**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

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**FORM 10-Q**

**(Mark One)**

**x**                              QUARTERLYREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIESEXCHANGE ACT OF 1934

**Forthe quarterly period ended June 30, 2006**

**OR**

**o**                                 TRANSITIONREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIESEXCHANGE ACT OF 1934

**Forthe transition period from                     to                    **

**Commissionfile Number: 0-11321**

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**UNIVERSAL AMERICAN FINANCIAL CORP.**

(Exact name of registrantas specified in its charter)

| **New York**                     |   | **11-2580136**       |
|----------------------------------|--------|----------------------|
| (State or other  jurisdiction of |   | (I.R.S. Employer     |
| incorporation or  organization)  |   | Identification  No.) |

 

**Six International Drive, Suite 190,Rye Brook, New York 10573**

(Address of principalexecutive offices and zip code)

**(914) 934-5200**

(Registrant’s telephonenumber, including area code)

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Indicate by checkmarkwhether the registrant (1) has filed all reports required to be filed by Section 13or 15 (d) of the Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period that the registrant was required tofile such reports), and (2) has been subject to such filing requirementsfor the past 90 days. Yes x  No o

Indicate by check markwhether the registrant is a large accelerated filer, an accelerated filer, or anon-accelerated filer. See definition of “accelerated filer and largeaccelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

| Large accelerated filer o | Accelerated filer  x | Non-accelerated  filer o |
|---------------------------|----------------------|-------------------------------|

 

Indicate by check markwhether the registrant is a shell company (as defined in Rule 12b-2of the Exchange Act). Yes o  No x

Asof August 3, 2006, 58,472,243 shares of the registrant’s common stock wereissued and outstanding.

 

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**TABLEOF CONTENTS**

|              | ** ** | **Item** | ** ** | **Description**                                                                                                                      | ** ** | **Page** |
|--------------|------------|----------|------------|--------------------------------------------------------------------------------------------------------------------------------------|------------|----------|
| PART 1  |       |     |       | Financial  Information                                                                                                               |       |     |   |
|         |       | 1        |       | Financial Statements  (unaudited):                                                                                                   |       |     |   |
|         |       |     |       | Consolidated Balance Sheets                                                                                                          |       | 4        |   |
|         |       |     |       | Consolidated Statements of  Operations—Three Months                                                                             |       | 5        |   |
|         |       |     |       | Consolidated Statements of  Operations—Six Months                                                                               |       | 6        |   |
|         |       |     |       | Consolidated Statements of  Stockholders’ Equity and Comprehensive Income                                                       |       | 7        |   |
|         |       |     |       | Consolidated Statements of  Cash Flows                                                                                               |       | 8        |   |
|         |       |     |       | Notes to Consolidated Financial  Statements                                                                                          |       | 9        |   |
|         |       | 2        |       | Management’s Discussion and  Analysis of Financial Condition and Results of Operations       |       | 27       |   |
|         |       | 3        |       | Quantitative and Qualitative  Disclosures About Market Risk                                                                          |       | 55       |   |
|         |       | 4        |       | Controls and Procedures                                                                                                              |       | 58       |   |
| PART II |       |     |       | Other  Information                                                                                                                   |       |     |   |
|         |       | 1        |       | Legal Proceedings                                                                                                                    |       | 59       |   |
|         |       | 1A       |       | Risk Factors                                                                                                                         |       | 60       |   |
|         |       | 2        |       | Unregistered Sales of Equity  Securities and Use of Proceeds                                                                         |       | 61       |   |
|         |       | 3        |       | Defaults Upon Senior  Securities                                                                                                     |       | 61       |   |
|         |       | 4        |       | Submission of Matters to a  Vote of Security Holders                                                                                 |       | 61       |   |
|         |       | 5        |       | Other Information                                                                                                                    |       | 62       |   |
|         |       | 6        |       | Exhibits                                                                                                                             |       | 62       |   |
|         |       |     |       | Signatures                                                                                                                           |       | 63       |   |

 

2

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As used in this QuarterlyReport on Form 10-Q, “Universal American,” “we,” “our,” and “us”refer to Universal American Financial Corp. and its subsidiaries, except wherethe context otherwise requires or as otherwise indicated.

**DISCLOSUREREGARDING FORWARD LOOKING STATEMENTS**

Portions of the information in this Quarterly Reporton Form 10-Q including, but not limited to, the informationcontained in “Item 2—Management’s Discussion and Analysis of FinancialCondition and Results of Operations” and certain oral statements made from timeto time by representatives of the Company may be considered “forward-lookingstatements” within the meaning of Section 21E of the Securities ExchangeAct of 1934, as amended, and the Private Securities Litigation Reform Act of 1995.The Company intends such forward-looking statements to be covered by the safeharbor provisions for forward-looking statements contained in Section 21Eof the Exchange Act and the Private Securities Litigation Reform Act of 1995.Such forward-looking statements relate to, without limitation, the Company’sfuture economic performance, plans and objectives for future operations andprojections of revenue and other financial items. Forward-looking statementscan be identified by the use of words such as “prospects,” “outlook,” “believes,”“estimates,” “intends,” “may,” “will,” “should,” “anticipates,” “expects” or “plans,”or the negative or other variation of these or similar words, or by discussionof trends and conditions, strategy or risks and uncertainties. Forward-lookingstatements are inherently subject to risks, trends and uncertainties, many ofwhich are beyond the Company’s ability to control or predict with accuracy andsome of which the Company might not even anticipate. Although the Company believesthat the expectations reflected in such forward-looking statements are basedupon reasonable assumptions at the time made, it can give no assurance that itsexpectations will be achieved. Future events and actual results, financial andotherwise, may differ materially from the results discussed in theforward-looking statements. Readers are cautioned not to place undue relianceon these forward-looking statements.

Important factorsthat may cause actual results to differ materially from forward-lookingstatements include, but are not limited to, the risks and uncertainties setforth in our Annual Report on Form 10-K and in this Quarterly Reporton Form 10-Q. The Company assumes no obligation to update andsupplement any forward-looking statements that may become untrue because ofsubsequent events, whether as a result of new information, future events orotherwise.

3

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**PART I**

**ITEM 1—FINANCIAL STATEMENTS (Unaudited)**

**UNIVERSALAMERICAN FINANCIAL CORP. AND SUBSIDIARIESCONSOLIDATED BALANCE SHEETS(In thousands)**

| ** **                                                                                                              | ** ** | **June 30,  2006** | ** ** | **December 31,  2005** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|-----------------------------|------------|
| ** **                                                                                                              | ** ** | **(Unaudited)**         | ** ** | ** **                  | ** ** |
| ASSETS                                                                                                                  |       |                    |       |                        |       |   |   |   |   |
| Investments (Note 5):                                                                                                   |       |                    |       |                        |       |   |   |   |   |
| Fixed maturities  available for sale, at fair value  (amortized cost: 2006, $1,320,169; 2005, $1,294,124)               |       |                    | $          | 1,329,590                   |       |   |   | $ | 1,344,775 |   |   |
| Policy loans                                                                                                            |       |                    | 23,032     |                        |       |   | 23,601 |   |   |
| Other invested  assets                                                                                                  |       |                    | 1,681      |                        |       |   | 2,175 |   |   |
| Total investments                                                                                                       |       |                    | 1,354,303  |                        |       |   | 1,370,551 |   |   |
| Cash and cash  equivalents                                                                                              |       |                    | 430,219    |                        |       |   | 138,899 |   |   |
| Accrued investment  income                                                                                              |       |                    | 13,150     |                        |       |   | 13,067 |   |   |
| Deferred policy  acquisition costs                                                                                      |       |                    | 290,163    |                        |       |   | 272,542 |   |   |
| Amounts due from  reinsurers                                                                                            |       |                    | 260,207    |                        |       |   | 227,392 |   |   |
| Due and unpaid  premiums                                                                                                |       |                    | 19,817     |                        |       |   | 7,815 |   |   |
| Present value of  future profits and other amortizing intangible assets (Note 4)                                   |       |                    | 58,327     |                        |       |   | 50,724 |   |   |
| Goodwill and other  indefinite lived intangible assets (Note 4)                                                         |       |                    | 73,000     |                        |       |   | 73,000 |   |   |
| Deferred income  tax asset                                                                                              |       |                    | 723        |                        |       |   | — |   |   |
| Income taxes  receivable                                                                                                |       |                    | —     |                        |       |   | 2,230 |   |   |
| Other assets                                                                                                            |       |                    | 153,576    |                        |       |   | 71,759 |   |   |
| Total assets                                                                                                            |       |                    | $          | 2,653,485                   |       |   |   | $ | 2,227,979 |   |   |
| LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                               |       |                    |       |                        |       |   |   |   |   |
| LIABILITIES                                                                                                             |       |                    |       |                        |       |   |   |   |   |
| Policyholder  account balances                                                                                          |       |                    | $          | 501,440                     |       |   |   | $ | 498,421 |   |   |
| Reserves for  future policy benefits                                                                                    |       |                    | 804,842    |                        |       |   | 781,363 |   |   |
| Policy and  contract claims—life                                                                                   |       |                    | 13,992     |                        |       |   | 14,525 |   |   |
| Policy and  contract claims—health                                                                                 |       |                    | 174,554    |                        |       |   | 115,779 |   |   |
| Advance Premiums                                                                                                        |       |                    | 98,623     |                        |       |   | 18,296 |   |   |
| CMS contract  deposits for amounts not at risk                                                                          |       |                    | 203,644    |                        |       |   | — |   |   |
| Loan payable (Note  9)                                                                                                  |       |                    | 93,188     |                        |       |   | 95,813 |   |   |
| Other long term  debt (Note 10)                                                                                         |       |                    | 75,000     |                        |       |   | 75,000 |   |   |
| Amounts due to  reinsurers                                                                                              |       |                    | 30,643     |                        |       |   | 6,028 |   |   |
| Income taxes  payable                                                                                                   |       |                    | 5,840      |                        |       |   | — |   |   |
| Deferred income  tax liability                                                                                          |       |                    | —     |                        |       |   | 20,072 |   |   |
| Other liabilities                                                                                                       |       |                    | 112,545    |                        |       |   | 70,798 |   |   |
| Total liabilities                                                                                                       |       |                    | 2,114,311  |                        |       |   | 1,696,095 |   |   |
| Commitments and contingencies (Note 12)                                                                                 |       |                    |       |                        |       |   |   |   |   |
| STOCKHOLDERS’ EQUITY (Note 6)                                                                                      |       |                    |       |                        |       |   |   |   |   |
| Common stock  (Authorized: 100 million shares, issued: 2006, 59.2 million  shares; 2005, 59.0 million shares) |       |                    | 592        |                        |       |   | 590 |   |   |
| Additional paid-in  capital                                                                                             |       |                    | 245,723    |                        |       |   | 242,433 |   |   |
| Accumulated other  comprehensive income (Notes 6 and 14)                                                                |       |                    | 17,987     |                        |       |   | 39,896 |   |   |
| Retained earnings                                                                                                       |       |                    | 285,335    |                        |       |   | 260,205 |   |   |
| Less: Treasury  stock (2006, 0.7 million shares; 2005, 0.8 million shares)                                              |       |                    | (10,463    | )                           |       |   | (11,240 | ) |   |
| Total  stockholders’ equity                                                                                        |       |                    | 539,174    |                        |       |   | 531,884 |   |   |
| Total liabilities  and stockholders’ equity                                                                        |       |                    | $          | 2,653,485                   |       |   |   | $ | 2,227,979 |   |   |

 

See notes to unaudited consolidated financial statements.

4

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**UNIVERSAL AMERICAN FINANCIAL CORP. AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF OPERATIONSFor the Three Months Ended June 30, 2006 and 2005(Unaudited)(In thousands, per share amounts in dollars)**

| ** **                                                 | ** ** | **2006** | ** ** | **2005** | ** ** |
|------------------------------------------------------------|------------|----------|------------|----------|------------|
| Revenues:                                                  |       |     |       |     |       |
| Direct premium and policyholder fees earned                |       | $        | 495,283    |     | $          | 251,464 |   |
| Reinsurance premiums assumed                               |       | 8,230    |       | 8,127    |       |
| Reinsurance premiums ceded                                 |       | (183,643 | )          | (54,689  | )          |
| Net premiums and policyholder fees earned                  |       | 319,870  |       | 204,902  |       |
| Net investment income                                      |       | 21,276   |       | 17,334   |       |
| Equity in earnings of unconsolidated subsidiary  (Note 15) |       | 12,867   |       | —   |       |
| Fee and other income                                       |       | 7,156    |       | 4,531    |       |
| Net realized gains (losses) on investments                 |       | 48       |       | 3,030    |       |
| Total revenues                                             |       | 361,217  |       | 229,797  |       |
| Benefits, Claims  and Expenses:                            |       |     |       |     |       |
| Claims and other benefits                                  |       | 240,548  |       | 141,198  |       |
| Net increase in reserves for future policy benefits        |       | 4,496    |       | 5,261    |       |
| Interest credited to policyholders                         |       | 4,740    |       | 4,630    |       |
| Increase in deferred acquisition costs                     |       | (5,547   | )          | (17,569  | )          |
| Amortization of intangible assets (Note 4)                 |       | 2,111    |       | 1,193    |       |
| Commissions                                                |       | 34,753   |       | 37,672   |       |
| Reinsurance commission and expense allowances              |       | (19,387  | )          | (14,392  | )          |
| Interest expense                                           |       | 3,186    |       | 2,670    |       |
| Other operating costs and expenses                         |       | 67,420   |       | 41,456   |       |
| Total benefits, claims and other deductions                |       | 332,320  |       | 202,119  |       |
| Income before taxes                                        |       | 28,897   |       | 27,678   |       |
| Income tax  expense                                        |       | 10,787   |       | 9,030    |       |
| Net income                                                 |       | $        | 18,110     |     | $          | 18,648 |   |
| Earnings per common  share (Note 13):                      |       |     |       |     |       |
| Basic                                                      |       | $        | 0.31       |     | $          | 0.33 |   |
| Diluted                                                    |       | $        | 0.30       |     | $          | 0.32 |   |

 

See notes to unaudited consolidated financial statements.

5

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**UNIVERSAL AMERICAN FINANCIAL CORP. AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF OPERATIONSFor the Six Months Ended June 30, 2006 and 2005(Unaudited)(In thousands, per share amounts in dollars)**

| ** **                                                 | ** ** | **2006** | ** ** | **2005** | ** ** |
|------------------------------------------------------------|------------|----------|------------|----------|------------|
| Revenues:                                                  |       |     |       |     |       |
| Direct premium and policyholder fees earned                |       | $        | 980,600    |     | $          | 504,807 |   |
| Reinsurance premiums assumed                               |       | 16,546   |       | 17,197   |       |
| Reinsurance premiums ceded                                 |       | (367,971 | )          | (114,833 | )          |
| Net premiums and policyholder fees earned                  |       | 629,175  |       | 407,171  |       |
| Net investment income                                      |       | 41,405   |       | 34,015   |       |
| Equity in earnings of unconsolidated subsidiary  (Note 15) |       | 22,674   |       | —   |       |
| Fee and other income                                       |       | 13,444   |       | 8,710    |       |
| Net realized gains (losses) on investments                 |       | 47       |       | 4,103    |       |
| Total revenues                                             |       | 706,745  |       | 453,999  |       |
| Benefits, Claims  and Expenses:                            |       |     |       |     |       |
| Claims and other benefits                                  |       | 483,236  |       | 278,854  |       |
| Net increase in reserves for future policy benefits        |       | 13,995   |       | 11,042   |       |
| Interest credited to policyholders                         |       | 9,210    |       | 9,175    |       |
| Increase in deferred acquisition costs                     |       | (10,932  | )          | (33,256  | )          |
| Amortization of intangible assets (Note 4)                 |       | 4,478    |       | 2,871    |       |
| Commissions                                                |       | 70,478   |       | 75,866   |       |
| Reinsurance commission and expense allowances              |       | (37,251  | )          | (28,800  | )          |
| Interest expense                                           |       | 6,228    |       | 5,181    |       |
| Other operating costs and expenses                         |       | 127,350  |       | 80,731   |       |
| Total benefits, claims and other deductions                |       | 666,792  |       | 401,664  |       |
| Income before taxes                                        |       | 39,953   |       | 52,335   |       |
| Income tax  expense                                        |       | 14,823   |       | 17,615   |       |
| Net income                                                 |       | $        | 25,130     |     | $          | 34,720 |   |
| Earnings per common  share (Note 13):                      |       |     |       |     |       |
| Basic                                                      |       | $        | 0.43       |     | $          | 0.62 |   |
| Diluted                                                    |       | $        | 0.42       |     | $          | 0.60 |   |

 

See notes to unaudited consolidated financial statements.

