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UNITED STATESSECURITIES AND EXCHANGE
COMMISSIONWashington, D.C. 20549

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FORM 10-Q

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(Mark One) xQUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT
OF 1934

For the quarterly period ended

OR



For the transition period from ________to _________

Commission file number    1-8865

Sierra Health Services, Inc.(Exact name of registrant as specified in its charter)



|Nevada                                                               | 88-0200415                               
|-------------------------------------------------------------------- | -----------------------------------------
|(State or other jurisdiction of incorporation or
      organization) | (I.R.S. Employer Identification
  Number)

2724 North Tenaya Way Las Vegas, Nevada   
89128

(702) 242-7000

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 reports), and (2) has
been subject to such filing requirements for the past 90 days.    Yes

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

Indicate by check mark whether the registrant
is a shell company (as defined in Rule 12b-2 of the Act).
      YesoNoxAs of October 24, 2005, there were 28,742,000
shares of common stock outstanding. SIERRA HEALTH SERVICES, INC. Quarterly
Report on Form 10-Q For the period ended September 30, 2005PART I. FINANCIAL INFORMATION
    Page No.Item
      1. Financial Statements (Unaudited):Condensed
      Consolidated Balance Sheets - September 30, 2005 and December 31,
      2004
    1Condensed
      Consolidated Statements of Operations - three and nine months ended
      September 30, 2005 and 2004
    2Condensed
      Consolidated Statements of Cash Flows - nine months ended September 30,
      2005 and 2004
    3Notes
      to Condensed Consolidated Financial Statements
    4 - 14Item
      2. Management's Discussion and Analysis of Financial Condition and Results
      of Operations
    15 - 29Item
      3. Quantitative and Qualitative Disclosures About Market
      Risk
    29Item
      4. Controls and Procedures
    29PART II. OTHER INFORMATIONItem
      1. Legal Proceedings
    30Item
      2. Unregistered Sales of Equity Securities and Use of
      Proceeds
    31 - 32Item
      3. Defaults upon Senior Securities
    32Item
      4. Submission of Matters to a Vote of Security Holders
    32Item
      5. Other Information
    32Item
      6. Exhibits
    33Signatures
    34iTable of ContentsPART I. FINANCIAL
INFORMATION
ITEM 1. FINANCIAL
STATEMENTS
SIERRA HEALTH SERVICES, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(In thousands, except per share data)
(Unaudited)

September 30, 2005
    
    
    December 31, 2004ASSETSCurrent Assets:Cash and cash equivalents
    
    $
    88,517
    
    
    $
    207,619Investments
    
    
    303,056
    
    
    
    147,575Accounts receivable (less allowance for doubtful accounts: 2005 -
      $5,616; 2004 - $5,380)
    
    
    18,384
    
    
    
    15,150Military accounts receivable (less allowance for doubtful accounts:
      2005 - $400; 2004 - $100)
    
    
    665
    
    
    
    25,452Current portion of deferred tax asset
    
    
    22,414
    
    
    
    17,555Prepaid expenses and other current assets
    
    
    29,517
    
    
    
    36,123Total Current Assets
    
    
    462,553
    
    
    
    449,474Property and equipment, net
    
    
    68,439
    
    
    
    71,152Restricted cash and investments
    
    
    17,248
    
    
    
    21,853Goodwill (less accumulated amortization: 2005 and 2004 -
      $6,972)
    
    
    14,782
    
    
    
    14,782Deferred tax asset (less current portion)
    
    
    12,656
    
    
    
    13,275Note receivable (less valuation
      allowance: 2005 and 2004 - $15,000)
    
    
    47,000
    
    
    
    47,000Other assets
    
    
    68,307
    
    
    
    72,244Total Assets
    
    $
    690,985
    
    
    $
    689,780LIABILITIES AND STOCKHOLDERS' EQUITYCurrent Liabilities:Accrued and other current liabilities
    
    $
    70,868
    
    
    $
    76,256Trade accounts payable
    
    
    3,016
    
    
    
    7,123Accrued payroll and taxes
    
    
    23,527
    
    
    
    27,668Medical claims payable
    
    
    127,032
    
    
    
    119,337Unearned premium revenue
    
    
    91,274
    
    
    
    50,763Military health care payable
    
    
    
    
    
    
    17,061Current portion of long-term debt
    
    
    104
    
    
    
    100Total Current Liabilities
    
    
    315,821
    
    
    
    298,308Long-term debt (less current portion)
    
    
    62,335
    
    
    
    125,395Other liabilities
    
    
    59,995
    
    
    
    64,380Total Liabilities
    
    
    438,151
    
    
    
    488,083Commitments and contingenciesStockholders' Equity:Preferred stock, $.01 par value, 1,000 shares authorized; none
      issued or outstanding
    
    
    
    Common stock, $.005 par value, 60,000 shares authorized; 2005 -
      39,929; 2004 - 35,573 shares issued
    
    
    200
    
    
    
    178Treasury stock: 2005 - 11,061; 2004 - 9,192 common stock
      shares
    
    
    (373,566
    )
    
    
    (237,876
    )Additional paid-in capital
    
    
    389,974
    
    
    
    286,571Deferred compensation
    
    
    (1,739)
    
    
    (288
    )Accumulated other comprehensive loss
    
    
    (1,304
    )
    
    
    (245
    )Retained earnings
    
    
    239,269
    
    
    
    153,357Total Stockholders' Equity
    
    
    252,834
    
    
    
    201,697Total Liabilities And Stockholders' Equity
    
    $
    690,985
    
    
    $
    689,780
See accompanying notes to condensed consolidated financial statements.1Table of Contents
SIERRA HEALTH SERVICES, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except per share data)
(Unaudited)
Three Months EndedSeptember 30,
    
    
    NineMonths EndedSeptember
      30,2005
    
    2004
    
    
    2005
    
    
    2004Operating Revenues:Medical premiums
    
    $
    327,084
    
    $
    288,485
    
    
    $
    958,834
    
    
    $
    834,584Military contract revenues
    
    
    11
    
    
    85,983
    
    
    
    16,322
    
    
    
    354,312Professional fees
    
    
    11,133
    
    
    8,705
    
    
    
    31,102
    
    
    
    26,268Investment and other revenues
    
    
    9,215
    
    
    10,117
    
    
    
    25,071
    
    
    
    27,641Total
    
    
    347,443
    
    
    393,290
    
    
    
    1,031,329
    
    
    
    1,242,805Operating Expenses:Medical expenses
    
    
    259,591
    
    
    224,132
    
    
    
    755,779
    
    
    
    650,435Military contract expenses
    
    
    (108
    )
    
    75,830
    
    
    
    2,265
    
    
    
    313,047General and administrative expenses
    
    
    43,451
    
    
    44,593
    
    
    
    127,082
    
    
    
    126,914Total
    
    
    302,934
    
    
    344,555
    
    
    
    885,126
    
    
    
    1,090,396Operating Income From Continuing Operations
    
    
    44,509
    
    
    48,735
    
    
    
    146,203
    
    
    
    152,409Interest expense
    
    
    (1,991
    )
    
    (1,221
    )
    
    
    (7,971
    )
    
    
    (3,561
    )Other income (expense), net
    
    
    427
    
    
    (49
    )
    
    
    828
    
    
    
    41Income From Continuing Operations Before Income Taxes
    
    
    42,945
    
    
    47,465
    
    
    
    139,060
    
    
    
    148,889Provision for income taxes
    
    
    (14,503
    )
    
    (16,738
    )
    
    
    (47,377
    )
    
    
    (53,430
    )Income From Continuing Operations
    
    
    28,442
    
    
    30,727
    
    
    
    91,683
    
    
    
    95,459Loss from discontinued operations (net of income tax benefit of
      $839)
    
    
    
    
    
    
    
    
    
    
    
    
    
    (682
    )Net
      Income
    
    $
    28,442
    
    $
    30,727
    
    
    $
    91,683
    
    
    $
    94,777Earnings Per Common Share:Income from continuing operations
    
    $
    1.00
    
    $
    1.16
    
    
    $
    3.34
    
    
    $
    3.57Loss from discontinued operations
    
    
    
    
    
    
    
    
    
    
    
    
    
    (0.03
    )Net
      Income
    
    $
    1.00
    
    $
    1.16
    
    
    $
    3.34
    
    
    $
    3.54Earnings Per Common Share Assuming Dilution:Income from continuing operations
    
    $
    0.87
    
    $
    0.90
    
    
    $
    2.75
    
    
    $
    2.76Loss from discontinued operations
    
    
    
    
    
    
    
    
    
    
    
    
    
    (0.02
    )Net
      Income
    
    $
    0.87
    
    $
    0.90
    
    
    $
    2.75
    
    
    $
    2.74
See accompanying notes to condensed consolidated financial statements.
2Table of ContentsSIERRA HEALTH SERVICES, INC. AND
SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
(Unaudited)

Nine Months EndedSeptember
      30,2005
    
    
    2004Cash Flows From Operating Activities:Net
      income
    
    $
    91,683
    
    
    $
    94,777Adjustments To Reconcile Net Income To Net Cash Provided By
      Operating Activities:Loss from discontinued operations
    
    
    
    
    
    682Depreciation
    
    
    11,167
    
    
    
    12,372Stock based compensation expense
    
    
    4,877
    
    
    
    4,451Provision for doubtful accounts
    
    
    1,910
    
    
    
    1,224Loss (gain) on property and equipment
    dispositions
    
    131
    
    (126)Change In Operating Assets And Liabilities:Military accounts receivable
    
    
    24,487
    
    
    11,096Deferred tax asset
    
    
    13,801
    
    
    
    31,489Other current assets
    
    
    2,521
    
    5,197Other assets
    
    
    (323
    )
    
    
    (8,220
    )Accrued payroll and taxes
    
    (4,141
    )
    
    
    15,613Medical claims payable
    
    
    7,695
    
    
    11,740Military health care payable
    
    (17,061)
    
    (37,474)Other current liabilities
    
    (19,928)
    
    (21,479)Unearned premium revenue
    
    
    40,511
    
    
    
    (28,386
    )Other liabilities
    (4,385
    )
    
    
    2,049Net
      Cash Provided By Operating Activities Of Continuing
    Operations
    
    
    152,945
    
    
    
    95,005Cash Flows From Investing Activities:Capital expenditures, net of dispositions
    
    
    (8,566)
    
    (16,767)(Purchase of) proceeds from investments, net
    
    
    (138,572)
    
    
    76,682Net
      Cash (Used For) Provided By Investing Activities Of Continuing
      Operations
    
    
    (147,138)
    
    
    59,915Cash Flows From Financing Activities:Payments on debt and capital leases
    
    
    (10,075)
    
    (1,544
    )Proceeds from other long-term debt
    
    
    10,000
    
    
    10,000Purchase of treasury stock
    
    
    (144,421
    )
    
    
    (112,277)Exercise of stock in connection with stock plans
    
    
    19,587
    
    
    22,686Net
      Cash Used For Financing Activities Of Continuing Operations
    
    
    (124,909)
    
    
    (81,135)Net
      cash provided by discontinued operations
    
    
    
    
    
    
    3,720Net
      (Decrease) Increase In Cash And Cash Equivalents
    
    
    (119,102)
    
    
    77,505Cash And Cash Equivalents At Beginning Of Period
    
    
    207,619
    
    
    118,520Cash And Cash Equivalents At End Of Period
    
    $
    88,517
    
    $
    196,025Supplemental Condensed Consolidated Continuing Operations Statement
      Of Cash Flows Information:Cash paid during the period for interest (net of amount
      capitalized)
    
    $
    8,533
    
    $
    2,848Net
      cash paid during the period for income taxes
    
    
    33,410
    
    
    7,411Non-Cash Investing And Financing Activities:Senior convertible debentures converted into Sierra common
      stock
    
    63,000
    
    
    
    Assets and liabilities recorded in conjunction with the sale of the
      workers' compensation operations
    
    
    
    
    
    54,060Stock issued for exercise of options and related tax
      benefits
    
    
    17,470
    
    
    
    21,632Additions to capital leases
    
    
    19
    
    
    
    166
See accompanying notes to condensed consolidated financial statements.3

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SIERRA HEALTH SERVICES, INC.NOTES TO
CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Unaudited)

1. BASIS OF PRESENTATION

The accompanying unaudited condensed consolidated financial
statements include the consolidated accounts of Sierra Health Services, Inc. and
its subsidiaries (collectively referred to herein as Sierra or the Company). All
material intercompany balances and transactions have been eliminated. These
statements and the Company's annual audited consolidated financial statements
have been prepared in conformity with accounting principles generally accepted
in the United States of America; however, these statements do not contain all of
the information and disclosures that would be required in a complete set of
audited financial statements. They should, therefore, be read in conjunction
with the Company's annual audited consolidated financial statements and related
notes thereto for the year ended December 31, 2004. In the opinion of
management, the accompanying unaudited condensed consolidated financial
statements reflect all material adjustments, consisting only of normal recurring
adjustments, necessary for a fair presentation of the financial results for the
interim periods presented.

The preparation of financial statements in conformity with
accounting principles generally accepted in the United States of America
requires management to make estimates and assumptions that affect the reported
amounts of assets and liabilities and disclosure of contingent assets and
liabilities at the date of the financial statements and the reported amounts of
revenues and expenses during the reporting period. Such estimates and
assumptions could change in the future as more information becomes available,
which could impact the amounts reported and disclosed herein. Actual results may
differ materially from estimates.

The Company had previously reported the Texas health care
operations as discontinued. The remaining Texas health care operations are
currently being run out and therefore do not currently meet the criteria for
discontinued operations. As a result, the Company has reclassified the Texas
health care operations to continuing operations for all periods presented.

Certain amounts in the condensed consolidated financial
statements for the three and nine months ended September 30, 2004 have been
reclassified to conform to the current presentation.

4

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2. EMPLOYEE STOCK PLANS

The Company accounts for its stock-based compensation using
the intrinsic value method prescribed by Accounting Principles Board Opinion No.
25, "Accounting for Stock Issued to Employees," (APB No. 25) as
amended. Accordingly, no compensation cost has been recognized for the Company's
employee stock plans except for those expenses associated with restricted stock
units and certain stock options in which vesting was, or has been agreed to be,
accelerated.

