | )    
|                                                                                |                                                                                   |                                                                                            |              |           |       |            |     |              |      |      |     |   |       |      
|Write-off of unamortized senior credit facility
    fees and paid advisory fees |                                                                                   | Total Second                                                                               |              |           | 18.3  |            |     |              | 11.4 |      |     |   | 0.16  |      
|                                                                                |                                                                                   |                                                                                            |              |           |       |            |     |              |      |      |     |   |       |      
|OPM credits                                                                     |                                                                                   | Fourth                                                                                     |              |           | (11.1 | )          |     |              | (6.9 | )    |     |   | (0.09 | )    
|Loss on disposition of subsidiary                                               |                                                                                   | Fourth                                                                                     |              |           | 9.0   |            |     |              | 5.6  |      |     |   | 0.07  |      
|Write-off of unamortized senior credit facility
    fees and paid advisory fees |                                                                                   | Fourth                                                                                     |              |           | 1.1   |            |     |              | 0.7  |      |     |   | 0.01  |      
|Restructuring change in estimate                                                |                                                                                   | Fourth                                                                                     |              |           | (0.7  | )          |     |              | (0.5 | )    |     |   |      |      
|                                                                                |                                                                                   |                                                                                            |              |           |       |            |     |              |      |      |     |   |       |      
|                                                                                | Total impairment, disposition, restructuring, OPM
    and other charges (credits) |                                                                                            | Total Fourth |           |       | (1.7       | )   |              |      | (1.1 | )   |   |       | (0.01 | )   
|                                                                                |                                                                                   |                                                                                            |              |           |       |            |     |              |      |      |     |   |       |      
|                                                                                |                                                                                   | Total net 2002 impairment, disposition,
    restructuring, OPM and other charges (credits) |              |           |       | $          | 3.7 |              |      | $    | 2.2 |   |       | $     | 0.04 | 
|                                                                                |                                                                                   |                                                                                            |              |           |       |            |     |              |      |      |     |   |       |      

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##### Table of Contents



PACIFICARE HEALTH SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)

|                                         |                                                                    |                                                                                            |              |           |      |            |      |              |      |      |      |   |       |      |      | 
|---------------------------------------- | ------------------------------------------------------------------ | ------------------------------------------------------------------------------------------ | ------------ | --------- | ---- | ---------- | ---- | ------------ | ---- | ---- | ---- | - | ----- | ---- | ---- | 
|                                         |                                                                    |                                                                                            |              | Pretax    |      |            |      | Diluted Loss
|                                         |                                                                    | Quarter                                                                                    |              | (Credits) |      | Net-of-Tax |      | (Earnings)  
|                                         |                                                                    | Recognized                                                                                 |              | Charges   |      | Amount     |      | per Share(1)
|                                         |                                                                    |                                                                                            |              |           |      |            |      |             
|                                         |                                                                    |                                                                                           
|                                         |                                                                    | (Amounts in millions, except per share data)                                              
|2001                                     |                                                                    |                                                                                            |              |           |      |            |      |              |      |      |      |   |       |     
|Gain from contract termination agreement |                                                                    | First                                                                                      |              | $         | (1.2 | )          |      | $            | (0.6 | )    |      | $ | (0.01 | )   
|Restructuring change in estimate         |                                                                    | First                                                                                      |              |           | 0.3  |            |      |              | 0.1  |      |      |   |      |     
|                                         |                                                                    |                                                                                            |              |           |      |            |      |              |      |      |      |   |       |     
|                                         |                                                                    | Total First                                                                                |              |           | (0.9 | )          |      |              | (0.5 | )    |      |   | (0.01 | )   
|                                         |                                                                    |                                                                                            |              |           |      |            |      |              |      |      |      |   |       |     
|Restructuring change in estimate         |                                                                    | Total Second                                                                               |              |           | (0.3 | )          |      |              | (0.1 | )    |      |   |      |     
|                                         |                                                                    |                                                                                            |              |           |      |            |      |              |      |      |      |   |       |     
|Debt offering costs                      |                                                                    | Third                                                                                      |              |           | 3.1  |            |      |              | 1.5  |      |      |   | 0.02  |     
|Restructuring change in estimate         |                                                                    | Third                                                                                      |              |           | (0.2 | )          |      |              | (0.1 | )    |      |   |      |     
|                                         |                                                                    |                                                                                            |              |           |      |            |      |              |      |      |      |   |       |     
|                                         |                                                                    | Total Third                                                                                |              |           | 2.9  |            |      |              | 1.4  |      |      |   | 0.02  |     
|                                         |                                                                    |                                                                                            |              |           |      |            |      |              |      |      |      |   |       |     
|Restructuring charge                     |                                                                    | Fourth                                                                                     |              |           | 59.9 |            |      |              | 38.5 |      |      |   | 0.56  |     
|Restructuring change in estimate         |                                                                    | Fourth                                                                                     |              |           | (0.5 | )          |      |              | (0.2 | )    |      |   |      |     
|                                         |                                                                    |                                                                                            |              |           |      |            |      |              |      |      |      |   |       |     
|                                         | Total impairment, disposition, restructuring and
    other charges |                                                                                            | Total Fourth |           |      | 59.4       |      |              |      | 38.3 |      |   |       | 0.56 |     
|                                         |                                                                    |                                                                                            |              |           |      |            |      |              |      |      |      |   |       |     
|                                         |                                                                    | Total net 2001 impairment, disposition,
    restructuring, OPM and other charges (credits) |              |           |      | $          | 61.1 |              |      | $    | 39.1 |   |       | $    | 0.57 | 
|                                         |                                                                    |                                                                                            |              |           |      |            |      |              |      |      |      |   |       |     



---



|    |                                                                                                                                                                                                                                                                                                                                                                                
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | The year to date diluted loss (earnings) per
    share is computed using the year to date weighted average common
    shares and equivalents outstanding and may not agree to the sum
    of each quarter. Per share amounts reflect the retroactive
    effects of the two-for-one common stock split in the form of a
    stock dividend that was effective January 20, 2004.

2003.During the
fourth quarter of 2003, we recognized a credit of
$1.9 million for changes in our December 2001 restructuring
estimates related to severance and related employee benefits.

2002.We recognized
net pretax charges of $4 million as described below:

Write-Off of Unamortized Senior Credit
Facility Fees.During 2002, we
recognized other charges of $19 million for the write off
of unamortized senior credit facility fees in connection with
our repayment of a significant portion of our senior credit
facility, and for advisory fees paid in connection with the
restructuring of our long-term debt.

OPM.During 2002, we
recognized OPM credits of $24 million, representing a
reduction to the net liability we had established in prior
periods as a result of settlements with the OPM, the
U.S. Department of Justice, or DOJ, and a private
individual to settle disputes and a private lawsuit under the
False Claims Act regarding alleged premium overcharges to the
government for the period 1990 through 1997, primarily related
to contracts held by FHP health plans prior to our acquisition
of FHP in 1997.

Loss on Disposition of Subsidiary.During the fourth quarter of 2002, we
recognized disposition charges of $9 million, in connection
with the sale of assets of our subsidiary, MEDeMORPHUS
Healthcare Solutions, Inc. The charge included severance, legal
and other expenses related to the disposition. See Note 4,
Dispositions.

F-26



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##### Table of Contents



PACIFICARE HEALTH SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)

Restructuring Change in Estimates.During the fourth quarter of 2002, we
recognized a credit of $0.7 million for changes in our
December 2001 restructuring estimates related to severance and
related employee benefits.

2001.We
recognized net pretax charges of $61 million as described
below:

Debt offering costs.During the third quarter of 2001, we
recognized charges of $3 million for expenses related to
our efforts to obtain senior note financing, which we
discontinued during the third quarter of 2001.

Restructuring Change in Estimates.We recognized changes in our January
2000 and December 2000 restructuring estimates related to
severance and related employee benefits. During the third
quarter of 2001, we recognized a credit of $0.2 million for
the January estimate. During the second quarter of 2001, we
recognized a credit of $0.1 million for the January
estimate and a credit of $0.2 million for the December
estimate. During the first quarter of 2001, we recognized a
credit of $0.1 million for the January estimate, offset by
a charge of $0.4 million for the December estimate.

Gain from Contract Termination Agreement.During the first quarter of 2001, we
recognized other credits of $1 million for a gain from a
contract termination agreement.

Restructuring Charge.In December 2001, we recognized a
restructuring charge of $60 million. Of the
$60 million charge, approximately $34 million
represented a liability for cash payments, of which
approximately $22 million was paid during the fourth
quarter of 2001 and during the year ended December 31,
2002. Approximately $20 million of the restructuring charge
was for severance and related employee benefits for 1,450
employees whose positions were eliminated. As of
December 31, 2003, approximately 1,240 employees have
left the company and 200 employees, whose positions were
eliminated, accepted other positions within the company. During
2003, we made severance payments totaling approximately
$3 million to terminated employees.

The restructuring charge also included
approximately $27 million related to the outsourcing of our
IT production and $13 million related to lease terminations.

The following table presents the activity through
December 31, 2003, on the restructuring charge we took in
2001:

|                             |                                     |                                   |   |           |      |          |   |          |       |              |   |          |      |            |   |              |       |   |   |     |      |  |   |      |      |   |   |      |      |   |   |     |     | 
|---------------------------- | ----------------------------------- | --------------------------------- | - | --------- | ---- | -------- | - | -------- | ----- | ------------ | - | -------- | ---- | ---------- | - | ------------ | ----- | - | - | --- | ---- |  | - | ---- | ---- | - | - | ---- | ---- | - | - | --- | --- | 
|                             |                                     | Initial                           |   |           |      |          |   |          |       | Balance at   |   |          |      |            |   | Balance at  
|                             |                                     | Pretax                            |   | Non-cash  |      | 2001     |   | 2002     |       | December 31, |   | 2003     |      | Changes in |   | December 31,
|                             |                                     | Charge                            |   | Write-off |      | Activity |   | Activity |       | 2002         |   | Payments |      | Estimate   |   | 2003        
|                             |                                     |                                   |   |           |      |          |   |          |       |              |   |          |      |            |   |             
|                             |                                     |                                  
|                             |                                     | (Amounts in millions)            
|December 2001 restructuring: |                                     |                                   |   |           |      |          |   |          |       |              |   |          |      |            |   |              |       |   |   |     |      |  |   |      |      |   |   |      |      |   |   |    
|                             | Lease cancellations and commitments |                                   | $ | 39.7      |      |          | $ | (25.8    | )     |              | $ |         |      |            | $ | (8.0         | )     |   | $ | 5.9 |      |  | $ | (3.1 | )    |   | $ |     |      |   | $ | 2.8 |    
|                             | Severance and separation benefits   |                                   |   | 20.2      |      |          |   |         |       |              |   | (0.6     | )    |            |   | (14.0        | )     |   |   | 5.6 |      |  |   | (2.9 | )    |   |   | (1.9 | )    |   |   | 0.8 |    
|                             |                                     |                                   |   |           |      |          |   |          |       |              |   |          |      |            |   |              |       |   |   |     |      |  |   |      |      |   |   |      |      |   |   |    
|                             |                                     | Total December 2001 restructuring |   | $         | 59.9 |          |   | $        | (25.8 | )            |   | $        | (0.6 | )          |   | $            | (22.0 | ) |   | $   | 11.5 |  |   | $    | (6.0 | ) |   | $    | (1.9 | ) |   | $   | 3.6 | 
|                             |                                     |                                   |   |           |      |          |   |          |       |              |   |          |      |            |   |              |       |   |   |     |      |  |   |      |      |   |   |      |      |   |   |    

F-27



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##### Table of Contents



PACIFICARE HEALTH SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)

11.     Incurred But
Not Reported Claims Reserves

The following table presents the roll-forward of
our incurred but not reported, or IBNR, claims reserves as of
the periods indicated:

|                                                           |                                   |                       |     |        |   |      |     |        |   |   |     |        |  
|---------------------------------------------------------- | --------------------------------- | --------------------- | --- | ------ | - | ---- | --- | ------ | - | - | --- | ------ | -
|                                                           |                                   |                      
|                                                           |                                   | Year Ended           
|                                                           |                                   |                      
|                                                           |                                   | 2003                  |     | 2002   |   | 2001
|                                                           |                                   |                       |     |        |   |     
|                                                           |                                   |                      
|                                                           |                                   | (Amounts in millions)
|IBNR as of January 1                                       |                                   | $                     | 753 |        |   | $    | 808 |        |   | $ | 913 |       
|Health care claim expenses incurred during the
    period: |                                   |                       |     |        |   |      |     |        |   |   |     |       
|                                                           | Related to current year           |                       |     | 4,682  |   |      |     | 4,343  |   |   |     | 4,514  |  
|                                                           | Related to prior years            |                       |     | (104   | ) |      |     |       |   |   |     | (45    | )
|                                                           |                                   |                       |     |        |   |      |     |        |   |   |     |       
|                                                           | Total incurred                    |                       |     | 4,578  |   |      |     | 4,343  |   |   |     | 4,469  |  
|Health care claims paid during the period:                 |                                   |                       |     |        |   |      |     |        |   |   |     |       
|                                                           | Related to current year           |                       |     | (3,918 | ) |      |     | (3,689 | ) |   |     | (3,783 | )
|                                                           | Related to prior years            |                       |     | (587   | ) |      |     | (709   | ) |   |     | (791   | )
|                                                           |                                   |                       |     |        |   |      |     |        |   |   |     |       
|                                                           | Total health care claims payments |                       |     | (4,505 | ) |      |     | (4,398 | ) |   |     | (4,574 | )
|                                                           |                                   |                       |     |        |   |      |     |        |   |   |     |       
|IBNR as of December 31                                     |                                   | $                     | 826 |        |   | $    | 753 |        |   | $ | 808 |       
|                                                           |                                   |                       |     |        |   |      |     |        |   |   |     |       

Included in IBNR is a provision for adverse
claims development. The provision for adverse claims development
at the beginning of each year is released against the health
care claims expenses related to prior periods in each period
presented. The provision for adverse claims development is then
re-evaluated based on actuarial calculations and recorded in the
current year expense. The release of the provision for adverse
claims development into each year presented was
$50 million, $51 million and $56 million for the
years 2003, 2002 and 2001, respectively.

12.     Health Care
Services and Other Expenses

The following table presents the components of
total health care services and other expenses for the years
ended December 31, 2003, 2002 and 2001:

|                                                  |  |                         |       |        |  |            |       |        |  |            |       |        |  |   |       |  |  |   |       |  |  |   |       | 
|------------------------------------------------- |  | ----------------------- | ----- | ------ |  | ---------- | ----- | ------ |  | ---------- | ----- | ------ |  | - | ----- |  |  | - | ----- |  |  | - | ----- | 
|                                                  |  |                        
|                                                  |  | Year Ended December 31,
|                                                  |  |                        
|                                                  |  |                         |       |        |  |           
|                                                  |  | 2003                    |       | 2002   |  | 2001      
|                                                  |  |                         |       |        |  |           
|                                                  |  | Commercial              |       | Senior |  | Commercial |       | Senior |  | Commercial |       | Senior
|                                                  |  |                         |       |        |  |            |       |        |  |            |       |       
|                                                  |  |                        
|                                                  |  | (Amounts in millions)  
|Capitation expense                                |  | $                       | 1,488 |        |  | $          | 2,704 |        |  | $          | 1,795 |        |  | $ | 2,994 |  |  | $ | 1,977 |  |  | $ | 3,738 | 
|All other health care services and other expenses |  |                         | 2,782 |        |  |            | 1,836 |        |  |            | 2,410 |        |  |   | 2,110 |  |  |   | 2,125 |  |  |   | 2,396 | 
|                                                  |  |                         |       |        |  |            |       |        |  |            |       |        |  |   |       |  |  |   |       |  |  |   |       | 
|Total health care services and other expenses     |  | $                       | 4,270 |        |  | $          | 4,540 |        |  | $          | 4,205 |        |  | $ | 5,104 |  |  | $ | 4,102 |  |  | $ | 6,134 | 
|                                                  |  |                         |       |        |  |            |       |        |  |            |       |        |  |   |       |  |  |   |       |  |  |   |       | 

13.     Contingencies

Provider Instability and Insolvency.Our health care services and other
expenses include write-offs of certain uncollectible receivables
from providers, and the estimated cost of unpaid health care
claims normally covered by our capitation payments. Depending on
state law, we may be held liable for unpaid health care claims
that were previously the responsibility of the capitated
provider and for

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PACIFICARE HEALTH SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)

which we have already paid capitation. Insolvency
reserves also include estimates for potentially insolvent
providers that we have specifically identified, where conditions
indicate claims are not being paid or claim payments have slowed
considerably, and we have determined that it is probable that we
will be required to make the providers claim payments. We
continue to monitor the financial condition of our providers
where there is perceived risk of insolvency and adjust our
insolvency reserves as necessary. Information provided by
provider groups may be unaudited, self-reported information or
may not ultimately be obtained. The balance of our insolvency
reserves included in medical claims and benefits payable totaled
$37 million at December 31, 2003 and $46 million
at December 31, 2002.

