##### 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,
    2002                                                 
|          
|or        
|          
|o          |  | TRANSITION REPORT PURSUANT TO SECTION 13
    OR 15(d)
    OF THE SECURITIES EXCHANGE ACT OF 1934
|          
|           |  | For the transition period
    from           to           .                                     

Commission file number 000-21949



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PACIFICARE HEALTH SYSTEMS, INC.

(Exact name of registrant as specified in its
charter)


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

5995 Plaza Drive, Cypress, California
90630

(Address of principal executive offices,
including zip code)


(714) 952-1121

(Registrants telephone number, including
area code)


Securities registered pursuant to
Section 12(b) of the Act: None


Securities registered pursuant to
Section 12(g) of the Act:


Common Stock, par value $0.01




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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

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

Non-affiliates of the Registrant held
approximately $737,800,000 of the aggregate market value of
common stock on June 28, 2002.

There were approximately 36,099,000 shares of
common stock outstanding on February 28, 2003.



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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                                      
|              | ITEM 14. CONTROLS AND PROCEDURES                                                             
|              | ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K                     
|SIGNATURES   
|              |                                                                                               | CONSOLIDATED STATEMENTS OF OPERATIONS     
|              |                                                                                               | NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
|EXHIBIT INDEX
|EXHIBIT 3.04 
|EXHIBIT 10.06
|EXHIBIT 10.07
|EXHIBIT 10.08
|EXHIBIT 10.10
|EXHIBIT 10.20
|EXHIBIT 10.21
|EXHIBIT 10.22
|EXHIBIT 10.23
|EXHIBIT 21   
|EXHIBIT 23   
|EXHIBIT 99.1 
|EXHIBIT 99.2 



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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,
2002


|         |  |                                                                                                    |  |      |    | 
|-------- |  | -------------------------------------------------------------------------------------------------- |  | ---- | -- | 
|         |  |                                                                                                    |  | Page
|         |  |                                                                                                    |  |     
|PART I  
|Item 1.  |  | Business                                                                                           |  |      | 1  | 
|Item 2.  |  | Properties                                                                                         |  |      | 19 | 
|Item 3.  |  | Legal Proceedings                                                                                  |  |      | 19 | 
|Item 4.  |  | Submission of Matters to a Vote of Security
    Holders                                            |  |      | 22 | 
|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 and Related Stockholder Matters |  |      | 65 | 
|Item 13. |  | Certain Relationships and Related Transactions                                                     |  |      | 68 | 
|Item 14. |  | Controls and Procedures                                                                            |  |      | 68 | 
|Item 15. |  | Exhibits, Financial Statement Schedules and
    Reports on Form 8-K                                |  |      | 69 | 

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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 senior plans are
designed to deliver quality health care and customer service to
members cost-effectively. These programs include health
maintenance organizations, or HMOs, preferred provider
organizations, or PPOs, and Medicare Supplement products. We
also offer a variety of specialty managed care products and
services that employees can purchase as a supplement to our
basic commercial and senior medical plans or as stand-alone
products. These products include pharmacy benefit management, or
PBM, behavioral health services, group life and health insurance
and dental and vision benefit plans. As of December 31, 2002, we
had approximately 3.1 million HMO and other commercial and
senior product members and approximately 9.1 million
members in our PBM, dental and behavioral plans, including both
members covered by our commercial or senior HMOs, and members
that are unaffiliated with our HMOs.

Industry Overview

Managed Care

Managed care plans develop health care provider
networks by entering into contracts with independent hospitals,
physicians and other health care professionals to deliver health
care services to their members cost effectively. Unlike
conventional indemnity insurance, managed care plans generally
credential network providers and incorporate medical management
and other measures to control costs and encourage the delivery
of medically necessary health care services. 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 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 deductible, coinsurance or
copayment requirements than their HMO counterparts, in exchange
for increased freedom of choice.

We expect health care costs to continue to rise
for many reasons, including:



|  |                                                                                                                                    
|- | -----------------------------------------------------------------------------------------------------------------------------------
| | an aging population that has greater medical
    needs;                                                                            
| 
| | the availability of more costly diagnostic and
    therapeutic procedures;                                                         
| 
| | new laws and regulations specifying covered
    services for managed care plans;                                                   
| 
| | increased unit prices for prescription drugs and
    other medications and the introduction of new, more expensive
    medications;
| 
| | increased utilization of health care services;                                                                                     

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|  |                                                                                                                                                                                                                  
|- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | defensive medical practices due to
    physicians fear of lawsuits; and                                                                                                                                         
| 
| | significant investments by pharmaceutical
    companies in advertising campaigns for branded drugs, which may
    increase consumer demand for these drugs, including
    lifestyle-enhancing prescription drugs.

As health care costs have risen, managed care
plans have become a lower-cost option for employers and
governmental entities that provide health care coverage for
their employees and constituents. Given the number of factors
that will impact future health care costs and their
unpredictability, we expect managed care plans to continue to
remain a lower-cost option for employers and governmental
entities that desire to access quality health care services for
their employees and constituents on a cost-effective basis.

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.

Under the Medicare+Choice program, managed care
plans can contract with the Centers for Medicare and Medicaid
Services, or CMS, to provide health insurance coverage in
exchange for a fixed monthly payment per member that varies
based on the geographic areas in which the members reside. 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 the services provided by the HMO exclusively and are
required to pay a Part B premium to the Medicare program. These
individuals also may be required to pay a monthly premium to the
HMO.

Rules intended to limit the number of enrollment
changes from traditional Medicare to a Medicare+Choice Plan or
among Medicare+Choice plans by Medicare beneficiaries with
individual Medicare coverage were originally scheduled to be
effective January 1, 2002. However, legislation passed in
June 2002 delayed the implementation of these rules until 2005.

Pharmacy Benefit Management

One of the most significant components of rising
health care costs in the United States has been increased
utilization of and rising costs for prescription drugs. As part
of their overall efforts to control health care costs,
employers, insurers, governmental entities and health care
providers have sought means to ensure the efficacy of
prescription drug treatments while controlling their costs,
resulting in a demand for PBM services that can accomplish both
objectives. This demand has created a market opportunity for PBM
companies that are committed to medical management as a means to
control prescription drug costs, especially through managed care
principles such as formulary management. Formulary management
entails using lists of physician-recommended drugs in different
therapeutic classes that have been reviewed for safety,
effectiveness and value to ensure that drugs prescribed are the
lowest cost option among equally effective alternatives.

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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. Consistent with industry
practice, certain fee-based hospital contracts contain
stop-loss provisions where the level of payment
increases once a minimum amount of billed charges is exceeded.
Due to the variable nature of these payment methodologies,
contracts containing stop-loss provisions are
generally more complex to administer and to predict than
payments made under a fixed fee schedule.

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. In some
cases, providers may be capitated for certain services and paid
on a fee-for-service basis for other services. 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 more than 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, including us, 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.

Business Strategy

Our mission is to create long-term stockholder
value as a health and consumer services company committed to
making peoples lives healthier and more secure. Our
strategy to achieve this mission is to continue to strengthen
our core HMO business, become a full-service managed care
organization by expanding our health services portfolio, and
ultimately evolve into a consumer health organization that
focuses on the financial, health and wellness needs of our
members.

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Strengthen Our Core HMO
Business

The first priority of our multiple-year
turnaround plan was to strengthen our core HMO business by
improving our operational capabilities and profitability. We
intend to continue to focus on the efficiency of our operations
as we pursue a growth strategy:



|  |                                                                                                                                                                                                                                            
|- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | We have implemented initiatives to stabilize both
    our commercial and senior medical loss ratios, while addressing
    the significant increases in health care costs that we have
    experienced over the last three years, including:



|  |                                                                                                                                                                                                                                                              
|- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Increasing commercial premium rates, and
    continuing efforts to tailor pricing and benefit designs to
    increase commercial membership in our larger, more profitable
    market segments;                                                              
| 
| | Redesigning Medicare+Choice benefits, charging
    higher senior member monthly premiums, and exiting or freezing
    enrollment in underperforming Medicare+Choice markets to
    increase the profitability of our Medicare+Choice operations; and         
| 
| | Enhancing our medical management capabilities,
    and continuing to implement 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 centralized several company operations,
    including accounting, customer service, large and small group
    underwriting and advertising, to improve operational efficiency;
    and                                                                                                                   
| 
| | We have outsourced our information technology, or
    IT, infrastructure, including our voice and data networks and
    our servers and software maintenance services to move toward a
    more simplified technology platform and to focus internally on
    moving toward a state-of-the-art IT infrastructure.

Become a Full-Service Managed Care
Organization

Since 2001, we have been expanding our health
services portfolio to support our strategy of becoming a full
service managed care organization and diversifying our revenue
sources. In connection with this objective, we have taken or are
taking the following actions:



|  |                                                                                                                                                                                                                                                                                                                                                                                                                     
|- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | In January 2003, we announced an affordable and
    flexible benefits package, combining our dental PPO plans,
    dental indemnity plans and vision PPO plans with our health
    insurance plans for large employers. This integrated benefit
    solution is offered in all of the states where we currently
    offer our medical HMO;                                                                          
| 
| | In 2002, we expanded the offering of our PPO
    products to employers in all of the states where we currently
    offer our medical HMO products, and also launched a new
    Administrative Services Only, or ASO PPO product to support
    employer groups that self-fund their benefit plans;                                                                                                                  
| 
| | In 2000, we launched our group retiree Senior
    Supplement plan, which provides employers a new option for their
    Medicare-eligible retirees, and in 2002 we expanded our
    individual offerings to include Medicare Supplement plans;                                                                                                                                                                       
| 
| | In October 2002, we began offering life,
    accidental death and dismemberment and short-term and long-term
    disability products to our commercial employer groups under a
    private label arrangement with Continental Assurance Company,
    Continental Casualty Company and CNA Group Life Assurance
    Company;                                                                                         
| 
| | 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 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 and
    health improvement programs as well as employee and member
    assistance programs; and

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|  |                                                                                                                                                                    
|- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | 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.

Evolve into a Consumer Health Services
Organization

Our ultimate strategy is to evolve into a
consumer health services organization that gives our members
more responsibility for health care spending, and expands our
product offerings to focus on the financial, health and wellness
needs of our members. We plan to accomplish this strategy by
structuring employer-purchased plans to increase consumer
involvement in purchasing decisions, increasing consumer-funded
optional coverage and offering wellness and lifestyle enhancing
products and services. To build a consumer-focused organization,
quality of care and quality of service are essential. Examples
of the steps we have taken or are taking to support this
evolution are the following:



|  |                                                                                                                                                                                                                                                                                                                                                                                                                       
|- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | We are offering consumers more freedom in health
    care spending by introducing new products such as self-directed
    health plans, our new Secure Horizons Prescription Advantages
    Plan, which is an indemnity prescription drug program for
    seniors, and our health care debit cards;                                                                                                                    
| 
| | We are offering wellness-enhancing products and
    services through our Womens Health Solutions initiative.
    To date we have designed more than 30 programs related to
    womens health, including expansion of our obstetrics and
    gynecology networks and our pediatric networks, adding a 24-hour
    nurse advice line and adding educational programs targeted at
    womens health issues;           
| 
| | We have established a proprietary quality
    measurement profile, the QUALITY INDEX®, that rates our
    contracting medical groups performance, and we are
    developing a similar profile for our contracting hospitals, to
    assist consumers in making better informed health care provider
    decisions. See Health Care Quality  Physician
    and Hospital Quality Reviews for further discussion; and
| 
| | We are extending the hours of our customer
    service centers, making welcome calls to new members, and adding
    service quality incentive plans for our customer service
    representatives.                                                                                                                                                                                                                     

Products

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

Commercial Products

Our commercial products accounted for
$5 billion, or 45% of our consolidated revenue, for the
year ended December 31, 2002. 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 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, 2002, this network
included approximately 700 hospitals and
59,000 primary care and specialty physicians. As of
December 31, 2002, we had approximately 2.3 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. We
also have contracts with the United

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States Office of Personnel Management, or OPM, to
provide managed health care services to members under the
Federal Employee Health Benefit Program, or FEHBP, for federal
employees, annuitants and their dependents. As of
December 31, 2002, we provided managed health care services
to approximately 191,000 members under these contracts.


Our strategy is to grow profitable commercial HMO
membership by focusing on product innovation and quality
management. For example, effective in 2003, we launched our
Value Network Plan. This plan is our first HMO network where
participating California members may choose from a list of
medical groups, and access their affiliated or referring
hospitals, that are in our Value Network. The Value Network
comprises medical groups and their affiliated or referring
hospitals that have been selected based on their affordability
and their scores on our QUALITY INDEX® profile. The QUALITY
INDEX® profile is a proprietary report that we publish in
California, Oregon, and Washington on our contracting medical
groups performance in the areas of clinical, service and
administrative data quality. We also now publish a report for
contracted hospitals in California.

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.As customers continue to desire choice
and flexibility in health care, we believe that there is a
substantial demand for competitively priced PPO products. 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, access is
extended to health care providers located outside of a given
geographic area through out-of-network benefits that allow
choice beyond the organized PPO network in exchange for reduced
coverage or higher coinsurance or copayments.

Our PPO product provides members open access to
network providers, with no primary care physician coordinating
care and simplified medical management practices. The PPO
product is designed around an administrative platform that
streamlines the members interactions with employers and
providers.

Effective January 1, 2003, we began offering
self-directed health plans to employers with 250 or more
employees. A self-directed health plan is a high-deductible PPO
plan, combined with an employee-controlled spending account that
the employer funds. In addition to paying the premiums for the
high-deductible plan, an employer deposits a certain amount per
year into each employees spending account. The employee
can use the money to pay health care expenses incurred, and if
money is left over at the end of the year, the balance can be
rolled over to the following year. A portion of the balance can
be used for health care expenses typically covered through
insurance or eligible health-related expenses that are
traditionally excluded from insurance coverage such as
nutritional counseling or smoking-cessation programs.

On January 1, 2003, we also launched our
health care debit card and Flexible Spending Account service, or
FSA. Tailored to meet the needs of employers and health care
consumers, our new service includes a stored-value card that
charges health care services directly to an employees FSA,
much like a bank-issued debit card. The debit card works off the
Cirrus® network so that fees for eligible medical expenses
are immediately deducted from the employees account,
eliminating the necessity of filing a paper claim for later
reimbursement.

During 2002, we also introduced our new ASO PPO
product to support employer groups whom self-fund their benefit
plans.

As of December 31, 2002, we had over
73,000 enrollees in our PPO product. We are actively
marketing these products to employers in all of the states where
we currently offer our commercial HMO products.

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Specialty Products

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

Prescription
Solutions®.Founded in
1993, Prescription Solutions provided integrated PBM services to
more than 4.6 million people, including approximately
0.8 million seniors, as of December 31, 2002. For the
year ended December 31, 2002, Prescription Solutions
processed 48.1 million claims, filled 3.4 million mail
service prescriptions and accounted for $173 million of our
consolidated revenue, net of intercompany transactions.
Prescription Solutions offers a broad range of innovative
programs, products and services designed to improve, enhance and
increase clinical and financial outcomes. Prescription Solutions
employs tools such as quality initiatives, utilization
management, targeted disease intervention, programs that assess
the interaction and efficacy of drugs prescribed to an
individual member, active formulary management,
prior-authorization review, health outcomes research and
real-time audits that are designed so that its members are
receiving the most appropriate medications in a cost-effective
manner. Prescription Solutions also offers a comprehensive,
fully integrated injectable program, which targets one of the
most rapidly growing and high cost categories of pharmacy
benefits today.

We believe Prescription Solutions strength
lies in its ability to influence medical outcomes and reduce
overall health care costs by focusing on appropriate
prescription drug use. For example, through its formulary
management program, Prescription Solutions uses lists of
physician-recommended drugs in different therapeutic classes
that have been reviewed for safety, efficacy and value to ensure
that drugs prescribed are the lowest cost option among equally
effective alternatives. Medically necessary drugs not included
in the formulary can be obtained through Prescription
Solutions prior 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. As part of its pharmacy management, Prescription
Solutions funds clinical outcomes research programs aimed at
measuring the health outcomes of patients using commercially
available prescription drugs.

We believe that Prescription Solutions mail
service capabilities also differentiate it from its competitors.
Prescription Solutions operates an 84,000-square-foot, fully
automated facility in Carlsbad, California. We believe we have
the ability to increase the number of mail service prescriptions
we process, which was 3.4 million in 2002, 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.

Prescription Solutions PBM 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 to unaffiliated health plans, employer
groups, union trusts and third party administrators.

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, Oregon and Pennsylvania. Our behavioral health care
services include managed mental health, employee assistance,
care management and chemical dependency benefit programs. As of
December 31, 2002, we provided these behavioral health care
services to approximately 3.9 million members through our
provider network of approximately 14,500 providers and
approximately 760 facilities. For the year ended
December 31, 2002, our behavioral health care subsidiaries
accounted for $160 million of our consolidated revenue, of
which $52 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 to issue life and
health care insurance in 40 states, including each of the
states where our HMOs operate, the District of Columbia and
Guam. By marketing our 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. In October 2002, we began
offering life, accidental death and dismemberment and short-term
and long-term disability products to our commercial employer
groups under a private label arrangement with Continental
Assurance Company, Continental Casualty Company and CNA Group
Life Assurance Company. For the year ended December 31,
2002, our life and health insurance subsidiaries accounted for
$292 million of our consolidated revenue, substantially all
of which was generated from our health plan customers.

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. We
offer these products in all of the states where we currently
offer our commercial HMO products.

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, 2002 membership of approximately
0.7 million, our dental and vision plans accounted for
$39 million of our consolidated revenue of which
$27 million was generated from unaffiliated health plans
and employer groups.

Senior Products

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

Medicare+Choice HMO.Medicare+Choice accounted for
$5.9 billion, or 53% of our consolidated revenue for the
year ended December 31, 2002. We are one of the largest
Medicare+Choice HMOs in the United States as measured by
membership with approximately 0.8 million members as of
December 31, 2002. Since March 2001, our Medicare+Choice
membership has declined by approximately 280,000, primarily due
to voluntary disenrollment and county exits. We will continue to
reduce our participation in the Medicare+Choice program if
federal funding does not increase. See Managements
Discussion and Analysis of Financial Condition and Results of
Operations-Forward-Looking Statements. 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 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 Indemnity Products.In 2000, we introduced a new product
under the PacifiCare brand, the group retiree Senior Supplement
product. The group retiree Senior Supplement plan is offered in
13 states, and provides employers with a new option for
their Medicare-eligible retirees. We plan to continue to
increase the marketing of this group retiree product within the
mid-size, large-size and national account market segments. In
2002, we introduced an individual Medicare Supplement product
under the Secure Horizons brand. For individuals who are not
covered by benefits offered by a former employer, we offer four
standardized Medicare Supplement plans, which are A, C, F and G.
These plans are currently offered in seven states and we are
working on expanding to as many as 20 additional states by
the third

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quarter of 2003. In 2002, we also introduced our
Secure Horizons Prescription Advantages Plan, an indemnity
prescription drug program for seniors.


These products are designed to fill gaps left by
traditional Medicare coverage. For example, the Supplement
products pay for hospital deductibles, physician copayments and
coinsurance for which an individual enrolled in the traditional
Medicare program would otherwise be responsible. The Secure
Horizons Prescription Advantages Plan has no annual deductible,
no annual maximums, and provides unlimited coverage for
approximately 400 generic medications covering many chronic
conditions and ailments. This plan offers discounts on most
other drugs depending on how the drugs are purchased.

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 maintain a network of qualified physicians,
hospitals and other health care providers in each geographic
area we serve. Our contracting strategy is to base the type of
contract utilized on our assessment of the underlying structure
and strengths of the medical communities within the applicable
geographic markets. For example, in markets with large medical
groups that we believe are able to assume financial risk, we may
continue to use capitation contracts effectively. In other
markets, where there are fewer of such large medical groups, we
may instead use fee-for-service or other shared risk
arrangements. In the past few years, and going forward, we have
experienced and expect to continue to experience a trend away
from capitation contracts. 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
create greater stability of our network.

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

Underwriting

In establishing premium rates for our health care
plans, we use underwriting criteria based upon our accumulated
actuarial data, with adjustments for factors such as the
physicians and hospitals utilized, claims experience, member 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.

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Our medical management programs include:



|  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | 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, and
    our on-site or telephonic medical managers become 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
    involves confirming our certifications of services provided to
    our members when our medical management staff has not been
    concurrently involved in the hospitalization of our members.
    This process can occur when our members receive emergency care
    at an out-of-area hospital or when medical claims may be
    disputed;                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
| 
| | Case Management.Our
    case management department provides multi-disciplinary
    coordination of personalized care for patients with complex
    medical conditions, including arranging access to appropriate
    medical and social services, to improve the health status and
    manage health care costs for these patients; and                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
| 
| | 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 2001, 5% of our California Secure
    Horizons members consumed more than 73% of our California
    Medicare+Choice plans hospital expenses within the year,
    and six chronic diseases accounted for 62% of these costs. As a
    result, we have supplemented our in-house programs by
    contracting with 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. During the fourth
    quarter of 2002, we added care management services for members
    admitted to neonatal intensive care units. These voluntary
    programs assist patients with intensive care management
    services, and better coordinate 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.

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 health plan, governed by a quality improvement
committee. The medical director for each health plan chairs that
health plans committee. Each committee consists of health
plan clinical professionals that may include contracted
physicians. All network physicians are initially credentialed
and periodically re-credentialed by that health plan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

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program for our HMOs in California, Oklahoma,
Oregon, Texas and Washington is our provider profile, which is a
comprehensive, quarterly risk-adjusted report card that 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® profile is a proprietary report that we
publish in California, Oregon, and Washington on our contracting
medical groups performance in the areas of clinical,
service and administrative data quality. We also now publish a
report for contracted hospitals in California. These reports
provide 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, and
hospitals in California, so that members have credible and
relevant information by which to select physicians.


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, end stage renal disease, cancer 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;                                                                                                                                                                                        
| 
| | Decreasing inappropriate denials and improving
    the appeals process for our members;                                                                                                                                                                                                                                                                                                                            
| 
| | 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 quality measures by which to
    reward better performing provider groups;                                                                                                                                                                                                                                                         
| 
| | Developing provider contracts with tiered
    compensation in California, 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 National Committee for Quality Assurance, or
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. As of March 2003, our commercial HMOs in
Arizona, California, Colorado, Oklahoma, Oregon, Texas and
Washington have all earned excellent accreditation
status, while our plan

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in Nevada has received commendable
accreditation status. Our Medicare+Choice HMOs in California,
Colorado, Oklahoma, Oregon and Washington have also all earned
excellent accreditation status, while our plans in
Arizona, Nevada and Texas have received commendable
accreditation status. In California, we were the first statewide
health plan to have achieved 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 all measures over the past two years. Our
health plans have met or exceeded the national 90th percentile
benchmarks in 18 measures.


Marketing

We believe that we have developed strong brand
recognition with our PacifiCare and Secure Horizons members. Our
commercial products are marketed under the PacifiCare brand,
which we believe has a reputation for quality and value. Our
senior products are marketed under the Secure Horizons 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 have expanded the marketing of our PBM
services by building a dedicated sales force targeting other
health care payors and other unaffiliated channels. For example,
in September 2002, Prescription Solutions contracted with MedE
America Corporation of Ohio, a subsidiary of WebMD Corporation,
to become the preferred mail service provider to MedE
Americas clients. MedE America provides pharmacy claims
processing for its clients and services four million lives.

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 directly to
consumers as the final health care decision makers. We launched
a new brand campaign in 2002 and expect to continue this
campaign in 2003.

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.
Further, we utilize multiple distribution channels such as
general agents, a proprietary on-line price quoting service, and
insurance brokers and consultants who represent many employer
groups. These brokers and consultants work directly with
employers to recommend or design employee benefits packages. We
pay insurance brokers commissions over the life of the contract,
if designated by the employer, while employers generally pay
consultants directly. Our new commercial business is a result of
new customers, as well as greater penetration in existing
employer groups. With each open enrollment, we identify a
specific approach for each employer group with the objective of
increasing the number of members from each employer.

We believe that our understanding of the senior
population and our attention to customer service differentiates
our Secure Horizons program from competing products. We market
our Secure Horizons programs to Medicare beneficiaries and
caregivers for Medicare beneficiaries primarily through direct
mail, telemarketing, our website, television, radio and
community-based events with participating physician groups. Most
Secure Horizons members enroll directly in a plan, generally
without the involvement of insurance brokers, except when
enrolling as part of an employer group retiree offering.
However, in late 2002, we began the development of a national
broker channel for our individual Medicare Supplement and
Prescription Advantages products.

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. The product is distributed both
directly to the consumer as well as through a network of
insurance agents that began

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marketing the product in late 2002. Additionally
in 2002, we entered into a strategic marketing partnership with
Readers Digest Financial Services Inc. Under this
partnership, Readers Digest Financial Services Inc. will
exclusively endorse our Medicare Supplement plans to its
customer base.


Customer Service

We provide customer service to members and
providers contracting with our health plans. Our customer
service centers support all of our commercial and Secure
Horizons products. Each year we receive approximately
21 million calls. Customer service representatives handle
approximately 14 million calls and approximately seven
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. These customer service centers handle all HMO
health plan claims in the continental United States. Our
customer service center in Cypress, California also supports our
PPO, indemnity and Medicare Supplement products. We also have
stand-alone customer service and claims processing centers to
support our specialty products companies and our HMO operations
in Guam.

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. These
systems also support on-line customer service functions,
provider and member administration functions, and support our
tracking and extensive analyses of health care costs and outcome
data.

We established corporate goals to have our IT
systems operate under one business platform and improve
operational efficiency. Simplification and integration of the
systems servicing our business are important components of
controlling health care and administrative expenses and
improving member satisfaction. To accomplish these goals, in
late 2001 and early 2002 we established a strategic outsourcing
arrangement with two suppliers: International Business Machines
Corporation, or IBM, and Keane, Inc., or Keane. We entered into
a 10-year contract with IBM to outsource our IT infrastructure
functions, including data center operations, support services
and information distribution. We also entered into a 10-year
contract with Keane to outsource our applications maintenance
and enhancement activities. In connection with these outsourcing
arrangements we transitioned approximately 550 employee
positions to IBM and Keane in March 2002.

Our internal IT team interacts with internal
business staff to build strategy, translate business
requirements into technical solutions, develop systems
architecture that promotes consistent processes and reduces
total cost of ownership, and perform project demand management,
prioritization and oversight. The IT team manages our
outsourcing suppliers for support of operations and systems
enhancements and maintenance. Our suppliers interact directly
with internal business staff in day-to-day support and project
activities.

Our ongoing IT investments include projects to
consolidate system platforms, enhance existing application
software and implement new financial system software and new
pre-adjudication system software to create a more robust EDI
architecture. We are also making other investments to ensure
that our systems comply with the Health Insurance Portability
and Accountability Act of 1996, or HIPAA.

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

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programs. We have significantly increased the
number and percentage of claims processed electronically to
improve claims turnaround times and accuracy.


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. 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, increasing automation through
technology while continuing 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 and payment;                          
| 
| | Quality assurance and utilization review
    procedures;
| 
| | Member grievance procedures;                            
| 
| | Physician and hospital contracts; and                   
| 
| | Marketing and advertising.                              

Our HMOs and indemnity insurance subsidiaries are
also required to maintain minimum statutory capital. The cash
necessary to satisfy our corporate obligations and our
subsidiaries needs is facilitated through intercompany
dividends and advances, which are regulated by state laws.

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,
and the Public Health Security and Bioterrorism Response Act of
2002. 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. Under BIPA, Medicare+Choice receives
increased government funding over the five years beginning March
2001. The changes for 2001 - 2006 include increases to the
monthly minimum payment floors, increases in the minimum annual
payment from 2% to 3% and modifications to the risk adjuster.

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

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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 2002, none of our health plans were selected
for audit. Our adjusted community rate proposals for the
contract year 2003 have been filed and approved.

Office of Personnel
Management

We have commercial contracts with OPM to provide
managed health care services to federal employees, annuitants
and their dependents under the FEHBP. As of December 31,
2002, we provided managed health care services to approximately
191,000 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 five years following the end of that
contract year. The final resolution and settlement of audits
have historically taken more than three years and as many as
seven years. We could become subject to actions under the False
Claims Act if, as a result of the audit process, OPM believes
that we knowingly overcharged the government or otherwise
submitted false documentation or certifications.

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 the audits that
have been conducted since the compliance program was
implemented, we believe that this program has been effective.

Health Insurance Portability and
Accountability Act of 1996

As a result of the HIPAA federal standards apply
to both the group and individual health insurance markets. 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 are currently working on modifications to 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 2002 HIPAA
compliance costs were approximately $16 million as well as
$2 million in capital expenditures. We estimate that our
HIPAA compliance costs will approximate $19 million in 2003
as well as $1 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.

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Required Statutory Capital

By law, regulation and governmental policy, our
HMO, indemnity and regulated specialty product subsidiaries,
which we refer to as our regulated subsidiaries, are required to
maintain minimum levels of statutory net worth. The minimum
statutory net worth requirements differ by state and are
generally based on a percentage of annualized premium revenue, a
percentage of annualized health care costs or risk-based
capital, or RBC, requirements. The RBC requirements are based on
guidelines established by the National Association of Insurance
Commissioners, or NAIC. If adopted, the RBC requirements may be
modified as each state legislature deems appropriate for that
state. The RBC formula, based on asset risk, underwriting risk,
credit risk, business risk and other factors, generates the
authorized control level, or ACL, which represents the 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.

Pharmacy Regulations

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

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

Other specific laws or regulations that may
affect our PBM business include:



|  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Laws that constrain our ability to limit access
    to a pharmacy provider network or remove network providers, such
    as those that require us to admit any retail pharmacy willing to
    meet the plans price and other terms for network
    participation, prohibit the removal of a provider except in
    compliance with due process procedures, or that
    prohibit supply limitations or co-payment differentials between
    mail service and retail pharmacy providers;
| 
| | Plan design or benefit mandates such as those
    that prohibit or restrict therapeutic substitution, require
    coverage of all drugs approved by the Food and Drug
    Administration, or FDA, or prohibit denial of coverage for
    off-label or non-FDA approved uses;                                                                                                                                                                                                           
| 
| | Federal anti-remuneration laws and state consumer
    protection laws that could prevent us from seeking or accepting
    discounts from drug manufacturers or participating in
    product conversion programs in which benefits are
    given by drug manufacturers for changing a prescription or
    recommending or requesting such a change from one drug to
    another unless we fit within a specific exemption or safe harbor
    of those laws;                             
| 
| | Medicaid laws requiring that a pharmacy
    participating in the Medicaid program give the best price that
    the pharmacy makes available to any third party payor, even if
    the payors are in different states, which                                                                                                                                                                                                                                                              

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|  |                                                                                                                                                                                                                         
|- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|  | may limit our ability to negotiate discounts in
    the future from network pharmacies and on the reimbursement we
    receive from state Medicaid programs; and                                                        
| 
| | Specific regulations of the FDA regarding the
    conduct of clinical trials for drugs, if we participate in
    clinical trials and assume some or all of the sponsors
    obligations related to the clinical trials.

In early 2000, we received a subpoena from an
Assistant United States Attorney in Boston relating to a
pharmaceutical product. We were advised that we were not a
target of the investigation, and fully cooperated with the
Assistant US Attorney. In the second and third quarters of 2002,
the same Assistant US Attorney in Boston requested additional
documents and served additional subpoenas relating to
pharmaceutical marketing contracts. The Assistant US Attorney
has reaffirmed that we are not a target of the investigation,
and we are fully cooperating with these subpoenas.

Risk Management

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

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

We have among the highest 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.
Beginning in 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. This is in response to
the rising health care costs of treating the senior population
and the inadequate rate of increase in levels of Medicare
reimbursement from the government. These changes have caused
members to leave our plans for competing plans or traditional
Medicare coverage. Many competing health 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.

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The Medicare Supplement product market is highly
fragmented with few large competitors. Our primary competition
in this market is the Medicare Supplement product marketed by
the American Association of Retired Persons, and underwritten by
UnitedHealth Group Incorporated. We believe that our product
offerings and distribution channels differentiate our Medicare
Supplement products from competing products. For example, in
2002, we introduced Prescription Advantages, one of the
nations first stand-alone, insured pharmacy products being
marketed exclusively to individual Medicare beneficiaries.
Additionally in 2002, we entered into a strategic marketing
partnership with Readers Digest Financial Services Inc.
Under this partnership, Readers Digest Financial Services
Inc. will exclusively endorse our Medicare Supplement plans to
its customer base.

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 Medco Health, WellPoint Pharmacy
Management, MedImpact Healthcare Systems, Inc.,
Caremark Rx, Inc., Express Scripts and Advance PCS. We
believe, when aligned with a managed care organization,
Prescription Solutions differentiates itself from other pharmacy
benefit organizations by managing prescription costs and
outcomes for managed care organization members. Our mail-order
prescription drug service competes with national, regional and
local pharmacies and other mail-order prescription drug
companies. Prescription Solutions also competes with firms
offering prescription discount cards, such large drugstore
chains.

In 2001, we began offering behavioral health
services to members who are not affiliated with our commercial
health plans. The managed behavioral health care industry is
dominated by a few large companies, principally Magellan Health
Services, Inc. and ValueOptions, Inc., as well as the behavioral
health divisions of health insurers such as UnitedHealth Group
Incorporated and CIGNA Corporation. Our ability to compete is
affected by a limited national supply of providers, particularly
psychiatrists and psychiatric hospital units. Our behavioral
health subsidiary has a core competency in managing at-risk
contracts, which we believe differentiate us competitively in
states with mental health parity laws that mandate equal
coverage for mental health benefits.

We believe that to retain our health plans
competitive advantages we should continue to focus on developing
additional products and services and eliminate or limit growth
of unprofitable products. We believe that consumers want
products and services that go beyond basic necessity, extending
to areas such as lifestyle and wellness enhancing products. The
factors that we believe give us competitive advantages are:



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

Intellectual Property

We own federally registered trademarks and other
trademarks, which include PacifiCare®,
SecureHorizons®, Prescription Solutions® and QUALITY
INDEX®. There is also a patent pending for certain methods
used in creating the QUALITY INDEX®.

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Employees

At February 28, 2003, we had approximately
7,800 full and part-time employees. None of our employees is
presently covered by a collective bargaining agreement. We
consider relations with our employees to be good and have never
experienced any work stoppage.

Available Information

Our electronically-filed reports with the
Securities Exchange Commission, or SEC, such as the annual
report on Form 10-K, quarterly reports on Form 10-Q,
current reports on Form 8-K and all amendments to those
reports, are currently available free of charge to the general
public through our company website at www.pacificare.com. These
reports are accessible at a reasonably practicable time after
being filed with the SEC.




ITEM
2.     PROPERTIES

As of December 31, 2002, we leased
approximately 214,000 aggregate square feet of space for our
principal corporate headquarters and executive offices in
Cypress and Santa Ana, California. In connection with our
operations, as of December 31, 2002, we leased
approximately 1.7 million aggregate square feet for office
space, subsidiary operations, customer service centers and space
for computer facilities. Such space corresponds to areas in
which our HMOs or specialty managed care products and services
operate, or where we have satellite administrative offices. Our
leases expire at various dates from 2003 through 2012.

In California and Guam, we own 2 buildings
encompassing approximately 225,000 aggregate square feet of
space primarily used for administrative operations. All of our
facilities are in good working condition, are well maintained
and are adequate for our present and currently anticipated
needs. We believe that we can rent additional space at
competitive rates when current leases expire, or if we need
additional space.




ITEM 3.     LEGAL
PROCEEDINGS

Class Action Legal Proceedings

On November 2, 1999, Jose Cruz filed a
purported class action complaint against us, our California
subsidiary, and FHP International Corporation, or 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. Oral argument before the California Supreme Court
occurred on February 4, 2003. We expect a ruling from the
California Supreme Court in May 2003. We deny all material
allegations in the amended complaint and intend to defend the
action vigorously.

In mid-2000, various federal actions against
managed care companies, including us, were joined in a
multi-district litigation that was coordinated for pretrial
proceedings only in the United States District Court for the
Southern District of Florida. This litigation is known as
In re Managed Care Litigation. Thereafter,
Dr. Dennis Breen, Dr. Leonard Klay, Dr. Jeffrey
Book and several other health care providers, along with

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several medical associations, including the
California Medical Association, joined the In re Managed
Care proceeding. These health care providers sued many
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 and Dr. Books
claims against us, except for their claims for violations of the
Racketeer Influenced and Corrupt Organizations Act, or RICO, and
for their conspiracy and aiding and abetting claims that stem
from contractual relationships with other managed care
companies. The District Court 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 appealed from the District
Courts arbitration rulings to the extent they denied
sending claims to arbitration. The Court of Appeals affirmed the
District Courts arbitration rulings in their entirety. We
filed a petition asking the United States Supreme Court to
review the Court of Appeals decision, and on
October 15, 2002 the United States Supreme Court granted
our petition. Oral argument before the United States Supreme
Court occurred on February 24, 2003. We expect a ruling by
the United States Supreme Court in or before June 2003.

In March 2001, the plaintiffs in the Breen
lawsuit filed an amended complaint, and we filed a motion to
dismiss the amended complaint. On September 26, 2002, the
District Court granted plaintiffs motion to amend their
complaint further and denied our pending motion to dismiss as
moot. On September 26, 2002, the District Court also
certified three classes of physicians on the claims asserted
against us in the plaintiffs complaint. Of the three
classes of physicians that were certified, two were nationwide
classes and one class was limited to California physicians. On
October 18, 2002, we filed a new motion to dismiss directed
at the plaintiffs second amended complaint. That motion
remains pending. Discovery in this litigation has recently
commenced. We deny all material allegations and intend to defend
the action vigorously.

PacifiCare of Texas v. The Texas Department of
Insurance and the State of Texas.In
November 2001, our Texas subsidiary, PacifiCare of Texas, filed
a lawsuit against the Texas Department of Insurance, or TDI, and
the State of Texas challenging the TDIs interpretation and
enforcement of state statutes and regulations that would make
Texas a double-pay state. The lawsuit relates to the
financial insolvency of three physician groups that had
capitation contracts with PacifiCare of Texas. Under these
contracts, the responsibility for claims payments to health care
providers was delegated to the contracted physician groups. We
made capitation payments to each of these physician groups, but
each of these physician groups failed to pay all of the health
care providers who provided health care services covered by the
capitation payments. On February 11, 2002, subsequent to
the filing of our lawsuit, the Attorney General of Texas, or AG,
on behalf of the State of Texas and the TDI, filed a civil
complaint against PacifiCare of Texas in the District Court of
Travis County, Texas alleging violations of the Texas Health
Maintenance Organization Act, Texas Insurance Code and
regulations under the Code and the Texas Deceptive Trade
Practices Consumer Protection Act. The AGs complaint
primarily alleges that despite its capitation payments to the
physician groups, PacifiCare of Texas is still financially
responsible for the failure of the delegated providers to pay
health care providers. The AG is seeking an injunction requiring
us to comply with state laws plus unspecified damages, civil
penalties and restitution. The AG also claimed that its
subsequent lawsuit, not ours, should govern the dispute. In
March 2002, we submitted a motion to be recognized as the
plaintiff in the lawsuit rather than the AG. In June 2002, the
District Court granted this motion. On September 11, 2002,
the Texas Medical Association, various providers and the
bankruptcy trustee for an affiliate of one of the physician
groups intervened, without our opposition, in the lawsuit.

On March 21, 2003, without the admission of
any wrongdoing, our Texas subsidiary entered into a binding
memorandum of understanding, or MOU, with the Sate of Texas, the
AG and the TDI setting forth the principal terms of a settlement
of all of the pending litigation between the parties and related
civil investigations by the TDI. Under the MOU, the parties have
agreed to enter into a definitive settlement

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agreement within 30 days. The settlement
agreement will provide that all pending litigation and related
civil investigations could by stayed for up to twelve months
from the date of execution of the definitive settlement
agreement. While the proceedings are stayed, the parties will
seek to settle the provider creditor claims in the remaining
outstanding bankruptcies relating to Medical Select Management
and Heritage Southwest Medical Group in accordance with the MOU
and engage in a review of provider claims of the Heritage
Physicians Network, or HPN. We agree to use our reasonable best
efforts to reach settlements in the bankruptcies and resolve the
HPN claims by specified dates and agree to make contributions to
fund provider creditor claims in the bankruptcies subject to the
process set forth in the MOU.


As part of the settlement, we agree to make
payments totaling $4.25 million, including attorneys fees
totaling $1.25 million to the AG, and administrative
services reimbursements totaling $1.5 million and
administrative penalties totaling $1.5 million to the TDI.
Of the $4.25 million payment, $2.45 million will be
paid upon execution of the settlement, and the remaining
$1.8 million will be paid upon the satisfaction of the
conditions for the settlement. All amounts paid upon execution
of the settlement will be held in trust pending the
effectiveness of the settlement. The settlement will become
effective upon us completing our settlements in the two
bankruptcies in accordance with the MOU, timely completion of
the HPN claims process, payment of all settlement amounts to the
AG and TDI, and compliance with certain Texas prompt payment
obligations with respect to members enrolled in our commercial
HMO plans. Concurrent with the settlement becoming effective:
(i) the parties would enter into a permanent injunction
with a term of one year that will require PacifiCare of Texas to
comply with applicable provisions of the Texas prompt payment
obligations with respect to members enrolled in our commercial
HMO plans; (ii) all of the pending litigation between the
parties will be dismissed with prejudice or with specified final
judgements; and (iii) the parties will enter into mutual
releases. We cannot provide any assurances that we will be able
to meet the conditions required to cause the settlement to
become effective. If we cannot reach the settlement, then we are
prepared to resume the litigation. We believe that we have
adequate reserves for this matter, including the satisfaction of
all the terms and conditions of the settlement, or any
liabilities that may arise if we are required to resume the
litigation.

OPM and Other Litigation

OPM Litigation.On
April 12, 2002, we resolved issues raised in various audits
of our health plans by the Office of Inspector General, or OIG,
as well as the False Claims investigations of the United States
Department of Justice, or DOJ and a private lawsuit under the
False Claims Act. The settlement primarily related to contracts
we acquired through our merger with FHP in 1997. As previously
disclosed, the OIG and others alleged that the former FHP
Arizona, California, Colorado, Guam and Ohio HMO subsidiaries,
as well as the former FHP Illinois, New Mexico and Utah HMO
subsidiaries that we sold in 1997 and 1998, substantially
overcharged the government for premiums from 1990 through 1997.
The allegations were referred to the DOJ for review of potential
claims under the False Claims Act. In addition, a private
individual filed a complaint under the False Claims Act in 1998
that remained under seal until the settlement. The OIG also
conducted audits of our Oregon HMO for contract years 1991
through 1996 and our California HMO for contract years 1993
through 1996 and referred these audits to the DOJ for potential
claims under the False Claims Act. The settlement resolved
issues raised in OIGs various audits of these 10 health
plans, as well as the False Claims investigations of the DOJ and
the private lawsuit under the False Claims Act. See Note 11
of the Notes to Consolidated Financial Statements for further
discussion.

Other Litigation.We
are involved in legal actions in the normal course of business,
including claims from our members and providers arising out of
decisions to deny or restrict reimbursement for services and
claims that seek monetary damages, including claims for punitive
damages that are not covered by insurance. Our establishment of
drug formularies, support of clinical trials and PBM services
may increase our exposure to product liability claims associated
with pharmaceuticals and medical devices. Based on current
information, including consultation with our lawyers, we believe
any ultimate liability that may arise from these actions,
including all class action legal proceedings and the settlement
or resumption of the State of Texas litigation, would not
materially affect our consolidated financial position, results of

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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, 2002.




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, 2002 |  |      |       |     |  |   |       | 
|First Quarter                |  | $    | 23.35 |     |  | $ | 14.60 | 
|Second Quarter               |  | $    | 32.62 |     |  | $ | 16.96 | 
|Third Quarter                |  | $    | 26.67 |     |  | $ | 19.71 | 
|Fourth Quarter               |  | $    | 33.66 |     |  | $ | 21.30 | 
|Year ended December 31, 2001 |  |      |       |     |  |   |       | 
|First Quarter                |  | $    | 40.50 |     |  | $ | 14.31 | 
|Second Quarter               |  | $    | 38.45 |     |  | $ | 15.50 | 
|Third Quarter                |  | $    | 21.70 |     |  | $ | 10.54 | 
|Fourth Quarter               |  | $    | 23.42 |     |  | $ | 12.00 | 

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.

As of February 28, 2003 there were 313
stockholders of record of our common stock.

On November 22, 2002, we issued and sold
$125 million of 3% convertible subordinated debentures due
2032 in a private placement to two accredited investors, Morgan
Stanley & Co. Incorporated and Goldman, Sachs and Co.,
which we refer to as the initial purchasers, in reliance on
Section 4(2) of and Rule 506 under the Securities Act of
1933, as amended, or the Securities Act. On December 20,
2002, we issued an additional $10 million of the debentures
in connection with the exercise in part by the initial
purchasers of their option to purchase additional debentures.
The initial purchasers resold the debentures in offerings in
reliance on an exemption from registration under Rule 144A
of the Securities Act. The aggregate discount received by the
initial purchasers in connection with their purchase of the
debentures from us was approximately $4 million. The
debentures are convertible into our common stock under certain
conditions, including satisfaction of a market price condition
for our common stock, satisfaction of a trading price condition
relating to the debentures, upon notice of redemption, or upon
specified corporate transactions. Each $1,000 of the debentures
is convertible into 23.8095 shares of our common stock.

Information regarding our securities authorized
for issuance under equity incentive plans is included in this
report in Item 12 under the caption Equity
Compensation Plan Information.