6

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**UNIVERSAL AMERICAN FINANCIAL CORP. AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY AND COMPREHENSIVE INCOMEFor the Six Months Ended June 30, 2006 and 2005(Unaudited)(In thousands)**

| ** **                                   | ** ** | **Common  Stock** | ** ** | **Additional  Paid-In  Capital** | ** ** | **Accumulated  Other  Comprehensive  Income** | ** ** | **Retained  Earnings** | ** ** | **Treasury  Stock** | ** ** | **Total** | ** ** |
|----------------------------------------------|------------|-------------------|------------|----------------------------------|------------|-----------------------------------------------|------------|------------------------|------------|---------------------|------------|-----------|------------|
| **2005**                                     |       |              |       |                             |       |                                          |       |                   |       |                |       |      |       |   |   |   |   |   |   |   |   |   |   |
| Balance,  January 1, 2005               |       |              | $          | 553                              |       |                                          |       | $                      | 172,525    |                |       |      | $          | 40,983 |   |   |   | $ | 206,329 |   |   |   | $ | (969 | ) |   | $ | 419,421 |   |
| Net income                                   |       |              | —     |                             |       |                                          | —     |                   |       |                | —     |      |       |   | 34,720 |   |   |   | — |   |   | 34,720 |   |
| Other comprehensive  income (Note 14)        |       |              | —     |                             |       |                                          | —     |                   |       |                | 7,956      |      |       |   | — |   |   |   | — |   |   | 7,956 |   |
| Comprehensive  income                        |       |              |       |                             |       |                                          |       |                   |       |                |       |      |       |   |   |   |   |   |   |   |   | 42,676 |   |
| Issuance of common  stock                    |       |              | 27         |                             |       |                                          | 49,189     |                   |       |                | —     |      |       |   | — |   |   |   | — |   |   | 49,216 |   |
| Stock-based  compensation                    |       |              | —     |                             |       |                                          | 985        |                   |       |                | —     |      |       |   | — |   |   |   | — |   |   | 985 |   |
| Repayments of  loans to officers             |       |              | —     |                             |       |                                          | 20         |                   |       |                | —     |      |       |   | — |   |   |   | — |   |   | 20 |   |
| Treasury shares  purchased, at cost (Note 6) |       |              | —     |                             |       |                                          | —     |                   |       |                | —     |      |       |   | — |   |   |   | (31 | ) |   | (31 | ) |
| Treasury shares  reissued (Note 6)           |       |              | —     |                             |       |                                          | 599        |                   |       |                | —     |      |       |   | — |   |   |   | 577 |   |   | 1,176 |   |
| Balance,  June 30, 2005                 |       |              | $          | 580                              |       |                                          |       | $                      | 223,318    |                |       |      | $          | 48,939 |   |   |   | $ | 241,049 |   |   |   | $ | (423 | ) |   | $ | 513,463 |   |
| **2006**                                     |       |              |       |                             |       |                                          |       |                   |       |                |       |      |       |   |   |   |   |   |   |   |   |   |   |
| Balance,  January 1, 2006               |       |              | $          | 590                              |       |                                          |       | $                      | 242,433    |                |       |      | $          | 39,896 |   |   |   | $ | 260,205 |   |   |   | $ | (11,240 | ) |   | $ | 531,884 |   |
| Net income                                   |       |              | —     |                             |       |                                          | —     |                   |       |                | —     |      |       |   | 25,130 |   |   |   | — |   |   | 25,130 |   |
| Other  comprehensive loss (Note 14)          |       |              | —     |                             |       |                                          | —     |                   |       |                | (21,909    | )         |       |   | — |   |   |   | — |   |   | (21,909 | ) |
| Comprehensive  income                        |       |              |       |                             |       |                                          |       |                   |       |                |       |      |       |   |   |   |   |   |   |   |   | 3,221 |   |
| Issuance of common  stock                    |       |              | 2          |                             |       |                                          | 970        |                   |       |                | —     |      |       |   | — |   |   |   | — |   |   | 972 |   |
| Stock-based  compensation                    |       |              | —     |                             |       |                                          | 2,298      |                   |       |                | —     |      |       |   | — |   |   |   | — |   |   | 2,298 |   |
| Treasury shares  purchased, at cost (Note 6) |       |              | —     |                             |       |                                          | —     |                   |       |                | —     |      |       |   | — |   |   |   | (44 | ) |   | (44 | ) |
| Treasury shares  reissued (Note 6)           |       |              | —     |                             |       |                                          | 22         |                   |       |                | —     |      |       |   | — |   |   |   | 821 |   |   | 843 |   |
| Balance,  June 30, 2006                 |       |              | $          | 592                              |       |                                          |       | $                      | 245,723    |                |       |      | $          | 17,987 |   |   |   | $ | 285,335 |   |   |   | $ | (10,463 | ) |   | $ | 539,174 |   |

 

See notes to unaudited consolidated financial statements.

7

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**UNIVERSAL AMERICAN FINANCIAL CORP. AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF CASH FLOWSFor the Six Months Ended June 30, 2006 and 2005(Unaudited)(In thousands)**

| ** **                                                                                                   | ** ** | **2006** | ** ** | **2005** | ** ** |
|--------------------------------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|
| Cash flows from operating activities:                                                                        |       |     |       |     |       |
| Net income                                                                                                   |       | $        | 25,130     |     | $          | 34,720 |   |
| Adjustments to reconcile net income to net cash  provided by operating activities, net of balances acquired: |       |     |       |     |       |
| Deferred income  taxes                                                                                       |       | (8,997   | )          | 11,975   |       |
| Change in reserves  for future policy benefits                                                               |       | 16,372   |       | 5,122    |       |
| Change in policy  and contract claims                                                                        |       | 58,242   |       | 8,124    |       |
| Change in  reinsurance balances                                                                              |       | (9,324   | )          | 1,914    |       |
| Change in advanced  premium                                                                                  |       | 68,324   |       | —   |       |
| Change in deferred  policy acquisition costs                                                                 |       | (10,932  | )          | (33,256  | )          |
| Amortization of  present value of future profits and other intangibles                                       |       | 4,478    |       | 2,871    |       |
| Other amortization  and depreciation                                                                         |       | 2,769    |       | 420      |       |
| Net accretion of  bond discount                                                                              |       | (3,356   | )          | (2,083   | )          |
| Realized gains on  investments                                                                               |       | (47      | )          | (4,103   | )          |
| Equity in the  earnings of unconsolidated subsidiary                                                         |       | (22,674  | )          | —   |       |
| Distribution from  unconsolidated subsidiary                                                                 |       | 18,500   |       | —   |       |
| Change in income  taxes payable                                                                              |       | 8,070    |       | (2,639   | )          |
| Change in policy  loans                                                                                      |       | 568      |       | 647      |       |
| Change in accrued  investment income                                                                         |       | (83      | )          | (2       | )          |
| Other, net                                                                                                   |       | (30,179  | )          | (3,371   | )          |
| Net cash provided  by operating activities                                                                   |       | 116,861  |       | 20,339   |       |
| Cash flows from investing activities:                                                                        |       |     |       |     |       |
| Proceeds from sale  or redemption of fixed maturities                                                        |       | 53,629   |       | 182,802  |       |
| Cost of fixed  maturities purchased                                                                          |       | (68,180  | )          | (219,796 | )          |
| Purchase of  business                                                                                        |       | (12,081  | )          | —   |       |
| Other investing  activities                                                                                  |       | (5,291   | )          | (3,720   | )          |
| Net cash used by  investing activities                                                                       |       | (31,923  | )          | (40,714  | )          |
| Cash flows from financing activities:                                                                        |       |     |       |     |       |
| Net proceeds from  issuance of common stock                                                                  |       | 1,535    |       | 47,814   |       |
| Cost of treasury  stock purchases                                                                            |       | (44      | )          | (31      | )          |
| Receipts from CMS  contract deposits                                                                         |       | 507,394  |       | —   |       |
| Withdrawals from  CMS contract deposits                                                                      |       | (303,750 | )          | —   |       |
| Change in  policyholder account balances                                                                     |       | 3,019    |       | 11,167   |       |
| Change in  reinsurance on policyholder account balances                                                      |       | 853      |       | 219      |       |
| Principal  repayment on loan payable                                                                         |       | (2,625   | )          | (2,625   | )          |
| Net cash provided  by financing activities                                                                   |       | 206,382  |       | 56,544   |       |
| Net increase in  cash and cash equivalents                                                                   |       | 291,320  |       | 36,169   |       |
| Cash and cash  equivalents at beginning of year                                                              |       | 138,899  |       | 181,257  |       |
| Cash and cash  equivalents at end of year                                                                    |       | $        | 430,219    |     | $          | 217,426 |   |
| Supplemental cash flow information:                                                                          |       |     |       |     |       |
| Cash paid for  interest                                                                                      |       | $        | 6,218      |     | $          | 5,149 |   |
| Cash paid for  income taxes                                                                                  |       | $        | 13,515     |     | $          | 7,274 |   |

 

See notes to unaudited consolidated financial statements.

8

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**UNIVERSAL AMERICAN FINANCIAL CORP. AND SUBSIDIARIESNOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**1.*   ORGANIZATION AND COMPANY BACKGROUND***

Universal AmericanFinancial Corp. (“we”, the “Company” or “Universal American”) is a specialtyhealth and life insurance holding company with an emphasis on providing a broadarray of health insurance and managed care products and services to the growingsenior population. Universal American was incorporated in the State of New Yorkin 1981. Collectively, our insurance company subsidiaries are licensed to selllife and accident & health insurance and annuities in all fiftystates, the District of Columbia, Puerto Rico and all the provinces of Canada.The principal insurance products currently sold by the Company are Medicare Supplementand Select, fixed benefit accident and sickness disability insurance, seniorlife insurance and fixed annuities. The Company distributes these productsthrough an independent general agency system and a career agency system. Thecareer agents focus on sales for Pennsylvania Life Insurance Company (“PennsylvaniaLife”), The Pyramid Life Insurance Company (“Pyramid Life”) and Penncorp LifeInsurance Company, a Canadian company (“Penncorp Life (Canada)”) while theindependent general agents sell for American Pioneer Life Insurance Company (“AmericanPioneer”), American Progressive Life & Health Insurance Company of NewYork (“American Progressive”), Constitution Life Insurance Company (“Constitution”),Marquette National Life Insurance Company (“Marquette”) and Union BankersInsurance Company (“Union Bankers”). Heritage Health Systems, Inc. (“Heritage”)operates Medicare Advantage plans in Houston and Beaumont Texas throughSelectCare of Texas, L.L.C., and in Oklahoma through SelectCare of Oklahoma, Inc.(formerly Eagle Life Insurance Company), and our Medicare Advantage privatefee-for-service plans (“PFFS”) through American Progressive and Pyramid Life.CHCS Services, Inc. (“CHCS”), the Company’s administrative servicescompany, acts as a service provider for both affiliated and unaffiliatedinsurance companies for senior market insurance and non-insurance programs. In2006, we began offering prescription drug benefit plans (“PDPs”) pursuant toMedicare Part D (“Part D”) through a strategic alliance withPharmaCare Management Services, Inc. (“PharmaCare”), a third partypharmacy benefits manager (“PBM”) and wholly-owned subsidiary of CVSCorporation (“CVS”)..

**2.   *SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES***

***Basis ofPresentation:***   The accompanying consolidatedfinancial statements have been prepared in accordance with accountingprinciples generally accepted in the United States (“GAAP”) and consolidate theaccounts of Universal American Financial Corp. (“Universal American”) and itssubsidiaries (collectively the “Company”), American Progressive, AmericanPioneer, American Exchange Life Insurance Company (“American Exchange”),Pennsylvania Life, Peninsular Life Insurance Company (“Peninsular”), UnionBankers, Constitution, Marquette, Penncorp Life (Canada), Pyramid Life,Heritage and CHCS. During 2005, we entered into a strategic alliance withPharmaCare and created Part D Management Services, L.L.C. (“PDMS”). PDMSis 50% owned by Universal American and 50% owned by PharmaCare. We do notcontrol PDMS and therefore PDMS is not consolidated in our financial statements.PDMS principally performs marketing and risk management services on behalf ofour PDPs and PharmaCare for which it receives fees and other remuneration fromour PDPs and PharmaCare.

For the insurance subsidiaries, GAAP differs fromstatutory accounting practices prescribed or permitted by regulatoryauthorities. All material intercompany transactions and balances betweenUniversal American and its subsidiaries have been eliminated.

The interim financial information herein is unaudited,but in the opinion of management, includes all adjustments (consisting ofnormal, recurring adjustments) necessary to present fairly the financialposition 

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and results of operationsfor such periods. The results of operations for the three or six months ended June 30,2006 and 2005 are not necessarily indicative of the results to be expected forthe full year. The accompanying consolidated financial statements and notesshould be read in conjunction with the Company’s Annual Report on Form 10-Kfor the year ended December 31, 2005.

***Use of Estimates:***   Thepreparation of our financial statements in conformity with GAAP requires us tomake estimates and assumptions that affect the amounts of assets andliabilities and disclosures of assets and liabilities reported by us at thedate of the financial statements and the revenues and expenses reported duringthe reporting period. As additional information becomes available or actualamounts become determinable, the recorded estimates may be revised andreflected in operating results. Actual results could differ from thoseestimates. In our judgment, the accounts involving estimates and assumptionsthat are most critical to the preparation of our financial statements arefuture policy benefits and claim liabilities, deferred policy acquisitioncosts, goodwill, present value of future profits and other intangibles, thevaluation of certain investments and income taxes. There have been no changesin our critical accounting policies during the current year.

***Significant Accounting Policies:  ***Fora description of significant accounting policies, see Note 2—Summary ofSignificant Accounting Policies in the notes to the Consolidated FinancialStatements included in the Company’s Annual Report on Form 10-K.

***Accounting forPrescription Drug Benefits under Medicare Part D***

On January 1, 2006, we began offeringprescription drug coverage in accordance with Medicare Part D as astand-alone benefit to Medicare-eligible beneficiaries under Prescription DrugPlans (“PDPs”).