To reduce insolvency risk, we have developed
contingency plans that include shifting members to other
providers and reviewing operational and financial plans to
monitor and maximize financial and network stability. As
capitation contracts are renewed for providers we have also
taken steps, where feasible, to have security reserves
established for insolvency issues. Security reserves are most
frequently in the forms of letters of credit or segregated funds
that are held in the providers name in a third party
financial institution. The reserves may be used to pay claims
that are the financial responsibility of the provider.

In Re Managed Care.In mid-2000, various federal actions
against managed care companies, including us, were joined in a
multi-district litigation that was coordinated for pretrial
proceedings in the United States District Court for the Southern
District of Florida. This litigation is known as In re
Managed Care Litigation. Thereafter, Dr. Dennis
Breen, Dr. Leonard Klay, Dr. Jeffrey Book and several
other health care providers, along with several medical
associations, including the California Medical Association,
joined the In re Managed Care proceeding as
plaintiffs. These health care providers sued several managed
care companies, including us, alleging, among other things, that
the companies have systematically underpaid providers for
medical services to members, have delayed payments, and that the
companies impose unfair contracting terms on providers and
negotiate capitation payments that are inadequate to cover the
costs of health care services provided.

We sought to compel arbitration of all of
Dr. Breens, Dr. Books and other physician
claims against us. The District Court granted our motion to
compel arbitration against all of these claims except for claims
for violations of the Racketeer Influenced and Corrupt
Organizations Act, or RICO (Direct RICO Claims), and
for their RICO conspiracy and aiding and abetting claims that
stem from contractual relationships with other managed care
companies. On April 7, 2003, the United States Supreme
Court held that the District Court should have compelled
arbitration of the Direct RICO Claims filed by Dr. Breen
and Dr. Book. On September 15, 2003, the District
Court entered another ruling on several of our motions to compel
arbitration, ordering arbitration of all claims arising out of
our contracts with plaintiffs containing arbitration clauses.
The District Court, however, also ruled that
(a) plaintiffs RICO conspiracy and aiding and
abetting claims against us that stem from contractual
relationships with other managed care companies and
(b) plaintiffs claims based on services they provided
to our members outside of any contractual relationship with us
or assignments from our members do not arise out of our
contracts with plaintiffs and thus do not need to be arbitrated.
As a result, the order to compel arbitration does not cover any
claims that may arise relating to our non-contracted providers.
We have filed an appeal from the District Courts ruling to
the extent it did not compel arbitration of all of
plaintiffs claims, but no oral argument has been scheduled
on the appeal yet.

On September 26, 2002, the District Court
certified a class action in the In re Managed Care
Litigation. On November 20, 2002, the United States
Court of Appeals for the Eleventh Circuit

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PACIFICARE HEALTH SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)

granted our petition to appeal the class
certification by the District Court. Oral argument for this
appeal was held on September 11, 2003 and the court has not
issued an opinion as of the date of this report. Discovery in
this litigation is currently ongoing. We deny all material
allegations and intend to defend the action vigorously.

PacifiCare of Texas v. The Texas
Department of Insurance and the State of
Texas.In November 2001, our Texas
subsidiary, PacifiCare of Texas, filed a lawsuit against the
Texas Department of Insurance, or TDI, and the State of Texas
challenging the TDIs interpretation and enforcement of
state statutes and regulations that would make Texas a
double-pay state. The lawsuit relates to the
financial insolvency of three physician groups that had
capitation contracts with PacifiCare of Texas. Under these
contracts, the responsibility for claims payments to health care
providers was delegated to the contracted physician groups. We
made capitation payments to each of these physician groups, but
they failed to pay all of the health care providers who provided
health care services covered by the capitation payments. On
February 11, 2002, after the date we filed our lawsuit, the
Attorney General of Texas or AG, on behalf of the State of Texas
and the TDI, filed a civil complaint against PacifiCare of Texas
in the District Court of Travis County, Texas alleging
violations of the Texas Health Maintenance Organization Act,
Texas Insurance Code and regulations under the Code and the
Texas Deceptive Trade Practices Consumer Protection Act. The
AGs complaint primarily alleges that despite its
capitation payments to the physician groups, PacifiCare of Texas
is still financially responsible for the failure of the
physician groups to pay the health care providers who provided
health care services covered by the capitation payments. The AG
sought an injunction requiring us to comply with state laws plus
unspecified damages, civil penalties and restitution.

On July 23, 2003, without the admission of
any wrongdoing, our Texas subsidiary entered into a definitive
settlement agreement with the State of Texas, the AG and the
TDI. The settlement agreement provides that all pending
litigation and related civil investigations will be stayed for
up to twelve months from the date of execution of the settlement
agreement or such additional period as the parties may mutually
agree. While the proceedings are stayed, the parties will seek
to settle the provider creditor claims in the remaining
outstanding bankruptcies relating to Medical Select Management
and Heritage Southwest Medical Group and engage in a review of
provider claims of the Heritage Physicians Network, or HPN. We
agreed to use our reasonable best efforts to reach settlements
in the bankruptcies and resolve the HPN claims by specified
dates and agreed to make contributions to fund provider creditor
claims in the bankruptcies subject to the process set forth in
the definitive settlement agreement.

As part of the settlement, we agreed to make
payments totaling $4.25 million, including attorneys fees
totaling $1.25 million to the AG, and administrative
services reimbursements totaling $1.5 million and
administrative penalties totaling $1.5 million to the TDI.
Of the $4.25 million payment, $2.45 million was paid
in July 2003, and the remaining $1.8 million will be paid
upon the satisfaction of the conditions for the settlement. All
amounts paid upon execution of the settlement agreement will be
held in trust pending the effectiveness of the settlement. The
settlement will become effective upon us completing settlements
in the two bankruptcies in accordance with the settlement
agreement, timely completion of the HPN claims process, payment
of all settlement amounts to the AG and TDI, and compliance with
certain Texas prompt payment obligations with respect to members
enrolled in our commercial HMO plans. Concurrent with the
settlement becoming effective: (i) the parties would enter
into a permanent injunction with a term of one year that will
require PacifiCare of Texas to comply with applicable provisions
of the Texas prompt payment obligations with respect to members
enrolled in our commercial HMO plans; (ii) all of the
pending litigation between the parties will be dismissed with
prejudice or with specified final

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PACIFICARE HEALTH SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)

judgments; and (iii) the parties will enter
into mutual releases. We cannot provide any assurances that we
will be able to meet the conditions required to cause the
settlement to become effective. If the settlement agreement does
not become effective, then we are prepared to resume the
litigation. We believe that recorded liabilities for this matter
are adequate, including the satisfaction of all the terms and
conditions of the settlement, or any liabilities that may arise
if we are required to resume the litigation.

OPM Litigation.On April 12, 2002, we resolved
issues raised in various audits of our health plans by the OIG
as well as the False Claims investigations of the United States
Department of Justice, or DOJ and a private lawsuit under the
False Claims Act. The settlement primarily related to contracts
we acquired through our merger with FHP International
Corporation, or FHP, in 1997. As previously disclosed, the OIG
and others alleged that the former FHP Arizona, California,
Colorado, Guam and Ohio HMO subsidiaries, as well as the former
FHP Illinois, New Mexico and Utah HMO subsidiaries that we sold
in 1997 and 1998, substantially overcharged the government for
premiums from 1990 through 1997. The allegations were referred
to the DOJ for review of potential claims under the False Claims
Act. In addition, a private individual filed a complaint under
the False Claims Act in 1998 that remained under seal until the
settlement. The OIG also conducted audits of our Oregon HMO for
contract years 1991 through 1996 and our California HMO for
contract years 1993 through 1996 and referred these audits to
the DOJ for potential claims under the False Claims Act. The
settlement resolved issues raised in OIGs various audits
of these 10 health plans, as well as the False Claims
investigations of the DOJ and the private lawsuit under the
False Claims Act.

We paid $88 million in 2002 and 2003 under
the settlement agreement. As part of the settlement, we received
from OPM in the second quarter of 2002 approximately
$15 million in premiums that were either withheld pending
resolution of these audits or were not paid by OPM for 2001 and
earlier periods. This settlement and the results of other 2002
OPM audits resulted in OPM credits of $24 million
($15 million or $0.42 diluted earnings per share, net of
tax) that we recorded in 2002, representing a reduction to the
net liability we had established in prior periods. We did not
admit to any wrongdoing as part of the settlement.

Irwin v. AdvancePCS, Inc. et
al.On March 26, 2003, Robert
Irwin filed a complaint in the California Superior Court of
Alameda County, California, against our PBM company,
Prescription Solutions, as well as nine other PBM companies. On
July 17, 2003, the Irwincase was coordinated with
American Federation of State, County & Municipal
Employees v. AdvancedPCS, et al, and transferred to Los
Angeles Superior Court for coordinated proceedings. The case
purports to be filed on behalf of non-ERISA health plans and
individuals with no prescription drug benefits who have
purchased drugs at retail rates. The first amended complaint,
filed on November 25, 2003, alleges that each of the
defendants violated Californias unfair competition law.
The complaint challenges alleged business practices of PBMs,
including practices relating to pricing, rebates, formulary
management, data utilization and accounting and administrative
processes. The complaint seeks unspecified monetary damages and
injunctive relief. We do not provide PBM services to non-ERISA
plans in California and do not believe we were properly named as
a defendant in this litigation. We deny all material allegations
and intend to defend the action vigorously.

Other Litigation.We
are involved in various legal actions in the normal course of
business, including claims from our members and providers
arising out of decisions to deny or restrict reimbursement for
services and claims that seek monetary damages, including claims
for punitive damages that are not covered by insurance. Our
establishment of drug formularies, support of clinical trials
and PBM services may increase our exposure to product liability
claims associated with

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PACIFICARE HEALTH SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)

pharmaceuticals and medical devices. Based on
current information, including consultation with our lawyers, we
believe any ultimate liability that may arise from these
actions, including the In re Managed Care litigation, would not
materially affect our consolidated financial position, results
of operations or cash flows. However, our evaluation of the
likely impact of these actions could change in the future and an
unfavorable outcome, depending upon the amount and timing, could
have a material effect on our results of operations or cash
flows of a future period. For example, the loss of even one
claim resulting in a significant punitive damage award could
have a material adverse effect on our business. Moreover, our
exposure to potential liability under punitive damage theories
may decrease significantly our ability to settle these claims on
reasonable terms.

14.     Comprehensive
Income

The following tables summarize the components of
other comprehensive income (loss) for the periods indicated:

|                                                                           |  |                        |         |           |  |            |         |   |  |   |        |  
|-------------------------------------------------------------------------- |  | ---------------------- | ------- | --------- |  | ---------- | ------- | - |  | - | ------ | -
|                                                                           |  |                        |         | Income    |  |           
|                                                                           |  |                        |         | Tax       |  |           
|                                                                           |  | Pretax                 |         | Benefit   |  | Net-of-Tax
|                                                                           |  | Amount                 |         | (Expense) |  | Amount    
|                                                                           |  |                        |         |           |  |           
|                                                                           |  |                       
|                                                                           |  | (Amounts in thousands)
|2003:                                                                      |  |                        |         |           |  |            |         |   |  |   |        |  
|Change in unrealized gains on marketable
    securities                    |  | $                      | 2,743   |           |  | $          | (1,111  | ) |  | $ | 1,632  |  
|Less: reclassification adjustment for net gains
    realized in net income |  |                        | (7,642  | )         |  |            | 3,095   |   |  |   | (4,547 | )
|                                                                           |  |                        |         |           |  |            |         |   |  |   |        |  
|Other comprehensive income (loss)                                          |  | $                      | (4,899  | )         |  | $          | 1,984   |   |  | $ | (2,915 | )
|                                                                           |  |                        |         |           |  |            |         |   |  |   |        |  
|2002:                                                                      |  |                        |         |           |  |            |         |   |  |   |        |  
|Change in unrealized gains on marketable
    securities                    |  | $                      | 36,234  |           |  | $          | (13,638 | ) |  | $ | 22,596 |  
|Less: reclassification adjustment for net gains
    realized in net income |  |                        | (4,514  | )         |  |            | 1,697   |   |  |   | (2,817 | )
|                                                                           |  |                        |         |           |  |            |         |   |  |   |        |  
|Other comprehensive income                                                 |  | $                      | 31,720  |           |  | $          | (11,941 | ) |  | $ | 19,779 |  
|                                                                           |  |                        |         |           |  |            |         |   |  |   |        |  
|2001:                                                                      |  |                        |         |           |  |            |         |   |  |   |        |  
|Change in unrealized gains on marketable
    securities                    |  | $                      | 21,589  |           |  | $          | (8,200  | ) |  | $ | 13,389 |  
|Less: reclassification adjustment for net gains
    realized in net income |  |                        | (13,650 | )         |  |            | 5,187   |   |  |   | (8,463 | )
|                                                                           |  |                        |         |           |  |            |         |   |  |   |        |  
|Other comprehensive income                                                 |  | $                      | 7,939   |           |  | $          | (3,013  | ) |  | $ | 4,926  |  
|                                                                           |  |                        |         |           |  |            |         |   |  |   |        |  



|    |                     
|--- | --------------------
|15. | Financial Guarantees

Certain of our domestic, unregulated
subsidiaries, which we refer to as the Initial Guarantor
Subsidiaries and certain subsidiaries of PacifiCare Health Plan
Administrators, Inc., or PHPA, which we refer to as the PHPA
Guarantor Subsidiaries, fully and unconditionally guarantee the
10 3/4% senior notes. Prior to September 15,
2003, the PHPA Guarantor Subsidiaries were restricted from
guaranteeing the 10 3/4% senior notes by the terms of
the FHP senior notes. As the FHP senior notes were repaid in
full on September 15, 2003, these subsidiaries now fully
and unconditionally guarantee the 10 3/4% senior
notes. The Initial Guarantor Subsidiaries and the PHPA Guarantor
Subsidiaries, excluding MEDeMORPHUS Healthcare Solutions, Inc.,
are also guarantors of our

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PACIFICARE HEALTH SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)

senior credit facility. The following unaudited
consolidating condensed financial statements quantify the
financial position as of December 31, 2002 and 2003 and the
operations and cash flows for the years ended December 31,
2001, 2002 and 2003 of the Initial Guarantor Subsidiaries and
the PHPA Guarantor Subsidiaries listed below. The following
unaudited consolidating condensed balance sheets, consolidating
condensed statements of operations and consolidating condensed
statements of cash flows present financial information for the
following entities and utilizing the following adjustments:

Parent
PacifiCare Health Systems, Inc. on a stand-alone basis (carrying
investments in subsidiaries under the equity method); PacifiCare
became the parent on February 14, 1997 effective with the
acquisition of FHP.

Initial Guarantor
Subsidiaries PHPA,
PacifiCare eHoldings, Inc., SeniorCo, Inc. and MEDeMORPHUS
Healthcare Solutions, Inc. on a stand-alone basis (carrying
investments in subsidiaries under the equity method.)

PHPA Guarantor
Subsidiaries RxSolutions,
Inc., doing business as Prescription Solutions, PacifiCare
Behavioral Health, Inc., and SecureHorizons USA, Inc. on a
stand-alone basis.

Non-Guarantor
Subsidiaries Represents
all other directly or indirectly wholly owned subsidiaries of
the Parent on a consolidated basis.

Consolidating
Adjustments Entries that
eliminate the investment in subsidiaries and intercompany
balances and transactions.

The
Company The financial
information for PacifiCare Health Systems, Inc. on a condensed
consolidated basis.

Provision For Income
Taxes PacifiCare and its
subsidiaries record the provision for income taxes in accordance
with an intercompany tax-sharing agreement. Income tax benefits
available to subsidiaries that arise from net operating losses
can only be used to offset the subsidiaries taxable income
from prior years in accordance with the Federal Tax Law and
taxable income in future periods.

