##### Table of Contents









UNITED STATES SECURITIES AND EXCHANGE
COMMISSION

Washington, D.C. 20549




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Form 10-K

|           |  |                                                                                           
|---------- |  | ------------------------------------------------------------------------------------------
|(Mark One) |  |                                                                                           
|þ          |  | ANNUAL REPORT PURSUANT TO SECTION 13
	OR 15(d)
	 OF THE SECURITIES EXCHANGE ACT OF 1934   
|          
|           |  | For the fiscal year ended December 31,
	2001                                              
|          
|or        
|          
|o          |  | TRANSITION REPORT PURSUANT TO SECTION 13
	OR 15(d)
	OF THE SECURITIES EXCHANGE ACT OF 1934
|          
|           |  | For the transition period
	from           to           .                                  

Commission file
number 000-21949



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PACIFICARE HEALTH SYSTEMS, INC.

(Exact name of registrant as specified in its
charter)


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

3120 Lake Center Drive, Santa Ana, California
92704

(Address of principal executive offices,
including zip code)


(714) 825-5200

(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 þ          No o

Indicate by check mark if disclosure of
delinquent filers pursuant to Item 405 of
Regulation S-K is not contained herein, and will not be
contained, to the best of 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.     þ

Non-affiliates of the Registrant held
approximately $386,200,000 of the aggregate market value of
common stock on February 28, 2002.

There were approximately 34,554,000 shares of
common stock outstanding on February 28, 2002.



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TABLE OF CONTENTS



|              |                                                                                               |                                            |  |  |  |  |  | 
|------------- | --------------------------------------------------------------------------------------------- | ------------------------------------------ |  |  |  |  |  | 
|PART I       
|              | ITEM 1. BUSINESS                                                                             
|              | ITEM 2. PROPERTIES                                                                           
|              | ITEM 3. LEGAL PROCEEDINGS                                                                    
|              | ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS                                  
|PART II      
|              | ITEM 5. MARKET FOR THE COMPANYS COMMON EQUITY AND RELATED STOCKHOLDER MATTERS               
|              | ITEM 6. SELECTED FINANCIAL DATA                                                              
|              | ITEM 7. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
|              | ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK                          
|              | ITEM 8. CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA                             
|              | ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS AND ACCOUNTING AND FINANCIAL DISCLOSURE
|PART III     
|              | ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT                                  
|              | SECTION 16(A) BENEFICIAL OWNERSHIP REPORTING COMPLIANCE                                      
|              | ITEM 11. EXECUTIVE COMPENSATION                                                              
|              | ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT                      
|              | ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS                                      
|PART IV      
|              | ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K                     
|SIGNATURES   
|              |                                                                                               | CONSOLIDATED STATEMENTS OF OPERATIONS     
|              |                                                                                               | NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
|EXHIBIT INDEX
|EXHIBIT 3.03 
|EXHIBIT 10.01
|EXHIBIT 10.02
|EXHIBIT 10.04
|EXHIBIT 10.05
|EXHIBIT 10.06
|EXHIBIT 10.07
|EXHIBIT 10.10
|EXHIBIT 10.26
|EXHIBIT 10.27
|EXHIBIT 10.28
|EXHIBIT 10.30
|EXHIBIT 10.31
|EXHIBIT 21   
|EXHIBIT 23   



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##### Table of Contents



PACIFICARE HEALTH SYSTEMS, INC.

INDEX TO ANNUAL REPORT ON FORM 10-K

For the Year Ended December 31,
2001


|         |  |                                                                                        |  |      |    | 
|-------- |  | -------------------------------------------------------------------------------------- |  | ---- | -- | 
|         |  |                                                                                        |  | Page
|         |  |                                                                                        |  |     
|PART I  
|Item 1.  |  | Business                                                                               |  |      | 1  | 
|Item 2.  |  | Properties                                                                             |  |      | 18 | 
|Item 3.  |  | Legal Proceedings                                                                      |  |      | 18 | 
|Item 4.  |  | Submission of Matters to a Vote of Security
	Holders                                   |  |      | 21 | 
|PART II 
|Item 5.  |  | Market for the Companys Common Equity and
	Related Stockholder Matters                |  |      | 22 | 
|Item 6.  |  | Selected Financial Data                                                                |  |      | 23 | 
|Item 7.  |  | Managements Discussion and Analysis of
	Financial Condition and Results of Operations |  |      | 25 | 
|Item 7A. |  | Quantitative and Qualitative Disclosures About
	Market Risk                            |  |      | 52 | 
|Item 8.  |  | Consolidated Financial Statements and
	Supplementary Data                              |  |      | 53 | 
|Item 9.  |  | Changes in and Disagreements with Accountants and
	Accounting and Financial Disclosure |  |      | 53 | 
|PART III
|Item 10. |  | Directors and Executive Officers of the Registrant                                     |  |      | 54 | 
|Item 11. |  | Executive Compensation                                                                 |  |      | 57 | 
|Item 12. |  | Security Ownership of Certain Beneficial Owners
	and Management                        |  |      | 65 | 
|         |  | Equity-Based Instruments Held by Management                                            |  |      | 66 | 
|Item 13. |  | Certain Relationships and Related Transactions                                         |  |      | 67 | 
|PART IV 
|Item 14. |  | Exhibits, Financial Statement Schedules and
	Reports on Form 8-K                       |  |      | 68 | 

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PART I




ITEM
1.     BUSINESS

Company Overview

We offer managed care and other health insurance
products to employer groups and Medicare beneficiaries in eight
Western states and Guam. Our commercial and Medicare programs
are designed to deliver quality health care and customer service
to our members in a cost-effective manner. These programs
include health maintenance organizations, or HMOs, preferred
provider organizations, or PPOs, and Medicare supplement
products. We also offer a variety of specialty products and
services that employers can purchase to supplement our basic
commercial plans, or as stand-alone products. These specialty
products include pharmacy benefit management, or PBM, behavioral
health services, life insurance, indemnity health insurance and
dental and vision benefit plans. As of December 31, 2001,
we had approximately 3.5 million HMO and other commercial
product members. We had approximately 9.1 million members
in our PBM, dental and behavioral health plans, including both
members covered by our commercial or Medicare HMOs, and members
that were unaffiliated with our HMOs.

Industry Overview



| |             
| | ------------
| | Managed Care

Managed care plans develop health care provider
networks by entering into contracts with hospitals, physicians
and other health care professionals to deliver health care cost
effectively. In comparison to conventional indemnity insurance,
managed care plans generally credential network providers and
incorporate medical management and other cost-control measures
to encourage the delivery of medically necessary health care.
Managed care plans promote the maintenance of good health of
their members as critical to managing health care costs. To that
end, managed care plans typically cover preventive medicine and
common diagnostic screening, and conduct member education
campaigns on common health issues aimed at improving the health
of their members. Conventional indemnity insurance usually
allows insured parties substantial freedom of choice in
selecting health care providers and requires satisfaction of an
annual deductible before insured parties are reimbursed for
health care costs on a full or partial basis. Such reimbursement
is often limited to the insurers assessment of the
reasonable and customary charges for the particular health care
procedure.

A network-model HMO is a managed health care
organization that combines aspects of a health care insurer with
those of a health care provider by arranging for health care
services for its members through a defined health care provider
network at a reduced deductible or a fixed copayment for
services received. Members generally select one primary care
physician from the network who is responsible for coordinating
health care services for the member. A PPO is a select group of
providers, such as physician groups, that offer discounted
fee-for-service health care. PPO managed care members can select
physicians without coordination through a primary care
physician. PPO managed care members may be subject to annual
deductible obligations and may be charged coinsurance or
copayments when utilizing services.



| |         
| | --------
| | Medicare

Medicare is a federal program that provides
persons age 65 and over and some disabled persons a variety of
hospital and medical insurance benefits. Most individuals
eligible for Medicare are entitled to receive inpatient hospital
care under Part A without the payment of any premium, but are
required to pay a premium to the federal government, which is
adjusted annually, to be eligible for physician care and other
services under Part B. Even though they participate in both
Part A and Part B of the traditional Medicare program,
beneficiaries are still required to pay deductible and
coinsurance amounts. They may, if they choose, supplement their
Medicare coverage by purchasing Medicare supplement policies,
which pay all or a portion of these deductibles and coinsurance
amounts. Many of these policies also cover other services such
as prescription drugs, which are not included in Medicare
coverage.

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Under the Medicare+Choice program, managed care
plans can contract with the Centers for Medicare and Medicaid
Services, or CMS, which until recently was known as the Health
Care Financing Administration, to provide health insurance
coverage in exchange for a fixed monthly payment per member that
varies based on the geographic areas in which they reside. The
fixed monthly payment per member is subject to periodic
adjustments determined by CMS based upon a number of factors,
including retroactive changes in members status, such as
Medicaid eligibility, and risk measures based on demographic
factors, such as age, gender, county of residence and health
status. The weighting of the risk measures on the amount of the
periodic adjustments to the fixed monthly payments is being
phased in over time, and these measures will have their full
impact on the calculation of those adjustments by 2007.
Individuals who elect to participate in the Medicare+Choice
program are relieved of the obligation to pay some or all of the
deductible or coinsurance amounts, but are generally required to
use exclusively the services provided by the HMO 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.

Effective January 1, 2002, Medicare
beneficiaries with individual Medicare coverage will only be
able to switch membership from traditional Medicare to a
Medicare+Choice plan or switch to a different Medicare+Choice
plan twice each year once during November open enrollment and
once during the first six months of the calendar year. Beginning
in 2003 and beyond, beneficiaries will only be able to make new
membership choices once during November open enrollment and once
during the first three months of the calendar year.



| |                                                        
| | -------------------------------------------------------
| | Contracting Arrangements with Physicians
	and Hospitals

Managed care plans generally contract with
physicians and hospitals under three methods:

Fee-for-service Contracts.Managed care plans contract with
health care providers to provide services to members based on
discounted or other fee schedules, such as the Medicare fee
schedule, for the services provided.

Risk-based Contracts.Managed care plans contract with
health care providers to provide services to members based on
modified discounted fee schedules, like the Medicare fee
schedule, for the services provided with elements of
risk-sharing through the development of and adherence to
agreed-on budgets. Under risk-based contracts, managed care
plans partially share the risk of health care costs with
hospitals and physicians. For example, the managed care plan may
share hospital costs in excess of a specified target or budget
with the physician group only or with both the physician group
and the hospital.

Capitated Contracts.Less frequently, managed care plans
contract with hospitals and physicians on a prepaid, capitated
fixed-fee per-member per-month basis, regardless of the services
provided to each member. Capitation payments to physicians and
hospitals may be based on a percentage of the premiums received
or a fixed per-member per-month amount that is often adjusted to
reflect membership age, sex and benefit plan variation. Under
capitated contracts, medical groups and hospitals may assume
administrative functions, including medical management and
claims processing, to support management of health care
services. Generally, under capitated contracts, if a member
utilizes services that cost in excess of the capitated fee, the
health care provider is responsible for the payment of the
excess, while if a members utilization cost is less than
the capitated fee, the provider keeps the difference.

Historically, the managed care industry has
relied primarily on risk-based or fee-for-service contracts
except in California, where capitation was used by a few large
managed care plans as the prevailing contracting model. With the
continuing consolidation of hospitals, especially in less
populated areas, and the insolvency of several prominent
physician groups in California and Texas, the industry is
reducing its reliance on capitated contracts and using more
fee-for-service and risk-based contracts, especially for
hospital services. Risk-based contracts generally present
managed care plans with greater challenges in accurately
estimating and reserving for claims and controlling health care
costs than capitated contracts, where the risk of excess health
care costs is borne by the health care provider.

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Business Strategy

Our mission as a health and consumer services
company is to make people healthier and more secure. Our
strategy to achieve this mission is:



|  |                                                                                                                                 
|- | --------------------------------------------------------------------------------------------------------------------------------
| | Continue to strengthen our core HMO business;                                                                                   
| 
| | Expand our health services portfolio; and                                                                                       
| 
| | Diversify our health care product offerings so
	that we ultimately transition into a health and consumer
	services organization.



| |                                  
| | ---------------------------------
| | Strengthen our Core HMO
	Business

To strengthen our core HMO business, we have
taken and are taking the following actions:



|  |                                                                                                                                                                                                                                                    
|- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | We have implemented initiatives to stabilize both
	our commercial and Medicare medical loss ratios, while
	addressing the significant increases in health care costs that
	we have experienced over the last two years. Our actions have
	included:



|  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Increasing commercial premium rates, and
	continuing efforts to tailor pricing and benefit designs to
	increase commercial membership in our larger, more profitable
	market segments. For example, effective January 2002, we are
	offering higher copayment plans, multi-tier benefit plans in
	California, and uniform benefit plans for national accounts. The
	new plans reduce premiums paid for by the employer with the
	member bearing more of the cost;
| 
| | Redesigning Medicare+Choice benefits, charging
	higher Medicare member monthly premiums, and exiting or freezing
	enrollment in underperforming Medicare+Choice markets to
	increase the profitability of our Medicare+Choice operations;                                                                                                                                                                                                                        
| 
| | Stabilizing our provider networks and
	transitioning providers who cannot perform under a delegated
	model to direct contract relationships;                                                                                                                                                                                                                                                                                                                     
| 
| | Implementing medical management programs such as
	on-site concurrent review to resolve coverage issues with
	hospitals and other health care providers at the time of
	treatment, that we believe will result in a decrease in the
	average length of stay at hospitals by our members and reduce
	hospital admissions;                                                                                                                                          
| 
| | Implementing chronic disease management programs
	that focus on prevention, member education, and evidence-based
	best practices to improve our members health and reduce
	costs. We have supplemented our in-house programs with
	contracted third parties to reduce our health care costs
	attributable to coronary artery disease and stroke, congestive
	heart failure, chronic lung disease and end stage renal disease;
	and                              
| 
| | Responding to the increased claims volume
	associated with the change in our business model, by improving
	capacity and performance. Our claims inventory was only
	6.3 days receipts on hand as of February 28, 2002,
	which represents a substantial reduction from prior periods and
	is evidence of our commitment to paying health care providers in
	a timely fashion.                                                                                     



|  |                                                                                                                                                                                                                                                                                                      
|- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | We are consolidating and reorganizing our company
	operations to focus on commercial business growth and to improve
	operational efficiency. To accomplish this we are reducing our
	work force by 15%, which we began doing in the fourth quarter of
	2001, in conjunction with the following steps:



|  |                                                                                                                                                                                           
|- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Consolidating our regional operations from five
	regions to three regions, and implementing standardized business
	processes to ensure that best practices are shared across the
	regions;
| 
| | Centralizing several areas of the business such
	as accounting, national accounts relationships, network
	management and medical management functions; and                                

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|  |                                                                                                                                                                                                                                                                                                      
|- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Consolidating five regional customer service
	centers into three centers, located in Arizona, California and
	Texas. We intend to take advantage of best practices and
	economies of scale to eliminate duplicative work, and reduce
	excess capacity thereby significantly reducing our fixed costs.



|  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | We have invested in our underwriting and
	actuarial capabilities, which are of added importance as we
	operate in an increasingly risk-based environment, and continue
	to improve our capabilities. We have implemented adjusted
	community ratings to establish premium rates for commercial
	groups based on their expected use of health care services;                                                                                                                                                                                                                                          
| 
| | We have outsourced our information technology, or
	IT, infrastructure, including our voice and data networks and
	our servers and software maintenance services, which we expect
	to result in cost savings of $380 to $400 million during
	the 10-year term of the contracts. This outsourcing will allow
	us to operate under one business technology platform, provide
	access to state-of-the-art infrastructure and allow us to focus
	on IT strategy, planning, architecture and application
	development; and                                                                                 
| 
| | We are increasing and intensifying marketing
	efforts to enhance and reposition our PacifiCare and Secure
	Horizons brands to increase our commercial market share in our
	existing markets and enhance our revenues. While we believe our
	brands are perceived positively by our customers and providers,
	we understand the importance of strengthening our brands and
	marketing the evolving nature of our company. To that end, we
	have decided to invest in brand building in 2002 and beyond, and
	plan to invest approximately $20 million in 2002 in a
	branding and advertising campaign.



| |                                      
| | -------------------------------------
| | Expand our Health Services
	Portfolio

We are pursuing opportunities to expand our
health services portfolio. We are also building on the strength
of the Secure Horizons brand and our core competencies in the
senior market to offer new products designed for seniors,
including Medicare supplemental insurance products. We have
taken or are taking the following actions:



|  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | We have introduced a womens health
	initiative to make our products and customer service more
	appealing to women. We believe that women make most health care
	decisions for their families. For example, we have expanded our
	obstetrics and gynecology, or OB/GYN, and pediatric networks,
	and have added a 24-hour nurse advice line and other educational
	programs targeted at womens health issues;                                                                                                                                                                 
| 
| | We have launched our enhanced PPO products in
	California, Colorado, Oklahoma and Texas, effective
	January 1, 2002. We intend to launch our enhanced PPO
	product in all of our remaining markets during the first half of
	2002. Once the PPO product has been launched in all of our
	existing markets, we may expand the PPO into states where we do
	not currently offer our commercial HMO products;                                                                                                                                                                     
| 
| | We are continuing to grow our behavioral health
	services business and diversify its revenue base, by increasing
	sales of our services and products to unaffiliated health plans
	and employer groups. We have also increased sales of our
	service-oriented products, which include disease management,
	health improvement programs as well as employee and member
	assistance programs;                                                                                                                                                                                    
| 
| | We are continuing to grow our dental and vision
	services business by cross-selling these products and services
	with our medical HMO and indemnity products. In addition, we
	have introduced new products in 2001 that include a dental PPO
	available in California, designed to contain costs while
	offering employees the freedom of provider choice. We are also
	offering enhanced dental HMO plans that emphasize the value of
	prevention and offer more premium levels, no limits on specialty
	referrals and additional services that were not previously
	covered;
| 
| | We are continuing to grow our PBM business,
	Prescription Solutions, by increasing sales of its services to
	unaffiliated health plans and employer groups and by expanding
	its mail-order business. We continue to enhance our PBM services
	through Rx-Connect, a prescription service that physicians use
	to submit prescriptions online and resolve formulary or
	drug-interaction issues at the point of care;                                                                                                                                                          

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|  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | We have launched a new group retiree Senior
	Supplement plan in seven of our eight states where we currently
	offer our Medicare+Choice products that provides employers a new
	option for their Medicare-eligible retirees. We plan to continue
	to increase the marketing of our group product within the
	mid-size, large-size and national account market segments;                                                                                                                                                                    
| 
| | Effective January 2002, we are offering an
	individual Medicare supplement plan targeting individuals who
	are newly Medicare-eligible or who are exiting Medicare+Choice
	plans. Beginning in the fourth quarter of 2001, we introduced
	this product in five of the eight states where we currently
	offer our Medicare+Choice products. In 2002, we will be
	introducing the product in two more of our eight states and also
	in as many as nine additional states where our Medicare+Choice
	products are not currently available; and
| 
| | We have established a division called Secure
	Horizons Senior Solutions that is responsible for managing sales
	and marketing for all of our senior businesses, including
	Medicare+Choice plans, Medicare supplement (individual) and
	Senior Supplement (group retirees), and other products and
	services especially designed for seniors.                                                                                                                                                                                              



| |                                                                  
| | -----------------------------------------------------------------
| | Transition into a Health Care and Consumer
	Services Organization

Over time, we intend to evolve into a health care
and consumer services organization offering health insurance,
lifestyle-enhancing products, health information products, and
other consumer products aimed at making people feel healthier
and more secure. We believe that consumers demand products and
services that go beyond basic health insurance and extend to
areas such as cosmetic surgery, weight management, senior
independent living and financial security. Examples of the steps
we have taken or are taking are:



|  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Developing tiered network products and defined
	contribution products that emphasize lower costs and provide
	decision support tools and incentives to assist and encourage
	consumers to make purchasing decisions based on cost, quality
	and service. In 2002, we are selling hospital tiered products in
	California and plan to expand to medical groups in the future;                                                                                                                                                                                             
| 
| | Developing a wider array of products and services
	directed towards the mature marketplace. These products will be
	focused on individuals experiencing specific life stages or life
	events rather than based solely on age or demographics. We are
	also developing alternative distribution channels for these
	products;                                                                                                                                                                                                                                             
| 
| | Developing a health care smart card
	that may include up to three types of cards with the member
	choosing one. This credit card-style card allows the holder to
	perform multiple functions quickly and conveniently. These
	functions may include the ability to access personal health
	information through a special smart card web portal, a flexible
	spending account debit feature allowing the member to purchase
	health care items and a credit card feature. Pilot phases on the
	smart card will begin in the first half of 2002; and                   
| 
| | Partnering with a leading clinical research and
	strategic consulting company to conduct clinical drug trials.
	The objective is to work with our physicians and hospitals to
	create clinical research centers within leading medical groups
	serving our members. We believe this will result in providing
	our members with expanded access to new drug therapies and
	strengthen our relationship with providers by providing the
	opportunity to participate in important medical research and
	develop expanded relationships with major pharmaceutical
	companies.

Products



| |                    
| | -------------------
| | Commercial Products

Our commercial products accounted for
$4.8 billion, or 40% of our consolidated revenue for the
year ended December 31, 2001. Our commercial HMO and PPO
products may be bundled with our specialty products and
services, including PBM, behavioral health services, group life
and health insurance products, and dental and vision services,
providing employer groups and individuals with more benefit
options from a

5



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single source and the ability to design tailored
benefit programs. We also sell our specialty products and
services on a stand-alone basis to unaffiliated health plans and
employer groups.


Health Maintenance Organizations.Our PacifiCare HMO plans provide
health care benefits to commercial members through a defined
provider network at a reduced deductible or a nominal copayment.
We believe we have developed one of the largest health care
provider networks among managed care companies in the Western
United States. As of December 31, 2001, this network
included approximately 500 hospitals and 60,000 primary
care and specialty physicians. As of December 31, 2001, we
had 2.4 million commercial HMO members.

We target a variety of plan sponsors including
employer groups and other purchasing coalitions, as well as
state and federal government agencies. We categorize our target
markets for the commercial HMO product into four groups,
including small group/ individual markets, mid-market groups,
major/ national accounts and labor and trust organizations. We
provide consolidated billing, eligibility, centralized sales,
account management and underwriting for larger customers.

Our strategy is to grow profitable commercial HMO
membership by focusing on product innovation and quality
management. We have, and will continue to develop commercial HMO
products that provide lower price points for corporate customers
through the use of alternative benefit plans and tiered access
to health care provider networks. Under these alternative
benefit plans, members may select more expensive health care
options only if they are willing to bear an increased share of
the expense.

Preferred Provider Organizations.A PPO is a network of physicians,
hospitals and other health care providers organized by an
insurer to facilitate the delivery of health care to its insured
enrollees on a discounted fee-for-service basis. Enrollees have
broad access to a wide range of providers without the
requirement of referral from a primary care physician. PPO
enrollees generally have higher coinsurance or copayments
requirements than their HMO counterparts in exchange for freedom
of choice. As customers continue to desire choice and
flexibility in health care, we believe that demand for
competitively priced PPO products will continue to increase.

Our PPO network supplements our existing HMO
network with additional health care providers and generally
includes a majority of all available providers in any given
geographic area, providing our PPO members with substantial
choice. Additionally, the network is extended to other health
care providers in a given geographic area through out-of-network
benefits that allows the member choice beyond the organized PPO
network in exchange for reduced coverage or higher coinsurance
or copayments.

Our enhanced PPO product provides members open
access to network providers, with no primary care physician
gatekeeper and simplified medical management practices. The PPO
product is designed around an administrative platform that
streamlines the members interactions with employers and
providers. This product includes standard plan designs,
supplemental benefits and provider networks that are comprised
of a combination of proprietary and rental network arrangements.
We support our PPO product through our enhanced customer service
and operating platforms, which include the following components:



|  |                                                                                                                                                                                                                        
|- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Our operations are organized into
	cross-functional teams composed of claims, customer service,
	membership accounting, and other functions, providing full
	service to employer purchasers, members and providers; and
| 
| | A single business platform that houses all
	enrollment, provider, claims and customer service transaction
	processing, yielding a comprehensive operational and financial
	reporting environment.                      

As of December 31, 2001, we had over 33,000
enrollees in our PPO product and had launched our enhanced PPO
products in California, Colorado, Oklahoma and Texas for
January 1, 2002 effective dates. We intend to launch our
enhanced PPO product in Arizona, Nevada, Oregon and Washington
during the first half of 2002. Once the PPO product has been
launched in all of our existing markets, we plan to continue the
expansion of the PPO into states where we do not currently offer
our commercial HMO products.

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| |                   
| | ------------------
| | Specialty Products

We use our existing employer group and Medicare
relationships to offer our specialty products and services in
conjunction with our commercial and Medicare products. These
specialty products and services include PBM, behavioral health
services, group life and health insurance products, and dental
and vision services. In addition, we sell our specialty products
and services to unaffiliated health plans and employer groups.
These specialty products and services provide employer groups
and individuals with more benefit options from a single source
and the ability to design tailored benefit programs for their
employees and themselves.

Pharmacy Benefit Management.Founded in 1993, Prescription
Solutions provides integrated PBM services to more than
4.5 million people, including approximately
0.9 million seniors. For the year ended December 31,
2001, Prescription Solutions processed 50.4 million claims,
filled 4.2 million mail service prescriptions and generated
$394 million of our consolidated revenue, of which
$259 million was generated from our affiliated health plans.

Prescription Solutions offers a broad range of
innovative programs, products and services designed to improve,
enhance and increase clinical and financial outcomes.
Prescription Solutions has a sophisticated claims processing
system that may be customized to each clients benefits,
and is able to notify a pharmacy when another medication is
preferred, or when prior authorization or a substitute agent is
required.

In addition, Prescription Solutions employs tools
such as quality initiatives, utilization management, targeted
disease intervention, active formulary management,
prior-authorization review, health outcomes research and
real-time audits that are designed to achieve measurable results
and to actively ensure that its members are receiving the most
appropriate and most effective medication in a cost-effective
manner. We also provide regulatory compliance assistance for
managed care organizations seeking compliance with National
Committee for Quality Assurance, or NCQA, guidelines or
regulatory requirements.

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. 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.
Medically necessary drugs not included in the formulary can be
obtained through our authorization process provided they are not
specifically excluded from coverage or for the treatment of
excluded benefits. Prescription Solutions operates independently
of pharmaceutical or retail drug organizations, which allows it
to focus primarily on improving clinical outcomes while managing
and controlling costs. This focus on pharmacy management is part
of what differentiates Prescription Solutions from its
competitors.

Prescription Solutions operates a
84,000-square-foot facility in Carlsbad, California. We believe
this fully automated state-of-the-art facility has the capacity
to process nine million mail-service prescriptions per year, and
could expand this capacity by adding more work shifts and hours
or days of operation. Prescription Solutions is aggressively
promoting mail-service pharmacy services and is developing other
business opportunities for its mail service pharmacy, such as
offering over-the-counter medications and health and beauty
products.

Behavioral Health Services.We provide behavioral health care
services to our HMO members in California, Colorado, Oklahoma,
Oregon, Texas and Washington, and unaffiliated health plans in
California and Oregon. Our behavioral health care services
include managed mental health, employee assistance, care
management and chemical dependency benefit programs. As of
December 31, 2001, we provided these behavioral health care
services to 3.7 million members through our provider
network of approximately 8,000 providers and approximately
430 facilities. For the year ended December 31, 2001,
our behavioral health care subsidiaries accounted for
$182 million of our consolidated revenue, of which
$47 million was generated from unaffiliated health plans
and employer groups.

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Managed mental health and chemical dependency
services are offered as a standard part of most of our
commercial health plans and are sold in conjunction with our
other commercial and Medicare products, and are offered on a
stand-alone basis, to unaffiliated health plans and employer
groups.

Group Life and Health Insurance.We are licensed through our
subsidiaries, PacifiCare Life and Health Insurance Company and
PacifiCare Life Assurance Company, to issue life and health care
insurance in 38 states, including each of the states where
our HMOs operate, the District of Columbia and Guam. By
marketing our HMO commercial product line in conjunction with
indemnity health care products, we are able to offer
multi-option health benefits programs. Other supplementary
benefits offered to employer groups include basic life
insurance, group term life insurance, indemnity dental and
indemnity behavioral health benefits. For the year ended
December 31, 2001, our life and health insurance
subsidiaries accounted for $212 million of our consolidated
revenue, substantially all of which was generated from our
health plans.

Dental and Vision Services.We provide HMO, PPO and indemnity
fee-for-service dental, and PPO vision benefits to individuals
and employer groups, and to seniors through Secure Horizons.
These products are offered through our subsidiaries PacifiCare
Dental, PacifiCare Dental of Colorado, Inc., PacifiCare Life
Assurance Company and PacifiCare Life Insurance Company, and are
administered internally. In 2001, we offered these products in
Arizona, California, Colorado, Nevada, Oklahoma, Oregon, Texas
and Washington.

Through our subsidiaries, we provide a complete
range of dental and vision product offerings for small, mid-size
and large employers, regardless of their existing medical plan
offering. With December 31, 2001 membership of
0.9 million, our dental and vision plans accounted for
$102 million of revenue, of which approximately
$44 million was generated from unaffiliated employer groups.



| |                  
| | -----------------
| | Medicare Products

We offer Medicare beneficiaries access to
Medicare+Choice and Medicare supplement products though our
Secure Horizons programs. We believe that our understanding of
the senior population and our attention to customer service
differentiates our Secure Horizons program from competing
products.

Medicare+Choice HMO.Medicare+Choice accounted for
$6.8 billion, or 57% of our consolidated revenue for the
year ended December 31, 2001. We are the largest
Medicare+Choice HMO in the United States as measured by
membership with approximately 0.9 million members as of
December 31, 2001. We currently offer our Medicare+Choice
products in 64 counties in eight Western states. Since January
2001, our Medicare+Choice membership has declined by
0.1 million, primarily due to county exits. We will
continue to reduce our participation in the Medicare+Choice
program if federal funding for the Medicare+Choice program does
not increase. See Managements Discussion and
Analysis of Financial Condition and Results of Operations-Risk
Factors. To the extent that we continue to reduce our
participation in the Medicare+Choice program, our revenue will
decline unless lost revenue from our Medicare+Choice products is
replaced with revenue from other sources, such as our new
Medicare supplement product offerings or other lines of business.

We regularly review our product design to include
appropriate cost sharing with plan members and we make annual
benefit changes to mitigate against increases in health care
costs that exceed the rate of increase in our CMS reimbursement
under Medicare+Choice contracts. We have also adopted a
political and legislative strategy designed to encourage the
federal government to reimburse Medicare+Choice payers on a
basis that more accurately reflects health care service costs
and inflation and to lessen the administrative burdens placed on
Medicare+Choice payers by CMS.

Medicare Supplement.During 2001, we introduced two new
products under the Secure Horizons brand: an individual Medicare
supplement product and the group retiree Senior Supplement
product. These products are designed to fill gaps left by
traditional Medicare coverage. For example, these products pay
for hospital deductibles, physician copayments and coinsurance
for which an individual enrolled in the traditional Medicare
program would otherwise be responsible.

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Launched during the first quarter of 2001, there
were nearly 13,000 policyholders enrolled in the group
retiree Senior Supplement plan by January 2002. The plan is
approved in seven states, and provides employers with a new
option for their Medicare-eligible retirees. We plan to continue
to increase the marketing of our group product within the
mid-size, large-size and national account market segments.

In the fourth quarter of 2001, we introduced our
individual Medicare supplement product in five states: Arizona,
California, Nevada, Oklahoma and Texas. In 2002, we will be
introducing the product in Colorado and Oregon in addition to as
many as nine states where our other products are not currently
available. We are offering four standardized Medicare supplement
plans (A, C, F and G). The primary focus of our individual
Medicare supplement marketing efforts is directed toward those
individuals just turning age 65 and becoming eligible for
Medicare for the first time. In addition, the product provides
an option for those Medicare+Choice members impacted by service
area exits.

We believe that these new products will increase
our capabilities in the indemnity insurance business, strengthen
and expand our Secure Horizons brand recognition on a national
level, and replace revenues and profits from the reduction in
Medicare+Choice membership. We expect that these products will
also establish an additional distribution channel and revenue
source for Prescription Solutions and our other specialty
businesses.

Physician and Hospital Relationships



| |                                                        
| | -------------------------------------------------------
| | Contracting Arrangements with Physicians
	and Hospitals

We primarily focus on maintaining a qualified
network of physicians, hospitals and other health care providers
in each geographic area we serve, as well as improving the
medical management of health services to achieve both better
quality and cost-effective care. Our provider contracting
processes include analysis and modeling of underlying cost and
utilization assumptions. Through these processes, we continually
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. We believe this allows us to
create more financially successful physician and hospital
networks. Many of our physician and hospital contracts have
one-year terms. However, we also have a number of multiple-year
contracts with physician groups and hospitals to ensure the
quality and stability of our network.

Over the past two years our contracting strategy
has shifted increasingly toward covering our membership under
risk-based or fee-for-service contracts, as indicated in the
table below. We typically process claims and perform medical
management and administrative functions under our risk-based
contracts.

The percentages of membership by contract type at
December 31, 2001 and 2000 were as follows:

|                           |  |              |    |           |  |      |    |      |  |  |    |   |  |  |    |  
|-------------------------- |  | ------------ | -- | --------- |  | ---- | -- | ---- |  |  | -- | - |  |  | -- | -
|                           |  |              |    |          
|                           |  | Hospital     |    | Physician
|                           |  |              |    |          
|                           |  |             
|                           |  | December 31,
|                           |  |             
|                           |  | 2001         |    | 2000      |  | 2001 |    | 2000
|                           |  |              |    |           |  |      |    |     
|Commercial:                |  |              |    |           |  |      |    |      |  |  |    |   |  |  |    |  
|Capitated                  |  |              | 48 | %         |  |      | 57 | %    |  |  | 79 | % |  |  | 84 | %
|Risk-based/fee-for-service |  |              | 52 | %         |  |      | 43 | %    |  |  | 21 | % |  |  | 16 | %
|Medicare:                  |  |              |    |           |  |      |    |      |  |  |    |   |  |  |    |  
|Capitated                  |  |              | 57 | %         |  |      | 65 | %    |  |  | 77 | % |  |  | 87 | %
|Risk-based/fee-for-service |  |              | 43 | %         |  |      | 35 | %    |  |  | 23 | % |  |  | 13 | %
|Total:                     |  |              |    |           |  |      |    |      |  |  |    |   |  |  |    |  
|Capitated                  |  |              | 51 | %         |  |      | 59 | %    |  |  | 79 | % |  |  | 85 | %
|Risk-based/fee-for-service |  |              | 49 | %         |  |      | 41 | %    |  |  | 21 | % |  |  | 15 | %

In 2002, we expect this trend to continue, but at
a slower pace. We expect commercial hospital risk-based
contracts to cover approximately 56% of our membership and
commercial physician risk-based contracts to

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cover approximately 23% of our membership as of
December 31, 2002. We expect Medicare hospital risk-based
contracts to cover approximately 46% of our membership and
Medicare physician risk-based contracts to cover approximately
25% of our membership as of December 31, 2002.




| |             
| | ------------
| | 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 mix
and industry differences. Predictive models using pharmacy data
and health status are also used to identify health care costs
that are likely to emerge. Our underwriting practices are filed
and approved in states requiring those actions and in all states
in which we operate in the individual, small group and Medicare
supplement markets. Because our members are in multiple states,
our underwriting practices, especially in the individual, small
group and Medicare supplement markets, are subject to a variety
of legislative and regulatory requirements and restrictions
unique to the state in which a member resides.



| |                   
| | ------------------
| | Medical Management

Our profitability depends, in part, on our
ability to control health care costs while providing quality
care. To reduce the financial risk associated with risk-based
contracts, we remain focused on the ongoing enhancement of our
internal medical management programs. Our medical management
staff consists of doctors and nurses who monitor the medical
treatment of our members in need of hospital and specialist
care. In some cases, our medical managers are located on-site at
some of our key hospitals.

Our medical management programs are composed of:



|  |                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Precertification of Admission.In the precertification stage, our
	medical managers are responsible for determining whether
	requests for hospitalization and specified health care
	procedures meet specific clinical criteria and are approved in
	advance.                                                                                                                                                                                                  
| 
| | Concurrent Review.Our concurrent review process begins
	once our member has been admitted to the hospital for care with
	our medical managers responsible for providing administrative
	oversight of the hospital process. The medical manager is also
	responsible for monitoring the discharge process, and
	coordinating any outpatient services needed by the patient,
	including skilled nursing facility, home nursing care and
	rehabilitation therapy.
| 
| | Retrospective Review.Our retrospective review process
	occurs when our medical management staff is not directly
	involved in the hospitalization of our members. This process can
	occur when our members receive emergency care at an out-of-area
	hospital.                                                                                                                                                                                                 

Chronic Disease Management.A small percentage of our members with
chronic diseases continue to account for a significant majority
of our health care costs. Our emphasis on disease management
focuses on prevention, member education, and evidence-based care
to improve our members health and reduce costs. Our
analysis has shown that during 2000, 5% of our California Secure
Horizons members consumed more than 55% of our California
Medicare+Choice plans hospital expenses within the year,
and six chronic diseases accounted for 83% of these costs. As a
result, we have supplemented our in-house programs with
contracted third parties who provide complementary disease
management programs for coronary artery disease and stroke,
congestive heart failure, end stage renal disease, chronic
obstructive pulmonary disease and cancer. These voluntary
programs assist patients with intensive care management
services, and better coordination of care among health care
providers with the objectives of preventing disease exacerbation
and the need for hospitalization and managed utilization of
medical procedures. We actively identify members who would
benefit from these disease management programs and seek to
enroll them in these programs.

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Health Care Quality

We believe that providing our members access to
continually improving health care services leads to improved
health for our members. To achieve this desired result, we focus
on physician peer reviews, physician and hospital quality
reviews, member quality initiatives and national industry
measures.



| |                       
| | ----------------------
| | Physician Peer Reviews

We have established a comprehensive peer review
procedure at each HMO, governed by a quality improvement
committee. The medical director for each HMO chairs that
HMOs committee. Each committee consists of health plan
clinical professionals and physician representatives from the
contracted physician groups. All physicians are initially
credentialed and approved by that HMOs quality improvement
committee. The quality assessment includes evaluating the
education, training and performance of that physician, as well
as the quality of the providers medical facilities,
medical records, laboratory and x-ray licenses and their
capacity to handle membership demands.



| |                                        
| | ---------------------------------------
| | Physician and Hospital Quality
	Reviews

We also engage in ongoing quality reviews of our
existing physicians and hospitals to ensure that members are
receiving quality medical care. For example, a highlight of our
physician and hospital management program for our HMOs in
California, Oklahoma, Oregon, Texas and Washington is our
provider profile, which is a comprehensive, quarterly
risk-adjusted report card of over 80 measures, which helps
physicians manage their performance in the areas of clinical
quality, utilization management, service quality and
administrative efficiency. In addition, the provider profile
serves as the data source for the QUALITY INDEX profile. The
QUALITY INDEX is a public report in California, Oregon, and
Washington on our contracting medical groups performance
in the areas of clinical, service and administrative data
quality. This report provides consumers with information to help
them become more active participants in their health care,
beginning with their selection of health care providers. Our
member information materials highlight best performing physician
groups, so that members have credible and relevant information
by which to select physicians. We have been able to demonstrate
substantial movement of market share and financial rewards to
better performing providers, as well as significant improvement
in clinical and service quality scores, as a result of this
profile.



| |                           
| | --------------------------
| | Member Quality Initiatives

To improve the quality of service and health for
our members, we have developed a comprehensive quality
improvement program that includes:



|  |                                                                                                                                                                                                                                                                                                                                                                                                  
|- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Conducting preventive health programs, cancer
	screening, immunization programs, smoking cessation, and senior
	health risk assessments;                                                                                                                                                                                                                                                         
| 
| | Implementing comprehensive health management
	programs in diabetes, coronary artery disease, congestive heart
	failure and other chronic diseases;                                                                                                                                                                                                                                               
| 
| | Enhancing and expanding our national
	pre-certification of procedures, concurrent medical review and
	case management services for those with serious and complex
	medical conditions;                                                                                                                                                                                                           
| 
| | Offering independent external review programs to
	members in which members can have a service or treatment denial
	of coverage decision reviewed by a physician or panel of
	physicians outside their health plan;                                                                                                                                                                               
| 
| | Participating in the Coalition for Affordable
	Quality Health Cares voluntary quality initiative whereby
	we, along with 21 other organizations, have committed to
	enabling consumers to have access to quality coverage and
	information, improving administrative simplicity for doctors and
	consumers, and working with doctors to improve overall health
	care quality and patient safety;
| 
| | Participating with five other health plans in
	California to agree on common measures by which to reward better
	quality performing provider groups;                                                                                                                                                                                                                                             

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|  |                                                                                                                                                                                                                                          
|- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Developing provider contracts with tiered
	compensation, whereby providers are compensated at higher levels
	when certain quality measures are achieved;                                                                                 
| 
| | Monitoring member satisfaction through surveys
	and internal operational report cards compared to our current
	established benchmarks; and                                                                                               
| 
| | Providing members with free access to in-depth
	health information on thousands of topics and guided self-care
	tools, such as personalized diaries, medication logs, exercise
	and diet records and reminder calendars, via our website.



| |                           
| | --------------------------
| | National Industry Measures

The NCQA is an independent, non-profit
organization that reviews and accredits HMOs. The NCQA performs
site reviews to determine if an HMO complies with over
270 standards it has established for quality improvement,
effectiveness of care, member satisfaction, utilization
management, physician and hospital credentialing and a
commitment to members rights and preventive health
services. HMOs that comply with NCQAs review requirements
and quality standards receive NCQA accreditation. At
December 31, 2001, our commercial HMOs in Arizona,
California, Oklahoma, Oregon, and Washington have all earned
excellent accreditation status, while those in
Colorado, Nevada and Texas have received commendable
accreditation status. Our Medicare+Choice HMOs in California,
Oklahoma, Oregon and Washington have also all earned
excellent accreditation status, while those in
Arizona, Colorado, Nevada and Texas have received
commendable accreditation status. In California, we
are the only statewide health plan to earn the three-year
excellent accreditation status. Furthermore, our
HMOs provide quality and service information under NCQAs
Health Plan Employer Data Information Set, or HEDIS®,
Program. Throughout PacifiCare, HEDIS scores have improved on
average 14% in 31 of 33 measures over the past two years.
Our health plans have met or exceeded the national
90th percentile benchmarks in 21 measures. Our
California health plan had HEDIS scores that were statistically
greater than our competitors (including Blue Cross of
California, Kaiser Foundation Health Plan, Health Net Inc.,
Aetna U.S. Healthcare Inc. and CIGNA Health Corporation) average
score in 18 measures.

Marketing

We have developed strong brand recognition with
our PacifiCare and Secure Horizons customers. Our commercial
products are marketed under the PacifiCare brand, which we
believe has a reputation for quality and value. Our Medicare
products are marketed under the Secure Horizons brand, which we
believe is the premier brand 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 PBM
services under our Prescription Solutions brand. We are
increasing and intensifying marketing efforts to enhance and
reposition our PacifiCare and Secure Horizons brands to increase
our commercial market share in our existing markets. While we
believe our brands are perceived positively by our customers and
providers, we understand the importance of strengthening our
brands and marketing the evolving nature of our company. To that
end, we have decided to invest in brand building in 2002 and
beyond, and plan to invest approximately $20 million in
2002 in a branding and advertising campaign.

Marketing to our commercial customers is a
two-step process in which we first market to employer groups,
then provide information directly to employees, primarily during
their open enrollment periods, once the employer has selected
our plan. Open enrollment periods typically occur during the
fourth quarter of the calendar year. 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.
Insurance brokers and consultants represent many employer groups
under contract with us. These brokers and consultants work
directly with employers to recommend or design employee benefits
packages. We pay insurance brokers commissions over the life of
the contract, if designated by the employer, while employers
generally pay consultants directly. Our commercial membership
growth is a result of in-market acquisitions as well as greater
penetration in existing employer groups. With each open
enrollment, we identify a specific

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approach for each employer group with the
objective of increasing the number of members from each employer.


We market our Secure Horizons programs to
Medicare beneficiaries and caregivers for Medicare beneficiaries
primarily through direct mail, telemarketing, our website,
television, radio and community based events with participating
physician groups. Most Secure Horizons members enroll directly
in a plan, generally without the involvement of insurance
brokers, except when enrolling as part of an employer group
retiree offering.

Customer Service

Our customer service centers support all of our
commercial and Secure Horizons products. We provide customer
service to members and providers contracting with our health
plans. Each year we receive approximately 16 million calls.
Customer service representatives handle approximately
10 million calls and approximately six million calls are
processed by our Interactive Voice Response System. We also
provide customer service on our member and provider websites.

We have three regionally based customer service
centers in Phoenix, Arizona; Cypress, California and San
Antonio, Texas, that handle all health plan claims in the
continental United States, and a stand-alone customer service
and claims processing function in Guam. On January 1, 2002
we established a separate customer service center in Cypress,
California to support our PPO, indemnity and Medicare supplement
products.

Management Information Systems

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. Our
systems also support on-line customer service functions,
provider administration functions, and support our tracking and
extensive analyses of health care costs and outcome data.
Historically, our internal information services organization has
been a provider or prime supplier of IT services using our
employees and a mix of external resources.

We established corporate goals to have our IT
system operate under one business platform and improve
operational efficiency. To accomplish these goals, in 2001, we
launched an IT project to determine if outsourcing certain
functions would bring us strategic benefits. This project
resulted in the creation of a model that moved technical
expertise to an outsource arrangement while retaining and
building management expertise within our IT organization. With
this model, we will ultimately operate under one business
technology platform and leverage external state-of-the art
technology to accomplish our strategic goals.

The culmination of the outsourcing project is a
10-year strategic outsourcing arrangement with two suppliers:
International Business Machines Corporation, or IBM, and Keane,
Inc, or Keane. IBM is the coordinator of our IT outsourcing
arrangement, and will provide day-to-day management of our IT
infrastructure, including data center operations, help desk and
support services and information distribution, such as claims
forms and membership cards. Keane will provide software
applications maintenance and enhancement services. In connection
with the IT outsourcing, 650 employee positions were
transitioned to IBM and Keane. We expect these agreements to
result in savings of $380 to $400 million over the life of
the contracts.

Our internal IT team will interact with internal
customers to build strategy, translate business requirements
into technical solutions and perform project demand management
and prioritization. The IT team will also manage our outsourcing
suppliers for daily support of operations and systems
enhancements and maintenance. Our suppliers will interact
directly with internal customers in day-to-day support and
project activities.

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| |                          
| | -------------------------
| | Claims Processing Systems

We use 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 ensure timely and accurate payments, we
regularly review reports on inventory levels and claims
statistics that focus on claims turn-around and accuracy of
payment. We also perform a variety of claim audits and cost
containment programs.

Claims are processed through our customer service
centers or through our claims processing center in Letterkenney,
Ireland, which is electronically connected to each of our
customer service centers to process their claims. This
connectivity allows us to efficiently route claims to sites that
have excess capacity or can provide lower cost services. We will
continue to take advantage of lower cost operations in
production areas such as the Ireland claims center and will
continue to evaluate the most efficient and effective ways of
supporting our health plans.

Government Regulation

We are subject to extensive federal and state
regulations that govern the scope of benefits provided to our
members, including regulations relating to:



|  |                                                      
|- | -----------------------------------------------------
| | Financial solvency requirements;                     
| 
| | Mandated benefits;                                   
| 
| | Claims processing;                                   
| 
| | Quality assurance and utilization review
	procedures;
| 
| | Member grievance procedures;                         
| 
| | Physician and hospital contracts; and                
| 
| | Marketing and advertising.                           

Our HMOs are also required to maintain restricted
cash reserves represented by interest-bearing investments that
are held by trustees or state regulatory agencies. These
requirements, which limit the ability of our subsidiaries to
transfer funds, may also limit their ability to pay dividends to
us. From time to time, we advance funds to our subsidiaries to
assist them in satisfying financial requirements. Our behavioral
health, group life and health insurance and dental subsidiaries
are also subject to extensive state regulation.



| |                
| | ---------------
| | Medicare+Choice

Background.Our
Medicare+Choice program is subject to regulation by CMS, the
Department of Health and Human Services, or DHHS, and state
regulatory entities. These agencies govern the benefits
provided, premiums paid, quality assurance procedures, marketing
and advertising for our Medicare+Choice products. CMS has
promulgated regulations, operational policy letters and
contracts implementing Medicare+Choice, including the Balanced
Budget Act of 1997, Balanced Budget Refinement Act of 1999 and
the Benefits Improvement and Protection Act of 2000, or BIPA.
These contracts and regulations established new and expanded
requirements for Medicare+Choice organizations. They also
establish new or expanded standards for quality assurance,
beneficiary protection, coordinated open enrollment, program
payment and audits, information disclosure and physician and
hospital participation. Compliance with Medicare+Choice
regulations has and will continue to increase our Medicare
administration costs. BIPA was passed by Congress in December
2000, effective for 2001. Under the new law, Medicare+Choice
will receive increased government funding over the next five
years beginning in March 2001. The changes for 2001 included
increases to the monthly minimum payment floors, increases in
the minimum annual payment from 2% to 3% and modifications to
the risk adjuster.

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It is possible that future legislation may create
additional changes in the payment formula or risk adjuster.
However, it is not certain that efforts to revise the laws
governing the Medicare+Choice program will succeed in increasing
the level of reimbursement to Medicare+Choice plan products.

Adjusted Community Rate Filings.As a result of the Balanced Budget Act
of 1997 and related CMS rules and regulations, our HMO
subsidiaries are required to submit separate adjusted community
rate proposals for every Medicare+Choice product that they offer
to Medicare beneficiaries. These rates are based upon our
average commercial rate for non-Medicare enrollees modified by a
factor that represents the difference in utilization
characteristics between Medicare and non-Medicare enrollees
within each geographic area. In effect, our benefits structure
for our Secure Horizons Medicare+Choice HMO program is
established based on these rates.