In general, prescription drug benefits under Part DPDPs may vary in terms of coverage levels and out-of-pocket costs forbeneficiary premiums, deductibles and co-insurance. However, all Part DPDPs must offer either “standard coverage” or its actuarial equivalent (without-of-pocket threshold and deductible amounts that do not exceed those ofstandard coverage). These defined “standard” benefits represent the minimumlevel of benefits mandated by Congress. We also offer other PDPs containingbenefits in excess of standard coverage limits for an additional beneficiarypremium.

The payment our PDPs receive monthly from the Centersfor Medicare and Medicaid Services, or CMS, generally represents our bid amountfor providing insurance coverage. We recognize premium revenue for providingthis insurance coverage during each month in which members are entitled tobenefits. However, our CMS payment includes subsidies and is subject to riskcorridor adjustments, which permits our PDPs and CMS to share the riskassociated with financing the ultimate costs of the Part D benefit.

The amount of revenue payable to our PDPs by CMS issubject to adjustment, positive or negative, based upon the application of riskcorridors that compare a plan’s actual prescription drug costs as a percentageof revenues to their targeted costs, as reflected in their bids (“target amount’).Variances exceeding, or below, certain thresholds may result in CMS makingadditional payments to us or requiring us to refund to CMS a portion of thepayments we received. Actual prescription drug costs subject to risk sharingwith CMS are limited to the costs that are, or would have been, incurred underthe CMS defined “standard” benefit plan. We estimate and recognize anadjustment to premium revenues related to the risk corridor payment adjustmentbased upon prescription drug claims experience to date, net of manufacturerrebates and other Part D revenues, as if the annual contract were to endat the end of each reporting period. Accordingly, this estimate does notconsider future prescription drug claims experience.

Certain subsidies represent reimbursements from CMSfor claims we pay for which we assume little or no risk, including reinsurancepayments and low-income cost subsidies. A large percentage of claims paid abovethe out-of-pocket or catastrophic threshold for which we are not at risk areall reimbursed by CMS 

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through the reinsurancesubsidy for PDP plans offering the standard coverage. Low-income cost subsidiesrepresent reimbursements from CMS for all or a portion of the deductible, thecoinsurance and the co-payment amounts for low-income beneficiaries. Weaccount for these subsidies as a deposit in our balance sheet and as afinancing activity in our statement of cash flows. We do not recognize premiumrevenue or claims expense for these subsidies. Receipt and payment activity isaccumulated at the contract level and recorded to the balance sheet as a CMScontract deposit account asset or liability depending on the net contractbalance at the end of the reporting period.

We recognize pharmacy benefit costs as incurred. Wehave subcontracted the pharmacy claims administration to PharmaCare, a thirdparty pharmacy benefit manager (“PBM”). Certain of our PDPs receive all or aportion of the rebates from drug companies on prescriptions filled. Theserebates are reflected as a reduction in pharmacy benefit costs. Pharmacybenefit costs are based on rates as contracted with PharmaCare.

For the six months ended June 30, 2006, we basedour membership for Part D on enrollment information provided by CMS whichindicated that, as of June 30, 2006, approximately 440,000 members wereenrolled in our PDPs for which we were paid by CMS. This includes approximately418,000 members in our PDPs that we participate in on a 50% basis and 22,000members in an unaffiliated PDP that we participate in on a 33% basis. Ourrevenues and claims expense are based on earned premium and incurred pharmacybenefits for the reported enrolled membership. The membership informationcontinues to be reconciled and refined by CMS with respect to the allocationamong all plans participating in the Part D program. As a result, it islikely that the membership data upon which we based our results for the firstsix months of 2006 will change, with a corresponding change in the financialresults for the segment. We are unable to precisely quantify the impact of anypotential change until the membership data is fully reconciled with CMS,however, we do not believe that any change from the amounts reported as of June 30,2006 is likely to be material.

***Reclassifications:***   Certainreclassifications have been made to prior years’ financial statements toconform to current period presentation.

**3.   *RECENT AND PENDING ACCOUNTING PRONOUNCEMENTS***

***Adoption of NewAccounting Pronouncements:***

***Accounting forStock-Based Compensation—******As of January 1, 2006, theCompany adopted***Financial Accounting Standards Board (“FASB”)Statement of Financial Accounting Standards No. 123-Revised, “Share-BasedPayment” (“FAS 123-R”) using the modified prospective method. FAS 123-Rrequires companies to recognize compensation costs for share-based payments toemployees and non-employee directors based on the grant date fair value of theaward and that this fair value be amortized over the grantees’ service period.The provisions of this standard require the fair value to be calculated using avaluation model (such as the Black-Scholes or binomial-lattice models). TheCompany has elected to use the Black-Scholes valuation model to value employeestock options, as it had done for its previous pro forma stock compensationdisclosures. Under the modified prospective method compensation cost isrecognized for the fair value of the unvested portion of existing arrangementsas of January 1, 2006, as well as the fair value for all new share-basedarrangements. Prior periods are not restated, as is allowed under the modifiedretrospective basis, but will continue to be disclosed on a pro forma basis inthe Notes to the Consolidated Financial Statements, as previously reported. SeeNote 7—Stock-Based Compensation for additional information.

***Other-Than-Temporary Impairment—******In*******November, 2005, the Financial Accounting Standards Boardissued FSP 115-1, “The Meaning of Other-Than-Temporary Impairment and ItsApplication to Certain Investments” (“FSP 115-1”). FSP 115-1modifies certain existing guidance and establishes a framework for theevaluation of whether an impairment of an investment is other-than-temporary.The evaluation is 

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based on the intentand ability to hold the security to recovery, and should be considered on anindividual security basis, not on a portfolio basis. FSP 115-1 alsoclarifies that subsequent to the recognition of an other-than-temporaryimpairment loss for debt securities, an investor shall account for the securityusing the constant effective yield method. FSP 115-1 is effective forreporting periods beginning after December 15, 2005, with earlierapplication permitted. The adoption of FSP 115-1 did not have an effecton the Company’s consolidated financial condition or results of operations.However, the framework provided in FSP 115-1 could potentially result inthe recognition of unrealized losses, including those declines in value thatare attributable to interest rate movements, as other-than-temporaryimpairments. As of June 30, 2006, the Company had $26.1 million of totalgross unrealized losses. The amount of impairments to be recognized, if any,will depend on market conditions and management’s intent and ability to holdsecurities with unrealized losses at the time of the impairment evaluation.

***Future Adoption ofAccounting Standards:***

***DeferredAcquisition Costs—******In*******September 2005, the American Institute of CertifiedPublic Accountants issued Statement of Position 05-1, “Accounting byInsurance Enterprises for Deferred Acquisition Costs (“DAC”) in Connection withModifications or Exchanges of Insurance Contracts”, (“SOP 05-1”). SOP 05-1provides guidance on accounting by insurance enterprises for DAC on internalreplacements of insurance and investment contracts. An internal replacement isa modification in product benefits, features, rights or coverages that occursby the exchange of a contract for a new contract, or by amendment, endorsement,or rider to a contract, or by the election of a feature or coverage within acontract. Modifications that result in a replacement contract that issubstantially changed from the replaced contract should be accounted for as anextinguishment of the replaced contract. Unamortized DAC, unearned revenueliabilities and deferred sales inducements from the replaced contract must bewritten-off. Modifications that result in a contract that is substantiallyunchanged from the replaced contract should be accounted for as a continuationof the replaced contract. SOP 05-1 is effective for internal replacementsoccurring in fiscal years beginning after December 15, 2006, with earlieradoption encouraged. Initial application of SOP 05-1 should be as of thebeginning of the entity’s fiscal year. The Company expects to adopt SOP 05-1effective January 1, 2007. Adoption of this statement is expected to havean effect on the Company’s consolidated financial statements; however, theeffect has not yet been determined.

***Income Taxes—******In*******July 2006, the FASB, issued FASB Interpretation No. 48,“Accounting for Uncertainty in Income Taxes-an Interpretation of FASB Statement109” (“FIN 48”). FIN 48 prescribes a comprehensive model for how a companyshould recognize, measure, present, and disclose in its financial statementsuncertain tax positions that the company has taken or expects to take on a taxreturn. The interpretation requires public companies to recognize the taxbenefits of uncertain tax positions only where the position is “more likelythan not” to be sustained assuming examination by tax authorities. The amountrecognized would be the amount that represents the largest amount of taxbenefit that is greater than 50% likely of being ultimately realized. Aliability would be recognized for any benefit claimed, or expected to beclaimed, in a tax return in excess of the benefit recorded in the financialstatements, along with any interest and penalty (if applicable) on the excess.FIN 48 will require a tabular reconciliation of the change in the aggregateunrecognized tax benefits claimed, or expected to be claimed, in tax returnsand disclosure relating to accrued interest and penalties for unrecognized taxbenefits. Discussion will also be required for those uncertain tax positionswhere it is reasonably possible that the estimate of the tax benefit will changesignificantly in the next 12 months. FIN 48 is effective for fiscal yearsbeginning after December 15, 2006. We currently are evaluating the impactof adopting FIN 48.

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**4.   *INTANGIBLE ASSETS***

Thefollowing table shows the Company’s acquired intangible assets that continue tobe subject to amortization and accumulated amortization expense:

| ** **                                         | ** ** | **June 30, 2006** | ** ** | **December 31, 2005** | ** ** |
|----------------------------------------------------|------------|-----------------------------|------------|---------------------------------|------------|
| ** **                                         | ** ** | **Value  Assigned**         | ** ** | **Accumulated  Amortization**   | ** ** | **Value  Assigned** | ** ** | **Accumulated  Amortization** | ** ** |
| ** **                                         | ** ** | **(In thousands)**     | ** ** |
| Senior Health  Insurance:                          |       |                        |       |                            |       |   |   |   |   |   |   |   |   |
| Present value of future profits (“PVFP”) |       | $                           | 18,473     |                            |       | $ | 8,687 |   |   | $ | 18,473 |   |   | $ | 6,761 |   |   |
| Distribution Channel                               |       | 22,055                      |       |                            | 2,389      |   |   | 22,055 |   |   | 2,022 |   |   |
| Life Insurance  and Annuity—PVFP              |       | 4,127                       |       |                            | 1,775      |   |   | 4,127 |   |   | 1,577 |   |   |
| Senior Managed  Care—Medicare Advantage:      |       |                        |       |                            |       |   |   |   |   |   |   |   |   |
| PVFP—Health plan membership                   |       | 15,381                      |       |                            | 4,493      |   |   | 15,381 |   |   | 3,558 |   |   |
| PVFP—IPA’s                               |       | 15,539                      |       |                            | 1,440      |   |   | 3,458 |   |   | 635 |   |   |
| Senior  Administrative Services                    |       |                        |       |                            |       |   |   |   |   |   |   |   |   |
| PVFP—Administrative service contracts         |       | 7,671                       |       |                            | 7,320      |   |   | 7,671 |   |   | 7,240 |   |   |
| PVFP—Override fees                            |       | 1,797                       |       |                            | 612        |   |   | 1,797 |   |   | 445 |   |   |
| Total                                              |       | $                           | 85,043     |                            |       | $ | 26,716 |   |   | $ | 72,962 |   |   | $ | 22,238 |   |   |

 

Changes in the present value of future profits andother amortizing intangible assets are presented below:

| ** **                     | ** ** | **Three months ended  June 30,** | ** ** | **Six months ended  June 30,** | ** ** |
|--------------------------------|------------|-------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                     | ** ** | **2006**                                        | ** ** | **2005**                                      | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                     | ** ** | **(In thousands)**                         | ** ** |
| Balance,  beginning of period  |       | $                                               | 60,432     |                                          | $          | 59,126 |   | $ | 50,724 |   | $ | 60,804 |   |
| Additions and  adjustments     |       | 5                                               |       | (3,173                                        | )          | 12,081 |   | (3,173 | ) |
| Amortization, net  of interest |       | (2,110                                          | )          | (1,193                                        | )          | (4,478 | ) | (2,871 | ) |
| Balance, end of period         |       | $                                               | 58,327     |                                          | $          | 54,760 |   | $ | 58,327 |   | $ | 54,760 |   |

 

During the first quarterof 2006, Heritage acquired an additional interest in the earnings of one of itsrisk pools, effective as of January 1, 2006, for $12.1 million. Thepurchase price was allocated to present value of the future profits,representing the value of the additional interest, and will be amortized overten years.

Estimatedfuture net amortization expense (in thousands) is as follows:

| 2006 (remainder  of year) |   | $      | 3,745  |   |
|---------------------------|--------|--------|--------|--------|
| 2007                      |   | 6,963  |   |
| 2008                      |   | 6,597  |   |
| 2009                      |   | 6,216  |   |
| 2010                      |   | 5,631  |   |
| Thereafter                |   | 29,175 |   |
|                      |   | $      | 58,327 |   |

 

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Thecarrying amounts of goodwill and intangible assets with indefinite lives areshown below:

| ** **                                   | ** ** | **June 30,**       | ** ** | **December 31,** | ** ** |
|----------------------------------------------|------------|-------------------------|------------|-----------------------|------------|
| ** **                                   | ** ** | **2006**                | ** ** | **2005**              | ** ** |
| ** **                                   | ** ** | **(In thousands)** | ** ** |
| Senior Market  Health Insurance              |       | $                       | 8,760      |                  |       | $ | 8,760 |   |   |
| Senior Managed  Care—Medicare Advantage |       | 59,883                  |       |                  | 59,883     |   |   |
| Senior  Administrative Services              |       | 4,357                   |       |                  | 4,357      |   |   |
| Total                                        |       | $                       | 73,000     |                  |       | $ | 73,000 |   |   |

 

**5.   *INVESTMENTS***

Theamortized cost and fair value of fixed maturities are as follows:

| ** **                                                        | ** ** | **June 30, 2006** | ** ** |
|-------------------------------------------------------------------|------------|-----------------------------|------------|
| ** **                                                        | ** ** | ** **                  | ** ** | **Gross** | ** ** | **Gross** | ** ** | ** ** | ** ** |
| ** **                                                        | ** ** | **Amortized**               | ** ** | **Unrealized** | ** ** | **Unrealized** | ** ** | **Fair** | ** ** |
| **Classification**                                                | ** ** | ** **                  | ** ** | **Cost** | ** ** | **Gains** | ** ** | **Losses** | ** ** | **Value** | ** ** |
| ** **                                                        | ** ** | **(In thousands)**     | ** ** |
|                                                              |       |                        |       |   |   |   |   |   |   |   |   |   |   |   |   |
| U.S. Treasury  securities and obligations of U.S. government |       |                        | $          | 116,802 |   |   |   | $ | 2 |   |   |   | $ | (2,956 | ) |   | $ | 113,848 |   |
| Corporate debt  securities                                        |       |                        | 451,338    |   |   |   | 5,321 |   |   |   | (11,614 | ) |   | 445,045 |   |
| Foreign debt  securities(1)                                       |       |                        | 240,754    |   |   |   | 28,013 |   |   |   | (1,937 | ) |   | 266,830 |   |
| Mortgage-backed  and asset-backed  securities                     |       |                        | 511,275    |   |   |   | 2,160 |   |   |   | (9,568 | ) |   | 503,867 |   |
|                                                              |       |                        | $          | 1,320,169 |   |   |   | $ | 35,496 |   |   |   | $ | (26,075 | ) |   | $ | 1,329,590 |   |
|                                                                   |            |                             |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

| ** **                                                        | ** ** | **December 31, 2005** | ** ** |
|-------------------------------------------------------------------|------------|---------------------------------|------------|
| ** **                                                        | ** ** | ** **                      | ** ** | **Gross** | ** ** | **Gross** | ** ** | ** ** | ** ** |
| ** **                                                        | ** ** | **Amortized**                   | ** ** | **Unrealized** | ** ** | **Unrealized** | ** ** | **Fair** | ** ** |
| **Classification**                                                | ** ** | ** **                      | ** ** | **Cost** | ** ** | **Gains** | ** ** | **Losses** | ** ** | **Value** | ** ** |
| ** **                                                        | ** ** | **(In thousands)**         | ** ** |
|                                                              |       |                            |       |   |   |   |   |   |   |   |   |   |   |
| U.S. Treasury  securities and obligations of U.S. government |       | $                               | 112,857    |   |   | $ | 262 |   |   |   | $ | (1,258 | ) |   | $ | 111,861 |   |
| Corporate debt  securities                                        |       | 449,639                         |       |   | 12,956 |   |   |   | (3,786 | ) |   | 458,809 |   |
| Foreign debt  securities(1)                                       |       | 223,428                         |       |   | 42,949 |   |   |   | (209 | ) |   | 266,168 |   |
| Mortgage-backed  and asset-backed securities                      |       | 508,200                         |       |   | 3,148 |   |   |   | (3,411 | ) |   | 507,937 |   |
|                                                              |       | $                               | 1,294,124  |   |   | $ | 59,315 |   |   |   | $ | (8,664 | ) |   | $ | 1,344,775 |   |
|                                                                   |            |                                 |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

----

       (1) Primarily Canadian dollar denominated bonds supporting our Canadianinsurance reserves.