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

Income Statement Data

|                                                                                                                        |                                                                                                             |                                               |            |           |   |         |            |            |   |         |            |           |   |   |            |           |   |   |           |           |  
|----------------------------------------------------------------------------------------------------------------------- | ----------------------------------------------------------------------------------------------------------- | --------------------------------------------- | ---------- | --------- | - | ------- | ---------- | ---------- | - | ------- | ---------- | --------- | - | - | ---------- | --------- | - | - | --------- | --------- | -
|                                                                                                                        |                                                                                                             |                                              
|                                                                                                                        |                                                                                                             | Year Ended December 31,                      
|                                                                                                                        |                                                                                                             |                                              
|                                                                                                                        |                                                                                                             | 2002(1)                                       |            | 2001(2)   |   | 2000(3) |            | 1999(4)    |   | 1998(5)
|                                                                                                                        |                                                                                                             |                                               |            |           |   |         |            |            |   |        
|                                                                                                                        |                                                                                                             |                                              
|                                                                                                                        |                                                                                                             | (Amounts in thousands, except per-share data)
|Operating revenue                                                                                                       |                                                                                                             | $                                             | 11,156,502 |           |   | $       | 11,843,972 |            |   | $       | 11,576,298 |           |   | $ | 10,073,140 |           |   | $ | 9,625,788 |          
|                                                                                                                        |                                                                                                             |                                               |            |           |   |         |            |            |   |         |            |           |   |   |            |           |   |   |           |          
|Expenses:                                                                                                               |                                                                                                             |                                               |            |           |   |         |            |            |   |         |            |           |   |   |            |           |   |   |           |          
|                                                                                                                        | Health care services                                                                                        |                                               |            | 9,485,701 |   |         |            | 10,367,657 |   |         |            | 9,913,657 |   |   |            | 8,368,690 |   |   |           | 8,002,260 |  
|                                                                                                                        | Other operating expenses                                                                                    |                                               |            | 1,370,160 |   |         |            | 1,288,374  |   |         |            | 1,286,790 |   |   |            | 1,181,773 |   |   |           | 1,166,011 |  
|                                                                                                                        | Impairment, disposition, restructuring, Office of
    Personnel Management and other charges (credits), net |                                               |            | 3,774     |   |         |            | 61,157     |   |         |            | 8,766     |   |   |            | (2,233    | ) |   |           | 11,020    |  
|                                                                                                                        |                                                                                                             |                                               |            |           |   |         |            |            |   |         |            |           |   |   |            |           |   |   |           |          
|Operating income                                                                                                        |                                                                                                             |                                               | 296,867    |           |   |         | 126,784    |            |   |         | 367,085    |           |   |   | 524,910    |           |   |   | 446,497   |          
|Interest expense                                                                                                        |                                                                                                             |                                               | (74,904    | )         |   |         | (70,282    | )          |   |         | (79,636    | )         |   |   | (43,001    | )         |   |   | (60,923   | )        
|Minority interest in consolidated subsidiary                                                                            |                                                                                                             |                                               |           |           |   |         |           |            |   |         | 637        |           |   |   |           |           |   |   |          |          
|                                                                                                                        |                                                                                                             |                                               |            |           |   |         |            |            |   |         |            |           |   |   |            |           |   |   |           |          
|Income before income taxes                                                                                              |                                                                                                             |                                               | 221,963    |           |   |         | 56,502     |            |   |         | 288,086    |           |   |   | 481,909    |           |   |   | 385,574   |          
|Provision for income taxes                                                                                              |                                                                                                             |                                               | 82,792     |           |   |         | 38,371     |            |   |         | 127,046    |           |   |   | 203,365    |           |   |   | 183,147   |          
|                                                                                                                        |                                                                                                             |                                               |            |           |   |         |            |            |   |         |            |           |   |   |            |           |   |   |           |          
|Income before cumulative effect of a change in
    accounting principle and extraordinary gain                          |                                                                                                             |                                               | 139,171    |           |   |         | 18,131     |            |   |         | 161,040    |           |   |   | 278,544    |           |   |   | 202,427   |          
|Cumulative effect of a change in accounting
    principle(1)                                                            |                                                                                                             |                                               | (897,000   | )         |   |         |           |            |   |         |           |           |   |   |           |           |   |   |          |          
|Extraordinary gain on early retirement of debt
    (less income taxes of $0.9 million)                                  |                                                                                                             |                                               |           |           |   |         | 875        |            |   |         |           |           |   |   |           |           |   |   |          |          
|                                                                                                                        |                                                                                                             |                                               |            |           |   |         |            |            |   |         |            |           |   |   |            |           |   |   |           |          
|Net (loss) income                                                                                                       |                                                                                                             | $                                             | (757,829   | )         |   | $       | 19,006     |            |   | $       | 161,040    |           |   | $ | 278,544    |           |   | $ | 202,427   |          
|                                                                                                                        |                                                                                                             |                                               |            |           |   |         |            |            |   |         |            |           |   |   |            |           |   |   |           |          
|Preferred dividends                                                                                                     |                                                                                                             |                                               |           |           |   |         |           |            |   |         |           |           |   |   |           |           |   |   | (5,259    | )        
|                                                                                                                        |                                                                                                             |                                               |            |           |   |         |            |            |   |         |            |           |   |   |            |           |   |   |           |          
|Net (loss) income available to common stockholders                                                                      |                                                                                                             | $                                             | (757,829   | )         |   | $       | 19,006     |            |   | $       | 161,040    |           |   | $ | 278,544    |           |   | $ | 197,168   |          
|                                                                                                                        |                                                                                                             |                                               |            |           |   |         |            |            |   |         |            |           |   |   |            |           |   |   |           |          
|Basic (loss) earnings per share:                                                                                        |                                                                                                             |                                               |            |           |   |         |            |            |   |         |            |           |   |   |            |           |   |   |           |          
|                                                                                                                        | Income before cumulative effect of a change in
    accounting principle and extraordinary gain              |                                               | $          | 3.95      |   |         | $          | 0.54       |   |         | $          | 4.59      |   |   | $          | 6.26      |   |   | $         | 4.50      |  
|                                                                                                                        | Cumulative effect of a change in accounting
    principle                                                   |                                               |            | (25.46    | ) |         |            |           |   |         |            |          |   |   |            |          |   |   |           |          |  
|                                                                                                                        | Extraordinary gain, net                                                                                     |                                               |            |          |   |         |            | 0.02       |   |         |            |          |   |   |            |          |   |   |           |          |  
|                                                                                                                        |                                                                                                             |                                               |            |           |   |         |            |            |   |         |            |           |   |   |            |           |   |   |           |          
|                                                                                                                        | Basic (loss) earnings per share                                                                             |                                               | $          | (21.51    | ) |         | $          | 0.56       |   |         | $          | 4.59      |   |   | $          | 6.26      |   |   | $         | 4.50      |  
|                                                                                                                        |                                                                                                             |                                               |            |           |   |         |            |            |   |         |            |           |   |   |            |           |   |   |           |          
|Diluted (loss) earnings per share:                                                                                      |                                                                                                             |                                               |            |           |   |         |            |            |   |         |            |           |   |   |            |           |   |   |           |          
|                                                                                                                        | Income before cumulative effect of a change in
    accounting principle and extraordinary gain              |                                               | $          | 3.95      |   |         | $          | 0.53       |   |         | $          | 4.58      |   |   | $          | 6.23      |   |   | $         | 4.40      |  
|                                                                                                                        | Cumulative effect of a change in accounting
    principle                                                   |                                               |            | (25.46    | ) |         |            |           |   |         |            |          |   |   |            |          |   |   |           |          |  
|                                                                                                                        | Extraordinary gain, net                                                                                     |                                               |            |          |   |         |            | 0.02       |   |         |            |          |   |   |            |          |   |   |           |          |  
|                                                                                                                        |                                                                                                             |                                               |            |           |   |         |            |            |   |         |            |           |   |   |            |           |   |   |           |          
|                                                                                                                        | Diluted (loss) earnings per share                                                                           |                                               | $          | (21.51    | ) |         | $          | 0.55       |   |         | $          | 4.58      |   |   | $          | 6.23      |   |   | $         | 4.40      |  
|                                                                                                                        |                                                                                                             |                                               |            |           |   |         |            |            |   |         |            |           |   |   |            |           |   |   |           |          
|Operating Statistics                                                                                                    |                                                                                                             |                                               |            |           |   |         |            |            |   |         |            |           |   |   |            |           |   |   |           |          
|Medical loss ratio (health care services as a
    percentage of premium revenue)                                        |                                                                                                             |                                               |            |           |   |         |            |            |   |         |            |           |   |   |            |           |   |   |           |          
|                                                                                                                        | Consolidated                                                                                                |                                               |            | 87.1      | % |         |            | 89.7       | % |         |            | 87.5      | % |   |            | 84.8      | % |   |           | 85.0      | %
|                                                                                                                        | Commercial                                                                                                  |                                               |            | 87.5      | % |         |            | 88.8       | % |         |            | 85.1      | % |   |            | 81.7      | % |   |           | 82.8      | %
|                                                                                                                        | Senior                                                                                                      |                                               |            | 86.8      | % |         |            | 90.3       | % |         |            | 89.4      | % |   |            | 86.9      | % |   |           | 86.5      | %
|Selling, general and administrative expenses as a
    percentage of operating revenue (excluding net investment income) |                                                                                                             |                                               | 12.1       | %         |   |         | 10.3       | %          |   |         | 10.5       | %         |   |   | 11.1       | %         |   |   | 11.4      | %        
|Operating income as a percentage of operating
    revenue                                                               |                                                                                                             |                                               | 2.7        | %         |   |         | 1.1        | %          |   |         | 3.2        | %         |   |   | 5.2        | %         |   |   | 4.6       | %        
|Effective tax rate(6)                                                                                                   |                                                                                                             |                                               | 37.3       | %         |   |         | 67.9       | %          |   |         | 44.1       | %         |   |   | 42.2       | %         |   |   | 47.5      | %        

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,          
|                                                              |  |                       
|                                                              |  | 2002                   |           | 2001 |  | 2000 |           | 1999 |  | 1998
|                                                              |  |                        |           |      |  |      |           |      |  |     
|                                                              |  |                       
|                                                              |  | (Dollars in thousands)
|Depreciation and amortization                                 |  | $                      | 73,884    |      |  | $    | 148,704   |      |  | $    | 130,563   |   |  | $ | 118,097   |   |  | $ | 121,029   |  
|Capital expenditures                                          |  | $                      | 59,274    |      |  | $    | 77,301    |      |  | $    | 105,256   |   |  | $ | 66,211    |   |  | $ | 41,631    |  
|Net cash flows provided by operating activities               |  | $                      | 242,379   |      |  | $    | 38,923    |      |  | $    | 631,236   |   |  | $ | 569,698   |   |  | $ | 455,587   |  
|Net cash flows provided by (used in) investing
    activities |  | $                      | (278,137  | )    |  | $    | (260,828  | )    |  | $    | 72,376    |   |  | $ | (250,859  | ) |  | $ | (18,911   | )
|Net cash flows provided by (used in) financing
    activities |  | $                      | 9,688     |      |  | $    | (51,971   | )    |  | $    | (301,041  | ) |  | $ | (194,411  | ) |  | $ | (392,714  | )
|HMO Membership Data                                           |  |                        |           |      |  |      |           |      |  |      |           |   |  |   |           |   |  |   |           |  
|Commercial                                                    |  |                        | 2,252,000 |      |  |      | 2,439,600 |      |  |      | 2,953,300 |   |  |   | 2,643,400 |   |  |   | 2,554,100 |  
|Senior                                                        |  |                        | 760,500   |      |  |      | 948,500   |      |  |      | 1,056,700 |   |  |   | 1,014,600 |   |  |   | 972,800   |  
|                                                              |  |                        |           |      |  |      |           |      |  |      |           |   |  |   |           |   |  |   |           |  
|Total HMO membership                                          |  |                        | 3,012,500 |      |  |      | 3,388,100 |      |  |      | 4,010,000 |   |  |   | 3,658,000 |   |  |   | 3,526,900 |  
|                                                              |  |                        |           |      |  |      |           |      |  |      |           |   |  |   |           |   |  |   |           |  
|Balance Sheet Data                                            |  |                        |           |      |  |      |           |      |  |      |           |   |  |   |           |   |  |   |           |  
|Cash and equivalents                                          |  | $                      | 951,689   |      |  | $    | 977,759   |      |  | $    | 1,251,635 |   |  | $ | 849,064   |   |  | $ | 724,636   |  
|Marketable securities                                         |  |                        | 1,195,517 |      |  |      | 1,062,353 |      |  |      | 864,013   |   |  |   | 999,194   |   |  |   | 875,553   |  
|Total assets                                                  |  |                        | 4,251,133 |      |  |      | 5,096,046 |      |  |      | 5,323,436 |   |  |   | 4,884,021 |   |  |   | 4,630,944 |  
|Medical claims and benefits payable                           |  |                        | 1,044,500 |      |  |      | 1,095,900 |      |  |      | 1,270,800 |   |  |   | 795,200   |   |  |   | 645,300   |  
|Long-term debt, due after one year                            |  |                        | 731,794   |      |  |      | 794,309   |      |  |      | 836,556   |   |  |   | 975,000   |   |  |   | 650,006   |  
|Stockholders equity                                          |  |                        | 1,328,305 |      |  |      | 2,033,785 |      |  |      | 2,003,560 |   |  |   | 1,977,719 |   |  |   | 2,238,096 |  



---



|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | The 2002 results include impairment, disposition,
    restructuring, OPM and other net pretax charges totaling
    $3.8 million ($2.4 million or $0.07 diluted loss per
    share, net of tax). See Note 10 of the Notes to
    Consolidated Financial Statements. Operating income before net
    pretax charges as a percentage of operating revenue was 2.7%.
    
     The 2002 results include a cumulative effect of a change in
    accounting principle in connection with the goodwill impairment
    recognized upon the adoption of Statement of Financial
    Accounting Standards (SFAS) No. 142, Goodwill and
    Other Intangible Assets, totaling $929 million
    ($897 million or $25.46 diluted loss per share, net of
    tax). See Note 7 of the Notes to Consolidated Financial
    Statements.
|   
|(2) | 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 10 of the Notes to
    Consolidated Financial Statements. Operating income before net
    pretax charges as a percentage of operating revenue was 1.6%.                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|   
|(3) | 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 10 of the Notes to
    Consolidated Financial Statements. Operating income before net
    pretax charges as a percentage of operating revenue was 3.2%.                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|   
|(4) | 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. Operating income before net pretax credits
    as a percentage of operating revenue was 5.2%.                                                                                                                                                                                                                                                                                                                                                                                             
|   
|(5) | The 1998 results include $11 million of net
    pretax charges ($6 million or $0.12 diluted loss per share,
    net of tax). Operating income before net pretax charges as a
    percentage of operating revenue was 4.8%.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|   
|(6) | Effective income tax rate includes the effect of
    nondeductible pretax charges, primarily goodwill amortization
    for the years ended December 31, 1998 through 2001.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           

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

Results of Operations

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

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, 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 periods up to one year. In
addition, each of our subsidiaries that offers Medicare+Choice
products must submit adjusted community rate proposals,
generally by county or service area, to CMS by September 9
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 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.
These 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 2003, 2002 and 2001. 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. The change in the number of counties from 2002 to
2003 for which we contracted with CMS to offer our

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##### Table of Contents



Medicare+Choice health plans was due to service
area exits in California as well as our exit from the Houston,
Texas market.


|                                                                                               |  |            |    |            |  |            |    |  |  |  |     | 
|---------------------------------------------------------------------------------------------- |  | ---------- | -- | ---------- |  | ---------- | -- |  |  |  | --- | 
|                                                                                               |  | January 1, |    | January 1, |  | January 1,
|                                                                                               |  | 2003       |    | 2002       |  | 2001      
|                                                                                               |  |            |    |            |  |           
|Counties in which Secure Horizons contracted with
    CMS to offer Medicare+Choice plans       |  |            | 64 |            |  |            | 68 |  |  |  | 104 | 
|Counties in which Secure Horizons has voluntarily
    closed enrollment or set capacity limits |  |            | 8  |            |  |            | 4  |  |  |  | 28  | 
|                                                                                               |  |            |    |            |  |            |    |  |  |  |     | 
|Counties in which Secure Horizons offers
    Medicare+Choice plans for new member enrollment   |  |            | 56 |            |  |            | 64 |  |  |  | 76  | 
|                                                                                               |  |            |    |            |  |            |    |  |  |  |     | 

Other Income.Other
income consists of revenue we receive from administrative
services we offer through our specialty products companies,
primarily from our pharmacy benefit management company. Our
pharmacy benefit management company generates mail-service
revenue where we, rather than network retail pharmacies, collect
the member copayments, for both affiliated and unaffiliated
members. Additionally, we record revenues for prescription
ingredient costs on prescriptions dispensed by our mail-service
pharmacy. For prescription drugs dispensed through retail
pharmacies, we record administrative services fees when a
prescription claim is reviewed and approved, and the
prescription is shipped or filled. For prescription drugs
dispensed through retail pharmacies, we do not record revenues
for drugs dispensed or the network pharmacies dispensing
fees; nor do we record revenues for copayments our members make
to the retail pharmacies.

Net Investment Income.Net investment income consists of
interest income, gross realized gains and losses experienced
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 become,
and will continue to be an important component to results of
operations. 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 for the agreed-upon
schedule of services, without regard to the volume of services
provided to a given member.

Expenses

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

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

The cost of health care provided is accrued in
the month services are provided to members, based in part on
estimates for hospital services and other health care costs that
have been incurred but not yet reported. We develop these
estimates using actuarial methods based on 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 senior plans is expensed when
the prescription drugs are dispensed. Our commercial and senior
plans also provide incentives, through a variety of programs,
for health care providers that participate in those plans to
control

26



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##### Table of Contents



health care costs while providing quality health
care. Expenses related to these programs, which are based in
part on estimates, are recorded in the period in which the
related services are provided. Historically, we have primarily
arranged health care services for our members by contracting
with health care providers on a capitated basis, regardless of
the services provided to each member. Under our risk-based
contracts, we generally bear or partially share the risk of
excess health care expenses with health care providers, meaning
that if member utilization of health care services exceeds
agreed-on amounts, we bear or partially share the excess
expenses with the applicable health care provider.


The following table illustrates our shift from
capitated contracts to risk-based contracts since 2000. We
expect this shift to continue in 2004. The percentages of HMO
membership by contract type at December 31, 2002, 2001 and
2000 were as follows:

|                           |  |              |    |           |  |      |    |      |  |      |    |      |  |  |    |   |  |  |    |   |  |  |    |  
|-------------------------- |  | ------------ | -- | --------- |  | ---- | -- | ---- |  | ---- | -- | ---- |  |  | -- | - |  |  | -- | - |  |  | -- | -
|                           |  |              |    |          
|                           |  | Hospital     |    | Physician
|                           |  |              |    |          
|                           |  |             
|                           |  | December 31,
|                           |  |             
|                           |  | 2002         |    | 2001      |  | 2000 |    | 2002 |  | 2001 |    | 2000
|                           |  |              |    |           |  |      |    |      |  |      |    |     
|Commercial                 |  |              |    |           |  |      |    |      |  |      |    |      |  |  |    |   |  |  |    |   |  |  |    |  
|Capitated                  |  |              | 46 | %         |  |      | 48 | %    |  |      | 57 | %    |  |  | 78 | % |  |  | 79 | % |  |  | 84 | %
|Risk-based/fee-for-service |  |              | 54 | %         |  |      | 52 | %    |  |      | 43 | %    |  |  | 22 | % |  |  | 21 | % |  |  | 16 | %
|Senior                     |  |              |    |           |  |      |    |      |  |      |    |      |  |  |    |   |  |  |    |   |  |  |    |  
|Capitated                  |  |              | 57 | %         |  |      | 57 | %    |  |      | 65 | %    |  |  | 77 | % |  |  | 77 | % |  |  | 87 | %
|Risk-based/fee-for-service |  |              | 43 | %         |  |      | 43 | %    |  |      | 35 | %    |  |  | 23 | % |  |  | 23 | % |  |  | 13 | %
|Total                      |  |              |    |           |  |      |    |      |  |      |    |      |  |  |    |   |  |  |    |   |  |  |    |  
|Capitated                  |  |              | 48 | %         |  |      | 51 | %    |  |      | 59 | %    |  |  | 78 | % |  |  | 79 | % |  |  | 85 | %
|Risk-based/fee-for-service |  |              | 52 | %         |  |      | 49 | %    |  |      | 41 | %    |  |  | 22 | % |  |  | 21 | % |  |  | 15 | %

2002 Compared with 2001

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

|                     |            |                      |  |                   |           |       |  |            |         |        |  |           |           |  |  |           |           |  |  |         |         |  |  |           |           | 
|-------------------- | ---------- | -------------------- |  | ----------------- | --------- | ----- |  | ---------- | ------- | ------ |  | --------- | --------- |  |  | --------- | --------- |  |  | ------- | ------- |  |  | --------- | --------- | 
|                     |            |                      |  |                  
|                     |            | December 31, 2002    |  | December 31, 2001
|                     |            |                      |  |                  
|                     |            | Commercial           |  | Senior            |           | Total |  | Commercial |         | Senior |  | Total    
|                     |            |                      |  |                   |           |       |  |            |         |        |  |          
|HMO Membership Data: |            |                      |  |                   |           |       |  |            |         |        |  |           |           |  |  |           |           |  |  |         |         |  |  |          
|                     | Arizona    |                      |  | 141,300           |           |       |  | 88,400     |         |        |  | 229,700   |           |  |  | 144,000   |           |  |  | 104,600 |         |  |  | 248,600   |          
|                     | California |                      |  | 1,543,000         |           |       |  | 386,100    |         |        |  | 1,929,100 |           |  |  | 1,579,000 |           |  |  | 487,000 |         |  |  | 2,066,000 |          
|                     | Colorado   |                      |  | 178,300           |           |       |  | 57,600     |         |        |  | 235,900   |           |  |  | 202,300   |           |  |  | 60,300  |         |  |  | 262,600   |          
|                     | Guam       |                      |  | 32,200            |           |       |  |           |         |        |  | 32,200    |           |  |  | 36,400    |           |  |  |        |         |  |  | 36,400    |          
|                     | Nevada     |                      |  | 24,300            |           |       |  | 27,400     |         |        |  | 51,700    |           |  |  | 36,100    |           |  |  | 30,900  |         |  |  | 67,000    |          
|                     | Oklahoma   |                      |  | 101,100           |           |       |  | 19,800     |         |        |  | 120,900   |           |  |  | 91,300    |           |  |  | 30,200  |         |  |  | 121,500   |          
|                     | Oregon     |                      |  | 68,000            |           |       |  | 25,300     |         |        |  | 93,300    |           |  |  | 93,200    |           |  |  | 26,800  |         |  |  | 120,000   |          
|                     | Texas      |                      |  | 101,100           |           |       |  | 100,400    |         |        |  | 201,500   |           |  |  | 180,400   |           |  |  | 149,600 |         |  |  | 330,000   |          
|                     | Washington |                      |  | 62,700            |           |       |  | 55,500     |         |        |  | 118,200   |           |  |  | 76,900    |           |  |  | 59,100  |         |  |  | 136,000   |          
|                     |            |                      |  |                   |           |       |  |            |         |        |  |           |           |  |  |           |           |  |  |         |         |  |  |          
|                     |            | Total HMO membership |  |                   | 2,252,000 |       |  |            | 760,500 |        |  |           | 3,012,500 |  |  |           | 2,439,600 |  |  |         | 948,500 |  |  |           | 3,388,100 | 
|                     |            |                      |  |                   |           |       |  |            |         |        |  |           |           |  |  |           |           |  |  |         |         |  |  |          

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|                       |                      |                                |  |                   |           |       |  |            |         |        |  |        |           |  |  |        |           |  |  |        |         |  |  |        |           | 
|---------------------- | -------------------- | ------------------------------ |  | ----------------- | --------- | ----- |  | ---------- | ------- | ------ |  | ------ | --------- |  |  | ------ | --------- |  |  | ------ | ------- |  |  | ------ | --------- | 
|                       |                      |                                |  |                  
|                       |                      | December 31, 2002              |  | December 31, 2001
|                       |                      |                                |  |                  
|                       |                      | Commercial                     |  | Senior            |           | Total |  | Commercial |         | Senior |  | Total 
|                       |                      |                                |  |                   |           |       |  |            |         |        |  |       
|Other Membership Data: |                      |                                |  |                   |           |       |  |            |         |        |  |        |           |  |  |        |           |  |  |       
|                       | PPO and indemnity    |                                |  | 75,100            |           |       |  |           |         |        |  | 75,100 |           |  |  | 38,400 |           |  |  |       |         |  |  | 38,400 |          
|                       | Employer self-funded |                                |  | 34,800            |           |       |  |           |         |        |  | 34,800 |           |  |  | 42,400 |           |  |  |       |         |  |  | 42,400 |          
|                       | Medicare supplement  |                                |  |                  |           |       |  | 15,600     |         |        |  | 15,600 |           |  |  |       |           |  |  | 11,000 |         |  |  | 11,000 |          
|                       |                      |                                |  |                   |           |       |  |            |         |        |  |        |           |  |  |        |           |  |  |        |         |  |  |       
|                       |                      | Total other membership         |  |                   | 109,900   |       |  |            | 15,600  |        |  |        | 125,500   |  |  |        | 80,800    |  |  |        | 11,000  |  |  |        | 91,800    | 
|                       |                      |                                |  |                   |           |       |  |            |         |        |  |        |           |  |  |        |           |  |  |        |         |  |  |       
|                       |                      | Total HMO and other membership |  |                   | 2,361,900 |       |  |            | 776,100 |        |  |        | 3,138,000 |  |  |        | 2,520,400 |  |  |        | 959,500 |  |  |        | 3,479,900 | 
|                       |                      |                                |  |                   |           |       |  |            |         |        |  |        |           |  |  |        |           |  |  |        |         |  |  |       

|                                                                          |                                |                   |  |                      |  |            |  |           |  |              |  |           |  |  |  |           |  |  |  |           |  |  |  |           | 
|------------------------------------------------------------------------- | ------------------------------ | ----------------- |  | -------------------- |  | ---------- |  | --------- |  | ------------ |  | --------- |  |  |  | --------- |  |  |  | --------- |  |  |  | --------- | 
|                                                                          |                                |                   |  |                     
|                                                                          |                                | December 31, 2002 |  | As December 31, 2001
|                                                                          |                                |                   |  |                     
|                                                                          |                                | PacifiCare        |  |                      |  | PacifiCare |  |          
|                                                                          |                                | HMO               |  | Unaffiliated         |  | Total      |  | HMO       |  | Unaffiliated |  | Total    
|                                                                          |                                |                   |  |                      |  |            |  |           |  |              |  |          
|Pharmacy Benefit Management,
    Behavioral Health and Dental Membership: |                                |                   |  |                      |  |            |  |           |  |              |  |           |  |  |  |          
|                                                                          | Pharmacy benefit management(1) |                   |  | 3,012,500            |  |            |  | 1,635,100 |  |              |  | 4,647,600 |  |  |  | 3,388,100 |  |  |  | 1,129,000 |  |  |  | 4,517,100 | 
|                                                                          | Behavioral health(2)           |                   |  | 2,194,700            |  |            |  | 1,681,300 |  |              |  | 3,876,000 |  |  |  | 2,337,200 |  |  |  | 1,373,400 |  |  |  | 3,710,600 | 
|                                                                          | Dental(2)                      |                   |  | 403,800              |  |            |  | 211,200   |  |              |  | 615,000   |  |  |  | 635,300   |  |  |  | 196,800   |  |  |  | 832,100   | 



---



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

Commercial HMO membership decreased approximately
8% at December 31, 2002 compared to the prior year due to
decreases of 79,300 members in Texas, 36,000 members in
California, 25,200 members in Oregon and 24,000 members in
Colorado. These decreases were primarily due to elimination of
unprofitable commercial business and the termination of
contracts with network providers. As previously announced, our
contract with the California Public Employee Retirement System
was not renewed for 2003, resulting in the loss of approximately
185,000 commercial HMO members effective January 1, 2003.

Senior HMO membership decreased approximately 20%
at December 31, 2002 compared to the prior year due to a
decrease of 150,100 members in California and Texas. This
decrease primarily resulted from county exits and member
disenrollments attributable to reduced benefits and increased
premiums effective January 1, 2002. As previously
announced, we exited five counties in California and Texas
resulting in the loss of approximately 37,000 senior HMO members
effective January 1, 2003.

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

Pharmacy benefit management unaffiliated
membership at December 31, 2002 increased approximately 45%
compared to the prior year due to increased marketing efforts.
Pharmacy benefit management HMO membership at December 31,
2002 decreased approximately 11% compared to the prior year as a
result of county exits and member disenrollments attributable to
reduced benefits and increased premiums effective
January 1, 2002.

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

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PacifiCare dental HMO membership at
December 31, 2002 decreased approximately 36% compared to
the prior year primarily due to senior membership losses in
California, attributable to dental benefit changes effective
January 1, 2002. Dental unaffiliated membership at
December 31, 2002 increased approximately 7% compared to
the prior year due to membership from new PPO product offerings.

Commercial Premiums.Commercial premiums increased 4%
or $214 million for the year ended December 31, 2002
compared to the prior year as follows:

|                                                                                                 |  |                       |      |  
|------------------------------------------------------------------------------------------------ |  | --------------------- | ---- | -
|                                                                                                 |  | Year Ended           
|                                                                                                 |  | December 31, 2002    
|                                                                                                 |  |                      
|                                                                                                 |  |                      
|                                                                                                 |  | (Amounts in millions)
|Premium yield increases that averaged
    approximately 15% for the year ended December 31, 2002 |  | $                     | 634  |  
|Net membership decreases, primarily in
    California, Colorado and Texas                        |  |                       | (420 | )
|                                                                                                 |  |                       |      |  
|Increase over prior year                                                                         |  | $                     | 214  |  
|                                                                                                 |  |                       |      |  

Senior Premiums.Senior premiums decreased 13% or
$880 million for the year ended December 31, 2002
compared to the prior year as follows:

|                                                                                                                                |  |                       |        |  
|------------------------------------------------------------------------------------------------------------------------------- |  | --------------------- | ------ | -
|                                                                                                                                |  | Year Ended           
|                                                                                                                                |  | December 31, 2002    
|                                                                                                                                |  |                      
|                                                                                                                                |  |                      
|                                                                                                                                |  | (Amounts in millions)
|Membership decreases, primarily in California and
    Texas                                                                     |  | $                     | (1,270 | )
|Premium yield increases, including member
    premiums, that averaged approximately 8% for the year ended
    December 31, 2002 |  |                       | 390    |  
|                                                                                                                                |  |                       |        |  
|Decrease over prior year                                                                                                        |  | $                     | (880   | )
|                                                                                                                                |  |                       |        |  

Other Income.Other income increased 15% or
$26 million for the year ended December 31, 2002
compared to the same period in the prior year. The increase was
primarily due to increased mail-service revenues of our pharmacy
benefit management subsidiary.

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

During 2002, we wrote off our entire
$11 million investment in MedUnite, Inc., or MedUnite. In
late 2002, MedUnite was acquired by ProxyMed Inc. Additionally,
during 2002, we wrote down certain telecommunications
investments to market value resulting in a charge of
approximately $2 million during the second quarter of 2002.
In total, we recorded a charge of $13 million
($8 million, or $0.22 diluted loss per share, net of tax)
for other than temporary impairments to the value of these
investments which is included in net investment income. In
addition to the impairment of these investments, we experienced
lower pretax rates of return on our portfolio as a result of
lower investable balances and interest rates that have been
declining since 2001.

Consolidated Medical Loss Ratio.The consolidated medical loss
ratio (health care services as a percentage of premium revenue)
decreased for the year ended December 31, 2002 compared to
the prior year as follows:

|                    |              |              |  |      |   |  |  |      |  
|------------------- | ------------ | ------------ |  | ---- | - |  |  | ---- | -
|                    |              |             
|                    |              | Year Ended  
|                    |              | December 31,
|                    |              |             
|                    |              | 2002         |  | 2001
|                    |              |              |  |     
|Medical loss ratio: |              |              |  |      |   |  |  |     
|                    | Consolidated |              |  | 87.1 | % |  |  | 89.7 | %
|                    | Commercial   |              |  | 87.5 | % |  |  | 88.8 | %
|                    | Senior       |              |  | 86.8 | % |  |  | 90.3 | %

Commercial Medical Loss Ratio.The commercial medical loss ratio
includes results from our specialty HMO and indemnity insurance
operations. Our commercial medical loss ratio decreased to 87.5%
for the

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year ended December 31, 2002 compared to 88.8% in
the prior year. This decrease was driven by significant premium
rate increases, partially offset by the membership losses
described above, that outpaced an increase in commercial health
care costs on an absolute dollar and per-member per-month basis.


Commercial health care costs increased
$123 million for the year ended December 31, 2002 compared
to the prior year. On a per-member per-month basis, these costs
increased 13% to $152.64 per member per month for the year ended
December 31, 2002 compared to $135.04 in 2001. The increase was
due primarily to a 10% increase in physician costs, a 13%
increase in hospital costs, and a 16% increase in pharmacy
costs, on a per-member per-month basis.

Senior Medical Loss Ratio.The senior medical loss ratio for
2002 includes results from our indemnity insurance operations
for the Medicare Supplement and Senior Supplement products. We
have not adjusted the prior-year period to include senior
indemnity insurance operations because these results, which were
previously included in our commercial medical loss ratio, were
not material to senior premiums or senior health care costs in
total. Our senior medical loss ratio decreased to 86.8% for the
year ended December 31, 2002 compared to 90.3% for the same
period in 2001. This decrease was driven by premium rate
increases from both CMS and member premiums, benefit reductions,
primarily of prescription drugs, effective January 1, 2002
and decreased utilization attributable to our medical management
programs, net of membership losses described above, that
outpaced an increase in senior health care costs on a per-member
per-month basis. Additionally, in 2002 we had one full year of
premium rate increases attributable to the Benefits Improvements
Act of 2000, or BIPA. Because BIPA became effective
March 1, 2001, the same period in 2001 included only ten
months of BIPA increases.

On an absolute dollar basis, senior health care
costs decreased $1 billion for the year ended
December 31, 2002 compared to the prior year due primarily
to the significant decline in senior membership. However, on a
per-member per-month basis, these costs increased 4% to $520.23
per member per month for the year ended December 31, 2002
as compared to $501.65 for the prior year. The per-member
per-month increase was due primarily to a 4% increase in
physician costs and a 4% increase in hospital costs, partially
offset by a 25% decrease in pharmacy costs.

Selling, General and Administrative
Expenses.Selling, general and
administrative expenses increased $141 million to
$1.3 billion for the year ended December 31, 2002,
from $1.2 billion in the prior year. Selling, general and
administrative expenses increased primarily due to increased
spending for information technology, or IT, initiatives, our
PacifiCare and Secure Horizons brand building campaign and
incentive compensation costs. These costs were partially offset
by lower labor costs as a result of our 2001 corporate
restructuring.

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

|                                                                                                                        |  |              |      |      |  |  |      |  
|----------------------------------------------------------------------------------------------------------------------- |  | ------------ | ---- | ---- |  |  | ---- | -
|                                                                                                                        |  |             
|                                                                                                                        |  | Year Ended  
|                                                                                                                        |  | December 31,
|                                                                                                                        |  |             
|                                                                                                                        |  | 2002         |      | 2001
|                                                                                                                        |  |              |      |     
|Selling, general and administrative expenses as a
    percentage of operating revenue (excluding net investment income) |  |              | 12.1 | %    |  |  | 10.3 | %

Impairment, Disposition, Restructuring, OPM
and Other Charges.We recognized
net pretax charges of approximately $3.7 million
($2.2 million or $0.07 diluted loss per share, net of tax)
for the year ended December 31, 2002. See Note 10 of the
Notes to Consolidated Financial Statements.

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

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##### Table of Contents



principal amount of 3% convertible subordinated
debentures in the fourth quarter of 2002, which carried a lower
annual interest rate than the debt we repaid using a portion of
the proceeds of that offering. See Note 5 of the Notes to
Consolidated Financial Statements.


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

Reconciliation of Reported Results to Pro
Forma Results.In our fourth
quarter 2002 earnings announcement, we disclosed pro forma
results as described in the following table. See Notes 5, 7
and 10 of the Notes to Consolidated Financial Statements.

|                         |                                                                                                                    |                       |   |              |   |      |   |       |   |  |   |        |   |  |   |       |  
|------------------------ | ------------------------------------------------------------------------------------------------------------------ | --------------------- | - | ------------ | - | ---- | - | ----- | - |  | - | ------ | - |  | - | ----- | -
|                         |                                                                                                                    |                       |   |              |   |     
|                         |                                                                                                                    | Three Months          |   |             
|                         |                                                                                                                    | Ended                 |   | Year Ended  
|                         |                                                                                                                    | December 31,          |   | December 31,
|                         |                                                                                                                    |                       |   |             
|                         |                                                                                                                    | 2002                  |   | 2001         |   | 2002 |   | 2001 
|                         |                                                                                                                    |                       |   |              |   |      |   |      
|                         |                                                                                                                    |                      
|                         |                                                                                                                    | (Amounts in millions)
|Net income (loss):       |                                                                                                                    |                       |   |              |   |      |   |       |   |  |   |        |   |  |   |      
|                         | As reported                                                                                                        |                       | $ | 37           |   |      | $ | (26   | ) |  | $ | (758   | ) |  | $ | 19    |  
|                         | Cumulative effect of a change in accounting
    principle, net of tax                                              |                       |   |             |   |      |   |      |   |  |   | 897    |   |  |   |      |  
|                         | Impairment, disposition, restructuring, Office of
    Personnel Management and other (credits) charges, net of tax |                       |   | (1           | ) |      |   | 38    |   |  |   | 2      |   |  |   | 39    |  
|                         | Gain on early retirement of debt, net of tax                                                                       |                       |   |             |   |      |   |       |   |  |   |       |   |  |   | (1    | )
|                         |                                                                                                                    |                       |   |              |   |      |   |       |   |  |   |        |   |  |   |      
|                         | Pro forma net income                                                                                               |                       | $ | 36           |   |      | $ | 12    |   |  | $ | 141    |   |  | $ | 57    |  
|                         |                                                                                                                    |                       |   |              |   |      |   |       |   |  |   |        |   |  |   |      
|                         | Goodwill amortization adjustment(1)                                                                                |                       |   |             |   |      |   | 14    |   |  |   |       |   |  |   | 58    |  
|                         |                                                                                                                    |                       |   |              |   |      |   |       |   |  |   |        |   |  |   |      
|                         | Pro forma net income, as adjusted(1)                                                                               |                       | $ | 36           |   |      | $ | 26    |   |  | $ | 141    |   |  | $ | 115   |  
|                         |                                                                                                                    |                       |   |              |   |      |   |       |   |  |   |        |   |  |   |      
|                         | Diluted earnings (loss) per share:                                                                                 |                       |   |              |   |      |   |       |   |  |   |        |   |  |   |       |  
|                         | As reported                                                                                                        |                       | $ | 1.00         |   |      | $ | (0.77 | ) |  | $ | (21.51 | ) |  | $ | 0.55  |  
|                         | Cumulative effect of a change in accounting
    principle, net of tax                                              |                       |   |             |   |      |   |      |   |  |   | 25.46  |   |  |   |      |  
|                         | Impairment, disposition, restructuring, Office of
    Personnel Management and other (credits) charges, net of tax |                       |   | (0.03        | ) |      |   | 1.11  |   |  |   | 0.07   |   |  |   | 1.13  |  
|                         | Impact of difference between basic and diluted
    weighted average shares outstanding(2)                          |                       |   |             |   |      |   |      |   |  |   | (0.10  | ) |  |   |      |  
|                         | Gain on early retirement of debt, net of tax                                                                       |                       |   |             |   |      |   |       |   |  |   |       |   |  |   | (0.02 | )
|                         |                                                                                                                    |                       |   |              |   |      |   |       |   |  |   |        |   |  |   |      
|                         | Pro forma diluted earnings per share                                                                               |                       | $ | 0.97         |   |      | $ | 0.34  |   |  | $ | 3.92   |   |  | $ | 1.66  |  
|                         |                                                                                                                    |                       |   |              |   |      |   |       |   |  |   |        |   |  |   |      
|                         | Goodwill amortization adjustment(1)                                                                                |                       |   |             |   |      |   | 0.42  |   |  |   |       |   |  |   | 1.69  |  
|                         |                                                                                                                    |                       |   |              |   |      |   |       |   |  |   |        |   |  |   |      
|                         | Pro forma diluted earnings per share, as
    adjusted(1)                                                           |                       | $ | 0.97         |   |      | $ | 0.76  |   |  | $ | 3.92   |   |  | $ | 3.35  |  
|                         |                                                                                                                    |                       |   |              |   |      |   |       |   |  |   |        |   |  |   |      
|Operating income (loss): |                                                                                                                    |                       |   |              |   |      |   |       |   |  |   |        |   |  |   |      
|                         | As reported                                                                                                        |                       | $ | 79           |   |      | $ | (19   | ) |  | $ | 297    |   |  | $ | 127   |  
|                         | Impairment, disposition, restructuring, Office of
    Personnel Management and other (credits) charges, net of tax |                       |   | (2           | ) |      |   | 59    |   |  |   | 4      |   |  |   | 61    |  
|                         |                                                                                                                    |                       |   |              |   |      |   |       |   |  |   |        |   |  |   |      
|                         | Pro forma operating income                                                                                         |                       | $ | 77           |   |      | $ | 40    |   |  | $ | 301    |   |  | $ | 188   |  
|                         |                                                                                                                    |                       |   |              |   |      |   |       |   |  |   |        |   |  |   |      
|                         | Goodwill amortization adjustment(1)                                                                                |                       |   |             |   |      |   | 15    |   |  |   |       |   |  |   | 59    |  
|                         |                                                                                                                    |                       |   |              |   |      |   |       |   |  |   |        |   |  |   |      
|                         | Pro forma operating income, as adjusted(1)                                                                         |                       | $ | 77           |   |      | $ | 55    |   |  | $ | 301    |   |  | $ | 247   |  
|                         |                                                                                                                    |                       |   |              |   |      |   |       |   |  |   |        |   |  |   |      

31



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|                                                              |                                                                                        |                       |  |              |   |      |  |      |    |  |  |     |   |  |  |     |  
|------------------------------------------------------------- | -------------------------------------------------------------------------------------- | --------------------- |  | ------------ | - | ---- |  | ---- | -- |  |  | --- | - |  |  | --- | -
|                                                              |                                                                                        |                       |  |              |   |     
|                                                              |                                                                                        | Three Months          |  |             
|                                                              |                                                                                        | Ended                 |  | Year Ended  
|                                                              |                                                                                        | December 31,          |  | December 31,
|                                                              |                                                                                        |                       |  |             
|                                                              |                                                                                        | 2002                  |  | 2001         |   | 2002 |  | 2001
|                                                              |                                                                                        |                       |  |              |   |      |  |     
|                                                              |                                                                                        |                      
|                                                              |                                                                                        | (Amounts in millions)
|Operating income as a percentage of operating
    revenue:(3) |                                                                                        |                       |  |              |   |      |  |      |    |  |  |     |   |  |  |    
|                                                              | As reported                                                                            |                       |  | 2.1          | % |      |  | (1.5 | )% |  |  | 2.1 | % |  |  | 0.1 | %
|                                                              | Pro forma operating income as a percentage of
    operating revenue(3)                 |                       |  | 2.0          | % |      |  | 0.6  | %  |  |  | 2.1 | % |  |  | 0.7 | %
|                                                              | Pro forma operating income as a percentage of
    operating revenue, as adjusted(1)(3) |                       |  | 2.0          | % |      |  | 1.1  | %  |  |  | 2.1 | % |  |  | 1.2 | %



---



|    |                                                                                                                                                                                                                                                              
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | As adjusted for the elimination of goodwill
    amortization under SFAS No. 142, as if adopted on
    January 1, 2001.                                                                                                                                       
|   
|(2) | Generally accepted accounting principles
    (GAAP) require the use of basic weighted average shares
    outstanding when reporting a net loss. The diluted weighted
    average shares outstanding were 36,137,000 for the year ended
    December 31, 2002.
|   
|(3) | Excluding net investment income.                                                                                                                                                                                                                             

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.

|                                  |                      |                                           |  |                   |           |       |  |            |         |        |  |           |           |  |  |           |           |  |  |         |           |  |  |           |           | 
|--------------------------------- | -------------------- | ----------------------------------------- |  | ----------------- | --------- | ----- |  | ---------- | ------- | ------ |  | --------- | --------- |  |  | --------- | --------- |  |  | ------- | --------- |  |  | --------- | --------- | 
|                                  |                      |                                           |  |                  
|                                  |                      | December 31, 2001                         |  | December 31, 2000
|                                  |                      |                                           |  |                  
|                                  |                      | Commercial                                |  | Senior            |           | Total |  | Commercial |         | Senior |  | 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: |                      |                                           |  |                   |           |       |  |            |         |        |  |           |           |  |  |           |           |  |  |        
|                                  | PPO and indemnity    |                                           |  | 38,400            |           |       |  |           |         |        |  | 38,400    |           |  |  | 42,900    |           |  |  |        |           |  |  | 42,900    |          
|                                  | Employer self-funded |                                           |  | 42,400            |           |       |  |           |         |        |  | 42,400    |           |  |  | 65,000    |           |  |  |        |           |  |  | 65,000    |          
|                                  | Medicare supplement  |                                           |  |                  |           |       |  | 11,000     |         |        |  | 11,000    |           |  |  |          |           |  |  | 500     |           |  |  | 500       |          
|                                  |                      |                                           |  |                   |           |       |  |            |         |        |  |           |           |  |  |           |           |  |  |         |           |  |  |          
|                                  |                      | Total other commercial membership         |  |                   | 80,800    |       |  |            | 11,000  |        |  |           | 91,800    |  |  |           | 107,900   |  |  |         | 500       |  |  |           | 108,400   | 
|                                  |                      |                                           |  |                   |           |       |  |            |         |        |  |           |           |  |  |           |           |  |  |         |           |  |  |          
|                                  |                      | Total HMO and other commercial membership |  |                   | 2,520,400 |       |  |            | 959,500 |        |  |           | 3,479,900 |  |  |           | 3,061,200 |  |  |         | 1,057,200 |  |  |           | 4,118,400 | 
|                                  |                      |                                           |  |                   |           |       |  |            |         |        |  |           |           |  |  |           |           |  |  |         |           |  |  |          

32



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



---



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

Senior HMO 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.                                                                    

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

33



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##### Table of Contents



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.

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 yield increases that averaged
    approximately 11% for the year ended December 31, 2001                                                                     |  |                       | 479  |  
|Membership losses resulting from the disposition
    of our Ohio HMO                                                                                                 |  |                       | (77  | )
|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 | )
|                                                                                                                                                                     |  |                       |      |  

Senior Premiums.Senior 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 yield 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 | %
|                    | Senior       |              |  | 90.3 | % |  |  | 89.4 | %

34



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##### Table of Contents



Commercial Medical Loss Ratio.The commercial medical loss ratio
includes results from our specialty HMO and indemnity insurance
operations. Our commercial medical loss ratio increased to 88.8%
for the year ended December 31, 2001, compared to 85.1% for
the year ended December 31, 2000. This increase was driven
by an increase in commercial health care costs that outpaced
premium rate increases. Commercial health care costs increased
$80 million for the year ended December 31, 2001
compared to the prior year. On a per-member per-month basis,
these costs increased 15% to $135.04 per member per month for
the year ended December 31, 2001 compared to $117.65 in
2000. This increase was due to a 10% increase in physician
costs, a 21% increase in hospital costs, and a 10% increase in
pharmacy costs. The increases in physician and hospital costs
were due in part to our Texas HMO, which experienced increased
health care costs because we paid hospitals and doctors for
expenses that were otherwise the obligations of our contracted
providers. See Note 11 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.