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PACIFICARE HEALTH SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)

CONSOLIDATING CONDENSED STATEMENTS OF
OPERATIONS

For the Year Ended December 31,
2001


(Unaudited)


|                                                                                                            |                         |                |         |              |  |              |          |               |  |               |         |         |  |   |            |            |  |   |          |          |   |   |            |            | 
|----------------------------------------------------------------------------------------------------------- | ----------------------- | -------------- | ------- | ------------ |  | ------------ | -------- | ------------- |  | ------------- | ------- | ------- |  | - | ---------- | ---------- |  | - | -------- | -------- | - | - | ---------- | ---------- | 
|                                                                                                            |                         |                |         | Initial      |  | PHPA         |          |               |  |               |         |        
|                                                                                                            |                         |                |         | Guarantor    |  | Guarantor    |          | Non-Guarantor |  | Consolidating |         |        
|                                                                                                            |                         | Parent         |         | Subsidiaries |  | Subsidiaries |          | Subsidiaries  |  | Adjustments   |         | Company
|                                                                                                            |                         |                |         |              |  |              |          |               |  |               |         |        
|                                                                                                            |                         |               
|                                                                                                            |                         | (In thousands)
|Operating revenue                                                                                           |                         | $              | 176     |              |  | $            | 33,280   |               |  | $             | 447,687 |         |  | $ | 11,733,870 |            |  | $ | (371,041 | )        |   | $ | 11,843,972 |           
|Income from subsidiaries                                                                                    |                         |                | 82,535  |              |  |              | 153,982  |               |  |               |        |         |  |   | 16,109     |            |  |   | (252,626 | )        |   |   |           |           
|                                                                                                            |                         |                |         |              |  |              |          |               |  |               |         |         |  |   |            |            |  |   |          |          |   |   |            |           
|                                                                                                            | Total operating revenue |                |         | 82,711       |  |              |          | 187,262       |  |               |         | 447,687 |  |   |            | 11,749,979 |  |   |          | (623,667 | ) |   |            | 11,843,972 | 
|Health care services and other expenses                                                                     |                         |                |        |              |  |              | 320      |               |  |               | 294,709 |         |  |   | 10,416,632 |            |  |   | (344,004 | )        |   |   | 10,367,657 |           
|Selling, general and administrative expenses                                                                |                         |                | (724    | )            |  |              | 160,264  |               |  |               | 93,434  |         |  |   | 1,056,545  |            |  |   | (21,145  | )        |   |   | 1,288,374  |           
|Impairment, disposition, restructuring, Office of
    Personnel Management and other charges (credits), net |                         |                | 3,097   |              |  |              | 52,254   |               |  |               | 178     |         |  |   | 5,628      |            |  |   |         |          |   |   | 61,157     |           
|                                                                                                            |                         |                |         |              |  |              |          |               |  |               |         |         |  |   |            |            |  |   |          |          |   |   |            |           
|Operating income (loss)                                                                                     |                         |                | 80,338  |              |  |              | (25,576  | )             |  |               | 59,366  |         |  |   | 271,174    |            |  |   | (258,518 | )        |   |   | 126,784    |           
|Interest expense                                                                                            |                         |                | (61,332 | )            |  |              | (11,974  | )             |  |               | (62     | )       |  |   | (2,806     | )          |  |   | 5,892    |          |   |   | (70,282    | )         
|                                                                                                            |                         |                |         |              |  |              |          |               |  |               |         |         |  |   |            |            |  |   |          |          |   |   |            |           
|Income (loss) before income taxes                                                                           |                         |                | 19,006  |              |  |              | (37,550  | )             |  |               | 59,304  |         |  |   | 268,368    |            |  |   | (252,626 | )        |   |   | 56,502     |           
|(Benefit) provision for income taxes                                                                        |                         |                |        |              |  |              | (119,210 | )             |  |               | 29,440  |         |  |   | 128,141    |            |  |   |         |          |   |   | 38,371     |           
|                                                                                                            |                         |                |         |              |  |              |          |               |  |               |         |         |  |   |            |            |  |   |          |          |   |   |            |           
|Income before extraordinary gain                                                                            |                         |                | 19,006  |              |  |              | 81,660   |               |  |               | 29,864  |         |  |   | 140,227    |            |  |   | (252,626 | )        |   |   | 18,131     |           
|Extraordinary gain on early retirement of debt,
    net                                                     |                         |                |        |              |  |              | 875      |               |  |               |        |         |  |   |           |            |  |   |         |          |   |   | 875        |           
|                                                                                                            |                         |                |         |              |  |              |          |               |  |               |         |         |  |   |            |            |  |   |          |          |   |   |            |           
|Net income                                                                                                  |                         | $              | 19,006  |              |  | $            | 82,535   |               |  | $             | 29,864  |         |  | $ | 140,227    |            |  | $ | (252,626 | )        |   | $ | 19,006     |           
|                                                                                                            |                         |                |         |              |  |              |          |               |  |               |         |         |  |   |            |            |  |   |          |          |   |   |            |           

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PACIFICARE HEALTH SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)

CONSOLIDATING CONDENSED STATEMENTS OF CASH
FLOWS

For the Year Ended December 31,
2001


(Unaudited)


|                                                    |                                                                                                       |                                                                                                             |                                                               |              |         |              |         |               |          |               |         |         |         |        |           |          |          |          |   |          |         |   |           |          |          |          |  
|--------------------------------------------------- | ----------------------------------------------------------------------------------------------------- | ----------------------------------------------------------------------------------------------------------- | ------------------------------------------------------------- | ------------ | ------- | ------------ | ------- | ------------- | -------- | ------------- | ------- | ------- | ------- | ------ | --------- | -------- | -------- | -------- | - | -------- | ------- | - | --------- | -------- | -------- | -------- | -
|                                                    |                                                                                                       |                                                                                                             |                                                               | Initial      |         | PHPA         |         |               |          |               |         |        
|                                                    |                                                                                                       |                                                                                                             |                                                               | Guarantor    |         | Guarantor    |         | Non-Guarantor |          | Consolidating |         |        
|                                                    |                                                                                                       | Parent                                                                                                      |                                                               | Subsidiaries |         | Subsidiaries |         | Subsidiaries  |          | Adjustments   |         | Company
|                                                    |                                                                                                       |                                                                                                             |                                                               |              |         |              |         |               |          |               |         |        
|                                                    |                                                                                                       |                                                                                                            
|                                                    |                                                                                                       | (In thousands)                                                                                             
|Operating activities:                               |                                                                                                       |                                                                                                             |                                                               |              |         |              |         |               |          |               |         |         |         |        |           |          |          |          |   |          |         |   |           |         
|                                                    | Net income                                                                                            |                                                                                                             | $                                                             | 19,006       |         |              | $       | 82,535        |          |               | $       | 29,864  |         |        | $         | 140,227  |          |          | $ | (252,626 | )       |   | $         | 19,006   |         
|                                                    | Adjustments to reconcile net income to net cash
    flows provided by (used in) operating activities: |                                                                                                             |                                                               |              |         |              |         |               |          |               |         |         |         |        |           |          |          |          |   |          |         |   |           |          |         
|                                                    |                                                                                                       | Equity in income of subsidiaries                                                                            |                                                               |              | (82,535 | )            |         |               | (153,982 | )             |         |         |        |        |           |          | (16,109  | )        |   |          | 252,626 |   |           |          |         |         
|                                                    |                                                                                                       | Amortization of goodwill and intangible assets                                                              |                                                               |              |        |              |         |               | 29,588   |               |         |         | 499     |        |           |          | 52,809   |          |   |          |        |   |           |          | 82,896   |         
|                                                    |                                                                                                       | Depreciation and amortization                                                                               |                                                               |              |        |              |         |               | 48,063   |               |         |         | 5,507   |        |           |          | 12,238   |          |   |          |        |   |           |          | 65,808   |         
|                                                    |                                                                                                       | Impairment, disposition, restructuring, Office of
    Personnel Management and other charges (credits), net |                                                               |              | 3,097   |              |         |               | 52,254   |               |         |         | 178     |        |           |          | 5,628    |          |   |          |        |   |           |          | 61,157   |         
|                                                    |                                                                                                       | Provision for doubtful accounts                                                                             |                                                               |              |        |              |         |               |         |               |         |         | 47      |        |           |          | 22,023   |          |   |          |        |   |           |          | 22,070   |         
|                                                    |                                                                                                       | Amortization of capitalized loan fees                                                                       |                                                               |              | 7,560   |              |         |               |         |               |         |         |        |        |           |          |         |          |   |          |        |   |           |          | 7,560    |         
|                                                    |                                                                                                       | (Gain) loss on disposal of property, plant and
    equipment and other                                      |                                                               |              |        |              |         |               | (1,141   | )             |         |         | (134    | )      |           |          | 7,328    |          |   |          |        |   |           |          | 6,053    |         
|                                                    |                                                                                                       | Deferred income taxes                                                                                       |                                                               |              |        |              |         |               | (14,473  | )             |         |         | 1,112   |        |           |          | 9,395    |          |   |          |        |   |           |          | (3,966   | )       
|                                                    |                                                                                                       | Stock-based compensation expense                                                                            |                                                               |              | 3,632   |              |         |               |         |               |         |         |        |        |           |          |         |          |   |          |        |   |           |          | 3,632    |         
|                                                    |                                                                                                       | Gain on early retirement of debt, net                                                                       |                                                               |              |        |              |         |               | (1,800   | )             |         |         |        |        |           |          |         |          |   |          |        |   |           |          | (1,800   | )       
|                                                    |                                                                                                       | Tax benefit realized for stock option exercises                                                             |                                                               |              | 21      |              |         |               |         |               |         |         |        |        |           |          |         |          |   |          |        |   |           |          | 21       |         
|                                                    |                                                                                                       | Changes in assets and liabilities, net of effects
    from acquisitions and dispositions                    |                                                               |              | 110,907 |              |         |               | (90,283  | )             |         |         | (40,875 | )      |           |          | (203,263 | )        |   |          |        |   |           |          | (223,514 | )       
|                                                    |                                                                                                       |                                                                                                             |                                                               |              |         |              |         |               |          |               |         |         |         |        |           |          |          |          |   |          |         |   |           |         
|                                                    |                                                                                                       |                                                                                                             | Net cash flows provided by (used in) operating
    activities |              |         | 61,688       |         |               |          | (49,239       | )       |         |         | (3,802 | )         |          |          | 30,276   |   |          |         |  |           |          |          | 38,923   |  
|                                                    |                                                                                                       |                                                                                                             |                                                               |              |         |              |         |               |          |               |         |         |         |        |           |          |          |          |   |          |         |   |           |         
|Investing activities:                               |                                                                                                       |                                                                                                             |                                                               |              |         |              |         |               |          |               |         |         |         |        |           |          |          |          |   |          |         |   |           |         
|                                                    | (Purchase) sale of marketable securities, net                                                         |                                                                                                             |                                                               | (10,001      | )       |              |         | 32,004        |          |               |         |        |         |        |           | (212,404 | )        |          |   |         |         |   |           | (190,401 | )       
|                                                    | Purchase of property, plant and equipment                                                             |                                                                                                             |                                                               |             |         |              |         | (55,735       | )        |               |         | (3,369  | )       |        |           | (18,197  | )        |          |   |         |         |   |           | (77,301  | )       
|                                                    | Proceeds from sale of property, plant and
    equipment                                               |                                                                                                             |                                                               |             |         |              |         | 25,139        |          |               |         |        |         |        |           |         |          |          |   |         |         |   |           | 25,139   |         
|                                                    | Sale (purchase) of marketable
    securities-restricted, net                                          |                                                                                                             |                                                               |             |         |              |         | 10            |          |               |         |        |         |        |           | (17,775  | )        |          |   |         |         |   |           | (17,765  | )       
|                                                    | Net cash (paid for) acquired from acquisitions                                                        |                                                                                                             |                                                               |             |         |              |         | (873          | )        |               |         |        |         |        |           | 373      |          |          |   |         |         |   |           | (500     | )       
|                                                    |                                                                                                       |                                                                                                             |                                                               |              |         |              |         |               |          |               |         |         |         |        |           |          |          |          |   |          |         |   |           |         
|                                                    |                                                                                                       |                                                                                                             | Net cash flows (used in) provided by investing
    activities |              |         | (10,001      | )       |               |          | 545           |         |         |         | (3,369 | )         |          |          | (248,003 | ) |          |         |  |           |          |          | (260,828 | )
|                                                    |                                                                                                       |                                                                                                             |                                                               |              |         |              |         |               |          |               |         |         |         |        |           |          |          |          |   |          |         |   |           |         
|Financing activities:                               |                                                                                                       |                                                                                                             |                                                               |              |         |              |         |               |          |               |         |         |         |        |           |          |          |          |   |          |         |   |           |         
|                                                    | Principal payments on long-term debt                                                                  |                                                                                                             |                                                               | (30,000      | )       |              |         |              |          |               |         |        |         |        |           | (284     | )        |          |   |         |         |   |           | (30,284  | )       
|                                                    | Credit facility amendment fees and expenses                                                           |                                                                                                             |                                                               | (12,949      | )       |              |         |              |          |               |         |        |         |        |           |         |          |          |   |         |         |   |           | (12,949  | )       
|                                                    | Purchase of minority interest in consolidated
    subsidiary                                          |                                                                                                             |                                                               | (8,821       | )       |              |         |              |          |               |         |        |         |        |           |         |          |          |   |         |         |   |           | (8,821   | )       
|                                                    | Proceeds from issuance of common and treasury
    stock                                               |                                                                                                             |                                                               | 83           |         |              |         |              |          |               |         |        |         |        |           |         |          |          |   |         |         |   |           | 83       |         
|                                                    | Intercompany activity:                                                                                |                                                                                                             |                                                               |              |         |              |         |               |          |               |         |         |         |        |           |          |          |          |   |          |         |   |           |          |         
|                                                    |                                                                                                       | Royalty dividends and loans received (paid)                                                                 |                                                               |              |        |              |         |               | 161,439  |               |         |         |        |        |           |          | (161,439 | )        |   |          |        |   |           |          |         |         
|                                                    |                                                                                                       | Dividends received (paid)                                                                                   |                                                               |              |        |              |         |               | 42,300   |               |         |         |        |        |           |          | (42,300  | )        |   |          |        |   |           |          |         |         
|                                                    |                                                                                                       | Subordinated loans (paid) received                                                                          |                                                               |              |        |              |         |               | (99,536  | )             |         |         |        |        |           |          | 99,536   |          |   |          |        |   |           |          |         |         
|                                                    |                                                                                                       |                                                                                                             |                                                               |              |         |              |         |               |          |               |         |         |         |        |           |          |          |          |   |          |         |   |           |         
|                                                    |                                                                                                       |                                                                                                             | Net cash flows (used in) provided by financing
    activities |              |         | (51,687      | )       |               |          | 104,203       |         |         |         |       |           |          |          | (104,487 | ) |          |         |  |           |          |          | (51,971  | )
|                                                    |                                                                                                       |                                                                                                             |                                                               |              |         |              |         |               |          |               |         |         |         |        |           |          |          |          |   |          |         |   |           |         
|Net increase (decrease) in cash and
    equivalents |                                                                                                       |                                                                                                             |                                                              |              |         |              | 55,509  |               |          |               | (7,171  | )       |         |        | (322,214  | )        |          |          |  |          |         |   | (273,876  | )       
|Beginning cash and equivalents                      |                                                                                                       |                                                                                                             |                                                               |              |         |              | 54,826  |               |          |               | (67,580 | )       |         |        | 1,264,389 |          |          |          |   |          |         |   | 1,251,635 |         
|                                                    |                                                                                                       |                                                                                                             |                                                               |              |         |              |         |               |          |               |         |         |         |        |           |          |          |          |   |          |         |   |           |         
|Ending cash and equivalents                         |                                                                                                       | $                                                                                                           |                                                              |              |         | $            | 110,335 |               |          | $             | (74,751 | )       |         | $      | 942,175   |          |          | $        |  |          |         | $ | 977,759   |         
|                                                    |                                                                                                       |                                                                                                             |                                                               |              |         |              |         |               |          |               |         |         |         |        |           |          |          |          |   |          |         |   |           |         

F-35



---



##### Table of Contents



PACIFICARE HEALTH SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)