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Theamortized cost and fair value of fixed maturities at June 30, 2006 bycontractual maturity are shown below. Expected maturities will differ fromcontractual maturities because borrowers may have the right to call or prepayobligations with or without call or prepayment penalties.

| ** **                                   | ** ** | **Amortized**           | ** ** | **Fair**  | ** ** |
|----------------------------------------------|------------|-------------------------|------------|-----------|------------|
| ** **                                   | ** ** | **Cost**                | ** ** | **Value** | ** ** |
| ** **                                   | ** ** | **(In thousands)** | ** ** |
| Due in 1 year or  less                       |       | $                       | 45,841     |      | $          | 46,848 |   |
| Due after 1 year  through 5 years            |       | 264,521                 |       | 263,377   |       |
| Due after 5 years  through 10 years          |       | 293,883                 |       | 293,612   |       |
| Due after 10  years                          |       | 212,007                 |       | 228,934   |       |
| Mortgage-backed  and asset-backed securities |       | 503,917                 |       | 496,819   |       |
|                                         |       | $                       | 1,320,169  |      | $          | 1,329,590 |   |

 

**6.   *STOCKHOLDERS’ EQUITY***

*Preferred Stock*

The Company has 2.0million authorized shares of preferred stock with no such shares issued oroutstanding at June 30, 2006 or December 31, 2005.

*Common Stock*

Thepar value of common stock is $0.01 per share with 100 million shares authorizedfor issuance. Changes in the number of shares of common stock issued were asfollows:

| ** **                                                                               | ** ** | **Six months ended  June 30,** | ** ** |
|------------------------------------------------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                                                               | ** ** | **2006**                                      | ** ** | **2005** | ** ** |
| Common stock  issued, beginning of year                                                  |       | 59,042,685                                    |       | 55,326,092 |   |
| Equity offering                                                                          |       | —                                        |       | 2,000,000 |   |
| Stock options  exercised                                                                 |       | 125,176                                       |       | 603,322 |   |
| Agent stock award                                                                        |       | (507                                          | )          | 60,002 |   |
| Stock purchases  pursuant to agents’ stock purchase and deferred compensation plans |       | 2,500                                         |       | 6,751 |   |
| Common stock issued, end  of period                                                      |       | 59,169,854                                    |       | 57,996,167 |   |

 

*Treasury Stock*

TheCompany currently has 997,729 shares available to purchase pursuant to sharerepurchase programs approved by our Board of Directors in November 2005and December 2003. Changes in the number of shares of Treasury stockissued were as follows:

| ** **                                           | ** ** | **Six months ended June 30,** | ** ** |
|------------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                           | ** ** | **2006**                                          | ** ** | **2005** | ** ** |
| ** **                                           | ** ** | **Shares**                                        | ** ** | **Amount** | ** ** | **Weighted  Average  Cost Per  Share** | ** ** | **Shares** | ** ** | **Amount** | ** ** | **Weighted  Average  Cost Per  Share** | ** ** |
| ** **                                           | ** ** | **(In thousands)**                           | ** ** | **(In thousands)** | ** ** |
| Treasury stock  beginning of year                    |       | 751,473                                           |       | $ | 11,240 |   |   | $ | 14.96 |   |   | 124,941 |   |   | $ | 969 |   |   |   | $ | 7.75 |   |   |
| Shares repurchased                                   |       | 3,039                                             |       | 44 |   |   | 14.32 |   |   | 1,674 |   |   | 31 |   |   |   | 18.73 |   |   |
| Shares distributed  in the form of employee  bonuses |       | (54,901                                           | )          | (821 | ) |   | 15.34 |   |   | (74,081 | ) |   | (577 | ) |   |   | 15.87 |   |   |
| Treasury stock,  end of period                       |       | 699,611                                           |       | $ | 10,463 |   |   | $ | 14.95 |   |   | 52,534 |   |   | $ | 423 |   |   |   | $ | 8.05 |   |   |

 

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*Accumulated OtherComprehensive Income*

Thecomponents of accumulated other comprehensive income are as follows:

| ** **                                 | ** ** | **June 30,  2006** | ** ** | **December 31,  2005** | ** ** |
|--------------------------------------------|------------|-------------------------|------------|-----------------------------|------------|
| ** **                                 | ** ** | **(In thousands)** | ** ** |
| Net unrealized appreciation on investments |       | $                       | 9,424      |                        |       | $ | 50,631 |   |   |
| Deferred  acquisition cost adjustment      |       | 4,181                   |       |                        | (1,265     | ) |   |
| Foreign currency  translation gains        |       | 12,297                  |       |                        | 10,469     |   |   |
| Fair value of  cash flow swap              |       | 1,770                   |       |                        | 1,544      |   |   |
| Deferred tax on  the above                 |       | (9,685                  | )          |                        | (21,483    | ) |   |
| Accumulated other  comprehensive income    |       | $                       | 17,987     |                        |       | $ | 39,896 |   |   |

 

**7.   *STOCK-BASED COMPENSATION***

The Company has variousstock-based incentive plans for its employees, non-employee directors and itsagents. The Company issues new shares upon the exercise of options. Detailedinformation for activity in the Company’s stock plans can be found in thefinancial statement section of our Annual Report on Form 10-K inNote 8—Stock-Based Compensation.

*Stock Option Awards*

The Company adopted FAS 123-R beginning January 1,2006, using the modified prospective method, and began recognizing compensationcost for share-based payments to employees and non-employee directors based onthe grant date fair value of the award, which is amortized over the grantees’service period. The Company has elected to use the Black-Scholes valuationmodel to value employee stock options, as it had done for its previous proforma stock compensation disclosures. The adoption of FAS 123-R didnot have a material effect on the Company’s method of computing compensationcosts for options from that used to prepare the pro forma disclosures in priorperiods.

Theeffect of the adoption of FAS 123-R on selected line items is as follows:

| ** **                  | ** ** | **Three months ended  June 30,  2006**                 | ** ** | **Six months ended  June 30,  2006** | ** ** |
|-----------------------------|------------|-----------------------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                  | ** ** | **(In thousands, except per share amounts)** | ** ** |
| Stock option  expense       |       |                                                                  | $          | 780                                                 |       |   |   | $ | 1,495 |   |   |
| Income before  taxes        |       |                                                                  | (780       | )                                                   |       |   | (1,495 | ) |   |
| Income tax  (benefit)       |       |                                                                  | (273       | )                                                   |       |   | (523 | ) |   |
| Net income                  |       |                                                                  | (507       | )                                                   |       |   | (972 | ) |   |
| Cash flows from  operations |       |                                                                  | (311       | )                                                   |       |   | (563 | ) |   |
| Cash flows from  financing  |       |                                                                  | 311        |                                                |       |   | 563 |   |   |
| Net income per  share:      |       |                                                                  |       |                                                |       |   |   |   |   |
| Basic                       |       |                                                                  | $          | 0.01                                                |       |   |   | $ | 0.02 |   |   |
| Diluted                     |       |                                                                  | $          | 0.01                                                |       |   |   | $ | 0.02 |   |   |

 

The Company did not capitalize any cost of stock-basedcompensation for its employees or non-employee directors. Future expense mayvary based upon factors such as the number of awards granted by the Company andthe then-current fair market value of such awards.

Compensationcosts for share-based payments to employees and non-employee directors underthe fair value method prior to adoption of FAS 123-R is not reflected inthe financial statements of those 

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periods. The following table illustrates the effect onnet income and earnings per share if the fair value based method had beenapplied to those periods.****

| ** **                                                                                                   | ** ** | **Three months ended  June 30,  2005**                 | ** ** | **Six months ended  June 30,  2005** | ** ** |
|--------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                                                                   | ** ** | **(In thousands, except per share amounts)** | ** ** |
| Reported net  income                                                                                         |       |                                                                  | $          | 18,648                                              |       |   |   | $ | 34,720 |   |   |
| Add back:  Stock-based compensation expense included in reported net income, net of tax                      |       |                                                                  | 471        |                                                |       |   | 752 |   |   |
| Less: Stock-based  compensation expense determined under fair value based method for all awards,  net of tax |       |                                                                  | (1,083     | )                                                   |       |   | (1,698 | ) |   |
| Pro forma net  income                                                                                        |       |                                                                  | $          | 18,036                                              |       |   |   | $ | 33,774 |   |   |
| Net income per share:                                                                                        |       |                                                                  |       |                                                |       |   |   |   |   |
| Basic, as reported                                                                                           |       |                                                                  | $          | 0.33                                                |       |   |   | $ | 0.62 |   |   |
| Basic, pro forma                                                                                             |       |                                                                  | $          | 0.32                                                |       |   |   | $ | 0.60 |   |   |
| Diluted, as reported                                                                                         |       |                                                                  | $          | 0.32                                                |       |   |   | $ | 0.60 |   |   |
| Diluted, pro  forma                                                                                          |       |                                                                  | $          | 0.31                                                |       |   |   | $ | 0.59 |   |   |

 

Thefair value for these options was estimated at the date of grant using aBlack-Scholes option pricing model with the following range of assumptions:

| Risk free  interest rates             |   | 3.12% - 5.28   | %      |
|---------------------------------------|--------|--------------------------|--------|
| Dividend yields                       |   | 0.0                      | %      |
| Expected  volatility                  |   | 40.00% - 47.23 | %      |
| Expected lives of  options (in years) |   | 3.0 - 9.0      |   |

 

Asummary of option activity for the six months ended June 30, 2006 ispresented below:

| **Stock Options**            | ** ** | ** ** | ** ** | **Options**             | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Weighted  Average  Remaining  Contractual  Term** | ** ** | **Aggregate  Intrinsic  Value** | ** ** |
|-----------------------------------|------------|------------|------------|-------------------------|------------|----------------------------------------|------------|-----------------------------------------------------|------------|---------------------------------|------------|
| ** **                        | ** ** | ** ** | ** ** | **(in thousands)** | ** ** | ** **                             | ** ** | **(in years)**                                 | ** ** | **(in thousands)**         | ** ** |
| Outstanding at  beginning of year |       |       | 4,823      |                    |       |                                   | $          | 6.81                                                |       |                            |       | 5.2 |   |   |   |   |   |   |
| Granted                           |       |       | 429        |                    |       |                                   | 15.37      |                                                |       |                            |       |   |   |   |   |   |   |
| Exercised                         |       |       | (125       | )                       |       |                                   | 7.84       |                                                |       |                            |       |   |   |   |   |   |   |
| Forfeited or  expired             |       |       | (37        | )                       |       |                                   | 13.52      |                                                |       |                            |       |   |   |   |   |   |   |
| Outstanding at  end of period     |       |       | 5,090      |                    |       |                                   | $          | 7.40                                                |       |                            |       | 4.4 |   |   |   | $ | 32,547 |   |   |
| Exercisable at end of  period     |       |       | 3,872      |                    |       |                                   | $          | 6.41                                                |       |                            |       | 4.2 |   |   |   | $ | 27,724 |   |   |

 

The weighted-average grant-date fair value of optionsgranted during the six months ended June 30, 2006 was $5.26 and was $6.10for options granted during the six months ended June 30, 2005. The totalintrinsic value of options exercised during the six months ended June 30,2006 was $0.8 million and was $7.3 million for options exercised during the sixmonths ended June 30, 2005.

As of June 30, 2006, the total compensation costrelated to non-vested awards not yet recognized was $4.5 million, which isexpected to be recognized over a weighted average period of 1 year.

Cash received from theexercise of stock options was $1.0 million in the first six months of 2006 andwas $3.6 million in the first six months of 2005. FAS 123-R also requiresthe benefits of tax deductions in 

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excessof recognized compensation cost to be reported as a financing cash flow, ratherthan as an operating cash flow as required under prior literature. The amountof financing cash flows recognized for such excess tax deductions were $0.6million for the six months ended June 30, 2006. The amount of operatingcash flows recognized for such excess tax deductions were $1.4 million for thesix months ended June 30, 2005.

*Employee StockAwards*

Inaccordance with the 1998 ICP, the Company may grant restricted stock to itsofficers and non-officer employees. These grants vest upon issue.Executive officers may be granted restricted stock in connection with theirbonuses. This restricted stock vests ratably over four years. Restricted stockawards are valued equal to the market price of the Company’s common stock onthe date of grant and are generally issued out of treasury shares. Compensationexpense for restricted stock awards is recognized on a straight line basis overthe vesting period. A summary of the status of the Company’s non-vestedrestricted stock awards as of June 30, 2006, and changes during the sixmonths ended June 30, 2006, is presented below: 

| **Nonvested Restricted Stock** | ** ** | ** ** | ** ** | **Shares**              | ** ** | **Weighted  Average  Grant-Date  Fair Value** | ** ** |
|------------------------------------------|------------|------------|------------|-------------------------|------------|----------------------------------------------------|------------|
| ** **                               | ** ** | ** ** | ** ** | **(in thousands)** | ** ** | ** **                                         | ** ** |
| Nonvested at  beginning of year          |       |       | 157        |                    |       |                                               | $          | 12.05 |   |   |
| Granted                                  |       |       | 54         |                    |       |                                               | 15.35      |   |   |
| Vested                                   |       |       | (51        | )                       |       |                                               | 11.05      |   |   |
| Forfeited                                |       |       | —     |                    |       |                                               | —     |   |   |
| Nonvested at end of  period              |       |       | 160        |                    |       |                                               | $          | 13.47 |   |   |

 

The total fair value ofshares vested was $0.8 million during the six months ended June 30, 2006and $0.5 million during the six months ended June 30, 2005.

