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UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549



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Form 10-K



FOR ANNUAL AND TRANSITION REPORTS PURSUANT TO SECTIONS 13

OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934



(Mark One)

| | x | ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)
| | - | ---------------------------------------------

| |  | OF THE SECURITIES EXCHANGE ACT OF 1934
| |  | --------------------------------------



| |  | For the fiscal year ended December 31, 2004
| |  | -------------------------------------------



or



| |  ̈ | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
| | - | -------------------------------------------------

| |  | OF THE SECURITIES EXCHANGE ACT OF 1934
| |  | --------------------------------------



| |  | For the transition period from  to
.
| |  | ------------------------------------



Commission file number 001-31700



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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          |  | (IRS Employer         
|incorporation or organization)           |  | Identification Number)
|                                         | 
|5995 Plaza Drive, Cypress, California    |  | 90630                 
|(Address of Principal Executive Offices) |  | (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



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Indicate by check mark whether the registrant (1) has filed all reports required to be filed by section 13 or 15(d) of the Securities Exchange Act of 1934 during the
preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes x    No ̈



Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§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. x



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



Non-affiliates of the Registrant held approximately $2,809,800,000
of the aggregate market value of common stock on June 30, 2004.



There were
approximately 86,665,000 shares of common stock outstanding on January 31, 2005.



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DOCUMENTS INCORPORATED BY REFERENCE



The following sections of the definitive Proxy Statement for the 2005 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, 2004



|         |  |                                                                                                                        |  |     
|-------- |  | ---------------------------------------------------------------------------------------------------------------------- |  | ----
|         |  |                                                                                                                        |  | Page
|         |  | PART I                                                                                                                 |  |     
|Item 1.  |  | Business                                                                                                               |  | 1   
|Item 2.  |  | Properties                                                                                                             |  | 10  
|Item 3.  |  | Legal Proceedings                                                                                                      |  | 10  
|Item 4.  |  | Submission of Matters to a Vote of Security Holders                                                                    |  | 10  
|         |  | PART II                                                                                                                |  |     
|Item 5.  |  | Market for the Registrants Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities       |  | 11  
|Item 6.  |  | Selected Financial Data                                                                                                |  | 13  
|Item 7.  |  | Managements Discussion and Analysis of Financial Condition and Results of Operations                                  |  | 15  
|Item 7A. |  | Quantitative and Qualitative Disclosures About Market Risk                                                             |  | 44  
|Item 8.  |  | Consolidated Financial Statements and Supplementary Data                                                               |  | 46  
|Item 9.  |  | Changes in and Disagreements with Independent Registered Public Accounting Firm on Accounting and Financial Disclosure |  | 46  
|Item 9A. |  | Controls and Procedures                                                                                                |  | 46  
|Item 9B. |  | Other Information                                                                                                      |  | 49  
|         |  | 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                                                         |  | 49  
|Item 13. |  | Certain Relationships and Related Transactions                                                                         |  | 49  
|Item 14. |  | Principal Accounting Fees and Services                                                                                 |  | 49  
|         |  | PART IV                                                                                                                |  |     
|Item 15. |  | Exhibits and Financial Statement Schedules                                                                             |  | 50  



I



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PART I



ITEM 1.  BUSINESS



Introduction



In this Annual Report on Form 10-K, we refer to PacifiCare Health
Systems, Inc. as PacifiCare, the Company, we, us, or our.



We offer managed care and other health insurance products to employer groups, individuals and Medicare beneficiaries throughout most of the United States and Guam. Our
commercial and senior plans are designed to deliver quality health care and customer service to members cost-effectively. These products include health insurance, health benefits administration and indemnity insurance products such as Medicare
Supplement products offered through health maintenance organizations, or HMOs, and preferred provider organizations, or PPOs. We also offer a variety of specialty managed care products and services that employees and individuals 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, 2004, we had approximately 3.3 million HMO and other commercial and senior product members and approximately 10.4 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 as soon as reasonably practicable 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, including our small group and individual business and maintain and grow our Medicare Advantage, formerly 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.



We operate one of the largest Medicare Advantage programs in the United States as measured by membership and we have used our long
experience in working with seniors to operate our program cost-effectively in what was a declining



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Medicare funding environment. On December 8, 2003, the President signed the new Medicare Prescription Drug, Improvement, and Modernization Act of 2003, or
MMA, into law. This law increases the Medicare Advantage 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. This law also
requires us to pass through, in 2005, 100% of the incremental funding to our members in the form of enhanced benefits, or to providers for increased network stabilization. With the changes in Medicare funding, beginning in 2004 we were able to
increase our membership in Medicare Advantage beginning in 2004 for the following reasons:



| |  | Increased government funding under the MMA legislation allowed 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, made our Medicare Advantage plans 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 Advantage market even during times when adequate funding may not
have been available.
|- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



One of our primary areas of focus has been
servicing large employer groups. In recent years, we have concentrated on small employer groups and individuals as demonstrated by our acquisition of American Medical Security Group, Inc., or AMS, and our pending acquisition of the group health
insurance business of Pacific Life Insurance Company, or Pacific Life.



Health Plans



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, PPO and Self Directed Health Plan, or SDHP, 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. This provides 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, employer groups and individuals.



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, 2004 included approximately 700 hospitals and 68,000 primary care and specialty physicians.



Our PPO network supplements our existing HMO network with additional health care providers.
We also contract with commercial PPO networks in geographic areas where we do not have HMOs. The PPOs generally enable members to have 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 give members open access
to network providers, with no primary care physician coordinating care and simplified medical management practices.



Our SDHP product, which was introduced in 2004, offers our members a self directed account, or SDA, that covers certain health care expenses coupled with a PPO plan for
expenses incurred that are outside of the coverage of the SDA, and after the applicable deductibles have been met. Unused amounts in the SDA can roll over from year to year and accumulate for future use (up to a plan maximum). The SDA feature gives
members control over their health care spending, provides greater personal choice in health care services and encourages members to budget and plan for health care expenses.



We also offer an exclusive provider organization, or EPO, product that combines all of our proprietary networks in each state where we offer
PPOs. This allows members to receive more cost-effective benefits on an in-network basis as



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long as they receive services from a contracted EPO provider. The EPO plan is an open-access product within the combined network and there is no primary care
physician gatekeeper. This makes the EPO an excellent option for providing members with broader access to network physicians.



We target a variety of plan sponsors including employer groups and other purchasing coalitions, as well as state and federal government agencies. We offer commercial
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.



As of December 31, 2004, we had approximately 1.9 million commercial HMO members and approximately 583,000 enrollees in our PPO products.



Group Life and Health Products



We are licensed to issue life and health care insurance in 47 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. Indemnity dental and behavioral health benefits are specialty products. We also offer life, accidental death and dismemberment and short-term and
long-term disability products to our commercial employer groups through AMS or under a private label arrangement with the Hartford Life Group.



Senior Products



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



Medicare Advantage Plans.  We are one of the largest Medicare Advantage organizations in the United States as measured by
membership with approximately 705,000 members as of December 31, 2004. Medicare is a federal program that provides persons age 65 and over and eligible 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. Beneficiaries are required to pay out-of-pocket deductibles and coinsurance in both Part A and Part B of the traditional Medicare program.



We contract with the Centers for Medicare and Medicaid Services, or CMS, under the Medicare Advantage program to provide health insurance
coverage in exchange for a fixed monthly payment per member that varies based on geographic and risk factors. Individuals who elect to participate in the Medicare Advantage program may receive benefits greater than the government program, such as
pharmacy drug coverage and reduced deductibles and coinsurance, 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 48 states to offer group and individual senior supplement products and have licenses pending in two states and Puerto Rico. 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.



Specialty



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



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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 5.6 million people, including approximately 743,000 seniors, as of December 31, 2004.
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 behavioral health, employee assistance, care management and chemical dependency benefit programs. As of December 31, 2004, we provided these behavioral health care services to approximately 3.8 million affiliated and unaffiliated
members through our provider network. Managed behavioral 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 to individuals and employer groups. Commercial plans include dental HMO, dental PPO, dental fee-for-service, vision
PPO, and dental and vision discount programs. We also provide dental services to seniors through Secure Horizons. We provide our commercial dental and vision products to small, mid-size and large employers, regardless of their existing medical
carrier. As of December 31, 2004, we provided these dental and vision services to approximately 1.0 million affiliated and unaffiliated members.



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.



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



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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 in which we operate and require those actions. 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 contracted 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, coronary artery disease, end-stage renal disease, chronic obstructive pulmonary disease and cancer. These programs focus on prevention, member education, effective care management, 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 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 and AMS brands,
which we believe have 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 small group, large group and National Account commercial customers is typically handled primarily through the broker and
consultant channels. After a large group or National Account is sold we market directly to employees, primarily during their open enrollment periods. For many of our larger commercial accounts, the open enrollment periods typically occur for 30 days
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.



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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. Commercial
marketing provides brokers with kits containing information about our products and programs. We engage in Broker Advisory Councils and conferences to provide brokers with education on our products and services. We send communications to our brokers
on a regular basis to update them on new products or changes.



We believe that
our commitment to service and offering of health programs, such as, HealthCredits, depression, diabetes, Pregnancy to Preschool and special programs including Womens Health Solutions and Latino Health Solutions differentiates us from other
carriers. Also, our product offering, including our SDHP product, provides solutions to commercial customers.



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, newspaper, television, telemarketing, our website, and community-based events. We also have a national broker channel for delivery of all of our 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 an integrated 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 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 us 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 our products, to increase prices for certain regulated products and to consummate acquisitions and
dispositions of health plans.



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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 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 could cause pharmaceutical companies to restructure the financial terms of their business arrangements with PBMs or health
plans;
|- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | patients bill of rights legislation at the state and federal level that could hold health plans 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;
|- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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



| |  | limiting the ability of small employer group health plans to use risk selection to control costs and health status and industry codes to set rates, as well as limiting the amount of
rate increases that can be given from year to year;
|- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | allowing employers to leverage their purchasing power through associations or other multiple employer arrangements; and
|- |  | -----------------------------------------------------------------------------------------------------------------------



| |  | adding further restrictions and administrative requirements related to the compensatory arrangements pertaining to our agents and brokers in connection with the sale of our products
and disclosure of such compensatory arrangements.
|- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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, OPM requires health plans 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 health plans to certify each year that rates meet these requirements. Periodically, the Office of the Inspector
General, or OIG, audits health plans 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.



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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 risk based capital, 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, 2004, 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 $800 million as of December 31, 2004. 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.



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.



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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 Aetna Inc., CIGNA Corporation, Health Net, Inc., WellPoint, Inc., other Blue
Cross and Blue Shield plans and UnitedHealth Group Incorporated, as well as other national and regional health insurers for membership. Regional competitors include Kaiser Foundation Health Plan Inc., Health Net, Inc., WellPoint, 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 Advantage organizations
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 Advantage market. In 2002 and 2003, we reduced 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 Advantage. 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 Advantage program and reduced benefits coverage.



Beginning in 2004, we were able to improve our competitive position in Medicare Advantage for the following reasons:



| |  | Increased government funding under the MMA legislation allowed 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, made our Medicare Advantage plans 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 Advantage market even during times when adequate funding may not
have been available.
|- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



Because of the increased government funding
under the MMA legislation, there is a greater risk that competition among private health plans for Medicare Advantage members could increase in 2005.



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., Caremark Rx, Inc. and Express Scripts Inc. We believe because it is aligned with a
managed care organization, Prescription Solutions differentiates itself from other independent 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.



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



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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 behavioral
health benefits.



We believe that to retain our health plans competitive
advantages we should continue to focus on developing additional products and services that are demanded by the market. We believe that consumers want products and services that go beyond basic necessity, extending to 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 the QUALITY INDEX® profile. There is also a patent pending for certain methods used in creating our QUALITY INDEX® profile.



Employees



At January 31, 2005, we had approximately 9,800 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,
2004, we leased approximately 104,000 aggregate square feet of space for our principal corporate headquarters and executive offices in Cypress, California. In connection with our operations, as of December 31, 2004, we leased approximately 1.8
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 2005 through 2012.



In California, Wisconsin, and Guam, we own three buildings encompassing approximately 625,000 aggregate square feet of space primarily used for the administrative operations of our subsidiary, AMS. 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, 2004.



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PART II



ITEM 5.  MARKET FOR THE REGISTRANTS COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER REPURCHASES OF EQUITY SECURITIES



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 outstanding 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, 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
|Year ended December 31, 2004 |  |      |       |     |   |      
|First Quarter                |  | $    | 39.96 |     | $ | 28.64
|Second Quarter               |  | $    | 42.72 |     | $ | 33.71
|Third Quarter                |  | $    | 38.70 |     | $ | 29.35
|Fourth Quarter               |  | $    | 57.53 |     | $ | 32.50



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 103/4% senior notes.



As of January 31, 2005 there were 281 stockholders of record of our common stock.



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. Beginning with the quarter ended September 30, 2003 and during each consecutive calendar quarter up through and including the quarter ended December 31, 2004, the market price condition described above was
satisfied. As a result, the debentures were convertible beginning October 1, 2003, and remain convertible at the option of the holder at any time during the quarter ended March 31, 2005. While no debentures were converted as of December 31, 2004,
they are considered common stock equivalents and are included in the calculation of weighted average shares outstanding on a diluted basis for the years ended December 31, 2004 and 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.



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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 103/4% senior notes. See Note 6 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 2005 Annual Meeting of Stockholders is incorporated herein by reference.



In May 2004, our Board of Directors authorized the repurchase of up to $150 million of our common stock under a stock repurchase program. Share repurchases are made under
our stock repurchase program from time to time through open market purchases or through privately negotiated transactions using available cash, and may be discontinued at any time. Also, in connection with our employee equity incentive plans, we may
repurchase shares of common stock from employees for the satisfaction of their individual payroll tax withholdings upon vesting of restricted stock. For a summary of our repurchase activity for the year ended December 31, 2004, see
Managements Discussion and Analysis of Financial Condition and Results of Operations-Financing Activities.



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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 and Financial Statement Schedules.



Income Statement Data



|                                                                                                                    |  |                                               |            |   |         |   |            |         |  |   |            |   |  |         |            |   |  |   |            |  
|------------------------------------------------------------------------------------------------------------------- |  | --------------------------------------------- | ---------- | - | ------- | - | ---------- | ------- |  | - | ---------- | - |  | ------- | ---------- | - |  | - | ---------- | -
|                                                                                                                    |  | Year Ended December 31,                       |           
|                                                                                                                    |  | 2004(2)                                       |            |   | 2003(3) |   |            | 2002(4) |  |   | 2001(5)    |   |  | 2000(6) |           
|                                                                                                                    |  | (Amounts in thousands, except per share data) |           
|Operating revenue                                                                                                   |  | $                                             | 12,276,804 |   |         | $ | 11,008,511 |         |  | $ | 11,156,502 |   |  | $       | 11,843,972 |   |  | $ | 11,576,298 |  
|Expenses:                                                                                                           |  |                                               |            |   |         |   |            |         |  |   |            |   |  |         |            |   |  |   |            |  
|Health care services and other                                                                                      |  |                                               | 10,173,779 |   |         |   | 9,065,794  |         |  |   | 9,485,701  |   |  |         | 10,367,657 |   |  |   | 9,913,657  |  
|Selling, general and administrative expenses                                                                        |  |                                               | 1,561,247  |   |         |   | 1,452,542  |         |  |   | 1,370,160  |   |  |         | 1,288,374  |   |  |   | 1,286,790  |  
|Impairment, disposition, restructuring, Office of Personnel Management and other charges (credits), net             |  |                                               |           |   |         |   |           |         |  |   | 3,774      |   |  |         | 61,157     |   |  |   | 8,766      |  
|                                                                                                                    |  |                                               |            |   |         |   |            |         |  |   |            |   |  |         |            |   |  |   |            |  
|Operating income                                                                                                    |  |                                               | 541,778    |   |         |   | 490,175    |         |  |   | 296,867    |   |  |         | 126,784    |   |  |   | 367,085    |  
|Interest expense, net                                                                                               |  |                                               | (48,041    | ) |         |   | (100,531   | )       |  |   | (74,904    | ) |  |         | (70,282    | ) |  |   | (79,636    | )
|Minority interest in consolidated subsidiary                                                                        |  |                                               |           |   |         |   |           |         |  |   |           |   |  |         |           |   |  |   | 637        |  
|                                                                                                                    |  |                                               |            |   |         |   |            |         |  |   |            |   |  |         |            |   |  |   |            |  
|Income before income taxes                                                                                          |  |                                               | 493,737    |   |         |   | 389,644    |         |  |   | 221,963    |   |  |         | 56,502     |   |  |   | 288,086    |  
|Provision for income taxes                                                                                          |  |                                               | 190,583    |   |         |   | 146,896    |         |  |   | 82,792     |   |  |         | 38,371     |   |  |   | 127,046    |  
|                                                                                                                    |  |                                               |            |   |         |   |            |         |  |   |            |   |  |         |            |   |  |   |            |  
|Income before cumulative effect of a change in accounting principle and extraordinary gain                          |  |                                               | 303,154    |   |         |   | 242,748    |         |  |   | 139,171    |   |  |         | 18,131     |   |  |   | 161,040    |  
|Cumulative effect of a change in accounting principle                                                               |  |                                               |           |   |         |   |           |         |  |   | (897,000   | ) |  |         |           |   |  |   |           |  
|Extraordinary gain on early retirement of debt (less income taxes of $0.9 million)                                  |  |                                               |           |   |         |   |           |         |  |   |           |   |  |         | 875        |   |  |   |           |  
|                                                                                                                    |  |                                               |            |   |         |   |            |         |  |   |            |   |  |         |            |   |  |   |            |  
|Net income (loss)                                                                                                   |  | $                                             | 303,154    |   |         | $ | 242,748    |         |  | $ | (757,829   | ) |  | $       | 19,006     |   |  | $ | 161,040    |  
|                                                                                                                    |  |                                               |            |   |         |   |            |         |  |   |            |   |  |         |            |   |  |   |            |  
|Basic earnings (loss) per share(1):                                                                                 |  |                                               |            |   |         |   |            |         |  |   |            |   |  |         |            |   |  |   |            |  
|Income before cumulative effect of a change in accounting principle and extraordinary gain                          |  | $                                             | 3.60       |   |         | $ | 3.26       |         |  | $ | 1.98       |   |  | $       | 0.27       |   |  | $ | 2.29       |  
|Cumulative effect of a change in accounting principle                                                               |  |                                               |           |   |         |   |           |         |  |   | (12.73     | ) |  |         |           |   |  |   |           |  
|Extraordinary gain, net                                                                                             |  |                                               |           |   |         |   |           |         |  |   |           |   |  |         | 0.01       |   |  |   |           |  
|                                                                                                                    |  |                                               |            |   |         |   |            |         |  |   |            |   |  |         |            |   |  |   |            |  
|Basic earnings (loss) per share                                                                                     |  | $                                             | 3.60       |   |         | $ | 3.26       |         |  | $ | (10.75     | ) |  | $       | 0.28       |   |  | $ | 2.29       |  
|                                                                                                                    |  |                                               |            |   |         |   |            |         |  |   |            |   |  |         |            |   |  |   |            |  
|Diluted earnings (loss) per share(1):                                                                               |  |                                               |            |   |         |   |            |         |  |   |            |   |  |         |            |   |  |   |            |  
|Income before cumulative effect of a change in accounting principle and extraordinary gain                          |  | $                                             | 3.20       |   |         | $ | 2.89       |         |  | $ | 1.98       |   |  | $       | 0.26       |   |  | $ | 2.29       |  
|Cumulative effect of a change in accounting principle                                                               |  |                                               |           |   |         |   |           |         |  |   | (12.73     | ) |  |         |           |   |  |   |           |  
|Extraordinary gain, net                                                                                             |  |                                               |           |   |         |   |           |         |  |   |           |   |  |         | 0.01       |   |  |   |           |  
|                                                                                                                    |  |                                               |            |   |         |   |            |         |  |   |            |   |  |         |            |   |  |   |            |  
|Diluted earnings (loss) per share                                                                                   |  | $                                             | 3.20       |   |         | $ | 2.89       |         |  | $ | (10.75     | ) |  | $       | 0.27       |   |  | $ | 2.29       |  
|                                                                                                                    |  |                                               |            |   |         |   |            |         |  |   |            |   |  |         |            |   |  |   |            |  
|Operating Statistics                                                                                                |  |                                               |            |   |         |   |            |         |  |   |            |   |  |         |            |   |  |   |            |  
|Fully-insured risk medical loss ratios:                                                                             |  |                                               |            |   |         |   |            |         |  |   |            |   |  |         |            |   |  |   |            |  
|Consolidated                                                                                                        |  |                                               | 84.7       | % |         |   | 84.0       | %       |  |   | 86.8       | % |  |         | 89.7       | % |  |   | 87.5       | %
|PrivateCommercial                                                                                                  |  |                                               | 83.5       | % |         |   | 84.0       | %       |  |   | 87.1       | % |  |         | 89.3       | % |  |   | 85.1       | %
|PrivateSenior                                                                                                      |  |                                               | 70.6       | % |         |   | 63.4       | %       |  |   | 53.5       | % |  |         | 79.7       | % |  |   |           |  
|PrivateConsolidated                                                                                                |  |                                               | 83.3       | % |         |   | 83.7       | %       |  |   | 86.7       | % |  |         | 89.2       | % |  |   | 85.1       | %
|GovernmentSenior                                                                                                   |  |                                               | 86.1       | % |         |   | 84.2       | %       |  |   | 86.9       | % |  |         | 90.1       | % |  |   | 89.4       | %
|GovernmentConsolidated                                                                                             |  |                                               | 86.1       | % |         |   | 84.2       | %       |  |   | 86.9       | % |  |         | 90.1       | % |  |   | 89.4       | %
|Selling, general and administrative expenses as a percentage of operating revenue (excluding net investment income) |  |                                               | 12.8       | % |         |   | 13.3       | %       |  |   | 12.4       | % |  |         | 11.0       | % |  |   | 11.2       | %
|Operating income as a percentage of operating revenue                                                               |  |                                               | 4.4        | % |         |   | 4.5        | %       |  |   | 2.7        | % |  |         | 1.1        | % |  |   | 3.2        | %
|Effective tax rate(7)                                                                                               |  |                                               | 38.6       | % |         |   | 37.7       | %       |  |   | 37.3       | % |  |         | 67.9       | % |  |   | 44.1       | %



See footnotes following
Balance Sheet Data.

Continued on next page



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##### Table of Contents

Other Financial and Operating Data



|                                                          |  |                        |            |   |      |   |           |      |  |   |           |   |  |      |           |   |  |   |           |  
|--------------------------------------------------------- |  | ---------------------- | ---------- | - | ---- | - | --------- | ---- |  | - | --------- | - |  | ---- | --------- | - |  | - | --------- | -
|                                                          |  | December 31,           |           
|                                                          |  | 2004                   |            |   | 2003 |   |           | 2002 |  |   | 2001      |   |  | 2000 |          
|                                                          |  | (Dollars in thousands) |           
|Depreciation and amortization                             |  | $                      | 70,289     |   |      | $ | 66,621    |      |  | $ | 73,884    |   |  | $    | 148,704   |   |  | $ | 130,563   |  
|Capital expenditures                                      |  | $                      | 73,066     |   |      | $ | 52,271    |      |  | $ | 59,274    |   |  | $    | 77,301    |   |  | $ | 105,256   |  
|Net cash flows provided by operating activities           |  | $                      | 28,100     |   |      | $ | 414,130   |      |  | $ | 242,379   |   |  | $    | 38,923    |   |  | $ | 631,236   |  
|Net cash flows provided by (used in) investing activities |  | $                      | (810,066   | ) |      | $ | (201,700  | )    |  | $ | (278,137  | ) |  | $    | (260,828  | ) |  | $ | 72,376    |  
|Net cash flows provided by (used in) financing activities |  | $                      | 407,648    |   |      | $ | 34,303    |      |  | $ | 9,688     |   |  | $    | (51,971   | ) |  | $ | (301,041  | )
|Membership Data                                           |  |                        |            |   |      |   |           |      |  |   |           |   |  |      |           |   |  |   |           |  
|Commercial                                                |  |                        | 2,593,000  |   |      |   | 2,202,900 |      |  |   | 2,361,900 |   |  |      | 2,520,400 |   |  |   | 3,061,200 |  
|Senior                                                    |  |                        | 743,400    |   |      |   | 709,200   |      |  |   | 776,100   |   |  |      | 959,500   |   |  |   | 1,057,200 |  
|                                                          |  |                        |            |   |      |   |           |      |  |   |           |   |  |      |           |   |  |   |           |  
|Total managed care and other membership                   |  |                        | 3,336,400  |   |      |   | 2,912,100 |      |  |   | 3,138,000 |   |  |      | 3,479,900 |   |  |   | 4,118,400 |  
|                                                          |  |                        |            |   |      |   |           |      |  |   |           |   |  |      |           |   |  |   |           |  
|Specialty membership:                                     |  |                        |            |   |      |   |           |      |  |   |           |   |  |      |           |   |  |   |           |  
|Pharmacy benefit management(8)                            |  |                        | 5,588,700  |   |      |   | 4,983,500 |      |  |   | 4,773,100 |   |  |      | 4,608,900 |   |  |   | 4,748,800 |  
|Behavioral health                                         |  |                        | 3,813,600  |   |      |   | 3,660,100 |      |  |   | 3,876,000 |   |  |      | 3,710,600 |   |  |   | 3,824,800 |  
|Dental and vision                                         |  |                        | 1,040,500  |   |      |   | 719,600   |      |  |   | 687,300   |   |  |      | 908,100   |   |  |   | 1,360,900 |  
|                                                          |  |                        |            |   |      |   |           |      |  |   |           |   |  |      |           |   |  |   |           |  
|Total specialty membership                                |  |                        | 10,442,800 |   |      |   | 9,363,200 |      |  |   | 9,336,400 |   |  |      | 9,227,600 |   |  |   | 9,934,500 |  
|                                                          |  |                        |            |   |      |   |           |      |  |   |           |   |  |      |           |   |  |   |           |  
|Balance Sheet Data                                        |  |                        |            |   |      |   |           |      |  |   |           |   |  |      |           |   |  |   |           |  
|Cash and equivalents                                      |  | $                      | 824,104    |   |      | $ | 1,198,422 |      |  | $ | 951,689   |   |  | $    | 977,759   |   |  | $ | 1,251,635 |  
|Marketable securities                                     |  |                        | 1,936,765  |   |      |   | 1,359,720 |      |  |   | 1,195,517 |   |  |      | 1,062,353 |   |  |   | 864,013   |  
|Total assets                                              |  |                        | 5,226,917  |   |      |   | 4,619,304 |      |  |   | 4,251,133 |   |  |      | 5,096,046 |   |  |   | 5,323,436 |  
|Medical claims and benefits payable                       |  |                        | 1,192,400  |   |      |   | 1,027,500 |      |  |   | 1,044,500 |   |  |      | 1,095,900 |   |  |   | 1,270,800 |  
|Long-term debt, due after one year                        |  |                        | 1,051,520  |   |      |   | 612,700   |      |  |   | 731,961   |   |  |      | 794,309   |   |  |   | 836,556   |  
|Stockholders equity                                      |  |                        | 2,188,438  |   |      |   | 1,851,537 |      |  |   | 1,328,305 |   |  |      | 2,033,785 |   |  |   | 2,003,560 |  

---

|(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 2004 results of operations include the results of the AMS acquisition for the period December 13, 2004 to December 31, 2004. See Note 3 of the Notes to Consolidated Financial
Statements.
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|(3) | The 2003 diluted earnings per share has been restated for the retroactive impact of Emerging Issues Task Force, or EITF, Issue No. 04-8, The Effect of Contingently Convertible
Debt on Diluted Earnings Per Share.See Note 2 of the Notes to Consolidated Financial Statements.
|--- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|(4) | 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, or 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.



|(5) | 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).
Operating income before net pretax charges as a percentage of operating revenue was 1.6%.
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|(6) | 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).
Operating income before net pretax charges as a percentage of operating revenue was 3.2%.
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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|(7) | Effective income tax rate includes the effect of nondeductible pretax charges, primarily goodwill amortization for the years ended December 31, 2000 and 2001.
|--- | --------------------------------------------------------------------------------------------------------------------------------------------------------------



|(8) | Pharmacy benefit management membership represents external members and members that are in our commercial, Medicare Advantage, Medicare Supplement or CMS Disease Management plans,
excluding members covered under other PBM contracts. 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 service.
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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



Overview



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 Estimates and in other parts of this report.



We offer managed care and other health insurance products to employer groups, individuals and
Medicare beneficiaries throughout most of the United States and Guam. Our commercial and senior plans are designed to deliver quality health care and customer service to members cost-effectively. These products include health insurance, health
benefits administration and indemnity insurance products such as Medicare Supplement products offered through health maintenance organizations, or HMOs, and preferred provider organizations, or PPOs. We also offer a variety of specialty managed care
products and services that employees and individuals 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.



Acquisitions.  During 2004, we entered into agreements to acquire two businesses. On December 13, 2004, we completed our acquisition of American Medical Security Group, Inc., or AMS. AMS provides an expansion of our
commercial membership, strengthens our position in the individual and small group markets and adds new proprietary products including a health savings account and group life products. We paid $32.75 in cash for each share of AMS common stock
outstanding and cashed out all outstanding options on a net basis for a total equity purchase price of approximately $505 million. We financed the acquisition through proceeds from a new $825 million credit facility and the use of internally
generated cash. The new credit facility includes a total of $625 million of term debt, approximately $148 million of which was used to refinance our existing senior credit facility and approximately $30 million was used to refinance AMSs
senior credit facility, and a new $200 million unutilized revolving credit facility. We recorded $295 million of goodwill and $26 million of intangible assets as a result of this acquisition. As of December 31, 2004, AMS provided a variety of
individual and small group insurance products to approximately 271,200 PPO members, 206,100 dental members and 40,900 employer self-funded members. See Note 3 of the Notes to Consolidated Financial Statements.



On November 29, 2004, we entered into a definitive agreement to purchase Pacific Life
Insurance Companys, or Pacific Life, group health insurance business. The transaction will be financed through internally generated cash. The group health insurance business we are acquiring from Pacific Life includes medical, dental and life
coverage for small and large group employers. Through the transaction, which is structured as a coinsurance arrangement, we expect to acquire up to 140,000 PPO members and obtain assets necessary to support and preserve the continuity of the
acquired business and the rights to offer employment to the approximately 700 Pacific Life employees who currently provide service and support to the group insurance business. The transaction is subject to approvals from the California Insurance
Commissioner and certain other state regulatory approvals. We anticipate the acquisition will be consummated during the spring of 2005.



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2004 Changes in Debt.



Senior Credit Facility.  In December 2004, concurrent with the acquisition of AMS, we replaced our senior credit facility
with a new syndicated senior credit agreement. The new facility consists of a $200 million term A loan, which matures on December 13, 2009, a $425 million term B loan, which matures on December 13, 2010, and a $200 million revolving line of credit,
which matures on December 13, 2009. We used the proceeds of the term A and term B loans to refinance approximately $149 million (including accrued interest and fees of approximately $1 million) outstanding under our previous senior credit facility
entered into in June 2003, refinance approximately $30 million outstanding under the senior credit facility of AMS and to fund a portion of the merger consideration paid to acquire AMS. See Note 3 of the Notes to Consolidated Financial Statements.
In connection with the credit agreement, we incurred approximately $9 million in fees and expenses that are being amortized over the term of the facility. As of December 31, 2004, we had $625 million outstanding on the term A and term B loans and no
balance outstanding on the revolving line of credit. There were no borrowings under the revolving line of credit (or the line of credit we refinanced) during the year ended December 31, 2004.



For additional details related to our debt and financings, see Note 5 of the Notes to
Consolidated Financial Statements.



Other



Segment Reporting.  We regularly review for changes in our segment
reporting. We expect our specialty product revenues may increase in 2005 and rise to the level of a reportable segment. As a result of entering into contracts that bear margin or pricing risk, we expect there will be an increase in revenues and
expenses. Accordingly, we have included in Note 15 of the Notes to Consolidated Financial Statements, disclosures related to our Health Plans and Specialty segments.



Intercompany Transactions.  All intercompany transactions and accounts are eliminated in consolidation.



Results of Operations



Revenue



Health Plans Segment.  Our commercial and senior revenues include all premium revenue we receive from our health plans,
indemnity insurance subsidiaries 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 Advantage, formerly 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 Advantage 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 Advantage products must submit adjusted community rate proposals, generally
by county or service area, to CMS, in early September for each Medicare Advantage 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 Segment.  Our specialty and other revenues include all premium
revenues we receive from our behavioral health, 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. Beginning in January 2004, our PBM subsidiary began



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entering into retail service contracts where we assume margin or pricing risk. Under these retail service contracts, we are separately obligated to pay our
network pharmacy providers for benefits provided to our plan sponsors members, and as a result, we have included the total revenues we are contracted to receive from the plan sponsors as specialty and other revenue. Payments we are obligated
to make under these retail service contracts to the network pharmacy providers are recorded as health care services and other expenses. For all contracts where we earn a fixed fee per transaction and we do not assume margin or pricing risk,
specialty and other revenue and specialty and other health care services and other expenses do not include the network pharmacies drug costs and dispensing fees. Instead, we record administrative services fees that we are entitled to receive,
in specialty and other revenue. In all retail pharmacy transactions, revenues recognized and expenses recorded are always exclusive of the members applicable copayment. Collection of copayments from members is the responsibility of the retail
pharmacies.



Net Investment Income.  Net investment income
consists of interest income and gross realized gains and losses incurred on cash investments during each period.



Expenses



Health Plans Segment.  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 for
services provided to our commercial and senior health plan members and indemnity insurance plan members. We pay our providers under capitated contracts, fee-for-service contracts, or a combination of both. In the situation where we pay a provider
under a combination of capitation and fee-for-service, a member, during the same episode of care, may incur services that are rendered and paid for under the capitated portion of a contract with a physician or hospital and also incur services that
are rendered and paid for under the fee-for-service component of the same contract.



Our fee-for-service 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.



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 fee-for-service 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 31st of last year were net favorable
adjustments of 2002 and prior period medical cost estimates of approximately $54 million. During 2003, both commercial and senior 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 made in prior periods 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 some of our capitation contracts, we 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 or falls into certain defined categories, we partially



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share the excess expenses with the applicable health care provider. Under fee-for- service arrangements, we generally bear the full risk of member
utilization of health care services.



Specialty
Segment.  Health care services and other expenses for our specialty companies primarily comprise payments to physicians, hospitals and other health care providers under capitated or fee-for-service based contracts for services provided
to our behavioral health and dental and vision members and the cost of acquiring drugs for our mail order PBM subsidiary where we assume margin or pricing risk. Health care services and other expenses also include expenses for administrative
services performed by our specialty companies.



2004 Compared With
2003



Membership



Health Plans Segment Membership.  Total managed care membership
increased 14% to approximately 3.3 million members at December 31, 2004 from approximately 2.9 million members at December 31, 2003.



Commercial membership increased approximately 18% at December 31, 2004 compared to the prior year primarily due to an increase in membership in our PPO and employer
self-funded products, which includes the addition of 271,200 PPO and 40,900 employer self-funded members as a result of the AMS acquisition. Membership increases were offset by a net decrease in commercial HMO membership primarily due to the planned
termination of large employer groups in Texas and Oklahoma.