CONSOLIDATING CONDENSED BALANCE
SHEETS

December 31, 2002


|                                           |                                                 |                            |           |              |           |              |           |               |           |               |         |         |         |   |           |           |           |   |            |            |            |   |           |           |           | 
|------------------------------------------ | ----------------------------------------------- | -------------------------- | --------- | ------------ | --------- | ------------ | --------- | ------------- | --------- | ------------- | ------- | ------- | ------- | - | --------- | --------- | --------- | - | ---------- | ---------- | ---------- | - | --------- | --------- | --------- | 
|                                           |                                                 |                            |           | Initial      |           | PHPA         |           |               |           |               |         |        
|                                           |                                                 |                            |           | Guarantor    |           | Guarantor    |           | Non-Guarantor |           | Consolidating |         |        
|                                           |                                                 | Parent                     |           | Subsidiaries |           | Subsidiaries |           | Subsidiaries  |           | Adjustments   |         | Company
|                                           |                                                 |                            |           |              |           |              |           |               |           |               |         |        
|                                           |                                                 |                           
|                                           |                                                 | (in thousands)            
|ASSETS                                    
|Current assets:                            |                                                 |                            |           |              |           |              |           |               |           |               |         |         |         |   |           |           |           |   |            |            |            |   |           |          
|                                           | Cash and equivalents                            |                            | $         | 16,207       |           |              | $         | 151,973       |           |               | $       | (47,595 | )       |   | $         | 831,104   |           |   | $          |           |            |   | $         | 951,689   |          
|                                           | Marketable securities                           |                            |           |             |           |              |           |              |           |               |         |        |         |   |           | 1,195,517 |           |   |            |           |            |   |           | 1,195,517 |          
|                                           | Receivables, net                                |                            |           | 33           |           |              |           | (44,362       | )         |               |         | 124,077 |         |   |           | 218,523   |           |   |            | (8,371     | )          |   |           | 289,900   |          
|                                           | Intercompany                                    |                            |           | (537,199     | )         |              |           | 415,167       |           |               |         | 137,002 |         |   |           | (14,970   | )         |   |            |           |            |   |           |          |          
|                                           | Prepaid expenses and other current assets       |                            |           | 1,015        |           |              |           | 24,853        |           |               |         | 8,596   |         |   |           | 16,073    |           |   |            | (3,732     | )          |   |           | 46,805    |          
|                                           | Restricted cash collateral for FHP senior notes |                            |           | 43,346       |           |              |           |              |           |               |         |        |         |   |           |          |           |   |            |           |            |   |           | 43,346    |          
|                                           | Deferred income taxes                           |                            |           |             |           |              |           | 61,399        |           |               |         | 3,508   |         |   |           | 63,108    |           |   |            | (27,257    | )          |   |           | 100,758   |          
|                                           |                                                 |                            |           |              |           |              |           |               |           |               |         |         |         |   |           |           |           |   |            |            |            |   |           |          
|                                           |                                                 | Total current assets       |           |              | (476,598  | )            |           |               | 609,030   |               |         |         | 225,588 |   |           |           | 2,309,355 |   |            |            | (39,360    | ) |           |           | 2,628,015 | 
|                                           |                                                 |                            |           |              |           |              |           |               |           |               |         |         |         |   |           |           |           |   |            |            |            |   |           |          
|Property, plant and equipment at cost, net |                                                 |                            |          |              |           |              | 99,610    |               |           |               | 17,890  |         |         |   | 44,185    |           |           |   |           |            |            |   | 161,685   |          
|Marketable securities  restricted         |                                                 |                            | 34,812    |              |           |              |          |               |           |               |        |         |         |   | 151,377   |           |           |   |           |            |            |   | 186,189   |          
|Deferred income taxes                      |                                                 |                            |          |              |           |              | 72,141    |               |           |               | 6,654   |         |         |   | 23,090    |           |           |   | (101,885   | )          |            |   |          |          
|Investment in subsidiaries                 |                                                 |                            | 2,513,858 |              |           |              | 1,555,158 |               |           |               | 13,264  |         |         |   | (15,453   | )         |           |   | (4,066,827 | )          |            |   |          |          
|Goodwill and intangible assets, net        |                                                 |                            |          |              |           |              | 11,923    |               |           |               | 16,480  |         |         |   | 1,197,717 |           |           |   |           |            |            |   | 1,226,120 |          
|Other assets                               |                                                 |                            | 22,615    |              |           |              | 25,533    |               |           |               | 1       |         |         |   | 975       |           |           |   |           |            |            |   | 49,124    |          
|                                           |                                                 |                            |           |              |           |              |           |               |           |               |         |         |         |   |           |           |           |   |            |            |            |   |           |          
|                                           |                                                 | $                          | 2,094,687 |              |           | $            | 2,373,395 |               |           | $             | 279,877 |         |         | $ | 3,711,246 |           |           | $ | (4,208,072 | )          |            | $ | 4,251,133 |          
|                                           |                                                 |                            |           |              |           |              |           |               |           |               |         |         |         |   |           |           |           |   |            |            |            |   |           |          
|LIABILITIES AND STOCKHOLDERS
    EQUITY  
|Current liabilities:                       |                                                 |                            |           |              |           |              |           |               |           |               |         |         |         |   |           |           |           |   |            |            |            |   |           |          
|                                           | Medical claims and benefits payable             |                            | $         |             |           |              | $         | 17,929        |           |               | $       | 36,522  |         |   | $         | 995,509   |           |   | $          | (5,460     | )          |   | $         | 1,044,500 |          
|                                           | Accounts payable and accrued liabilities        |                            |           | 5,313        |           |              |           | 253,597       |           |               |         | 47,971  |         |   |           | 135,434   |           |   |            | (3,673     | )          |   |           | 438,642   |          
|                                           | Deferred income taxes                           |                            |           |             |           |              |           | 15,487        |           |               |         | 553     |         |   |           | 11,217    |           |   |            | (27,257    | )          |   |           |          |          
|                                           | Unearned premium revenue                        |                            |           |             |           |              |           | 200           |           |               |         | 1,353   |         |   |           | 480,970   |           |   |            | (2,971     | )          |   |           | 479,552   |          
|                                           | Current portion of long-term debt               |                            |           | 60,484       |           |              |           | 46,546        |           |               |         |        |         |   |           | 205       |           |   |            |           |            |   |           | 107,235   |          
|                                           |                                                 |                            |           |              |           |              |           |               |           |               |         |         |         |   |           |           |           |   |            |            |            |   |           |          
|                                           |                                                 | Total current liabilities  |           |              | 65,797    |              |           |               | 333,759   |               |         |         | 86,399  |   |           |           | 1,623,335 |   |            |            | (39,361    | ) |           |           | 2,069,929 | 
|                                           |                                                 |                            |           |              |           |              |           |               |           |               |         |         |         |   |           |           |           |   |            |            |            |   |           |          
|Long-term debt                             |                                                 |                            | 587,315   |              |           |              | 8,109     |               |           |               |        |         |         |   | 1,537     |           |           |   |           |            |            |   | 596,961   |          
|Convertible subordinated debentures        |                                                 |                            | 135,000   |              |           |              |          |               |           |               |        |         |         |   |          |           |           |   |           |            |            |   | 135,000   |          
|Deferred income taxes                      |                                                 |                            |          |              |           |              | 100,833   |               |           |               | 8,445   |         |         |   | 96,397    |           |           |   | (101,885   | )          |            |   | 103,790   |          
|Other liabilities                          |                                                 |                            |          |              |           |              | 17,148    |               |           |               |        |         |         |   |          |           |           |   |           |            |            |   | 17,148    |          
|Stockholders equity:                      |                                                 |                            |           |              |           |              |           |               |           |               |         |         |         |   |           |           |           |   |            |            |            |   |           |          
|                                           | Capital stock                                   |                            |           | 954          |           |              |           |              |           |               |         |        |         |   |           |          |           |   |            |           |            |   |           | 954       |          
|                                           | Unearned compensation                           |                            |           | (2,000       | )         |              |           |              |           |               |         |        |         |   |           |          |           |   |            |           |            |   |           | (2,000    | )        
|                                           | Additional paid-in capital                      |                            |           | 1,560,308    |           |              |           |              |           |               |         |        |         |   |           |          |           |   |            |           |            |   |           | 1,560,308 |          
|                                           | Accumulated other comprehensive income          |                            |           |             |           |              |           |              |           |               |         |        |         |   |           | 21,730    |           |   |            |           |            |   |           | 21,730    |          
|                                           | Retained earnings                               |                            |           | 350,369      |           |              |           |              |           |               |         |        |         |   |           |          |           |   |            |           |            |   |           | 350,369   |          
|                                           | Treasury stock                                  |                            |           | (603,056     | )         |              |           |              |           |               |         |        |         |   |           |          |           |   |            |           |            |   |           | (603,056  | )        
|                                           | Equity in income of subsidiaries                |                            |           |             |           |              |           | 1,913,546     |           |               |         | 185,033 |         |   |           | 1,968,247 |           |   |            | (4,066,826 | )          |   |           |          |          
|                                           |                                                 |                            |           |              |           |              |           |               |           |               |         |         |         |   |           |           |           |   |            |            |            |   |           |          
|                                           |                                                 | Total stockholders equity |           |              | 1,306,575 |              |           |               | 1,913,546 |               |         |         | 185,033 |   |           |           | 1,989,977 |   |            |            | (4,066,826 | ) |           |           | 1,328,305 | 
|                                           |                                                 |                            |           |              |           |              |           |               |           |               |         |         |         |   |           |           |           |   |            |            |            |   |           |          
|                                           |                                                 | $                          | 2,094,687 |              |           | $            | 2,373,395 |               |           | $             | 279,877 |         |         | $ | 3,711,246 |           |           | $ | (4,208,072 | )          |            | $ | 4,251,133 |          
|                                           |                                                 |                            |           |              |           |              |           |               |           |               |         |         |         |   |           |           |           |   |            |            |            |   |           |          

F-36



---



##### Table of Contents



PACIFICARE HEALTH SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)

CONSOLIDATING CONDENSED STATEMENTS OF
OPERATIONS

For the Year Ended December 31,
2002


(Unaudited)


|                                                                                                            |                         |                |          |              |   |              |          |               |   |               |         |         |  |   |            |            |  |   |           |         |  |   |            |            | 
|----------------------------------------------------------------------------------------------------------- | ----------------------- | -------------- | -------- | ------------ | - | ------------ | -------- | ------------- | - | ------------- | ------- | ------- |  | - | ---------- | ---------- |  | - | --------- | ------- |  | - | ---------- | ---------- | 
|                                                                                                            |                         |                |          | Initial      |   | PHPA         |          |               |   |               |         |        
|                                                                                                            |                         |                |          | Guarantor    |   | Guarantor    |          | Non-Guarantor |   | Consolidating |         |        
|                                                                                                            |                         | Parent         |          | Subsidiaries |   | Subsidiaries |          | Subsidiaries  |   | Adjustments   |         | Company
|                                                                                                            |                         |                |          |              |   |              |          |               |   |               |         |        
|                                                                                                            |                         |               
|                                                                                                            |                         | (In thousands)
|Operating revenue                                                                                           |                         | $              | (10,346  | )            |   | $            | 29,204   |               |   | $             | 450,770 |         |  | $ | 11,027,550 |            |  | $ | (340,676  | )       |  | $ | 11,156,502 |           
|Income from subsidiaries                                                                                    |                         |                | (661,977 | )            |   |              | (556,987 | )             |   |               |        |         |  |   | (4,591     | )          |  |   | 1,223,555 |         |  |   |           |           
|                                                                                                            |                         |                |          |              |   |              |          |               |   |               |         |         |  |   |            |            |  |   |           |         |  |   |            |           
|                                                                                                            | Total operating revenue |                |          | (672,323     | ) |              |          | (527,783      | ) |               |         | 450,770 |  |   |            | 11,022,959 |  |   |           | 882,879 |  |   |            | 11,156,502 | 
|Health care services and other expenses                                                                     |                         |                |         |              |   |              | 19,101   |               |   |               | 295,370 |         |  |   | 9,491,872  |            |  |   | (320,642  | )       |  |   | 9,485,701  |           
|Selling, general and administrative expenses                                                                |                         |                | (121     | )            |   |              | 261,742  |               |   |               | 98,799  |         |  |   | 1,026,808  |            |  |   | (17,068   | )       |  |   | 1,370,160  |           
|Impairment, disposition, restructuring, Office of
    Personnel Management and other charges (credits), net |                         |                | 18,162   |              |   |              | (12,687  | )             |   |               | (89     | )       |  |   | (1,612     | )          |  |   |          |         |  |   | 3,774      |           
|                                                                                                            |                         |                |          |              |   |              |          |               |   |               |         |         |  |   |            |            |  |   |           |         |  |   |            |           
|Operating income                                                                                            |                         |                | (690,364 | )            |   |              | (795,939 | )             |   |               | 56,690  |         |  |   | 505,891    |            |  |   | 1,220,589 |         |  |   | 296,867    |           
|Interest expense                                                                                            |                         |                | (67,465  | )            |   |              | (7,728   | )             |   |               |        |         |  |   | (2,677     | )          |  |   | 2,966     |         |  |   | (74,904    | )         
|                                                                                                            |                         |                |          |              |   |              |          |               |   |               |         |         |  |   |            |            |  |   |           |         |  |   |            |           
|Income before income taxes                                                                                  |                         |                | (757,829 | )            |   |              | (803,667 | )             |   |               | 56,690  |         |  |   | 503,214    |            |  |   | 1,223,555 |         |  |   | 221,963    |           
|(Benefit) provision for income taxes                                                                        |                         |                |         |              |   |              | (141,413 | )             |   |               | 22,275  |         |  |   | 201,930    |            |  |   |          |         |  |   | 82,792     |           
|                                                                                                            |                         |                |          |              |   |              |          |               |   |               |         |         |  |   |            |            |  |   |           |         |  |   |            |           
|(Loss) income before cumulative effect of a
    change in accounting principle                              |                         |                | (757,829 | )            |   |              | (662,254 | )             |   |               | 34,415  |         |  |   | 301,284    |            |  |   | 1,223,555 |         |  |   | 139,171    |           
|Cumulative effect of a change in accounting
    principle                                                   |                         |                |         |              |   |              |         |               |   |               |        |         |  |   | (897,000   | )          |  |   |          |         |  |   | (897,000   | )         
|                                                                                                            |                         |                |          |              |   |              |          |               |   |               |         |         |  |   |            |            |  |   |           |         |  |   |            |           
|Net (loss) income                                                                                           |                         | $              | (757,829 | )            |   | $            | (662,254 | )             |   | $             | 34,415  |         |  | $ | (595,716   | )          |  | $ | 1,223,555 |         |  | $ | (757,829   | )         
|                                                                                                            |                         |                |          |              |   |              |          |               |   |               |         |         |  |   |            |            |  |   |           |         |  |   |            |           

F-37



---



##### Table of Contents



PACIFICARE HEALTH SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)