In the normal course of business, all information
submitted as part of the adjusted community rate process is
subject to audit by CMS or any person or organization designated
by CMS. Our adjusted community rate proposal is based on
historical data and information available to us at the time of
the filing. During 2001, audits for our 2001 adjusted community
rate proposals for Arizona, Oklahoma, Oregon and Washington were
conducted. No material findings were noted as a result of the
audits. Our adjusted community rate proposals for the contract
year 2002 have been filed and approved.



| |                                
| | -------------------------------
| | Office of Personnel
	Management

We have commercial contracts with the United
States Office of Personnel Management, or OPM, to provide
managed health care services to federal employees, annuitants
and their dependents under the Federal Employee Health Benefit
Program, or FEHBP. As of December 31, 2001, we provided
managed health care services to approximately 174,000 members
under these contracts. Rather than negotiating rates with us,
OPM requires us to provide the FEHBP with rates comparable to
the rates charged to the two employer groups with enrollment
closest in size to the FEHBP in the applicable community after
making required adjustments. OPM further requires us to certify
each year that its rates meet these requirements. Periodically,
the Office of Inspector General, or OIG, audits us to verify
that the premiums charged are calculated and charged in
compliance with these regulations and guidelines. OPM has the
right to audit the premiums charged during any period for up to
six years following that period. The final resolution and
settlement of audits have historically taken more than three
years and as many as seven years.

During the audit process, OPM has referred and
may continue to refer its findings to the United States
Department of Justice, or DOJ, if it believes that we knowingly
overcharged the government or otherwise submitted false
documentation or certifications in violation of the False Claims
Act. Under the False Claims Act, an action can be considered
knowingly committed if the government contractor acted with
actual knowledge, or with reckless disregard or deliberate
ignorance of the governments rules and regulations. If the
government were to win a False Claims Act lawsuit against us,
the government could obtain the amounts overcharged and a
trebling of these damages, plus interest and substantial civil
penalties, and the government could also permanently disqualify
us from participating in all federal government programs. We
have a number of pending audits that we are seeking to resolve
with the DOJ. For a description of these pending audits, see
Item 3. Legal Proceedings  OPM
Litigation.

In late 1997, we established 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. Based on the results of 15 audited
contract years that have been conducted since the compliance
program was implemented, we believe that this program has been
effective.

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| |                                                             
| | ------------------------------------------------------------
| | Health Insurance Portability and
	Accountability Act of 1996

As a result of Health Insurance Portability and
Accountability Act of 1996, or HIPAA, federal standards apply to
both the group and individual health insurance markets. The
portability provisions in HIPAA require us to:



|  |                                                                                                                    
|- | -------------------------------------------------------------------------------------------------------------------
| | Guarantee the availability and renewability of
	health insurance for certain employers, employees and
	individuals;
| 
| | Disclose prior coverage; and                                                                                       
| 
| | Make it easier for members to continue coverage
	in cases where an employee is terminated or changes employers.    

HIPAA also prohibits us from discriminating
against potential enrollees on the basis of health status.

HIPAA includes administrative simplification
provisions directed at standardizing transactions and codes,
establishing uniform health care provider, payer, employer and
patient identifiers and seeking protections for confidentiality
and security of patient data. We expect to modify our
information systems and business processes to comply with HIPAA
regulations.

In addition, we continue to work with various
industry groups to find a common way to work with external
business associates, such as physicians, hospitals and vendors,
to ensure their compliance with the HIPAA rules. Our 2001 HIPAA
compliance costs were approximately $10 million and we
estimate that our HIPAA compliance costs will approximate
$27 million in 2002 as well as $3 million in capital
expenditures.



| |                                                 
| | ------------------------------------------------
| | Employee Retirement Income Security Act of
	1974

Pursuant to the Employee Retirement Income
Security Act of 1974, or ERISA, the federal government regulates
insured and self-insured health coverage plans offered by
employers. There have been recent highly publicized legislative
attempts to amend ERISA to remove the current limitation on the
ability of states to regulate employer health plans and the
limitations on an employees ability to sue a health plan
under state law. If such proposals were enacted, states may have
the ability to regulate other aspects of our business
operations, and increase our exposure to state law claims that
relate to employee health benefits.



| |                           
| | --------------------------
| | 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 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. 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.

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.

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Risk Management

We shift part of our risk of catastrophic losses
by maintaining reinsurance coverage for specified hospital costs
incurred in the treatment of catastrophic illnesses. We require
contracting physicians, physician groups and hospitals to
maintain individual malpractice insurance coverage. We also
maintain general liability, property, managed care errors and
omissions and medical malpractice insurance coverage. Coverages
typically include varying and increasing levels of self-insured
retention or deductibles that increase our risk of loss. In
2001, we capitalized and began operating a wholly owned captive
reinsurance company designed to assist us in managing this risk
of loss.

Competition

In general, the health care industry has
experienced significant consolidation. Acute care hospitals have
consolidated and excess bed capacity has been reduced,
increasing their leverage in the marketplace. Continued
consolidation of insurance carriers, other HMOs, employer
self-funded programs and PPOs, some of which have substantially
larger enrollments or greater financial resources than ours, has
created competition for physicians, hospitals 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. The
cost of pharmaceuticals, a significant component of benefits,
continues to increase, and the development of high cost
therapeutic agents that are expected as part of commercial
formularies and the desire by employers for more choice in
formulary design impacts the ability of Prescription Solutions,
our PBM, to manage costs. We anticipate that premium pricing
will continue to be highly competitive.

In offering health insurance coverage, we compete
with CIGNA Health Corporation, Aetna U.S. Healthcare Inc.,
WellPoint Health Networks, Inc. and UnitedHealth Group for
membership from national employers. We also compete with
regional HMOs and small group employers, which vary depending on
the geographic market. Regional competitors include Kaiser
Foundation Health Plan, Health Net Inc., WellPoint Health
Networks Inc., Humana Inc., and state Blue Cross and Blue Shield
organizations. 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. Beginning in January 2002, we are offering an
enhanced PPO as either a stand-alone product or in conjunction
with our HMO products that will compete against health plans
offered by health insurers with more experience in the PPO
business. Our enhanced PPO product includes a number of features
that we believe distinguishes it from competitive products.
These features include expanded provider choices, discounted
alternative care and other non-traditional benefit options, such
as chiropractic care and employee assistance programs, as well
as access to our specialty products and services.

We have the largest Medicare+Choice membership in
the nation, both in absolute terms and as a percentage of
overall membership, offering competitive advantages and
economies of scale in the Medicare+Choice market. For 2002, we
have 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+Choice, in response to our rising health care costs of
treating the senior population and the current levels of
Medicare reimbursement from the government. These changes have
caused members to leave our plans for competing plans or
traditional Medicare. Many competing Medicare+Choice plans have
also reduced their participation in the Medicare+Choice program
and reduced benefits coverage. In the markets where we have
remained and structured our benefits to offset rising costs,
exits and benefit reductions made by competitors may result in
increased membership in our program.

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. Competitors include Merck-Medco Managed Care, WellPoint
Pharmacy Management, Med Impact, Caremark Rx, Express Scripts
and Advance PCS. We believe, when aligned with a managed
care organization, Prescription Solutions

17



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##### Table of Contents



differentiates itself from other pharmacy benefit
organizations by managing prescription costs and outcomes for
managed care organization members. Our mail-order prescription
drug service competes with national, regional and local
pharmacies and other mail-order prescription drug companies.
Prescription Solutions also competes with firms offering
prescription discount cards, such as Costco and large drug store
chains.


Trademarks

We own federally registered trademarks and other
trademarks, which include PacifiCare®,
SecureHorizons®, Prescription Solutions® and Quality
Index® (for which there is a patent pending).

Employees

At February 28, 2002, we had approximately
8,200 full and part-time employees. None of our employees is
presently covered by a collective bargaining agreement. However,
pharmacists at our Prescription Solutions mail service center
voted to join the Paper, Allied-Industrial, Chemical and Energy
Workers International Union. A collective bargaining agreement
is currently in negotiations. We consider relations with our
employees to be good and have never experienced any work
stoppage.




ITEM
2.     PROPERTIES

As of December 31, 2001, we leased
approximately 114,000 aggregate square feet of space for our
principal corporate headquarters and executive offices in Costa
Mesa and Santa Ana, California. In connection with our
operations, as of December 31, 2001, we leased
approximately 2.0 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 2002 through 2011.

We own six buildings encompassing approximately
328,000 aggregate square feet of space. Two of the buildings,
representing approximately 225,000 aggregate square feet of
space, are primarily used for administrative operations and are
located in California and Guam. The remaining four buildings are
medical office buildings, all of which are leased to third
parties under a master lease agreement. All four medical
buildings are being marketed for sale. We also own one parcel of
vacant land for a total of two acres, which is being marketed
for sale.

In connection with consolidating and reorganizing
our company operations, we plan to consolidate or close certain
locations currently used for subsidiary operations, customer
service, computer processing and administrative offices. Costs
for consolidating and/or closing such office space have been
identified and are included in the fourth quarter 2001
restructuring charge. See Note 9 of the Notes to Consolidated
Financial Statements.

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

OPM Litigation

We have contracts that were audited by the OIG
that we acquired through our merger with FHP International
Corporation, or FHP, in 1997. The OIG and others allege that the
former FHP Arizona, California, Colorado, Guam and Ohio HMO
subsidiaries, as well as former FHP Illinois, New Mexico and
Utah HMO subsidiaries that we sold in 1997 and 1998,
substantially overcharged the government from 1990 through 1997.
Several of these contract years have already been audited, but
are yet to be settled. We responded to the audit reports,
challenging many of the auditors assertions. The
allegations were referred to the DOJ for review of potential
claims under the False Claims Act.

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The OIG conducted an audit of our Oregon HMO
subsidiary. The OIG issued a draft audit report in July 1997,
alleging that we substantially overcharged the government for
contract years 1991 through 1996. We responded to this draft
audit report in April 1998, disagreeing with OIGs claims.
In March 2000, we were notified that the auditors had referred
the above-mentioned audit report to the DOJ for review of
potential claims under the False Claims Act. We entered into a
tolling agreement with the U.S. Attorney extending the time
in which the U.S. Attorney has to file a civil complaint
until July 3, 2002.

The OIG conducted an audit of our California HMO
subsidiary. The OIG issued a draft audit report in January 1998,
alleging that we substantially overcharged the government for
contract years 1993 through 1996. We responded to this draft
audit report in May 1998, disagreeing with OIGs claims. In
January 2001, we were notified that the auditors had referred
the above-mentioned audit report to the DOJ for review of
potential claims under the False Claims Act. We entered into a
tolling agreement with the U.S. Attorney extending the time
in which the U.S. Attorney has to file a civil complaint
until May 31, 2002.

As indicated above, OPM has referred and may
continue to refer its findings to the DOJ if OPM believes that
we may have knowingly overcharged the government or otherwise
submitted false documentation or certifications in violation of
the False Claims Act. Under the False Claims Act, an action can
be considered knowingly committed if the government contractor
acted with actual knowledge, or with reckless disregard or
deliberate ignorance of the governments rules and
regulations. If the government were to win a False Claims Act
lawsuit against us with regard to any of the above matters, the
government could obtain amounts overcharged and a trebling of
these damages, plus interest and substantial civil penalties.
The DOJ has indicated an intention to seek additional recoveries
under the False Claims Act in relation to the above matters. The
government could also permanently disqualify us from
participating in all federal government programs.

We intend to continue to negotiate with OPM and
the DOJ on any existing or future unresolved matters to attain a
mutually satisfactory result. We cannot be certain that any
ongoing future negotiations will be concluded satisfactorily,
that additional audits will not be referred to the DOJ or that
additional, possibly material, liabilities will not be incurred.
Based on information currently available, we believe that any
liability in excess of amounts accrued would not materially
affect our consolidated financial position. However, such
liability could have a material effect on our results of
operations or cash flows of a future period if any of these
matters are resolved unfavorably.

Class Action Legal Proceedings

On November 21, 2000, Michael Russ filed a
purported class action complaint against us and several of our
present and former directors and executive officers in the
Central District of California. This complaint was consolidated
with other subsequent complaints into a single proceeding. The
complaints relate to the period between October 27, 1999
and October 10, 2000 and primarily allege that we made
false projections about our financial performance in 2000. The
complaints seek an unspecified amount of damages plus
attorneys fees. A consolidated class action complaint was
filed on April 23, 2001, and on June 22, 2001 we filed
a motion to dismiss the consolidated complaint. On
October 19, 2001, the Court granted our motion and
dismissed the complaint, but gave the plaintiffs permission to
file an amended complaint. A second consolidated amended class
action complaint was filed on December 3, 2001, and on
January 17, 2002 we filed a motion to dismiss the second
consolidated complaint. We deny all material allegations and
intend to defend the actions vigorously.

On November 2, 1999, Jose Cruz filed a
purported class action complaint against us, our California
subsidiary, and FHP in the San Francisco Superior Court. On
November 9, 1999, Cruz filed a first amended purported
class action complaint that omitted FHP as a defendant. The
amended complaint relates to the period from November 2,
1995 to the present and purports to be filed on behalf of all
enrollees in our health care plans operating in California other
than Medicare and Medicaid enrollees. The amended complaint
alleges that we have engaged in unfair business acts in
violation of California law, engaged in false, deceptive and
misleading advertising in violation of California law and
violated the

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California Consumer Legal Remedies Act. It also
alleges that we have received unjust payments as a result of our
conduct. The amended complaint seeks injunctive and declaratory
relief, an order requiring the defendants to inform and warn all
California consumers regarding our financial compensation
programs, unspecified monetary damages for restitution of
premiums and disgorgement of improper profits, attorneys
fees and interest. We moved to compel arbitration and the
Superior Court denied our motion. We filed an appeal from this
denial, and the Court of Appeal affirmed the Superior
Courts decision. Thereafter, we filed a petition asking
the California Supreme Court to review the Court of
Appeals decision, and the California Supreme Court granted
the petition. No date for oral argument before the California
Supreme Court has been set. We deny all material allegations in
the amended complaint and intend to defend the action vigorously.


On November 22, 1999, Debbie Hitsman filed a
purported class action complaint against us in the United States
District Court for the Southern District of Mississippi,
Hattiesburg Division. The complaint relates to the period from
November 22, 1995 to the present and purports to be on
behalf of all enrollees in our health care plans other than
Medicare and Medicaid enrollees. The complaint alleges causes of
action for violations of the Racketeer Influenced and Corrupt
Organizations Act, or RICO, and ERISA. The complaint seeks an
unspecified amount of compensatory and treble damages,
injunctive and restitutionary relief, attorneys fees, the
imposition of a constructive trust and interest. On
June 23, 2000, Hitsman filed and served an additional
complaint as a purported part of a multi-district litigation
proceeding known as In re Managed Care Litigation
coordinated for pretrial proceedings in the United States
District Court for the Southern District of Miami. In December
2000, the District Court granted our motion to compel
arbitration of all of the Hitsman claims against us. On
July 24, 2001, the District Court entered an order
dismissing the Hitsman case against us with prejudice.

Subsequently, Dr. Dennis Breen,
Dr. Leonard Klay, Dr. Jeffrey Book and a number of
other health care providers, along with several medical
associations, including the California Medical Association,
joined the In re Managed Care proceeding. These health care
providers sued a number of managed care companies, including us,
alleging that the companies claims processing systems
automatically and impermissibly alter codes included on
providers reimbursement/ claims forms to reduce the amount
of reimbursement, and that the companies impose unfair
contracting terms on providers, impermissibly delay making
capitated payments under their capitated contracts, and
negotiate capitation payments that are inadequate to cover the
costs of health care services provided.

The District Court granted our motion to compel
arbitration of all of Dr. Breens claims against us,
except for his claims for violations of the RICO Act, and for
his conspiracy and aiding and abetting claims that stem from
contractual relationships with other managed care companies. We
filed an appeal from the District Courts partial denial of
our Breen motion to compel arbitration. In April 2001, the
District Court granted our motion to compel arbitration of all
of Dr. Books claims except for his RICO claims and
his conspiracy and aiding and abetting claims, but it denied our
motion to compel arbitration by several other doctors because
the District Court concluded that they were only pursuing
conspiracy and aiding and abetting claims against us. We filed
an appeal from the District Courts partial denial of these
motions to compel arbitration. The Court of Appeals consolidated
our appeals and heard oral argument on those appeals in January
2002.

In March 2001, the District Court granted our
motion to dismiss the Breen lawsuit, but gave the plaintiff
permission to file an amended complaint. Such a complaint was
filed at the end of March 2001, and we have filed a motion to
dismiss this new complaint. A few months after our motion to
dismiss was filed, the Court of Appeals stayed the Breen lawsuit
pending its resolution of our consolidated appeals. We deny all
material allegations and intend to defend the actions vigorously.

In December 1997, William Madruga and others
filed a purported class action suit against us and several of
our directors and officers in the United States District Court
for the Central District of California. The complaint alleges
claims on behalf of purchasers of our common stock from
February 14, 1997 through our November 24, 1997
announcement that earnings for the fourth quarter of 1997 would
be lower than expected. The complaint primarily alleged that we
previously omitted and/or misrepresented material facts

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with respect to our acquisition of FHP and our
financial position. On October 9, 2001, the trial court
dismissed the Madruga case with prejudice and without leave to
amend. Thereafter, the plaintiffs filed a notice of appeal with
the Ninth Circuit Court of Appeals. The plaintiffs subsequently
requested dismissal of this case which the Ninth Circuit Court
of Appeals entered on March 12, 2002, thereby terminating
this case.


State of Texas Litigation

On February 11, 2002, the Attorney General
of Texas, on behalf of the State of Texas, filed a civil
complaint against our Texas subsidiary in the Texas District
Court of Travis County. The complaint alleges violations of the
Texas Health Maintenance Organization Act, Texas Insurance Code
and regulations under the Code and the Texas Deceptive Trade
Practices Consumer Protection Act. The complaint relates to the
financial insolvency of three physician groups under capitation
contracts with PacifiCare of Texas. Under these contracts,
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 each of these
physician groups failed to pay all of the health care providers
who provided health care services covered by the capitation
payments. The complaint primarily alleges that despite its
capitation payments to the physician groups, PacifiCare of Texas
is still financially responsible for the failure of the
delegated providers to pay health care providers. The Attorney
General is seeking an injunction requiring us to comply with
state laws plus unspecified damages, civil penalties and
restitution. We do not believe that our Texas plan is liable
under Texas law to pay unpaid health claims that were the
responsibility of the capitated provider and for which we have
already paid capitation. We deny all material allegations in the
complaint and we intend to defend this action vigorously.

Other Litigation

We are involved in legal actions in the normal
course of business, including claims from our members arising
out of decisions to deny or restrict reimbursement for services
and claims that seek monetary damages, including claims for
punitive damages that are not covered by insurance. As we
increase our medical management capabilities and take a more
active oversight role in the treatment process, more claims
relating to the denial or restriction of services may arise. In
addition, we may be subject to more claims of this nature from
our Medicare+Choice members that will be litigated in state
court, rather than under the Medicare Acts administrative
review process, based on a recent California Supreme Court
decision that the United States Supreme Court declined to
review. Based on current information and review, including
consultation with our lawyers, we believe any ultimate liability
that may arise from these actions, including all OPM litigation,
class action legal proceedings and industry 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.




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, 2001.

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PART II






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

Our common stock is listed on the Nasdaq National
Market under the symbol PHSY. The following table indicates the
high and low reported sale prices per share as furnished by
Nasdaq.

|                             |  |      |        |     |  |   |        | 
|---------------------------- |  | ---- | ------ | --- |  | - | ------ | 
|                             |  | High |        | Low
|                             |  |      |        |    
|Year ended December 31, 2001 |  |      |        |     |  |   |        | 
|First Quarter                |  | $    | 40.500 |     |  | $ | 14.313 | 
|Second Quarter               |  | $    | 38.450 |     |  | $ | 15.500 | 
|Third Quarter                |  | $    | 21.700 |     |  | $ | 10.540 | 
|Fourth Quarter               |  | $    | 23.420 |     |  | $ | 12.000 | 
|Year ended December 31, 2000 |  |      |        |     |  |   |        | 
|First Quarter                |  | $    | 53.750 |     |  | $ | 40.500 | 
|Second Quarter               |  | $    | 72.313 |     |  | $ | 43.625 | 
|Third Quarter                |  | $    | 72.313 |     |  | $ | 34.625 | 
|Fourth Quarter               |  | $    | 38.250 |     |  | $ | 9.813  | 

We have never paid cash dividends on our common
stock. We do not expect to declare 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 common stock dividends in the future, such dividends
may only be made in shares of our common stock, according to the
terms of our credit facility. See Note 6 of the Notes to
Consolidated Financial Statements.

As of February 28, 2002 there were 300
stockholders of record of our common stock.

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ITEM 6.     SELECTED
FINANCIAL DATA

The following selected financial and operating
data are derived from our audited consolidated financial
statements, or from our unaudited internal financial data. 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 8. Consolidated
Financial Statements and Supplementary Data.

Income Statement Data

|                                                                                                                     |                                                                     |                                               |            |            |   |         |            |           |   |         |            |           |   |   |           |           |   |   |           |           |  
|-------------------------------------------------------------------------------------------------------------------- | ------------------------------------------------------------------- | --------------------------------------------- | ---------- | ---------- | - | ------- | ---------- | --------- | - | ------- | ---------- | --------- | - | - | --------- | --------- | - | - | --------- | --------- | -
|                                                                                                                     |                                                                     |                                              
|                                                                                                                     |                                                                     | Year Ended December 31,                      
|                                                                                                                     |                                                                     |                                              
|                                                                                                                     |                                                                     | 2001(1)                                       |            | 2000(2)    |   | 1999(3) |            | 1998(4)   |   | 1997(5)
|                                                                                                                     |                                                                     |                                               |            |            |   |         |            |           |   |        
|                                                                                                                     |                                                                     |                                              
|                                                                                                                     |                                                                     | (Amounts in thousands, except per-share data)
|Operating revenue                                                                                                    |                                                                     | $                                             | 11,843,972 |            |   | $       | 11,576,298 |           |   | $       | 10,073,140 |           |   | $ | 9,625,788 |           |   | $ | 9,063,345 |          
|                                                                                                                     |                                                                     |                                               |            |            |   |         |            |           |   |         |            |           |   |   |           |           |   |   |           |          
|Expenses:                                                                                                            |                                                                     |                                               |            |            |   |         |            |           |   |         |            |           |   |   |           |           |   |   |           |          
|                                                                                                                     | Health care services                                                |                                               |            | 10,367,657 |   |         |            | 9,913,657 |   |         |            | 8,368,690 |   |   |           | 8,002,260 |   |   |           | 7,658,879 |  
|                                                                                                                     | Other operating expenses                                            |                                               |            | 1,288,374  |   |         |            | 1,286,790 |   |         |            | 1,181,773 |   |   |           | 1,166,011 |   |   |           | 1,125,299 |  
|                                                                                                                     | Impairment, disposition, restructuring and other
	charges (credits) |                                               |            | 61,157     |   |         |            | 11,730    |   |         |            | (2,233    | ) |   |           | 15,644    |   |   |           | 154,507   |  
|                                                                                                                     | Office of Personnel Management credits                              |                                               |            |           |   |         |            | (2,964    | ) |         |            |          |   |   |           | (4,624    | ) |   |           |          |  
|                                                                                                                     |                                                                     |                                               |            |            |   |         |            |           |   |         |            |           |   |   |           |           |   |   |           |          
|Operating income                                                                                                     |                                                                     |                                               | 126,784    |            |   |         | 367,085    |           |   |         | 524,910    |           |   |   | 446,497   |           |   |   | 124,660   |          
|Interest expense                                                                                                     |                                                                     |                                               | (70,282    | )          |   |         | (79,636    | )         |   |         | (43,001    | )         |   |   | (60,923   | )         |   |   | (64,536   | )        
|Minority interest in consolidated subsidiary                                                                         |                                                                     |                                               |           |            |   |         | 637        |           |   |         |           |           |   |   |          |           |   |   |          |          
|                                                                                                                     |                                                                     |                                               |            |            |   |         |            |           |   |         |            |           |   |   |           |           |   |   |           |          
|Income before income taxes                                                                                           |                                                                     |                                               | 56,502     |            |   |         | 288,086    |           |   |         | 481,909    |           |   |   | 385,574   |           |   |   | 60,124    |          
|Provision for income taxes                                                                                           |                                                                     |                                               | 38,371     |            |   |         | 127,046    |           |   |         | 203,365    |           |   |   | 183,147   |           |   |   | 81,825    |          
|                                                                                                                     |                                                                     |                                               |            |            |   |         |            |           |   |         |            |           |   |   |           |           |   |   |           |          
|Income (loss) before extraordinary gain                                                                              |                                                                     |                                               | 18,131     |            |   |         | 161,040    |           |   |         | 278,544    |           |   |   | 202,427   |           |   |   | (21,701   | )        
|Extraordinary gain on early retirement of debt
	(less income taxes of $0.9 million)                                  |                                                                     |                                               | 875        |            |   |         |           |           |   |         |           |           |   |   |          |           |   |   |          |          
|                                                                                                                     |                                                                     |                                               |            |            |   |         |            |           |   |         |            |           |   |   |           |           |   |   |           |          
|Net income (loss)                                                                                                    |                                                                     | $                                             | 19,006     |            |   | $       | 161,040    |           |   | $       | 278,544    |           |   | $ | 202,427   |           |   | $ | (21,701   | )        
|                                                                                                                     |                                                                     |                                               |            |            |   |         |            |           |   |         |            |           |   |   |           |           |   |   |           |          
|Preferred dividends                                                                                                  |                                                                     |                                               |           |            |   |         |           |           |   |         |           |           |   |   | (5,259    | )         |   |   | (8,792    | )        
|                                                                                                                     |                                                                     |                                               |            |            |   |         |            |           |   |         |            |           |   |   |           |           |   |   |           |          
|Net income (loss) available to common
	stockholders                                                                  |                                                                     | $                                             | 19,006     |            |   | $       | 161,040    |           |   | $       | 278,544    |           |   | $ | 197,168   |           |   | $ | (30,493   | )        
|                                                                                                                     |                                                                     |                                               |            |            |   |         |            |           |   |         |            |           |   |   |           |           |   |   |           |          
|Basic earnings (loss) per share(6):                                                                                  |                                                                     |                                               |            |            |   |         |            |           |   |         |            |           |   |   |           |           |   |   |           |          
|                                                                                                                     | Income before extraordinary gain                                    |                                               | $          | 0.54       |   |         | $          | 4.59      |   |         | $          | 6.26      |   |   | $         | 4.50      |   |   | $         | (0.75     | )
|                                                                                                                     | Extraordinary gain, net                                             |                                               |            | 0.02       |   |         |            |          |   |         |            |          |   |   |           |          |   |   |           |          |  
|                                                                                                                     |                                                                     |                                               |            |            |   |         |            |           |   |         |            |           |   |   |           |           |   |   |           |          
|                                                                                                                     | Basic earnings (loss) per share(6)                                  |                                               | $          | 0.56       |   |         | $          | 4.59      |   |         | $          | 6.26      |   |   | $         | 4.50      |   |   | $         | (0.75     | )
|                                                                                                                     |                                                                     |                                               |            |            |   |         |            |           |   |         |            |           |   |   |           |           |   |   |           |          
|Diluted earnings (loss) per share(6):                                                                                |                                                                     |                                               |            |            |   |         |            |           |   |         |            |           |   |   |           |           |   |   |           |          
|                                                                                                                     | Income before extraordinary gain                                    |                                               | $          | 0.53       |   |         | $          | 4.58      |   |         | $          | 6.23      |   |   | $         | 4.40      |   |   | $         | (0.75     | )
|                                                                                                                     | Extraordinary gain, net                                             |                                               |            | 0.02       |   |         |            |          |   |         |            |          |   |   |           |          |   |   |           |          |  
|                                                                                                                     |                                                                     |                                               |            |            |   |         |            |           |   |         |            |           |   |   |           |           |   |   |           |          
|                                                                                                                     | Diluted earnings (loss) per share(6)                                |                                               | $          | 0.55       |   |         | $          | 4.58      |   |         | $          | 6.23      |   |   | $         | 4.40      |   |   | $         | (0.75     | )
|                                                                                                                     |                                                                     |                                               |            |            |   |         |            |           |   |         |            |           |   |   |           |           |   |   |           |          
|Operating Statistics                                                                                                 |                                                                     |                                               |            |            |   |         |            |           |   |         |            |           |   |   |           |           |   |   |           |          
|Medical loss ratio (health care services as a
	percentage of premium revenue)                                        |                                                                     |                                               |            |            |   |         |            |           |   |         |            |           |   |   |           |           |   |   |           |          
|                                                                                                                     | Consolidated                                                        |                                               |            | 89.7       | % |         |            | 87.5      | % |         |            | 84.8      | % |   |           | 85.0      | % |   |           | 85.7      | %
|                                                                                                                     | Commercial                                                          |                                               |            | 88.8       | % |         |            | 85.1      | % |         |            | 81.7      | % |   |           | 82.8      | % |   |           | 85.8      | %
|                                                                                                                     | Medicare                                                            |                                               |            | 90.3       | % |         |            | 89.4      | % |         |            | 86.9      | % |   |           | 86.5      | % |   |           | 85.6      | %
|Selling, general and administrative expenses as a
	percentage of operating revenue (excluding net investment income) |                                                                     |                                               | 10.3       | %          |   |         | 10.5       | %         |   |         | 11.1       | %         |   |   | 11.4      | %         |   |   | 11.7      | %        
|Operating income as a percentage of operating
	revenue                                                               |                                                                     |                                               | 1.1        | %          |   |         | 3.2        | %         |   |         | 5.2        | %         |   |   | 4.6       | %         |   |   | 1.4       | %        
|Effective tax rate(7)                                                                                                |                                                                     |                                               | 67.9       | %          |   |         | 44.1       | %         |   |         | 42.2       | %         |   |   | 47.5      | %         |   |   | 136.1     | %        

See footnotes following Balance Sheet
Data.

Continued on next page


23



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##### Table of Contents



Other Financial and Operating Data

|                                                           |  |                        |           |      |  |      |           |      |  |      |           |   |  |   |           |   |  |   |            |  
|---------------------------------------------------------- |  | ---------------------- | --------- | ---- |  | ---- | --------- | ---- |  | ---- | --------- | - |  | - | --------- | - |  | - | ---------- | -
|                                                           |  |                       
|                                                           |  | December 31,          
|                                                           |  |                       
|                                                           |  | 2001                   |           | 2000 |  | 1999 |           | 1998 |  | 1997
|                                                           |  |                        |           |      |  |      |           |      |  |     
|                                                           |  |                       
|                                                           |  | (Dollars in thousands)
|Consolidated EBITDA(8)                                     |  | $                      | 336,645   |      |  | $    | 507,051   |      |  | $    | 640,774   |   |  | $ | 578,546   |   |  | $ | 396,044    |  
|Depreciation and amortization                              |  | $                      | 148,704   |      |  | $    | 130,563   |      |  | $    | 118,097   |   |  | $ | 121,029   |   |  | $ | 116,877    |  
|Capital expenditures                                       |  | $                      | 77,301    |      |  | $    | 105,256   |      |  | $    | 66,211    |   |  | $ | 41,631    |   |  | $ | 68,533     |  
|Net cash flows provided by operating activities            |  | $                      | 38,923    |      |  | $    | 631,236   |      |  | $    | 569,698   |   |  | $ | 455,587   |   |  | $ | 413,489    |  
|Net cash flows (used in) provided by investing
	activities |  | $                      | (260,828  | )    |  | $    | 72,376    |      |  | $    | (250,859  | ) |  | $ | (18,911   | ) |  | $ | (1,013,041 | )
|Net cash flows (used in) provided by financing
	activities |  | $                      | (51,971   | )    |  | $    | (301,041  | )    |  | $    | (194,411  | ) |  | $ | (392,714  | ) |  | $ | 912,478    |  
|HMO Membership Data                                        |  |                        |           |      |  |      |           |      |  |      |           |   |  |   |           |   |  |   |            |  
|Commercial                                                 |  |                        | 2,439,600 |      |  |      | 2,953,300 |      |  |      | 2,643,400 |   |  |   | 2,554,100 |   |  |   | 2,790,000  |  
|Medicare                                                   |  |                        | 948,500   |      |  |      | 1,056,700 |      |  |      | 1,014,600 |   |  |   | 972,800   |   |  |   | 1,001,100  |  
|                                                           |  |                        |           |      |  |      |           |      |  |      |           |   |  |   |           |   |  |   |            |  
|Total HMO membership                                       |  |                        | 3,388,100 |      |  |      | 4,010,000 |      |  |      | 3,658,000 |   |  |   | 3,526,900 |   |  |   | 3,791,100  |  
|                                                           |  |                        |           |      |  |      |           |      |  |      |           |   |  |   |           |   |  |   |            |  
|Balance Sheet Data                                         |  |                        |           |      |  |      |           |      |  |      |           |   |  |   |           |   |  |   |            |  
|Cash and equivalents                                       |  | $                      | 977,759   |      |  | $    | 1,251,635 |      |  | $    | 849,064   |   |  | $ | 724,636   |   |  | $ | 680,674    |  
|Marketable securities                                      |  |                        | 1,062,353 |      |  |      | 864,013   |      |  |      | 999,194   |   |  |   | 875,553   |   |  |   | 864,708    |  
|Total assets                                               |  |                        | 5,096,046 |      |  |      | 5,323,436 |      |  |      | 4,884,021 |   |  |   | 4,630,944 |   |  |   | 4,963,046  |  
|Medical claims and benefits payable                        |  |                        | 1,095,900 |      |  |      | 1,270,800 |      |  |      | 795,200   |   |  |   | 645,300   |   |  |   | 721,500    |  
|Long-term debt, due after one year                         |  |                        | 794,309   |      |  |      | 836,556   |      |  |      | 975,000   |   |  |   | 650,006   |   |  |   | 1,011,234  |  
|Stockholders equity                                       |  |                        | 2,033,785 |      |  |      | 2,003,560 |      |  |      | 1,977,719 |   |  |   | 2,238,096 |   |  |   | 2,062,187  |  



---



|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | The 2001 results include impairment, disposition,
	restructuring, OPM and other net pretax charges totaling
	$61 million ($39 million or $1.13 diluted loss per
	share, net of tax). See Note 9 of the Notes to Consolidated
	Financial Statements. Operating income before net pretax charges
	as a percentage of operating revenue was 1.6%.                                                                                                                       
|   
|(2) | The 2000 results include impairment, disposition,
	restructuring, OPM and other net pretax charges totaling
	$9 million ($5 million or $0.15 diluted loss per
	share, net of tax). See Note 9 of the Notes to Consolidated
	Financial Statements. Operating income before net pretax charges
	as a percentage of operating revenue was 3.2%.                                                                                                                         
|   
|(3) | The 1999 results include impairment, disposition,
	restructuring and other net pretax credits totaling
	$2 million ($2 million or $0.04 diluted loss per
	share, net of tax). The after tax and per share amounts were
	losses because the goodwill impairment was not deductible for
	income tax purposes. See Note 9 of the Notes to
	Consolidated Financial Statements. Operating income before net
	pretax credits as a percentage of operating revenue was 5.2%.
|   
|(4) | The 1998 results include $11 million of net
	pretax charges ($6 million or $0.12 diluted loss per share,
	net of tax). See Note 9 of the Notes to Consolidated
	Financial Statements. Operating income before net pretax charges
	as a percentage of operating revenue was 4.8%.                                                                                                                                                                                     
|   
|(5) | The 1997 results include the results of
	operations for the FHP acquisition from February 14, 1997.
	The 1997 results also include $155 million of net pretax charges
	($129 million or $3.18 diluted loss per share, net of tax)
	for the impairment of long-lived assets, restructuring and
	certain other charges. Operating income before pretax charges as
	a percentage of operating revenue was 3.1%.                                                         
|   
|(6) | Earnings per share were restated to conform with
	the provisions of Statement of Financial Accounting Standards
	No. 128, Earnings per Share.                                                                                                                                                                                                                                                                                                                        
|   
|(7) | Effective income tax rate includes the effect of
	nondeductible pretax charges, primarily goodwill amortization.                                                                                                                                                                                                                                                                                                                                                     
|   
|(8) | Consolidated EBITDA represents EBITDA (net income
	plus interest expense, provision for income taxes and
	depreciation and amortization expense) before impairment,
	disposition, restructuring and                                                                                                                                                                                                                                                                  

24



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##### Table of Contents



| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | other charges (credits), OPM credits and pretax
	gain on early retirement of debt. We have included consolidated
	EBITDA because we understand that it is one measure used by some
	investors to determine our operating cash flow and historical
	ability to service our indebtedness. Other companies in our
	business may present EBITDA differently than we do. Consolidated
	EBITDA is not a measurement of financial performance under
	generally accepted accounting principles and should not be
	considered by an investor as an alternative to net income or
	operating income as an indicator of our operating performance or
	cash flow from operations, as a measure of liquidity.






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

Results of Operations

Overview.We
sell managed care and other health insurance products to
employer groups and Medicare beneficiaries in eight Western
states and Guam. We also offer a variety of specialty products
and services that employers can purchase to supplement our basic
commercial plans, or as stand-alone products. These specialty
products include pharmacy benefit management, behavioral health
services, life and health insurance and dental and vision
services.

Events significant to our business and actual or
future operating results that occurred in 2001 and to date have
included the following:



|  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Effective January 1, 2002, we reduced
	benefits and increased premiums in our Medicare+Choice health
	plan. These actions affected the majority of our
	0.9 million members currently enrolled in our
	Medicare+Choice health plans and have and may continue to result
	in disenrollment of some of our Medicare membership in counties
	where we continue to offer plans. In addition, effective
	January 1, 2002, we withdrew our Medicare+Choice products
	in 44 counties in Arizona, California, Oklahoma, Oregon,
	Texas and Washington. In January 2002, this withdrawal had
	affected approximately 50,000 members, representing about
	5% of our Medicare health maintenance organization, or HMO,
	membership as of December 31, 2001.
| 
| | In January 2002, we announced a 10-year
	outsourcing arrangement with International Business Machines, or
	IBM, and Keane, Inc., or Keane, which we have estimated will
	result in approximately $380 to $400 million in savings
	over 10 years. IBM will provide information technology, or
	IT, services and day-to-day management of our IT infrastructure,
	including data center operations, support services and
	information distribution, while Keane will provide software
	applications maintenance and enhancement services. See
	Note 5 of the Notes to Consolidated Financial Statements.                                                                                                                                          
| 
| | In December 2001, in connection with the IBM
	outsourcing contract, we sold IBM computer equipment with a net
	book value of $42 million. The consideration we received
	from IBM for the sale included $25 million in cash, and a
	note receivable for the $17 million balance. In January
	2002, we paid and permanently retired $25 million of the
	outstanding balance on our term loan with proceeds we received
	from this sale. See Note 5 of the Notes to Consolidated
	Financial Statements.                                                                                                                                                                                                                                           
| 
| | 2001 results include impairment, disposition,
	restructuring, Office of Personnel Management, or OPM, and other
	pretax charges totaling $61 million ($39 million or
	$1.13 diluted loss per share, net of tax). See Note 9 of
	the Notes to Consolidated Financial Statements.                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
| 
| | In September 2001, we retired $12 million of
	the FHP International Corporation, or FHP, senior notes that we
	assumed when we acquired FHP in 1997 by exchanging approximately
	0.8 million shares of common stock for those notes. We
	reissued treasury stock to provide the common stock used in the
	exchange. Retirement of these notes resulted in a pretax
	extraordinary gain of $2 million ($0.9 million or
	$0.02 diluted earnings per share, net of tax), and a net equity
	increase of $10 million. See Notes 5 and 6 of the
	Notes to Consolidated Financial Statements.                                                                                                                                                          
| 
| | In August 2001, we executed an amendment to our
	existing senior credit facility with our lenders to extend its
	maturity date. The amended and restated credit facility matures
	on January 2, 2003, and                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       

25



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##### Table of Contents



|  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|  | provides for a $650 million term loan and a
	$150 million revolving line of credit. See Note 5 of
	the Notes to Consolidated Financial Statements.                                                                                                                                                                                                                                                                                                              
| 
| | Effective May 1, 2001, we withdrew our
	commercial HMO and point-of-service, or POS, products from
	15 Colorado counties. This withdrawal affected
	approximately 25,000 commercial HMO and POS members. We
	retained our commercial HMO products in other Colorado counties
	where the vast majority of our members reside. Qualified
	employers may apply for our preferred provider organization, or
	PPO, which is not affected by this service area change.
| 
| | Effective March 1, 2001, we withdrew our
	commercial HMO product from 24 Texas counties. This exit
	affected approximately 3,000 members.                                                                                                                                                                                                                                                                                                                       



| |        
| | -------
| | Revenue

Commercial and Medicare Premiums.We receive per-member per-month
payments on behalf of each member enrolled in our commercial
HMOs and our behavioral health services, life and health
insurance and dental and vision services plans. Generally, our
Medicare+Choice contracts entitle us to per-member per-month
payments from the Centers for Medicare and Medicaid Services, or
CMS, which until recently was known as the Health Care Financing
Administration, on behalf of each enrolled Medicare beneficiary.
We report prepaid health care premiums received from our
commercial plans enrolled groups, CMS, and our Medicare
plans members as revenue in the month that members are
entitled to receive health care. We record premiums received in
advance as unearned premium revenue.

Premiums for our commercial products and
Medicare+Choice products are generally fixed in advance of the
periods covered. Of our commercial business, more than 50% of
our membership renews on January 1 of each year, with premiums
that are generally fixed for a one-year period. In addition,
each of our subsidiaries that offers Medicare+Choice products
must submit adjusted community rate proposals, generally by
county or service area, to CMS by July 1 for each such
product that will be offered in a subsequent year. As a result,
increases in the costs of health care service 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.

Generally, since the Balanced Budget Act of 1997
went into effect, annual premium increases for Medicare+Choice
members have not kept pace with increases in the costs of health
care. CMS recently announced that federal payments to
Medicare+Choice managed care organizations are projected to
increase only 2%, the guaranteed minimum required by law, in
calendar year 2003. Such shortfalls in Medicare+Choice premiums
compared to our health care service expenses in some of our
operating areas contributed to our decision to cease offering,
close enrollment, or obtain capacity limits in our
Medicare+Choice plans in various counties in 2002, 2001 and
2000. These premium trends also contributed to changes in our
benefits, copayments and deductibles. The following table
provides information on the number of counties where we did
offer or currently offer our Medicare+Choice plans for new
member enrollment as of the dates indicated. Additionally, it
provides information on the number of counties for which we
contracted with CMS to offer our Medicare+Choice plans, as of
the beginning of each calendar year indicated.

|                                                                                            |  |            |    |              |  |              |     |  |  |  |     | 
|------------------------------------------------------------------------------------------- |  | ---------- | -- | ------------ |  | ------------ | --- |  |  |  | --- | 
|                                                                                            |  | January 1, |    | December 31, |  | December 31,
|                                                                                            |  | 2002       |    | 2001         |  | 2000        
|                                                                                            |  |            |    |              |  |             
|Counties in which we offer Secure Horizons
	Medicare+Choice plans for new member enrollment |  |            | 64 |              |  |              | 76  |  |  |  | 82  | 
|Counties in which we have voluntarily closed
	enrollment or set capacity limits             |  |            | 4  |              |  |              | 28  |  |  |  | 41  | 
|                                                                                            |  |            |    |              |  |              |     |  |  |  |     | 
|Counties for which we contracted with CMS to
	offer Secure Horizons Medicare+Choice plans   |  |            | 68 |              |  |              | 104 |  |  |  | 123 | 
|                                                                                            |  |            |    |              |  |              |     |  |  |  |     | 

Other Income.Other
income consists of revenue we receive from administrative
services we offer through our specialty products and services
companies. For example, PacifiCare Life and Health Insurance is
paid

26



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##### Table of Contents



a fee per claim processed rather than a premium,
for the services that it provides. Prescription Solutions
generates mail-service revenue where we, rather than network
retail pharmacies, collect the member copayments. We provide
similar administrative services to employer groups that want to
be self-insured for behavioral health services and dental and
vision services.


Net Investment Income.Net investment income consists of
interest income, gross realized gains and gross realized losses
experienced based on the level of cash invested over each
period. As we have increased the number of our contracts that
are risk-based rather than capitated contracts, our net
investment income has been and continues to be an important
component in managing health care cost risk of our business.
Under risk-based contracts, cash disbursements to health care
providers for services provided to members are made 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.



| |         
| | --------
| | Expenses

Commercial and Medicare Health Care Services.Health care service expenses for our
commercial plans and our Medicare plans primarily comprise
payments to physicians, hospitals and other health care
providers under capitated or risk-based contracts for services
provided to our members. Health care service expenses also
include expenses for health care provided and administrative
services performed under our specialty products and services
companies.

The cost of health care provided is accrued in
the month services are provided to members, based in part on
estimates for hospital services and other health care costs that
have been incurred but not yet reported. We develop these
estimates using actuarial methods based upon historical data for
payment patterns, cost trends, product mix, seasonality,
utilization of health care services and other relevant factors.
These estimates are adjusted in future periods as we receive
actual claims data, and can either increase or reduce our
accrued health care costs. The cost of prescription drugs
covered under our commercial and Medicare plans is expensed when
the prescription drugs are dispensed. Our commercial and
Medicare 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.

During 2000 and 2001, health care providers
increasingly demanded risk-based contracts. The trend away from
capitated contracts to risk-based and fee-for-service agreements
continues, especially for hospital services. The percentages of
membership by contract type at December 31, 2001 and 2000
were as follows:

|                           |  |              |     |           |  |      |     |      |  |  |     |  |  |  |     | 
|-------------------------- |  | ------------ | --- | --------- |  | ---- | --- | ---- |  |  | --- |  |  |  | --- | 
|                           |  |              |     |          
|                           |  | Hospital     |     | Physician
|                           |  |              |     |          
|                           |  |             
|                           |  | December 31,
|                           |  |             
|                           |  | 2001         |     | 2000      |  | 2001 |     | 2000
|                           |  |              |     |           |  |      |     |     
|Commercial:                |  |              |     |           |  |      |     |      |  |  |     |  |  |  |     | 
|Capitated                  |  |              | 48% |           |  |      | 57% |      |  |  | 79% |  |  |  | 84% | 
|Risk-based/fee-for-service |  |              | 52% |           |  |      | 43% |      |  |  | 21% |  |  |  | 16% | 
|Medicare:                  |  |              |     |           |  |      |     |      |  |  |     |  |  |  |     | 
|Capitated                  |  |              | 57% |           |  |      | 65% |      |  |  | 77% |  |  |  | 87% | 
|Risk-based/fee-for-service |  |              | 43% |           |  |      | 35% |      |  |  | 23% |  |  |  | 13% | 
|Total:                     |  |              |     |           |  |      |     |      |  |  |     |  |  |  |     | 
|Capitated                  |  |              | 51% |           |  |      | 59% |      |  |  | 79% |  |  |  | 85% | 
|Risk-based/fee-for-service |  |              | 49% |           |  |      | 41% |      |  |  | 21% |  |  |  | 15% | 

We have experienced a significant increase in our
health care service expenses as we have increasingly covered our
membership through risk-based contracts. Our profitability
declined beginning with the third quarter of 2000 because we did
not fully anticipate the extent to which our reimbursement
methodology would shift to risk-based contracts. The shift
toward risk-based contracts exposed us to increased health

27



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care costs that we did not fully anticipate in
our pricing and underwriting decisions when we designed and
priced our products for 2001 and 2000. In 2002, we expect this
trend to continue, but at a slower pace. We expect commercial
hospital risk-based contracts to cover approximately 56% of our
membership and commercial physician risk-based contracts to
cover approximately 23% of our membership by December 31,
2002. We expect Medicare hospital risk-based contracts to cover
approximately 46% of our membership and Medicare physician
risk-based contracts to cover approximately 25% of our
membership by December 31, 2002.