Medicare Advantage
membership increased approximately 3% at December 31, 2004 compared to the prior year primarily due to increased membership in the HMO product in Arizona, California and Texas from service area expansions and sales through new broker channels.



Medicare Supplement membership increased approximately 35% at December 31,
2004 compared to the prior year primarily due to membership growth in Texas and expansion into 19 new states through new broker channels.



We anticipate that our health plans segment membership will increase in 2005.



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Below is a summary of our commercial and senior membership.



|                              |  |                   |  |                   |  |           |  |            |  |                   |  |          
|----------------------------- |  | ----------------- |  | ----------------- |  | --------- |  | ---------- |  | ----------------- |  | ---------
|                              |  | December 31, 2004 |  | December 31, 2003
|                              |  | Commercial        |  | MedicareAdvantage |  | Total     |  | Commercial |  | MedicareAdvantage |  | Total    
|Managed Care Membership(1)(2) |  |                   |  |                   |  |           |  |            |  |                   |  |          
|Arizona                       |  | 167,700           |  | 102,900           |  | 270,600   |  | 159,900    |  | 86,600            |  | 246,500  
|California                    |  | 1,503,300         |  | 357,800           |  | 1,861,100 |  | 1,410,400  |  | 348,400           |  | 1,758,800
|Colorado                      |  | 250,300           |  | 52,100            |  | 302,400   |  | 229,300    |  | 52,600            |  | 281,900  
|Florida                       |  | 30,400            |  |                  |  | 30,400    |  |           |  |                  |  |         
|Guam                          |  | 27,100            |  |                  |  | 27,100    |  | 26,400     |  |                  |  | 26,400   
|Illinois                      |  | 36,900            |  |                  |  | 36,900    |  |           |  |                  |  |         
|Michigan                      |  | 43,800            |  |                  |  | 43,800    |  |           |  |                  |  |         
|Nevada                        |  | 40,900            |  | 25,700            |  | 66,600    |  | 33,300     |  | 25,300            |  | 58,600   
|Oklahoma                      |  | 101,700           |  | 15,500            |  | 117,200   |  | 96,700     |  | 18,400            |  | 115,100  
|Oregon                        |  | 57,400            |  | 22,700            |  | 80,100    |  | 61,100     |  | 24,000            |  | 85,100   
|Texas                         |  | 119,200           |  | 84,300            |  | 203,500   |  | 116,000    |  | 74,500            |  | 190,500  
|Washington                    |  | 75,800            |  | 43,700            |  | 119,500   |  | 69,800     |  | 52,500            |  | 122,300  
|Other states                  |  | 138,500           |  |                  |  | 138,500   |  |           |  |                  |  |         
|                              |  |                   |  |                   |  |           |  |            |  |                   |  |          
|Total Managed Care Membership |  | 2,593,000         |  | 704,700           |  | 3,297,700 |  | 2,202,900  |  | 682,300           |  | 2,885,200
|                              |  |                   |  |                   |  |           |  |            |  |                   |  |          
|Total Membership              |  |                   |  |                   |  |           |  |            |  |                   |  |          
|Commercial                    |  |                   |  |                   |  |           |  |            |  |                   |  |          
|HMO                           |  |                   |  |                   |  | 1,927,900 |  |            |  |                   |  | 1,994,800
|PPO(2)                        |  |                   |  |                   |  | 582,500   |  |            |  |                   |  | 183,500  
|Employer self-funded(2)       |  |                   |  |                   |  | 82,600    |  |            |  |                   |  | 24,600   
|                              |  |                   |  |                   |  |           |  |            |  |                   |  |          
|Total Commercial              |  |                   |  |                   |  | 2,593,000 |  |            |  |                   |  | 2,202,900
|                              |  |                   |  |                   |  |           |  |            |  |                   |  |          
|Senior                        |  |                   |  |                   |  |           |  |            |  |                   |  |          
|Medicare Advantage            |  |                   |  |                   |  | 704,700   |  |            |  |                   |  | 682,300  
|Medicare Supplement           |  |                   |  |                   |  | 36,200    |  |            |  |                   |  | 26,900   
|CMS Disease Management        |  |                   |  |                   |  | 2,500     |  |            |  |                   |  |         
|                              |  |                   |  |                   |  |           |  |            |  |                   |  |          
|Total Senior                  |  |                   |  |                   |  | 743,400   |  |            |  |                   |  | 709,200  
|                              |  |                   |  |                   |  |           |  |            |  |                   |  |          
|Total Membership              |  |                   |  |                   |  | 3,336,400 |  |            |  |                   |  | 2,912,100
|                              |  |                   |  |                   |  |           |  |            |  |                   |  |          

---

|(1) | Managed care membership includes HMO and PPO membership whether shared-risk or self-funded.
|--- | -------------------------------------------------------------------------------------------



|(2) | At December 31, 2004, commercial managed care membership includes 271,200 PPO and 40,900 employer self-funded members as a result of the AMS acquisition.
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------------------



Specialty Segment Membership.  PBM unaffiliated membership at
December 31, 2004 increased approximately 24% compared to the prior year primarily due to a net addition of 22 new clients, or approximately 175,000 new members, and approximately 317,000 new members from existing clients. PBM PacifiCare membership
at December 31, 2004 increased 4% compared to the prior year primarily due to managed care membership growth.



Total behavioral health membership at December 31, 2004, increased approximately 4% compared to the prior year primarily due to growth in PacifiCare commercial membership in the PPO products, partially offset by group
terminations in the Employee Assistance Program.



Total dental and vision
membership at December 31, 2004, increased approximately 45% compared to the prior year primarily due to the addition of 206,100 members as a result of the AMS acquisition and new PacifiCare vision product offerings which resulted in increased
membership in Arizona, California and Nevada.



We anticipate that our specialty
segment membership will increase in 2005.



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##### Table of Contents

Below is a summary of our specialty membership.



|                               |  |                   |  |                   |  |           |  |            |  |              |  |          
|------------------------------ |  | ----------------- |  | ----------------- |  | --------- |  | ---------- |  | ------------ |  | ---------
|                               |  | December 31, 2004 |  | December 31, 2003
|                               |  | PacifiCare        |  | Unaffiliated      |  | Total     |  | PacifiCare |  | Unaffiliated |  | Total    
|Specialty Membership:          |  |                   |  |                   |  |           |  |            |  |              |  |          
|Pharmacy benefit management(1) |  | 3,024,300         |  | 2,564,400         |  | 5,588,700 |  | 2,912,100  |  | 2,071,400    |  | 4,983,500
|Behavioral health(2)           |  | 2,083,900         |  | 1,729,700         |  | 3,813,600 |  | 2,013,400  |  | 1,646,700    |  | 3,660,100
|Dental and vision(2)(3)        |  | 601,200           |  | 439,300           |  | 1,040,500 |  | 485,000    |  | 234,600      |  | 719,600  

---

|(1) | Pharmacy benefit management PacifiCare membership represents members that are in our commercial, Medicare Advantage, Medicare Supplement or CMS Disease Management plans, excluding
members covered under other PBM contracts. 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 service.
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|(2) | Behavioral health, dental and vision PacifiCare membership represents members in our commercial, Medicare Advantage, and Medicare Supplement plans that are also enrolled in our
behavioral health, dental and/or vision plans.
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|(3) | At December 31, 2004, dental and vision membership includes 60,800 PacifiCare and 145,300 unaffiliated members as a result of the AMS acquisition.
|--- | --------------------------------------------------------------------------------------------------------------------------------------------------



Revenues



Health Plans Segment Revenue



Commercial Revenue.  Commercial revenue increased 13%, or $643 million, to $5.69 billion for the year ended December 31, 2004, from $5.04 billion
for the year ended December 31, 2003 as follows:



|                                                               |  |                              |    
|-------------------------------------------------------------- |  | ---------------------------- | ---
|                                                               |  | Year Ended December 31, 2004
|                                                               |  | (Amounts in millions)       
|Premium rate increases                                         |  | $                            | 437
|Net membership increases, primarily in California and Colorado |  |                              | 173
|Increase as a result of AMS acquisition on December 13, 2004   |  |                              | 33 
|                                                               |  |                              |    
|Increase over the comparable period of the prior year          |  | $                            | 643
|                                                               |  |                              |    



We anticipate revenue increases in
2005 primarily due to rate increases and membership growth, which includes expansion through our completed and announced and pending acquisitions.



Senior Revenue.  Senior revenue increased 8%, or $415 million, to $5.81 billion for the year ended December 31, 2004 from $5.40 billion for the
year ended December 31, 2003 as follows:



|                                                      |  |                             |    
|----------------------------------------------------- |  | --------------------------- | ---
|                                                      |  | Year EndedDecember 31, 2004
|                                                      |  | (Amounts in millions)      
|Premium rate increases                                |  | $                           | 363
|Net membership increases                              |  |                             | 52 
|                                                      |  |                             |    
|Increase over the comparable period of the prior year |  | $                           | 415
|                                                      |  |                             |    



Premium rate increases include
additional retroactive premiums received from CMS during the year ended December 31, 2004, based upon the health status of our members as of December 31, 2003. Retroactive premiums recorded during the quarter ended September 30, 2004 and year ended
December 31, 2004 were approximately $28 million and represented reimbursement for fee-for-service health care costs incurred during the period January 1 through June 30, 2004. In addition, upon receipt of the additional premium revenue, we recorded
retroactive capitation expense to providers of approximately $15 million. Ongoing premium payments reflecting the health status of our members were adjusted effective July 1, 2004.



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In 2005, during the third quarter, we anticipate receiving additional premiums related to health status similar to what
we experienced in the third quarter of 2004. However in 2005, since we now have historical information related to this payment from 2004, we will estimate and record premium revenue and associated expenses on a quarterly basis during the quarter in
which health care services are rendered.



We anticipate revenue increases in
2005 primarily due to membership and rate increases as well as from changes due to the MMA legislation.



Specialty Segment Revenue.  Specialty and other revenue increased 39%, or $193 million, to $692 million for the year ended December 31, 2004, from $499 million for the year ended December 31,
2003. The increase was primarily due to the growth of unaffiliated PBM membership which resulted in increased service fee revenue charged to external customers, overall growth in the volume of mail service business which generated increased revenue
from mail service customers of our PBM subsidiary, volume of PBM service contracts where we assume margin or pricing risk, and premium rate increases in our behavioral health business. Our PBM subsidiary began entering into retail service contracts
where we assume margin or pricing risk as of January 2004. For these contracts, revenues we are contractually entitled to receive are included in Specialty and Other Revenue with corresponding costs recorded as Health Care Services and Other
Expenses. Please refer to the section entitled Specialty Segment Margin for a discussion of the net growth of the Specialty Segment.



We anticipate revenue increases in 2005 primarily due to membership increases.



Net Investment Income.  Net investment income increased 25%, or $17 million, to $88 million for the year ended December 31, 2004 from $71 million
for the year ended December 31, 2003. The increase was primarily due to increased net realized gains and higher invested balances compared to the same period in the prior year.



Segment Margins



Health Plans Segment Margin



Commercial Margin.  Our commercial margin increased 16%, or $127 million, to $900 million for the year ended December 31, 2004, from $773 million
for the year ended December 31, 2003 as follows:



|                                                                                                                                              |  |                             |      |  
|--------------------------------------------------------------------------------------------------------------------------------------------- |  | --------------------------- | ---- | -
|                                                                                                                                              |  | Year EndedDecember 31, 2004 |     
|                                                                                                                                              |  | (Amounts in millions)       |     
|Commercial revenue increases (as noted above)                                                                                                 |  | $                           | 643  |  
|Increases in health care services and other expenses as a result of trend increases                                                           |  |                             | (347 | )
|Increases in health care services and other expenses as a result of net commercial membership increases, primarily in California and
Colorado |  |                             | (147 | )
|Increases in health care services and other expenses as a result of AMS acquisition                                                           |  |                             | (22  | )
|                                                                                                                                              |  |                             |      |  
|Increase over the comparable period of the prior year                                                                                         |  | $                           | 127  |  
|                                                                                                                                              |  |                             |      |  



We anticipate our commercial margin in
2005 will be slightly higher than 2004.



21





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Senior Margin.  Our senior margin decreased 6%, or $53 million, to $802 million for the year ended
December 31, 2004, from $855 million for the year ended December 31, 2003 as follows:



|                                                                                                                                                                                                                |  |                             |      |  
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | --------------------------- | ---- | -
|                                                                                                                                                                                                                |  | Year EndedDecember 31, 2004 |     
|                                                                                                                                                                                                                |  | (Amounts in millions)       |     
|Senior revenue increases (as noted above)                                                                                                                                                                       |  | $                           | 415  |  
|Increases in health care services and other expenses as a result of required reimbursement and benefit increases under the enacted MMA
legislation and trend increases, partially offset by benefit adjustments |  |                             | (424 | )
|Increases in health care services and other expenses as a result of net senior membership increases                                                                                                             |  |                             | (44  | )
|                                                                                                                                                                                                                |  |                             |      |  
|Decrease over the comparable period of the prior year                                                                                                                                                           |  | $                           | (53  | )
|                                                                                                                                                                                                                |  |                             |      |  



We anticipate our senior margin in
2005 will be lower than in 2004 primarily due to health care services and other expenses which are expected to outpace the increases in our premium revenue.



Specialty Segment Margin.  Our specialty and other margin increased 28%, or $69 million, to $313 million for the year ended December 31, 2004 from
$244 million for the year ended December 31, 2003, which was primarily driven by growth of unaffiliated PBM membership, additional funds received for our Medicare drug discount card program under MMA, and premium rate increases in our behavioral
health business.



We anticipate our specialty segment margin in 2005
will be higher than in 2004 primarily due to membership increases.



Medical Loss Ratios.  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 Advantage, 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.



The consolidated MLR and its components, unadjusted for any prior period changes in health care cost estimates, for the year ended December 31, 2004 and 2003 are as
follows:



|                        |  |                        |   |  |      |  
|----------------------- |  | ---------------------- | - |  | ---- | -
|                        |  | Year EndedDecember 31, |  
|                        |  | 2004                   |   |  | 2003 |  
|Medical loss ratio:     |  |                        |   |  |      |  
|Consolidated            |  | 84.7                   | % |  | 84.0 | %
|PrivateCommercial      |  | 83.5                   | % |  | 84.0 | %
|PrivateSenior          |  | 70.6                   | % |  | 63.4 | %
|PrivateConsolidated    |  | 83.3                   | % |  | 83.7 | %
|GovernmentSenior       |  | 86.1                   | % |  | 84.2 | %
|GovernmentConsolidated |  | 86.1                   | % |  | 84.2 | %



22





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##### Table of Contents

PrivateCommercial MLR.  Our privatecommercial MLR decreased to 83.5% for the year
ended December 31, 2004 compared to 84.0% for the same period in 2003. The decrease was primarily due to a 13% increase in premium revenue, offset by a 12% increase in health care services and other expenses.



PrivateSenior MLR.  Our privatesenior MLR increased to
70.6% for the year ended December 31, 2004 compared to 63.4% for the same period in 2003 primarily due a 39% increase in health care services and other expenses, offset by a 24% increase in premium revenue.



GovernmentSenior MLR.  Our governmentsenior MLR increased
to 86.1% for the year ended December 31, 2004 compared to 84.2% for the same period in 2003 primarily due to a 10% increase in health care services and other expenses, offset by a 8% increase in premium revenue.



Selling, General and Administrative Expenses.  Total selling, general
and administrative expenses increased 7%, or $109 million, to $1.56 billion for the year ended December 31, 2004 from $1.45 billion for the year ended December 31, 2003. Total selling, general and administrative expenses increased primarily due to
increased labor expense to support product development and membership growth, increased broker and internal sales commissions and premium taxes as a result of a shift in product mix, and higher expenses related to employee compensation programs,
such as our employee stock purchase plan. This increase was partially offset by a lower write-off of property and equipment in 2004 as compared to 2003.



For the year ended December 31, 2004, total selling, general and administrative expenses as a percentage of operating revenue (excluding net investment income)
decreased compared to the same period in the prior year primarily due to an increase in operating revenue (excluding net investment income) that outpaced the increase in selling, general and administrative expenses described above. Operating revenue
(excluding net investment income) increased $1.25 billion for the year ended December 31, 2004.



|                                                                                                                                |  |                        |   |  |      |  
|------------------------------------------------------------------------------------------------------------------------------- |  | ---------------------- | - |  | ---- | -
|                                                                                                                                |  | Year EndedDecember 31, |  
|                                                                                                                                |  | 2004                   |   |  | 2003 |  
|Total selling, general and administrative expenses as a percentage of total operating revenue (excluding net investment
income) |  | 12.8                   | % |  | 13.3 | %



We anticipate selling, general and
administrative expenses will increase in 2005 from 2004 primarily due to labor expense to support membership growth and new initiatives under MMA legislation and increases in broker and internal sales commissions.



Interest Expense.  Interest expense decreased 52%, or $53 million, to
$48 million for the year ended December 31, 2004, from $101 million for the year ended December 31, 2003. The decrease 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 103/4% senior notes in December 2003 with no comparable activity in 2004;
|- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | lower debt outstanding due to the redemption of $175 million in principal of our 103/4% senior notes in December 2003; and
|- |  | --------------------------------------------------------------------------------------------------------------------------



| |  | the payment of the $43 million in remaining principal of our FHP International Corporation, or FHP, senior notes in September 2003.
|- |  | -----------------------------------------------------------------------------------------------------------------------------------



Provision for Income Taxes.  The effective income tax rate was 38.6%
for the year ended December 31, 2004, compared with 37.7% for the year ended December 31, 2003. The increase in our effective income tax rate is primarily due to increases in non-deductible stock-based compensation in 2004.



Our effective tax rate is based on expected income, statutory tax rates and tax planning
opportunities available to us in the various jurisdictions in which we operate. Significant management estimates and judgments are required in determining our effective tax rate. We are routinely under audit by federal, state or local authorities
regarding the timing and amount of deductions, nexus of income among various tax jurisdictions and compliance with federal, state and local tax laws. Tax assessments related to these audits may not arise until several years after tax returns have
been



23





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##### Table of Contents

filed. Although predicting the outcome of such tax assessments involves uncertainty, we believe that the recorded tax liabilities appropriately account for
our analysis of probable outcomes, including interest and other potential obligations. Our tax liabilities are adjusted in light of changing facts and circumstances, such as the progress of audits, case law and emerging legislation and such
adjustments are included in the effective tax rate.



2003 Compared with 2002



Membership



Health Plans Segment Membership.  Total managed care membership
decreased 8% to approximately 2.9 million members at December 31, 2003 from approximately 3.1 million members at December 31, 2002.



Commercial membership decreased approximately 7% at December 31, 2003 compared to the prior year primarily due to elimination of unprofitable commercial HMO business and
the termination of contracts with network providers. As previously announced, our contract with the California Public Employee Retirement System, or CalPERS, was not renewed for 2003, resulting in the loss of approximately 180,100 commercial HMO
members in California effective January 1, 2003. The decreases were offset by increased PPO and indemnity membership primarily due to enhanced marketing and the addition of approximately 14,900 members from new product initiatives primarily in
California and Colorado.



Medicare Advantage membership decreased approximately
10% at December 31, 2003 compared to the prior year primarily due to 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.



Medicare Supplement membership increased approximately 72% at December 31, 2003 compared to the prior year primarily due to membership increases in the individual and
group Medicare Supplement product across core states.



Below is a summary of
our commercial and senior membership.



|                              |  |                   |  |                   |  |           |  |            |  |                   |  |          
|----------------------------- |  | ----------------- |  | ----------------- |  | --------- |  | ---------- |  | ----------------- |  | ---------
|                              |  | December 31, 2003 |  | December 31, 2002
|                              |  | Commercial        |  | MedicareAdvantage |  | Total     |  | Commercial |  | MedicareAdvantage |  | Total    
|Managed Care Membership(1)    |  |                   |  |                   |  |           |  |            |  |                   |  |          
|Arizona                       |  | 159,900           |  | 86,600            |  | 246,500   |  | 147,600    |  | 88,400            |  | 236,000  
|California                    |  | 1,410,400         |  | 348,400           |  | 1,758,800 |  | 1,577,000  |  | 386,100           |  | 1,963,100
|Colorado                      |  | 229,300           |  | 52,600            |  | 281,900   |  | 213,000    |  | 57,600            |  | 270,600  
|Guam                          |  | 26,400            |  |                  |  | 26,400    |  | 32,200     |  |                  |  | 32,200   
|Nevada                        |  | 33,300            |  | 25,300            |  | 58,600    |  | 26,700     |  | 27,400            |  | 54,100   
|Oklahoma                      |  | 96,700            |  | 18,400            |  | 115,100   |  | 106,300    |  | 19,800            |  | 126,100  
|Oregon                        |  | 61,100            |  | 24,000            |  | 85,100    |  | 68,200     |  | 25,300            |  | 93,500   
|Texas                         |  | 116,000           |  | 74,500            |  | 190,500   |  | 127,600    |  | 100,400           |  | 228,000  
|Washington                    |  | 69,800            |  | 52,500            |  | 122,300   |  | 63,300     |  | 55,500            |  | 118,800  
|                              |  |                   |  |                   |  |           |  |            |  |                   |  |          
|Total Managed Care Membership |  | 2,202,900         |  | 682,300           |  | 2,885,200 |  | 2,361,900  |  | 760,500           |  | 3,122,400
|                              |  |                   |  |                   |  |           |  |            |  |                   |  |          
|Total Membership              |  |                   |  |                   |  |           |  |            |  |                   |  |          
|Commercial                    |  |                   |  |                   |  |           |  |            |  |                   |  |          
|HMO                           |  |                   |  |                   |  | 1,994,800 |  |            |  |                   |  | 2,252,000
|PPO                           |  |                   |  |                   |  | 183,500   |  |            |  |                   |  | 75,100   
|Employer self-funded          |  |                   |  |                   |  | 24,600    |  |            |  |                   |  | 34,800   
|                              |  |                   |  |                   |  |           |  |            |  |                   |  |          
|Total Commercial              |  |                   |  |                   |  | 2,202,900 |  |            |  |                   |  | 2,361,900
|                              |  |                   |  |                   |  |           |  |            |  |                   |  |          
|Senior                        |  |                   |  |                   |  |           |  |            |  |                   |  |          
|Medicare Advantage            |  |                   |  |                   |  | 682,300   |  |            |  |                   |  | 760,500  
|Medicare Supplement           |  |                   |  |                   |  | 26,900    |  |            |  |                   |  | 15,600   
|CMS Disease Management        |  |                   |  |                   |  |          |  |            |  |                   |  |         
|                              |  |                   |  |                   |  |           |  |            |  |                   |  |          
|Total Senior                  |  |                   |  |                   |  | 709,200   |  |            |  |                   |  | 776,100  
|                              |  |                   |  |                   |  |           |  |            |  |                   |  |          
|Total Membership              |  |                   |  |                   |  | 2,912,100 |  |            |  |                   |  | 3,138,000
|                              |  |                   |  |                   |  |           |  |            |  |                   |  |          

---

|(1) | Managed care membership includes HMO and PPO membership whether shared-risk or self-funded.
|--- | -------------------------------------------------------------------------------------------



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Specialty Segment Membership.  PBM 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. PBM 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.



Below is a
summary of our specialty membership.



|                               |  |                   |  |                   |  |           |  |            |  |              |  |          
|------------------------------ |  | ----------------- |  | ----------------- |  | --------- |  | ---------- |  | ------------ |  | ---------
|                               |  | December 31, 2003 |  | 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) | Pharmacy benefit management PacifiCare membership represents members that are in our commercial, Medicare Advantage 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 service.
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|(2) | Behavioral health, dental and vision PacifiCare membership represents members in our commercial, Medicare Advantage and Medicare Supplement plans that are also enrolled in our
behavioral health, dental and/or vision plans.
|--- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



Revenues



Health Plans Segment Revenue



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 the comparable period of the prior year                                                               |  | $                            | 260  |  
|                                                                                                                    |  |                              |      |  



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 the comparable period of the prior year                                                              |  | $                            | (492 | )
|                                                                                                                   |  |                              |      |  



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##### Table of Contents

Specialty Segment Revenue.  Specialty and other revenue increased 18%, or $77 million to $499
million for the year ended December 31, 2003 as 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.
|- |  | -----------------------------------------------------------------------------



Segment Margins



Health Plans Segment Margin



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  |  
|                                                                                                                                            |  |                              |      |  



Senior
Margin.  Our senior margin increased 9%, or $72 million, to $855 million for the year ended December 31, 2003, compared to $783 million for 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   |  
|                                                                                                                                    |  |                              |      |  



Specialty Segment
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.



26





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##### Table of Contents

Medical Loss Ratios.  The consolidated MLR and its components, unadjusted for any prior period
changes in health care cost estimates, for the year ended December 31, 2003 and 2002 are as follows:



|                        |  |                        |   |  |      |  
|----------------------- |  | ---------------------- | - |  | ---- | -
|                        |  | Year EndedDecember 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.  Total selling, general and administrative expenses increased 6%, or $82 million, to $1.5 billion for the year ended December 31, 2003, from $1.4 billion in the prior year. Total 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.



Total 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 EndedDecember 31, |  
|                                                                                                                                |  | 2003                   |   |  | 2002 |  
|Total selling, general and administrative expenses as a percentage of total 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 103/4% senior notes in December 2003 with no comparable activity in the prior year;
|- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | 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 103/4% 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.
|- |  | ------------------------------------------------------------------------------------------------------



27





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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 expected income, statutory tax
rates and tax planning opportunities available to us in the various jurisdictions in which we operate. Significant management estimates and judgments are required in determining our effective tax rate. We are routinely under audit by federal, state
or local authorities regarding the timing and amount of deductions, nexus of income among various tax jurisdictions and compliance with federal, state and local tax laws. Tax assessments related to these audits may not arise until several years
after tax returns have been filed. Although predicting the outcome of such tax assessments involves uncertainty, we believe that the recorded tax liabilities appropriately account for our analysis of probable outcomes, including interest and other
potential obligations. Our tax liabilities are adjusted in light of changing facts and circumstances, such as the progress of audits, case law and emerging legislation and such adjustments are included in the effective tax rate.



Liquidity and Capital Resources



Operating Cash Flows.  Our consolidated cash and equivalents and
marketable securities increased $203 million or 8% to $2.8 billion at December 31, 2004, from $2.6 billion at December 31, 2003.



Cash flows provided by operations were $28 million (or $457 million, excluding the impact of unearned premium revenue) for the year ended December 31, 2004 compared to
cash flows provided by operations of $414 million (or $397 million, excluding the impact of unearned premium revenue) for the year ended December 31, 2003. The decrease was primarily due to a change in the timing of our January premium payment from
CMS that was received on January 3, 2005 compared to the January 2004 payment that was received on December 31, 2003. Other changes in cash flows provided by operations are discussed below in Other Balance Sheet Change Explanations.



Investing Activities.  For the year ended December 31,
2004, cash flows used in investing activities were $810 million compared to $202 million used during the year ended December 31, 2003. The change was primarily related to the use of $446 million in connection with the acquisition of AMS and
increased purchases of unrestricted marketable securities.



Financing
Activities.  For the year ended December 31, 2004, financing activities provided $408 million of cash, compared to $34 million provided during the year ended December 31, 2003. The changes were as follows:



| |  | During the year ended December 31, 2004, we received $625 million from our new senior credit facility, paid $148 million on our previous senior credit facility entered into in June
2003 and paid $30 million of outstanding indebtedness of AMS assumed in connection with the acquisition of AMS. During the year ended December 31, 2003, we received $150 million in proceeds from our senior credit facility entered into in June 2003
and paid $151 million on our 2002 senior credit facility.
|- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | We paid $103 million for the purchase and retirement of our common stock, primarily in connection with repurchases under our stock repurchases program which commenced in May 2004,
with no comparable activity in 2003.
|- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | We received $82 million from the issuance of common stock for the year ended December 31, 2004 in connection with our employee stock purchase plan and exercises of employee stock
options compared to $41 million during the same period in 2003.
|- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | We paid $9 million in loan fees in 2004 in connection with the replacement of our 2003 senior credit facility as discussed above. During the year ended December 31, 2003, we paid $7
million in connection with the replacement of our 2002 senior credit facility.
|- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | We paid $7 million in 2004 in connection with our database financing agreements compared to $4 million during the same period in 2003.
|- |  | --------------------------------------------------------------------------------------------------------------------------------------



| |  | We redeemed $175 million in principal of our 103/4% 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 during 2003 with no comparable activity in 2004.
|- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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In May 2004, our Board of Directors authorized the repurchase of up to $150 million of our common stock under a stock
repurchase program. Share repurchases are made under our stock repurchase program from time to time through open market purchases or through privately negotiated transactions using available cash, and may be discontinued at any time. Also, in
connection with our employee equity incentive plans, we may repurchase shares of common stock from employees for the satisfaction of their individual payroll tax withholdings upon vesting of restricted stock.



A summary of our repurchase activity for the year ended December 31, 2004 is as follows:



|                           |  |                                   |  |                            |       |                                                                   |           |                                                                              |   |            
|-------------------------- |  | --------------------------------- |  | -------------------------- | ----- | ----------------------------------------------------------------- | --------- | ---------------------------------------------------------------------------- | - | -----------
|                           |  | Total Number ofSharesPurchased(1) |  | AveragePrice PaidPer Share |       | Total Number OfSharesPurchased UnderOur StockRepurchaseProgram(2) |           | Dollar Value ofShares that MayYet Be PurchasedUnder the
RepurchaseProgram(2)
|January 1  January 31     |  | 70,200                            |  | $                          | 33.87 |                                                                   |          |                                                                              | $ |           
|February 1  February 29   |  | 3,875                             |  | $                          | 31.72 |                                                                   |          |                                                                              | $ |           
|March 1  March 31         |  | 303                               |  | $                          | 37.16 |                                                                   |          |                                                                              | $ |           
|April 1  April 30         |  | 5,035                             |  | $                          | 41.04 |                                                                   |          |                                                                              | $ |           
|May 1  May 31             |  | 221,928                           |  | $                          | 35.84 |                                                                   | 218,500   |                                                                              | $ | 142,172,000
|June 1  June 30           |  | 818,326                           |  | $                          | 36.50 |                                                                   | 818,300   |                                                                              | $ | 112,304,000
|July 1  July 31           |  | 350                               |  | $                          | 37.91 |                                                                   |          |                                                                              | $ | 112,304,000
|August 1  August 31       |  | 2,049,500                         |  | $                          | 30.40 |                                                                   | 2,049,500 |                                                                              | $ | 49,993,000 
|September 1  September 30 |  | 2,590                             |  | $                          | 32.58 |                                                                   |          |                                                                              | $ | 49,993,000 
|October 1  October 31     |  | 1,415                             |  | $                          | 36.90 |                                                                   |          |                                                                              | $ | 49,993,000 
|November 1  November 30   |  | 4,165                             |  | $                          | 43.14 |                                                                   |          |                                                                              | $ | 49,993,000 
|December 1  December 31   |  | 1,987                             |  | $                          | 54.94 |                                                                   |          |                                                                              | $ | 49,993,000 
|                           |  |                                   |  |                            |       |                                                                   |           |                                                                              |   |            
|Total                      |  | 3,179,674                         |  | $                          | 32.48 |                                                                   | 3,086,300 |                                                                              |   |            
|                           |  |                                   |  |                            |       |                                                                   |           |                                                                              |   |            

---

|(1) | The total number of shares purchased includes shares delivered to, or withheld by us in connection with employee payroll tax withholding upon vesting of restricted stock and shares
purchased under our stock repurchase program.
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|(2) | Our stock repurchase program authorized the repurchase of up to $150 million of our common stock.
|--- | -------------------------------------------------------------------------------------------------



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.



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 103/4% senior notes due in 2009 outstanding. The 103/4% senior notes were issued in May 2002 at 99.389% of the aggregate principal amount representing an initial 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 103/4% 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 103/4% 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.



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Certain of our domestic subsidiaries fully and unconditionally guarantee the 103/4% senior
notes. See Note 16 of the Notes to Consolidated Financial Statements.



In April 2003, we entered into an interest rate swap on $300 million of our 103⁄4% 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, or LIBO Rate, plus 692 basis points and receive interest payments based on the
103⁄4% fixed rate. Our current floating rate under the swap agreement was 9.32%, at December 31, 2004 which is based on a 90-day LIBO Rate of 2.40% plus 692 basis points. The three-month LIBO 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 December 2004, we replaced our senior credit facility with a new syndicated senior Credit Agreement, or the Credit Agreement, with the Lenders named therein, JPMorgan
Chase Bank, N.A., as Administrative Agent and Collateral Agent, J.P. Morgan Securities Inc., as Sole Lead Arranger and Sole Bookrunner, Morgan Stanley Senior Funding, Inc., as Syndication Agent and Co-Arranger and CIBC, Inc., The Bank of New York,
and Wells Fargo Bank, N.A., as Co-Documentation Agents. The new facility consists of a $200 million term A loan, which matures on December 13, 2009, a $425 million term B loan, which matures on December 13, 2010, and a $200 million revolving line of
credit, which matures on December 13, 2009. We used the proceeds of the term A and term B loans to refinance approximately $149 million (including accrued interest and fees of approximately $1 million) outstanding under our previous senior credit
facility entered into in June 2003, refinance approximately $30 million outstanding under the senior credit facility of AMS and to fund a portion of the merger consideration paid to acquire AMS. See Notes 3 and 5 of the Notes to Consolidated
Financial Statements. In connection with the Credit Agreement, we incurred approximately $9 million in fees and expenses that are being amortized over the life of the facility. As of December 31, 2004, we had $625 million outstanding on the term A
and term B loans and no balance outstanding on the revolving line of credit. There were no borrowings under the revolving line of credit (or the line of credit we refinanced) during the year ended December 31, 2004.



The credit facility provides us with two interest rate options for borrowings under the term
loans, to which a margin spread is added: (1) the LIBO Rate multiplied by the Statutory Reserve Rate and (2) JPMorgan Chase Banks prime rate (or, if greater, the Federal Funds Rate plus 0.5%), which we refer to as the alternate base rate. The
margin spread for the term loans is based upon our current Standard & Poors Ratings Services and Moodys Investor Service debt ratings. The margin spread for LIBO Rate borrowings range from 0.75% to 1.75% per annum under the term A
loan and 1.25% to 1.5% per annum under the term B loan. The margin spread for alternate base rate borrowings range from 0% to 0.75% per annum under the term A loan and 0.25% to 0.5% per annum under the term B loan. All of our borrowings under the
term loans are currently LIBO Rate borrowings with rates ranging from 3.9% to 4.3%. The interest rates per annum applicable to revolving credit borrowings are, at our option, either LIBO Rate borrowings with the same margin spread as our term A loan
or alternate base rate borrowings with the same margin spread applicable to the term A loan. We also pay a commitment fee on the average daily unused amount of the revolving credit commitment. The commitment fee range is based upon our current debt
rating and ranges from 0.15% and 0.5% per annum. The current commitment fee rate is 0.375% per annum.



The Credit Agreement contains 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 Credit Agreement also requires we meet various financial ratios, including a maximum consolidated leverage ratio, a
minimum consolidated net worth requirement and a minimum fixed charge coverage requirement. At December 31, 2004, we were in compliance with all of these covenants.