The following table represents the effect on net income and
earnings per share if the Company had applied the fair value based method and
recognition provisions of Statement of Financial Accounting Standards No. 123,
"Accounting for Stock-Based Compensation" (SFAS No. 123), to
stock-based compensation:

|                                                                                                                                 |  |                                       |        |      |                                |        |      |  |   |        |   |  |   |        |  
|-------------------------------------------------------------------------------------------------------------------------------- |  | ------------------------------------- | ------ | ---- | ------------------------------ | ------ | ---- |  | - | ------ | - |  | - | ------ | -
|                                                                                                                                 |  | Three Months Ended

  September 30,   |        |      | Nine
Months EndedSeptember 30, |       
|                                                                                                                                 |  | 2005                                  |        | 2004 |                                |        | 2005 |  |   | 2004   |  
|                                                                                                                                 |  | (In thousands, except per share data) |       
|Net income, as reported                                                                                                          |  | $                                     | 28,442 |      | $                              | 30,727 |      |  | $ | 91,683 |   |  | $ | 94,777 |  
|Add: stock-based employee compensation expense
for restricted stock and stock awards included in reported net income, net of tax |  |                                       | 1,110  |      |                                | 2,275  |      |  |   | 3,170  |   |  |   | 2,893  |  
|Less: total stock-based employee compensation expense determined under fair value based methods for all awards, net of tax       |  |                                       | (2,530 | )    |                                | (3,714 | )    |  |   | (8,127 | ) |  |   | (9,153 | )
|                                                                                                                                 |  |                                       |        |      |                                |        |      |  |   |        |   |  |   |        |  
|Pro Forma Net Income                                                                                                             |  | $                                     | 27,022 |      | $                              | 29,288 |      |  | $ | 86,726 |   |  | $ | 88,517 |  
|                                                                                                                                 |  |                                       |        |      |                                |        |      |  |   |        |   |  |   |        |  
|Net income per share, as reported                                                                                                |  | $                                     | 1.00   |      | $                              | 1.16   |      |  | $ | 3.34   |   |  | $ | 3.54   |  
|Pro forma net income, per share                                                                                                  |  |                                       | 0.95   |      |                                | 1.11   |      |  |   | 3.16   |   |  |   | 3.31   |  
|                                                                                                                                 |  |                                       |        |      |                                |        |      |  |   |        |   |  |   |        |  
|Net income per share assuming dilution, as reported                                                                              |  | $                                     | 0.87   |      | $                              | 0.90   |      |  | $ | 2.75   |   |  | $ | 2.74   |  
|Pro forma net income, per share                                                                                                  |  |                                       | 0.82   |      |                                | 0.86   |      |  |   | 2.61   |   |  |   | 2.56   |  

In December 2004, the Financial Accounting Standards Board
issued Statement of Financial Accounting Standards No. 123 (revised 2004),
"Share-Based Payment" (SFAS 123R), which replaces SFAS No. 123 and
supercedes APB Opinion No. 25. SFAS 123R requires all share-based payments to
employees, including grants of employee stock options, to be recognized in the
financial statements based on their fair values. The pro forma disclosures
previously permitted under SFAS 123 no longer will be an alternative to
financial statement recognition. Under SFAS 123R, the Company must determine the
appropriate fair value model to be used for valuing share-based payments, the
amortization method for compensation cost and the transition method to be used
at date of adoption. The transition methods include prospective and retroactive
adoption options. The prospective method requires that compensation expense be
recorded for all unvested stock options and restricted stock at the beginning of
the first quarter of adoption of SFAS 123R. The retroactive methods would record
compensation expense for all unvested stock options and restricted stock
beginning with the first period restated. Prior periods may be restated either
as of the beginning of the year of adoption or for all periods presented.

On April 14, 2005, the Securities and Exchange Commission
announced that the effective date of SFAS 123R would be postponed until January
1, 2006 for calendar year companies. The Company anticipates adopting the
prospective method of SFAS 123R in 2006 and expects that the impact in 2006 will
reduce its net income by approximately $2.5 to $3.0 million based on the options
outstanding as of September 30, 2005 that vest subsequent to December 31, 2005.

5

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3. INVESTMENTS

Of the cash and cash equivalents and current unrestricted
investments that total $391.6 million in the accompanying Consolidated Balance
Sheet at September 30, 2005, $316.1 million is limited for use only by the
Company's regulated subsidiaries. Such amounts are available for transfer to
Sierra from the regulated subsidiaries only to the extent that they can be
remitted in accordance with terms of existing management agreements and by
dividends, which customarily must be approved by regulating state insurance
departments. The remainder is available to Sierra on an unrestricted basis.

Investments consist primarily of U.S. Government and its
agencies' securities, municipal bonds, corporate bonds, securities, and trust
deed mortgage notes. At September 30, 2005, approximately 82% of the Company's
investment portfolio is invested in U.S. Government and its agencies' securities
and municipal bonds. All non-restricted investments that are designated as
available-for-sale are classified as current assets and stated at fair value.
Fair value is estimated primarily from published market values at the balance
sheet date. These investments are available for use in the current operations
regardless of contractual maturity dates. Restricted investments are classified
as non-current assets. Realized gains and losses are calculated using the
specific identification method and are included in investment and other
revenues. Unrealized holding gains and losses on available-for-sale securities
are included as a separate component of stockholders' equity, net of income tax
effects, until realized. The Company does not have any held-to-maturity
investments.

The Company's investments in trust deed mortgage notes are
stated at cost and classified as current assets if expected maturity is within
one year of the balance sheet date. Otherwise, they are classified as long-term
investments. The Company does not believe any of its investments were other than
temporarily impaired at September 30, 2005.

The Company entered into a short sale of U.S. Treasury Bonds
during the first quarter of 2005. The short sale did not meet the accounting
definition of a hedge. The position was adjusted to fair value at March 31, 2005
and a gain of $500,000 was included in investment and other revenues for the
period. Interest income on the short position and the gain/loss on the position
is included in investment and other revenues and the interest expense on the
short position is included in interest expense. During the second quarter, the
position was covered and the Company recognized a loss of $1.8 million for the
transaction.

4. LONG-TERM DEBT

Sierra Debentures - In March 2003, the Company issued $115.0
million aggregate principal amount of its 21⁄4% senior convertible debentures due
March 15, 2023. The debentures are not guaranteed by any of Sierra's
subsidiaries. The debentures pay interest, which is due semi-annually on March
15 and September 15 of each year. Each $1,000 principal amount of debentures is
convertible, at the option of the holders, into 54.6747 shares of Sierra Health
Services, Inc., common stock prior to March 15, 2023 if: (i) the market price of
the Company's common stock for at least 20 trading days in a period of 30
consecutive trading days ending on the last trading day of the preceding fiscal
quarter exceeds 120% of the conversion price per share of the Company's common
stock; (ii) the debentures are called for redemption; (iii) there is an event of
default with respect to the debentures; or (iv) specified corporate transactions
have occurred. Beginning December 2003 and for each subsequent period, the
market price of the Company's common stock has exceeded 120% of the conversion
price for at least 20 trading days in a period of 30 consecutive trading days.
The conversion rate is subject to certain adjustments. This conversion rate
initially represents a conversion price of $18.29 per share. Holders of the
debentures may require the Company to repurchase all or a portion of their
debentures on March 15 in 2008, 2013 and 2018 or upon certain corporate events
including a change in control. In either case, the Company may choose to pay the
purchase price of such debentures in cash or common stock or a combination of
cash and common stock. The debentures can be redeemed by the Company for cash
beginning on or after March 20, 2008.

6

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During the second and third quarters of 2005, the Company
received offers and entered into privately negotiated transactions with
debenture holders (holders) pursuant to which the holders converted the
debentures they owned into Sierra common stock in accordance with the indenture
governing the debentures. During the second quarter, Sierra entered into three
separate transactions converting a total of $34.0 million in debentures for
approximately 1.9 million shares of common stock. During the third quarter,
Sierra entered into two separate transactions converting a total of $29.0
million in debentures for approximately 1.6 million shares of common stock. As a
result of these transactions, the Company paid approximately $1.5 million in
prepaid interest as an incentive for conversion and wrote-off approximately $1.2
million in deferred debenture-related costs for a total expense of approximately
$2.7 million.

Revolving Credit Facility - On March 3, 2003, the Company
entered into a $65.0 million revolving credit facility, which replaced its
amended and restated credit facility. The facility was set to expire on April
30, 2006. Effective October 19, 2004, the facility was amended to extend the
maturity to December 31, 2009, increase the availability to $100.0 million and
reduce the interest rate. Effective June 24, 2005, the Company elected to
increase the aggregate commitments of the facility to $140.0 million. The
current interest rate is LIBOR plus .75%. The facility is available for general
corporate purposes and at September 30, 2005, the Company had drawn $10.0
million on this facility.

The credit facility remains secured by guarantees by certain
of the Company's subsidiaries and a first priority perfected security interest
in (i) all of the capital stock of each of the Company's unregulated, material
domestic subsidiaries (direct or indirect) as well as all of the capital stock
of certain regulated, material domestic subsidiaries; and (ii) all other present
and future assets and properties of the Company and those of its subsidiaries
that guarantee the credit agreement obligations (including, without limitation,
accounts receivable, inventory, real property, equipment, contracts, trademarks,
copyrights, patents, license rights and general intangibles) subject, in each
case, to the exclusion of the capital stock of CII Financial, Inc. (CII) and
certain other exclusions.

The revolving credit facility has covenants that limit the
Company's ability and the ability of the Company's subsidiaries to dispose of
assets, incur indebtedness, incur other liens, make investments, loans or
advances, make acquisitions, engage in mergers or consolidations, make capital
expenditures and otherwise restrict certain corporate activities. Under the most
recent amendment dated October 19, 2004, based on the Company exceeding a
certain leverage ratio requirement, the Company's ability to pay dividends,
repurchase its common stock and prepay other debt is unlimited provided that the
Company can still maintain the required ratios after such transaction or any
borrowing incurred as a result of such transaction. In addition, the Company is
required to comply with specified financial ratios as set forth in the credit
agreement. The Company believes it is in compliance with all covenants of the
credit agreement.

5. SHARE REPURCHASES

From January 1, 2005 through September 30, 2005, the Company
purchased approximately 2.2 million shares of its common stock, in the open
market or through negotiated transactions, for $144.4 million at an average cost
per share of $66.07. Since the repurchase program began in early 2003 and
through September 30, 2005, the Company has purchased, in the open market or
through negotiated transactions, approximately 10.9 million shares for $377.7
million at an average cost per share of $34.65. On August 11, 2005, the
Company's Board of Directors authorized the Company to purchase an additional
$75.0 million worth of its common stock. At September 30, 2005, $52.1 million
was still available under the Board of Directors' authorized plan.

The Company's revolving credit facility, as amended,
currently allows for unlimited stock repurchases based on meeting a certain
covenant ratio. The Company has repurchased 80,000 shares for $5.6 million at an
average cost of $70.01 subsequent to September 30, 2005 through October 24,
2005.

7

---



6. CII FINANCIAL, INC. DISCONTINUED OPERATIONS

On January 15, 2003, the Company announced that it was
exploring strategic alternatives to dispose of its workers' compensation
company, CII. Sierra's Board of Directors approved the sale of the operations on
December 31, 2002. Accordingly, beginning in the fourth quarter of 2002, the
Company reclassified its workers' compensation insurance business as
discontinued operations.

On March 31, 2004, the Company completed the sale of California Indemnity
Insurance Company (Cal Indemnity), which was CII's only significant asset. Cal
Indemnity's subsidiaries, which were included in the sale, are Commercial
Casualty Insurance Company, Sierra Insurance Company of Texas, and CII Insurance
Company.

The Company received $14.2 million in cash at the closing, which was
subsequently reduced by $2.7 million based on the final closing date balance
sheet. The $2.7 million adjustment is a timing difference and is expected to be
repaid to the Company over the next few years. The transaction also includes a
note receivable of $62.0 million, plus accrued interest, payable to the Company
in January 2010. The note receivable can be increased or decreased depending on
favorable or adverse claim and expense development from the date of closing
through December 31, 2009, and other offsets and additions based on certain
agreements between the parties. The $62.0 million note receivable can be
increased on a dollar for dollar basis for the first $15 million in positive
loss reserve development and $.50 per dollar on any positive development in
excess of $15 million. The note receivable can also be decreased on a dollar for
dollar basis for the first $58 million in adverse loss development.

During the fourth quarter of 2004, the Company engaged a new
independent actuary to evaluate the loss development. Based on the independent
actuarial projections, the Company recorded a $15.0 million valuation allowance
at December 31, 2004 reducing the note receivable to $47.0 million. The Company
was required to engage a new actuary to avoid a potential conflict of interest
with its former actuary, who was still engaged by Cal Indemnity, and the
resulting impact to internal controls. At September 30, 2005, the Company
received an updated independent actuarial projection. Based on the updated
projection, no further adjustment is required at this time.

A third-party claims administrator was engaged to administer
claims for a period of 15 years. Under the terms of this agreement, the
administrator will provide certain claims services for Cal Indemnity and its
subsidiaries. Although the evaluation of the third-party claims administrator
performance is controlled by Cal Indemnity's new parent company, Sierra will be
responsible for this administrators' costs and, if applicable, any replacement
administrator's costs. Sierra must also provide certain transition services for
varying terms to Cal Indemnity. The purchaser of Cal Indemnity will pay Sierra
for these costs from an account consisting of the unallocated loss adjustment
expense (ULAE) reserves and accrued liabilities as of the closing, a percentage
of premiums earned after the closing, plus accrued interest on the ULAE
reserves. In addition, Sierra is providing workers' compensation managed care
services at market rates to Cal Indemnity. For the nine months ended September
30, 2005, the Company recorded $2.1 million in administrative services revenue
and operating expenses to provide the contractual administrative services.

Due to the disposal of the assets and liabilities of Cal
Indemnity at March 31, 2004, the Company's Consolidated Balance Sheet beginning
March 31, 2004 does not include the assets and liabilities of Cal Indemnity.