**8.   *STATUTORY FINANCIAL DATA***

Our U.S. insurance subsidiaries are required tomaintain minimum amounts of statutory capital and surplus as required byregulatory authorities. However, substantially more than such minimum amountsare needed to meet statutory and administrative requirements of adequatecapital and surplus to support the current level of our insurance subsidiaries’operations. Each of our U.S. insurance subsidiaries’ statutory capital andsurplus exceeds its respective minimum statutory requirement at levels webelieve are sufficient to support their current levels of operation.Additionally, the National Association of Insurance Commissioners (“NAIC”)imposes regulatory risk-based capital (“RBC”) requirements on life insuranceenterprises. At June 30, 2006, all of our U.S. insurance subsidiariesmaintained ratios of total adjusted capital to RBC in excess of the “authorizedcontrol level”. The combined statutory capital and surplus, including assetvaluation reserve, of our U.S. insurance subsidiaries totaled $169.4 million atJune 30, 2006 and $158.4 million at December 31, 2005. For the sixmonths ended June 30, 2006, our U.S. insurance subsidiaries generatedstatutory net income of $9.2 million and for the six months ended June 30,2005, our U.S. insurance subsidiaries generated statutory net income of $0.3million.

Our health plans are also required to maintain minimumamounts of capital and surplus, as required by regulatory authorities and arealso subject to RBC requirements. At June 30, 2006, the statutory capitaland surplus of each of our health plans exceed minimum requirements and theirRBCs are in excess of the “authorized control level”. The statutory capital andsurplus for our health plan was $33.7 million at June 30, 2006 and $23.0million at December 31, 2005. Statutory net income for our health planswas $7.7 million for the six months ended June 30, 2006 and$4.9 million for the six months ended June 30, 2005.

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Our Canadian insurancesubsidiary, Penncorp Life (Canada), reports to Canadian regulatory authoritiesbased upon Canadian statutory accounting principles that vary in some respectsfrom U.S. statutory accounting principles. Penncorp Life (Canada)’s net assetsbased upon Canadian statutory accounting principles were C$62.8 million(US$56.3 million) as of June 30, 2006 and were C$62.3 million(US$53.6 million) as of December 31, 2005. Penncorp Life (Canada)maintained a Minimum Continuing Capital and Surplus Requirement Ratio (“MCCSR”)in excess of the minimum requirement at June 30, 2006. Net income forPenncorp Life (Canada) based on Canadian generally accepted accountingprinciples was C$5.4 million (US$4.7 million) for the six months ended June 30,2006, C$5.6 million (US$4.5 million) for the six months ended June 30,2005.

**9.   *LOAN PAYABLE***

*Credit Facility, asAmended in May 2004*

In connection with the acquisition of Heritage on May 28,2004, the Company amended the Credit Agreement by increasing the facility to$120.0 million from $80.0 million (the “Amended Credit Agreement”), includingan increase in the term loan portion to $105.0 million from $36.4 million (thebalance outstanding at May 28, 2004) and maintaining the $15.0 millionrevolving loan facility. None of the revolving loan facility has been drawn as ofJune 30, 2006. Under the Amended Credit Agreement, the spread over LIBORwas reduced to 225 basis points. Effective July 1, 2006, the interest rateon the term loan was 7.6%. Principal repayments are scheduled at $5.3 millionper year over a five-year period with a final payment of $80.1 million due uponmaturity on March 31, 2009.

The Company made regularly scheduled principalpayments of $2.6 million during the six months ended June 30, 2006 and$2.6 million during the six months ended June 30, 2005, in connection withits credit facilities. The Company paid interest of $3.4 million during the sixmonths ended June 30, 2006 and $2.5 million during the six months ended June 30,2005, in connection with its credit facilities.

Thefollowing table shows the schedule of principal payments (in thousands)remaining on the Amended Credit Agreement, with the final payment in March 2009:

| 2006 (remainder  of the year) |   | $      | 2,625  |   |
|-------------------------------|--------|--------|--------|--------|
| 2007                          |   | 5,250  |   |
| 2008                          |   | 5,250  |   |
| 2009                          |   | 80,063 |   |
|                          |   | $      | 93,188 |   |

 

**10.**   *OTHER LONG TERM DEBT*

The Company has formed separate statutory businesstrusts (the “Trusts”), which exist for the exclusive purpose of issuing trustpreferred securities representing undivided beneficial interests in the assetsof the trust, investing the gross proceeds of the trust preferred securities injunior subordinated deferrable interest debentures of the Company (the “JuniorSubordinated Debt”) and engaging in only those activities necessary orincidental thereto. In accordance with the adoption of FASB Interpretation No. 46(R),“Consolidation of Variable Interest Entities,” the Company does not consolidatethe trusts. The Trusts have issued a combined $75.0 million in thirty yeartrust preferred securities.

The Company paid $2.8million in interest in connection with the Junior Subordinated Debt during thesix months ended June 30, 2006, and $2.6 million during the six monthsended June 30, 2005.

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**11.**   *DERIVATIVE INSTRUMENTS—CASH FLOW HEDGE*

Effective September 4,2003, the Company entered into a swap agreement whereby it pays a fixed rate of 6.7% on a $15.0 millionnotional amount relating to the December 2002 trust preferred securitiesissuance, in exchange for a floating rate of LIBOR plus 400 basis points,capped at 12.5%. The swap contract expires in December 2007. Effective April 29,2004, the Company entered into a second swap agreement whereby it pays a fixedrate of 6.98% on a $20.0 million notional amount relating to the October 2003trust preferred securities issuance, in exchange for a floating rate of LIBORplus 395 basis points, capped at 12.45%. The swap contract expires in October 2008.The swaps are designated and qualify as cash flow hedges, and changes in theirfair value are recorded in accumulated other comprehensive income. The combinedfair value of the swaps was $1.8 million at June 30, 2006 and $1.5 millionat December 31, 2005 and is included in other assets.

**12.   *COMMITMENTS AND CONTINGENCIES***

***Securities Class Action and Derivative Litigation***

Five actions containing related factual allegationswere filed against the Company and certain of its officers and directorsbetween November 22, 2005 and February 2, 2006. One of these actionswas voluntarily withdrawn by plaintiffs, and four actions are now pending, twoof which have been consolidated.

In the first action, Robert Kemp filed a purportedclass action complaint (the “Kemp Action”) on November 22, 2005, in theUnited States District Court for the Southern District of New York. The KempAction is a purported class action asserted on behalf of those shareholders ofthe Company who acquired the Company’s common stock between February 16,2005 and October 28, 2005. Plaintiffs in the Kemp Action seek unspecifieddamages under Section 10(b) and 20(a) of the Securities ExchangeAct of 1934 based upon allegedly false statements by the Company and Richard A.Barasch, Robert A. Waegelein and Gary W. Bryant (hereinafter, the “OfficerDefendants”) in press releases, financial statements and analyst conferencesduring the class period.

Another purported class action was filed by WesternTrust Laborers-Employers Pension Trust (the “Western Trust Action”), a putativeclass member in the Kemp Action who had filed a motion to be named as leadplaintiff in that action, on February 2, 2006, in the United StatesDistrict Court for the Southern District of New York. The factual and legalallegations in the Western Trust Action, which also purports to be a classaction, are similar to those in the Kemp Action. By order dated May 1,2006, the Kemp Action and the Western Trust Action were consolidated.

On June 26, 2006, a consolidated amended classaction complaint was filed in the Kemp Action (the “Amended Complaint”), whichwill now subsume the Western Trust Action. The Amended Complaint asserts thesame legal claims as in the original Kemp and Western Trust Actions, but alsonames an additional defendant and includes additional allegations. The additionaldefendant is William E. Wehner, a former director and former president ofPennsylvania Life Insurance Company, a subsidiary of the Company. The AmendedComplaint alleges that Mr. Wehner is liable for violations of Sections 10(b)and 20(a) of the Securities Exchange Act of 1934 on grounds similar to thoseasserted against the Officer Defendants. The additional assertions aresupposedly based in part upon information from six former employees and agentsof the Company and its subsidiaries concerning, among other things, the Company’smedical loss ratio. Like the original complaints in the Kemp and Western TrustActions, the Amended Complaint seeks damages in an unspecified amount. Under ascheduling order entered by the Court, defendants will file a motion to dismissthe Amended Complaint on or before August 14, 2006.

Two additional actions have been brought derivativelyby shareholders purporting to act on behalf of the Company, and not as classactions. One of these was filed by Green Meadows Partners LLP (the 

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“Green Meadows Action”) onDecember 13, 2005, in the United States District Court for the SouthernDistrict of New York, and has been assigned to the same judge presiding overthe Kemp Action and the Western Trust Action. In the Green Meadows Action,plaintiffs seek contribution under Section 10(b) and 21D of theExchange Act on the ground that if the Company is found liable to have violatedthe securities laws in the Kemp Action, then the Officer Defendants are liablefor contribution. The Green Meadows Action also asserts three claims understate law for breach of fiduciary duty against the Officer Defendants.

On July 19, 2006, the plaintiff in the GreenMeadows Action filed a Verified Amended Shareholder Derivative Complaint (the “GMAmended Complaint”). The GM Amended Complaint adds as new defendants Mr. Wehner,Capital Z Financial Services Fund II, L.P. (“Capital Z”) and three directors ofthe Company who are affiliated with Capital Z, namely Bradley E. Cooper, RobertA. Spass and Eric W. Leathers. Capital Z is the largest shareholder of theCompany. The GM Amended Complaint carries forward the legal claims asserted inthe original complaint against the original defendants (with additionalallegations), and adds new claims (i) against the new director defendantsfor alleged breach of fiduciary duty in connection with a secondary offering inJune 2005 that included 5 million shares of the Company’s common stockthat had been owned by Capital Z and (ii) against Capital Z for allegedunjust enrichment with respect to the proceeds Capital Z realized from the saleof the 5 million shares it formerly owned in the secondary offering. Under anorder entered by the Court, defendants are scheduled to file a motion todismiss the GM Amended Complaint on or before September 8, 2006.

The second derivative action was filed by plaintiffArthur Tsutsui (the “Tsutsui Action”) on December 30, 2005, in The SupremeCourt for New York State, Westchester County. The defendants in the TsutsuiAction are the three Officer Defendants named in the other actions, as well asall of the directors sitting on the Company’s Board of Directors as of the timethe complaint was filed. The Tsutsui Action alleges that the same allegedmisstatements that are the subject of the Kemp Action constituted a breach offiduciary duty by the Officer Defendants and the directors that caused theCompany to sustain damages. The Tsutsui Action also seeks recovery of anyproceeds derived by the Officer Defendants from the sale of Company stock thatwas in breach of their fiduciary duties. Defendants in the Tsutsui Action fileda motion to dismiss the complaint on June 9, 2006. Plaintiff has not yetresponded to that motion and counsel for the parties are discussing a proposedstipulation under which the Tsutsui Action would be stayed pending developmentsin the federal case.

Each of the OfficerDefendants and Mr. Wehner denies the allegations in the above-describedcases and has indicated that he intends to vigorously defend against the allegations.Management believes that after liability insurance recoveries, none of theseactions will have a material adverse effect on the Company.

***Other Litigation***

The Company has litigationin the ordinary course of its business, including claims for medical,disability and life insurance benefits, and in some cases, seeking punitivedamages. Management believes that after liability insurance recoveries, none ofthese actions will have a material adverse effect on the Company. In addition,our insurance company subsidiaries and health plan affiliates are subject tothe regulations of, and supervision by, the insurance departments of each ofthe jurisdictions in which they are admitted and authorized to transactbusiness.  Periodically, these insurancedepartments conduct examinations and/or investigations of our insurance companysubsidiaries and health plan affiliates, which could result in adversefindings, monetary fines or disciplinary action, as more fully described in“Item 1—Business—Regulation” of our Annual Report on Form 10-K.

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**13.**   *EARNINGS PER SHARE*

Thereconciliation of the numerators and the denominators for the computation ofbasic and diluted EPS is as follows: 

| ** **                                 | ** ** | **Three months ended June 30,**                            | ** ** |
|--------------------------------------------|------------|--------------------------------------------------------------------------------|------------|
| ** **                                 | ** ** | **2006**                                                                       | ** ** | **2005** | ** ** |
| ** **                                 | ** ** | **Income**                                                                     | ** ** | **Shares** | ** ** | **Per Share** | ** ** | **Income** | ** ** | **Shares** | ** ** | **Per Share** | ** ** |
| ** **                                 | ** ** | **(Numerator)**                                                                | ** ** | **(Denominator)** | ** ** | **Amount** | ** ** | **(Numerator)** | ** ** | **(Denominator)** | ** ** | **Amount** | ** ** |
| ** **                                 | ** ** | **(In thousands, per share amounts in dollars)** | ** ** |
| Weighted average  common stock outstanding |       |                                                                           |       |   |   |   | 59,116 |   |   |   |   |   |   |   |   |   |   |   | 55,986 |   |   |   |   |   |   |
| Less: Weighted  average treasury shares    |       |                                                                           |       |   |   |   | (697 | ) |   |   |   |   |   |   |   |   |   |   | (51 | ) |   |   |   |   |   |
| Basic earnings  per share                  |       |                                                                           | $          | 18,110 |   |   |   | 58,419 |   |   |   | $ | 0.31 |   |   |   | $ | 18,648 |   |   |   | 55,935 |   |   |   | $ | 0.33 |   |   |
| Effect of  dilutive securities             |       |                                                                           |       |   |   |   | 1,403 |   |   |   |   |   |   |   |   |   |   |   | 2,055 |   |   |   |   |   |   |
| Diluted EPS                                |       |                                                                           | $          | 18,110 |   |   |   | 59,822 |   |   |   | $ | 0.30 |   |   |   | $ | 18,648 |   |   |   | 57,990 |   |   |   | $ | 0.32 |   |   |

 

| ** **                                 | ** ** | **Six months ended June 30,**                              | ** ** |
|--------------------------------------------|------------|--------------------------------------------------------------------------------|------------|
| ** **                                 | ** ** | **2006**                                                                       | ** ** | **2005** | ** ** |
| ** **                                 | ** ** | **Income**                                                                     | ** ** | **Shares** | ** ** | **Per Share** | ** ** | **Income** | ** ** | **Shares** | ** ** | **Per Share** | ** ** |
| ** **                                 | ** ** | **(Numerator)**                                                                | ** ** | **(Denominator)** | ** ** | **Amount** | ** ** | **(Numerator)** | ** ** | **(Denominator)** | ** ** | **Amount** | ** ** |
| ** **                                 | ** ** | **(In thousands, per share amounts in dollars)** | ** ** |
| Weighted average  common stock outstanding |       |                                                                           |       |   |   |   | 59,086 |   |   |   |   |   |   |   |   |   |   |   | 55,686 |   |   |   |   |   |   |
| Less: Weighted  average treasury shares    |       |                                                                           |       |   |   |   | (724 | ) |   |   |   |   |   |   |   |   |   |   | (76 | ) |   |   |   |   |   |
| Basic earnings  per share                  |       |                                                                           | $          | 25,130 |   |   |   | 58,362 |   |   |   | $ | 0.43 |   |   |   | $ | 34,720 |   |   |   | 55,610 |   |   |   | $ | 0.62 |   |   |
| Effect of dilutive  securities             |       |                                                                           |       |   |   |   | 1,507 |   |   |   |   |   |   |   |   |   |   |   | 2,027 |   |   |   |   |   |   |
| Diluted EPS                                |       |                                                                           | $          | 25,130 |   |   |   | 59,869 |   |   |   | $ | 0.42 |   |   |   | $ | 34,720 |   |   |   | 57,637 |   |   |   | $ | 0.60 |   |   |

 