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Certain of our domestic subsidiaries provide guarantees and have granted security interests to the lenders in
substantially all of their personal property in order to secure our obligations and their guarantees under the Credit Agreement. See Note 16 of the Notes to Consolidated Financial Statements. We have also pledged the equity of certain of our
subsidiaries to the lenders as security for the Credit Agreement.



|                                                                      |  |                       |      |   |                           |   |     |       |  |   |      |  
|--------------------------------------------------------------------- |  | --------------------- | ---- | - | ------------------------- | - | --- | ----- |  | - | ---- | -
|                                                                      |  | Term Loan Facility    |      |   | Revolving Credit Facility |   |     | Total | 
|                                                                      |  | (Amounts in millions) |     
|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  |  
|                                                                      |  |                       |      |   |                           |   |     |       |  |   |      |  
|Scheduled payments under prior senior credit facility                 |  |                       | (1   | ) |                           |   |    |       |  |   | (1   | )
|Assumption of debt related to acquisition of AMS                      |  |                       |     |   |                           |   | 30  |       |  |   | 30   |  
|Repayment of outstanding balance under prior senior credit facilities |  |                       | (148 | ) |                           |   | (30 | )     |  |   | (178 | )
|Proceeds from borrowing under new senior credit facility              |  |                       | 625  |   |                           |   |    |       |  |   | 625  |  
|                                                                      |  |                       |      |   |                           |   |     |       |  |   |      |  
|Balance at December 31, 2004                                          |  | $                     | 625  |   |                           | $ |    |       |  | $ | 625  |  
|                                                                      |  |                       |      |   |                           |   |     |       |  |   |      |  



On December 13, 2004, we completed our
acquisition of AMS. See Note 3 of the Notes to Consolidated Financial Statements. We paid $32.75 in cash for each share of AMS common stock outstanding and cashed out all outstanding options on a net basis for a total equity purchase price of
approximately $505 million. We also repaid approximately $30 million of outstanding indebtedness of AMS in connection with the closing of the acquisition. We financed the acquisition through proceeds from a new $825 million credit facility as
described above and the use of internally generated cash.



On November 29,
2004, we entered into a definitive agreement to acquire Pacific Lifes group health insurance business. We anticipate the acquisition will be consummated during the spring of 2005.



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Our contractual cash obligations as of December 31, 2004, including long-term debt and other commitments, were as
follows:



|                                                                      |  |                        |       |                  |   |            |  |            |     |                   |   |     |  |   |    
|--------------------------------------------------------------------- |  | ---------------------- | ----- | ---------------- | - | ---------- |  | ---------- | --- | ----------------- | - | --- |  | - | ---
|                                                                      |  | Payments Due by Period
|                                                                      |  | Total                  |       | Less than 1 year |   | 1 - 3years |  | 3 - 5years |     | More than 5 years
|                                                                      |  | (Amounts in millions) 
|Long-term debt:                                                       |  |                        |       |                  |   |            |  |            |     |                   |   |     |  |   |    
|JPMorgan term loan B facility                                         |  | $                      | 425   |                  | $ | 4          |  | $          | 8   |                   | $ | 132 |  | $ | 281
|103⁄4% senior notes, net of discount                                    |  |                        | 324   |                  |   |           |  |            |    |                   |   | 324 |  |   |   
|JPMorgan term loan A facility                                         |  |                        | 200   |                  |   | 30         |  |            | 70  |                   |   | 100 |  |   |   
|Convertible subordinated debentures                                   |  |                        | 135   |                  |   |           |  |            |    |                   |   |    |  |   | 135
|Database financing agreement                                          |  |                        | 2     |                  |   | 2          |  |            |    |                   |   |    |  |   |   
|Other                                                                 |  |                        | 3     |                  |   | 2          |  |            | 1   |                   |   |    |  |   |   
|                                                                      |  |                        |       |                  |   |            |  |            |     |                   |   |     |  |   |    
|Total long-term debt commitments, including current maturities        |  |                        | 1,089 |                  |   | 38         |  |            | 79  |                   |   | 556 |  |   | 416
|                                                                      |  |                        |       |                  |   |            |  |            |     |                   |   |     |  |   |    
|Other commitments:                                                    |  |                        |       |                  |   |            |  |            |     |                   |   |     |  |   |    
|Information technology outsourcing contracts(1)                       |  |                        | 872   |                  |   | 158        |  |            | 260 |                   |   | 232 |  |   | 222
|Operating leases                                                      |  |                        | 117   |                  |   | 31         |  |            | 51  |                   |   | 27  |  |   | 8  
|Purchase obligations(2)                                               |  |                        | 51    |                  |   | 25         |  |            | 17  |                   |   | 6   |  |   | 3  
|Interest on long-term debt, including current maturities(3)           |  |                        | 368   |                  |   | 61         |  |            | 117 |                   |   | 90  |  |   | 100
|Other long-term liabilities reflected on our balance sheet under GAAP |  |                        | 38    |                  |   |           |  |            |    |                   |   |    |  |   | 38 
|                                                                      |  |                        |       |                  |   |            |  |            |     |                   |   |     |  |   |    
|Total other commitments                                               |  |                        | 1,446 |                  |   | 275        |  |            | 445 |                   |   | 355 |  |   | 371
|                                                                      |  |                        |       |                  |   |            |  |            |     |                   |   |     |  |   |    
|Total contractual cash obligations                                    |  | $                      | 2,535 |                  | $ | 313        |  | $          | 524 |                   | $ | 911 |  | $ | 787
|                                                                      |  |                        |       |                  |   |            |  |            |     |                   |   |     |  |   |    

---

|(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, 2004.
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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 some of the above terms are unable to be determined (e.g., the timing
and volume of future services provided under fee-for-service arrangements or what membership levels will be for capitated arrangements are not known for December 31, 2004).



The future contractual obligations in the contractual obligation tables are estimated based on information currently
available. The timing of and actual payment amounts may differ based on actual events.



|(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 103⁄4% senior
notes and the senior term loans, the rates in place as of December 31, 2004 were used to estimate all remaining payments.
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



As of December 31, 2004 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.



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In February 2005, our debt was rated by the major credit rating agencies as follows:



|                  |  |          |  |                        |  |                   |  |                                   
|----------------- |  | -------- |  | ---------------------- |  | ----------------- |  | ----------------------------------
|Agency            |  | Outlook  |  | Senior Credit Facility |  | 103⁄4% Senior Notes |  | Convertible SubordinatedDebentures
|Moodys           |  | Stable   |  | Ba2                    |  | Ba3               |  | B1                                
|Standard & Poors |  | Negative |  | BBB-                   |  | BBB-              |  | BB+                               
|Fitch IBCA        |  | Stable   |  | BB+                    |  | BB+               |  | BB                                



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 2009 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, 2004, 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, 2004, increased $51 million from the balance as of December 31, 2003 primarily due to an increase of pharmacy rebates receivable.



Medical Claims and Benefits Payable.  The majority of our medical claims and benefits payable represents liabilities related to our
fee-for-service based contracts. Under fee-for-service 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 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, 2004, approximately 87% of medical claims and benefits payable was attributable to fee-for-service based contracts.



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



|                                                             |  |                       |       |                   |   |      
|------------------------------------------------------------ |  | --------------------- | ----- | ----------------- | - | -----
|                                                             |  | December 31, 2004     |       | December 31, 2003
|                                                             |  | (Amounts in millions)
|Incurred But Not Reported (IBNR)                             |  | $                     | 1,004 |                   | $ | 826  
|Capitation and All Other Medical Claims and Benefits Payable |  |                       | 188   |                   |   | 202  
|                                                             |  |                       |       |                   |   |      
|Medical Claims and Benefits Payable                          |  | $                     | 1,192 |                   | $ | 1,028
|                                                             |  |                       |       |                   |   |      



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Medical claims and benefits payable as of December 31, 2004 increased $164 million from the balance as of
December 31, 2003, primarily due to an increase in IBNR of $178 million, as a result of IBNR assumed of $87 million due to the acquisition of AMS, an increase in commercial PPO membership for which providers are reimbursed on a fee-for-service
basis, commercial health care cost trend increases and an increase in senior health care costs as a result of required benefit increase from the enacted MMA legislation. These increased costs were partially offset by an increase in payments of
fee-for-service claims in 2004 as compared to 2003.



Accounts Payable and
Accrued Liabilities.  Accounts payable and accrued liabilities, including accrued compensation and employee benefits, increased $24 million from the balance as of December 31, 2003, primarily due to the assumption of AMS
liabilities of $48 million, offset primarily by the effect of the timing of payment of accounts payable and accrued liabilities.



Stockholders Equity.  The increase of $337 million in stockholders equity from December 31, 2003, to December 31, 2004, was
primarily due to net income and the activity related to share-based compensation. This increase was partially offset by the costs incurred to acquire treasury shares.



Critical Accounting Estimates



When we prepare our consolidated financial statements, we use estimates and assumptions that may affect reported amounts and disclosures. We base these estimates on
historical results and various other assumptions believed to be reasonable, the results of which form the basis for making estimates concerning the carrying value of assets and liabilities that are not readily available from other sources. Actual
results could differ from the amounts previously estimated, which were based on the information available at the time the estimates were made. Changes in estimates are recorded if and when better information becomes available.



We consider an accounting estimate to be critical if: (1) the accounting estimate requires us
to make an assumption about a matter that was highly uncertain at the time the estimate was made, and (2) changes in the estimate that are reasonably likely to occur from period to period, or use of a different estimate that we reasonably could have
used in the current period, would have a material impact on our consolidated results of operations or financial condition.



Although these critical accounting estimates are primarily the responsibility of our management, our management has discussed the development and selection of these
critical accounting estimates with the Audit Committee of our Board of Directors and the Audit Committee has reviewed the disclosure presented below relating to them.



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 fee-for-service 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 along with a provision for adverse claims development. The provision for adverse claims development is intended to account for variability in the following types of current and other environmental factors:



| |  | Changes in claims payment patterns to the extent to which emerging claims payment patterns differ from the historical payment patterns selected to calculate the IBNR reserve
estimate;
|- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | Differences between the estimated per member per month, or PMPM, incurred expense for the most recent months and the expected PMPM based on historical PMPM incurred estimates and
the estimated trend from the historical period to the most recent months;
|- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | Differences between the estimated impact of known differences in environmental factors and the actual impact of known environmental factors; and
|- |  | ------------------------------------------------------------------------------------------------------------------------------------------------



| |  | The healthcare expense impact of present but unknown environmental factors that differ from historical norms.
|- |  | -------------------------------------------------------------------------------------------------------------



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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 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 our operating results caused by these factors:



|                                                   |  |                                              
|-------------------------------------------------- |  | ---------------------------------------------
|Completion Factor(a) Increase (Decrease) in Factor |  | Increase (Decrease) in Medical Claims Payable
|                                                   |  | (Amounts in millions)                        
|(3)%                                               |  | $ 52                                         
|(2)%                                               |  | 34                                           
|(1)%                                               |  | 17                                           
|1%                                                 |  | (17)                                         
|2%                                                 |  | (33)                                         
|3%                                                 |  | (48)                                         
|                                                   | 
|Claims Trend(b)Increase (Decrease) in Factor       |  | Increase (Decrease) in Medical Claims Payable
|                                                   |  | (Amounts in millions)                        
|(3)%                                               |  | $(20)                                        
|(2)%                                               |  | (13)                                         
|(1)%                                               |  | (7)                                          
|1%                                                 |  | 7                                            
|2%                                                 |  | 13                                           
|3%                                                 |  | 20                                           

---

|(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 PMPM claims for the most recent four months.
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



In addition, assuming a hypothetical 1% difference between our
December 31, 2004 estimated claims liability and the actual claims incurred run-out, net income for the year ended December 31, 2004 would increase or decrease by approximately $10 million, while diluted net income per share would increase or
decrease by $0.06 per share, net of tax.



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, 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



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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.



Intangible Assets and Goodwill.  In June 2001, the Financial Accounting Standards Board, or FASB, issued SFAS No. 141, Business Combinations, and SFAS No. 142, Goodwill and
Other Intangible Assets. SFAS No. 141 requires that all business combinations initiated after June 30, 2001 be accounted for using the purchase method. SFAS No. 142, which became effective for fiscal years beginning after December 15, 2001,
eliminates amortization of goodwill and other intangible assets with indefinite useful lives. Rather, these assets are subject to impairment tests at least annually. We are required to make estimates of fair value and apply certain assumptions, such
as a discount factor in applying these annual impairment tests. Such estimates could produce significantly different results if other assumptions, which could also be considered reasonable, were to be used. Intangible assets with definite useful
lives are being amortized using a straight-line basis or the timing of related cash flows. An intangible asset subject to amortization must be reviewed for impairment pursuant to SFAS No. 144, Accounting for the Impairment or Disposal of
Long-Lived Assets.



We adopted SFAS No. 142 on January 1, 2002 and,
accordingly, no longer amortize goodwill and other intangible assets with indefinite useful lives. In accordance with SFAS No. 142, we determined no adjustments to recorded amounts were required as of December 31, 2004 and 2003 based on our annual
impairment testing.



Ordinary Course Legal
Proceedings.  We are routinely 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 filing in this
Annual Report on Form 10-K 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, provider network 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 Advantage products must submit adjusted community rate proposals, generally by county or service area, to CMS in early September for each
Medicare Advantage 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 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 fee-for-service 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.



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 Advantage program in light of the MMA legislation and ultimately evolving into a consumer health organization. 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;
|- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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| |  | 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. In a limited number of circumstances, we have also taken steps
to establish security reserves 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. If our reserves are inadequate to cover these claims, our
operating results could be adversely affected.



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 and provider networks on favorable terms. In any particular market, health
care providers or provider networks could refuse to contract with us, demand higher payments or take other actions that could result in higher health care costs or difficulty in meeting our 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.



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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 higher unit costs for currently available medications, 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 the extent to which these factors will impact our costs when establishing our premiums or we may otherwise be unable to 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, 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 commissions we pay to brokers and agents;
|- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | the necessity to comply with regulatory requirements, including, without limitation, the MMA legislation and other recent changes in privacy and health care laws;
|- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | 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- and long-term strategic plans.



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.



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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.



Efforts to bring suit against health plans continue, with a number of lawsuits brought against us and other health plans, including In re Managed Care. In general, the In re Managed Care
lawsuits brought by health care providers allege that health plans claims processing systems automatically and impermissibly alter codes included on providers reimbursement/claims forms to reduce the amount of reimbursement, and that
health plans impose unfair contracting terms on health care providers, delay making capitated payments under their capitated contracts, and negotiate capitation payments that are inadequate to cover the costs of health care services provided.



We are also subject to class action litigation that was pending against AMS
when we acquired AMS. For example, AMS recently received final approval from an Alabama Circuit Court of the certification and settlement of a class action lawsuit involving the rating methodology formerly used by AMS for group health benefit plans
marketed to individuals in Alabama and Georgia. For additional information, see Note 13 of the Notes to Consolidated Financial Statements.



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 health care 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 health care 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.



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 Advantage products or our willingness to participate in the Medicare program.



The Medicare program has accounted for approximately 47% of our total revenue in 2004 and approximately 4% additional revenue was attributable to the Federal Employee
Health Benefits Program. CMS regulates the benefits provided, premiums paid, quality assurance procedures, marketing and advertising for our Medicare Advantage products. CMS may terminate our Medicare Advantage contracts or elect not to renew those
contracts when those contracts come up for renewal every 12 months. Although we are receiving increased government funding under the MMA, 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 Advantage program or the program itself could have a material adverse effect on our financial position, results of operations or
cash flows.



In August 2004, CMS published proposed regulations for Title I
(Prescription Drug Plan) and Title II (Medicare Advantage Program) of the MMA. Depending on how the final regulations are written, there may be a significant impact on our business. Existing Medicare Advantage plans and new entities will need to
demonstrate compliance with the new rules. Achieving timely compliance with the rules could require substantial additional risk capital as well as investments in modifying our existing systems and work processes and developing new systems and
processes.



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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 health plans 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;
|- |  | -------------------------------------------------------



| |  | licensing requirements;
|- |  | -----------------------



| |  | approval of policy language and benefits;
|- |  | -----------------------------------------



| |  | mandated benefits and administrative processes;
|- |  | -----------------------------------------------



| |  | mandated claims and appeals review procedures;
|- |  | ----------------------------------------------



| |  | provider compensation arrangements;
|- |  | -----------------------------------



| |  | member disclosure;
|- |  | ------------------



| |  | privacy concerns;
|- |  | -----------------



| |  | periodic audits and investigations by state and federal agencies;
|- |  | -----------------------------------------------------------------



| |  | rating practices;
|- |  | -----------------



| |  | 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 could cause pharmaceutical companies to restructure the financial terms of their business arrangements with PBMs or health
plans;
|- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | patients bill of rights legislation at the state and federal level that could hold health plans 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;
|- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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| |  | 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;
|- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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



| |  | limiting the ability of small employer group health plans to use risk selection to control costs and health status and industry codes to set rates, as well as limiting the amount of
rate increases that can be given from year to year;
|- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | allowing employers to leverage their purchasing power through associations or other multiple employer arrangements; and
|- |  | -----------------------------------------------------------------------------------------------------------------------



| |  | adding further restrictions and administrative requirements related to the compensatory arrangements pertaining to our agents and brokers in connection with the sale of our products
and disclosure of such compensatory arrangements.
|- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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.



Current investigations of the insurance industry by regulators may result in changes in industry practices that could have an adverse affect on our ability to
market our products.



Like other health care companies, we use agents and
independent brokers to sell our HMO and insurance products. While we are not aware of any unlawful practices by our agents and brokers in connection with the sale of our products, current investigations of the insurance industry by the New York
Attorney General, the Commissioner of Insurance of California and other regulators could result in changes in industry practices that could have an adverse affect on our ability to market our products.



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 $200 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
|- |  | --------------------------------------------------------------------------------------------



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| |  | 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 health plan
regulations or insurance regulations and may be subject to substantial supervision by one or more health plan or insurance regulators. Subsidiaries subject to regulation must meet or exceed various capital standards imposed by health plan 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 103/4% senior notes
contain restrictive covenants that may limit our ability to expand or pursue our business strategy.



Our senior credit facility and our 103/4% 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.



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 103/4% 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 103/4% 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 103/4% senior notes may accelerate our debt repayment under the senior credit facility
and our 103/4% senior notes. If the indebtedness under the senior credit facility or our 103/4% 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.



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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.



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 requires that our convertible subordinated debenture be included in our calculation of weighted average shares outstanding in every quarter.



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.



Our acquisitions may increase costs, liabilities, or create disruptions in our business.



We have recently acquired AMS and announced the acquisition of the Pacific Lifes group health insurance business and we may pursue
other acquisitions of other companies or businesses from time to time. Although we review the records of companies or businesses we plan to acquire, even an in-depth review of records may not reveal existing or potential problems or permit us to
become familiar enough with a business to assess fully its capabilities and deficiencies. As a result, we may assume unanticipated liabilities or adverse operating conditions, or an acquisition may not perform as well as expected. We face the risk
that the returns on acquisitions will not support the expenditures or indebtedness incurred to acquire such businesses, or the capital expenditures needed to develop such businesses. We also face the risk that we will not be able to integrate
acquisitions into our existing operations effectively without substantial expense, delay or other operational or financial problems. Integration may be hindered by, among other things, differing procedures, including internal controls, business
practices and technology systems. We may need to divert more management resources to integration than we planned, which may adversely affect our ability to pursue other profitable activities.



ITEM 7A.  QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK



Market Risk



The principal objectives
of our asset management activities are to ensure liquidity and maximize net investment income, while maintaining acceptable levels of interest rate and credit 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.



Investments



We are exposed to interest rate and credit risk due to our investing and borrowing
activities. Interest rate risk is the risk of loss of principal value on financial securities as a result of changes in market interest rates. Our fixed income



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portfolio consists of U.S. dollar-denominated assets, invested primarily in U.S. Treasury and federal agency securities, corporate bonds and notes, mortgage
and asset-backed securities, and municipal bonds, all of which represent an exposure to changes in the level of market interest rates. We are also exposed to credit quality risk which is defined as the risk of a credit downgrade to an individual
security and the potential loss attributable to that downgrade.



We manage our
asset interest rate risk within a duration band established by us, and tied to our liabilities. Credit risk is managed by maintaining a high level of average credit ratings and both sector and issuer diversification. We regularly evaluate our
interest rate risks, as well as the appropriateness of investments, relative to our internal investment guidelines and those of the states in which we do business. We operate within these guidelines by maintaining a well-diversified portfolio, both
across market sectors and within asset classes.



As of December 31, 2004, our
current marketable securities at fair value totaled $1.9 billion of which 100% was invested in fixed income securities. The following table presents the pre-tax impact to the fair value of our fixed income portfolio over a 12-month period from a
hypothetical change in all interest rates of 100, 200 and 300 basis points, or bp. Considerable judgment is required to develop estimates of fair value. Our model incorporates assumptions about portfolio-generated cash flows from future coupon
interest income and pre-payments of mortgage-backed securities. Projected cash flows received into the portfolio during the year along with proceeds from maturing securities are assumed to be reinvested at forecasted prevailing rates and offset
declines in the fair value of the portfolio attributable to a rise in interest rates. As shown in the table below, the fair value of the portfolio increases under the 100 bp scenario as the projected cash flow exceeds the decrease in fair value
associated with the rise in interest rates. Under the 200 bp and 300 bp scenarios, the fair value of the portfolio decreases as the decline in the fair value of the portfolio associated with the rise in interest rates exceeds the projected cash
flows. The use of different market assumptions and/or estimation methodologies may have a material effect on the estimated fair value amounts.



|                         |  |                                                          |        |        |   |         |        |  |   |         |  
|------------------------ |  | -------------------------------------------------------- | ------ | ------ | - | ------- | ------ |  | - | ------- | -
|As of December 31, 2004: |  | Change in fair value given an interest rate increase of: |       
|                         |  | (Amounts in thousands)                                   |       
|                         |  | 100 bp                                                   |        | 200 bp |   |         | 300 bp | 
|Fixed income portfolio   |  | $                                                        | 19,286 |        | $ | (40,249 | )      |  | $ | (98,929 | )
|                         | 
|As of December 31, 2003: |  | Change in fair value given an interest rate increase of: |       
|                         |  | (Amounts in thousands)                                   |       
|                         |  | 100 bp                                                   |        | 200 bp |   |         | 300 bp | 
|Fixed income portfolio   |  | $                                                        | 9,695  |        | $ | (32,371 | )      |  | $ | (73,726 | )



Changes in the value of our investment
portfolio which is available-for-sale are recognized, net of tax, in the balance sheet through stockholders equity. We believe that our cash flows and short duration of our investment portfolio allow us to hold securities to maturity, thereby
avoiding realized losses should interest rates rise significantly.



Debt



We use an interest rate swap contract as a part of our hedging
strategy to manage certain exposures related to the effects of changes in interest rates on the fair value of our indebtedness. In April 2003, we entered into an interest rate swap on $300 million in aggregate principal of our 103/4% senior notes. Under the terms of the agreement, we make interest payments based on the three-month London
Interbank Offered Rate, or LIBO Rate, plus 692 basis points and receive interest payments based on the 103/4% fixed rate. The three-month LIBO 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.



Our senior notes, due in 2009, have a fixed interest rate of 103/4%. Our convertible subordinated debentures, due in 2032, have a fixed interest rate of 3%. The fair value of these instruments is affected by changes in market interest rates, and in the case of the
convertible subordinated debentures, the value of the underlying shares. As of December 31, 2004, the combined carrying value of our senior notes and convertible subordinated debentures, net of discount, was $459 million. The combined fair value of
our senior notes and convertible subordinated debentures was $746 million. Considerable judgment is required to develop estimates of fair value. Accordingly, the estimates are not necessarily indicative of the amounts we could realize in a current
market exchange. The use of different market assumptions and/or estimation methodologies may have a material effect on the estimated fair value amounts.



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The following table presents the expected cash outflows relating to our fixed rate long-term borrowings as of December
31, 2004. These outflows include both expected principal and interest payments consistent with the terms of the outstanding debt as of December 31, 2004, prior to our swap arrangement. The rates in place on our swap agreement as of December 31, 2004
were used to estimate all future receipts. For terms relating to our long-term debt, see Note 5 of the Notes to Consolidated Financial Statements.



|                       |  |                       |      |   |      |   |      |      |  |   |      |   |  |      |      |   |            |   |       |   |  |   |       |  |   |       |  
|---------------------- |  | --------------------- | ---- | - | ---- | - | ---- | ---- |  | - | ---- | - |  | ---- | ---- | - | ---------- | - | ----- | - |  | - | ----- |  | - | ----- | -
|                       |  | 2005                  |      |   | 2006 |   |      | 2007 |  |   | 2008 |   |  | 2009 |      |   | Thereafter |   | Total |  
|                       |  | (Amounts in millions) |     
|Fixed rate borrowings: |  |                       |      |   |      |   |      |      |  |   |      |   |  |      |      |   |            |   |       |   |  |   |       |  |   |       |  
|                       |  |                       |      |   |      |   |     
|Principal              |  | $                     |     |   |      | $ |     |      |  | $ |     |   |  | $    |     |   |            | $ | 325.0 |   |  | $ | 135.0 |  | $ | 460.0 |  
|Interest               |  |                       | 39.0 |   |      |   | 39.0 |      |  |   | 39.0 |   |  |      | 39.0 |   |            |   | 18.7  |   |  |   | 93.2  |  |   | 267.9 |  
|Swap                   |  |                       | (4.3 | ) |      |   | (4.3 | )    |  |   | (4.3 | ) |  |      | (4.3 | ) |            |   | (1.7  | ) |  |   |      |  |   | (18.9 | )
|                       |  |                       |      |   |      |   |      |      |  |   |      |   |  |      |      |   |            |   |       |   |  |   |       |  |   |       |  
|                       |  | $                     | 34.7 |   |      | $ | 34.7 |      |  | $ | 34.7 |   |  | $    | 34.7 |   |            | $ | 342.0 |   |  | $ | 228.2 |  | $ | 709.0 |  
|                       |  |                       |      |   |      |   |      |      |  |   |      |   |  |      |      |   |            |   |       |   |  |   |       |  |   |       |  



ITEM 8.  CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA



See Item 15. Exhibits and Financial Statement Schedules.



ITEM 9.  CHANGES IN AND DISAGREEMENTS WITH INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM ON 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.



ITEM 9A.  CONTROLS AND PROCEDURES



We
maintain disclosure controls and procedures, which are designed to ensure that information required to be disclosed in the reports we file or submit under the Securities Exchange Act of 1934, as amended, is recorded, processed, summarized and
reported within the time periods specified in the Securities and Exchange Commissions rules and forms, and that such information is accumulated and communicated to our management, including our chief executive officer, or CEO, and chief
financial officer, or CFO, as appropriate to allow timely decisions regarding required disclosure.



Under the supervision and with the participation of our management, including our CEO and 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, 2004.



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 quarter 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 quarter and that has materially affected, or is reasonably likely to materially affect,
our internal controls over financial reporting.



Managements Report on
Internal Control Over Financial Reporting



Our management is responsible
for establishing and maintaining adequate internal control over financial reporting, as this term is defined in Exchange Act Rules 13a-15(f). All internal control systems, no matter how well designed, have inherent limitations. Therefore, even those
systems determined to be effective can provide only reasonable assurance with respect to financial statement preparation and presentation.



Our management has not conducted an assessment of the internal control over financial reporting of our wholly-owned subsidiary, American Medical Security Group, Inc., or
AMS, or AMS subsidiaries. We completed the acquisition of



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AMS on December 13, 2004, and it was not possible to conduct a complete assessment of AMS internal control over financial reporting in the period
between the completion of the acquisition and the date of our managements assessment of our internal control over financial reporting. Our conclusion in this Annual Report on Form 10-K regarding the effectiveness of our internal control over
financial reporting as of December 31, 2004 does not include the internal controls over financial reporting of AMS and its subsidiaries. Included in our consolidated financial statements was 19 days of operations which amounted to approximately $37
million of total revenues and $2 million of net income. Additionally, AMS total assets as of December 31, 2004 was approximately $750 million, or 14% of consolidated total assets and net assets totaled approximately $550 million, or 25% of
consolidated net assets.



Under the supervision and with the participation of
our management, including our CEO and CFO, we conducted an evaluation of the effectiveness of our internal control over financial reporting based on the framework in Internal ControlIntegrated Framework issued by the Committee of
Sponsoring Organizations of the Treadway Commission. Based on our evaluation under the framework in Internal ControlIntegrated Framework, our management concluded that our internal control over financial reporting was effective as of
December 31, 2004.



Our managements assessment of the effectiveness of
our internal control over financial reporting as of December 31, 2004 has been audited by Ernst & Young LLP, an independent registered public accounting firm, as stated in their report which is included below.



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Report of Independent Registered Public Accounting Firm on Internal Control over Financial Reporting



To the Board of Directors and Stockholders of PacifiCare Health Systems, Inc.



We have audited managements assessment, included in the
accompanying Managements Report on Internal Control Over Financial Reporting, that PacifiCare Health Systems, Inc. (PacifiCare) maintained effective internal control over financial reporting as of December 31, 2004, based on criteria
established in Internal ControlIntegrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). PacifiCares management is responsible for maintaining effective internal
control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on managements assessment and an opinion on the effectiveness of
PacifiCares internal control over financial reporting based on our audit.



We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective
internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating managements assessment, testing and evaluating the design
and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.



A companys internal control over financial reporting is a process designed to provide
reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A companys internal control over financial
reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable
assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with
authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the companys assets that could have a material effect
on the financial statements.



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



As
indicated in the accompanying Managements Report on Internal Control Over Financial Reporting, managements assessment of and conclusion on the effectiveness of internal control over financial reporting did not include the internal
controls of American Medical Security Group, Inc. (AMS), which are included in the 2004 consolidated financial statements of PacifiCare and constituted approximately $750 million and approximately $550 million of total and net assets, respectively,
as of December 31, 2004 and approximately $37 million and approximately $2 million of total revenues and net income, respectively, for the year then ended. Management did not assess the effectiveness of internal control over financial reporting at
this entity because PacifiCare acquired this entity effective December 13, 2004 and has not completed its assessment of those internal controls. Our audit of internal control over financial reporting of PacifiCare also did not include an evaluation
of the internal control over financial reporting of AMS.



In our opinion,
managements assessment that PacifiCare maintained effective internal control over financial reporting as of December 31, 2004, is fairly stated, in all material respects, based on the COSO criteria. Also, in our opinion, PacifiCare maintained,
in all material respects, effective internal control over financial reporting as of December 31, 2004, based on the COSO criteria.



We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of PacifiCare
Health Systems, Inc., as of December 31, 2004 and 2003 and the related consolidated statements of operations, stockholders equity and cash flows for each of the three years in the period ended December 31, 2004 of PacifiCare and our report
dated February 24, 2005 expressed an unqualified opinion thereon.



/s/ ERNST & YOUNG LLP



Irvine, California

February 24, 2005



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ITEM 9B.  OTHER INFORMATION



Other
information not previously reported on Form 8-K



None.



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 our definitive Proxy Statement for our 2005 Annual Meeting of Stockholders is incorporated herein by reference.



The information regarding our 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 our definitive Proxy Statement for its 2005 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 our definitive Proxy Statement for its 2005 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 our definitive Proxy Statement for our 2005 Annual Meeting of Stockholders is incorporated herein by reference.



ITEM 11.  EXECUTIVE COMPENSATION



The
information contained in the section entitled Executive Compensation in our definitive Proxy Statement for our 2005 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 our definitive Proxy
Statement for our 2005 Annual Meeting of Stockholders is incorporated herein by reference.



The information contained in the section entitled Equity Compensation Plan Information in our definitive Proxy Statement for our 2005 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 our definitive Proxy Statement for our 2005 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 our definitive Proxy Statement for our 2005 Annual Meeting of Stockholders is incorporated herein by reference.



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PART IV



ITEM 15.  EXHIBITS AND FINANCIAL STATEMENT SCHEDULES



The following documents are filed as part of this report:



|   |  |                                                                                                                                                  |  |               
|-- |  | ------------------------------------------------------------------------------------------------------------------------------------------------ |  | --------------
|   |  |                                                                                                                                                  |  | Page Reference
|1. |  | Consolidated Financial Statements:                                                                                                               |  |               
|   |  | Consolidated Balance Sheets as of December 31, 2004 and 2003                                                                                     |  | F-1           
|   |  | Consolidated Statements of Operations for the years ended December 31, 2004, 2003 and 2002                                                       |  | F-2           
|   |  | Consolidated Statements of Stockholders Equity for the years ended December 31, 2004, 2003 and 2002                                             |  | F-3           
|   |  | Consolidated Statements of Cash Flows for the years ended December 31, 2004, 2003 and 2002                                                       |  | F-4           
|   |  | Notes to Consolidated Financial Statements                                                                                                       |  | F-6           
|   |  | Report of Independent Registered Public Accounting Firm                                                                                          |  | F-41          
|   |  | Quarterly Information for 2004 and 2003 (Unaudited)                                                                                              |  | F-42          
|2. |  | Financial Statement Schedule:                                                                                                                    |  |               
|   |  | Schedule IIValuation and Qualifying Accounts                                                                                                    |  | F-43          
|   |  |                                                                                                                                                 
|   |  | 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 herein reference.                   |  |               



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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. PHANSTIELHoward G. Phanstiel Chairman of the Board and Chief Executive
Officer (Principal Executive Officer)




Date: February 25, 2005



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)    |  | February 25, 2005
|                                           |  |                                                                                   
|/s/ GREGORY W. SCOTTGregory W. Scott       |  | Executive Vice President and Chief Financial Officer (Principal Financial Officer) |  | February 25, 2005
|                                           |  |                                                                                   
|/s/ PETER A. REYNOLDSPeter A. Reynolds     |  | Senior Vice President and Corporate Controller (Principal Accounting Officer)      |  | February 25, 2005
|                                           |  |                                                                                   
|/s/ DAVID A. REEDDavid A. Reed             |  | Lead Independent Director                                                          |  | February 25, 2005
|                                           |  |                                                                                   
|/s/ AIDA ALVAREZAida Alvarez               |  | Director                                                                           |  | February 25, 2005
|                                           |  |                                                                                   
|/s/ BRADLEY C. CALLBradley C. Call         |  | Director                                                                           |  | February 25, 2005



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|                                               |  |          |  |                  
|---------------------------------------------- |  | -------- |  | -----------------
|Name                                           |  | Title    |  | Date             
|                                               |  |         
|/s/ TERRY O. HARTSHORNTerry O. Hartshorn       |  | Director |  | February 25, 2005
|                                               |  |         
|/s/ DOMINIC NGDominic Ng                       |  | Director |  | February 25, 2005
|                                               |  |         
|/s/ WARREN E. PINCKERT IIWarren E. Pinckert II |  | Director |  | February 25, 2005
|                                               |  |         
|/s/ CHARLES R. RINEHARTCharles R. Rinehart     |  | Director |  | February 25, 2005
|                                               |  |         
|/s/ LINDA ROSENSTOCKLinda Rosenstock           |  | Director |  | February 25, 2005
|                                               |  |         
|/s/ LLOYD E. ROSSLloyd E. Ross                 |  | Director |  | February 25, 2005



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PACIFICARE HEALTH SYSTEMS, INC.