8

---



The following are the unaudited condensed
statements of operations of the discontinued operations of CII:

|                                                    |                      |                                       
|--------------------------------------------------- | -------------------- | --------------------------------------
|                                                    |                      | Three Months EndedMarch 31,
      2004
|                                                    | (In
      thousands)
|Operating Revenues:                                 |                      |                                       
|Specialty product revenues                          | $                    | 19,015                                
|Investment and other revenues                       |                      | 1,290                                 
|                                                    |                      |                                       
|Total Revenues                                      |                      | 20,305                                
|                                                    |                      |                                       
|Operating Expenses:                                 |                      |                                       
|Specialty product expenses                          |                      | 21,917                                
|Interest expense and other, net                     |                      | (91                                   
|                                                    |                      |                                       
|Total Expenses                                      |                      | 21,826                                
|                                                    |                      |                                       
|Loss From Discontinued Operations Before Income Tax |                      | (1,521                                
|Income tax benefit                                  |                      | 839                                   
|                                                    |                      |                                       
|Net
      Loss From Discontinued Operations         | $                    | (682                                  
|                                                    |                      |                                       

The activity for 2004 is through the disposal date, March 31,
2004. There is no activity for the discontinued operations beyond that date. Any
subsequent activity related to this disposal has been reflected in continuing
operations. Specialty product revenues consist of workers' compensation
insurance net earned premiums. Specialty product expenses consist of loss and
loss adjustment expenses incurred and general and administrative expenses.

9

---



7. EARNINGS PER SHARE:

The following table provides a reconciliation of basic and
diluted earnings per share:

|                                                              |  |                                       |        |      |                                  |        |      |  |   |        |  |  |   |        |  
|------------------------------------------------------------- |  | ------------------------------------- | ------ | ---- | -------------------------------- | ------ | ---- |  | - | ------ |  |  | - | ------ | -
|                                                              |  | Three Months EndedSeptember
  30,     |        |      | Nine
  Months EndedSeptember 30, |       
|                                                              |  | 2005                                  |        | 2004 |                                  |        | 2005 |  |   | 2004   | 
|                                                              |  | (In thousands, except per share data) |       
|Basic Income (Loss) Per Share:                                |  |                                       |        |      |                                  |        |      |  |   |        |  |  |   |        |  
|Income from continuing operations                             |  | $                                     | 28,442 |      | $                                | 30,727 |      |  | $ | 91,683 |  |  | $ | 95,459 |  
|Lossfrom discontinued operations                              |  |                                       |       |      |                                  |       |      |  |   |       |  |  |   | (682   | )
|                                                              |  |                                       |        |      |                                  |        |      |  |   |        |  |  |   |        |  
|Net Income                                                    |  | $                                     | 28,442 |      | $                                | 30,727 |      |  | $ | 91,683 |  |  | $ | 94,777 |  
|                                                              |  |                                       |        |      |                                  |        |      |  |   |        |  |  |   |        |  
|                                                              |  |                                       |        |      |                                  |        |      |  |   |        |  |  |   |        |  
|Weighted average common shares outstanding                    |  |                                       | 28,385 |      |                                  | 26,498 |      |  |   | 27,409 |  |  |   | 26,767 |  
|                                                              |  |                                       |        |      |                                  |        |      |  |   |        |  |  |   |        |  
|                                                              |  |                                       |        |      |                                  |        |      |  |   |        |  |  |   |        |  
|Earnings Per Common Share:                                    |  |                                       |        |      |                                  |        |      |  |   |        |  |  |   |        |  
|Income from continuing operations                             |  | $                                     | 1.00   |      | $                                | 1.16   |      |  | $ | 3.34   |  |  | $ | 3.57   |  
|Loss from discontinued operations                             |  |                                       |       |      |                                  |       |      |  |   |       |  |  |   | (0.03  | )
|                                                              |  |                                       |        |      |                                  |        |      |  |   |        |  |  |   |        |  
|Net Income                                                    |  | $                                     | 1.00   |      | $                                | 1.16   |      |  | $ | 3.34   |  |  | $ | 3.54   |  
|                                                              |  |                                       |        |      |                                  |        |      |  |   |        |  |  |   |        |  
|                                                              |  |                                       |        |      |                                  |        |      |  |   |        |  |  |   |        |  
|Diluted Income (Loss) Per Share:                              |  |                                       |        |      |                                  |        |      |  |   |        |  |  |   |        |  
|Income from continuing operations                             |  | $                                     | 28,442 |      | $                                | 30,727 |      |  | $ | 91,683 |  |  | $ | 95,459 |  
|Loss from discontinued operations                             |  |                                       |       |      |                                  |       |      |  |   |       |  |  |   | (682   | )
|                                                              |  |                                       |        |      |                                  |        |      |  |   |        |  |  |   |        |  
|Net Income                                                    |  |                                       | 28,442 |      |                                  | 30,727 |      |  |   | 91,683 |  |  |   | 94,777 |  
|Interest expense on Sierra
  debentures, net of tax           |  |                                       | 239    |      |                                  | 421    |      |  |   | 1,066  |  |  |   | 1,262  |  
|                                                              |  |                                       |        |      |                                  |        |      |  |   |        |  |  |   |        |  
|Income For Purposes Of Computing Diluted Net Income Per Share |  | $                                     | 28,681 |      | $                                | 31,148 |      |  | $ | 92,749 |  |  | $ | 96,039 |  
|                                                              |  |                                       |        |      |                                  |        |      |  |   |        |  |  |   |        |  
|                                                              |  |                                       |        |      |                                  |        |      |  |   |        |  |  |   |        |  
|Weighted average common shares outstanding                    |  |                                       | 28,385 |      |                                  | 26,498 |      |  |   | 27,409 |  |  |   | 26,767 |  
|Dilutive options and restricted shares outstanding            |  |                                       | 838    |      |                                  | 1,668  |      |  |   | 1,010  |  |  |   | 1,977  |  
|Dilutive impact of conversion of Sierra debentures            |  |                                       | 3,899  |      |                                  | 6,288  |      |  |   | 5,277  |  |  |   | 6,288  |  
|                                                              |  |                                       |        |      |                                  |        |      |  |   |        |  |  |   |        |  
|Weighted Average Common Shares Outstanding Assuming Dilution  |  |                                       | 33,122 |      |                                  | 34,454 |      |  |   | 33,696 |  |  |   | 35,032 |  
|                                                              |  |                                       |        |      |                                  |        |      |  |   |        |  |  |   |        |  
|                                                              |  |                                       |        |      |                                  |        |      |  |   |        |  |  |   |        |  
|Earnings Per Common Share Assuming Dilution:                  |  |                                       |        |      |                                  |        |      |  |   |        |  |  |   |        |  
|Income from continuing operations                             |  | $                                     | 0.87   |      | $                                | 0.90   |      |  | $ | 2.75   |  |  | $ | 2.76   |  
|Lossfrom discontinued operations                              |  |                                       |       |      |                                  |       |      |  |   |       |  |  |   | (0.02  | )
|                                                              |  |                                       |        |      |                                  |        |      |  |   |        |  |  |   |        |  
|Net Income                                                    |  | $                                     | 0.87   |      | $                                | 0.90   |      |  | $ | 2.75   |  |  | $ | 2.74   |  
|                                                              |  |                                       |        |      |                                  |        |      |  |   |        |  |  |   |        |  

10

---



8. DEFINED BENEFIT PLAN

The Company previously disclosed that it expected to
contribute approximately $1.1 million to its defined benefit plan in 2005 to
fund expected benefit payments. For the nine months ended September 30, 2005,
the Company contributed $878,000 to the plan to fund benefit payments and
anticipates making $182,000 in additional contributions during 2005.

The following table presents net periodic benefit costs for
the periods indicated:

|                                         |  |                                   |     |      |                                  |     |      |  |   |       |  |  |   |       | 
|---------------------------------------- |  | --------------------------------- | --- | ---- | -------------------------------- | --- | ---- |  | - | ----- |  |  | - | ----- | 
|                                         |  | Three Months EndedSeptember
  30, |     |      | Nine
  Months EndedSeptember 30, |    
|                                         |  | 2005                              |     | 2004 |                                  |     | 2005 |  |   | 2004  | 
|                                         |  | (In thousands)                    |    
|Components Of Net Periodic Benefit Cost: |  |                                   |     |      |                                  |     |      |  |   |       |  |  |   |       | 
|Service cost                             |  | $                                 | 94  |      | $                                | 106 |      |  | $ | 283   |  |  | $ | 318   | 
|Interest cost                            |  |                                   | 321 |      |                                  | 418 |      |  |   | 962   |  |  |   | 1,254 | 
|Amortization of prior service credits    |  |                                   | 303 |      |                                  | 303 |      |  |   | 908   |  |  |   | 909   | 
|Recognized actuarial loss                |  |                                   |    |      |                                  | 109 |      |  |   |      |  |  |   | 327   | 
|                                         |  |                                   |     |      |                                  |     |      |  |   |       |  |  |   |       | 
|Net Periodic Benefit Cost                |  | $                                 | 718 |      | $                                | 936 |      |  | $ | 2,153 |  |  | $ | 2,808 | 
|                                         |  |                                   |     |      |                                  |     |      |  |   |       |  |  |   |       | 

9. COMPREHENSIVE INCOME

The following table presents comprehensive income for the periods indicated:

|                                                                   |  |                                   |        |      |                                  |        |      |  |   |        |   |  |   |        | 
|------------------------------------------------------------------ |  | --------------------------------- | ------ | ---- | -------------------------------- | ------ | ---- |  | - | ------ | - |  | - | ------ | 
|                                                                   |  | Three Months EndedSeptember
  30, |        |      | Nine
  Months EndedSeptember 30, |       
|                                                                   |  | 2005                              |        | 2004 |                                  |        | 2005 |  |   | 2004   |  
|                                                                   |  | (In thousands)                    |       
|Net income                                                         |  | $                                 | 28,442 |      | $                                | 30,727 |      |  | $ | 91,683 |   |  | $ | 94,777 | 
|Change in unrealized holding
losson available-for-sale investments |  |                                   | (909   | )    |                                  | 719    |      |  |   | (1,059 | ) |  |   | 367    | 
|                                                                   |  |                                   |        |      |                                  |        |      |  |   |        |   |  |   |        | 
|Comprehensive Income                                               |  | $                                 | 27,533 |      | $                                | 31,446 |      |  | $ | 90,624 |   |  | $ | 95,144 | 
|                                                                   |  |                                   |        |      |                                  |        |      |  |   |        |   |  |   |        | 

10. SEGMENT REPORTING

The Company has two reportable segments based on the products
and services offered: managed care and corporate operations, and military health
services operations. The managed care segment includes managed health care
services provided through our health maintenance organization (HMO), managed
indemnity plans, third-party administrative services programs for
employer-funded health benefit plans and self-insured workers' compensation
plans, multi-specialty medical groups, other ancillary services and corporate
operations. The military health services segment administered a managed care
federal contract for the Department of Defense's TRICARE program in Region 1.

Sierra Military Health Services LLC (SMHS) completed the
fifth year of a five-year contract in May 2003. SMHS then operated under a
negotiated contract extension period, which ended August 31, 2004. The new
contractor became operational on September 1, 2004 and the new contract
superseded the remainder of the Company's TRICARE Region 1 contract. On
September 1, 2004, SMHS commenced an eight-month phase-

11

---



out of operations at prices previously negotiated with the
Department of Defense (DoD). SMHS does not meet the definition of discontinued
operations since the Company did not dispose of the operations before the
phase-out was complete. We believe the remaining SMHS liabilities are
appropriate and that no revisions to the estimates at September 30, 2005, are
necessary at this time.

During the second quarter of 2005, the Company reached a
negotiated settlement with the DoD for certain outstanding change order and bid
price adjustments related to option period six and the phase-out of its military
health care operations. Included in the settlement was the determination of the
final military health care payable balance.

Through participation in Medicare, TRICARE and the Federal
Employees Health Benefit Plan programs, the Company generated approximately 37%
and 52% of its total consolidated revenues from agencies of the U.S. government
for the three months ended September 30, 2005 and 2004, respectively. The
Company generated approximately 39% and 56% of its total consolidated revenues
from agencies of the U.S. government for the nine months ended September 30,
2005 and 2004, respectively. The TRICARE revenue is presented below in the
military health services operations segment and the remainder of the revenue
described above is included in the managed care and corporate operations
segment.

The Company evaluates each segment's performance based on
segment operating profit. The accounting policies of the operating segments are
the same as those described in the summary of significant accounting policies.