Senior Medical Loss Ratio.Our senior medical loss ratio
increased to 90.3% for the year ended December 31, 2001,
compared to 89.4% for the year ended December 31, 2000. This
increase was driven by an increase in senior health care costs
that outpaced premium rate increases, including BIPA (effective
March 1, 2001) and supplemental premiums. Senior health
care costs increased $374 million for the year ended
December 31, 2001 compared to the prior year. On a
per-member per-month basis, these costs increased 9% to $501.65
per member per month for the year ended December 31, 2001
compared to $466.18 in 2000. This increase was due to a 20%
increase in hospital costs, offset by a 1% decrease in physician
costs, and a 2% decrease in pharmacy costs. 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 11 of the Notes to Consolidated Financial Statements.
Substantial premium rate increases at our Colorado HMO and
Washington HMO partially offset increased health care costs.

Selling, General and Administrative
Expenses.Selling, general and
administrative expenses of $1.2 billion 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.

|                                                                                                                        |  |              |      |      |  |  |      |  
|----------------------------------------------------------------------------------------------------------------------- |  | ------------ | ---- | ---- |  |  | ---- | -
|                                                                                                                        |  |             
|                                                                                                                        |  | 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 | %

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 10 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 | %

35



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##### Table of Contents



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 senior credit facility during 2000 and 2001; and                
| 
| | Lower overall interest rates paid on our senior
    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 10 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, Office of
    Personnel Management and other charges (credits), net of tax |                                              |   | 38           |   |      |   | 6    |  |  |   | 39   |  |  |   | 5    | 
|                                   |                                                                                                                    |                                              |   |              |   |      |   |      |  |  |   |      |  |  |   |     
|                                   | 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, Office of
    Personnel Management and other charges (credits), net of tax |                                              |   | 1.11         |   |      |   | 0.17 |  |  |   | 1.13 |  |  |   | 0.15 | 
|                                   |                                                                                                                    |                                              |   |              |   |      |   |      |  |  |   |      |  |  |   |     
|                                   | Pro forma diluted earnings per share                                                                               |                                              | $ | 0.34         |   |      | $ | 0.52 |  |  | $ | 1.68 |  |  | $ | 4.73 | 
|                                   |                                                                                                                    |                                              |   |              |   |      |   |      |  |  |   |      |  |  |   |     

Liquidity and Capital Resources

Operating Cash Flows.Our consolidated cash, equivalents
and marketable securities increased $0.1 billion or 5% to
$2.1 billion at December 31, 2002, from
$2.0 billion at December 31, 2001.

Cash flows provided by operations, excluding the
impact of unearned premium revenue, were $315 million for
the year ended December 31, 2002 compared to cash flows
used in operations, excluding the impact of unearned premium
revenue, of $86 million for the year ended
December 31, 2001. The increase 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, 2002, investing activities used
$278 million of cash, compared to $261 million used
during the year ended December 31, 2001. The increase was
primarily related to increased purchases of marketable
securities.

Financing Activities.For the year ended
December 31, 2002, financing activities provided
$10 million of cash, compared to $52 million used
during the year ended December 31, 2001. During the year
ended December 31, 2002, the significant changes were as
follows:



|  |                                                                                                                                                                                                                                             
|- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | We received gross proceeds totaling
    $497 million from the 10 3/4% senior notes offering
    and $135 million from the 3% convertible subordinated
    debentures offering, and received no proceeds from debt
    offerings during 2001;

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|  |                                                                                                                                                                                                                                                                                                                                                
|- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | We repaid $554 million under our senior
    credit facility, including $499 million under the term loan
    facility and $55 million under the revolving credit
    facility. In 2001, we repaid $30 million under our senior
    credit facility;                                                                                             
| 
| | We repurchased and permanently retired
    $42 million of FHP International Corporation, or FHP,
    senior notes with funds from a restricted cash collateral
    account maintained under our senior credit facility. In 2001, we
    did not repurchase FHP senior notes;                                                                   
| 
| | We paid $38 million in loan fees, including
    $20 million in connection with the 10 3/4% senior
    notes offering, $13 million in connection with the
    amendment to the senior credit facility, and $5 million in
    connection with the 3% convertible subordinated debentures
    offering. In 2001, we paid $13 million in loan fees;
| 
| | We received $9 million in proceeds from a
    draw down on our equity commitment arrangement, with no
    comparable activity during 2001;                                                                                                                                                                                                     
| 
| | We reissued $5 million of treasury stock in
    connection with employee benefit plans compared with
    insignificant activity in 2001;                                                                                                                                                                                                       
| 
| | We repaid $2 million on our database
    financing agreement with no comparable activity in 2001; and                                                                                                                                                                                                                                          
| 
| | During 2001, we paid $9 million to three
    minority stockholders for all outstanding stock of our
    consolidated minority subsidiary, with no comparable activity
    during 2002.                                                                                                                                                         

In the fourth quarter of 2002, we sold
$135 million in aggregate principal amount of 3%
convertible subordinated debentures due in 2032 through a
private placement. We used a portion of the net proceeds from
the debentures to repay $53 million in indebtedness under
our term loan facility. The debentures are convertible into
common stock under certain conditions, including satisfaction of
a market price condition for our common stock, satisfaction of a
trading price condition relating to the debentures, upon notice
of redemption, or upon specified corporate transactions. Each
$1,000 of the debentures is convertible into 23.8095 shares
of our common stock. Beginning in October 2007, we may redeem
for cash all or any portion of the debentures, at a purchase
price of 100% of the principal amount plus accrued interest,
upon not less than 30 nor more than 60 days written
notice to the holders. Beginning in October 2007, and in
successive 5-year increments, our holders may require us to
repurchase the debentures for cash at a repurchase price of 100%
of the principal amount plus accrued interest. Our payment
obligations under the debentures are subordinated to our senior
indebtedness, and effectively subordinated to all indebtedness
and other liabilities of our subsidiaries. In connection with
the debentures offering, we incurred approximately
$5 million in fees that will be amortized over the term of
the debentures.

In the second quarter of 2002, we sold
$500 million in aggregate principal amount of 10 3/4%
senior notes due in 2009 in a private placement. The
10 3/4% senior notes were issued at 99.389%, for a discount
of $3 million that is being amortized over the term of the
notes. We used a portion of the net proceeds from the
10 3/4% senior notes to repay $369 million in
indebtedness under our senior credit facility, including
$315 million under our term loan facility and
$54 million under our revolving credit facility.
Additionally, we used $85 million of the net proceeds to
fund a restricted cash collateral account that has been and will
be used, subject to our being in compliance with the senior
credit facility, to repurchase or repay the FHP senior notes
prior to, or on, their stated maturity date. As of
December 31, 2002, we had used $42 million of the
restricted cash collateral account to purchase and permanently
retire FHP senior notes. We also used $22 million of the
net proceeds as a deposit against outstanding letters of credit
under our senior credit facility. We subsequently replaced all
but approximately $1 million of these letters of credit,
and the corresponding deposits were released to us. As of
December 31, 2002, our letter of credit commitments totaled
$19 million, and were backed by funds deposited in
restricted cash accounts maintained by us. In connection with
the 10 3/4% senior notes offering, we incurred
approximately $20 million in fees that will be amortized
over the term of the notes.

Certain of our domestic, unregulated subsidiaries
fully and unconditionally guarantee the 10 3/4% senior
notes. Certain of our other domestic, unregulated subsidiaries
are currently restricted from guaranteeing

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the 10 3/4% senior notes by the terms of the
FHP senior notes, but will fully and unconditionally guarantee
the 10 3/4% senior notes once we permanently repay the FHP
senior notes. See Note 13 of the Notes to Consolidated
Financial Statements.


In April 2002, we executed an amendment with our
lenders to extend the maturity date of our senior credit
facility to January 3, 2005. The extension of the maturity
date to January 3, 2005 was conditioned on the reduction of
the senior credit facility by $250 million on or prior to
January 2, 2003. We satisfied this condition using a
portion of the proceeds of the offering of the 10 3/4%
senior notes. Since December 31, 2001, we have repaid
indebtedness under the senior credit facility as follows:

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

The senior credit facility amortizes at a rate of
$25 million per quarter. Each quarterly amortization
payment includes a $20 million cash payment on the term
loan facility and a $5 million reduction in borrowing
capacity under the revolving credit facility. As of
December 31, 2002, the total size of the committed
revolving credit facility was $36 million, of which at
least $35 million was available for borrowing.

The interest rates per annum applicable to
amounts outstanding under the term loan facility and revolving
credit facility were increased in connection with the amendment
of our senior credit facility and 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 4% per annum, or the rate of Eurodollar
borrowings for the applicable interest period plus a margin of
5% per annum. Based on our outstanding balance under the credit
facility as of December 31, 2002, our average overall
interest rate, excluding the facility fee, was 6.4% per annum.

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 and a maximum debt to earnings before interest,
taxes, depreciation and amortization, or EBITDA, requirement. At
December 31, 2002, we were in compliance with all of these
covenants. Our domestic, unregulated subsidiaries provide
guarantees and have granted security interests to the lenders in
substantially all of their personal property to secure our
obligations under the senior credit facility. We have also
pledged the equity of certain of our subsidiaries to the lenders
under the senior credit facility.

We had $43 million in senior notes
outstanding as of December 31, 2002 that we assumed when we
acquired FHP in 1997. These notes mature on September 15,
2003, and bear interest at 7% payable semiannually. As described
above, $85 million of the net proceeds from the
10 3/4% senior notes offering was used to fund a restricted
cash collateral account that has been and will be used, subject
to our being in compliance with the senior credit facility, to
repurchase or repay the FHP senior notes prior to or on their
stated maturity date. As of December 31, 2002, we had used
$42 million of the restricted cash collateral account to
purchase and permanently retire FHP senior notes. Additionally,
in May 2002, we retired $3 million of the FHP senior notes
by exchanging approximately 0.1 million shares of our
common stock for those FHP senior notes. We reissued treasury
stock to provide the common stock used in the exchange. The FHP
notes share in the collateral securing our obligations under our
senior credit facility.

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Our ability to repay debt depends in part 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.
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 may continue to seek to refinance our senior
bank credit facility, which will mature in January 2005, using
equity or debt financing alternatives. Our debt is rated below
investment grade by the major credit rating agencies as follows:

|                  |  |          |  |          |     |         |  |              |    |  |  |  |     | 
|----------------- |  | -------- |  | -------- | --- | ------- |  | ------------ | -- |  |  |  | --- | 
|                  |  |          |  | Senior   |     | 10 3/4% |  | Convertible 
|                  |  |          |  | Credit   |     | Senior  |  | Subordinated
|Agency            |  | Outlook  |  | Facility |     | Notes   |  | Debentures  
|                  |  |          |  |          |     |         |  |             
|Moodys           |  | Positive |  |          | B1  |         |  |              | B2 |  |  |  | B3  | 
|Standard & Poors |  | Stable   |  |          | BB- |         |  |              | B+ |  |  |  | B   | 
|Fitch IBCA        |  | Stable   |  |          | BB  |         |  |              | BB |  |  |  | BB- | 

Consequently, if we seek to raise funds in
capital markets transactions, our ability to do so will be
limited to issuing additional non-investment grade debt or
issuing equity and/or equity-linked instruments. We may not be
able to issue any such securities at all or on terms favorable
to us. Any issuance of equity or equity-linked securities may
result in substantial dilution to our stockholders.

In December 2001, we entered into an equity
commitment arrangement with Acqua Wellington North American
Equities Fund Ltd., or Acqua Wellington, an institutional
investor, for the purchase by Acqua Wellington of up to
6.9 million shares or $150 million in our common
stock. In April 2002, we made a draw down under our equity
commitment arrangement with Acqua Wellington. As a result of
this draw down, we sold 420,720 shares to Acqua Wellington for
an average price of $21.39 per share. The total proceeds from
the draw down were approximately $9 million. This equity
commitment arrangement will expire in June 2003.

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 of steps to increase our internally generated cash flow,
including increasing premiums, increasing our marketing of
specialty product lines, introducing new products to generate
new revenue sources and reducing our expenses by, among other
things, exiting from unprofitable markets and cost savings
initiatives. If our cash flow is less than we expect due to one
or more of the risk factors described in Forward-Looking
Statements, or our cash flow requirements increase for
reasons we do not currently foresee, then we may need to draw
down remaining available funds on our revolving credit facility
which matures in January 2005, or our equity commitment
arrangement which expires in June 2003. A failure to comply with
any covenant in the senior credit facility could make funds
under our revolving credit facility 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

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objectives. Our contractual cash obligations,
including long-term debt and other commitments, as of
December 31, 2002 were as follows:


|                                   |                                              |                                  |       |       |       |      |     |      |     |      |     |      |     |            |     |     |     |   |     |     |     |   |     |     |     |   |       |     |     | 
|---------------------------------- | -------------------------------------------- | -------------------------------- | ----- | ----- | ----- | ---- | --- | ---- | --- | ---- | --- | ---- | --- | ---------- | --- | --- | --- | - | --- | --- | --- | - | --- | --- | --- | - | ----- | --- | --- | 
|                                   |                                              |                                 
|                                   |                                              | Payments Due by Period          
|                                   |                                              |                                 
|                                   |                                              | Total                            |       | 2003  |       | 2004 |     | 2005 |     | 2006 |     | 2007 |     | Thereafter
|                                   |                                              |                                  |       |       |       |      |     |      |     |      |     |      |     |           
|                                   |                                              |                                 
|                                   |                                              | (Amounts in millions)           
|Long-term debt:                    |                                              |                                  |       |       |       |      |     |      |     |      |     |      |     |            |     |     |     |   |     |     |     |   |     |     |     |   |       |    
|                                   | 10 3/4% senior notes, net of discount        |                                  | $     | 497   |       |      | $   |     |     |      | $   |     |     |            | $   |    |     |   | $   |    |     |   | $   |    |     |   | $     | 497 |    
|                                   | Senior credit facility                       |                                  |       | 151   |       |      |     | 61   |     |      |     | 81   |     |            |     | 9   |     |   |     |    |     |   |     |    |     |   |       |    |    
|                                   | Convertible subordinated debentures          |                                  |       | 135   |       |      |     |     |     |      |     |     |     |            |     |    |     |   |     |    |     |   |     |    |     |   |       | 135 |    
|                                   | FHP senior notes(1)                          |                                  |       | 43    |       |      |     | 43   |     |      |     |     |     |            |     |    |     |   |     |    |     |   |     |    |     |   |       |    |    
|                                   | Database financing agreement                 |                                  |       | 11    |       |      |     | 3    |     |      |     | 5    |     |            |     | 3   |     |   |     |    |     |   |     |    |     |   |       |    |    
|                                   | Other                                        |                                  |       | 2     |       |      |     |     |     |      |     |     |     |            |     |    |     |   |     |    |     |   |     |    |     |   |       | 2   |    
|                                   |                                              |                                  |       |       |       |      |     |      |     |      |     |      |     |            |     |     |     |   |     |     |     |   |     |     |     |   |       |    
|                                   |                                              | Total long-term debt commitments |       |       | 839   |      |     |      | 107 |      |     |      | 86  |            |     |     | 12  |   |     |     |    |   |     |     |    |   |       |     | 634 | 
|                                   |                                              |                                  |       |       |       |      |     |      |     |      |     |      |     |            |     |     |     |   |     |     |     |   |     |     |     |   |       |    
|Other commitments:                 |                                              |                                  |       |       |       |      |     |      |     |      |     |      |     |            |     |     |     |   |     |     |     |   |     |     |     |   |       |    
|                                   | Information technology outsourcing contracts |                                  |       | 1,275 |       |      |     | 174  |     |      |     | 168  |     |            |     | 158 |     |   |     | 139 |     |   |     | 132 |     |   |       | 504 |    
|                                   | Operating leases                             |                                  |       | 176   |       |      |     | 41   |     |      |     | 34   |     |            |     | 28  |     |   |     | 25  |     |   |     | 21  |     |   |       | 27  |    
|                                   |                                              |                                  |       |       |       |      |     |      |     |      |     |      |     |            |     |     |     |   |     |     |     |   |     |     |     |   |       |    
|                                   |                                              | Total other commitments          |       |       | 1,451 |      |     |      | 215 |      |     |      | 202 |            |     |     | 186 |   |     |     | 164 |   |     |     | 153 |   |       |     | 531 | 
|                                   |                                              |                                  |       |       |       |      |     |      |     |      |     |      |     |            |     |     |     |   |     |     |     |   |     |     |     |   |       |    
|Total contractual cash obligations |                                              | $                                | 2,290 |       |       | $    | 322 |      |     | $    | 288 |      |     | $          | 198 |     |     | $ | 164 |     |     | $ | 153 |     |     | $ | 1,165 |    
|                                   |                                              |                                  |       |       |       |      |     |      |     |      |     |      |     |            |     |     |     |   |     |     |     |   |     |     |     |   |       |    



---



|    |                                                                                                                                                                         
|--- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | As of December 31, 2002, we had
    $43 million available in a restricted cash collateral
    account that will be used to repurchase or repay the FHP senior
    notes.

Other Balance Sheet Change
Explanations

Receivables, Net.Receivables, net as of
December 31, 2002, decreased $86 million from
December 31, 2001 as follows:



|  |                                                                                                                                                                                                                                                                                
|- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | $39 million decrease in provider
    receivables, primarily from collections of amounts owed by
    various providers in California and Texas;                                                                                                                                 
| 
| | $21 million decrease in premiums receivable
    primarily related to a reduction in membership and an increase
    in collection efforts, partially offset by premium rate
    increases;                                                                                      
| 
| | $11 million decrease in trade receivables,
    primarily due to the impact of lower 2002 rebates earned due to
    changes in senior prescription drug benefits, partially offset
    by increased billings for new unaffiliated pharmacy benefit
    management customers; and
| 
| | $15 million decrease in other receivables.                                                                                                                                                                                                                                     

Goodwill and Intangible Assets, Net.Goodwill and intangible assets as
of December 31, 2002 decreased 44% from December 31,
2001 due primarily to a $929 million goodwill impairment
charge (before the deferred tax impact) and $24 million of
intangible amortization expense. As more fully described in
Note 7 of the Notes to Consolidated Financial Statements,
we recorded impairment charges as the cumulative effect of a
change in accounting principle in connection with our adoption
of SFAS No. 142, Goodwill and Other Intangible
Assets, as of January 1, 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

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that may occur. As of December 31, 2002,
approximately 78% of medical claims and benefits payable was
attributable to risk-based contracts.


Medical claims and benefits payable as of
December 31, 2002 decreased $51 million from
December 31, 2001, primarily because senior shared-risk
membership has decreased 6% since December 31, 2001. This
senior membership decrease more than offset increased senior
health care costs trends.

Accounts Payable and Accrued Liabilities.Accounts payable and accrued
liabilities decreased $26 million from December 31,
2001, primarily due to the decrease in the OPM reserve, offset
in part by increased selling, general and administrative
expenses, as described in Results of
Operations  Selling, General and Administrative
Expenses.

Stockholders Equity.The decreases in treasury stock
and additional paid-in capital from December 31, 2001 were
primarily due to the reissuance of approximately
1,071,000 shares of treasury stock, of which approximately
421,000 shares were reissued under the equity commitment
arrangement, approximately 101,000 shares were reissued in
connection with the retirement of FHP senior notes and
approximately 549,000 shares were reissued in connection
with our employee benefit plans during the year ended
December 31, 2002.

Critical Accounting Policies and
Estimates

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

Incurred But Not Reported or Paid Claims
Reserves.We estimate the amount of
our reserves for incurred but not reported, 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, disputed claims activity, expected health care
cost inflation, utilization, seasonality patterns and changes in
membership. The estimates for submitted claims and IBNR claims
liabilities are made on an accrual basis and adjusted, based on
actual claims data, in future periods as required. For new
products, such as our PPO products, estimates are initially
based on health care cost data provided by third parties. This
data includes assumptions for member age, gender and geography.
The models that we use to prepare estimates for each product are
adjusted as we accumulate actual claims data. Such estimates
could materially understate or overstate our actual liability
for medical claims and benefits payable. These estimates are
reviewed by outside parties and state regulatory authorities on
a periodic basis. The estimates for submitted claims and IBNR
claims liabilities are made on an accrual basis and adjusted in
future periods as required. Adjustments to prior period
estimates, if any, are included in the current period.

Provider Insolvency Reserves.We maintain insolvency reserves for
our capitated contracts with providers that include estimates
for potentially insolvent providers, where conditions indicate
claims are not being paid or have slowed considerably. 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. These estimates could
materially understate or overstate our actual liability for
medical claims and benefits payable.

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

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

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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 below, that could cause actual
results to differ materially from those anticipated as of the
date of this report. In addition, past financial and/or
operating performance is not necessarily a reliable indicator of
future performance and you should not use our historical
performance to anticipate results or future period trends. In
evaluating these statements, you should specifically consider
the risks described below and in other parts of this report.
Except as required by law, we undertake no obligation to
publicly revise these forward-looking statements to reflect
events or circumstances that arise after the date of this report.

Risks Relating to Us and Our
Industry

We cannot predict whether we will be able to
replace some or all of the revenue we may lose in the future
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.

We have reduced our participation in the
Medicare+Choice program, which has accounted for more than 50%
of our total revenue in each year since 1998, because of
shortfalls in Medicare+Choice premiums compared to our rising
health care services expenses and increased Medicare
administration costs. These shortfalls contributed to our
decision to cease offering or close enrollment in our
Medicare+Choice products in various counties in 2000 through
2003, including our plan to withdraw our Medicare+Choice
products in five counties in California and Texas in 2003
affecting 37,000 members or approximately 5% of our senior
HMO membership. These shortfalls 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, together with the voluntary attrition
that we attribute to reduced benefits and increased premiums
resulted in a reduction of approximately 225,000 members in the
year ended December 31, 2002. We currently expect
Medicare+Choice membership to decline 11% during 2003, due
primarily to benefit design changes and our exit from five
counties affecting 37,000 members. 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 Medicare supplement product offerings or
other lines of business. We cannot predict whether or when 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 periods up to one year. In
addition, each of our subsidiaries that offers Medicare+Choice
products must submit adjusted community rate proposals,
generally by county or service area, to the CMS by
September 9 for each Medicare+Choice product that will be
offered in a subsequent year. As a result, increases in the
costs of health care services in excess of the estimated future
health care costs reflected in the premiums or the adjusted
community rate proposals generally cannot be recovered in the
applicable contract year through higher premiums or benefit
designs. 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.

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

We use our underwriting systems to establish and
assess premium rates based on accumulated actuarial data, with
adjustments for factors such as claims experience and hospital
and physician contract changes. We may be less able to
accurately price our new products than our other products
because of our relative lack of experience and accumulated data
for our new products. Our future profitability will depend in
part on our ability to predict health care costs and control
future health care costs through underwriting criteria, medical
and disease management programs, product design and negotiation
of favorable provider and hospital contracts, and we may be less
able to do so for our new products than for our other products.
These factors are of greater significance, to the extent that we
have entered into and may continue to increasingly enter into
fee-for-service contracts with hospitals and physicians due to
the continuing industry trend away from capitation contracts. In
addition, changes in demographic characteristics, the regulatory
environment, health care practices, inflation, new technologies,
continued consolidation of physician, hospital and other
provider groups, contractual disputes with providers and
numerous other factors may adversely affect our ability to
predict and control health care costs as well as our financial
condition, results of operations or cash flows.

Our financial and operating performance could
be adversely affected by a reduction in revenue caused by
membership losses, a failure to achieve expected membership
levels in new products or products targeted for growth, or
lower-than-expected premiums.

Our revenues have declined during 2002 compared
to 2001 due to commercial and senior membership losses,
primarily as a result of our exits of unprofitable markets and
products, termination of contracts with network providers and
increased premiums and benefit reductions. 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 result in lower revenues than
expected and 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 premium revenue 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;                  

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|  |                                                                                                                                                                             
|- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | our exit from selected service areas, including
    Medicare+Choice markets or commercial markets;                                                                          
| 
| | our limits on enrollment of new Medicare+Choice
    and commercial members in selected markets, through a
    combination of capacity waivers and voluntary closure notices;
| 
| | 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;                                                                        
| 
| | the loss of key sales and marketing employees; and                                                                                                                          
| 
| | the inability of our providers to accept
    additional members.                                                                                                            

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.

Providers with whom we have capitated contracts
could become insolvent and could expose us to unanticipated
expenses. We maintain insolvency reserves that include estimates
for potentially insolvent providers, where conditions indicate
claims are not being paid or have slowed considerably. Depending
on states laws, we may be held liable for unpaid health
care claims that were previously the responsibility of the
capitated provider and for which we have already paid
capitation. We may also incur additional health care costs in
the event of provider instability 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 with us, and in
third party institutions. Because our access to provider
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 claims if we are
ultimately denied access to these funds.

In 2001, the Texas legislature adopted changes to
legislation that 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 comply with the oversight requirements of the legislation.
As of December 31, 2002, our Texas subsidiary had contracts
with two capitated network providers that pay their own claims,
covering approximately 33,000 or 17% of our Texas membership. 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, or may
be the only health care provider available in that market. 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 in Texas in 2001. 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.

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Our results of operations could be adversely
affected by understatements in our actual liabilities caused by
understatements in our actuarial estimates of incurred but not
reported claims.

We estimate the amount of our reserves for
incurred but not reported (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, disputed claims activity, expected health care cost
inflation, utilization, seasonality patterns and changes in
membership. The estimates for submitted claims and IBNR claims
liabilities are made on an accrual basis and adjusted in future
periods as required. These estimates could materially understate
or overstate our actual liability for claims and benefits
payable. Any increases to these prior estimates could adversely
affect our results of operations in future periods.

If our claims processing system is unable to
handle an increasing claims volume and unable to meet regulatory
claims payment requirements, we may become subject to regulatory
actions. If our claims processing system is unable to process
claims accurately, our ability to accurately estimate claims
liabilities and establish related reserves could be adversely
affected.

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

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

Overall, prescription drug costs have been rising
for the past few years. The increases are due to the
introduction of new drugs 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 and expect to
continue to decrease these benefits in 2003. Despite these
efforts, however, we may be unable to adequately control this
health care cost component, which could adversely impact our
profitability.

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

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



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

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|  |                                                                                                                                                   
|- | --------------------------------------------------------------------------------------------------------------------------------------------------
| | the necessity to comply with regulatory
    requirements, 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 ability to estimate costs for our
    self-insured retention for medical malpractice claims;                                                  
| 
| | our inability to achieve efficiency goals and
    resulting cost savings from announced restructuring or other
    initiatives; and               
| 
| | our ability to estimate legal expenses and
    settlements associated with litigation that has been or could be
    brought against us.           

In addition, our selling, general and
administrative expenses as a percentage of our revenue could
increase due to changes in our product mix between senior and
commercial products and expected declines in our revenue, and
could be adversely affected if we exit Medicare+Choice or
commercial 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 expenses and/or our ability to execute portions of
our business strategy.

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 security and privacy requirements. We
currently estimate that our HIPAA compliance costs will
approximate $19 million in 2003 as well as another $1
million in capital expenditures. We continue to evaluate the
future work and costs that will be 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, as well as a lawsuit brought by
the State of Texas. 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 brought against us and other HMOs. The class action
lawsuits brought by health care providers allege that HMOs
claims processing systems automatically and impermissibly alter
codes included on providers reimbursement/claims forms to
reduce the amount of reimbursement, and that HMOs impose unfair
contracting terms on health care providers, impermissibly delay
making capitated payments under their capitated contracts, and
negotiate capitation payments that are inadequate to cover the
costs of health care services provided. The Jose Cruzlawsuit filed in November 1999 alleged that we engaged in a
number of purportedly undisclosed practices designed to limit
the amount and cost of health care services provided to members,
such as:



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

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|  |                                                                                                                                                                                            
|- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | manipulating determinations of whether health
    care services are medically necessary by excluding expensive
    procedures and treatments from being considered medically
    necessary.

In addition, as part of our lawsuit with the
State of Texas, the Texas Attorney General, or AG, alleges that
we violated Texas laws relating to prompt payment in connection
with the administration of our capitated contracts with three
insolvent physician groups. On March 21, 2003, we entered
into a binding memorandum of understanding, or MOU, with the
State of Texas, the AG and the Texas Department of Insurance, or
TDI, setting forth the principal terms of a settlement of all of
the pending litigation between the parties and related civil
investigations by the TDI. We cannot provide assurances that we
will be able to meet the conditions required to cause the
settlement to become effective.

These lawsuits, including those filed to date
against us, may take years to resolve and cause us to incur
substantial litigation expenses. Depending upon the outcomes of
these cases, these lawsuits may cause or force changes in
practices of the HMO industry, including our ability to settle
disputes with our providers by arbitration. 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.

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, including medical malpractice claims
related to our taking a more active role in managing the cost of
medical care. The loss of even one of these claims, if it
results in a significant punitive damage award, could have a
material adverse effect on our business. In addition, our
exposure to potential liability under punitive damage theories
may significantly decrease our ability to settle these claims on
reasonable terms. We maintain general liability, property,
managed care errors and omissions and medical malpractice
insurance coverage. We are at risk for our self-insured
retention on these claims, and are substantially self-insured
for medical malpractice 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 more than
50% of our total revenue in each year since 1998. CMS regulates
the benefits provided, premiums paid, quality assurance
procedures, marketing and advertising for our Medicare+Choice
products. CMS may terminate our Medicare+Choice contracts or
elect not to renew those contracts when those contracts come up
for renewal every 12 months. 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 2003 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.

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

We operate in highly competitive markets.
Consolidation of acute care hospitals and continuing
consolidation of insurance carriers, other HMOs, employer
self-funded programs and PPOs, some of which have substantially
larger enrollments or greater financial resources than ours, has
created competition for hospitals, physicians and members,
impacting profitability and the ability to influence medical
management. The cost of providing benefits is in many instances
the controlling factor in obtaining and retaining employer
groups as clients and some of our competitors have set premium
rates at levels below our rates for comparable products. We
anticipate that premium pricing will continue to be highly
competitive. In addition, 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.

Recently enacted or proposed legislation,
regulations and initiatives could materially and adversely
affect our business by increasing our operating costs,
increasing required capital amounts, 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 government or other payors, including reduced
    Medicare or commercial premiums, reduction of provider
    reimbursements, discontinuance of, or limitation on,
    governmentally funded programs, recovery by governmental payors
    of previously paid amounts, the inability to increase premiums
    or prospective or retroactive reductions to premium rates for
    federal employees;                                                                                                                                                
| 
| | draft compliance guidelines from the Office of
    Inspector General that propose voluntary guidelines for
    pharmaceutical manufacturers to establish internal controls,
    which, if implemented, may result in pharmaceutical companies
    restructuring the financial terms of their business arrangements
    with PBMs, HMOs or other health service plans;                                                                                                                                                                                                                                                     
| 
| | proposed legislation and regulation 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 and commercial 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 United States Supreme Court has ruled that state
    laws that establish independent review boards to which members
    can appeal when HMOs deny coverage for certain treatments or
    procedures are not pre-empted by The Employee Retirement Income
    Security Act of 1974, or ERISA;
| 
| | 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 or new 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;                                                                                                                                                                                                                                                                                                                                                                       

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|  |                                                                                                                                                                                                                                                                                                                                                                                                                              
|- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | state regulations that may increase the financial
    capital requirements of physicians and hospitals that contract
    with HMOs to accept financial risk for health services;                                                                                                                                                                                                                                             
| 
| | new and proposed state and federal legislation
    that would attempt to address increases in medical malpractice
    insurance premiums and tort reform;                                                                                                                                                                                                                                                                    
| 
| | 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, 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;
| 
| | new regulations requiring protection of the
    integrity and availability of personally identifiable health
    information which exists in electronic form, including the
    proposed HIPAA security standards;                                                                                                                                                                                                           
| 
| | new regulations that place additional
    restrictions and administrative requirements on the
    transmission, processing and receipt of electronic data as
    required by HIPAA; and                                                                                                                                                                                                                                      
| 
| | existing or new state and federal legislation and
    regulations governing the timely payment and administration of
    claims by HMOs and insurers, and imposing financial and other
    penalties for non-compliance.                                                                                                                                                                                                     

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 goodwill or 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.

We have a significant amount of indebtedness,
which could adversely affect our operations.

As of December 31 , 2002, we had
approximately $840 million of outstanding indebtedness.
Additionally, the total size of our committed revolving credit
facility was $36 million, of which at least
$35 million was available for borrowing. For the year ended
December 31, 2002, our aggregate interest expense was
approximately $75 million. Our debt service requirements
will increase if interest rates increase because indebtedness
under our senior credit facility, which represented
$151 million of our debt as of December 31, 2002,
bears interest at variable rates.

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



|  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | we could use a substantial portion of our
    consolidated cash flow from operations to pay principal and
    interest on our debt, thereby reducing the funds available 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                                                                                                                                                                                                                                                                                                                                                                                                                                                   

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|  |                                                                                                                                                            
|- | -----------------------------------------------------------------------------------------------------------------------------------------------------------
| | our debt service obligations increase our
    vulnerabilities to competitive pressures, because many of our
    competitors are less leveraged than we are.

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

Our senior credit facility and our 10 3/4%
senior notes limit, and in some circumstances prohibit, our
ability to:



|  |                                                                                                                    
|- | -------------------------------------------------------------------------------------------------------------------
| | incur additional indebtedness;                                                                                     
| 
| | create liens;                                                                                                      
| 
| | pay dividends and make distributions in respect
    of our capital stock and the capital stock of our subsidiaries;
| 
| | redeem capital stock;                                                                                              
| 
| | place restrictions on our subsidiaries
    ability to pay dividends, make distributions or transfer assets;       
| 
| | make investments or other restricted payments;                                                                     
| 
| | sell or otherwise dispose of assets;                                                                               
| 
| | enter into sale-leaseback transactions;                                                                            
| 
| | engage in transactions with stockholders and
    affiliates; and                                                   
| 
| | effect a consolidation or merger.                                                                                  

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

We could have to change our investment
practices in the future to avoid being deemed to be an
investment company under the Investment Company Act of 1940, as
amended, which could adversely affect our rate of return on our
investments and our results of operations.

Due to changes in accounting rules implemented in
2002, our legal structure and our recent operating results, we
may inadvertently fail the statistical test for being regulated
as an investment company under the Investment Company Act of
1940, as amended, or the Investment Company Act. The Investment
Company Act requires registration of, and imposes substantial
operating restrictions on, companies that engage, or propose to
engage, primarily in the business of investing, reinvesting,
owning, holding, or trading in securities, or that meet certain
statistical tests concerning a companys asset composition
and sources of income.

Because we are primarily engaged through our
existing operating subsidiaries in the health care and insurance
industries and we intend our future operating subsidiaries to be
engaged in these businesses or related consumer businesses, we
believe that we are primarily engaged in a business other than
investing, reinvesting, owning, holding or trading in securities
and that we are not an investment company. We are able to rely
on an SEC rule that exempts us from the requirement of
registering as an investment company for up to one year. In the
interim, we and our operating subsidiaries are seeking an order
from the SEC, declaring our HMO operating subsidiaries not to be
investment companies  so that we would

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be exempt from the provisions of the Investment
Company Act. The granting of this type of order is a matter of
SEC discretion and, therefore, we cannot assure you that it will
be granted to our HMO operating subsidiaries. Even if we were to
receive an SEC order, there can be no assurance that our
business activities would not ultimately subject us to
regulation under the Investment Company Act.


If the SEC does not grant the requested order, to
avoid registration under the Investment Company Act, we may have
to restructure our subsidiaries or our investments so that we do
not fail the statistical tests relating to asset composition.
These changes might include increasing the component of our
investments held in government securities or refraining from
buying or selling securities when we would otherwise not choose
to do so. This could have a negative impact on our results of
operations.

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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, 2002 and 2001. 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, 2002:

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

As of December 31, 2001:

|                                                        |                       |                        |   |        |   |      |   |         |   |      |   |        |   |       |   |            |   |  |   |         |   |  |   |         |   |  |   |           |   |  |   |           | 
|------------------------------------------------------- | --------------------- | ---------------------- | - | ------ | - | ---- | - | ------- | - | ---- | - | ------ | - | ----- | - | ---------- | - |  | - | ------- | - |  | - | ------- | - |  | - | --------- | - |  | - | --------- | 
|                                                        |                       | 2002                   |   | 2003   |   | 2004 |   | 2005    |   | 2006 |   | Beyond |   | Total |   | Fair Value
|                                                        |                       |                        |   |        |   |      |   |         |   |      |   |        |   |       |   |           
|                                                        |                       |                       
|                                                        |                       | (Amounts in thousands)
|Assets:                                                 |                       |                        |   |        |   |      |   |         |   |      |   |        |   |       |   |            |   |  |   |         |   |  |   |         |   |  |   |           |   |  |   |          
|Marketable securities:                                  |                       |                        |   |        |   |      |   |         |   |      |   |        |   |       |   |            |   |  |   |         |   |  |   |         |   |  |   |           |   |  |   |          
|                                                        | Fixed rate            |                        | $ | 83,975 |   |      | $ | 75,614  |   |      | $ | 37,610 |   |       | $ | 88,591     |   |  | $ | 116,463 |   |  | $ | 621,883 |   |  | $ | 1,024,136 |   |  | $ | 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   |   |  | $ | 113,001   | 
|                                                        | 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    | % |  |   |          |   |  |   |          | 

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ITEM
8.     CONSOLIDATED FINANCIAL
STATEMENTS AND SUPPLEMENTARY DATA

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






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

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

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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                 |  |     | 70 |       |  | Chairman of the Board                                                                          
|Howard G. Phanstiel           |  |     | 54 |       |  | Director, President and Chief Executive Officer                                                
|Bradley C. Call               |  |     | 60 |       |  | Director                                                                                       
|Shirley S. Chater, Ph.D.      |  |     | 70 |       |  | Director                                                                                       
|Terry O. Hartshorn            |  |     | 58 |       |  | Director                                                                                       
|Gary L. Leary                 |  |     | 68 |       |  | Director                                                                                       
|Sanford M. Litvack            |  |     | 66 |       |  | Director                                                                                       
|Dominic Ng                    |  |     | 44 |       |  | Director                                                                                       
|Warren E. Pinckert II         |  |     | 59 |       |  | Director                                                                                       
|Charles R. Rinehart           |  |     | 56 |       |  | Director                                                                                       
|Lloyd E. Ross                 |  |     | 62 |       |  | Director                                                                                       
|                             
|Corporate Executive Officers  |  |     |    |       |  |                                                                                                
|Bradford A. Bowlus            |  |     | 47 |       |  | Executive Vice President and President and Chief
    Executive Officer, PacifiCare Health Plans
|Katherine F. Feeny            |  |     | 50 |       |  | Executive Vice President, Senior Solutions                                                     
|Sharon D. Garrett, Ph.D.      |  |     | 54 |       |  | Executive Vice President, Enterprise Services                                                  
|Joseph S. Konowiecki          |  |     | 49 |       |  | Executive Vice President, General Counsel and
    Secretary                                    
|Jacqueline B. Kosecoff, Ph.D. |  |     | 53 |       |  | Executive Vice President, Pharmaceutical Services                                              
|Gregory W. Scott              |  |     | 49 |       |  | Executive Vice President and Chief Financial
    Officer                                       
|Peter A. Reynolds             |  |     | 44 |       |  | Senior Vice President, Corporate Controller                                                    

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.

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 was President and Chief Executive Officer of
Stellex Aerospace, Inc., a privately held aerospace component
manufacturing firm with multiple plant operations throughout the
U.S., from 1988 to 2001. Mr. Call was a member of the board
of directors of UniHealth Foundation from 1998 until June 2001,
and its predecessor UniHealth from 1995 to 1998. Mr. Call
became a member of the board of directors of UniHealth
Foundation again in November 2002.

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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.

Mr. Leary was appointed to our Board in 1989
and is an independent business and legal consultant. From 1997
to 1998, Mr. Leary served as General Counsel 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 1997. 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 January 2003, Mr. Litvack joined the law
firm of Quinn, Emmanuel, Urquhart, Oliver and Hedges, LLP as a
partner. From 2001 to 2003, Mr. Litvack was of counsel to
the law firm of Dewey Ballantine LLP where he specialized 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. 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 Hewlett-Packard Company.

Mr. Ng was appointed to our Board in
February 2003 and has served as President and Chief Executive
Officer of East West Bancorp since 1992 and as Chairman of its
board of directors since 1998. Mr. Ng is a member of the
board of directors of ESS Technology, Inc. and is a certified
public accountant.

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. Mr. Pinckert
is a certified public accountant.

Mr. Rinehart was appointed to our Board in
February 2003 and is a member of the board of directors of
UnionBanCal Corporation. From 1995 through 1998,
Mr. Rinehart was Chairman and Chief Executive Officer of HF
Ahmanson & Co. and its principal subsidiary, Home
Savings of America.

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. 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 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 was
Senior Vice President, Secure Horizons Sales and Marketing from
2000 to January 2002. 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.

Dr. Garrett was appointed Executive Vice
President, Enterprise Services in December 2002. From 2000 to
December 2002, Dr. Garrett provided interim executive
management expertise to large companies in

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various industries. Dr. Garrett served as Chief
Information Officer of the Walt Disney Company from 1989 to 2000.


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 K & R Law
Group LLP (formerly known as Konowiecki & Rank LLP),
including a professional corporation, or its predecessor from
1980 to December 2001, and has over 22 years of practice in
business, corporate and health care law.

Dr. Kosecoff was appointed Executive Vice
President, Pharmaceutical Services in July 2002.
Dr. Kosecoff was Founder, President and Chief Operating
Officer of Protocare, a firm whose line of business include the
clinical development of drugs, devices, biopharmaceutical and
nutritional products and health services consulting, from 1998
to July 2002.

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.

Mr. Reynolds was appointed Senior Vice
President, Corporate Controller in October 2002.
Mr. Reynolds was Vice President of Finance and Assistant
Corporate Controller from December 2001 to 2002. From 1997 to
2001, Mr. Reynolds was Controller of PacifiCare of California.