CONSOLIDATING CONDENSED STATEMENTS OF CASH
FLOWS

For the Year Ended December 31,
2002


(Unaudited)


|                                                    |                                                                                                       |                                                                                                             |                                                               |              |         |              |         |               |         |               |         |         |        |        |          |          |          |          |   |           |            |   |         |          |         |          |  
|--------------------------------------------------- | ----------------------------------------------------------------------------------------------------- | ----------------------------------------------------------------------------------------------------------- | ------------------------------------------------------------- | ------------ | ------- | ------------ | ------- | ------------- | ------- | ------------- | ------- | ------- | ------ | ------ | -------- | -------- | -------- | -------- | - | --------- | ---------- | - | ------- | -------- | ------- | -------- | -
|                                                    |                                                                                                       |                                                                                                             |                                                               | Initial      |         | PHPA         |         |               |         |               |         |        
|                                                    |                                                                                                       |                                                                                                             |                                                               | Guarantor    |         | Guarantor    |         | Non-Guarantor |         | Consolidating |         |        
|                                                    |                                                                                                       | Parent                                                                                                      |                                                               | Subsidiaries |         | Subsidiaries |         | Subsidiaries  |         | Adjustments   |         | Company
|                                                    |                                                                                                       |                                                                                                             |                                                               |              |         |              |         |               |         |               |         |        
|                                                    |                                                                                                       |                                                                                                            
|                                                    |                                                                                                       | (In thousands)                                                                                             
|Operating activities:                               |                                                                                                       |                                                                                                             |                                                               |              |         |              |         |               |         |               |         |         |        |        |          |          |          |          |   |           |            |   |         |         
|                                                    | Net (loss) income                                                                                     |                                                                                                             | $                                                             | (757,829     | )       |              | $       | (662,254      | )       |               | $       | 34,415  |        |        | $        | (595,716 | )        |          | $ | 1,223,555 |            |   | $       | (757,829 | )      
|                                                    | Adjustments to reconcile net income to net cash
    flows provided by (used in) operating activities: |                                                                                                             |                                                               |              |         |              |         |               |         |               |         |         |        |        |          |          |          |          |   |           |            |   |         |          |        
|                                                    |                                                                                                       | Equity in income of subsidiaries                                                                            |                                                               |              | 661,977 |              |         |               | 556,987 |               |         |         |       |        |          |          | 4,591    |          |   |           | (1,223,555 | ) |         |          |        |         
|                                                    |                                                                                                       | Cumulative effect of a change in accounting
    principle                                                   |                                                               |              |        |              |         |               |        |               |         |         |       |        |          |          | 897,000  |          |   |           |            |   |         |          | 897,000 |         
|                                                    |                                                                                                       | Amortization of intangible assets                                                                           |                                                               |              |        |              |         |               | 1,249   |               |         |         |       |        |          |          | 22,351   |          |   |           |            |   |         |          | 23,600  |         
|                                                    |                                                                                                       | Deferred income taxes                                                                                       |                                                               |              |        |              |         |               | (3,064  | )             |         |         | 199    |        |          |          | 21,424   |          |   |           |            |   |         |          | 18,559  |         
|                                                    |                                                                                                       | (Gain) loss on disposal of property, plant and
    equipment                                                |                                                               |              |        |              |         |               | 15,792  |               |         |         | 21     |        |          |          | (3,020   | )        |   |           |           |   |         |          | 12,793  |         
|                                                    |                                                                                                       | Marketable and other securities impairment for
    other than temporary declines in value                   |                                                               |              | 11,001  |              |         |               |        |               |         |         |       |        |          |          | 1,542    |          |   |           |           |   |         |          | 12,543  |         
|                                                    |                                                                                                       | Employee benefit plan contributions in treasury
    stock                                                   |                                                               |              | 12,132  |              |         |               |        |               |         |         |       |        |          |          |         |          |   |           |           |   |         |          | 12,132  |         
|                                                    |                                                                                                       | Amortization of capitalized loan fees                                                                       |                                                               |              | 7,784   |              |         |               |        |               |         |         |       |        |          |          |         |          |   |           |           |   |         |          | 7,784   |         
|                                                    |                                                                                                       | Provision for doubtful accounts                                                                             |                                                               |              |        |              |         |               |        |               |         |         | 329    |        |          |          | 6,017    |          |   |           |            |   |         |          | 6,346   |         
|                                                    |                                                                                                       | Impairment, disposition, restructuring, Office of
    Personnel Management and other charges (credits), net |                                                               |              | 18,162  |              |         |               | (12,687 | )             |         |         | (89    | )      |          |          | (1,612   | )        |   |           |            |   |         |          | 3,774   |         
|                                                    |                                                                                                       | Amortization of notes receivable from sale of
    fixed assets                                              |                                                               |              |        |              |         |               | (3,107  | )             |         |         |       |        |          |          |         |          |   |           |           |   |         |          | (3,107  | )       
|                                                    |                                                                                                       | Tax benefit realized for stock option exercises                                                             |                                                               |              | 1,009   |              |         |               |        |               |         |         |       |        |          |          |         |          |   |           |           |   |         |          | 1,009   |         
|                                                    |                                                                                                       | Stock-based compensation expense                                                                            |                                                               |              | 693     |              |         |               |        |               |         |         |       |        |          |          |         |          |   |           |           |   |         |          | 693     |         
|                                                    |                                                                                                       | Amortization of discount on
    10 3/4% senior notes                                                        |                                                               |              | 266     |              |         |               |        |               |         |         |       |        |          |          |         |          |   |           |           |   |         |          | 266     |         
|                                                    |                                                                                                       | Adjustment to cash received in purchase
    transaction                                                     |                                                               |              |        |              |         |               | 17      |               |         |         |       |        |          |          |         |          |   |           |           |   |         |          | 17      |         
|                                                    |                                                                                                       | Depreciation and amortization                                                                               |                                                               |              |        |              |         |               | 33,281  |               |         |         | 6,100  |        |          |          | 10,903   |          |   |           |           |   |         |          | 50,284  |         
|                                                    |                                                                                                       | Changes in assets and liabilities                                                                           |                                                               |              | 84,815  |              |         |               | (64,224 | )             |         |         | (9,918 | )      |          |          | (54,158  | )        |   |           |           |   |         |          | (43,485 | )       
|                                                    |                                                                                                       |                                                                                                             |                                                               |              |         |              |         |               |         |               |         |         |        |        |          |          |          |          |   |           |            |   |         |         
|                                                    |                                                                                                       |                                                                                                             | Net cash flows provided by (used in) operating
    activities |              |         | 40,010       |         |               |         | (138,010      | )       |         |        | 31,057 |          |          |          | 309,322  |   |           |            |  |         |          |         | 242,379  |  
|                                                    |                                                                                                       |                                                                                                             |                                                               |              |         |              |         |               |         |               |         |         |        |        |          |          |          |          |   |           |            |   |         |         
|Investing activities:                               |                                                                                                       |                                                                                                             |                                                               |              |         |              |         |               |         |               |         |         |        |        |          |          |          |          |   |           |            |   |         |         
|                                                    | Purchase of marketable securities-restricted                                                          |                                                                                                             |                                                               | (78,158      | )       |              |         |              |         |               |         |        |        |        |          | (39,210  | )        |          |   |          |            |   |         | (117,368 | )      
|                                                    | Purchase of marketable securities, net                                                                |                                                                                                             |                                                               |             |         |              |         |              |         |               |         |        |        |        |          | (113,987 | )        |          |   |          |            |   |         | (113,987 | )      
|                                                    | Purchase of property, plant and equipment                                                             |                                                                                                             |                                                               |             |         |              |         | (47,596       | )       |               |         | (3,901  | )      |        |          | (7,777   | )        |          |   |          |            |   |         | (59,274  | )      
|                                                    | Proceeds from the sale of property, plant and
    equipment                                           |                                                                                                             |                                                               |             |         |              |         | 104           |         |               |         |        |        |        |          | 12,388   |          |          |   |          |            |   |         | 12,492   |        
|                                                    |                                                                                                       |                                                                                                             |                                                               |              |         |              |         |               |         |               |         |         |        |        |          |          |          |          |   |           |            |   |         |         
|                                                    |                                                                                                       |                                                                                                             | Net cash flows used in investing activities                   |              |         | (78,158      | )       |               |         | (47,492       | )       |         |        | (3,901 | )        |          |          | (148,586 | ) |           |            |  |         |          |         | (278,137 | )
|                                                    |                                                                                                       |                                                                                                             |                                                               |              |         |              |         |               |         |               |         |         |        |        |          |          |          |          |   |           |            |   |         |         
|Financing activities:                               |                                                                                                       |                                                                                                             |                                                               |              |         |              |         |               |         |               |         |         |        |        |          |          |          |          |   |           |            |   |         |         
|                                                    | Principal payments on long-term debt                                                                  |                                                                                                             |                                                               | (554,412     | )       |              |         |              |         |               |         |        |        |        |          | 104      |          |          |   |          |            |   |         | (554,308 | )      
|                                                    | Proceeds from borrowings of long-term debt                                                            |                                                                                                             |                                                               | 496,945      |         |              |         |              |         |               |         |        |        |        |          |         |          |          |   |          |            |   |         | 496,945  |        
|                                                    | Proceeds from issuance of convertible
    subordinated debentures                                     |                                                                                                             |                                                               | 135,000      |         |              |         |               |         |               |         |        |        |        |          |         |          |          |   |          |            |   |         | 135,000  |        
|                                                    | Principal payments on FHP senior notes                                                                |                                                                                                             |                                                               |             |         |              |         | (41,750       | )       |               |         |        |        |        |          |         |          |          |   |          |            |   |         | (41,750  | )      
|                                                    | Credit facility amendment fees and expenses                                                           |                                                                                                             |                                                               | (37,789      | )       |              |         |              |         |               |         |        |        |        |          |         |          |          |   |          |            |   |         | (37,789  | )      
|                                                    | Proceeds from draw down under equity commitment
    arrangement                                       |                                                                                                             |                                                               | 8,928        |         |              |         |              |         |               |         |        |        |        |          |         |          |          |   |          |            |   |         | 8,928    |        
|                                                    | Proceeds from issuance of common and treasury
    stock                                               |                                                                                                             |                                                               | 4,893        |         |              |         |              |         |               |         |        |        |        |          |         |          |          |   |          |            |   |         | 4,893    |        
|                                                    | Payments on software financing agreement                                                              |                                                                                                             |                                                               |             |         |              |         | (2,231        | )       |               |         |        |        |        |          |         |          |          |   |          |            |   |         | (2,231   | )      
|                                                    | Intercompany activity:                                                                                |                                                                                                             |                                                               |              |         |              |         |               |         |               |         |         |        |        |          |          |          |          |   |           |            |   |         |          |        
|                                                    |                                                                                                       | Dividends received (paid)                                                                                   |                                                               |              | 790     |              |         |               | 143,399 |               |         |         |       |        |          |          | (144,189 | )        |   |           |           |   |         |          |        |         
|                                                    |                                                                                                       | Royalty dividends and loans received (paid)                                                                 |                                                               |              |        |              |         |               | 117,613 |               |         |         |       |        |          |          | (117,613 | )        |   |           |           |   |         |          |        |         
|                                                    |                                                                                                       | Subordinated loans (paid) received                                                                          |                                                               |              |        |              |         |               | (17,179 | )             |         |         |       |        |          |          | 17,179   |          |   |           |           |   |         |          |        |         
|                                                    |                                                                                                       | Capital contributions received (paid)                                                                       |                                                               |              |        |              |         |               | 27,288  |               |         |         |       |        |          |          | (27,288  | )        |   |           |           |   |         |          |        |         
|                                                    |                                                                                                       |                                                                                                             |                                                               |              |         |              |         |               |         |               |         |         |        |        |          |          |          |          |   |           |            |   |         |         
|                                                    |                                                                                                       |                                                                                                             | Net cash flows provided by (used in) financing
    activities |              |         | 54,355       |         |               |         | 227,140       |         |         |        |       |          |          |          | (271,807 | ) |           |            |  |         |          |         | 9,688    |  
|                                                    |                                                                                                       |                                                                                                             |                                                               |              |         |              |         |               |         |               |         |         |        |        |          |          |          |          |   |           |            |   |         |         
|Net increase (decrease) in cash and
    equivalents |                                                                                                       |                                                                                                             | 16,207                                                        |              |         |              | 41,638  |               |         |               | 27,156  |         |        |        | (111,071 | )        |          |          |  |           |            |   | (26,070 | )       
|Beginning cash and equivalents                      |                                                                                                       |                                                                                                             |                                                              |              |         |              | 110,335 |               |         |               | (74,751 | )       |        |        | 942,175  |          |          |          |  |           |            |   | 977,759 |         
|                                                    |                                                                                                       |                                                                                                             |                                                               |              |         |              |         |               |         |               |         |         |        |        |          |          |          |          |   |           |            |   |         |         
|Ending cash and equivalents                         |                                                                                                       | $                                                                                                           | 16,207                                                        |              |         | $            | 151,973 |               |         | $             | (47,595 | )       |        | $      | 831,104  |          |          | $        |  |           |            | $ | 951,689 |         
|                                                    |                                                                                                       |                                                                                                             |                                                               |              |         |              |         |               |         |               |         |         |        |        |          |          |          |          |   |           |            |   |         |         

F-38



---



##### Table of Contents



PACIFICARE HEALTH SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)

CONSOLIDATING CONDENSED BALANCE
SHEETS

December 31, 2003


(Unaudited)


|                                           |                                           |                            |           |              |           |              |           |               |           |               |         |         |         |   |           |           |           |   |            |            |            |   |           |           |           | 
|------------------------------------------ | ----------------------------------------- | -------------------------- | --------- | ------------ | --------- | ------------ | --------- | ------------- | --------- | ------------- | ------- | ------- | ------- | - | --------- | --------- | --------- | - | ---------- | ---------- | ---------- | - | --------- | --------- | --------- | 
|                                           |                                           |                            |           | Initial      |           | PHPA         |           |               |           |               |         |        
|                                           |                                           |                            |           | Guarantor    |           | Guarantor    |           | Non-Guarantor |           | Consolidating |         |        
|                                           |                                           | Parent                     |           | Subsidiaries |           | Subsidiaries |           | Subsidiaries  |           | Adjustments   |         | Company
|                                           |                                           |                            |           |              |           |              |           |               |           |               |         |        
|                                           |                                           |                           
|                                           |                                           | (In thousands)            
|ASSETS                                    
|Current assets:                            |                                           |                            |           |              |           |              |           |               |           |               |         |         |         |   |           |           |           |   |            |            |            |   |           |          
|                                           | Cash and equivalents                      |                            | $         |             |           |              | $         | 242,246       |           |               | $       | 601     |         |   | $         | 955,575   |           |   | $          |           |            |   | $         | 1,198,422 |          
|                                           | Marketable securities                     |                            |           | 37           |           |              |           |              |           |               |         |        |         |   |           | 1,359,683 |           |   |            |           |            |   |           | 1,359,720 |          
|                                           | Receivables, net                          |                            |           | 991          |           |              |           | (70,112       | )         |               |         | 125,622 |         |   |           | 217,138   |           |   |            | (7,696     | )          |   |           | 265,943   |          
|                                           | Intercompany                              |                            |           | 10,110       |           |              |           | 38,248        |           |               |         | 24,424  |         |   |           | (72,782   | )         |   |            |           |            |   |           |          |          
|                                           | Prepaid expenses and other current assets |                            |           | 8,074        |           |              |           | 32,033        |           |               |         | 7,672   |         |   |           | 13,427    |           |   |            | (3,907     | )          |   |           | 57,299    |          
|                                           | Deferred income taxes                     |                            |           | (15          | )         |              |           | 65,497        |           |               |         | 5,511   |         |   |           | 107,464   |           |   |            | (28,640    | )          |   |           | 149,817   |          
|                                           |                                           |                            |           |              |           |              |           |               |           |               |         |         |         |   |           |           |           |   |            |            |            |   |           |          
|                                           |                                           | Total current assets       |           |              | 19,197    |              |           |               | 307,912   |               |         |         | 163,830 |   |           |           | 2,580,505 |   |            |            | (40,243    | ) |           |           | 3,031,201 | 
|                                           |                                           |                            |           |              |           |              |           |               |           |               |         |         |         |   |           |           |           |   |            |            |            |   |           |          
|Property, plant and equipment at cost, net |                                           |                            |          |              |           |              | 95,805    |               |           |               | 15,689  |         |         |   | 37,913    |           |           |   |           |            |            |   | 149,407   |          
|Marketable securities-restricted           |                                           |                            | 33,436    |              |           |              |          |               |           |               |        |         |         |   | 133,110   |           |           |   |           |            |            |   | 166,546   |          
|Deferred income taxes                      |                                           |                            |          |              |           |              | 80,431    |               |           |               | 9,327   |         |         |   | 26,907    |           |           |   | (116,665   | )          |            |   |          |          
|Investment in subsidiaries                 |                                           |                            | 2,376,929 |              |           |              | 1,713,296 |               |           |               | 13,264  |         |         |   | (7,903    | )         |           |   | (4,095,586 | )          |            |   |          |          
|Goodwill and intangible assets, net        |                                           |                            |          |              |           |              | 11,923    |               |           |               | 16,480  |         |         |   | 1,175,809 |           |           |   |           |            |            |   | 1,204,212 |          
|Other assets                               |                                           |                            | 17,549    |              |           |              | 26,262    |               |           |               | 408     |         |         |   | 23,719    |           |           |   |           |            |            |   | 67,938    |          
|                                           |                                           |                            |           |              |           |              |           |               |           |               |         |         |         |   |           |           |           |   |            |            |            |   |           |          
|                                           |                                           | $                          | 2,447,111 |              |           | $            | 2,235,629 |               |           | $             | 218,998 |         |         | $ | 3,970,060 |           |           | $ | (4,252,494 | )          |            | $ | 4,619,304 |          
|                                           |                                           |                            |           |              |           |              |           |               |           |               |         |         |         |   |           |           |           |   |            |            |            |   |           |          
|LIABILITIES AND STOCKHOLDERS
    EQUITY  
|Current liabilities:                       |                                           |                            |           |              |           |              |           |               |           |               |         |         |         |   |           |           |           |   |            |            |            |   |           |          
|                                           | Medical claims and benefits payable       |                            | $         |             |           |              | $         | 15,581        |           |               | $       | 50,874  |         |   | $         | 965,704   |           |   | $          | (4,659     | )          |   | $         | 1,027,500 |          
|                                           | Accounts payable and accrued liabilities  |                            |           | 6,646        |           |              |           | 249,411       |           |               |         | 91,098  |         |   |           | 148,457   |           |   |            | (4,802     | )          |   |           | 490,810   |          
|                                           | Deferred income taxes                     |                            |           |             |           |              |           | 17,010        |           |               |         | 734     |         |   |           | 10,896    |           |   |            | (28,640    | )          |   |           |          |          
|                                           | Unearned premium revenue                  |                            |           |             |           |              |           | 254           |           |               |         | 1,288   |         |   |           | 497,080   |           |   |            | (2,142     | )          |   |           | 496,480   |          
|                                           | Current portion of long-term debt         |                            |           | 1,500        |           |              |           | 5,766         |           |               |         |        |         |   |           | 230       |           |   |            |           |            |   |           | 7,496     |          
|                                           |                                           |                            |           |              |           |              |           |               |           |               |         |         |         |   |           |           |           |   |            |            |            |   |           |          
|                                           |                                           | Total current liabilities  |           |              | 8,146     |              |           |               | 288,022   |               |         |         | 143,994 |   |           |           | 1,622,367 |   |            |            | (40,243    | ) |           |           | 2,022,286 | 
|                                           |                                           |                            |           |              |           |              |           |               |           |               |         |         |         |   |           |           |           |   |            |            |            |   |           |          
|Long-term debt                             |                                           |                            | 471,221   |              |           |              | 4,883     |               |           |               |        |         |         |   | 1,596     |           |           |   |           |            |            |   | 477,700   |          
|Convertible subordinated debentures        |                                           |                            | 135,000   |              |           |              |          |               |           |               |        |         |         |   |          |           |           |   |           |            |            |   | 135,000   |          
|Deferred income taxes                      |                                           |                            |          |              |           |              | 117,052   |               |           |               | 10,968  |         |         |   | 93,422    |           |           |   | (116,665   | )          |            |   | 104,777   |          
|Other liabilities                          |                                           |                            |          |              |           |              | 28,004    |               |           |               |        |         |         |   |          |           |           |   |           |            |            |   | 28,004    |          
|Stockholders equity:                      |                                           |                            |           |              |           |              |           |               |           |               |         |         |         |   |           |           |           |   |            |            |            |   |           |          
|                                           | Common stock                              |                            |           | 848          |           |              |           |              |           |               |         |        |         |   |           |          |           |   |            |           |            |   |           | 848       |          
|                                           | Unearned compensation                     |                            |           | (16,843      | )         |              |           |              |           |               |         |        |         |   |           |          |           |   |            |           |            |   |           | (16,843   | )        
|                                           | Additional paid-in capital                |                            |           | 1,458,310    |           |              |           |              |           |               |         |        |         |   |           |          |           |   |            |           |            |   |           | 1,458,310 |          
|                                           | Accumulated other comprehensive loss      |                            |           | 22           |           |              |           |              |           |               |         |        |         |   |           | 18,793    |           |   |            |           |            |   |           | 18,815    |          
|                                           | Retained earnings                         |                            |           | 390,407      |           |              |           |              |           |               |         |        |         |   |           |          |           |   |            |           |            |   |           | 390,407   |          
|                                           | Treasury stock                            |                            |           |             |           |              |           |              |           |               |         |        |         |   |           |          |           |   |            |           |            |   |           |          |          
|                                           | Equity in income of subsidiaries          |                            |           |             |           |              |           | 1,797,668     |           |               |         | 64,036  |         |   |           | 2,233,882 |           |   |            | (4,095,586 | )          |   |           |          |          
|                                           |                                           |                            |           |              |           |              |           |               |           |               |         |         |         |   |           |           |           |   |            |            |            |   |           |          
|                                           |                                           | Total stockholders equity |           |              | 1,832,744 |              |           |               | 1,797,668 |               |         |         | 64,036  |   |           |           | 2,252,675 |   |            |            | (4,095,586 | ) |           |           | 1,851,537 | 
|                                           |                                           |                            |           |              |           |              |           |               |           |               |         |         |         |   |           |           |           |   |            |            |            |   |           |          
|                                           |                                           | $                          | 2,447,111 |              |           | $            | 2,235,629 |               |           | $             | 218,998 |         |         | $ | 3,970,060 |           |           | $ | (4,252,494 | )          |            | $ | 4,619,304 |          
|                                           |                                           |                            |           |              |           |              |           |               |           |               |         |         |         |   |           |           |           |   |            |            |            |   |           |          