12

---



Information concerning the operations of the reportable segments is as
follows:

|                                               |  |                                     |           |   |                                   |   |         |       |  |   |           |  
|---------------------------------------------- |  | ----------------------------------- | --------- | - | --------------------------------- | - | ------- | ----- |  | - | --------- | -
|                                               |  | Managed CareAnd CorporateOperations |           |   | Military HealthServicesOperations |   |         | Total | 
|                                               |  | (In
      thousands)                |          
|Three Months Ended
      September 30, 2005    |  |                                     |           |   |                                   |   |         |       |  |   |           |  
|Medical premiums                               |  | $                                   | 327,084   |   |                                   | $ |        |       |  | $ | 327,084   |  
|Military contract revenues                     |  |                                     |          |   |                                   |   | 11      |       |  |   | 11        |  
|Professional fees                              |  |                                     | 11,133    |   |                                   |   |        |       |  |   | 11,133    |  
|Investment and other revenues                  |  |                                     | 9,171     |   |                                   |   | 44      |       |  |   | 9,215     |  
|                                               |  |                                     |           |   |                                   |   |         |       |  |   |           |  
|Total Revenue                                  |  | $                                   | 347,388   |   |                                   | $ | 55      |       |  | $ | 347,443   |  
|                                               |  |                                     |           |   |                                   |   |         |       |  |   |           |  
|Segment operating profit                       |  | $                                   | 44,346    |   |                                   | $ | 163     |       |  | $ | 44,509    |  
|Interest expense                               |  |                                     | (1,991    | ) |                                   |   |        |       |  |   | (1,991    | )
|Other income (expense), net                    |  |                                     | 408       |   |                                   |   | 19      |       |  |   | 427       |  
|                                               |  |                                     |           |   |                                   |   |         |       |  |   |           |  
|Income Before Income Taxes                     |  | $                                   | 42,763    |   |                                   | $ | 182     |       |  | $ | 42,945    |  
|                                               |  |                                     |           |   |                                   |   |         |       |  |   |           |  
|Three Months Ended
  
      September 30, 2004 |  |                                     |           |   |                                   |   |         |       |  |   |           |  
|Medical premiums                               |  | $                                   | 288,485   |   |                                   | $ |        |       |  | $ | 288,485   |  
|Military contract revenues                     |  |                                     |          |   |                                   |   | 85,983  |       |  |   | 85,983    |  
|Professional fees                              |  |                                     | 8,705     |   |                                   |   |        |       |  |   | 8,705     |  
|Investment and other revenues                  |  |                                     | 9,849     |   |                                   |   | 268     |       |  |   | 10,117    |  
|                                               |  |                                     |           |   |                                   |   |         |       |  |   |           |  
|Total Revenue                                  |  | $                                   | 307,039   |   |                                   | $ | 86,251  |       |  | $ | 393,290   |  
|                                               |  |                                     |           |   |                                   |   |         |       |  |   |           |  
|Segment operating profit                       |  | $                                   | 38,314    |   |                                   | $ | 10,421  |       |  | $ | 48,735    |  
|Interest expense                               |  |                                     | (1,218    | ) |                                   |   | (3      | )     |  |   | (1,221    | )
|Other income (expense), net                    |  |                                     | (54       | ) |                                   |   | 5       |       |  |   | (49       | )
|                                               |  |                                     |           |   |                                   |   |         |       |  |   |           |  
|Income Before Income Taxes                     |  | $                                   | 37,042    |   |                                   | $ | 10,423  |       |  | $ | 47,465    |  
|                                               |  |                                     |           |   |                                   |   |         |       |  |   |           |  
|Nine Months Ended September 30, 2005           |  |                                     |           |   |                                   |   |         |       |  |   |           |  
|Medical premiums                               |  | $                                   | 958,834   |   |                                   | $ |        |       |  | $ | 958,834   |  
|Military contract revenues                     |  |                                     |          |   |                                   |   | 16,322  |       |  |   | 16,322    |  
|Professional fees                              |  |                                     | 31,102    |   |                                   |   |        |       |  |   | 31,102    |  
|Investment and other revenues                  |  |                                     | 24,551    |   |                                   |   | 520     |       |  |   | 25,071    |  
|                                               |  |                                     |           |   |                                   |   |         |       |  |   |           |  
|Total Revenue                                  |  | $                                   | 1,014,487 |   |                                   | $ | 16,842  |       |  | $ | 1,031,329 |  
|                                               |  |                                     |           |   |                                   |   |         |       |  |   |           |  
|Segment operating profit                       |  | $                                   | 131,626   |   |                                   | $ | 14,577  |       |  | $ | 146,203   |  
|Interest expense                               |  |                                     | (7,961    | ) |                                   |   | (10     | )     |  |   | (7,971    | )
|Other income (expense), net                    |  |                                     | 1,136     |   |                                   |   | (308    | )     |  |   | 828       |  
|                                               |  |                                     |           |   |                                   |   |         |       |  |   |           |  
|Income Before Income Taxes                     |  | $                                   | 124,801   |   |                                   | $ | 14,259  |       |  | $ | 139,060   |  
|                                               |  |                                     |           |   |                                   |   |         |       |  |   |           |  
|Nine
Months EndedSeptember 30, 2004            |  |                                     |           |   |                                   |   |         |       |  |   |           |  
|Medical premiums                               |  | $                                   | 834,584   |   |                                   | $ |        |       |  | $ | 834,584   |  
|Military contract revenues                     |  |                                     |          |   |                                   |   | 354,312 |       |  |   | 354,312   |  
|Professional fees                              |  |                                     | 26,268    |   |                                   |   |        |       |  |   | 26,268    |  
|Investment and other revenues                  |  |                                     | 26,442    |   |                                   |   | 1,199   |       |  |   | 27,641    |  
|                                               |  |                                     |           |   |                                   |   |         |       |  |   |           |  
|Total Revenue                                  |  | $                                   | 887,294   |   |                                   | $ | 355,511 |       |  | $ | 1,242,805 |  
|                                               |  |                                     |           |   |                                   |   |         |       |  |   |           |  
|Segment operating profit                       |  | $                                   | 109,945   |   |                                   | $ | 42,464  |       |  | $ | 152,409   |  
|Interest expense                               |  |                                     | (3,515    | ) |                                   |   | (46     | )     |  |   | (3,561    | )
|Other income (expense), net                    |  |                                     | 73        |   |                                   |   | (32     | )     |  |   | 41        |  
|                                               |  |                                     |           |   |                                   |   |         |       |  |   |           |  
|Income Before Income Taxes                     |  | $                                   | 106,503   |   |                                   | $ | 42,386  |       |  | $ | 148,889   |  
|                                               |  |                                     |           |   |                                   |   |         |       |  |   |           |  

13

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11. COMMITMENTS AND CONTINGENCIES

Litigation and Legal Matters. Although the Company has not
been sued, it was identified in discovery submissions in pending class action
litigation against major managed care companies, as having allegedly
participated in an unlawful conspiracy to improperly deny, diminish or delay
payments to physicians. In Re: Managed Care Litigation, MDL No. 1334 (S.D.Fl.).

Beginning in 1999, a series of class action lawsuits were
filed against many major firms in the health benefits business. The Company has
not been named as a defendant in these lawsuits. A multi-district litigation
panel has consolidated for pre-trial discovery some of these cases in the United
States District Court for the Southern District of Florida, Miami Division. In
the lead case, known as Shane, the amended complaint alleges multiple violations
under the Racketeer Influenced and Corrupt Organizations Act (RICO). The suit
seeks injunctive, compensatory and equitable relief as well as restitution,
costs, fees and interest payments. Discovery remains ongoing. On April 7, 2003,
the United States Supreme Court determined that certain claims against certain
defendants should be arbitrated. Subsequent lower court rulings have further
resolved which of the plaintiffs' claims are subject to arbitration. In 2004,
the Court of Appeals for the Eleventh Circuit upheld a district court ruling
certifying a plaintiff class in the Shane case. The district court has recently
determined to bifurcate the case, holding a trial phase limited to liability
issues, and a second, if necessary, regarding damages. A trial date has been set
for January 2006. Plaintiffs in the Shane proceeding have stated their intention
to introduce evidence at trial concerning Sierra and other parties not named as
defendants in the litigation. Two of the defendants, Aetna Inc. and Cigna
Corporation, have entered into settlement agreements, which have been approved
by the district court. Three of the other defendants, Wellpoint Inc., Health Net
Inc. and Humana Inc., have recently entered into settlement agreements whose
approval is currently pending before the district court.

The Company is subject to various claims and litigation in
the ordinary course of business. Such litigation includes, but is not limited
to, claims of medical malpractice, claims for coverage or payment for medical
services rendered to HMO and other members and claims by providers for payment
for medical services rendered to HMO and other members. Some litigation may also
include claims for punitive damages that are not covered by insurance. In
addition, under the terms of the note receivable due from the sale of Cal
Indemnity, which is subject to adjustment based on loss development, the Company
can be indirectly affected by claims for our former workers' compensation business and claims by
providers for payment of medical services rendered to such injured workers. These
actions are in various stages of litigation and some may ultimately be brought
to trial. With respect to certain pending actions, the Company maintains
commercial insurance coverage with varying deductibles for which the Company
maintains estimated reserves for its self-insured portion based upon its current
assessment of such litigation. Due to recent unfavorable changes in the
commercial insurance market, the Company has, for certain risks, purchased
coverage with higher deductibles and lower limits of coverage. In the opinion of
management, based on information presently available, the amount or range of any
potential loss for certain claims and litigation cannot be reasonably estimated
or is not considered probable, but the ultimate resolution of these pending
legal proceedings should not have a material adverse effect on the Company's
financial condition.

14

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Table of Contents

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS

ITEM 2.

The following discussion and analysis provides information
which management believes is relevant for an assessment and understanding of our
consolidated financial condition and results of operations. The discussion
should be read in conjunction with our audited consolidated financial statements
and accompanying notes for the year ended December 31, 2004, and
"Management's Discussion and Analysis of Financial Condition and Results of
Operations" included in our 2004 Annual Report on Form 10-K filed with the
Securities and Exchange Commission on March 14, 2005, and in conjunction with
our unaudited condensed consolidated financial statements and accompanying notes
for the three and nine month periods ended September 30, 2005 and 2004, included
in this Form 10-Q. The information contained below is subject to risk factors.
We urge the reader to review carefully the section "Risk Factors" in
Part 1, Item 1 of our 2004 Annual Report on Form 10-K for a more complete
discussion of the risks associated with an investment in our securities. See
"Note on Forward-Looking Statements and Risk Factors" under Part 1,
Item 1 of our 2004 Annual Report on Form 10-K.

This report on Form 10-Q contains "forward-looking
statements" within the meaning of Section 27A of the Securities Act of 1933
and Section 21E of the Securities Exchange Act of 1934, both as amended. The
forward-looking statements regarding our business and results of operations
should be considered by our stockholders or any reader of our business or
financial information along with the risk factors discussed in our 2004 Annual
Report on Form 10-K. All statements other than statements of historical fact are
forward-looking statements for purposes of federal and state securities laws.
The cautionary statements are made pursuant to the "safe harbor"
provisions of the Private Securities Litigation Reform Act of 1995, as amended,
and identify important factors that could cause our actual results to differ
materially from those expressed in any projected, estimated or forward-looking
statements relating to us. These forward-looking statements are generally
identified by their use of terms and phrases such as "anticipate,"
"believe," "continue," "could,"
"estimate," "expect," "hope," "intend,"
"may," "plan," "predict," "project,"
"seeks," "will," and other similar terms and phrases,
including all references to assumptions.

Although we believe that the expectations reflected in any of
our forward-looking statements are reasonable, actual results could differ
materially from those projected or assumed in any of our forward-looking
statements. Readers are cautioned not to place undue reliance on these
forward-looking statements that speak only as of the date hereof. We undertake
no obligation to publish revised forward-looking statements to reflect events or
circumstances after the date hereof or to reflect the occurrence of
unanticipated events.

15

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Summary of Consolidated Results  Three Months Ended
September 30, 2005 and 2004

|                                                   |                                                                | Three Months Ended
  
      September 30, |         |          | Percent Of RevenueThree Months Ended
      September 30, |  |       |      | Increase (Decrease) |     
|-------------------------------------------------- | -------------------------------------------------------------- | ----------------------------------------- | ------- | -------- | -------------------------------------------------------- |  | ----- | ---- | ------------------- | ----
|                                                   |                                                                | 2005                                      |         | 2004     |                                                          |  | 2005  |      | 2004                |     
|                                                   | (In thousands, except percentages, per share and
  membership)
|Operating Revenues:                                |                                                                |                                           |         |          |                                                          |  |       |      |                     |     
|                                                   | Medical premiums                                               | $                                         | 327,084 | $        | 288,485                                                  |  |       | 94.1 | %                   | 73.3
|                                                   | Military contract revenues                                     |                                           | 11      |          | 85,983                                                   |  |       |     |                     | 21.9
|                                                   | Professional fees                                              |                                           | 11,133  |          | 8,705                                                    |  |       | 3.2  |                     | 2.2 
|                                                   | Investment and other revenues                                  |                                           | 9,215   |          | 10,117                                                   |  |       | 2.7  |                     | 2.6 
|                                                   |                                                                |                                           |         |          |                                                          |  |       |      |                     |     
|Total                                              |                                                                | 347,443                                   |         | 393,290  |                                                          |  | 100.0 |      | 100.0               |     
|                                                   |                                                                |                                           |         |          |                                                          |  |       |      |                     |     
|                                                   |                                                                |                                           |         |          |                                                          |  |       |      |                     |     
|Operating Expenses:                                |                                                                |                                           |         |          |                                                          |  |       |      |                     |     
|                                                   | Medical expenses                                               |                                           | 259,591 |          | 224,132                                                  |  |       | 74.7 |                     | 57.0
|                                                   | Medical Care
      Ratio                                       |                                           | 76.8%   |          | 75.4%                                                    |  |       |      |                     |     
|                                                   | Military contract expenses                                     |                                           | (108)   |          | 75,830                                                   |  |       |     |                     | 19.3
|                                                   | General and administrative
    expenses                        |                                           | 43,451  |          | 44,593                                                   |  |       | 12.5 |                     | 11.3
|                                                   |                                                                |                                           |         |          |                                                          |  |       |      |                     |     
|Total                                              |                                                                | 302,934                                   |         | 344,555  |                                                          |  | 87.2  |      | 87.6                |     
|                                                   |                                                                |                                           |         |          |                                                          |  |       |      |                     |     
|                                                   |                                                                |                                           |         |          |                                                          |  |       |      |                     |     
|Operating Income                                   |                                                                | 44,509                                    |         | 48,735   |                                                          |  | 12.8  |      | 12.4                |     
|Interest expense                                   |                                                                | (1,991)                                   |         | (1,221)  |                                                          |  | (0.5) |      | (0.3)               |     
|Other income (expense), net                        |                                                                | 427                                       |         | (49)     |                                                          |  | 0.1   |      |                    |     
|                                                   |                                                                |                                           |         |          |                                                          |  |       |      |                     |     
|Income
      Before Income Taxes                   |                                                                | 42,945                                    |         | 47,465   |                                                          |  | 12.4  |      | 12.1                |     
|Provision for income taxes                         |                                                                | (14,503)                                  |         | (16,738) |                                                          |  | (4.2) |      | (4.3)               |     
|                                                   | Tax Rate                                                       |                                           | 33.8%   |          | 35.3%                                                    |  |       |      |                     |     
|                                                   |                                                                |                                           |         |          |                                                          |  |       |      |                     |     
|Net Income                                         | $                                                              | 28,442                                    | $       | 30,727   |                                                          |  | 8.2   | %    | 7.8                 | %   
|                                                   |                                                                |                                           |         |          |                                                          |  |       |      |                     |     
|                                                   |                                                                |                                           |         |          |                                                          |  |       |      |                     |     
|Earnings Per Common Share Assuming
      Dilution: |                                                                |                                           |         |          |                                                          |  |       |      |                     |     
|Net Income                                         | $                                                              | 0.87                                      | $       | 0.90     |                                                          |  |       |      |                     |     
|                                                   |                                                                |                                           |         |          |                                                          |  |       |      |                     |     
|                                                   |                                                                |                                           |         |          |                                                          |  |       |      |                     |     
|HMO Membership:                                    |                                                                |                                           |         |          |                                                          |  |       |      |                     |     
|                                                   | Commercial                                                     |                                           | 251,000 |          | 222,200                                                  |  |       |      |                     |     
|                                                   | Medicare                                                       |                                           | 55,200  |          | 53,000                                                   |  |       |      |                     |     
|                                                   | Medicaid                                                       |                                           | 53,300  |          | 49,100                                                   |  |       |      |                     |     
|                                                   |                                                                |                                           |         |          |                                                          |  |       |      |                     |     
|Total                                              |                                                                | 359,500                                   |         | 324,300  |                                                          |  |       |      |                     |     
|                                                   |                                                                |                                           |         |          |                                                          |  |       |      |                     |     