CONSOLIDATED BALANCE SHEETS



|                                                                                                                 |  |                        |           |   |                   |   |           |  
|---------------------------------------------------------------------------------------------------------------- |  | ---------------------- | --------- | - | ----------------- | - | --------- | -
|                                                                                                                 |  | December 31, 2004      |           |   | December 31, 2003 |  
|                                                                                                                 |  | (Amounts in thousands, |          
|                                                                                                                 |  | except per share data) |          
|ASSETS                                                                                                           |  |                        |           |   |                   |   |           |  
|Current assets:                                                                                                  |  |                        |           |   |                   |   |           |  
|Cash and equivalents                                                                                             |  | $                      | 824,104   |   |                   | $ | 1,198,422 |  
|Marketable securities                                                                                            |  |                        | 1,936,765 |   |                   |   | 1,359,720 |  
|Receivables, net                                                                                                 |  |                        | 317,362   |   |                   |   | 265,943   |  
|Prepaid expenses and other current assets                                                                        |  |                        | 54,746    |   |                   |   | 57,299    |  
|Deferred income taxes                                                                                            |  |                        | 148,702   |   |                   |   | 149,817   |  
|                                                                                                                 |  |                        |           |   |                   |   |           |  
|Total current assets                                                                                             |  |                        | 3,281,679 |   |                   |   | 3,031,201 |  
|                                                                                                                 |  |                        |           |   |                   |   |           |  
|Property, plant and equipment, net                                                                               |  |                        | 226,594   |   |                   |   | 149,407   |  
|Marketable securities-restricted                                                                                 |  |                        | 140,298   |   |                   |   | 166,546   |  
|Goodwill                                                                                                         |  |                        | 1,278,677 |   |                   |   | 983,104   |  
|Intangible assets, net                                                                                           |  |                        | 227,122   |   |                   |   | 221,108   |  
|Other assets                                                                                                     |  |                        | 72,547    |   |                   |   | 67,938    |  
|                                                                                                                 |  |                        |           |   |                   |   |           |  
|                                                                                                                 |  | $                      | 5,226,917 |   |                   | $ | 4,619,304 |  
|                                                                                                                 |  |                        |           |   |                   |   |           |  
|LIABILITIES AND STOCKHOLDERS EQUITY                                                                             |  |                        |           |   |                   |   |           |  
|Current liabilities:                                                                                             |  |                        |           |   |                   |   |           |  
|Medical claims and benefits payable                                                                              |  | $                      | 1,192,400 |   |                   | $ | 1,027,500 |  
|Accounts payable                                                                                                 |  |                        | 75,356    |   |                   |   | 65,222    |  
|Accrued liabilities                                                                                              |  |                        | 319,837   |   |                   |   | 326,051   |  
|Accrued compensation and employee benefits                                                                       |  |                        | 119,143   |   |                   |   | 99,537    |  
|Unearned premium revenue                                                                                         |  |                        | 89,496    |   |                   |   | 496,480   |  
|Current portion of long-term debt                                                                                |  |                        | 37,534    |   |                   |   | 7,496     |  
|                                                                                                                 |  |                        |           |   |                   |   |           |  
|Total current liabilities                                                                                        |  |                        | 1,833,766 |   |                   |   | 2,022,286 |  
|                                                                                                                 |  |                        |           |   |                   |   |           |  
|Long-term debt                                                                                                   |  |                        | 916,520   |   |                   |   | 477,700   |  
|Convertible subordinated debentures                                                                              |  |                        | 135,000   |   |                   |   | 135,000   |  
|Deferred income taxes                                                                                            |  |                        | 114,733   |   |                   |   | 104,777   |  
|Other liabilities                                                                                                |  |                        | 38,460    |   |                   |   | 28,004    |  
|Stockholders equity:                                                                                            |  |                        |           |   |                   |   |           |  
|Common stock, $0.01 par value; 200,000 shares authorized; issued 86,072 shares in 2004 and 84,854 shares in 2003 |  |                        | 861       |   |                   |   | 848       |  
|Unearned compensation                                                                                            |  |                        | (32,207   | ) |                   |   | (16,843   | )
|Additional paid-in capital                                                                                       |  |                        | 1,569,118 |   |                   |   | 1,458,310 |  
|Accumulated other comprehensive income                                                                           |  |                        | 3,498     |   |                   |   | 18,815    |  
|Retained earnings                                                                                                |  |                        | 647,168   |   |                   |   | 390,407   |  
|                                                                                                                 |  |                        |           |   |                   |   |           |  
|Total stockholders equity                                                                                       |  |                        | 2,188,438 |   |                   |   | 1,851,537 |  
|                                                                                                                 |  |                        |           |   |                   |   |           |  
|                                                                                                                 |  | $                      | 5,226,917 |   |                   | $ | 4,619,304 |  
|                                                                                                                 |  |                        |           |   |                   |   |           |  



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.



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PACIFICARE HEALTH SYSTEMS, INC.



CONSOLIDATED STATEMENTS OF OPERATIONS



|                                                                                                        |  |                                               |            |   |                              |   |            |                              |  |   |            |  
|------------------------------------------------------------------------------------------------------- |  | --------------------------------------------- | ---------- | - | ---------------------------- | - | ---------- | ---------------------------- |  | - | ---------- | -
|                                                                                                        |  | Year Ended December 31, 2004                  |            |   | Year Ended December 31, 2003 |   |            | Year Ended December 31, 2002 | 
|                                                                                                        |  | (Amounts in thousands, except per share data) |           
|Revenue:                                                                                                |  |                                               |            |   |                              |   |            |                              |  |   |            |  
|Commercial                                                                                              |  | $                                             | 5,686,373  |   |                              | $ | 5,043,257  |                              |  | $ | 4,782,973  |  
|Senior                                                                                                  |  |                                               | 5,810,247  |   |                              |   | 5,395,265  |                              |  |   | 5,887,603  |  
|Specialty and other                                                                                     |  |                                               | 691,367    |   |                              |   | 498,668    |                              |  |   | 421,439    |  
|Net investment income                                                                                   |  |                                               | 88,817     |   |                              |   | 71,321     |                              |  |   | 64,487     |  
|                                                                                                        |  |                                               |            |   |                              |   |            |                              |  |   |            |  
|Total operating revenue                                                                                 |  |                                               | 12,276,804 |   |                              |   | 11,008,511 |                              |  |   | 11,156,502 |  
|Expenses:                                                                                               |  |                                               |            |   |                              |   |            |                              |  |   |            |  
|Health care services and other:                                                                         |  |                                               |            |   |                              |   |            |                              |  |   |            |  
|Commercial                                                                                              |  |                                               | 4,786,830  |   |                              |   | 4,270,329  |                              |  |   | 4,205,376  |  
|Senior                                                                                                  |  |                                               | 5,007,852  |   |                              |   | 4,540,301  |                              |  |   | 5,104,275  |  
|Specialty and other                                                                                     |  |                                               | 379,097    |   |                              |   | 255,164    |                              |  |   | 176,050    |  
|                                                                                                        |  |                                               |            |   |                              |   |            |                              |  |   |            |  
|Total health care services and other                                                                    |  |                                               | 10,173,779 |   |                              |   | 9,065,794  |                              |  |   | 9,485,701  |  
|Selling, general and administrative expenses                                                            |  |                                               | 1,561,247  |   |                              |   | 1,452,542  |                              |  |   | 1,370,160  |  
|Impairment, disposition, restructuring, Office of Personnel Management and other charges (credits), net |  |                                               |           |   |                              |   |           |                              |  |   | 3,774      |  
|                                                                                                        |  |                                               |            |   |                              |   |            |                              |  |   |            |  
|Operating income                                                                                        |  |                                               | 541,778    |   |                              |   | 490,175    |                              |  |   | 296,867    |  
|Interest expense, net                                                                                   |  |                                               | (48,041    | ) |                              |   | (100,531   | )                            |  |   | (74,904    | )
|                                                                                                        |  |                                               |            |   |                              |   |            |                              |  |   |            |  
|Income before income taxes                                                                              |  |                                               | 493,737    |   |                              |   | 389,644    |                              |  |   | 221,963    |  
|Provision for income taxes                                                                              |  |                                               | 190,583    |   |                              |   | 146,896    |                              |  |   | 82,792     |  
|                                                                                                        |  |                                               |            |   |                              |   |            |                              |  |   |            |  
|Income before cumulative effect of a change in accounting principle                                     |  |                                               | 303,154    |   |                              |   | 242,748    |                              |  |   | 139,171    |  
|Cumulative effect of a change in accounting principle                                                   |  |                                               |           |   |                              |   |           |                              |  |   | (897,000   | )
|                                                                                                        |  |                                               |            |   |                              |   |            |                              |  |   |            |  
|Net income (loss)                                                                                       |  | $                                             | 303,154    |   |                              | $ | 242,748    |                              |  | $ | (757,829   | )
|                                                                                                        |  |                                               |            |   |                              |   |            |                              |  |   |            |  
|Basic earnings (loss) per share(1):                                                                     |  |                                               |            |   |                              |   |            |                              |  |   |            |  
|Income before cumulative effect of a change in accounting principle                                     |  | $                                             | 3.60       |   |                              | $ | 3.26       |                              |  | $ | 1.98       |  
|Cumulative effect of a change in accounting principle                                                   |  |                                               |           |   |                              |   |           |                              |  |   | (12.73     | )
|                                                                                                        |  |                                               |            |   |                              |   |            |                              |  |   |            |  
|Basic earnings (loss) per share                                                                         |  | $                                             | 3.60       |   |                              | $ | 3.26       |                              |  | $ | (10.75     | )
|                                                                                                        |  |                                               |            |   |                              |   |            |                              |  |   |            |  
|Diluted earnings (loss) per share(1)(2):                                                                |  |                                               |            |   |                              |   |            |                              |  |   |            |  
|Income before cumulative effect of a change in accounting principle                                     |  | $                                             | 3.20       |   |                              | $ | 2.89       |                              |  | $ | 1.98       |  
|Cumulative effect of a change in accounting principle                                                   |  |                                               |           |   |                              |   |           |                              |  |   | (12.73     | )
|                                                                                                        |  |                                               |            |   |                              |   |            |                              |  |   |            |  
|Diluted earnings (loss) per share                                                                       |  | $                                             | 3.20       |   |                              | $ | 2.89       |                              |  | $ | (10.75     | )
|                                                                                                        |  |                                               |            |   |                              |   |            |                              |  |   |            |  

---

|(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.
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|(2) | The diluted earnings per share for the year ended December 31, 2003 has been restated for the retroactive impact of Emerging Issues Task Force, or EITF, Issue No. 04-8, The
Effect of Contingently Convertible Debt on Diluted Earnings Per Share. The dilutive effect of EITF 04-8 did not have an impact on the diluted loss per share for the year ended December 31, 2002 as it was antidilutive. See Note 2 of the Notes to
Consolidated Financial Statements.
|--- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



See
accompanying notes.



F-2





---

##### Table of Contents

PACIFICARE HEALTH SYSTEMS, INC.



CONSOLIDATED STATEMENTS OF STOCKHOLDERS EQUITY



|                                                                                        |  |                        |      |   |                       |   |         |                            |  |   |                                               |   |  |                   |         |   |                |   |           |       |  |   |          |   |  |   |           |  
|--------------------------------------------------------------------------------------- |  | ---------------------- | ---- | - | --------------------- | - | ------- | -------------------------- |  | - | --------------------------------------------- | - |  | ----------------- | ------- | - | -------------- | - | --------- | ----- |  | - | -------- | - |  | - | --------- | -
|                                                                                        |  | Common Stock           |      |   | Unearned Compensation |   |         | Additional Paid-in Capital |  |   | Accumulated Other Comprehensive Income (Loss) |   |  | Retained Earnings |         |   | Treasury Stock |   |           | Total | 
|                                                                                        |  | (Amounts in thousands) |     
|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 |  
|                                                                                        |  |                        |      |   |                       |   |         |                            |  |   |                                               |   |  |                   |         |   |                |   |           |       |  |   |          |   |  |   |           |  
|Comprehensive income (loss):                                                            |  |                        |      |   |                       |   |         |                            |  |   |                                               |   |  |                   |         |   |                |   |           |       |  |   |          |   |  |   |           |  
|Net income                                                                              |  |                        |     |   |                       |   |        |                            |  |   |                                              |   |  |                   |        |   |                |   | 303,154   |       |  |   |         |   |  |   | 303,154   |  
|Other comprehensive loss, net of tax:                                                   |  |                        |      |   |                       |   |         |                            |  |   |                                               |   |  |                   |         |   |                |   |           |       |  |   |          |   |  |   |           |  
|Change in unrealized gains on marketable securities, net of reclassification adjustment |  |                        |     |   |                       |   |        |                            |  |   |                                              |   |  |                   | (15,317 | ) |                |   |          |       |  |   |         |   |  |   | (15,317   | )
|                                                                                        |  |                        |      |   |                       |   |         |                            |  |   |                                               |   |  |                   |         |   |                |   |           |       |  |   |          |   |  |   |           |  
|Comprehensive income (loss)                                                             |  |                        |     |   |                       |   |        |                            |  |   |                                              |   |  |                   | (15,317 | ) |                |   | 303,154   |       |  |   |         |   |  |   | 287,837   |  
|                                                                                        |  |                        |      |   |                       |   |         |                            |  |   |                                               |   |  |                   |         |   |                |   |           |       |  |   |          |   |  |   |           |  
|Capital stock activity:                                                                 |  |                        |      |   |                       |   |         |                            |  |   |                                               |   |  |                   |         |   |                |   |           |       |  |   |          |   |  |   |           |  
|Employee benefit plans                                                                  |  |                        | 44   |   |                       |   | (15,364 | )                          |  |   | 134,548                                       |   |  |                   |        |   |                |   |          |       |  |   |         |   |  |   | 119,228   |  
|Purchase of treasury stock                                                              |  |                        | (31  | ) |                       |   |        |                            |  |   |                                              |   |  |                   |        |   |                |   | (46,393   | )     |  |   | 31       |   |  |   | (46,393   | )
|Retirement of treasury stock                                                            |  |                        |     |   |                       |   |        |                            |  |   | (56,867                                       | ) |  |                   |        |   |                |   |          |       |  |   | (31      | ) |  |   | (56,898   | )
|Tax benefit associated with exercise of stock options                                   |  |                        |     |   |                       |   |        |                            |  |   | 29,627                                        |   |  |                   |        |   |                |   |          |       |  |   |         |   |  |   | 29,627    |  
|Tax benefit for Unihealth consideration                                                 |  |                        |     |   |                       |   |        |                            |  |   | 3,500                                         |   |  |                   |        |   |                |   |          |       |  |   |         |   |  |   | 3,500     |  
|                                                                                        |  |                        |      |   |                       |   |         |                            |  |   |                                               |   |  |                   |         |   |                |   |           |       |  |   |          |   |  |   |           |  
|Balances at December 31, 2004                                                           |  | $                      | 861  |   |                       | $ | (32,207 | )                          |  | $ | 1,569,118                                     |   |  | $                 | 3,498   |   |                | $ | 647,168   |       |  | $ |         |   |  | $ | 2,188,438 |  
|                                                                                        |  |                        |      |   |                       |   |         |                            |  |   |                                               |   |  |                   |         |   |                |   |           |       |  |   |          |   |  |   |           |  



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





---

##### Table of Contents

PACIFICARE HEALTH SYSTEMS, INC.



CONSOLIDATED STATEMENTS OF CASH FLOWS



|                                                                                                        |  |                              |           |   |                              |   |           |                              |  |   |          |  
|------------------------------------------------------------------------------------------------------- |  | ---------------------------- | --------- | - | ---------------------------- | - | --------- | ---------------------------- |  | - | -------- | -
|                                                                                                        |  | Year Ended December 31, 2004 |           |   | Year Ended December 31, 2003 |   |           | Year Ended December 31, 2002 | 
|                                                                                                        |  | (Amounts in thousands)       |          
|Operating activities:                                                                                   |  |                              |           |   |                              |   |           |                              |  |   |          |  
|Net income (loss)                                                                                       |  | $                            | 303,154   |   |                              | $ | 242,748   |                              |  | $ | (757,829 | )
|Adjustments to reconcile net income (loss) to net cash flows provided by operating activities:          |  |                              |           |   |                              |   |           |                              |  |   |          |  
|Depreciation and amortization                                                                           |  |                              | 50,503    |   |                              |   | 44,713    |                              |  |   | 50,284   |  
|Stock-based compensation expense                                                                        |  |                              | 33,467    |   |                              |   | 19,092    |                              |  |   | 693      |  
|Deferred income taxes                                                                                   |  |                              | 30,874    |   |                              |   | (46,088   | )                            |  |   | 18,559   |  
|Tax benefit realized for stock option exercises                                                         |  |                              | 29,627    |   |                              |   | 17,838    |                              |  |   | 1,009    |  
|Amortization of intangible assets                                                                       |  |                              | 19,786    |   |                              |   | 21,908    |                              |  |   | 23,600   |  
|Amortization of capitalized loan fees                                                                   |  |                              | 8,364     |   |                              |   | 7,481     |                              |  |   | 7,784    |  
|Amortization of notes receivable from sale of fixed assets                                              |  |                              | (5,626    | ) |                              |   | (5,641    | )                            |  |   | (3,107   | )
|Loss on disposal of property, plant and equipment and other                                             |  |                              | 2,478     |   |                              |   | 22,328    |                              |  |   | 12,793   |  
|Provision for doubtful accounts                                                                         |  |                              | 1,604     |   |                              |   | 10,271    |                              |  |   | 6,346    |  
|Amortization of discount on 103/4% senior notes                                                         |  |                              | 284       |   |                              |   | 424       |                              |  |   | 266      |  
|Impairment, disposition, restructuring, Office of Personnel Management and other charges (credits), net |  |                              |          |   |                              |   |          |                              |  |   | 3,774    |  
|Expenses related to bond redemption                                                                     |  |                              |          |   |                              |   | 28,155    |                              |  |   |         |  
|Employer benefit plan contributions in treasury stock                                                   |  |                              |          |   |                              |   | 1,363     |                              |  |   | 12,132   |  
|Cumulative effect of a change in accounting principle                                                   |  |                              |          |   |                              |   |          |                              |  |   | 897,000  |  
|Marketable and other securities impairment for other than temporary declines in value                   |  |                              |          |   |                              |   |          |                              |  |   | 12,543   |  
|Adjustment to cash received in purchase transaction                                                     |  |                              |          |   |                              |   |          |                              |  |   | 17       |  
|Changes in assets and liabilities net of effects of acquisition:                                        |  |                              |           |   |                              |   |           |                              |  |   |          |  
|Receivables, net                                                                                        |  |                              | (44,857   | ) |                              |   | 19,327    |                              |  |   | 82,369   |  
|Prepaid expenses and other assets                                                                       |  |                              | 1,153     |   |                              |   | (33,748   | )                            |  |   | 2,627    |  
|Medical claims and benefits payable                                                                     |  |                              | 44,016    |   |                              |   | (17,000   | )                            |  |   | (52,226  | )
|Accounts payable and accrued liabilities:                                                               |  |                              |           |   |                              |   |           |                              |  |   |          |  
|Payment for Office of Personnel Management settlement, net of amounts received                          |  |                              |          |   |                              |   | (10,000   | )                            |  |   | (65,441  | )
|Accrued taxes                                                                                           |  |                              | (20,379   | ) |                              |   | 9,750     |                              |  |   | (6,749   | )
|Other changes in accounts payable and accrued liabilities                                               |  |                              | 2,439     |   |                              |   | 64,281    |                              |  |   | 65,776   |  
|Unearned premium revenue                                                                                |  |                              | (428,787  | ) |                              |   | 16,928    |                              |  |   | (69,841  | )
|                                                                                                        |  |                              |           |   |                              |   |           |                              |  |   |          |  
|Net cash flows provided by operating activities                                                         |  |                              | 28,100    |   |                              |   | 414,130   |                              |  |   | 242,379  |  
|                                                                                                        |  |                              |           |   |                              |   |           |                              |  |   |          |  
|Investing activities:                                                                                   |  |                              |           |   |                              |   |           |                              |  |   |          |  
|Acquisition of AMS, net of cash acquired                                                                |  |                              | (445,886  | ) |                              |   |          |                              |  |   |         |  
|Purchase of marketable securities, net                                                                  |  |                              | (321,061  | ) |                              |   | (169,102  | )                            |  |   | (113,987 | )
|Purchase of property, plant and equipment                                                               |  |                              | (73,066   | ) |                              |   | (52,271   | )                            |  |   | (59,274  | )
|Sale (purchase) of marketable securities-restricted, net                                                |  |                              | 29,517    |   |                              |   | 19,643    |                              |  |   | (117,368 | )
|Proceeds from the sale of property, plant and equipment                                                 |  |                              | 430       |   |                              |   | 30        |                              |  |   | 12,492   |  
|                                                                                                        |  |                              |           |   |                              |   |           |                              |  |   |          |  
|Net cash flows used in investing activities                                                             |  |                              | (810,066  | ) |                              |   | (201,700  | )                            |  |   | (278,137 | )
|                                                                                                        |  |                              |           |   |                              |   |           |                              |  |   |          |  
|Financing activities:                                                                                   |  |                              |           |   |                              |   |           |                              |  |   |          |  
|Proceeds from borrowings of long-term debt                                                              |  |                              | 625,000   |   |                              |   | 150,000   |                              |  |   | 496,945  |  
|Principal payments on long-term debt                                                                    |  |                              | (179,591  | ) |                              |   | (151,329  | )                            |  |   | (554,308 | )
|Purchase and retirement of common stock                                                                 |  |                              | (103,291  | ) |                              |   | (493      | )                            |  |   |         |  
|Proceeds from issuance of common and treasury stock                                                     |  |                              | 81,787    |   |                              |   | 41,146    |                              |  |   | 4,893    |  
|Loan fees                                                                                               |  |                              | (9,264    | ) |                              |   | (6,949    | )                            |  |   | (37,789  | )
|Payments on software financing agreement                                                                |  |                              | (6,993    | ) |                              |   | (3,683    | )                            |  |   | (2,231   | )
|Proceeds from equity offering used for redemption of $175 million of senior notes                       |  |                              |          |   |                              |   | 199,424   |                              |  |   |         |  
|Principal payments on senior note redemption                                                            |  |                              |          |   |                              |   | (175,000  | )                            |  |   |         |  
|Use of restricted cash collateral for payment of FHP senior notes                                       |  |                              |          |   |                              |   | 43,250    |                              |  |   |         |  
|Principal payments on FHP senior notes                                                                  |  |                              |          |   |                              |   | (43,250   | )                            |  |   | (41,750  | )
|Payment of premium to bondholders for senior note redemption                                            |  |                              |          |   |                              |   | (18,813   | )                            |  |   |         |  
|Proceeds from issuance of convertible subordinated debentures                                           |  |                              |          |   |                              |   |          |                              |  |   | 135,000  |  
|Proceeds from draw down under equity commitment arrangement                                             |  |                              |          |   |                              |   |          |                              |  |   | 8,928    |  
|                                                                                                        |  |                              |           |   |                              |   |           |                              |  |   |          |  
|Net cash flows provided by financing activities                                                         |  |                              | 407,648   |   |                              |   | 34,303    |                              |  |   | 9,688    |  
|                                                                                                        |  |                              |           |   |                              |   |           |                              |  |   |          |  
|Net increase (decrease) in cash and equivalents                                                         |  |                              | (374,318  | ) |                              |   | 246,733   |                              |  |   | (26,070  | )
|Beginning cash and equivalents                                                                          |  |                              | 1,198,422 |   |                              |   | 951,689   |                              |  |   | 977,759  |  
|                                                                                                        |  |                              |           |   |                              |   |           |                              |  |   |          |  
|Ending cash and equivalents                                                                             |  | $                            | 824,104   |   |                              | $ | 1,198,422 |                              |  | $ | 951,689  |  
|                                                                                                        |  |                              |           |   |                              |   |           |                              |  |   |          |  



See accompanying
notes.

Table continued on next page



F-4





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##### Table of Contents

PACIFICARE HEALTH SYSTEMS, INC.



CONSOLIDATED STATEMENTS OF CASH FLOWS (Continued)



|                                                                      |  |                              |          |   |                              |   |         |                              |  |   |         |  
|--------------------------------------------------------------------- |  | ---------------------------- | -------- | - | ---------------------------- | - | ------- | ---------------------------- |  | - | ------- | -
|                                                                      |  | Year Ended December 31, 2004 |          |   | Year Ended December 31, 2003 |   |         | Year Ended December 31, 2002 | 
|                                                                      |  | (Amounts in thousands)       |         
|Supplemental cash flow information:                                   |  |                              |          |   |                              |   |         |                              |  |   |         |  
|Cash paid (received) during the year for:                             |  |                              |          |   |                              |   |         |                              |  |   |         |  
|Income taxes, net of refunds                                          |  | $                            | 154,193  |   |                              | $ | 168,933 |                              |  | $ | (68,123 | )
|Interest                                                              |  | $                            | 39,653   |   |                              | $ | 67,363  |                              |  | $ | 68,732  |  
|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 tax liability                               |  |                              |         |   |                              |   |        |                              |  |   | (32,436 | )
|                                                                      |  |                              |          |   |                              |   |         |                              |  |   |         |  
|Goodwill impairment, net of tax                                       |  | $                            |         |   |                              | $ |        |                              |  | $ | 897,000 |  
|                                                                      |  |                              |          |   |                              |   |         |                              |  |   |         |  
|Stock-based compensation                                              |  | $                            | 3,974    |   |                              | $ | 5,028   |                              |  | $ | 1,915   |  
|                                                                      |  |                              |          |   |                              |   |         |                              |  |   |         |  
|Treasury stock reissued in exchange for retirement of long-term debt: |  |                              |          |   |                              |   |         |                              |  |   |         |  
|Treasury stock                                                        |  | $                            |         |   |                              | $ |        |                              |  | $ | 5,218   |  
|Additional paid-in capital                                            |  |                              |         |   |                              |   |        |                              |  |   | (2,398  | )
|Long-term debt retired                                                |  |                              |         |   |                              |   |        |                              |  |   | (3,000  | )
|                                                                      |  |                              |          |   |                              |   |         |                              |  |   |         |  
|Extraordinary gain on early retirement of debt                        |  | $                            |         |   |                              | $ |        |                              |  | $ | (180    | )
|                                                                      |  |                              |          |   |                              |   |         |                              |  |   |         |  
|Details of accumulated other comprehensive income:                    |  |                              |          |   |                              |   |         |                              |  |   |         |  
|Change in market value on marketable securities                       |  | $                            | (24,093  | ) |                              | $ | (4,899  | )                            |  | $ | 31,720  |  
|Decrease (increase) in deferred tax liability                         |  |                              | 8,776    |   |                              |   | 1,984   |                              |  |   | (11,941 | )
|                                                                      |  |                              |          |   |                              |   |         |                              |  |   |         |  
|Change in stockholders equity                                        |  | $                            | (15,317  | ) |                              | $ | (2,915  | )                            |  | $ | 19,779  |  
|                                                                      |  |                              |          |   |                              |   |         |                              |  |   |         |  
|Details of discount on 103/4% senior notes:                           |  |                              |          |   |                              |   |         |                              |  |   |         |  
|Discount                                                              |  | $                            | (1,529   | ) |                              | $ | (2,789  | )                            |  | $ | (3,055  | )
|Discount reduction related to bond redemption                         |  |                              |         |   |                              |   | 836     |                              |  |   |        |  
|Amortization                                                          |  |                              | 284      |   |                              |   | 424     |                              |  |   | 266     |  
|                                                                      |  |                              |          |   |                              |   |         |                              |  |   |         |  
|Net discount on notes payable                                         |  | $                            | (1,245   | ) |                              | $ | (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                                         |  | $                            |         |   |                              | $ |        |                              |  | $ |        |  
|                                                                      |  |                              |          |   |                              |   |         |                              |  |   |         |  
|Details of businesses acquired in purchase transactions:              |  |                              |          |   |                              |   |         |                              |  |   |         |  
|Fair value of assets acquired                                         |  | $                            | 754,416  |   |                              | $ |        |                              |  | $ |        |  
|Less liabilities assumed or created                                   |  |                              | (246,941 | ) |                              |   |        |                              |  |   |        |  
|                                                                      |  |                              |          |   |                              |   |         |                              |  |   |         |  
|Cash paid for fair value of assets acquired                           |  |                              | 507,475  |   |                              |   |        |                              |  |   |        |  
|Cash acquired in acquisitions                                         |  |                              | (61,589  | ) |                              |   |        |                              |  |   |        |  
|                                                                      |  |                              |          |   |                              |   |         |                              |  |   |         |  
|Net cash paid for acquisitions                                        |  | $                            | 445,886  |   |                              | $ |        |                              |  | $ |        |  
|                                                                      |  |                              |          |   |                              |   |         |                              |  |   |         |  



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, individuals and Medicare beneficiaries throughout most of the United States and Guam. Our commercial and senior
medical plans are designed to deliver quality health care and customer service to members cost-effectively. These products include health insurance, health benefits administration and indemnity insurance products such as Medicare Supplement products
offered through health maintenance organizations, or HMOs, and preferred provider organizations, or PPOs. 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. Our statement of operations shows 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.



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.



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 2004 presentation.



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



F-6





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##### Table of Contents

PACIFICARE HEALTH SYSTEMS, INC.



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)



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 4, 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, 2004.



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 fair values of our 103/4% senior notes and convertible subordinate debentures are estimated based on the quoted market prices. The carrying value of our 103/4% senior notes, net of discount, was $324 million as of December 31, 2004 and 2003 and the fair values were $370 million and $382 million as of December 31, 2004 and 2003, respectively. The carrying
value of our convertible subordinated debentures was $135 million as of December 31, 2004 and 2003 and the fair values were $376 million and $237 million as of December 31, 2004 and 2003, respectively. Considerable judgment is required to develop
estimates of fair value. Accordingly, the estimates are not necessarily indicative of the amounts we could realize in a current market exchange. The use of different market assumptions and/or estimation methodologies may have a material effect on
the estimated fair value amounts. The fair value of our term debt of $625 million at December 31, 2004 approximated its fair value since this debt was incurred in December 2004.



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 40
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 $256 million at December 31, 2004 and $212 million at December 31, 2003.



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



F-7





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##### Table of Contents

PACIFICARE HEALTH SYSTEMS, INC.



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)



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 48% in 2004, 50% in 2003 and 53% in 2002 as a percentage of total premiums.



Health Care Services.  Our HMOs arrange for comprehensive health care services to their members through capitation or fee-for-service 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-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. 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, however, at each reporting period management records its best estimate of the liability for
incurred claims. 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 Accounting
Principals Board, or 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 loss for the year ended December 31, 2002, 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 SFAS 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, costs related to stock-based
employee and director compensation included in the determination of net income for 2003 and 2004 are 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



F-8





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##### Table of Contents

PACIFICARE HEALTH SYSTEMS, INC.



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)



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 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                                    |        
|                                                                                                                           |  | 2004                                          |         |   | 2003 |   |         | 2002 | 
|                                                                                                                           |  | (Amounts in thousands, except per share data) |        
|Net income (loss), as reported                                                                                             |  | $                                             | 303,154 |   |      | $ | 242,748 |      |  | $ | (757,829 | )
|Add stock-based compensation expense included in reported net income (loss), net of related tax effect                     |  |                                               | 15,119  |   |      |   | 8,228   |      |  |   |         |  
|Deduct total stock-based compensation expense determined under fair value method for all awards, net of related tax effect |  |                                               | (17,839 | ) |      |   | (16,703 | )    |  |   | (18,360  | )
|                                                                                                                           |  |                                               |         |   |      |   |         |      |  |   |          |  
|Pro forma net income (loss)                                                                                                |  | $                                             | 300,434 |   |      | $ | 234,273 |      |  | $ | (776,189 | )
|                                                                                                                           |  |                                               |         |   |      |   |         |      |  |   |          |  
|Earnings (loss) per share:                                                                                                 |  |                                               |         |   |      |   |         |      |  |   |          |  
|Basicas reported                                                                                                          |  | $                                             | 3.60    |   |      | $ | 3.26    |      |  | $ | (10.75   | )
|                                                                                                                           |  |                                               |         |   |      |   |         |      |  |   |          |  
|Basicpro forma                                                                                                            |  | $                                             | 3.57    |   |      | $ | 3.15    |      |  | $ | (11.01   | )
|                                                                                                                           |  |                                               |         |   |      |   |         |      |  |   |          |  
|Dilutedas reported                                                                                                        |  | $                                             | 3.20    |   |      | $ | 2.89    |      |  | $ | (10.75   | )
|                                                                                                                           |  |                                               |         |   |      |   |         |      |  |   |          |  
|Dilutedpro forma                                                                                                          |  | $                                             | 3.17    |   |      | $ | 2.79    |      |  | $ | (11.01   | )
|                                                                                                                           |  |                                               |         |   |      |   |         |      |  |   |          |  



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



|                             |  |                        |        |                   |   |                |  |                   |        |                |   |                   |  |   |     |  |   |    
|---------------------------- |  | ---------------------- | ------ | ----------------- | - | -------------- |  | ----------------- | ------ | -------------- | - | ----------------- |  | - | --- |  | - | ---
|                             |  | Year Ended            
|                             |  | 2004                   |        | 2003              |   | 2002          
|                             |  | Pretax Charges         |        | Net-of-Tax Amount |   | Pretax Charges |  | Net-of-Tax Amount |        | Pretax Charges |   | Net-of-Tax Amount
|                             |  | (Amounts in thousands)
|Stock options                |  | $                      | 9,868  |                   | $ | 6,059          |  | $                 | 7,545  |                | $ | 4,512             |  | $ |    |  | $ |   
|Employee Stock Purchase Plan |  |                        | 14,755 |                   |   | 9,060          |  |                   | 6,214  |                |   | 3,716             |  |   |    |  |   |   
|                             |  |                        |        |                   |   |                |  |                   |        |                |   |                   |  |   |     |  |   |    
|                             |  |                        | 24,623 |                   |   | 15,119         |  |                   | 13,759 |                |   | 8,228             |  |   |    |  |   |   
|Restricted stock(1)          |  |                        | 8,844  |                   |   | 5,430          |  |                   | 5,333  |                |   | 3,189             |  |   | 693 |  |   | 414
|                             |  |                        |        |                   |   |                |  |                   |        |                |   |                   |  |   |     |  |   |    
|Total                        |  | $                      | 33,467 |                   | $ | 20,549         |  | $                 | 19,092 |                | $ | 11,417            |  | $ | 693 |  | $ | 414
|                             |  |                        |        |                   |   |                |  |                   |        |                |   |                   |  |   |     |  |   |    

---

|(1) | The recognition and measurement of restricted stock is the same under APB Opinion No. 25 and SFAS 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.
|--- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



In December 2004, the Financial Accounting Standards Board, or FASB, issued SFAS No. 123
(Revised 2004), Share-Based Payment,or SFAS No. 123R, which is a revision of SFAS No. 123. SFAS No. 123R supersedes APB Opinion No. 25, Accounting for Stock Issued to Employees, and amends SFAS No. 95, Statement of Cash Flows.
SFAS No. 123R requires all share-based payments to employees, including grants of employee stock options, to be recognized in the income statement based on their fair values. SFAS No. 123R is effective for us beginning July 1, 2005 and will require
us to expense share-based payments under the modified prospective method. Under this method, compensation expense is recognized for all share-based payments granted after July 1, 2005 and also for all awards granted prior to July 1, 2005
that remain unvested on the effective date. We adopted the transitional provisions of SFAS No. 123 effective January 1, 2003 using the prospective method. Consequently, compensation expense for awards that we granted prior to January 1, 2003 that
are not fully vested on July 1, 2005 will be subject to expense beginning July 1, 2005 under SFAS No. 123R. We do not expect that the adoption of SFAS No. 123R will have a significant impact on our results of operations or financial position.