2001 Compared With 2000

Membership.Total HMO membership decreased 16%
to approximately 3.4 million members at December 31,
2001 from approximately 4.0 million members at
December 31, 2000. Our total HMO membership excludes
employer self-funded, PPO, indemnity and Medicare supplement
members.

|                                  |                      |                                         |  |                         |           |       |  |            |         |          |  |           |           |  |  |           |           |  |  |         |           |  |  |           |           | 
|--------------------------------- | -------------------- | --------------------------------------- |  | ----------------------- | --------- | ----- |  | ---------- | ------- | -------- |  | --------- | --------- |  |  | --------- | --------- |  |  | ------- | --------- |  |  | --------- | --------- | 
|                                  |                      |                                         |  |                        
|                                  |                      | As of December 31, 2001                 |  | As of December 31, 2000
|                                  |                      |                                         |  |                        
|                                  |                      | Commercial                              |  | Medicare                |           | Total |  | Commercial |         | Medicare |  | Total    
|                                  |                      |                                         |  |                         |           |       |  |            |         |          |  |          
|HMO Membership Data:              |                      |                                         |  |                         |           |       |  |            |         |          |  |           |           |  |  |           |           |  |  |         |           |  |  |          
|                                  | Arizona              |                                         |  | 144,000                 |           |       |  | 104,600    |         |          |  | 248,600   |           |  |  | 124,700   |           |  |  | 103,100 |           |  |  | 227,800   |          
|                                  | California           |                                         |  | 1,579,000               |           |       |  | 487,000    |         |          |  | 2,066,000 |           |  |  | 1,812,000 |           |  |  | 564,800 |           |  |  | 2,376,800 |          
|                                  | Colorado             |                                         |  | 202,300                 |           |       |  | 60,300     |         |          |  | 262,600   |           |  |  | 285,800   |           |  |  | 74,000  |           |  |  | 359,800   |          
|                                  | Guam                 |                                         |  | 36,400                  |           |       |  |           |         |          |  | 36,400    |           |  |  | 50,500    |           |  |  |        |           |  |  | 50,500    |          
|                                  | Nevada               |                                         |  | 36,100                  |           |       |  | 30,900     |         |          |  | 67,000    |           |  |  | 34,300    |           |  |  | 32,200  |           |  |  | 66,500    |          
|                                  | Ohio                 |                                         |  |                        |           |       |  |           |         |          |  |          |           |  |  | 35,000    |           |  |  | 3,500   |           |  |  | 38,500    |          
|                                  | Oklahoma             |                                         |  | 91,300                  |           |       |  | 30,200     |         |          |  | 121,500   |           |  |  | 88,300    |           |  |  | 31,400  |           |  |  | 119,700   |          
|                                  | Oregon               |                                         |  | 93,200                  |           |       |  | 26,800     |         |          |  | 120,000   |           |  |  | 103,700   |           |  |  | 31,600  |           |  |  | 135,300   |          
|                                  | Texas                |                                         |  | 180,400                 |           |       |  | 149,600    |         |          |  | 330,000   |           |  |  | 319,100   |           |  |  | 151,400 |           |  |  | 470,500   |          
|                                  | Washington           |                                         |  | 76,900                  |           |       |  | 59,100     |         |          |  | 136,000   |           |  |  | 99,900    |           |  |  | 64,700  |           |  |  | 164,600   |          
|                                  |                      |                                         |  |                         |           |       |  |            |         |          |  |           |           |  |  |           |           |  |  |         |           |  |  |          
|                                  |                      | Total HMO membership                    |  |                         | 2,439,600 |       |  |            | 948,500 |          |  |           | 3,388,100 |  |  |           | 2,953,300 |  |  |         | 1,056,700 |  |  |           | 4,010,000 | 
|                                  |                      |                                         |  |                         |           |       |  |            |         |          |  |           |           |  |  |           |           |  |  |         |           |  |  |          
|Other Commercial Membership Data: |                      |                                         |  |                         |           |       |  |            |         |          |  |           |           |  |  |           |           |  |  |        
|                                  | Employer self-funded |                                         |  | 42,400                  |           |       |  |           |         |          |  | 42,400    |           |  |  | 65,000    |           |  |  |        |           |  |  | 65,000    |          
|                                  | PPO and indemnity    |                                         |  | 38,400                  |           |       |  |           |         |          |  | 38,400    |           |  |  | 42,900    |           |  |  |        |           |  |  | 42,900    |          
|                                  | Medicare supplement  |                                         |  | 11,000                  |           |       |  |           |         |          |  | 11,000    |           |  |  | 500       |           |  |  |        |           |  |  | 500       |          
|                                  |                      |                                         |  |                         |           |       |  |            |         |          |  |           |           |  |  |           |           |  |  |         |           |  |  |          
|                                  |                      | Total other commercial membership       |  |                         | 91,800    |       |  |            |        |          |  |           | 91,800    |  |  |           | 108,400   |  |  |         |          |  |  |           | 108,400   | 
|                                  |                      |                                         |  |                         |           |       |  |            |         |          |  |           |           |  |  |           |           |  |  |         |           |  |  |          
|                                  |                      | Total HMO & other commercial membership |  |                         | 2,531,400 |       |  |            | 948,500 |          |  |           | 3,479,900 |  |  |           | 3,061,700 |  |  |         | 1,056,700 |  |  |           | 4,118,400 | 
|                                  |                      |                                         |  |                         |           |       |  |            |         |          |  |           |           |  |  |           |           |  |  |         |           |  |  |          

|                                          |                                |                         |  |                         |  |            |  |           |  |              |  |           |  |  |  |           |  |  |  |           |  |  |  |           | 
|----------------------------------------- | ------------------------------ | ----------------------- |  | ----------------------- |  | ---------- |  | --------- |  | ------------ |  | --------- |  |  |  | --------- |  |  |  | --------- |  |  |  | --------- | 
|                                          |                                |                         |  |                        
|                                          |                                | As of December 31, 2001 |  | As of December 31, 2000
|                                          |                                |                         |  |                        
|                                          |                                | PacifiCare              |  |                         |  | PacifiCare |  |          
|                                          |                                | HMO                     |  | Unaffiliated            |  | Total      |  | HMO       |  | Unaffiliated |  | Total    
|                                          |                                |                         |  |                         |  |            |  |           |  |              |  |          
|Pharmacy Benefit Management,              |                                |                         |  |                         |  |            |  |           |  |              |  |           |  |  |  |           |  |  |  |           |  |  |  |          
|Dental and Behavioral Health
	Membership: |                                |                         |  |                         |  |            |  |           |  |              |  |           |  |  |  |          
|                                          | Pharmacy benefit management(1) |                         |  | 3,388,100               |  |            |  | 1,129,000 |  |              |  | 4,517,100 |  |  |  | 4,010,000 |  |  |  | 630,400   |  |  |  | 4,640,400 | 
|                                          | Dental(2)                      |                         |  | 635,300                 |  |            |  | 196,800   |  |              |  | 832,100   |  |  |  | 899,300   |  |  |  | 286,400   |  |  |  | 1,185,700 | 
|                                          | Behavioral health(2)           |                         |  | 2,337,200               |  |            |  | 1,373,400 |  |              |  | 3,710,600 |  |  |  | 2,611,300 |  |  |  | 1,213,500 |  |  |  | 3,824,800 | 

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---



|    |                                                                                                                                                                                                                                                                                              
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | Pharmacy benefit management PacifiCare HMO
	membership represents members that are in our commercial or
	Medicare HMO. 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) | Dental and behavioral health PacifiCare HMO
	membership represents members that are in our commercial HMO
	that are also enrolled in our dental or behavioral health plan.                                                                                                                   

Commercial HMO membership decreased approximately
17% at December 31, 2001 compared to the prior year
primarily due to a:



|  |                                                                                                                                                                                                            
|- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Decrease of 233,000 members in California and
	138,700 members in Texas primarily due to premium rate increases
	that averaged 8% in California and 13% in Texas in 2001 and
	provider network disruptions;
| 
| | Decrease of 83,500 members in Colorado, primarily
	due to premium rate increases that averaged 14% in 2001 and 2001
	county exits; and                                                                     
| 
| | Decrease of 35,000 members as a result of our
	exit of all HMO operations in Ohio.                                                                                                                         

During 2002, we expect commercial HMO membership
to decline by approximately 150,000, primarily due to exits of
unprofitable markets and products, and stricter underwriting
standards.

Medicare membership decreased approximately 10%
at December 31, 2001 compared to the prior year primarily
due to a:



|  |                                                                                                                                                                                  
|- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Decrease of 101,900 members primarily as a result
	of 2000 and 2001 county exits, capacity waivers and voluntary
	closure notices in California, Colorado, Oregon and Washington;
| 
| | Decrease of 3,500 members as a result of our exit
	of all HMO operations in Ohio; and                                                                                            
| 
| | Decrease of 1,800 members in Texas due to member
	disenrollments in anticipation of reduced benefits that were
	effective January 1, 2002; partially offset by an                
| 
| | Increase of 1,500 members in Arizona primarily
	due to competitor exits in areas where Secure Horizons remained.                                                                 

During 2002, we expect Medicare HMO membership to
decline by approximately 130,000 primarily due to county exits,
increased premiums and benefit reductions.

Employer self-funded membership decreased
approximately 35% at December 31, 2001 compared to the
prior year primarily due to membership losses in Texas. PPO and
indemnity membership decreased approximately 10% at
December 31, 2001 compared to the prior year primarily due
to membership losses in California attributable to premium rate
increases in 2001.

Pharmacy benefit management, or PBM, unaffiliated
membership at December 31, 2001 increased approximately 79%
compared to the prior year due to new membership from five
additional customers of approximately 512,300 members, partially
offset by membership losses of approximately 13,700 members
primarily in connection with the loss of two customers.

PacifiCare dental HMO membership at
December 31, 2001 decreased approximately 29% compared to
the prior year primarily due to membership losses in Arizona,
California and Washington, mainly due to Secure Horizon member
disenrollments, attributable to benefit changes effective
January 1, 2001. Dental unaffiliated membership at
December 31, 2001 decreased approximately 31% compared to
the prior year due to commercial member disenrollments in
California.

PacifiCare behavioral health HMO membership at
December 31, 2001 decreased approximately 10% compared to
the prior year primarily due membership losses in Arizona,
Colorado and Texas. Behavioral health unaffiliated membership at
December 31, 2001 increased approximately 13% compared to
prior year primarily due to additional membership in Oregon.

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Commercial Premiums.Commercial premiums include
results from our specialty HMO and indemnity insurance
operations. Commercial premiums decreased 2% or $116 million for
the year ended December 31, 2001 compared to the prior year
as follows:

|                                                                                                                                                                    |  |                       |      |  
|------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | --------------------- | ---- | -
|                                                                                                                                                                    |  | Year Ended           
|                                                                                                                                                                    |  | December 31, 2001    
|                                                                                                                                                                    |  |                      
|                                                                                                                                                                    |  |                      
|                                                                                                                                                                    |  | (Amounts in millions)
|Net membership losses (excluding Ohio), primarily
	in California, Colorado and Texas                                                                                |  | $                     | (538 | )
|Premium rate increases that averaged
	approximately 11% for the year ended December 31, 2001                                                                        |  |                       | 479  |  
|Membership losses resulting from the disposition
	of our Ohio HMO                                                                                                   |  |                       | (77  | )
|The inclusion of premiums from the Harris
	Methodist Texas Health Plan, Inc. and Harris Methodist
	Health Insurance Company, Inc. (together, Harris)
	acquisition |  |                       | 20   |  
|                                                                                                                                                                    |  |                       |      |  
|Decrease over prior year                                                                                                                                            |  | $                     | (116 | )
|                                                                                                                                                                    |  |                       |      |  

Medicare Premiums.Medicare premiums increased 5% or
$348 million for the year ended December 31, 2001
compared to the prior year as follows:

|                                                                                            |  |                       |      |  
|------------------------------------------------------------------------------------------- |  | --------------------- | ---- | -
|                                                                                            |  | Year Ended           
|                                                                                            |  | December 31, 2001    
|                                                                                            |  |                      
|                                                                                            |  |                      
|                                                                                            |  | (Amounts in millions)
|Premium rate increases that averaged
	approximately 8% for the year ended December 31, 2001 |  | $                     | 520  |  
|Net membership losses (excluding Ohio), primarily
	in California                            |  |                       | (162 | )
|Membership losses resulting from the disposition
	of our Ohio HMO                           |  |                       | (30  | )
|The inclusion of premiums from the Harris
	acquisition                                      |  |                       | 20   |  
|                                                                                            |  |                       |      |  
|Increase over prior year                                                                    |  | $                     | 348  |  
|                                                                                            |  |                       |      |  

Other Income.Other income increased
approximately 24% or $33 million for the year ended
December 31, 2001 compared to the prior year primarily due
to increased mail-service revenues of Prescription Solutions,
our PBM.

Net Investment Income.Net investment income increased
approximately 3% to $111 million for the year ended
December 31, 2001 compared to the prior year primarily due
to higher overall net realized gains compared to the prior year.

Consolidated Medical Loss Ratio.The consolidated medical loss
ratio (health care services as a percentage of premium revenue)
changed for the year ended December 31, 2001 compared to
the prior year as follows:

|                    |              |              |  |      |   |  |  |      |  
|------------------- | ------------ | ------------ |  | ---- | - |  |  | ---- | -
|                    |              |             
|                    |              | Year Ended  
|                    |              | December 31,
|                    |              |             
|                    |              | 2001         |  | 2000
|                    |              |              |  |     
|Medical loss ratio: |              |              |  |      |   |  |  |     
|                    | Consolidated |              |  | 89.7 | % |  |  | 87.5 | %
|                    | Commercial   |              |  | 88.8 | % |  |  | 85.1 | %
|                    | Medicare     |              |  | 90.3 | % |  |  | 89.4 | %

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Commercial Medical Loss Ratio.The commercial medical loss ratio
includes results from our specialty HMO and indemnity insurance
operations. The commercial medical loss ratio for the year ended
December 31, 2001 increased compared to the prior year due
to:



|  |                                                                                                                                                 
|- | ------------------------------------------------------------------------------------------------------------------------------------------------
| | Higher inpatient, physician, outpatient and out
	of area service utilization under fee-for-service or risk-based
	contracts; partially offset by
| 
| | Premium rate increases.                                                                                                                         

For the year ended December 31, 2001, our
increases in commercial health care costs outpaced our premium
rate increases primarily in California, Texas and Washington. In
these states more members accessed more services, at a higher
cost, from providers with whom we have shared-risk, rather than
capitation contracts. Additionally, our Texas HMO experienced
increased health care costs because we paid hospitals and
doctors for expenses that were otherwise the obligations of our
contracted providers. See Note 10 of the Notes to Consolidated
Financial Statements.

In the fourth quarter of 2001, our commercial
health care costs were partially offset by the impact of
favorable claims experience for our new indemnity products,
including PPO, Medicare supplement, and in our behavioral health
business. We do not expect these favorable changes in estimates
to continue in 2002. In 2002, we expect our commercial medical
loss ratio to be in the range of 86% to 87%. We expect the
decrease to be driven by price increases, exits from high-cost
markets, and the positive effect on utilization of our medical
management investments.

Medicare Medical Loss
Ratio.The
Medicare medical loss ratio increased for the year ended
December 31, 2001 compared to the prior year due to:



|  |                                                                                                                                                    
|- | ---------------------------------------------------------------------------------------------------------------------------------------------------
| | Higher inpatient, physician and outpatient
	service utilization under fee-for-service or risk-based
	contracts; largely offset by                  
| 
| | Premium rate increases including the Benefits
	Improvement and Protection Act of 2000 (effective March 1,
	2001), and supplemental member premiums.

For the year ended December 31, 2001, our
increases in Medicare health care costs slightly outpaced
premium rate increases. At our Texas HMO more members accessed
more services, at a higher cost, from providers with whom we
have shared-risk, rather than capitation contracts.
Additionally, our Texas HMO experienced increased health care
costs because we paid hospitals and doctors for expenses that
were otherwise the obligations of our contracted providers and
for which we previously paid capitation. See Note 10 of the
Notes to Consolidated Financial Statements. Substantial premium
rate increases at our Colorado HMO and Washington HMO partially
offset increased health care costs. In 2002, we expect our
Medicare medical loss ratio to be in the range of 89% to 90%,
based on current CMS reimbursement levels. We expect the slight
decrease to result from benefit reductions, and the positive
effect on utilization of our medical and disease management
investments.

Selling, General and Administrative
Expenses.Selling, general and
administrative expenses of $1.2 million for the year ended
December 31, 2001 were comparable to the prior year. For
the year ended December 31, 2001, 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 higher operating
revenue in 2001. Our expectation for selling, general and
administrative expenses as a percentage of operating revenue for
2002 is that the percentage will rise to at least 11.5%,
primarily as a result of the $80 million that we expect to
spend for IT investments, PBM expansion and a branding
advertising campaign. We plan to fund these expenditures in part
through savings that result from the restructuring program that
we began in the fourth quarter of 2001.

|                                                                                                                     |  |              |      |      |  |  |      |  
|-------------------------------------------------------------------------------------------------------------------- |  | ------------ | ---- | ---- |  |  | ---- | -
|                                                                                                                     |  |             
|                                                                                                                     |  | Year Ended  
|                                                                                                                     |  | December 31,
|                                                                                                                     |  |             
|                                                                                                                     |  | 2001         |      | 2000
|                                                                                                                     |  |              |      |     
|Selling, general and administrative expenses as a
	percentage of operating revenue (excluding net investment income) |  |              | 10.3 | %    |  |  | 10.5 | %

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Impairment, Disposition, Restructuring, OPM
and Other Charges (Credits).We
recognized net pretax charges of $61 million
($39 million or $1.13 diluted loss per share, net of tax)
for the year ended December 31, 2001. See Note 9 of the
Notes to Consolidated Financial Statements.

Operating Income.Operating income decreased 65% to
$127 million for the year ended December 31, 2001,
compared to the prior year. Factors contributing to the change
are discussed above.

|                                                   |  |              |     |      |  |  |     |  
|-------------------------------------------------- |  | ------------ | --- | ---- |  |  | --- | -
|                                                   |  |             
|                                                   |  | Year Ended  
|                                                   |  | December 31,
|                                                   |  |             
|                                                   |  | 2001         |     | 2000
|                                                   |  |              |     |     
|Operating income as a percent of operating revenue |  |              | 1.1 | %    |  |  | 3.2 | %

Interest Expense.Interest expense decreased
approximately 12% to $70 million for the year ended
December 31, 2001 compared to the prior year due to:



|  |                                                                                                                   
|- | ------------------------------------------------------------------------------------------------------------------
| | Lower outstanding debt balances due to payments
	made on our credit facility during 2000 and 2001; and            
| 
| | Lower overall interest rates paid on our credit
	facility, as a result of Federal Reserve rate reductions in 2001.

Provision for Income Taxes.The effective income tax rate was
67.9% for the year ended December 31, 2001, compared with
44.1% in 2000. Because of lower 2001 earnings, the
non-deductible goodwill amortization expense is a higher
percentage of pretax income, increasing our 2001 effective tax
rate.

Reconciliation of Reported Results to Pro
Forma Results.In our fourth
quarter 2001 earnings announcement, we disclosed pro forma
results as described in the following table. See Note 9 of the
Notes to Consolidated Financial Statements.

|                                   |                                                                       |                        |   |              |   |      |   |      |  |  |   |      |  |  |   |       |  
|---------------------------------- | --------------------------------------------------------------------- | ---------------------- | - | ------------ | - | ---- | - | ---- |  |  | - | ---- |  |  | - | ----- | -
|                                   |                                                                       |                        |   |              |   |     
|                                   |                                                                       | Three Months           |   |             
|                                   |                                                                       | Ended                  |   | Year Ended  
|                                   |                                                                       | December 31,           |   | December 31,
|                                   |                                                                       |                        |   |             
|                                   |                                                                       | 2001                   |   | 2000         |   | 2001 |   | 2000
|                                   |                                                                       |                        |   |              |   |      |   |     
|                                   |                                                                       |                       
|                                   |                                                                       | (Amounts in millions, 
|                                   |                                                                       | except per-share data)
|Net (loss) income:                 |                                                                       |                        |   |              |   |      |   |      |  |  |   |      |  |  |   |      
|                                   | As reported                                                           |                        | $ | (26          | ) |      | $ | 12   |  |  | $ | 19   |  |  | $ | 161   |  
|                                   | Impairment, disposition, restructuring and other
	charges, net of tax |                        |   | 38           |   |      |   | 6    |  |  |   | 39   |  |  |   | 7     |  
|                                   | Office of Personnel Management credits, net of tax                    |                        |   |             |   |      |   |     |  |  |   |     |  |  |   | (2    | )
|                                   |                                                                       |                        |   |              |   |      |   |      |  |  |   |      |  |  |   |      
|                                   | Pro forma net income                                                  |                        | $ | 12           |   |      | $ | 18   |  |  | $ | 58   |  |  | $ | 166   |  
|                                   |                                                                       |                        |   |              |   |      |   |      |  |  |   |      |  |  |   |      
|Diluted (loss) earnings per share: |                                                                       |                        |   |              |   |      |   |      |  |  |   |      |  |  |   |      
|                                   | As reported                                                           |                        | $ | (0.77        | ) |      | $ | 0.35 |  |  | $ | 0.55 |  |  | $ | 4.58  |  
|                                   | Impairment, disposition, restructuring and other
	charges, net of tax |                        |   | 1.11         |   |      |   | 0.17 |  |  |   | 1.13 |  |  |   | 0.20  |  
|                                   | Office of Personnel Management credits, net of tax                    |                        |   |             |   |      |   |     |  |  |   |     |  |  |   | (0.05 | )
|                                   |                                                                       |                        |   |              |   |      |   |      |  |  |   |      |  |  |   |      
|                                   | Pro forma diluted earnings per share                                  |                        | $ | 0.34         |   |      | $ | 0.52 |  |  | $ | 1.68 |  |  | $ | 4.73  |  
|                                   |                                                                       |                        |   |              |   |      |   |      |  |  |   |      |  |  |   |      

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2000 Compared with 1999

Membership.Total HMO membership increased
approximately 10%, to 4.0 million members at
December 31, 2000 from approximately 3.7 million
members at December 31, 1999. Our total HMO membership
excludes employer self-funded and PPO, indemnity and Medicare
supplement members.

|                                  |                      |                                         |           |                      |           |       |         |            |           |          |           |           |           |  |           |           |           |  |         |           |           |  |           |           |           | 
|--------------------------------- | -------------------- | --------------------------------------- | --------- | -------------------- | --------- | ----- | ------- | ---------- | --------- | -------- | --------- | --------- | --------- |  | --------- | --------- | --------- |  | ------- | --------- | --------- |  | --------- | --------- | --------- | 
|                                  |                      |                                         |           |                     
|                                  |                      | At December 31, 2000                    |           | At December 31, 1999
|                                  |                      |                                         |           |                     
|                                  |                      | Commercial                              |           | Medicare             |           | Total |         | Commercial |           | Medicare |           | Total    
|                                  |                      |                                         |           |                      |           |       |         |            |           |          |           |          
|HMO Membership Data:              |                      |                                         |           |                      |           |       |         |            |           |          |           |           |           |  |           |           |           |  |         |           |           |  |           |          
|Arizona                           |                      |                                         | 124,700   |                      |           |       | 103,100 |            |           |          | 227,800   |           |           |  | 105,000   |           |           |  | 89,300  |           |           |  | 194,300   |          
|California                        |                      |                                         | 1,812,000 |                      |           |       | 564,800 |            |           |          | 2,376,800 |           |           |  | 1,720,000 |           |           |  | 608,100 |           |           |  | 2,328,100 |          
|Colorado                          |                      |                                         | 285,800   |                      |           |       | 74,000  |            |           |          | 359,800   |           |           |  | 318,300   |           |           |  | 78,200  |           |           |  | 396,500   |          
|Guam                              |                      |                                         | 50,500    |                      |           |       |        |            |           |          | 50,500    |           |           |  | 41,500    |           |           |  |        |           |           |  | 41,500    |          
|Nevada                            |                      |                                         | 34,300    |                      |           |       | 32,200  |            |           |          | 66,500    |           |           |  | 35,100    |           |           |  | 28,500  |           |           |  | 63,600    |          
|Ohio                              |                      |                                         | 35,000    |                      |           |       | 3,500   |            |           |          | 38,500    |           |           |  | 42,700    |           |           |  | 16,500  |           |           |  | 59,200    |          
|Oklahoma                          |                      |                                         | 88,300    |                      |           |       | 31,400  |            |           |          | 119,700   |           |           |  | 84,300    |           |           |  | 29,000  |           |           |  | 113,300   |          
|Oregon                            |                      |                                         | 103,700   |                      |           |       | 31,600  |            |           |          | 135,300   |           |           |  | 109,000   |           |           |  | 36,500  |           |           |  | 145,500   |          
|Texas(1)                          |                      |                                         | 319,100   |                      |           |       | 151,400 |            |           |          | 470,500   |           |           |  | 112,600   |           |           |  | 64,100  |           |           |  | 176,700   |          
|Washington                        |                      |                                         | 99,900    |                      |           |       | 64,700  |            |           |          | 164,600   |           |           |  | 74,900    |           |           |  | 64,400  |           |           |  | 139,300   |          
|                                  |                      |                                         |           |                      |           |       |         |            |           |          |           |           |           |  |           |           |           |  |         |           |           |  |           |          
|                                  | Total HMO membership |                                         |           | 2,953,300            |           |       |         | 1,056,700  |           |          |           | 4,010,000 |           |  |           | 2,643,400 |           |  |         | 1,014,600 |           |  |           | 3,658,000 |          
|                                  |                      |                                         |           |                      |           |       |         |            |           |          |           |           |           |  |           |           |           |  |         |           |           |  |           |          
|Other Commercial Membership Data: |                      |                                         |           |                      |           |       |         |            |           |          |           |           |           |  |           |           |           |  |         |          
|                                  | Employer self-funded |                                         |           | 65,000               |           |       |         |           |           |          |           | 65,000    |           |  |           | 55,100    |           |  |         |          |           |  |           | 55,100    |          
|                                  | PPO and indemnity    |                                         |           | 42,900               |           |       |         |           |           |          |           | 42,900    |           |  |           | 29,800    |           |  |         |          |           |  |           | 29,800    |          
|                                  | Medicare supplement  |                                         |           | 500                  |           |       |         |           |           |          |           | 500       |           |  |           |          |           |  |         |          |           |  |           |          |          
|                                  |                      |                                         |           |                      |           |       |         |            |           |          |           |           |           |  |           |           |           |  |         |           |           |  |           |          
|                                  |                      | Total other commercial membership       |           |                      | 108,400   |       |         |            |          |          |           |           | 108,400   |  |           |           | 84,900    |  |         |           |          |  |           |           | 84,900    | 
|                                  |                      |                                         |           |                      |           |       |         |            |           |          |           |           |           |  |           |           |           |  |         |           |           |  |           |          
|                                  |                      | Total HMO & other commercial membership |           |                      | 3,061,700 |       |         |            | 1,056,700 |          |           |           | 4,118,400 |  |           |           | 2,728,300 |  |         |           | 1,014,600 |  |           |           | 3,742,900 | 
|                                  |                      |                                         |           |                      |           |       |         |            |           |          |           |           |           |  |           |           |           |  |         |           |           |  |           |          

|                                                    |  |                         |           |                         |  |            |           |     |  |              |           |       |  |  |           |  |  |  |           |  |  |  |           | 
|--------------------------------------------------- |  | ----------------------- | --------- | ----------------------- |  | ---------- | --------- | --- |  | ------------ | --------- | ----- |  |  | --------- |  |  |  | --------- |  |  |  | --------- | 
|                                                    |  |                         |           |                        
|                                                    |  | As of December 31, 2000 |           | As of December 31, 1999
|                                                    |  |                         |           |                        
|                                                    |  | PacifiCare              |           |                         |  | PacifiCare |           |    
|                                                    |  | HMO                     |           | Unaffiliated            |  | Total      |           | HMO |  | Unaffiliated |           | Total
|                                                    |  |                         |           |                         |  |            |           |     |  |              |           |      
|PBM, Dental and Behavioral Health Membership
	Data: |  |                         |           |                         |  |            |           |     |  |              |           |       |  |  |           |  |  |  |           |  |  |  |           | 
|Pharmacy benefit management(2)                      |  |                         | 4,010,000 |                         |  |            | 630,400   |     |  |              | 4,640,400 |       |  |  | 3,658,000 |  |  |  | 728,900   |  |  |  | 4,386,900 | 
|Dental(3)                                           |  |                         | 899,300   |                         |  |            | 286,400   |     |  |              | 1,185,700 |       |  |  | 932,600   |  |  |  | 318,000   |  |  |  | 1,250,600 | 
|Behavioral health(3)                                |  |                         | 2,611,300 |                         |  |            | 1,213,500 |     |  |              | 3,824,800 |       |  |  | 1,815,600 |  |  |  | 1,163,700 |  |  |  | 2,979,300 | 



---



|    |                                                                                                                                                                                                                                                                                               
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | Texas membership includes Harris members totaling
	approximately 130,000 commercial and 43,000 Medicare at
	December 31, 2000.                                                                                                                                                                
|   
|(2) | Pharmacy benefit management PacifiCare HMO
	membership represents members that are in our commercial or
	Medicare HMOs. 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.
|   
|(3) | Dental and behavioral health PacifiCare HMO
	membership represents members that are in our commercial HMOs
	that are also enrolled in our dental or behavioral health plan.                                                                                                                   

33



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##### Table of Contents



Commercial HMO membership increased approximately
12% at December 31, 2000 compared to the prior year due to:



|  |                                                                                                                                                                                                                   
|- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Net membership increases from acquired membership
	in Colorado, Texas and Washington, partially offset by
	membership decreases in Colorado attributable to premium rate
	increases that averaged 14% in 2000; and
| 
| | Growth in California primarily from marketing
	efforts to retain membership and renew major employer accounts.                                                                                                    

Medicare membership increased 4% at
December 31, 2000 compared to the prior year due to:



|  |                                                                                                                                                                                                               
|- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Members acquired primarily in Texas and
	Washington; and                                                                                                                                                      
| 
| | Competitor exits in markets where Secure Horizons
	will remain, primarily in Arizona, Nevada and Texas; partially
	offset by                                                                                  
| 
| | Membership decreases primarily in California due
	to disenrollment resulting from reduced benefits, increased
	copayments and instituted or increased member-paid supplemental
	premiums in some counties; and
| 
| | Membership decreases as a result of our January
	2000 county exits in California, Ohio, Oregon and Washington.                                                                                                

Employer self-funded membership increased
approximately 18% at December 31, 2000 compared to the
prior year primarily due to additional membership from the
Harris acquisition, partially offset by membership losses in
Colorado. PPO and indemnity membership increased approximately
44% at December 31, 2000 compared to the prior year
primarily due to additional Harris membership.

Pharmacy benefit management unaffiliated
membership as of December 31, 2000 decreased approximately
14% compared to the prior year, due to the loss of approximately
120,000 members primarily in connection with the loss of three
customers, partially offset by increases in new membership from
additional customers of approximately 21,000 members.

PacifiCare dental HMO membership as of
December 31, 2000 decreased approximately 4% compared to
the prior year primarily due to membership losses in California
and Colorado. Dental unaffiliated membership as of
December 31, 2000 decreased approximately 10% compared to
the prior year due to membership losses in California.

PacifiCare behavioral health HMO membership as of
December 31, 2000 increased approximately 44% compared to
the prior year primarily due to additional membership in
California mainly related to the passage of mental health parity
legislation and additional membership in Arizona, Oklahoma and
Texas. Behavioral health unaffiliated membership as of
December 31, 2000 increased approximately 4% compared to
the prior year primarily due to increased membership in employee
assistance programs.

Commercial Premiums.Commercial premiums include
results from our specialty HMO and indemnity insurance
operations. Commercial premiums increased 23% or $918 million
for the year ended December 31, 2000 compared to the prior
year as follows:

|                                                                                            |  |                   |     | 
|------------------------------------------------------------------------------------------- |  | ----------------- | --- | 
|                                                                                            |  | Year Ended       
|                                                                                            |  | December 31, 2000
|                                                                                            |  |                  
|                                                                                            |  | (Amounts         
|                                                                                            |  | in millions)     
|Premium rate increases that averaged
	approximately 8% for the year ended December 31, 2000 |  | $                 | 337 | 
|The inclusion of premiums from the Harris
	acquisition                                      |  |                   | 316 | 
|Net membership increases, primarily in California                                           |  |                   | 265 | 
|                                                                                            |  |                   |     | 
|Increase over prior year                                                                    |  | $                 | 918 | 
|                                                                                            |  |                   |     | 

34



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##### Table of Contents



Medicare Premiums.Medicare premiums increased 9% or
$540 million for the year ended December 31, 2000
compared to the prior year as follows:

|                                                                                            |  |                   |      |  
|------------------------------------------------------------------------------------------- |  | ----------------- | ---- | -
|                                                                                            |  | Year Ended       
|                                                                                            |  | December 31, 2000
|                                                                                            |  |                  
|                                                                                            |  | (Amounts         
|                                                                                            |  | in millions)     
|Premium rate increases that averaged
	approximately 7% for the year ended December 31, 2000 |  | $                 | 425  |  
|The inclusion of premiums from the Harris
	acquisition                                      |  |                   | 221  |  
|Net membership losses, primarily in California                                              |  |                   | (106 | )
|                                                                                            |  |                   |      |  
|Increase over prior year                                                                    |  | $                 | 540  |  
|                                                                                            |  |                   |      |  

Other Income.Other income increased
approximately 17% or $21 million for the year ended
December 31, 2000 compared to the prior year. The increases
were primarily due to increased mail-service revenues of
Prescription Solutions, including mail-service revenues from the
acquired Harris business. Prescription Solutions generates
mail-service revenues, where we, rather than network retail
pharmacies, collect the member copayments.

Net Investment Income.Net investment income increased
approximately 29% to $108 million for the year ended
December 31, 2000 compared to the prior year due to higher
average invested balances and increases in short- and long-term
interest rates combined with the gradual shift of tax-exempt
investments to higher yielding taxable securities.

Consolidated Medical Loss Ratio.The consolidated medical loss
ratio (health care services as a percentage of premium revenue)
changed for the year ended December 31, 2000 compared to
the prior year as follows:

|                    |              |              |  |      |   |  |  |      |  
|------------------- | ------------ | ------------ |  | ---- | - |  |  | ---- | -
|                    |              |             
|                    |              | Year Ended  
|                    |              | December 31,
|                    |              |             
|                    |              | 2000         |  | 1999
|                    |              |              |  |     
|Medical loss ratio: |              |              |  |      |   |  |  |     
|                    | Consolidated |              |  | 87.5 | % |  |  | 84.8 | %
|                    | Commercial   |              |  | 85.1 | % |  |  | 81.7 | %
|                    | Medicare     |              |  | 89.4 | % |  |  | 86.9 | %

Commercial Medical Loss Ratio.The commercial medical loss ratio
includes results from our specialty HMO and indemnity insurance
operations. The commercial medical loss ratio for the year ended
December 31, 2000 increased compared to the prior year due
to:



|  |                                                                                                                               
|- | ------------------------------------------------------------------------------------------------------------------------------
| | Higher physician, inpatient, outpatient and
	emergency service utilization under fee-for-service or
	risk-based contracts; and
| 
| | Higher prescription drug costs; partially offset
	by                                                                          
| 
| | Premium rate increases.                                                                                                       

For the year ended December 31, 2000,
commercial health care costs outpaced premium rate increases
primarily in California, Colorado and Texas. In these states,
more members accessed more services from providers with whom we
have shared-risk, rather than capitation contracts.
Additionally, our California HMO experienced increased health
care costs because we became responsible for unpaid health care
claims that were previously the responsibility of providers who
became insolvent. See Note 10 of the Notes to Consolidated
Financial Statements.

35



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##### Table of Contents



Medicare Medical Loss Ratio.The Medicare medical loss ratio
increased for the year ended December 31, 2000 compared to
the prior year due to:



|  |                                                                                                                               
|- | ------------------------------------------------------------------------------------------------------------------------------
| | Higher physician, inpatient, outpatient and
	emergency service utilization under fee-for-service or
	risk-based contracts; and
| 
| | Higher prescription drug costs; partially offset
	by                                                                          
| 
| | Premium rate increases, which include Medicare
	rates and supplemental member premiums.                                       

For the year ended December 31, 2000,
Medicare health care costs outpaced premium rate increases
primarily in California, where more members accessed more
services from providers with whom we have shared-risk, rather
than capitation contracts. Additionally, our California HMO
became responsible for unpaid health care claims that were
previously the responsibility of providers who became insolvent.
Increased Medicare health care costs were partially offset by
significant premium rate increases in Colorado, Oregon and
Washington.

Selling, General and Administrative
Expenses.For the year ended
December 31, 2000, selling, general and administrative
expenses as a percentage of operating revenue (excluding net
investment income) decreased compared to the prior year due to
higher operating revenue in 2000.

|                                                                                                                     |  |              |      |      |  |  |      |  
|-------------------------------------------------------------------------------------------------------------------- |  | ------------ | ---- | ---- |  |  | ---- | -
|                                                                                                                     |  |             
|                                                                                                                     |  | Year Ended  
|                                                                                                                     |  | December 31,
|                                                                                                                     |  |             
|                                                                                                                     |  | 2000         |      | 1999
|                                                                                                                     |  |              |      |     
|Selling, general and administrative expenses as a
	percentage of operating revenue (excluding net investment income) |  |              | 10.5 | %    |  |  | 11.1 | %

Impairment, Disposition, Restructuring, OPM
and Other Charges (Credits).We
recognized net pretax charges of $9 million
($5 million or $0.15 diluted loss per share, net of tax)
for the year ended December 31, 2000. See Note 9 of
the Notes to Consolidated Financial Statements.

Operating Income.Operating income decreased 30% to
$367 million for the year ended December 31, 2000,
compared to the prior year. Factors contributing to the change
are discussed above.

|                                                   |  |              |     |      |  |  |     |  
|-------------------------------------------------- |  | ------------ | --- | ---- |  |  | --- | -
|                                                   |  |             
|                                                   |  | Year Ended  
|                                                   |  | December 31,
|                                                   |  |             
|                                                   |  | 2000         |     | 1999
|                                                   |  |              |     |     
|Operating income as a percent of operating revenue |  |              | 3.2 | %    |  |  | 5.2 | %

Interest Expense.Interest expense increased
approximately 85% to $80 million for the year ended
December 31, 2000 compared to the prior year due to:



|  |                                                                                                                  
|- | -----------------------------------------------------------------------------------------------------------------
| | Increased borrowings on our credit facility to
	fund our share repurchase program; and                           
| 
| | Higher short-term interest rates combined with a
	higher interest fee structure in the credit facility agreement.

Provision for Income Taxes.The effective income tax rate was
44.1% for the year ended December 31, 2000, compared with
42.2% in 1999. Because of lower 2000 earnings, the
non-deductible goodwill amortization expense is a higher
percentage of pretax income, increasing our 2000 effective tax
rate.

Significant Fourth Quarter Items.During the fourth quarter of 2000,
our claims incurred but not reported increased by
$21 million for periods prior to September 30, 2000,
primarily due to increased utilization and cost of claims under
risk-based hospital arrangements. This increase was partially
offset by $15 million of reductions in related ancillary
reserves, such as reserves for claims backlog and vision and
mental health claims. Additionally, during the fourth quarter of
2000, our selling, general and administrative expenses decreased
by $11 million, related to incentive compensation and other
accruals.

36



---



##### Table of Contents



Reconciliation of Reported Results to Pro
Forma Results.In our fourth
quarter 2000 earnings announcement, we disclosed pro forma
results as described in the following table. See Note 9 of
the Notes to Consolidated Financial Statements.

|                            |                                                                       |                        |   |              |  |      |   |      |  |  |   |       |   |  |   |      | 
|--------------------------- | --------------------------------------------------------------------- | ---------------------- | - | ------------ |  | ---- | - | ---- |  |  | - | ----- | - |  | - | ---- | 
|                            |                                                                       |                        |   |              |  |     
|                            |                                                                       | Three Months           |   |             
|                            |                                                                       | Ended                  |   | Year Ended  
|                            |                                                                       | December 31,           |   | December 31,
|                            |                                                                       |                        |   |             
|                            |                                                                       | 2000                   |   | 1999         |  | 2000 |   | 1999
|                            |                                                                       |                        |   |              |  |      |   |     
|                            |                                                                       |                       
|                            |                                                                       | (Amounts in millions, 
|                            |                                                                       | except per-share data)
|Net income:                 |                                                                       |                        |   |              |  |      |   |      |  |  |   |       |   |  |   |     
|                            | As reported                                                           |                        | $ | 12           |  |      | $ | 66   |  |  | $ | 161   |   |  | $ | 279  | 
|                            | Impairment, disposition, restructuring and other
	charges, net of tax |                        |   | 6            |  |      |   |     |  |  |   | 7     |   |  |   | 2    | 
|                            | Office of Personnel Management credits, net of tax                    |                        |   |             |  |      |   |     |  |  |   | (2    | ) |  |   |     | 
|                            |                                                                       |                        |   |              |  |      |   |      |  |  |   |       |   |  |   |     
|                            | Pro forma net income                                                  |                        | $ | 18           |  |      | $ | 66   |  |  | $ | 166   |   |  | $ | 281  | 
|                            |                                                                       |                        |   |              |  |      |   |      |  |  |   |       |   |  |   |     
|Diluted earnings per share: |                                                                       |                        |   |              |  |      |   |      |  |  |   |       |   |  |   |     
|                            | As reported                                                           |                        | $ | 0.35         |  |      | $ | 1.59 |  |  | $ | 4.58  |   |  | $ | 6.23 | 
|                            | Impairment, disposition, restructuring and other
	charges, net of tax |                        |   | 0.17         |  |      |   |     |  |  |   | 0.20  |   |  |   | 0.04 | 
|                            | Office of Personnel Management credits, net of tax                    |                        |   |             |  |      |   |     |  |  |   | (0.05 | ) |  |   |     | 
|                            |                                                                       |                        |   |              |  |      |   |      |  |  |   |       |   |  |   |     
|                            | Pro forma diluted earnings per share                                  |                        | $ | 0.52         |  |      | $ | 1.59 |  |  | $ | 4.73  |   |  | $ | 6.27 | 
|                            |                                                                       |                        |   |              |  |      |   |      |  |  |   |       |   |  |   |     

Liquidity and Capital Resources

Operating Cash Flows.Our consolidated cash, equivalents
and marketable securities decreased $76 million or 4% to
$2.0 billion at December 31, 2001, from
$2.1 billion at December 31, 2000.

Cash flows provided by operations, excluding the
impact of deferred revenue, were $86 million at
December 31, 2001 compared to cash flows provided from
operations, excluding the impact of deferred revenue of
$605 million at December 31, 2000. The decrease was
primarily related to changes in assets and liabilities as
discussed below in Other Balance Sheet Explanations.

Investing Activities.For the year ended
December 31, 2001, we used $261 million for investing
activities compared to $72 million provided during the year
ended December 31, 2000. We purchased $208 million of
marketable securities in 2001 to obtain longer-duration
securities with higher yields during a period of falling
interest rates, compared to $170 million of marketable
securities sold in the prior year to provide cash to fund the
Harris acquisition and share repurchases.

In December 2001, we entered into a 10-year
contract to outsource our IT operations to IBM. Under the
contract, IBM is the coordinator of our IT outsourcing
arrangement, and will provide IT services and day-to-day
management of our IT infrastructure, including data center
operations, support services and information distribution. In
January 2002, we entered into a 10-year contract to outsource
our IT software applications maintenance and enhancement
services to Keane, Inc. Our total cash obligations for base fees
under these contracts over the 10-year terms will be
$1.3 billion. For a table that describes our future
contractual cash obligations, see Note 5 of the Notes to
Consolidated Financial Statements. In connection with the IBM
outsourcing contract, we sold IBM computer equipment with a net
book value of $42 million. The consideration we received
from IBM for the sale included $25 million in cash, and a
note receivable for the $17 million balance. We will
collect the note receivable in the form of credits against our
base fee payments from 2002 through 2005.

37



---



##### Table of Contents



Financing Activities.For the year ended
December 31, 2001, we used $52 million of cash for
financing activities compared to $301 million used for the
same period in the prior year. The changes were as follows:



|  |                                                                                                                                                                                                                                                                                                                    
|- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | We repurchased 4.0 million shares of our
	common stock in 2000 for $173 million under our stock
	repurchase program. No shares were repurchased in 2001;                                                                                                                                                           
| 
| | We paid a net $30 million on our credit
	facility in 2001 compared to a net $138 million in 2000;                                                                                                                                                                                                                  
| 
| | We paid a total of $13 million in amendment
	fees and expenses in 2001 in connection with the extension of
	our credit facility;                                                                                                                                                                                   
| 
| | There were no material proceeds from issuing
	common shares in 2001 compared to $2 million received in
	2000; and                                                                                                                                                                                                  
| 
| | We paid $9 million to three minority
	stockholders for all outstanding stock of our consolidated
	minority subsidiary compared to $8 million received from
	one minority stockholder that invested in our consolidated
	minority subsidiary in 2000. See Note 2 of the Notes to
	Consolidated Financial Statements.

In August 2001, we executed an amendment to our
existing senior credit facility with our lenders to extend its
maturity date. The amended and restated credit facility provided
for a $650 million term loan and a $150 million
revolving line of credit, and will mature on January 2,
2003. As of December 31, 2001, there was $705 million
outstanding under the credit facility, including the
$650 million term loan and $55 million under the
revolving line of credit. Included in the amount outstanding as
of December 31, 2001 under the revolving line of credit are
letters of credit equal to $29 million, which left us with
$66 million for additional borrowing under the revolving
line of credit as of that date. On January 2, 2002, we paid
and permanently retired $25 million of the outstanding
balance on our term loan with proceeds we received from computer
equipment sold to IBM.

The interest rates per annum applicable to
amounts outstanding under the term loan and revolving line of
credit are, at our option, either the administrative
agents publicly announced prime rate (or, if
greater, the Federal Funds Rate plus 0.5%) plus a margin of 2.5%
per annum, or the rate of Eurodollar borrowings for the
applicable interest period plus a margin of 3.5% per annum.
These margins will increase by 1% per annum if we do not
permanently pay down the term loan by at least $250 million
by March 31, 2002. We do not intend to pay down the term
loan to avoid this margin increase. Based on our outstanding
balance under the credit facility at December 31, 2001, our
average overall interest rate, excluding the facility fee, was
5.7% per annum.

At December 31, 2001 we were in compliance
with all of our senior credit facility covenants. The terms of
the senior credit facility contain various covenants usual for
financings of this type, including a minimum net worth
requirement, a minimum fixed-charge coverage requirement, a
minimum leverage ratio and a minimum liquidity requirement. On
January 23, 2002 we negotiated an amendment to our senior
credit facility to exclude our fourth quarter restructuring
charge from our financial covenants. In connection with the
extension of the maturity of the senior credit facility, our
unregulated subsidiaries provided guarantees and have granted
security interests to the lenders in all of their personal
property.

We also have $88 million in senior notes
outstanding that we assumed when we acquired FHP in 1997. These
notes mature on September 15, 2003, and bear interest at 7%
payable semiannually. In September 2001, we retired
$12 million of the FHP senior notes by exchanging
approximately 0.8 million shares of common stock for those
notes. We reissued treasury stock to provide the common stock
used in the exchange. The note retirements resulted in a pretax
extraordinary gain of $2 million ($0.9 million or
$0.02 diluted earnings per share, net of tax), and a net equity
increase of $10 million. The FHP notes share in the
security granted under our amended and restated credit facility.

In December 2001, we entered into an arrangement
with Acqua Wellington North American Equities Fund Ltd., or
Acqua Wellington, an institutional investor, for the purchase by
Acqua Wellington of up to 6.9 million shares or
$150 million in our common stock. We have the ability to
call the equity commitment for an 18-month period beginning
December 26, 2001, the effective date of our registration

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statement relating to the equity commitment, at a
price per share equal to the daily volume weighted average price
of our common stock on each of the 18 consecutive trading days
in a draw down period that the weighted average price is above
the threshold price we determine for the applicable draw down,
less a discount ranging from 3.2% to 4.7% that is based on the
threshold price. We have the sole discretion to present up to
15 draw down notices to Acqua Wellington. Each draw down
notice sets the threshold price and the dollar value of shares
Acqua Wellington may be obligated to purchase during a draw down
period. The threshold price we choose cannot be less than $11.00
per share. The threshold price we select determines the maximum
dollar value of shares and the discount to the market price
based upon a predetermined schedule. As funds are drawn,
proceeds will be used to reduce our outstanding bank term debt.


Our ability to repay debt depends on dividends
and cash transfers from our subsidiaries. Nearly all of the
subsidiaries are subject to HMO regulations or insurance
regulations and may be subject to substantial supervision by one
or more HMO or insurance regulators. Subsidiaries subject to
regulation must meet or exceed various capital standards imposed
by HMO or insurance regulations, which may from time to time
impact the amount of funds the subsidiaries can pay to us. Our
subsidiaries are not obligated to make funds available to us and
creditors of our subsidiaries have superior claims to our
subsidiaries assets. 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 dividends or make other cash
transfers.

We expect to fund our working capital
requirements and capital expenditures during the next twelve
months from our cash flow from operations. We have taken a
number steps to increase our cash flow from operations,
including premium increases, increased marketing for specialty
product lines and the introduction of new products as well as
exits from unprofitable markets and cost savings initiatives,
including our restructuring announced in December 2001 and our
outsourcing of our IT infrastructure and software maintenance.
If our cash flows are less than we expect due to one or more of
the risk factors described in Forward-Looking
Statements, or our cash flow requirements increase for
reasons we do not currently foresee, then we may need to draw
down our remaining available funds ($66 million as of
December 31, 2001) on our senior revolving credit facility
which matures in January 2003. A failure to comply with any
covenant in the senior credit facility could make these funds
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.

In addition, we do not expect to retire our
senior credit facility from internally generated cash flows
prior to its maturity in January 2003. Accordingly, we will seek
to extend or refinance all or a portion of the senior credit
facility. In addition, we may also seek to refinance the
$88 million in senior notes that mature in September 2003.
In late 2000, during 2001 and to date, the agencies that assign
ratings to our long-term debt have downgraded our credit
ratings. As of March 2002, Moodys rating of our long-term
debt was B2, with a negative outlook, Standard and Poors
rating was BB- with a stable outlook and Fitch IBCAs
rating was BB- with an evolving outlook. Because we no longer
qualify for an investment grade rating, our ability to refinance
our debt in capital markets is limited to non-investment grade
debt and equity or equity-linked instruments. We may not be able
to refinance all or any portion of this debt or do so on terms
favorable to us. We may need to draw upon our $150 million
equity line of credit and/or raise additional capital to retire
a portion of our debt, and additional capital may not be
available on terms favorable to us. Any issuance of equity or
equity-linked securities may result in substantial dilution to
our stockholders.

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Other Balance Sheet Change
Explanations

Receivables, Net.Receivables as of
December 31, 2001, net decreased $35 million from
December 31, 2000 as follows:



|  |                                                                                                                                                                                                                                     
|- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | $58 million decrease in premium receivables,
	primarily related to a reduction in membership and an increase
	in collection efforts to reduce the overall aging of our
	receivables, partially offset by premium rate increases; and
| 
| | $17 million decrease in provider
	receivables, primarily due to a reduction in provider incentive
	and capitation receivables; partially offset by                                                                                  
| 
| | $36 million increase in trade receivables,
	due to higher rebates and increased billings for new
	unaffiliated pharmacy benefit management customers; and                                                                           
| 
| | $4 million increase in other receivables,
	due primarily to the timing of interest income.                                                                                                                                          

Goodwill and Intangible Assets, Net.Goodwill and intangible assets as
of December 31, 2001 decreased $80 million from
December 31, 2000 due to goodwill and intangible
amortization expense. As more fully described in Note 2 of
the Notes to Consolidated Financial Statements, we expect to
record impairment charges as the cumulative effect of a change
in accounting principle in connection with our adoption of
Statements of Financial Accounting Standard, or SFAS,
No. 142, Goodwill and Other Intangible Assets, as of
January 1, 2002. Excluding any impairment charges, we
expect application of the goodwill nonamortization provisions of
SFAS No. 142 to result in an increase in net income of
approximately $56 million in 2002.