F-39



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##### Table of Contents



PACIFICARE HEALTH SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)

CONSOLIDATING CONDENSED STATEMENTS OF
OPERATIONS

For the Year Ended December 31,
2003


(Unaudited)


|                                                                                                            |                         |                |         |              |  |              |         |               |  |               |         |         |  |   |            |            |  |   |          |            |   |   |            |            | 
|----------------------------------------------------------------------------------------------------------- | ----------------------- | -------------- | ------- | ------------ |  | ------------ | ------- | ------------- |  | ------------- | ------- | ------- |  | - | ---------- | ---------- |  | - | -------- | ---------- | - | - | ---------- | ---------- | 
|                                                                                                            |                         |                |         | Initial      |  | PHPA         |         |               |  |               |         |        
|                                                                                                            |                         |                |         | Guarantor    |  | Guarantor    |         | Non-Guarantor |  | Consolidating |         |        
|                                                                                                            |                         | Parent         |         | Subsidiaries |  | Subsidiaries |         | Subsidiaries  |  | Adjustments   |         | Company
|                                                                                                            |                         |                |         |              |  |              |         |               |  |               |         |        
|                                                                                                            |                         |               
|                                                                                                            |                         | (In thousands)
|Operating revenue                                                                                           |                         | $              | 841     |              |  | $            | 31,287  |               |  | $             | 529,607 |         |  | $ | 10,810,692 |            |  | $ | (363,916 | )          |   | $ | 11,008,511 |           
|Income from subsidiaries                                                                                    |                         |                | 339,072 |              |  |              | 475,286 |               |  |               |        |         |  |   | 7,550      |            |  |   | (821,908 | )          |   |   |           |           
|                                                                                                            |                         |                |         |              |  |              |         |               |  |               |         |         |  |   |            |            |  |   |          |            |   |   |            |           
|                                                                                                            | Total operating revenue |                |         | 339,913      |  |              |         | 506,573       |  |               |         | 529,607 |  |   |            | 10,818,242 |  |   |          | (1,185,824 | ) |   |            | 11,008,511 | 
|Health care services and other                                                                              |                         |                |        |              |  |              | 3,646   |               |  |               | 363,447 |         |  |   | 9,019,918  |            |  |   | (321,217 | )          |   |   | 9,065,794  |           
|Selling, general and administrative expenses                                                                |                         |                | 166     |              |  |              | 234,129 |               |  |               | 124,878 |         |  |   | 1,133,537  |            |  |   | (40,168  | )          |   |   | 1,452,542  |           
|Impairment, disposition, restructuring, Office of
    Personnel Management and other charges (credits), net |                         |                |        |              |  |              | 619     |               |  |               | (29     | )       |  |   | (590       | )          |  |   |         |            |   |   |           |           
|                                                                                                            |                         |                |         |              |  |              |         |               |  |               |         |         |  |   |            |            |  |   |          |            |   |   |            |           
|Operating income                                                                                            |                         |                | 339,747 |              |  |              | 268,179 |               |  |               | 41,311  |         |  |   | 665,377    |            |  |   | (824,439 | )          |   |   | 490,175    |           
|Interest expense                                                                                            |                         |                | (96,999 | )            |  |              | (5,337  | )             |  |               |        |         |  |   | (726       | )          |  |   | 2,531    |            |   |   | (100,531   | )         
|                                                                                                            |                         |                |         |              |  |              |         |               |  |               |         |         |  |   |            |            |  |   |          |            |   |   |            |           
|Income before income taxes                                                                                  |                         |                | 242,748 |              |  |              | 262,842 |               |  |               | 41,311  |         |  |   | 664,651    |            |  |   | (821,908 | )          |   |   | 389,644    |           
|(Benefit) provision for income taxes                                                                        |                         |                |        |              |  |              | (77,064 | )             |  |               | 16,308  |         |  |   | 207,652    |            |  |   |         |            |   |   | 146,896    |           
|                                                                                                            |                         |                |         |              |  |              |         |               |  |               |         |         |  |   |            |            |  |   |          |            |   |   |            |           
|Net income                                                                                                  |                         | $              | 242,748 |              |  | $            | 339,906 |               |  | $             | 25,003  |         |  | $ | 456,999    |            |  | $ | (821,908 | )          |   | $ | 242,748    |           
|                                                                                                            |                         |                |         |              |  |              |         |               |  |               |         |         |  |   |            |            |  |   |          |            |   |   |            |           

F-40



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##### Table of Contents



PACIFICARE HEALTH SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)

CONSOLIDATING CONDENSED STATEMENTS OF CASH
FLOWS

For the Year Ended December 31,
2003


(Unaudited)


|                                                    |                                                                                                       |                                                                                          |                                                               |              |          |              |         |               |          |               |         |         |        |        |         |          |          |          |   |          |         |   |           |          |         |          |  
|--------------------------------------------------- | ----------------------------------------------------------------------------------------------------- | ---------------------------------------------------------------------------------------- | ------------------------------------------------------------- | ------------ | -------- | ------------ | ------- | ------------- | -------- | ------------- | ------- | ------- | ------ | ------ | ------- | -------- | -------- | -------- | - | -------- | ------- | - | --------- | -------- | ------- | -------- | -
|                                                    |                                                                                                       |                                                                                          |                                                               | Initial      |          | PHPA         |         |               |          |               |         |        
|                                                    |                                                                                                       |                                                                                          |                                                               | Guarantor    |          | Guarantor    |         | Non-Guarantor |          | Consolidating |         |        
|                                                    |                                                                                                       | Parent                                                                                   |                                                               | Subsidiaries |          | Subsidiaries |         | Subsidiaries  |          | Adjustments   |         | Company
|                                                    |                                                                                                       |                                                                                          |                                                               |              |          |              |         |               |          |               |         |        
|                                                    |                                                                                                       |                                                                                         
|                                                    |                                                                                                       | (In thousands)                                                                          
|Operating activities:                               |                                                                                                       |                                                                                          |                                                               |              |          |              |         |               |          |               |         |         |        |        |         |          |          |          |   |          |         |   |           |         
|                                                    | Net income                                                                                            |                                                                                          | $                                                             | 242,748      |          |              | $       | 339,906       |          |               | $       | 25,003  |        |        | $       | 456,999  |          |          | $ | (821,908 | )       |   | $         | 242,748  |        
|                                                    | Adjustments to reconcile net income to net cash
    flows provided by (used in) operating activities: |                                                                                          |                                                               |              |          |              |         |               |          |               |         |         |        |        |         |          |          |          |   |          |         |   |           |          |        
|                                                    |                                                                                                       | Equity in income of subsidiaries                                                         |                                                               |              | (339,071 | )            |         |               | (475,287 | )             |         |         |       |        |         |          | (7,550   | )        |   |          | 821,908 |   |           |          |        |         
|                                                    |                                                                                                       | Deferred income taxes                                                                    |                                                               |              |         |              |         |               | 5,354    |               |         |         | (1,972 | )      |         |          | (49,470  | )        |   |          |        |   |           |          | (46,088 | )       
|                                                    |                                                                                                       | Depreciation and amortization                                                            |                                                               |              |         |              |         |               | 28,779   |               |         |         | 6,462  |        |         |          | 9,472    |          |   |          |        |   |           |          | 44,713  |         
|                                                    |                                                                                                       | Expense related to bond redemption                                                       |                                                               |              | 28,155   |              |         |               |         |               |         |         |       |        |         |          |         |          |   |          |        |   |           |          | 28,155  |         
|                                                    |                                                                                                       | Loss on disposal of property, plant and equipment
    and other                          |                                                               |              |         |              |         |               | 19,877   |               |         |         | 15     |        |         |          | 2,436    |          |   |          |        |   |           |          | 22,328  |         
|                                                    |                                                                                                       | Amortization of intangible asset                                                         |                                                               |              |         |              |         |               |         |               |         |         |       |        |         |          | 21,908   |          |   |          |        |   |           |          | 21,908  |         
|                                                    |                                                                                                       | Stock-based compensation expense                                                         |                                                               |              | 19,092   |              |         |               |         |               |         |         |       |        |         |          |         |          |   |          |        |   |           |          | 19,092  |         
|                                                    |                                                                                                       | Tax benefit realized for stock option exercises                                          |                                                               |              | 17,838   |              |         |               |         |               |         |         |       |        |         |          |         |          |   |          |        |   |           |          | 17,838  |         
|                                                    |                                                                                                       | Provision for doubtful accounts                                                          |                                                               |              |         |              |         |               | 4,213    |               |         |         | 6,058  |        |         |          |         |          |   |          |        |   |           |          | 10,271  |         
|                                                    |                                                                                                       | Amortization of capitalized loan fees                                                    |                                                               |              | 7,481    |              |         |               |         |               |         |         |       |        |         |          |         |          |   |          |        |   |           |          | 7,481   |         
|                                                    |                                                                                                       | Amortization of notes receivable from sale of
    fixed assets                           |                                                               |              |         |              |         |               | (5,641   | )             |         |         |       |        |         |          |         |          |   |          |        |   |           |          | (5,641  | )       
|                                                    |                                                                                                       | Employer benefit plan contributions in treasury
    stock                                |                                                               |              | 1,363    |              |         |               |         |               |         |         |       |        |         |          |         |          |   |          |        |   |           |          | 1,363   |         
|                                                    |                                                                                                       | Amortization of discount on 10 3/4% senior
    notes                                     |                                                               |              | 424      |              |         |               |         |               |         |         |       |        |         |          |         |          |   |          |        |   |           |          | 424     |         
|                                                    |                                                                                                       | Changes in assets and liabilities, net of effects
    from acquisitions and dispositions |                                                               |              | (552,849 | )            |         |               | 398,268  |               |         |         | 16,884 |        |         |          | 187,235  |          |   |          |        |   |           |          | 49,538  |         
|                                                    |                                                                                                       |                                                                                          |                                                               |              |          |              |         |               |          |               |         |         |        |        |         |          |          |          |   |          |         |   |           |         
|                                                    |                                                                                                       |                                                                                          | Net cash flows (used in) provided by operating
    activities |              |          | (574,819     | )       |               |          | 315,469       |         |         |        | 52,450 |         |          |          | 621,030  |   |          |         |  |           |          |         | 414,130  |  
|                                                    |                                                                                                       |                                                                                          |                                                               |              |          |              |         |               |          |               |         |         |        |        |         |          |          |          |   |          |         |   |           |         
|Investing activities:                               |                                                                                                       |                                                                                          |                                                               |              |          |              |         |               |          |               |         |         |        |        |         |          |          |          |   |          |         |   |           |         
|                                                    | Purchase of marketable securities, net                                                                |                                                                                          |                                                               |             |          |              |         |              |          |               |         |        |        |        |         | (169,102 | )        |          |   |         |         |   |           | (169,102 | )      
|                                                    | Purchase of property, plant and equipment                                                             |                                                                                          |                                                               |             |          |              |         | (42,058       | )        |               |         | (4,268  | )      |        |         | (5,945   | )        |          |   |         |         |   |           | (52,271  | )      
|                                                    | Sale of marketable securities-restricted, net                                                         |                                                                                          |                                                               | 1,376        |          |              |         |              |          |               |         |        |        |        |         | 18,267   |          |          |   |         |         |   |           | 19,643   |        
|                                                    | Proceeds from the sale of property, plant and
    equipment                                           |                                                                                          |                                                               |             |          |              |         | 16            |          |               |         | 14      |        |        |         |         |          |          |   |         |         |   |           | 30       |        
|                                                    |                                                                                                       |                                                                                          |                                                               |              |          |              |         |               |          |               |         |         |        |        |         |          |          |          |   |          |         |   |           |         
|                                                    |                                                                                                       |                                                                                          | Net cash flows provided by (used in) investing
    activities |              |          | 1,376        |         |               |          | (42,042       | )       |         |        | (4,254 | )       |          |          | (156,780 | ) |          |         |  |           |          |         | (201,700 | )
|                                                    |                                                                                                       |                                                                                          |                                                               |              |          |              |         |               |          |               |         |         |        |        |         |          |          |          |   |          |         |   |           |         
|Financing activities:                               |                                                                                                       |                                                                                          |                                                               |              |          |              |         |               |          |               |         |         |        |        |         |          |          |          |   |          |         |   |           |         
|                                                    | Proceeds from equity offering used for redemption
    of $175 million of senior notes                 |                                                                                          |                                                               | 199,424      |          |              |         |              |          |               |         |        |        |        |         |         |          |          |   |         |         |   |           | 199,424  |        
|                                                    | Principal payments on senior note redemption                                                          |                                                                                          |                                                               | (175,000     | )        |              |         |              |          |               |         |        |        |        |         |         |          |          |   |         |         |   |           | (175,000 | )      
|                                                    | Principal payments on long-term debt                                                                  |                                                                                          |                                                               | (151,329     | )        |              |         |              |          |               |         |        |        |        |         |         |          |          |   |         |         |   |           | (151,329 | )      
|                                                    | Proceeds from borrowings of long-term debt                                                            |                                                                                          |                                                               | 150,000      |          |              |         |              |          |               |         |        |        |        |         |         |          |          |   |         |         |   |           | 150,000  |        
|                                                    | Principal payments on FHP senior notes                                                                |                                                                                          |                                                               |             |          |              |         | (43,250       | )        |               |         |        |        |        |         |         |          |          |   |         |         |   |           | (43,250  | )      
|                                                    | Use of restricted cash collateral for payment of
    FHP senior notes                                 |                                                                                          |                                                               | 43,250       |          |              |         |              |          |               |         |        |        |        |         |         |          |          |   |         |         |   |           | 43,250   |        
|                                                    | Proceeds from issuance of common and treasury
    stock                                               |                                                                                          |                                                               | 41,146       |          |              |         |              |          |               |         |        |        |        |         |         |          |          |   |         |         |   |           | 41,146   |        
|                                                    | Payments of premium to bondholders for senior
    note redemption                                     |                                                                                          |                                                               | (18,813      | )        |              |         |              |          |               |         |        |        |        |         |         |          |          |   |         |         |   |           | (18,813  | )      
|                                                    | Loan fees                                                                                             |                                                                                          |                                                               | (6,949       | )        |              |         |              |          |               |         |        |        |        |         |         |          |          |   |         |         |   |           | (6,949   | )      
|                                                    | Payments on software financing agreements                                                             |                                                                                          |                                                               |             |          |              |         | (3,683        | )        |               |         |        |        |        |         |         |          |          |   |         |         |   |           | (3,683   | )      
|                                                    | Common stock repurchases                                                                              |                                                                                          |                                                               | (493         | )        |              |         |              |          |               |         |        |        |        |         |         |          |          |   |         |         |   |           | (493     | )      
|                                                    | Intercompany activity:                                                                                |                                                                                          |                                                               |              |          |              |         |               |          |               |         |         |        |        |         |          |          |          |   |          |         |   |           |          |        
|                                                    |                                                                                                       | Dividends received (paid)                                                                |                                                               |              | 476,000  |              |         |               | 248,083  |               |         |         |       |        |         |          | (724,083 | )        |   |          |        |   |           |          |        |         
|                                                    |                                                                                                       | Royalty dividends and loans received (paid)                                              |                                                               |              |         |              |         |               | 87,576   |               |         |         |       |        |         |          | (87,576  | )        |   |          |        |   |           |          |        |         
|                                                    |                                                                                                       | Capital contributions (paid) received                                                    |                                                               |              |         |              |         |               | (471,880 | )             |         |         |       |        |         |          | 471,880  |          |   |          |        |   |           |          |        |         
|                                                    |                                                                                                       |                                                                                          |                                                               |              |          |              |         |               |          |               |         |         |        |        |         |          |          |          |   |          |         |   |           |         
|                                                    |                                                                                                       |                                                                                          | Net cash flows provided by (used in) financing
    activities |              |          | 557,236      |         |               |          | (183,154      | )       |         |        |       |         |          |          | (339,779 | ) |          |         |  |           |          |         | 34,303   |  
|                                                    |                                                                                                       |                                                                                          |                                                               |              |          |              |         |               |          |               |         |         |        |        |         |          |          |          |   |          |         |   |           |         
|Net (decrease) increase in cash and
    equivalents |                                                                                                       |                                                                                          | (16,207                                                       | )            |          |              | 90,273  |               |          |               | 48,196  |         |        |        | 124,471 |          |          |          |  |          |         |   | 246,733   |         
|Beginning cash and equivalents                      |                                                                                                       |                                                                                          | 16,207                                                        |              |          |              | 151,973 |               |          |               | (47,595 | )       |        |        | 831,104 |          |          |          |  |          |         |   | 951,689   |         
|                                                    |                                                                                                       |                                                                                          |                                                               |              |          |              |         |               |          |               |         |         |        |        |         |          |          |          |   |          |         |   |           |         
|Ending cash and equivalents                         |                                                                                                       | $                                                                                        |                                                              |              |          | $            | 242,246 |               |          | $             | 601     |         |        | $      | 955,575 |          |          | $        |  |          |         | $ | 1,198,422 |         
|                                                    |                                                                                                       |                                                                                          |                                                               |              |          |              |         |               |          |               |         |         |        |        |         |          |          |          |   |          |         |   |           |         