16

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Summary of Consolidated Results  Nine Months Ended September 30, 2005 and 2004

|                                                   |                                                  | Nine Months Ended September 30, |         |           | Percent Of Revenue
  
      Nine Months Ended September 30, |  |       |      | Increase (Decrease) |      
|-------------------------------------------------- | ------------------------------------------------ | ------------------------------- | ------- | --------- | ----------------------------------------------------------- |  | ----- | ---- | ------------------- | -----
|                                                   |                                                  | 2005                            |         | 2004      |                                                             |  | 2005  |      | 2004                |      
|                                                   | (In thousands, except percentages and per share)
|Operating Revenues:                                |                                                  |                                 |         |           |                                                             |  |       |      |                     |      
|                                                   | Medical premiums                                 | $                               | 958,834 | $         | 834,584                                                     |  |       | 93.0 | %                   | 67.2 
|                                                   | Military contract revenues                       |                                 | 16,322  |           | 354,312                                                     |  |       | 1.6  |                     | 28.5 
|                                                   | Professional fees                                |                                 | 31,102  |           | 26,268                                                      |  |       | 3.0  |                     | 2.1  
|                                                   | Investment and other revenues                    |                                 | 25,071  |           | 27,641                                                      |  |       | 2.4  |                     | 2.2  
|                                                   |                                                  |                                 |         |           |                                                             |  |       |      |                     |      
|Total                                              |                                                  | 1,031,329                       |         | 1,242,805 |                                                             |  | 100.0 |      | 100.0               |      
|                                                   |                                                  |                                 |         |           |                                                             |  |       |      |                     |      
|                                                   |                                                  |                                 |         |           |                                                             |  |       |      |                     |      
|Operating Expenses:                                |                                                  |                                 |         |           |                                                             |  |       |      |                     |      
|                                                   | Medical expenses                                 |                                 | 755,779 |           | 650,435                                                     |  |       | 73.3 |                     | 52.3 
|                                                   | Medical Care
      Ratio                         |                                 | 76.3%   |           | 75.6%                                                       |  |       |      |                     |      
|                                                   | Military contract expenses                       |                                 | 2,265   |           | 313,047                                                     |  |       | 0.2  |                     | 25.2 
|                                                   | General and administrative
    expenses          |                                 | 127,082 |           | 126,914                                                     |  |       | 12.3 |                     | 10.2 
|                                                   |                                                  |                                 |         |           |                                                             |  |       |      |                     |      
|Total                                              |                                                  | 885,126                         |         | 1,090,396 |                                                             |  | 85.8  |      | 87.7                |      
|                                                   |                                                  |                                 |         |           |                                                             |  |       |      |                     |      
|                                                   |                                                  |                                 |         |           |                                                             |  |       |      |                     |      
|Operating Income From Continuing Operations        |                                                  | 146,203                         |         | 152,409   |                                                             |  | 14.2  |      | 12.3                |      
|Interest expense                                   |                                                  | (7,971)                         |         | (3,561)   |                                                             |  | (0.8) |      | (0.3)               |      
|Other income (expense), net                        |                                                  | 828                             |         | 41        |                                                             |  | 0.1   |      |                    |      
|                                                   |                                                  |                                 |         |           |                                                             |  |       |      |                     |      
|Income
      From Continuing Operations Before     |                                                  |                                 |         |           |                                                             |  |       |      |                     |      
|                                                   | Income Taxes                                     |                                 | 139,060 |           | 148,889                                                     |  |       | 13.5 |                     | 12.0 
|Provision for income taxes                         |                                                  | (47,377)                        |         | (53,430)  |                                                             |  | (4.6) |      | (4.3)               |      
|                                                   | Tax Rate                                         |                                 | 34.1%   |           | 35.9%                                                       |  |       |      |                     |      
|                                                   |                                                  |                                 |         |           |                                                             |  |       |      |                     |      
|Income From Continuing Operations                  |                                                  | 91,683                          |         | 95,459    |                                                             |  | 8.9   |      | 7.7                 |      
|Loss from discontinued operations                  |                                                  |                                 |         |           |                                                             |  |       |      |                     |      
|                                                   | (net of income tax benefit of $839)              |                                 |        |           | (682)                                                       |  |       |     |                     | (0.1)
|                                                   |                                                  |                                 |         |           |                                                             |  |       |      |                     |      
|Net Income                                         | $                                                | 91,683                          | $       | 94,777    |                                                             |  | 8.9   | %    | 7.6                 | %    
|                                                   |                                                  |                                 |         |           |                                                             |  |       |      |                     |      
|                                                   |                                                  |                                 |         |           |                                                             |  |       |      |                     |      
|Earnings Per Common Share Assuming
      Dilution: |                                                  |                                 |         |           |                                                             |  |       |      |                     |      
|                                                   | Income
      from continuing operations          | $                               | 2.75    | $         | 2.76                                                        |  |       |      |                     |      
|                                                   | Loss from discontinued operations                |                                 |        |           | (0.02)                                                      |  |       |      |                     |      
|                                                   |                                                  |                                 |         |           |                                                             |  |       |      |                     |      
|Net Income                                         | $                                                | 2.75                            | $       | 2.74      |                                                             |  |       |      |                     |      
|                                                   |                                                  |                                 |         |           |                                                             |  |       |      |                     |      
|                                                   |                                                  |                                 |         |           |                                                             |  |       |      |                     |      

Overview

We derive revenues primarily from our health maintenance
organization (HMO) and managed indemnity plans. To a lesser extent, we also
derive revenues from professional fees (consisting primarily of fees for
providing health care services to non-members, co-payment fees received from
members and ancillary products), and investment and other revenue (consisting of
fees for workers' compensation third party administration, utilization
management services and ancillary products). We also have revenues from our
military health services segment, which continue to decrease during our phase
out of the operations, starting September 1, 2004.

Our principal expenses consist of medical expenses and
general and administrative expenses. Medical expenses represent capitation fees
and other fee-for-service payments paid to independent contracted physicians,
hospitals and other health care providers to cover members, pharmacy costs, as
well as the aggregate expenses to operate and manage our wholly-owned
multi-specialty medical group and other provider subsidiaries. As a provider of
health care management services, we seek to positively affect quality of care
and expenses by contracting with physicians, hospitals and other health care
providers at negotiated price

17

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levels, by adopting quality assurance programs, monitoring
and coordinating utilization of physician and hospital services and providing
incentives to use cost-effective providers. Military contract expenses represent
payments to providers for health care services rendered under the TRICARE
program, administrative costs to operate the military health care subsidiary
and, subsequent to August 31, 2004, costs to phase-out the military health care
operations. General and administrative expenses generally represent operational
costs other than those directly associated with the delivery of health care
services and military contract services.

Executive Summary

Continuing Operations. Net Income for the nine months
ended September 30, 2005 was $91.7 million compared to $94.8 million for the
same period in 2004. The decrease is related to the phase out of our military
operations beginning September 1, 2004 as discussed in more detail below.
Operating income from our core managed care and corporate operations segment
increased from $109.9 million to $131.6 million for the nine months ended
September 30, 2004 and 2005, respectively. The increase in operating income for
the managed care and corporate operations was primarily driven by medical
premium revenue growth from new members, premium rate increases and an expansion
of our operating margin. This was partially offset by an increase in our medical
care ratio.

Our HMO membership increased by 10.9% from 324,300 at
September 30, 2004, to 359,500 at September 30, 2005 from the addition of new
accounts and in-case growth. Our aggregate 2005 premium rates increased by
approximately 5% over 2004. The combination of these factors resulted in a 14.9%
increase in our medical premium revenues to $958.8 million, which was partially
offset by an increase in medical expenses, which increased by 16.2% to $755.8
million. Medical expenses, as a percentage of medical premiums and professional
fees, increased from 75.6% to 76.3%, or 70 basis points for the nine months
ended September 30, 2005. Our operating margin (operating income from continuing
operations divided by total revenues) improved by 190 basis points to 14.2%.

Our military health services operations segment represented
1.6% of our operating revenues and 10.0% of our operating income for the nine
months ended September 30, 2005. This segment had operating income of $14.6
million for the nine months ended September 30, 2005 compared to $42.5 million
for the same period in 2004. We were not awarded the T-Nex North Region contract
and our appeal to the United States General Accounting Office was denied in
December 2003. Health care services under our TRICARE contract for Region 1
ended on August 31, 2004. On September 1, 2004, we entered an eight-month
phase-out period at substantially reduced revenues and reduced earnings. During
the second quarter of 2005, we reached a negotiated settlement with the
Department of Defense (DoD) for certain outstanding change order and bid price
adjustments related to option period six and the phase-out of our military
health care operations. Included in the settlement was the determination of the
final military health care payable balance. The gains recorded during the
quarter, as described above, resulted in a net credit to expenses for the second
quarter.

For the nine months ended September 30, 2005, compared to
2004, investment and other revenues decreased from $27.6 million to $25.1
million, a decrease of approximately $2.6 million or 9.3%. There was a $5.2
million increase in investment revenue offset by a decrease of $7.8 million
related to the services we are providing relative to our sales agreement for the
workers' compensation insurance operations, beginning April 1, 2004, and accrued
interest on the associated note receivable. For a further description of this
agreement, see below in the discussion of investment and other revenues.

For the nine months ended September 30, 2005, compared to
2004, our general and administrative (G&A) expenses increased from $126.9
million to $127.1 million, an increase of approximately $200,000 or .1%. We had
an increase of $8.4 million primarily due to higher employee compensation
related expenses, premium taxes, brokers' fees and costs associated with
marketing our new Medicare programs offset by an $8.2 million decrease for
the cost to provide services related to the sale of the workers' compensation
insurance operations referred to above.

18

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We had cash flows from operating activities of continuing
operations for the nine months ended September 30, 2005, of $152.9 million
compared to $95.0 million for 2004. We received nine monthly payments from the
Centers for Medicare and Medicaid Services (CMS) during the first nine months of
2005 compared to eight monthly payments during the first nine months of 2004.
The January payments were received at the end of December while the October 2005
payment was received at the end of September 2005. We have also received
additional payments from CMS in 2005, of over $30 million, which have been
recorded as unearned revenue. See below under Medical Premiums for further
discussion on this unearned revenue. When the nine months ended 2004 and 2005
are adjusted for the items described above the cash flow from continuing
operations would be $112.9 million in 2005 compared to $127.9 million in 2004.
We believe presenting the adjustments for the CMS payments is useful for making
a period-to-period comparison of our cash flow from continuing operations. The
decrease in the adjusted cash flow from continuing operations is primarily due
to the timing of income tax payments, which represented a fluctuation of $26.0
million between the periods.

RESULTS OF OPERATIONS, THREE MONTHS ENDED SEPTEMBER 30,
2005, COMPARED TO THREE MONTHS ENDED SEPTEMBER 30, 2004

Medical Premiums. The increase in premium revenue for
the three months ended September 30, 2005 reflects a 12.5% increase in
commercial member months (the number of months individuals are enrolled in a
plan), and a 4.2% increase in both Medicaid and Medicare member months. The
growth in Medicare member months contributes significantly to the increase in
premium revenues as the Medicare per member premium rates are more than three
times the average commercial premium rate.

HMO and POS premium rates for renewing commercial groups
increased approximately 6% while the overall recorded per member per month
revenue increase, including new and continuing business, was approximately 6%,
net of changes in benefits. We received a 1% increase in Medicaid rates for 2005
but we did not receive an increase in 2004.

In December 2003, President Bush signed the Medicare
Prescription Drug, Improvement, and Modernization Act of 2003 (MMA), into law,
which, among other changes to Medicare, alters the Medicare+Choice program.
Under the MMA, Medicare+Choice plans, renamed Medicare Advantage plans, received
increased funding from CMS starting March 2004. Because of the way the increased
funding was calculated, both our non-Social HMO Medicare Advantage benefit plans
and our Social HMO benefit plans received the increased funding. MMA increased
our Medicare premium rates by over 15% starting March 1, 2004. The increased
funding was used to reduce beneficiary cost sharing, enhance benefits, and
stabilize the provider network. In addition, some of the funds were placed into
a benefit stabilization fund.

Effective January 2004, CMS adopted a new risk adjustment
payment methodology for Medicare beneficiaries enrolled in managed care
programs, including the Social HMO. For Social HMO members, the new methodology
includes a frailty adjuster that uses measures of functional impairment to
predict expenditures. CMS is transitioning to the new payment methodology on a
graduated basis from 2004 through 2007. In 2004, we were paid 90% based on the
previous payment approach and 10% based on the new approach. Excluding the
effects of MMA, the new payment methodology reduced our rate increase by 60
basis points. The Social HMO program has been administratively extended by CMS
through 2007. For 2005, 2006 and 2007, we will be paid 70%, 50% and 25%, based
on the previous payment approach and 30%, 50% and 75%, based on the new
approach, respectively. The extension of the Social HMO program will serve as a
transition plan so that we can convert to a Medicare Advantage plan in 2008. Our
2005 annual Medicare increase, before the effect of the new payment approach and
the MMA, would have been 7.9%. The new payment approach reduced this to
approximately 4%, although the actual increase we received over the fourth
quarter of 2004 was approximately 2%. The increased MMA funds were earned over
the last 10 months of the year and included a proportionate share for January
and February 2004.