SECTION 16(A) BENEFICIAL OWNERSHIP REPORTING
COMPLIANCE

We believe that during 2002, 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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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 |  | All Other   
|                            |                               |                     |      | Compensation        |  | Stock Awards |         | Underlying |  | Compensation
|Name and Principal Position |                               | Year                |      | Salary($)           |  | Bonus($)(1)  |         | ($)(2)     |  | ($)(3)       |           | Options(#) |  | ($)(4)
|                            |                               |                     |      |                     |  |              |         |            |  |              |           |            |  |       
|Howard G. Phanstiel(5)      |                               |                     | 2002 |                     |  |              | 917,309 |            |  |              | 1,690,000 |            |  |        | 330,160 |         |  |  |        |         |  |  | 400,000 |         |  |  | 68,312 |       
|                            | President and                 |                     |      | 2001                |  |              |         | 900,001    |  |              |           | 360,000    |  |        |         | 95,642  |  |  |         |        |  |  |         |        |  |  |        | 75,396 | 
|                            | Chief Executive Officer       |                     |      | 2000                |  |              |         | 259,808    |  |              |           | 450,000    |  |        |         | 9,962   |  |  |         |        |  |  |         | 500,000 |  |  |        | 8,423  | 
|Bradford A. Bowlus          |                               |                     | 2002 |                     |  |              | 600,001 |            |  |              | 780,000   |            |  |        | 196,348 |         |  |  |        |         |  |  | 175,000 |         |  |  | 42,228 |       
|                            | Executive Vice President      |                     |      | 2001                |  |              |         | 600,001    |  |              |           | 180,144    |  |        |         | 101,534 |  |  |         |        |  |  |         | 150,000 |  |  |        | 50,162 | 
|                            | and President and CEO,        |                     |      | 2000                |  |              |         | 600,001    |  |              |           | 200,000    |  |        |         |        |  |  |         |        |  |  |         | 100,000 |  |  |        | 45,100 | 
|                            | PacifiCare Health Plans       |                     |      |                     |  |              |         |            |  |              |           |            |  |        |         |         |  |  |         |         |  |  |         |         |  |  |        |        | 
|Joseph S. Konowiecki(6)     |                               |                     | 2002 |                     |  |              | 547,887 |            |  |              | 800,000   |            |  |        | 136,511 |         |  |  |        |         |  |  | 300,000 |         |  |  | 24,362 |       
|                            | Executive Vice President,     |                     |      | 2001                |  |              |         | 132,000    |  |              |           |           |  |        |         |        |  |  |         | 982,500 |  |  |         |        |  |  |        |       | 
|                            | General Counsel and Secretary |                     |      | 2000                |  |              |         | 132,000    |  |              |           |           |  |        |         |        |  |  |         |        |  |  |         | 35,000  |  |  |        |       | 
|Gregory W. Scott(7)         |                               |                     | 2002 |                     |  |              | 501,696 |            |  |              | 650,000   |            |  |        | 195,788 |         |  |  | 275,700 |         |  |  | 150,000 |         |  |  | 38,292 |       
|                            | Executive Vice President and  |                     |      | 2001                |  |              |         | 471,155    |  |              |           | 275,050    |  |        |         | 140,170 |  |  |         |        |  |  |         | 150,000 |  |  |        | 17,665 | 
|                            | Chief Financial Officer       |                     |      | 2000                |  |              |         |           |  |              |           |           |  |        |         |        |  |  |         |        |  |  |         |        |  |  |        |       | 
|Katherine F. Feeny          |                               |                     | 2002 |                     |  |              | 374,910 |            |  |              | 206,250   |            |  |        | 62,139  |         |  |  |        |         |  |  | 30,000  |         |  |  | 25,382 |       
|                            | Executive Vice President,     |                     |      | 2001                |  |              |         | 249,999    |  |              |           | 90,000     |  |        |         | 23,074  |  |  |         |        |  |  |         | 20,000  |  |  |        | 10,488 | 
|                            | Senior Solutions              |                     |      | 2000                |  |              |         | 249,999    |  |              |           | 49,500     |  |        |         | 30,611  |  |  |         |        |  |  |         |        |  |  |        | 10,488 | 



---



|    |                                                                                                                                                                                                                                                                                                                                                                                                                                          
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(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. Konowiecki in
    2002 and $100,000 for Mr. Scott 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 forgiveness of loans that were made prior to the
    passage of the Sarbanes-Oxley Act of 2002 pursuant to automatic
    forgiveness terms in the loans, relocation expenses and other
    perquisites as shown in the following chart.

|               |  |             |        |                     |  |                   |       |       |  |      |        |      |  |      |        |      |  |      |        |  |  |   |        |  |  |   |        |  |  |   |         |  |  |   |        | 
|-------------- |  | ----------- | ------ | ------------------- |  | ----------------- | ----- | ----- |  | ---- | ------ | ---- |  | ---- | ------ | ---- |  | ---- | ------ |  |  | - | ------ |  |  | - | ------ |  |  | - | ------- |  |  | - | ------ | 
|               |  | Forgiveness |        |                     |  |                   |       |      
|               |  | of Loan     |        | Relocation Expenses |  | Other Perquisites |       | Total
|               |  |             |        |                     |  |                   |       |      
|               |  | 2002        |        | 2002                |  | 2001              |       | 2002  |  | 2001 |        | 2000 |  | 2002 |        | 2001 |  | 2000
|               |  |             |        |                     |  |                   |       |       |  |      |        |      |  |      |        |      |  |     
|Mr. Phanstiel  |  | $           |       |                     |  | $                 |      |       |  | $    |       |      |  | $    | 59,760 |      |  | $    | 23,642 |  |  | $ | 9,962  |  |  | $ | 59,760 |  |  | $ | 23,642  |  |  | $ | 9,962  | 
|Mr. Bowlus     |  | $           |       |                     |  | $                 |      |       |  | $    |       |      |  | $    | 40,348 |      |  | $    | 65,505 |  |  | $ |       |  |  | $ | 40,348 |  |  | $ | 65,505  |  |  | $ |       | 
|Mr. Konowiecki |  | $           |       |                     |  | $                 |      |       |  | $    |       |      |  | $    | 26,511 |      |  | $    |       |  |  | $ |       |  |  | $ | 26,511 |  |  | $ |        |  |  | $ |       | 
|Mr. Scott      |  | $           | 27,340 |                     |  | $                 | 1,757 |       |  | $    | 82,116 |      |  | $    | 36,391 |      |  | $    | 23,044 |  |  | $ |       |  |  | $ | 65,788 |  |  | $ | 105,160 |  |  | $ |       | 
|Ms. Feeny      |  | $           |       |                     |  | $                 |      |       |  | $    |       |      |  | $    | 20,889 |      |  | $    | 23,074 |  |  | $ | 30,611 |  |  | $ | 20,889 |  |  | $ | 23,074  |  |  | $ | 30,611 | 



| |  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
| |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | SEC regulations exclude from reporting
    requirements a named executive officers perquisites if the
    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 and signing 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

57



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##### Table of Contents



| |  |                                                                                                                                                                                               
| |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | made in shares of common stock. In 2002, 2001 and
    2000, 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  |  |  | 2002 |             |  |            | 676,000 |          |  |  | 270,400 |  |  |  | 59,150 | 
|               |  |  | 2001 |             |  |            | 180,000 |          |  |  | 72,000  |  |  |  | 16,800 | 
|Mr. Bowlus     |  |  | 2002 |             |  |            | 390,000 |          |  |  | 156,000 |  |  |  | 34,125 | 
|               |  |  | 2001 |             |  |            | 90,072  |          |  |  | 36,029  |  |  |  | 8,407  | 
|Mr. Konowiecki |  |  | 2002 |             |  |            | 275,000 |          |  |  | 110,000 |  |  |  | 24,063 | 
|Mr. Scott      |  |  | 2002 |             |  |            | 325,000 |          |  |  | 130,000 |  |  |  | 28,438 | 
|               |  |  | 2001 |             |  |            | 87,525  |          |  |  | 35,010  |  |  |  | 8,169  | 
|Ms. Feeny      |  |  | 2002 |             |  |            | 103,125 |          |  |  | 41,250  |  |  |  | 9,024  | 



|    |                                                                                                                                                                                                                                                                                                               
|--- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(3) | On January 2, 2001, we granted
    Mr. Konowiecki 60,000 shares of restricted common stock.
    The shares vest in equal installments on January 2, 2002,
    2003, 2004 and 2005. As of December 31, 2002, the remaining
    unvested shares underlying this grant had a fair market value of
    $1,264,500.
|   
|    | On May 28, 2002, we granted Mr. Scott
    10,000 shares of restricted common stock. The shares vest in
    equal installments on May 28, 2003, 2004 and 2005. As of
    December 31, 2002, unvested shares underlying this grant
    had a fair market value of $281,000.                                     
|   
|(4) | 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
|               |  |             |        |                           
|               |  | 2002        |        | 2001                       |  | 2000 |        | 2002 |  | 2001 |        | 2000
|               |  |             |        |                            |  |      |        |      |  |      |        |     
|Mr. Phanstiel  |  | $           | 11,500 |                            |  | $    | 10,200 |      |  | $    | 8,423  |      |  | $ | 56,416 |  |  | $ | 64,800 |  |  | $ |       | 
|Mr. Bowlus     |  | $           | 11,500 |                            |  | $    | 9,889  |      |  | $    | 10,200 |      |  | $ | 30,332 |  |  | $ | 39,877 |  |  | $ | 34,610 | 
|Mr. Konowiecki |  | $           | 11,500 |                            |  | $    |       |      |  | $    |       |      |  | $ | 12,565 |  |  | $ |       |  |  | $ |       | 
|Mr. Scott      |  | $           | 11,500 |                            |  | $    | 7,408  |      |  | $    |       |      |  | $ | 26,396 |  |  | $ | 9,993  |  |  | $ |       | 
|Ms. Feeny      |  | $           | 11,500 |                            |  | $    | 10,200 |      |  | $    | 10,200 |      |  | $ | 13,486 |  |  | $ |       |  |  | $ |       | 



|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|    | 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.                                         
|   
|(5) | Mr. Phanstiel joined us in July 2000.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|   
|(6) | Mr. Konowiecki joined us as an employee in
    January 2002. Prior to his employment, Mr. Konowiecki
    served as our Executive Vice President since 1999, General
    Counsel since 1989 and Secretary since 1993. On
    December 31, 2001, Mr. Konowieckis professional
    corporation withdrew as a partner of K&R Law Group LLP
    (formerly known as Konowiecki & Rank LLP), or K&R, an
    outside law firm that provides legal services to us. Prior to
    such withdrawal, Mr. Konowieckis professional
    corporation, as a partner of K&R, received a share of
    K&Rs net income, which amounts were in addition to the
    amounts listed above.
|   
|(7) | Mr. Scott 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 2002

|                     |  |               |         |            |  |             |    |            |  |               |        |  |  |  |         |  |  |  |           | 
|-------------------- |  | ------------- | ------- | ---------- |  | ----------- | -- | ---------- |  | ------------- | ------ |  |  |  | ------- |  |  |  | --------- | 
|                     |  |               |         | Percentage |  |             |    |            |  |              
|                     |  | Number of     |         | of Options |  | Exercise or |    |            |  |              
|                     |  | Securities    |         | Granted to |  | Base Price  |    |            |  | Grant Date   
|                     |  | Underlying    |         | Employees  |  | Per Share   |    | Expiration |  | Present Value
|Name                 |  | Options(#)(1) |         | in 2002    |  | ($/SH)(2)   |    | Date       |  | ($)(3)       
|                     |  |               |         |            |  |             |    |            |  |              
|Howard G. Phanstiel  |  |               | 400,000 |            |  |             | 22 |            |  |               | 18.380 |  |  |  | 1/24/12 |  |  |  | 5,332,490 | 
|Bradford A. Bowlus   |  |               | 175,000 |            |  |             | 10 |            |  |               | 18.380 |  |  |  | 1/24/12 |  |  |  | 2,332,964 | 
|Joseph S. Konowiecki |  |               | 300,000 |            |  |             | 16 |            |  |               | 16.080 |  |  |  | 1/02/12 |  |  |  | 3,498,900 | 
|Gregory W. Scott     |  |               | 150,000 |            |  |             | 8  |            |  |               | 18.380 |  |  |  | 1/24/12 |  |  |  | 1,999,684 | 
|Katherine F. Feeny   |  |               | 30,000  |            |  |             | 2  |            |  |               | 18.380 |  |  |  | 1/24/12 |  |  |  | 399,937   | 



---



|    |                                                                                                                                                                         
|--- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | Option grants in 2002 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 that have been held for more than six
    months, and that are 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:



| |   |                                          
| | - | -----------------------------------------
| |  | $16.080 were granted on January 2, 2002. 
|
| |  | $18.380 were granted on January 24, 2002.



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

|                               |  |  |         | 
|------------------------------ |  |  | ------- | 
| Expected Volatility          |  |  | 83%     | 
| Risk-Free Interest Rate      |  |  | 4%      | 
| Expected Life until Exercise |  |  | 4 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.

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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 2002 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  |  |             |       |          |  |                        |        |                      |  |             | 250,000 |               |  |  | 650,000 |  |  |  | 2,405,625 |  |  |  | 6,293,625 | 
|Bradford A. Bowlus   |  |             | 11,000 |          |  |                        | 128,975 |                      |  |             | 320,000 |               |  |  | 372,500 |  |  |  | 310,713   |  |  |  | 3,020,063 | 
|Joseph S. Konowiecki |  |             |       |          |  |                        |        |                      |  |             | 229,000 |               |  |  | 317,500 |  |  |  |          |  |  |  | 3,606,000 | 
|Gregory W. Scott     |  |             |       |          |  |                        |        |                      |  |             | 37,500  |               |  |  | 262,500 |  |  |  | 404,531   |  |  |  | 2,671,594 | 
|Katherine F. Feeny   |  |             |       |          |  |                        |        |                      |  |             | 17,621  |               |  |  | 41,550  |  |  |  | 103,300   |  |  |  | 394,900   | 



---



|    |                                      
|--- | -------------------------------------
|(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, 2002 closing market price ($28.10 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. The
benefits are not subject to any deduction for Social Security or
other offset amounts.

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, 2003 for the eligible named executive
officers are six years for Mr. Phanstiel and one year for
Mr. Bowlus, Mr. Konowiecki, Mr. Scott and
Ms. Feeny.

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. Konowiecki and Mr. Scott have
three year terms, and Ms. Feeny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 provided 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 and Mr. Scott, 36 months for
Mr. Bowlus and Mr. Konowiecki, and 18 months for
Ms. Feeny. 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                              

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|  |                                                                                                                                 
|- | --------------------------------------------------------------------------------------------------------------------------------
| | any other bonus amounts or benefits to which the
    named executive officer may be entitled under any of our benefit
    plans.

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

As of December 31, 2002, 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), if
termination occurred on that date, would be approximately
$3,620,400 to Mr. Phanstiel, $3,000,600 to Mr. Bowlus,
$2,753,100 to Mr. Konowiecki, $1,670,400 to Mr. Scott
and $885,400 to Ms. Feeny.

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. Bowlus, Mr. Konowiecki and Mr. Scott and 24
months of benefits for Ms. Feeny. The lump-sum payments
would include the same items described under Termination
Without Cause,plus the following:



|  |                                                                                                 
|- | ------------------------------------------------------------------------------------------------
| | prorated annual incentive plan bonus for the year
    in which the change of control occurs, 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.

As of December 31, 2002, 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), if termination occurred as of
that date, would be approximately $5,430,600 to
Mr. Phanstiel, $3,000,600 to Mr. Bowlus, $2,753,100 to
Mr. Konowiecki, $2,505,600 to Mr. Scott and $1,180,500
to Ms. Feeny.

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 our termination of them after a change of control;

62



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|  |                                                                                                                                                               
|- | --------------------------------------------------------------------------------------------------------------------------------------------------------------
| | 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 and Mr. Konowiecki 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 the premium priced options outstanding is
$92.50 per share. The premium priced options expire in October
2007. The maximum cash payments under this program could total
approximately $3 million for Mr. Bowlus and
$2 million for Mr. Konowiecki.

DIRECTOR COMPENSATION

For compensation purposes, board years begin each
July 1 and end the following June 30. We do not pay
directors who are also our employees additional compensation for
their service as directors. In 2002, 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 early 2003, the board approved retainers for
the Chairman of the Board and committee chairpersons, in
addition to the annual retainer described above. The chairman
will receive $75,000 annually. The Audit, Finance and Ethics
Committee chairperson will receive $20,000 annually, the
Compensation Committee chairperson will receive $10,000
annually, and all other committee chairpersons will receive
$5,000 annually. The committee chairpersons will receive a five
months prorated amount for their services over the period
February 1, 2003 through June 30, 2003. Also effective
February 1, 2003, committee chairpersons receive the same
per-meeting fees as those paid to non-committee chairpersons,
now totaling $1,500 per meeting (with telephone attendance paid
at 50%).

Annual retainers are paid to the directors each
July 1 for the succeeding board year. New directors,
including Messrs. Ng and Rinehart in 2003, receive a
pro-rata amount of the annual retainer for their service on the
board from their start date through June 30. Board members
who leave before their annual board year is complete are
required to repay the pro-rata portion of the retainer for the
unserved months.

Stock Units

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, and a risk premium is 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

63



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##### Table of Contents



stock. Beginning with the 2002-2003 board year,
each director is 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.


Stock Options

In 2002, 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
received 10,000 options. These options were granted on
July 1, 2002 with an exercise price of $25.85 per share.

For the 2002-2003 board year that began on
July 1, 2002, each non-employee director had the ability to
receive one-half of his or her annual retainer, or $20,000, in
stock options rather than cash. The number of shares underlying
the options granted were 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 July 1, 2002. Based on this formula,
Mr. Litvack and Mr. Reed were granted options to
purchase 3,095 shares each, with an exercise price of $25.85 per
share. In early 2003, the board removed the ability to defer any
portion of the annual retainer into stock options, effective
with the 2003-2004 board year that will begin on July 1,
2003.

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.
Messrs. Ng and Rinehart were awarded such options when they
joined the board in early 2003. These options were granted on
February 20, 2003 with an exercise price of $22.17 per
share.

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

Our directors are eligible, at their election, to
receive medical and dental coverage under our health care
programs. The benefits received in 2002 were valued at
approximately $11,000 for Mr. Call, $500 for
Dr. Chater, $8,100 for Mr. Hartshorn, $900 for
Mr. Leary, $900 for Mr. Reed and $8,100 for
Mr. Ross.

Chairman of the Board

During 2002, Mr. Reed received $75,000 for
his services as chairman under a consulting agreement. In
addition to the annual consulting fees, Mr. Reed also
received all of the items described under Cash
Compensation. On September 17, 2002, Mr. Reed
terminated his consulting agreement effective September 30,
2002. Mr. Reed continues to serve as Chairman of our board.

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, the directors
and executive officers as a group and owners of more than 5% of
our outstanding common stock, as of February 28, 2003.

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)                                    |  |           | 4,383,600 |            |  |             |          |  |  |  | 12.1 | 
|FMR Corp.(5)                                                            |  |           | 3,518,863 |            |  |             |          |  |  |  | 9.7  | 
|Par Capital Management, Inc.(6)                                         |  |           | 2,240,900 |            |  |             |          |  |  |  | 6.2  | 
|Goldman Sachs Asset Management(7)                                       |  |           | 1,817,444 |            |  |             |          |  |  |  | 5.0  | 
|David A. Reed                                                           |  |           | 1,000     |            |  |             | 97,623    |  |  |  | *    | 
|Howard G. Phanstiel                                                     |  |           | 65,069    |            |  |             | 350,000   |  |  |  | 1.1  | 
|Bradley C. Call                                                         |  |           | 1,000     |            |  |             | 55,784    |  |  |  | *    | 
|Shirley S. Chater, Ph.D.                                                |  |           |          |            |  |             | 40,852    |  |  |  | *    | 
|Terry O. Hartshorn                                                      |  |           | 204,732   |            |  |             | 100,778   |  |  |  | *    | 
|Gary L. Leary                                                           |  |           | 1,000     |            |  |             | 66,778    |  |  |  | *    | 
|Sanford M. Litvack                                                      |  |           |          |            |  |             | 43,089    |  |  |  | *    | 
|Dominic Ng                                                              |  |           |          |            |  |             | 25,000    |  |  |  | *    | 
|Warren E. Pinckert II                                                   |  |           | 1,632     |            |  |             | 61,784    |  |  |  | *    | 
|Charles R. Rinehart                                                     |  |           |          |            |  |             | 25,000    |  |  |  | *    | 
|Lloyd E. Ross                                                           |  |           | 5,600     |            |  |             | 66,778    |  |  |  | *    | 
|Bradford A. Bowlus                                                      |  |           | 7,055     |            |  |             | 411,250   |  |  |  | 1.1  | 
|Katherine F. Feeny                                                      |  |           | 589       |            |  |             | 25,121    |  |  |  | *    | 
|Joseph S. Konowiecki                                                    |  |           | 77,517    |            |  |             | 304,000   |  |  |  | 1.0  | 
|Gregory W. Scott                                                        |  |           | 18,747    |            |  |             | 112,500   |  |  |  | *    | 
|All Directors and Executive Officers as a
    Group(8)
    (18 persons) |  |           | 397,059   |            |  |             | 1,791,787 |  |  |  | 5.8  | 



---



| |   |             
| | - | ------------
| | * | 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,
    2003.           
|   
|(3) | The percentage of beneficial ownership is based
    on 36,098,700 shares of common stock outstanding as of
    February 28, 2003.

65



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|    |                                                                                                                                                                                                                                                    
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(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.
|   
|(5) | Based on information contained in a report on
    Schedule 13-G/A filed with the SEC on February 14,
    2003. The address of FMR Corp. is 82 Devonshire Street,
    Boston, Massachusetts 02109.                                                  
|   
|(6) | 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.               
|   
|(7) | Based on information contained in a report on
    Schedule 13-G filed with the SEC on February 12, 2003.
    The address of Goldman Sachs Asset Management is 1 New York
    Plaza, New York, New York 10004.                                      
|   
|(8) | In addition to the officers and directors named
    in this table, three other executive officers are members of the
    group.                                                                                                                    

EQUITY-BASED INSTRUMENTS HELD BY
MANAGEMENT

The following table shows the equity-based
instruments, other than common stock and restricted stock, held
by our directors and executive officers as of February 28,
2003.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      |               |              |  |             
|                         |  |               |         |                 |  | Deferred       |               |              |  |             
|                         |  |               |         |                 |  | Stock Units    |               | Distribution |  | Total       
|                         |  | Number of     |         | Exercise Price  |  | and Restricted |               | Price        |  | Equity-Based
|                         |  | Stock Options |         | Range Per Share |  | Stock Units    |               | Range/Share  |  | Instruments 
|Name                     |  | Held(#)       |         | ($/SH)          |  | Held(#)(1)     |               | ($/SH)       |  | Held(#)     
|                         |  |               |         |                 |  |                |               |              |  |             
|Directors                |  |               |         |                 |  |                |               |              |  |              |       |  |  |  |               |  |  |  |         | 
|David A. Reed            |  |               | 97,623  |                 |  |                | 16.02 - 87.00 |              |  |              | 2,333 |  |  |  | 16.02 - 25.85 |  |  |  | 99,956  | 
|Bradley C. Call          |  |               | 55,784  |                 |  |                | 16.30 - 79.50 |              |  |              | 1,249 |  |  |  | 16.02         |  |  |  | 57,033  | 
|Shirley S. Chater, Ph.D. |  |               | 40,852  |                 |  |                | 13.67 - 25.85 |              |  |              | 2,548 |  |  |  | 13.67 - 25.85 |  |  |  | 43,400  | 
|Terry O. Hartshorn       |  |               | 100,778 |                 |  |                | 16.02 - 85.25 |              |  |              | 2,333 |  |  |  | 16.02 - 25.85 |  |  |  | 103,111 | 
|Gary L. Leary            |  |               | 66,778  |                 |  |                | 16.02 - 87.00 |              |  |              | 2,333 |  |  |  | 16.02 - 25.85 |  |  |  | 69,111  | 
|Sanford M. Litvack       |  |               | 43,089  |                 |  |                | 16.02 - 38.50 |              |  |              | 2,333 |  |  |  | 16.02 - 25.85 |  |  |  | 45,422  | 
|Dominic Ng               |  |               | 25,000  |                 |  |                | 22.17         |              |  |              |      |  |  |  |              |  |  |  | 25,000  | 
|Warren E. Pinckert II    |  |               | 61,784  |                 |  |                | 16.30 - 87.00 |              |  |              | 1,249 |  |  |  | 16.02         |  |  |  | 63,033  | 
|Charles R. Rinehart      |  |               | 25,000  |                 |  |                | 22.17         |              |  |              |      |  |  |  |              |  |  |  | 25,000  | 
|Lloyd E. Ross            |  |               | 66,778  |                 |  |                | 16.02 - 87.00 |              |  |              | 2,333 |  |  |  | 16.02 - 25.85 |  |  |  | 69,111  | 

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|                                                                    |  |               |           |                 |  |                |               |              |  |              |         |  |  |  |               |  |  |  |           | 
|------------------------------------------------------------------- |  | ------------- | --------- | --------------- |  | -------------- | ------------- | ------------ |  | ------------ | ------- |  |  |  | ------------- |  |  |  | --------- | 
|                                                                    |  |               |           |                 |  | Number of      |               |              |  |             
|                                                                    |  |               |           |                 |  | Deferred       |               |              |  |             
|                                                                    |  |               |           |                 |  | Stock Units    |               | Distribution |  | Total       
|                                                                    |  | Number of     |           | Exercise Price  |  | and Restricted |               | Price        |  | Equity-Based
|                                                                    |  | Stock Options |           | Range Per Share |  | Stock Units    |               | Range/Share  |  | Instruments 
|Name                                                                |  | Held(#)       |           | ($/SH)          |  | Held(#)(1)     |               | ($/SH)       |  | Held(#)     
|                                                                    |  |               |           |                 |  |                |               |              |  |             
|Executive Officers                                                  |  |               |           |                 |  |                |               |              |  |              |         |  |  |  |               |  |  |  |           | 
|Howard G. Phanstiel                                                 |  |               | 1,125,000 |                 |  |                | 12.06 - 57.88 |              |  |              | 150,950 |  |  |  | 15.00 - 28.50 |  |  |  | 1,275,950 | 
|Bradford A. Bowlus                                                  |  |               | 780,000   |                 |  |                | 16.38 - 92.50 |              |  |              | 71,699  |  |  |  | 15.00 - 28.50 |  |  |  | 851,699   | 
|Joseph S. Konowiecki                                                |  |               | 606,500   |                 |  |                | 16.08 - 92.50 |              |  |              | 44,063  |  |  |  | 16.00 - 28.50 |  |  |  | 650,563   | 
|Gregory W. Scott                                                    |  |               | 375,000   |                 |  |                | 17.31 - 28.55 |              |  |              | 61,607  |  |  |  | 15.00 - 28.50 |  |  |  | 436,607   | 
|Katherine F. Feeny                                                  |  |               | 96,671    |                 |  |                | 17.77 - 53.88 |              |  |              | 21,524  |  |  |  | 16.00 - 28.50 |  |  |  | 118,195   | 
|All Directors and Executive Officers as a
    Group(2) (18 persons) |  |               | 3,789,737 |                 |  |                | 12.06- 92.50  |              |  |              | 416,950 |  |  |  | 13.67 - 28.50 |  |  |  | 4,206,687 | 



---



|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|--- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | In January of 2003, we granted, under the 1996
    Stock Option Plan for Officers and Key Employees, as amended, or
    1996 Officers Plan, shares of restricted common stock, or
    Restricted Stock, to certain officers and employees. The
    Restricted Stock granted to our Senior Executives generally vest
    over a four year period. To allow for the deferral of receipt of
    the Restricted Stock by vice presidents and above, or Senior
    Executives, we amended our Stock Unit Deferred Compensation
    Plan, or Stock Unit Plan. Senior vice presidents and above were
    required to defer receipt of their Restricted Stock under the
    Stock Unit Plan for a minimum of four years from the date of
    grant. Vice presidents, who elected to defer receipt of their
    Restricted Stock, were not subject to any minimum deferral
    period. Upon deferral, the Restricted Stock was converted into
    an equal number of restricted common stock units, or Restricted
    Stock Units. The Restricted Stock Units vest pursuant to the
    original vesting schedule for the Restricted Stock. Upon
    expiration of the deferral period, Senior Executives will
    receive shares of common stock equal to the number of vested
    shares underlying the Restricted Stock Units and shares of
    restricted common stock if a Senior Executive elected a deferral
    period shorter than the vesting schedule. Vesting of the
    Restricted Stock accelerates upon the occurrence of certain
    events.
|   
|(2) | In addition to the directors and officers named
    in this table, three other executive officers are members of
    this group.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  

EQUITY COMPENSATION PLAN INFORMATION

The following table provides information relating
to our equity compensation plans as of December 31, 2002:

|                                                                  |  |                         |           |                               |  |                                 |         |  |  |  |           | 
|----------------------------------------------------------------- |  | ----------------------- | --------- | ----------------------------- |  | ------------------------------- | ------- |  |  |  | --------- | 
|                                                                  |  |                         |           |                               |  | Number of securities           
|                                                                  |  |                         |           |                               |  | remaining available for        
|                                                                  |  | Number of securities to |           |                               |  | future issuance under          
|                                                                  |  | be issued upon exercise |           | Weighted-average exercise     |  | equity compensation plans      
|                                                                  |  | of outstanding options, |           | price of outstanding options, |  | (excluding securities reflected
|Plan Category                                                     |  | warrants and rights(#)  |           | warrants and rights($)        |  | in column (a))(#)              
|                                                                  |  |                         |           |                               |  |                                
|                                                                  |  | (a)                     |           | (b)                           |  | (c)                            
|Equity compensation plans approved by security
    holders(1)     |  |                         | 4,531,169 |                               |  |                                 | 39.2125 |  |  |  | 4,272,910 | 
|Equity compensation plans not approved by
    security holders(2) |  |                         | 2,575,936 |                               |  |                                 | 21.9382 |  |  |  | 322,785   | 
|                                                                  |  |                         |           |                               |  |                                 |         |  |  |  |           | 
|Total                                                             |  |                         | 7,107,105 |                               |  |                                 | 32.9515 |  |  |  | 4,595,695 | 
|                                                                  |  |                         |           |                               |  |                                 |         |  |  |  |           | 



---



|    |                                                                                                                                                                                                                    
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | The 1996 Officers Plan is one of our equity
    incentive plans approved by stockholders. On July 1 of each
    year, the total number of shares available for awards under the
    Plan is automatically increased

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##### Table of Contents



|    |                                                                                                                                                                                                                                                                                                                 
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|    | by an amount equal to 2% of the total number of
    shares of our common stock issued and outstanding as of the
    immediately preceding June 30.                                                                                                                                                              
|   
|(2) | We currently maintain one equity-based
    compensation plan that has not been approved by our
    stockholders, the 2000 Employee Plan of PacifiCare Health
    Systems, Inc., or 2000 Employee Plan. Under the 2000 Employee
    Plan, we may 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.                                                                                                      



| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Under the 2000 Employee Plan, not more than 50%
    of the awards made can be granted to officers. Stock options
    granted under the 2000 Employee Plan typically vest over four
    years in equal increments, and expire 10 years after the
    grant date. Options granted under the 2000 Employee Plan
    automatically vest upon a change of control (as defined in the
    2000 Employee Plan). In late 2001, we granted approximately
    2,000,000 options under the 2000 Employee Plan that vest over
    two years. Awards under the 2000 Employee Plan are generally
    subject to continuous employment.




ITEM 13.     CERTAIN
RELATIONSHIPS AND RELATED TRANSACTIONS

In January 2002, we extended a loan in the amount
of $250,000 to Mr. Konowiecki as part of his compensation
package for joining us as an employee. The loan bears interest
at the Internal Revenue Service mandated rate, and lapses in a
series of annual installments over a four-year period that began
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. As of
December 31, 2002, $250,000 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, 2002,
$75,000 remained outstanding.

We have not modified or extended the terms of the
loans to Mr. Konowiecki or Mr. Scott.




ITEM 14.     CONTROLS
AND PROCEDURES

Under the supervision and with the participation
of our management, including our chief executive officer, or
CEO, and chief financial officer, or CFO, an evaluation was
performed on the effectiveness of the design and operation of
our disclosure controls and procedures within 90 days
before the filing date of this annual report. Based on that
evaluation, our management, including the CEO and CFO, concluded
that our disclosure controls and procedures were effective.
There have been no significant changes in our internal controls
or in other factors that could significantly affect internal
controls subsequent to their evaluation.

68



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

The following documents are filed as part of this
report:

|      |  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                               |  |           |      | 
|----- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | --------- | ---- | 
|      |  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                               |  | Page     
|      |  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                               |  | Reference
|      |  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                               |  |          
|(a)1. |  | Consolidated Financial Statements:                                                                                                                                                                                                                                                                                                                                                                                                                                            |  |           |      | 
|      |  | Consolidated Balance Sheets as of
    December 31, 2002 and 2001                                                                                                                                                                                                                                                                                                                                                                                                              |  |           | F-1  | 
|      |  | Consolidated Statements of Operations for the
    years ended December 31, 2002, 2001 and 2000                                                                                                                                                                                                                                                                                                                                                                                |  |           | F-2  | 
|      |  | Consolidated Statements of Stockholders
    Equity for the years ended December 31, 2002, 2001 and 2000                                                                                                                                                                                                                                                                                                                                                                      |  |           | F-3  | 
|      |  | Consolidated Statements of Cash Flows for the
    years ended December 31, 2002, 2001 and 2000                                                                                                                                                                                                                                                                                                                                                                                |  |           | F-4  | 
|      |  | Notes to Consolidated Financial Statements                                                                                                                                                                                                                                                                                                                                                                                                                                    |  |           | F-6  | 
|      |  | Report of Ernst & Young LLP, Independent
    Auditors                                                                                                                                                                                                                                                                                                                                                                                                                         |  |           | F-40 | 
|      |  | Quarterly Information for 2002 and 2001
    (Unaudited)                                                                                                                                                                                                                                                                                                                                                                                                                       |  |           | F-41 | 
|     
|2.    |  | Financial Statement Schedule:                                                                                                                                                                                                                                                                                                                                                                                                                                                 |  |           |      | 
|      |  | Schedule II  Valuation and
    Qualifying Accounts                                                                                                                                                                                                                                                                                                                                                                                                                           |  |           | F-42 | 
|      |  | 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 November 18, 2002, we filed a
    Form 8-K announcing our intention to offer
    $100 million in aggregate principal amount of convertible
    subordinated debentures due October 2032 for sale in a private
    placement. We also announced that the terms of the offering were
    expected to include an option exercisable by the initial
    purchasers of the debentures to purchase up to an additional
    $25 million aggregate principal amount of debentures. |  |           |      | 
|      |  | On November 19, 2002, we filed a
    Form 8-K in connection with the pricing of a private
    placement of $125 million aggregate principal amount of 3%
    convertible subordinated debentures due October 2032. We further
    announced that we granted an option exercisable by the initial
    purchasers of the debentures to purchase up to an additional
    $25 million aggregate principal amount of debentures.                                                   |  |           |      | 
|      |  | On December 23, 2002, we filed a
    Form 8-K in connection with the sale of $10 million
    aggregate principal amount of 3% convertible subordinated
    debentures due 2032, which resulted from the exercise in part by
    the initial purchasers in our private placement of
    $125 million aggregate principal amount of such debentures
    of their option to purchase additional debentures.                                                                      |  |           |      | 

69



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SIGNATURES

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



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



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

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

Date: March 25, 2003

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 25, 2003
|                                                    
|/s/ GREGORY W. SCOTTGregory W. Scott                 |  | Executive Vice President and
    Chief Financial Officer
    (Principal Financial Officer) |  | March 25, 2003
|                                                    
|/s/ PETER A. REYNOLDSPeter A. Reynolds               |  | Senior Vice President and
    Corporate Controller
    (Chief Accounting Officer)          |  | March 25, 2003
|                                                    
|/s/ DAVID A. REEDDavid A. Reed                       |  | Chairman of the Board                                                                      |  | March 25, 2003
|                                                    
|/s/ BRADLEY C. CALLBradley C. Call                   |  | Director                                                                                   |  | March 25, 2003
|                                                    
|/s/ SHIRLEY S. CHATER, PH.D.Shirley S. Chater, PH.D. |  | Director                                                                                   |  | March 25, 2003

70



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|                                               |  |          |  |               
|---------------------------------------------- |  | -------- |  | --------------
|Name                                           |  | Title    |  | Date          
|                                               |  |          |  |               
|                                              
|/s/ TERRY O. HARTSHORNTerry O. Hartshorn       |  | Director |  | March 25, 2003
|                                              
|/s/ GARY L. LEARYGary L. Leary                 |  | Director |  | March 25, 2003
|                                              
|/s/ SANFORD M. LITVACKSanford M. Litvack       |  | Director |  | March 25, 2003
|                                              
|Dominic Ng                                     |  | Director |  |               
|                                              
|/s/ WARREN E. PINCKERT IIWarren E. Pinckert II |  | Director |  | March 25, 2003
|                                              
|Charles R. Rinehart                            |  | Director |  |               
|                                              
|/s/ LLOYD E. ROSSLloyd E. Ross                 |  | Director |  | March 25, 2003

71



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##### Table of Contents



CERTIFICATION PURSUANT TO

SECTION 302 OF THE SARBANES-OXLEY ACT OF
2002


I, Howard G. Phanstiel, certify that:

1.     I have reviewed
this annual report on Form 10-K of PacifiCare Health
Systems, Inc.;

2.     Based on my
knowledge, this annual report does not contain any untrue
statement of a material fact or omit to state a material fact
necessary to make the statements made, in light of the
circumstances under which such statements were made, not
misleading with respect to the period covered by this annual
report;

3.     Based on my
knowledge, the financial statements, and other financial
information included in this annual report, fairly present in
all material respects the financial condition, results of
operations and cash flows of the registrant as of, and for, the
periods presented in this annual report;

4.     The
registrants other certifying officers and I are
responsible for establishing and maintaining disclosure controls
and procedures (as defined in Exchange Act Rules 13a-14 and
15d-14) for the registrant and we have:



| |                                                                                                                                                                                                                                                                                                                        
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | a)     designed such
    disclosure controls and procedures to ensure that material
    information relating to the registrant, including its
    consolidated subsidiaries, is made known to us by others within
    those entities, particularly during the period in which this
    annual report is being prepared;
|
| | b)     evaluated the
    effectiveness of the registrants disclosure controls and
    procedures as of a date within 90 days prior to the filing
    date of this annual report (the Evaluation Date); and                                                                                                          
|
| | c)     presented in this
    annual report our conclusions about the effectiveness of the
    disclosure controls and procedures based on our evaluation as of
    the Evaluation Date;                                                                                                                                

5.     The
registrants other certifying officers and I have
disclosed, based on our most recent evaluation, to the
registrants auditors and the audit committee of
registrants board of directors (or persons performing the
equivalent function):



| |                                                                                                                                                                                                                                                                                                                          
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | a)     all significant
    deficiencies in the design or operation of internal controls
    which could adversely affect the registrants ability to
    record, process, summarize and report financial data and have
    identified for the registrants auditors any material
    weaknesses in internal controls; and
|
| | b)     any fraud,
    whether or not material, that involves management or other
    employees who have a significant role in the registrants
    internal controls; and                                                                                                                                                

6.     The
registrants other certifying officers and I have indicated
in this annual report whether or not there were significant
changes in internal controls or in other factors that could
significantly affect internal controls subsequent to the date of
our most recent evaluation, including any corrective actions
with regard to significant deficiencies and material weaknesses.



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

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

Date: March 25, 2003

72



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##### Table of Contents



CERTIFICATION PURSUANT TO

SECTION 302 OF THE SARBANES-OXLEY ACT OF
2002


I, Gregory W. Scott, certify that:

1.     I have reviewed
this annual report on Form 10-K of PacifiCare Health
Systems, Inc.;

2.     Based on my
knowledge, this annual report does not contain any untrue
statement of a material fact or omit to state a material fact
necessary to make the statements made, in light of the
circumstances under which such statements were made, not
misleading with respect to the period covered by this annual
report;

3.     Based on my
knowledge, the financial statements, and other financial
information included in this annual report, fairly present in
all material respects the financial condition, results of
operations and cash flows of the registrant as of, and for, the
periods presented in this annual report;

4.     The
registrants other certifying officers and I are
responsible for establishing and maintaining disclosure controls
and procedures (as defined in Exchange Act Rules 13a-14 and
15d-14) for the registrant and we have:



| |                                                                                                                                                                                                                                                                                                                        
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | a)     designed such
    disclosure controls and procedures to ensure that material
    information relating to the registrant, including its
    consolidated subsidiaries, is made known to us by others within
    those entities, particularly during the period in which this
    annual report is being prepared;
|
| | b)     evaluated the
    effectiveness of the registrants disclosure controls and
    procedures as of a date within 90 days prior to the filing
    date of this annual report (the Evaluation Date); and                                                                                                          
|
| | c)     presented in this
    annual report our conclusions about the effectiveness of the
    disclosure controls and procedures based on our evaluation as of
    the Evaluation Date;                                                                                                                                

5.     The
registrants other certifying officers and I have
disclosed, based on our most recent evaluation, to the
registrants auditors and the audit committee of
registrants board of directors (or persons performing the
equivalent function):



| |                                                                                                                                                                                                                                                                                                                          
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | a)     all significant
    deficiencies in the design or operation of internal controls
    which could adversely affect the registrants ability to
    record, process, summarize and report financial data and have
    identified for the registrants auditors any material
    weaknesses in internal controls; and
|
| | b)     any fraud,
    whether or not material, that involves management or other
    employees who have a significant role in the registrants
    internal controls; and                                                                                                                                                

6.     The
registrants other certifying officers and I have indicated
in this annual report whether or not there were significant
changes in internal controls or in other factors that could
significantly affect internal controls subsequent to the date of
our most recent evaluation, including any corrective actions
with regard to significant deficiencies and material weaknesses.



| |     |                     
| | --- | --------------------
| | By: | /s/ GREGORY W. SCOTT

| |                              
| | -----------------------------
| |                              
| | Gregory W. Scott             
| | Executive Vice President and 
| | Chief Financial Officer      
| | (Principal Financial Officer)

Date: March 25, 2003

73



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PACIFICARE HEALTH SYSTEMS, INC.

CONSOLIDATED BALANCE SHEETS

|                                           |                                                                                                                          |                            |           |              |           |   |           |           |           | 
|------------------------------------------ | ------------------------------------------------------------------------------------------------------------------------ | -------------------------- | --------- | ------------ | --------- | - | --------- | --------- | --------- | 
|                                           |                                                                                                                          | December 31,               |           | December 31,
|                                           |                                                                                                                          | 2002                       |           | 2001        
|                                           |                                                                                                                          |                            |           |             
|                                           |                                                                                                                          |                           
|                                           |                                                                                                                          | (Amounts in thousands,    
|                                           |                                                                                                                          | except per share data)    
|ASSETS                                    
|Current assets:                            |                                                                                                                          |                            |           |              |           |   |           |          
|                                           | Cash and equivalents                                                                                                     |                            | $         | 951,689      |           |   | $         | 977,759   |          
|                                           | Marketable securities                                                                                                    |                            |           | 1,195,517    |           |   |           | 1,062,353 |          
|                                           | Receivables, net                                                                                                         |                            |           | 289,735      |           |   |           | 375,661   |          
|                                           | Prepaid expenses and other current assets                                                                                |                            |           | 46,970       |           |   |           | 40,254    |          
|                                           | Restricted cash collateral for FHP senior notes                                                                          |                            |           | 43,346       |           |   |           |          |          
|                                           | Deferred income taxes                                                                                                    |                            |           | 100,758      |           |   |           | 132,159   |          
|                                           |                                                                                                                          |                            |           |              |           |   |           |          
|                                           |                                                                                                                          | Total current assets       |           |              | 2,628,015 |   |           |           | 2,588,186 | 
|                                           |                                                                                                                          |                            |           |              |           |   |           |          
|Property, plant and equipment at cost, net |                                                                                                                          |                            | 161,685   |              |           |   | 166,724   |          
|Marketable securities-restricted           |                                                                                                                          |                            | 186,189   |              |           |   | 112,167   |          
|Goodwill, net                              |                                                                                                                          |                            | 983,104   |              |           |   | 1,915,370 |          
|Intangible assets, net                     |                                                                                                                          |                            | 243,016   |              |           |   | 266,616   |          
|Other assets                               |                                                                                                                          |                            | 49,124    |              |           |   | 46,983    |          
|                                           |                                                                                                                          |                            |           |              |           |   |           |          
|                                           |                                                                                                                          | $                          | 4,251,133 |              |           | $ | 5,096,046 |          
|                                           |                                                                                                                          |                            |           |              |           |   |           |          
|LIABILITIES AND STOCKHOLDERS
    EQUITY  
|Current liabilities:                       |                                                                                                                          |                            |           |              |           |   |           |          
|                                           | Medical claims and benefits payable                                                                                      |                            | $         | 1,044,500    |           |   | $         | 1,095,900 |          
|                                           | Accounts payable                                                                                                         |                            |           | 143,185      |           |   |           | 122,625   |          
|                                           | Accrued liabilities                                                                                                      |                            |           | 213,327      |           |   |           | 260,560   |          
|                                           | Accrued compensation and employee benefits                                                                               |                            |           | 83,891       |           |   |           | 83,623    |          
|                                           | Unearned premium revenue                                                                                                 |                            |           | 477,791      |           |   |           | 550,910   |          
|                                           | Long-term debt due within one year                                                                                       |                            |           | 107,235      |           |   |           | 124       |          
|                                           |                                                                                                                          |                            |           |              |           |   |           |          
|                                           |                                                                                                                          | Total current liabilities  |           |              | 2,069,929 |   |           |           | 2,113,742 | 
|                                           |                                                                                                                          |                            |           |              |           |   |           |          
|Long-term debt due after one year          |                                                                                                                          |                            | 596,794   |              |           |   | 794,309   |          
|Convertible subordinated debentures        |                                                                                                                          |                            | 135,000   |              |           |   |          |          
|Deferred income taxes                      |                                                                                                                          |                            | 103,790   |              |           |   | 137,127   |          
|Other liabilities                          |                                                                                                                          |                            | 17,315    |              |           |   | 17,083    |          
|Stockholders equity:                      |                                                                                                                          |                            |           |              |           |   |           |          
|                                           | Common stock, $0.01 par value; 200,000 shares
    authorized; issued 47,709 shares in 2002 and 47,313 shares in
    2001 |                            |           | 477          |           |   |           | 473       |          
|                                           | Unearned compensation                                                                                                    |                            |           | (2,000       | )         |   |           | (1,153    | )        
|                                           | Additional paid-in capital                                                                                               |                            |           | 1,560,785    |           |   |           | 1,582,566 |          
|                                           | Accumulated other comprehensive income                                                                                   |                            |           | 21,730       |           |   |           | 1,951     |          
|                                           | Retained earnings                                                                                                        |                            |           | 350,369      |           |   |           | 1,108,198 |          
|                                           | Treasury stock, at cost; 11,704 shares in 2002
    and 12,776 shares in 2001                                             |                            |           | (603,056     | )         |   |           | (658,250  | )        
|                                           |                                                                                                                          |                            |           |              |           |   |           |          
|                                           |                                                                                                                          | Total stockholders equity |           |              | 1,328,305 |   |           |           | 2,033,785 | 
|                                           |                                                                                                                          |                            |           |              |           |   |           |          
|                                           |                                                                                                                          | $                          | 4,251,133 |              |           | $ | 5,096,046 |          
|                                           |                                                                                                                          |                            |           |              |           |   |           |          

See accompanying notes.

F-1



---



##### Table of Contents



PACIFICARE HEALTH SYSTEMS, INC.