F-41



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##### Table of Contents



REPORT OF ERNST & YOUNG LLP, INDEPENDENT
AUDITORS

The Board of Directors and Stockholders

PacifiCare Health Systems, Inc.


We have audited the accompanying consolidated
balance sheets of PacifiCare Health Systems, Inc. (the Company)
as of December 31, 2003 and 2002 and the related
consolidated statements of operations, stockholders equity
and cash flows for each of the three years in the period ended
December 31, 2003. Our audits also included the financial
statement schedule listed in the Index at Item 15(a)(2).
These consolidated financial statements and schedule are the
responsibility of the Companys management. Our
responsibility is to express an opinion on these consolidated
financial statements and schedule based on our audits.

We conducted our audits in accordance with
auditing standards generally accepted in the United States.
Those standards require that we plan and perform the audit to
obtain reasonable assurance about whether the consolidated
financial statements are free of material misstatement. An audit
includes examining, on a test basis, evidence supporting the
amounts and disclosures in the consolidated 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 consolidated financial position of PacifiCare
Health Systems, Inc. at December 31, 2003 and 2002, and the
consolidated results of its operations and its cash flows for
each of the three years in the period ended December 31,
2003 in conformity with accounting principles generally accepted
in the United States. Also in our opinion, the related financial
statement schedule, when considered in relation to the basic
consolidated financial statements taken as a whole, presents
fairly in all material respects the information set forth
therein.

As discussed in Note 2 to the consolidated
financial statements, the Company adopted the fair value
recognition provisions of Statement of Financial Accounting
Standard No. 123, Accounting for Stock-Based Compensation,
on a prospective basis for all employee and director awards
granted, modified, or settled on or after January 1, 2003.
Also, as discussed in Note 2 to the consolidated financial
statements, the company adopted Statement of Financial
Accounting Standard No. 142, Goodwill and Other Intangible
Assets, in 2002.



| |                      
| | ---------------------
| | /s/ ERNST & YOUNG LLP

Irvine, California

January 30, 2004


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PACIFICARE HEALTH SYSTEMS, INC.

QUARTERLY INFORMATION FOR 2003 AND 2002
(Unaudited)

|                                                                                                            |                                                                         |                                               |           |         |   |              |           |             |  |   |           |      |  |   |           |      | 
|----------------------------------------------------------------------------------------------------------- | ----------------------------------------------------------------------- | --------------------------------------------- | --------- | ------- | - | ------------ | --------- | ----------- |  | - | --------- | ---- |  | - | --------- | ---- | 
|                                                                                                            |                                                                         |                                              
|                                                                                                            |                                                                         | Quarters Ended                               
|                                                                                                            |                                                                         |                                              
|                                                                                                            |                                                                         | March 31                                      |           | June 30 |   | September 30 |           | December 31
|                                                                                                            |                                                                         |                                               |           |         |   |              |           |            
|                                                                                                            |                                                                         |                                              
|                                                                                                            |                                                                         | (Amounts in thousands, except per share data)
|2003                                                                                                        |                                                                         |                                               |           |         |   |              |           |             |  |   |           |      |  |   |           |     
|Operating revenue                                                                                           |                                                                         | $                                             | 2,739,595 |         |   | $            | 2,730,234 |             |  | $ | 2,742,167 |      |  | $ | 2,796,515 |     
|Operating expenses                                                                                          |                                                                         |                                               | 2,606,994 |         |   |              | 2,592,108 |             |  |   | 2,616,912 |      |  |   | 2,702,322 |     
|Interest expense                                                                                            |                                                                         |                                               | (19,550   | )       |   |              | (20,410   | )           |  |   | (16,924   | )    |  |   | (43,647   | )   
|                                                                                                            |                                                                         |                                               |           |         |   |              |           |             |  |   |           |      |  |   |           |     
|Income before income taxes                                                                                  |                                                                         |                                               | 113,051   |         |   |              | 117,716   |             |  |   | 108,331   |      |  |   | 50,546    |     
|Provision for income taxes                                                                                  |                                                                         |                                               | 42,281    |         |   |              | 44,718    |             |  |   | 40,841    |      |  |   | 19,056    |     
|                                                                                                            |                                                                         |                                               |           |         |   |              |           |             |  |   |           |      |  |   |           |     
|Net income                                                                                                  |                                                                         | $                                             | 70,770    |         |   | $            | 72,998    |             |  | $ | 67,490    |      |  | $ | 31,490    |     
|                                                                                                            |                                                                         |                                               |           |         |   |              |           |             |  |   |           |      |  |   |           |     
|Basic earnings per share(2)                                                                                 |                                                                         | $                                             | 0.98      |         |   | $            | 1.00      |             |  | $ | 0.91      |      |  | $ | 0.40      |     
|                                                                                                            |                                                                         |                                               |           |         |   |              |           |             |  |   |           |      |  |   |           |     
|Diluted earnings per share(2)                                                                               |                                                                         | $                                             | 0.96      |         |   | $            | 0.96      |             |  | $ | 0.86      |      |  | $ | 0.36      |     
|                                                                                                            |                                                                         |                                               |           |         |   |              |           |             |  |   |           |      |  |   |           |     
|HMO and other membership(1)                                                                                 |                                                                         |                                               | 2,897     |         |   |              | 2,885     |             |  |   | 2,883     |      |  |   | 2,912     |     
|                                                                                                            |                                                                         |                                               |           |         |   |              |           |             |  |   |           |      |  |   |           |     
|2002                                                                                                        |                                                                         |                                               |           |         |   |              |           |             |  |   |           |      |  |   |           |     
|Operating revenue                                                                                           |                                                                         | $                                             | 2,863,451 |         |   | $            | 2,769,360 |             |  | $ | 2,779,745 |      |  | $ | 2,743,946 |     
|Operating expenses                                                                                          |                                                                         |                                               | 2,799,250 |         |   |              | 2,699,744 |             |  |   | 2,689,750 |      |  |   | 2,667,117 |     
|Interest expense                                                                                            |                                                                         |                                               | (16,191   | )       |   |              | (18,955   | )           |  |   | (20,205   | )    |  |   | (19,553   | )   
|Impairment, disposition, restructuring, Office of
    Personnel Management and other charges (credits), net |                                                                         |                                               | (12,851   | )       |   |              | 18,336    |             |  |   |          |      |  |   | (1,711    | )   
|                                                                                                            |                                                                         |                                               |           |         |   |              |           |             |  |   |           |      |  |   |           |     
|Income before income taxes                                                                                  |                                                                         |                                               | 60,861    |         |   |              | 32,325    |             |  |   | 69,790    |      |  |   | 58,987    |     
|Provision for income taxes                                                                                  |                                                                         |                                               | 22,701    |         |   |              | 12,058    |             |  |   | 26,031    |      |  |   | 22,002    |     
|                                                                                                            |                                                                         |                                               |           |         |   |              |           |             |  |   |           |      |  |   |           |     
|Income before cumulative effect of a change in
    accounting principle                                     |                                                                         |                                               | 38,160    |         |   |              | 20,267    |             |  |   | 43,759    |      |  |   | 36,985    |     
|Cumulative effect of a change in accounting
    principle                                                   |                                                                         |                                               | (897,000  | )       |   |              |          |             |  |   |          |      |  |   |          |     
|                                                                                                            |                                                                         |                                               |           |         |   |              |           |             |  |   |           |      |  |   |           |     
|Net (loss) income                                                                                           |                                                                         | $                                             | (858,840  | )       |   | $            | 20,267    |             |  | $ | 43,759    |      |  | $ | 36,985    |     
|                                                                                                            |                                                                         |                                               |           |         |   |              |           |             |  |   |           |      |  |   |           |     
|Basic (loss) earnings per share(2):                                                                         |                                                                         |                                               |           |         |   |              |           |             |  |   |           |      |  |   |           |     
|                                                                                                            | Income before cumulative effect of a change in
    accounting principle |                                               | $         | 0.55    |   |              | $         | 0.29        |  |   | $         | 0.62 |  |   | $         | 0.52 | 
|                                                                                                            | Cumulative effect of a change in accounting
    principle               |                                               |           | (12.98  | ) |              |           |            |  |   |           |     |  |   |           |     | 
|                                                                                                            |                                                                         |                                               |           |         |   |              |           |             |  |   |           |      |  |   |           |     
|                                                                                                            | Basic (loss) earnings per share                                         |                                               | $         | (12.43  | ) |              | $         | 0.29        |  |   | $         | 0.62 |  |   | $         | 0.52 | 
|                                                                                                            |                                                                         |                                               |           |         |   |              |           |             |  |   |           |      |  |   |           |     
|Diluted (loss) earnings per share(2):                                                                       |                                                                         |                                               |           |         |   |              |           |             |  |   |           |      |  |   |           |     
|                                                                                                            | Income before cumulative effect of a change in
    accounting principle |                                               | $         | 0.55    |   |              | $         | 0.28        |  |   | $         | 0.60 |  |   | $         | 0.50 | 
|                                                                                                            | Cumulative effect of a change in accounting
    principle               |                                               |           | (12.98  | ) |              |           |            |  |   |           |     |  |   |           |     | 
|                                                                                                            |                                                                         |                                               |           |         |   |              |           |             |  |   |           |      |  |   |           |     
|                                                                                                            | Diluted (loss) earnings per share                                       |                                               | $         | (12.43  | ) |              | $         | 0.28        |  |   | $         | 0.60 |  |   | $         | 0.50 | 
|                                                                                                            |                                                                         |                                               |           |         |   |              |           |             |  |   |           |      |  |   |           |     
|HMO and other membership(1)                                                                                 |                                                                         |                                               | 3,330     |         |   |              | 3,263     |             |  |   | 3,189     |      |  |   | 3,138     |     
|                                                                                                            |                                                                         |                                               |           |         |   |              |           |             |  |   |           |      |  |   |           |     



---



|    |                                                                                                                                                                                        
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | HMO and other membership as of quarter end.                                                                                                                                            
|   
|(2) | All applicable per-share amounts reflect the
    retroactive effects of the two-for-one common stock split in the
    form of a stock dividend that was effective January 20,
    2004.

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PACIFICARE HEALTH SYSTEMS, INC.

SCHEDULE II  VALUATION AND
QUALIFYING ACCOUNTS

For The Years Ended December 31, 2003,
2002 and 2001


|                                 |                          |                        |  |                   |        |                 |  |            |        |  |  |  |         |   |  |   |        | 
|-------------------------------- | ------------------------ | ---------------------- |  | ----------------- | ------ | --------------- |  | ---------- | ------ |  |  |  | ------- | - |  | - | ------ | 
|                                 |                          | Balance at             |  | Charged to        |        |                 |  | Balance at
|                                 |                          | Beginning              |  | Provision for     |        | Deductions or   |  | End of    
|                                 |                          | of Period              |  | Doubtful Accounts |        | Write-offs, net |  | Period    
|                                 |                          |                        |  |                   |        |                 |  |           
|                                 |                          |                       
|                                 |                          | (Amounts in thousands)
|Allowance for doubtful accounts: |                          |                        |  |                   |        |                 |  |            |        |  |  |  |         |   |  |  
|                                 | Years ended December 31: |                        |  |                   |        |                 |  |            |        |  |  |  |         |   |  |   |       
|                                 |                          | 2003                   |  | $                 | 29,814 |                 |  |            | 10,271 |  |  |  | (16,953 | ) |  | $ | 23,132 | 
|                                 |                          | 2002                   |  | $                 | 36,230 |                 |  |            | 6,346  |  |  |  | (12,762 | ) |  | $ | 29,814 | 
|                                 |                          | 2001                   |  | $                 | 48,989 |                 |  |            | 22,070 |  |  |  | (34,829 | ) |  | $ | 36,230 | 

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PACIFICARE HEALTH SYSTEMS, INC.