Early in 2005, CMS replaced its Legacy Group Health Plan computer
system. The transition to the new system has led to some incorrect transactions
and inconsistencies in the payments and data we have received from CMS. We have
recorded our best estimate for Medicare premium revenues as of September 30,
2005. We

19

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have received over $30 million from CMS in excess of our current best estimate
of Medicare premiums, as of September 30, 2005. The funds have been
recorded as unearned revenue.

Continued medical premium revenue growth is principally
dependent upon continued enrollment in our products and upon competitive and
regulatory factors.

Our commercial membership increased from 222,200 at September
30, 2004 to 251,000 at September 30, 2005. The increase in commercial membership
is attributed to in-case growth and new accounts including movement from
self-insured plans to our commercial products.

Pursuant to an existing contract with the Division of
Healthcare Financing and Policy of the State of Nevada ("DHCFP"), we
provide health care coverage to certain Medicaid eligible individuals and
uninsured children who do not qualify for Medicaid. As of September 30, 2005, we
had approximately 40,700 members enrolled in our HMO Medicaid risk program. To
enroll in this program, an individual must be eligible for the Temporary
Assistance for Needy Families or the Children's Health Assurance Program
categories of the State of Nevada's Medicaid program. We also have an additional 12,600 Nevada
Check Up members. Nevada Check Up is the State Children's Health Insurance
Program, which covers uninsured children who do not qualify for Medicaid. We
receive a monthly fee for each Medicaid and Nevada Check Up member enrolled by
the state's managed care division and we also receive a per case fee for each
Medicaid and Nevada Check Up eligible newborn delivery.

The DHCFP recently issued a request for proposal (RFP) to
provide services to these members and we have responded to the RFP. The two
contractors will not be selected based upon a financial bid. The two selected
contractors will be chosen primarily based upon the demonstrated competence and
experience of the company and management in providing, and arranging for, the
healthcare services requested in the RFP. The RFP will also be evaluated on full
and complete responses to the questions and requests for information contained
in the RFP. The award decision for this contract is currently expected to be
made on November 30, 2005. Once awarded, the new contract will be effective for
a two-year period beginning July 1, 2006. The new contract includes a provision,
which allows the DHCFP, at its sole option, to extend the contract on a
year-to-year basis for up to three additional years.

Military Contract Revenues. The decrease in military
contract revenue for the three months ended September 30, 2005 is due to Sierra
Military Health Services LLC (SMHS) completing its health care operations under
the TRICARE contract on August 31, 2004.

SMHS completed the fifth year of a five-year contract in May
2003. SMHS then operated under a negotiated contract extension period, which
ended August 31, 2004. The new contractor became operational in Region 1 on
September 1, 2004 and the new contract superseded the remainder of our TRICARE
Region 1 contract. On September 1, 2004, SMHS commenced an eight-month phase-out
of operations at prices previously negotiated with the DoD. SMHS does not meet
the definition of discontinued operations since we did not dispose of the
operations before the phase-out was complete.

During the second quarter of 2005, we reached a negotiated
settlement with the DoD for certain outstanding change order and bid price
adjustments related to option period six and the phase-out of our military
health care operations. Included in the settlement was the determination of the
final military health care payable balance.

For more information on SMHS' results of operations, see Note
10, Segment Reporting, in the Notes to the Condensed Consolidated Financial
Statements.

Professional Fees. The increase in professional fees
is a result of increased visits due primarily to membership growth and to a new
contract to provide anesthesiology services at a local hospital.

20

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Investment and Other Revenues. We had an overall
decrease in investment and other revenues of approximately $900,000. We had a
decrease of $3.8 million in administrative services revenue for the serviceswe are providing relative to our sales agreement for the
workers' compensation insurance operations beginning April 1, 2004, and accrued
interest on the associated note receivable. On March 31, 2004, we completed the
sale of the workers' compensation insurance operations and we have engaged a
third party claims administrator to administer claims for a period of fifteen
years as well as perform certain transition and managed care services directly.
Total revenue associated with these services for the three months ended
September 30, 2005 and 2004 was $600,000 and $4.3 million, respectively. The
cost to provide these services is reflected in our general and administrative
expenses. In addition, we recorded accrued interest of approximately $500,000 on
the note receivable in 2005 compared to approximately $600,000 in 2004.

Excluding the workers' compensation related revenue decrease,
we had an increase in investment and other revenues of $2.9 million due to an
increase in average yield during 2005 and higher average invested balances.

Medical Expenses. Our medical care ratio, which is
medical expenses as a percentage of medical premiums and professional fees,
increased from 75.4%, for the third quarter of 2004 to 76.8% for the third
quarter of 2005. The increase in our medical care ratio is due primarily to
increased prescription drug costs along with other medical cost trends. The
number of days in claims payable, computed as medical claims payable balance
divided by the average medical expense per day for the period, at September 30,
2005, was 45 compared to 47 at September 30, 2004. The decrease in days in
claims payable is primarily attributable to lower bed days per thousand in the
third quarter of 2005, fewer pended claims and the payment of a negotiated
settlement previously accrued.

We contract with hospitals, physicians and other independent
providers of health care under capitated or discounted fee-for-service
arrangements, including hospital per diems, to provide medical care services to
members. Capitated providers are at risk for a portion of the cost of medical
care services provided to our members in the relevant geographic areas; however,
we are ultimately responsible for the provision of services to our members
should the capitated provider be unable to provide the contracted services. We
incurred capitation expenses with non-affiliated providers of $31.9 million and
$29.0 million, or 12.3% and 12.9%, of our total medical expenses for 2005 and
2004, respectively.

Military Contract Expenses. The decrease in military
contract expenses is the result of SMHS completing its final month of health
care operations under the TRICARE contract in August 2004. The expense credit
for the three months ended September 30, 2005 is the result of settlement
adjustments to previously accrued amounts. Included in our military contract
expenses for the three months ended September 30, 2004 is an allocation of
corporate overhead of $1.0 million per quarter for direct and indirect services
provided to SMHS. There has been no allocation of overhead in 2005.

General and Administrative Expenses. G&A expenses
decreased due to lower expenses to provide services relative to our sales
agreement for the workers' compensation insurance operations as discussed above,
offset by higher employee compensation related expenses, premium taxes, brokers'
fees and costs associated with marketing our new Medicare programs. As a
percentage of medical premium revenue, G&A expenses were 13.3% for 2005,
compared to 15.5% for 2004. Excluding the services relative to our sales
agreement for the workers' compensation insurance operations, our G&A
expenses, as a percentage of medical premium revenue, were 13.1% and 14.1% for
2005 and 2004, respectively.

Interest Expense. Interest expense increased due to
the prepaid interest paid for the conversion of $29.0 million in debentures and
the associated write-off in deferred debenture-related costs. For more
information on the conversion of our senior convertible debentures, see Note 4,
Long-Term Debt, in the Notes to the Condensed Consolidated Financial Statements.

Other Income (Expense), Net. Other income (expense),
net increased in 2005 as a result of gains on asset sales in 2005 compared to
losses in 2004.

21

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Provision for Income Taxes. The effective tax rate for
2005 was 33.8% compared to 35.3% for 2004. Our effective tax rate is less than
the 35% statutory federal rate due primarily to tax-preferred investments and a
favorable state tax settlement during the period. We expect our effective tax
rate for the fourth quarter of 2005 to be slightly below 35%.

Our effective tax rate is based on actual or expected income,
statutory tax rates and tax planning opportunities available to us. We may use
significant estimates and judgments in determining our effective tax rate. We
are occasionally audited by federal, state or local jurisdictions regarding
compliance with federal, state and local tax laws and the recognition of income
and deductibility of expenses. Tax assessments may not arise until several years
after tax returns are filed. While there is an element of uncertainty in
predicting the outcome of tax audits, we believe that the recorded tax assets
and liabilities are appropriately stated based on our analyses of probable
outcomes, including interest and other potential adjustments. Our tax assets and
liabilities are adjusted based on the most current facts and circumstances,
including the progress of audits, case law and emerging legislation; any
adjustments are included in the effective tax rate in the period of adjustment.

RESULTS OF OPERATIONS, NINE MONTHS ENDED SEPTEMBER 30,
2005, COMPARED TO NINE MONTHS ENDED SEPTEMBER 30, 2004

Medical Premiums. The increase in premium revenue for
the nine months ended September 30, 2005 reflects a 13.1% increase in commercial
member months (the number of months individuals are enrolled in a plan), a 6.4%
increase in Medicaid member months and a 4.4% increase in Medicare member
months. The growth in Medicare member months contributes significantly to the
increase in premium revenues as the Medicare per member premium rates are more
than three times the average commercial premium rate. Of the 6.4% increase in
Medicaid member months, 2.5% is due to the expansion of our Medicaid service
area to Reno, Nevada beginning February 2004.

HMO and POS premium rates for renewing commercial groups
increased approximately 6% while the overall recorded per member per month
revenue increase, including new and continuing business, was approximately 7%,
net of changes in benefits. We received a 1% increase in Medicaid rates for 2005
but we did not receive an increase in 2004.

Military Contract Revenues. The decrease in military
contract revenue for the nine months ended September 30, 2005 is the result of
SMHS completing its health care operations under the TRICARE contract on August
31, 2004.

During the second quarter of 2005, we reached a negotiated
settlement with the DoD for certain outstanding change order and bid price
adjustments related to option period six and the phase-out of our military
health care operations. Included in the settlement was the determination of the
final military health care payable balance. Primarily as a result of the
settlements described above, the segment reported operating profit for the three
months ended June 30, 2005, of $12.0 million. The segment operating profit for
the nine months ended September 30, 2005, was $14.6 million.

For more information on SMHS' results of operations, see Note
10, Segment Reporting, in the Notes to the Condensed Consolidated Financial
Statements.

Professional Fees. The increase in professional fees
is a result of increased visits due primarily to membership growth.

Investment and Other Revenues. We had an overall
decrease in investment and other revenues of $2.6 million. We had a decrease of
$7.8 million in administrative services revenue for the services we are
providing relative to our sales agreement for the workers' compensation
insurance operations, beginning April 1, 2004, and accrued interest on the note
receivable. On March 31, 2004, we completed the sale of the workers'
compensation insurance operations and we have engaged a third party claims
administrator to administer

22

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claims for a period of fifteen years as well as
perform certain transition and managed care services directly.Total revenue associated with these services for the nine
months ended September 30, 2005 and 2004 was $2.1 million and $10.1 million,
respectively. The cost to provide these services is reflected in our general and
administrative expenses. In addition, we recorded accrued interest of
approximately $1.5 million on the note receivable in 2005 compared to
approximately $1.2 million in 2004.

Excluding the workers' compensation related revenue decrease,
we had an increase in investment and other revenues of $5.2 million due to an
increase in yield during 2005 and higher average invested balances, partially
offset by a loss on a short sale of U.S. Treasury bonds as described in Note 3,
Investments, in the Notes to the Condensed Consolidated Financial Statements.

Medical Expenses. Our medical care ratio, which is
medical expenses as a percentage of medical premiums and professional fees,
increased from 75.6% to 76.3%. The increase in our medical care ratio is due
primarily to higher average bed days and increased prescription drug costs. We
incurred capitation expenses with non-affiliated providers of $96.2 million and
$85.1 million, or 12.7% and 13.1%, of our total medical expenses for 2005 and
2004, respectively.

Military Contract Expenses. The decrease in military
contract expenses is primarily the result of SMHS completing its final month of
health care operations under the TRICARE contract in August 2004. Expenses for
2005 primarily consist of costs incurred related to the phase-out of the
military health care operations as previously discussed.

General and Administrative Expenses. G&A expenses
increased primarily due to higher employee compensation related expenses,
premium taxes, brokers' fees and costs associated with marketing our new
Medicare programs, offset by a decrease in expenses to provide services relative
to our sales agreement for the workers' compensation insurance operations as
discussed above. As a percentage of medical premium revenue, G&A expenses
were 13.3% for 2005, compared to 15.2% for 2004. Excluding the services relative
to our sales agreement for the workers' compensation insurance operations, our
G&A expenses, as a percentage of medical premium revenue, were 13.0% and
14.0% for 2005 and 2004, respectively.

Interest Expense. Interest expense increased due to
interest expense related to the short sale of U.S. Treasury bonds and the
prepaid interest paid for the conversion of $63.0 million in debentures and the
associated write-off in deferred debenture-related costs. For more information
on our short position see Note 3, Investments, in the Notes to the Condensed
Consolidated Financial Statements. For more information on the conversion of our
senior convertible debentures see Note 4, Long-Term Debt, in the Notes to the
Condensed Consolidated Financial Statements.

Other Income (Expense), Net. Other income (expense),
net increased in 2005 as a result of interest related to an income tax
settlement.

Provision for Income Taxes. The effective tax rate for
2005 was 34.1% compared to 35.9% for 2004. Our effective tax rate is less than
the statutory rate due to tax-preferred investments and a settlement benefit
recorded relative to state taxes during the period.

Discontinued Operations. On January 15, 2003, we
announced that we were exploring strategic alternatives to dispose of CII
Financial, Inc. (CII). Sierra's Board of Directors authorized the sale of the
operations on December 31, 2002. Accordingly, beginning in the fourth quarter of
2002, we reclassified our workers' compensation insurance business as
discontinued operations.

On November 25, 2003, we announced that we had reached an
agreement to sell California Indemnity Insurance Company (Cal Indemnity), and
its subsidiaries. Cal Indemnity was CII's only significant asset. In the fourth
quarter of 2003, we recorded a charge of $15.6 million, gross and net of tax, to
write down the investment in Cal Indemnity to its estimated net sales proceeds.

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On March 31, 2004, we completed the sale of Cal Indemnity.
Cal Indemnity's subsidiaries, which were included in the sale, are Commercial
Casualty Insurance Company, Sierra Insurance Company of Texas, and CII Insurance
Company.