**14.   *OTHER COMPREHENSIVE INCOME***

Thecomponents of other comprehensive income, and the related tax effects for eachcomponent, are as follows:

| ** **                                                                                   | ** ** | **Three months ended June 30,** | ** ** |
|----------------------------------------------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                                                   | ** ** | **2006**                                            | ** ** | **2005** | ** ** |
| ** **                                                                                   | ** ** | **Before Tax  Amount**                         | ** ** | **Tax Expense  (Benefit)** | ** ** | **Net of Tax  Amount** | ** ** | **Before Tax  Amount** | ** ** | **Tax Expense  (Benefit)** | ** ** | **Net of Tax  Amount** | ** ** |
| ** **                                                                                   | ** ** | **(In thousands)**                             | ** ** |
| Net unrealized (loss) gain arising during the year (net of  deferred acquisition costs) |       |                                                | $          | (18,207 | ) |   |   | $ | (6,375 | ) |   | $ | (11,832 | ) |   | $ | 28,890 |   |   |   | $ | 10,111 |   |   |   | $ | 18,779 |   |   |
| Reclassification adjustment for gains included in net income                                 |       |                                                | (48        | ) |   |   | (17 | ) |   | (31 | ) |   | (3,030 | ) |   |   | (1,060 | ) |   |   | (1,970 | ) |   |
| Net unrealized (loss) gain                                                                   |       |                                                | (18,255    | ) |   |   | (6,392 | ) |   | (11,863 | ) |   | 25,860 |   |   |   | 9,051 |   |   |   | 16,809 |   |   |
| Cash Flow Hedge                                                                              |       |                                                | 56         |   |   |   | 20 |   |   | 36 |   |   | (438 | ) |   |   | (153 | ) |   |   | (285 | ) |   |
| Foreign currency translation adjustment                                                      |       |                                                | 2,114      |   |   |   | 740 |   |   | 1,374 |   |   | (393 | ) |   |   | (138 | ) |   |   | (255 | ) |   |
| Other  comprehensive (loss) income                                                           |       |                                                | $          | (16,085 | ) |   |   | $ | (5,632 | ) |   | $ | (10,453 | ) |   | $ | 25,029 |   |   |   | $ | 8,760 |   |   |   | $ | 16,269 |   |   |

 

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| ** **                                                                                   | ** ** | **Six months ended June 30,** | ** ** |
|----------------------------------------------------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                                                                   | ** ** | **2006**                                          | ** ** | **2005** | ** ** |
| ** **                                                                                   | ** ** | **Before Tax  Amount**                       | ** ** | **Tax Expense  (Benefit)** | ** ** | **Net of Tax  Amount** | ** ** | **Before Tax  Amount** | ** ** | **Tax Expense  (Benefit)** | ** ** | **Net of Tax  Amount** | ** ** |
| ** **                                                                                   | ** ** | **(In thousands)**                           | ** ** |
| Net unrealized (loss) gain arising during the year (net of  deferred acquisition costs) |       |                                              | $          | (35,714 | ) |   |   | $ | (12,501 | ) |   | $ | (23,213 | ) |   | $ | 16,744 |   |   |   | $ | 5,860 |   |   |   | $ | 10,884 |   |   |   |
| Reclassification adjustment for gains included in net income                                 |       |                                              | (47        | ) |   |   | (16 | ) |   | (31 | ) |   | (4,103 | ) |   |   | (1,436 | ) |   |   | (2,667 | ) |   |   |
| Net unrealized (loss) gain                                                                   |       |                                              | (35,761    | ) |   |   | (12,517 | ) |   | (23,244 | ) |   | 12,641 |   |   |   | 4,424 |   |   |   | 8,217 |   |   |   |
| Cash Flow Hedge                                                                              |       |                                              | 226        |   |   |   | 79 |   |   | 147 |   |   | 219 |   |   |   | 77 |   |   |   | 142 |   |   |   |
| Foreign currency translation adjustment                                                      |       |                                              | 1,828      |   |   |   | 640 |   |   | 1,188 |   |   | (620 | ) |   |   | (217 | ) |   |   | (403 | ) |   |   |
| Other  comprehensive (loss) income                                                           |       |                                              | $          | (33,707 | ) |   |   | $ | (11,798 | ) |   | $ | (21,909 | ) |   | $ | 12,240 |   |   |   | $ | 4,284 |   |   |   | $ | 7,956 |   |   |   |

 

**15.   *UNCONSOLIDATED SUBSIDIARY***

During 2005, we entered into a strategic alliance withPharmaCare and created Part D Management Services, L.L.C. (“PDMS”), whichis 50% owned by Universal American and 50% owned by PharmaCare. PDMSprincipally performs marketing and risk management services on behalf of ourPDPs and PharmaCare for which it receives fees and other remuneration from ourPDPs and PharmaCare. We do not control PDMS and therefore PDMS is notconsolidated in our financial statements. Our investment in PDMS is accountedfor on an equity basis and is included in other assets. At June 30, 2006,our investment in the equity in PDMS was $4.4 million and at December 31,2005, our share of the deficit of PDMS was $1.0 million. Our share in the netincome of PDMS was $22.7 million for the six months ended June 30, 2006and is included in “equity in earnings of unconsolidated subsidiary.”  During the six months ended June 30,2006, PDMS made distributions to its owners aggregating $37.0 million. Ourshare of these distributions was $18.5 million.

Thecondensed financial information for 100% of PDMS is as follows:

| ** **                    | ** ** | **June 30,  2006** | ** ** | **December  31,  2005** | ** ** |
|-------------------------------|------------|-------------------------|------------|-----------------------------------|------------|
| ** **                    | ** ** | **(in thousands)** | ** ** |
| *Assets*                      | * *   |                    | * *   | * *                          |       |   | * * | * * |   |
| Cash and  investments         |       |                    | $          | 1,215                             | * *   |   |   | $ | 131 | * * |   |
| Other                         |       |                    | 8,339      | * *                          |       |   | 2,353 | * * |   |
| Total Assets                  |       |                    | $          | 9,554                             | * *   |   |   | $ | 2,484 | * * |   |
| *Liabilities*                 | * *   |                    | * *   | * *                          |       |   | * * | * * |   |
| Accrued expenses  and other   |       |                    | $          | 667                               | * *   |   |   | $ | 4,444 | * * |   |
| Equity                        |       |                    | 8,887      | * *                          |       |   | (1,960 | ) |   |
| Total liabilities  and equity |       |                    | $          | 9,554                             | * *   |   |   | $ | 2,484 | * * |   |

 

| ** **     | ** ** | **Three months ended  June 30,**                      | ** ** | **Six months ended  June 30,**                        | ** ** |
|----------------|------------|----------------------------------------------------------------------|------------|----------------------------------------------------------------------|------------|
| ** **     | ** ** | **     2006     ** | ** ** | **     2005     ** | ** ** | **     2006     ** | ** ** | **     2005     ** | ** ** |
| ** **     | ** ** | **(In thousands)**                                              | ** ** |
| Total revenue  |       |                                                                 | $          | 27,712                                                               |       |   |   | $ | — |   |   |   | $ | 48,816 |   |   |   | $ | — |   |   |
| Total expenses |       |                                                                 | 1,978      |                                                                 |       |   | 354 |   |   |   | 3,468 |   |   |   | 354 |   |   |
| Net income     |       |                                                                 | $          | 25,734                                                               |       |   |   | $ | (354 | ) |   |   | $ | 45,348 |   |   |   | $ | (354 | ) |   |

 

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**16.  ***BUSINESS SEGMENT INFORMATION*

The Company’s principal business segments are based onproduct and include:  Senior Managed Care—MedicareAdvantage, Senior Market Health Insurance, Specialty Health Insurance, LifeInsurance and Annuity and Senior Administrative Services. The Company alsoreports the activities of our holding company in a separate segment.Reclassifications have been made to conform prior year amounts to the currentyear presentation. A description of these segments follows:

**SeniorManaged Care—Medicare Advantage****—The**Senior ManagedCare—Medicare Advantage segment includes the operations of our initiatives inmanaged care for seniors. We operate various health plans, including SelectCareof Texas, that offer coverage to Medicare beneficiaries, under a contract withCMS, in Southeastern Texas, Oklahoma and Florida. The health plans are sold byour career and independent agents and directly by employee representatives. Inconnection with the health plans, we operate separate Management ServiceOrganizations (“MSO’s”) that manage that business and affiliated IndependentPhysician Associations (“IPA’s”). We participate in the net results derivedfrom these affiliated IPA’s. Our Medicare Advantage private fee-for-serviceplans, also under a contract with CMS, and are sold by our career andindependent agents. We currently market PFFS products in 459 countiesthroughout 15 states.

**SeniorMarket Health Insurance****—This** segment consists of ourMedicare Supplement business and other senior market health productsdistributed through our career agency sales force and through our network ofindependent general agencies, as well as our new Medicare Part D plansthat began offering prescription drug coverage for seniors on January 1,2006. The inclusion of the operating results from our Medicare Part Dbusiness with those of our Medicare Supplement business has resulted in anincrease in the level of seasonality in our reported results during a givencalendar year. These businesses generally see higher claim experience in theearly quarters of the year, with lower claims experience in the later quartersof the year, resulting in a pattern of increasing reported net incomeattributable to those businesses.

**SpecialtyHealth Insurance****—This** segment includes specialtyhealth insurance products, primarily fixed benefit accident and sicknessdisability insurance sold to the middle income self-employed market in theUnited States and Canada. This segment also includes certain products that weno longer sell such as long term care and major medical insurance. This segment’sproducts are distributed primarily by our career agents.

**LifeInsurance and Annuity****—This**segment includes all of thelife insurance and annuity business sold in the United States. This segment’sproducts include senior, traditional and universal life insurance and fixedannuities and are distributed through both independent general agents and ourcareer agency distribution systems.

**SeniorAdministrative Services****—Our** senior administrativeservices subsidiary acts as a third party administrator and service provider ofsenior market insurance products and geriatric care management for bothaffiliated and unaffiliated insurance companies. The services provided includepolicy underwriting and issuance, telephone and face-to-face verification,policyholder services, claims adjudication, case management, care assessment,referral to health care facilities and administration of our Part Dprescription drug plans on behalf of our subsidiaries which commenced on January 1,2006.

**Corporate****—This**segmentreflects the activities of Universal American, including debt service, certainsenior executive compensation, and compliance with requirements resulting fromour status as a public company.

Intersegment revenues and expenses are reported on agross basis in each of the operating segments but eliminated in theconsolidated results. These intersegment revenues and expenses affect theamounts reported on the individual financial statement line items, but areeliminated in consolidation and do not change income before taxes. Thesignificant items eliminated include intersegment revenue and expense 

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relating to servicesperformed by the Senior Administrative Services segment for our other segmentsand interest on notes payable or receivable between the Corporate segment andthe operating segments.

Financialdata by segment, including a reconciliation of segment revenues and segmentincome (loss) before income taxes to total revenue and net income in accordancewith generally accepted accounting principles is as follows:

| ** **                                   | ** ** | **Three months ended June 30,** | ** ** |
|----------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                   | ** ** | **2006**                                            | ** ** | **2005** | ** ** |
| ** **                                   | ** ** | **Revenue**                                         | ** ** | **Income  (Loss)  Before  Income  Taxes** | ** ** | **Revenue** | ** ** | **Income  (Loss)  Before  Income  Taxes** | ** ** |
| ** **                                   | ** ** | **(In thousands)**                             | ** ** |
| Senior Managed  Care—Medicare Advantage |       | $                                                   | 111,297    |   | $ | 10,371 |   | $ | 57,852 |   | $ | 7,089 |   |
| Senior Market  Health Insurance              |       | 173,975                                             |       | 8,316 |   | 97,983 |   | 8,449 |   |
| Specialty Health  Insurance                  |       | 44,615                                              |       | 8,017 |   | 43,713 |   | 6,798 |   |
| Life Insurance  and Annuity                  |       | 24,999                                              |       | 3,758 |   | 23,368 |   | 3,405 |   |
| Senior  Administrative Services              |       | 21,758                                              |       | 4,775 |   | 14,703 |   | 3,041 |   |
| Corporate                                    |       | 135                                                 |       | (6,388 | ) | 58 |   | (4,134 | ) |
| Intersegment  revenues                       |       | (15,610                                             | )          | — |   | (10,910 | ) | — |   |
| Adjustments to segment  amounts:             |       |                                                |       |   |   |   |   |   |   |
| Net realized gains(1)                        |       | 48                                                  |       | 48 |   | 3,030 |   | 3,030 |   |
| Total                                        |       | $                                                   | 361,217    |   | $ | 28,897 |   | $ | 229,797 |   | $ | 27,678 |   |

 

| ** **                                   | ** ** | **Six months ended June 30,** | ** ** |
|----------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                   | ** ** | **2006**                                          | ** ** | **2005** | ** ** |
| ** **                                   | ** ** | **Revenue**                                       | ** ** | **Income  (Loss)  Before  Income  Taxes** | ** ** | **Revenue** | ** ** | **Income  (Loss)  Before  Income  Taxes** | ** ** |
| ** **                                   | ** ** | **(In thousands)**                           | ** ** |
| Senior Managed  Care—Medicare Advantage |       | $                                                 | 202,332    |   | $ | 19,603 |   | $ | 111,129 |   | $ | 14,130 |   |
| Senior Market  Health Insurance              |       | 352,765                                           |       | 7,456 |   | 197,214 |   | 15,279 |   |
| Specialty Health  Insurance                  |       | 89,569                                            |       | 12,714 |   | 87,827 |   | 12,372 |   |
| Life Insurance  and Annuity                  |       | 50,041                                            |       | 4,800 |   | 46,201 |   | 7,445 |   |
| Senior  Administrative Services              |       | 41,962                                            |       | 7,202 |   | 29,611 |   | 6,656 |   |
| Corporate                                    |       | 350                                               |       | (11,869 | ) | 109 |   | (7,650 | ) |
| Intersegment  revenues                       |       | (30,321                                           | )          | — |   | (22,195 | ) | — |   |
| Adjustments to segment  amounts:             |       |                                              |       |   |   |   |   |   |   |
| Net realized gains(1)                        |       | 47                                                |       | 47 |   | 4,103 |   | 4,103 |   |
| Total                                        |       | $                                                 | 706,745    |   | $ | 39,953 |   | $ | 453,999 |   | $ | 52,335 |   |

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       (1) We evaluate the results of operations of our segments based onincome before realized gains and losses and income taxes. Management believesthat realized gains and losses are not indicative of overall operating trends.

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Identifiableassets by segment are as follows:

| ** **                                   | ** ** | **June 30,2006**   | ** ** | **December 31,2005** | ** ** |
|----------------------------------------------|------------|-------------------------|------------|---------------------------|------------|
| ** **                                   | ** ** | **(In thousands)** | ** ** |
| Senior Managed  Care—Medicare Advantage |       | $                       | 290,801    |                      |       | $ | 182,754 |   |   |
| Senior Market  Health Insurance              |       | 820,103                 |       |                      | 426,180    |   |   |
| Specialty Health  Insurance                  |       | 732,801                 |       |                      | 811,154    |   |   |
| Life Insurance  and Annuity                  |       | 755,176                 |       |                      | 744,185    |   |   |
| Senior  Administrative Services              |       | 28,011                  |       |                      | 26,149     |   |   |
| Corporate                                    |       | 710,265                 |       |                      | 705,409    |   |   |
| Intersegment  assets(1)                      |       | (683,672                | )          |                      | (667,852   | ) |   |
| Total Assets                                 |       | $                       | 2,653,485  |                      |       | $ | 2,227,979 |   |   |

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       (1) Intersegment assets include the elimination of the parent holdingcompany’s investment in its subsidiaries as well as the elimination of otherintercompany balances.