Medical Claims and Benefits Payable.The majority of our medical claims
and benefits payable represent liabilities related to our
risk-based contracts. Under risk-based contracts, claims are
payable once incurred and cash disbursements are made to health
care providers for services provided to members after the
related claim has been submitted and adjudicated. Under
capitated contracts, health care providers are prepaid on a
fixed-fee per-member per-month basis, regardless of the 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, 2001,
approximately 79% of medical claims and benefits payable are
attributable to risk-based contracts.

Medical claims and benefits payable as of
December 31, 2001 decreased $175 million from
December 31, 2000 primarily due to the following:



|  |                                                                                                                                                                                                                                                                       
|- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | $106 million decrease in claims incurred but
	not reported or not paid due to membership declines, claims
	processing productivity improvements that resulted in faster
	claims payments and the reduction of older, high dollar claims;                              
| 
| | $23 million decrease in withhold pools due
	to the payment of administered claims for previously capitated
	providers that switched to fee-for-service arrangements and
	additional decreases related to risk program settlements, which
	offset provider receivables;
| 
| | $27 million decrease in capitation
	liabilities primarily due to payments of capitation to settle
	contracts with terminated providers; and                                                                                                                           
| 
| | $19 million decrease in provider incentive
	liabilities.                                                                                                                                                                                                              

Long-Term Debt and Stockholders
Equity.In September 2001, we
retired $12 million of the FHP senior notes by exchanging
approximately 0.8 million shares of common stock for those
notes. We reissued treasury stock to provide the common stock
used in the exchange. The retirements resulted in a pretax
extraordinary gain of $2 million ($0.9 million or
$0.02 diluted earnings per share, net of tax), and a net equity
increase of $10 million. See Note 5 of the Notes to
Consolidated Financial Statements.

New Accounting Pronouncements.See Note 2 of the Notes to
Consolidated Financial Statements for a discussion of future
application of accounting standards.

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Critical Accounting Policies and
Estimates

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



| |                                     
| | ------------------------------------
| | Medical Claims and Benefits
	Payable

Incurred But Not Reported or Paid Claims
Reserves.We estimate the amount of
our reserves for incurred but not reported or not paid, or IBNR,
claims submitted under our risk-based provider contracts,
primarily using standard actuarial methodologies based on
historical data. These standard actuarial methodologies include,
among other factors, the average interval between the date
services are rendered and the date claims are received and/or
paid, denied claims activity, expected health care cost
inflation, utilization, seasonality patterns and changes in
membership. The estimates for submitted claims and IBNR 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 data. Such estimates could materially understate
or overstate our actual liability for medical claims and
benefits payable. In addition, if our claims processing system
is unable to handle increased claims volume, 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.

Provider Insolvency
Reserves.We maintain insolvency
reserves with respect to our capitated contracts with providers
that include estimates for potentially insolvent providers,
where conditions indicate claims are not being paid or have
slowed considerably. These insolvency reserves include
write-offs of certain uncollectable receivables from providers
and 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. Such estimates could materially understate or
overstate our actual liability for medical claims and benefits
payable.



| |                    
| | -------------------
| | Legal Contingencies

Reserves relating to the OPM.We have commercial contracts with OPM
to provide managed health care services to federal employees,
annuitants and their dependents under the Federal Employee
Health Benefits Program. Periodically, OPMs Office of
Inspector General, or OIG, audits us to verify that the premiums
charged are calculated and charged in compliance with OPMs
regulations and guidelines. During the audit process, OPM has
referred and may continue to refer its findings to the United
States Department of Justice, or DOJ, if it believes that we may
have knowingly overcharged the government or otherwise submitted
false documentation or certifications in violation of the False
Claims Act. The resolution of these matters could result in a
material adverse effect on our results of operations or cash
flows. In addition, we cannot be certain that additional audits
will not be referred to the DOJ, or that additional, possibly
material, liability will not be incurred.

Ordinary Course Legal Proceedings.From time to time, we are involved in
legal proceedings that involve claims for coverage and tort
liability encountered in the ordinary course of business. The
loss of even one such claim, 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.

For further discussion of risk factors associated
with these accounting estimates, read Forward Looking
Statements  Risk Factors.

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FORWARD-LOOKING STATEMENTS

Some of the statements contained in this report
are forward-looking statements within the meaning of
Section 27A of the Securities Act of 1933, as amended, or
Securities Act, and Section 21E of the Securities Exchange
Act of 1934, as amended, or Exchange Act, and are subject to the
safe harbor created by the Securities Litigation Reform Act of
1995. 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 under Risk
Factors, 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.

RISK FACTORS

We may substantially reduce our participation
in the Medicare+Choice program, which without a replacement for
any lost premiums resulting from reduced participation in that
program with revenue from other sources could adversely affect
our results of operations.

We have reduced our participation in the
Medicare+Choice program, which has accounted for approximately
60% of our total premiums in each year since 1998, because of
shortfalls in Medicare+Choice premiums compared to our rising
health care service expenses and increased Medicare
administration costs. Such shortfalls contributed to our
decision to cease offering or close enrollment in our
Medicare+Choice products in various counties in 2002, 2001 and
2000. These premium trends also contributed to changes in our
benefits, copayments and deductibles.

We also expect to experience voluntary attrition,
which may be significant, in our Medicare+Choice membership as
we continue to scale back benefits and increase monthly premiums
under our Medicare+Choice products to achieve more profitable
levels. Our market exits have so far resulted in a reduction of
approximately 50,000 members in January 2002. We cannot predict
the magnitude of voluntary attrition and do not expect to be
able to assess any trends relating to voluntary attrition until
the second quarter of 2002. CMS recently announced that federal
payments to Medicare+Choice managed care organizations are
projected to increase only 2%, the guaranteed minimum required
by law, in calendar year 2003 and we expect we will continue to
reduce our participation in the Medicare+Choice program if
federal funding for the Medicare+Choice program does not
increase. To the extent that we continue to reduce our
participation in the Medicare+Choice program, our revenue will
decline unless lost revenue from our Medicare+Choice products is
replaced with revenue from other sources, such as our new
Medicare supplement product offerings or other lines of
business. We cannot predict whether we will be able to replace
some or all of our lost revenue from our Medicare+Choice
products with new sources of revenue. Without a replacement for
any lost revenue from our Medicare+Choice products, our results
of operations could be adversely affected, for example by
increasing our administrative costs as a percentage of our
revenue.

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Our premiums for our commercial products and
Medicare+Choice products are generally fixed in advance of the
periods covered and our profitability may suffer to the extent
that those premiums do not adequately allow for increases in the
costs of health care services over those periods.

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 one-year period. In addition,
each of our subsidiaries that offers Medicare+Choice products
must submit adjusted community rate proposals, generally by
county or service area, to CMS by July 1 for each such
product that will be offered in a subsequent year. As a result,
increases in the costs of health care services in excess of the
estimated future health care costs reflected in the premiums or
the adjusted community rate proposals generally cannot be
recovered in the applicable contract year through higher
premiums or benefit designs. Many factors, including health care
costs that rise faster than premium increases, increases in
utilization and regulatory changes, could cause actual health
care costs to exceed what was estimated and reflected in
premiums. To the extent that such excesses occur, our results of
operations will be adversely affected.

If we do not continue to enhance our
underwriting capabilities, our abilities to appropriately price
our commercial products in light of the risk we assume and
assess the profitability of our different markets could be
materially and adversely affected.

We use our underwriting systems to establish and
assess premium rates based upon accumulated actuarial data, with
adjustments for factors such as claims experience and hospital
and physician contract changes. We have made significant
progress in enhancing our actuarial and underwriting
capabilities so that we are able to better price our commercial
products, particularly in light of the continuing shift away
from capitated contracts to risk-based contracts, and make
market exit decisions for our Medicare+Choice markets. The
further development and implementation of these capabilities is
an ongoing process that will continue for a period of time. To
the extent that we are not able to develop and implement these
capabilities in a timely and cost effective manner, our results
of operations and cash flows may be materially and adversely
affected.

Our financial and operating performance could
be adversely affected by a reduction in revenue caused by
membership losses or lower-than-expected premiums.

We expect our revenues to decline approximately
6%, or approximately $700 million during 2002, compared to
2001 revenues. We expect to lose approximately
150,000 commercial members and 130,000 Medicare
members during 2002, primarily as a result of our exits of
unprofitable markets and products and increased premiums and
benefit reductions, and we expect our membership declines to
more than offset our premium increases. A loss of profitable
membership, an inability to increase commercial membership in
targeted markets, including unaffiliated membership in our PBM
and other specialty businesses, including our PPO and Medicare
supplement products, an inability to gain market acceptance and
expected membership in new product lines, including our PPO and
Medicare supplement products, or an inability to achieve
expected premium increases could negatively affect our financial
position, results of operations or cash flows. Factors that
could contribute to the loss of membership, failure to gain new
members in targeted markets or new product lines, or lower
premiums include:



|  |                                                                                                                                                                                
|- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | the effect of premium increases, benefit changes
	and member-paid supplemental premiums and copayments on the
	retention of existing members and the enrollment of new members;
| 
| | the inability of our marketing and sales plans to
	attract new customers or retain existing customers for existing
	products and new products;                                 
| 
| | 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;                  
| 
| | our exit from selected service areas, including
	Medicare+Choice markets;                                                                                                      
| 
| | our limits on enrollment of new Medicare+Choice
	members in selected markets, through a combination of capacity
	waivers and voluntary closure notices;                        

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|  |                                                                                                               
|- | --------------------------------------------------------------------------------------------------------------
| | reductions in work force by existing customers
	and/or reductions in benefits purchased by existing customers;
| 
| | negative publicity and news coverage about us or
	litigation or threats of litigation against us;             
| 
| | our failure to successfully complete and/or
	integrate acquisitions; and                                      
| 
| | the loss of key sales and marketing employees.                                                                

Our profitability has been adversely affected,
and will continue to be significantly impacted, by our ability
to control our health care costs under risk-based
contracts.

We have experienced a significant increase in our
health care costs as a greater proportion of our membership was
covered through risk-based hospital and physician contracts. For
percentages of membership by contract type, see
Managements Discussion and Analysis of Financial
Condition and Results of Operations, Expenses 
Commercial and Medicare Health Care Services. We
expect this shift to risk-based contracts to continue, primarily
as a result of planned transitions in Arizona, California,
Oklahoma and Texas. To the extent that we have entered into and
may continue to increasingly enter into risk-based contracts
with hospitals and physicians, our ability to control our health
care costs and profitability will increasingly depend on our
ability to accurately predict member utilization of health care
services and claims costs, and proportionately less on our
ability to control health care costs under capitated contracts.
Our inability to control health care costs under risk-based
contracts could have a material adverse effect on our financial
condition and results of operations.

Our results of operations could be adversely
affected by increased health care costs caused by increased
utilization of health care services under risk-based
contracts.

Under risk-based contracts, we risk incurring
higher than expected health care costs due to increased
utilization of hospital and physician services. To reduce the
risk of higher than medically warranted utilization, we have
developed medical management programs to manage health care
costs, and are investing in the development of systems to
monitor and manage the utilization of health care services,
while maintaining quality of care, and renegotiating provider
contracts to reduce costs. Our consolidated medical loss ratio
could continue to increase if our programs for controlling
utilization are not successful and we are not able to increase
premiums appropriately to offset the cost of such utilization
increases.

We could become subject to material unpaid
health care claims and health care costs that we would not
otherwise incur because of insolvencies of providers with whom
we have capitated contracts.

We maintain insolvency reserves that include
estimates for potentially insolvent providers, where conditions
indicate claims are not being paid or have slowed considerably.
Providers with whom we have capitated contracts could become
insolvent. 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 where we are
unable to agree upon a contract that is mutually beneficial.
These costs may be incurred when we need to contract with other
providers at less than cost-effective rates to continue
providing health care services to our members. In addition to
our insolvency exposure, our providers have deposited security
reserves in third party institutions. Because our access to
provider security reserves has, and may be subject to challenge
by the provider group or other third parties at interest, we
could incur additional charges for unpaid health care claims if
we are ultimately denied access to these funds. During 2001, we
recorded $58 million in insolvency reserves, primarily as a
result of Texas physician bankruptcies and other potentially
insolvent providers in Texas.

In 2001, the Texas legislature adopted changes to
legislation that may affect contracts that our Texas subsidiary
enters into or renews with its delegated network providers after
January 1, 2002. State regulators may take the position
that this legislation provides that HMOs are liable for paying
individual provider claims that are otherwise the financial
responsibility of the capitated physician group if the HMO does
not

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comply with the oversight requirements of the
legislation. See Item 3. Legal Proceedings, State of
Texas Litigation. We cannot predict whether the financial
condition of our Texas providers will continue to deteriorate.
To the extent that we do not accurately estimate the timing,
amount or outcome of claims asserted against us based on
providers with whom we have capitated contracts and who become
insolvent, our results of operations or cash flows for a future
period could be materially and 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.

In any particular market, health care providers
could refuse to contract, demand higher payments, or take other
actions that could result in higher health care costs or
difficulty meeting regulatory or accreditation requirements. In
some markets, some health care providers, particularly
hospitals, physician/hospital organizations or multi-specialty
physician groups, may have significant market positions. 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 such as those that
occurred recently in Texas. A reduction in our membership
resulting from disruptions in our health care provider networks
would reduce our revenue and increase the proportion of our
premium revenue needed to cover our health care costs.

Our results of operations could be adversely
affected by understatements in our actual liabilities caused by
understatements in our actuarial estimates of IBNR
claims.

We estimate the amount of our reserves for IBNR
claims primarily using standard actuarial methodologies based
upon historical data. These standard actuarial methodologies
include, among other factors, the average interval between the
date services are rendered and the date claims are received
and/or paid, denied claims activity, expected health care cost
inflation, utilization, seasonality patterns and changes in
membership. The estimates for submitted claims and IBNR are made
on an accrual basis and adjusted in future periods as required.
Such estimates could understate or overstate our actual
liability for claims and benefits payable. Any increases to such
prior estimates could adversely affect our results of operations
in future periods.

If our claims processing system is unable to
handle an increasing claims volume, we may become subject to
additional regulatory actions or less able to accurately
estimate claims liabilities and establish related
reserves.

We have regulatory risk for the accurate and
timely processing and payment of claims. If we are unable to
handle continued increased claims volume, 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 handle
such increased claims volume, 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. See Item 3. Legal Proceedings, State of
Texas Litigation.

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

Overall, prescription drug costs have been rising
for the past few years. The increases are due to the
introduction of new drugs 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. As a way of controlling this health
care cost component, we have implemented a significant decrease
in prescription drug benefits for our Medicare+Choice members in
almost all of our geographic areas in 2002. Despite these
efforts, however, we may be unable to adequately control this
health care cost component, which could adversely impact our
profitability.

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

During 2002, we expect our selling, general and
administrative expenses, net of savings from our December 2001
restructuring, to increase in connection with a new advertising
campaign, new technology initiatives, increased expenses to
market our PBM to unaffiliated members and plan sponsors, and
expenses to expand our electronic prescription capabilities.
Despite our efforts to control our selling, general and
administrative expenses, these expenses 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 medical
	management, underwriting and actuarial resources and technology;                            
| 
| | our need for increased claims administration,
	personnel and systems;                                                                       
| 
| | the necessity to comply with regulatory
	requirements, including the Health Insurance Portability and
	Accountability Act of 1996, or HIPAA;
| 
| | the success or lack of success of our marketing
	and sales plans to attract new customers, and create customer
	acceptance for new products;
| 
| | our need for additional advertising, marketing,
	administrative or management information systems expenditures;                             
| 
| | our ability to estimate costs for our retention
	for medical malpractice claims; and                                                        
| 
| | our inability to achieve efficiency goals and
	resulting cost savings from announced restructuring or other
	initiatives.                   

In addition, our selling, general and
administrative expenses as a percentage of our revenue could
increase due to changes in our product mix between Medicare and
commercial products and expected declines in our revenue, and
could be adversely affected if we exit Medicare+Choice markets
without replacing our revenue from those markets with revenue
from other sources, such as our new Medicare supplement product
offerings. If we do not generate expected cash flow from
operations, we could be forced to postpone or cancel some of
these planned investments, which would adversely affect our
ability to meet our short term strategic plan.

We may not accurately estimate the amounts we
will need to spend to comply with HIPAA, which may adversely
affect our ability to execute portions of our business strategy
or our expenses.

HIPAA includes administrative simplification
provisions directed at standardizing transactions and codes and
seeking protections for confidentiality and security of patient
data. We expect to modify all of our information systems and
business processes to comply with HIPAA regulations regarding
standardizing transactions and codes. We also expect to incur
expense developing systems and refining processes and contracts
to comply with HIPAA. We currently estimate that our HIPAA
compliance costs will approximate $27 million in 2002 as
well as $3 million in capital expenditures. We continue to
evaluate the work required to meet HIPAA requirements and
mandated compliance timeframes. To the extent that our estimated
HIPAA compliance costs are less than our actual HIPAA compliance
costs, amounts we had budgeted for other purposes will need to
be used for HIPAA compliance which may adversely affect our
ability to execute portions of our business strategy or may
increase our selling, general and administrative expenses.

We are subject to several lawsuits brought by
health care providers and members alleging that we engage in a
number of improper practices. Depending upon their outcome,
these lawsuits could result in material liabilities to us or
cause us to incur material costs, to change our operating
procedures or comply with increased regulatory
requirements.

Health care providers and members are currently
attacking practices of the HMO industry through a number of
lawsuits, including purported class action lawsuits brought
against us and other HMOs. The

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lawsuits brought by health care providers allege
that HMOs claims processing systems automatically and
impermissibly alter codes included on providers
reimbursement/claims forms to reduce the amount of
reimbursement, and that HMOs impose unfair contracting terms on
health care providers, impermissibly delay making capitated
payments under their capitated contracts, and negotiate
capitation payments that are inadequate to cover the costs of
health care services provided. The lawsuits brought by members
allege that HMOs engage in a number of purportedly undisclosed
practices designed to limit the amount and cost of health care
services provided to members. These alleged practices include:




|  |                                                                                                                                                                                                  
|- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | providing health care providers with financial
	incentives to restrict hospitalizations, referrals to specialist
	physicians, and prescriptions for high cost drugs;                             
| 
| | entering into capitated contracts with health
	care providers, since capitated providers have financial
	incentives to limit health care services;                                               
| 
| | manipulating prescription drug formularies by
	removing drugs from formularies after members enroll;                                                                                             
| 
| | manipulating determinations of whether health
	care services are medically necessary by excluding expensive
	procedures and treatments from being considered medically
	necessary; and           
| 
| | making determinations that established procedures
	and treatments for certain diseases, illnesses or injuries are
	experimental or investigational and so not provided for under
	HMOs coverage.

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

Audits by the OIG of the premiums charged
under our contracts with OPM could result in material
liabilities to us.

We have commercial contracts with OPM to provide
managed health care services to federal employees, annuitants
and their dependents under the Federal Employee Health Benefits
Program, or FEHBP. Periodically, OPMs OIG audits us to
verify that the premiums charged are calculated and charged in
compliance with OPMs regulations and guidelines. OPM has
the right to audit the premiums charged during any period for up
to six years following that period. The final resolution and
settlement of audits have historically taken more than three
years and as many as seven years. During the audit process, OPM
has referred and may continue to refer its findings to the DOJ
if it believes that we may have knowingly overcharged the
government or otherwise submitted false documentation or
certifications in violation of the False Claims Act. Under the
False Claims Act, an action can be considered knowingly
committed if the government contractor acted with actual
knowledge, or with reckless disregard or deliberate ignorance of
the governments rules and regulations. If the government
were to win a False Claims Act lawsuit against us, the
government could obtain the amounts overcharged and a trebling
of these damages, plus interest and substantial civil penalties.
The government could also permanently disqualify us from
participating in all federal government programs. We have a
number of pending audits that we are seeking to resolve with the
DOJ. These audits claim that substantial amounts were
overcharged. In addition, the DOJ has indicated an intention to
seek additional recoveries under the False Claims Act in
relation to some of these audits, which could include up to a
trebling of any amounts that are found to have been overcharged.
The resolution of these matters could result in a material
adverse effect on our results of operations or cash flows. In
addition, we cannot be certain that additional audits will not
be referred to the DOJ, or that additional, possibly material,
liability will not be incurred. Such liability could have a
material adverse effect on results of operations or cash flows.

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

From time to time, we are involved in legal
proceedings that involve claims for coverage encountered in the
ordinary course of business. We, like other HMOs and health
insurers generally, exclude payment for some health care
services from coverage under our HMO and other plans. 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. The shift away from capitated
contracts to risk-based contracts may result in more claims of
this nature as we increase our medical management capabilities
and take a more active role in managing the cost of medical
care. In addition, we may be subject to more claims of this
nature from our Medicare+Choice members that will be litigated
in state court, rather than under the Medicare Acts
administrative review process, based on a recent California
Supreme Court decision that the United States Supreme Court
declined to review. The loss of even one such claim, 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,
managed care errors and omissions and medical malpractice
insurance coverage. We are at risk for our self-insured
retention on these claims. Coverages typically include varying
and increasing levels of self-insured retention or deductibles
that increase our risk of loss.

Regulators could terminate or elect not to
renew our Medicare contracts, change the program or its
regulatory requirements, or audit our proposals for Medicare
plans, all of which could materially affect our revenue or
profitability from our Medicare+Choice products.

The Medicare program has accounted for
approximately 60% of our total premiums in each year since 1998.
CMS, the Department of Health and Human Services, or DHHS, and
state regulatory agencies regulate the benefits provided,
premiums paid, quality assurance procedures, marketing and
advertising for our Medicare+Choice products. CMS may terminate
our Medicare+Choice contracts or elect not to renew those
contracts when those contracts come up for renewal every
12 months. The loss of Medicare contracts or changes in the
regulatory requirements governing the Medicare+Choice program or
the program itself could have a material adverse effect on our
financial position, results of operations or cash flows.

Our adjusted community rate proposals for the
contract year 2002 have been filed and approved. In the normal
course of business, all information submitted as part of the
adjusted community rate process is subject to audit and
approval. We cannot be certain that any ongoing and future
audits will be concluded satisfactorily. We may incur
additional, possibly material, liability as a result of these
audits. The incurrence of such liability could have a material
adverse effect on our financial position, results of operations
or cash flows.

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

We operate in highly competitive markets.
Consolidation of acute care hospitals and continuing
consolidation of insurance carriers, other HMOs, employer
self-funded programs and PPOs, some of which have substantially
larger enrollments or greater financial resources than ours, has
created competition for hospitals, physicians and members,
impacting profitability and the ability to influence medical
management. In addition, PBM companies have continued to
consolidate, competing with the pharmacy cost management
capability of our wholly owned subsidiary, Prescription
Solutions. 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, brokers and employers may react
negatively to adverse press associated with HMOs in general or
directly about us, and consequently look to alternatives such as
indemnity products or self-funded programs. If we are unable to
compete effectively in any of our markets, our business may be
adversely affected.

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Recently enacted or proposed legislation,
regulations and initiatives could materially and adversely
affect our business by increasing our operating costs, reducing
our membership or subjecting us to additional
litigation.

Recent changes in state and federal legislation
have increased and will continue to increase the costs of
regulatory compliance, and proposed changes in the law may
negatively impact our financial and operating results. These
changes may increase our health care costs, decrease our
membership or otherwise adversely affect our revenue and our
profitability. Regulation and enforcement is increasing both at
the state and federal level. Increased regulations, mandated
benefits and more oversight, audits and investigations and
changes in laws allowing access to federal and state courts to
challenge health care decisions may increase our administrative,
litigation and health care costs. The following recent or
proposed legislation, regulation or initiatives could materially
affect our financial position:



|  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | proposed legislation and regulation could include
	adverse actions of governmental payers, including reduced
	Medicare premiums, discontinuance of, or limitation on,
	governmentally funded programs, recovery by governmental payers
	of previously paid amounts, the inability to increase premiums
	or prospective or retroactive reductions to premium rates for
	federal employees;                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
| 
| | proposed legislation to provide payment and
	administrative relief for the Medicare+Choice program and
	regulate drug pricing by the state and federal government could
	include provisions that impact our Medicare+Choice products;                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
| 
| | new and proposed patients bill of
	rights legislation at the state level that would hold HMOs
	liable for medical malpractice, including legislation enacted in
	Arizona, California, Oklahoma, Texas and Washington, may
	increase the likelihood of lawsuits against HMOs for malpractice
	liability. The proposed federal patients bill of
	rights has passed both the Senate and the House of
	Representatives but conference action is still pending at this
	time. This legislation would remove or limit the federal
	preemption set forth in the Employee Retirement Income Security
	Act of 1974, or ERISA, that precludes most individuals from
	suing their employer-sponsored health benefit plans for causes
	of action based upon state law and enable members to challenge
	coverage/ benefits decisions in state and federal courts;
| 
| | new and increased initiatives at the DOJ, the OIG
	of the DHHS, the OIG and the various enforcement divisions of
	the state regulatory agencies governing health care programs
	that pursue both civil and criminal investigations against
	physicians, hospitals, payers, and pharmaceutical companies for
	misconduct relating to potential health care fraud and abuse,
	false claims, ERISA violations, violations of the Medicare
	program, overbilling of government programs, incorrect reporting
	of data, and improper denial or mismanagement of care;                                                                                                                                                                                                                                                                                          
| 
| | new and proposed state legislation, regulation,
	or litigation that would otherwise limit our ability to capitate
	physicians and hospitals or delegate financial risk, utilization
	review, quality assurance or other medical decisions to our
	contracting physicians and hospitals;                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
| 
| | existing state legislation and regulation that
	may require increases in minimum capital, reserves, and other
	financial liability requirements and proposed state legislation
	that may limit the admissibility of certain assets;                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
| 
| | state regulations that may increase the financial
	capital requirements of physicians and hospitals who contract
	with HMOs to accept financial risk for health services;                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
| 
| | new and proposed legislation that permits and
	would permit independent physicians to collectively bargain with
	health plans on a number of issues, including financial
	compensation;                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
| 
| | state and federal regulations that place
	additional restrictions and administrative requirements on the
	use, electronic retention, transmission and disclosure of
	personally identifiable health information, such as HIPAA, and
	federal regulations that enforce the current HIPAA
	administrative simplification deadlines of April 2003 for
	privacy compliance and October 2003 for data standards
	compliance;                                                                                                                                                                                                                                                                                                                                                                                                                                   

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|  |                                                                                                                                                                           
|- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | new state and proposed federal laws mandating
	benefits including those that mandate equal coverage for mental
	health benefits, commonly called mental health parity; and
| 
| | existing and proposed legislation that would
	limit our ability to manage care and utilization such as
	any willing provider and direct access
	laws.                 

We may take charges for long-lived asset
impairments or dispositions, or restructurings that could
materially impact our results of operations or cash
flows.

In the future, we may announce dispositions of
assets or product exits as we continue to evaluate whether our
subsidiaries or products fit within our business strategy. We
may also record long-lived asset impairment charges if one or
more of our subsidiaries with operating losses generates less
operating cash flows than we currently expect. In addition, as
we refocus and retool our work force as part of attempting to
improve our operating performance, we expect some positions to
change or be eliminated, which could result in future
restructuring charges. We cannot be certain that dispositions,
impairments or restructuring activities will not result in
additional charges. In addition, disposition or restructuring
charges could have a material adverse effect on our results of
operations or cash flows.

In June 2001, the Financial Accounting Standards
Board issued SFAS No. 141, Business Combinations,
and No. 142, Goodwill and Other Intangible Assets,
effective for fiscal years beginning after December 15,
2001. Under the new rules, goodwill will no longer be amortized
but will be subject to annual impairment tests in accordance
with SFAS No. 141 and No. 142. Other intangible assets
will continue to be amortized over their useful lives. We will
apply the new rules on accounting for goodwill and other
intangible assets beginning in the first quarter of 2002.

During 2002, we will perform the first of the
required goodwill impairment tests as of January 1, 2002.
The tests for measuring goodwill impairment under SFAS
No. 142 are more stringent than the existing tests required
by SFAS No. 121, Accounting for the Impairment of
Long-Lived Assets and for Long-Lived Assets to Be Disposed Of.Under SFAS No. 121, we applied an undiscounted cash
flow model when assessing the possible impairment of our
reporting units, which did not result in the recognition of
goodwill impairment in 2001. Under SFAS No. 142, we will be
required to use a fair value methodology when assessing the
possible impairment of our reporting units, which will likely
result in impairment charges. We will record such impairment
charges as the cumulative effect of a change in accounting
principle as of January 1, 2002. Impairment charges will
have a material adverse effect on our financial position, but
will not impact operating income or cash flows.

Our guidance for our 2002 operating results is
based on a number of assumptions that are subject to risks and
uncertainties, including the risks discussed above, and our
actual results may differ materially from our
guidance.

We expect our full-year 2002 diluted earnings per
share to range between $3.55 and $3.65, including the positive
impact of the elimination of goodwill amortization under SFAS
No. 142, which amounts to approximately $1.60 per
share. Our earnings per share expectations do not include any
anticipated goodwill impairment charges during 2002. Excluding
the effect of SFAS No. 142 altogether, our expected 2002
earnings per share range of $1.95 to $2.05 indicates that we
expect to achieve at least 15% growth in operating income over
2001. Our guidance assumes that during 2002, total revenues will
decline approximately 6%, or approximately $700 million,
from 2001 revenues. We expect to lose approximately 150,000
commercial members and 130,000 Medicare members, primarily as a
result of exits of unprofitable markets and products, increased
premiums and benefit reductions, and for our membership declines
to more than offset our premium increases. During 2002, as a
result of our efforts to expand our health services portfolio,
we expect our PBM, dental and behavioral health plan membership
to increase by approximately 2.0 million, including both
members covered by our commercial or Medicare HMOs, and members
unaffiliated with our HMOs. In 2002, we expect the commercial
medical loss ratio to range from 86% to 87%, and the Medicare
medical loss ratio to range from 89% to 90%. Our expectation for
selling, general and administrative expenses as a percentage of
operating revenue for 2002 is that the percentage

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will rise to at least 11.5%, primarily as a
result of $80 million that we expect to spend for IT
investments, PBM expansion and a branding advertising campaign.
We plan to fund these expenditures in part through savings that
result from the restructuring program that we began in the
fourth quarter of 2001. We expect EBITDA, defined as net income
plus interest expense, provision for income taxes and
depreciation and amortization expense, before impairment,
disposition, restructuring and other charges (credits) and
Office of Personnel Management credits, for 2002 to approximate
$375 million. Due to the risks described above and
throughout other parts of this report, particularly those
relating to our membership and our ability to control health
care costs, we may not achieve our expected operating results.
Our results may also be impacted by other factors beyond our
control, such as returns on our investment portfolio and
interest rates on our senior credit facility.


We have a significant amount of indebtedness
and it is approaching maturity, which could adversely affect our
operations.

We will seek to extend or refinance, rather than
retire, all or a portion of our amended and restated senior
secured credit facility prior to its maturity on January 2,
2003. As of December 31, 2001, we had outstanding
borrowings of $705 million under that facility. We may also
seek to refinance $88 million of senior notes that we have
outstanding prior to their maturity on September 15, 2003.
In late 2000 and during 2001 and to date in 2002, the agencies
that assign ratings to our long-term debt downgraded our credit
ratings. Because we no longer qualify for an investment grade
rating, we will only be able to refinance our debt in capital
markets transactions by issuing non-investment grade debt or
equity or equity-linked securities. Any non-investment grade
debt securities that we issue to refinance our debt will likely
carry interest rates that increase our already significant debt
service requirements.

Our significant indebtedness and its approaching
maturity poses risks to our business, including the risks that:



|  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | we may not be able to refinance all or any
	portion of our indebtedness or do so on terms favorable to us,
	whether by issuing non-investment grade securities, equity
	securities, equity-linked securities or otherwise;                                                                                                                                                                                                                                                                                                
| 
| | we will use a substantial portion of our
	consolidated cash flow from operations to pay principal and
	interest on our debt, thereby reducing the funds available for
	working capital, capital expenditures, acquisitions and other
	general corporate purposes, including executing our business
	strategy of diversifying our product offerings and making
	planned investments in our branding campaign, the marketing of
	our specialty products and technology initiatives for further
	streamlining our operations;
| 
| | insufficient cash flow from operations may force
	us to sell assets, or seek additional capital, which we may be
	unable to do at all or on terms favorable to us;                                                                                                                                                                                                                                                                                                                                                        
| 
| | our level of indebtedness may make us more
	vulnerable to economic or industry downturns; and                                                                                                                                                                                                                                                                                                                                                                                                                             
| 
| | our debt service obligations increase our
	vulnerabilities to competitive pressures, as many of our
	competitors are less leveraged than we are.                                                                                                                                                                                                                                                                                                                                                                          

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ITEM
7A.     QUANTITATIVE AND QUALITATIVE
DISCLOSURES ABOUT MARKET RISK

Market Risk

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

The following table provides information about
our financial instruments that are sensitive to changes in
interest rates as of December 31, 2001 and 2000. For
investment securities and debt obligations, the table presents
principal cash flows and related weighted average interest rates
by expected maturity dates. Additionally, we have assumed our
marketable securities and marketable securities-restricted,
comprised primarily of U.S. government, state, municipal, and
corporate debt securities, are similar enough to aggregate into
fixed rate and variable rate securities for presentation
purposes. For terms relating to our long term debt, see
Note 5 of the Notes to Consolidated Financial Statements.

As of December 31, 2001:

|                                                     |                       |                        |   |        |   |      |   |         |   |      |   |        |   |       |   |            |   |  |   |         |   |  |   |         |   |  |   |           |   |  |   |           | 
|---------------------------------------------------- | --------------------- | ---------------------- | - | ------ | - | ---- | - | ------- | - | ---- | - | ------ | - | ----- | - | ---------- | - |  | - | ------- | - |  | - | ------- | - |  | - | --------- | - |  | - | --------- | 
|                                                     |                       | 2002                   |   | 2003   |   | 2004 |   | 2005    |   | 2006 |   | Beyond |   | Total |   | Fair Value
|                                                     |                       |                        |   |        |   |      |   |         |   |      |   |        |   |       |   |           
|                                                     |                       |                       
|                                                     |                       | (Amounts in thousands)
|Assets:                                              |                       |                        |   |        |   |      |   |         |   |      |   |        |   |       |   |            |   |  |   |         |   |  |   |         |   |  |   |           |   |  |   |          
|Marketable securities:                               |                       |                        |   |        |   |      |   |         |   |      |   |        |   |       |   |            |   |  |   |         |   |  |   |         |   |  |   |           |   |  |   |          
|                                                     | Fixed rate            |                        | $ | 84,365 |   |      | $ | 75,614  |   |      | $ | 37,610 |   |       | $ | 88,591     |   |  | $ | 116,463 |   |  | $ | 621,883 |   |  | $ | 1,024,526 |   |  | $ | 1,029,707 | 
|                                                     | Average interest rate |                        |   | 4.84   | % |      |   | 4.75    | % |      |   | 5.85   | % |       |   | 6.73       | % |  |   | 6.05    | % |  |   | 6.07    | % |  |   | 5.92      | % |  |   |          | 
|                                                     | Variable rate         |                        | $ | 15,851 |   |      | $ |        |   |      | $ | 3,500  |   |       | $ |           |   |  | $ |        |   |  | $ | 15,829  |   |  | $ | 35,180    |   |  | $ | 32,646    | 
|                                                     | Average interest rate |                        |   | 4.17   | % |      |   |        |   |      |   | 6.53   | % |       |   |           |   |  |   |        |   |  |   | 4.62    | % |  |   | 3.42      | % |  |   |          | 
|Marketable securities  restricted:                  |                       |                        |   |        |   |      |   |         |   |      |   |        |   |       |   |            |   |  |   |         |   |  |   |         |   |  |   |           |   |  |   |          
|                                                     | Fixed rate            |                        | $ | 35,415 |   |      | $ | 14,293  |   |      | $ | 20,907 |   |       | $ | 7,304      |   |  | $ | 4,302   |   |  | $ | 28,795  |   |  | $ | 111,016   |   |  | $ | 113,293   | 
|                                                     | Average interest rate |                        |   | 5.21   | % |      |   | 3.93    | % |      |   | 5.19   | % |       |   | 6.36       | % |  |   | 5.17    | % |  |   | 5.60    | % |  |   | 5.22      | % |  |   |          | 
|                                                     | Variable rate         |                        | $ |       |   |      | $ |        |   |      | $ |       |   |       | $ |           |   |  | $ |        |   |  | $ | 1,151   |   |  | $ | 1,151     |   |  | $ | 1,157     | 
|                                                     | Average interest rate |                        |   |       |   |      |   |        |   |      |   |       |   |       |   |           |   |  |   |        |   |  |   | 4.24    | % |  |   | 4.24      | % |  |   |          | 
|Liabilities:                                         |                       |                        |   |        |   |      |   |         |   |      |   |        |   |       |   |            |   |  |   |         |   |  |   |         |   |  |   |           |   |  |   |          
|Long term debt, including debt due within one
	year: |                       |                        |   |        |   |      |   |         |   |      |   |        |   |       |   |            |   |  |   |         |   |  |   |         |   |  |   |           |   |  |   |          
|                                                     | Variable rate         |                        | $ | 124    |   |      | $ | 793,163 |   |      | $ | 174    |   |       | $ | 186        |   |  | $ | 199     |   |  | $ | 587     |   |  | $ | 794,433   |   |  | $ | 794,433   | 
|                                                     | Average interest rate |                        |   | 6.67   | % |      |   | 5.84    | % |      |   | 6.77   | % |       |   | 6.77       | % |  |   | 6.77    | % |  |   | 6.77    | % |  |   |          |   |  |   |          | 

As of December 31, 2000:

|                                                     |                       |                        |   |        |   |      |   |         |   |      |   |         |   |       |   |            |   |  |   |        |   |  |   |         |   |  |   |         |   |  |   |         | 
|---------------------------------------------------- | --------------------- | ---------------------- | - | ------ | - | ---- | - | ------- | - | ---- | - | ------- | - | ----- | - | ---------- | - |  | - | ------ | - |  | - | ------- | - |  | - | ------- | - |  | - | ------- | 
|                                                     |                       | 2001                   |   | 2002   |   | 2003 |   | 2004    |   | 2005 |   | Beyond  |   | Total |   | Fair Value
|                                                     |                       |                        |   |        |   |      |   |         |   |      |   |         |   |       |   |           
|                                                     |                       |                       
|                                                     |                       | (Amounts in thousands)
|Assets:                                              |                       |                        |   |        |   |      |   |         |   |      |   |         |   |       |   |            |   |  |   |        |   |  |   |         |   |  |   |         |   |  |   |        
|Marketable securities:                               |                       |                        |   |        |   |      |   |         |   |      |   |         |   |       |   |            |   |  |   |        |   |  |   |         |   |  |   |         |   |  |   |        
|                                                     | Fixed rate            |                        | $ | 93,821 |   |      | $ | 29,453  |   |      | $ | 37,092  |   |       | $ | 38,770     |   |  | $ | 54,311 |   |  | $ | 533,169 |   |  | $ | 786,616 |   |  | $ | 784,799 | 
|                                                     | Average interest rate |                        |   | 2.71   | % |      |   | 6.01    | % |      |   | 5.78    | % |       |   | 6.18       | % |  |   | 6.32   | % |  |   | 5.71    | % |  |   | 5.40    | % |  |   |        | 
|                                                     | Variable rate         |                        | $ | 10,010 |   |      | $ | 13,714  |   |      |   |        |   |       | $ | 5,000      |   |  | $ | 7,000  |   |  | $ | 46,575  |   |  | $ | 82,299  |   |  | $ | 79,214  | 
|                                                     | Average interest rate |                        |   | 6.48   | % |      |   | 6.47    | % |      |   |        |   |       |   | 6.53       | % |  |   | 6.30   | % |  |   | 5.34    | % |  |   | 5.82    | % |  |   |        | 
|Marketable securities  restricted:                  |                       |                        |   |        |   |      |   |         |   |      |   |         |   |       |   |            |   |  |   |        |   |  |   |         |   |  |   |         |   |  |   |        
|                                                     | Fixed rate            |                        | $ | 37,600 |   |      | $ | 27,088  |   |      |   |        |   |       | $ | 4,875      |   |  | $ | 5,721  |   |  | $ | 17,867  |   |  | $ | 93,151  |   |  | $ | 93,937  | 
|                                                     | Average interest rate |                        |   | 2.22   | % |      |   | 6.19    | % |      |   |        |   |       |   | 5.74       | % |  |   | 6.68   | % |  |   | 5.40    | % |  |   | 4.45    | % |  |   |        | 
|                                                     | Variable rate         |                        |   |       |   |      |   |        |   |      |   |        |   |       |   |           |   |  |   |       |   |  | $ | 1,251   |   |  | $ | 1,251   |   |  | $ | 1,256   | 
|                                                     | Average interest rate |                        |   |       |   |      |   |        |   |      |   |        |   |       |   |           |   |  |   |       |   |  |   | 6.25    | % |  |   | 6.25    | % |  |   |        | 
|Liabilities:                                         |                       |                        |   |        |   |      |   |         |   |      |   |         |   |       |   |            |   |  |   |        |   |  |   |         |   |  |   |         |   |  |   |        
|Long term debt, including debt due within one
	year: |                       |                        |   |        |   |      |   |         |   |      |   |         |   |       |   |            |   |  |   |        |   |  |   |         |   |  |   |         |   |  |   |        
|                                                     | Variable rate         |                        | $ | 161    |   |      | $ | 735,171 |   |      | $ | 100,172 |   |       | $ | 184        |   |  | $ | 197    |   |  | $ | 832     |   |  | $ | 836,717 |   |  | $ | 836,717 | 
|                                                     | Average interest rate |                        |   | 6.68   | % |      |   | 7.88    | % |      |   | 7.00    | % |       |   | 6.77       | % |  |   | 6.77   | % |  |   | 6.77    | % |  |   |        |   |  |   |        | 

52



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ITEM
8.     CONSOLIDATED FINANCIAL
STATEMENTS AND SUPPLEMENTARY DATA

See Item 14. Exhibits, Financial
Statement Schedules, and Reports on Form 8-K.






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

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

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PART III






ITEM
10.     DIRECTORS AND EXECUTIVE
OFFICERS OF THE REGISTRANT


The following table provides information about
each of our current directors and executive officers. Executive
officers are elected by and serve at the discretion of our board
of directors.

|                             |  |     |    |       |  |                                                                                             
|---------------------------- |  | --- | -- | ----- |  | --------------------------------------------------------------------------------------------
|Directors                    |  | Age |    | Title
|                             |  |     |    |      
|David A. Reed                |  |     | 69 |       |  | Chairman of the Board                                                                       
|Howard G. Phanstiel          |  |     | 53 |       |  | Director, President and Chief Executive Officer                                             
|Bradley C. Call              |  |     | 59 |       |  | Director                                                                                    
|Shirley S. Chater, Ph.D.     |  |     | 69 |       |  | Director                                                                                    
|Terry O. Hartshorn           |  |     | 57 |       |  | Director                                                                                    
|Arthur B. Laffer, Ph.D.      |  |     | 61 |       |  | Director                                                                                    
|Gary L. Leary                |  |     | 67 |       |  | Director                                                                                    
|Sanford M. Litvack           |  |     | 65 |       |  | Director                                                                                    
|Warren E. Pinckert II        |  |     | 58 |       |  | Director                                                                                    
|Lloyd E. Ross                |  |     | 61 |       |  | Director                                                                                    
|                            
|Corporate Executive Officers |  |     |    |       |  |                                                                                             
|Bary G. Bailey*              |  |     | 43 |       |  | Executive Vice President, Pharmacy and Technology                                           
|Bradford A. Bowlus*          |  |     | 46 |       |  | Executive Vice President and President and Chief
	Executive Officer, PacifiCare Health Plans
|Katherine F. Feeny*          |  |     | 49 |       |  | Executive Vice President, Senior Solutions                                                  
|Joseph S. Konowiecki*        |  |     | 48 |       |  | Executive Vice President, General Counsel and
	Secretary                                    
|Gregory W. Scott*            |  |     | 48 |       |  | Executive Vice President and Chief Financial
	Officer                                       
|Susan L. Berkel              |  |     | 40 |       |  | Senior Vice President, Corporate Controller                                                 
|Judy A. Ehrenreich*          |  |     | 48 |       |  | Senior Vice President, Human Resources                                                      
|James A. Frey II*            |  |     | 35 |       |  | Senior Vice President, PacifiCare of California                                             
|John F. Fritz                |  |     | 57 |       |  | Senior Vice President and Chief Actuary                                                     



---



|  |                                                                                                                                                                                                                                                                                                                                     
|- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|* | Member of the Office of the President. The Office
	of the President was formed in November 2000 as a focal point
	for setting priorities, authorizing major new products and
	projects, and monitoring our progress against these initiatives.
	The Office of the President meets regularly and serves as
	counsel to Mr. Phanstiel.

Mr. Reed has been Chairman of the Board
since 1999 and a member of our Board since 1992. Mr. Reed
currently is the President of DAR Consulting Group, and
previously served as chairman of the American Hospital
Association. Mr. Reed is a member of the board of directors
of In Vitro International and Medstone International Inc.

Mr. Phanstiel was appointed President and
Chief Executive Officer and became a director in December 2000
after having served as acting Chief Executive Officer since
October 2000. Mr. Phanstiel was appointed Executive Vice
President and Chief Financial Officer in July 2000. Prior to
that, Mr. Phanstiel was an executive of NetCatalyst from
January 2000 to June 2000, Chairman and Chief Executive Officer
of ARV Assisted Living, Inc. from 1997 to 1999, and Executive
Vice President of Finance and Information Services at WellPoint
Health Networks Inc. from 1994 to 1997. Mr. Phanstiel has
served as a member of the board of directors of Wedbush Morgan
Securities since January 2000.

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Mr. Call was appointed to our Board in 1997
and has been the Managing Director of JMW Capital Partners,
Inc.  Southern California Region since November 2001.
Mr. Call has been President and Chief Executive Officer of
Stellex Aerospace , Inc., a privately held aerospace component
manufacturing firm with multiple plant operations throughout the
U.S., since 1988. Mr. Call was Director of UniHealth
Foundation from 1998 until June 2001, when he resigned.

Dr. Chater was appointed to our Board in
August 2001. Dr. Chater has been an independent management
consultant serving colleges, universities and foundations
including the Robert Wood Johnson Foundation and the Canadian
Health Services Research Foundation since 1998. From 1997 to
1998, Dr. Chater served as Regents Professor for the
University of California. Dr. Chater served as the
Commissioner of the U.S. Social Security Administration
from 1993 to 1997 and as a member of the board of the Social
Security and Medicare Trust Fund from 1994 to 1997.

Mr. Hartshorn was appointed to our Board in
1985 and was Chairman of our Board from 1993 to 1998 and
President and Chief Executive Officer of UniHealth from 1994
to 1997.

Dr. Laffer was appointed to our Board in
February 2001. Dr. Laffer has served as the founder and
Chairman of Laffer Associates, an economics research and
consulting firm that provides investment research services to
institutional asset managers, since 1979. Dr. Laffer has
also served as the founder and Chairman of Laffer Advisers,
Inc., an investment advisor and broker-dealer, since 1981, and
founder and Chairman of Laffer Investments, an institutional
investment management company, since 2000. Dr. Laffer is a
member of the board of directors of MasTec, Inc., Neff Corp.,
OXiGENE, Inc., Nicholas-Applegate Growth Equity Fund and Vivendi
Environnement.

Mr. Leary was appointed to our Board in 1989
and is an independent business and legal consultant. From 1998
through 1999, Mr. Leary served as an Executive Vice
President and President of UniHealth Foundation. He was also
Executive Vice President and General Counsel to UniHealth
Foundation from 1998 to 2000, and its predecessor, UniHealth,
from 1992 to 1998. From 1961 to 1992, Mr. Leary was engaged
in the private practice of law, with emphasis on corporate and
health care law.

Mr. Litvack was appointed to our Board in
February 2001. In March 2001, Mr. Litvack rejoined the
international law firm of Dewey Ballantine LLP where he
specializes in complex litigation and antitrust matters. During
his original tenure with the firm, he was a member of the
executive committee and Chairman of the Litigation Department.
Mr. Litvack served as Vice Chairman of the board of
directors of Walt Disney Co. from 1999 to 2000. Mr. Litvack
continues at the Walt Disney Co. part-time in an executive role.
From 1994 through 1999, Mr. Litvack served as Senior Vice
President and Chief of Corporate Operations of Walt Disney Co.
Mr. Litvack is a member of the board of directors of
Euro Disney S.C.A., Compaq Computer Corporation and Cyber
Capital. Mr. Litvack is also a member of the board of
directors of Antigenics Inc. and a member of its compensation
committee.

Mr. Pinckert was appointed to our Board in
1985 and has been President and Chief Executive Officer and a
member of the board of directors of Cholestech Corporation, a
medical device manufacturing firm, since 1993, and is a
certified public accountant.

Mr. Ross was appointed to our Board in 1985
and is Chairman of the Board of American States Water Company.
Mr. Ross was Managing Partner of InverMex, L.P. from
1996 to 1997. Prior to that, Mr. Ross served as Vice
President/ Division Manager of SMI Corporation, a division of
ARB, Inc., a commercial and industrial building company.

Mr. Bailey was appointed Executive Vice
President, Pharmacy and Technology in March 2002.
Mr. Bailey has been Executive Vice President and Chief
Strategic Officer since July 2000. Mr. Bailey was Executive
Vice President of Finance, Information Technology and Strategic
Initiatives and Chief Financial Officer at Premier Inc., a
hospital alliance, from 1995 to 2000. Mr. Bailey is a
member of the board of directors of LTC Healthcare, Inc. and a
member of its compensation committee.

Mr. Bowlus has been Executive Vice President
and President and Chief Executive Officer of PacifiCare Health
Plans since 1999. Mr. Bowlus was Regional Vice President,
Western Region and President and

55



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##### Table of Contents



Chief Executive Officer of PacifiCare of
California from 1997 to 1999. From 1994 to 1997, Mr. Bowlus
served in various capacities for PacifiCare, including President
and Chief Executive Officer of PacifiCare of Washington, Inc.,
President and Chief Executive Officer of PacifiCare Dental and
Vice President of PacifiCare of California.