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PACIFICARE HEALTH SYSTEMS, INC.



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)



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 $43 million in 2004, $34
million in 2003 and $27 million in 2002.



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.



|                                                                                                 |  |                                               |         |   |      |   |         |  |   |          |  
|------------------------------------------------------------------------------------------------ |  | --------------------------------------------- | ------- | - | ---- | - | ------- |  | - | -------- | -
|                                                                                                 |  | 2004                                          |         |   | 2003 |   | 2002    | 
|                                                                                                 |  | (Amounts in thousands, except per share data) |        
|Basic Earnings (Loss) Per Share Calculation:                                                     |  |                                               |         |   |      |   |         |  |   |          |  
|Numerator                                                                                        |  |                                               |         |   |      |   |         |  |   |          |  
|Net income (loss)                                                                                |  | $                                             | 303,154 |   |      | $ | 242,748 |  | $ | (757,829 | )
|                                                                                                 |  |                                               |         |   |      |   |         |  |   |          |  
|Denominator                                                                                      |  |                                               |         |   |      |   |         |  |   |          |  
|Shares outstanding at the beginning of the period(1)                                             |  |                                               | 83,339  |   |      |   | 71,782  |  |   | 68,894   |  
|Weighted average number of shares issued:                                                        |  |                                               |         |   |      |   |         |  |   |          |  
|Treasury stock repurchases                                                                       |  |                                               | (1,488  | ) |      |   |        |  |   |         |  
|Stock options exercised and treasury stock reissued, net                                         |  |                                               | 2,405   |   |      |   | 1,627   |  |   | 1,580    |  
|Common stock offering(2)                                                                         |  |                                               |        |   |      |   | 1,000   |  |   |         |  
|                                                                                                 |  |                                               |         |   |      |   |         |  |   |          |  
|Denominator for basic earnings (loss) per share                                                  |  |                                               | 84,256  |   |      |   | 74,409  |  |   | 70,474   |  
|                                                                                                 |  |                                               |         |   |      |   |         |  |   |          |  
|Basic earnings (loss) per share                                                                  |  | $                                             | 3.60    |   |      | $ | 3.26    |  | $ | (10.75   | )
|                                                                                                 |  |                                               |         |   |      |   |         |  |   |          |  
|Diluted Earnings (Loss) Per Share Calculation:                                                   |  |                                               |         |   |      |   |         |  |   |          |  
|Numerator                                                                                        |  |                                               |         |   |      |   |         |  |   |          |  
|Net income (loss)                                                                                |  | $                                             | 303,154 |   |      | $ | 242,748 |  | $ | (757,829 | )
|Adjustment for interest expense avoided on convertible subordinated debentures, net of tax(3)(6) |  |                                               | 2,487   |   |      |   | 2,523   |  |   | 253      |  
|                                                                                                 |  |                                               |         |   |      |   |         |  |   |          |  
|Net income, as adjusted for interest expense avoided on convertible subordinated debentures      |  | $                                             | 305,641 |   |      | $ | 245,271 |  | $ | (757,576 | )
|                                                                                                 |  |                                               |         |   |      |   |         |  |   |          |  
|Denominator                                                                                      |  |                                               |         |   |      |   |         |  |   |          |  
|Denominator for basic earnings (loss) per share                                                  |  |                                               | 84,256  |   |      |   | 74,409  |  |   | 70,474   |  
|Common stock equivalents related to convertible subordinated debentures(3)(5)                    |  |                                               | 6,429   |   |      |   | 6,429   |  |   |         |  
|Employee stock options and other dilutive potential common shares(4)(5)                          |  |                                               | 4,805   |   |      |   | 3,933   |  |   |         |  
|                                                                                                 |  |                                               |         |   |      |   |         |  |   |          |  
|Denominator for diluted earnings (loss) per share                                                |  |                                               | 95,490  |   |      |   | 84,771  |  |   | 70,474   |  
|                                                                                                 |  |                                               |         |   |      |   |         |  |   |          |  
|Diluted earnings (loss) per share                                                                |  | $                                             | 3.20    |   |      | $ | 2.89    |  | $ | (10.75   | )
|                                                                                                 |  |                                               |         |   |      |   |         |  |   |          |  

---

|(1) | Excludes 910,000, 1,515,000 and 226,000 shares of restricted common stock which have been granted under our stock-based compensation plans but have not vested as of December 31,
2004, 2003 and 2002, respectively.
|--- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|(2) | In November 2003, we issued 7.6 million shares of our common stock in a public offering. See Note 6, Stockholders Equity.
|--- | ----------------------------------------------------------------------------------------------------------------------------



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PACIFICARE HEALTH SYSTEMS, INC.



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)



|(3) | In November 2004, the Emerging Issues Task Force, or EITF, ratified its decision on EITF Issue No. 04-8, The Effect of Contingently Convertible Debt on Diluted Earnings Per
Share, which impacts when the conversion to shares of common stock should be recognized for periods prior to the satisfaction of the market price condition. EITF No. 04-8 requires issuers of contingently convertible debt instruments which become
convertible into common stock if certain events occurs, such as the underlying common stock achieving a specified price target, to include the dilutive impact of the instrument in diluted earnings per share upon issuance, rather than waiting until
the specified share price is met. This consensus is effective for all periods ending after December 15, 2004 and must be applied by restating all periods during which the instrument was outstanding.
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|(4) | 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 year ended December 31, 2004 and 2003, these excluded weighted options outstanding totaled 1.5 million shares and 4.6 million shares, respectively, with exercise prices ranging from $14.26 to
$54.57 per share. For the year ended December 31, 2004 and 2003, the average market value used in the computation of dilutive employee stock options and other dilutive potential common shares was $37.68 and $21.73, respectively.
|--- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|(5) | Common stock equivalents related to convertible subordinated debentures and 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.
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|(6) | The adjusted interest expense avoided on convertible subordinated debentures was prorated for issuance in November 2002.
|--- | ------------------------------------------------------------------------------------------------------------------------



3.  Acquisitions of Businesses



American Medical Security Group, Inc.On December 13, 2004, we completed
our acquisition of American Medical Security Group, Inc., or AMS, through a cash merger in which AMS became our wholly-owned subsidiary. AMS provides an expansion of our commercial membership, strengthens our position in the individual and small
group markets and adds new proprietary products including a health savings account and group life products. Under the terms of the merger agreement, total consideration paid to all holders of AMS common stock and the cash out of options in the
merger was approximately $505 million in cash. We also assumed $30 million of existing long-term debt which we repaid concurrent with the completion of the acquisition. See Note 5, Long-Term Debt and Other Commitments. The total purchase
price of $505 million was used to purchase net assets with a fair value of approximately $221 million. As a result of the acquisition of AMS, we incurred $35 million in transaction costs. In accordance with generally accepted accounting principles,
costs which are not associated with the generation of future revenues and have no future economic benefit, will be reflected as assumed liabilities in the allocation of the purchase price to net assets acquired. Included in the assumed liabilities
is an estimate of integration costs expected to be incurred for plans to be finalized within one year of the date of acquisition. Any difference between actual and estimated integration costs will be recorded as an adjustment to goodwill through the
date in which the allocation of the purchase price is completed. Estimated goodwill and other intangibles totaling $321 million includes $10 million of deferred tax liabilities relating to identified intangibles. In accordance with SFAS No. 142,
Goodwill and Other Intangible Assets, goodwill and other intangible assets with indefinite useful lives are not amortized, but instead are subject to impairment tests. Identified intangibles with definite useful lives are being amortized on a
straight-line basis over two to 15 years. The current estimated purchase price allocation between goodwill and identifiable intangible assets is $295 million and $26 million, respectively. The entire estimated goodwill amount of $295 million is not
deductible for tax purposes. The operating results for AMS were included in our consolidated statement of operations beginning December 13, 2004.



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PACIFICARE HEALTH SYSTEMS, INC.



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)



The following table summarizes our preliminary estimate of the fair value of the assets acquired and liabilities assumed at date of
acquisition.



|                              |  |                         |        
|----------------------------- |  | ----------------------- | -------
|                              |  | As of December 13, 2004
|                              |  | (Amounts in thousands) 
|Current assets                |  | $                       | 370,812
|Property, plant and equipment |  |                         | 58,962 
|Goodwill                      |  |                         | 295,573
|Intangible assets             |  |                         | 25,800 
|Other assets                  |  |                         | 3,269  
|                              |  |                         |        
|Total assets acquired         |  |                         | 754,416
|Current liabilities           |  |                         | 238,038
|                              |  |                         |        
|Total liabilities assumed     |  |                         | 238,038
|                              |  |                         |        
|Net assets acquired           |  | $                       | 516,378
|                              |  |                         |        



The unaudited pro forma financial
information presented below assumes that the acquisition of AMS had occurred as of the beginning of each respective period. The pro forma information includes the results of operations for AMS for the period prior to its acquisition, adjusted for
interest expense on long-term debt incurred to fund the acquisitions, amortization of intangible assets with definite useful lives and the related income tax effects. The pro forma financial information is presented for informational purposes only
and may not be indicative of the results of operations had AMS been a wholly-owned subsidiary during the years ended December 31, 2004 and 2003, nor is it necessarily indicative of future results of operations.



Pro forma earnings per share are based on 84.3 million and 74.4 million weighted average
shares for the years ended December 31, 2004 and 2003, respectively. Pro forma earnings per share assuming full dilution is based on 95.5 million and 84.8 million weighted average shares for the years ended December 31, 2004 and 2003, respectively.



|                              |  |                                              |            |      |   |           
|----------------------------- |  | -------------------------------------------- | ---------- | ---- | - | ----------
|                              |  | 2004                                         |            | 2003
|                              |  | (Unaudited)                                 
|                              |  | (Amounts in thousands,except per share data)
|Pro forma revenues            |  | $                                            | 12,975,796 |      | $ | 11,752,227
|Pro forma net income          |  | $                                            | 305,903    |      | $ | 259,707   
|Pro forma earnings per share: |  |                                              |            |      |   |           
|Basic                         |  | $                                            | 3.63       |      | $ | 3.49      
|Diluted                       |  | $                                            | 3.23       |      | $ | 3.09      



Pacific Life Insurance
Company.  On November 29, 2004, we entered into a definitive agreement to purchase Pacific Life Insurance Companys, or Pacific Life, group health insurance business. The transaction will be financed through internally generated
cash. The group health insurance business we are acquiring from Pacific Life includes medical, dental and life coverage for small and large group employers. Through the transaction, which is structured as a coinsurance arrangement, we expect to
acquire up to 140,000 PPO members and obtain assets necessary to support and preserve the continuity of the acquired business and the rights to offer employment to the approximately 700 Pacific Life employees who currently provide service and
support to the group insurance business. The transaction is subject to approvals from the California Insurance Commissioner and certain other state regulatory approvals. We anticipate the acquisition will be consummated during the spring of 2005.



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PACIFICARE HEALTH SYSTEMS, INC.



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)



4.  Marketable Securities



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



|                                            |  |                        |           |                        |   |                         |  |   |            |   |  |   |          
|------------------------------------------- |  | ---------------------- | --------- | ---------------------- | - | ----------------------- |  | - | ---------- | - |  | - | ---------
|                                            |  | Amortized Cost         |           | Gross Unrealized Gains |   | Gross Unrealized Losses |  |   | Fair Value
|                                            |  | (Amounts in thousands)
|Marketable securities:                      |  |                        |           |                        |   |                         |  |   |            |   |  |   |          
|U.S. government and agency                  |  | $                      | 428,259   |                        | $ | 841                     |  | $ | (2,061     | ) |  | $ | 427,039  
|State, municipal and state and local agency |  |                        | 624,701   |                        |   | 10,463                  |  |   | (1,842     | ) |  |   | 633,322  
|Corporate debt and other securities         |  |                        | 878,042   |                        |   | 6,346                   |  |   | (7,984     | ) |  |   | 876,404  
|                                            |  |                        |           |                        |   |                         |  |   |            |   |  |   |          
|Total marketable securities                 |  |                        | 1,931,002 |                        |   | 17,650                  |  |   | (11,887    | ) |  |   | 1,936,765
|                                            |  |                        |           |                        |   |                         |  |   |            |   |  |   |          
|Marketable securities-restricted:           |  |                        |           |                        |   |                         |  |   |            |   |  |   |          
|U.S. government and agency                  |  |                        | 67,995    |                        |   | 41                      |  |   | (647       | ) |  |   | 67,389   
|State, municipal and state and local agency |  |                        | 11,547    |                        |   | 156                     |  |   | (24        | ) |  |   | 11,679   
|Corporate debt and other securities         |  |                        | 60,756    |                        |   | 169                     |  |   | (452       | ) |  |   | 60,473   
|                                            |  |                        |           |                        |   |                         |  |   |            |   |  |   |          
|Total marketable securities-restricted      |  |                        | 140,298   |                        |   | 366                     |  |   | (1,123     | ) |  |   | 139,541  
|                                            |  |                        |           |                        |   |                         |  |   |            |   |  |   |          
|Balance at December 31, 2004                |  | $                      | 2,071,300 |                        | $ | 18,016                  |  | $ | (13,010    | ) |  | $ | 2,076,306
|                                            |  |                        |           |                        |   |                         |  |   |            |   |  |   |          



|                                            |  |                        |           |                        |   |                         |  |   |            |   |  |   |          
|------------------------------------------- |  | ---------------------- | --------- | ---------------------- | - | ----------------------- |  | - | ---------- | - |  | - | ---------
|                                            |  | Amortized Cost         |           | Gross Unrealized Gains |   | Gross Unrealized 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
|                                            |  |                        |           |                        |   |                         |  |   |            |   |  |   |          



As of December 31, 2004, 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                |  | $                      | 127,726   |                                  | $ | 127,797        |  | $          | 34,133  |  | $ | 34,089 
|Due after one year through five years  |  |                        | 788,930   |                                  |   | 790,135        |  |            | 93,348  |  |   | 92,571 
|Due after five years through ten years |  |                        | 571,784   |                                  |   | 578,437        |  |            | 7,821   |  |   | 7,875  
|Due after ten years                    |  |                        | 419,863   |                                  |   | 422,099        |  |            | 4,996   |  |   | 5,006  
|                                       |  |                        |           |                                  |   |                |  |            |         |  |   |        
|Contractual maturities                 |  |                        | 1,908,303 |                                  |   | 1,918,468      |  |            | 140,298 |  |   | 139,541
|Equity securities (no maturity)        |  |                        | 22,699    |                                  |   | 18,297         |  |            |        |  |   |       
|                                       |  |                        |           |                                  |   |                |  |            |         |  |   |        
|Total marketable securities            |  | $                      | 1,931,002 |                                  | $ | 1,936,765      |  | $          | 140,298 |  | $ | 139,541
|                                       |  |                        |           |                                  |   |                |  |            |         |  |   |        



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##### Table of Contents

PACIFICARE HEALTH SYSTEMS, INC.



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)



Proceeds from sales and maturities of marketable securities were $5.1 billion in 2004, $7.4 billion in 2003 and $7.7 billion in 2002. Gross
realized gains and gross realized losses are included in net investment income under the specific identification method.



The following table shows the gross unrealized losses and fair value of our investments with unrealized losses that are not deemed to be other-than-temporarily impaired,
aggregated by investment category and length of time that individual securities have been in continuous unrealized loss position, at December 31, 2004.



|                                            |  |                        |           |                   |                      |        |            |       |                   |        |  |            |        |                   |  |   |           |  |   |         |  
|------------------------------------------- |  | ---------------------- | --------- | ----------------- | -------------------- | ------ | ---------- | ----- | ----------------- | ------ |  | ---------- | ------ | ----------------- |  | - | --------- |  | - | ------- | -
|                                            |  | Less Than 12 Months    |           |                   | 12 Months or Greater |        |            | Total |                  
|                                            |  | Fair Value             |           | Unrealized Losses |                      |        | Fair Value |       | Unrealized Losses |        |  | Fair Value |        | Unrealized Losses | 
|                                            |  | (Amounts in thousands) |          
|Marketable securities:                      |  |                        |           |                   |                      |        |            |       |                   |        |  |            |        |                   |  |   |           |  |   |         |  
|U.S. government and agency                  |  | $                      | 432,444   |                   | $                    | (2,595 | )          |       | $                 | 9,659  |  | $          | (113   | )                 |  | $ | 442,103   |  | $ | (2,708  | )
|State, municipal and state and local agency |  |                        | 195,617   |                   |                      | (1,770 | )          |       |                   | 6,252  |  |            | (96    | )                 |  |   | 201,869   |  |   | (1,866  | )
|Corporate debt and other securities         |  |                        | 537,615   |                   |                      | (3,631 | )          |       |                   | 30,050 |  |            | (4,805 | )                 |  |   | 567,665   |  |   | (8,436  | )
|                                            |  |                        |           |                   |                      |        |            |       |                   |        |  |            |        |                   |  |   |           |  |   |         |  
|Total marketable securities                 |  | $                      | 1,165,676 |                   | $                    | (7,996 | )          |       | $                 | 45,961 |  | $          | (5,014 | )                 |  | $ | 1,211,637 |  | $ | (13,010 | )
|                                            |  |                        |           |                   |                      |        |            |       |                   |        |  |            |        |                   |  |   |           |  |   |         |  



The following table shows the gross
unrealized losses and fair value of our investments with unrealized losses that are not deemed to be other-than-temporarily impaired, aggregated by investment category and length of time that individual securities have been in continuous unrealized
loss position, at December 31, 2003.



|                                            |  |                        |         |                   |                      |        |            |       |                   |        |  |            |        |                   |  |   |         |  |   |        |  
|------------------------------------------- |  | ---------------------- | ------- | ----------------- | -------------------- | ------ | ---------- | ----- | ----------------- | ------ |  | ---------- | ------ | ----------------- |  | - | ------- |  | - | ------ | -
|                                            |  | Less Than 12 Months    |         |                   | 12 Months or Greater |        |            | Total |                  
|                                            |  | Fair Value             |         | Unrealized Losses |                      |        | Fair Value |       | Unrealized Losses |        |  | Fair Value |        | Unrealized Losses | 
|                                            |  | (Amounts in thousands) |        
|Marketable securities:                      |  |                        |         |                   |                      |        |            |       |                   |        |  |            |        |                   |  |   |         |  |   |        |  
|U.S. government and agency                  |  | $                      | 128,920 |                   | $                    | (899   | )          |       | $                 | 19,685 |  | $          | (3,013 | )                 |  | $ | 148,605 |  | $ | (3,912 | )
|State, municipal and state and local agency |  |                        | 63,378  |                   |                      | (1,061 | )          |       |                   | 8,067  |  |            | (337   | )                 |  |   | 71,445  |  |   | (1,398 | )
|Corporate debt and other securities         |  |                        | 91,799  |                   |                      | (2,401 | )          |       |                   | 4,696  |  |            | (257   | )                 |  |   | 96,495  |  |   | (2,658 | )
|                                            |  |                        |         |                   |                      |        |            |       |                   |        |  |            |        |                   |  |   |         |  |   |        |  
|Total marketable securities                 |  | $                      | 284,097 |                   | $                    | (4,361 | )          |       | $                 | 32,448 |  | $          | (3,607 | )                 |  | $ | 316,545 |  | $ | (7,968 | )
|                                            |  |                        |         |                   |                      |        |            |       |                   |        |  |            |        |                   |  |   |         |  |   |        |  



Investment Grade
Securities.Our investments in investment grade debt securities consist primarily of U.S. Treasury and federal agency securities, mortgage and asset-backed securities, corporate bonds and notes, and municipal bonds. The unrealized
losses on our investments were caused by interest rate increases. We considered the unrealized losses to be temporary at December 31, 2004 and 2003 because the decline in market value is attributable to changes in interest rates and not credit
quality, and because the severity and duration of the unrealized losses were not significant.



In September 2004, the FASB issued FASB Staff Position, or FSP, EITF Issue 03-1-1 Effective Date of Paragraphs 10-20 of EITF Issue No. 03-01, The Meaning of Other-Than-Temporary Impairment and Its Application to
Certain Investments, which delayed the effective date for paragraphs 10-20 of EITF Issue No. 03-01. Paragraphs 10-20 provide guidance for assessing impairment losses on debt and equity investments. The delay does not suspend the requirement to
recognize other-than-temporary impairments as required by existing literature. In addition, the FASB staff issued a proposed FSP EITF Issue No. 03-1-a, Implementation Guidance for the Application of Paragraph 16 of EITF Issue No. 03-01, The
Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments. The proposed FSP would provide implementation guidance with respect to debt securities that are impaired solely due to interest rates and/or sector spreads
and analyzed for other-than-temporary impairment under EITF Issue No. 03-01. The delay of the effective date for paragraphs 10-20 of EITF 03-01 will be superceded with the final issuance of EITF Issue No. 03-1-a. We will evaluate the effect, if any,
of the EITF Issue No. 03-1-a when final guidance is released.



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##### Table of Contents

PACIFICARE HEALTH SYSTEMS, INC.



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)



5.  Long-Term Debt and Other Commitments



Our contractual cash obligations as of December 31, 2004, including long-term debt and other commitments, were as follows:



|                                             |  |                        |       |      |   |      |  |      |     |      |   |      |  |            |     |  |   |     |  |   |    
|-------------------------------------------- |  | ---------------------- | ----- | ---- | - | ---- |  | ---- | --- | ---- | - | ---- |  | ---------- | --- |  | - | --- |  | - | ---
|                                             |  | Payments Due by Period
|                                             |  | Total                  |       | 2005 |   | 2006 |  | 2007 |     | 2008 |   | 2009 |  | Thereafter
|                                             |  | (Amounts in millions) 
|Long-term debt:                              |  |                        |       |      |   |      |  |      |     |      |   |      |  |            |     |  |   |     |  |   |    
|JPMorgan term loan B facility                |  | $                      | 425   |      | $ | 4    |  | $    | 4   |      | $ | 4    |  | $          | 4   |  | $ | 128 |  | $ | 281
|103⁄4% senior notes, net of discount           |  |                        | 324   |      |   |     |  |      |    |      |   |     |  |            |    |  |   | 324 |  |   |   
|JPMorgan term loan A facility                |  |                        | 200   |      |   | 30   |  |      | 30  |      |   | 40   |  |            | 50  |  |   | 50  |  |   |   
|Convertible subordinated debentures          |  |                        | 135   |      |   |     |  |      |    |      |   |     |  |            |    |  |   |    |  |   | 135
|Database financing agreement                 |  |                        | 2     |      |   | 2    |  |      |    |      |   |     |  |            |    |  |   |    |  |   |   
|Other                                        |  |                        | 3     |      |   | 2    |  |      | 1   |      |   |     |  |            |    |  |   |    |  |   |   
|                                             |  |                        |       |      |   |      |  |      |     |      |   |      |  |            |     |  |   |     |  |   |    
|Total long-term debt commitments             |  |                        | 1,089 |      |   | 38   |  |      | 35  |      |   | 44   |  |            | 54  |  |   | 502 |  |   | 416
|                                             |  |                        |       |      |   |      |  |      |     |      |   |      |  |            |     |  |   |     |  |   |    
|Other commitments:                           |  |                        |       |      |   |      |  |      |     |      |   |      |  |            |     |  |   |     |  |   |    
|Information technology outsourcing contracts |  |                        | 872   |      |   | 158  |  |      | 136 |      |   | 124  |  |            | 118 |  |   | 114 |  |   | 222
|Operating leases                             |  |                        | 117   |      |   | 31   |  |      | 28  |      |   | 23   |  |            | 15  |  |   | 12  |  |   | 8  
|                                             |  |                        |       |      |   |      |  |      |     |      |   |      |  |            |     |  |   |     |  |   |    
|Total other commitments                      |  |                        | 989   |      |   | 189  |  |      | 164 |      |   | 147  |  |            | 133 |  |   | 126 |  |   | 230
|                                             |  |                        |       |      |   |      |  |      |     |      |   |      |  |            |     |  |   |     |  |   |    
|Total contractual cash obligations           |  | $                      | 2,078 |      | $ | 227  |  | $    | 199 |      | $ | 191  |  | $          | 187 |  | $ | 628 |  | $ | 646
|                                             |  |                        |       |      |   |      |  |      |     |      |   |      |  |            |     |  |   |     |  |   |    



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 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. Beginning
with the quarter ended September 30, 2003 and during each consecutive calendar quarter up through and including the quarter ended December 31, 2004, the market price condition described above was satisfied. As a result, the debentures were
convertible beginning October 1, 2003, and remain convertible at the option of the holder at any time during the quarter ended March 31, 2005. While no debentures were converted as of December 31, 2004, they are considered common stock equivalents
and are included in the calculation of weighted average shares outstanding on a diluted basis.



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.



103⁄4% Senior Notes.  We have $325 million in aggregate principal amount of 103⁄4% senior notes due in 2009 outstanding. The 103⁄4% senior notes were issued in May 2002 at 99.389% of the aggregate principal amount
representing an initial 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



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PACIFICARE HEALTH SYSTEMS, INC.



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)



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 103⁄4% 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 103⁄4% 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 subsidiaries fully and unconditionally guarantee the 103⁄4% senior notes. See Note 16, Financial Guarantees.



In April 2003, we entered into an interest rate swap on $300 million of our 103⁄4% 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, or LIBO Rate,
plus 692 basis points and receive interest payments based on the 103⁄4% fixed rate. Our current floating rate under the swap agreement was 9.32%, at December 31, 2004 which is based on a 90-day LIBO Rate of 2.40% plus 692 basis points. The
three-month LIBO 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 December 2004, we replaced our senior credit
facility with a new syndicated senior Credit Agreement, or the Credit Agreement, with the Lenders named therein, JPMorgan Chase Bank, N.A., as Administrative Agent and Collateral Agent, J.P. Morgan Securities Inc., as Sole Lead Arranger and Sole
Bookrunner, Morgan Stanley Senior Funding, Inc., as Syndication Agent and Co-Arranger and CIBC, Inc., The Bank of New York, and Wells Fargo Bank, N.A., as Co-Documentation Agents. The new facility consists of a $200 million term A loan, which
matures on December 13, 2009, a $425 million term B loan, which matures on December 13, 2010, and a $200 million revolving line of credit, which matures on December 13, 2009. We used the proceeds of the term A and term B loans to refinance
approximately $149 million (including accrued interest and fees of approximately $1 million) outstanding under our previous senior credit facility entered into in June 2003, refinance approximately $30 million outstanding under the senior credit
facility of AMS and to fund a portion of the merger consideration paid to acquire AMS. See Note 3, Acquisitions of Businesses. In connection with the Credit Agreement, we incurred approximately $9 million in fees and expenses that are
being amortized over the life of the facility. As of December 31, 2004, we had $625 million outstanding on the term A and term B loans and no balance outstanding on the revolving line of credit. There were no borrowings under the revolving line of
credit (or the line of credit we refinanced) during the year ended December 31, 2004.



The credit facility provides us with two interest rate options for borrowings under the term loans, to which a margin spread is added: (1) the LIBO Rate multiplied by the Statutory Reserve Rate and (2) JPMorgan Chase Banks prime rate
(or, if greater, the Federal Funds Rate plus 0.5%), which we refer to as the alternate base rate. The margin spread for the term loans is based upon our current Standard & Poors Ratings Services and Moodys Investor Service debt
ratings. The margin spread for LIBO Rate borrowings range from 0.75% to 1.75% per annum under the term A loan and 1.25% to 1.5% per annum under the term B loan. The margin spread for alternate base rate borrowings range from 0% to 0.75% per annum
under the term A loan and 0.25% to 0.5% per annum under the term B loan. All of our borrowings under the term loans are currently LIBO Rate borrowings with rates ranging from 3.9% to 4.3%. The interest rates per annum applicable to revolving credit
borrowings are, at our option, either LIBO Rate borrowings with the same margin spread as our term A loan or alternate base rate borrowings with the same margin spread applicable to the term A loan. We also pay a commitment fee on the average daily
unused amount of the revolving credit commitment. The commitment fee range is based upon our current debt rating and ranges from 0.15% and 0.5% per annum. The current commitment fee rate is 0.375% per annum.



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PACIFICARE HEALTH SYSTEMS, INC.



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)



The Credit Agreement contains 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 Credit Agreement also requires
we meet various financial ratios, including a maximum consolidated leverage ratio, a minimum consolidated net worth requirement and a minimum fixed charge coverage requirement. At December 31, 2004, we were in compliance with all of these covenants.



Certain of our domestic subsidiaries provide guarantees and have granted
security interests to the lenders in substantially all of their personal property in order to secure our obligations and their guarantees under the Credit Agreement. See Note 16, Financial Guarantees. We have also pledged the equity of
certain of our subsidiaries to the lenders as security for the Credit Agreement.



|                                                                      |  |                       |      |   |                           |   |     |       |  |   |      |  
|--------------------------------------------------------------------- |  | --------------------- | ---- | - | ------------------------- | - | --- | ----- |  | - | ---- | -
|                                                                      |  | TermLoan Facility     |      |   | Revolving Credit Facility |   |     | Total | 
|                                                                      |  | (Amounts in millions) |     
|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  |  
|                                                                      |  |                       |      |   |                           |   |     |       |  |   |      |  
|Scheduled payments under prior senior credit facility                 |  |                       | (1   | ) |                           |   |    |       |  |   | (1   | )
|Assumption of debt related to acquisition of AMS                      |  |                       |     |   |                           |   | 30  |       |  |   | 30   |  
|Repayment of outstanding balance under prior senior credit facilities |  |                       | (148 | ) |                           |   | (30 | )     |  |   | (178 | )
|Proceeds from borrowing under new senior credit facility              |  |                       | 625  |   |                           |   |    |       |  |   | 625  |  
|                                                                      |  |                       |      |   |                           |   |     |       |  |   |      |  
|Balance at December 31, 2004                                          |  | $                     | 625  |   |                           | $ |    |       |  | $ | 625  |  
|                                                                      |  |                       |      |   |                           |   |     |       |  |   |      |  



Database Financing
Agreements.  As of December 31, 2004, we had $2 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 October 2006. The interest imputed on the payment plan agreements ranges from 4.0% to 6.5%.



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 $17 million and $19 million at December 31, 2004 and
2003, respectively. As of December 31, 2004, 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 provides 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 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 are approximately $900 million, 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. Additionally, in the event of contract termination, we may be
responsible to pay termination fees to IBM and Keane. These termination fees decline as each successive year of the contract term is completed.



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PACIFICARE HEALTH SYSTEMS, INC.



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)



Operating Leases.We lease office space and equipment under various non-cancelable operating leases. Rent expense totaled
$26 million in 2004, $30 million in 2003 and $43 million in 2002.



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 Repurchase Program.In May 2004, our Board of Directors authorized a share repurchase program under which up to $150 million of our common stock may be repurchased. Under the program,
repurchases may be made from time to time in the open market or through privately negotiated transactions using available cash, and may be discontinued at any time. During the year ended December 31, 2004, we repurchased approximately 3 million
shares which cost approximately $100 million. The remaining authorization under our stock repurchase program as of December 31, 2004 was $50 million.



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 103⁄4% senior notes. See Note 5,
Long-Term Debt and Other Commitments.



Restricted Stock
Awards.We granted approximately 817,000 and 1,489,000 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, 2004 and 2003, 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 141,000 and 108,000 shares were forfeited for the
year ended December 31, 2004 and 2003, respectively.



All shares of restricted
stock were issued from our 1996 Officer and Key Employee Stock Option Plan, as amended. See Note 9, Employee Benefit Plans. 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 $32 million and $17 million as of December 31, 2004 and 2003, respectively. Expenses related to the vesting of restricted stock (charged to selling,
general and administrative expenses) were $8.8 million and $5.3 million for the year ended December 31, 2004 and 2003, respectively.



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.



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PACIFICARE HEALTH SYSTEMS, INC.



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)



Dividends.  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 103/4% senior notes.



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 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. Under the guidance of SFAS 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, 2004 and 2003. Based on the results of our impairment testing, no additional adjustments were required.



Other intangible assets are being amortized over their useful lives ranging from 2 to 40
years. As part of the implementation SFAS No. 142, we reassessed the remaining useful lives of the other intangible assets. We estimate our intangible asset amortization will be $20 million in 2005, $19 million in 2006, $18 million in 2007, $15
million in 2008 and $15 million in 2009. The following table sets forth balances of identified intangible assets, by major class, for the periods indicated:



|                             |  |                        |         |                          |   |             |  |   |        
|---------------------------- |  | ---------------------- | ------- | ------------------------ | - | ----------- |  | - | -------
|                             |  | Cost                   |         | Accumulated Amortization |   | Net Balance
|                             |  | (Amounts in thousands)
|Intangible assets:           |  |                        |         |                          |   |             |  |   |        
|Employer groups              |  | $                      | 252,320 |                          | $ | 140,854     |  | $ | 111,466
|Provider networks            |  |                        | 122,751 |                          |   | 24,132      |  |   | 98,619 
|Other                        |  |                        | 26,329  |                          |   | 9,292       |  |   | 17,037 
|                             |  |                        |         |                          |   |             |  |   |        
|Balance at December 31, 2004 |  | $                      | 401,400 |                          | $ | 174,278     |  | $ | 227,122
|                             |  |                        |         |                          |   |             |  |   |        
|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
|                             |  |                        |         |                          |   |             |  |   |        



The changes in the carrying amount of
goodwill, by reportable segment are as follows:



|                                              |  |                        |           |           |   |                     |  |              |   |  |   |          
|--------------------------------------------- |  | ---------------------- | --------- | --------- | - | ------------------- |  | ------------ | - |  | - | ---------
|                                              |  | Health Plans           |           | Specialty |   | Corporate And Other |  | Consolidated
|                                              |  | (Amounts in thousands)
|Balance as of January 1 and December 31, 2003 |  | $                      | 954,701   |           | $ | 28,403              |  | $            |  |  | $ | 983,104  
|Goodwill acquired during 2004                 |  |                        | 295,573   |           |   |                    |  |              |  |  |   | 295,573  
|                                              |  |                        |           |           |   |                     |  |              |   |  |   |          
|Balance at December 31, 2004                  |  | $                      | 1,250,274 |           | $ | 28,403              |  | $            |  |  | $ | 1,278,677
|                                              |  |                        |           |           |   |                     |  |              |   |  |   |          



On December 13, 2004, we completed our
acquisition of AMS. See Note 3, Acquisitions of Businesses. As a result of the acquisition of AMS, we recorded $295 million of goodwill and $26 million of intangible assets. We assume no residual value for its amortizable intangible
assets.



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PACIFICARE HEALTH SYSTEMS, INC.



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)



8.  Income Taxes



Deferred income taxes are recognized for the difference between the carrying amounts of assets and liabilities for financial statement and tax purposes. Deferred income
tax assets are required to be reduced by a valuation allowance when it is determined that it is more likely than not some portion or all of a deferred tax asset will not be realized.