LIQUIDITY AND CAPITAL RESOURCES

We had cash flows from operating activities for continuing
operations of $152.9 million for 2005 compared to $95.0 million in 2004. We
received nine monthly payments from the Centers for Medicare and Medicaid
Services (CMS) during the first nine months of 2005 compared to eight monthly
payments during the first nine months of 2004. The January payments were
received at the end of December while the October 2005 payment was received at
the end of September 2005. We have also received additional payments from CMS in
2005 of over $30 million, which have been recorded as unearned revenue. See
previous discussion under Medical Premiums for more information on the unearned revenue.
When the nine months ended 2004 and 2005 are adjusted for the items described
above, the cash flow from continuing operations would be $112.9 million in 2005
compared to $127.9 million in 2004. We believe presenting the adjustments for
the CMS payments is useful for making a period-to-period comparison of our cash
flow from continuing operations. The decrease in the adjusted cash flow from
continuing operations is primarily due to the timing of income tax payments,
which represented a fluctuation of $26.0 million between the periods.

We expect that SMHS will require approximately $5.0 million
of its cash, as the payout of the remaining liabilities will exceed SMHS'
accounts receivable and other non-cash asset balances.

Net cash used for investing activities during 2005 included
$8.9 million in capital expenditures associated with the continued
implementation of new computer systems, leasehold improvements on facilities,
furniture and equipment and other capital purchases to support our growth. The
net cash change in investments for the period was an increase in investments of
$138.6 million as cash equivalents were used to purchase investments.

Net cash used for financing activities in 2005 included
proceeds from the issuance of stock in connection with stock plans of $19.6
million and cash of $144.4 million was used to repurchase Sierra common stock.

Discontinued operations provided cash of $3.7 million in 2004
primarily as a result of the sale of Cal Indemnity.

Sierra Debentures

In March 2003, we issued $115.0 million aggregate principal
amount of 21⁄4% senior convertible debentures due March 15, 2023. The debentures
pay interest, which is due semi-annually on March 15 and September 15 of each
year. Each $1,000 principal amount of debentures is convertible, at the option
of the holders, into 54.6747 shares of Sierra Health Services, Inc., common
stock prior to March 15, 2023: if (i) the market price of our common stock for
at least 20 trading days in a period of 30 consecutive trading days ending on
the last trading day of the preceding fiscal quarter exceeds 120% of the
conversion price per share of our common stock; (ii) the debentures are called
for redemption; (iii) there is an event of default with respect to the
debentures; or (iv) specified corporate transactions have occurred. Beginning
December 2003 and for each subsequent period, the market price of our common
stock has exceeded 120% of the conversion price for at least 20 trading days in
a period of 30 consecutive trading days. The conversion rate is subject to
certain adjustments. This conversion rate initially represents a conversion
price of $18.29 per share. Holders of the debentures may require us to
repurchase all or a portion of their debentures on March 15 in 2008, 2013 and
2018 or upon certain corporate events including a change in control. In either
case, we may choose to pay the purchase price of such debentures in cash or
common stock or a combination of cash and common stock. The debentures can be
redeemed by us for cash beginning on or after March 20, 2008.

During the second and third quarters of 2005, we received
offers and entered into privately negotiated transactions with debenture holders
(holders) pursuant to which the holders converted the debentures they owned into
our common stock in accordance with the indenture governing the debentures.
During the second

24

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quarter, we entered into three separate transactions
converting a total of $34.0 million in debentures for approximately 1.9 million
shares of common stock. During the third quarter, we entered into two separate
transactions converting a total of $29.0 million in debentures for approximately
1.6 million shares of common stock. As a result of these transactions, we paid
approximately $1.5 million in prepaid interest as an incentive for conversion
and wrote-off approximately $1.2 million in deferred debenture-related costs for
a total interest expense of approximately $2.7 million.

Revolving Credit Facility

On March 3, 2003, we entered into a $65.0 million revolving
credit facility, which replaced our amended and restated credit facility. The
facility was set to expire on April 30, 2006. Effective October 19, 2004, the
facility was amended to extend the maturity to December 31, 2009, increase the
availability to $100.0 million and reduce the interest rate. Effective June 24,
2005, we elected to increase the aggregate commitments of the facility to $140.0
million. The current interest rate is LIBOR plus .75%. The facility is available
for general corporate purposes and at September 30, 2005, we have drawn $10.0
million on this facility.

The credit facility is secured by guarantees by certain of
our subsidiaries and a first priority perfected security interest in: (i) all of
the capital stock of each of our unregulated, material domestic subsidiaries
(direct or indirect) as well as all of the capital stock of certain regulated,
material domestic subsidiaries; and (ii) all other present and future assets and
properties of ours and those of our subsidiaries that guarantee our credit
agreement obligations (including, without limitation, accounts receivable,
inventory, real property, equipment, contracts, trademarks, copyrights, patents,
license rights and general intangibles) subject, in each case, to the exclusion
of the capital stock of CII and certain other exclusions.

The revolving credit facility has covenants that limit our
ability and the ability of our subsidiaries to dispose of assets, incur
indebtedness, incur other liens, make investments, loans or advances, make
acquisitions, engage in mergers or consolidations, make capital expenditures and
otherwise restrict certain corporate activities. Under the most recent amendment
dated October 19, 2004, based on our exceeding a certain covenant leverage ratio
requirement, our ability to pay dividends, repurchase our common stock and
prepay other debt is unlimited provided that we can still maintain the required
ratios after such transaction or any borrowing incurred as a result of such
transaction. In addition, we are required to comply with specified financial
ratios as set forth in the credit agreement. We believe that we are in
compliance with all covenants of the credit agreement.

Sierra Share Repurchases

From January 1, 2005 through September 30, 2005, we purchased
2.2 million shares of our common stock, in the open market or through negotiated
transactions, for $144.4 million at an average cost per share of $66.07. On
August 11, 2005, our Board of Directors authorized us to purchase an additional
$75.0 million worth of our common stock. At September 30, 2005, $52.1 million
was still available under the Board of Directors' authorized plan.

Our revolving credit facility, as amended, currently allows
for unlimited stock repurchases. We have repurchased 80,000 shares for $5.6
million at an average cost of $70.01 subsequent to September 30, 2005 through
October 24, 2005.

Statutory Capital and Deposit Requirements

Our HMO and insurance subsidiaries are required by state
regulatory agencies to maintain certain deposits and must also meet certain net
worth and reserve requirements. The HMO and insurance subsidiaries had
restricted assets on deposit in various states totaling $16.6 million at
September 30, 2005. The HMO and insurance subsidiaries must also meet
requirements to maintain minimum stockholders' equity, on a statutory basis, as
well as minimum risk-based capital requirements, which are determined annually.
In conjunction with the exit from the Texas HMO health care market, the Texas
Department of Insurance approved a plan of

25

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withdrawal and Texas Health Choice, L.C., is now required to
maintain deposits of $1.5 million and net worth of at least $3.5 million. We
believe we are in material compliance with our regulatory requirements.

Of the $88.5 million in cash and cash equivalents held at
September 30, 2005, $60.6 million was designated for use only by the regulated
subsidiaries. Amounts are available for transfer to the holding company from the
HMO and insurance subsidiaries only to the extent that they can be remitted in
accordance with the terms of existing management agreements and by dividends.
The holding company will not receive dividends from its regulated subsidiaries
if such dividend payment would cause violation of statutory net worth and
reserve requirements.

Obligations and Commitments

We believe that funds from future operating cash flows, cash
and investments and funds available under our credit agreement will be
sufficient for future operations and commitments and for capital acquisitions
and other strategic transactions.

For additional information regarding our estimated
contractual obligations and commitments at December 31, 2004, see
"Obligations and Commitments" included in the "Liquidity and
Capital Resources" section included in our 2004 Annual Report on Form 10-K
filed with the Securities and Exchange Commission on March 14, 2005.

Recently Issued Accounting Standards

In December 2004, the Financial Accounting Standards Board
issued Statement of Financial Accounting Standards No. 123 (revised 2004),
"Share-Based Payment" (SFAS 123R), which replaces SFAS No. 123 and
supercedes APB Opinion No. 25, "Accounting for Stock Issued to
Employees." SFAS 123R requires all share-based payments to employees,
including grants of employee stock options, to be recognized in the financial
statements based on their fair values. The pro forma disclosures previously
permitted under SFAS 123 no longer will be an alternative to financial statement
recognition. Under SFAS 123R, we must determine the appropriate fair value model
to be used for valuing share-based payments, the amortization method for
compensation cost and the transition method to be used at date of adoption. The
transition methods include prospective and retroactive adoption options. The
prospective method requires that compensation expense be recorded for all
unvested stock options and restricted stock at the beginning of the first
quarter of adoption of SFAS 123R. The retroactive methods would record
compensation expense for all unvested stock options and restricted stock
beginning with the first period restated. Prior periods may be restated either
as of the beginning of the year of adoption or for all periods presented.

On April 14, 2005, the Securities and Exchange Commission
announced that the effective date of SFAS 123R would be postponed until January
1, 2006, for calendar year companies. We anticipate adopting the prospective
method of SFAS 123R in 2006 and expect that the impact in 2006 will reduce our
net income by approximately $2.5 to $3.0 million based on the options
outstanding as of September 30, 2005 which vest subsequent to December 31, 2005.

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Ratings

Financial strength ratings are the opinion of the rating
agencies and the significance of individual ratings varies from agency to
agency. Companies with higher ratings generally, in the opinion of the rating
agency, have the strongest capacity for repayment of debt or payment of claims,
while companies at the bottom end of the range have the weakest capacity. Rating
agencies continually review the financial performance and condition of insurers.
The current financial strength ratings of Sierra's HMO and health and life
insurance subsidiaries and senior convertible debt are as follows:



|                                               |  | A.M. Best Company,
      Inc. |  | Fitch Ratings |  | Standard & Poor's
    Corp.
|---------------------------------------------- |  | ----------------------------- |  | ------------- |  | ---------------------------
|                                               |  |                               |  |               |  |                            
|                                               |  | Rating                        |  | Ranking       |  | Rating                     
|                                               |  |                               |  |               |  |                            
|Financial Strength Rating:                     |  |                               |  |               |  |                            
|HMO and health and life insurance subsidiaries |  | B++ Very Good                 |  | 5th of 16     |  | BBB+ Good                  
|Issuer Credit Ratings:                         |  |                               |  |               |  |                            
|HMO and health and life insurance subsidiaries |  | bbb Very Good                 |  | 9th of 22     |  | n/a                        
|Parent
      Company                           |  | bb Speculative                |  | 12th of 22    |  | BB+ Speculative            
|Counterparty Credit Rating                     |  | n/a                           |  | n/a           |  | n/a                        
|Senior Convertible Debentures                  |  | bb Speculative                |  | 12th of 22    |  | BB+ Speculative            

The financial strength ratings reflect the opinion of each
rating agency on our operating performance and ability to meet obligations to
policyholders and debenture holders, and are not evaluations directed toward the
protection of investors in our common stock or senior convertible debentures.

Other

During the remainder of 2005 we expect to continue to incur
expenditures related to preliminary construction costs on a new medical clinic,
the purchase of computer hardware and software, furniture and equipment and
other normal capital requirements. Our liquidity needs over the next 12 months
will also be primarily for the capital items noted above. We expect to spend $25
to $35 million in capital expenditures in 2006, which is less than the limit
under our revolving credit facility. We believe that our existing working
capital, operating cash flow and amounts available under our credit facility
should be sufficient to fund our capital expenditures and liquidity needs.
Additionally, subject to unanticipated cash requirements, we believe that our
existing working capital and operating cash flow should enable us to meet our
liquidity needs on a long-term basis.

Inflation

Health care costs continue to rise at a rate faster than the
Consumer Price Index. We use various strategies to mitigate the negative effects
of health care cost inflation, including setting commercial premiums based on
our anticipated health care costs, risk-sharing arrangements with our various
health care providers and other health care cost containment measures including
member co-payments. There can be no assurance, however, that in the future, our
ability to manage medical costs will not be negatively impacted by items such as
technological advances, competitive pressures, applicable regulations, increases
in pharmacy, hospital, and other costs, utilization changes and catastrophic
items, which could, in turn, result in medical cost increases equaling or
exceeding premium increases.

Government Regulation

Our business, offering health care coverage, health care
management services and, to a lesser extent, the delivery of medical services,
is heavily regulated at both the federal and state levels.

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Government regulation of health care coverage products and
services is a dynamic area of law that varies from jurisdiction to jurisdiction.
Amendments to existing laws and regulations are continually being considered and
interpretations of the existing laws and rules change from time to time.
Regulatory agencies generally exercise broad discretion in interpreting laws and
promulgating regulations to enforce their interpretations.

While we are unable to predict what legislative or regulatory
changes may occur or the impact of any particular change, our operations and
financial results could be negatively affected by any legislative or regulatory
requirements. For example, any proposals to eliminate or reduce the Employee
Retirement Income Security Act (ERISA), which regulates insured and self-insured
health care coverage plans offered by employers, to eliminate or reduce the
pre-emption of state laws that would increase litigation exposure, affect
underwriting practices, limit rate increases, require new or additional benefits
or affect contracting arrangements (including proposals to require HMOs and PPOs
to accept any health care provider willing to abide by an HMO's or PPO's
contract terms or commission arrangements) may have a material adverse effect on
our business. The continued consideration and enactment of "anti-managed
care" laws and regulations by federal and state bodies may make it more
difficult for us to manage medical costs and may adversely affect financial
results.

In addition to changes in existing laws and regulations, we
are subject to audits, investigations and enforcement actions. These include,
but are not limited to, possible government actions relating to ERISA, the
Federal Employees Health Benefit Plan, the TRICARE contract, federal and state
fraud and abuse laws and laws relating to utilization management and the
delivery and payment of health care. In addition, our Medicare business is
subject to Medicare regulations promulgated by CMS. Violation of government laws
and regulations may result in an assessment of damages, civil or criminal fines
or penalties, or other sanctions, including exclusion from participation in
government programs. In addition, disclosure of any adverse investigation or
audit results or sanctions could negatively affect our reputation in various
markets and make it more difficult for us to sell our products and services.

In addition to the items described above, we urge you to
review carefully the section "Risk Factors" in Part 1, Item 1 of our
2004 Annual Report on Form 10-K for a more complete discussion of the risks
associated with an investment in our securities. See "Note on
Forward-Looking Statements and Risk Factors" in Part 1, Item 1 of our 2004
Annual Report on Form 10-K.