EXHIBIT INDEX


|        |       |             |  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|------- | ----- | ----------- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit |       |            
|Number  |       | Description
|        |       |            
|        | 3.01  |             |  | Amended and Restated Certificate of Incorporation
    of Registrant (incorporated by reference to Exhibit 99.1 to
    Registrants Registration Statement on Form S-3
    (File No. 333-83069)).                                                                                                                                                                                                                                                                                                                                                                       
|        | 3.02  |             |  | Certificate of Designation of Series A
    Junior Participating Preferred Stock (incorporated by reference
    to Exhibit 4.1 to Registrants Form 8-K, dated
    November 19, 1999).                                                                                                                                                                                                                                                                                                                                                                                  
|        | 3.03  |             |  | Amendment to Amended and Restated Certificate of
    Incorporation of Registrant (incorporated by reference to
    Exhibit 3.03 to the Registrants Form 10-Q for
    the quarter ended June 30, 2003).                                                                                                                                                                                                                                                                                                                                                                
|        | *3.04 |             |  | First Amended and Restated Bylaws of Registrant,
    a copy of which is filed herewith.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|        | 4.01  |             |  | Form of Specimen Certificate For
    Registrants Common Stock (incorporated by reference to
    Exhibit 4.02 to Registrants Form 10-K for the
    year ended December 31, 1999).                                                                                                                                                                                                                                                                                                                                                                                     
|        | 4.02  |             |  | Indenture, dated as of November 22, 2002,
    between Registrant and U.S. Bank National Association (as
    Trustee) (incorporated by reference to Exhibit 4.4 to
    Registrants Registration Statement on Form S-3 (File
    No. 333-102909)).                                                                                                                                                                                                                                                                                                                      
|        | 4.03  |             |  | Registration Rights Agreement, dated as of
    November 22, 2002, between the Registrant and Morgan
    Stanley & Co. Incorporated and Goldman,
    Sachs & Co. (incorporated by reference to
    Exhibit 4.6 to Registrants Registration Statement on
    Form S-3 (File No. 333-102909)).                                                                                                                                                                                                                                                                           
|        | 4.04  |             |  | Indenture dated as of May 21, 2002 among
    PacifiCare Health Systems, Inc., as issuer of 10 3/4%
    Senior Notes due 2009, PacifiCare Health Plan Administrators,
    Inc., PacifiCare eHoldings, Inc., Rx-Connect, Inc. and SeniorCo,
    Inc., as initial subsidiary guarantors, and State Street Bank
    and Trust Company of California, N.A., as trustee
    (incorporated by reference to Exhibit 4.1 to
    Registrants Registration Statement on Form S-4
    (File No. 333-91704)).                                                                      
|        | 4.05  |             |  | Registration Rights Agreement dated May 21,
    2002 by and among PacifiCare Health Systems, Inc., PacifiCare
    Health Plan Administrators, Inc., PacifiCare eHoldings, Inc.,
    Rx-Connect, Inc., SeniorCo, Inc., Morgan Stanley & Co.
    Incorporated, and UBS Warburg LLC (incorporated by reference to
    Exhibit 4.5 to Registrants Registration Statement on
    Form S-4 (File No. 333-91704)).                                                                                                                                                           
|        | *4.06 |             |  | Supplemental Indenture, dated as of
    September 15, 2003, by and among PacifiCare Health Systems,
    Inc., PacifiCare Health Plan Administrators, Inc., PacifiCare
    eHoldings, Inc., Rx-Connect, Inc., and SeniorCo, Inc., as
    initial subsidiary guarantors, Rx Solutions, Inc., PacifiCare
    Behavioral Health, Inc., and SecureHorizons USA, Inc., as PHPA
    subsidiary guarantors, U.S. Bank National Association, as
    successor to the State Street Bank and Trust Company of
    California, N.A., as trustee, a copy of which is filed herewith.
|        | 4.07  |             |  | Specimen form of Exchange Global Note for the
    10 3/4% Senior Notes due 2009 (incorporated by reference to
    Exhibit 4.4 to Registrants Registration Statement on
    Form S-4 (File No. 333-91704).                                                                                                                                                                                                                                                                                                                                                             

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##### Table of Contents



|        |         |             |  |                                                                                                                                                                                                                                                                                         
|------- | ------- | ----------- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit |         |            
|Number  |         | Description
|        |         |            
|        | 4.08    |             |  | Rights Agreement, dated as of November 19,
    1999, between the Registrant and ChaseMellon Shareholder
    Services, L.L.C. (incorporated by reference to Exhibit 99.2
    to Registrants Form 8-K, dated November 19,
    1999).                                                     
|        | 10.01  |             |  | Senior Executive Employment Agreement, dated as
    of November 1, 2001, between the Registrant and Howard G.
    Phanstiel (incorporated by reference to Exhibit 10.01 to
    Registrants Form 10-K for the year ended
    December 31, 2001).                                        
|        | 10.02  |             |  | Senior Executive Employment Agreement, dated as
    of August 1, 2001, between the Registrant and Gregory W.
    Scott (incorporated by reference to Exhibit 10.04 to
    Registrants Form 10-K for the year ended
    December 31, 2001).                                             
|        | 10.03  |             |  | Senior Executive Employment Agreement, dated as
    of March 1, 2002, between Registrant and Bradford A. Bowlus
    (incorporated by reference to Exhibit 99.4 to
    Registrants Form 10-Q for the quarter ended
    March 31, 2002).                                                 
|        | 10.04  |             |  | Senior Executive Employment Agreement, dated as
    of July 22, 2002, between the Registrant and Jacqueline B.
    Kosecoff, Ph.D. (incorporated by reference to Exhibit 10.2 to
    Registrants Form 10-Q for the quarter ended
    September 30, 2002).                              
|        | 10.05  |             |  | Senior Executive Employment Agreement, dated as
    of March 30, 2001, between the Registrant and Kathy Feeny
    (incorporated by reference to Exhibit 10.06 to
    Registrants Form 10-K for the year ended
    December 31, 2002).                                                  
|        | 10.06  |             |  | First Amendment, dated as of March 30, 2001,
    to Senior Executive Agreement, dated as of March 30, 2001
    between Registrant and Kathy Feeny (incorporated by reference to
    Exhibit 10.07 to Registrants Form 10-K for the
    year ended December 31, 2002).                  
|        | 10.07  |             |  | Second Amendment, dated as of April 15,
    2002, to Senior Executive Agreement, dated as of March 30,
    2001, as amended, between Registrant and Kathy Feeny
    (incorporated by reference to Exhibit 10.08 to
    Registrants Form 10-K for the year ended
    December 31, 2002).
|        | 10.08  |             |  | Senior Executive Employment Agreement, dated as
    of January 1, 2002, between the Registrant and Joseph S.
    Konowiecki (incorporated by reference to Exhibit 10.26 to
    Registrants Form 10-K for the year ended
    December 31, 2001).                                        
|        | 10.09  |             |  | Senior Executive Employment Agreement, dated as
    of December 2, 2002, between the Registrant and Sharon D.
    Garrett (incorporated by reference to Exhibit 10.10 to
    Registrants Form 10-K for the year ended
    December 31, 2002).                                          
|        | *10.10 |             |  | Senior Executive Employment Agreement, dated as
    of October 3, 2002, between the Registrant and Peter A.
    Reynolds, a copy of which is filed herewith.                                                                                                                            
|        | 10.11  |             |  | 1996 Stock Option Plan for Officers and Key
    Employees of the Registrant (incorporated by reference to
    Exhibit 10.05 to Registrants Form 8-B, dated
    January 23, 1997).                                                                                                      
|        | 10.12  |             |  | First Amendment to 1996 Stock Option Plan for
    Officers and Key Employees of the Registrant (incorporated by
    reference to Exhibit D to Registrants Proxy
    Statement, dated May 25, 1999).                                                                                    
|        | 10.13  |             |  | Second Amendment to the 1996 Stock Option Plan
    for Officers and Key Employees of the Registrant (incorporated
    by reference to Exhibit 10.13 to the Registrants
    Form 10-Q for the quarter ended June 30, 2003).                                                             
|        | 10.14  |             |  | 2000 Employee Plan (incorporated by reference to
    Exhibit 4.1 to Registrants Registration Statement on
    Form S-8 (File No. 333-44038)).                                                                                                                                          

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|        |         |             |  |                                                                                                                                                                                                                                                                                                               
|------- | ------- | ----------- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit |         |            
|Number  |         | Description
|        |         |            
|        | 10.15  |             |  | First Amendment to the 2000 Employee Plan of the
    Registrant (incorporated by reference to Exhibit 10.15 to
    the Registrants Form 10-Q for the quarter ended June
    30, 2003).                                                                                                                       
|        | 10.16  |             |  | Amended and Restated 2000 Non-Employee Directors
    Stock Plan (incorporated by reference to Exhibit 1 to
    Registrants Proxy Statement, dated May 18, 2001).                                                                                                                                             
|        | 10.17  |             |  | First Amendment to the Amended and Restated 2000
    Non-Employee Directors Stock Plan (incorporated by reference to
    Exhibit 10.17 to the Registrants Form 10-Q for
    the quarter ended June 30, 2003).                                                                                                
|        | 10.18  |             |  | Second Amendment to the Amended and Restated 2000
    Non-Employee Directors Stock Plan (incorporated by reference to
    Exhibit 10.18 to Registrants Form 10-Q for the
    quarter ended September 30, 2003).                                                                                              
|        | 10.19  |             |  | Amended and Restated 1996 Non-Officer Directors
    Stock Plan (incorporated by reference to Exhibit E to
    Registrants Proxy Statement, dated May 25, 1999).                                                                                                                                              
|        | 10.20  |             |  | First Amendment to Amended and Restated 1996
    Non-Officer Directors Stock Option Plan (incorporated by
    reference to Exhibit 4.4 to Registrants Registration
    Statement on Form S-8, (File No. 333-49272)).                                                                                         
|        | *10.21 |             |  | 2003 Incentive Bonus Plan of the Registrant, a
    copy of which is filed herewith.                                                                                                                                                                                                                           
|        | 10.22  |             |  | 2003 Management Incentive Compensation Plan of
    the Registrant (incorporated by reference to Annex B to
    Registrants Proxy Statement, dated May 8, 2003).                                                                                                                                              
|        | 10.23  |             |  | Amended 1997 Premium Priced Stock Option Plan of
    the Registrant (incorporated by reference to Exhibit A to
    Registrants Definitive Proxy Statement, dated
    April 28, 1998).                                                                                                                        
|        | 10.24  |             |  | First Amendment to Amended 1997 Premium Priced
    Stock Option Plan, dated as of August 27, 1998 (incorporated by
    reference to Exhibit 10.12 to Registrants
    Form 10-K for the year ended December 31, 1998).                                                                                        
|        | 10.25  |             |  | Third Amended and Restated PacifiCare Health
    Systems, Inc. Stock Unit Deferred Compensation Plan, dated
    January 1, 2002 (incorporated by reference to
    Exhibit 10.20 to Registrants Form 10-K for the
    year ended December 31, 2002).                                                          
|        | 10.26  |             |  | First Amendment, dated as of January 22,
    2003, to the Third Amended and Restated PacifiCare Health
    Systems, Inc. Stock Unit Deferred Compensation Plan, dated
    January 1, 2002 (incorporated by reference to
    Exhibit 10.21 to Registrants Form 10-K for the
    year ended December 31, 2002).
|        | 10.27  |             |  | Third Amended and Restated PacifiCare Health
    Systems, Inc. Non-Qualified Deferred Compensation Plan, dated as
    of October 23, 2003 (incorporated by reference to
    Exhibit 10.27 to Registrants Form 10-Q for the
    quarter ended September 30, 2003).                                            
|        | 10.28  |             |  | Second Amended and Restated PacifiCare Health
    Systems, Inc. Statutory Restoration Plan, dated as of
    January 1, 2002 (incorporated by reference to
    Exhibit 10.23 to Registrants Form 10-K for the
    year ended December 31, 2002).                                                              
|        | 10.29  |             |  | 2001 Employee Stock Purchase Plan (incorporated
    by reference to Exhibit 1 to PacifiCare Health Systems
    Inc.s Proxy Statement dated May 8, 2002
    (File No. 000-21949)).                                                                                                                            
|        | *10.30  |             |  | Form of Contract with Eligible Medicare+Choice
    Organization and the Centers for Medicare and Medicaid Services
    for the period January 1, 2004 to December 31, 2004, a
    copy of which is filed herewith.                                                                                            

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|        |        |             |  |                                                                                                                                                                                                                                                                                                                                                                                      
|------- | ------ | ----------- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit |        |            
|Number  |        | Description
|        |        |            
|        | 10.31  |             |  | Form of Indemnification Agreement by and between
    the Registrant and certain of its Directors and Executive
    Officers (incorporated by reference to Exhibit 10.26 to
    Registrants Form 10-Q for the quarter ended
    March 31, 2003).                                                                                                                                     
|        | 10.32  |             |  | Information Technology Services Agreement, dated
    as of December 31, 2001, between the Registrant and
    International Business Machines Corporation (incorporated by
    reference to Exhibit 10.27 to Registrants
    Form 10-K for the year ended December 31, 2001).                                                                                                        
|        | 10.33  |             |  | Information Technology Services Agreement, dated
    as of January 11, 2002, between the Registrant and Keane,
    Inc. (incorporated by reference to Exhibit 10.28 to
    Registrants Form 10-K for the year ended
    December 31, 2001).                                                                                                                                         
|        | 10.34  |             |  | Credit Agreement, dated as of June 3, 2003,
    between the Registrant, the Subsidiary Guarantors party thereto,
    the Lenders party thereto and JPMorgan Chase Bank as
    Administrative Agent and Collateral Agent (incorporated by
    reference to Exhibit 10.33 to the Registrants
    Form 10-Q for the quarter ended June 30, 2003).                                      
|        | *10.35 |             |  | Amendment No. 1 to the Credit Agreement,
    dated as of November 13, 2003, between the Registrant, the
    Subsidiary Guarantors party thereto and JPMorgan Chase Bank as
    Administrative Agent, a copy of which is filed herewith.                                                                                                                                              
|        | *10.36 |             |  | Amendment No. 2 to the Credit Agreement,
    dated as of December 17, 2003, between the Registrant, the
    Subsidiary Guarantors party thereto and JPMorgan Chase Bank as
    Administrative Agent, a copy of which is filed herewith.                                                                                                                                              
|        | 10.37  |             |  | Memorandum of Understanding, dated as of
    March 21, 2003, by and among the State of Texas, the Office
    of the Attorney General, the Texas Department of Insurance,
    including the Texas Insurance Commissioner, and PacifiCare of
    Texas, Inc. (incorporated by reference to Exhibit 10.35 to
    Registrants Form 10-Q for the quarter ended
    March 31, 2003).      
|        | 10.38  |             |  | Definitive Settlement Agreement, dated as of
    July 23, 2003, by and among the State of Texas, the Office
    of the Attorney General, the Texas Department of Insurance,
    including the Texas Insurance Commissioner, and PacifiCare of
    Texas, Inc. (incorporated by reference to Exhibit 10.36 to
    the Registrants Form 10-Q for the quarter ended
    June 30, 2003).
|        | 11.1   |             |  | Statement regarding computation of per share
    earnings (included in Note 2 to the Notes to Consolidated
    Financial Statements contained in this Annual Report on
    Form 10-K).                                                                                                                                                                                               
|        | *14.1  |             |  | Financial Code of Ethics, a copy of which is
    filed herewith.                                                                                                                                                                                                                                                                                                                     
|        | *21    |             |  | List of Subsidiaries, a copy of which is filed
    herewith.                                                                                                                                                                                                                                                                                                                         
|        | *23    |             |  | Consent of Ernst & Young LLP, Independent
    Auditors, a copy of which is filed herewith.                                                                                                                                                                                                                                                                                           
|        | *31.1  |             |  | Certification of Principal Executive Officer
    Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002,
    a copy of which is filed herewith.                                                                                                                                                                                                                                   
|        | *31.2  |             |  | Certification of Principal Financial Officer
    Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002,
    a copy of which is filed herewith.                                                                                                                                                                                                                                   

E-4



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##### Table of Contents



|        |       |             |  |                                                                                                                                                                                                      
|------- | ----- | ----------- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit |       |            
|Number  |       | Description
|        |       |            
|        | *32.1 |             |  | Certification of Principal Executive Officer
    pursuant to 18 U.S.C. Section 1350, as adopted pursuant to
    Section 906 of the Sarbanes-Oxley Act of 2002, a copy of
    which is filed herewith.
|        | *32.2 |             |  | Certification of Principal Financial Officer
    pursuant to 18 U.S.C. Section 1350, as adopted pursuant to
    Section 906 of the Sarbanes-Oxley Act of 2002, a copy of
    which is filed herewith.



---



|  |                                                                                
|- | -------------------------------------------------------------------------------
|* | A copy of this exhibit is being filed with this
    Annual Report on Form 10-K.



|  |                                                                                                                                                                                                                  
|- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Management contract or compensatory plan or
    arrangement required to be filed (and/or incorporated by
    reference) as an exhibit to this Annual Report on Form 10-K
    pursuant to Item 14(c) of Form 10-K.

E-5