CONSOLIDATED STATEMENTS OF
OPERATIONS


|                                                                                                            |                                                                                                |                                               |           |              |            |              |           |           |            |   |           |           |            | 
|----------------------------------------------------------------------------------------------------------- | ---------------------------------------------------------------------------------------------- | --------------------------------------------- | --------- | ------------ | ---------- | ------------ | --------- | --------- | ---------- | - | --------- | --------- | ---------- | 
|                                                                                                            |                                                                                                | Year Ended                                    |           | Year Ended   |            | Year Ended  
|                                                                                                            |                                                                                                | December 31,                                  |           | December 31, |            | December 31,
|                                                                                                            |                                                                                                | 2002                                          |           | 2001         |            | 2000        
|                                                                                                            |                                                                                                |                                               |           |              |            |             
|                                                                                                            |                                                                                                |                                              
|                                                                                                            |                                                                                                | (Amounts in thousands, except per share data)
|Revenue:                                                                                                    |                                                                                                |                                               |           |              |            |              |           |           |            |   |           |          
|                                                                                                            | Commercial premiums                                                                            |                                               | $         | 5,009,862    |            |              | $         | 4,795,741 |            |   | $         | 4,912,216 |           
|                                                                                                            | Senior premiums                                                                                |                                               |           | 5,883,844    |            |              |           | 6,764,164 |            |   |           | 6,416,039 |           
|                                                                                                            | Other income                                                                                   |                                               |           | 198,309      |            |              |           | 172,804   |            |   |           | 139,672   |           
|                                                                                                            | Net investment income                                                                          |                                               |           | 64,487       |            |              |           | 111,263   |            |   |           | 108,371   |           
|                                                                                                            |                                                                                                |                                               |           |              |            |              |           |           |            |   |           |          
|                                                                                                            |                                                                                                | Total operating revenue                       |           |              | 11,156,502 |              |           |           | 11,843,972 |   |           |           | 11,576,298 | 
|Expenses:                                                                                                   |                                                                                                |                                               |           |              |            |              |           |           |            |   |           |          
|Health care services:                                                                                       |                                                                                                |                                               |           |              |            |              |           |           |            |   |           |          
|                                                                                                            | Commercial services                                                                            |                                               |           | 4,381,426    |            |              |           | 4,258,412 |            |   |           | 4,178,701 |           
|                                                                                                            | Senior services                                                                                |                                               |           | 5,104,275    |            |              |           | 6,109,245 |            |   |           | 5,734,956 |           
|                                                                                                            |                                                                                                |                                               |           |              |            |              |           |           |            |   |           |          
|                                                                                                            |                                                                                                | Total health care services                    |           |              | 9,485,701  |              |           |           | 10,367,657 |   |           |           | 9,913,657  | 
|Selling, general and administrative expenses                                                                |                                                                                                |                                               | 1,346,560 |              |            |              | 1,205,478 |           |            |   | 1,203,573 |          
|Amortization of intangible assets                                                                           |                                                                                                |                                               | 23,600    |              |            |              | 23,781    |           |            |   | 24,496    |          
|Amortization of goodwill                                                                                    |                                                                                                |                                               |          |              |            |              | 59,115    |           |            |   | 58,721    |          
|Impairment, disposition, restructuring, Office of
    Personnel Management and other charges (credits), net |                                                                                                |                                               | 3,774     |              |            |              | 61,157    |           |            |   | 8,766     |          
|                                                                                                            |                                                                                                |                                               |           |              |            |              |           |           |            |   |           |          
|Operating income                                                                                            |                                                                                                |                                               | 296,867   |              |            |              | 126,784   |           |            |   | 367,085   |          
|Interest expense                                                                                            |                                                                                                |                                               | (74,904   | )            |            |              | (70,282   | )         |            |   | (79,636   | )        
|Minority interest in consolidated subsidiary                                                                |                                                                                                |                                               |          |              |            |              |          |           |            |   | 637       |          
|                                                                                                            |                                                                                                |                                               |           |              |            |              |           |           |            |   |           |          
|Income before income taxes                                                                                  |                                                                                                |                                               | 221,963   |              |            |              | 56,502    |           |            |   | 288,086   |          
|Provision for income taxes                                                                                  |                                                                                                |                                               | 82,792    |              |            |              | 38,371    |           |            |   | 127,046   |          
|                                                                                                            |                                                                                                |                                               |           |              |            |              |           |           |            |   |           |          
|Income before cumulative effect of a change in
    accounting principle and extraordinary gain              |                                                                                                |                                               | 139,171   |              |            |              | 18,131    |           |            |   | 161,040   |          
|Cumulative effect of a change in accounting
    principle                                                   |                                                                                                |                                               | (897,000  | )            |            |              |          |           |            |   |          |          
|Extraordinary gain on early retirement of debt                                                              |                                                                                                |                                               |          |              |            |              | 875       |           |            |   |          |          
|                                                                                                            |                                                                                                |                                               |           |              |            |              |           |           |            |   |           |          
|Net (loss) income                                                                                           |                                                                                                | $                                             | (757,829  | )            |            | $            | 19,006    |           |            | $ | 161,040   |          
|                                                                                                            |                                                                                                |                                               |           |              |            |              |           |           |            |   |           |          
|Basic (loss) earnings per share:                                                                            |                                                                                                |                                               |           |              |            |              |           |           |            |   |           |          
|                                                                                                            | Income before cumulative effect of a change in
    accounting principle and extraordinary gain |                                               | $         | 3.95         |            |              | $         | 0.54      |            |   | $         | 4.59      |           
|                                                                                                            | Cumulative effect of a change in accounting
    principle                                      |                                               |           | (25.46       | )          |              |           |          |            |   |           |          |           
|                                                                                                            | Extraordinary gain, net                                                                        |                                               |           |             |            |              |           | 0.02      |            |   |           |          |           
|                                                                                                            |                                                                                                |                                               |           |              |            |              |           |           |            |   |           |          
|                                                                                                            | Basic (loss) earnings per share                                                                |                                               | $         | (21.51       | )          |              | $         | 0.56      |            |   | $         | 4.59      |           
|                                                                                                            |                                                                                                |                                               |           |              |            |              |           |           |            |   |           |          
|Diluted (loss) earnings per share:                                                                          |                                                                                                |                                               |           |              |            |              |           |           |            |   |           |          
|                                                                                                            | Income before cumulative effect of a change in
    accounting principle and extraordinary gain |                                               | $         | 3.95         |            |              | $         | 0.53      |            |   | $         | 4.58      |           
|                                                                                                            | Cumulative effect of a change in accounting
    principle                                      |                                               |           | (25.46       | )          |              |           |          |            |   |           |          |           
|                                                                                                            | Extraordinary gain, net                                                                        |                                               |           |             |            |              |           | 0.02      |            |   |           |          |           
|                                                                                                            |                                                                                                |                                               |           |              |            |              |           |           |            |   |           |          
|                                                                                                            | Diluted (loss) earnings per share                                                              |                                               | $         | (21.51       | )          |              | $         | 0.55      |            |   | $         | 4.58      |           
|                                                                                                            |                                                                                                |                                               |           |              |            |              |           |           |            |   |           |          

See accompanying notes.

F-2



---



##### Table of Contents



PACIFICARE HEALTH SYSTEMS, INC.

CONSOLIDATED STATEMENTS OF STOCKHOLDERS
EQUITY

|                                                                       |                                       |                                                                                             |     |              |   |            |        |               |   |          |           |          |   |       |         |   |        |   |           |          |   |   |          |          |   |   |           |          |        | 
|---------------------------------------------------------------------- | ------------------------------------- | ------------------------------------------------------------------------------------------- | --- | ------------ | - | ---------- | ------ | ------------- | - | -------- | --------- | -------- | - | ----- | ------- | - | ------ | - | --------- | -------- | - | - | -------- | -------- | - | - | --------- | -------- | ------ | 
|                                                                       |                                       |                                                                                             |     |              |   |            |        | Accumulated   |   |          |           |          |   |      
|                                                                       |                                       |                                                                                             |     |              |   |            |        | Other         |   |          |           |          |   |      
|                                                                       |                                       |                                                                                             |     |              |   | Additional |        | Comprehensive |   |          |           |          |   |      
|                                                                       |                                       | Common                                                                                      |     | Unearned     |   | Paid-in    |        | Income        |   | Retained |           | Treasury |   |      
|                                                                       |                                       | Stock                                                                                       |     | Compensation |   | Capital    |        | (Loss)        |   | Earnings |           | Stock    |   | Total
|                                                                       |                                       |                                                                                             |     |              |   |            |        |               |   |          |           |          |   |      
|                                                                       |                                       |                                                                                            
|                                                                       |                                       | (Amounts in thousands)                                                                     
|Balances at December 31, 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: |                                                                                             |     |              |   |            |        |               |   |          |           |          |   |       |         |   |        |   |           |          |   |   |          |          |   |   |           |          |       
|                                                                       |                                       | Change in unrealized gains on marketable
    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: |                                                                                             |     |              |   |            |        |               |   |          |           |          |   |       |         |   |        |   |           |          |   |   |          |          |   |   |           |          |       
|                                                                       |                                       | Change in unrealized gains on marketable
    securities, net of reclassification adjustment |     |              |  |            |        |               |  |          |           |          |  |       |         |   | 4,926  |   |           |          |  |   |          |          |  |   |           |          | 4,926  | 
|                                                                       |                                       |                                                                                             |     |              |   |            |        |               |   |          |           |          |   |       |         |   |        |   |           |          |   |   |          |          |   |   |           |         
|Comprehensive income                                                   |                                       |                                                                                             |    |              |   |            |       |               |   |          |          |          |   |       | 4,926   |   |        |   | 19,006    |          |   |   |         |          |   |   | 23,932    |         
|                                                                       |                                       |                                                                                             |     |              |   |            |        |               |   |          |           |          |   |       |         |   |        |   |           |          |   |   |          |          |   |   |           |         
|Capital stock activity:                                                |                                       |                                                                                             |     |              |   |            |        |               |   |          |           |          |   |       |         |   |        |   |           |          |   |   |          |          |   |   |           |         
|                                                                       | Employee benefit plans                |                                                                                             |     | 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 |         
|                                                                       |                                       |                                                                                             |     |              |   |            |        |               |   |          |           |          |   |       |         |   |        |   |           |          |   |   |          |          |   |   |           |         
|Comprehensive income (loss):                                           |                                       |                                                                                             |     |              |   |            |        |               |   |          |           |          |   |       |         |   |        |   |           |          |   |   |          |          |   |   |           |         
|                                                                       | Net loss                              |                                                                                             |     |             |   |            |        |              |   |          |           |         |   |       |         |  |        |   |           | (757,829 | ) |   |          |         |   |   |           | (757,829 | )     
|                                                                       | Other comprehensive gain, net of tax: |                                                                                             |     |              |   |            |        |               |   |          |           |          |   |       |         |   |        |   |           |          |   |   |          |          |   |   |           |          |       
|                                                                       |                                       | Change in unrealized gains on marketable
    securities, net of reclassification adjustment |     |              |  |            |        |               |  |          |           |          |  |       |         |   | 19,779 |   |           |          |  |   |          |          |  |   |           |          | 19,779 | 
|                                                                       |                                       |                                                                                             |     |              |   |            |        |               |   |          |           |          |   |       |         |   |        |   |           |          |   |   |          |          |   |   |           |         
|Comprehensive income (loss)                                            |                                       |                                                                                             |    |              |   |            |       |               |   |          |          |          |   |       | 19,779  |   |        |   | (757,829  | )        |   |   |         |          |   |   | (738,050  | )       
|                                                                       |                                       |                                                                                             |     |              |   |            |        |               |   |          |           |          |   |       |         |   |        |   |           |          |   |   |          |          |   |   |           |         
|Capital stock activity:                                                |                                       |                                                                                             |     |              |   |            |        |               |   |          |           |          |   |       |         |   |        |   |           |          |   |   |          |          |   |   |           |         
|                                                                       | Employee benefit plans                |                                                                                             |     | 4            |   |            |        | (847          | ) |          |           | (7,645   | ) |       |         |  |        |   |           |          |   |   |          | 28,301   |   |   |           | 19,813   |       
|                                                                       | Reissue of treasury stock             |                                                                                             |     |             |   |            |        |              |   |          |           | (15,145  | ) |       |         |  |        |   |           |         |   |   |          | 26,893   |   |   |           | 11,748   |       
|Tax benefit associated with exercise of stock
    options              |                                       |                                                                                             |    |              |   |            |       |               |   |          | 1,009     |          |   |       |        |   |        |   |          |          |   |   |         |          |   |   | 1,009     |         
|                                                                       |                                       |                                                                                             |     |              |   |            |        |               |   |          |           |          |   |       |         |   |        |   |           |          |   |   |          |          |   |   |           |         
|Balances at December 31, 2002                                          |                                       | $                                                                                           | 477 |              |   | $          | (2,000 | )             |   | $        | 1,560,785 |          |   | $     | 21,730  |   |        | $ | 350,369   |          |   | $ | (603,056 | )        |   | $ | 1,328,305 |         
|                                                                       |                                       |                                                                                             |     |              |   |            |        |               |   |          |           |          |   |       |         |   |        |   |           |          |   |   |          |          |   |   |           |         

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,
|                                                    |                                                                                                    | 2002                                                                                                        |                                           | 2001                                                                               |         | 2000        
|                                                    |                                                                                                    |                                                                                                             |                                           |                                                                                    |         |             
|                                                    |                                                                                                    |                                                                                                            
|                                                    |                                                                                                    | (Amounts in thousands)                                                                                     
|Operating activities:                               |                                                                                                    |                                                                                                             |                                           |                                                                                    |         |              |           |          |        |          |           |         
|                                                    | Net (loss) income                                                                                  |                                                                                                             | $                                         | (757,829                                                                           | )       |              | $         | 19,006   |        |          | $         | 161,040  |       
|                                                    | Adjustments to reconcile net (loss) income
    to net cash flows provided by operating activities: |                                                                                                             |                                           |                                                                                    |         |              |           |          |        |          |           |          |       
|                                                    |                                                                                                    | Cumulative effect of a change in accounting
    principle                                                   |                                           |                                                                                    | 897,000 |              |           |          |       |          |           |          |       |         
|                                                    |                                                                                                    | Depreciation and amortization                                                                               |                                           |                                                                                    | 50,284  |              |           |          | 65,808 |          |           |          | 47,346 |         
|                                                    |                                                                                                    | Amortization of intangible assets                                                                           |                                           |                                                                                    | 23,600  |              |           |          | 23,781 |          |           |          | 24,496 |         
|                                                    |                                                                                                    | Deferred income taxes                                                                                       |                                           |                                                                                    | 18,559  |              |           |          | (3,966 | )        |           |          | 6,107  |         
|                                                    |                                                                                                    | Loss on disposal of property, plant and equipment
    and other                                             |                                           |                                                                                    | 12,793  |              |           |          | 6,053  |          |           |          | 7,664  |         
|                                                    |                                                                                                    | Marketable and other securities impairment for
    other than temporary declines in value                   |                                           |                                                                                    | 12,543  |              |           |          |       |          |           |          |       |         
|                                                    |                                                                                                    | Employer benefit plan contributions in treasury
    stock                                                   |                                           |                                                                                    | 12,132  |              |           |          |       |          |           |          |       |         
|                                                    |                                                                                                    | Amortization of capitalized loan fees                                                                       |                                           |                                                                                    | 7,784   |              |           |          | 7,560  |          |           |          | 4,846  |         
|                                                    |                                                                                                    | Provision for doubtful accounts                                                                             |                                           |                                                                                    | 6,346   |              |           |          | 22,070 |          |           |          | 37,598 |         
|                                                    |                                                                                                    | Impairment, disposition, restructuring, Office of
    Personnel Management and other charges (credits), net |                                           |                                                                                    | 3,774   |              |           |          | 61,157 |          |           |          | 8,766  |         
|                                                    |                                                                                                    | Amortization of notes receivable from sale of
    fixed assets                                              |                                           |                                                                                    | (3,107  | )            |           |          |       |          |           |          |       |         
|                                                    |                                                                                                    | Tax benefit realized for stock option exercises                                                             |                                           |                                                                                    | 1,009   |              |           |          | 21     |          |           |          | 1,801  |         
|                                                    |                                                                                                    | Unearned compensation amortization                                                                          |                                           |                                                                                    | 693     |              |           |          | 3,632  |          |           |          |       |         
|                                                    |                                                                                                    | Amortization of discount on 10 3/4% senior
    notes                                                        |                                           |                                                                                    | 266     |              |           |          |       |          |           |          |       |         
|                                                    |                                                                                                    | Adjustment to cash received in purchase
    transaction                                                     |                                           |                                                                                    | 17      |              |           |          |       |          |           |          |       |         
|                                                    |                                                                                                    | Amortization of goodwill                                                                                    |                                           |                                                                                    |        |              |           |          | 59,115 |          |           |          | 58,721 |         
|                                                    |                                                                                                    | Gain on early retirement of debt                                                                            |                                           |                                                                                    |        |              |           |          | (1,800 | )        |           |          |       |         
|                                                    |                                                                                                    | Minority interest in consolidated subsidiary                                                                |                                           |                                                                                    |        |              |           |          |       |          |           |          | (637   | )       
|                                                    |                                                                                                    | Changes in assets and liabilities, net of effects
    from acquisitions and dispositions:                   |                                           |                                                                                    |         |              |           |          |        |          |           |          |        |         
|                                                    |                                                                                                    |                                                                                                             | Receivables, net                          |                                                                                    |         | 82,592       |           |          |        | 16,070   |           |          |        | (122,194 | )       
|                                                    |                                                                                                    |                                                                                                             | Prepaid expenses and other assets         |                                                                                    |         | 2,404        |           |          |        | 7,837    |           |          |        | 24       |         
|                                                    |                                                                                                    |                                                                                                             | Medical claims and benefits payable       |                                                                                    |         | (51,400      | )         |          |        | (174,900 | )         |          |        | 371,584  |         
|                                                    |                                                                                                    |                                                                                                             | Accounts payable and accrued liabilities: |                                                                                    |         |              |           |          |        |          |           |          |        |          |         
|                                                    |                                                                                                    |                                                                                                             |                                           | Payment for Office of Personnel Management
    settlement, net of amounts received |         |              | (65,441   | )        |        |          |          |          |        |          |         |  
|                                                    |                                                                                                    |                                                                                                             |                                           | Other changes in accounts payable and accrued
    liabilities                      |         |              | 61,479    |          |        |          | (25,216   | )        |        |          | (2,079   | )
|                                                    |                                                                                                    |                                                                                                             | Unearned premium revenue                  |                                                                                    |         | (73,119      | )         |          |        | (47,305  | )         |          |        | 26,153   |         
|                                                    |                                                                                                    |                                                                                                             |                                           |                                                                                    |         |              |           |          |        |          |           |         
|                                                    |                                                                                                    |                                                                                                             |                                           | Net cash flows provided by operating activities                                    |         |              | 242,379   |          |        |          | 38,923    |          |        |          | 631,236  |  
|                                                    |                                                                                                    |                                                                                                             |                                           |                                                                                    |         |              |           |          |        |          |           |         
|Investing activities:                               |                                                                                                    |                                                                                                             |                                           |                                                                                    |         |              |           |          |        |          |           |         
|                                                    | (Purchase) sale of marketable securities, net                                                      |                                                                                                             |                                           | (113,987                                                                           | )       |              |           | (190,401 | )      |          |           | 177,598  |       
|                                                    | Purchase of marketable securities-restricted, net                                                  |                                                                                                             |                                           | (117,368                                                                           | )       |              |           | (17,765  | )      |          |           | (7,660   | )     
|                                                    | Purchase of property, plant and equipment                                                          |                                                                                                             |                                           | (59,274                                                                            | )       |              |           | (77,301  | )      |          |           | (105,256 | )     
|                                                    | Proceeds from the sale of property, plant and
    equipment                                        |                                                                                                             |                                           | 12,492                                                                             |         |              |           | 25,139   |        |          |           | 3,596    |       
|                                                    | Net cash (paid for) acquired from acquisitions                                                     |                                                                                                             |                                           |                                                                                   |         |              |           | (500     | )      |          |           | 4,098    |       
|                                                    |                                                                                                    |                                                                                                             |                                           |                                                                                    |         |              |           |          |        |          |           |         
|                                                    |                                                                                                    |                                                                                                             |                                           | Net cash flows provided by (used in) investing
    activities                      |         |              | (278,137  | )        |        |          | (260,828  | )        |        |          | 72,376   |  
|                                                    |                                                                                                    |                                                                                                             |                                           |                                                                                    |         |              |           |          |        |          |           |         
|Financing activities:                               |                                                                                                    |                                                                                                             |                                           |                                                                                    |         |              |           |          |        |          |           |         
|                                                    | Principal payments on long-term debt                                                               |                                                                                                             |                                           | (554,308                                                                           | )       |              |           | (30,284  | )      |          |           | (400,200 | )     
|                                                    | Proceeds from borrowings of long-term debt                                                         |                                                                                                             |                                           | 496,945                                                                            |         |              |           |         |        |          |           | 261,917  |       
|                                                    | Proceeds from issuance of convertible
    subordinated debentures                                  |                                                                                                             |                                           | 135,000                                                                            |         |              |           |         |        |          |           |         |       
|                                                    | Principal payments on FHP senior notes                                                             |                                                                                                             |                                           | (41,750                                                                            | )       |              |           |         |        |          |           |         |       
|                                                    | Credit facility amendment fees and expenses                                                        |                                                                                                             |                                           | (37,789                                                                            | )       |              |           | (12,949  | )      |          |           |         |       
|                                                    | Proceeds from draw down under equity commitment
    arrangement                                    |                                                                                                             |                                           | 8,928                                                                              |         |              |           |         |        |          |           |         |       
|                                                    | Proceeds from issuance of common and treasury
    stock                                            |                                                                                                             |                                           | 4,916                                                                              |         |              |           | 83       |        |          |           | 2,466    |       
|                                                    | Payments on software financing agreement                                                           |                                                                                                             |                                           | (2,231                                                                             | )       |              |           |         |        |          |           |         |       
|                                                    | Common stock registration fees                                                                     |                                                                                                             |                                           | (23                                                                                | )       |              |           |         |        |          |           |         |       
|                                                    | Purchase of minority interest in consolidated
    subsidiary                                       |                                                                                                             |                                           |                                                                                   |         |              |           | (8,821   | )      |          |           |         |       
|                                                    | Common stock repurchases                                                                           |                                                                                                             |                                           |                                                                                   |         |              |           |         |        |          |           | (173,332 | )     
|                                                    | Cash received from minority stockholders                                                           |                                                                                                             |                                           |                                                                                   |         |              |           |         |        |          |           | 8,108    |       
|                                                    |                                                                                                    |                                                                                                             |                                           |                                                                                    |         |              |           |          |        |          |           |         
|                                                    |                                                                                                    |                                                                                                             |                                           | Net cash flows provided by (used in) financing
    activities                      |         |              | 9,688     |          |        |          | (51,971   | )        |        |          | (301,041 | )
|                                                    |                                                                                                    |                                                                                                             |                                           |                                                                                    |         |              |           |          |        |          |           |         
|Net (decrease) increase in cash and
    equivalents |                                                                                                    |                                                                                                             | (26,070                                   | )                                                                                  |         |              | (273,876  | )        |        |          | 402,571   |         
|Beginning cash and equivalents                      |                                                                                                    |                                                                                                             | 977,759                                   |                                                                                    |         |              | 1,251,635 |          |        |          | 849,064   |         
|                                                    |                                                                                                    |                                                                                                             |                                           |                                                                                    |         |              |           |          |        |          |           |         
|Ending cash and equivalents                         |                                                                                                    | $                                                                                                           | 951,689                                   |                                                                                    |         | $            | 977,759   |          |        | $        | 1,251,635 |         
|                                                    |                                                                                                    |                                                                                                             |                                           |                                                                                    |         |              |           |          |        |          |           |         



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,
|                                                                         |                                                                           | 2002                                                    |                              | 2001                                         |         | 2000        
|                                                                         |                                                                           |                                                         |                              |                                              |         |             
|                                                                         |                                                                           |                                                        
|                                                                         |                                                                           | (Amounts in thousands)                                 
|Supplemental cash flow information:                                      |                                                                           |                                                         |                              |                                              |         |              |   |      |         |        |     |      
|                                                                         | Cash paid (received) during the year for:                                 |                                                         |                              |                                              |         |              |   |      |         |        |     |       |         
|                                                                         |                                                                           |                                                         | Income taxes, net of refunds |                                              | $       | (68,123      | ) |      | $       | 7,328  |     |       | $        | 115,092 |       
|                                                                         |                                                                           |                                                         | Interest                     |                                              | $       | 68,732       |   |      | $       | 73,140 |     |       | $        | 71,034  |       
|Supplemental schedule of noncash investing and
    financing activities: |                                                                           |                                                         |                              |                                              |         |              |   |      |         |        |     |      
|                                                                         | Details of cumulative effect of a change in
    accounting principle:     |                                                         |                              |                                              |         |              |   |      |         |        |     |       |         
|                                                                         |                                                                           | Goodwill impairment                                     |                              | $                                            | 929,436 |              |   | $    |        |        |     | $     |         |        
|                                                                         |                                                                           | Less decrease in deferred liability                     |                              |                                              | (32,436 | )            |   |      |        |        |     |       |         |        
|                                                                         |                                                                           |                                                         |                              |                                              |         |              |   |      |         |        |     |      
|                                                                         |                                                                           | Goodwill impairment, net of tax                         |                              | $                                            | 897,000 |              |   | $    |        |        |     | $     |         |        
|                                                                         |                                                                           |                                                         |                              |                                              |         |              |   |      |         |        |     |      
|                                                                         | Stock-based compensation                                                  |                                                         | $                            | 1,915                                        |         |              | $ | (506 | )       |        | $   | 6,325 |         
|                                                                         |                                                                           |                                                         |                              |                                              |         |              |   |      |         |        |     |      
|                                                                         | Treasury stock reissued in exchange for
    retirement of long-term debt: |                                                         |                              |                                              |         |              |   |      |         |        |     |       |         
|                                                                         |                                                                           | Treasury stock                                          |                              | $                                            | 5,218   |              |   | $    | 38,821  |        |     | $     |         |        
|                                                                         |                                                                           | Additional paid-in capital                              |                              |                                              | (2,398  | )            |   |      | (28,621 | )      |     |       |         |        
|                                                                         |                                                                           | Long-term debt retired                                  |                              |                                              | (3,000  | )            |   |      | (12,000 | )      |     |       |         |        
|                                                                         |                                                                           |                                                         |                              |                                              |         |              |   |      |         |        |     |      
|                                                                         |                                                                           | Extraordinary gain on early retirement of debt          |                              | $                                            | (180    | )            |   | $    | (1,800  | )      |     | $     |         |        
|                                                                         |                                                                           |                                                         |                              |                                              |         |              |   |      |         |        |     |      
|                                                                         | Details of accumulated other comprehensive income:                        |                                                         |                              |                                              |         |              |   |      |         |        |     |       |         
|                                                                         |                                                                           | Change in unrealized gains on marketable
    securities |                              | $                                            | 31,720  |              |   | $    | 7,939   |        |     | $     | 34,935   |        
|                                                                         |                                                                           | Less change in deferred income taxes                    |                              |                                              | (11,941 | )            |   |      | (3,013  | )      |     |       | (13,514  | )      
|                                                                         |                                                                           |                                                         |                              |                                              |         |              |   |      |         |        |     |      
|                                                                         |                                                                           | Change in stockholders equity                          |                              | $                                            | 19,779  |              |   | $    | 4,926   |        |     | $     | 21,421   |        
|                                                                         |                                                                           |                                                         |                              |                                              |         |              |   |      |         |        |     |      
|                                                                         | 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  |        
|                                                                         |                                                                           | Less liabilities assumed or created                     |                              |                                              |        |              |   |      | (2,745  | )      |     |       | (134,243 | )      
|                                                                         |                                                                           |                                                         |                              |                                              |         |              |   |      |         |        |     |      
|                                                                         |                                                                           | Cash paid for fair value of assets acquired             |                              |                                              |        |              |   |      | 500     |        |     |       | 129,693  |        
|                                                                         |                                                                           | Cash acquired in acquisitions                           |                              |                                              |        |              |   |      |        |        |     |       | (133,791 | )      
|                                                                         |                                                                           |                                                         |                              |                                              |         |              |   |      |         |        |     |      
|                                                                         |                                                                           |                                                         |                              | Net cash paid for (acquired in) acquisitions |         | $            |  |      |         | $      | 500 |       |          | $       | (4,098 | )
|                                                                         |                                                                           |                                                         |                              |                                              |         |              |   |      |         |        |     |      
|                                                                         | Details of discount on 10 3/4% senior notes:                              |                                                         |                              |                                              |         |              |   |      |         |        |     |       |         
|                                                                         |                                                                           | Discount                                                |                              | $                                            | (3,055  | )            |   | $    |        |        |     | $     |         |        
|                                                                         |                                                                           | Amortization                                            |                              |                                              | 266     |              |   |      |        |        |     |       |         |        
|                                                                         |                                                                           |                                                         |                              |                                              |         |              |   |      |         |        |     |      
|                                                                         |                                                                           | Net discount on notes payable                           |                              | $                                            | (2,789  | )            |   | $    |        |        |     | $     |         |        
|                                                                         |                                                                           |                                                         |                              |                                              |         |              |   |      |         |        |     |      
|                                                                         | Details of assets acquired:                                               |                                                         |                              |                                              |         |              |   |      |         |        |     |       |         
|                                                                         |                                                                           | Net book value of assets acquired                       |                              | $                                            | (13,674 | )            |   | $    |        |        |     | $     |         |        
|                                                                         |                                                                           | Note payable                                            |                              |                                              | 13,674  |              |   |      |        |        |     |       |         |        
|                                                                         |                                                                           |                                                         |                              |                                              |         |              |   |      |         |        |     |      
|                                                                         |                                                                           | Cash paid for assets acquired                           |                              | $                                            |        |              |   | $    |        |        |     | $     |         |        
|                                                                         |                                                                           |                                                         |                              |                                              |         |              |   |      |         |        |     |      

See accompanying notes.

F-5



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##### Table of Contents



PACIFICARE HEALTH SYSTEMS, INC.






NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS


1.     Basis of
Presentation

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

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,
commercial and senior. Revenues from non-Medicare members,
generally employees or early retirees of businesses, are
reported in the commercial product line. Revenues from our
Medicare customers are reported in the senior product line. Our
single largest customer is the federal government. Sources of
federal government revenues include revenues from Medicare
beneficiaries and from federal employees covered by the Federal
Employee Health Benefits Program, or FEHBP, who are included in
our commercial product line. Federal government revenues were
$6.3 billion in 2002, $7.1 billion in 2001 and
$6.7 billion in 2000.

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;                                                      
| 
| | Impairment of long-lived assets;                                                    
| 
| | Medical claims and benefits payable;                                                
| 
| | Professional and general liability; and                                             
| 
| | Reserves relating to the United States Office of
    Personnel Management, or OPM.

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

Reclassifications.We reclassified certain prior year
amounts in the accompanying consolidated financial statements to
conform to the 2002 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.

F-6



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##### Table of Contents



PACIFICARE HEALTH SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)

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

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

Concentrations of Credit Risk.Financial instruments that potentially
subject us to concentrations of credit risk consist primarily of
investments in marketable securities and 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, 2002.

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

Long-Lived Assets.

Property, Plant and Equipment.We record property, plant and
equipment at cost. We capitalize replacements and major
improvements and certain internal and external costs associated
with the purchase or development of internal-use software. We
charge repairs and maintenance to expense as incurred. We
eliminate the costs and related accumulated depreciation when we
sell property, plant and equipment, and any resulting gains or
losses are included in net income. We depreciate property, plant
and equipment, including assets under capital leases, evenly
over the assets useful lives ranging from three to
25 years. We amortize leasehold improvements evenly over
the shorter of the lease term or five years. We amortize
software costs evenly over estimated useful lives ranging from
three to five years. Accumulated depreciation and amortization
on property, plant and equipment totaled $192 million at
December 31, 2002 and $164 million at
December 31, 2001.

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

In August 2001, the Financial Accounting
Standards Board (FASB) issued Statements of Financial
Accounting Standards (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

F-7



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##### Table of Contents



PACIFICARE HEALTH SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)

Assets to Be Disposed Of.SFAS No. 144 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. The adoption of this statement did not have a material
impact on our consolidated financial position or results of
operations in 2002.

Goodwill and Intangible Assets.When we acquire a business, we
allocate the excess of the purchase price over the fair value of
the net assets acquired to goodwill and identified intangible
assets. Prior to 2002, we amortized goodwill and intangible
assets evenly over periods ranging from three to 40 years
and tested for impairment in accordance with SFAS No. 121.
Under SFAS No. 121, we applied an undiscounted cash flow
model to assess the fair value of our reporting units, which did
not result in the recognition of goodwill impairment in 2001. On
January 1, 2002, we adopted SFAS No. 141, Business
Combinations, and SFAS No. 142, Goodwill and Other
Intangible Assets.Under the new rules, goodwill is no
longer amortized, but is subject to impairment tests on an
annual basis or more frequently if impairment indicators exist.
The tests for measuring goodwill impairment under SFAS
No. 142 are more stringent than the previous tests required
by SFAS No. 121. See Note 7, Goodwill and
Intangible Assets.

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 2002 or 2001.

Premiums and Revenue Recognition.We report prepaid health care premiums
received from our HMOs enrolled groups as revenue in the
month that enrollees are entitled to receive health care. We
record premiums received in advance as unearned premium revenue.
Funds received under the federal Medicare program accounted for
approximately 53% in 2002, 59% in 2001 and 57% in 2000 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 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, or IBNR.

F-8



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##### Table of Contents



PACIFICARE HEALTH SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)

Management develops these estimates using
standard actuarial methods which include, among other factors,
the average interval between the date services are rendered and
the date claims are received and/or paid, denied claims
activity, disputed claims activity, expected health care cost
inflation, utilization, seasonality patterns and changes in
membership. The estimates for submitted claims and IBNR claims
liabilities are made on an accrual basis and adjusted based on
actual claims data in future periods as required. For new
products, such as our PPO products, estimates are initially
based on health care cost data provided by third parties. This
data includes assumptions for member age, gender and geography.
The models that we use to prepare estimates for each product are
adjusted as we accumulate actual claims data. Such estimates
could materially understate or overstate our actual liability
for medical claims and benefits payable. These estimates are
reviewed by outside parties and state regulatory authorities on
a periodic basis. The estimates for submitted claims and IBNR
claims liabilities are made on an accrual basis and adjusted in
future periods as required. Adjustments to prior period
estimates, if any, are included in current operations. We have
also recorded reserves, based in part on estimates, to indemnify
our members against potential claims made by specialists or
other providers whose fees should have been paid by the
insolvent medical groups. See Note 11,
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 (APB) No. 25, Accounting for Stock Issued to
Employees, 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 $27 million in 2002,
$26 million in 2001 and $30 million in 2000.

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

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:

|                                                                            |                                         |                        |        |      |  |      |        |     |  |  |        |        |  
|--------------------------------------------------------------------------- | --------------------------------------- | ---------------------- | ------ | ---- |  | ---- | ------ | --- |  |  | ------ | ------ | -
|                                                                            |                                         | 2002                   |        | 2001 |  | 2000
|                                                                            |                                         |                        |        |      |  |     
|                                                                            |                                         |                       
|                                                                            |                                         | (Amounts in thousands)
|Shares outstanding at the beginning of the
    period(1)                    |                                         |                        | 34,447 |      |  |      | 33,454 |     |  |  | 37,252 |       
|Weighted average number of shares issued
    (acquired):                    |                                         |                        |        |      |  |      |        |     |  |  |        |       
|                                                                            | Treasury stock reissued (acquired), net |                        |        | 659  |  |      |        | 212 |  |  |        | (2,274 | )
|                                                                            | Stock options exercised                 |                        |        | 131  |  |      |        | 109 |  |  |        | 94     |  
|                                                                            |                                         |                        |        |      |  |      |        |     |  |  |        |       
|Denominator for basic earnings per share                                    |                                         |                        | 35,237 |      |  |      | 33,775 |     |  |  | 35,072 |       
|Employee stock options and other dilutive
    potential common shares(2)(3) |                                         |                        |       |      |  |      | 254    |     |  |  | 95     |       
|                                                                            |                                         |                        |        |      |  |      |        |     |  |  |        |       
|Denominator for diluted earnings per share(2)(3)                            |                                         |                        | 35,237 |      |  |      | 34,029 |     |  |  | 35,167 |       
|                                                                            |                                         |                        |        |      |  |      |        |     |  |  |        |       



---



|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | Excludes 112,976 and 89,951 shares of restricted
    common stock which have been granted but have not vested as of
    December 31, 2002 and 2001, respectively.                                                                                                                                                                                                                                                                                                                 
|   
|(2) | Certain options to purchase common stock were not
    included in the calculation of diluted earnings per share
    because their exercise prices were greater than the average
    market price of our common stock for the periods presented. For
    the years ended December 31, 2001 and 2000, these weighted
    options outstanding totaled 6.1 million shares and
    8.0 million shares, respectively, with exercise prices
    ranging from $24.69 to $114.00 per share.
|   
|(3) | Employee stock options and other dilutive
    potential common shares for the year ended December 31,
    2002 were not included in the calculation of diluted earnings
    per share because they were antidilutive.                                                                                                                                                                                                                                                             

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                  |                                        | $         | 339,514    |           |            | $      | 9,010      |        |   | $      | (1,696 | )      |   | $         | 346,828 |          
|                                  | State, municipal and state and local agency |                                        |           | 391,370    |           |            |        | 16,057     |        |   |        | (759   | )      |   |           | 406,668 |          
|                                  | Corporate debt and other securities         |                                        |           | 429,876    |           |            |        | 15,726     |        |   |        | (3,581 | )      |   |           | 442,021 |          
|                                  |                                             |                                        |           |            |           |            |        |            |        |   |        |        |        |   |           |        
|                                  |                                             | Total marketable securities            |           |            | 1,160,760 |            |        |            | 40,793 |   |        |        | (6,036 | ) |           |         | 1,195,517 | 
|                                  |                                             |                                        |           |            |           |            |        |            |        |   |        |        |        |   |           |        
|Marketable securities-restricted: |                                             |                                        |           |            |           |            |        |            |        |   |        |        |        |   |           |        
|                                  | U.S. government and agency                  |                                        |           | 103,287    |           |            |        | 2,542      |        |   |        |       |        |   |           | 105,289 |          
|                                  | State, municipal and state and local agency |                                        |           | 25,679     |           |            |        | 736        |        |   |        | (68    | )      |   |           | 26,347  |          
|                                  | Corporate debt and other securities         |                                        |           | 57,223     |           |            |        | 924        |        |   |        | (2     | )      |   |           | 58,145  |          
|                                  |                                             |                                        |           |            |           |            |        |            |        |   |        |        |        |   |           |        
|                                  |                                             | Total marketable securities-restricted |           |            | 186,189   |            |        |            | 4,202  |   |        |        | (70    | ) |           |         | 190,321   | 
|                                  |                                             |                                        |           |            |           |            |        |            |        |   |        |        |        |   |           |        
|Balance at December 31, 2002      |                                             | $                                      | 1,346,949 |            |           | $          | 44,995 |            |        | $ | (6,106 | )      |        | $ | 1,385,838 |        
|                                  |                                             |                                        |           |            |           |            |        |            |        |   |        |        |        |   |           |        

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PACIFICARE HEALTH SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)

|                                  |                                             |                                        |           |            |           |            |        |            |        |   |        |        |        |   |           |         |           | 
|--------------------------------- | ------------------------------------------- | -------------------------------------- | --------- | ---------- | --------- | ---------- | ------ | ---------- | ------ | - | ------ | ------ | ------ | - | --------- | ------- | --------- | 
|                                  |                                             |                                        |           | Gross      |           | Gross      |        |           
|                                  |                                             | Amortized                              |           | Unrealized |           | Unrealized |        |           
|                                  |                                             | Cost                                   |           | Gains      |           | Losses     |        | Fair Value
|                                  |                                             |                                        |           |            |           |            |        |           
|                                  |                                             |                                       
|                                  |                                             | (Amounts in thousands)                
|Marketable securities:            |                                             |                                        |           |            |           |            |        |            |        |   |        |        |        |   |           |        
|                                  | U.S. government and agency                  |                                        | $         | 355,234    |           |            | $      | 2,227      |        |   | $      | (1,739 | )      |   | $         | 355,722 |          
|                                  | State, municipal and state and local agency |                                        |           | 288,581    |           |            |        | 2,564      |        |   |        | (1,199 | )      |   |           | 289,946 |          
|                                  | Corporate debt and other securities         |                                        |           | 415,501    |           |            |        | 5,231      |        |   |        | (4,047 | )      |   |           | 416,685 |          
|                                  |                                             |                                        |           |            |           |            |        |            |        |   |        |        |        |   |           |        
|                                  |                                             | Total marketable securities            |           |            | 1,059,316 |            |        |            | 10,022 |   |        |        | (6,985 | ) |           |         | 1,062,353 | 
|                                  |                                             |                                        |           |            |           |            |        |            |        |   |        |        |        |   |           |        
|Marketable securities-restricted: |                                             |                                        |           |            |           |            |        |            |        |   |        |        |        |   |           |        
|                                  | U.S. government and agency                  |                                        |           | 60,402     |           |            |        | 1,220      |        |   |        | (25    | )      |   |           | 61,597  |          
|                                  | State, municipal and state and local agency |                                        |           | 33,298     |           |            |        | 242        |        |   |        | (56    | )      |   |           | 33,484  |          
|                                  | Corporate debt and other securities         |                                        |           | 18,467     |           |            |        | 610        |        |   |        |       |        |   |           | 19,077  |          
|                                  |                                             |                                        |           |            |           |            |        |            |        |   |        |        |        |   |           |        
|                                  |                                             | Total marketable securities-restricted |           |            | 112,167   |            |        |            | 2,072  |   |        |        | (81    | ) |           |         | 114,158   | 
|                                  |                                             |                                        |           |            |           |            |        |            |        |   |        |        |        |   |           |        
|Balance at December 31, 2001      |                                             | $                                      | 1,171,483 |            |           | $          | 12,094 |            |        | $ | (7,066 | )      |        | $ | 1,176,511 |        
|                                  |                                             |                                        |           |            |           |            |        |            |        |   |        |        |        |   |           |        

As of December 31, 2002 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                |  | $                      | 89,716    |                         |  | $              | 88,257    |            |  | $ | 56,097  |  |  | $ | 56,209  | 
|Due after one year through five years  |  |                        | 312,189   |                         |  |                | 326,549   |            |  |   | 106,999 |  |  |   | 110,244 | 
|Due after five years through ten years |  |                        | 376,401   |                         |  |                | 392,458   |            |  |   | 16,009  |  |  |   | 16,672  | 
|Due after ten years                    |  |                        | 382,454   |                         |  |                | 388,253   |            |  |   | 7,084   |  |  |   | 7,196   | 
|                                       |  |                        |           |                         |  |                |           |            |  |   |         |  |  |   |         | 
|                                       |  | $                      | 1,160,760 |                         |  | $              | 1,195,517 |            |  | $ | 186,189 |  |  | $ | 190,321 | 
|                                       |  |                        |           |                         |  |                |           |            |  |   |         |  |  |   |         | 

Proceeds from sales and maturities of marketable
securities were $7.7 billion in 2002, $8.8 billion in
2001 and $7.1 billion in 2000. Gross realized gains and
gross realized losses are included in net investment income
under the specific identification method.

4.     Dispositions

2002 Dispositions.In the fourth quarter of 2002, we
entered into an agreement with HEALTHvisionunder which
HEALTHvisionacquired the e-prescribing assets of our
subsidiary MEDeMORPHUS Healthcare Solutions, Inc. in exchange
for assuming certain liabilities. Under this agreement,
HEALTHvisionassumed responsibility for
MEDeMORPHUSs existing contracts with more than
1,600 physicians, including the delivery of
MEDeMORPHUSs handheld devices and wireless functionality.
In connection with the sale of assets, we recognized pretax
charges of $9 million ($6 million or $0.15 diluted
loss per share, net of tax). See Note 10, Impairment,
Disposition, Restructuring, Office of Personnel Management and
Other Charges (Credits).

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

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PACIFICARE HEALTH SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)

approximately $4 million ($2 million or
$0.07 diluted loss per share, net of tax). See Note 10,
Impairment, Disposition, Restructuring, Office of
Personnel Management and Other Charges (Credits).

5.     Long-Term Debt
and Other Commitments

Our contractual cash obligations as of
December 31, 2002, including long-term debt and other
commitments, were as follows:

|                                             |                                       |                                  |       |      |       |      |     |      |     |      |     |      |     |            |     |   |     |   |     |   |     |   |     |   |     |   |       |     |     | 
|-------------------------------------------- | ------------------------------------- | -------------------------------- | ----- | ---- | ----- | ---- | --- | ---- | --- | ---- | --- | ---- | --- | ---------- | --- | - | --- | - | --- | - | --- | - | --- | - | --- | - | ----- | --- | --- | 
|                                             |                                       |                                 
|                                             |                                       | Payments Due by Period          
|                                             |                                       |                                 
|                                             |                                       | Total                            |       | 2003 |       | 2004 |     | 2005 |     | 2006 |     | 2007 |     | Thereafter
|                                             |                                       |                                  |       |      |       |      |     |      |     |      |     |      |     |           
|                                             |                                       |                                 
|                                             |                                       | (Amounts in millions)           
|Long-term debt:                              |                                       |                                  |       |      |       |      |     |      |     |      |     |      |     |            |     |   |     |   |     |   |     |   |     |   |     |   |       |    
|                                             | 10 3/4% senior notes, net of discount |                                  | $     | 497  |       |      | $   |     |     |      | $   |     |     |            | $   |  |     |   | $   |  |     |   | $   |  |     |   | $     | 497 |    
|                                             | Senior credit facility                |                                  |       | 151  |       |      |     | 61   |     |      |     | 81   |     |            |     | 9 |     |   |     |  |     |   |     |  |     |   |       |    |    
|                                             | Convertible subordinated debentures   |                                  |       | 135  |       |      |     |     |     |      |     |     |     |            |     |  |     |   |     |  |     |   |     |  |     |   |       | 135 |    
|                                             | FHP senior notes(1)                   |                                  |       | 43   |       |      |     | 43   |     |      |     |     |     |            |     |  |     |   |     |  |     |   |     |  |     |   |       |    |    
|                                             | Database financing agreement          |                                  |       | 11   |       |      |     | 3    |     |      |     | 5    |     |            |     | 3 |     |   |     |  |     |   |     |  |     |   |       |    |    
|                                             | Other                                 |                                  |       | 2    |       |      |     |     |     |      |     |     |     |            |     |  |     |   |     |  |     |   |     |  |     |   |       | 2   |    
|                                             |                                       |                                  |       |      |       |      |     |      |     |      |     |      |     |            |     |   |     |   |     |   |     |   |     |   |     |   |       |    
|                                             |                                       | Total long-term debt commitments |       |      | 839   |      |     |      | 107 |      |     |      | 86  |            |     |   | 12  |   |     |   |    |   |     |   |    |   |       |     | 634 | 
|                                             |                                       |                                  |       |      |       |      |     |      |     |      |     |      |     |            |     |   |     |   |     |   |     |   |     |   |     |   |       |    
|Other commitments:                           |                                       |                                  |       |      |       |      |     |      |     |      |     |      |     |            |     |   |     |   |     |   |     |   |     |   |     |   |       |    
|Information technology outsourcing contracts |                                       |                                  | 1,275 |      |       |      | 174 |      |     |      | 168 |      |     |            | 158 |   |     |   | 139 |   |     |   | 132 |   |     |   | 504   |    
|Operating leases                             |                                       |                                  | 176   |      |       |      | 41  |      |     |      | 34  |      |     |            | 28  |   |     |   | 25  |   |     |   | 21  |   |     |   | 27    |    
|                                             |                                       |                                  |       |      |       |      |     |      |     |      |     |      |     |            |     |   |     |   |     |   |     |   |     |   |     |   |       |    
|                                             |                                       | Total other commitments          |       |      | 1,451 |      |     |      | 215 |      |     |      | 202 |            |     |   | 186 |   |     |   | 164 |   |     |   | 153 |   |       |     | 531 | 
|                                             |                                       |                                  |       |      |       |      |     |      |     |      |     |      |     |            |     |   |     |   |     |   |     |   |     |   |     |   |       |    
|Total contractual cash obligations           |                                       | $                                | 2,290 |      |       | $    | 322 |      |     | $    | 288 |      |     | $          | 198 |   |     | $ | 164 |   |     | $ | 153 |   |     | $ | 1,165 |    
|                                             |                                       |                                  |       |      |       |      |     |      |     |      |     |      |     |            |     |   |     |   |     |   |     |   |     |   |     |   |       |    



---



|    |                                                                                                                                                                         
|--- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | As of December 31, 2002, we had
    $43 million available in a restricted cash collateral
    account that will be used to repurchase or repay the FHP senior
    notes.