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



|                                               |  |                        |          |   |      |   |          |  
|---------------------------------------------- |  | ---------------------- | -------- | - | ---- | - | -------- | -
|                                               |  | 2004                   |          |   | 2003 |  
|                                               |  | (Amounts in thousands) |         
|Current deferred tax assets (liabilities):     |  |                        |          |   |      |   |          |  
|Medical claims and benefits payable            |  | $                      | 40,110   |   |      | $ | 63,295   |  
|Accrued compensation                           |  |                        | 33,166   |   |      |   | 21,389   |  
|Accrued expenses                               |  |                        | 32,509   |   |      |   | 44,243   |  
|Insurance liabilities                          |  |                        | 17,539   |   |      |   |         |  
|Prepaid expenses                               |  |                        | (11,236  | ) |      |   | (12,673  | )
|Stock-based compensation                       |  |                        | 9,405    |   |      |   | 4,903    |  
|State franchise taxes                          |  |                        | 9,020    |   |      |   | 6,963    |  
|Provider receivables                           |  |                        | 7,992    |   |      |   | 20,702   |  
|Contract termination accrual                   |  |                        | 7,338    |   |      |   |         |  
|Restructuring                                  |  |                        | 2,946    |   |      |   | 7,325    |  
|Unrealized gains on marketable securities      |  |                        | (2,267   | ) |      |   | (11,043  | )
|Other                                          |  |                        | 2,180    |   |      |   | 4,713    |  
|                                               |  |                        |          |   |      |   |          |  
|                                               |  |                        | 148,702  |   |      |   | 149,817  |  
|                                               |  |                        |          |   |      |   |          |  
|Non-current deferred tax (liabilities) assets: |  |                        |          |   |      |   |          |  
|Identifiable intangibles                       |  |                        | (89,227  | ) |      |   | (84,816  | )
|Depreciation and software amortization         |  |                        | (30,007  | ) |      |   | (27,308  | )
|Net operating loss and capital loss carryover  |  |                        | 6,616    |   |      |   |         |  
|Valuation allowance                            |  |                        | (6,616   | ) |      |   |         |  
|Goodwill amortization                          |  |                        | 4,501    |   |      |   | 7,347    |  
|                                               |  |                        |          |   |      |   |          |  
|                                               |  |                        | (114,733 | ) |      |   | (104,777 | )
|                                               |  |                        |          |   |      |   |          |  
|Net deferred tax assets                        |  | $                      | 33,969   |   |      | $ | 45,040   |  
|                                               |  |                        |          |   |      |   |          |  



The provision for income taxes
consisted of the following:



|                           |  |                        |         |      |   |         |      |  |   |       
|-------------------------- |  | ---------------------- | ------- | ---- | - | ------- | ---- |  | - | ------
|                           |  | 2004                   |         | 2003 |   |         | 2002
|                           |  | (Amounts in thousands)
|Current:                   |  |                        |         |      |   |         |      |  |   |       
|Federal                    |  | $                      | 138,297 |      | $ | 165,009 |      |  | $ | 60,063
|State                      |  |                        | 21,412  |      |   | 27,975  |      |  |   | 4,170 
|                           |  |                        |         |      |   |         |      |  |   |       
|Total current              |  |                        | 159,709 |      |   | 192,984 |      |  |   | 64,233
|                           |  |                        |         |      |   |         |      |  |   |       
|Deferred:                  |  |                        |         |      |   |         |      |  |   |       
|Federal                    |  |                        | 25,201  |      |   | (39,148 | )    |  |   | 15,321
|State                      |  |                        | 5,673   |      |   | (6,940  | )    |  |   | 3,238 
|                           |  |                        |         |      |   |         |      |  |   |       
|Total deferred             |  |                        | 30,874  |      |   | (46,088 | )    |  |   | 18,559
|                           |  |                        |         |      |   |         |      |  |   |       
|Provision for income taxes |  | $                      | 190,583 |      | $ | 146,896 |      |  | $ | 82,792
|                           |  |                        |         |      |   |         |      |  |   |       



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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:



|                                       |  |      |   |  |      |   |  |      |  
|-------------------------------------- |  | ---- | - |  | ---- | - |  | ---- | -
|                                       |  | 2004 |   |  | 2003 |   |  | 2002 |  
|Computed expected provision            |  | 35.0 | % |  | 35.0 | % |  | 35.0 | %
|State taxes, net of federal benefit    |  | 3.7  |   |  | 3.7  |   |  | 3.2  |  
|Tax-exempt interest                    |  | (1.6 | ) |  | (1.6 | ) |  | (2.1 | )
|Nondeductible stock-based compensation |  | 0.9  |   |  |     |   |  |     |  
|Nondeductible expenses                 |  | 0.4  |   |  | 0.3  |   |  | 0.9  |  
|Other, net                             |  | 0.2  |   |  | 0.3  |   |  | 0.3  |  
|                                       |  |      |   |  |      |   |  |      |  
|Provision for income taxes             |  | 38.6 | % |  | 37.7 | % |  | 37.3 | %
|                                       |  |      |   |  |      |   |  |      |  



Our effective tax rate is based on
expected income, statutory tax rates and tax planning opportunities available to us in the various jurisdictions in which we operate. Significant management estimates and judgments are required in determining our effective tax rate. We are routinely
under audit by federal, state or local authorities regarding the timing and amount of deductions, nexus of income among various tax jurisdictions and compliance with federal, state and local tax laws. Tax assessments related to these audits may not
arise until several years after tax returns have been filed. Although predicting the outcome of such tax assessments involves uncertainty, we believe that the recorded tax liabilities appropriately account for our analysis of probable outcomes,
including interest and other potential obligations. Our tax liabilities are adjusted in light of changing facts and circumstances, such as the progress of audits, case law and emerging legislation and such adjustments are included in the effective
tax rate.



9.  Employee Benefit Plans



Savings and profit-sharing plan.Most of our employees may participate in
our savings and profit-sharing plan, or the 401(k) Plan. Features of the 401(k) Plan in 2004 were as follows:



| |  | Participants may defer from 2% to 50% of annual compensation up to $13,000. Participants age 50 or older may be eligible to make additional contributions.
|- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | 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 2004, 2003 or 2002. Charges to income for the 401(k) Plan were $24 million in 2004, $21 million in 2003 and $18 million in 2002.



We also have a nonqualified statutory restoration plan which 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, or SERP, covering certain senior executives. This plan provides defined benefits based on years of service and final average compensation. The accumulated benefit
obligation for the SERP at the end of 2004 and 2003 was $14 million and $10 million respectively, of which $8 million and $3 million respectively, were the net amounts recognized (excludes unrecognized prior service costs which offsets the
accumulated benefit obligation).



Retirement savings
plan.  Employees of AMS may participate in our retirement savings plan with profit sharing and discretionary savings provisions covering all eligible salaried and hourly employees. Features of the plan in 2004 were as follows:



| |  | Participant contributions up to 6% of the participants compensation were matched 70 percent; and
|- |  | -------------------------------------------------------------------------------------------------



| |  | Participants vest in the companys contributions in three years.
|- |  | ----------------------------------------------------------------



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##### Table of Contents

PACIFICARE HEALTH SYSTEMS, INC.



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)



Our contributions to the plan were not material to our consolidated financial statements.



Nonqualified deferred compensation plan.  We have a nonqualified deferred
compensation plan, or the Deferred Compensation Plan, to provide supplemental retirement income benefits for certain key management employees due to compensation limitations imposed by the Internal Revenue Service. The Deferred Compensation Plan is
funded through a rabbi trust and has contribution and investment options similar to those of our savings and profit-sharing plans.



Nonqualified executive retirement plan.  We have a nonqualified executive retirement plan, or the Nonqualified Plan, to provide certain key management
employees of AMS with the opportunity to accumulate deferred compensation which cannot be accumulated under our retirement savings plan due to compensation limitations imposed by the Internal Revenue Service. The Nonqualified Plan is funded through
a rabbi trust and has contribution and investment options similar to those of our retirement savings plan. Our expense recognized in 2004 associated with the plan was not material to our consolidated financial statements.



Employee Stock Purchase Plan.  Our ESPP provides that up to 3,700,000 shares
of our common stock can be sold to our employees, representing an initial pool of 2,200,000 shares, 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, plus an additional
1,500,000 authorized by our Board of Directors on February 26, 2004 and approved by our stockholders on May 20, 2004. Features of the plan in 2004 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;
|- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | Beginning with the first offering period on February 1, 2002, each offering period was two years, and there were four purchase dates within each offering period;
|- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | Beginning on February 1, 2004, each offering period was reduced to six months; and
|- |  | ----------------------------------------------------------------------------------



| |  | Purchase dates were the last day of each six-month purchase period within the offering period.
|- |  | ----------------------------------------------------------------------------------------------



Approximately 1,900 employees are currently participating in this plan.



Equity Incentive Plans.



Employee Plans.  As of December 31, 2004, 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, 2004, approximately 6.0 million shares were available for awards under the Employee Plans.



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



F-22





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##### Table of Contents

PACIFICARE HEALTH SYSTEMS, INC.



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)



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, 2004, 0.3 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.



Director Plans.  As of December 31, 2004 under the 2000 and 1996 Director Plans, we granted non-employee directors the following stock incentives:



| |  | Options to purchase 7,000 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 14,000 shares of common stock are automatically granted annually to the non-employee Lead Independent Director on June 30, at no less than 100% of the market
price on the date the options are granted;
|- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | Options to purchase up to 25,000 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, 2004, approximately 0.1 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 APB Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations. Effective January 1, 2003, we adopted the fair value recognition provisions of SFAS No. 123, Accounting for Stock-Based Compensation
on a prospective basis. Under the prospective method provisions of SFAS No. 148, Accounting for Stock-Based CompensationTransition and Disclosure, 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 SFAS No. 123, as amended by SFAS No. 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 estimated at the date of grant using a Black-Scholes option-pricing model with the following weighted-average assumptions for
2004, 2003 and 2002:



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##### Table of Contents

PACIFICARE HEALTH SYSTEMS, INC.



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)



|                                                      |  |                        |       |   |      |   |      |      |  |   |      |   |  |      |       |   |      |   |       |   |  |   |      |  
|----------------------------------------------------- |  | ---------------------- | ----- | - | ---- | - | ---- | ---- |  | - | ---- | - |  | ---- | ----- | - | ---- | - | ----- | - |  | - | ---- | -
|                                                      |  | Employee Stock Options |       |   | ESPP |  
|                                                      |  | 2004                   |       |   | 2003 |   |      | 2002 |  |   | 2004 |   |  | 2003 |       |   | 2002 |  
|Expected dividend yield                               |  |                        | 0     | % |      |   | 0    | %    |  |   | 0    | % |  |      | 0     | % |      |   | 0     | % |  |   | 0    | %
|Risk-free interest rate                               |  |                        | 2     | % |      |   | 4    | %    |  |   | 3    | % |  |      | 1     | % |      |   | 1     | % |  |   | 2    | %
|Expected stock price volatility                       |  |                        | 54    | % |      |   | 80   | %    |  |   | 83   | % |  |      | 40    | % |      |   | 59    | % |  |   | 67   | %
|Expected term until exercise upon vesting (years)     |  |                        | 2     |   |      |   | 2    |      |  |   | 2    |   |  |      | 0.5   |   |      |   | 0.5   |   |  |   | 0.5  |  
|Weighted average fair value of options on grant date: |  |                        |       |   |      |   |      |      |  |   |      |   |  |      |       |   |      |   |       |   |  |   |      |  
|Granted at market prices                              |  | $                      | 15.12 |   |      | $ | 9.11 |      |  | $ | 6.75 |   |  | $    | 15.23 |   |      | $ | 11.49 |   |  | $ | 5.04 |  



Nonqualified stock option activity for
all plans was as follows:



|                                 |  |            |   |  |                                 |       |                     |           |                                 |   |      
|-------------------------------- |  | ---------- | - |  | ------------------------------- | ----- | ------------------- | --------- | ------------------------------- | - | -----
|                                 |  | Options    |   |  | Weighted Average Exercise Price |       | Options Exercisable |           | Weighted Average Exercise Price
|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
|Granted at market price          |  | 849,300    |   |  | $                               | 34.22 |                     |          |                                 | $ |     
|Exercised                        |  | (3,765,067 | ) |  | $                               | 18.56 |                     |          |                                 | $ |     
|Canceled                         |  | (149,236   | ) |  | $                               | 17.42 |                     |          |                                 | $ |     
|                                 |  |            |   |  |                                 |       |                     |           |                                 |   |      
|Outstanding at December 31, 2004 |  | 8,002,749  |   |  | $                               | 19.00 |                     | 4,435,999 |                                 | $ | 21.07
|                                 |  |            |   |  |                                 |       |                     |           |                                 |   |      



The following is a summary of
information about options outstanding and options exercisable at December 31, 2004:



|                         |  |                     |  |                          |  |                                 |       |                    |           |                                 |   |      
|------------------------ |  | ------------------- |  | ------------------------ |  | ------------------------------- | ----- | ------------------ | --------- | ------------------------------- | - | -----
|                         |  | Options Outstanding |  | Options Exercisable     
|Range of Exercise Prices |  | Number Outstanding  |  | Weighted Average Life(1) |  | Weighted Average Exercise Price |       | Number Exercisable |           | Weighted Average Exercise Price
|$6.03 - $9.00            |  | 1,786,398           |  | 6.63                     |  | $                               | 7.73  |                    | 1,213,898 |                                 | $ | 7.48 
|$9.13 - $13.55           |  | 1,926,818           |  | 7.26                     |  | $                               | 10.21 |                    | 780,068   |                                 | $ | 10.24
|$14.27 - $22.66          |  | 1,439,600           |  | 7.64                     |  | $                               | 15.39 |                    | 421,100   |                                 | $ | 18.05
|$24.67 - $37.69          |  | 2,229,633           |  | 6.34                     |  | $                               | 30.94 |                    | 1,451,633 |                                 | $ | 30.42
|$38.66 - $54.57          |  | 620,300             |  | 4.06                     |  | $                               | 44.22 |                    | 569,300   |                                 | $ | 43.30
|                         |  |                     |  |                          |  |                                 |       |                    |           |                                 |   |      
|                         |  | 8,002,749           |  |                          |  |                                 |       |                    | 4,435,999 |                                 |   |      
|                         |  |                     |  |                          |  |                                 |       |                    |           |                                 |   |      

---

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



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##### Table of Contents

PACIFICARE HEALTH SYSTEMS, INC.



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)



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



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



|                                                                                       |  |                                              |  |                          |       |   |                   |   |      |                                      |  |   |       |  
|-------------------------------------------------------------------------------------- |  | -------------------------------------------- |  | ------------------------ | ----- | - | ----------------- | - | ---- | ------------------------------------ |  | - | ----- | -
|                                                                                       |  | Quarter Recognized                           |  | Pretax (Credits) Charges |       |   | Net-of-Tax Amount |   |      | Diluted Loss (Earnings) per Share(1) | 
|                                                                                       |  | (Amounts in millions, except per share data) | 
|2003(2)                                                                                |  |                                              |  |                          |       |   |                   |   |      |                                      |  |   |       |  
|Restructuring change in estimate                                                       |  | Total Fourth                                 |  | $                        | (1.9  | ) |                   | $ | (1.2 | )                                    |  | $ | (0.01 | )
|                                                                                       |  |                                              |  |                          |       |   |                   |   |      |                                      |  |   |       |  
|2002(3)                                                                                |  |                                              |  |                          |       |   |                   |   |      |                                      |  |   |       |  
|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  |  
|                                                                                       |  |                                              |  |                          |       |   |                   |   |      |                                      |  |   |       |  

---

|(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.
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|(2) | 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.
|--- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|(3) | During 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.



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.



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



F-25





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##### Table of Contents

PACIFICARE HEALTH SYSTEMS, INC.



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)



As of December 31, 2004, approximately 1,250 employees have left the company and 200 employees, whose positions were eliminated, accepted
other positions within the company. During 2004, we made severance payments totaling approximately $.8 million to terminated employees.



The following table presents the activity through December 31, 2004, on the restructuring charge we took in 2001:



|                                    |  |                       |      |                    |   |       |               |  |   |               |   |  |               |       |   |                              |   |               |   |  |                              |     |  |   |      |   |  |   |  
|----------------------------------- |  | --------------------- | ---- | ------------------ | - | ----- | ------------- |  | - | ------------- | - |  | ------------- | ----- | - | ---------------------------- | - | ------------- | - |  | ---------------------------- | --- |  | - | ---- | - |  | - | -
|                                    |  | Initial Pretax Charge |      | Non-cash Write-off |   |       | 2001 Activity |  |   | 2002 Activity |   |  | 2003 Activity |       |   | Balance at December 31, 2003 |   | 2004 Payments |   |  | Balance at December 31, 2004
|                                    |  | (Amounts in millions)
|December 2001 restructuring:        |  |                       |      |                    |   |       |               |  |   |               |   |  |               |       |   |                              |   |               |   |  |                              |     |  |   |      |   |  |   |  
|Lease cancellations and commitments |  | $                     | 39.7 |                    | $ | (25.8 | )             |  | $ |              |   |  | $             | (8.0  | ) |                              | $ | (3.1          | ) |  | $                            | 2.8 |  | $ | (2.8 | ) |  | $ | 
|Severance and separation benefits   |  |                       | 20.2 |                    |   |      |               |  |   | (0.6          | ) |  |               | (14.0 | ) |                              |   | (4.8          | ) |  |                              | 0.8 |  |   | (0.8 | ) |  |   | 
|                                    |  |                       |      |                    |   |       |               |  |   |               |   |  |               |       |   |                              |   |               |   |  |                              |     |  |   |      |   |  |   |  
|Total December 2001 restructuring   |  | $                     | 59.9 |                    | $ | (25.8 | )             |  | $ | (0.6          | ) |  | $             | (22.0 | ) |                              | $ | (7.9          | ) |  | $                            | 3.6 |  | $ | (3.6 | ) |  | $ | 
|                                    |  |                       |      |                    |   |       |               |  |   |               |   |  |               |       |   |                              |   |               |   |  |                              |     |  |   |      |   |  |   |  



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            |       
|                                                                 |  | 2004                  |        |   | 2003 |   |        | 2002 | 
|                                                                 |  | (Amounts in millions) |       
|IBNR as of January 1                                             |  | $                     | 826    |   |      | $ | 753    |      |  | $ | 808    |  
|Medical claims reserves from business acquired during the period |  |                       | 87     |   |      |   |       |      |  |   |       |  
|Health care claim expenses incurred during the period            |  |                       |        |   |      |   |        |      |  |   |        |  
|Related to current year                                          |  |                       | 5,491  |   |      |   | 4,682  |      |  |   | 4,343  |  
|Related to prior years                                           |  |                       | (63    | ) |      |   | (104   | )    |  |   |       |  
|                                                                 |  |                       |        |   |      |   |        |      |  |   |        |  
|Total incurred                                                   |  |                       | 5,428  |   |      |   | 4,578  |      |  |   | 4,343  |  
|Health care claims paid during the period:                       |  |                       |        |   |      |   |        |      |  |   |        |  
|Related to current year                                          |  |                       | (4,659 | ) |      |   | (3,918 | )    |  |   | (3,689 | )
|Related to prior years                                           |  |                       | (678   | ) |      |   | (587   | )    |  |   | (709   | )
|                                                                 |  |                       |        |   |      |   |        |      |  |   |        |  
|Total health care claims payments                                |  |                       | (5,337 | ) |      |   | (4,505 | )    |  |   | (4,398 | )
|                                                                 |  |                       |        |   |      |   |        |      |  |   |        |  
|IBNR as of December 31                                           |  | $                     | 1,004  |   |      | $ | 826    |      |  | $ | 753    |  
|                                                                 |  |                       |        |   |      |   |        |      |  |   |        |  



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. Health care claim expenses incurred during the periodRelated to current year includes a provision for adverse claims
development related to the variability in the factors used to estimate IBNR. This expense amount totaled $59 million, $53 million and $50 million in 2004, 2003 and 2002, respectively. Included in the line Health care claims expenses incurred
during the periodRelated to prior years is the release of the prior year provision for adverse claims development which totaled $53 million, $50 million and $51 million in 2004, 2003 and 2002, respectively.



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PACIFICARE HEALTH SYSTEMS, INC.



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)



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, 2004, 2003 and
2002:



|                                                  |  |                         |       |        |   |            |  |        |       |            |   |        |  |   |       |  |   |      
|------------------------------------------------- |  | ----------------------- | ----- | ------ | - | ---------- |  | ------ | ----- | ---------- | - | ------ |  | - | ----- |  | - | -----
|                                                  |  | Year Ended December 31,
|                                                  |  | 2004                    |       | 2003   |   | 2002      
|                                                  |  | Commercial              |       | Senior |   | Commercial |  | Senior |       | Commercial |   | Senior
|                                                  |  | (Amounts in millions)  
|Capitation expense                                |  | $                       | 1,574 |        | $ | 2,846      |  | $      | 1,488 |            | $ | 2,704  |  | $ | 1,795 |  | $ | 2,994
|All other health care services and other expenses |  |                         | 3,213 |        |   | 2,162      |  |        | 2,782 |            |   | 1,836  |  |   | 2,410 |  |   | 2,110
|                                                  |  |                         |       |        |   |            |  |        |       |            |   |        |  |   |       |  |   |      
|Total health care services and other expenses     |  | $                       | 4,787 |        | $ | 5,008      |  | $      | 4,270 |            | $ | 4,540  |  | $ | 4,205 |  | $ | 5,104
|                                                  |  |                         |       |        |   |            |  |        |       |            |   |        |  |   |       |  |   |      



13.  Contingencies



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 pre-trial 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 physicians, along with several medical associations, including the California Medical Association, joined the In re
Managed Care proceeding as plaintiffs. These physicians 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 need to be arbitrated. As a result, the order to compel arbitration does not cover part of the conspiracy and aiding and abetting claims
of all plaintiffs or any of the direct claims by a subset of plaintiffs (non-contracted plaintiffs who provide services to our members but do not accept assignments from them). We appealed the District Courts ruling to the extent it did not
compel arbitration of all of plaintiffs claims, and the United States Court of Appeals for the Eleventh Circuit heard oral argument on this appeal on August 12, 2004. A decision is currently pending and on September 20, 2004, the Eleventh
Circuit stayed the matter pending its decision.



On September 26, 2002, the
District Court certified a nationwide RICO class of virtually all physicians in the country as well as a nationwide state-law subclass of physicians. On September 1, 2004, the Eleventh Circuit upheld part of the class certified by the District
Court. Specifically, the Eleventh Circuit upheld the District Courts certification of a nationwide RICO class of physicians, but reversed the District Courts certification of plaintiffs state law claims. On October 15, 2004, we
filed a Petition for Writ of Certiorari with the United States Supreme Court seeking review of the Eleventh Circuits decision to uphold the nationwide RICO class. The petition was denied. The District Court has set a trial date for September
2005. We deny all material allegations and intend to defend the action vigorously.



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PACIFICARE HEALTH SYSTEMS, INC.



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)



Several additional lawsuits have been filed against us and the other defendants in the In re Managed Care Litigation by
non-physician providers of health care services, such as chiropractors and podiatrists. Those lawsuits have been assigned to the District Court for pre-trial proceedings, but are currently stayed pending the completion of pre-trial matters in the
physician class action.



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 members of non-ERISA
health plans and individuals with no prescription drug coverage 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. On May 5, 2004, Prescription Solutions filed a petition to compel arbitration. On July 9, 2004, the Superior Court granted the petition, holding that Irwins request for monetary relief can only be resolved in arbitration and
staying Irwins request for injunctive relief against Prescription Solutions until an appropriate arbitration is completed. Discovery is proceeding against most other defendants but is stayed as to Prescription Solutions pending arbitration. We
deny all material allegations and intend to defend the action vigorously.



Ronald Allen Gass v. Wellpoint Health Networks, Inc., et al. No. BC318704.  On July 19, 2004, Ronald Gass filed a complaint in the California Superior Court of Los Angeles County, California, against our subsidiary,
PacifiCare of California, Inc. as well as eleven other managed care companies. On or about September 22, 2004, plaintiff Gass filed a second amended complaint. The second amended complaint alleges that hospitals, by placing liens on third-party
recoveries obtained by members of the Managed Care Organizations, or MCOs, health plans, were collecting more money from the members than the hospitals were entitled to receive under their contracts with the MCOs. Gass further alleged that the
MCOs were permitting the hospitals to file such liens (or at least not preventing them from doing so), and the MCOs failure to prevent this hospital practice amounted to illegal, unfair and fraudulent conduct by the MCOs in violation of
California Business and Professions Code sec. 17200, et seq. The complaint seeks unspecified monetary damages and injunctive relief. The case has been designated a complex case under California law. We deny all material allegations in the lawsuit
and intend to defend this action vigorously.



Gadson v. United Wisconsin
Life Insurance Company.  On September 29, 2004, the Circuit Court of Montgomery County, Alabama, granted final approval of the certification and settlement of a class action lawsuit, Gadson v. United Wisconsin Life Insurance
Company, although approval of the settlement has been appealed to the Alabama Supreme Court. The Circuit Court had granted preliminary approval of the certification and settlement in March 2004. The lawsuit was filed in 2001 and involves issues
relating to the rating methodology formerly used by AMS for group health benefit plans marketed to individuals in Alabama and Georgia. All claims of participating class members have been dismissed in exchange for the settlement consideration. On
June 14, 2004, the Superior Court of Cobb County, Georgia in Parker v. American Medical Security Group, Inc.,issued an order enjoining AMS from settling with Georgia residents who are members of the Gadson class. On September 2, 2004 the
Superior Court certified a class of Georgia residents. AMS has appealed this injunction and certification to the Georgia Supreme Court, where its appeal of the order is currently pending.



PacifiCare of Texas, Inc. v. The Texas Department of Insurance and the State of Texas.  In November 2001, our Texas
subsidiary, PacifiCare of Texas, Inc., 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



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PACIFICARE HEALTH SYSTEMS, INC.



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)



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. We entered into a complete settlement of this matter and on July 26, 2004, the Court entered orders dismissing with prejudice all of the pending litigation between the parties and
issued a final judgment in the lawsuit.



Also, on July 20, 2004, the Texas
Medical Association and various physicians and providers who had intervened as plaintiffs were severed from the lawsuit with the State of Texas, the AG and the TDI. Litigation regarding payment of claims of the physicians and providers who
intervened in the lawsuit will continue under the case name Texas Medical Association, et al. v. PacifiCare of Texas, Inc. We deny all material allegations and intend to defend this action vigorously.



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 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 $30 million at December 31, 2004 and $37 million at December 31, 2003.



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.



Other Litigation.  We are involved in various legal actions in the normal
course of business, including a variety of legal actions and claims that seek monetary damages (or punitive damages that are not covered by insurance) relating but not limited to the following: (i) denial of healthcare benefits, (ii) disputes
related to managed care or cost containment activities, (iii) disputes with providers, agents or brokers over compensation or other matters, (iv) disputes related to claim administration errors and failure to disclose network rate discounts and
other fee and rebate arrangements, (v) disputes over rating methodology and practices or termination of coverage, (vi) disputes over copayment calculations, (vii) customer audits of our administration of ERISA and other plans, and (viii) disputes
with payers and other third parties over contracted services provided by us. Our establishment of drug formularies, support of clinical trials and PBM services may increase our exposure to product liability claims associated with 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.



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PACIFICARE HEALTH SYSTEMS, INC.



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)



14.  Comprehensive Income (Loss)



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



|                                                                       |  |                        |         |   |                              |   |         |                   |  |   |         |  
|---------------------------------------------------------------------- |  | ---------------------- | ------- | - | ---------------------------- | - | ------- | ----------------- |  | - | ------- | -
|                                                                       |  | Pretax Amount          |         |   | Income Tax Benefit (Expense) |   |         | Net-of-Tax Amount | 
|                                                                       |  | (Amounts in thousands) |        
|2004:                                                                  |  |                        |         |   |                              |   |         |                   |  |   |         |  
|Change in unrealized gains on marketable securities                    |  | $                      | (40,512 | ) |                              | $ | 14,753  |                   |  | $ | (25,759 | )
|Less: reclassification adjustment for net gains realized in net income |  |                        | 16,419  |   |                              |   | (5,977  | )                 |  |   | 10,442  |  
|                                                                       |  |                        |         |   |                              |   |         |                   |  |   |         |  
|Other comprehensive income (loss)                                      |  | $                      | (24,093 | ) |                              | $ | 8,776   |                   |  | $ | (15,317 | )
|                                                                       |  |                        |         |   |                              |   |         |                   |  |   |         |  
|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  |  
|                                                                       |  |                        |         |   |                              |   |         |                   |  |   |         |  



15.  Business Segment
Information



We sell health care services in the form of bundled managed
care and supplemental managed care products to members of all ages. Thus, our customer is the individual. However, we are paid by employer groups and the Federal Government who offer our health plans, along with other health plans, to their
employees (or in the case of Medicare, to the individual Medicare beneficiary). The member can select our plan, or a plan offered by another health care provider. We also offer our health plans to individuals directly. We have identified our product
lines as commercial, Medicare and supplemental managed care products based on the benefits offered and source of payment (commercial premiums are paid for by a combination of the employer and employee, whereas the government pays most of the premium
for Medicare beneficiaries).



We have two reportable segments, the Health Plans
segment, which is comprised of eight geographic operating segments and the Specialty segment which is comprised of pharmacy products, pharmacy benefit management, and dental, vision and behavioral health services. The operating segments within the
Health Plans segment all have similar economic characteristics. In addition, the operating segments within the Health Plans reportable segment meet the additional following five aggregation criteria as defined under paragraph 17 of SFAS No. 131,
Disclosures About Segments of An Enterprise and Related Information:



|1. | All operating segments provide similar health care products to the same class of customers, individuals. We generally market the same health care products throughout the country for
each of our customer groups. We provide a broad spectrum of health plans to our members through programs such as HMOs for members of all ages, including senior members, PPOs, and Medicare supplement products.
|-- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|2. | The production processes are substantially similar for all operating segments as they support similar customer groups and products.
|-- | -----------------------------------------------------------------------------------------------------------------------------------



|3. | Each operating segment has the same class of customers, individuals within large and small employer groups and senior and commercial individuals.
|-- | -------------------------------------------------------------------------------------------------------------------------------------------------



|4. | Each operating segment has similar distribution channels. We use multiple distribution channels such as general agents, an on-line price-quoting service, insurance brokers and
consultants who represent many employer groups and direct plan enrollment for a portion of our senior members. These methods are similar across geographies.
|-- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)



|5. | The health care industry is highly regulated at both the federal and state levels. All of the geographies must comply with the same federal regulations. While each states laws
are in some respects unique, many states have similar laws and regulations applicable to managed care and insurance companies.
|-- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



The team which comprises the chief operating decision maker reviews commercial and senior product lines (Health Plans segment) and the specialty product line
to operating income. We regularly review for changes in our segment reporting. We expect our specialty product revenues may increase in 2005 and rise to the level of a reportable segment. As a result of entering into contracts that bear margin or
pricing risk, we expect there will be an increase in revenues and expenses. Accordingly, we have provided disclosures related to our Health Plans and Specialty segments in the table below.



The accounting policies of the segments are consistent with generally accepted accounting
principles in the United States. The following table presents segment information for the Health Plans and Specialty segments for the years ended December 31, 2004, 2003 and 2002, as if our segment reporting structure had been effective on January
1, 2002. Intersegment revenues include internal pharmaceutical sales by our mail order pharmacy to the Health Plans segments members and fees recognized by the Specialty segment for services provided to the Health Plans segment. Amounts under
the heading Corporate and Other include revenues and expenses not allocable to reportable segments. Intersegment transactions are eliminated in consolidation under the heading Corporate and Other.



|                                                                                                        |  |                        |            |     |           |   |                     |  |   |              |   |  |   |           
|------------------------------------------------------------------------------------------------------- |  | ---------------------- | ---------- | --- | --------- | - | ------------------- |  | - | ------------ | - |  | - | ----------
|                                                                                                        |  | Health Plans           |            |     | Specialty |   | Corporate and Other |  |   | Consolidated
|                                                                                                        |  | (Amounts in thousands)
|2004:                                                                                                   |  |                        |            |     |           |   |                     |  |   |              |   |  |   |           
|Operating revenue from external customers                                                               |  | $                      | 11,496,620 |     |           | $ | 691,367             |  | $ |             |   |  | $ | 12,187,987
|Intersegment revenues                                                                                   |  |                        | 18,759     |     |           |   | 349,846             |  |   | (368,605     | ) |  |   |          
|Net investment income                                                                                   |  |                        | 87,443     |     |           |   | 1,374               |  |   |             |   |  |   | 88,817    
|Selling, general and administrative expenses                                                            |  |                        | 1,362,089  |     |           |   | 199,158             |  |   |             |   |  |   | 1,561,247 
|Depreciation and amortization expense                                                                   |  |                        | 59,357     |     |           |   | 10,932              |  |   |             |   |  |   | 70,289    
|Segment operating income                                                                                |  |                        | 427,291    |     |           |   | 114,487             |  |   |             |   |  |   | 541,778   
|Segment assets                                                                                          |  | $                      | 4,440,448  |     |           | $ | 364,768             |  | $ | 421,701      |   |  | $ | 5,226,917 
|                                                                                                        |  |                        |            |    
|2003:                                                                                                   |  |                        |            |     |           |   |                     |  |   |              |   |  |   |           
|Operating revenue from external customers                                                               |  | $                      | 10,438,522 |     |           | $ | 498,668             |  | $ |             |   |  | $ | 10,937,190
|Intersegment revenues                                                                                   |  |                        | 1,360      |     |           |   | 276,281             |  |   | (277,641     | ) |  |   |          
|Net investment income                                                                                   |  |                        | 70,538     |     |           |   | 783                 |  |   |             |   |  |   | 71,321    
|Selling, general and administrative expenses                                                            |  |                        | 1,272,244  |     |           |   | 180,298             |  |   |             |   |  |   | 1,452,542 
|Depreciation and amortization expense                                                                   |  |                        | 56,026     |     |           |   | 10,595              |  |   |             |   |  |   | 66,621    
|Segment operating income                                                                                |  |                        | 426,187    | (a) |           |   | 63,988              |  |   |             |   |  |   | 490,175   
|Segment assets                                                                                          |  | $                      | 3,904,510  |     |           | $ | 318,258             |  | $ | 396,536      |   |  | $ | 4,619,304 
|                                                                                                        |  |                        |            |    
|2002:                                                                                                   |  |                        |            |     |           |   |                     |  |   |              |   |  |   |           
|Operating revenue from external customers                                                               |  | $                      | 10,670,576 |     |           | $ | 421,439             |  | $ |             |   |  | $ | 11,092,015
|Intersegment revenues                                                                                   |  |                        | 577        |     |           |   | 271,960             |  |   | (272,537     | ) |  |   |          
|Net investment income                                                                                   |  |                        | 63,398     |     |           |   | 1,089               |  |   |             |   |  |   | 64,487    
|Selling, general and administrative expenses                                                            |  |                        | 1,209,264  |     |           |   | 160,896             |  |   |             |   |  |   | 1,370,160 
|Impairment, disposition, restructuring, Office of Personnel Management and other charges (credits), net |  |                        | 3,774      |     |           |   |                    |  |   |             |   |  |   | 3,774     
|Depreciation and amortization expense                                                                   |  |                        | 63,302     |     |           |   | 10,582              |  |   |             |   |  |   | 73,884    
|Segment operating income                                                                                |  |                        | 211,285    |     |           |   | 85,582              |  |   |             |   |  |   | 296,867   
|Segment assets                                                                                          |  | $                      | 3,699,973  |     |           | $ | 337,909             |  | $ | 213,251      |   |  | $ | 4,251,133 

---

|(a) | Includes $54 million of favorable prior period health care cost adjustments recorded in 2003 related to the 2002 and prior estimate.
|--- | ------------------------------------------------------------------------------------------------------------------------------------





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PACIFICARE HEALTH SYSTEMS, INC.