**17.   *FOREIGN OPERATIONS***

Aportion of the Company’s operations is conducted in Canada through PenncorpLife (Canada). These assets and liabilities are located in Canada where theinsurance risks are written. Revenues, excluding capital gains and losses, ofthe Company by geographic distribution by country are as follows:

| ** **    | ** ** | **Three months ended  June 30,** | ** ** | **Six months ended  June 30,** | ** ** |
|---------------|------------|-------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **    | ** ** | **2006**                                        | ** ** | **2005**                                      | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **    | ** ** | **(In thousands)**                         | ** ** |
| United States |       | $                                               | 340,877    |                                          | $          | 208,845 |   | $ | 666,344 |   | $ | 413,519 |   |
| Canada        |       | 20,292                                          |       | 17,922                                        |       | 40,354 |   | 36,377 |   |
| Total         |       | $                                               | 361,169    |                                          | $          | 226,767 |   | $ | 706,698 |   | $ | 449,896 |   |

 

Totalassets and liabilities of Penncorp Life (Canada), located entirely in Canada,are as follows:

| ** **  | ** ** | **June 30,  2006** | ** ** | **December 31,  2005** | ** ** |
|-------------|------------|-------------------------|------------|-----------------------------|------------|
| ** **  | ** ** | **(In thousands)** | ** ** |
| Assets      |       | $                       | 286,099    |                        |       | $ | 277,695 |   |   |
| Liabilities |       | $                       | 228,241    |                        |       | $ | 212,270 |   |   |

 

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**ITEM 2—**MANAGEMENT’S DISCUSSION AND ANALYSIS OFFINANCIAL CONDITION ANDRESULTS OF OPERATIONS

**Introduction**

The following discussionand analysis presents a review of the Company as of June 30, 2006 and itsresults of operations for the three and six months ended June 30, 2006,and 2005. The following analysis of our consolidated results of operations andfinancial condition should be read in conjunction with the consolidatedfinancial statements and related consolidated footnotes as well as theManagement’s Discussion and Analysis of Financial Condition and Results ofOperations included in our Annual Report on Form 10-K for the yearended December 31, 2005.

**Overview**

Our principal business segments are based on ourproducts and include: Senior Managed Care—Medicare Advantage, Senior MarketHealth Insurance, Specialty Health Insurance, Life Insurance and Annuity andSenior Administrative Services. We also report the activities of our holdingcompany in a separate segment. Reclassifications have been made to conformprior year amounts to the current year presentation. See “Note 16—BusinessSegment Information” in our consolidated financial statements included in thisQuarterly Report on Form 10-Q for a description of our segments.

Inter-segment revenues andexpenses are reported on a gross basis in each of the operating segments buteliminated in the consolidated results. These inter-segment revenues andexpenses affect the amounts reported on the individual financial statement lineitems, but are eliminated in consolidation and do not change income beforetaxes. The significant items eliminated include inter-segment revenue andexpense relating to services performed by the Senior Administrative Servicessegment for our other segments and interest on notes payable or receivablebetween the Corporate segment and the other operating segments.

**Critical AccountingPolicies**

Our consolidated financialstatements have been prepared in accordance with accounting principlesgenerally accepted in the United States (“GAAP”). The preparation of ourfinancial statements in conformity with GAAP requires us to make estimates andassumptions that affect the amounts of assets and liabilities and disclosuresof assets and liabilities reported by us at the date of the financial statementsand the revenues and expenses reported during the reporting period. Asadditional information becomes available or actual amounts become determinable,the recorded estimates may be revised and reflected in operating results.Actual results could differ from those estimates. Accounts that, in ourjudgment, are most critical to the preparation of our financial statementsinclude policy related liabilities, deferred policy acquisition costs,intangible assets, valuation of certain investments and deferred income taxes.There have been no changes in our critical accounting policies during thecurrent quarter.

***Accident & Health Insurance Policy relatedliabilities***

We calculate and maintainreserves for the estimated future payment of claims to our policyholders usingthe same actuarial assumptions that we use in the pricing of our products. Forour accident and health insurance business, we establish an active life reservefor expected future policy benefits, plus a liability for due and unpaidclaims, claims in the course of settlement and incurred but not reportedclaims. Many factors can affect these reserves and liabilities, such aseconomic and social conditions, inflation, hospital and pharmaceutical costs,changes in doctrines of legal liability, premium rate increases and extracontractual damage awards. Therefore, the reserves and liabilities we establishare based on estimates, assumptions and prior years’ statistics. When weacquire other insurance companies or blocks of insurance, our assessment of theadequacy of acquired policy liabilities is subject to similar estimates andassumptions. Establishing reserves involves inherent uncertainties, and it ispossible that actual claims 

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couldmaterially exceed our reserves and have a material adverse effect on ourresults of operations and financial condition. Our net income dependssignificantly upon the extent to which our actual claims experience isconsistent with the assumptions we used in setting our reserves and pricing ourpolicies. If our assumptions with respect to future claims are incorrect, andour reserves are insufficient to cover our actual losses and expenses, we wouldbe required to increase our liabilities resulting in reduced net income andshareholders’ equity.

***Deferred policy acquisition costs***

The cost of acquiring new accident & healthinsurance, life insurance and annuity business, principally non-levelcommissions, agency production, policy underwriting, policy issuance, andassociated costs, all of which vary with, and are primarily related to theproduction of new and renewal business, are deferred. For interest-sensitivelife and annuity products, these costs are amortized in relation to the presentvalue of expected gross profits on the policies arising principally frominvestment, mortality and expense margins in accordance with FAS No. 97, “Accountingand Reporting by Insurance Enterprises for Certain Long-DurationContracts and for Realized Gains and Losses from the Sale of Investments”. Forother life and accident & health products, these costs are amortizedin proportion to premium revenue using the same assumptions used in estimatingthe liabilities for future policy benefits in accordance with FAS No. 60, “Accountingand Reporting by Insurance Enterprises.” Amortization of deferred acquisitioncosts for Medicare Supplement policies is periodically adjusted for significantchanges in benefit structures and differences in assumed premium rates on aprospective basis, consistent with assumptions used in the related reserves forfuture policy benefits. During 2005, the Company determined that the historicalactual approved rate increases and persistency were higher than assumed levels.The prospective unlocking of these assumptions resulted in a sloweramortization of Medicare Supplement deferred acquisition costs.

The determination ofexpected gross profits for interest-sensitive products is an inherentlyuncertain process that relies on assumptions including projected interestrates, the persistency of the policies issued as well as anticipated benefits,commissions and expenses. It is possible that the actual profits from thebusiness may vary materially from the assumptions used in the determination andamortization of deferred acquisition costs. Deferred policy acquisition costs arewritten off to the extent that it is determined that future policy premiums andinvestment income or expected gross profits would not be adequate to recoverthe unamortized costs.

***Present value of future profits and other intangibles***

Business combinations accounted for as a purchaseresult in the allocation of the purchase consideration to the fair values ofthe assets and liabilities acquired, including the present value of futureprofits, establishing such fair values as the new accounting basis. The presentvalue of future profits is based on an estimate of the cash flows of thein-force business acquired, discounted to reflect the present value of thosecash flows. The discount rate selected depends upon the general marketconditions at the time of the acquisition and the inherent risk in thetransaction. Purchase consideration in excess of the fair value of net assetsacquired, including the present value of future profits and other identifiedintangibles, for a specific acquisition, is allocated to goodwill. Allocationof purchase price is performed in the period in which the purchase isconsummated. Adjustments, if any, in subsequent periods relate to resolution ofpre-acquisition contingencies and refinements made to estimates of fair valuein connection with the preliminary allocation.

Amortization of present value of future profits isbased upon the pattern of the projected cash flows of the in-force businessacquired, over weighted average lives ranging from six to forty years. Otheridentified intangibles are amortized over their estimated lives.

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On a periodic basis,management reviews the unamortized balances of present value of future profits,goodwill and other identified intangibles to determine whether events orcircumstances indicate the carrying value of such assets is not recoverable, inwhich case an impairment charge would be recognized. Management believes thatno impairments of present value of future profits, goodwill or other identifiedintangibles existed as of June 30, 2006.

***Investment valuation***

Fair value of investments is based upon quoted marketprices, where available, or on values obtained from independent pricingservices. For certain mortgage-backed and asset-backed securities, thedetermination of fair value is based primarily upon the amount and timing ofexpected future cash flows of the security. Estimates of these cash flows arebased upon current economic conditions, past credit loss experience and othercircumstances.

We regularly evaluate theamortized cost of our investments compared to the fair value of thoseinvestments. Impairments of securities generally are recognized when a declinein fair value below the amortized cost basis is considered to beother-than-temporary. Generally, we consider a decline in fair value to beother-than-temporary when the fair value of an individual security is belowamortized cost for an extended period and we do not believe that recovery infair value is probable. Impairment losses for certain mortgage-backed andasset-backed securities are recognized when an adverse change in the amount ortiming of estimated cash flows occurs, unless the adverse change is solely aresult of changes in estimated market interest rates and we intend to hold thesecurity until recovery. The cost basis for securities determined to beimpaired are reduced to their fair value, with the excess of the cost basisover the fair value recognized as a realized investment loss.

***Income taxes***

We use the liability method to account for deferredincome taxes. Under the liability method, deferred tax assets and liabilitiesare recognized for the future tax consequences attributable to differencesbetween the financial statement carrying amounts of existing assets andliabilities and their respective tax bases. Deferred tax assets and liabilitiesare measured using enacted tax rates expected to apply to taxable income in theyears in which those temporary differences are expected to be recovered orsettled. The effect on deferred tax assets and liabilities of a change in taxrates is recognized in income in the period that includes the enactment date ofa change in tax rates.

We establish valuationallowances on our deferred tax assets for amounts that we determine will not berecoverable based upon our analysis of projected taxable income and our abilityto implement prudent and feasible tax planning strategies. Increases in thesevaluation allowances are recognized as deferred tax expense. Subsequentdeterminations that portions of the valuation allowances are no longer necessaryare reflected as deferred tax benefits. To the extent that valuation allowanceswere established in conjunction with acquisitions, changes in those allowancesare first applied to increasing or decreasing the goodwill (but not below zero)or other intangibles related to the acquisition and then applied as an increaseor decrease in income tax expense.

**SignificantTransactions and Initiatives**

***Medicare Opportunity***

We believe that attractivegrowth opportunities exist in providing a range of products, particularlyhealth insurance, to the growing senior market. At present, more than44 million Americans are eligible for Medicare, the Federal program thatoffers basic hospital and medical insurance to people over 65 years old pluscertain disabled people under the age of 65. The standard Medicare coveragedoes not cover prescription drugs except as required in the course of a coveredhospital stay. According to the 

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U.S. CensusBureau, more than 2 million Americans turn 65 in the United States eachyear, and this number is expected to grow as the so-called baby boomersbegin to turn 65. In addition, many large employers who traditionally providedmedical and prescription drug coverage to their retirees have begun to curtailthese benefits. Finally, the passage of the Medicare Modernization Act of 2003(the “MMA”) demonstrated the Federal government’s commitment to expand thehealthcare options available to Medicare beneficiaries through the expansion ofMedicare managed care plans (“Medicare Advantage”) and the authorization of asubsidized prescription drug insurance benefit pursuant to Part D (“Part D”).Taken together, these conditions present significant opportunities for us toincrease the sale of our products. We expect to expand into new Part D andMedicare HMO markets and to expand our PFFS product from 15 to 35 states in2007. We anticipate that we will incur additional costs in order to executethese expansion initiatives during the fourth quarter of 2006; however, we willnot know the total projected costs until our expansion plans our finalized.

***Medicare Advantage***

As a result of the increased reimbursement rates fromthe Centers for Medicare and Medicaid Services (“CMS”), the Federal agency thatadministers the Medicare Advantage program, Medicare Advantage plans are ableto offer more attractive benefits including enhanced prescription drug coveragepursuant to Part D. Consequently, we believe that enrollment in MedicareAdvantage programs is likely to increase in the coming years.

We entered the MedicareAdvantage business in 2004 with the acquisition of Heritage Health Systems, Inc.which operates Medicare Advantage coordinated care plans in Southeastern Texas.Since 2005, we have expanded our service area to include 8 counties in Texas,10 counties in Oklahoma, and have begun to offer a coordinated care product in3 counties in Florida in 2006. In 2004, we also began to offer MedicareAdvantage private fee-for-service (“PFFS”) plans in New York and Pennsylvania.As of January 2006, we are marketing PFFS plans in a total of 15 states.

***Medicare Supplement***

Medicare Supplement insurance reimburses thepolicyholder for certain expenses that are not covered by standard Medicarecoverage such as deductibles and co-pays. This coverage is designed for peoplewho want the freedom to choose providers who participate in the standardMedicare program, as opposed to the more restrictive networks that exist inMedicare Advantage products. In the past ten years, we have become a successfulprovider of Medicare Supplement coverage as well as other products designed forthe senior market. We believe that the market for Medicare Supplement productswill continue to be attractive, especially because many seniors may losesimilar coverage that had previously been offered to them as a retiree benefitby their former employers.

Recently, there has beenincreased competition from other Medicare Supplement carriers, as well as fromMedicare Advantage plans, which has affected our production and persistency ofMedicare Supplement business. As a result, we continue to experience higherthan expected lapsation in our Medicare Supplement business. This excesslapsation has accelerated the amortization of the deferred acquisition cost andpresent value of future profits assets associated with the business thatlapsed. We cannot give assurances that lapsation of our Medicare Supplementbusiness will decline, requiring faster amortization of the deferred costs.

***Medicare Part D***

Effective January 1, 2006, private insurers werepermitted to sponsor insured stand-alone prescription drug benefit plans (“PDPs”)pursuant to Part D, which was established by the MMA. A portion of thepremium for this insurance is paid by the Federal government, and the balance,if any, is paid by the 

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individuals who enroll.The Federal government will also provide additional subsidies in the form ofpremium support and coverage of the cost-sharing elements of the plan tocertain low income Medicare beneficiaries. We have been approved to offer theseprograms in 32 of the 34 regions that have been established for this programfor the 2006 plan year and had bids below the benchmark in 26 regions. As aresult, we were auto-assigned approximately 328,000 Medicare and Medicaideligible (dual eligible) and facilitated enrollees by CMS for the current planyear. We believe that this new program provides increased opportunities tooffer a much needed coverage and to further serve our target markets.

We have entered into astrategic alliance with PharmaCare Management services, Inc. (“PharmaCare”),a pharmacy benefits manager (“PBM”) that is a wholly-owned subsidiary of CVSCorporation. PharmaCare performs PBM services for our Medicare Part DPlans. We retain 50% of the Medicare Part D business of our PDPs. Theremainder is reinsured to PharmaCare’s wholly-owned reinsurance subsidiary,PharmaCare Captive Re, Ltd (“PharmaCare Re”) on a 50% quota share basis. Additionally,as part of the strategic alliance, we created Part D Management Services,L.L.C. (“PDMS”), which is 50% owned by Universal American and 50% owned byPharmaCare. PDMS principally performs marketing and risk management services onbehalf of our PDPs and PharmaCare.