Convertible Subordinated Debentures.In the fourth quarter of 2002 we sold
$135 million in aggregate principal amount of 3%
convertible subordinated debentures due in 2032 through a
private placement. We used a portion of the net proceeds from
the debentures to repay $53 million in indebtedness under
our term loan facility. The debentures are convertible into
common stock under certain conditions, including satisfaction of
a market price condition for our common stock, satisfaction of a
trading price condition relating to the debentures, upon notice
of redemption, or upon specified corporate transactions. Each
$1,000 of the debentures is convertible into 23.8095 shares
of our common stock. Beginning in October 2007, we may redeem
for cash all or any portion of the debentures, at a purchase
price of 100% of the principal amount plus accrued interest,
upon not less than 30 nor more than 60 days written
notice to the holders. Beginning in October 2007, and in
successive 5-year increments, our holders may require us to
repurchase the debentures for cash at a repurchase price of 100%
of the principal amount plus accrued interest. Our payment
obligations under the debentures are subordinated to our senior
indebtedness, and effectively subordinated to all indebtedness
and other liabilities of our subsidiaries. In connection with
the debentures offering, we incurred approximately
$5 million in fees that will be amortized over the initial
five-year term of the debentures.

10 3/4% Senior Notes.In May 2002, we sold $500 million
in aggregate principal amount of 10 3/4% senior notes due
in 2009 through a private placement. The 10 3/4% senior
notes were issued at 99.389%, for a discount of $3 million
that will be amortized over the term of the notes. We used a
portion of the net proceeds from the 10 3/4% senior notes
to repay $369 million in indebtedness under our senior
credit facility,

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PACIFICARE HEALTH SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)

including $315 million under our term loan
facility and $54 million under our revolving credit
facility. Additionally, we used $85 million of the net
proceeds to fund a restricted cash collateral account that has
been and will be used, subject to our being in compliance with
the senior credit facility, to repurchase or repay the FHP
senior notes prior to or on their stated maturity date. As of
December 31, 2002, we had used $42 million of the
restricted cash collateral account to purchase and permanently
retire FHP senior notes. We also used $22 million of the
net proceeds as a deposit against outstanding letters of credit
under our senior credit facility. We subsequently replaced all
but approximately $1 million of these letters of credit,
and the corresponding deposits were released to us. As of
December 31, 2002, our letter of credit commitments totaled
$19 million, and were backed by funds deposited in
restricted cash accounts maintained by us. In connection with
the 10 3/4% senior notes offering, we incurred
approximately $20 million in fees that will be amortized
over the term of the notes.

We may redeem the 10 3/4% senior notes at
any time on or after June 1, 2006 at an initial redemption
price equal to 105.375% of their principal amount plus accrued
and unpaid interest. The redemption price will thereafter
decline annually. We also have the option before June 1,
2005 to redeem up to $175 million in aggregate principal
amount of the 10 3/4% senior notes at a redemption price of
110.750% of their principal amount plus accrued and unpaid
interest using the proceeds from sales of certain kinds of our
capital stock. Additionally, at any time on or prior to
June 1, 2006, we may redeem the 10 3/4% senior notes
upon a change of control, as defined in the indenture for the
notes, at 100% of their principal amount plus accrued and unpaid
interest and a make-whole premium.

Certain of our domestic, unregulated subsidiaries
fully and unconditionally guarantee the 10 3/4% senior
notes. Certain of our other domestic, unregulated subsidiaries
are currently restricted from guaranteeing the 10 3/4%
senior notes by the terms of the FHP senior notes, but will
fully and unconditionally guarantee the 10 3/4% senior
notes once we permanently repay the FHP senior notes. See
Note 13, Financial Guarantees.

Senior Credit Facility.In April 2002, we executed an
amendment with our lenders to extend the maturity date of our
senior credit facility to January 3, 2005. Since
December 31, 2001, we have repaid indebtedness under the
senior credit facility as follows:

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

The senior credit facility amortizes at a rate of
$25 million per quarter. Each quarterly amortization
payment includes a $20 million cash payment on the term
loan facility and a $5 million reduction in borrowing
capacity under the revolving credit facility. As of
December 31, 2002, the total size of the committed
revolving credit facility was $36 million, of which at
least $35 million was available for borrowing.

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PACIFICARE HEALTH SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)

The interest rates per annum applicable to
amounts outstanding under the term loan facility and revolving
credit facility were increased in connection with the amendment
of our senior credit facility and 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 4% per annum, or the rate of Eurodollar
borrowings for the applicable interest period plus a margin of
5% per annum. Based on our outstanding balance under the credit
facility as of December 31, 2002, our average overall
interest rate, excluding the facility fee, was 6.4% per annum.
In connection with the restructuring of our long-term debt, we
wrote off unamortized senior credit facility fees, and paid
advisory fees totaling $19 million ($12 million or
$0.35 diluted loss per share, net of tax) during 2002.

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 and a maximum debt to earnings before interest,
taxes, depreciation and amortization, or EBITDA, requirement. At
December 31, 2002, we were in compliance with all of these
covenants. Our domestic, unregulated subsidiaries provide
guarantees and have granted security interests to the lenders in
substantially all of their personal property to collateralize
our obligations under the senior credit facility. We have also
pledged the equity of certain of our subsidiaries to the lenders
under the senior credit facility.

FHP Senior Notes.We
had $43 million in senior notes outstanding as of
December 31, 2002 that we assumed when we acquired FHP
International Corporation, or FHP, in 1997. These notes mature
on September 15, 2003, and bear interest at 7% payable
semiannually. As described above, $85 million of the net
proceeds from the 10 3/4% senior notes offering was used to
fund a restricted cash collateral account that has been and will
be used, subject to our being in compliance with the senior
credit facility, to repurchase or repay the FHP senior notes
prior to or on their stated maturity date. As of
December 31, 2002, we had used $42 million of the
restricted cash collateral account to purchase and permanently
retire FHP senior notes. Additionally, in May 2002, we retired
$3 million of the FHP senior notes by exchanging
approximately 0.1 million shares of our common stock for
those FHP senior notes. We reissued treasury stock to provide
the common stock used in the exchange. The FHP senior notes
share in the collateral securing our obligations under our
senior credit facility.

Database Financing Agreement.In August 2002, we entered into a
payment plan agreement to purchase database licenses, financial
accounting system software and related maintenance in connection
with the implementation of our Information Technology, or IT,
initiatives. We financed $14 million of this purchase,
payable in quarterly installments through July 2005. The
interest imputed on the payment plan agreement ranges from 4% to
5.3%.

Letters of Credit.Letters of credit are purchased
guarantees that ensure our performance or payment to third
parties in connection with professional liability insurance
policies and lease commitments. Letters of credit commitments
totaled $19 million at December 31, 2002 and
$33 million at December 31, 2001. As of
December 31, 2002, our letters of credit commitments were
backed by funds deposited in restricted cash accounts maintained
by us.

Information Technology Outsourcing Contracts.In December 2001, we entered into a
10-year contract to outsource our IT operations to International
Business Machines Corporation, or IBM. Under the contract, IBM
is the coordinator of our IT outsourcing arrangement, and will
provide IT services and day-to-day management of our IT
infrastructure, including data center operations, support
services and information distribution. In January 2002, we
entered into a 10-year contract to outsource our IT software
applications maintenance and enhancement services to Keane,
Inc., or Keane. Our total cash obligations for base fees under
these contracts over the 10-year terms will be
$1.3 billion. However, because we have the ability to
reduce services from the vendors under the contracts, our
ultimate cash commitment may be less than the stated contract
amounts. The contracts also provide for variable fees, based on
services provided above certain contractual baselines. During
2002, we entered into additional services contracts

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PACIFICARE HEALTH SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)

with IBM totaling $127 million over the
remaining term of the original contract. Additionally, in the
event of contract termination, we would be responsible to pay
termination fees to IBM and Keane. These termination fees
decline as each successive year of the contract term is
completed. In connection with these outsourcing agreements, we
transitioned approximately 550 employee positions to IBM
and Keane in March 2002.

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

Operating Leases.We
lease office space and equipment under various non-cancelable
operating leases. Rent expense totaled $76 million in 2002,
$57 million in 2001, and $62 million in 2000.

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 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. During 2002, as part of an employee recognition
and retention program, we granted an additional
53,000 shares of our restricted common stock to certain
employees for their outstanding performance. Restrictions on the
84,000 shares expired on December 10, 2001 for holders
who remained employees of PacifiCare on that date. Restrictions
on the 90,000 and 53,000 shares, respectively, will expire,
and related charges are being amortized as earned over the
vesting period, not to exceed four years. 3,200 restricted
shares were forfeited for the year ended December 31, 2001.
None were forfeited during the year ended December 31, 2002.

All shares of restricted stock were issued from
our 1996 Officer and Key Employee Stock Option Plan, as amended.
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 $2 million and $1 million as of
December 31, 2002 and 2001, respectively. Related expenses
(charged to selling, general and administrative expenses) were
$1 million and $3 million for the years ended
December 31, 2002 and 2001.

Acqua Wellington Arrangement.In December 2001, we entered into an
equity commitment arrangement with Acqua Wellington North
American Equities Fund Ltd., or Acqua Wellington, an
institutional investor, for the purchase by Acqua Wellington of
up to 6.9 million shares or $150 million of 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

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##### Table of Contents



PACIFICARE HEALTH SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)

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. In April 2002, we made a draw down
under our equity commitment arrangement with Acqua Wellington.
As a result of this draw down, we sold 420,720 shares to
Acqua Wellington for an average price of $21.39 per share. The
total proceeds from the draw down were approximately
$9 million. This equity commitment arrangement will expire
in June 2003.

Treasury Stock.As
of December 31, 2002, we held approximately
11.7 million shares of treasury stock totaling
$603 million. During the year ended December 31, 2002,
we reissued approximately 1.1 million shares of treasury
stock in connection with our employee benefit plans, the early
retirement of FHP senior notes, and a draw down of the Acqua
Wellington equity commitment arrangement. We will continue to
reissue treasury stock in connection with our employee benefit
plans and future draw downs, if any, under the Acqua Wellington
equity commitment arrangement, or for other corporate purposes.

Minority Interest.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 Computer Corporation, as a
return on their original investment of $8 million. No
operating results were allocated to minority stockholders in
2002 or 2001.

7.     Goodwill and
Intangible Assets.

In July 2001, the FASB issued SFAS No. 141,
Business Combinations,and SFAS 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 impairment
tests on an annual basis or more frequently if impairment
indicators exist. Under the guidance of SFAS No. 142, we
used a discounted cash flow methodology to assess the fair
values of our reporting units as of January 1, 2002. For
reporting units with book equity values that exceeded the fair
values, we performed a hypothetical purchase price allocation.
Impairment was measured by comparing the goodwill derived from
the hypothetical purchase price allocation to the carrying value
of the goodwill balance. As a result, we recognized
$897 million (net of $32 million of deferred tax
liability reversals) of goodwill impairment as the cumulative
effect of a change in accounting principle during the three
months ended March 31, 2002. The following table reflects
consolidated results adjusted as though the adoption of the SFAS
No. 142 non-amortization of goodwill provisions occurred
for the years ended December 31, 2000 and 2001:

|                           |  |                                               |        |             |  |             |        |             |  |             |        |             |  |   |         |  |  |   |        |  |  |   |         | 
|-------------------------- |  | --------------------------------------------- | ------ | ----------- |  | ----------- | ------ | ----------- |  | ----------- | ------ | ----------- |  | - | ------- |  |  | - | ------ |  |  | - | ------- | 
|                           |  |                                              
|                           |  | Year Ended December 31,                      
|                           |  |                                              
|                           |  |                                               |        |            
|                           |  | 2001                                          |        | 2000       
|                           |  |                                               |        |            
|                           |  | As Reported                                   |        | Adjustments |  | As Adjusted |        | As Reported |  | Adjustments |        | As Adjusted
|                           |  |                                               |        |             |  |             |        |             |  |             |        |            
|                           |  |                                              
|                           |  | (Amounts in thousands, except per-share data)
|Net income                 |  | $                                             | 19,066 |             |  | $           | 57,411 |             |  | $           | 76,417 |             |  | $ | 161,040 |  |  | $ | 57,057 |  |  | $ | 218,097 | 
|Basic earnings per share   |  | $                                             | 0.56   |             |  | $           | 1.70   |             |  | $           | 2.26   |             |  | $ | 4.59    |  |  | $ | 1.63   |  |  | $ | 6.22    | 
|Diluted earnings per share |  | $                                             | 0.55   |             |  | $           | 1.69   |             |  | $           | 2.25   |             |  | $ | 4.58    |  |  | $ | 1.62   |  |  | $ | 6.20    | 

Other intangible assets will continue to be
amortized over their useful lives. Under the current accounting
rules and based on our current intangible assets, our future
intangible asset amortization will be

F-16



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##### Table of Contents



PACIFICARE HEALTH SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)

$22 million in 2003, $21 million in 2004,
$17 million in 2005, $15 million in 2006 and
$15 million in 2007. Balances of identified intangible
assets, by major class, were as follows for the periods
indicated:

|                   |                   |                              |   |              |         |             |   |         |         |  |   |         |         | 
|------------------ | ----------------- | ---------------------------- | - | ------------ | ------- | ----------- | - | ------- | ------- |  | - | ------- | ------- | 
|                   |                   |                              |   | Accumulated  |         |            
|                   |                   | Cost                         |   | Amortization |         | Net Balance
|                   |                   |                              |   |              |         |            
|                   |                   |                             
|                   |                   | (Amounts in thousands)      
|Intangible assets: |                   |                              |   |              |         |             |   |         |         |  |   |        
|                   | Employer groups   |                              | $ | 243,820      |         |             | $ | 105,406 |         |  | $ | 138,414 |        
|                   | Provider networks |                              |   | 121,051      |         |             |   | 17,986  |         |  |   | 103,065 |        
|                   | Other             |                              |   | 10,729       |         |             |   | 9,192   |         |  |   | 1,537   |        
|                   |                   |                              |   |              |         |             |   |         |         |  |   |        
|                   |                   | Balance at December 31, 2002 |   | $            | 375,600 |             |   | $       | 132,584 |  |   | $       | 243,016 | 
|                   |                   |                              |   |              |         |             |   |         |         |  |   |        
|Intangible assets: |                   |                              |   |              |         |             |   |         |         |  |   |        
|                   | Employer groups   |                              | $ | 243,820      |         |             | $ | 86,738  |         |  | $ | 157,082 |        
|                   | Provider networks |                              |   | 121,051      |         |             |   | 14,395  |         |  |   | 106,656 |        
|                   | Other             |                              |   | 10,729       |         |             |   | 7,851   |         |  |   | 2,878   |        
|                   |                   |                              |   |              |         |             |   |         |         |  |   |        
|                   |                   | Balance at December 31, 2001 |   | $            | 375,600 |             |   | $       | 108,984 |  |   | $       | 266,616 | 
|                   |                   |                              |   |              |         |             |   |         |         |  |   |        

8.     Income
Taxes

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

|                                                   |                                           |                        |          |         |   |   |          |          |  
|-------------------------------------------------- | ----------------------------------------- | ---------------------- | -------- | ------- | - | - | -------- | -------- | -
|                                                   |                                           | 2002                   |          | 2001   
|                                                   |                                           |                        |          |        
|                                                   |                                           |                       
|                                                   |                                           | (Amounts in thousands)
|Current deferred tax assets (liabilities):         |                                           |                        |          |         |   |   |          |         
|                                                   | Accrued expenses                          |                        | $        | 48,632  |   |   | $        | 65,329   |  
|                                                   | Medical claims and benefits payable       |                        |          | 28,453  |   |   |          | 29,919   |  
|                                                   | Restructuring                             |                        |          | 11,275  |   |   |          | 15,420   |  
|                                                   | Accrued compensation                      |                        |          | 16,588  |   |   |          | 15,190   |  
|                                                   | Provider receivables                      |                        |          | 14,204  |   |   |          | 6,681    |  
|                                                   | Prepaid expenses                          |                        |          | (10,130 | ) |   |          | (6,309   | )
|                                                   | State franchise taxes                     |                        |          | 2,039   |   |   |          | 2,818    |  
|                                                   | Unrealized gains on marketable securities |                        |          | (13,027 | ) |   |          | (1,085   | )
|                                                   | Other                                     |                        |          | 2,724   |   |   |          | 4,196    |  
|                                                   |                                           |                        |          |         |   |   |          |         
|                                                   |                                           | $                      | 100,758  |         |   | $ | 132,159  |         
|                                                   |                                           |                        |          |         |   |   |          |         
|Non-current deferred tax
    (liabilities) assets: |                                           |                        |          |         |   |   |          |         
|                                                   | Identifiable intangibles                  |                        | $        | (91,402 | ) |   | $        | (100,538 | )
|                                                   | Goodwill amortization(1)                  |                        |          | 6,860   |   |   |          | (24,131  | )
|                                                   | Depreciation and software amortization    |                        |          | (21,131 | ) |   |          | (12,458  | )
|                                                   | Other                                     |                        |          | 1,883   |   |   |          |         |  
|                                                   |                                           |                        |          |         |   |   |          |         
|                                                   |                                           | $                      | (103,790 | )       |   | $ | (137,127 | )       
|                                                   |                                           |                        |          |         |   |   |          |         



---



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

F-17



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##### Table of Contents



PACIFICARE HEALTH SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)

The provision for income taxes consisted of the
following:

|          |                            |                        |   |        |        |      |   |        |        |   |   |         |         | 
|--------- | -------------------------- | ---------------------- | - | ------ | ------ | ---- | - | ------ | ------ | - | - | ------- | ------- | 
|          |                            | 2002                   |   | 2001   |        | 2000
|          |                            |                        |   |        |        |     
|          |                            |                       
|          |                            | (Amounts in thousands)
|Current:  |                            |                        |   |        |        |      |   |        |        |   |   |        
|          | Federal                    |                        | $ | 60,063 |        |      | $ | 34,286 |        |   | $ | 106,529 |        
|          | State                      |                        |   | 4,170  |        |      |   | 8,051  |        |   |   | 14,410  |        
|          |                            |                        |   |        |        |      |   |        |        |   |   |        
|          |                            | Total current          |   |        | 64,233 |      |   |        | 42,337 |   |   |         | 120,939 | 
|          |                            |                        |   |        |        |      |   |        |        |   |   |        
|Deferred: |                            |                        |   |        |        |      |   |        |        |   |   |        
|          | Federal                    |                        |   | 15,321 |        |      |   | 959    |        |   |   | 6,507   |        
|          | State                      |                        |   | 3,238  |        |      |   | (4,925 | )      |   |   | (400    | )      
|          |                            |                        |   |        |        |      |   |        |        |   |   |        
|          |                            | Total deferred         |   |        | 18,559 |      |   |        | (3,966 | ) |   |         | 6,107   | 
|          |                            |                        |   |        |        |      |   |        |        |   |   |        
|          | Provision for income taxes |                        | $ | 82,792 |        |      | $ | 38,371 |        |   | $ | 127,046 |        
|          |                            |                        |   |        |        |      |   |        |        |   |   |        

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

|                                    |  |      |      |      |  |      |      |   |  |  |      |  
|----------------------------------- |  | ---- | ---- | ---- |  | ---- | ---- | - |  |  | ---- | -
|                                    |  | 2002 |      | 2001 |  | 2000
|                                    |  |      |      |      |  |     
|Computed expected provision         |  |      | 35.0 | %    |  |      | 35.0 | % |  |  | 35.0 | %
|Amortization of intangibles         |  |      |     |      |  |      | 32.3 |   |  |  | 6.4  |  
|Tax-exempt interest                 |  |      | (2.1 | )    |  |      | (8.6 | ) |  |  | (2.1 | )
|State taxes, net of federal benefit |  |      | 3.2  |      |  |      | 3.6  |   |  |  | 3.2  |  
|Nondeductible expenses              |  |      | 0.9  |      |  |      | 3.2  |   |  |  | 0.2  |  
|Other, net                          |  |      | 0.3  |      |  |      | 2.4  |   |  |  | 1.4  |  
|                                    |  |      |      |      |  |      |      |   |  |  |      |  
|Provision for income taxes          |  |      | 37.3 | %    |  |      | 67.9 | % |  |  | 44.1 | %
|                                    |  |      |      |      |  |      |      |   |  |  |      |  

9.     Employee
Benefit Plans

Savings and profit-sharing plans.Most of our employees may participate
in our savings and profit-sharing plan. Features of the plan in
2002 were as follows:



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

The plan authorizes us to contribute a
discretionary amount to each employees account, generally
based on a percentage of pretax income. We did not contribute a
discretionary amount in 2002, 2001 or 2000. Charges to income
for the plan were $18 million in 2002, $19 million in
2001 and $19 million in 2000.

Employee Stock Purchase Plan.In September 2001, our board of
directors adopted a non-compensatory employee stock purchase
plan, or ESPP. The ESPP provides that up to 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 was the
date of 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-

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##### Table of Contents



PACIFICARE HEALTH SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)

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, 2002, 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.                                                                                                      

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, 2002, approximately 3.4 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, 2002, 0.3 million of the vested premium
options were outstanding and will expire in 2007. The balance of
the premium options expired because the closing market price of
our common stock did not reach $114.00 prior to October 6,
2002. There are no shares available for future awards under the
Premium Plan.

Director Plans.As
of December 31, 2002 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 the associated common
stock may not be sold within six months after the grant date. As
of December 31, 2002, 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-19



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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,
    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 | 
|Granted at market price              |  |         | 1,891,172  |                  |  | $           | 19.46 |                  |  |  |          |  |  | $ |      | 
|Exercised                            |  |         | (206,563   | )                |  | $           | 15.22 |                  |  |  |          |  |  | $ |      | 
|Canceled                             |  |         | (2,913,142 | )                |  | $           | 60.79 |                  |  |  |          |  |  | $ |      | 
|                                     |  |         |            |                  |  |             |       |                  |  |  |           |  |  |   |       | 
|Outstanding at December 31,
    2002 |  |         | 6,763,818  |                  |  | $           | 33.62 |                  |  |  | 3,314,102 |  |  | $ | 44.68 | 
|                                     |  |         |            |                  |  |             |       |                  |  |  |           |  |  |   |       | 

The following is a summary of information about
options outstanding and options exercisable at December 31,
2002:

|                         |  |                     |           |                     |  |                |   |             |  |                |       |  |  |  |           |  |  |   |       | 
|------------------------ |  | ------------------- | --------- | ------------------- |  | -------------- | - | ----------- |  | -------------- | ----- |  |  |  | --------- |  |  | - | ----- | 
|                         |  |                     |           |                    
|                         |  | 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 - $14.70          |  |                     | 755,438   |                     |  |                | 8 |             |  | $              | 12.98 |  |  |  | 410,926   |  |  | $ | 12.91 | 
|$16.02 - $27.10          |  |                     | 3,531,503 |                     |  |                | 9 |             |  | $              | 18.71 |  |  |  | 910,328   |  |  | $ | 18.71 | 
|$30.91 - $46.03          |  |                     | 692,981   |                     |  |                | 7 |             |  | $              | 43.72 |  |  |  | 569,806   |  |  | $ | 43.79 | 
|$51.46 - $75.38          |  |                     | 1,382,014 |                     |  |                | 6 |             |  | $              | 61.70 |  |  |  | 1,021,160 |  |  | $ | 63.49 | 
|$79.50 - $92.50          |  |                     | 401,882   |                     |  |                | 5 |             |  | $              | 89.46 |  |  |  | 401,882   |  |  | $ | 89.46 | 
|                         |  |                     |           |                     |  |                |   |             |  |                |       |  |  |  |           |  |  |   |       | 
|                         |  |                     | 6,763,818 |                     |  |                |   |             |  |                |       |  |  |  | 3,314,102 |  |  |   |       | 
|                         |  |                     |           |                     |  |                |   |             |  |                |       |  |  |  |           |  |  |   |       | 



---



|    |                                                          
|--- | ---------------------------------------------------------
|(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:

|                                                          |                          |      |    |       |  |      |     |       |  |  |    |       | 
|--------------------------------------------------------- | ------------------------ | ---- | -- | ----- |  | ---- | --- | ----- |  |  | -- | ----- | 
|                                                          |                          | 2002 |    | 2001  |  | 2000
|                                                          |                          |      |    |       |  |     
|Expected dividend yield                                   |                          |      | 0  | %     |  |      | 0   | %     |  |  | 0  | %    
|Risk-free interest rate                                   |                          |      | 3  | %     |  |      | 3   | %     |  |  | 6  | %    
|Expected stock price volatility                           |                          |      | 83 | %     |  |      | 110 | %     |  |  | 64 | %    
|Expected term until exercise (years)                      |                          |      | 2  |       |  |      | 2   |       |  |  | 2  |      
|Weighted average fair value of options on grant
    date: |                          |      |    |       |  |      |     |       |  |  |    |      
|                                                          | Granted at market prices |      | $  | 13.50 |  |      | $   | 12.59 |  |  | $  | 27.86 | 

F-20



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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
2002, 2001 and 2000:

|                                   |             |                                               |   |          |   |      |   |        |  |  |   |         | 
|---------------------------------- | ----------- | --------------------------------------------- | - | -------- | - | ---- | - | ------ |  |  | - | ------- | 
|                                   |             | 2002                                          |   | 2001     |   | 2000
|                                   |             |                                               |   |          |   |     
|                                   |             |                                              
|                                   |             | (Amounts in thousands, except per share data)
|Net (loss) income:                 |             |                                               |   |          |   |      |   |        |  |  |   |        
|                                   | As reported |                                               | $ | (757,829 | ) |      | $ | 19,006 |  |  | $ | 161,040 | 
|                                   | Pro forma   |                                               | $ | (775,320 | ) |      | $ | 12,579 |  |  | $ | 135,098 | 
|Basic (loss) earnings per share:   |             |                                               |   |          |   |      |   |        |  |  |   |        
|                                   | As reported |                                               | $ | (21.51   | ) |      | $ | 0.56   |  |  | $ | 4.59    | 
|                                   | Pro forma   |                                               | $ | (22.00   | ) |      | $ | 0.37   |  |  | $ | 3.85    | 
|Diluted (loss) earnings per share: |             |                                               |   |          |   |      |   |        |  |  |   |        
|                                   | As reported |                                               | $ | (21.51   | ) |      | $ | 0.55   |  |  | $ | 4.58    | 
|                                   | Pro forma   |                                               | $ | (22.00   | ) |      | $ | 0.37   |  |  | $ | 3.84    | 

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.

F-21



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PACIFICARE HEALTH SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)



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

We recognized net pretax charges (credits) in
2002, 2001 and 2000 as follows:

|                                                                                |                                                                                   |                                                                                            |              |           |       |            |      |              |      |      |      |   |       |       |      | 
|------------------------------------------------------------------------------- | --------------------------------------------------------------------------------- | ------------------------------------------------------------------------------------------ | ------------ | --------- | ----- | ---------- | ---- | ------------ | ---- | ---- | ---- | - | ----- | ----- | ---- | 
|                                                                                |                                                                                   |                                                                                            |              | Pretax    |       |            |      | Diluted Loss
|                                                                                |                                                                                   | Quarter                                                                                    |              | (Credits) |       | Net-of-Tax |      | (Earnings)  
|                                                                                |                                                                                   | Recognized                                                                                 |              | Charges   |       | Amount     |      | per Share(1)
|                                                                                |                                                                                   |                                                                                            |              |           |       |            |      |             
|                                                                                |                                                                                   |                                                                                           
|                                                                                |                                                                                   | (Amounts in millions, except per share data)                                              
|2002                                                                            |                                                                                   |                                                                                            |              |           |       |            |      |              |      |      |      |   |       |      
|OPM credits                                                                     |                                                                                   | Total First                                                                                |              | $         | (12.9 | )          |      | $            | (8.1 | )    |      | $ | (0.23 | )    
|                                                                                |                                                                                   |                                                                                            |              |           |       |            |      |              |      |      |      |   |       |      
|Write off of unamortized senior credit facility
    fees and paid advisory fees |                                                                                   | Total Second                                                                               |              |           | 18.3  |            |      |              | 11.4 |      |      |   | 0.32  |      
|                                                                                |                                                                                   |                                                                                            |              |           |       |            |      |              |      |      |      |   |       |      
|OPM credits                                                                     |                                                                                   | Fourth                                                                                     |              |           | (11.1 | )          |      |              | (6.9 | )    |      |   | (0.19 | )    
|Loss on disposition of subsidiary                                               |                                                                                   | Fourth                                                                                     |              |           | 9.0   |            |      |              | 5.6  |      |      |   | 0.15  |      
|Write off of unamortized senior credit facility
    fees and paid advisory fees |                                                                                   | Fourth                                                                                     |              |           | 1.1   |            |      |              | 0.7  |      |      |   | 0.02  |      
|Restructuring change in estimate                                                |                                                                                   | Fourth                                                                                     |              |           | (0.7  | )          |      |              | (0.5 | )    |      |   | (0.01 | )    
|                                                                                |                                                                                   |                                                                                            |              |           |       |            |      |              |      |      |      |   |       |      
|                                                                                | Total impairment, disposition, restructuring, OPM
    and other charges (credits) |                                                                                            | Total Fourth |           |       | (1.7       | )    |              |      | (1.1 | )    |   |       | (0.03 | )   
|                                                                                |                                                                                   |                                                                                            |              |           |       |            |      |              |      |      |      |   |       |      
|                                                                                |                                                                                   | Total net 2002 impairment, disposition,
    restructuring, OPM and other charges (credits) |              |           |       | $          | 3.7  |              |      | $    | 2.2  |   |       | $     | 0.07 | 
|                                                                                |                                                                                   |                                                                                            |              |           |       |            |      |              |      |      |      |   |       |      
|2001                                                                            |                                                                                   |                                                                                            |              |           |       |            |      |              |      |      |      |   |       |      
|Gain from contract termination agreement                                        |                                                                                   | First                                                                                      |              | $         | (1.2  | )          |      | $            | (0.6 | )    |      | $ | (0.02 | )    
|Restructuring change in estimate                                                |                                                                                   | First                                                                                      |              |           | 0.3   |            |      |              | 0.1  |      |      |   |      |      
|                                                                                |                                                                                   |                                                                                            |              |           |       |            |      |              |      |      |      |   |       |      
|                                                                                |                                                                                   | Total First                                                                                |              |           | (0.9  | )          |      |              | (0.5 | )    |      |   | (0.02 | )    
|                                                                                |                                                                                   |                                                                                            |              |           |       |            |      |              |      |      |      |   |       |      
|Restructuring change in estimate                                                |                                                                                   | 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 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 (credits) |              |           |       | $          | 61.1 |              |      | $    | 39.1 |   |       | $     | 1.13 | 
|                                                                                |                                                                                   |                                                                                            |              |           |       |            |      |              |      |      |      |   |       |      

F-22



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##### Table of Contents



PACIFICARE HEALTH SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)

|                                         |                                                                         |                                                                                            |              |           |      |            |     |              |      |      |     |   |       |       |      | 
|---------------------------------------- | ----------------------------------------------------------------------- | ------------------------------------------------------------------------------------------ | ------------ | --------- | ---- | ---------- | --- | ------------ | ---- | ---- | --- | - | ----- | ----- | ---- | 
|                                         |                                                                         |                                                                                            |              | Pretax    |      |            |     | Diluted Loss
|                                         |                                                                         | Quarter                                                                                    |              | (Credits) |      | Net-of-Tax |     | (Earnings)  
|                                         |                                                                         | Recognized                                                                                 |              | Charges   |      | Amount     |     | per Share(1)
|                                         |                                                                         |                                                                                            |              |           |      |            |     |             
|                                         |                                                                         |                                                                                           
|                                         |                                                                         | (Amounts in millions, except per share data)                                              
|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 (credits) |              |           |      | $          | 8.8 |              |      | $    | 5.0 |   |       | $     | 0.15 | 
|                                         |                                                                         |                                                                                            |              |           |      |            |     |              |      |      |     |   |       |      



---



|    |                                                                                                                                                                                                           
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | The year to date diluted loss (earnings) per
    share is computed using the year to date weighted average common
    shares and equivalents outstanding and may not agree to the sum
    of each quarter.

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

Write Off of Unamortized Senior Credit
Facility Fees.During 2002, we
recognized other charges of $19 million for the write off
of unamortized senior credit facility fees in connection with
our repayment of a significant portion of our senior credit
facility, and for advisory fees paid in connection with the
restructuring of our long-term debt. See Note 5,
Long-Term Debt and Other Commitments.

OPM.During 2002, we
recognized OPM credits of $24 million, representing a
reduction to the net liability we had established in prior
periods as a result of settlements with the OPM, the U.S.
Department of Justice, or DOJ, and a private individual to
settle disputes and a private lawsuit under the False Claims Act
regarding alleged premium overcharges to the government for the
period 1990 through 1997, primarily related to contracts held by
FHP health plans prior to our acquisition of FHP in 1997. See
Note 11, Contingencies  OPM and Related
Litigation.

Loss on Disposition of Subsidiary.During the fourth quarter of 2002, we
recognized disposition charges of $9 million, in connection
with the sale of assets of our subsidiary, MEDeMORPHUS Healthcare

F-23



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##### Table of Contents



PACIFICARE HEALTH SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)

Solutions, Inc. The charge included severance,
legal and other expenses related to the disposition. See
Note 4, Dispositions.

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

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

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

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

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

Restructuring Charge.In December 2001, we announced a
reorganization to enhance our focus on commercial business
growth and to improve our operational efficiency. In connection
with this reorganization, we terminated approximately 1,450
employees and we recognized a restructuring charge of
$60 million in the fourth quarter of 2001. Of the
$60 million charge, approximately $34 million
represented a liability for cash payments, of which
$0.6 million was paid during the fourth quarter of 2001 and
the remainder will be paid throughout 2002 and 2003.
Approximately $20 million of this restructuring charge was
for severance and related employee benefits for employees whose
positions will be eliminated by December 2003. More than half of
the employee reductions were related to consolidation and
standardization of company operations. As of December 31,
2002, approximately 1,170 employees had left and approximately
180 employees whose positions were eliminated had accepted other
positions within the company. The remaining employees are
expected to be terminated by December 2003. During 2002, we paid
approximately $2 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 realized net annual selling,
general and administrative savings of approximately
$55 million as a result of our consolidation and
standardization of operations from our December 2001
restructuring. We have and may continue to reinvest these
savings in planned selling, general and administrative expenses,
including an advertising campaign, new technology initiatives,
and increased marketing expense related to marketing
Prescription Solutions, our pharmacy benefit management, or PBM,
company to unaffiliated members and plan sponsors.

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.

F-24



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##### Table of Contents



PACIFICARE HEALTH SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)

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,
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 left and
60 employees, whose positions were eliminated, 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 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 was relieved
in early 2002, as severance payments were completed. During
2000, we realized estimated net annualized selling, general and
administrative salary savings from the January 2000
restructuring of $11 million (unaudited) 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 left and approximately
64 employees, whose positions were eliminated, 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. During 2001, we
realized estimated net annual selling, general and
administrative salary savings from our December 2000
restructuring of

F-25



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##### Table of Contents



PACIFICARE HEALTH SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)

$21 million (unaudited) as a result of
streamlining our operations. We reinvested these savings in
medical management and other infrastructure to help us operate
in an increasingly risk-based environment.

The following table presents the activity through
December 31, 2002, on the restructuring charge we took in
2001:

|                             |                                     |                                   |   |           |      |          |   |              |       |          |   |            |      |              |   |      |      |  |   |       |       |   |   |      |      |   |   |     |      | 
|---------------------------- | ----------------------------------- | --------------------------------- | - | --------- | ---- | -------- | - | ------------ | ----- | -------- | - | ---------- | ---- | ------------ | - | ---- | ---- |  | - | ----- | ----- | - | - | ---- | ---- | - | - | --- | ---- | 
|                             |                                     | Initial                           |   |           |      |          |   | Balance at   |       |          |   |            |      | Balance at  
|                             |                                     | Pretax                            |   | Non-cash  |      | 2001     |   | December 31, |       | 2002     |   | Changes in |      | December 31,
|                             |                                     | Charge                            |   | Write-off |      | Payments |   | 2001         |       | Payments |   | Estimate   |      | 2002        
|                             |                                     |                                   |   |           |      |          |   |              |       |          |   |            |      |             
|                             |                                     |                                  
|                             |                                     | (Amounts in millions)            
|December 2001 restructuring: |                                     |                                   |   |           |      |          |   |              |       |          |   |            |      |              |   |      |      |  |   |       |       |   |   |      |      |   |   |    
|                             | Lease cancellations and Commitments |                                   | $ | 39.7      |      |          | $ | (25.8        | )     |          | $ |           |      |              | $ | 13.9 |      |  | $ | (8.0  | )     |   | $ |     |      |   | $ | 5.9 |     
|                             | Severance and separation benefits   |                                   |   | 20.2      |      |          |   |             |       |          |   | (0.6       | )    |              |   | 19.6 |      |  |   | (13.3 | )     |   |   | (0.7 | )    |   |   | 5.6 |     
|                             |                                     |                                   |   |           |      |          |   |              |       |          |   |            |      |              |   |      |      |  |   |       |       |   |   |      |      |   |   |    
|                             |                                     | Total December 2001 Restructuring |   | $         | 59.9 |          |   | $            | (25.8 | )        |   | $          | (0.6 | )            |   | $    | 33.5 |  |   | $     | (21.3 | ) |   | $    | (0.7 | ) |   | $   | 11.5 | 
|                             |                                     |                                   |   |           |      |          |   |              |       |          |   |            |      |              |   |      |      |  |   |       |       |   |   |      |      |   |   |    



|    |              
|--- | -------------
|11. | Contingencies



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

Our insolvency expenses 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. Insolvency reserves also include
estimates for potentially insolvent providers that we have
specifically identified, where conditions indicate claims are
not being paid or claim payments have slowed considerably. We
continue to monitor the financial condition of our providers
where there is perceived risk of insolvency and will adjust our
insolvency reserves as necessary. Information provided by
provider groups may be unaudited, self-reported information or
may not ultimately be obtained. The balance of our insolvency
reserves included in medical claims and benefits payable totaled
$46 million at December 31, 2002 and $41 million
at December 31, 2001.

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

Class Action Legal Proceedings

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

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PACIFICARE HEALTH SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)

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. Oral argument
before the California Supreme Court occurred on February 4,
2003. We expect a ruling from the California Supreme Court in
May 2003. We deny all material allegations in the amended
complaint and intend to defend the action vigorously.

In mid-2000, various federal actions against
managed care companies, including us, were joined in a
multi-district litigation that was coordinated for pretrial
proceedings only in the United States District Court for the
Southern District of Florida. This litigation is known as
In re Managed Care Litigation. Thereafter,
Dr. Dennis Breen, Dr. Leonard Klay, Dr. Jeffrey
Book and several other health care providers, along with several
medical associations, including the California Medical
Association, joined the In re Managed Care
proceeding. These health care providers sued many 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 and
Dr. Books claims against us, except for their claims
for violations of the Racketeer Influenced and Corrupt
Organizations Act, or RICO, and for their conspiracy and aiding
and abetting claims that stem from contractual relationships
with other managed care companies. The District Court 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
appealed from the District Courts arbitration rulings to
the extent they denied sending claims to arbitration. The Court
of Appeals affirmed the District Courts arbitration
rulings in their entirety. We filed a petition asking the United
States Supreme Court to review the Court of Appeals
decision, and on October 15, 2002 the United States Supreme
Court granted our petition. Oral argument before the United
States Supreme Court occurred on February 24, 2003. We
expect a ruling by the United States Supreme Court in or before
June 2003.

In March 2001, the plaintiffs in the Breen
lawsuit filed an amended complaint, and we filed a motion to
dismiss the amended complaint. On September 26, 2002, the
District Court granted plaintiffs motion to amend their
complaint further and denied our pending motion to dismiss as
moot. On September 26, 2002, the District Court also
certified three classes of physicians on the claims asserted
against us in the plaintiffs complaint. Of the three
classes of physicians that were certified, two were nationwide
classes and one class was limited to California physicians. On
October 18, 2002, we filed a new motion to dismiss directed
at the plaintiffs second amended complaint. That motion
remains pending. Discovery in this litigation has recently
commenced. We deny all material allegations and intend to defend
the action vigorously.

PacifiCare of Texas v. The Texas Department of
Insurance and the State of Texas.In
November 2001, our Texas subsidiary, PacifiCare of Texas, filed
a lawsuit against the Texas Department of Insurance, or TDI, and
the State of Texas challenging the TDIs interpretation and
enforcement of state statutes and regulations that would make
Texas a double-pay state. The lawsuit relates to the
financial insolvency of three physician groups that had
capitation contracts with PacifiCare of Texas. Under these
contracts, the responsibility for claims payments to health care
providers was delegated to the contracted physician groups. We
made capitation payments to each of these physician groups, but
each of these physician

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PACIFICARE HEALTH SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)

groups failed to pay all of the health care
providers who provided health care services covered by the
capitation payments. On February 11, 2002, subsequent to
the filing of our lawsuit, the Attorney General of Texas or AG,
on behalf of the State of Texas and the TDI, filed a civil
complaint against PacifiCare of Texas in the District Court of
Travis County, Texas alleging violations of the Texas Health
Maintenance Organization Act, Texas Insurance Code and
regulations under the Code and the Texas Deceptive Trade
Practices Consumer Protection Act. The AGs complaint
primarily alleges that despite its capitation payments to the
physician groups, PacifiCare of Texas is still financially
responsible for the failure of the delegated providers to pay
health care providers. The AG is seeking an injunction requiring
us to comply with state laws plus unspecified damages, civil
penalties and restitution. The AG also claimed that its
subsequent lawsuit, not ours, should govern the dispute. In
March 2002, we submitted a motion to be recognized as the
plaintiff in the lawsuit rather than the AG. In June 2002, the
District Court granted this motion. On September 11, 2002,
the Texas Medical Association, various providers and the
bankruptcy trustee for an affiliate of one of the physician
groups intervened, without our opposition, in the lawsuit.

On March 21, 2003, without the admission of
any wrongdoing, our Texas subsidiary entered into a binding
memorandum of understanding, or MOU, with the Sate of Texas, the
AG and the TDI setting forth the principal terms of a settlement
of all of the pending litigation between the parties and related
civil investigations by the TDI. Under the MOU, the parties have
agreed to enter into a definitive settlement agreement within
30 days. The settlement agreement will provide that all
pending litigation and related civil investigations could by
stayed for up to twelve months from the date of execution of the
definitive settlement agreement. While the proceedings are
stayed, the parties will seek to settle the provider creditor
claims in the remaining outstanding bankruptcies relating to
Medical Select Management and Heritage Southwest Medical Group
in accordance with the MOU and engage in a review of provider
claims of the Heritage Physicians Network, or HPN. We agree to
use our reasonable best efforts to reach settlements in the
bankruptcies and resolve the HPN claims by specified dates and
agree to make contributions to fund provider creditor claims in
the bankruptcies subject to the process set forth in the MOU.

As part of the settlement, we agree to make
payments totaling $4.25 million, including attorneys fees
totaling $1.25 million to the AG, and administrative
services reimbursements totaling $1.5 million and
administrative penalties totaling $1.5 million to the TDI.
Of the $4.25 million payment, $2.45 million will be
paid upon execution of the settlement, and the remaining
$1.8 million will be paid upon the satisfaction of the
conditions for the settlement. All amounts paid upon execution
of the settlement will be held in trust pending the
effectiveness of the settlement. The settlement will become
effective upon us completing our settlements in the two
bankruptcies in accordance with the MOU, timely completion of
the HPN claims process, payment of all settlement amounts to the
AG and TDI, and compliance with certain Texas prompt payment
obligations with respect to members enrolled in our commercial
HMO plans. Concurrent with the settlement becoming effective:
(i) the parties would enter into a permanent injunction
with a term of one year that will require PacifiCare of Texas to
comply with applicable provisions of the Texas prompt payment
obligations with respect to members enrolled in our commercial
HMO plans; (ii) all of the pending litigation between the
parties will be dismissed with prejudice or with specified final
judgements; and (iii) the parties will enter into mutual
releases. We cannot provide any assurances that we will be able
to meet the conditions required to cause the settlement to
become effective. If we cannot reach the settlement, then we are
prepared to resume the litigation. We believe that we have
adequate reserves for this matter, including the satisfaction of
all the terms and conditions of the settlement, or any
liabilities that may arise if we are required to resume the
litigation.

OPM and Other Litigation

OPM Litigation.On
April 12, 2002, we resolved issues raised in various audits
of our health plans by the Office of Inspector General, or OIG,
as well as the False Claims investigations of the United States
Department of Justice, or DOJ and a private lawsuit under the
False Claims Act. The settlement primarily

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PACIFICARE HEALTH SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)

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

The settlement requires us to pay
$88 million. We paid $68 million in April 2002,
$10 million in October 2002 and will pay the final
$10 million in April 2003. As part of the settlement, we
received from OPM in the second quarter of 2002 approximately
$15 million in premiums that were either withheld pending
resolution of these audits or were not paid by OPM for 2001 and
earlier periods. This settlement and the results of other 2002
OPM audits resulted in OPM credits of $24 million
($15 million or $0.42 diluted earnings per share, net of
tax) that we recorded in 2002, representing a reduction to the
net liability we had established in prior periods. The
$88 million settlement includes approximately
$67 million paid out of fully funded reserves by our
operating subsidiaries, and $21 million paid by the parent
company on behalf of health plans we no longer own. We did not
admit to any wrongdoing as part of the settlement. The
settlement preserves our right to seek recovery from OPM of
premium underpayments, if any, for understatements of membership
census during the contracts years covered by the settlement.

Other Litigation.We
are involved in legal actions in the normal course of business,
including claims from our members and providers arising out of
decisions to deny or restrict reimbursement for services and
claims that seek monetary damages, including claims for punitive
damages that are not covered by insurance. Our establishment of
drug formularies, support of clinical trials and PBM services
may increase our exposure to product liability claims associated
with pharmaceuticals and medical devices. Based on current
information, including consultation with our lawyers, we believe
any ultimate liability that may arise from these actions,
including all class action legal proceedings and the settlement
or resumption of the State of Texas litigation, would not
materially affect our consolidated financial position, results
of operations or cash flows. However, our evaluation of the
likely impact of these actions could change in the future and an
unfavorable outcome, depending upon the amount and timing, could
have a material effect on our results of operations or cash
flows of a future period. For example, the loss of even one
claim resulting in a significant punitive damage award could
have a material adverse effect on our business. Moreover, our
exposure to potential liability under punitive damage theories
may decrease significantly our ability to settle these claims on
reasonable terms.