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)



Our largest source of revenue 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 $6.2 billion in 2004, $5.9 billion in 2003 and $6.3 billion in 2002.



16.  Financial Guarantees



Certain of our domestic subsidiaries fully and unconditionally guarantee the 103/4% senior notes. The Guarantor Subsidiaries, excluding MEDeMORPHUS Healthcare Solutions, Inc., PacifiCare of Arizona, Inc. and PacifiCare of Oklahoma, Inc., are also guarantors of our senior credit facility.



The following condensed consolidating financial statements quantify the financial position as
of December 31, 2003 and 2004 and the operations and cash flows for the years ended December 31, 2002, 2003 and 2004 of the Guarantor Subsidiaries listed below. The following condensed consolidating balance sheets, condensed consolidating statements
of operations and condensed consolidating 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 International Corporation, or FHP.



Guarantor Subsidiaries(a) PacifiCare Health Plan Administrators, Inc., or PHPA, PacifiCare eHoldings, Inc., SeniorCo, Inc., MEDeMORPHUS Healthcare Solutions,
Inc., RxSolutions, Inc., doing business as Prescription Solutions, PacifiCare Behavioral Health, Inc., American Medical Security Group, Inc. and SecureHorizons USA, Inc. on a stand-alone basis (carrying investments in subsidiaries under the equity
method) and (b) PacifiCare of Arizona, Inc., PacifiCare of Oklahoma, Inc. and PacifiCare Southwest Operations, Inc., which are fully owned subsidiaries of PHPA.



Non-Guarantor SubsidiariesRepresents all other directly or indirectly wholly owned subsidiaries of the Parent on a condensed 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)



CONDENSED CONSOLIDATING STATEMENTS OF OPERATIONS

For the Year Ended December 31, 2002



|                                                                                                        |  |                        |          |   |                        |   |           |                            |  |   |                           |   |  |         |           |   |  |   |            |  
|------------------------------------------------------------------------------------------------------- |  | ---------------------- | -------- | - | ---------------------- | - | --------- | -------------------------- |  | - | ------------------------- | - |  | ------- | --------- | - |  | - | ---------- | -
|                                                                                                        |  | Parent                 |          |   | Guarantor Subsidiaries |   |           | Non-Guarantor Subsidiaries |  |   | Consolidating Adjustments |   |  | Company |          
|                                                                                                        |  | (Amounts in thousands) |         
|Operating revenue                                                                                       |  | $                      | (10,346  | ) |                        | $ | 1,762,065 |                            |  | $ | 9,745,459                 |   |  | $       | (340,676  | ) |  | $ | 11,156,502 |  
|Loss from subsidiaries                                                                                  |  |                        | (661,977 | ) |                        |   | (561,578  | )                          |  |   |                          |   |  |         | 1,223,555 |   |  |   |           |  
|                                                                                                        |  |                        |          |   |                        |   |           |                            |  |   |                           |   |  |         |           |   |  |   |            |  
|Total operating revenue                                                                                 |  |                        | (672,323 | ) |                        |   | 1,200,487 |                            |  |   | 9,745,459                 |   |  |         | 882,879   |   |  |   | 11,156,502 |  
|Health care services and other expenses                                                                 |  |                        |         |   |                        |   | 1,335,766 |                            |  |   | 8,470,577                 |   |  |         | (320,642  | ) |  |   | 9,485,701  |  
|Selling, general and administrative expenses                                                            |  |                        | (121     | ) |                        |   | 535,996   |                            |  |   | 851,353                   |   |  |         | (17,068   | ) |  |   | 1,370,160  |  
|Impairment, disposition, restructuring, Office of Personnel Management and other charges (credits), net |  |                        | 18,162   |   |                        |   | (16,894   | )                          |  |   | 2,506                     |   |  |         |          |   |  |   | 3,774      |  
|                                                                                                        |  |                        |          |   |                        |   |           |                            |  |   |                           |   |  |         |           |   |  |   |            |  
|Operating income (loss)                                                                                 |  |                        | (690,364 | ) |                        |   | (654,381  | )                          |  |   | 421,023                   |   |  |         | 1,220,589 |   |  |   | 296,867    |  
|Interest expense, net                                                                                   |  |                        | (67,465  | ) |                        |   | (8,508    | )                          |  |   | (1,897                    | ) |  |         | 2,966     |   |  |   | (74,904    | )
|                                                                                                        |  |                        |          |   |                        |   |           |                            |  |   |                           |   |  |         |           |   |  |   |            |  
|Income (loss) before income taxes                                                                       |  |                        | (757,829 | ) |                        |   | (662,889  | )                          |  |   | 419,126                   |   |  |         | 1,223,555 |   |  |   | 221,963    |  
|Provision (benefit) for income taxes                                                                    |  |                        |         |   |                        |   | (88,540   | )                          |  |   | 171,332                   |   |  |         |          |   |  |   | 82,792     |  
|                                                                                                        |  |                        |          |   |                        |   |           |                            |  |   |                           |   |  |         |           |   |  |   |            |  
|Income (loss) before cumulative effect of a change in accounting principle                              |  |                        | (757,829 | ) |                        |   | (574,349  | )                          |  |   | 247,794                   |   |  |         | 1,223,555 |   |  |   | 139,171    |  
|Cumulative effect of a change in accounting principle                                                   |  |                        |         |   |                        |   | (273,222  | )                          |  |   | (623,778                  | ) |  |         |          |   |  |   | (897,000   | )
|                                                                                                        |  |                        |          |   |                        |   |           |                            |  |   |                           |   |  |         |           |   |  |   |            |  
|Net loss                                                                                                |  | $                      | (757,829 | ) |                        | $ | (847,571  | )                          |  | $ | (375,984                  | ) |  | $       | 1,223,555 |   |  | $ | (757,829   | )
|                                                                                                        |  |                        |          |   |                        |   |           |                            |  |   |                           |   |  |         |           |   |  |   |            |  



F-33





---

##### Table of Contents

PACIFICARE HEALTH SYSTEMS, INC.



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)



CONDENSED CONSOLIDATING STATEMENTS OF CASH FLOWS

For the Year Ended December 31, 2002



|                                                                                                        |  |                        |          |   |                        |   |          |                            |  |   |                           |   |  |         |            |   |  |   |          |  
|------------------------------------------------------------------------------------------------------- |  | ---------------------- | -------- | - | ---------------------- | - | -------- | -------------------------- |  | - | ------------------------- | - |  | ------- | ---------- | - |  | - | -------- | -
|                                                                                                        |  | Parent                 |          |   | Guarantor Subsidiaries |   |          | Non-Guarantor Subsidiaries |  |   | Consolidating Adjustments |   |  | Company |           
|                                                                                                        |  | (Amounts in thousands) |         
|Operating activities:                                                                                   |  |                        |          |   |                        |   |          |                            |  |   |                           |   |  |         |            |   |  |   |          |  
|Net loss                                                                                                |  | $                      | (757,829 | ) |                        | $ | (847,571 | )                          |  | $ | (375,984                  | ) |  | $       | 1,223,555  |   |  | $ | (757,829 | )
|Adjustments to reconcile net loss to net cash flows provided by (used in) operating activities:         |  |                        |          |   |                        |   |          |                            |  |   |                           |   |  |         |            |   |  |   |          |  
|Equity in income of subsidiaries                                                                        |  |                        | 661,977  |   |                        |   | 561,578  |                            |  |   |                          |   |  |         | (1,223,555 | ) |  |   |         |  
|Depreciation and amortization                                                                           |  |                        |         |   |                        |   | 39,381   |                            |  |   | 10,903                    |   |  |         |           |   |  |   | 50,284   |  
|Stock-based compensation expense                                                                        |  |                        | 693      |   |                        |   |         |                            |  |   |                          |   |  |         |           |   |  |   | 693      |  
|Deferred income taxes                                                                                   |  |                        |         |   |                        |   | (1,096   | )                          |  |   | 19,655                    |   |  |         |            |   |  |   | 18,559   |  
|Tax benefit realized for stock option exercises                                                         |  |                        | 1,009    |   |                        |   |         |                            |  |   |                          |   |  |         |           |   |  |   | 1,009    |  
|Amortization of intangible assets                                                                       |  |                        |         |   |                        |   | 4,103    |                            |  |   | 19,497                    |   |  |         |            |   |  |   | 23,600   |  
|Amortization of capitalized loan fees                                                                   |  |                        | 7,784    |   |                        |   |         |                            |  |   |                          |   |  |         |           |   |  |   | 7,784    |  
|Amortization of notes receivable from sale of fixed assets                                              |  |                        |         |   |                        |   | (3,107   | )                          |  |   |                          |   |  |         |           |   |  |   | (3,107   | )
|Loss (gain) on disposal of property, plant and equipment                                                |  |                        |         |   |                        |   | 15,813   |                            |  |   | (3,020                    | ) |  |         |           |   |  |   | 12,793   |  
|Provision (recovery) for doubtful accounts                                                              |  |                        |         |   |                        |   | (5,330   | )                          |  |   | 11,676                    |   |  |         |           |   |  |   | 6,346    |  
|Amortization of discount on 103/4% senior notes                                                         |  |                        | 266      |   |                        |   |         |                            |  |   |                          |   |  |         |           |   |  |   | 266      |  
|Impairment, disposition, restructuring, Office of Personnel Management and other charges (credits), net |  |                        | 18,162   |   |                        |   | (12,776  | )                          |  |   | (1,612                    | ) |  |         |           |   |  |   | 3,774    |  
|Employee benefit plan contributions in treasury stock                                                   |  |                        | 12,132   |   |                        |   |         |                            |  |   |                          |   |  |         |           |   |  |   | 12,132   |  
|Cumulative effect of a change in accounting principle                                                   |  |                        |         |   |                        |   | 273,222  |                            |  |   | 623,778                   |   |  |         |           |   |  |   | 897,000  |  
|Marketable and other securities impairment for other than temporary declines in value                   |  |                        | 11,001   |   |                        |   |         |                            |  |   | 1,542                     |   |  |         |           |   |  |   | 12,543   |  
|Adjustment to cash received in purchase transaction                                                     |  |                        |         |   |                        |   | 17       |                            |  |   |                          |   |  |         |           |   |  |   | 17       |  
|Changes in assets and liabilities                                                                       |  |                        | 84,815   |   |                        |   | (89,490  | )                          |  |   | (38,810                   | ) |  |         |           |   |  |   | (43,485  | )
|                                                                                                        |  |                        |          |   |                        |   |          |                            |  |   |                           |   |  |         |            |   |  |   |          |  
|Net cash flows provided by (used in) operating activities                                               |  |                        | 40,010   |   |                        |   | (65,256  | )                          |  |   | 267,625                   |   |  |         |           |   |  |   | 242,379  |  
|                                                                                                        |  |                        |          |   |                        |   |          |                            |  |   |                           |   |  |         |            |   |  |   |          |  
|Investing activities:                                                                                   |  |                        |          |   |                        |   |          |                            |  |   |                           |   |  |         |            |   |  |   |          |  
|Purchase of marketable securities, net                                                                  |  |                        |         |   |                        |   | (48,827  | )                          |  |   | (65,160                   | ) |  |         |           |   |  |   | (113,987 | )
|Purchase of property, plant and equipment                                                               |  |                        |         |   |                        |   | (51,497  | )                          |  |   | (7,777                    | ) |  |         |           |   |  |   | (59,274  | )
|Purchase of marketable securities-restricted                                                            |  |                        | (78,158  | ) |                        |   | (1       | )                          |  |   | (39,209                   | ) |  |         |           |   |  |   | (117,368 | )
|Proceeds from the sale of property, plant and equipment                                                 |  |                        |         |   |                        |   | 104      |                            |  |   | 12,388                    |   |  |         |           |   |  |   | 12,492   |  
|                                                                                                        |  |                        |          |   |                        |   |          |                            |  |   |                           |   |  |         |            |   |  |   |          |  
|Net cash flows used in investing activities                                                             |  |                        | (78,158  | ) |                        |   | (100,221 | )                          |  |   | (99,758                   | ) |  |         |           |   |  |   | (278,137 | )
|                                                                                                        |  |                        |          |   |                        |   |          |                            |  |   |                           |   |  |         |            |   |  |   |          |  
|Financing activities:                                                                                   |  |                        |          |   |                        |   |          |                            |  |   |                           |   |  |         |            |   |  |   |          |  
|Proceeds from borrowings of long-term debt                                                              |  |                        | 496,945  |   |                        |   |         |                            |  |   |                          |   |  |         |           |   |  |   | 496,945  |  
|Principal payments on long-term debt                                                                    |  |                        | (554,412 | ) |                        |   |         |                            |  |   | 104                       |   |  |         |           |   |  |   | (554,308 | )
|Proceeds from issuance of common and treasury stock                                                     |  |                        | 4,893    |   |                        |   |         |                            |  |   |                          |   |  |         |           |   |  |   | 4,893    |  
|Credit facility amendment fees and expenses                                                             |  |                        | (37,789  | ) |                        |   |         |                            |  |   |                          |   |  |         |           |   |  |   | (37,789  | )
|Payments on software financing agreement                                                                |  |                        |         |   |                        |   | (2,231   | )                          |  |   |                          |   |  |         |           |   |  |   | (2,231   | )
|Principal payments on FHP senior notes                                                                  |  |                        |         |   |                        |   | (41,750  | )                          |  |   |                          |   |  |         |           |   |  |   | (41,750  | )
|Proceeds from issuance of convertible subordinated debentures                                           |  |                        | 135,000  |   |                        |   |         |                            |  |   |                          |   |  |         |           |   |  |   | 135,000  |  
|Proceeds from draw down under equity commitment arrangement                                             |  |                        | 8,928    |   |                        |   |         |                            |  |   |                          |   |  |         |           |   |  |   | 8,928    |  
|Intercompany activity:                                                                                  |  |                        |          |   |                        |   |          |                            |  |   |                           |   |  |         |            |   |  |   |          |  
|Dividends received (paid)                                                                               |  |                        | 790      |   |                        |   | 143,399  |                            |  |   | (144,189                  | ) |  |         |           |   |  |   |         |  
|Royalty dividends and loans received (paid)                                                             |  |                        |         |   |                        |   | 117,613  |                            |  |   | (117,613                  | ) |  |         |           |   |  |   |         |  
|Subordinated loans received (paid)                                                                      |  |                        |         |   |                        |   | (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   |   |                        |   | 61,663   |                            |  |   | (103,940                  | ) |  |         |           |   |  |   | (26,070  | )
|Beginning cash and equivalents                                                                          |  |                        |         |   |                        |   | 152,137  |                            |  |   | 825,622                   |   |  |         |           |   |  |   | 977,759  |  
|                                                                                                        |  |                        |          |   |                        |   |          |                            |  |   |                           |   |  |         |            |   |  |   |          |  
|Ending cash and equivalents                                                                             |  | $                      | 16,207   |   |                        | $ | 213,800  |                            |  | $ | 721,682                   |   |  | $       |           |   |  | $ | 951,689  |  
|                                                                                                        |  |                        |          |   |                        |   |          |                            |  |   |                           |   |  |         |            |   |  |   |          |  



F-34





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##### Table of Contents

PACIFICARE HEALTH SYSTEMS, INC.



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)



CONDENSED CONSOLIDATING BALANCE SHEETS

December 31, 2003



|                                           |  |                        |           |   |                        |   |                            |  |   |                           |   |  |         |            |   |  |   |           |  
|------------------------------------------ |  | ---------------------- | --------- | - | ---------------------- | - | -------------------------- |  | - | ------------------------- | - |  | ------- | ---------- | - |  | - | --------- | -
|                                           |  | Parent                 |           |   | Guarantor Subsidiaries |   | Non-Guarantor Subsidiaries |  |   | Consolidating Adjustments |   |  | Company |           
|                                           |  | (Amounts in thousands) |          
|ASSETS                                     | 
|Current assets:                            |  |                        |           |   |                        |   |                            |  |   |                           |   |  |         |            |   |  |   |           |  
|Cash and equivalents                       |  | $                      |          |   |                        | $ | 373,527                    |  | $ | 824,895                   |   |  | $       |           |   |  | $ | 1,198,422 |  
|Marketable securities                      |  |                        | 37        |   |                        |   | 162,666                    |  |   | 1,197,017                 |   |  |         |           |   |  |   | 1,359,720 |  
|Receivables, net                           |  |                        | 991       |   |                        |   | 80,985                     |  |   | 191,663                   |   |  |         | (7,696     | ) |  |   | 265,943   |  
|Intercompany                               |  |                        | 10,110    |   |                        |   | 62,769                     |  |   | (72,879                   | ) |  |         |           |   |  |   |          |  
|Prepaid expenses and other current assets  |  |                        | 8,074     |   |                        |   | 39,999                     |  |   | 13,133                    |   |  |         | (3,907     | ) |  |   | 57,299    |  
|Deferred income taxes                      |  |                        | (15       | ) |                        |   | 76,792                     |  |   | 101,680                   |   |  |         | (28,640    | ) |  |   | 149,817   |  
|                                           |  |                        |           |   |                        |   |                            |  |   |                           |   |  |         |            |   |  |   |           |  
|Total current assets                       |  |                        | 19,197    |   |                        |   | 796,738                    |  |   | 2,255,509                 |   |  |         | (40,243    | ) |  |   | 3,031,201 |  
|                                           |  |                        |           |   |                        |   |                            |  |   |                           |   |  |         |            |   |  |   |           |  
|Property, plant and equipment at cost, net |  |                        |          |   |                        |   | 111,494                    |  |   | 37,913                    |   |  |         |           |   |  |   | 149,407   |  
|Marketable securities-restricted           |  |                        | 33,436    |   |                        |   | 3,250                      |  |   | 129,860                   |   |  |         |           |   |  |   | 166,546   |  
|Deferred income taxes                      |  |                        |          |   |                        |   | 89,758                     |  |   | 26,907                    |   |  |         | (116,665   | ) |  |   |          |  
|Investment in subsidiaries                 |  |                        | 2,376,929 |   |                        |   | 2,312,024                  |  |   | 3,688                     |   |  |         | (4,692,641 | ) |  |   |          |  
|Goodwill and intangible assets, net        |  |                        |          |   |                        |   | 118,755                    |  |   | 1,085,457                 |   |  |         |           |   |  |   | 1,204,212 |  
|Other assets                               |  |                        | 17,549    |   |                        |   | 28,688                     |  |   | 21,701                    |   |  |         |           |   |  |   | 67,938    |  
|                                           |  |                        |           |   |                        |   |                            |  |   |                           |   |  |         |            |   |  |   |           |  
|                                           |  | $                      | 2,447,111 |   |                        | $ | 3,460,707                  |  | $ | 3,561,035                 |   |  | $       | (4,849,549 | ) |  | $ | 4,619,304 |  
|                                           |  |                        |           |   |                        |   |                            |  |   |                           |   |  |         |            |   |  |   |           |  
|                                          
|LIABILITIES AND STOCKHOLDERS EQUITY       | 
|Current liabilities:                       |  |                        |           |   |                        |   |                            |  |   |                           |   |  |         |            |   |  |   |           |  
|Medical claims and benefits payable        |  | $                      |          |   |                        | $ | 168,015                    |  | $ | 864,144                   |   |  | $       | (4,659     | ) |  | $ | 1,027,500 |  
|Accounts payable and accrued liabilities   |  |                        | 6,646     |   |                        |   | 353,203                    |  |   | 135,763                   |   |  |         | (4,802     | ) |  |   | 490,810   |  
|Deferred income taxes                      |  |                        |          |   |                        |   | 17,846                     |  |   | 10,794                    |   |  |         | (28,640    | ) |  |   |          |  
|Unearned premium revenue                   |  |                        |          |   |                        |   | 67,150                     |  |   | 431,472                   |   |  |         | (2,142     | ) |  |   | 496,480   |  
|Current portion of long-term debt          |  |                        | 1,500     |   |                        |   | 5,766                      |  |   | 230                       |   |  |         |           |   |  |   | 7,496     |  
|                                           |  |                        |           |   |                        |   |                            |  |   |                           |   |  |         |            |   |  |   |           |  
|Total current liabilities                  |  |                        | 8,146     |   |                        |   | 611,980                    |  |   | 1,442,403                 |   |  |         | (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                      |  |                        |          |   |                        |   | 141,590                    |  |   | 79,852                    |   |  |         | (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        |   |                        |   | 2,202                      |  |   | 16,591                    |   |  |         |           |   |  |   | 18,815    |  
|Retained earnings                          |  |                        | 390,407   |   |                        |   |                           |  |   |                          |   |  |         |           |   |  |   | 390,407   |  
|Treasury stock                             |  |                        |          |   |                        |   |                           |  |   |                          |   |  |         |           |   |  |   |          |  
|Equity in income of subsidiaries           |  |                        |          |   |                        |   | 2,672,048                  |  |   | 2,020,593                 |   |  |         | (4,692,641 | ) |  |   |          |  
|                                           |  |                        |           |   |                        |   |                            |  |   |                           |   |  |         |            |   |  |   |           |  
|Total stockholders equity                 |  |                        | 1,832,744 |   |                        |   | 2,674,250                  |  |   | 2,037,184                 |   |  |         | (4,692,641 | ) |  |   | 1,851,537 |  
|                                           |  |                        |           |   |                        |   |                            |  |   |                           |   |  |         |            |   |  |   |           |  
|                                           |  | $                      | 2,447,111 |   |                        | $ | 3,460,707                  |  | $ | 3,561,035                 |   |  | $       | (4,849,549 | ) |  | $ | 4,619,304 |  
|                                           |  |                        |           |   |                        |   |                            |  |   |                           |   |  |         |            |   |  |   |           |  



F-35





---

##### 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



|                                                                                                        |  |                        |         |   |                        |   |           |                            |  |   |                           |   |  |         |            |   |  |   |            |  
|------------------------------------------------------------------------------------------------------- |  | ---------------------- | ------- | - | ---------------------- | - | --------- | -------------------------- |  | - | ------------------------- | - |  | ------- | ---------- | - |  | - | ---------- | -
|                                                                                                        |  | Parent                 |         |   | Guarantor Subsidiaries |   |           | Non-Guarantor Subsidiaries |  |   | Consolidating Adjustments |   |  | Company |           
|                                                                                                        |  | (Amounts in thousands) |        
|Operating revenue                                                                                       |  | $                      | 841     |   |                        | $ | 1,928,172 |                            |  | $ | 9,443,414                 |   |  | $       | (363,916   | ) |  | $ | 11,008,511 |  
|Income from subsidiaries                                                                                |  |                        | 339,072 |   |                        |   | 482,836   |                            |  |   | 349                       |   |  |         | (822,257   | ) |  |   |           |  
|                                                                                                        |  |                        |         |   |                        |   |           |                            |  |   |                           |   |  |         |            |   |  |   |            |  
|Total operating revenue                                                                                 |  |                        | 339,913 |   |                        |   | 2,411,008 |                            |  |   | 9,443,763                 |   |  |         | (1,186,173 | ) |  |   | 11,008,511 |  
|Health care services and other expenses                                                                 |  |                        |        |   |                        |   | 1,482,158 |                            |  |   | 7,904,853                 |   |  |         | (321,217   | ) |  |   | 9,065,794  |  
|Selling, general and administrative expenses                                                            |  |                        | 166     |   |                        |   | 551,149   |                            |  |   | 941,395                   |   |  |         | (40,168    | ) |  |   | 1,452,542  |  
|Impairment, disposition, restructuring, Office of Personnel Management and other charges (credits), net |  |                        |        |   |                        |   | 590       |                            |  |   | (590                      | ) |  |         |           |   |  |   |           |  
|                                                                                                        |  |                        |         |   |                        |   |           |                            |  |   |                           |   |  |         |            |   |  |   |            |  
|Operating income                                                                                        |  |                        | 339,747 |   |                        |   | 377,111   |                            |  |   | 598,105                   |   |  |         | (824,788   | ) |  |   | 490,175    |  
|Interest expense, net                                                                                   |  |                        | (96,999 | ) |                        |   | (5,337    | )                          |  |   | (726                      | ) |  |         | 2,531      |   |  |   | (100,531   | )
|                                                                                                        |  |                        |         |   |                        |   |           |                            |  |   |                           |   |  |         |            |   |  |   |            |  
|Income before income taxes                                                                              |  |                        | 242,748 |   |                        |   | 371,774   |                            |  |   | 597,379                   |   |  |         | (822,257   | ) |  |   | 389,644    |  
|Provision (benefit) for income taxes                                                                    |  |                        |        |   |                        |   | (40,432   | )                          |  |   | 187,328                   |   |  |         |           |   |  |   | 146,896    |  
|                                                                                                        |  |                        |         |   |                        |   |           |                            |  |   |                           |   |  |         |            |   |  |   |            |  
|Net income                                                                                              |  | $                      | 242,748 |   |                        | $ | 412,206   |                            |  | $ | 410,051                   |   |  | $       | (822,257   | ) |  | $ | 242,748    |  
|                                                                                                        |  |                        |         |   |                        |   |           |                            |  |   |                           |   |  |         |            |   |  |   |            |  



F-36





---

##### Table of Contents

PACIFICARE HEALTH SYSTEMS, INC.



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)



CONDENSED CONSOLIDATING STATEMENTS OF CASH FLOWS

For the Year Ended December 31, 2003



|                                                                                                  |  |                        |          |   |                        |   |          |                            |  |   |                           |   |  |         |          |   |  |   |           |  
|------------------------------------------------------------------------------------------------- |  | ---------------------- | -------- | - | ---------------------- | - | -------- | -------------------------- |  | - | ------------------------- | - |  | ------- | -------- | - |  | - | --------- | -
|                                                                                                  |  | Parent                 |          |   | Guarantor Subsidiaries |   |          | Non-Guarantor Subsidiaries |  |   | Consolidating Adjustments |   |  | Company |         
|                                                                                                  |  | (Amounts in thousands) |         
|Operating activities:                                                                             |  |                        |          |   |                        |   |          |                            |  |   |                           |   |  |         |          |   |  |   |           |  
|Net income                                                                                        |  | $                      | 242,748  |   |                        | $ | 412,206  |                            |  | $ | 410,051                   |   |  | $       | (822,257 | ) |  | $ | 242,748   |  
|Adjustments to reconcile net income to net cash flows provided (used in) by operating activities: |  |                        |          |   |                        |   |          |                            |  |   |                           |   |  |         |          |   |  |   |           |  
|Equity in income of subsidiaries                                                                  |  |                        | (339,072 | ) |                        |   | (482,836 | )                          |  |   | (349                      | ) |  |         | 822,257  |   |  |   |          |  
|Depreciation and amortization                                                                     |  |                        |         |   |                        |   | 35,240   |                            |  |   | 9,473                     |   |  |         |         |   |  |   | 44,713    |  
|Stock-based compensation expense                                                                  |  |                        | 19,092   |   |                        |   |         |                            |  |   |                          |   |  |         |         |   |  |   | 19,092    |  
|Deferred income taxes                                                                             |  |                        |         |   |                        |   | 2,320    |                            |  |   | (48,408                   | ) |  |         |         |   |  |   | (46,088   | )
|Tax benefit realized for stock option exercises                                                   |  |                        | 17,838   |   |                        |   |         |                            |  |   |                          |   |  |         |         |   |  |   | 17,838    |  
|Amortization of intangible assets                                                                 |  |                        |         |   |                        |   | 2,854    |                            |  |   | 19,054                    |   |  |         |         |   |  |   | 21,908    |  
|Amortization of capitalized loan fees                                                             |  |                        | 7,481    |   |                        |   |         |                            |  |   |                          |   |  |         |         |   |  |   | 7,481     |  
|Amortization of notes receivable from sale of fixed assets                                        |  |                        |         |   |                        |   | (5,641   | )                          |  |   |                          |   |  |         |         |   |  |   | (5,641    | )
|Loss on disposal of property, plant and equipment and other                                       |  |                        |         |   |                        |   | 19,952   |                            |  |   | 2,376                     |   |  |         |         |   |  |   | 22,328    |  
|Provision for doubtful accounts                                                                   |  |                        |         |   |                        |   | 3,616    |                            |  |   | 6,655                     |   |  |         |         |   |  |   | 10,271    |  
|Amortization of discount on 103/4% senior notes                                                   |  |                        | 424      |   |                        |   |         |                            |  |   |                          |   |  |         |         |   |  |   | 424       |  
|Expense related to bond redemption                                                                |  |                        | 28,155   |   |                        |   |         |                            |  |   |                          |   |  |         |         |   |  |   | 28,155    |  
|Employer benefit plan contributions in treasury stock                                             |  |                        | 1,363    |   |                        |   |         |                            |  |   |                          |   |  |         |         |   |  |   | 1,363     |  
|Changes in assets and liabilities, net of effects from acquisitions and dispositions              |  |                        | (552,840 | ) |                        |   | 581,081  |                            |  |   | 21,297                    |   |  |         |         |   |  |   | 49,538    |  
|                                                                                                  |  |                        |          |   |                        |   |          |                            |  |   |                           |   |  |         |          |   |  |   |           |  
|Net cash flows provided by (used in) operating activities                                         |  |                        | (574,811 | ) |                        |   | 568,792  |                            |  |   | 420,149                   |   |  |         |         |   |  |   | 414,130   |  
|                                                                                                  |  |                        |          |   |                        |   |          |                            |  |   |                           |   |  |         |          |   |  |   |           |  
|Investing activities:                                                                             |  |                        |          |   |                        |   |          |                            |  |   |                           |   |  |         |          |   |  |   |           |  
|Purchase of marketable securities, net                                                            |  |                        |         |   |                        |   | (14,156  | )                          |  |   | (154,946                  | ) |  |         |         |   |  |   | (169,102  | )
|Purchase of property, plant and equipment                                                         |  |                        |         |   |                        |   | (46,287  | )                          |  |   | (5,984                    | ) |  |         |         |   |  |   | (52,271   | )
|Sale of marketable securities-restricted, net                                                     |  |                        | 1,376    |   |                        |   | 502      |                            |  |   | 17,765                    |   |  |         |         |   |  |   | 19,643    |  
|Proceeds from the sale of property, plant and equipment                                           |  |                        |         |   |                        |   | 30       |                            |  |   |                          |   |  |         |         |   |  |   | 30        |  
|                                                                                                  |  |                        |          |   |                        |   |          |                            |  |   |                           |   |  |         |          |   |  |   |           |  
|Net cash flows provided by (used in) investing activities                                         |  |                        | 1,376    |   |                        |   | (59,911  | )                          |  |   | (143,165                  | ) |  |         |         |   |  |   | (201,700  | )
|                                                                                                  |  |                        |          |   |                        |   |          |                            |  |   |                           |   |  |         |          |   |  |   |           |  
|Financing activities:                                                                             |  |                        |          |   |                        |   |          |                            |  |   |                           |   |  |         |          |   |  |   |           |  
|Proceeds from borrowings of long-term debt                                                        |  |                        | 150,000  |   |                        |   |         |                            |  |   |                          |   |  |         |         |   |  |   | 150,000   |  
|Principal payments on long-term debt                                                              |  |                        | (151,337 | ) |                        |   |         |                            |  |   | 8                         |   |  |         |         |   |  |   | (151,329  | )
|Common stock repurchases                                                                          |  |                        | (493     | ) |                        |   |         |                            |  |   |                          |   |  |         |         |   |  |   | (493      | )
|Proceeds from issuance of common and treasury stock                                               |  |                        | 41,146   |   |                        |   |         |                            |  |   |                          |   |  |         |         |   |  |   | 41,146    |  
|Loan fees                                                                                         |  |                        | (6,949   | ) |                        |   |         |                            |  |   |                          |   |  |         |         |   |  |   | (6,949    | )
|Payments on software financing agreements                                                         |  |                        |         |   |                        |   | (3,683   | )                          |  |   |                          |   |  |         |         |   |  |   | (3,683    | )
|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  | )
|Use of restricted cash collateral for payment of FHP senior notes                                 |  |                        | 43,250   |   |                        |   |         |                            |  |   |                          |   |  |         |         |   |  |   | 43,250    |  
|Principal payments on FHP senior notes                                                            |  |                        |         |   |                        |   | (43,250  | )                          |  |   |                          |   |  |         |         |   |  |   | (43,250   | )
|Payments of premium to bondholders for senior note redemption                                     |  |                        | (18,813  | ) |                        |   |         |                            |  |   |                          |   |  |         |         |   |  |   | (18,813   | )
|Intercompany activity:                                                                            |  |                        |          |   |                        |   |          |                            |  |   |                           |   |  |         |          |   |  |   |           |  
|Dividends received (paid)                                                                         |  |                        | 476,000  |   |                        |   | (393,917 | )                          |  |   | (82,083                   | ) |  |         |         |   |  |   |          |  
|Royalty dividends and loans received (paid)                                                       |  |                        |         |   |                        |   | 87,576   |                            |  |   | (87,576                   | ) |  |         |         |   |  |   |          |  
|Capital contributions received (paid)                                                             |  |                        |         |   |                        |   | 4,120    |                            |  |   | (4,120                    | ) |  |         |         |   |  |   |          |  
|                                                                                                  |  |                        |          |   |                        |   |          |                            |  |   |                           |   |  |         |          |   |  |   |           |  
|Net cash flows provided by (used in) financing activities                                         |  |                        | 557,228  |   |                        |   | (349,154 | )                          |  |   | (173,771                  | ) |  |         |         |   |  |   | 34,303    |  
|                                                                                                  |  |                        |          |   |                        |   |          |                            |  |   |                           |   |  |         |          |   |  |   |           |  
|Net increase (decrease) in cash and equivalents                                                   |  |                        | (16,207  | ) |                        |   | 159,727  |                            |  |   | 103,213                   |   |  |         |         |   |  |   | 246,733   |  
|Beginning cash and equivalents                                                                    |  |                        | 16,207   |   |                        |   | 213,800  |                            |  |   | 721,682                   |   |  |         |         |   |  |   | 951,689   |  
|                                                                                                  |  |                        |          |   |                        |   |          |                            |  |   |                           |   |  |         |          |   |  |   |           |  
|Ending cash and equivalents                                                                       |  | $                      |         |   |                        | $ | 373,527  |                            |  | $ | 824,895                   |   |  | $       |         |   |  | $ | 1,198,422 |  
|                                                                                                  |  |                        |          |   |                        |   |          |                            |  |   |                           |   |  |         |          |   |  |   |           |  





F-37





---

##### Table of Contents

PACIFICARE HEALTH SYSTEMS, INC.