Ms. Feeny was appointed Executive Vice
President, Senior Solutions in January 2002. Ms. Feeny has
been Senior Vice President, Secure Horizons Sales and Marketing
since January 2000. During 1999, Ms. Feeny was Vice
President, Sales and Marketing, Secure Horizons of California,
and was Regional Sales Director, Secure Horizons of California
from 1995 to 1997. Ms. Feeny joined Secure Horizons of
California in November 1993 as Director of Medi-Cal sales.

Mr. Konowiecki assumed a full-time position
as our Executive Vice President, General Counsel and Secretary
in January 2002. Mr. Konowiecki has been our Executive Vice
President since 1999, General Counsel since 1989, and Secretary
since 1993. Mr. Konowiecki was a partner of Konowiecki
& Rank LLP, including a professional corporation, or its
predecessor, from 1980 to December 2001, and has over
21 years of practice in business, corporate and health care
law.

Mr. Scott was appointed Executive Vice
President and Chief Financial Officer in January 2001.
Mr. Scott was Chief Operating Officer and Chief Financial
Officer of Medsite, Inc., an e-commerce and pharmaceutical
services company, from 1999 through January 2001. Mr. Scott
was Senior Vice President and Chief Financial Officer of
Prudential HealthCare Group from 1995 to 1999.

Ms. Berkel was appointed Senior Vice
President, Corporate Controller in 2000. Ms. Berkel was
Vice President, Finance and Assistant Corporate Controller from
1999 to 2000 and Director, Finance from 1995 to 1999.

Ms. Ehrenreich was appointed Senior Vice
President of Human Resources in June 2001. Ms. Ehrenreich
served as Vice President of Corporate Human Resource Operations
since 1995. Ms. Ehrenreich was Senior Vice President of
Human Resources at First Interstate Bancorp from 1984
to 1995.

Mr. Frey was appointed Senior Vice
President, PacifiCare of California in March 2002. Mr. Frey
served as Senior Vice President, Branding and Strategic
Initiatives in 2001. Mr. Frey was appointed Senior Vice
President, Strategic Programs and Chief of Staff in 2000.
Mr. Frey was Senior Vice President, Operations during 2000.
Mr. Frey was President, PacifiCare of Nevada, Inc. during
1999, and was Vice President of Operations, Desert Region from
1997 to 1999. Mr. Frey was Director of Regulatory Affairs,
Desert Region from 1996 to 1997.

Mr. Fritz was appointed Senior Vice
President and Chief Actuary in January 2001. Mr. Fritz was
a Partner with Ernst & Young LLP from 1996 to January
2001.




SECTION 16(A) BENEFICIAL OWNERSHIP
REPORTING COMPLIANCE

We believe that during 2001, all filings with the
SEC by our officers, directors and 10% stockholders complied
with requirements for reporting ownership and changes in
ownership of our common stock under Section 16(a) of the
Securities Exchange Act of 1934.

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##### Table of Contents






ITEM
11.     EXECUTIVE
COMPENSATION

This table shows, for the last three years,
compensation information for our Chief Executive Officer and the
next four most highly compensated executive officers. We refer
to each of these officers as a named executive
officer.

Summary Compensation Table

|                            |                              |                     |      |                     |  |             |         |            |  |              |         |              |  |        |         |         |  |  |         |   |  |  |         |         |  |  |   |        |  |  |        |        | 
|--------------------------- | ---------------------------- | ------------------- | ---- | ------------------- |  | ----------- | ------- | ---------- |  | ------------ | ------- | ------------ |  | ------ | ------- | ------- |  |  | ------- | - |  |  | ------- | ------- |  |  | - | ------ |  |  | ------ | ------ | 
|                            |                              |                     |      |                     |  |             |         |            |  |             
|                            |                              |                     |      | Long-Term          
|                            |                              | Annual Compensation |      | Compensation Awards
|                            |                              |                     |      |                    
|                            |                              |                     |      | Other Annual        |  | Restricted  |         | Securities |  | LTIP         |         | All Other   
|                            |                              |                     |      | Compensation        |  | Stock       |         | Underlying |  | Payouts      |         | Compensation
|Name and Principal Position |                              | Year                |      | Salary($)           |  | Bonus($)(1) |         | ($)(2)     |  | Awards($)(3) |         | Options(#)   |  | ($)(4) |         | ($)(5) 
|                            |                              |                     |      |                     |  |             |         |            |  |              |         |              |  |        |         |        
|Howard G. Phanstiel(6)      |                              |                     | 2001 |                     |  |             | 900,001 |            |  |              | 360,000 |              |  |        | 95,642  |         |  |  |        |   |  |  |        |         |  |  |  |        |  |  | 75,396 |       
|                            | President and                |                     |      | 2000                |  |             |         | 259,808    |  |              |         | 450,000      |  |        |         | 9,962   |  |  |         |  |  |  |         | 500,000 |  |  |   |       |  |  |        | 8,423  | 
|                            | Chief Executive Officer      |                     |      | 1999                |  |             |         |           |  |              |         |             |  |        |         |        |  |  |         |  |  |  |         |        |  |  |   |       |  |  |        |       | 
|Bradford A. Bowlus          |                              |                     | 2001 |                     |  |             | 600,001 |            |  |              | 180,144 |              |  |        | 101,534 |         |  |  |        |   |  |  | 150,000 |         |  |  |  |        |  |  | 50,162 |       
|                            | Executive Vice President     |                     |      | 2000                |  |             |         | 600,001    |  |              |         | 200,000      |  |        |         |        |  |  |         |  |  |  |         | 100,000 |  |  |   |       |  |  |        | 45,100 | 
|                            | and President and CEO,       |                     |      | 1999                |  |             |         | 501,923    |  |              |         | 449,856      |  |        |         | 188,953 |  |  |         |  |  |  |         | 140,000 |  |  |   | 75,504 |  |  |        | 43,908 | 
|                            | PacifiCare Health Plans      |                     |      |                     |  |             |         |            |  |              |         |              |  |        |         |         |  |  |         |   |  |  |         |         |  |  |   |        |  |  |        |        | 
|Bary G. Bailey(6)           |                              |                     | 2001 |                     |  |             | 550,002 |            |  |              | 165,000 |              |  |        | 249,034 |         |  |  |        |   |  |  |        |         |  |  |  |        |  |  | 24,396 |       
|                            | Executive Vice President and |                     |      | 2000                |  |             |         | 219,231    |  |              |         | 250,000      |  |        |         |        |  |  |         |  |  |  |         | 400,000 |  |  |   |       |  |  |        | 5,920  | 
|                            | Chief Strategic Officer      |                     |      | 1999                |  |             |         |           |  |              |         |             |  |        |         |        |  |  |         |  |  |  |         |        |  |  |   |       |  |  |        |       | 
|Gregory W. Scott(7)         |                              |                     | 2001 |                     |  |             | 471,155 |            |  |              | 275,050 |              |  |        | 140,170 |         |  |  |        |   |  |  | 150,000 |         |  |  |  |        |  |  | 17,665 |       
|                            | Executive Vice President and |                     |      | 2000                |  |             |         |           |  |              |         |             |  |        |         |        |  |  |         |  |  |  |         |        |  |  |   |       |  |  |        |       | 
|                            | Chief Financial Officer      |                     |      | 1999                |  |             |         |           |  |              |         |             |  |        |         |        |  |  |         |  |  |  |         |        |  |  |   |       |  |  |        |       | 
|John F. Fritz(7)            |                              |                     | 2001 |                     |  |             | 352,391 |            |  |              | 532,850 |              |  |        | 42,917  |         |  |  | 728,108 |   |  |  | 60,000  |         |  |  |  |        |  |  | 18,595 |       
|                            | Senior Vice President and    |                     |      | 2000                |  |             |         |           |  |              |         |             |  |        |         |        |  |  |         |  |  |  |         |        |  |  |   |       |  |  |        |       | 
|                            | Chief Actuary                |                     |      | 1999                |  |             |         |           |  |              |         |             |  |        |         |        |  |  |         |  |  |  |         |        |  |  |   |       |  |  |        |       | 



---



|    |                                                                                                                                                                                                                                                                                                                                      
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | The amounts shown in this column include bonuses
	awarded and accrued during the years earned, but paid in the
	following year under our annual incentive plan. Additionally,
	this column includes signing bonuses totaling $100,000 for
	Mr. Phanstiel in 2000, $100,000 for Mr. Scott in 2001
	and $364,100 for Mr. Fritz in 2001.
|   
|(2) | Other Annual Compensation includes a
	risk premium applied to amounts deferred under our Stock Unit
	Deferred Compensation Plan (explained below). Additionally, this
	column includes signing bonuses, relocation expenses and other
	perquisites as shown in the following chart.                                                

|              |  |             |         |            |  |                   |        |       |  |      |        |      |  |      |       |      |  |   |        |  |  |   |         |  |  |   |       |  |  |   |        | 
|------------- |  | ----------- | ------- | ---------- |  | ----------------- | ------ | ----- |  | ---- | ------ | ---- |  | ---- | ----- | ---- |  | - | ------ |  |  | - | ------- |  |  | - | ----- |  |  | - | ------ | 
|              |  | Forgiveness |         | Relocation |  |                   |        |      
|              |  | of Loan     |         | Expenses   |  | Other Perquisites |        | Total
|              |  |             |         |            |  |                   |        |      
|              |  | 2001        |         | 2001       |  | 2001              |        | 2000  |  | 1999 |        | 2001 |  | 2000 |       | 1999
|              |  |             |         |            |  |                   |        |       |  |      |        |      |  |      |       |     
|Mr. Phanstiel |  | $           |        |            |  | $                 |       |       |  | $    | 23,642 |      |  | $    | 9,962 |      |  | $ |       |  |  | $ | 23,642  |  |  | $ | 9,962 |  |  | $ |       | 
|Mr. Bowlus    |  | $           |        |            |  | $                 |       |       |  | $    | 65,505 |      |  | $    |      |      |  | $ | 44,999 |  |  | $ | 65,505  |  |  | $ |      |  |  | $ | 44,999 | 
|Mr. Bailey    |  | $           | 212,559 |            |  | $                 |       |       |  | $    | 19,975 |      |  | $    |      |      |  | $ |       |  |  | $ | 232,534 |  |  | $ |      |  |  | $ |       | 
|Mr. Scott     |  | $           |        |            |  | $                 | 82,116 |       |  | $    | 23,044 |      |  | $    |      |      |  | $ |       |  |  | $ | 105,160 |  |  | $ |      |  |  | $ |       | 
|Mr. Fritz     |  | $           |        |            |  | $                 |       |       |  | $    | 26,042 |      |  | $    |      |      |  | $ |       |  |  | $ | 26,042  |  |  | $ |      |  |  | $ |       | 



| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | SEC regulations exclude from reporting
	requirements a named executive officers perquisites if the
	executives value in any year does not exceed the lesser of
	(a) $50,000 or (b) 10% of the total of the named
	executive officers annual salary and bonus for that year.                                                                                                                                                                                                                                                                                                                                           
|
| | Under the stock unit deferred compensation plan,
	executive officers may defer all or a portion of their annual
	bonus. The Chief Executive Officer may also defer all or a
	portion of his salary. Amounts deferred 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
	the Nasdaq National Market on a predetermined date. The stock
	price is based on a date selected by the Compensation Committee.
	Distributions are made in shares of common

57



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##### Table of Contents



| |                                                                                                                                                            
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------
| | stock. In 2001, 2000 and 1999, the risk premium
	applied to amounts deferred was 40%. Stock unit activity for the
	named executive officers was as follows:

|              |  |  |      |             |  |            |         |          |  |  |         |  |  |  |        | 
|------------- |  |  | ---- | ----------- |  | ---------- | ------- | -------- |  |  | ------- |  |  |  | ------ | 
|              |  |  |      | Amount      |  | Risk       |         | Stock   
|              |  |  |      | Deferred($) |  | Premium($) |         | Units(#)
|              |  |  |      |             |  |            |         |         
|Mr. Phanstiel |  |  | 2001 |             |  |            | 180,000 |          |  |  | 72,000  |  |  |  | 16,800 | 
|Mr. Bowlus    |  |  | 2001 |             |  |            | 90,072  |          |  |  | 36,029  |  |  |  | 8,407  | 
|              |  |  | 1999 |             |  |            | 359,885 |          |  |  | 143,954 |  |  |  | 6,338  | 
|Mr. Bailey    |  |  | 2001 |             |  |            | 41,250  |          |  |  | 16,500  |  |  |  | 3,850  | 
|Mr. Scott     |  |  | 2001 |             |  |            | 87,525  |          |  |  | 35,010  |  |  |  | 8,169  | 
|Mr. Fritz     |  |  | 2001 |             |  |            | 42,188  |          |  |  | 16,875  |  |  |  | 3,938  | 



|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(3) | On January 31, 2001, we granted
	Mr. Fritz 29,951 shares of restricted common stock as part
	of his compensation package for joining PacifiCare as an
	executive officer. The shares vest in equal installments on
	May 1, 2002 and 2003. As of December 31, 2001, the
	shares underlying this grant had a fair market value of $479,216.                                                                                                                                                                                                     
|   
|(4) | Includes amounts awarded and accrued under our
	Long-Term Performance Incentive Plan during the years earned,
	but paid in the following year. In 1999, the last performance
	cycle of the Plan, 60% of the awards were paid in cash and 40%
	of the awards were paid in shares of common stock. The shares of
	common stock distributed were valued at $45.13 per share in 1999
	(the fair market values of the common stock at the time the
	payments were awarded). Mr. Bowlus was awarded 669 shares,
	and was paid cash totaling $45,302.
|   
|(5) | Represents our contributions under the Amended
	and Restated PacifiCare Health Systems, Inc. Savings and
	Profit-Sharing (401(k)) Plan, and the Statutory Restoration Plan
	as follows:                                                                                                                                                                                                                                                                                                                                                       

|              |  |             |        |                            |  |      |        |      |  |      |        |      |  |   |        |  |  |   |        |  |  |   |        | 
|------------- |  | ----------- | ------ | -------------------------- |  | ---- | ------ | ---- |  | ---- | ------ | ---- |  | - | ------ |  |  | - | ------ |  |  | - | ------ | 
|              |  |             |        |                           
|              |  | 401(k) Plan |        | Statutory Restoration Plan
|              |  |             |        |                           
|              |  | 2001        |        | 2000                       |  | 1999 |        | 2001 |  | 2000 |        | 1999
|              |  |             |        |                            |  |      |        |      |  |      |        |     
|Mr. Phanstiel |  | $           | 10,200 |                            |  | $    | 8,423  |      |  | $    |       |      |  | $ | 64,800 |  |  | $ |       |  |  | $ |       | 
|Mr. Bowlus    |  | $           | 9,889  |                            |  | $    | 10,200 |      |  | $    | 12,759 |      |  | $ | 39,877 |  |  | $ | 34,610 |  |  | $ | 30,859 | 
|Mr. Bailey    |  | $           | 5,100  |                            |  | $    | 2,960  |      |  | $    |       |      |  | $ | 18,900 |  |  | $ | 2,960  |  |  | $ |       | 
|Mr. Scott     |  | $           | 7,408  |                            |  | $    |       |      |  | $    |       |      |  | $ | 9,993  |  |  | $ |       |  |  | $ |       | 
|Mr. Fritz     |  | $           | 5,100  |                            |  | $    |       |      |  | $    |       |      |  | $ | 13,231 |  |  | $ |       |  |  | $ |       | 



| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | All of our employees who have completed
	3 1/2 months of continuous service are eligible to
	participate in the 401(k) Plan. The Statutory Restoration
	Plan allows participants to defer the portion of their pay that
	otherwise would be deferred under the 401(k) Plan, but for
	statutory limitations, and to receive excess matching
	contributions, profit-sharing contributions and discretionary
	contributions in the same percentages as those provided by the
	401(k) Plan. Employees in our two highest salary grades are
	eligible to participate in the Statutory Restoration Plan.



|    |                                                      
|--- | -----------------------------------------------------
|(6) | Mr. Phanstiel and Mr. Bailey joined us
	in July 2000.
|   
|(7) | Mr. Scott and Mr. Fritz joined us in
	January 2001.  

58



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##### Table of Contents



OPTION GRANTS

This table shows stock option grants to the named
executive officers during the last fiscal year.

Options Granted in 2001

|                   |  |               |         |            |  |             |     |            |  |               |        |  |  |  |          |  |  |  |           | 
|------------------ |  | ------------- | ------- | ---------- |  | ----------- | --- | ---------- |  | ------------- | ------ |  |  |  | -------- |  |  |  | --------- | 
|                   |  |               |         | Percent    |  |             |     |            |  |              
|                   |  | Number of     |         | Options    |  | Exercise or |     |            |  |              
|                   |  | Securities    |         | Granted to |  | Base Price  |     |            |  | Grant Date   
|                   |  | Underlying    |         | Employees  |  | Per Share   |     | Expiration |  | Present Value
|Name               |  | Options(#)(1) |         | in 2001    |  | ($/SH)(2)   |     | Date       |  | ($)(3)       
|                   |  |               |         |            |  |             |     |            |  |              
|Bradford A. Bowlus |  |               | 150,000 |            |  |             | 6.0 |            |  |               | 16.375 |  |  |  | 1/02/11  |  |  |  | 1,467,300 | 
|Gregory W. Scott   |  |               | 150,000 |            |  |             | 6.0 |            |  |               | 17.313 |  |  |  | 1/22/11  |  |  |  | 1,551,308 | 
|John F. Fritz      |  |               | 30,000  |            |  |             | 1.2 |            |  |               | 17.313 |  |  |  | 1/22/11  |  |  |  | 310,262   | 
|                   |  |               | 30,000  |            |  |             | 1.2 |            |  |               | 17.770 |  |  |  | 11/29/11 |  |  |  | 412,427   | 



---



|    |                                                                                                                                                                   
|--- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | Option grants in 2001 were made under the Amended
	and Restated 1996 Stock Option Plan for Officers and Key
	Employees, and the 2000 Employee Plan. These options:



| |   |                                                                                                                                                                                                                                             
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | are granted at an exercise price equal to 100% of
	the fair market value of the common stock on the date of grant,                                                                                                                          
|
| |  | expire 10 years from the date of grant,
	unless otherwise earlier terminated because of certain events
	related to termination of employment, and                                                                                           
|
| |  | generally vest in 25% increments on each
	anniversary date of the grant, subject to the terms and
	conditions of the Plan. Options granted to Mr. Fritz on
	November 29, 2001 vest in 50% increments on each
	anniversary date of the grant.



| |                                                                                                                                                                                         
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Options that have been held for more than six
	months, and not already exercisable or expired, will
	automatically become exercisable upon a change of control, as
	defined in the Plan.

(2) Options with exercise prices of:



| |   |                                           
| | - | ------------------------------------------
| |  | $16.375 were granted on January 2, 2001.  
|
| |  | $17.313 were granted on January 22, 2001. 
|
| |  | $17.770 were granted on November 29, 2001.



|    |                                                                                                                           
|--- | --------------------------------------------------------------------------------------------------------------------------
|(3) | Grant date present values were calculated using
	the Black-Scholes option valuation model with the following
	assumptions:

|                               |  |  |         | 
|------------------------------ |  |  | ------- | 
| Expected Volatility          |  |  | 110%    | 
| Risk-Free Interest Rate      |  |  | 3%      | 
| Expected Life until Exercise |  |  | 3 years | 
| Dividend Yield               |  |  | 0%      | 
| Forfeiture Rate              |  |  | 0%      | 



| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | The actual value, if any, that a named executive
	officer may realize will be based on the difference between the
	market price of our common stock on the date of exercise and the
	exercise price. There is no assurance that the actual realized
	value, if any, will be at or near the value estimated by the
	Black-Scholes model. The Black-Scholes model is only one method
	of valuing options, and our use of the model should not be
	construed as an endorsement of its accuracy.

59



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##### Table of Contents



OPTIONS EXERCISED

This table shows stock option exercises and the
value of unexercised stock options held by the named executive
officers during the last fiscal year.

Aggregated Option Exercises in 2001 and Fiscal
Year-End Option Values

|                    |  |             |   |          |  |                        |   |                      |  |             |         |               |  |  |         |  |  |  |         |  |  |  |         | 
|------------------- |  | ----------- | - | -------- |  | ---------------------- | - | -------------------- |  | ----------- | ------- | ------------- |  |  | ------- |  |  |  | ------- |  |  |  | ------- | 
|                    |  |             |   |          |  |                        |   |                     
|                    |  |             |   |          |  | Number of Securities   |   | Value of Unexercised
|                    |  |             |   |          |  | Underlying Unexercised |   | In-the-Money Options
|                    |  | Shares      |   | Value    |  | Options at FY-End(#)   |   | at FY-End($)(2)     
|                    |  | Acquired on |   | Realized |  |                        |   |                     
|Name                |  | Exercise(#) |   | ($)(1)   |  | Exercisable            |   | Unexercisable        |  | Exercisable |         | Unexercisable
|                    |  |             |   |          |  |                        |   |                      |  |             |         |              
|Howard G. Phanstiel |  |             |  |          |  |                        |  |                      |  |             | 125,000 |               |  |  | 375,000 |  |  |  | 295,313 |  |  |  | 885,938 | 
|Bradford A. Bowlus  |  |             |  |          |  |                        |  |                      |  |             | 231,000 |               |  |  | 372,500 |  |  |  |        |  |  |  |        | 
|Bary G. Bailey      |  |             |  |          |  |                        |  |                      |  |             | 100,000 |               |  |  | 300,000 |  |  |  | 196,875 |  |  |  | 590,625 | 
|Gregory W. Scott    |  |             |  |          |  |                        |  |                      |  |             |        |               |  |  | 150,000 |  |  |  |        |  |  |  |        | 
|John F. Fritz       |  |             |  |          |  |                        |  |                      |  |             |        |               |  |  | 60,000  |  |  |  |        |  |  |  |        | 



---



|    |                                      
|--- | -------------------------------------
|(1) | This number is calculated as follows:



| |   |                                                                                                              
| | - | -------------------------------------------------------------------------------------------------------------
| |  | using the sale price as the market
	price,                                                                 
|
| |  | then subtracting the option exercise price from
	the market price to get the value realized per
	share, and
|
| |  | then multiplying the value realized per share by
	the number of options exercised.                           



| |                                                                                                         
| | --------------------------------------------------------------------------------------------------------
| | The amounts in this column may not represent
	amounts actually realized by the named executive officers.

(2) This number is calculated by:



| |   |                                                                                                                                                                                              
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | subtracting the option exercise price from our
	December 31, 2001 closing market price ($16.00 per share,
	as reported by Nasdaq National Market) to get the average
	value per option, and
|
| |  | multiplying the average value per option by the
	number of exercisable and unexercisable options.                                                                                            



| |                                                                                                                       
| | ----------------------------------------------------------------------------------------------------------------------
| | The amounts in this column may not represent
	amounts that will actually be realized by the named executive
	officers.

PENSION PLAN

Effective January 1, 2002, we maintain an
executive pension plan under which certain named executive
officers are eligible to participate. This plan is an unfunded,
nonqualified plan. Executives who retire at or after age 62
receive an annual benefit equal to 4% of their highest
consecutive three-year average annual base salary, or Covered
Compensation, per year of service with a maximum annual benefit
of 50% of Covered Compensation. Executives with five years of
covered employment may retire at or after age 55. A
discount of 3% per year is applied for retirement before
age 62. Named executive officers are 100% vested after
completing five years of participation. Immediate vesting and
unreduced early commencement is granted for any employee
terminated within two years following a change in control event.

60



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##### Table of Contents



This table shows the amount of annual retirement
benefits that would be accrued at age 62 under our executive
pension plan calculated on a life annuity basis.

Estimated Annual Benefits

|                |         |                           |         |         |  |    |         |         |  |    |         |         |  |  |         |         |  |  |         |         |  |  |         |         | 
|--------------- | ------- | ------------------------- | ------- | ------- |  | -- | ------- | ------- |  | -- | ------- | ------- |  |  | ------- | ------- |  |  | ------- | ------- |  |  | ------- | ------- | 
|                |         |                          
|                |         | Years of Credited Service
|Covered         |         |                          
|Compensation($) |         | 5                         |         | 10      |  | 15 |         | 20      |  | 25 |         | 30     
|                |         |                           |         |         |  |    |         |         |  |    |         |        
|                | 100,000 |                           |         | 20,000  |  |    |         | 40,000  |  |    |         | 50,000  |  |  |         | 50,000  |  |  |         | 50,000  |  |  |         | 50,000  | 
|                | 200,000 |                           |         | 40,000  |  |    |         | 80,000  |  |    |         | 100,000 |  |  |         | 100,000 |  |  |         | 100,000 |  |  |         | 100,000 | 
|                | 400,000 |                           |         | 80,000  |  |    |         | 160,000 |  |    |         | 200,000 |  |  |         | 200,000 |  |  |         | 200,000 |  |  |         | 200,000 | 
|                | 500,000 |                           |         | 100,000 |  |    |         | 200,000 |  |    |         | 250,000 |  |  |         | 250,000 |  |  |         | 250,000 |  |  |         | 250,000 | 
|                | 600,000 |                           |         | 120,000 |  |    |         | 240,000 |  |    |         | 300,000 |  |  |         | 300,000 |  |  |         | 300,000 |  |  |         | 300,000 | 
|                | 900,000 |                           |         | 180,000 |  |    |         | 360,000 |  |    |         | 450,000 |  |  |         | 450,000 |  |  |         | 450,000 |  |  |         | 450,000 | 
|1,000,000       |         |                           | 200,000 |         |  |    | 400,000 |         |  |    | 500,000 |         |  |  | 500,000 |         |  |  | 500,000 |         |  |  | 500,000 |        

The credited full years of service under the plan
as of January 1, 2002 for the eligible named executive
officers are five years for Mr. Phanstiel and zero years
for Mr. Bowlus, Mr. Bailey and Mr. Scott.

EMPLOYMENT AND SEVERANCE AGREEMENTS

We have entered into employment agreements with
each of our named executive officers. The agreements entitle the
executive officers to base salary, participation in all employee
benefit programs, reimbursement for business expenses and
participation in our annual incentive plan and employee stock
option plans. The employment agreements for Mr. Phanstiel,
Mr. Bowlus, Mr. Bailey and Mr. Scott have three year
terms, and Mr. Fritzs employment agreement has a two
year term. The term of the employment agreements for the named
executive officers,



|  |                                                                                                                                                                                                                                                                                                  
|- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | may be extended if we provide written notice
	within 60 days prior to the expiration of the term,                                                                                                                                                                                                
| 
| | are automatically extended for two years if a
	change of ownership or control occurs, and                                                                                                                                                                                                        
| 
| | upon expiration, if we offer the executive
	officer a new employment agreement and the executive does not
	accept it, the executives continued employment will be
	without the benefit of a written agreement and any severance
	benefits will be in accordance with our policies and practices.

Upon death, disability, misconduct or written
termination by either us or the executive officer, the
employment agreements for the effected officer will be
terminated. In the event an executive officer is terminated for
death, disability, termination without cause or termination
following a change of ownership or control of PacifiCare, the
agreements provide for severance benefits.

Termination Without Cause.If we terminate the named executive
officer without cause (other than for incapacity, disability,
habitual neglect or gross misconduct), the employment agreements
provide for severance payments in equal installments over the
severance period. The severance periods are 24 months for
Mr. Phanstiel, Mr. Bailey and Mr. Scott,
36 months for Mr. Bowlus, and 18 months for
Mr. Fritz. Severance benefits include the following:



|  |                                                                                                                           
|- | --------------------------------------------------------------------------------------------------------------------------
| | multiple of base salary,                                                                                                  
| 
| | multiple of historical average incentive plan
	bonus,                                                                     
| 
| | continuation of medical, dental and vision
	coverage,                                                                     
| 
| | automobile allowance,                                                                                                     
| 
| | outplacement services, and                                                                                                
| 
| | any other bonus amounts or benefits to which the
	named executive officer may be entitled under any of our benefit
	plans.

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Additionally, upon termination the named
executive officers retain the right to exercise any vested
options for one year following the effective date of termination.

The contingent liability for severance payments
that we would be required to make for termination without cause
under the employment agreements (excluding amounts that may be
payable under incentive plans and the value of certain benefits)
would be approximately $3,260,400 to Mr. Phanstiel,
$1,670,400 to Mr. Bailey, $2,907,000 to Mr. Bowlus,
$1,520,400 to Mr. Scott and $829,100 to Mr. Fritz.

Noncompetition
Arrangements.If, while receiving
severance payments following termination, any named executive
officer is employed by a competitor, their severance payments
will be reduced by an amount equal to the payment received from
the competitor.

Termination Within 24 months of a Change
of Control.Under the employment
agreements, a change of ownership or control would result from:



|  |                                                                                                                                                                                                        
|- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | any transaction that results in a person or group
	acquiring beneficial ownership of 20% or more of
	PacifiCares voting power,                                                                        
| 
| | any merger or consolidation including the company
	in which the stockholders of the company immediately prior to
	the transaction control less than 50% of the voting power
	following the transaction,
| 
| | any transaction in which we sell substantially
	all of our material assets,                                                                                                                            
| 
| | our dissolution or liquidation, or                                                                                                                                                                     
| 
| | our incumbent directors (as defined in the
	agreements) cease for any reason to constitute a majority of the
	members of the board of directors.                                                       

If we terminate the named executive officers
within 24 months of a change of control (other than for
incapacity, disability, habitual neglect or gross misconduct),
the employment agreements provide for lump-sum payment of base
salary and specified benefits. The lump-sum payments would
include 36 months of benefits for Mr. Phanstiel,
Mr. Bailey, Mr. Bowlus and Mr. Scott and
24 months of benefits for Mr. Fritz. The lump-sum
payments would include the same items described under
Termination Without Cause, plus the following:



|  |                                           
|- | ------------------------------------------
| | prorated annual incentive plan bonus, and 
| 
| | amounts to cover any excise tax penalties.

Additionally, the named executive officers would
receive the right to exercise all unexercised stock options as
if all such options were fully vested, within one year of the
effective date of termination.

The contingent liability for severance payments
that we would be required to make for a change of control under
the employment agreements (excluding amounts that may be payable
under incentive plans and the value of certain benefits) would
be approximately $4,890,600 to Mr. Phanstiel, $2,907,000 to
Mr. Bowlus, $2,505,600 to Mr. Bailey, $2,280,600 to
Mr. Scott and $1,105,500 to Mr. Fritz.

Additionally, the named executive officers
agreements provide that if they continued to be employed
12 months following the effective date of a change of
control, they will be given a 30-day window period during which
they may elect to voluntarily terminate their employment with
us. If they elect to voluntary terminate their employment during
this 30-day window period, they receive:



|  |                                                                                                                                                         
|- | --------------------------------------------------------------------------------------------------------------------------------------------------------
| | one-half of the lump sum payment they would have
	received upon termination after a change of control;                                                  
| 
| | the right to exercise all unexercised stock
	options as if all such options were fully vested within one year
	of the effective date of termination, and
| 
| | outplacement services.                                                                                                                                  

1997 Premium Priced Stock Option
Plan.Upon a change of control (as
defined in the employee stock option plan), and if a minimum
per-share consideration is paid for the transaction,
Mr. Bowlus will receive a cash payment for each unexercised
premium priced option equal to the difference between
(x) 110% of the price per share at which our common stock
is sold in the change of control transaction and (y) the
exercise price of the premium priced option. If the per-share
consideration equals or exceeds $115.00 per share, the executive
officers will not receive a cash payment. The exercise price for
one-half of the premium priced options outstanding is $92.50 per
share. The exercise price for the balance is $114.00 per

62



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share. For Mr. Bowlus, the maximum cash
payments under this program could total approximately
$3 million.


DIRECTOR COMPENSATION

We do not pay directors who are also our
employees additional compensation for their service as
directors. In 2001, compensation for non-employee directors
included the following:

Cash Compensation



|  |                                                                                                                        
|- | -----------------------------------------------------------------------------------------------------------------------
| | an annual retainer of $40,000,                                                                                         
| 
| | $1,200 to directors for each board meeting
	attended (telephone attendance is paid at 50%),                            
| 
| | $1,000 to directors for each board committee
	meeting attended (telephone attendance is paid at 50%),                  
| 
| | $2,400 to the chairman for each board meeting
	attended (telephone attendance is paid at 50%),                         
| 
| | $2,000 to committee chairpersons for each board
	committee meeting attended (telephone attendance is paid at
	50%), and
| 
| | expenses for attending board and board committee
	meetings.                                                            

In 2001, the board approved an increase of $5,000
in the annual retainer for a total annual retainer equal to
$40,000. This increase was retroactive to July 1, 2000.
Dr. Laffer and Mr. Litvack received a pro-rata amount
of the annual retainer for their service on the board from
February 2001 through June 2001. Each non-employee director,
other than Dr. Laffer and Mr. Litvack, was given the
choice of receiving the additional $5,000 retainer payment, for
the 2000-2001 board year, in cash or in nonqualified options to
purchase shares of our common stock. All of the directors
elected to receive options. The number of shares underlying the
options was calculated based on a formula where the cash amount
was multiplied by a factor of four, then divided by the closing
price of our common stock on the Nasdaq National Market on
February 5, 2001. Based on this formula, each director was
granted options to purchase 784 shares with an exercise price of
$25.50 per share.

Stock Units

Beginning with the 2001-2002 board year (with
board years beginning in July), each non-employee director has
the ability to receive one-half of his or her annual retainer,
or $20,000, in deferred stock units. Any amounts deferred are
converted into units of our common stock. In 2002, a risk
premium will be applied to all amounts deferred. The number of
stock units are equal to the amount of annual retainer deferred,
multiplied by a risk premium, then divided by the closing price
of our common stock on the Nasdaq National Market on the date
the annual retainer would have been paid but for the deferral.
For the 2002-2003 board year, the risk premium is 40%.
Distributions are made in shares of our common stock. Beginning
with the 2002-2003 board year, each director will be encouraged
to defer one-half of the annual retainer payment in stock units
until they have accumulated the suggested minimum ownership
level of 2,000 shares each. This minimum suggested ownership
level was approved by the board in 2001.

Stock Options

In 2001, under the 2000 Non-Employee Directors
Stock Option Plan, each director received an annual, automatic
grant of nonqualified options to purchase 5,000 shares of our
common stock, with an exercise price equal to 100% of the fair
market value of our common stock on the grant date. The chairman

63



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##### Table of Contents



received 10,000 options. These options were
granted on June 29, 2001 with an exercise price of $16.30
per share.


As an incentive to defer one-half of the 2001
annual retainer payment in stock units, each non-employee
director, other than Dr. Laffer and Mr. Litvack,
received a discretionary grant of nonqualified options to
purchase 10,000 shares of our common stock. These options were
granted on February 5, 2001 with an exercise price of
$25.50 per share.

Beginning in July 2001, each non-employee
director had the ability to receive half of his or her annual
retainer, or $20,000, in stock options rather than cash. The
number of shares underlying the options granted are calculated
based on a formula where the cash amount is multiplied by a
factor of four, then divided by the closing price of our common
stock on the Nasdaq National Market on July 1 of each year.
Based on this formula, Mr. Hartshorn, Mr. Leary,
Mr. Reed and Mr. Ross were granted options to purchase
4,994 shares with an exercise price of $16.02 per share.
Dr. Chater, who joined the board in August, was granted
5,365 options on August 1, 2001 with an exercise price of
$13.67 per share.

The Plan also provides for an automatic grant of
nonqualified stock options to purchase 25,000 shares of our
common stock to new directors when first elected to the board.
In 2001, the board approved an increase in the number of options
granted to new directors from 10,000 shares to 25,000 shares.
These options were awarded to Dr. Laffer, Mr. Litvack
and Dr. Chater, who joined the board in 2001.

Nonqualified stock options granted under the
non-employee director stock option plans:



|  |                                                                                                   
|- | --------------------------------------------------------------------------------------------------
| | vest immediately on the grant date,                                                               
| 
| | the underlying common stock may not be sold
	within the first six months after the grant date, and
| 
| | may not be exercised after the expiration of
	10 years from the option grant date.                

Grants under the Plan are subject to the
condition that during the previous 12 months, the director
must have served on the board continuously, and was not eligible
to receive awards under the employee stock option plans.

Other Benefits

Beginning in 2001, each director was eligible, at
their election, to receive medical and dental coverage under our
health care programs. The benefits received in 2001 were valued
at approximately $900 for Mr. Call, $200 for Dr. Chater,
$7,800 for Mr. Hartshorn, $300 for Mr. Leary, $700 for
Mr. Reed and $4,300 for Mr. Ross.

Chairman of the Board

During 2001, Mr. Reed received $125,000 for
his services as chairman under a consulting agreement. Effective
January 2002, Mr. Reed will receive $75,000 annually for
his consulting services to PacifiCare. In addition to the annual
consulting fees, Mr. Reed also received all of the items
described under Cash Compensation. Under the terms of the
agreement, Mr. Reed will continue his term as chairman
until the earlier of:



| |   |                                                                  
| | - | -----------------------------------------------------------------
| |  | his resignation from or failure to be reelected
	as chairman,    
|
| |  | a written election to terminate the agreement by
	us or Mr. Reed,
|
| |  | automatic termination or breach of the agreement,
	or            
|
| |  | nonpayment of Mr. Reeds annual
	compensation by us.             

Under the agreement, Mr. Reed is also
entitled to receive 10,000 options for the annual, automatic
grant of options to non-employee directors.

64



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

PRINCIPAL STOCKHOLDERS

This table shows how much of our common stock is
owned by the directors, named executive officers and owners of
more than 5% of our outstanding common stock, as of
February 28, 2002.

Amount and Nature of Shares Beneficially
Owned

|                                                                 |  |           |           |            |  |             |           |  |  |  |      | 
|---------------------------------------------------------------- |  | --------- | --------- | ---------- |  | ----------- | --------- |  |  |  | ---- | 
|                                                                 |  | Number    |           |            |  | Percent of 
|                                                                 |  | of Shares |           | Right to   |  | Outstanding
|Name                                                             |  | Owned(1)  |           | Acquire(2) |  | Shares(3)  
|                                                                 |  |           |           |            |  |            
|Capital Group International, Inc.(4)                             |  |           | 4,383,660 |            |  |             |          |  |  |  | 12.7 | 
|PIMCO Equity Advisors LLC(5)                                     |  |           | 3,617,800 |            |  |             |          |  |  |  | 10.5 | 
|FMR Corp.(6)                                                     |  |           | 3,436,700 |            |  |             |          |  |  |  | 9.9  | 
|Par Capital Management, Inc.(7)                                  |  |           | 2,240,900 |            |  |             |          |  |  |  | 6.5  | 
|AXA Financial, Inc.(8)                                           |  |           | 2,182,953 |            |  |             |          |  |  |  | 6.3  | 
|David A. Reed                                                    |  |           | 1,000     |            |  |             | 74,944    |  |  |  | *    | 
|Howard G. Phanstiel                                              |  |           | 26,600    |            |  |             | 125,000   |  |  |  | *    | 
|Bradley C. Call                                                  |  |           | 1,000     |            |  |             | 49,534    |  |  |  | *    | 
|Shirley S. Chater, Ph.D.                                         |  |           |          |            |  |             | 35,365    |  |  |  | *    | 
|Terry O. Hartshorn                                               |  |           | 204,732   |            |  |             | 114,528   |  |  |  | *    | 
|Arthur B. Laffer, Ph.D.                                          |  |           |          |            |  |             | 34,994    |  |  |  | *    | 
|Gary L. Leary                                                    |  |           | 1,000     |            |  |             | 62,528    |  |  |  | *    | 
|Sanford M. Litvack                                               |  |           |          |            |  |             | 34,994    |  |  |  | *    | 
|Warren E. Pinckert II                                            |  |           | 1,632     |            |  |             | 57,534    |  |  |  | *    | 
|Lloyd E. Ross                                                    |  |           | 5,600     |            |  |             | 62,528    |  |  |  | *    | 
|Bary G. Bailey                                                   |  |           | 1,400     |            |  |             | 100,000   |  |  |  | *    | 
|Bradford A. Bowlus                                               |  |           |          |            |  |             | 287,338   |  |  |  | *    | 
|Gregory W. Scott                                                 |  |           | 5,000     |            |  |             | 37,500    |  |  |  | *    | 
|John F. Fritz                                                    |  |           | 29,951    |            |  |             | 7,500     |  |  |  | *    | 
|All Directors and Executive Officers as a
	Group(9) (19 persons) |  |           | 367,869   |            |  |             | 1,316,987 |  |  |  | 4.7  | 



---



|    |                                            
|--- | -------------------------------------------
|*   | Less than 1%                               
|   
|(1) | Includes shares for which the named person:



| |   |                                                                                                                         
| | - | ------------------------------------------------------------------------------------------------------------------------
| |  | has sole voting and investment power,                                                                                   
|
| |  | has shared voting and investment power with his
	or her spouse, or                                                      
|
| |  | holds in an account under the PacifiCare Savings
	and Profit-Sharing Plan, unless otherwise indicated in the
	footnotes.



|    |                                                                                                                                                                                                                                         
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(2) | Shares that can be acquired through stock option
	exercises or stock unit distributions through April 29,
	2002.                                                                                                                        
|   
|(3) | The percentage of beneficial ownership is based
	on 34,553,700 shares of common stock outstanding as of
	February 28, 2002.                                                                                                             
|   
|(4) | Based on information contained in a report on
	Schedule 13-G/ A filed with the SEC on February 14,
	2002. The address of Capital Group International, Inc. is
	11100 Santa Monica Boulevard, 15th Floor,
	Los Angeles, California 90025.

65



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##### Table of Contents





|    |                                                                                                                                                                                                                          
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(5) | Based on information contained in a report on
	Schedule 13-G filed with the SEC on February 13, 2001.
	The address of PIMCO Equity Advisors LLC is 1345 Avenue of
	the Americas, 49th Floor, New York, New York
	10105.  
|   
|(6) | Based on information contained in a report on
	Schedule 13-G/ A filed with the SEC on February 14,
	2002. The address of FMR Corp. is 82 Devonshire
	Street, Boston, Massachusetts 02109.                                
|   
|(7) | Based on information contained in a report on
	Schedule 13-G/ A filed with the SEC on February 14,
	2002. The address of Par Capital Management, Inc. is
	One Financial Center, Suite 1600, Boston,
	Massachusetts 02111.
|   
|(8) | Based on information contained in a report on
	Schedule 13-G/ A filed with the SEC on February 12,
	2002. The address of AXA Financial, Inc. is
	1290 Avenue of the Americas, New York, New York
	10104.                 
|   
|(9) | In addition to the officers and directors named
	in this table, five other executive officers are members of the
	group.                                                                                                 

EQUITY-BASED INSTRUMENTS HELD BY
MANAGEMENT

The following table shows the equity-based
instruments held by our directors and executive officers as of
February 28, 2002. This table includes the number of shares
of our common stock underlying: (1) all stock options held
by our directors and executive officers, including options not
exercisable within 60 days, and (2) the deferred stock
units granted to our directors under the 2000 Non-Employee
Directors Stock Plan and to our executive officers under our
stock unit deferred compensation plan. For further discussion of
the Stock Plan, refer to Director Compensation, and
for further discussion of the stock unit deferred compensation
plan, refer to Summary Compensation Table. Directors
and executive officers are not entitled to receive distributions
of deferred stock units held, or to vote the shares except as
described in the Stock Plan and the stock unit deferred
compensation plan.

|                                                                 |  |               |           |                 |  |             |              |                |  |              |        |  |  |  |             |  |  |  |           | 
|---------------------------------------------------------------- |  | ------------- | --------- | --------------- |  | ----------- | ------------ | -------------- |  | ------------ | ------ |  |  |  | ----------- |  |  |  | --------- | 
|                                                                 |  |               |           |                 |  | Number of   |              |                |  | Total       
|                                                                 |  | Number of     |           | Exercise Price  |  | Deferred    |              | Distribution   |  | Equity-Based
|                                                                 |  | Stock Options |           | Range Per Share |  | Stock Units |              | Price          |  | Instruments 
|Name                                                             |  | Held(#)       |           | ($/SH)          |  | Held(#)     |              | Range/Share($) |  | Held(#)     
|                                                                 |  |               |           |                 |  |             |              |                |  |             
|Directors                                                        |  |               |           |                 |  |             |              |                |  |              |        |  |  |  |             |  |  |  |           | 
|                                                                 |  |               |           |                 |  |             |              |                |  |              |        |  |  |  |             |  |  |  |           | 
|David A. Reed                                                    |  |               | 84,528    |                 |  |             | 16.02- 87.00 |                |  |              | 1,249  |  |  |  | 16.02       |  |  |  | 85,777    | 
|Bradley C. Call                                                  |  |               | 50,784    |                 |  |             | 16.30- 79.50 |                |  |              | 1,249  |  |  |  | 16.02       |  |  |  | 52,033    | 
|Shirley S. Chater, Ph.D.                                         |  |               | 35,365    |                 |  |             | 13.67        |                |  |              | 1,464  |  |  |  | 13.67       |  |  |  | 36,829    | 
|Terry O. Hartshorn                                               |  |               | 115,778   |                 |  |             | 16.02- 85.25 |                |  |              | 1,249  |  |  |  | 16.02       |  |  |  | 117,027   | 
|Arthur B. Laffer, Ph.D.                                          |  |               | 34,994    |                 |  |             | 16.02- 38.50 |                |  |              |       |  |  |  |            |  |  |  | 34,994    | 
|Gary L. Leary                                                    |  |               | 63,778    |                 |  |             | 16.02- 87.00 |                |  |              | 1,249  |  |  |  | 16.02       |  |  |  | 65,027    | 
|Sanford M. Litvack                                               |  |               | 34,994    |                 |  |             | 16.02- 38.50 |                |  |              | 1,249  |  |  |  | 16.02       |  |  |  | 36,243    | 
|Warren E. Pinckert II                                            |  |               | 58,784    |                 |  |             | 16.30- 87.00 |                |  |              | 1,249  |  |  |  | 16.02       |  |  |  | 60,033    | 
|Lloyd E. Ross                                                    |  |               | 63,778    |                 |  |             | 16.02- 87.00 |                |  |              | 1,249  |  |  |  | 16.02       |  |  |  | 65,027    | 
|Executive Officers                                               |  |               |           |                 |  |             |              |                |  |              |        |  |  |  |             |  |  |  |           | 
|                                                                 |  |               |           |                 |  |             |              |                |  |              |        |  |  |  |             |  |  |  |           | 
|Howard G. Phanstiel                                              |  |               | 900,000   |                 |  |             | 12.06- 57.88 |                |  |              | 16,800 |  |  |  | 15.00       |  |  |  | 916,800   | 
|Bary G. Bailey                                                   |  |               | 525,000   |                 |  |             | 12.06- 57.88 |                |  |              | 3,850  |  |  |  | 15.00       |  |  |  | 528,850   | 
|Bradford A. Bowlus                                               |  |               | 778,500   |                 |  |             | 16.38-114.00 |                |  |              | 14,745 |  |  |  | 15.00-79.50 |  |  |  | 793,245   | 
|Gregory W. Scott                                                 |  |               | 300,000   |                 |  |             | 17.31- 18.38 |                |  |              | 8,169  |  |  |  | 15.00       |  |  |  | 308,169   | 
|John F. Fritz                                                    |  |               | 60,000    |                 |  |             | 17.31- 17.77 |                |  |              | 3,938  |  |  |  | 15.00       |  |  |  | 63,938    | 
|All Directors and Executive Officers as a
	Group(1) (19 persons) |  |               | 3,864,854 |                 |  |             | 12.06-114.00 |                |  |              | 79,479 |  |  |  | 13.67-79.50 |  |  |  | 3,944,333 | 



---



|    |                                                                                                                          
|--- | -------------------------------------------------------------------------------------------------------------------------
|(1) | In addition to the directors and officers named
	in this table, five other executive officers are members of this
	group.

66



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##### Table of Contents






ITEM 13.     CERTAIN
RELATIONSHIPS AND RELATED TRANSACTIONS

Prior to January 2002, we contracted with
Joseph S. Konowiecki, a professional corporation, for
Joseph S. Konowiecki to provide services as our Executive
Vice President, General Counsel and Secretary. For those
services, we paid the professional corporation $132,000 per
year. In addition, Mr. Konowiecki was eligible to
participate and did participate in the employee stock option
plan and the Premium Priced Stock Option Plan. As of
December 31, 2001, Mr. Konowiecki held 222,750 vested
nonqualified stock options at a weighted average exercise price
of $69.91 per share. In January 2001, we granted
Mr. Konowiecki 60,000 shares of restricted common
stock. The stock vests in 25%, or 15,000 share, increments
on each successive anniversary of the date of grant. If
Mr. Konowiecki voluntarily terminates his relationship with
us or if we terminate the relationship for cause,
Mr. Konowiecki would lose all rights to any of the unvested
stock. The vesting of the stock will accelerate if a change of
control occurs or in the event of Mr. Konowieckis
death or disability.

On January 1, 2002, Mr. Konowiecki
entered into an agreement with PacifiCare to become a full-time
employee and to serve as our Executive Vice President, General
Counsel and Secretary. In his new role for PacifiCare, he will
be responsible for legal and corporate affairs, state and
federal regulatory compliance, and will assist in strategy
formation and oversight. As part of his compensation package for
assuming his full-time position with us Mr. Konowiecki
received a $100,000 signing bonus, and we extended him a loan in
the amount of $250,000. Mr. Konowiecki will be obligated to
repay the signing bonus if he resigns or is terminated for cause
prior to January 2003. The loan bears interest at the Internal
Revenue Service mandated rate, and will lapse in a series of
installments over a four-year period beginning January 1,
2003. If Mr. Konowiecki is terminated for cause or
Mr. Konowiecki terminates his employment for reasons other
than death or disability, Mr. Konowiecki will be obligated
to repay the outstanding balance of the loan. Prior to
Mr. Konowieckis employment with us, and on
December 31, 2001, Mr. Konowiecki and his professional
corporation withdrew as a partner of, and resigned all positions
with, Konowiecki & Rank LLP, or K&R. K&R is
paying Mr. Konowiecki a fixed amount over time in
connection with his withdrawal as a partner.