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PACIFICARE HEALTH SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)



|    |                     
|--- | --------------------
|12. | Comprehensive Income

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

|                                                                            |  |                        |         |           |  |            |         |   |  |   |        |  
|--------------------------------------------------------------------------- |  | ---------------------- | ------- | --------- |  | ---------- | ------- | - |  | - | ------ | -
|                                                                            |  |                        |         | Income    |  |           
|                                                                            |  |                        |         | Tax       |  |           
|                                                                            |  | Pretax                 |         | Benefit   |  | Net-of-Tax
|                                                                            |  | Amount                 |         | (Expense) |  | Amount    
|                                                                            |  |                        |         |           |  |           
|                                                                            |  |                       
|                                                                            |  | (Amounts in thousands)
|2002:                                                                       |  |                        |         |           |  |            |         |   |  |   |        |  
|Change in unrealized gains on marketable
    securities                     |  | $                      | 36,234  |           |  | $          | (13,638 | ) |  | $ | 22,596 |  
|Less: reclassification adjustment for net gains
    realized in net income  |  |                        | (4,514  | )         |  |            | 1,697   |   |  |   | (2,817 | )
|                                                                            |  |                        |         |           |  |            |         |   |  |   |        |  
|Other comprehensive income                                                  |  | $                      | 31,720  |           |  | $          | (11,941 | ) |  | $ | 19,779 |  
|                                                                            |  |                        |         |           |  |            |         |   |  |   |        |  
|2001:                                                                       |  |                        |         |           |  |            |         |   |  |   |        |  
|Change in unrealized gains on marketable
    securities                     |  | $                      | 21,589  |           |  | $          | (8,200  | ) |  | $ | 13,389 |  
|Less: reclassification adjustment for net gains
    realized in net income  |  |                        | (13,650 | )         |  |            | 5,187   |   |  |   | (8,463 | )
|                                                                            |  |                        |         |           |  |            |         |   |  |   |        |  
|Other comprehensive income                                                  |  | $                      | 7,939   |           |  | $          | (3,013  | ) |  | $ | 4,926  |  
|                                                                            |  |                        |         |           |  |            |         |   |  |   |        |  
|2000:                                                                       |  |                        |         |           |  |            |         |   |  |   |        |  
|Change in unrealized gains on marketable
    securities                     |  | $                      | 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 |  
|                                                                            |  |                        |         |           |  |            |         |   |  |   |        |  



|    |                     
|--- | --------------------
|13. | Financial Guarantees

Certain of our domestic, unregulated
subsidiaries, which we refer to as the Initial Guarantor
Subsidiaries, fully and unconditionally guarantee the
10 3/4% senior notes. Certain of our other domestic,
unregulated subsidiaries, which we refer to as the PacifiCare
Health Plan Administrators, Inc., or PHPA, Guarantor
Subsidiaries, are currently restricted from guaranteeing the
10 3/4% senior notes by the terms of the FHP senior notes,
but will fully and unconditionally guarantee the 10 3/4%
senior notes once we permanently repay the FHP senior notes. The
Initial Guarantors and the PHPA Guarantors are guarantors of our
senior credit facility.

The following unaudited consolidating condensed
financial statements quantify the financial position as of
December 31, 2001 and 2002 and the operations and cash
flows for years ended December 31, 2000, 2001 and 2002 of
the Initial Guarantor Subsidiaries listed below and the PHPA
Guarantor Subsidiaries listed below. The following unaudited
consolidating condensed balance sheets, consolidating condensed
statements of operations and consolidating condensed statements
of cash flows present financial information for:

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

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

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PACIFICARE HEALTH SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)

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

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

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

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

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

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PACIFICARE HEALTH SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)

CONSOLIDATING CONDENSED STATEMENTS OF
OPERATIONS

For the Year Ended December 31,
2000


(Unaudited)


|                                                                                                            |                         |                |         |              |  |              |         |               |  |               |         |         |  |   |            |            |  |   |          |          |   |   |            |            | 
|----------------------------------------------------------------------------------------------------------- | ----------------------- | -------------- | ------- | ------------ |  | ------------ | ------- | ------------- |  | ------------- | ------- | ------- |  | - | ---------- | ---------- |  | - | -------- | -------- | - | - | ---------- | ---------- | 
|                                                                                                            |                         |                |         | Initial      |  | PHPA         |         |               |  |               |         |        
|                                                                                                            |                         |                |         | Guarantor    |  | Guarantor    |         | Non-Guarantor |  | Consolidating |         |        
|                                                                                                            |                         | Parent         |         | Subsidiaries |  | Subsidiaries |         | Subsidiaries  |  | Adjustments   |         | Company
|                                                                                                            |                         |                |         |              |  |              |         |               |  |               |         |        
|                                                                                                            |                         |               
|                                                                                                            |                         | (In thousands)
|Operating revenue                                                                                           |                         | $              |        |              |  | $            | 32,600  |               |  | $             | 384,040 |         |  | $ | 11,492,420 |            |  | $ | (332,762 | )        |   | $ | 11,576,298 |           
|Income from subsidiaries                                                                                    |                         |                | 232,755 |              |  |              | 292,276 |               |  |               | 13,116  |         |  |   |           |            |  |   | (538,147 | )        |   |   |           |           
|                                                                                                            |                         |                |         |              |  |              |         |               |  |               |         |         |  |   |            |            |  |   |          |          |   |   |            |           
|                                                                                                            | Total operating revenue |                |         | 232,755      |  |              |         | 324,876       |  |               |         | 397,156 |  |   |            | 11,492,420 |  |   |          | (870,909 | ) |   |            | 11,576,298 | 
|Health care services                                                                                        |                         |                |        |              |  |              | 772     |               |  |               | 257,073 |         |  |   | 9,972,496  |            |  |   | (316,684 | )        |   |   | 9,913,657  |           
|Selling, general and administrative expenses                                                                |                         |                | 312     |              |  |              | 107,392 |               |  |               | 79,201  |         |  |   | 1,028,925  |            |  |   | (12,257  | )        |   |   | 1,203,573  |           
|Amortization of goodwill and intangible assets                                                              |                         |                |        |              |  |              | 29,166  |               |  |               | 500     |         |  |   | 53,551     |            |  |   |         |          |   |   | 83,217     |           
|Impairment, disposition, restructuring, Office of
    Personnel Management and other charges (credits), net |                         |                |        |              |  |              | 20,764  |               |  |               | (11,387 | )       |  |   | (611       | )          |  |   |         |          |   |   | 8,766      |           
|                                                                                                            |                         |                |         |              |  |              |         |               |  |               |         |         |  |   |            |            |  |   |          |          |   |   |            |           
|Operating income                                                                                            |                         |                | 232,443 |              |  |              | 166,782 |               |  |               | 71,769  |         |  |   | 438,059    |            |  |   | (541,968 | )        |   |   | 367,085    |           
|Interest expense                                                                                            |                         |                | (72,040 | )            |  |              | (9,710  | )             |  |               |        |         |  |   | (1,707     | )          |  |   | 3,821    |          |   |   | (79,636    | )         
|Minority interest in consolidated subsidiary                                                                |                         |                | 637     |              |  |              |        |               |  |               |        |         |  |   |           |            |  |   |         |          |   |   | 637        |           
|                                                                                                            |                         |                |         |              |  |              |         |               |  |               |         |         |  |   |            |            |  |   |          |          |   |   |            |           
|Income before income taxes                                                                                  |                         |                | 161,040 |              |  |              | 157,072 |               |  |               | 71,769  |         |  |   | 436,352    |            |  |   | (538,147 | )        |   |   | 288,086    |           
|(Benefit) provision for income taxes                                                                        |                         |                |        |              |  |              | (75,682 | )             |  |               | 24,177  |         |  |   | 178,551    |            |  |   |         |          |   |   | 127,046    |           
|                                                                                                            |                         |                |         |              |  |              |         |               |  |               |         |         |  |   |            |            |  |   |          |          |   |   |            |           
|Net income                                                                                                  |                         | $              | 161,040 |              |  | $            | 232,754 |               |  | $             | 47,592  |         |  | $ | 257,801    |            |  | $ | (538,147 | )        |   | $ | 161,040    |           
|                                                                                                            |                         |                |         |              |  |              |         |               |  |               |         |         |  |   |            |            |  |   |          |          |   |   |            |           

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PACIFICARE HEALTH SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)

CONSOLIDATING CONDENSED STATEMENTS OF CASH
FLOWS

For the Year Ended December 31,
2000


(Unaudited)


|                                                    |                                                                                                       |                                                                                                             |                                                               |              |          |              |          |               |          |               |         |         |         |         |           |         |          |          |   |          |         |   |           |          |         |          |  
|--------------------------------------------------- | ----------------------------------------------------------------------------------------------------- | ----------------------------------------------------------------------------------------------------------- | ------------------------------------------------------------- | ------------ | -------- | ------------ | -------- | ------------- | -------- | ------------- | ------- | ------- | ------- | ------- | --------- | ------- | -------- | -------- | - | -------- | ------- | - | --------- | -------- | ------- | -------- | -
|                                                    |                                                                                                       |                                                                                                             |                                                               | Initial      |          | PHPA         |          |               |          |               |         |        
|                                                    |                                                                                                       |                                                                                                             |                                                               | Guarantor    |          | Guarantor    |          | Non-Guarantor |          | Consolidating |         |        
|                                                    |                                                                                                       | Parent                                                                                                      |                                                               | Subsidiaries |          | Subsidiaries |          | Subsidiaries  |          | Adjustments   |         | Company
|                                                    |                                                                                                       |                                                                                                             |                                                               |              |          |              |          |               |          |               |         |        
|                                                    |                                                                                                       |                                                                                                            
|                                                    |                                                                                                       | (In thousands)                                                                                             
|Operating activities:                               |                                                                                                       |                                                                                                             |                                                               |              |          |              |          |               |          |               |         |         |         |         |           |         |          |          |   |          |         |   |           |         
|                                                    | Net income                                                                                            |                                                                                                             | $                                                             | 161,040      |          |              | $        | 232,754       |          |               | $       | 47,592  |         |         | $         | 257,801 |          |          | $ | (538,147 | )       |   | $         | 161,040  |        
|                                                    | Adjustments to reconcile net income to net cash
    flows provided by (used in) operating activities: |                                                                                                             |                                                               |              |          |              |          |               |          |               |         |         |         |         |           |         |          |          |   |          |         |   |           |          |        
|                                                    |                                                                                                       | Equity in income of subsidiaries                                                                            |                                                               |              | (232,755 | )            |          |               | (292,276 | )             |         |         | (13,116 | )       |           |         |         |          |   |          | 538,147 |   |           |          |        |         
|                                                    |                                                                                                       | Amortization of goodwill and intangible assets                                                              |                                                               |              |         |              |          |               | 29,166   |               |         |         | 500     |         |           |         | 53,551   |          |   |          |        |   |           |          | 83,217  |         
|                                                    |                                                                                                       | Depreciation and amortization                                                                               |                                                               |              |         |              |          |               | 35,365   |               |         |         | 2,661   |         |           |         | 9,320    |          |   |          |        |   |           |          | 47,346  |         
|                                                    |                                                                                                       | Impairment, disposition, restructuring, Office of
    Personnel Management and other charges (credits), net |                                                               |              |         |              |          |               | 20,764   |               |         |         | (11,387 | )       |           |         | 611      |          |   |          |        |   |           |          | 8,766   |         
|                                                    |                                                                                                       | Loss on disposal of property, plant and equipment
    and other                                             |                                                               |              |         |              |          |               | 6,874    |               |         |         | 329     |         |           |         | 461      |          |   |          |        |   |           |          | 7,664   |         
|                                                    |                                                                                                       | Deferred income taxes                                                                                       |                                                               |              |         |              |          |               | 15,364   |               |         |         | 628     |         |           |         | (9,885   | )        |   |          |        |   |           |          | 6,107   |         
|                                                    |                                                                                                       | Provision for doubtful accounts                                                                             |                                                               |              |         |              |          |               | 112      |               |         |         | 34      |         |           |         | 37,452   |          |   |          |        |   |           |          | 37,598  |         
|                                                    |                                                                                                       | Tax benefit realized for stock option exercises                                                             |                                                               |              | 1,801    |              |          |               |         |               |         |         |        |         |           |         |         |          |   |          |        |   |           |          | 1,801   |         
|                                                    |                                                                                                       | Minority interest in consolidated subsidiary                                                                |                                                               |              | (637     | )            |          |               |         |               |         |         |        |         |           |         |         |          |   |          |        |   |           |          | (637    | )       
|                                                    |                                                                                                       | Changes in assets and liabilities, net of effects
    from acquisitions and dispositions                    |                                                               |              | 422,244  |              |          |               | (412,085 | )             |         |         | (40,965 | )       |           |         | 309,140  |          |   |          |        |   |           |          | 278,334 |         
|                                                    |                                                                                                       |                                                                                                             |                                                               |              |          |              |          |               |          |               |         |         |         |         |           |         |          |          |   |          |         |   |           |         
|                                                    |                                                                                                       |                                                                                                             | Net cash flows provided by (used in) operating
    activities |              |          | 351,693      |          |               |          | (363,962      | )       |         |         | (13,724 | )         |         |          | 657,229  |   |          |         |  |           |          |         | 631,236  |  
|                                                    |                                                                                                       |                                                                                                             |                                                               |              |          |              |          |               |          |               |         |         |         |         |           |         |          |          |   |          |         |   |           |         
|Investing activities:                               |                                                                                                       |                                                                                                             |                                                               |              |          |              |          |               |          |               |         |         |         |         |           |         |          |          |   |          |         |   |           |         
|                                                    | Sale of marketable securities, net                                                                    |                                                                                                             |                                                               |             |          |              |          | 36,488        |          |               |         |        |         |         |           | 141,110 |          |          |   |         |         |   |           | 177,598  |        
|                                                    | Purchase of property, plant and equipment                                                             |                                                                                                             |                                                               |             |          |              |          | (82,486       | )        |               |         | (15,975 | )       |         |           | (6,795  | )        |          |   |         |         |   |           | (105,256 | )      
|                                                    | Sale (purchase) of marketable
    securities-restricted, net                                          |                                                                                                             |                                                               |             |          |              |          | 15            |          |               |         |        |         |         |           | (7,675  | )        |          |   |         |         |   |           | (7,660   | )      
|                                                    | Net cash acquired from (paid for) acquisitions                                                        |                                                                                                             |                                                               |             |          |              |          | (123,754      | )        |               |         |        |         |         |           | 127,852 |          |          |   |         |         |   |           | 4,098    |        
|                                                    | Proceeds from the sale of property, plant and
    equipment                                           |                                                                                                             |                                                               |             |          |              |          | 3,131         |          |               |         | 465     |         |         |           |        |          |          |   |         |         |   |           | 3,596    |        
|                                                    |                                                                                                       |                                                                                                             |                                                               |              |          |              |          |               |          |               |         |         |         |         |           |         |          |          |   |          |         |   |           |         
|                                                    |                                                                                                       |                                                                                                             | Net cash flows provided by (used in) investing
    activities |              |          |             |          |               |          | (166,606      | )       |         |         | (15,510 | )         |         |          | 254,492  |   |          |         |  |           |          |         | 72,376   |  
|                                                    |                                                                                                       |                                                                                                             |                                                               |              |          |              |          |               |          |               |         |         |         |         |           |         |          |          |   |          |         |   |           |         
|Financing activities:                               |                                                                                                       |                                                                                                             |                                                               |              |          |              |          |               |          |               |         |         |         |         |           |         |          |          |   |          |         |   |           |         
|                                                    | Principal payments on long-term debt                                                                  |                                                                                                             |                                                               | (400,000     | )        |              |          |              |          |               |         |        |         |         |           | (200    | )        |          |   |         |         |   |           | (400,200 | )      
|                                                    | Proceeds from borrowings of long-term debt                                                            |                                                                                                             |                                                               | 260,000      |          |              |          |              |          |               |         |        |         |         |           | 1,917   |          |          |   |         |         |   |           | 261,917  |        
|                                                    | Common stock repurchases                                                                              |                                                                                                             |                                                               | (173,332     | )        |              |          |              |          |               |         |         |         |         |           |        |          |          |   |         |         |   |           | (173,332 | )      
|                                                    | Cash received from minority stockholders                                                              |                                                                                                             |                                                               | 8,108        |          |              |          |              |          |               |         |        |         |         |           |        |          |          |   |         |         |   |           | 8,108    |        
|                                                    | Proceeds from issuance of common and treasury
    stock                                               |                                                                                                             |                                                               | 2,466        |          |              |          |              |          |               |         |        |         |         |           |        |          |          |   |         |         |   |           | 2,466    |        
|                                                    | Intercompany activity:                                                                                |                                                                                                             |                                                               |              |          |              |          |               |          |               |         |         |         |         |           |         |          |          |   |          |         |   |           |          |        
|                                                    |                                                                                                       | Dividends received (paid)                                                                                   |                                                               |              |         |              |          |               | 256,260  |               |         |         |        |         |           |         | (256,260 | )        |   |          |        |   |           |          |        |         
|                                                    |                                                                                                       | Royalty dividends and loans received (paid)                                                                 |                                                               |              |         |              |          |               | 216,259  |               |         |         |        |         |           |         | (216,259 | )        |   |          |        |   |           |          |        |         
|                                                    |                                                                                                       | Capital infusions (paid) received                                                                           |                                                               |              |         |              |          |               | (71,500  | )             |         |         |        |         |           |         | 71,500   |          |   |          |        |   |           |          |        |         
|                                                    |                                                                                                       | Subordinated loans received (paid)                                                                          |                                                               |              |         |              |          |               | 24,794   |               |         |         |        |         |           |         | (24,794  | )        |   |          |        |   |           |          |        |         
|                                                    |                                                                                                       |                                                                                                             |                                                               |              |          |              |          |               |          |               |         |         |         |         |           |         |          |          |   |          |         |   |           |         
|                                                    |                                                                                                       |                                                                                                             | Net cash flows provided by (used in) financing
    activities |              |          | (302,758     | )        |               |          | 425,813       |         |         |         |        |           |         |          | (424,096 | ) |          |         |  |           |          |         | (301,041 | )
|                                                    |                                                                                                       |                                                                                                             |                                                               |              |          |              |          |               |          |               |         |         |         |         |           |         |          |          |   |          |         |   |           |         
|Net increase (decrease) in cash and
    equivalents |                                                                                                       |                                                                                                             | 48,935                                                        |              |          |              | (104,755 | )             |          |               | (29,234 | )       |         |         | 487,625   |         |          |          |  |          |         |   | 402,571   |         
|Beginning cash and equivalents                      |                                                                                                       |                                                                                                             | (48,935                                                       | )            |          |              | 159,581  |               |          |               | (38,346 | )       |         |         | 776,764   |         |          |          |  |          |         |   | 849,064   |         
|                                                    |                                                                                                       |                                                                                                             |                                                               |              |          |              |          |               |          |               |         |         |         |         |           |         |          |          |   |          |         |   |           |         
|Ending cash and equivalents                         |                                                                                                       | $                                                                                                           |                                                              |              |          | $            | 54,826   |               |          | $             | (67,580 | )       |         | $       | 1,264,389 |         |          | $        |  |          |         | $ | 1,251,635 |         
|                                                    |                                                                                                       |                                                                                                             |                                                               |              |          |              |          |               |          |               |         |         |         |         |           |         |          |          |   |          |         |   |           |         

F-33



---



##### Table of Contents



PACIFICARE HEALTH SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)

CONSOLIDATING CONDENSED BALANCE
SHEETS

December 31, 2001


(Unaudited)


|                                           |                                           |                            |           |              |           |              |           |               |           |               |         |         |         |   |           |           |           |   |            |            |            |   |           |           |           | 
|------------------------------------------ | ----------------------------------------- | -------------------------- | --------- | ------------ | --------- | ------------ | --------- | ------------- | --------- | ------------- | ------- | ------- | ------- | - | --------- | --------- | --------- | - | ---------- | ---------- | ---------- | - | --------- | --------- | --------- | 
|                                           |                                           |                            |           | Initial      |           | PHPA         |           |               |           |               |         |        
|                                           |                                           |                            |           | Guarantor    |           | Guarantor    |           | Non-Guarantor |           | Consolidating |         |        
|                                           |                                           | Parent                     |           | Subsidiaries |           | Subsidiaries |           | Subsidiaries  |           | Adjustments   |         | Company
|                                           |                                           |                            |           |              |           |              |           |               |           |               |         |        
|                                           |                                           |                           
|                                           |                                           | (In thousands)            
|ASSETS                                    
|Current assets:                            |                                           |                            |           |              |           |              |           |               |           |               |         |         |         |   |           |           |           |   |            |            |            |   |           |          
|                                           | Cash and equivalents                      |                            | $         |             |           |              | $         | 110,335       |           |               | $       | (74,751 | )       |   | $         | 942,175   |           |   | $          |           |            |   | $         | 977,759   |          
|                                           | Marketable securities                     |                            |           | 10,001       |           |              |           |              |           |               |         |        |         |   |           | 1,052,352 |           |   |            |           |            |   |           | 1,062,353 |          
|                                           | Receivables, net                          |                            |           |             |           |              |           | (51,433       | )         |               |         | 134,197 |         |   |           | 295,516   |           |   |            | (2,619     | )          |   |           | 375,661   |          
|                                           | Intercompany                              |                            |           | (454,127     | )         |              |           | 325,418       |           |               |         | 88,307  |         |   |           | 40,402    |           |   |            |           |            |   |           |          |          
|                                           | Prepaid expenses and other current assets |                            |           | 156          |           |              |           | 12,632        |           |               |         | 12,307  |         |   |           | 15,159    |           |   |            |           |            |   |           | 40,254    |          
|                                           | Deferred income taxes                     |                            |           |             |           |              |           | 62,596        |           |               |         | 3,534   |         |   |           | 83,316    |           |   |            | (17,287    | )          |   |           | 132,159   |          
|                                           |                                           |                            |           |              |           |              |           |               |           |               |         |         |         |   |           |           |           |   |            |            |            |   |           |          
|                                           |                                           | Total current assets       |           |              | (443,970  | )            |           |               | 459,548   |               |         |         | 163,594 |   |           |           | 2,428,920 |   |            |            | (19,906    | ) |           |           | 2,588,186 | 
|                                           |                                           |                            |           |              |           |              |           |               |           |               |         |         |         |   |           |           |           |   |            |            |            |   |           |          
|Property, plant and equipment at cost, net |                                           |                            |          |              |           |              | 89,972    |               |           |               | 20,110  |         |         |   | 56,642    |           |           |   |           |            |            |   | 166,724   |          
|Marketable securities-restricted           |                                           |                            |          |              |           |              |          |               |           |               |        |         |         |   | 112,167   |           |           |   |           |            |            |   | 112,167   |          
|Deferred income taxes                      |                                           |                            |          |              |           |              | 49,288    |               |           |               | 4,180   |         |         |   | 12,999    |           |           |   | (66,467    | )          |            |   |          |          
|Investment in subsidiaries                 |                                           |                            | 3,173,723 |              |           |              | 2,387,155 |               |           |               | 13,264  |         |         |   | 1,502     |           |           |   | (5,575,644 | )          |            |   |          |          
|Goodwill and intangible assets, net        |                                           |                            |          |              |           |              | 1,017,005 |               |           |               | 16,479  |         |         |   | 1,148,502 |           |           |   |           |            |            |   | 2,181,986 |          
|Other assets                               |                                           |                            | 11,129    |              |           |              | 34,897    |               |           |               | 4       |         |         |   | 953       |           |           |   |           |            |            |   | 46,983    |          
|                                           |                                           |                            |           |              |           |              |           |               |           |               |         |         |         |   |           |           |           |   |            |            |            |   |           |          
|                                           |                                           | $                          | 2,740,882 |              |           | $            | 4,037,865 |               |           | $             | 217,631 |         |         | $ | 3,761,685 |           |           | $ | (5,662,017 | )          |            | $ | 5,096,046 |          
|                                           |                                           |                            |           |              |           |              |           |               |           |               |         |         |         |   |           |           |           |   |            |            |            |   |           |          
|LIABILITIES AND STOCKHOLDERS
    EQUITY  
|Current liabilities:                       |                                           |                            |           |              |           |              |           |               |           |               |         |         |         |   |           |           |           |   |            |            |            |   |           |          
|                                           | Medical claims and benefits payable       |                            | $         |             |           |              | $         | 100           |           |               | $       | 32,637  |         |   | $         | 1,065,601 |           |   | $          | (2,438     | )          |   | $         | 1,095,900 |          
|                                           | Accounts payable and accrued liabilities  |                            |           | 4,048        |           |              |           | 264,066       |           |               |         | 33,483  |         |   |           | 165,392   |           |   |            | (181       | )          |   |           | 466,808   |          
|                                           | Deferred income taxes                     |                            |           |             |           |              |           | 10,630        |           |               |         | 683     |         |   |           | 5,974     |           |   |            | (17,287    | )          |   |           |          |          
|                                           | Unearned premium revenue                  |                            |           |             |           |              |           | 1,079         |           |               |         | 270     |         |   |           | 549,561   |           |   |            |           |            |   |           | 550,910   |          
|                                           | Long-term debt due within one year        |                            |           |             |           |              |           |              |           |               |         |        |         |   |           | 124       |           |   |            |           |            |   |           | 124       |          
|                                           |                                           |                            |           |              |           |              |           |               |           |               |         |         |         |   |           |           |           |   |            |            |            |   |           |          
|                                           |                                           | Total current liabilities  |           |              | 4,048     |              |           |               | 275,875   |               |         |         | 67,073  |   |           |           | 1,786,652 |   |            |            | (19,906    | ) |           |           | 2,113,742 | 
|                                           |                                           |                            |           |              |           |              |           |               |           |               |         |         |         |   |           |           |           |   |            |            |            |   |           |          
|Long-term debt due after one year          |                                           |                            | 705,000   |              |           |              | 88,000    |               |           |               |        |         |         |   | 1,309     |           |           |   |           |            |            |   | 794,309   |          
|Deferred income taxes                      |                                           |                            |          |              |           |              | 87,098    |               |           |               | 5,668   |         |         |   | 110,828   |           |           |   | (66,467    | )          |            |   | 137,127   |          
|Other liabilities                          |                                           |                            |          |              |           |              | 16,915    |               |           |               |        |         |         |   | 168       |           |           |   |           |            |            |   | 17,083    |          
|Intercompany notes payable (receivable)    |                                           |                            |          |              |           |              | (176,842  | )             |           |               |        |         |         |   | 176,842   |           |           |   |           |            |            |   |          |          
|Stockholders equity:                      |                                           |                            |           |              |           |              |           |               |           |               |         |         |         |   |           |           |           |   |            |            |            |   |           |          
|                                           | Capital stock                             |                            |           | 473          |           |              |           |              |           |               |         |        |         |   |           |          |           |   |            |           |            |   |           | 473       |          
|                                           | Unearned compensation                     |                            |           | (1,153       | )         |              |           |              |           |               |         |        |         |   |           |          |           |   |            |           |            |   |           | (1,153    | )        
|                                           | Additional paid-in capital                |                            |           | 1,582,566    |           |              |           |              |           |               |         |        |         |   |           |          |           |   |            |           |            |   |           | 1,582,566 |          
|                                           | Accumulated other comprehensive loss      |                            |           |             |           |              |           |              |           |               |         |        |         |   |           | 1,951     |           |   |            |           |            |   |           | 1,951     |          
|                                           | Retained earnings                         |                            |           | 1,108,198    |           |              |           |              |           |               |         |        |         |   |           |          |           |   |            |           |            |   |           | 1,108,198 |          
|                                           | Treasury stock                            |                            |           | (658,250     | )         |              |           |              |           |               |         |        |         |   |           |          |           |   |            |           |            |   |           | (658,250  | )        
|                                           | Equity in income of subsidiaries          |                            |           |             |           |              |           | 3,746,819     |           |               |         | 144,890 |         |   |           | 1,683,935 |           |   |            | (5,575,644 | )          |   |           |          |          
|                                           |                                           |                            |           |              |           |              |           |               |           |               |         |         |         |   |           |           |           |   |            |            |            |   |           |          
|                                           |                                           | Total stockholders equity |           |              | 2,031,834 |              |           |               | 3,746,819 |               |         |         | 144,890 |   |           |           | 1,685,886 |   |            |            | (5,575,644 | ) |           |           | 2,033,785 | 
|                                           |                                           |                            |           |              |           |              |           |               |           |               |         |         |         |   |           |           |           |   |            |            |            |   |           |          
|                                           |                                           | $                          | 2,740,882 |              |           | $            | 4,037,865 |               |           | $             | 217,631 |         |         | $ | 3,761,685 |           |           | $ | (5,662,017 | )          |            | $ | 5,096,046 |          
|                                           |                                           |                            |           |              |           |              |           |               |           |               |         |         |         |   |           |           |           |   |            |            |            |   |           |          

F-34



---



##### Table of Contents



PACIFICARE HEALTH SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)

CONSOLIDATING CONDENSED STATEMENTS OF
OPERATIONS

For the Year Ended December 31,
2001


(Unaudited)


|                                                                                                            |                         |                |         |              |  |              |          |               |  |               |         |         |  |   |            |            |  |   |          |          |   |   |            |            | 
|----------------------------------------------------------------------------------------------------------- | ----------------------- | -------------- | ------- | ------------ |  | ------------ | -------- | ------------- |  | ------------- | ------- | ------- |  | - | ---------- | ---------- |  | - | -------- | -------- | - | - | ---------- | ---------- | 
|                                                                                                            |                         |                |         | Initial      |  | PHPA         |          |               |  |               |         |        
|                                                                                                            |                         |                |         | Guarantor    |  | Guarantor    |          | Non-Guarantor |  | Consolidating |         |        
|                                                                                                            |                         | Parent         |         | Subsidiaries |  | Subsidiaries |          | Subsidiaries  |  | Adjustments   |         | Company
|                                                                                                            |                         |                |         |              |  |              |          |               |  |               |         |        
|                                                                                                            |                         |               
|                                                                                                            |                         | (In thousands)
|Operating revenue                                                                                           |                         | $              | 176     |              |  | $            | 33,280   |               |  | $             | 447,687 |         |  | $ | 11,733,870 |            |  | $ | (371,041 | )        |   | $ | 11,843,972 |           
|Income from subsidiaries                                                                                    |                         |                | 82,535  |              |  |              | 153,982  |               |  |               |        |         |  |   | 16,109     |            |  |   | (252,626 | )        |   |   |           |           
|                                                                                                            |                         |                |         |              |  |              |          |               |  |               |         |         |  |   |            |            |  |   |          |          |   |   |            |           
|                                                                                                            | Total operating revenue |                |         | 82,711       |  |              |          | 187,262       |  |               |         | 447,687 |  |   |            | 11,749,979 |  |   |          | (623,667 | ) |   |            | 11,843,972 | 
|Health care services                                                                                        |                         |                |        |              |  |              | 320      |               |  |               | 294,709 |         |  |   | 10,416,632 |            |  |   | (344,004 | )        |   |   | 10,367,657 |           
|Selling, general and administrative expenses                                                                |                         |                | (724    | )            |  |              | 130,676  |               |  |               | 92,935  |         |  |   | 1,003,736  |            |  |   | (21,145  | )        |   |   | 1,205,478  |           
|Amortization of goodwill and intangible assets                                                              |                         |                |        |              |  |              | 29,588   |               |  |               | 499     |         |  |   | 52,809     |            |  |   |         |          |   |   | 82,896     |           
|Impairment, disposition, restructuring, Office of
    Personnel Management and other charges (credits), net |                         |                | 3,097   |              |  |              | 52,254   |               |  |               | 178     |         |  |   | 5,628      |            |  |   |         |          |   |   | 61,157     |           
|                                                                                                            |                         |                |         |              |  |              |          |               |  |               |         |         |  |   |            |            |  |   |          |          |   |   |            |           
|Operating income (loss)                                                                                     |                         |                | 80,338  |              |  |              | (25,576  | )             |  |               | 59,366  |         |  |   | 271,174    |            |  |   | (258,518 | )        |   |   | 126,784    |           
|Interest expense                                                                                            |                         |                | (61,332 | )            |  |              | (11,974  | )             |  |               | (62     | )       |  |   | (2,806     | )          |  |   | 5,892    |          |   |   | (70,282    | )         
|                                                                                                            |                         |                |         |              |  |              |          |               |  |               |         |         |  |   |            |            |  |   |          |          |   |   |            |           
|Income (loss) before income taxes                                                                           |                         |                | 19,006  |              |  |              | (37,550  | )             |  |               | 59,304  |         |  |   | 268,368    |            |  |   | (252,626 | )        |   |   | 56,502     |           
|(Benefit) provision for income taxes                                                                        |                         |                |        |              |  |              | (119,210 | )             |  |               | 29,440  |         |  |   | 128,141    |            |  |   |         |          |   |   | 38,371     |           
|                                                                                                            |                         |                |         |              |  |              |          |               |  |               |         |         |  |   |            |            |  |   |          |          |   |   |            |           
|Income before extraordinary gain                                                                            |                         |                | 19,006  |              |  |              | 81,660   |               |  |               | 29,864  |         |  |   | 140,227    |            |  |   | (252,626 | )        |   |   | 18,131     |           
|Extraordinary gain on early retirement of debt                                                              |                         |                |        |              |  |              | 875      |               |  |               |        |         |  |   |           |            |  |   |         |          |   |   | 875        |           
|                                                                                                            |                         |                |         |              |  |              |          |               |  |               |         |         |  |   |            |            |  |   |          |          |   |   |            |           
|Net income                                                                                                  |                         | $              | 19,006  |              |  | $            | 82,535   |               |  | $             | 29,864  |         |  | $ | 140,227    |            |  | $ | (252,626 | )        |   | $ | 19,006     |           
|                                                                                                            |                         |                |         |              |  |              |          |               |  |               |         |         |  |   |            |            |  |   |          |          |   |   |            |           

F-35



---



##### Table of Contents



PACIFICARE HEALTH SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)

CONSOLIDATING CONDENSED STATEMENTS OF CASH
FLOWS

For the Year Ended December 31,
2001


(Unaudited)


|                                                    |                                                                                                       |                                                                                                             |                                                               |              |         |                |         |               |          |               |         |         |         |        |           |          |          |          |   |          |         |   |           |          |          |          |  
|--------------------------------------------------- | ----------------------------------------------------------------------------------------------------- | ----------------------------------------------------------------------------------------------------------- | ------------------------------------------------------------- | ------------ | ------- | -------------- | ------- | ------------- | -------- | ------------- | ------- | ------- | ------- | ------ | --------- | -------- | -------- | -------- | - | -------- | ------- | - | --------- | -------- | -------- | -------- | -
|                                                    |                                                                                                       |                                                                                                             |                                                               | Initial      |         | PHPA           |         |               |          |               |         |        
|                                                    |                                                                                                       |                                                                                                             |                                                               | Guarantor    |         | Guarantor      |         | Non-Guarantor |          | Consolidating |         |        
|                                                    |                                                                                                       | Parent                                                                                                      |                                                               | Subsidiaries |         | Subsidiaries   |         | Subsidiaries  |          | Adjustments   |         | Company
|                                                    |                                                                                                       |                                                                                                             |                                                               |              |         |                |         |               |          |               |         |        
|                                                    |                                                                                                       |                                                                                                             |                                                               |              |         |                |         |               |          |              
|                                                    |                                                                                                       |                                                                                                             |                                                               |              |         | (In thousands) |         |               |          |              
|Operating activities:                               |                                                                                                       |                                                                                                             |                                                               |              |         |                |         |               |          |               |         |         |         |        |           |          |          |          |   |          |         |   |           |         
|                                                    | Net income                                                                                            |                                                                                                             | $                                                             | 19,006       |         |                | $       | 82,535        |          |               | $       | 29,864  |         |        | $         | 140,227  |          |          | $ | (252,626 | )       |   | $         | 19,006   |         
|                                                    | Adjustments to reconcile net income to net cash
    flows provided by (used in) operating activities: |                                                                                                             |                                                               |              |         |                |         |               |          |               |         |         |         |        |           |          |          |          |   |          |         |   |           |          |         
|                                                    |                                                                                                       | Equity in income of subsidiaries                                                                            |                                                               |              | (82,535 | )              |         |               | (153,982 | )             |         |         |        |        |           |          | (16,109  | )        |   |          | 252,626 |   |           |          |         |         
|                                                    |                                                                                                       | Amortization of goodwill and intangible assets                                                              |                                                               |              |        |                |         |               | 29,588   |               |         |         | 499     |        |           |          | 52,809   |          |   |          |        |   |           |          | 82,896   |         
|                                                    |                                                                                                       | Depreciation and amortization                                                                               |                                                               |              |        |                |         |               | 48,063   |               |         |         | 5,507   |        |           |          | 12,238   |          |   |          |        |   |           |          | 65,808   |         
|                                                    |                                                                                                       | Impairment, disposition, restructuring, Office of
    Personnel Management and other charges (credits), net |                                                               |              | 3,097   |                |         |               | 52,254   |               |         |         | 178     |        |           |          | 5,628    |          |   |          |        |   |           |          | 61,157   |         
|                                                    |                                                                                                       | Provision for doubtful accounts                                                                             |                                                               |              |        |                |         |               |         |               |         |         | 47      |        |           |          | 22,023   |          |   |          |        |   |           |          | 22,070   |         
|                                                    |                                                                                                       | (Gain) loss on disposal of property, plant and
    equipment and other                                      |                                                               |              |        |                |         |               | (1,141   | )             |         |         | (134    | )      |           |          | 7,328    |          |   |          |        |   |           |          | 6,053    |         
|                                                    |                                                                                                       | Deferred income taxes                                                                                       |                                                               |              |        |                |         |               | (14,473  | )             |         |         | 1,112   |        |           |          | 9,395    |          |   |          |        |   |           |          | (3,966   | )       
|                                                    |                                                                                                       | Unearned compensation amortization                                                                          |                                                               |              | 3,632   |                |         |               |         |               |         |         |        |        |           |          |         |          |   |          |        |   |           |          | 3,632    |         
|                                                    |                                                                                                       | Gain on early retirement of debt                                                                            |                                                               |              |        |                |         |               | (1,800   | )             |         |         |        |        |           |          |         |          |   |          |        |   |           |          | (1,800   | )       
|                                                    |                                                                                                       | Tax benefit realized for stock option exercises                                                             |                                                               |              | 21      |                |         |               |         |               |         |         |        |        |           |          |         |          |   |          |        |   |           |          | 21       |         
|                                                    |                                                                                                       | Changes in assets and liabilities, net of effects
    from acquisitions and dispositions                    |                                                               |              | 118,467 |                |         |               | (90,283  | )             |         |         | (40,875 | )      |           |          | (203,263 | )        |   |          |        |   |           |          | (215,954 | )       
|                                                    |                                                                                                       |                                                                                                             |                                                               |              |         |                |         |               |          |               |         |         |         |        |           |          |          |          |   |          |         |   |           |         
|                                                    |                                                                                                       |                                                                                                             | Net cash flows provided by (used in) operating
    activities |              |         | 61,688         |         |               |          | (49,239       | )       |         |         | (3,802 | )         |          |          | 30,276   |   |          |         |  |           |          |          | 38,923   |  
|                                                    |                                                                                                       |                                                                                                             |                                                               |              |         |                |         |               |          |               |         |         |         |        |           |          |          |          |   |          |         |   |           |         
|Investing activities:                               |                                                                                                       |                                                                                                             |                                                               |              |         |                |         |               |          |               |         |         |         |        |           |          |          |          |   |          |         |   |           |         
|                                                    | (Purchase) sale of marketable securities, net                                                         |                                                                                                             |                                                               | (10,001      | )       |                |         | 32,004        |          |               |         |        |         |        |           | (212,404 | )        |          |   |         |         |   |           | (190,401 | )       
|                                                    | Purchase of property, plant and equipment                                                             |                                                                                                             |                                                               |             |         |                |         | (55,735       | )        |               |         | (3,369  | )       |        |           | (18,197  | )        |          |   |         |         |   |           | (77,301  | )       
|                                                    | Proceeds from sale of property, plant and
    equipment                                               |                                                                                                             |                                                               |             |         |                |         | 25,139        |          |               |         |        |         |        |           |         |          |          |   |         |         |   |           | 25,139   |         
|                                                    | Sale (purchase) of marketable
    securities-restricted, net                                          |                                                                                                             |                                                               |             |         |                |         | 10            |          |               |         |        |         |        |           | (17,775  | )        |          |   |         |         |   |           | (17,765  | )       
|                                                    | Net cash (paid for) acquired from acquisitions                                                        |                                                                                                             |                                                               |             |         |                |         | (873          | )        |               |         |        |         |        |           | 373      |          |          |   |         |         |   |           | (500     | )       
|                                                    |                                                                                                       |                                                                                                             |                                                               |              |         |                |         |               |          |               |         |         |         |        |           |          |          |          |   |          |         |   |           |         
|                                                    |                                                                                                       |                                                                                                             | Net cash flows provided by (used in) investing
    activities |              |         | (10,001        | )       |               |          | 545           |         |         |         | (3,369 | )         |          |          | (248,003 | ) |          |         |  |           |          |          | (260,828 | )
|                                                    |                                                                                                       |                                                                                                             |                                                               |              |         |                |         |               |          |               |         |         |         |        |           |          |          |          |   |          |         |   |           |         
|Financing activities:                               |                                                                                                       |                                                                                                             |                                                               |              |         |                |         |               |          |               |         |         |         |        |           |          |          |          |   |          |         |   |           |         
|                                                    | Principal payments on long-term debt                                                                  |                                                                                                             |                                                               | (30,000      | )       |                |         |              |          |               |         |        |         |        |           | (284     | )        |          |   |         |         |   |           | (30,284  | )       
|                                                    | Credit facility amendment fees and expenses                                                           |                                                                                                             |                                                               | (12,949      | )       |                |         |              |          |               |         |        |         |        |           |         |          |          |   |         |         |   |           | (12,949  | )       
|                                                    | Purchase of minority interest in consolidated
    subsidiary                                          |                                                                                                             |                                                               | (8,821       | )       |                |         |              |          |               |         |        |         |        |           |         |          |          |   |         |         |   |           | (8,821   | )       
|                                                    | Proceeds from issuance of common and treasury
    stock                                               |                                                                                                             |                                                               | 83           |         |                |         |              |          |               |         |        |         |        |           |         |          |          |   |         |         |   |           | 83       |         
|                                                    | Intercompany activity:                                                                                |                                                                                                             |                                                               |              |         |                |         |               |          |               |         |         |         |        |           |          |          |          |   |          |         |   |           |          |         
|                                                    |                                                                                                       | Royalty dividends and loans received (paid)                                                                 |                                                               |              |        |                |         |               | 161,439  |               |         |         |        |        |           |          | (161,439 | )        |   |          |        |   |           |          |         |         
|                                                    |                                                                                                       | Dividends received (paid)                                                                                   |                                                               |              |        |                |         |               | 42,300   |               |         |         |        |        |           |          | (42,300  | )        |   |          |        |   |           |          |         |         
|                                                    |                                                                                                       | Subordinated loans (paid) received                                                                          |                                                               |              |        |                |         |               | (99,536  | )             |         |         |        |        |           |          | 99,536   |          |   |          |        |   |           |          |         |         
|                                                    |                                                                                                       |                                                                                                             |                                                               |              |         |                |         |               |          |               |         |         |         |        |           |          |          |          |   |          |         |   |           |         
|                                                    |                                                                                                       |                                                                                                             | Net cash flows provided by (used in) financing
    activities |              |         | (51,687        | )       |               |          | 104,203       |         |         |         |       |           |          |          | (104,487 | ) |          |         |  |           |          |          | (51,971  | )
|                                                    |                                                                                                       |                                                                                                             |                                                               |              |         |                |         |               |          |               |         |         |         |        |           |          |          |          |   |          |         |   |           |         
|Net increase (decrease) in cash and
    equivalents |                                                                                                       |                                                                                                             |                                                              |              |         |                | 55,509  |               |          |               | (7,171  | )       |         |        | (322,214  | )        |          |          |  |          |         |   | (273,876  | )       
|Beginning cash and equivalents                      |                                                                                                       |                                                                                                             |                                                               |              |         |                | 54,826  |               |          |               | (67,580 | )       |         |        | 1,264,389 |          |          |          |   |          |         |   | 1,251,635 |         
|                                                    |                                                                                                       |                                                                                                             |                                                               |              |         |                |         |               |          |               |         |         |         |        |           |          |          |          |   |          |         |   |           |         
|Ending cash and equivalents                         |                                                                                                       | $                                                                                                           |                                                              |              |         | $              | 110,335 |               |          | $             | (74,751 | )       |         | $      | 942,175   |          |          | $        |  |          |         | $ | 977,759   |         
|                                                    |                                                                                                       |                                                                                                             |                                                               |              |         |                |         |               |          |               |         |         |         |        |           |          |          |          |   |          |         |   |           |         

F-36



---



##### Table of Contents



PACIFICARE HEALTH SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)