Critical Accounting Policies and Estimates

Our consolidated financial statements have been prepared in
conformity with accounting principles generally accepted in the United States of
America. In preparing these financial statements, we are required to make
judgments, assumptions and estimates, which we believe are reasonable and
prudent based on the available facts and circumstances. These judgments,
assumptions and estimates affect certain of our revenues and expenses and their
related balance sheet accounts and disclosure of our contingent assets and
liabilities. We base our assumptions and estimates primarily on historical
experience and trends and factor in known and projected trends. On an on-going
basis, we re-evaluate our selection of assumptions and the method of calculating
our estimates. Actual results, however, may materially differ from our
calculated estimates and this difference would be reported in our current
operations. Our critical accounting policies and estimates have been reviewed by
the Audit Committee of our Board of Directors.

For a more detailed description of all our critical
accounting policies and estimates, see Part II, Item 7 of our 2004 Annual Report
on Form 10-K. As of September 30, 2005, our critical accounting policies have
not changed from those described in our 2004 Annual Report on Form 10-K. For a
more extensive discussion of our accounting policies, see Note 2, Summary of
Significant Accounting Policies, in the Notes to the Consolidated Financial
Statements in our 2004 Annual Report on Form 10-K.

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Membership

|                        |  |                                          |         |  |      |  |         | 
|----------------------- |  | ---------------------------------------- | ------- |  | ---- |  | ------- | 
|                        |  | Number
      of Members at September 30, |        
|                        |  | 2005                                     |         |  | 2004 | 
|HMO:                    |  |                                          |         |  |      |  |         | 
|Commercial              |  |                                          | 251,000 |  |      |  | 222,200 | 
|Medicare                |  |                                          | 55,200  |  |      |  | 53,000  | 
|Medicaid                |  |                                          | 53,300  |  |      |  | 49,100  | 
|Managed indemnity       |  |                                          | 27,000  |  |      |  | 25,600  | 
|Medicare supplement     |  |                                          | 15,900  |  |      |  | 16,600  | 
|Administrative services |  |                                          | 202,000 |  |      |  | 186,600 | 
|                        |  |                                          |         |  |      |  |         | 
|Total Membership        |  |                                          | 604,400 |  |      |  | 553,100 | 
|                        |  |                                          |         |  |      |  |         | 

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT
MARKET RISK

At September 30, 2005, we had unrealized holding losses on
available for sale investments of $1.3 million, net of tax, compared to
unrealized holding losses of $245,000, net of tax, at December 31, 2004. We
believe that changes in market interest rates, resulting in unrealized holding
gains or losses, should not have a material impact on future earnings or cash
flows, as it is unlikely that we would need or choose to substantially liquidate
our investment portfolio.

At September 30, 2005, we had outstanding $52.0 million in
aggregate principal amount of our 21⁄4% senior convertible debentures due March
15, 2023. The debentures are fixed rate, and therefore, the interest expense on
the debentures will not be impacted by future interest rate fluctuations. The
interest rate on our revolving credit facility is currently LIBOR plus .75%. At
September 30, 2005, we have drawn $10.0 million on this facility.

ITEM 4. CONTROLS AND PROCEDURES

Evaluation of Disclosure Controls and Procedures

The Company's management, with the participation of the
Company's Chief Executive Officer and Chief Financial Officer, evaluated the
effectiveness of the Company's disclosure controls and procedures as of the end
of the period covered by this report. Based on that evaluation, the Chief
Executive Officer and Chief Financial Officer concluded that the Company's
disclosure controls and procedures as of the end of the period covered by this
report were designed and were functioning effectively to provide reasonable
assurance that the information required to be disclosed by the Company in
reports filed under the Securities Exchange Act of 1934 is recorded, processed,
summarized and reported within the time periods specified in the SEC's rules and
forms. The Company believes that a system of controls, no matter how well
designed and operated, cannot provide absolute assurance that the objectives of
the controls are met, and no evaluation of controls can provide absolute
assurance that all control issues and instances of fraud, if any, within a
company have been detected.

Change in Internal Control over Financial Reporting

No change in the Company's internal control over financial
reporting occurred during the Company's most recent fiscal quarter that has
materially affected, or is reasonably likely to materially affect, the Company's
internal control over financial reporting.



29

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SIERRA HEALTH SERVICES, INC. AND SUBSIDIARIES
PART II. OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

Although Sierra has not been sued, we were identified in
discovery submissions in pending class action litigation against major managed
care companies, as having allegedly participated in an unlawful conspiracy to
improperly deny, diminish or delay payments to physicians. In Re: Managed Care
Litigation, MDL No. 1334 (S.D.Fl.).

Beginning in 1999, a series of class action lawsuits were
filed against many major firms in the health benefits business. We have not been
named as a defendant in these lawsuits. A multi-district litigation panel has
consolidated for pre-trial discovery some of these cases in the United States
District Court for the Southern District of Florida, Miami Division. In the lead
case, known as Shane, the amended complaint alleges multiple violations under
the Racketeer Influenced and Corrupt Organizations Act (RICO). The suit seeks
injunctive, compensatory and equitable relief as well as restitution, costs,
fees and interest payments. Discovery remains ongoing. On April 7, 2003, the
United States Supreme Court determined that certain claims against certain
defendants should be arbitrated. Subsequent lower court rulings have further
resolved which of the plaintiffs' claims are subject to arbitration. In 2004,
the Court of Appeals for the Eleventh Circuit upheld a district court ruling
certifying a plaintiff class in the Shane case. The district court has recently
determined to bifurcate the case, holding a trial phase limited to liability
issues, and a second, if necessary, regarding damages. A trial date has been set
for January 2006. Plaintiffs in the Shane proceeding have stated their intention
to introduce evidence at trial concerning Sierra and other parties not named as
defendants in the litigation. Two of the defendants, Aetna Inc. and Cigna
Corporation, have entered into settlement agreements, which have been approved
by the district court. Three of the other defendants, Wellpoint Inc., Health Net
Inc. and Humana Inc., have recently entered into settlement agreements whose
approval is currently pending before the district court.

We are subject to various claims and litigation in the
ordinary course of business. Such litigation includes, but is not limited to,
claims of medical malpractice, claims for coverage or payment for medical
services rendered to HMO and other members and claims by providers for payment
for medical services rendered to HMO and other members. Some litigation may also
include claims for punitive damages that are not covered by insurance. In
addition, under the terms of the note receivable due from the sale of Cal
Indemnity, which is subject to adjustment based on loss development, we can be
indirectly affected by claims for our former workers' compensation business and claims by providers
for payment of medical services rendered to such injured workers. These actions are
in various stages of litigation and some may ultimately be brought to trial.
With respect to certain pending actions, we maintain commercial insurance
coverage with varying deductibles for which we maintain estimated reserves for
our self-insured portion based upon our current assessment of such litigation.
Due to recent unfavorable changes in the commercial insurance market, we have,
for certain risks, purchased coverage with higher deductibles and lower limits
of coverage. In the opinion of management, based on information presently
available, the amount or range of any potential loss for certain claims and
litigation cannot be reasonably estimated or is not considered probable, but the
ultimate resolution of these pending legal proceedings should not have a
material adverse effect on our financial condition.

30

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|(c) | Below, is a summary of stock repurchases for the nine months ended
      September 30, 2005. See Note 5 of our Notes to Condensed Consolidated
      Financial Statements for information regarding our stock repurchase plan.
|--- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                                                                             |  |                                      |  |                                   |  |                                                                                  |  |         |                                                                                 
|---------------------------------------------------------------------------- |  | ------------------------------------ |  | --------------------------------- |  | -------------------------------------------------------------------------------- |  | ------- | --------------------------------------------------------------------------------
|(In thousands, except per share
      data) Period                           |  | Total NumberOf SharesRepurchased (1) |  | Average
      PricePaid Per Share |  | Total Number OfShares Purchased AsPart
      Of PubliclyAnnounced Plan OrProgram |  |         | ApproximateDollar Value OfShares ThatMay Yet
      BePurchased UnderThe Plan (2)
|Beginning approximate dollar value of shares that may yet be
      purchased |  |                                      |  |                                   |  |                                                                                  |  | $71,444
|January 1, 2005 - January 31, 2005                                           |  | 42                                   |  | $53.21                            |  | 42                                                                               |  |         | 69,183                                                                          
|February 1, 2005 - February 28, 2005                                         |  | 79                                   |  | 58.29                             |  | 79                                                                               |  |         | 64,604                                                                          
|March 1, 2005 - March 31, 2005                                               |  | 57                                   |  | 61.61                             |  | 57                                                                               |  |         | 61,093                                                                          
|April 1, 2005 - April 30, 2005                                               |  | 80                                   |  | 60.82                             |  | 80                                                                               |  |         | 56,205                                                                          
|May 1, 2005 - May 31, 2005                                                   |  | 474                                  |  | 65.54                             |  | 474                                                                              |  |         | 75,148                                                                          
|June 1, 2005 - June 30, 2005                                                 |  | 68                                   |  | 67.37                             |  | 68                                                                               |  |         | 70,602                                                                          
|July1, 2005 -
      July
  31, 2005                                          |  | 35                                   |  | 70.62                             |  | 35                                                                               |  |         | 68,166                                                                          
|August1, 2005 -
      August31, 2005                                         |  | 1,046                                |  | 68.07                             |  | 1,046                                                                            |  |         | 71,971                                                                          
|September1, 2005 -
      September30, 2005                                   |  | 305                                  |  | 65.22                             |  | 305                                                                              |  |         | 52,082                                                                          

|(1) | Certain repurchases
      were made pursuant to a 10b5-1plan.
|--- | -------------------------------------------------------------

|(2) | On May 20, 2004, the Company's
      Board of Directors authorized the Company to purchase $70.0 million of its
      common stock. On December 7, 2004, May 24, 2005, and August 11, 2005, the Company's Board of Directors
      authorized the Company to purchase an additional $50.0 million, $50.0
      million and $75.0 million,respectively, of its
      common stock. The repurchase program has no stated expiration date, and
      commenced after the previously authorized share repurchase was
      completed.
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

31

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|(d) | Below, is a summary of 21⁄4% senior convertible debenture
      conversions for the
      nine months ended September 30, 2005. See Note 4 of our Notes to Condensed Consolidated
      Financial Statements for information regarding our senior convertible
      debentures.
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                                             |  |                                                 |  |                                                                                                                                                                                                   |  |                                                                                             |  |  |                                                                                 
|-------------------------------------------- |  | ----------------------------------------------- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ------------------------------------------------------------------------------------------- |  |  | --------------------------------------------------------------------------------
|Period                                       |  | Total Dollar
      ValueOf Debentures Converted |  | Average
      PricePaid Per Debenture                                                                                                                                                             |  | Total Dollar Value OfDebentures Purchased AsPart
      Of PubliclyAnnounced Plan Or Program |  |  | ApproximateDollar Value OfDebentures ThatMay Yet
      BePurchased UnderThe Plan
|January 1, 2005 - January 31, 2005           |  |                                                |  |                                                                                                                                                                                                  |  |                                                                                            |  |  |                                                                                
|February 1, 2005 - February 28, 2005         |  |                                                |  |                                                                                                                                                                                                  |  |                                                                                            |  |  |                                                                                
|March 1, 2005 - March 31, 2005               |  |                                                |  |                                                                                                                                                                                                  |  |                                                                                            |  |  |                                                                                
|April 1, 2005 - April 30, 2005               |  |                                                |  |                                                                                                                                                                                                  |  |                                                                                            |  |  |                                                                                
|May 1, 2005 - May 31, 2005                   |  | $14,000,000                                     |  | 54.67 shares of common
      stock for each $1,000 principal amount of debentures,
      $338,000 in prepaid interest as an incentive for conversionand accrued and
      unpaid interest thereon |  | None                                                                                        |  |  | None                                                                            
|June 1, 2005 - June 30, 2005                 |  | 20,000,000                                      |  | 54.67shares of common
      stock for each $1,000 principal amount of debentures,
      $525,000 in prepaid interest as an incentive for conversion and accrued and
      unpaid interest thereon |  | None                                                                                        |  |  | None                                                                            
|July 1, 2005 - July 31, 2005                 |  |                                                |  |                                                                                                                                                                                                  |  |                                                                                            |  |  |                                                                                
|August1, 2005 -
      August31, 2005         |  | 19,000,000                                      |  | 54.67shares of common
      stock for each $1,000 principal amount of debentures,
      $451,000 in prepaid interest as an incentive for conversion and accrued and
      unpaid interest thereon |  | None                                                                                        |  |  | None                                                                            
|September
      1, 2005 - September 30, 2005 |  | 10,000,000                                      |  | 54.67 shares of common
      stock for each $1,000 principal amount of debentures,
      $225,000 in prepaid interest as an incentive for conversionand accrued and
      unpaid interest thereon |  | None                                                                                        |  |  | None                                                                            

ITEM 3. DEFAULTS UPON SENIOR
    SECURITIES

None

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

None

ITEM 5. OTHER INFORMATION

None

32

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ITEM 6. EXHIBITS

|(10.1) | Sierra Health Services, Inc. 1995 Long-Term Incentive Plan, as amended and
    restated May 20, 2004.                                                                                       
|------ | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(10.2) | Form of Contract with Approved Entity Pursuant to
      Sections 1860D-1 through 1860D-42 of the Social Security Act for the
      Operation of a Voluntary Medicare Prescription Drug Plan.
|(31.1) | Rule 13a - 14(a) or 15d - 14(a) Certification of Chief Executive
      Officer.                                                                                                             
|(31.2) | Rule 13a - 14(a) or 15d - 14(a) Certification of Chief Financial
      Officer.                                                                                                             
|(32.1) | Certification pursuant to 18 U.S.C. Section 1350 as adopted pursuant to
      Section 906 of the Sarbanes-Oxley Act of 2002 of Principal Executive
      Officer.                           
|(32.2) | Certification pursuant to 18 U.S.C. Section 1350 as adopted pursuant to
      Section 906 of the Sarbanes-Oxley Act of 2002 of Principal Financial
      Officer.                           

33

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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 caused this report to be
signed on its behalf by the undersigned thereto duly authorized.



| | SIERRA HEALTH SERVICES,
      INC. Registrant By:/s/ Paul H. Palmer Paul H.
      PalmerSenior Vice President of Finance,Chief Financial Officer and
      Treasurer(Principal Financial and Accounting Officer)
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

Date: October 25, 2005

34

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