We have an agreement with K&R, or the
K&R Agreement, pursuant to which K&R provides legal
services required by us. In addition to providing legal services
directly to us, K&R assists in arranging for other law firms
to provide legal services for us, as needed. The
K&R Agreement has a three-year term that is
automatically extended by one year on each January 1. The
contract currently expires on December 31, 2004. Either we
or K&R may end the automatic one-year extension of the term
by providing notice at least six months prior to the January
extension date. We pay K&R for its legal services on an
hourly basis at rates established each year, and prior to
January 1, 2002, we paid K&R legal fees for legal
services provided directly by Mr. Konowiecki based on a
fixed monthly charge. During 2001, we paid K&R approximately
$11 million for legal services. Until January 1, 2002,
Mr. Konowieckis professional corporation was a
partner of K&R and, as a partner, the professional
corporation received a share of K&Rs net income.

In 2000, we extended a loan in the amount of
$540,000 to Mr. Bailey as part of his compensation package
for joining us as an executive officer. The loan bears interest
at the Internal Revenue Service mandated rate, and lapses in a
series of annual installments over a three-year period that
began July 17, 2001. If Mr. Bailey is terminated for
cause or Mr. Bailey terminates his employment for reasons
other than death or disability, Mr. Bailey will be
obligated to repay the outstanding balance of the loan. As of
December 31, 2001, $360,000 remained outstanding.

In August 2001, we extended a loan in the amount
of $100,000 to Mr. Scott as part of his compensation
package for joining us as an executive officer, and relocating
to California. The loan bears interest at the Internal Revenue
Service mandated rate, and lapses in a series of installments
over a four-year period that began January 22, 2002. If
Mr. Scott is terminated for cause or Mr. Scott
terminates his employment for reasons other than death or
disability, Mr. Scott will be obligated to repay the
outstanding balance of the loan. As of December 31, 2001,
$100,000 remained outstanding.

67



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##### Table of Contents






PART IV




ITEM 14. EXHIBITS, FINANCIAL STATEMENT
SCHEDULES AND REPORTS ON FORM 8-K

The following documents are filed as part of this
report:



| | 
| | 
| | 

|      |  |                                                                                                                                                                                   |  |           |      | 
|----- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | --------- | ---- | 
|      |  |                                                                                                                                                                                   |  | Page     
|      |  |                                                                                                                                                                                   |  | Reference
|      |  |                                                                                                                                                                                   |  |          
|(a)1. |  | Consolidated Financial Statements:                                                                                                                                                |  |           |      | 
|      |  | Consolidated Balance Sheets as of
	December 31, 2001 and 2000.                                                                                                                    |  |           | F-1  | 
|      |  | Consolidated Statements of Operations for the
	years ended December 31, 2001, 2000 and 1999                                                                                       |  |           | F-2  | 
|      |  | Consolidated Statements of Stockholders
	Equity for the years ended December 31, 2001, 2000 and 1999                                                                             |  |           | F-3  | 
|      |  | Consolidated Statements of Cash Flows for the
	years ended December 31, 2001, 2000 and 1999                                                                                       |  |           | F-4  | 
|      |  | Notes to Consolidated Financial Statements                                                                                                                                        |  |           | F-6  | 
|      |  | Report of Ernst & Young LLP, Independent
	Auditors                                                                                                                                |  |           | F-31 | 
|      |  | Quarterly Information for 2001 and 2000
	(Unaudited)                                                                                                                              |  |           | F-32 | 
|     
|2.    |  | Financial Statement Schedule:                                                                                                                                                     |  |           |      | 
|      |  | Schedule II  Valuation and
	Qualifying Accounts                                                                                                                                  |  |           | F-33 | 
|      |  | All other schedules are omitted because they are
	not required or the information is included elsewhere in the
	consolidated financial statements.                                |  |           |      | 
|     
|3.    |  | Exhibits:An
	Exhibit Index is filed as part of this
	Form 10-K beginning on page E-1 and is incorporated by
	reference                                                          |  |           |      | 
|     
|(b)   |  | Reports on Form 8-K: On October 4,
	2001, we filed a Form 8-K in connection with the completion
	of a debt for equity exchange with a holder of our 7% Senior
	Notes due in 2003. |  |           |      | 

68



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SIGNATURES

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



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



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

| |                                      
| | -------------------------------------
| |                                      
| | Howard G. Phanstiel                  
| | President and Chief Executive Officer
| | (Principal Executive Officer)        

Date: March 19, 2002

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           |  | President and Chief Executive Officer (Principal
	Executive Officer)                 |  | March 19, 2002
|                                                    
|/s/ GREGORY W. SCOTTGregory W. Scott                 |  | Executive Vice President and
	Chief Financial Officer
	(Principal Financial Officer) |  | March 19, 2002
|                                                    
|/s/ SUSAN L. BERKELSusan L. Berkel                   |  | Senior Vice President and
	Corporate Controller
	(Chief Accounting Officer)          |  | March 19, 2002
|                                                    
|/s/ DAVID A. REEDDavid A. Reed                       |  | Chairman of the Board                                                                |  | March 19, 2002
|                                                    
|/s/ BRADLEY C. CALLBradley C. Call                   |  | Director                                                                             |  | March 19, 2002
|                                                    
|/s/ SHIRLEY S. CHATER, PH.D.Shirley S. Chater, Ph.D. |  | Director                                                                             |  | March 19, 2002

69



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|                                                   |  |          |  |               
|-------------------------------------------------- |  | -------- |  | --------------
|Name                                               |  | Title    |  | Date          
|                                                   |  |          |  |               
|                                                  
|/s/ TERRY O. HARTSHORNTerry O. Hartshorn           |  | Director |  | March 19, 2002
|                                                  
|/s/ ARTHUR B. LAFFER, PH.D.Arthur B. Laffer, Ph.D. |  | Director |  | March 19, 2002
|                                                  
|/s/ GARY L. LEARYGary L. Leary                     |  | Director |  | March 19, 2002
|                                                  
|/s/ SANFORD M. LITVACKSanford M. Litvack           |  | Director |  | March 19, 2002
|                                                  
|/s/ WARREN E. PINCKERT IIWarren E. Pinckert II     |  | Director |  | March 19, 2002
|                                                  
|/s/ LLOYD E. ROSSLloyd E. Ross                     |  | Director |  | March 19, 2002

70



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##### Table of Contents



PACIFICARE HEALTH SYSTEMS, INC.

CONSOLIDATED BALANCE SHEETS

|                                           |                                                                                                                    |                            |           |              |           |   |           |           |           | 
|------------------------------------------ | ------------------------------------------------------------------------------------------------------------------ | -------------------------- | --------- | ------------ | --------- | - | --------- | --------- | --------- | 
|                                           |                                                                                                                    | December 31,               |           | December 31,
|                                           |                                                                                                                    | 2001                       |           | 2000        
|                                           |                                                                                                                    |                            |           |             
|                                           |                                                                                                                    |                           
|                                           |                                                                                                                    | (Amounts in thousands,    
|                                           |                                                                                                                    | except per share data)    
|ASSETS                                    
|Current assets:                            |                                                                                                                    |                            |           |              |           |   |           |          
|                                           | Cash and equivalents                                                                                               |                            | $         | 977,759      |           |   | $         | 1,251,635 |          
|                                           | Marketable securities                                                                                              |                            |           | 1,062,353    |           |   |           | 864,013   |          
|                                           | Receivables, net                                                                                                   |                            |           | 375,661      |           |   |           | 410,694   |          
|                                           | Prepaid expenses and other current assets                                                                          |                            |           | 40,254       |           |   |           | 42,852    |          
|                                           | Deferred income taxes                                                                                              |                            |           | 132,159      |           |   |           | 139,712   |          
|                                           |                                                                                                                    |                            |           |              |           |   |           |          
|                                           |                                                                                                                    | Total current assets       |           |              | 2,588,186 |   |           |           | 2,708,906 | 
|                                           |                                                                                                                    |                            |           |              |           |   |           |          
|Property, plant and equipment at cost, net |                                                                                                                    |                            | 166,724   |              |           |   | 225,551   |          
|Marketable securities-restricted           |                                                                                                                    |                            | 112,167   |              |           |   | 94,402    |          
|Goodwill and intangible assets, net        |                                                                                                                    |                            | 2,181,986 |              |           |   | 2,261,637 |          
|Other assets                               |                                                                                                                    |                            | 46,983    |              |           |   | 32,940    |          
|                                           |                                                                                                                    |                            |           |              |           |   |           |          
|                                           |                                                                                                                    | $                          | 5,096,046 |              |           | $ | 5,323,436 |          
|                                           |                                                                                                                    |                            |           |              |           |   |           |          
|LIABILITIES AND STOCKHOLDERS EQUITY      
|Current liabilities:                       |                                                                                                                    |                            |           |              |           |   |           |          
|                                           | Medical claims and benefits payable                                                                                |                            | $         | 1,095,900    |           |   | $         | 1,270,800 |          
|                                           | Accounts payable                                                                                                   |                            |           | 122,625      |           |   |           | 131,196   |          
|                                           | Accrued liabilities                                                                                                |                            |           | 260,560      |           |   |           | 241,927   |          
|                                           | Accrued compensation and employee benefits                                                                         |                            |           | 83,623       |           |   |           | 72,958    |          
|                                           | Unearned premium revenue                                                                                           |                            |           | 550,910      |           |   |           | 598,215   |          
|                                           | Long-term debt due within one year                                                                                 |                            |           | 124          |           |   |           | 161       |          
|                                           |                                                                                                                    |                            |           |              |           |   |           |          
|                                           |                                                                                                                    | Total current liabilities  |           |              | 2,113,742 |   |           |           | 2,315,257 | 
|                                           |                                                                                                                    |                            |           |              |           |   |           |          
|Long-term debt due after one year          |                                                                                                                    |                            | 794,309   |              |           |   | 836,556   |          
|Deferred income taxes                      |                                                                                                                    |                            | 137,127   |              |           |   | 145,633   |          
|Other liabilities                          |                                                                                                                    |                            | 17,083    |              |           |   | 20,746    |          
|Minority interest                          |                                                                                                                    |                            |          |              |           |   | 1,684     |          
|Commitments and contingencies              |                                                                                                                    |                            |           |              |           |   |           |          
|Stockholders equity:                      |                                                                                                                    |                            |           |              |           |   |           |          
|                                           | Common stock, $0.01 par value; 200,000 shares
	authorized;
	issued 47,313 shares in 2001 and 46,986 shares in 2000 |                            |           | 473          |           |   |           | 470       |          
|                                           | Unearned compensation                                                                                              |                            |           | (1,153       | )         |   |           |          |          
|                                           | Additional paid-in capital                                                                                         |                            |           | 1,582,566    |           |   |           | 1,613,944 |          
|                                           | Accumulated other comprehensive income (loss)                                                                      |                            |           | 1,951        |           |   |           | (2,975    | )        
|                                           | Retained earnings                                                                                                  |                            |           | 1,108,198    |           |   |           | 1,089,192 |          
|                                           | Treasury stock, at cost; 12,776 shares in 2001
	and 13,532 shares in 2000                                          |                            |           | (658,250     | )         |   |           | (697,071  | )        
|                                           |                                                                                                                    |                            |           |              |           |   |           |          
|                                           |                                                                                                                    | Total stockholders equity |           |              | 2,033,785 |   |           |           | 2,003,560 | 
|                                           |                                                                                                                    |                            |           |              |           |   |           |          
|                                           |                                                                                                                    | $                          | 5,096,046 |              |           | $ | 5,323,436 |          
|                                           |                                                                                                                    |                            |           |              |           |   |           |          

See accompanying notes.

F-1



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##### Table of Contents



PACIFICARE HEALTH SYSTEMS, INC.






CONSOLIDATED STATEMENTS OF
OPERATIONS


|                                                                                    |                                  |                                               |           |              |            |              |           |           |            |   |           |           |            | 
|----------------------------------------------------------------------------------- | -------------------------------- | --------------------------------------------- | --------- | ------------ | ---------- | ------------ | --------- | --------- | ---------- | - | --------- | --------- | ---------- | 
|                                                                                    |                                  | Year Ended                                    |           | Year Ended   |            | Year Ended  
|                                                                                    |                                  | December 31,                                  |           | December 31, |            | December 31,
|                                                                                    |                                  | 2001                                          |           | 2000         |            | 1999        
|                                                                                    |                                  |                                               |           |              |            |             
|                                                                                    |                                  |                                              
|                                                                                    |                                  | (Amounts in thousands, except per share data)
|Revenue:                                                                            |                                  |                                               |           |              |            |              |           |           |            |   |           |          
|                                                                                    | Commercial premiums              |                                               | $         | 4,795,741    |            |              | $         | 4,912,216 |            |   | $         | 3,994,475 |           
|                                                                                    | Medicare premiums                |                                               |           | 6,764,164    |            |              |           | 6,416,039 |            |   |           | 5,875,687 |           
|                                                                                    | Other income                     |                                               |           | 172,804      |            |              |           | 139,672   |            |   |           | 118,928   |           
|                                                                                    | Net investment income            |                                               |           | 111,263      |            |              |           | 108,371   |            |   |           | 84,050    |           
|                                                                                    |                                  |                                               |           |              |            |              |           |           |            |   |           |          
|                                                                                    |                                  | Total operating revenue                       |           |              | 11,843,972 |              |           |           | 11,576,298 |   |           |           | 10,073,140 | 
|Expenses:                                                                           |                                  |                                               |           |              |            |              |           |           |            |   |           |          
|Health care services:                                                               |                                  |                                               |           |              |            |              |           |           |            |   |           |          
|                                                                                    | Commercial services              |                                               |           | 4,258,412    |            |              |           | 4,178,701 |            |   |           | 3,262,261 |           
|                                                                                    | Medicare services                |                                               |           | 6,109,245    |            |              |           | 5,734,956 |            |   |           | 5,106,429 |           
|                                                                                    |                                  |                                               |           |              |            |              |           |           |            |   |           |          
|                                                                                    |                                  | Total health care services                    |           |              | 10,367,657 |              |           |           | 9,913,657  |   |           |           | 8,368,690  | 
|Selling, general and administrative expenses                                        |                                  |                                               | 1,205,478 |              |            |              | 1,203,573 |           |            |   | 1,105,816 |          
|Amortization of goodwill and intangible assets                                      |                                  |                                               | 82,896    |              |            |              | 83,217    |           |            |   | 75,957    |          
|Impairment, disposition, restructuring and other
	charges (credits)                 |                                  |                                               | 61,157    |              |            |              | 11,730    |           |            |   | (2,233    | )        
|Office of Personnel Management credits                                              |                                  |                                               |          |              |            |              | (2,964    | )         |            |   |          |          
|                                                                                    |                                  |                                               |           |              |            |              |           |           |            |   |           |          
|Operating income                                                                    |                                  |                                               | 126,784   |              |            |              | 367,085   |           |            |   | 524,910   |          
|Interest expense                                                                    |                                  |                                               | (70,282   | )            |            |              | (79,636   | )         |            |   | (43,001   | )        
|Minority interest in consolidated subsidiary                                        |                                  |                                               |          |              |            |              | 637       |           |            |   |          |          
|                                                                                    |                                  |                                               |           |              |            |              |           |           |            |   |           |          
|Income before income taxes                                                          |                                  |                                               | 56,502    |              |            |              | 288,086   |           |            |   | 481,909   |          
|Provision for income taxes                                                          |                                  |                                               | 38,371    |              |            |              | 127,046   |           |            |   | 203,365   |          
|                                                                                    |                                  |                                               |           |              |            |              |           |           |            |   |           |          
|Income before extraordinary gain                                                    |                                  |                                               | 18,131    |              |            |              | 161,040   |           |            |   | 278,544   |          
|Extraordinary gain on early retirement of debt
	(less income taxes of $0.9 million) |                                  |                                               | 875       |              |            |              |          |           |            |   |          |          
|                                                                                    |                                  |                                               |           |              |            |              |           |           |            |   |           |          
|Net income                                                                          |                                  | $                                             | 19,006    |              |            | $            | 161,040   |           |            | $ | 278,544   |          
|                                                                                    |                                  |                                               |           |              |            |              |           |           |            |   |           |          
|Basic earnings per share:                                                           |                                  |                                               |           |              |            |              |           |           |            |   |           |          
|                                                                                    | Income before extraordinary gain |                                               | $         | 0.54         |            |              | $         | 4.59      |            |   | $         | 6.26      |           
|                                                                                    | Extraordinary gain, net          |                                               |           | 0.02         |            |              |           |          |            |   |           |          |           
|                                                                                    |                                  |                                               |           |              |            |              |           |           |            |   |           |          
|                                                                                    | Basic earnings per share         |                                               | $         | 0.56         |            |              | $         | 4.59      |            |   | $         | 6.26      |           
|                                                                                    |                                  |                                               |           |              |            |              |           |           |            |   |           |          
|Diluted earnings per share:                                                         |                                  |                                               |           |              |            |              |           |           |            |   |           |          
|                                                                                    | Income before extraordinary gain |                                               | $         | 0.53         |            |              | $         | 4.58      |            |   | $         | 6.23      |           
|                                                                                    | Extraordinary gain, net          |                                               |           | 0.02         |            |              |           |          |            |   |           |          |           
|                                                                                    |                                  |                                               |           |              |            |              |           |           |            |   |           |          
|                                                                                    | Diluted earnings per share       |                                               | $         | 0.55         |            |              | $         | 4.58      |            |   | $         | 6.23      |           
|                                                                                    |                                  |                                               |           |              |            |              |           |           |            |   |           |          

See accompanying notes.

F-2



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##### Table of Contents



PACIFICARE HEALTH SYSTEMS, INC.

CONSOLIDATED STATEMENTS OF STOCKHOLDERS
EQUITY

|                                                                           |                                       |                                                                      |     |              |   |            |        |               |   |          |           |          |   |       |         |   |         |   |           |         |   |   |          |          |   |   |           |          |         |  
|-------------------------------------------------------------------------- | ------------------------------------- | -------------------------------------------------------------------- | --- | ------------ | - | ---------- | ------ | ------------- | - | -------- | --------- | -------- | - | ----- | ------- | - | ------- | - | --------- | ------- | - | - | -------- | -------- | - | - | --------- | -------- | ------- | -
|                                                                           |                                       |                                                                      |     |              |   |            |        | Accumulated   |   |          |           |          |   |      
|                                                                           |                                       |                                                                      |     |              |   | Additional |        | Other         |   |          |           |          |   |      
|                                                                           |                                       | Common                                                               |     | Unearned     |   | Paid-in    |        | Comprehensive |   | Retained |           | Treasury |   |      
|                                                                           |                                       | Stock                                                                |     | Compensation |   | Capital    |        | Income (Loss) |   | Earnings |           | Stock    |   | Total
|                                                                           |                                       |                                                                      |     |              |   |            |        |               |   |          |           |          |   |      
|                                                                           |                                       |                                                                     
|                                                                           |                                       | (Amounts in thousands)                                              
|Balances at December 31, 1998                                              |                                       | $                                                                    | 464 |              |   | $          |       |               |   | $        | 1,624,619 |          |   | $     | 7,359   |   |         | $ | 649,608   |         |   | $ | (43,954  | )        |   | $ | 2,238,096 |         
|                                                                           |                                       |                                                                      |     |              |   |            |        |               |   |          |           |          |   |       |         |   |         |   |           |         |   |   |          |          |   |   |           |         
|Comprehensive income:                                                      |                                       |                                                                      |     |              |   |            |        |               |   |          |           |          |   |       |         |   |         |   |           |         |   |   |          |          |   |   |           |         
|                                                                           | Net income                            |                                                                      |     |             |   |            |        |              |   |          |           |         |   |       |         |  |         |   |           | 278,544 |   |   |          |         |   |   |           | 278,544  |        
|                                                                           | Other comprehensive loss, net of tax: |                                                                      |     |              |   |            |        |               |   |          |           |          |   |       |         |   |         |   |           |         |   |   |          |          |   |   |           |          |        
|                                                                           |                                       | Unrealized losses on securities, net of
	reclassification adjustment |     |              |  |            |        |               |  |          |           |          |  |       |         |   | (31,755 | ) |           |         |  |   |          |          |  |   |           |          | (31,755 | )
|                                                                           |                                       |                                                                      |     |              |   |            |        |               |   |          |           |          |   |       |         |   |         |   |           |         |   |   |          |          |   |   |           |         
|Comprehensive income                                                       |                                       |                                                                      |    |              |   |            |       |               |   |          |          |          |   |       | (31,755 | ) |         |   | 278,544   |         |   |   |         |          |   |   | 246,789   |         
|                                                                           |                                       |                                                                      |     |              |   |            |        |               |   |          |           |          |   |       |         |   |         |   |           |         |   |   |          |          |   |   |           |         
|Capital stock activity:                                                    |                                       |                                                                      |     |              |   |            |        |               |   |          |           |          |   |       |         |   |         |   |           |         |   |   |          |          |   |   |           |         
|                                                                           | Employee benefit plans                |                                                                      |     | 4            |   |            |        |              |   |          |           | 29,803   |   |       |         |  |         |   |           |        |   |   |          |         |   |   |           | 29,807   |        
|                                                                           | Purchase of treasury stock            |                                                                      |     |             |   |            |        |              |   |          |           |         |   |       |         |  |         |   |           |        |   |   |          | (480,036 | ) |   |           | (480,036 | )      
|Common stock reclassification payments to
	UniHealth Foundation and others |                                       |                                                                      |    |              |   |            |       |               |   |          | (61,880   | )        |   |       |        |   |         |   |          |         |   |   |         |          |   |   | (61,880   | )       
|Tax benefit associated with exercise of stock
	options                     |                                       |                                                                      |    |              |   |            |       |               |   |          | 4,943     |          |   |       |        |   |         |   |          |         |   |   |         |          |   |   | 4,943     |         
|                                                                           |                                       |                                                                      |     |              |   |            |        |               |   |          |           |          |   |       |         |   |         |   |           |         |   |   |          |          |   |   |           |         
|Balances at December 31, 1999                                              |                                       |                                                                      | 468 |              |   |            |       |               |   |          | 1,597,485 |          |   |       | (24,396 | ) |         |   | 928,152   |         |   |   | (523,990 | )        |   |   | 1,977,719 |         
|                                                                           |                                       |                                                                      |     |              |   |            |        |               |   |          |           |          |   |       |         |   |         |   |           |         |   |   |          |          |   |   |           |         
|Comprehensive income:                                                      |                                       |                                                                      |     |              |   |            |        |               |   |          |           |          |   |       |         |   |         |   |           |         |   |   |          |          |   |   |           |         
|                                                                           | Net income                            |                                                                      |     |             |   |            |        |              |   |          |           |         |   |       |         |  |         |   |           | 161,040 |   |   |          |         |   |   |           | 161,040  |        
|                                                                           | Other comprehensive gain, net of tax: |                                                                      |     |              |   |            |        |               |   |          |           |          |   |       |         |   |         |   |           |         |   |   |          |          |   |   |           |          |        
|                                                                           |                                       | Unrealized gains on securities, net of
	reclassification adjustment  |     |              |  |            |        |               |  |          |           |          |  |       |         |   | 21,421  |   |           |         |  |   |          |          |  |   |           |          | 21,421  |  
|                                                                           |                                       |                                                                      |     |              |   |            |        |               |   |          |           |          |   |       |         |   |         |   |           |         |   |   |          |          |   |   |           |         
|Comprehensive income                                                       |                                       |                                                                      |    |              |   |            |       |               |   |          |          |          |   |       | 21,421  |   |         |   | 161,040   |         |   |   |         |          |   |   | 182,461   |         
|                                                                           |                                       |                                                                      |     |              |   |            |        |               |   |          |           |          |   |       |         |   |         |   |           |         |   |   |          |          |   |   |           |         
|Capital stock activity:                                                    |                                       |                                                                      |     |              |   |            |        |               |   |          |           |          |   |       |         |   |         |   |           |         |   |   |          |          |   |   |           |         
|                                                                           | Employee benefit plans                |                                                                      |     | 2            |   |            |        |              |   |          |           | 8,538    |   |       |         |  |         |   |           |        |   |   |          | 251      |   |   |           | 8,791    |        
|                                                                           | Purchase of treasury stock            |                                                                      |     |             |   |            |        |              |   |          |           |         |   |       |         |  |         |   |           |        |   |   |          | (173,332 | ) |   |           | (173,332 | )      
|Contribution for minority interest in
	consolidated subsidiary             |                                       |                                                                      |    |              |   |            |       |               |   |          | 6,120     |          |   |       |        |   |         |   |          |         |   |   |         |          |   |   | 6,120     |         
|Tax benefit associated with exercise of stock
	options                     |                                       |                                                                      |    |              |   |            |       |               |   |          | 1,801     |          |   |       |        |   |         |   |          |         |   |   |         |          |   |   | 1,801     |         
|                                                                           |                                       |                                                                      |     |              |   |            |        |               |   |          |           |          |   |       |         |   |         |   |           |         |   |   |          |          |   |   |           |         
|Balances at December 31, 2000                                              |                                       |                                                                      | 470 |              |   |            |       |               |   |          | 1,613,944 |          |   |       | (2,975  | ) |         |   | 1,089,192 |         |   |   | (697,071 | )        |   |   | 2,003,560 |         
|                                                                           |                                       |                                                                      |     |              |   |            |        |               |   |          |           |          |   |       |         |   |         |   |           |         |   |   |          |          |   |   |           |         
|Comprehensive income:                                                      |                                       |                                                                      |     |              |   |            |        |               |   |          |           |          |   |       |         |   |         |   |           |         |   |   |          |          |   |   |           |         
|                                                                           | Net income                            |                                                                      |     |             |   |            |        |              |   |          |           |         |   |       |         |  |         |   |           | 19,006  |   |   |          |         |   |   |           | 19,006   |        
|                                                                           | Other comprehensive gain, net of tax: |                                                                      |     |              |   |            |        |               |   |          |           |          |   |       |         |   |         |   |           |         |   |   |          |          |   |   |           |          |        
|                                                                           |                                       | Unrealized gains on securities, net of
	reclassification adjustment  |     |              |  |            |        |               |  |          |           |          |  |       |         |   | 4,926   |   |           |         |  |   |          |          |  |   |           |          | 4,926   |  
|                                                                           |                                       |                                                                      |     |              |   |            |        |               |   |          |           |          |   |       |         |   |         |   |           |         |   |   |          |          |   |   |           |         
|Comprehensive income                                                       |                                       |                                                                      |    |              |   |            |       |               |   |          |          |          |   |       | 4,926   |   |         |   | 19,006    |         |   |   |         |          |   |   | 23,932    |         
|                                                                           |                                       |                                                                      |     |              |   |            |        |               |   |          |           |          |   |       |         |   |         |   |           |         |   |   |          |          |   |   |           |         
|Capital stock activity:                                                    |                                       |                                                                      |     |              |   |            |        |               |   |          |           |          |   |       |         |   |         |   |           |         |   |   |          |          |   |   |           |         
|                                                                           | Employee benefit plans                |                                                                      |     | 3            |   |            |        | (1,153        | ) |          |           | 4,360    |   |       |         |  |         |   |           |        |   |   |          |         |   |   |           | 3,210    |        
|                                                                           | Reissue of treasury stock             |                                                                      |     |             |   |            |        |              |   |          |           | (28,621  | ) |       |         |  |         |   |           |        |   |   |          | 38,821   |   |   |           | 10,200   |        
|Purchase of remaining minority interest in
	consolidated subsidiary        |                                       |                                                                      |    |              |   |            |       |               |   |          | (7,138    | )        |   |       |        |   |         |   |          |         |   |   |         |          |   |   | (7,138    | )       
|Tax benefit associated with exercise of stock
	options                     |                                       |                                                                      |    |              |   |            |       |               |   |          | 21        |          |   |       |        |   |         |   |          |         |   |   |         |          |   |   | 21        |         
|                                                                           |                                       |                                                                      |     |              |   |            |        |               |   |          |           |          |   |       |         |   |         |   |           |         |   |   |          |          |   |   |           |         
|Balances at December 31, 2001                                              |                                       | $                                                                    | 473 |              |   | $          | (1,153 | )             |   | $        | 1,582,566 |          |   | $     | 1,951   |   |         | $ | 1,108,198 |         |   | $ | (658,250 | )        |   | $ | 2,033,785 |         
|                                                                           |                                       |                                                                      |     |              |   |            |        |               |   |          |           |          |   |       |         |   |         |   |           |         |   |   |          |          |   |   |           |         

See accompanying notes.

F-3



---



##### Table of Contents



PACIFICARE HEALTH SYSTEMS, INC.

CONSOLIDATED STATEMENTS OF CASH
FLOWS

|                                                 |                                                                                                    |                                                                                        |                                                                                       |                                                            |        |              |           |          |        |          |          |          |        |         |          |  
|------------------------------------------------ | -------------------------------------------------------------------------------------------------- | -------------------------------------------------------------------------------------- | ------------------------------------------------------------------------------------- | ---------------------------------------------------------- | ------ | ------------ | --------- | -------- | ------ | -------- | -------- | -------- | ------ | ------- | -------- | -
|                                                 |                                                                                                    | Year Ended                                                                             |                                                                                       | Year Ended                                                 |        | Year Ended  
|                                                 |                                                                                                    | December 31,                                                                           |                                                                                       | December 31,                                               |        | December 31,
|                                                 |                                                                                                    | 2001                                                                                   |                                                                                       | 2000                                                       |        | 1999        
|                                                 |                                                                                                    |                                                                                        |                                                                                       |                                                            |        |             
|                                                 |                                                                                                    |                                                                                       
|                                                 |                                                                                                    | (Amounts in thousands)                                                                
|Operating activities:                            |                                                                                                    |                                                                                        |                                                                                       |                                                            |        |              |           |          |        |          |          |         
|                                                 | Net income                                                                                         |                                                                                        | $                                                                                     | 19,006                                                     |        |              | $         | 161,040  |        |          | $        | 278,544  |       
|                                                 | Adjustments to reconcile net income to net cash
	flows provided by (used in) operating activities: |                                                                                        |                                                                                       |                                                            |        |              |           |          |        |          |          |          |       
|                                                 |                                                                                                    | Amortization of goodwill and intangible assets                                         |                                                                                       |                                                            | 82,896 |              |           |          | 83,217 |          |          |          | 75,957 |        
|                                                 |                                                                                                    | Depreciation and amortization                                                          |                                                                                       |                                                            | 65,808 |              |           |          | 47,346 |          |          |          | 42,140 |        
|                                                 |                                                                                                    | Impairment, disposition, restructuring and other
	charges (credits)                    |                                                                                       |                                                            | 61,157 |              |           |          | 11,730 |          |          |          | (2,233 | )      
|                                                 |                                                                                                    | Provision for doubtful accounts                                                        |                                                                                       |                                                            | 22,070 |              |           |          | 37,598 |          |          |          | (8,687 | )      
|                                                 |                                                                                                    | Loss on disposal of property, plant and equipment
	and other                           |                                                                                       |                                                            | 6,053  |              |           |          | 7,664  |          |          |          | 9,283  |        
|                                                 |                                                                                                    | Deferred income taxes                                                                  |                                                                                       |                                                            | (3,966 | )            |           |          | 6,107  |          |          |          | 26,668 |        
|                                                 |                                                                                                    | Unearned compensation amortization                                                     |                                                                                       |                                                            | 3,632  |              |           |          |       |          |          |          |       |        
|                                                 |                                                                                                    | Gain on early retirement of debt                                                       |                                                                                       |                                                            | (1,800 | )            |           |          |       |          |          |          |       |        
|                                                 |                                                                                                    | Tax benefit realized for stock option exercises                                        |                                                                                       |                                                            | 21     |              |           |          | 1,801  |          |          |          | 4,943  |        
|                                                 |                                                                                                    | Office of Personnel Management credits                                                 |                                                                                       |                                                            |       |              |           |          | (2,964 | )        |          |          |       |        
|                                                 |                                                                                                    | Minority interest in consolidated subsidiary                                           |                                                                                       |                                                            |       |              |           |          | (637   | )        |          |          |       |        
|                                                 |                                                                                                    | Changes in assets and liabilities, net of effects
	from acquisitions and dispositions: |                                                                                       |                                                            |        |              |           |          |        |          |          |          |        |        
|                                                 |                                                                                                    |                                                                                        | Receivables, net                                                                      |                                                            |        | 16,070       |           |          |        | (122,194 | )        |          |        | (22,010 | )       
|                                                 |                                                                                                    |                                                                                        | Prepaid expenses and other assets                                                     |                                                            |        | 15,397       |           |          |        | 4,870    |          |          |        | (31,805 | )       
|                                                 |                                                                                                    |                                                                                        | Medical claims and benefits payable                                                   |                                                            |        | (174,900     | )         |          |        | 371,584  |          |          |        | 158,655 |         
|                                                 |                                                                                                    |                                                                                        | Accounts payable, accrued liabilities and accrued
	compensation and employee benefits |                                                            |        | (25,216      | )         |          |        | (2,079   | )        |          |        | (17,713 | )       
|                                                 |                                                                                                    |                                                                                        | Unearned premium revenue                                                              |                                                            |        | (47,305      | )         |          |        | 26,153   |          |          |        | 55,956  |         
|                                                 |                                                                                                    |                                                                                        |                                                                                       |                                                            |        |              |           |          |        |          |          |         
|                                                 |                                                                                                    |                                                                                        |                                                                                       | Net cash flows provided by operating activities            |        |              | 38,923    |          |        |          | 631,236  |          |        |         | 569,698  |  
|                                                 |                                                                                                    |                                                                                        |                                                                                       |                                                            |        |              |           |          |        |          |          |         
|Investing activities:                            |                                                                                                    |                                                                                        |                                                                                       |                                                            |        |              |           |          |        |          |          |         
|                                                 | (Purchase) sale of marketable securities, net                                                      |                                                                                        |                                                                                       | (190,401                                                   | )      |              |           | 177,598  |        |          |          | (175,368 | )     
|                                                 | Purchase of property, plant and equipment                                                          |                                                                                        |                                                                                       | (77,301                                                    | )      |              |           | (105,256 | )      |          |          | (66,211  | )     
|                                                 | Proceeds from the sale of property, plant and
	equipment                                           |                                                                                        |                                                                                       | 25,139                                                     |        |              |           | 3,596    |        |          |          | 15,765   |       
|                                                 | Purchase of marketable securities-restricted                                                       |                                                                                        |                                                                                       | (17,765                                                    | )      |              |           | (7,660   | )      |          |          | (3,811   | )     
|                                                 | Net cash (paid for) acquired from acquisitions                                                     |                                                                                        |                                                                                       | (500                                                       | )      |              |           | 4,098    |        |          |          | (21,234  | )     
|                                                 |                                                                                                    |                                                                                        |                                                                                       |                                                            |        |              |           |          |        |          |          |         
|                                                 |                                                                                                    |                                                                                        |                                                                                       | Net cash flows (used in) provided by investing
	activities |        |              | (260,828  | )        |        |          | 72,376   |          |        |         | (250,859 | )
|                                                 |                                                                                                    |                                                                                        |                                                                                       |                                                            |        |              |           |          |        |          |          |         
|Financing activities:                            |                                                                                                    |                                                                                        |                                                                                       |                                                            |        |              |           |          |        |          |          |         
|                                                 | Principal payments on long-term debt                                                               |                                                                                        |                                                                                       | (30,284                                                    | )      |              |           | (400,200 | )      |          |          | (75,093  | )     
|                                                 | Credit facility amendment fees and expenses                                                        |                                                                                        |                                                                                       | (12,949                                                    | )      |              |           |         |        |          |          |         |       
|                                                 | Purchase of minority interest in consolidated
	subsidiary                                          |                                                                                        |                                                                                       | (8,821                                                     | )      |              |           |         |        |          |          |         |       
|                                                 | Proceeds from issuance of common and treasury
	stock                                               |                                                                                        |                                                                                       | 83                                                         |        |              |           | 2,466    |        |          |          | 22,598   |       
|                                                 | Proceeds from borrowings of long-term debt                                                         |                                                                                        |                                                                                       |                                                           |        |              |           | 261,917  |        |          |          | 400,000  |       
|                                                 | Common stock repurchases                                                                           |                                                                                        |                                                                                       |                                                           |        |              |           | (173,332 | )      |          |          | (480,036 | )     
|                                                 | Cash received from minority stockholders                                                           |                                                                                        |                                                                                       |                                                           |        |              |           | 8,108    |        |          |          |         |       
|                                                 | Common stock reclassification payments to
	UniHealth Foundation                                    |                                                                                        |                                                                                       |                                                           |        |              |           |         |        |          |          | (61,880  | )     
|                                                 |                                                                                                    |                                                                                        |                                                                                       |                                                            |        |              |           |          |        |          |          |         
|                                                 |                                                                                                    |                                                                                        |                                                                                       | Net cash flows used in financing activities                |        |              | (51,971   | )        |        |          | (301,041 | )        |        |         | (194,411 | )
|                                                 |                                                                                                    |                                                                                        |                                                                                       |                                                            |        |              |           |          |        |          |          |         
|Net (decrease) increase in cash and
	equivalents |                                                                                                    |                                                                                        | (273,876                                                                              | )                                                          |        |              | 402,571   |          |        |          | 124,428  |         
|Beginning cash and equivalents                   |                                                                                                    |                                                                                        | 1,251,635                                                                             |                                                            |        |              | 849,064   |          |        |          | 724,636  |         
|                                                 |                                                                                                    |                                                                                        |                                                                                       |                                                            |        |              |           |          |        |          |          |         
|Ending cash and equivalents                      |                                                                                                    | $                                                                                      | 977,759                                                                               |                                                            |        | $            | 1,251,635 |          |        | $        | 849,064  |         
|                                                 |                                                                                                    |                                                                                        |                                                                                       |                                                            |        |              |           |          |        |          |          |         



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                                     |                              | Year Ended                                   |         | Year Ended  
|                                                                      |                                                                        | December 31,                                   |                              | December 31,                                 |         | December 31,
|                                                                      |                                                                        | 2001                                           |                              | 2000                                         |         | 1999        
|                                                                      |                                                                        |                                                |                              |                                              |         |             
|                                                                      |                                                                        |                                               
|                                                                      |                                                                        | (Amounts in thousands)                        
|Supplemental cash flow information:                                   |                                                                        |                                                |                              |                                              |         |              |     |          |   |         |        |        
|                                                                      | Cash paid during the year for:                                         |                                                |                              |                                              |         |              |     |          |   |         |        |         |  
|                                                                      |                                                                        |                                                | Income taxes, net of refunds |                                              | $       | 7,328        |     |          | $ | 115,092 |        |         | $ | 209,754 |       
|                                                                      |                                                                        |                                                | Interest                     |                                              | $       | 73,140       |     |          | $ | 71,034  |        |         | $ | 35,621  |       
|Supplemental schedule of noncash investing and
	financing activities: |                                                                        |                                                |                              |                                              |         |              |     |          |   |         |        |        
|                                                                      | Stock-based compensation                                               |                                                | $                            | (506                                         | )       |              | $   | 6,325    |   |         | $      | 7,209   |  
|                                                                      | Treasury stock reissued in exchange for
	retirement of long-term debt: |                                                |                              |                                              |         |              |     |          |   |         |        |         |  
|                                                                      |                                                                        | Treasury stock                                 |                              | $                                            | 38,821  |              |     | $        |  |         |        | $       |  |        
|                                                                      |                                                                        | Additional paid-in capital                     |                              |                                              | (28,621 | )            |     |          |  |         |        |         |  |        
|                                                                      |                                                                        | Long-term debt retired                         |                              |                                              | (12,000 | )            |     |          |  |         |        |         |  |        
|                                                                      |                                                                        |                                                |                              |                                              |         |              |     |          |   |         |        |        
|                                                                      |                                                                        | Extraordinary gain on early retirement of debt |                              | $                                            | (1,800  | )            |     | $        |  |         |        | $       |  |        
|                                                                      |                                                                        |                                                |                              |                                              |         |              |     |          |   |         |        |        
|Details of accumulated other comprehensive income
	(loss):            |                                                                        |                                                |                              |                                              |         |              |     |          |   |         |        |        
|                                                                      | Change in marketable securities                                        |                                                | $                            | 7,939                                        |         |              | $   | 34,935   |   |         | $      | (51,727 | )
|                                                                      | Less change in deferred income taxes                                   |                                                |                              | (3,013                                       | )       |              |     | (13,514  | ) |         |        | 19,972  |  
|                                                                      |                                                                        |                                                |                              |                                              |         |              |     |          |   |         |        |        
|                                                                      | Change in stockholders equity                                         |                                                | $                            | 4,926                                        |         |              | $   | 21,421   |   |         | $      | (31,755 | )
|                                                                      |                                                                        |                                                |                              |                                              |         |              |     |          |   |         |        |        
|Details of assets sold:                                               |                                                                        |                                                |                              |                                              |         |              |     |          |   |         |        |        
|                                                                      | Net book value of assets sold                                          |                                                | $                            | (42,000                                      | )       |              | $   |         |   |         | $      |        |  
|                                                                      | Less cash received                                                     |                                                |                              | 25,000                                       |         |              |     |         |   |         |        |        |  
|                                                                      |                                                                        |                                                |                              |                                              |         |              |     |          |   |         |        |        
|                                                                      | Note receivable from sale of assets                                    |                                                | $                            | (17,000                                      | )       |              | $   |         |   |         | $      |        |  
|                                                                      |                                                                        |                                                |                              |                                              |         |              |     |          |   |         |        |        
|Details of businesses acquired in purchase
	transactions:             |                                                                        |                                                |                              |                                              |         |              |     |          |   |         |        |        
|                                                                      | Fair value of assets acquired                                          |                                                | $                            | 3,245                                        |         |              | $   | 263,936  |   |         | $      | 21,234  |  
|                                                                      | Less liabilities assumed or created                                    |                                                |                              | (2,745                                       | )       |              |     | (134,243 | ) |         |        |        |  
|                                                                      |                                                                        |                                                |                              |                                              |         |              |     |          |   |         |        |        
|                                                                      | Cash paid for fair value of assets acquired                            |                                                |                              | 500                                          |         |              |     | 129,693  |   |         |        | 21,234  |  
|                                                                      | Cash acquired in acquisitions                                          |                                                |                              |                                             |         |              |     | (133,791 | ) |         |        |        |  
|                                                                      |                                                                        |                                                |                              |                                              |         |              |     |          |   |         |        |        
|                                                                      |                                                                        |                                                |                              | Net cash paid for (acquired in) acquisitions |         | $            | 500 |          |   | $       | (4,098 | )       |   | $       | 21,234 | 
|                                                                      |                                                                        |                                                |                              |                                              |         |              |     |          |   |         |        |        



See accompanying notes.


Table continued on next page


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. owns
and operates managed care organizations that arrange health care
services principally for a predetermined, prepaid periodic fee
to enrolled subscriber groups through independent health care
organizations under contract. Our commercial plans and Medicare
program are designed to deliver quality health care and customer
service to members at cost-effective prices. We also offer a
variety of specialty managed care products and services that
employees can purchase as a supplement to our basic commercial
plans or as stand-alone products. These products include
pharmacy benefit management, behavioral health services, life
and health insurance and dental and vision services.

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

Segment Information.We present segment information
externally the same way management uses financial data
internally to make operating decisions and assess performance.
Because we sell health care packages in the form of bundled
managed care and supplemental managed care products to members
of all ages, we have one reportable operating segment. These
managed care members generally fall within two product lines.
Revenues from non-Medicare members, generally employees or early
retirees of businesses, are reported in the commercial product
line. Revenues from our Medicare customers are reported in the
Medicare product line. Our single largest customer is the
federal government. Sources of federal government revenues
include revenues from Medicare beneficiaries and from federal
employees covered by the Federal Employee Health Benefits
Program, or FEHBP, who are included in our commercial product
line. Federal government revenues were $7.1 billion in
2001, $6.7 billion in 2000 and $6.2 billion in 1999.

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;                                                 
| 
| | Internally developed software;                                                     
| 
| | Medical claims and benefits payable;                                               
| 
| | Professional and general liability;                                                
| 
| | Reserves relating to the United States Office of
	Personnel Management, or OPM; and
| 
| | Certain other reserves.                                                            

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 2001 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

F-6



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##### Table of Contents



PACIFICARE HEALTH SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)

designated as available-for-sale. Accordingly,
marketable securities are carried at fair value and unrealized
gains or losses, net of applicable income taxes, are recorded in
stockholders equity. Because marketable securities are
available for use in current operations, they are classified as
current assets without regard to the securities
contractual maturity dates.

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

Concentrations of Credit Risk.Financial instruments that potentially
subject us to concentrations of credit risk consist primarily of
investments in marketable securities and commercial premium
receivables. 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. Concentrations of credit risk with respect to
commercial premium receivables are limited due to the large
number of employer groups comprising our customer base. We had
no significant concentrations of credit risk at
December 31, 2001.

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

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 identifiable intangible
assets. Identifiable intangible assets can include employer
group contracts, Medicare contracts, physician and hospital
networks and assembled work force. During 2001 and 2000, we
amortized goodwill and intangible assets evenly over periods
ranging from three to 40 years. Accumulated amortization
totaled $401 million at December 31, 2001 and
$318 million at December 31, 2000.

In June 2001, the Financial Accounting Standards
Board issued Statement of Financial Accounting Standards, or
SFAS, No. 141, Business Combinations, and
No. 142, Goodwill and Other Intangible Assets,
effective for fiscal years beginning after December 15,
2001. Under the new rules, goodwill is no longer amortized but
is subject to annual impairment tests. Other intangible assets
continue to be amortized over their useful lives. We began
applying the new rules on accounting for goodwill and other
intangible assets in the first quarter of 2002. Excluding any
impairment charges, we expect application of the goodwill
nonamortization provisions of SFAS No. 142 to result in an
increase in net income of approximately $56 million in 2002.

We are currently evaluating the first of the
required goodwill impairment tests as of January 1, 2002.
The tests for measuring goodwill impairment under SFAS
No. 142 are more stringent than the existing tests required
by SFAS No. 121, Accounting for the Impairment of
Long-Lived Assets and for Long-Lived Assets to Be Disposed
Of. Under SFAS No. 121, we applied an undiscounted cash
flow model when assessing the possible impairment of our
reporting units, which did not result in the recognition of
goodwill impairment in 2001. Under SFAS No. 142, we will be
required to use fair value methodology when assessing the
possible impairment of our reporting units, which will likely
result in impairment charges.

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##### Table of Contents



PACIFICARE HEALTH SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)

We will record such impairment charges as the
cumulative effect of a change in accounting principle as of
January 1, 2002.

Long-Lived Assets.

Property, Plant and Equipment.We record property, plant and
equipment at cost. We capitalize replacements and major
improvements. We also capitalize certain internal and external
costs associated with the purchase or development of
internal-use software. We charge repairs and maintenance to
expense as incurred. We eliminate the costs and related
accumulated depreciation when we sell property, plant and
equipment, and any resulting gains or losses are included in net
income. We depreciate property, plant and equipment, including
assets under capital leases, evenly over the assets useful
lives ranging from three to 25 years. We amortize leasehold
improvements evenly over the shorter of the lease term or five
years. We amortize software costs evenly over estimated useful
lives ranging from three to five years. Accumulated depreciation
and amortization on property, plant and equipment totaled
$164 million at December 31, 2001 and
$166 million at December 31, 2000.

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 the present value of the expected associated cash flows.

In August 2001, the Financial Accounting
Standards Board issued SFAS No. 144, Accounting for the
Impairment or Disposal of Long-Lived Assets, which
supersedes SFAS No. 121, Accounting for the Impairment
of Long-Lived Assets and for Long-Lived Assets to Be Disposed
Of. SFAS No. 144 statement retained many of the
fundamental impairment recognition and measurement criteria of
SFAS No. 121, including recognizing impairment losses on
long-lived assets used in operations when indicators of
impairment are present and the undiscounted cash flows estimated
to be generated by those assets are less than the assets
carrying amount. In addition, SFAS No. 144 removed goodwill
from its scope and modified the criteria required to classify an
asset as held-for-sale. The statement is effective for our
consolidated financial statements beginning January 1,
2002. We believe that the adoption of this statement will not
have a material impact on our consolidated financial position or
results of operations.

Minority Interest.In June 2000, PacifiCare and Compaq
Computer Corporation, or Compaq, agreed to jointly invest in a
newly formed Internet company for seniors called SeniorCo, Inc.
PacifiCare had majority ownership with approximately 80% of the
outstanding voting shares at December 31, 2000. The 2000
operating results of this entity were included in our
consolidated financial statements from the date of its
formation, partially offset by the portion of operating results
allocated to minority stockholders, primarily Compaq. In the
first quarter of 2001, we purchased all outstanding stock of
SeniorCo, Inc. from minority stockholders, for $9 million.
Of this amount, $6 million was paid to Compaq, as a return
on their original investment of $8 million. No operating
results were allocated to minority stockholders in 2001.

Premiums and Revenue Recognition.We report prepaid health care premiums
received from our health maintenance organizations, or
HMOs, enrolled groups as revenue in the month that
enrollees are entitled to receive health care. We record
premiums received in advance as unearned premium revenue. Funds
received under the federal Medicare program accounted for
approximately 59% in 2001, 57% in 2000 and 60% in 1999 as a
percentage of total premiums.

Health Care Services.Our HMOs arrange for comprehensive
health care services to their members through capitation or
risk-based arrangements. Capitation is a fixed monthly payment
made without regard to the frequency, extent or nature of the
health care services actually furnished. We provide benefits to
enrolled members generally through our contractual relationships
with physician groups and hospitals. Our

F-8



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##### Table of Contents



PACIFICARE HEALTH SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)

contracted physicians and hospitals may, in turn,
contract with specialists or referral physicians and hospitals
for specific services and are 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. Expenses related to these
programs that are based in part on estimates are recorded in the
period in which the related services are dispensed. The cost of
health care provided is accrued in the period it is dispensed to
the enrolled members, based in part on estimates for hospital
services and other health care costs that have been incurred but
not yet reported. Management develops these estimates using
actuarial methods based upon historical data for payment
patterns, cost trends, product mix, seasonality, utilization of
health care services and other relevant factors. 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 10, Contingencies. Our
HMOs have stop-loss insurance to cover unusually high costs of
care when incurred beyond a predetermined annual amount per
enrollee.