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)



CONDENSED CONSOLIDATING BALANCE SHEETS

December 31, 2004



|                                              |  |                        |           |   |                       |   |           |                           |  |   |                          |   |  |         |            |   |  |   |           |  
|--------------------------------------------- |  | ---------------------- | --------- | - | --------------------- | - | --------- | ------------------------- |  | - | ------------------------ | - |  | ------- | ---------- | - |  | - | --------- | -
|                                              |  | Parent                 |           |   | GuarantorSubsidiaries |   |           | Non-GuarantorSubsidiaries |  |   | ConsolidatingAdjustments |   |  | Company |           
|                                              |  | (Amounts in thousands) |          
|ASSETS                                        | 
|Current assets:                               |  |                        |           |   |                       |   |           |                           |  |   |                          |   |  |         |            |   |  |   |           |  
|Cash and equivalents                          |  | $                      |          |   |                       | $ | 394,295   |                           |  | $ | 429,809                  |   |  | $       |           |   |  | $ | 824,104   |  
|Marketable securities                         |  |                        |          |   |                       |   | 207,181   |                           |  |   | 1,729,584                |   |  |         |           |   |  |   | 1,936,765 |  
|Receivables, net                              |  |                        | 996       |   |                       |   | 89,426    |                           |  |   | 235,527                  |   |  |         | (8,587     | ) |  |   | 317,362   |  
|Intercompany                                  |  |                        | (49,021   | ) |                       |   | 84,977    |                           |  |   | (35,956                  | ) |  |         |           |   |  |   |          |  
|Prepaid expenses and other current assets     |  |                        | 5,800     |   |                       |   | 38,721    |                           |  |   | 16,268                   |   |  |         | (6,043     | ) |  |   | 54,746    |  
|Deferred income taxes                         |  |                        |          |   |                       |   | 80,512    |                           |  |   | 112,845                  |   |  |         | (44,655    | ) |  |   | 148,702   |  
|                                              |  |                        |           |   |                       |   |           |                           |  |   |                          |   |  |         |            |   |  |   |           |  
|Total current assets                          |  |                        | (42,225   | ) |                       |   | 895,112   |                           |  |   | 2,488,077                |   |  |         | (59,285    | ) |  |   | 3,281,679 |  
|                                              |  |                        |           |   |                       |   |           |                           |  |   |                          |   |  |         |            |   |  |   |           |  
|Property, plant and equipment, net            |  |                        |          |   |                       |   | 133,033   |                           |  |   | 93,561                   |   |  |         |           |   |  |   | 226,594   |  
|Marketable securities-restricted              |  |                        | 31,940    |   |                       |   | 4,949     |                           |  |   | 103,409                  |   |  |         |           |   |  |   | 140,298   |  
|Deferred income taxes                         |  |                        |          |   |                       |   | 111,201   |                           |  |   | 30,060                   |   |  |         | (141,261   | ) |  |   |          |  
|Investment in subsidiaries                    |  |                        | 3,273,114 |   |                       |   | 2,646,361 |                           |  |   | 7,341                    |   |  |         | (5,926,816 | ) |  |   |          |  
|Goodwill and intangible assets, net           |  |                        |          |   |                       |   | 437,274   |                           |  |   | 1,068,525                |   |  |         |           |   |  |   | 1,505,799 |  
|Other assets                                  |  |                        | 21,069    |   |                       |   | 29,778    |                           |  |   | 21,700                   |   |  |         |           |   |  |   | 72,547    |  
|                                              |  |                        |           |   |                       |   |           |                           |  |   |                          |   |  |         |            |   |  |   |           |  
|                                              |  | $                      | 3,283,898 |   |                       | $ | 4,257,708 |                           |  | $ | 3,812,673                |   |  | $       | (6,127,362 | ) |  | $ | 5,226,917 |  
|                                              |  |                        |           |   |                       |   |           |                           |  |   |                          |   |  |         |            |   |  |   |           |  
|                                             
|LIABILITIES AND STOCKHOLDERS EQUITY          | 
|Current liabilities:                          |  |                        |           |   |                       |   |           |                           |  |   |                          |   |  |         |            |   |  |   |           |  
|Medical claims and benefits payable           |  | $                      |          |   |                       | $ | 180,890   |                           |  | $ | 1,020,428                |   |  | $       | (8,918     | ) |  | $ | 1,192,400 |  
|Accounts payable and accrued liabilities      |  |                        | 15,203    |   |                       |   | 324,455   |                           |  |   | 178,034                  |   |  |         | (3,356     | ) |  |   | 514,336   |  
|Deferred income taxes                         |  |                        |          |   |                       |   | 28,083    |                           |  |   | 16,212                   |   |  |         | (44,295    | ) |  |   |          |  
|Unearned premium revenue                      |  |                        |          |   |                       |   | 4,671     |                           |  |   | 87,181                   |   |  |         | (2,356     | ) |  |   | 89,496    |  
|Current portion of long-term debt             |  |                        | 34,250    |   |                       |   | 3,028     |                           |  |   | 256                      |   |  |         |           |   |  |   | 37,534    |  
|                                              |  |                        |           |   |                       |   |           |                           |  |   |                          |   |  |         |            |   |  |   |           |  
|Total current liabilities                     |  |                        | 49,453    |   |                       |   | 541,127   |                           |  |   | 1,302,111                |   |  |         | (58,925    | ) |  |   | 1,833,766 |  
|                                              |  |                        |           |   |                       |   |           |                           |  |   |                          |   |  |         |            |   |  |   |           |  
|Long-term debt                                |  |                        | 914,505   |   |                       |   | 627       |                           |  |   | 1,388                    |   |  |         |           |   |  |   | 916,520   |  
|Convertible subordinated debentures           |  |                        | 135,000   |   |                       |   |          |                           |  |   |                         |   |  |         |           |   |  |   | 135,000   |  
|Deferred income taxes                         |  |                        |          |   |                       |   | 168,940   |                           |  |   | 87,054                   |   |  |         | (141,261   | ) |  |   | 114,733   |  
|Other liabilities                             |  |                        |          |   |                       |   | 38,460    |                           |  |   |                         |   |  |         |           |   |  |   | 38,460    |  
|Stockholders equity:                         |  |                        |           |   |                       |   |           |                           |  |   |                          |   |  |         |            |   |  |   |           |  
|Common stock                                  |  |                        | 861       |   |                       |   |          |                           |  |   |                         |   |  |         |           |   |  |   | 861       |  
|Unearned compensation                         |  |                        | (32,207   | ) |                       |   |          |                           |  |   |                         |   |  |         |           |   |  |   | (32,207   | )
|Additional paid-in capital                    |  |                        | 1,569,118 |   |                       |   |          |                           |  |   |                         |   |  |         |           |   |  |   | 1,569,118 |  
|Accumulated other comprehensive income (loss) |  |                        |          |   |                       |   | (83       | )                         |  |   | 3,581                    |   |  |         |           |   |  |   | 3,498     |  
|Retained earnings                             |  |                        | 647,168   |   |                       |   |          |                           |  |   |                         |   |  |         |           |   |  |   | 647,168   |  
|Equity in income of subsidiaries              |  |                        |          |   |                       |   | 3,508,637 |                           |  |   | 2,418,539                |   |  |         | (5,927,176 | ) |  |   |          |  
|                                              |  |                        |           |   |                       |   |           |                           |  |   |                          |   |  |         |            |   |  |   |           |  
|Total stockholders equity                    |  |                        | 2,184,940 |   |                       |   | 3,508,554 |                           |  |   | 2,422,120                |   |  |         | (5,927,176 | ) |  |   | 2,188,438 |  
|                                              |  |                        |           |   |                       |   |           |                           |  |   |                          |   |  |         |            |   |  |   |           |  
|                                              |  | $                      | 3,283,898 |   |                       | $ | 4,257,708 |                           |  | $ | 3,812,673                |   |  | $       | (6,127,362 | ) |  | $ | 5,226,917 |  
|                                              |  |                        |           |   |                       |   |           |                           |  |   |                          |   |  |         |            |   |  |   |           |  





F-38





---

##### Table of Contents

PACIFICARE HEALTH SYSTEMS, INC.



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)



CONDENSED CONSOLIDATING STATEMENTS OF OPERATIONS

For the Year Ended December 31, 2004



|                                             |  |                        |         |   |                       |   |           |                           |  |   |                          |   |  |         |            |   |  |   |            |  
|-------------------------------------------- |  | ---------------------- | ------- | - | --------------------- | - | --------- | ------------------------- |  | - | ------------------------ | - |  | ------- | ---------- | - |  | - | ---------- | -
|                                             |  | Parent                 |         |   | GuarantorSubsidiaries |   |           | Non-GuarantorSubsidiaries |  |   | ConsolidatingAdjustments |   |  | Company |           
|                                             |  | (Amounts in thousands) |        
|Operating revenue                            |  | $                      | 974     |   |                       | $ | 2,274,899 |                           |  | $ | 10,498,439               |   |  | $       | (497,508   | ) |  | $ | 12,276,804 |  
|Income from subsidiaries                     |  |                        | 349,426 |   |                       |   | 563,902   |                           |  |   | 3,668                    |   |  |         | (916,996   | ) |  |   |           |  
|                                             |  |                        |         |   |                       |   |           |                           |  |   |                          |   |  |         |            |   |  |   |            |  
|Total operating revenue                      |  |                        | 350,400 |   |                       |   | 2,838,801 |                           |  |   | 10,502,107               |   |  |         | (1,414,504 | ) |  |   | 12,276,804 |  
|Health care services and other expenses      |  |                        |        |   |                       |   | 1,779,421 |                           |  |   | 8,834,658                |   |  |         | (440,300   | ) |  |   | 10,173,779 |  
|Selling, general and administrative expenses |  |                        | 180     |   |                       |   | 704,449   |                           |  |   | 911,401                  |   |  |         | (54,783    | ) |  |   | 1,561,247  |  
|                                             |  |                        |         |   |                       |   |           |                           |  |   |                          |   |  |         |            |   |  |   |            |  
|Operating income                             |  |                        | 350,220 |   |                       |   | 354,931   |                           |  |   | 756,048                  |   |  |         | (919,421   | ) |  |   | 541,778    |  
|Interest expense, net                        |  |                        | (47,066 | ) |                       |   | (2,890    | )                         |  |   | (510                     | ) |  |         | 2,425      |   |  |   | (48,041    | )
|                                             |  |                        |         |   |                       |   |           |                           |  |   |                          |   |  |         |            |   |  |   |            |  
|Income before income taxes                   |  |                        | 303,154 |   |                       |   | 352,041   |                           |  |   | 755,538                  |   |  |         | (916,996   | ) |  |   | 493,737    |  
|Provision (benefit) for income taxes         |  |                        |        |   |                       |   | (55,277   | )                         |  |   | 245,860                  |   |  |         |           |   |  |   | 190,583    |  
|                                             |  |                        |         |   |                       |   |           |                           |  |   |                          |   |  |         |            |   |  |   |            |  
|Net income                                   |  | $                      | 303,154 |   |                       | $ | 407,318   |                           |  | $ | 509,678                  |   |  | $       | (916,996   | ) |  | $ | 303,154    |  
|                                             |  |                        |         |   |                       |   |           |                           |  |   |                          |   |  |         |            |   |  |   |            |  



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PACIFICARE HEALTH SYSTEMS, INC.



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)



CONDENSED CONSOLIDATING STATEMENTS OF CASH FLOWS

For the Year Ended December 31, 2004



|                                                                                                  |  |                        |          |   |                       |   |          |                            |  |   |                          |   |  |         |          |   |  |   |           |  
|------------------------------------------------------------------------------------------------- |  | ---------------------- | -------- | - | --------------------- | - | -------- | -------------------------- |  | - | ------------------------ | - |  | ------- | -------- | - |  | - | --------- | -
|                                                                                                  |  | Parent                 |          |   | GuarantorSubsidiaries |   |          | Non-Guarantor Subsidiaries |  |   | ConsolidatingAdjustments |   |  | Company |         
|                                                                                                  |  | (Amounts in thousands) |         
|Operating activities:                                                                             |  |                        |          |   |                       |   |          |                            |  |   |                          |   |  |         |          |   |  |   |           |  
|Net income                                                                                        |  | $                      | 303,154  |   |                       | $ | 407,318  |                            |  | $ | 509,678                  |   |  | $       | (916,996 | ) |  | $ | 303,154   |  
|Adjustments to reconcile net income to net cash flows provided by (used in) operating activities: |  |                        |          |   |                       |   |          |                            |  |   |                          |   |  |         |          |   |  |   |           |  
|Equity in income of subsidiaries                                                                  |  |                        | (349,426 | ) |                       |   | (563,902 | )                          |  |   | (3,668                   | ) |  |         | 916,996  |   |  |   |          |  
|Depreciation and amortization                                                                     |  |                        |         |   |                       |   | 41,934   |                            |  |   | 8,569                    |   |  |         |         |   |  |   | 50,503    |  
|Stock-based compensation expense                                                                  |  |                        | 33,467   |   |                       |   |         |                            |  |   |                         |   |  |         |         |   |  |   | 33,467    |  
|Deferred income taxes                                                                             |  |                        |         |   |                       |   | 15,038   |                            |  |   | 15,836                   |   |  |         |         |   |  |   | 30,874    |  
|Tax benefit realized upon exercise of stock-based compensation                                    |  |                        | 29,627   |   |                       |   |         |                            |  |   |                         |   |  |         |         |   |  |   | 29,627    |  
|Amortization of intangible assets                                                                 |  |                        |         |   |                       |   | 2,856    |                            |  |   | 16,930                   |   |  |         |         |   |  |   | 19,786    |  
|Amortization of capitalized loan fees                                                             |  |                        | 8,364    |   |                       |   |         |                            |  |   |                         |   |  |         |         |   |  |   | 8,364     |  
|Amortization of notes receivable from sale of fixed assets                                        |  |                        |         |   |                       |   | (5,626   | )                          |  |   |                         |   |  |         |         |   |  |   | (5,626    | )
|Loss on disposal of property, plant and equipment                                                 |  |                        |         |   |                       |   | 3,052    |                            |  |   | (574                     | ) |  |         |         |   |  |   | 2,478     |  
|Provision (recovery) for doubtful accounts                                                        |  |                        |         |   |                       |   | (5,955   | )                          |  |   | 7,559                    |   |  |         |         |   |  |   | 1,604     |  
|Amortization of discount on 103/4% senior notes                                                   |  |                        | 284      |   |                       |   |         |                            |  |   |                         |   |  |         |         |   |  |   | 284       |  
|Changes in assets and liabilities                                                                 |  |                        | 4,096    |   |                       |   | (109,266 | )                          |  |   | (341,245                 | ) |  |         |         |   |  |   | (446,415  | )
|                                                                                                  |  |                        |          |   |                       |   |          |                            |  |   |                          |   |  |         |          |   |  |   |           |  
|Net cash flows provided by (used in) operating activities                                         |  |                        | 29,566   |   |                       |   | (214,551 | )                          |  |   | 213,085                  |   |  |         |         |   |  |   | 28,100    |  
|                                                                                                  |  |                        |          |   |                       |   |          |                            |  |   |                          |   |  |         |          |   |  |   |           |  
|Investing activities:                                                                             |  |                        |          |   |                       |   |          |                            |  |   |                          |   |  |         |          |   |  |   |           |  
|Acquisition of AMS, net of cash acquired                                                          |  |                        | (445,886 | ) |                       |   | 3,424    |                            |  |   | (3,424                   | ) |  |         |         |   |  |   | (445,886  | )
|Purchase of marketable securities, net                                                            |  |                        |         |   |                       |   | (40,607  | )                          |  |   | (280,454                 | ) |  |         |         |   |  |   | (321,061  | )
|Purchase of property, plant and equipment                                                         |  |                        |         |   |                       |   | (64,401  | )                          |  |   | (8,665                   | ) |  |         |         |   |  |   | (73,066   | )
|Sale (purchase) of marketable securitiesrestricted, net                                          |  |                        | 1,496    |   |                       |   | (1,699   | )                          |  |   | 29,720                   |   |  |         |         |   |  |   | 29,517    |  
|Proceeds from sale of property, plant and equipment                                               |  |                        |         |   |                       |   | 249      |                            |  |   | 181                      |   |  |         |         |   |  |   | 430       |  
|                                                                                                  |  |                        |          |   |                       |   |          |                            |  |   |                          |   |  |         |          |   |  |   |           |  
|Net cash flows used in investing activities                                                       |  |                        | (444,390 | ) |                       |   | (103,034 | )                          |  |   | (262,642                 | ) |  |         |         |   |  |   | (810,066  | )
|                                                                                                  |  |                        |          |   |                       |   |          |                            |  |   |                          |   |  |         |          |   |  |   |           |  
|Financing activities:                                                                             |  |                        |          |   |                       |   |          |                            |  |   |                          |   |  |         |          |   |  |   |           |  
|Proceeds from borrowing of long-term debt                                                         |  |                        | 625,000  |   |                       |   |         |                            |  |   |                         |   |  |         |         |   |  |   | 625,000   |  
|Principal payments on long-term debt                                                              |  |                        | (179,408 | ) |                       |   |         |                            |  |   | (183                     | ) |  |         |         |   |  |   | (179,591  | )
|Purchase and retirement of common stock                                                           |  |                        | (103,291 | ) |                       |   |         |                            |  |   |                         |   |  |         |         |   |  |   | (103,291  | )
|Proceeds from issuance of common and treasury stock                                               |  |                        | 81,787   |   |                       |   |         |                            |  |   |                         |   |  |         |         |   |  |   | 81,787    |  
|Loan fees                                                                                         |  |                        | (9,264   | ) |                       |   |         |                            |  |   |                         |   |  |         |         |   |  |   | (9,264    | )
|Payments on software financing agreement                                                          |  |                        |         |   |                       |   | (6,993   | )                          |  |   |                         |   |  |         |         |   |  |   | (6,993    | )
|Intercompany activity:                                                                            |  |                        |          |   |                       |   |          |                            |  |   |                          |   |  |         |          |   |  |   |           |  
|Dividends received (paid)                                                                         |  |                        |         |   |                       |   | 390,346  |                            |  |   | (390,346                 | ) |  |         |         |   |  |   |          |  
|Capital contributions received (paid)                                                             |  |                        |         |   |                       |   | (45,000  | )                          |  |   | 45,000                   |   |  |         |         |   |  |   |          |  
|                                                                                                  |  |                        |          |   |                       |   |          |                            |  |   |                          |   |  |         |          |   |  |   |           |  
|Net cash flows provided by (used in) financing activities                                         |  |                        | 414,824  |   |                       |   | 338,353  |                            |  |   | (345,529                 | ) |  |         |         |   |  |   | 407,648   |  
|                                                                                                  |  |                        |          |   |                       |   |          |                            |  |   |                          |   |  |         |          |   |  |   |           |  
|Net increase (decrease) in cash and equivalents                                                   |  |                        |         |   |                       |   | 20,768   |                            |  |   | (395,086                 | ) |  |         |         |   |  |   | (374,318  | )
|Beginning cash and equivalents                                                                    |  |                        |         |   |                       |   | 373,527  |                            |  |   | 824,895                  |   |  |         |         |   |  |   | 1,198,422 |  
|                                                                                                  |  |                        |          |   |                       |   |          |                            |  |   |                          |   |  |         |          |   |  |   |           |  
|Ending cash and equivalents                                                                       |  | $                      |         |   |                       | $ | 394,295  |                            |  | $ | 429,809                  |   |  | $       |         |   |  | $ | 824,104   |  
|                                                                                                  |  |                        |          |   |                       |   |          |                            |  |   |                          |   |  |         |          |   |  |   |           |  



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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM



To the Board of Directors and Stockholders of PacifiCare Health Systems, Inc.



We have audited the accompanying consolidated balance sheets of PacifiCare Health Systems, Inc. (the Company) as of December 31, 2004 and 2003 and the related consolidated statements of operations, stockholders
equity and cash flows for each of the three years in the period ended December 31, 2004. 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 of the Public Company Accounting Oversight Board (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, 2004 and 2003, and the consolidated results of its operations
and its cash flows for each of the three years in the period ended December 31, 2004 in conformity with U.S. generally accepted accounting principles. 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.



We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of PacifiCare Health Systems,
Inc.s internal control over financial reporting as of December 31, 2004, based on criteria established in Internal ControlIntegrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our
report dated February 24, 2005, expressed an unqualified opinion thereon.



/s/ ERNST & YOUNG LLP



Irvine, California

February 24, 2005



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PACIFICARE HEALTH SYSTEMS, INC.



QUARTERLY INFORMATION FOR 2004 AND 2003 (Unaudited)



|                                     |  |                                               |           |         |   |              |  |             |           |  |   |          
|------------------------------------ |  | --------------------------------------------- | --------- | ------- | - | ------------ |  | ----------- | --------- |  | - | ---------
|                                     |  | Quarters Ended                               
|                                     |  | March 31                                      |           | June 30 |   | September 30 |  | December 31
|                                     |  | (Amounts in thousands, except per share data)
|2004                                 |  |                                               |           |         |   |              |  |             |           |  |   |          
|Operating revenue                    |  | $                                             | 2,964,123 |         | $ | 3,047,448    |  | $           | 3,105,626 |  | $ | 3,159,607
|Operating expenses                   |  |                                               | 2,843,648 |         |   | 2,912,170    |  |             | 2,952,991 |  |   | 3,026,217
|Interest expense, net                |  |                                               | 10,817    |         |   | 10,853       |  |             | 10,182    |  |   | 16,189   
|                                     |  |                                               |           |         |   |              |  |             |           |  |   |          
|Income before income taxes           |  |                                               | 109,658   |         |   | 124,425      |  |             | 142,453   |  |   | 117,201  
|Provision for income taxes           |  |                                               | 42,657    |         |   | 48,401       |  |             | 54,285    |  |   | 45,240   
|                                     |  |                                               |           |         |   |              |  |             |           |  |   |          
|Net income                           |  | $                                             | 67,001    |         | $ | 76,024       |  | $           | 88,168    |  | $ | 71,961   
|                                     |  |                                               |           |         |   |              |  |             |           |  |   |          
|Basic earnings per share(2)          |  | $                                             | 0.80      |         | $ | 0.90         |  | $           | 1.05      |  | $ | 0.86     
|                                     |  |                                               |           |         |   |              |  |             |           |  |   |          
|Diluted earnings per share(2)        |  | $                                             | 0.71      |         | $ | 0.80         |  | $           | 0.94      |  | $ | 0.76     
|                                     |  |                                               |           |         |   |              |  |             |           |  |   |          
|Managed care and other membership(1) |  |                                               | 2,959     |         |   | 2,992        |  |             | 2,998     |  |   | 3,336    
|                                     |  |                                               |           |         |   |              |  |             |           |  |   |          
|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, net                |  |                                               | 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)(3)     |  | $                                             | 0.89      |         | $ | 0.89         |  | $           | 0.80      |  | $ | 0.36     
|                                     |  |                                               |           |         |   |              |  |             |           |  |   |          
|Managed care and other membership(1) |  |                                               | 2,897     |         |   | 2,885        |  |             | 2,883     |  |   | 2,912    
|                                     |  |                                               |           |         |   |              |  |             |           |  |   |          

---

|(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.
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|(3) | The diluted earnings per share has been restated for the retroactive impact of Emerging Issues Task Force, or EITF, Issue No. 04-8, The Effect of Contingently Convertible Debt on
Diluted Earnings Per Share.See Note 2 of the Notes to Consolidated Financial Statements.
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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PACIFICARE HEALTH SYSTEMS, INC.



SCHEDULE IIVALUATION AND QUALIFYING ACCOUNTS

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



|                                 |  |                                |        |                                            |        |                               |         |   |                          |   |       
|-------------------------------- |  | ------------------------------ | ------ | ------------------------------------------ | ------ | ----------------------------- | ------- | - | ------------------------ | - | ------
|                                 |  | Balance at Beginning of Period |        | Charged to Provision for Doubtful Accounts |        | Deductions or Write-offs, net |         |   | Balance at End of Period
|                                 |  | (Amounts in thousands)        
|Allowance for doubtful accounts: |  |                                |        |                                            |        |                               |         |   |                          |   |       
|Years ended December 31:         |  |                                |        |                                            |        |                               |         |   |                          |   |       
|2004                             |  | $                              | 23,132 |                                            | 1,604  |                               | (8,662  | ) |                          | $ | 16,074
|2003                             |  | $                              | 29,814 |                                            | 10,271 |                               | (16,953 | ) |                          | $ | 23,132
|2002                             |  | $                              | 36,230 |                                            | 6,346  |                               | (12,762 | ) |                          | $ | 29,814



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PACIFICARE HEALTH SYSTEMS, INC.



EXHIBIT INDEX



|     |  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|---- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|2.01 |  | Agreement and Plan of Merger, dated as of September 15, 2004 between the Registrant, Ashland Acquisition Corp., and American Medical Security Group, Inc. (incorporated by reference to Exhibit
2.01 of Registrants Form 8-K, dated September 15, 2004).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|     | 
|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 (incorporated by reference to Exhibit 3.04 to Registrants Form 10-K for the year ended December 31, 2003).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|     | 
|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 103/4% 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., as issuer of 103/4% Senior Notes due 2009, PacifiCare Health Plan Administrators, Inc., PacifiCare eHoldings, Inc., Rx-Connect, Inc., and SeniorCo, Inc., as initial subsidiary guarantors,
RxSolutions, Inc., PacifiCare Behavioral Health, Inc. and Secure Horizons 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 (incorporated
by reference to Exhibit 4.06 to Registrants Form 10-K for the year ended December 31, 2003).                                                                                                                                                                       
|     | 
|4.07 |  | Second Supplemental Indenture, dated as of November 19, 2003, by and among PacifiCare Health Systems, Inc., as issuer of 103/4% Senior Notes due 2009, PacifiCare Health Plan Administrators, Inc., PacifiCare eHoldings, Inc., MEDeMORPHUS Healthcare Solutions, Inc. (formerly known as Rx-Connect, Inc.) and
SeniorCo, Inc., as initial subsidiary guarantors, RxSolutions, Inc., PacifiCare Behavioral Health, Inc. and Secure Horizons USA, Inc., as PHPA subsidiary guarantors, PacifiCare of Arizona, Inc. and PacifiCare of Oklahoma, Inc., as additional
subsidiary guarantors, U.S. Bank National Association, as successor to the State Street Bank and Trust Company of California, N.A., as trustee (incorporated by reference to Exhibit 4.07 to Registrants Form 10-Q for the quarter ended September
30, 2004).
|     | 
|4.08 |  | Third Supplemental Indenture, dated as of January 14, 2004, by and among PacifiCare Health Systems, Inc., as issuer of 103/4% Senior Notes due 2009, PacifiCare Health Plan Administrators, Inc., PacifiCare eHoldings, Inc., MEDeMORPHUS Healthcare Solutions, Inc. (formerly known as Rx-Connect,
Inc.),                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      





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##### Table of Contents

PACIFICARE HEALTH SYSTEMS, INC.



EXHIBIT INDEX



|       |  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|------ |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|       |  | SeniorCo, Inc., RxSolutions, Inc., PacifiCare Behavioral Health, Inc., Secure Horizons USA, Inc., PacifiCare of Arizona, Inc. and PacifiCare of Oklahoma, Inc., as existing subsidiary
guarantors, PacifiCare Southwest Operations, Inc., as additional subsidiary guarantor, U.S. Bank National Association, as successor to the State Street Bank and Trust Company of California, N.A., as trustee (incorporated by reference to Exhibit 4.08
to Registrants Form 10-Q for the quarter ended September 30, 2004).                                                                                                                                                                                                                                                                          
|       | 
|*4.09  |  | Fourth Supplemental Indenture, dated as of December 13, 2004, by and among PacifiCare Health Systems, Inc., as issuer of 103/4% Senior Notes due 2009, PacifiCare Health Plan Administrators, Inc., PacifiCare eHoldings, Inc., MEDeMORPHUS Healthcare Solutions, Inc. (formerly known as Rx-Connect, Inc.),
SeniorCo, Inc., Rx Solutions, Inc., PacifiCare Behavioral Health, Inc., Secure Horizons USA, Inc., PacifiCare of Arizona, Inc., PacifiCare of Oklahoma, Inc., and PacifiCare Southwest Operations, Inc., as existing subsidiary guarantors, American
Medical Security Group, Inc., as additional subsidiary guarantor, 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.
|       | 
|4.10   |  | Specimen Form of Exchange Global Note for the 103/4%
Senior Notes due 2009 (incorporated by reference to Exhibit 4.4 to Registrants Registration Statement on Form S-4 (File No. 333-91704)).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|       | 
|4.11   |  | Rights Agreement, dated as of November 19, 1999, between the Registrant and Chase Mellon 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 March 30, 2004, between the Registrant and Howard G. Phanstiel (incorporated by reference to Exhibit 10.01 to Registrants Form 10-Q
for the quarter ended March 31, 2004).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|       | 
|10.02 |  | Senior Executive Employment Agreement, dated as of August 1, 2004, between the Registrant and Gregory W. Scott (incorporated by reference to Exhibit 99.1 to Registrants Form 8-K, dated
October 13, 2004).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|       | 
|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 31, 2004, between the Registrant and Katherine F. Feeny (incorporated by reference to Exhibit 10.05 to Registrants Form 10-Q for
the quarter ended March 31, 2004).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|       | 
|10.06 |  | Senior Executive Employment Agreement, dated as of January 1, 2002, between the Registrant and Joseph S. Konowiecki (incorporated by reference to Exhibit 99.1 to Registrants Form 8-K,
dated January 4, 2005).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|       | 
|10.07 |  | 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).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|       | 
|10.08 |  | Senior Executive Employment Agreement, dated as of October 3, 2004, between the Registrant and Peter A. Reynolds (incorporated by reference to Exhibit 99.2 to Registrants Form 8-K,
dated October 13, 2004).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|       | 
|10.09 |  | 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).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|       | 
|10.10 |  | 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).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       





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##### Table of Contents

PACIFICARE HEALTH SYSTEMS, INC.



EXHIBIT INDEX



|       |  |                                                                                                                                                                                                                                                                                      
|------ |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|10.11 |  | 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).                                                                      
|       | 
|10.12 |  | Form of Restricted Stock Grant Notice and Restricted Stock Grant Agreement under the 1996 Stock Option Plan for Officers and Key Employees of the Registrant, as amended (incorporated by
reference to Exhibit 10.12 to Registrants Form 10-Q for the quarter ended March 31, 2004).
|       | 
|10.13 |  | Form of Stock Option Agreement under the 1996 Stock Option Plan for Officers and Key Employees of the Registrant, as amended (incorporated by reference to Exhibit 10.13 to Registrants
Form 10-Q for the quarter ended March 31, 2004).                                            
|       | 
|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)).                                                                                                                                               
|       | 
|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 |  | Form of Restricted Stock Grant Notice and Restricted Stock Grant Agreement under the 2000 Employee Plan of the Registrant, as amended (incorporated by reference to Exhibit 10.16 to
Registrants Form 10-Q for the quarter ended March 31, 2004).                                   
|       | 
|10.17 |  | Form of Stock Option Agreement under the 2000 Employee Plan of the Registrant, as amended (incorporated by reference to Exhibit 10.17 to Registrants Form 10-Q for the quarter ended
March 31, 2004).                                                                               
|       | 
|10.18 |  | Amended and Restated 2000 Non-Employee Directors Stock Plan (incorporated by reference to Exhibit 1 to Registrants Proxy Statement, dated May 18, 2001).                                                                                                                            
|       | 
|10.19 |  | 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).                                                                                   
|       | 
|10.20 |  | 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).                                                                                 
|       | 
|10.21 |  | Form of Stock Option Agreement under the Amended and Restated 2000 Non-Employee Directors Stock Plan of the Registrant, as amended (incorporated by reference to Exhibit 10.21 to
Registrants Form 10-Q for the quarter ended March 31, 2004).                                      
|       | 
|10.22 |  | Amended and Restated 1996 Non-Officer Directors Stock Plan (incorporated by reference to Exhibit E to Registrants Proxy Statement, dated May 25, 1999).                                                                                                                             
|       | 
|10.23 |  | 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)).                                                                             
|       | 
|10.24 |  | Form of Stock Option Agreement under the Amended and Restated 1996 Non-Officer Directors Stock Option Plan of the Registrant, as amended (incorporated by reference to Exhibit 10.24 to
Registrants Form 10-Q for the quarter ended March 31, 2004).                                
|       | 
|10.25 |  | 2003 Incentive Bonus Plan of the Registrant (incorporated by reference to Exhibit 10.21 to Registrants Form 10-K for the year ended December 31, 2003).                                                                                                                             
|       | 
|10.26 |  | 2003 Management Incentive Compensation Plan of the Registrant (incorporated by reference to Annex B to Registrants Proxy Statement, dated May 8, 2003).                                                                                                                             
|       | 
|10.27 |  | 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).                                                                                                           
|       | 
|10.28 |  | 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).                                                                           





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##### Table of Contents

PACIFICARE HEALTH SYSTEMS, INC.



EXHIBIT INDEX



|       |  |                                                                                                                                                                                                                                                                                                                                                              
|------ |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|10.29 |  | 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).                                                                                                                         
|       | 
|10.30 |  | 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).                                                                   
|       | 
|10.31 |  | 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).                                                                                                           
|       | 
|10.32 |  | 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).                                                                                                                             
|       | 
|10.33 |  | Amended and Restated 2001 Employee Stock Purchase Plan (incorporated by reference to Exhibit A to Registrants Proxy Statement dated April 22, 2004).                                                                                                                                                                                                        
|       | 
|10.34  |  | 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 (incorporated by reference
to Exhibit 10.30 to Registrants Form 10-K for the year ended December 31, 2003).                                                                              
|       | 
|10.35  |  | 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).                                                                                                                             
|       | 
|10.36  |  | 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).                                                                                                
|       | 
|10.37  |  | 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).                                                                                                                                 
|       | 
|10.38  |  | 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).                                  
|       | 
|10.39  |  | 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
(incorporated by reference to Exhibit 10.35 to Registrants Form 10-K for the year ended December 31, 2003).                                                         
|       | 
|10.40  |  | 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
(incorporated by reference to Exhibit 10.36 to Registrants Form 10-K for the year ended December 31, 2003).                                                         
|       | 
|10.41  |  | Amendment No. 3 to the Credit Agreement, dated as of May 19, 2004, between the Registrant, the Subsidiary Guarantors party thereto and JPMorgan Chase Bank as Administrative Agent
(incorporated by reference to Exhibit 10.41 to the Registrants Form 10-Q for the quarter ended June 30, 2004).                                                           
|       | 
|10.42  |  | 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).                                                                                                                                                                                   





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##### Table of Contents

PACIFICARE HEALTH SYSTEMS, INC.



EXHIBIT INDEX



|      |  |                                                                                                                                           
|----- |  | ------------------------------------------------------------------------------------------------------------------------------------------
|14.1  |  | Financial Code of Ethics (incorporated by reference to Exhibit 14.1 to Registrants Form 10-K for the year ended December 31, 2003).      
|      | 
|*21   |  | List of Subsidiaries, a copy of which is filed herewith.                                                                                  
|      | 
|*23   |  | Consent of Ernst & Young LLP, Independent Registered Public Accounting Firm, a copy of which is filed herewith.                           
|      | 
|24    |  | Power of Attorney (included on signature page).                                                                                           
|      | 
|*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.
|      | 
|*32.1 |  | Certification of Principal Executive Officer 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 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.
|- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------