CONSOLIDATING CONDENSED BALANCE
SHEETS

December 31, 2002


(Unaudited)


|                                           |                                                 |                            |           |              |           |                |           |               |           |               |         |         |         |   |           |           |           |   |            |            |            |   |           |           |           | 
|------------------------------------------ | ----------------------------------------------- | -------------------------- | --------- | ------------ | --------- | -------------- | --------- | ------------- | --------- | ------------- | ------- | ------- | ------- | - | --------- | --------- | --------- | - | ---------- | ---------- | ---------- | - | --------- | --------- | --------- | 
|                                           |                                                 |                            |           | Initial      |           | PHPA           |           |               |           |               |         |        
|                                           |                                                 |                            |           | Guarantor    |           | Guarantor      |           | Non-Guarantor |           | Consolidating |         |        
|                                           |                                                 | Parent                     |           | Subsidiaries |           | Subsidiaries   |           | Subsidiaries  |           | Adjustments   |         | Company
|                                           |                                                 |                            |           |              |           |                |           |               |           |               |         |        
|                                           |                                                 |                            |           |              |           |                |           |               |           |              
|                                           |                                                 |                            |           |              |           | (In thousands) |           |               |           |              
|ASSETS                                    
|Current assets:                            |                                                 |                            |           |              |           |                |           |               |           |               |         |         |         |   |           |           |           |   |            |            |            |   |           |          
|                                           | Cash and equivalents                            |                            | $         | 16,207       |           |                | $         | 151,973       |           |               | $       | (47,595 | )       |   | $         | 831,104   |           |   | $          |           |            |   | $         | 951,689   |          
|                                           | Marketable securities                           |                            |           |             |           |                |           |              |           |               |         |        |         |   |           | 1,195,517 |           |   |            |           |            |   |           | 1,195,517 |          
|                                           | Receivables, net                                |                            |           | 33           |           |                |           | (50,003       | )         |               |         | 242,309 |         |   |           | 100,127   |           |   |            | (8,372     | )          |   |           | 284,094   |          
|                                           | Intercompany                                    |                            |           | (537,199     | )         |                |           | 415,166       |           |               |         | 18,770  |         |   |           | 103,263   |           |   |            |           |            |   |           |          |          
|                                           | Prepaid expenses and other current assets       |                            |           | 1,015        |           |                |           | 24,853        |           |               |         | 8,596   |         |   |           | 16,238    |           |   |            | (3,732     | )          |   |           | 46,970    |          
|                                           | Restricted cash collateral for FHP senior notes |                            |           | 43,346       |           |                |           |              |           |               |         |        |         |   |           |          |           |   |            |           |            |   |           | 43,346    |          
|                                           | Deferred income taxes                           |                            |           |             |           |                |           | 61,399        |           |               |         | 3,508   |         |   |           | 63,108    |           |   |            | (27,257    | )          |   |           | 100,758   |          
|                                           |                                                 |                            |           |              |           |                |           |               |           |               |         |         |         |   |           |           |           |   |            |            |            |   |           |          
|                                           |                                                 | Total current assets       |           |              | (476,598  | )              |           |               | 603,388   |               |         |         | 225,588 |   |           |           | 2,309,357 |   |            |            | (39,361    | ) |           |           | 2,622,374 | 
|                                           |                                                 |                            |           |              |           |                |           |               |           |               |         |         |         |   |           |           |           |   |            |            |            |   |           |          
|Property, plant and equipment at cost, net |                                                 |                            |          |              |           |                | 99,610    |               |           |               | 17,890  |         |         |   | 44,185    |           |           |   |           |            |            |   | 161,685   |          
|Marketable securities-restricted           |                                                 |                            | 34,812    |              |           |                |          |               |           |               |        |         |         |   | 151,377   |           |           |   |           |            |            |   | 186,189   |          
|Deferred income taxes                      |                                                 |                            |          |              |           |                | 72,141    |               |           |               | 6,654   |         |         |   | 23,090    |           |           |   | (101,885   | )          |            |   |          |          
|Investment in subsidiaries                 |                                                 |                            | 2,513,858 |              |           |                | 1,555,158 |               |           |               | 13,264  |         |         |   | 1,501     |           |           |   | (4,083,781 | )          |            |   |          |          
|Goodwill and intangible assets, net        |                                                 |                            |          |              |           |                | 11,923    |               |           |               | 16,480  |         |         |   | 1,197,717 |           |           |   |           |            |            |   | 1,226,120 |          
|Other assets                               |                                                 |                            | 22,615    |              |           |                | 31,175    |               |           |               | 1       |         |         |   | 974       |           |           |   |           |            |            |   | 54,765    |          
|                                           |                                                 |                            |           |              |           |                |           |               |           |               |         |         |         |   |           |           |           |   |            |            |            |   |           |          
|                                           |                                                 | $                          | 2,094,687 |              |           | $              | 2,373,395 |               |           | $             | 279,877 |         |         | $ | 3,728,201 |           |           | $ | (4,225,027 | )          |            | $ | 4,251,133 |          
|                                           |                                                 |                            |           |              |           |                |           |               |           |               |         |         |         |   |           |           |           |   |            |            |            |   |           |          
|LIABILITIES AND STOCKHOLDERS
    EQUITY  
|Current liabilities:                       |                                                 |                            |           |              |           |                |           |               |           |               |         |         |         |   |           |           |           |   |            |            |            |   |           |          
|                                           | Medical claims and benefits payable             |                            | $         |             |           |                | $         | 17,929        |           |               | $       | 36,523  |         |   | $         | 995,508   |           |   | $          | (5,460     | )          |   | $         | 1,044,500 |          
|                                           | Accounts payable and accrued liabilities        |                            |           | 5,313        |           |                |           | 253,691       |           |               |         | 49,324  |         |   |           | 136,102   |           |   |            | (4,027     | )          |   |           | 440,403   |          
|                                           | Deferred income taxes                           |                            |           |             |           |                |           | 15,487        |           |               |         | 553     |         |   |           | 11,217    |           |   |            | (27,257    | )          |   |           |          |          
|                                           | Unearned premium revenue                        |                            |           |             |           |                |           | 200           |           |               |         |        |         |   |           | 480,208   |           |   |            | (2,617     | )          |   |           | 477,791   |          
|                                           | Long-term debt due within one year              |                            |           | 60,484       |           |                |           | 48,778        |           |               |         |        |         |   |           | (2,027    | )         |   |            |           |            |   |           | 107,235   |          
|                                           |                                                 |                            |           |              |           |                |           |               |           |               |         |         |         |   |           |           |           |   |            |            |            |   |           |          
|                                           |                                                 | Total current liabilities  |           |              | 65,797    |                |           |               | 336,085   |               |         |         | 86,400  |   |           |           | 1,621,008 |   |            |            | (39,361    | ) |           |           | 2,069,929 | 
|                                           |                                                 |                            |           |              |           |                |           |               |           |               |         |         |         |   |           |           |           |   |            |            |            |   |           |          
|Long-term debt due after one year          |                                                 |                            | 587,315   |              |           |                | 5,878     |               |           |               |        |         |         |   | 3,601     |           |           |   |           |            |            |   | 596,794   |          
|Convertible subordinated debentures        |                                                 |                            | 135,000   |              |           |                |          |               |           |               |        |         |         |   |          |           |           |   |           |            |            |   | 135,000   |          
|Deferred income taxes                      |                                                 |                            |          |              |           |                | 100,833   |               |           |               | 8,445   |         |         |   | 96,397    |           |           |   | (101,885   | )          |            |   | 103,790   |          
|Other liabilities                          |                                                 |                            |          |              |           |                | 17,148    |               |           |               |        |         |         |   | 167       |           |           |   |           |            |            |   | 17,315    |          
|Intercompany notes payable (receivable)    |                                                 |                            |          |              |           |                | (194,021  | )             |           |               |        |         |         |   | 194,021   |           |           |   |           |            |            |   |          |          
|Stockholders equity:                      |                                                 |                            |           |              |           |                |           |               |           |               |         |         |         |   |           |           |           |   |            |            |            |   |           |          
|                                           | Capital stock                                   |                            |           | 477          |           |                |           |              |           |               |         |        |         |   |           |          |           |   |            |           |            |   |           | 477       |          
|                                           | Unearned compensation                           |                            |           | (2,000       | )         |                |           |              |           |               |         |        |         |   |           |          |           |   |            |           |            |   |           | (2,000    | )        
|                                           | Additional paid-in capital                      |                            |           | 1,560,785    |           |                |           |              |           |               |         |        |         |   |           |          |           |   |            |           |            |   |           | 1,560,785 |          
|                                           | Accumulated other comprehensive loss            |                            |           |             |           |                |           |              |           |               |         |        |         |   |           | 21,730    |           |   |            |           |            |   |           | 21,730    |          
|                                           | Retained earnings                               |                            |           | 350,369      |           |                |           |              |           |               |         |        |         |   |           |          |           |   |            |           |            |   |           | 350,369   |          
|                                           | Treasury stock                                  |                            |           | (603,056     | )         |                |           |              |           |               |         |        |         |   |           |          |           |   |            |           |            |   |           | (603,056  | )        
|                                           | Equity in income of subsidiaries                |                            |           |             |           |                |           | 2,107,472     |           |               |         | 185,032 |         |   |           | 1,791,277 |           |   |            | (4,083,781 | )          |   |           |          |          
|                                           |                                                 |                            |           |              |           |                |           |               |           |               |         |         |         |   |           |           |           |   |            |            |            |   |           |          
|                                           |                                                 | Total stockholders equity |           |              | 1,306,575 |                |           |               | 2,107,472 |               |         |         | 185,032 |   |           |           | 1,813,007 |   |            |            | (4,083,781 | ) |           |           | 1,328,305 | 
|                                           |                                                 |                            |           |              |           |                |           |               |           |               |         |         |         |   |           |           |           |   |            |            |            |   |           |          
|                                           |                                                 | $                          | 2,094,687 |              |           | $              | 2,373,395 |               |           | $             | 279,877 |         |         | $ | 3,728,201 |           |           | $ | (4,225,027 | )          |            | $ | 4,251,133 |          
|                                           |                                                 |                            |           |              |           |                |           |               |           |               |         |         |         |   |           |           |           |   |            |            |            |   |           |          

F-37



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##### Table of Contents



PACIFICARE HEALTH SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)

CONSOLIDATING CONDENSED STATEMENTS OF
OPERATIONS

For the Year Ended December 31,
2002


(Unaudited)


|                                                                                                            |                         |                |          |              |   |              |          |               |   |               |         |         |  |   |            |            |  |   |           |         |  |   |            |            | 
|----------------------------------------------------------------------------------------------------------- | ----------------------- | -------------- | -------- | ------------ | - | ------------ | -------- | ------------- | - | ------------- | ------- | ------- |  | - | ---------- | ---------- |  | - | --------- | ------- |  | - | ---------- | ---------- | 
|                                                                                                            |                         |                |          | Initial      |   | PHPA         |          |               |   |               |         |        
|                                                                                                            |                         |                |          | Guarantor    |   | Guarantor    |          | Non-Guarantor |   | Consolidating |         |        
|                                                                                                            |                         | Parent         |          | Subsidiaries |   | Subsidiaries |          | Subsidiaries  |   | Adjustments   |         | Company
|                                                                                                            |                         |                |          |              |   |              |          |               |   |               |         |        
|                                                                                                            |                         |               
|                                                                                                            |                         | (In thousands)
|Operating revenue                                                                                           |                         | $              | (10,346  | )            |   | $            | 29,204   |               |   | $             | 450,770 |         |  | $ | 11,027,550 |            |  | $ | (340,676  | )       |  | $ | 11,156,502 |           
|Income from subsidiaries                                                                                    |                         |                | (661,977 | )            |   |              | (556,987 | )             |   |               |        |         |  |   | (4,591     | )          |  |   | 1,223,555 |         |  |   |           |           
|                                                                                                            |                         |                |          |              |   |              |          |               |   |               |         |         |  |   |            |            |  |   |           |         |  |   |            |           
|                                                                                                            | Total operating revenue |                |          | (672,323     | ) |              |          | (527,783      | ) |               |         | 450,770 |  |   |            | 11,022,959 |  |   |           | 882,879 |  |   |            | 11,156,502 | 
|Health care services                                                                                        |                         |                |         |              |   |              | 19,101   |               |   |               | 295,370 |         |  |   | 9,491,872  |            |  |   | (320,642  | )       |  |   | 9,485,701  |           
|Selling, general and administrative expenses                                                                |                         |                | (121     | )            |   |              | 260,493  |               |   |               | 98,799  |         |  |   | 1,004,457  |            |  |   | (17,068   | )       |  |   | 1,346,560  |           
|Amortization of intangible assets                                                                           |                         |                |         |              |   |              | 1,249    |               |   |               |        |         |  |   | 22,351     |            |  |   |          |         |  |   | 23,600     |           
|Impairment, disposition, restructuring, Office of
    Personnel Management and other charges (credits), net |                         |                | 18,162   |              |   |              | (12,687  | )             |   |               | (89     | )       |  |   | (1,612     | )          |  |   |          |         |  |   | 3,774      |           
|                                                                                                            |                         |                |          |              |   |              |          |               |   |               |         |         |  |   |            |            |  |   |           |         |  |   |            |           
|Operating income                                                                                            |                         |                | (690,364 | )            |   |              | (795,939 | )             |   |               | 56,690  |         |  |   | 505,891    |            |  |   | 1,220,589 |         |  |   | 296,867    |           
|Interest expense                                                                                            |                         |                | (67,465  | )            |   |              | (7,728   | )             |   |               |        |         |  |   | (2,677     | )          |  |   | 2,966     |         |  |   | (74,904    | )         
|                                                                                                            |                         |                |          |              |   |              |          |               |   |               |         |         |  |   |            |            |  |   |           |         |  |   |            |           
|Income before income taxes                                                                                  |                         |                | (757,829 | )            |   |              | (803,667 | )             |   |               | 56,690  |         |  |   | 503,214    |            |  |   | 1,223,555 |         |  |   | 221,963    |           
|(Benefit) provision for income taxes                                                                        |                         |                |         |              |   |              | (141,413 | )             |   |               | 22,275  |         |  |   | 201,930    |            |  |   |          |         |  |   | 82,792     |           
|                                                                                                            |                         |                |          |              |   |              |          |               |   |               |         |         |  |   |            |            |  |   |           |         |  |   |            |           
|(Loss) income before cumulative effect of a
    change in accounting principle                              |                         |                | (757,829 | )            |   |              | (662,254 | )             |   |               | 34,415  |         |  |   | 301,284    |            |  |   | 1,223,555 |         |  |   | 139,171    |           
|Cumulative effect of a change in accounting
    principle                                                   |                         |                |         |              |   |              |         |               |   |               |        |         |  |   | (897,000   | )          |  |   |          |         |  |   | (897,000   | )         
|                                                                                                            |                         |                |          |              |   |              |          |               |   |               |         |         |  |   |            |            |  |   |           |         |  |   |            |           
|Net (loss) income                                                                                           |                         | $              | (757,829 | )            |   | $            | (662,254 | )             |   | $             | 34,415  |         |  | $ | (595,716   | )          |  | $ | 1,223,555 |         |  | $ | (757,829   | )         
|                                                                                                            |                         |                |          |              |   |              |          |               |   |               |         |         |  |   |            |            |  |   |           |         |  |   |            |           

F-38



---



##### Table of Contents



PACIFICARE HEALTH SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)

CONSOLIDATING CONDENSED STATEMENTS OF CASH
FLOWS

For the Year Ended December 31,
2002


(Unaudited)


|                                                    |                                                                                                       |                                                                                                             |                                                               |              |         |              |         |               |         |               |         |         |        |        |          |          |         |          |   |           |            |   |         |          |         |          |  
|--------------------------------------------------- | ----------------------------------------------------------------------------------------------------- | ----------------------------------------------------------------------------------------------------------- | ------------------------------------------------------------- | ------------ | ------- | ------------ | ------- | ------------- | ------- | ------------- | ------- | ------- | ------ | ------ | -------- | -------- | ------- | -------- | - | --------- | ---------- | - | ------- | -------- | ------- | -------- | -
|                                                    |                                                                                                       |                                                                                                             |                                                               | Initial      |         | PHPA         |         |               |         |               |         |        
|                                                    |                                                                                                       |                                                                                                             |                                                               | Guarantor    |         | Guarantor    |         | Non-Guarantor |         | Consolidating |         |        
|                                                    |                                                                                                       | Parent                                                                                                      |                                                               | Subsidiaries |         | Subsidiaries |         | Subsidiaries  |         | Adjustments   |         | Company
|                                                    |                                                                                                       |                                                                                                             |                                                               |              |         |              |         |               |         |               |         |        
|                                                    |                                                                                                       |                                                                                                            
|                                                    |                                                                                                       | (In thousands)                                                                                             
|Operating activities:                               |                                                                                                       |                                                                                                             |                                                               |              |         |              |         |               |         |               |         |         |        |        |          |          |         |          |   |           |            |   |         |         
|                                                    | Net (loss) income                                                                                     |                                                                                                             | $                                                             | (757,829     | )       |              | $       | (662,254      | )       |               | $       | 34,415  |        |        | $        | (595,716 | )       |          | $ | 1,223,555 |            |   | $       | (757,829 | )      
|                                                    | Adjustments to reconcile net income to net cash
    flows provided by (used in) operating activities: |                                                                                                             |                                                               |              |         |              |         |               |         |               |         |         |        |        |          |          |         |          |   |           |            |   |         |          |        
|                                                    |                                                                                                       | Equity in income of subsidiaries                                                                            |                                                               |              | 661,977 |              |         |               | 556,987 |               |         |         |       |        |          |          | 4,591   |          |   |           | (1,223,555 | ) |         |          |        |         
|                                                    |                                                                                                       | Cumulative effect of a change in accounting
    principle                                                   |                                                               |              |        |              |         |               |        |               |         |         |       |        |          |          | 897,000 |          |   |           |            |   |         |          | 897,000 |         
|                                                    |                                                                                                       | Amortization of intangible assets                                                                           |                                                               |              |        |              |         |               | 1,249   |               |         |         |       |        |          |          | 22,351  |          |   |           |            |   |         |          | 23,600  |         
|                                                    |                                                                                                       | Deferred income taxes                                                                                       |                                                               |              |        |              |         |               | (3,064  | )             |         |         | 199    |        |          |          | 21,424  |          |   |           |            |   |         |          | 18,559  |         
|                                                    |                                                                                                       | (Gain) loss on disposal of property, plant and
    equipment                                                |                                                               |              |        |              |         |               | 15,792  |               |         |         | 21     |        |          |          | (3,020  | )        |   |           |           |   |         |          | 12,793  |         
|                                                    |                                                                                                       | Marketable and other securities impairment for
    other than temporary declines in value                   |                                                               |              | 11,001  |              |         |               |        |               |         |         |       |        |          |          | 1,542   |          |   |           |           |   |         |          | 12,543  |         
|                                                    |                                                                                                       | Employee benefit plan contributions in treasury
    stock                                                   |                                                               |              | 12,132  |              |         |               |        |               |         |         |       |        |          |          |        |          |   |           |           |   |         |          | 12,132  |         
|                                                    |                                                                                                       | Amortization of capitalized loan fees                                                                       |                                                               |              | 7,784   |              |         |               |        |               |         |         |       |        |          |          |        |          |   |           |           |   |         |          | 7,784   |         
|                                                    |                                                                                                       | Provision for doubtful accounts                                                                             |                                                               |              |        |              |         |               |        |               |         |         | 329    |        |          |          | 6,017   |          |   |           |            |   |         |          | 6,346   |         
|                                                    |                                                                                                       | Impairment, disposition, restructuring, Office of
    Personnel Management and other charges (credits), net |                                                               |              | 18,162  |              |         |               | (12,687 | )             |         |         | (89    | )      |          |          | (1,612  | )        |   |           |            |   |         |          | 3,774   |         
|                                                    |                                                                                                       | Amortization of notes receivable from sale of
    fixed assets                                              |                                                               |              |        |              |         |               | (3,107  | )             |         |         |       |        |          |          |        |          |   |           |           |   |         |          | (3,107  | )       
|                                                    |                                                                                                       | Tax benefit realized for stock option exercises                                                             |                                                               |              | 1,009   |              |         |               |        |               |         |         |       |        |          |          |        |          |   |           |           |   |         |          | 1,009   |         
|                                                    |                                                                                                       | Unearned compensation amortization                                                                          |                                                               |              | 693     |              |         |               |        |               |         |         |       |        |          |          |        |          |   |           |           |   |         |          | 693     |         
|                                                    |                                                                                                       | Amortization of discount on 10 3/4% senior
    notes                                                        |                                                               |              | 266     |              |         |               |        |               |         |         |       |        |          |          |        |          |   |           |           |   |         |          | 266     |         
|                                                    |                                                                                                       | Adjustment to cash received in purchase
    transaction                                                     |                                                               |              |        |              |         |               | 17      |               |         |         |       |        |          |          |        |          |   |           |           |   |         |          | 17      |         
|                                                    |                                                                                                       | Depreciation and amortization                                                                               |                                                               |              |        |              |         |               | 33,281  |               |         |         | 6,100  |        |          |          | 10,903  |          |   |           |           |   |         |          | 50,284  |         
|                                                    |                                                                                                       | Changes in assets and liabilities                                                                           |                                                               |              | 84,815  |              |         |               | (64,224 | )             |         |         | (9,918 | )      |          |          | (54,158 | )        |   |           |           |   |         |          | (43,485 | )       
|                                                    |                                                                                                       |                                                                                                             |                                                               |              |         |              |         |               |         |               |         |         |        |        |          |          |         |          |   |           |            |   |         |         
|                                                    |                                                                                                       |                                                                                                             | Net cash flows provided by (used in) operating
    activities |              |         | 40,010       |         |               |         | (138,010      | )       |         |        | 31,057 |          |          |         | 309,322  |   |           |            |  |         |          |         | 242,379  |  
|                                                    |                                                                                                       |                                                                                                             |                                                               |              |         |              |         |               |         |               |         |         |        |        |          |          |         |          |   |           |            |   |         |         
|Investing activities:                               |                                                                                                       |                                                                                                             |                                                               |              |         |              |         |               |         |               |         |         |        |        |          |          |         |          |   |           |            |   |         |         
|                                                    | Purchase of marketable securities -
    restricted                                                    |                                                                                                             |                                                               | (78,158      | )       |              |         |              |         |               |         |        |        |        |          | (39,210  | )       |          |   |          |            |   |         | (117,368 | )      
|                                                    | Purchase of marketable securities, net                                                                |                                                                                                             |                                                               |             |         |              |         |              |         |               |         |        |        |        |          | (113,987 | )       |          |   |          |            |   |         | (113,987 | )      
|                                                    | Purchase of property, plant and equipment                                                             |                                                                                                             |                                                               |             |         |              |         | (47,596       | )       |               |         | (3,901  | )      |        |          | (7,777   | )       |          |   |          |            |   |         | (59,274  | )      
|                                                    | Proceeds from the sale of property, plant and
    equipment                                           |                                                                                                             |                                                               |             |         |              |         | 104           |         |               |         |        |        |        |          | 12,388   |         |          |   |          |            |   |         | 12,492   |        
|                                                    |                                                                                                       |                                                                                                             |                                                               |              |         |              |         |               |         |               |         |         |        |        |          |          |         |          |   |           |            |   |         |         
|                                                    |                                                                                                       |                                                                                                             | Net cash flows provided by (used in) investing
    activities |              |         | (78,158      | )       |               |         | (47,492       | )       |         |        | (3,901 | )        |          |         | (148,586 | ) |           |            |  |         |          |         | (278,137 | )
|                                                    |                                                                                                       |                                                                                                             |                                                               |              |         |              |         |               |         |               |         |         |        |        |          |          |         |          |   |           |            |   |         |         
|Financing activities:                               |                                                                                                       |                                                                                                             |                                                               |              |         |              |         |               |         |               |         |         |        |        |          |          |         |          |   |           |            |   |         |         
|                                                    | Principal payments on long-term debt                                                                  |                                                                                                             |                                                               | (554,412     | )       |              |         |              |         |               |         |        |        |        |          | 104      |         |          |   |          |            |   |         | (554,308 | )      
|                                                    | Proceeds from borrowings of long-term debt                                                            |                                                                                                             |                                                               | 496,945      |         |              |         |              |         |               |         |        |        |        |          |         |         |          |   |          |            |   |         | 496,945  |        
|                                                    | Proceeds from issuance of convertible
    subordinated debentures                                     |                                                                                                             |                                                               | 135,000      |         |              |         |               |         |               |         |        |        |        |          |         |         |          |   |          |            |   |         | 135,000  |        
|                                                    | Principal payments on FHP senior notes                                                                |                                                                                                             |                                                               |             |         |              |         | (41,750       | )       |               |         |        |        |        |          |         |         |          |   |          |            |   |         | (41,750  | )      
|                                                    | Credit facility amendment fees and expenses                                                           |                                                                                                             |                                                               | (37,789      | )       |              |         |              |         |               |         |        |        |        |          |         |         |          |   |          |            |   |         | (37,789  | )      
|                                                    | Proceeds from draw down under equity commitment
    arrangement                                       |                                                                                                             |                                                               | 8,928        |         |              |         |              |         |               |         |        |        |        |          |         |         |          |   |          |            |   |         | 8,928    |        
|                                                    | Proceeds from issuance of common and treasury
    stock                                               |                                                                                                             |                                                               | 4,916        |         |              |         |              |         |               |         |        |        |        |          |         |         |          |   |          |            |   |         | 4,916    |        
|                                                    | Payments on software financing agreement                                                              |                                                                                                             |                                                               |             |         |              |         | (2,231        | )       |               |         |        |        |        |          |         |         |          |   |          |            |   |         | (2,231   | )      
|                                                    | Common stock registration fees                                                                        |                                                                                                             |                                                               | (23          | )       |              |         |              |         |               |         |        |        |        |          |         |         |          |   |          |            |   |         | (23      | )      
|                                                    | Intercompany activity:                                                                                |                                                                                                             |                                                               |              |         |              |         |               |         |               |         |         |        |        |          |          |         |          |   |           |            |   |         |          |        
|                                                    | Dividends received (paid)                                                                             |                                                                                                             |                                                               | 790          |         |              |         | 143,399       |         |               |         |        |        |        |          | (144,189 | )       |          |   |          |            |   |         |         |        
|                                                    | Royalty dividends and loans received (paid)                                                           |                                                                                                             |                                                               |             |         |              |         | 117,613       |         |               |         |        |        |        |          | (117,613 | )       |          |   |          |            |   |         |         |        
|                                                    | Subordinated loans received (paid)                                                                    |                                                                                                             |                                                               |             |         |              |         | (17,179       | )       |               |         |        |        |        |          | 17,179   |         |          |   |          |            |   |         |         |        
|                                                    | Capital contributions received (paid)                                                                 |                                                                                                             |                                                               |             |         |              |         | 27,288        |         |               |         |        |        |        |          | (27,288  | )       |          |   |          |            |   |         |         |        
|                                                    |                                                                                                       |                                                                                                             |                                                               |              |         |              |         |               |         |               |         |         |        |        |          |          |         |          |   |           |            |   |         |         
|                                                    |                                                                                                       |                                                                                                             | Net cash flows provided by (used in) financing
    activities |              |         | 54,355       |         |               |         | 227,140       |         |         |        |       |          |          |         | (271,807 | ) |           |            |  |         |          |         | 9,688    |  
|                                                    |                                                                                                       |                                                                                                             |                                                               |              |         |              |         |               |         |               |         |         |        |        |          |          |         |          |   |           |            |   |         |         
|Net increase (decrease) in cash and
    equivalents |                                                                                                       |                                                                                                             | 16,207                                                        |              |         |              | 41,638  |               |         |               | 27,156  |         |        |        | (111,071 | )        |         |          |  |           |            |   | (26,070 | )       
|Beginning cash and equivalents                      |                                                                                                       |                                                                                                             |                                                              |              |         |              | 110,335 |               |         |               | (74,751 | )       |        |        | 942,175  |          |         |          |  |           |            |   | 977,759 |         
|                                                    |                                                                                                       |                                                                                                             |                                                               |              |         |              |         |               |         |               |         |         |        |        |          |          |         |          |   |           |            |   |         |         
|Ending cash and equivalents                         |                                                                                                       | $                                                                                                           | 16,207                                                        |              |         | $            | 151,973 |               |         | $             | (47,595 | )       |        | $      | 831,104  |          |         | $        |  |           |            | $ | 951,689 |         
|                                                    |                                                                                                       |                                                                                                             |                                                               |              |         |              |         |               |         |               |         |         |        |        |          |          |         |          |   |           |            |   |         |         

F-39



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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, 2002 and 2001 and the related
consolidated statements of operations, stockholders equity
and cash flows for each of the three years in the period ended
December 31, 2002. Our audits also included the financial
statement schedule listed in the Index at Item 15(a)(2).
These consolidated financial statements and schedule are the
responsibility of the Companys management. Our
responsibility is to express an opinion on these consolidated
financial statements and schedule based on our audits.

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

In our opinion, the consolidated financial
statements referred to above present fairly, in all material
respects, the consolidated financial position of PacifiCare
Health Systems, Inc. at December 31, 2002 and 2001, and the
consolidated results of its operations and its cash flows for
each of the three years in the period ended December 31,
2002 in conformity with accounting principles generally accepted
in the United States. Also in our opinion, the related financial
statement schedule, when considered in relation to the basic
consolidated financial statements taken as a whole, presents
fairly in all material respects the information set forth
therein.

As discussed in Note 2 to the consolidated
financial statements, the Company adopted Statement of Financial
Accounting Standard No. 142, Goodwill and Other Intangible
Assets, in 2002.



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

Irvine, California

January 30, 2003


| |                                            
| | -------------------------------------------
| | Except for Note 11, as to which the date is
| | March 21, 2003                             

F-40



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##### Table of Contents



PACIFICARE HEALTH SYSTEMS, INC.

QUARTERLY INFORMATION FOR 2002 AND 2001
(Unaudited)

|                                                                                                            |                                                                         |                                               |           |         |   |              |           |             |  |   |           |      |  |   |           |       |  
|----------------------------------------------------------------------------------------------------------- | ----------------------------------------------------------------------- | --------------------------------------------- | --------- | ------- | - | ------------ | --------- | ----------- |  | - | --------- | ---- |  | - | --------- | ----- | -
|                                                                                                            |                                                                         |                                              
|                                                                                                            |                                                                         | Quarters Ended                               
|                                                                                                            |                                                                         |                                              
|                                                                                                            |                                                                         | March 31                                      |           | June 30 |   | September 30 |           | December 31
|                                                                                                            |                                                                         |                                               |           |         |   |              |           |            
|                                                                                                            |                                                                         |                                              
|                                                                                                            |                                                                         | (Amounts in thousands, except per share data)
|2002                                                                                                        |                                                                         |                                               |           |         |   |              |           |             |  |   |           |      |  |   |           |      
|Operating revenue                                                                                           |                                                                         | $                                             | 2,863,451 |         |   | $            | 2,769,360 |             |  | $ | 2,779,745 |      |  | $ | 2,743,946 |      
|Operating expenses                                                                                          |                                                                         |                                               | 2,799,250 |         |   |              | 2,699,744 |             |  |   | 2,689,750 |      |  |   | 2,667,117 |      
|Interest expense                                                                                            |                                                                         |                                               | (16,191   | )       |   |              | (18,955   | )           |  |   | (20,205   | )    |  |   | (19,553   | )    
|Impairment, disposition, restructuring, Office of
    Personnel Management and other charges (credits), net |                                                                         |                                               | (12,851   | )       |   |              | 18,336    |             |  |   |          |      |  |   | (1,711    | )    
|                                                                                                            |                                                                         |                                               |           |         |   |              |           |             |  |   |           |      |  |   |           |      
|Income before income taxes                                                                                  |                                                                         |                                               | 60,861    |         |   |              | 32,325    |             |  |   | 69,790    |      |  |   | 58,987    |      
|Provision for income taxes                                                                                  |                                                                         |                                               | 22,701    |         |   |              | 12,058    |             |  |   | 26,031    |      |  |   | 22,002    |      
|                                                                                                            |                                                                         |                                               |           |         |   |              |           |             |  |   |           |      |  |   |           |      
|Income before cumulative effect of a change in
    accounting principle                                     |                                                                         |                                               | 38,160    |         |   |              | 20,267    |             |  |   | 43,759    |      |  |   | 36,985    |      
|Cumulative effect of a change in accounting
    principle                                                   |                                                                         |                                               | (897,000  | )       |   |              |          |             |  |   |          |      |  |   |          |      
|                                                                                                            |                                                                         |                                               |           |         |   |              |           |             |  |   |           |      |  |   |           |      
|Net (loss) income                                                                                           |                                                                         | $                                             | (858,840  | )       |   | $            | 20,267    |             |  | $ | 43,759    |      |  | $ | 36,985    |      
|                                                                                                            |                                                                         |                                               |           |         |   |              |           |             |  |   |           |      |  |   |           |      
|Basic (loss) earnings per share:                                                                            |                                                                         |                                               |           |         |   |              |           |             |  |   |           |      |  |   |           |      
|                                                                                                            | Income before cumulative effect of a change in
    accounting principle |                                               | $         | 1.10    |   |              | $         | 0.58        |  |   | $         | 1.23 |  |   | $         | 1.03  |  
|                                                                                                            | Cumulative effect of a change in accounting
    principle               |                                               |           | (25.96  | ) |              |           |            |  |   |           |     |  |   |           |      |  
|                                                                                                            |                                                                         |                                               |           |         |   |              |           |             |  |   |           |      |  |   |           |      
|                                                                                                            | Basic (loss) earnings per share                                         |                                               | $         | (24.86  | ) |              | $         | 0.58        |  |   | $         | 1.23 |  |   | $         | 1.03  |  
|                                                                                                            |                                                                         |                                               |           |         |   |              |           |             |  |   |           |      |  |   |           |      
|Diluted (loss) earnings per share:                                                                          |                                                                         |                                               |           |         |   |              |           |             |  |   |           |      |  |   |           |      
|                                                                                                            | Income before cumulative effect of a change in
    accounting principle |                                               | $         | 1.10    |   |              | $         | 0.56        |  |   | $         | 1.20 |  |   | $         | 1.00  |  
|                                                                                                            | Cumulative effect of a change in accounting
    principle               |                                               |           | 25.96   |   |              |           |            |  |   |           |     |  |   |           |      |  
|                                                                                                            |                                                                         |                                               |           |         |   |              |           |             |  |   |           |      |  |   |           |      
|                                                                                                            | Diluted (loss) earnings per share                                       |                                               | $         | (24.86  | ) |              | $         | 0.56        |  |   | $         | 1.20 |  |   | $         | 1.00  |  
|                                                                                                            |                                                                         |                                               |           |         |   |              |           |             |  |   |           |      |  |   |           |      
|HMO Membership(1)                                                                                           |                                                                         |                                               | 3,226     |         |   |              | 3,154     |             |  |   | 3,076     |      |  |   | 3,013     |      
|                                                                                                            |                                                                         |                                               |           |         |   |              |           |             |  |   |           |      |  |   |           |      
|2001                                                                                                        |                                                                         |                                               |           |         |   |              |           |             |  |   |           |      |  |   |           |      
|Operating revenue                                                                                           |                                                                         | $                                             | 3,030,699 |         |   | $            | 2,973,726 |             |  | $ | 2,964,464 |      |  | $ | 2,875,083 |      
|Operating expenses                                                                                          |                                                                         |                                               | 2,986,449 |         |   |              | 2,922,759 |             |  |   | 2,911,500 |      |  |   | 2,835,323 |      
|Interest expense                                                                                            |                                                                         |                                               | (20,135   | )       |   |              | (17,834   | )           |  |   | (16,833   | )    |  |   | (15,480   | )    
|Impairment, disposition, restructuring, Office of
    Personnel Management and other charges (credits), net |                                                                         |                                               | (928      | )       |   |              | (295      | )           |  |   | 2,937     |      |  |   | 59,443    |      
|                                                                                                            |                                                                         |                                               |           |         |   |              |           |             |  |   |           |      |  |   |           |      
|Income (loss) before income taxes                                                                           |                                                                         |                                               | 25,043    |         |   |              | 33,428    |             |  |   | 33,194    |      |  |   | (35,163   | )    
|Provision for income taxes                                                                                  |                                                                         |                                               | 11,895    |         |   |              | 18,159    |             |  |   | 17,062    |      |  |   | (8,745    | )    
|                                                                                                            |                                                                         |                                               |           |         |   |              |           |             |  |   |           |      |  |   |           |      
|Income 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(1)                                                                                           |                                                                         |                                               | 3,726     |         |   |              | 3,600     |             |  |   | 3,522     |      |  |   | 3,388     |      
|                                                                                                            |                                                                         |                                               |           |         |   |              |           |             |  |   |           |      |  |   |           |      



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|    |                                  
|--- | ---------------------------------
|(1) | HMO membership as of quarter end.

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##### Table of Contents



PACIFICARE HEALTH SYSTEMS, INC.

SCHEDULE II  VALUATION AND
QUALIFYING ACCOUNTS

For The Years Ended December 31, 2002,
2001 and 2000


|                                 |                          |                        |  |                   |        |                 |  |            |        |  |  |  |         |   |  |   |        | 
|-------------------------------- | ------------------------ | ---------------------- |  | ----------------- | ------ | --------------- |  | ---------- | ------ |  |  |  | ------- | - |  | - | ------ | 
|                                 |                          | Balance at             |  | Charged to        |        |                 |  | Balance at
|                                 |                          | Beginning              |  | Provision for     |        | Deductions or   |  | End of    
|                                 |                          | of Period              |  | Doubtful Accounts |        | Write-offs, net |  | Period    
|                                 |                          |                        |  |                   |        |                 |  |           
|                                 |                          |                       
|                                 |                          | (Amounts in thousands)
|Allowance for doubtful accounts: |                          |                        |  |                   |        |                 |  |            |        |  |  |  |         |   |  |  
|                                 | Years ended December 31: |                        |  |                   |        |                 |  |            |        |  |  |  |         |   |  |   |       
|                                 |                          | 2002                   |  | $                 | 36,230 |                 |  |            | 6,346  |  |  |  | (12,762 | ) |  | $ | 29,814 | 
|                                 |                          | 2001                   |  | $                 | 48,989 |                 |  |            | 22,070 |  |  |  | (34,829 | ) |  | $ | 36,230 | 
|                                 |                          | 2000(1)                |  | $                 | 39,501 |                 |  |            | 37,598 |  |  |  | (28,110 | ) |  | $ | 48,989 | 



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|    |                                                                                                                                                              
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | We reclassified certain amounts to include
    allowances for provider withhold pools and notes receivables to
    conform to the 2001 and 2002 presentation.

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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 (incorporated
    by reference to Exhibit 3.03 to Registrants
    Form 10-K for the year ended December 31, 2001).                                                                                                                                                                                                                                                                                                                                       
|        | 3.04  |             |  | Fourth 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  |             |  | Indenture, dated as of November 22, 2002,
    between Registrant and U.S. Bank National Association (as
    Trustee) (incorporated by reference to Exhibit 4.4 to
    Registrants Registration Statement on Form S-3 (File
    No. 333-102909)).                                                                                                                                                                                                                                           
|        | 4.04  |             |  | Registration Rights Agreement, dated as of
    November 22, 2002, between the Registrant and Morgan
    Stanley & Co. Incorporated and Goldman, Sachs & Co.
    (incorporated by reference to Exhibit 4.6 to
    Registrants Registration Statement on Form S-3 (File
    No. 333-102909)).                                                                                                                                                                                                
|        | 4.05  |             |  | Indenture dated as of May 21, 2002 among
    PacifiCare Health Systems, Inc. as issuer of 10 3/4% Senior
    Notes due 2009, PacifiCare Health Plan Administrators, Inc.,
    PacifiCare eHoldings, Inc., Rx-Connect, Inc. and SeniorCo, Inc.,
    as initial subsidiary guarantors, and State Street Bank and
    Trust Company of California, N.A., as trustee (incorporated by
    reference to Exhibit 4.1 to Registrants Registration
    Statement on Form S-4 (File No. 333-91704)).
|        | 4.06  |             |  | Registration Rights Agreement dated May 21,
    2002 by and among PacifiCare Health Systems, Inc., PacifiCare
    Health Plan Administrators, Inc., PacifiCare eHoldings, Inc.,
    Rx-Connect, Inc., SeniorCo, Inc., Morgan Stanley & Co.
    Incorporated, and UBS Warburg LLC (incorporated by reference to
    Exhibit 4.5 to Registrants Registration Statement on
    Form S-4 (File No. 333-91704)).                                                                                
|        | 4.07  |             |  | Specimen form of Exchange Global Note for the
    10 3/4% Senior Notes due 2009 (incorporated by reference to
    Exhibit 4.4 to Registrants Registration Statement on
    Form S-4 (File No. 333-91704).                                                                                                                                                                                                                                                                                  
|        | 4.08  |             |  | Rights Agreement, dated as of November 19,
    1999, between the Registrant and ChaseMellon Shareholder
    Services, L.L.C. (incorporated by reference to Exhibit 99.1
    to Registrants Form 8-K, dated November 22, 1999).                                                                                                                                                                                                                                                             
|        | 10.01 |             |  | Senior Executive Employment Agreement, dated as
    of November 1, 2001, between the Registrant and Howard G.
    Phanstiel (incorporated by reference to Exhibit 10.01 to
    Registrants Form 10-K for the year ended
    December 31, 2001).(2)                                                                                                                                                                                                                                         
|        | 10.02 |             |  | Senior Executive Employment Agreement, dated as
    of August 1, 2001, between the Registrant and Gregory W.
    Scott (incorporated by reference to Exhibit 10.04 to
    Registrants Form 10-K for the year ended
    December 31, 2001).(2)                                                                                                                                                                                                                                              

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|        |       |             |  |                                                                                                                                                                                                                                                                                                    
|------- | ----- | ----------- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit |       |            
|Number  |       | Description
|        |       |            
|        | 10.03 |             |  | Senior Executive Employment Agreement, dated as
    of March 1, 2002, between Registrant and Bradford A. Bowlus
    (incorporated by reference to Exhibit 99.4 to
    Registrants Form 10-Q for the quarter ended
    March 31, 2002).(2)                                                         
|        | 10.04 |             |  | Termination of Consulting Agreement, dated as of
    September 17, 2002, between the Registrant and David A.
    Reed (incorporated by reference to Exhibit 10.1 to
    Registrants Form 10-Q for the quarter ended
    September 30, 2002).(2)                                                   
|        | 10.05 |             |  | Senior Executive Employment Agreement, dated as
    of July 22, 2002, between the Registrant and Jacqueline B.
    Kosecoff, Ph.D (incorporated by reference to Exhibit 10.2
    to Registrants Form 10-Q for the quarter ended
    September 30, 2002).(2)                                       
|        | 10.06 |             |  | Senior Executive Employment Agreement, dated as
    of March 30, 2001, between the Registrant and Kathy
    Feeny.(2)                                                                                                                                                                              
|        | 10.07 |             |  | First Amendment, dated as of March 30, 2001,
    to Senior Executive Agreement, dated as of March 30, 2001
    between Registrant and Kathy Feeny.(2)                                                                                                                                              
|        | 10.08 |             |  | Second Amendment, dated as of April 15,
    2002, to Senior Executive Agreement, dated as of March 30,
    2001, as amended, between Registrant and Kathy Feeny.(2)                                                                                                                                
|        | 10.09 |             |  | 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
    (incorporated by reference to Exhibit 10.10 to
    Registrants Form 10-K for the year ended
    December 31, 2001).
|        | 10.10 |             |  | Senior Executive Employment Agreement, dated as
    of December 2, 2002, between Registrant and Sharon D.
    Garrett.                                                                                                                                                                             
|        | 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 Plan (incorporated by reference to Exhibit E to
    Registrants Proxy Statement, dated May 25, 1999).(2)                                                                                                                                
|        | 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. 333-492752)).(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 |             |  | Third Amended and Restated PacifiCare Health
    Systems, Inc. Stock Unit Deferred Compensation Plan, dated
    January 1, 2002.                                                                                                                                                                   
|        | 10.21 |             |  | First Amendment, dated as of January 22,
    2003, to the Third Amended and Restated PacifiCare Health
    Systems, Inc. Stock Unit Deferred Compensation Plan, dated
    January 1, 2002.(2)                                                                                                      

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|        |       |             |  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|------- | ----- | ----------- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit |       |            
|Number  |       | Description
|        |       |            
|        | 10.22 |             |  | Second Amended and Restated PacifiCare Health
    Systems, Inc. Non-Qualified Deferred Compensation Plan, dated as
    of January 1, 2002.(2)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|        | 10.23 |             |  | Second Amended and Restated PacifiCare Health
    Systems, Inc. Statutory Restoration Plan, dated as of
    January 1, 2002.(2)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|        | 10.24 |             |  | 2001 Employee Stock Purchase Plan (incorporated
    by reference to Exhibit 1 to PacifiCare Health Systems
    Inc.s Proxy Statement dated May 8, 2002 (File
    No. 000-21949)).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|        | 10.25 |             |  | Senior Executive Employment Agreement, dated as
    of January 1, 2002, between the Registrant and Joseph S.
    Konowiecki (incorporated by reference to Exhibit 10.26 to
    Registrants Form 10-K for the year ended December 31,
    2001).(2)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|        | 10.26 |             |  | Information Technology Services Agreement, dated
    as of December 31, 2001, between the Registrant and
    International Business Machines Corporation (incorporated by
    reference to Exhibit 10.27 to Registrants
    Form 10-K for the year ended December 31, 2001).(3)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|        | 10.27 |             |  | Information Technology Services Agreement, dated
    as of January 11, 2002, between the Registrant and Keane,
    Inc. (incorporated by reference to Exhibit 10.28 to
    Registrants Form 10-K for the year ended
    December 31, 2001).(3)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|        | 10.28 |             |  | 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).                                                                                                                                                                                                                                                                                                                   
|        | 10.29 |             |  | 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
    (incorporated by reference to Exhibit 10.30 to
    Registrants Form 10-K for the year ended
    December 31, 2001).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|        | 10.30 |             |  | 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, as amended, and
    Bank of America N.A. in its capacity as Administrative Agent
    (incorporated by reference to Exhibit 10.31 to
    Registrants Form 10-K for the year ended
    December 31, 2001).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|        | 10.31 |             |  | Amendment No. 3, dated as of April 18,
    2002, to the Amended and Restated Credit Agreement, dated as of
    August 20, 2001, among the Registrant, the subsidiary
    guarantors parties thereto, the banks and financial institutions
    and other institutional lenders listed on the signature pages
    thereto as the lenders, the bank listed on the signature pages
    thereof as the initial issuing bank (the initial issuing bank
    and the lenders, the Lender Parties) and the Swing
    Line Bank, Banc of America Securities LLC and J.P. Morgan
    Securities Inc. as co-lead arrangers, and Banc of America
    Securities LLC, J.P. Morgan Securities Inc. and Salomon Smith
    Barney Inc. as joint book-running managers, Bank of America,
    N.A., as collateral agent together with any successor collateral
    agent, and Bank of America, as administrative agent for the
    Lender Parties, as amended (incorporated by reference to
    Exhibit 99.1 to Registrants Form 10-Q for the
    quarter ended March 31, 2002).
|        | 10.32 |             |  | Cash Collateral Account Agreement, dated as of
    April 18, 2002, between the Registrant and Bank of America,
    N.A. (incorporated by reference to Exhibit 99.2 to
    Registrants Form 10-Q for the quarter ended
    March 31, 2002).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     

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##### Table of Contents



|        |       |             |  |                                                                                                                                                                                                                                                                                         
|------- | ----- | ----------- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit |       |            
|Number  |       | Description
|        |       |            
|        | 10.33 |             |  | Common Stock Purchase Agreement, dated as of
    December 4, 2001, by and between the Registrant and Acqua
    Wellington North American Equities Fund Ltd. (incorporated by
    reference to Exhibit 99.5 to Registrants Registration
    Statement on Form S-3 (File No. 333-74812)).
|        | 21    |             |  | List of Subsidiaries.                                                                                                                                                                                                                                                                   
|        | 23    |             |  | Consent of Ernst & Young LLP, Independent
    Auditors.                                                                                                                                                                                                                                 
|        | 99.1  |             |  | Officer Certificate for Principal Executive
    Officer.                                                                                                                                                                                                                                
|        | 99.2  |             |  | Officer Certificate for Principal Financial
    Officer.                                                                                                                                                                                                                                



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|    |                                                                                                                                                                                                                       
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(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 15(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.

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