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 use Accounting Principles Board
Opinion, or APB, No. 25 to account for our employee
stock-based compensation plans. Because we typically set the
exercise price of options granted at our stocks market
price on the grant date, there is no associated compensation
expense.

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 $26 million in 2001,
$30 million in 2000 and $15 million in 1999.

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 7, Income Taxes.

F-9



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##### Table of Contents



PACIFICARE HEALTH SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)

Earnings per Share.We calculated the denominators for the
computation of basic and diluted earnings per share as follows:

|                                                                      |                                         |                        |        |      |  |      |        |        |   |  |        |        |  
|--------------------------------------------------------------------- | --------------------------------------- | ---------------------- | ------ | ---- |  | ---- | ------ | ------ | - |  | ------ | ------ | -
|                                                                      |                                         | 2001                   |        | 2000 |  | 1999
|                                                                      |                                         |                        |        |      |  |     
|                                                                      |                                         |                       
|                                                                      |                                         | (Amounts in thousands)
|Shares outstanding at the beginning of the period                     |                                         |                        | 33,454 |      |  |      | 37,252 |        |   |  | 45,616 |       
|Weighted average number of shares issued
	(acquired):                 |                                         |                        |        |      |  |      |        |        |   |  |        |       
|                                                                      | Treasury stock reissued (acquired), net |                        |        | 321  |  |      |        | (2,274 | ) |  |        | (1,387 | )
|                                                                      | Stock options exercised                 |                        |        |     |  |      |        | 94     |   |  |        | 277    |  
|                                                                      |                                         |                        |        |      |  |      |        |        |   |  |        |       
|Denominator for basic earnings per share                              |                                         |                        | 33,775 |      |  |      | 35,072 |        |   |  | 44,506 |       
|Employee stock options and other dilutive
	potential common shares(1) |                                         |                        | 254    |      |  |      | 95     |        |   |  | 211    |       
|                                                                      |                                         |                        |        |      |  |      |        |        |   |  |        |       
|Denominator for diluted earnings per share                            |                                         |                        | 34,029 |      |  |      | 35,167 |        |   |  | 44,717 |       
|                                                                      |                                         |                        |        |      |  |      |        |        |   |  |        |       



---



|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | 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, 2001, these weighted options
	outstanding totaled 6.1 million shares, with exercise
	prices ranging from $24.69 to $114.00 per share. For the years
	ended December 31, 2000 and 1999, these weighted options
	outstanding totaled 8.0 million shares and 6.3 million
	shares respectively, with exercise prices ranging from $44.19 to
	$114.00 per share.

F-10



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##### Table of Contents



PACIFICARE HEALTH SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)

3.     Marketable
Securities

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

|                                  |                                             |                                        |           |            |           |            |        |            |       |   |         |        |         |   |           |         |           | 
|--------------------------------- | ------------------------------------------- | -------------------------------------- | --------- | ---------- | --------- | ---------- | ------ | ---------- | ----- | - | ------- | ------ | ------- | - | --------- | ------- | --------- | 
|                                  |                                             |                                        |           | Gross      |           | Gross      |        |           
|                                  |                                             | Amortized                              |           | Unrealized |           | Unrealized |        |           
|                                  |                                             | Cost                                   |           | Gains      |           | Losses     |        | Fair Value
|                                  |                                             |                                        |           |            |           |            |        |           
|                                  |                                             |                                       
|                                  |                                             | (Amounts in thousands)                
|Marketable securities:            |                                             |                                        |           |            |           |            |        |            |       |   |         |        |         |   |           |        
|                                  | U.S. government and agency                  |                                        | $         | 355,234    |           |            | $      | 2,157      |       |   | $       | (1,739 | )       |   | $         | 355,652 |          
|                                  | State, municipal and state and local agency |                                        |           | 288,581    |           |            |        | 2,415      |       |   |         | (1,173 | )       |   |           | 289,823 |          
|                                  | Corporate debt and other securities         |                                        |           | 415,891    |           |            |        | 5,034      |       |   |         | (4,047 | )       |   |           | 416,878 |          
|                                  |                                             |                                        |           |            |           |            |        |            |       |   |         |        |         |   |           |        
|                                  |                                             | Total marketable securities            |           |            | 1,059,706 |            |        |            | 9,606 |   |         |        | (6,959  | ) |           |         | 1,062,353 | 
|                                  |                                             |                                        |           |            |           |            |        |            |       |   |         |        |         |   |           |        
|Marketable securities-restricted: |                                             |                                        |           |            |           |            |        |            |       |   |         |        |         |   |           |        
|                                  | U.S. government and agency                  |                                        |           | 60,402     |           |            |        | 1,290      |       |   |         | (25    | )       |   |           | 61,667  |          
|                                  | State, municipal and state and local agency |                                        |           | 33,298     |           |            |        | 391        |       |   |         | (83    | )       |   |           | 33,606  |          
|                                  | Corporate debt and other securities         |                                        |           | 18,467     |           |            |        | 710        |       |   |         |       |         |   |           | 19,177  |          
|                                  |                                             |                                        |           |            |           |            |        |            |       |   |         |        |         |   |           |        
|                                  |                                             | Total marketable securities-restricted |           |            | 112,167   |            |        |            | 2,391 |   |         |        | (108    | ) |           |         | 114,450   | 
|                                  |                                             |                                        |           |            |           |            |        |            |       |   |         |        |         |   |           |        
|Balance at December 31, 2001      |                                             | $                                      | 1,171,873 |            |           | $          | 11,997 |            |       | $ | (7,067  | )      |         | $ | 1,176,803 |        
|                                  |                                             |                                        |           |            |           |            |        |            |       |   |         |        |         |   |           |        
|Marketable securities:            |                                             |                                        |           |            |           |            |        |            |       |   |         |        |         |   |           |        
|                                  | U.S. government and agency                  |                                        | $         | 44,999     |           |            | $      | 403        |       |   | $       | (582   | )       |   | $         | 44,820  |          
|                                  | State, municipal and state and local agency |                                        |           | 323,205    |           |            |        | 2,796      |       |   |         | (1,351 | )       |   |           | 324,650 |          
|                                  | Corporate debt and other securities         |                                        |           | 500,711    |           |            |        | 2,361      |       |   |         | (8,529 | )       |   |           | 494,543 |          
|                                  |                                             |                                        |           |            |           |            |        |            |       |   |         |        |         |   |           |        
|                                  |                                             | Total marketable securities            |           |            | 868,915   |            |        |            | 5,560 |   |         |        | (10,462 | ) |           |         | 864,013   | 
|                                  |                                             |                                        |           |            |           |            |        |            |       |   |         |        |         |   |           |        
|Marketable securities-restricted: |                                             |                                        |           |            |           |            |        |            |       |   |         |        |         |   |           |        
|                                  | U.S. government and agency                  |                                        |           | 45,885     |           |            |        | 444        |       |   |         | (24    | )       |   |           | 46,305  |          
|                                  | State, municipal and state and local agency |                                        |           | 13,060     |           |            |        | 168        |       |   |         | (55    | )       |   |           | 13,173  |          
|                                  | Corporate debt and other securities         |                                        |           | 35,457     |           |            |        | 347        |       |   |         | (89    | )       |   |           | 35,715  |          
|                                  |                                             |                                        |           |            |           |            |        |            |       |   |         |        |         |   |           |        
|                                  |                                             | Total marketable securities-restricted |           |            | 94,402    |            |        |            | 959   |   |         |        | (168    | ) |           |         | 95,193    | 
|                                  |                                             |                                        |           |            |           |            |        |            |       |   |         |        |         |   |           |        
|Balance at December 31, 2000      |                                             | $                                      | 963,317   |            |           | $          | 6,519  |            |       | $ | (10,630 | )      |         | $ | 959,206   |        
|                                  |                                             |                                        |           |            |           |            |        |            |       |   |         |        |         |   |           |        

As of December 31, 2001 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                |  | $                      | 100,216   |                         |  | $              | 99,001    |            |  | $ | 35,415  |  |  | $ | 35,968  | 
|Due after one year through five years  |  |                        | 321,778   |                         |  |                | 325,886   |            |  |   | 46,806  |  |  |   | 48,023  | 
|Due after five years through ten years |  |                        | 346,036   |                         |  |                | 345,668   |            |  |   | 24,129  |  |  |   | 24,654  | 
|Due after ten years                    |  |                        | 291,676   |                         |  |                | 291,798   |            |  |   | 5,817   |  |  |   | 5,805   | 
|                                       |  |                        |           |                         |  |                |           |            |  |   |         |  |  |   |         | 
|                                       |  | $                      | 1,059,706 |                         |  | $              | 1,062,353 |            |  | $ | 112,167 |  |  | $ | 114,450 | 
|                                       |  |                        |           |                         |  |                |           |            |  |   |         |  |  |   |         | 

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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 $8.8 billion in 2001, $7.1 billion in
2000 and $6.9 billion in 1999. Gross realized gains and
gross realized losses are included in net investment income
under the specific identification method.

4.     Acquisitions
and Dispositions

2000 Acquisitions.On February 1, 2000, we completed
our acquisition of Harris Methodist Texas Health Plan, Inc. and
Harris Methodist Health Insurance Company, Inc. (together,
Harris), a health plan and insurance company in
Texas, for an approximate purchase price of $122 million.
This acquisition added approximately 250,000 commercial
members and 50,000 Medicare members to our Texas HMO
and was accounted for as a purchase. The related goodwill and
acquired intangible assets are being amortized over periods
ranging from three to 30 years. The operating results of
these entities are included in our consolidated financial
statements from the acquisition date.

During the first half of 2000, we assumed
approximately 18,000 members in Colorado and approximately
21,000 members in Washington for a purchase price of
approximately $6 million. These membership assumptions are
the result of transition agreements signed with QualMed Plans
for Health of Colorado, Inc. in September 1999 and with QualMed
Washington Health Plans, Inc. in October 1999, each a subsidiary
of Health Net, Inc.

2000 Dispositions.In June 2000, we announced our
intention to exit our Ohio HMO operations. This plan affected
approximately 35,000 commercial members and
3,500 Medicare members located in Ohio and Kentucky who
were enrolled in our plans during 2000. The exit was completed
in January 2001. We entered into an agreement with Anthem Blue
Cross and Blue Shield to assist in transitioning Ohios
commercial membership. Medicare members were provided a choice
of another Medicare+Choice HMO or traditional fee-for-service
Medicare. In connection with the disposition, we recognized
pretax charges of approximately $4 million ($2 million
or $0.07 diluted loss per share, net of tax). See Note 9,
Impairment, Disposition, Restructuring, Office of
Personnel Management and Other Charges (Credits).

1999 Acquisitions.In September 1999, we acquired Antero
Health Plans in Colorado for a purchase price of
$14 million. This acquisition added approximately
32,000 commercial members and 4,000 Medicare members
to our Colorado HMO. In February 1999, we assumed approximately
15,000 commercial members in Texas for $4 million.
These acquisitions were accounted for as purchases with
substantially the entire purchase price allocated to goodwill
and other acquired intangible assets. The goodwill and acquired
intangible assets are being amortized over periods ranging from
three to 20 years. The operating results of these entities
are included in our consolidated financial statements from the
acquisition date.

Pro Forma Financial Statements.The pro forma information below
presents our consolidated results of operations as if the Harris
acquisition occurred at the beginning of each period presented.
The pro forma information gives effect to actual results prior
to these transactions plus adjustments for depreciation expense,
goodwill amortization, net investment income and income taxes.
Because our 1999 membership acquisitions in Colorado and Texas
as well as our 2000 membership assumptions in Colorado and

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##### Table of Contents



PACIFICARE HEALTH SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)

Washington were not material to our consolidated
results of operations, these transactions were not included in
the pro forma information below.

|                           |  |                         |            |      |  |   |            | 
|-------------------------- |  | ----------------------- | ---------- | ---- |  | - | ---------- | 
|                           |  |                        
|                           |  | Year Ended December 31,
|                           |  |                        
|                           |  | 2000                    |            | 1999
|                           |  |                         |            |     
|                           |  |                        
|                           |  | (Amounts in thousands, 
|                           |  | except per share data) 
|Total operating revenue    |  | $                       | 11,633,520 |      |  | $ | 10,822,513 | 
|Income before income taxes |  | $                       | 280,460    |      |  | $ | 403,417    | 
|Net income                 |  | $                       | 156,434    |      |  | $ | 231,135    | 
|Basic earnings per share   |  | $                       | 4.46       |      |  | $ | 5.19       | 
|Diluted earnings per share |  | $                       | 4.45       |      |  | $ | 5.17       | 

5.     Long-Term Debt
and Other Commitments

Our contractual cash obligations as of
December 31, 2001, including long-term debt and other
commitments, were as follows:

|                                                |                        |                        |       |      |  |      |     |      |  |      |     |      |  |            |     |   |  |   |     |   |  |   |     |   |  |   |     |   | 
|----------------------------------------------- | ---------------------- | ---------------------- | ----- | ---- |  | ---- | --- | ---- |  | ---- | --- | ---- |  | ---------- | --- | - |  | - | --- | - |  | - | --- | - |  | - | --- | - | 
|                                                |                        |                       
|                                                |                        | Payments Due by Period
|                                                |                        |                       
|                                                |                        | Total                  |       | 2002 |  | 2003 |     | 2004 |  | 2005 |     | 2006 |  | Thereafter
|                                                |                        |                        |       |      |  |      |     |      |  |      |     |      |  |           
|                                                |                        |                       
|                                                |                        | (Amounts in millions) 
|Long-term debt:                                 |                        |                        |       |      |  |      |     |      |  |      |     |      |  |            |     |   |  |   |     |   |  |   |     |   |  |   |     |  
|                                                | Senior credit facility |                        | $     | 705  |  |      | $   |     |  |      | $   | 705  |  |            | $   |  |  |   | $   |  |  |   | $   |  |  |   | $   |  | 
|                                                | Senior notes           |                        |       | 88   |  |      |     |     |  |      |     | 88   |  |            |     |  |  |   |     |  |  |   |     |  |  |   |     |  | 
|                                                | Other                  |                        |       | 1    |  |      |     |     |  |      |     |     |  |            |     |  |  |   |     |  |  |   |     |  |  |   |     | 1 | 
|Other commitments:                              |                        |                        |       |      |  |      |     |      |  |      |     |      |  |            |     |   |  |   |     |   |  |   |     |   |  |   |     |  
|Information technology outsourcing contracts(1) |                        |                        | 1,261 |      |  |      | 139 |      |  |      | 158 |      |  |            | 150 |   |  |   | 140 |   |  |   | 123 |   |  |   | 551 |  
|Operating leases                                |                        |                        | 191   |      |  |      | 48  |      |  |      | 33  |      |  |            | 29  |   |  |   | 23  |   |  |   | 19  |   |  |   | 39  |  
|                                                |                        |                        |       |      |  |      |     |      |  |      |     |      |  |            |     |   |  |   |     |   |  |   |     |   |  |   |     |  
|Total contractual cash obligations              |                        | $                      | 2,246 |      |  | $    | 187 |      |  | $    | 984 |      |  | $          | 179 |   |  | $ | 163 |   |  | $ | 142 |   |  | $ | 591 |  
|                                                |                        |                        |       |      |  |      |     |      |  |      |     |      |  |            |     |   |  |   |     |   |  |   |     |   |  |   |     |  



---



|    |                                                                                                                                                                             
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | The Keane, Inc. contract was executed
	January 11, 2002, but is included in the table. See further
	discussion below, under Information Technology Outsourcing
	Contracts.

Long-Term Debt.In
August 2001, we executed an amendment to our existing senior
credit facility with our lenders to extend its maturity date.
The amended and restated credit facility matures on
January 2, 2003, and provides for a $650 million term
loan and a $150 million revolving line of credit. The
interest rates per annum applicable to amounts outstanding under
the term loan and revolving line of credit are, at our option,
either the administrative agents publicly announced
prime rate (or, if greater, the Federal Funds Rate
plus 0.5%) plus a margin of 2.5% per annum, or the rate of
Eurodollar borrowings for the applicable interest period plus a
margin of 3.5% per annum. These margins will increase by 1% per
annum if we do not permanently pay down the term loan by at
least $250 million by March 31, 2002. Based on our
outstanding balance under the credit facility at
December 31, 2001, our average overall interest rate,
excluding the facility fee, was 5.7% per annum. In connection
with the extension of the senior credit facility, we paid
approximately $12 million in amendment fees and expenses
that are being amortized over the remaining life of the senior
credit facility.

As of December 31, 2001, there was
$705 million outstanding under the credit facility,
including the $650 million term loan and $55 million
under the revolving line of credit. Included in the amount
outstanding under the revolving line of credit are letters of
credit equal to $29 million. This leaves

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PACIFICARE HEALTH SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)

$66 million available to us for additional
borrowing under the revolving line of credit. On January 2,
2002, we paid and permanently retired $25 million of the
outstanding balance on our term loan with proceeds we received
from computer equipment sold to International Business Machines
Corporation, or IBM. See Information Technology
Outsourcing Contracts, below.

The terms of the senior credit facility contain
various covenants usual for financings of this type, including a
minimum net worth requirement, a minimum fixed-charge coverage
requirement, a minimum leverage ratio and a minimum liquidity
requirement. At December 31, 2001, we were in compliance
with all such covenants. On January 23, 2002 we negotiated
an amendment to our senior credit facility to exclude our fourth
quarter restructuring charge from all provisions of the credit
facility.

In connection with the extension of the maturity
of the senior credit facility, our unregulated subsidiaries
provide guarantees and have granted security interests to the
lenders in all of their personal property.

We also have $88 million in senior notes
outstanding that we assumed when we acquired FHP in 1997. These
notes mature on September 15, 2003, and bear interest at 7%
payable semiannually. In September 2001, we retired
$12 million of the FHP senior notes by exchanging
approximately 0.8 million shares of common stock for those
notes. We reissued treasury stock to provide the common stock
used in the exchange. The note retirements resulted in a pretax
extraordinary gain of $2 million ($0.9 million or
$0.02 diluted earnings per share, net of tax), and a net equity
increase of $10 million. The FHP notes share in the
collateral securing our amended and restated credit facility.

Information Technology Outsourcing Contracts.In December 2001, we entered into a
10-year contract to outsource our information technology,
or IT, operations to IBM. Under the contract, IBM is the
coordinator of our IT outsourcing arrangement, and will provide
IT services and day-to-day management of our
IT infrastructure, including data center operations,
support services and information distribution. In January 2002,
we entered into a 10-year contract to outsource our
IT software applications maintenance and enhancement
services to Keane, Inc., or Keane. In connection with these
outsourcing agreements, we transitioned approximately
650 employee positions to IBM and Keane. The cash
obligations in the table above include base fees only. The
contracts also provide for variable fees, based on services
provided above certain contractual baselines. Additionally, in
the event of contract termination, we would be responsible to
pay termination fees to IBM and Keane. These termination fees
decline as each successive year of the contract term is
completed.

In connection with the IBM outsourcing contract,
we sold IBM computer equipment with a net book value of
$42 million. The consideration we received from IBM for the
sale included $25 million in cash, and a note receivable
for the $17 million balance. We will collect the note
receivable, which bears interest at approximately 7%, in the
form of credits against our future base fee payments from 2002
through 2005.

Operating Leases.We
lease office space and equipment under various non-cancelable
operating leases. Rent expense totaled $57 million in 2001,
$62 million in 2000 and $55 million in 1999.

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.

Restricted Stock Awards.In the first quarter of 2001, as part
of an employee recognition and retention program, we granted
84,000 shares of our restricted common stock to certain
employees in exchange for

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##### Table of Contents



PACIFICARE HEALTH SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)

the cancellation of outstanding stock options to
acquire approximately 1.5 million shares of our common
stock with exercise prices per share of $53.00 or more.
Approximately 1,593,000 stock options were cancelled in the
exchange. An additional 90,000 shares of restricted common
stock were granted to others who did not participate in the
option exchange. Restrictions on the 84,000 shares expired
on December 10, 2001 for holders who remained employees of
PacifiCare on that date. Approximately 3,200 restricted
shares were forfeited for the year ended December 31, 2001.
Restrictions on the 90,000 shares will expire, and related
charges are being amortized as earned over the vesting period,
not exceeding four years. All shares of restricted stock were
issued from our 1996 Officer and Key Employee Stock Option Plan,
as amended. For employees, 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. For non-employees, the amount of
unearned compensation is based on the fair value of the shares
at each reporting period until the shares are vested. Unearned
compensation totaled $1 million as of December 31,
2001. Related expenses (charged to selling, general and
administrative expenses) were $3 million for the year ended
December 31, 2001.

Acqua Wellington Arrangement.In December 2001, we entered into an
arrangement with Acqua Wellington North American Equities Fund
Ltd., or Acqua Wellington, an institutional investor, for the
purchase by Acqua Wellington of up to 6.9 million shares or
$150 million in our common stock. We have the ability to
call the equity commitment for an 18-month period beginning
December 26, 2001, the effective date of our registration
statement relating to the equity commitment, at a price per
share equal to the daily volume weighted average price of our
common stock on each of the 18 consecutive trading days in
a draw down period that the weighted average price is above the
threshold price we determine for the applicable draw down, less
a discount ranging from 3.2% to 4.7% that is based on the
threshold price. We have the sole discretion to present up to 15
draw down notices to Acqua Wellington. Each draw down notice
sets the threshold price and the dollar value of shares Acqua
Wellington may be obligated to purchase during a draw down
period. The threshold price we choose cannot be less than $11.00
per share. The threshold price we select determines the maximum
dollar value of shares and the discount to the market priced
based upon a predetermined schedule. As funds are drawn,
proceeds will be used to reduce our outstanding bank term debt.
No draws have been made under the arrangement.

Treasury Stock.As
of December 31, 2001, we held approximately 13 million
treasury shares totaling $658 million. These shares were
purchased pursuant to an October 1999 repurchase program that
allowed us to repurchase up to 12 million shares of common
stock including shares purchased from UniHealth Foundation and
prior repurchase programs. In September 2001, we reissued
0.8 million shares of treasury stock for the early
retirement of debt. See Note 5, Long-Term Debt and
Other Commitments. We have reissued, and will continue to
reissue these shares for our employee benefit plans or for other
corporate purposes.

UniHealth Foundation Stock Purchase Agreement.In May 1999, we entered into a stock
purchase agreement with UniHealth Foundation, then our largest
stockholder, to repurchase up to 5.9 million shares of our
common stock held by UniHealth Foundation. During 2000, we
purchased 1.5 million shares for a total of
$57 million under this agreement. In June 2001, we
terminated our stock purchase agreement and agreed to extend the
shelf registration for sale of our common stock held by
UniHealth Foundation until June 2002.

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##### Table of Contents



PACIFICARE HEALTH SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)

7.  Income Taxes

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

|                                                |                                                     |                        |          |          |   |   |          |          |  
|----------------------------------------------- | --------------------------------------------------- | ---------------------- | -------- | -------- | - | - | -------- | -------- | -
|                                                |                                                     | 2001                   |          | 2000    
|                                                |                                                     |                        |          |         
|                                                |                                                     |                       
|                                                |                                                     | (Amounts in thousands)
|Current deferred tax assets (liabilities):      |                                                     |                        |          |          |   |   |          |         
|                                                | Accrued expenses                                    |                        | $        | 65,329   |   |   | $        | 82,844   |  
|                                                | Medical claims and benefits payable                 |                        |          | 29,919   |   |   |          | 45,612   |  
|                                                | Restructuring                                       |                        |          | 15,420   |   |   |          |         |  
|                                                | Accrued compensation                                |                        |          | 15,190   |   |   |          | 20,168   |  
|                                                | Provider receivables                                |                        |          | 6,681    |   |   |          | (8,264   | )
|                                                | Prepaid expenses                                    |                        |          | (6,309   | ) |   |          | (6,171   | )
|                                                | State franchise taxes                               |                        |          | 2,818    |   |   |          | 4,497    |  
|                                                | Unrealized (gains) losses on marketable
	securities |                        |          | (1,085   | ) |   |          | 1,927    |  
|                                                | Pharmacy rebates                                    |                        |          |         |   |   |          | (2,257   | )
|                                                | Other                                               |                        |          | 4,196    |   |   |          | 1,356    |  
|                                                |                                                     |                        |          |          |   |   |          |         
|                                                |                                                     | $                      | 132,159  |          |   | $ | 139,712  |         
|                                                |                                                     |                        |          |          |   |   |          |         
|Non-current deferred tax
	(liabilities) assets: |                                                     |                        |          |          |   |   |          |         
|                                                | Identifiable intangibles                            |                        | $        | (100,538 | ) |   | $        | (106,905 | )
|                                                | Goodwill amortization                               |                        |          | (24,131  | ) |   |          | (15,281  | )
|                                                | Depreciation and software amortization              |                        |          | (12,458  | ) |   |          | (26,908  | )
|                                                | Other                                               |                        |          |         |   |   |          | 3,461    |  
|                                                |                                                     |                        |          |          |   |   |          |         
|                                                |                                                     | $                      | (137,127 | )        |   | $ | (145,633 | )       
|                                                |                                                     |                        |          |          |   |   |          |         

The provision for income taxes consisted of the
following:

|          |                            |                        |   |        |        |      |   |         |         |  |   |         |         | 
|--------- | -------------------------- | ---------------------- | - | ------ | ------ | ---- | - | ------- | ------- |  | - | ------- | ------- | 
|          |                            | 2001                   |   | 2000   |        | 1999
|          |                            |                        |   |        |        |     
|          |                            |                       
|          |                            | (Amounts in thousands)
|Current:  |                            |                        |   |        |        |      |   |         |         |  |   |        
|          | Federal                    |                        | $ | 34,286 |        |      | $ | 106,529 |         |  | $ | 156,958 |        
|          | State                      |                        |   | 8,051  |        |      |   | 14,410  |         |  |   | 19,739  |        
|          |                            |                        |   |        |        |      |   |         |         |  |   |        
|          |                            | Total current          |   |        | 42,337 |      |   |         | 120,939 |  |   |         | 176,697 | 
|          |                            |                        |   |        |        |      |   |         |         |  |   |        
|Deferred: |                            |                        |   |        |        |      |   |         |         |  |   |        
|          | Federal                    |                        |   | 959    |        |      |   | 6,507   |         |  |   | 19,973  |        
|          | State                      |                        |   | (4,925 | )      |      |   | (400    | )       |  |   | 6,695   |        
|          |                            |                        |   |        |        |      |   |         |         |  |   |        
|          |                            | Total deferred         |   |        | (3,966 | )    |   |         | 6,107   |  |   |         | 26,668  | 
|          |                            |                        |   |        |        |      |   |         |         |  |   |        
|          | Provision for income taxes |                        | $ | 38,371 |        |      | $ | 127,046 |         |  | $ | 203,365 |        
|          |                            |                        |   |        |        |      |   |         |         |  |   |        

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##### Table of Contents



PACIFICARE HEALTH SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)

Reconciliations of the U.S. statutory income
tax rate to our effective tax rate were as follows:

|                                      |  |      |      |      |  |      |      |   |  |  |      |  
|------------------------------------- |  | ---- | ---- | ---- |  | ---- | ---- | - |  |  | ---- | -
|                                      |  | 2001 |      | 2000 |  | 1999
|                                      |  |      |      |      |  |     
|Computed expected provision           |  |      | 35.0 | %    |  |      | 35.0 | % |  |  | 35.0 | %
|Amortization of intangibles           |  |      | 32.3 |      |  |      | 6.4  |   |  |  | 3.8  |  
|Tax-exempt interest                   |  |      | (8.6 | )    |  |      | (2.1 | ) |  |  | (1.3 | )
|State taxes, net of federal benefit   |  |      | 3.6  |      |  |      | 3.2  |   |  |  | 3.6  |  
|Nondeductible expenses                |  |      | 3.2  |      |  |      | 0.2  |   |  |  |     |  
|Impairment of non-deductible goodwill |  |      |     |      |  |      |     |   |  |  | 0.8  |  
|Other, net                            |  |      | 2.4  |      |  |      | 1.4  |   |  |  | 0.3  |  
|                                      |  |      |      |      |  |      |      |   |  |  |      |  
|Provision for income taxes            |  |      | 67.9 | %    |  |      | 44.1 | % |  |  | 42.2 | %
|                                      |  |      |      |      |  |      |      |   |  |  |      |  

8.     Employee
Benefit Plans

Savings and profit-sharing plans.Most of our employees may participate
in our savings and profit-sharing plan. Features of the plan in
2001 were as follows:



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

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 2001 or 2000, but did in 1999. Charges
to income for the plan were $19 million in 2001,
$19 million in 2000 and $28 million in 1999.

Employee Stock Purchase Plan.In September 2001, our board of
directors adopted a non-compensatory employee stock purchase
plan, or ESPP. Subject to stockholder approval in June 2002, the
ESPP provides that up to 1,100,000 shares of our common stock
can be sold to our employees. Employees who elect to participate
in the ESPP may have from 1% to 15% of their after-tax earnings
withheld and applied to the purchase of these shares. The
purchase price under the ESPP is 85% of the lower of the market
price of our common stock on the offering date (generally the
first day of each offering period, except for the first offering
period where the offering date will occur upon stockholder
approval), or on the purchase date. Each offering period is two
years, and there are four purchase dates within each offering
period. Purchase dates are the last day of each six-month
purchase period within the offering period. Our first offering
period commenced February 1, 2002 and will end on
January 31, 2004. Approximately 1,000 employees elected to
participate in the first offering period.

Stock Incentive Plans.

Employee Plans.As
of December 31, 2001, under the 2000 and 1996 Employee
Plans, we could grant officers and employees the following stock
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 vested or unvested common stock; and                                                                            
| 
| | Stock appreciation rights.                                                                                                

F-17



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##### Table of Contents



PACIFICARE HEALTH SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)

Stock options typically vest over four years in
equal increments, and expire 10 years after the grant date.
In late 2001, we granted approximately two million options that
vest over two years. Awards under the Employee Plans are
generally subject to continuous employment. As of
December 31, 2001, approximately 2.6 million shares
were available for awards under the Employee Plans.

Premium Plan.In
1997 and 1998, we granted certain executives options to purchase
2.6 million shares of our common stock under the Premium
Plan. One-half of these options vested in 1999 when the closing
market price of our common stock reached $92.50. As of
December 31, 2001, 0.8 million of the vested premium
options were outstanding and will expire in 2007. The balance of
the premium options, totaling 0.3 million outstanding as of
December 31, 2001, vest if the closing market price of our
common stock reaches $114.00 prior to October 6, 2002. If
these options vest, they will expire in 2007. If they do not
vest, they will expire on October 6, 2002. There are no
shares available for future awards under the Premium Plan. We
recorded compensation expense totaling $1 million when the
options vested in 1999, according to variable-plan accounting.

Director Plans.As
of December 31, 2001 under the 2000 and 1996 Director
Plans, we could grant non-employee directors the following stock
incentives:



|  |                                                                                                                                                                                     
|- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Options to purchase 5,000 shares of common
	stock annually to members 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 10,000 shares of common stock
	annually to 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 25,000 shares of common stock
	awarded when new members are elected or appointed to the board
	of directors;                                                    
| 
| | Options to purchase shares of common stock on a
	discretionary basis;                                                                                                               
| 
| | Options to purchase shares of common stock in
	lieu of cash payment of 50% of directors annual retainer;
	and                                                                      
| 
| | Stock units issued as a deferral of 50% of
	directors annual retainer.                                                                                                             

Stock options granted under the Director Plans
vest immediately on the grant date, but once the options are
exercised, the associated common stock may not be sold within
six months after the grant date. As of December 31, 2001,
approximately 0.2 million shares were available for awards
under the Director Plans.

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

F-18



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##### Table of Contents



PACIFICARE HEALTH SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)

Nonqualified stock option activity for all plans
was as follows:

|                                  |  |         |            |                  |  |             |       |                  |  |  |           |  |  |   |       | 
|--------------------------------- |  | ------- | ---------- | ---------------- |  | ----------- | ----- | ---------------- |  |  | --------- |  |  | - | ----- | 
|                                  |  |         |            | Weighted Average |  | Options     |       | Weighted Average
|                                  |  | Options |            | Exercise Price   |  | Exercisable |       | Exercise Price  
|                                  |  |         |            |                  |  |             |       |                 
|Outstanding at December 31,
	1998 |  |         | 6,316,858  |                  |  | $           | 80.38 |                  |  |  | 1,532,079 |  |  | $ | 55.61 | 
|Granted at market price           |  |         | 2,422,098  |                  |  | $           | 58.96 |                  |  |  |          |  |  | $ |      | 
|Exercised                         |  |         | (395,031   | )                |  | $           | 54.88 |                  |  |  |          |  |  | $ |      | 
|Canceled                          |  |         | (602,285   | )                |  | $           | 87.76 |                  |  |  |          |  |  | $ |      | 
|                                  |  |         |            |                  |  |             |       |                  |  |  |           |  |  |   |       | 
|Outstanding at December 31,
	1999 |  |         | 7,741,640  |                  |  | $           | 74.41 |                  |  |  | 2,981,611 |  |  | $ | 72.89 | 
|Granted at market price           |  |         | 3,026,498  |                  |  | $           | 46.72 |                  |  |  |          |  |  | $ |      | 
|Exercised                         |  |         | (143,913   | )                |  | $           | 14.89 |                  |  |  |          |  |  | $ |      | 
|Canceled                          |  |         | (1,709,637 | )                |  | $           | 74.86 |                  |  |  |          |  |  | $ |      | 
|                                  |  |         |            |                  |  |             |       |                  |  |  |           |  |  |   |       | 
|Outstanding at December 31,
	2000 |  |         | 8,914,588  |                  |  | $           | 65.88 |                  |  |  | 3,807,478 |  |  | $ | 72.55 | 
|Granted at market price           |  |         | 2,762,162  |                  |  | $           | 17.77 |                  |  |  |          |  |  | $ |      | 
|Exercised                         |  |         | (4,800     | )                |  | $           | 17.25 |                  |  |  |          |  |  | $ |      | 
|Canceled                          |  |         | (3,679,599 | )                |  | $           | 72.16 |                  |  |  |          |  |  | $ |      | 
|                                  |  |         |            |                  |  |             |       |                  |  |  |           |  |  |   |       | 
|Outstanding at December 31,
	2001 |  |         | 7,992,351  |                  |  | $           | 46.40 |                  |  |  | 3,597,517 |  |  | $ | 63.82 | 
|                                  |  |         |            |                  |  |             |       |                  |  |  |           |  |  |   |       | 

The following is a summary of information about
options outstanding and options exercisable at December 31,
2001:

|                         |  |                     |           |                     |  |                |    |             |  |                |       |  |  |  |           |  |  |   |       | 
|------------------------ |  | ------------------- | --------- | ------------------- |  | -------------- | -- | ----------- |  | -------------- | ----- |  |  |  | --------- |  |  | - | ----- | 
|                         |  |                     |           |                    
|                         |  | Options Outstanding |           | Options Exercisable
|                         |  |                     |           |                    
|                         |  |                     |           | Weighted            |  | Weighted       |    |             |  | Weighted      
|                         |  | Number              |           | Average             |  | Average        |    | Number      |  | Average       
|Range of Exercise Prices |  | Outstanding         |           | Life(1)             |  | Exercise Price |    | Exercisable |  | Exercise Price
|                         |  |                     |           |                     |  |                |    |             |  |               
|$10.06 - $ 15.40         |  |                     | 1,182,560 |                     |  |                | 9  |             |  | $              | 12.92 |  |  |  | 202,865   |  |  | $ | 12.29 | 
|$16.02 - $ 25.56         |  |                     | 2,145,852 |                     |  |                | 10 |             |  | $              | 17.92 |  |  |  | 148,252   |  |  | $ | 21.11 | 
|$30.91 - $ 46.03         |  |                     | 936,931   |                     |  |                | 7  |             |  | $              | 43.42 |  |  |  | 645,672   |  |  | $ | 43.07 | 
|$50.25 - $ 75.38         |  |                     | 2,387,551 |                     |  |                | 7  |             |  | $              | 62.69 |  |  |  | 1,542,849 |  |  | $ | 65.52 | 
|$79.50 - $114.00         |  |                     | 1,339,457 |                     |  |                | 6  |             |  | $              | 94.58 |  |  |  | 1,057,879 |  |  | $ | 89.89 | 
|                         |  |                     |           |                     |  |                |    |             |  |                |       |  |  |  |           |  |  |   |       | 
|                         |  |                     | 7,992,351 |                     |  |                |    |             |  |                |       |  |  |  | 3,597,517 |  |  |   |       | 
|                         |  |                     |           |                     |  |                |    |             |  |                |       |  |  |  |           |  |  |   |       | 



---



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

Pro Forma Stock Option Disclosure.We used the Black-Scholes option
pricing model to calculate the fair value of grants in the years
presented below. We applied the following assumptions to
determine pro forma compensation expense:

|                                                       |                          |      |     |       |  |      |    |       |  |  |    |       | 
|------------------------------------------------------ | ------------------------ | ---- | --- | ----- |  | ---- | -- | ----- |  |  | -- | ----- | 
|                                                       |                          | 2001 |     | 2000  |  | 1999
|                                                       |                          |      |     |       |  |     
|Expected dividend yield                                |                          |      | 0   | %     |  |      | 0  | %     |  |  | 0  | %    
|Risk-free interest rate                                |                          |      | 3   | %     |  |      | 6  | %     |  |  | 5  | %    
|Expected stock price volatility                        |                          |      | 110 | %     |  |      | 64 | %     |  |  | 52 | %    
|Expected term until exercise (years)                   |                          |      | 2   |       |  |      | 2  |       |  |  | 2  |      
|Weighted average fair value of options on grant
	date: |                          |      |     |       |  |      |    |       |  |  |    |      
|                                                       | Granted at market prices |      | $   | 12.59 |  |      | $  | 27.86 |  |  | $  | 27.15 | 

F-19



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##### Table of Contents



PACIFICARE HEALTH SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)

We generally do not record compensation expense
for stock option grants to employees since we use APB
No. 25. The following table summarizes results as if we had
recorded compensation expense using a Black-Scholes model for
2001, 2000 and 1999:

|                            |             |      |   |        |  |      |   |         |  |  |   |         | 
|--------------------------- | ----------- | ---- | - | ------ |  | ---- | - | ------- |  |  | - | ------- | 
|                            |             | 2001 |   | 2000   |  | 1999
|                            |             |      |   |        |  |     
|Net income:                 |             |      |   |        |  |      |   |         |  |  |   |        
|                            | As reported |      | $ | 19,006 |  |      | $ | 161,040 |  |  | $ | 278,544 | 
|                            | Pro forma   |      | $ | 12,579 |  |      | $ | 135,098 |  |  | $ | 246,113 | 
|Basic earnings per share:   |             |      |   |        |  |      |   |         |  |  |   |        
|                            | As reported |      | $ | 0.56   |  |      | $ | 4.59    |  |  | $ | 6.26    | 
|                            | Pro forma   |      | $ | 0.37   |  |      | $ | 3.85    |  |  | $ | 5.53    | 
|Diluted earnings per share: |             |      |   |        |  |      |   |         |  |  |   |        
|                            | As reported |      | $ | 0.55   |  |      | $ | 4.58    |  |  | $ | 6.23    | 
|                            | Pro forma   |      | $ | 0.37   |  |      | $ | 3.84    |  |  | $ | 5.50    | 

These figures reflect only the impact of grants
since October 1, 1995, and reflect only part of the
possible compensation expense that we amortize over the vesting
period of the grants (generally up to four years). Therefore,
the effect on net income and earnings per share may differ in
future years from the amounts shown above.



|   |                                                                                                    
|-- | ---------------------------------------------------------------------------------------------------
|9. | Impairment, Disposition, Restructuring, Office
	of Personnel Management and Other Charges (Credits)

We recognized net pretax charges
(credits) in 2001, 2000 and 1999 as follows:

|                                         |                                                                 |                                                                               |        |              |  |            |      |              |      |   |      |      |      |   |       |       |      | 
|---------------------------------------- | --------------------------------------------------------------- | ----------------------------------------------------------------------------- | ------ | ------------ |  | ---------- | ---- | ------------ | ---- | - | ---- | ---- | ---- | - | ----- | ----- | ---- | 
|                                         |                                                                 |                                                                               |        | Pretax       |  |            |      | Diluted Loss
|                                         |                                                                 | Quarter                                                                       |        | Charges      |  | Net-of-Tax |      | (Earnings)  
|                                         |                                                                 | Recognized                                                                    |        | (Credits)    |  | Amount     |      | per Share   
|                                         |                                                                 |                                                                               |        |              |  |            |      |             
|                                         |                                                                 |                                                                              
|                                         |                                                                 | (Amounts in millions, except per share data)                                 
|2001                                     |                                                                 |                                                                               |        |              |  |            |      |              |      |   |      |      |      |   |       |      
|Gain from contract termination agreement |                                                                 |                                                                               | First  |              |  | $          | (1.2 | )            |      | $ | (0.6 | )    |      | $ | (0.02 | )    
|Restructuring change in estimate         |                                                                 |                                                                               | First  |              |  |            | 0.3  |              |      |   | 0.1  |      |      |   |      |      
|                                         |                                                                 |                                                                               |        |              |  |            |      |              |      |   |      |      |      |   |       |      
|                                         | Total impairment, disposition, restructuring and
	other charges |                                                                               |        | Total First  |  |            |      | (0.9         | )    |   |      | (0.5 | )    |   |       | (0.02 | )   
|                                         |                                                                 |                                                                               |        |              |  |            |      |              |      |   |      |      |      |   |       |      
|Restructuring change in estimate         |                                                                 |                                                                               | Second |              |  |            | (0.3 | )            |      |   | (0.1 | )    |      |   |      |      
|                                         |                                                                 |                                                                               |        |              |  |            |      |              |      |   |      |      |      |   |       |      
|                                         | Total impairment, disposition, restructuring and
	other charges |                                                                               |        | Total Second |  |            |      | (0.3         | )    |   |      | (0.1 | )    |   |       |      |     
|                                         |                                                                 |                                                                               |        |              |  |            |      |              |      |   |      |      |      |   |       |      
|Debt offering costs                      |                                                                 |                                                                               | Third  |              |  |            | 3.1  |              |      |   | 1.5  |      |      |   | 0.04  |      
|Restructuring change in estimate         |                                                                 |                                                                               | Third  |              |  |            | (0.2 | )            |      |   | (0.1 | )    |      |   |      |      
|                                         |                                                                 |                                                                               |        |              |  |            |      |              |      |   |      |      |      |   |       |      
|                                         | Total impairment, disposition, restructuring and
	other charges |                                                                               |        | Total Third  |  |            |      | 2.9          |      |   |      | 1.4  |      |   |       | 0.04  |     
|                                         |                                                                 |                                                                               |        |              |  |            |      |              |      |   |      |      |      |   |       |      
|Restructuring charge                     |                                                                 |                                                                               | Fourth |              |  |            | 59.9 |              |      |   | 38.5 |      |      |   | 1.12  |      
|Restructuring change in estimate         |                                                                 |                                                                               | Fourth |              |  |            | (0.5 | )            |      |   | (0.2 | )    |      |   | (0.01 | )    
|                                         |                                                                 |                                                                               |        |              |  |            |      |              |      |   |      |      |      |   |       |      
|                                         | Total impairment, disposition, restructuring and
	other charges |                                                                               |        | Total Fourth |  |            |      | 59.4         |      |   |      | 38.3 |      |   |       | 1.11  |     
|                                         |                                                                 |                                                                               |        |              |  |            |      |              |      |   |      |      |      |   |       |      
|                                         |                                                                 | Total net 2001 impairment, disposition,
	restructuring, OPM and other charges |        |              |  |            |      | $            | 61.1 |   |      | $    | 39.1 |   |       | $     | 1.13 | 
|                                         |                                                                 |                                                                               |        |              |  |            |      |              |      |   |      |      |      |   |       |      

F-20



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##### Table of Contents



PACIFICARE HEALTH SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)

|                                          |                                                                      |                                                                                    |        |              |  |            |       |              |      |   |      |      |     |   |       |       |      | 
|----------------------------------------- | -------------------------------------------------------------------- | ---------------------------------------------------------------------------------- | ------ | ------------ |  | ---------- | ----- | ------------ | ---- | - | ---- | ---- | --- | - | ----- | ----- | ---- | 
|                                          |                                                                      |                                                                                    |        | Pretax       |  |            |       | Diluted Loss
|                                          |                                                                      | Quarter                                                                            |        | Charges      |  | Net-of-Tax |       | (Earnings)  
|                                          |                                                                      | Recognized                                                                         |        | (Credits)    |  | Amount     |       | per Share   
|                                          |                                                                      |                                                                                    |        |              |  |            |       |             
|                                          |                                                                      |                                                                                   
|                                          |                                                                      | (Amounts in millions, except per share data)                                      
|2000                                      |                                                                      |                                                                                    |        |              |  |            |       |              |      |   |      |      |     |   |       |      
|Restructuring charge                      |                                                                      |                                                                                    | First  |              |  | $          | 9.0   |              |      | $ | 5.2  |      |     | $ | 0.14  |      
|Other changes in estimates                |                                                                      |                                                                                    | First  |              |  |            | (3.4  | )            |      |   | (2.0 | )    |     |   | (0.05 | )    
|OPM credits                               |                                                                      |                                                                                    | First  |              |  |            | (3.0  | )            |      |   | (1.7 | )    |     |   | (0.05 | )    
|                                          |                                                                      |                                                                                    |        |              |  |            |       |              |      |   |      |      |     |   |       |      
|                                          | Total impairment, disposition, restructuring, OPM
	and other charges |                                                                                    |        | Total First  |  |            |       | 2.6          |      |   |      | 1.5  |     |   |       | 0.04  |     
|                                          |                                                                      |                                                                                    |        |              |  |            |       |              |      |   |      |      |     |   |       |      
|Loss on disposition of Ohio HMO           |                                                                      |                                                                                    | Second |              |  |            | 3.8   |              |      |   | 2.2  |      |     |   | 0.06  |      
|Restructuring change in estimate          |                                                                      |                                                                                    | Second |              |  |            | (1.0  | )            |      |   | (0.6 | )    |     |   | (0.01 | )    
|                                          |                                                                      |                                                                                    |        |              |  |            |       |              |      |   |      |      |     |   |       |      
|                                          | Total impairment, disposition, restructuring and
	other charges      |                                                                                    |        | Total Second |  |            |       | 2.8          |      |   |      | 1.6  |     |   |       | 0.05  |     
|                                          |                                                                      |                                                                                    |        |              |  |            |       |              |      |   |      |      |     |   |       |      
|Gain from license termination agreement   |                                                                      |                                                                                    | Third  |              |  |            | (6.9  | )            |      |   | (3.8 | )    |     |   | (0.11 | )    
|Loss on disposition of Ohio HMO           |                                                                      |                                                                                    | Third  |              |  |            | 0.5   |              |      |   | 0.2  |      |     |   | 0.01  |      
|Restructuring change in estimate          |                                                                      |                                                                                    | Third  |              |  |            | (0.4  | )            |      |   | (0.2 | )    |     |   | (0.01 | )    
|                                          |                                                                      |                                                                                    |        |              |  |            |       |              |      |   |      |      |     |   |       |      
|                                          | Total impairment, disposition, restructuring and
	other credits      |                                                                                    |        | Total Third  |  |            |       | (6.8         | )    |   |      | (3.8 | )   |   |       | (0.11 | )   
|                                          |                                                                      |                                                                                    |        |              |  |            |       |              |      |   |      |      |     |   |       |      
|Restructuring charge                      |                                                                      |                                                                                    | Fourth |              |  |            | 15.2  |              |      |   | 8.5  |      |     |   | 0.25  |      
|Gain from contract termination agreement  |                                                                      |                                                                                    | Fourth |              |  |            | (4.4  | )            |      |   | (2.5 | )    |     |   | (0.07 | )    
|Restructuring change in estimate          |                                                                      |                                                                                    | Fourth |              |  |            | (0.6  | )            |      |   | (0.3 | )    |     |   | (0.01 | )    
|                                          |                                                                      |                                                                                    |        |              |  |            |       |              |      |   |      |      |     |   |       |      
|                                          | Total impairment, disposition, restructuring and
	other charges      |                                                                                    |        | Total Fourth |  |            |       | 10.2         |      |   |      | 5.7  |     |   |       | 0.17  |     
|                                          |                                                                      |                                                                                    |        |              |  |            |       |              |      |   |      |      |     |   |       |      
|                                          |                                                                      | Total net 2000 impairment, disposition,
	restructuring, OPM and other charges      |        |              |  |            |       | $            | 8.8  |   |      | $    | 5.0 |   |       | $     | 0.15 | 
|                                          |                                                                      |                                                                                    |        |              |  |            |       |              |      |   |      |      |     |   |       |      
|1999                                      |                                                                      |                                                                                    |        |              |  |            |       |              |      |   |      |      |     |   |       |      
|Ohio HMO goodwill impairment              |                                                                      |                                                                                    | Third  |              |  | $          | 14.1  |              |      | $ | 11.3 |      |     | $ | 0.25  |      
|Utah HMO disposition changes in estimates |                                                                      |                                                                                    | Third  |              |  |            | (10.7 | )            |      |   | (6.3 | )    |     |   | (0.14 | )    
|Other disposition changes in estimates    |                                                                      |                                                                                    | Third  |              |  |            | (5.6  | )            |      |   | (3.3 | )    |     |   | (0.07 | )    
|                                          |                                                                      |                                                                                    |        |              |  |            |       |              |      |   |      |      |     |   |       |      
|                                          |                                                                      | Total net 1999 impairment, disposition,
	restructuring and other charges (credits) |        |              |  |            |       | $            | (2.2 | ) |      | $    | 1.7 |   |       | $     | 0.04 | 
|                                          |                                                                      |                                                                                    |        |              |  |            |       |              |      |   |      |      |     |   |       |      

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



|  |                                                                                                                                                                                                                                                                                                                                                                                                               
|- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Gain from Contract Termination Agreement.During the first quarter of 2001, we
	recognized credits of $1 million for a gain from a contract
	termination agreement.                                                                                                                                                                                                                                            
| 
| | Debt Offering Costs.During the third quarter of 2001, we
	recognized charges of $3 million for expenses related to
	our efforts to obtain senior note financing, which we abandoned
	during the third quarter of 2001.                                                                                                                                                                                        
| 
| | Restructuring
	Charges.In December 2001, we
	announced a reorganization to enhance our focus on commercial
	business growth and to improve our operational efficiency. In
	connection with this reorganization, we recognized a
	restructuring charge of $60 million in the fourth quarter
	of 2001. Of the $60 million charge, approximately
	$34 million represents a liability for cash payments, of
	which

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)



| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | $0.6 million was paid during the fourth
	quarter and the remainder will be paid during 2002.
	Approximately $20 million of this restructuring charge was
	for severance and related employee benefits for employees whose
	positions will be eliminated by December 2002. More than half of
	the reductions were related to consolidation and standardization
	of company operations. We terminated approximately
	1,340 employees, of which 190 have left the company as
	of December 31, 2001. During the quarter ended
	December 31, 2001, we paid approximately $0.6 million
	to terminated employees.

The restructuring charge also included
approximately $27 million related to our outsourcing of IT
production. The charge primarily included abandoned software
development projects and lease terminations. The remaining
restructuring charge, or $13 million, related to lease
terminations for excess office space related to the
consolidation of our operations.

During 2002, we expect net annual selling,
general and administrative salary savings from our December 2001
restructuring of approximately $66 million
(unaudited) as a result of our consolidation and
standardization of operations. These savings will be reinvested
in planned selling, general and administrative expenses,
including an advertising campaign, new technology initiatives,
increased expense to market Prescription Solutions, our pharmacy
benefit management, or PBM, company to unaffiliated members and
plan sponsors and expense to expand our electronic prescription
capabilities.

2000.We recognized
net pretax charges of $9 million as described below.



|  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Gain from contract termination agreement.In the fourth quarter, we recognized
	other credits of $4 million for a gain from a contract
	termination agreement.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
| 
| | Gain from license termination agreement.In the third quarter, we recognized
	other credits of $7 million for a gain from a license
	termination agreement relating to our subsidiary, Secure
	Horizons USA, Inc. This gain was a result of an early
	termination of the license agreement between Presbyterian
	Healthcare Services, Inc. and Secure Horizons USA, Inc.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
| 
| | Loss on Disposition of Ohio HMO.In the second quarter, we recognized
	disposition charges of $4 million to exit our Ohio HMO
	operations. The charge included severance and legal costs. In
	the third quarter, we recognized additional disposition charges
	of $0.5 million as a result of changes in estimated legal
	costs. See Note 4, Acquisitions and
	Dispositions.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
| 
| | Other Changes in Estimates.In the first quarter, we recognized
	credits for changes in estimates of $3 million. We
	successfully settled certain contingencies related to
	acquisitions and dispositions in 1997 and 1998 including pending
	and threatened litigation, as well as indemnifications made to
	the buyers of sold subsidiaries.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
| 
| | OPM Credits.In the
	first quarter, we recognized OPM credits of $3 million as a
	result of Oklahoma HMO premiums received from rate
	reconciliations re-filed for years 1996 and 1997.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
| 
| | Restructuring Charge and Restructuring Changes
	in Estimates.In January 2000, we
	announced a plan to strengthen our operations and improve our
	competitive advantage and growth opportunities. In connection
	with this plan, we recognized restructuring charges of
	$9 million in the first quarter of 2000. This restructuring
	charge included severance and related employee benefits for
	employees whose positions were eliminated by December 31,
	2000. The majority of the terminations were in the sales and
	marketing and human resources departments where the corporate
	and regional functions were centralized and consolidated. The
	total number of employees terminated was approximately 270. Of
	the 270 employees terminated, 210 have left and
	60 employees, whose positions were eliminated, have
	accepted other positions within the company.

No increases to the January 2000 restructuring
charge have been made. A total of $2 million of the
restructuring charge was not required due to changes in
estimates related to severance and related

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)

employee benefits and was released during 2000.
During 2001, we recognized additional credits for changes in
estimates and released $0.2 million. We made severance
payments totaling approximately $0.2 million to terminated
employees during the quarter ended December 31, 2001. The
remaining accrual will be relieved early 2002, as severance
payments are completed. During 2000, we realized net annualized
selling, general and administrative salary savings from the
January 2000 restructuring of approximately $11 million as
a result of centralization and consolidation of corporate and
regional functions. We reinvested these savings in medical
management and other infrastructure to help us operate in an
increasingly risk-based environment.

In December 2000, we announced plans to further
streamline our operations to enhance cost efficiency. In
connection with this plan, we recognized restructuring charges
of $15 million in the fourth quarter of 2000. Approximately
$11 million of this restructuring charge was for severance
and related employee benefits for employees whose positions were
eliminated by August 2001. More than half of the reductions were
related to sales and marketing positions, primarily for the
Medicare+Choice program, resulting from our decision to limit
new enrollment for 2001 in approximately 40% of our Medicare
markets due to rising health care costs and insufficient federal
funding. The remaining reductions affected many areas throughout
the regions and our corporate headquarters. The $4 million
balance of the December 2000 restructuring charge related to
lease terminations for excess office space.

Of the 500 employees terminated,
approximately 436 employees have left and approximately
64 employees, whose positions were eliminated, have
accepted other positions within the company. The elimination of
positions began January 2, 2001. During 2001, we recognized
changes in the restructuring estimate relating to severance and
related employee benefits and released $0.5 million. During
the quarter ended December 31, 2001, we paid approximately
$1 million to terminated employees. We expect that the
remaining accrual will be paid by the end of 2002. Cash flows
from operations are expected to fund the restructuring charge.
During 2001, we realized net annual selling, general and
administrative salary savings from our December 2000
restructuring of approximately $21 million as a result of
streamlining our operations. We have, and expect to continue to
reinvest these savings in medical management and other
infrastructure that will help us operate in an increasingly
risk-based environment.

The following tables present the 2001 and 2000
restructuring activity:

|                             |                                     |                       |   |          |  |            |   |              |  |  |   |   |  |  |   |      | 
|---------------------------- | ----------------------------------- | --------------------- | - | -------- |  | ---------- | - | ------------ |  |  | - | - |  |  | - | ---- | 
|                             |                                     |                       |   |          |  |            |   | Balance at  
|                             |                                     | Pretax                |   |          |  | Changes in |   | December 31,
|                             |                                     | Charges               |   | Payments |  | Estimate   |   | 2001        
|                             |                                     |                       |   |          |  |            |   |             
|                             |                                     |                      
|                             |                                     | (Amounts in millions)
|2001 Restructuring           |                                     |                       |   |          |  |            |   |              |  |  |   |   |  |  |   |     
|December 2001 restructuring: |                                     |                       |   |          |  |            |   |              |  |  |   |   |  |  |   |     
|                             | Lease cancellations and commitments |                       | $ | 39.7     |  |            | $ |             |  |  | $ |  |  |  | $ | 39.7 | 
|                             | Severance and separation benefits   |                       |   | 20.2     |  |            |   | 0.6          |  |  |   |  |  |  |   | 19.6 | 
|                             |                                     |                       |   |          |  |            |   |              |  |  |   |   |  |  |   |     
|                             | Total December 2001 restructuring   |                       | $ | 59.9     |  |            | $ | 0.6          |  |  | $ |  |  |  | $ | 59.3 | 
|                             |                                     |                       |   |          |  |            |   |              |  |  |   |   |  |  |   |     

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)

|                             |                                     |                          |   |          |      |                   |   |          |      |            |   |                   |      |  |   |       |       |   |   |      |      |   |   |     |     | 
|---------------------------- | ----------------------------------- | ------------------------ | - | -------- | ---- | ----------------- | - | -------- | ---- | ---------- | - | ----------------- | ---- |  | - | ----- | ----- | - | - | ---- | ---- | - | - | --- | --- | 
|                             |                                     | Pretax                   |   | 2000     |      | Balance at        |   |          |      | Changes in |   | Balance at       
|                             |                                     | Charges                  |   | Activity |      | December 31, 2000 |   | Payments |      | Estimate   |   | December 31, 2001
|                             |                                     |                          |   |          |      |                   |   |          |      |            |   |                  
|                             |                                     |                         
|                             |                                     | (Amounts in millions)   
|2000 Restructurings          |                                     |                          |   |          |      |                   |   |          |      |            |   |                   |      |  |   |       |       |   |   |      |      |   |   |    
|January 2000 restructuring:  |                                     |                          |   |          |      |                   |   |          |      |            |   |                   |      |  |   |       |       |   |   |      |      |   |   |    
|                             | Severance and separation benefits   |                          | $ | 9.0      |      |                   | $ | (6.7     | )    |            | $ | 2.3               |      |  | $ | (1.4  | )     |   | $ | (0.2 | )    |   | $ | 0.7 |    
|                             |                                     |                          |   |          |      |                   |   |          |      |            |   |                   |      |  |   |       |       |   |   |      |      |   |   |    
|December 2000 restructuring: |                                     |                          |   |          |      |                   |   |          |      |            |   |                   |      |  |   |       |       |   |   |      |      |   |   |    
|                             | Severance and separation benefits   |                          |   | 11.0     |      |                   |   |         |      |            |   | 11.0              |      |  |   | (9.2  | )     |   |   | (0.5 | )    |   |   | 1.3 |    
|                             | Lease cancellations and commitments |                          |   | 4.2      |      |                   |   |         |      |            |   | 4.2               |      |  |   | (1.6  | )     |   |   |     |      |   |   | 2.6 |    
|                             |                                     |                          |   |          |      |                   |   |          |      |            |   |                   |      |  |   |       |       |   |   |      |      |   |   |    
|                             | Total December 2000 restructuring   |                          |   | 15.2     |      |                   |   |         |      |            |   | 15.2              |      |  |   | (10.8 | )     |   |   | (0.5 | )    |   |   | 3.9 |    
|                             |                                     |                          |   |          |      |                   |   |          |      |            |   |                   |      |  |   |       |       |   |   |      |      |   |   |    
|                             |                                     | Total 2000 restructuring |   | $        | 24.2 |                   |   | $        | (6.7 | )          |   | $                 | 17.5 |  |   | $     | (12.2 | ) |   | $    | (0.7 | ) |   | $   | 4.6 | 
|                             |                                     |                          |   |          |      |                   |   |          |      |            |   |                   |      |  |   |       |       |   |   |      |      |   |   |    

1999.We recognized
net pretax credits of $2 million as described below.



|  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Ohio HMO Goodwill Impairment.We recognized $14 million of Ohio
	HMO goodwill impairment charges. Third quarter operating losses,
	provider contract terminations and a lower membership base did
	not support the recoverability of goodwill. The majority of the
	impairment was not deductible for income tax purposes.                                                                                                                                                                                                                                          
| 
| | Utah HMO Disposition Changes in Estimates.We recognized $11 million of
	disposition credits. When we sold our Utah HMO, we retained
	responsibility for all medical claims and benefits payable for
	services rendered through September 30, 1998. Payments made
	through September 30, 1999, plus our current estimate of
	claims incurred but not reported, were $7 million less than
	original reserves existing at disposition. In addition,
	$4 million of severance, legal, and receivable reserves
	were settled for amounts less than originally estimated.
| 
| | Other Disposition Changes in Estimates.We recognized $6 million of other
	disposition credits for changes in estimates. We have or expect
	to successfully settle certain contingencies related to other
	dispositions from 1996 to 1998. Contingencies include pending
	and threatened litigation as well as indemnifications made to
	the buyers of sold subsidiaries.                                                                                                                                                                                           

10.     Contingencies



| |                                     
| | ------------------------------------
| | Provider Instability and Insolvency.

General.Our
insolvency reserves include write-offs of certain uncollectable
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. These 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. We continue to
monitor the financial condition of our providers and will adjust
our insolvency reserves as necessary. The balance of our
insolvency reserves included in medical claims and benefit
payable increased to $41 million at December 31, 2001
from $34 million at December 31, 2000. For further
discussion of increases to our insolvency reserves, see
Texas Physician Groups below.

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

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)

of letters of credit or segregated funds that are
held in the providers name in a third party financial
institution. The reserves are used to pay claims in the event a
provider fails to timely pay such claims.

Texas Physician Groups.In the third quarter of 2001, we
received and reviewed detailed claims information for two Texas
physician groups, covering about 100,000 members that declared
bankruptcy in July. Based on this specific data, we revised our
estimates of liability and concluded that our total exposure
exceeded the security reserves we previously established for
these providers, and recorded $58 million in additional
insolvency reserve expenses during the year ended
December 31, 2001 primarily as a result of physician group
bankruptcies and other potentially insolvent providers in Texas.
In addition to our insolvency exposure, our providers have
deposited security reserves in third party institutions. Because
our access to provider security reserves has, and may continue
to be subject to challenge by the provider group or other third
parties at interest, we could incur additional charges for
unpaid health care costs if we are ultimately denied access to
these funds. A potential change in the contract status of these
groups or new arrangements with other physicians to maintain
care for our members may result in an increase in health care
costs. Under Texas law, we believe we are not liable for paying
individual provider claims that are the financial responsibility
of the capitated physician group to whom we have already paid
capitation. See State of Texas Litigation below. We
cannot be certain that we will avoid all liability for claims
not paid by the capitated groups.

Based on information currently available, we
believe that any liability in excess of amounts accrued as
insolvency reserves or amounts held as security reserves would
not materially affect our consolidated financial position.
However, our evaluation of the likely impact of claims asserted
against us could change in the future and an unfavorable
outcome, depending on the amount and timing, could have a
material effect on our results of operations or cash flows for a
future period.

KPC Medical Management.In the second quarter of 2000, we,
along with other HMOs loaned approximately $12 million to
KPC Medical Management, Inc. or KPC, a purchaser of some of the
former MedPartners Network practices, and Chaudhuri Medical
Corporation, an affiliate of KPC. Our portion of the loan, which
matures in April 2002, was approximately $3 million. The
principal and interest of the loan are guaranteed by Caremark
Rx, Inc., formerly MedPartners, Inc. In November 2000, KPC and
its medical affiliates filed for reorganization under
Chapter 11 of the bankruptcy code. The KPC bankruptcy has
been converted to a Chapter 7 and KPC and its medical
affiliates continue to liquidate their assets through the
bankruptcy process.

In the third quarter of 2000, we, along with six
other HMOs loaned approximately $30 million to real estate
entities affiliated with KPC. This loan was secured by certain
real property owned by the KPC real estate entities. Our portion
of this loan was approximately $10 million. A portion of
each plans loan was used to pay outstanding physician and
hospital claims for its members and operating expenses of
certain KPC medical entities. Throughout 2001, parcels of the
real property used to secure this loan were sold. We have
received approximately $3 million from the proceeds of
these sales. Both loans were fully reserved in the quarter each
loan was made because of the uncertain financial condition of
KPC and its affiliates.

OPM and Related Litigation.

General.We have
commercial contracts with OPM to provide managed health care
services to federal employees, annuitants and their dependents
under FEHBP. Rather than negotiating rates with us, OPM requires
us to provide the FEHBP with rates comparable to the rates
charged to the two employer groups with enrollment closest in
size to the FEHBP in the applicable community after making
required adjustments. OPM further requires us to certify each
year that its rates meet these requirements. Periodically,
OPMs Office of Inspector General, or OIG, audits us to
verify that the premiums charged are calculated and charged in
compliance with these regulations and guidelines. OPM has the
right to

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PACIFICARE HEALTH SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)

audit the premiums charged during any period for
up to six years following that period. The final resolution and
settlement of audits have historically taken more than three
years and as many as seven years.

During the audit process, OPM may refer its
findings to the United States Department of Justice, or DOJ, if
it believes that we knowingly overcharged the government or
otherwise submitted false documentation or certifications in
violation of the False Claims Act. Under the False Claims Act,
an action can be considered knowingly committed if the
government contractor acted with actual knowledge, or with
reckless disregard or deliberate ignorance of the
governments rules and regulations. If the government were
to win a False Claims Act lawsuit against us, the government
could obtain the amounts overcharged and a trebling of these
damages, plus interest and substantial civil penalties. The
government could also permanently disqualify us from
participating in all federal government programs. We have a
number of pending audits that we are seeking to resolve with the
DOJ. These audits claim that substantial amounts were
overcharged. In addition, the DOJ has indicated an intention to
seek additional recoveries under the False Claims Act in
relation to some of these audits, which could include up to a
trebling of any amounts that are found to have been overcharged.

In late 1997, we established 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. Based on the results of 15 audited
contract years that have been conducted since the compliance
program was implemented, we believe that this program has been
effective.

OPM Litigation.We
have contracts that were audited by the OIG that we acquired
through our merger with FHP in 1997. The OIG and others allege
that the former FHP Arizona, California, Colorado, Guam and Ohio
HMO subsidiaries, as well as former FHP Illinois, New Mexico and
Utah HMO subsidiaries that we sold in 1997 and 1998,
substantially overcharged the government from 1990 through 1997.
Several of these contract years have already been audited, but
are yet to be settled. We responded to the audit reports,
challenging many of the auditors assertions. The
allegations were referred to the DOJ for review of potential
claims under the False Claims Act.

The OIG conducted an audit of our Oregon HMO
subsidiary. The OIG issued a draft audit report in July 1997,
alleging that we substantially overcharged the government for
contract years 1991 through 1996. We responded to this draft
audit report in April 1998, strongly disagreeing with OIGs
claims. In March 2000, we were notified that the auditors had
referred the above-mentioned audit report to the DOJ for review
of potential claims under the False Claims Act. We entered into
a tolling agreement with the U.S. Attorney extending the time in
which the U.S. Attorney has to file a civil complaint until
July 3, 2002.

The OIG conducted an audit of our California HMO
subsidiary. The OIG issued a draft audit report in January 1998,
alleging that we substantially overcharged the government for
contract years 1993 through 1996. We responded to this draft
audit report in May 1998, strongly disagreeing with OIGs
claims. In January 2001, we were notified that the auditors had
referred the above-mentioned audit report to the DOJ for review
of potential claims under the False Claims Act. We entered into
a tolling agreement with the U.S. Attorney extending the time in
which the U.S. Attorney has to file a civil complaint until
May 31, 2002.

As indicated above, OPM has referred and may
continue to refer its findings to the DOJ if OPM believes that
we may have knowingly overcharged the government or otherwise
submitted false documentation or certifications in violation of
the False Claims Act. Under the False Claims Act, an action can
be considered knowingly committed if the government contractor
acted with actual knowledge, or with reckless disregard or
deliberate ignorance of the governments rules and
regulations. If the government

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PACIFICARE HEALTH SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)

were to win a False Claims Act lawsuit against us
with regard to any of the above matters, the government could
obtain amounts overcharged and a trebling of these damages, plus
interest and substantial civil penalties. The DOJ has indicated
an intention to seek additional recoveries under the False
Claims Act in relation to the above matters. The government
could also permanently disqualify us from participating in all
federal government programs.

We intend to continue to negotiate with OPM and
the DOJ on any existing or future unresolved matters to attain a
mutually satisfactory result. We cannot be certain that any
ongoing future negotiations will be concluded satisfactorily,
that additional audits will not be referred to the DOJ or that
additional, possibly material, liabilities will not be incurred.
Based on information currently available, we believe that any
liability in excess of amounts accrued would not materially
affect our consolidated financial position. However, such
liability could have a material effect on our results of
operations or cash flows of a future period if resolved
unfavorably.

Class Action Legal Proceedings.On November 21, 2000, Michael
Russ filed a purported class action complaint against us and
several of our present and former directors and executive
officers in the Central District of California. This complaint
was consolidated with other subsequent complaints into a single
proceeding. The complaints relate to the period between
October 27, 1999 and October 10, 2000 and primarily
allege that we made false projections about our financial
performance in 2000. The complaints seek an unspecified amount
of damages plus attorneys fees. A consolidated class
action complaint was filed on April 23, 2001, and on
June 22, 2001 we filed a motion to dismiss the consolidated
complaint. On October 19, 2001, the Court granted our
motion and dismissed the complaint, but gave the plaintiffs
permission to file an amended complaint. A second consolidated
amended class action complaint was filed on December 3,
2001, and on January 17, 2002 we filed a motion to dismiss
the second consolidated complaint. We deny all material
allegations and intend to defend the actions vigorously.

On November 2, 1999, Jose Cruz filed a
purported class action complaint against us, our California
subsidiary, and FHP in the San Francisco Superior Court. On
November 9, 1999, Cruz filed a first amended purported
class action complaint that omitted FHP as a defendant. The
amended complaint relates to the period from November 2,
1995 to the present and purports to be filed on behalf of all
enrollees in our health care plans operating in California other
than Medicare and Medicaid enrollees. The amended complaint
alleges that we have engaged in unfair business acts in
violation of California law, engaged in false, deceptive and
misleading advertising in violation of California law and
violated the California Consumer Legal Remedies Act. It also
alleges that we have received unjust payments as a result of our
conduct. The amended complaint seeks injunctive and declaratory
relief, an order requiring the defendants to inform and warn all
California consumers regarding our financial compensation
programs, unspecified monetary damages for restitution of
premiums and disgorgement of improper profits, attorneys
fees and interest. We moved to compel arbitration and the
Superior Court denied our motion. We filed an appeal from this
denial, and the Court of Appeal affirmed the Superior
Courts decision. Thereafter, we filed a petition asking
the California Supreme Court to review the Court of
Appeals decision, and the California Supreme Court granted
the petition. No date for oral argument before the California
Supreme Court has been set. We deny all material allegations in
the amended complaint and intend to defend the action vigorously.

On November 22, 1999, Debbie Hitsman filed a
purported class action complaint against us in the United States
District Court for the Southern District of Mississippi,
Hattiesburg Division. The complaint relates to the period from
November 22, 1995 to the present and purports to be on
behalf of all enrollees in our health care plans other than
Medicare and Medicaid enrollees. The complaint alleges causes of
action for violations of the Racketeer Influenced and Corrupt
Organizations Act, or RICO, and the Employee Retirement Income
Security Act of 1974, or ERISA. The complaint seeks an
unspecified amount of compensatory and treble damages,
injunctive and restitutionary relief, attorneys fees, the
imposition of a

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)

constructive trust and interest. On June 23,
2000, Hitsman filed and served an additional complaint as a
purported part of a multi-district litigation proceeding known
as In re Managed Care Litigation coordinated for pretrial
proceedings in the United States District Court for the Southern
District of Miami. In December 2000, the District Court granted
our motion to compel arbitration of all of the Hitsman claims
against us. On July 24, 2001, the District Court entered an
order dismissing the Hitsman case against us with prejudice.

Subsequently, Dr. Dennis Breen,
Dr. Leonard Klay, Dr. Jeffrey Book and a number of
other health care providers, along with several medical
associations, including the California Medical Association,
joined the In re Managed Care proceeding. These health care
providers sued a number of managed care companies, including us,
alleging that the companies claims processing systems
automatically and impermissibly alter codes included on
providers reimbursement/ claims forms to reduce the amount
of reimbursement, and that the companies impose unfair
contracting terms on providers, impermissibly delay making
capitated payments under their capitated contracts, and
negotiate capitation payments that are inadequate to cover the
costs of health care services provided.

The District Court also granted our motion to
compel arbitration of all of Dr. Breens claims
against us, except for his claims for violations of the RICO
Act, and for his conspiracy and aiding and abetting claims that
stem from contractual relationships with other managed care
companies. We filed an appeal from the District Courts
partial denial of our Breen motion to compel arbitration. In
April 2001, the District Court granted our motion to compel
arbitration of all of Dr. Books claims except for his
RICO claims and his conspiracy and aiding and abetting claims,
but it denied our motion to compel arbitration by several other
doctors because the District Court concluded that they were only
pursuing conspiracy and aiding and abetting claims against us.
We filed an appeal from the District Courts partial denial
of these motions to compel arbitration. The Court of Appeals
consolidated our appeals and heard oral argument on those
appeals in January 2002.

In March 2001, the District Court granted our
motion to dismiss the Breen lawsuit, but gave the plaintiff
permission to file an amended complaint. Such a complaint was
filed at the end of March 2001, and we have filed a motion to
dismiss this new complaint. A few months after our motion to
dismiss was filed, the Court of Appeals stayed the Breen lawsuit
pending its resolution of our consolidated appeals. We deny all
material allegations and intend to defend the actions vigorously.

In December 1997, William Madruga and others
filed a purported class action suit against us and several of
our directors and officers in the United States District Court
for the Central District of California. The complaint alleges
claims on behalf of purchasers of our common stock from
February 14, 1997 through our November 24, 1997
announcement that earnings for the fourth quarter of 1997 would
be lower than expected. The complaint primarily alleged that we
previously omitted and/or misrepresented material facts with
respect to our acquisition of FHP and our financial position. On
October 9, 2001, the trial court dismissed the Madruga case
with prejudice and without leave to amend. Thereafter, the
plaintiffs filed a notice of appeal with the Ninth Circuit Court
of Appeals. The plaintiffs subsequently requested dismissal of
this case which the Ninth Circuit Court of Appeals entered on
March 12, 2002, thereby terminating this case.

State of Texas Litigation.On February 11, 2002, the
Attorney General of Texas, on behalf of the State of Texas,
filed a civil complaint against our Texas subsidiary in the
Texas District Court of Travis County. The complaint alleges
violations of the Texas Health Maintenance Organization Act,
Texas Insurance Code and regulations under the Code and the
Texas Deceptive Trade Practices Consumer Protection Act. The
complaint relates to the financial insolvency of three physician
groups under capitation contracts with PacifiCare of Texas.
Under these contracts, 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 each of these physician groups failed to pay all of
the health care providers who provided

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##### Table of Contents



PACIFICARE HEALTH SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)

health care services covered by the capitation
payments. The complaint primarily alleges that despite its
capitation payments to the physician groups, PacifiCare of Texas
is still financially responsible for the failure of the
delegated providers to pay health care providers. The Attorney
General is seeking an injunction requiring us to comply with
state laws plus unspecified damages, civil penalties and
restitution. We do not believe that our Texas plan is liable
under Texas law to pay unpaid health claims that were the
responsibility of the capitated provider and for which we have
already paid capitation. We deny all material allegations in the
complaint and we intend to defend this action vigorously.

Other Litigation.We
are involved in legal actions in the normal course of business,
including claims from our members arising out of decisions to
deny or restrict reimbursement for services and claims that seek
monetary damages, including claims for punitive damages which
are not covered by insurance. As we increase our medical
management capabilities and take a more active oversight role in
the treatment process, more claims relating to the denial or
restriction of services may arise. In addition, we may be
subject to more claims of this nature from our Medicare+Choice
members that will be litigated in state court, rather than under
the Medicare Acts administrative review process, based on
a recent California Supreme Court decision that the United
States Supreme Court declined to review. Based on current
information and review, including consultation with our lawyers,
we believe any ultimate liability that may arise from these
actions, including all OPM litigation, class action legal
proceedings and industry 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.

Employment Agreements.We have employment agreements with our
chief executive officer and certain other executives. The
agreements entitle these executives to receive severance
benefits, payable if employment is terminated for various
reasons, including termination following a change of control of
PacifiCare. The maximum severance amount we would owe these
executives according to their employment agreements (excluding
amounts that may be payable under incentive plans and the value
of certain other benefits including stock options) was
approximately $46 million at December 31, 2001.

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##### Table of Contents



PACIFICARE HEALTH SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)

11.     Comprehensive
Income

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

|                                                                         |  |                        |         |           |  |            |         |   |  |   |         |  
|------------------------------------------------------------------------ |  | ---------------------- | ------- | --------- |  | ---------- | ------- | - |  | - | ------- | -
|                                                                         |  |                        |         | Income    |  |           
|                                                                         |  |                        |         | Tax       |  |           
|                                                                         |  | Pretax                 |         | Benefit   |  | Net-of-Tax
|                                                                         |  | Amount                 |         | (Expense) |  | Amount    
|                                                                         |  |                        |         |           |  |           
|                                                                         |  |                       
|                                                                         |  | (Amounts in thousands)
|2001:                                                                    |  |                        |         |           |  |            |         |   |  |   |         |  
|Unrealized holding gains arising during the period                       |  | $                      | 21,589  |           |  | $          | (8,200  | ) |  | $ | 13,389  |  
|Less: reclassification adjustment for net gains
	realized in net income  |  |                        | (13,650 | )         |  |            | 5,187   |   |  |   | (8,463  | )
|                                                                         |  |                        |         |           |  |            |         |   |  |   |         |  
|Other comprehensive income                                               |  | $                      | 7,939   |           |  | $          | (3,013  | ) |  | $ | 4,926   |  
|                                                                         |  |                        |         |           |  |            |         |   |  |   |         |  
|2000:                                                                    |  |                        |         |           |  |            |         |   |  |   |         |  
|Unrealized holding gains arising during the period                       |  | $                      | 34,700  |           |  | $          | (13,423 | ) |  | $ | 21,277  |  
|Less: reclassification adjustment for net losses
	realized in net income |  |                        | 235     |           |  |            | (91     | ) |  |   | 144     |  
|                                                                         |  |                        |         |           |  |            |         |   |  |   |         |  
|Other comprehensive income                                               |  | $                      | 34,935  |           |  | $          | (13,514 | ) |  | $ | 21,421  |  
|                                                                         |  |                        |         |           |  |            |         |   |  |   |         |  
|1999:                                                                    |  |                        |         |           |  |            |         |   |  |   |         |  
|Unrealized holding losses arising during the
	period                     |  | $                      | (50,739 | )         |  | $          | 19,591  |   |  | $ | (31,148 | )
|Less: reclassification adjustment for net gains
	realized in net income  |  |                        | (988    | )         |  |            | 381     |   |  |   | (607    | )
|                                                                         |  |                        |         |           |  |            |         |   |  |   |         |  
|Other comprehensive loss                                                 |  | $                      | (51,727 | )         |  | $          | 19,972  |   |  | $ | (31,755 | )
|                                                                         |  |                        |         |           |  |            |         |   |  |   |         |  

F-30



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##### Table of Contents



REPORT OF ERNST & YOUNG LLP, INDEPENDENT
AUDITORS

The Board of Directors and Stockholders

PacifiCare Health Systems, Inc.


We have audited the accompanying consolidated
balance sheets of PacifiCare Health Systems, Inc. (the Company)
as of December 31, 2001, and 2000 and the related
consolidated statements of operations, stockholders equity
and cash flows for each of the three years in the period ended
December 31, 2001. Our audits also included the financial
statement schedule listed in the Index at Item 14(a)(2).
These consolidated financial statements and schedule are the
responsibility of the Companys management. Our
responsibility is to express an opinion on these consolidated
financial statements and schedule based on our audits.

We conducted our audits in accordance with
auditing standards generally accepted in the United States.
Those standards require that we plan and perform the audit to
obtain reasonable assurance about whether the consolidated
financial statements are free of material misstatement. An audit
includes examining, on a test basis, evidence supporting the
amounts and disclosures in the consolidated financial
statements. An audit also includes assessing the accounting
principles used and significant estimates made by management, as
well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our
opinion.

In our opinion, the consolidated financial
statements referred to above present fairly, in all material
respects, the consolidated financial position of PacifiCare
Health Systems, Inc. at December 31, 2001 and 2000, and the
consolidated results of its operations and its cash flows for
each of the three years in the period ended December 31,
2001 in conformity with accounting principles generally accepted
in the United States. Also in our opinion, the related financial
statement schedule, when considered in relation to the basic
consolidated financial statements taken as a whole, presents
fairly in all material respects the information set forth
therein.



| |                  
| | -----------------
| | ERNST & YOUNG LLP

Irvine, California

January 31, 2002




| |                                            
| | -------------------------------------------
| | Except for Note 10, as to which the date is
| | March 12, 2002                             

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##### Table of Contents



PACIFICARE HEALTH SYSTEMS, INC.

QUARTERLY INFORMATION FOR 2001 AND 2000
(Unaudited)

|                                               |                                   |                                               |           |         |  |              |           |             |  |   |           |      |  |   |           |       |  
|---------------------------------------------- | --------------------------------- | --------------------------------------------- | --------- | ------- |  | ------------ | --------- | ----------- |  | - | --------- | ---- |  | - | --------- | ----- | -
|                                               |                                   |                                              
|                                               |                                   | Quarters Ended                               
|                                               |                                   |                                              
|                                               |                                   | March 31                                      |           | June 30 |  | September 30 |           | December 31
|                                               |                                   |                                               |           |         |  |              |           |            
|                                               |                                   |                                              
|                                               |                                   | (Amounts in thousands, except per share data)
|2001(1)                                        |                                   |                                               |           |         |  |              |           |             |  |   |           |      |  |   |           |      
|Operating revenue                              |                                   | $                                             | 3,030,699 |         |  | $            | 2,973,726 |             |  | $ | 2,964,464 |      |  | $ | 2,875,083 |      
|Operating expenses                             |                                   |                                               | 2,985,521 |         |  |              | 2,922,464 |             |  |   | 2,914,437 |      |  |   | 2,894,766 |      
|Interest expense                               |                                   |                                               | (20,135   | )       |  |              | (17,834   | )           |  |   | (16,833   | )    |  |   | (15,480   | )    
|                                               |                                   |                                               |           |         |  |              |           |             |  |   |           |      |  |   |           |      
|Income before income taxes                     |                                   |                                               | 25,043    |         |  |              | 33,428    |             |  |   | 33,194    |      |  |   | (35,163   | )    
|Provision for income taxes                     |                                   |                                               | 11,895    |         |  |              | 18,159    |             |  |   | 17,062    |      |  |   | (8,745    | )    
|                                               |                                   |                                               |           |         |  |              |           |             |  |   |           |      |  |   |           |      
|Income (loss) before extraordinary gain        |                                   |                                               | 13,148    |         |  |              | 15,269    |             |  |   | 16,132    |      |  |   | (26,418   | )    
|Extraordinary gain on early retirement of debt |                                   |                                               |          |         |  |              |          |             |  |   | 875       |      |  |   |          |      
|                                               |                                   |                                               |           |         |  |              |           |             |  |   |           |      |  |   |           |      
|Net income (loss)                              |                                   | $                                             | 13,148    |         |  | $            | 15,269    |             |  | $ | 17,007    |      |  | $ | (26,418   | )    
|                                               |                                   |                                               |           |         |  |              |           |             |  |   |           |      |  |   |           |      
|Basic earnings (loss) per share:               |                                   |                                               |           |         |  |              |           |             |  |   |           |      |  |   |           |      
|                                               | Income before extraordinary gain  |                                               | $         | 0.39    |  |              | $         | 0.46        |  |   | $         | 0.48 |  |   | $         | (0.77 | )
|                                               | Extraordinary gain, net           |                                               |           |        |  |              |           |            |  |   |           | 0.02 |  |   |           |      |  
|                                               |                                   |                                               |           |         |  |              |           |             |  |   |           |      |  |   |           |      
|                                               | Basic earnings (loss) per share   |                                               | $         | 0.39    |  |              | $         | 0.46        |  |   | $         | 0.50 |  |   | $         | (0.77 | )
|                                               |                                   |                                               |           |         |  |              |           |             |  |   |           |      |  |   |           |      
|Diluted earnings (loss) per share:             |                                   |                                               |           |         |  |              |           |             |  |   |           |      |  |   |           |      
|                                               | Income before extraordinary gain  |                                               | $         | 0.39    |  |              | $         | 0.45        |  |   | $         | 0.48 |  |   | $         | (0.77 | )
|                                               | Extraordinary gain, net           |                                               |           |        |  |              |           |            |  |   |           | 0.02 |  |   |           |      |  
|                                               |                                   |                                               |           |         |  |              |           |             |  |   |           |      |  |   |           |      
|                                               | Diluted earnings (loss) per share |                                               | $         | 0.39    |  |              | $         | 0.45        |  |   | $         | 0.50 |  |   | $         | (0.77 | )
|                                               |                                   |                                               |           |         |  |              |           |             |  |   |           |      |  |   |           |      
|HMO Membership(3)                              |                                   |                                               | 3,726     |         |  |              | 3,600     |             |  |   | 3,522     |      |  |   | 3,388     |      
|                                               |                                   |                                               |           |         |  |              |           |             |  |   |           |      |  |   |           |      
|2000(2)                                        |                                   |                                               |           |         |  |              |           |             |  |   |           |      |  |   |           |      
|Operating revenue                              |                                   | $                                             | 2,827,771 |         |  | $            | 2,878,587 |             |  | $ | 2,896,364 |      |  | $ | 2,973,576 |      
|Operating expenses                             |                                   |                                               | 2,679,350 |         |  |              | 2,739,582 |             |  |   | 2,857,859 |      |  |   | 2,932,422 |      
|Interest expense                               |                                   |                                               | (20,182   | )       |  |              | (20,250   | )           |  |   | (19,252   | )    |  |   | (19,952   | )    
|Minority interest in consolidated subsidiary   |                                   |                                               |          |         |  |              | 131       |             |  |   | 252       |      |  |   | 254       |      
|                                               |                                   |                                               |           |         |  |              |           |             |  |   |           |      |  |   |           |      
|Income before income taxes                     |                                   |                                               | 128,239   |         |  |              | 118,886   |             |  |   | 19,505    |      |  |   | 21,456    |      
|Provision for income taxes                     |                                   |                                               | 53,604    |         |  |              | 49,694    |             |  |   | 14,286    |      |  |   | 9,462     |      
|                                               |                                   |                                               |           |         |  |              |           |             |  |   |           |      |  |   |           |      
|Net income                                     |                                   | $                                             | 74,635    |         |  | $            | 69,192    |             |  | $ | 5,219     |      |  | $ | 11,994    |      
|                                               |                                   |                                               |           |         |  |              |           |             |  |   |           |      |  |   |           |      
|Basic earnings per share                       |                                   | $                                             | 2.04      |         |  | $            | 1.97      |             |  | $ | 0.15      |      |  | $ | 0.35      |      
|                                               |                                   |                                               |           |         |  |              |           |             |  |   |           |      |  |   |           |      
|Diluted earnings per share                     |                                   | $                                             | 2.04      |         |  | $            | 1.96      |             |  | $ | 0.15      |      |  | $ | 0.35      |      
|                                               |                                   |                                               |           |         |  |              |           |             |  |   |           |      |  |   |           |      
|HMO Membership(3)                              |                                   |                                               | 4,005     |         |  |              | 3,991     |             |  |   | 4,016     |      |  |   | 4,010     |      
|                                               |                                   |                                               |           |         |  |              |           |             |  |   |           |      |  |   |           |      



---



|    |                                                                                                                                                                                                                                         
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | We recognized impairment, disposition,
	restructuring, OPM and other net pretax charges totaling
	$61 million ($39 million or $1.13 diluted loss per
	share, net of tax). See Note 9 of the Notes to Consolidated
	Financial Statements.
|   
|(2) | We recognized impairment, disposition,
	restructuring, OPM and other net pretax charges totaling
	$9 million ($5 million or $0.15 diluted loss per
	share, net of tax). See Note 9 of the Notes to Consolidated
	Financial Statements.  
|   
|(3) | HMO membership as of quarter end.                                                                                                                                                                                                       

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##### Table of Contents



PACIFICARE HEALTH SYSTEMS, INC. AND
SUBSIDIARIES

SCHEDULE II  VALUATION AND
QUALIFYING ACCOUNTS

For The Years Ended December 31, 2001,
2000 and 1999


|                                 |                          |                        |  |                   |        |                 |  |            |        |   |  |  |         |   |  |   |        | 
|-------------------------------- | ------------------------ | ---------------------- |  | ----------------- | ------ | --------------- |  | ---------- | ------ | - |  |  | ------- | - |  | - | ------ | 
|                                 |                          | Balance at             |  | Charged to        |        | Deductions      |  | Balance at
|                                 |                          | Beginning              |  | Provision for     |        | or              |  | End       
|                                 |                          | of Period              |  | Doubtful Accounts |        | Write-offs, net |  | of Period 
|                                 |                          |                        |  |                   |        |                 |  |           
|                                 |                          |                       
|                                 |                          | (Amounts in thousands)
|Allowance for doubtful accounts: |                          |                        |  |                   |        |                 |  |            |        |   |  |  |         |   |  |  
|                                 | Years ended December 31: |                        |  |                   |        |                 |  |            |        |   |  |  |         |   |  |   |       
|                                 |                          | 2001                   |  | $                 | 48,989 |                 |  |            | 22,070 |   |  |  | (34,829 | ) |  | $ | 36,230 | 
|                                 |                          | 2000(1)                |  | $                 | 39,501 |                 |  |            | 37,598 |   |  |  | (28,110 | ) |  | $ | 48,989 | 
|                                 |                          | 1999(1)                |  | $                 | 47,178 |                 |  |            | (8,687 | ) |  |  | 1,010   |   |  | $ | 39,501 | 



---



|    |                                                                                                                                                                          
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | We reclassified certain prior year amounts to
	include receivables and allowances for provider withhold pools
	and notes receivables to conform to the 2001 presentation.

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##### Table of Contents



PACIFICARE HEALTH SYSTEMS, INC.






EXHIBIT INDEX


|        |       |             |  |                                                                                                                                                                                                                                                                                    
|------- | ----- | ----------- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit |       |            
|Number  |       | Description
|        |       |            
|        | 3.01  |             |  | Amended and Restated Certificate of Incorporation
	of Registrant (including Certificate of Designation of Series A
	Junior Participating Preferred Stock) [incorporated by reference
	to Exhibit 99.1 to Registrants Registration Statement
	on Form S-3 (File No. 333-83069)].(1)
|        | 3.02  |             |  | Bylaws of Registrant [incorporated by reference
	to Exhibit 99.2 to Registrants Registration Statement
	on Form S-3 (File No. 333-83069)].                                                                                                                                        
|        | 3.03  |             |  | Amendment to Bylaws of Registrant.                                                                                                                                                                                                                                                 
|        | 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  |             |  | First Supplemental Indenture, dated as of
	February 14, 1997, by and among the Registrant, FHP
	International Corporation and The Chase Manhattan Bank, N.A.
	[incorporated by reference to Exhibit 4.01 to
	Registrants Form 10-Q for the quarter ended March 31,
	1997].        
|        | 4.03  |             |  | Registration Rights Agreement, dated as of
	May 4, 1999, between the Registrant and UniHealth
	Foundation [incorporated by reference to Exhibit 99.4 to
	Registrants Registration Statement on Form S-3 (File
	No. 333-83069)].                                                   
|        | 4.04  |             |  | Rights Agreement, dated as of November 19,
	1999, between the Registrant and ChaseMellon Shareholder
	Services, L.L.C [incorporated by reference to Exhibit 99.1
	to Registrants Form 8-K, dated November 22,
	1999].                                                             
|        | 10.01 |             |  | Senior Executive Employment Agreement, dated as
	of March 30, 2001, between the Registrant and Howard G.
	Phanstiel.(2)                                                                                                                                                            
|        | 10.02 |             |  | Senior Executive Employment Agreement, dated as
	of November 1, 2001, between the Registrant and Bary G.
	Bailey.(2)                                                                                                                                                               
|        | 10.04 |             |  | Senior Executive Employment Agreement, dated as
	of August 1, 2001, between the Registrant and Gregory W.
	Scott.(2)                                                                                                                                                               
|        | 10.05 |             |  | Senior Executive Employment Agreement, dated as
	of March 30, 2001, between the Registrant and John F.
	Fritz.(2)                                                                                                                                                                  
|        | 10.06 |             |  | First Amendment to Senior Executive Employment
	Agreement, dated as of March 30, 2001, between the
	Registrant and John F. Fritz.(2)                                                                                                                                               
|        | 10.07 |             |  | Consulting Agreement, dated as of January 1,
	2001, between the Registrant and David A. Reed.(2)                                                                                                                                                                                   
|        | 10.10 |             |  | Form of Contract With Eligible Medicare+Choice
	Organization and the Centers for Medicare and Medicaid Services
	for the period January 1, 2001 and December 3, 2001.                                                                                                              
|        | 10.11 |             |  | 1996 Stock Option Plan for Officers and Key
	Employees of the Registrant [incorporated by reference to
	Exhibit 10.05 to Registrants Form 8-B, dated
	January 23, 1997].(2)                                                                                                       
|        | 10.12 |             |  | First Amendment to 1996 Stock Option Plan for
	Officers and Key Employees of the Registrant [incorporated by
	reference to Exhibit D to Registrants Proxy
	Statement, dated May 25, 1999].(2)                                                                                     
|        | 10.13 |             |  | 2000 Employee Plan [incorporated by reference to
	Exhibit 4.1 to Registrants Registration Statement on
	Form S-8 (File No. 333-44038)].(2)                                                                                                                                        
|        | 10.14 |             |  | Amended and Restated 2000 Non-Employee Directors
	Stock Plan [incorporated by reference to Exhibit 1 to
	Registrants Proxy Statement, dated May 18, 2001].(2)                                                                                                                     
|        | 10.15 |             |  | Amended and Restated 1996 Non-Officer Directors
	Stock Option Plan of the Registrant [incorporated by reference
	to Exhibit E to Registrants Proxy Statement, dated
	May 25, 1999].(2)                                                                                            

E-1



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##### Table of Contents



|        |       |             |  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|------- | ----- | ----------- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit |       |            
|Number  |       | Description
|        |       |            
|        | 10.16 |             |  | 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)].(2)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|        | 10.17 |             |  | 1996 Management Incentive Compensation Plan of
	the Registrant [incorporated by reference to Exhibit 10.07
	to Registrants Form 8-B, dated January 23,
	1997].(2)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|        | 10.18 |             |  | 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].(2)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|        | 10.19 |             |  | 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].(2)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|        | 10.20 |             |  | PacifiCare Health Systems, Inc. Amended and
	Restated Non-Qualified Deferred Compensation Plan [incorporated
	by reference to Exhibit 10.22 to Registrants
	Form 10-K for the year ended December 31, 2000].(2)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|        | 10.21 |             |  | PacifiCare Health Systems, Inc. Statutory
	Restoration Plan [incorporated by reference to
	Exhibit 10.16 to Registrants Form 10-K for the
	year ended December 31, 1997].(2)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|        | 10.22 |             |  | First Amendment to the PacifiCare Health Systems,
	Inc. Statutory Restoration Plan, dated November 1, 2000
	[incorporated by reference to Exhibit 10.24 to
	Registrants Form 10-K for the year ended
	December 31, 2000].                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|        | 10.23 |             |  | PacifiCare Health Systems, Inc. Stock Unit
	Deferred Compensation Plan [incorporated by reference to Exhibit
	10.17 to Registrants Form 10-K for the year ended
	December 31, 1997].(2)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|        | 10.24 |             |  | Amended Services Agreement, dated as of
	June 1, 1999, between the Registrant and Joseph S.
	Konowiecki, a professional corporation [incorporated by
	reference to Exhibit 10.24 to Registrants
	Form 10-K for the year ended December 31, 1999].                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|        | 10.25 |             |  | Legal Services Agreement, dated as of
	January 1, 1999, between the Registrant and Konowiecki
	& Rank, a law partnership [incorporated by reference to
	Exhibit 10.34 to Registrants Form 10-K for the
	year ended December 31, 2000].                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|        | 10.26 |             |  | Senior Executive Employment Agreement, dated as
	of January 1, 2002, between the Registrant and
	Joseph S. Konowiecki.(2)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|        | 10.27 |             |  | Information Technology Services Agreement, dated
	as of December 31, 2001, between the Registrant and
	International Business Machines Corporation.(3)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|        | 10.28 |             |  | Information Technology Services Agreement, dated
	as of January 11, 2002, between the Registrant and Keane,
	Inc.(3)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|        | 10.29 |             |  | Amended and Restated Credit Agreement, dated as
	of August 20, 2001, among the Registrant, the Initial
	Lenders, the Initial Issuing Bank and Swing Line Banks named in
	the Credit Agreement, as Initial Lenders, Initial Issuing Bank
	and Swing Line Bank, Bank of America, N.A. in its capacity as
	Collateral Agent and Administrative Agent, Banc of America
	Securities LLC and J.P. Morgan Securities, Inc. in their
	capacity as Co-Lead Arrangers, and Banc of America Securities
	LLC, J.P. Morgan Securities Inc. and Salomon Smith Barney Inc.
	in their capacity as Joint Book-Running Managers [Incorporated
	by reference to Exhibit 99.2 to Registrants
	Form 8-K, dated August 21, 2001].

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##### Table of Contents



|        |       |             |  |                                                                                                                                                                                                                                                                                    
|------- | ----- | ----------- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit |       |            
|Number  |       | Description
|        |       |            
|        | 10.30 |             |  | Letter Amendment to Amended and Restated Credit
	Agreement, dated as of August 30, 2001, among the Registrant,
	the Lender Parties to the Amended and Restated Credit Agreement,
	dated as of August 20, 2001, and Bank of America N.A. in its
	Capacity as Administrative Agent.  
|        | 10.31 |             |  | Letter Amendment to Amended and Restated Credit
	Agreement, dated as of January 23, 2002, among the
	Registrant, the Lender Parties to the Amended and Restated
	Credit Agreement, dated as of August 20, 2001, and Bank of
	America, N.A. in its capacity as Administrative Agent.
|        | 21    |             |  | List of Subsidiaries.                                                                                                                                                                                                                                                              
|        | 23    |             |  | Consent of Ernst & Young LLP, Independent
	Auditors.                                                                                                                                                                                                                               



---



|    |                                                                                                                                                                                                              
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | Certificate of Designation of Series A
	Junior Participating Preferred Stock is incorporated by
	reference to Exhibit 4.1 to Registrants Form 8-K,
	dated November 19, 1999.                                
|   
|(2) | Management contract or compensatory plan or
	arrangement required to be filed as an exhibit to this
	Form 10-K pursuant to Item 14(c) of Form 10-K.                                                          
|   
|(3) | Certain confidential portions of this Exhibit
	have been omitted pursuant to a request for confidential
	treatment. Omitted portions have been filed separately with the
	Securities and Exchange Commission.

E-3