***Reinsurance—Connecticut State Employees***

During the third quarterof 2005, we began to provide an insured drug benefit for the employees of theState of Connecticut. This coverage is renewable annually by the State ofConnecticut. The risk is reinsured to PharmaCare’s wholly-owned reinsurancesubsidiary, PharmaCare Re on a 100% first dollar quota share basis. We receivean underwriting fee of two percent of premium. As a result of this arrangement,both direct and ceded premium increased by approximately $140.3 million for thesix months ended June 30, 2006, with no impact on net premium.

**Results of Operations—ConsolidatedOverview**

The inclusion of the operating results from ourMedicare Part D business with those of our Medicare Supplement businesshas resulted in an increase in the level of seasonality in our reported resultsduring a given calendar year. These businesses generally see higher claimexperience in the early quarters of the year, with lower claims experience inthe later quarters of the year, resulting in a pattern of increasing reportednet income over the calendar year attributable to those businesses.

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Thefollowing table reflects income from each of our segments(1) and containsa reconciliation to reported net income:

| ** **                                 | ** ** | **Three months endedJune 30,** | ** ** | **Six months endedJune 30,** | ** ** |
|--------------------------------------------|------------|-----------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                 | ** ** | **2006**                                      | ** ** | **2005**                                    | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                 | ** ** | **(In thousands)**                       | ** ** |
| Senior Managed  Care-Medicare Advantage(1) |       | $                                             | 10,371     |                                        | $          | 7,089 |   | $ | 19,603 |   | $ | 14,130 |   |
| Senior Market  Health Insurance(1)         |       | 8,316                                         |       | 8,449                                       |       | 7,456 |   | 15,279 |   |
| Specialty Health  Insurance(1)             |       | 8,017                                         |       | 6,798                                       |       | 12,714 |   | 12,372 |   |
| Life Insurance  and Annuity(1)             |       | 3,758                                         |       | 3,405                                       |       | 4,800 |   | 7,445 |   |
| Senior  Administrative Services(1)         |       | 4,775                                         |       | 3,041                                       |       | 7,202 |   | 6,656 |   |
| Corporate(1)                               |       | (6,388                                        | )          | (4,134                                      | )          | (11,869 | ) | (7,650 | ) |
| Realized gains                             |       | 48                                            |       | 3,030                                       |       | 47 |   | 4,103 |   |
| Income before  income taxes(1)             |       | 28,897                                        |       | 27,678                                      |       | 39,953 |   | 52,335 |   |
| Income taxes, excluding realized gains     |       | 10,770                                        |       | 8,970                                       |       | 14,807 |   | 17,179 |   |
| Income taxes on realized gains             |       | 17                                            |       | 60                                          |       | 16 |   | 436 |   |
| Total income taxes                         |       | 10,787                                        |       | 9,030                                       |       | 14,823 |   | 17,615 |   |
| Net income                                 |       | $                                             | 18,110     |                                        | $          | 18,648 |   | $ | 25,130 |   | $ | 34,720 |   |
| Per Share Data  (Diluted):                 |       |                                          |       |                                        |       |   |   |   |   |
| Net income                                 |       | $                                             | 0.30       |                                        | $          | 0.32 |   | $ | 0.42 |   | $ | 0.60 |   |

----

       (1) We evaluate the results of operations of oursegments based on income before realized gains and income taxes. Managementbelieves that realized gains and losses are not indicative of overall operatingtrends. This differs from generally accepted accounting principles, whichincludes the effect of realized gains in the determination of net income. Theschedule above reconciles our segment income to net income in accordance withgenerally accepted accounting principles.

***Three months ended June 30, 2006 and 2005***

Net income for the second quarter of 2006 declined to$18.1 million, or $0.30 per diluted share, compared to $18.6 million, or $0.32per diluted share for the second quarter of 2005. Net income for the secondquarter of 2005 includes realized investment gains, net of tax, of $3.0million, or $0.05 per diluted share, which reflects the benefit from a $1.0million release of a tax valuation allowance relating to net capital losscarryforwards. The realized investment gains during the second quarter of 2005were generated as we took advantage of the tightening of the yield curve andsold longer duration investments. Our overall effective tax rate was 37.3% forthe second quarter of 2006, and 32.6% for the second quarter of 2005,reflecting the release of the valuation allowance noted above.

Our Senior Managed Care—Medicare Advantage segmentgenerated segment income of $10.4 million during the second quarter of2006, an increase of $3.3 million, compared to $7.1 million for the secondquarter of 2005, primarily due to the continued growth in membership in ourMedicare Advantage plans.

Our Senior Market Health Insurance segmenthistorically has included our Medicare Supplement business and other healthinsurance products designed for the senior market. On January 1, 2006, webegan covering prescription drug benefits in accordance with Medicare Part Das a stand-alone benefit to Medicare eligible beneficiaries under PDPs. TheSenior Market Health Insurance segment income declined by $0.1 million to $8.3million for the second quarter of 2006, compared to $8.4 million for the secondquarter of 2005. Results for our Medicare Supplement business declined by $8.4million, compared to the second quarter of 2005, as a result of increased lossratios and the continued effect of higher than expected lapsation of ourMedicare Supplement in force business, which resulted in an acceleration of the

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amortization of deferredacquisition costs and present value of future profits. This was substantiallyoffset by the segment income of $7.9 million generated by our Part Dbusiness for the second quarter of 2006, compared to a loss of $0.4 million forthe second quarter of 2005.

Our Specialty Health Insurance segment incomeincreased by $1.2 million, or 18%, compared to the second quarter of 2005,primarily as a result of the underwriting fees earned on the reinsurancearrangement with PharmaCare Re and the strengthening of the Canadian dollar.

Segment income from our Life Insurance and Annuitysegment increased by $0.4 million, compared to the second quarter of 2005,primarily as a result of a decrease in claim costs.

Segment income for our Senior Administrative Servicessegment increased by $1.7 million, or 57%, to $4.8 million for the secondquarter of 2006, as compared to the same period of 2005. This increase isprimarily the result of new business administered.

The loss from ourCorporate segment increased by $2.3 million, or 55%, for the three months endedJune 30, 2006 compared to the three months ended June 30, 2005. Theincrease was due primarily to the increase in stock-based compensation expenseas a result of the adoption of FAS 123-R, costs of due diligence andhigher interest cost.

***Six months ended June 30, 2006 and 2005***

Net income for the first six months of 2006 declinedto $25.1 million, or $0.42 per diluted share, compared to $34.7 million, or$0.60 per diluted share for the first six months of 2005. Net income for thefirst six months of 2006 was affected by higher claim costs in our MedicareSupplement, long term care and life businesses and increased lapsation of ourMedicare Supplement in force business, which resulted in an acceleration of theamortization of deferred acquisition costs and present value of future profits.These items are offset, in part, by the growth in our Senior Managed Carebusiness and the income from our new Part D business.

Net income for the first six months of 2005 includesrealized investment gains, net of tax, of $3.7 million, or $0.06 perdiluted share, which reflects the benefit from a $1.0 million release of a taxvaluation allowance relating to net capital loss carryforwards. The realizedinvestment gains during the second quarter of 2005 were generated as we tookadvantage of the tightening of the yield curve and sold longer durationinvestments.

Our overall effective tax rate was 37.1% for the firstsix months of 2006, and 33.7% for the first six months of 2005, reflecting therelease of the valuation allowance noted above.

Our Senior Managed Care—Medicare Advantage segment generatedsegment income of $19.6 million during the first six months of 2006, anincrease of $5.5 million, compared to $14.1 million for the first six months of2005, primarily due to the continued growth in membership in our Medicare Advantageplans.

The Senior Market Health Insurance segment incomedeclined by $7.8 million to $7.5 million for the first six months of 2006,compared to segment income of $15.3 million for the first six months of 2005. Resultsfor our Medicare Supplement business declined by $21.6 million, compared to thefirst six months of 2005, as a result of increased loss ratios and thecontinued effect of higher than expected lapsation of our Medicare Supplementin force business, which resulted in an acceleration of the amortization ofdeferred acquisition costs and present value of future profits. This wasoffset, in part, by the segment income of $13.3 million generated by our Part Dbusiness for the first six months of 2006, compared to a loss of $0.4 millionfor the first six months of 2005.

Our Specialty Health Insurance segment incomeincreased by $0.3 million, or 3%, compared to the first six months of 2005. Theunderwriting fees earned on the reinsurance arrangement with 

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PharmaCare Re and thestrengthening of the Canadian dollar were partially offset by higher claimcosts in our runoff block of long term care business.

Segment income from our Life Insurance and Annuitysegment decreased by $2.6 million, compared to the first six months of 2005,primarily as a result of an increase in claim costs and an increase in theamortization of deferred acquisition costs.

Segment income for our Senior Administrative Servicessegment increased by $0.5 million, or 8%, to $7.2 million for the first sixmonths of 2006, as compared to the same period of 2005. This increase isprimarily the result of new business administered, offset in part by the $1.2million incremental increase in expenses incurred in this segment relating to Part D,as compared to 2005.

The loss from our Corporatesegment increased by $4.2 million, or 55%, for the six months ended June 30,2006 compared to the six months ended June 30, 2005. The increase was dueprimarily to the increase in stock-based compensation expense as a result ofthe adoption of FAS 123-R, costs of due diligence and higher interestcost.

**Segment Results—Senior Managed Care—Medicare Advantage**

| ** **                                                                              | ** ** | **Three months endedJune 30,** | ** ** | **Six months ended  June 30,** | ** ** |
|-----------------------------------------------------------------------------------------|------------|-----------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                                                              | ** ** | **2006**                                      | ** ** | **2005**                                      | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                                                              | ** ** | **(In thousands)**                       | ** ** |
| Net premiums                                                                            |       | $                                             | 110,036    |                                          | $          | 57,093 |   | $ | 199,995 |   | $ | 109,930 |   |
| Net investment  and other income                                                        |       | 1,261                                         |       | 759                                           |       | 2,337 |   | 1,199 |   |
| Total revenue                                                                           |       | 111,297                                       |       | 57,852                                        |       | 202,332 |   | 111,129 |   |
| Medical expenses                                                                        |       | 80,680                                        |       | 41,512                                        |       | 146,880 |   | 79,016 |   |
| Amortization of  intangible assets                                                      |       | 870                                           |       | 247                                           |       | 1,740 |   | 1,003 |   |
| Commissions and  general expenses                                                       |       | 19,376                                        |       | 9,004                                         |       | 34,109 |   | 16,980 |   |
| Total benefits, claims and other deductions                                             |       | 100,926                                       |       | 50,763                                        |       | 182,729 |   | 96,999 |   |
| Segment income                                                                          |       | 10,371                                        |       | 7,089                                         |       | 19,603 |   | 14,130 |   |
| Depreciation,  amortization and interest                                                |       | 1,125                                         |       | 403                                           |       | 2,059 |   | 1,293 |   |
| Earnings before  interest, taxes, depreciation and amortization (“EBITDA”)(1) |       | $                                             | 11,496     |                                          | $          | 7,492 |   | $ | 21,662 |   | $ | 15,423 |   |

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       (1) In addition to segment income, we also evaluate the results of ourMedicare Advantage segment based on earnings before interest, taxes,depreciation and amortization (“EBITDA”). EBITDA is a common alternativemeasure of performance used by investors, financial analysts and ratingagencies. It is also a measure that is included in the fixed charge ratiorequired by the covenants for our outstanding bank debt. Accordingly, thesegroups use EBITDA, along with other measures, to estimate the value of acompany and evaluate the Company’s ability to meet its debt servicerequirements. While we consider EBITDA to be an important measure of comparativeoperating performance, it should not be construed as an alternative to segmentincome or cash flows from operating activities (as determined in accordancewith generally accepted accounting principles).

Our Senior Managed Care—MedicareAdvantage segment includes the operations of our initiatives in managed carefor seniors. We operate various health plans, including SelectCare of Texas,that offer coverage to Medicare beneficiaries, under a contract with CMS, inSoutheastern Texas, Oklahoma and Florida. The health plans are sold by ourcareer and independent agents and directly by employee representatives. Inconnection with the health plans, we operate separate Management ServiceOrganizations (“MSO’s”) that manage that business and affiliated IndependentPhysician Associations (“IPA’s”). We participate in the net results derivedfrom these affiliated IPA’s. Our Medicare Advantage 

34

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PFFSplans, also under a contract with CMS, are sold by our career and independentagents through American Progressive and Pyramid Life.

***Three months ended June 30, 2006 and 2005***

*Revenues.*   Netpremiums for the Senior Managed Care segment increased by $52.9 million, or93%, compared to the second quarter of 2005. Approximately $49.9 million of theincrease was due to growth in membership. Pursuant to the MMA, we began toreceive incremental revenue from CMS for the Part D prescription drugbenefit in 2006. In the second quarter of 2006, our health plans received $7.7million from CMS for the Part D prescription drug benefit. Those increaseswere partially offset by the reduction in the average premium per member permonth (“PMPM”) due to an increase in the percentage of members in our PFFSplans which have a lower PMPM than our health plans. Net investment and otherincome increased by $0.5 million, due primarily to growth in invested assets asa result of growth in business, as well as increased yields.

*Benefits,Claims and Expenses.*   Medical expenses increasedby $39.2 million, or 94%, compared to the second quarter of 2005. Growth inmembership added approximately $30.8 million. The enhanced prescription drugbenefit increased pharmacy benefit costs by $3.6 million to $6.2 million. Thebalance of $4.8 million was due to an increase in the loss ratio. Overall lossratios for the segment increased by 60 basis points to 73.3% for the secondquarter of 2006 from 72.7% for the second quarter of 2005. Commissions andgeneral expenses increased by $10.4 million compared to the second quarter of2005, due primarily to the growth in business, including marketing costs fornew service areas and other development activities, as well as an increase incommissions, as more of the Medicare Advantage product is being sold by ouragents.

Thecomponents of the revenues and results within the segment are as follows:

| ** **                | ** ** | **Three months ended June 30,** | ** ** |
|---------------------------|------------|-----------------------------------------------------|------------|
| ** **                | ** ** | **2006**                                            | ** ** | **2005** | ** ** |
| ** **                | ** ** | **Revenue**                                         | ** ** | **Segment Income** | ** ** | **Revenue** | ** ** | **Segment Income** | ** ** |
| ** **                | ** ** | **(In thousands)**                             | ** ** |
| Health Plans              |       | $                                                   | 82,682     |   |   | $ | 3,446 |   |   | $ | 52,907 |   |   | $ | 2,271 |   |   |
| Affiliated IPA’s     |       | 35,328                                              |       |   | 2,988 |   |   | 28,890 |   |   | 2,838 |   |   |
| MSO’s and  Corporate |       | 11,375                                              |       |   | 520 |   |   | 8,143 |   |   | 1,692 |   |   |
| Private Fee-for  Service  |       | 28,114                                              |       |   | 3,417 |   |   | 4,606 |   |   | 288 |   |   |
| Eliminations              |       | (46,202                                             | )          |   | — |   |   | (36,694 | ) |   | — |   |   |
| Total                     |       | $                                                   | 111,297    |   |   | $ | 10,371 |   |   | $ | 57,852 |   |   | $ | 7,089 |   |   |

 

Intra-segment revenues are reported on a gross basisin each of the above components of the Medicare Advantage segment. Theseintra-segment revenues are eliminated in the consolidation for the segmenttotals. The eliminations include premiums received by the IPA’s from our healthplans amounting to $35.1 million for three months ended June 30, 2006 and$28.8 million for three months ended June 30, 2005 and management feesreceived by the MSO’s from the health plans and the IPA’s amounting to $11.1 millionfor three months ended June 30, 2006 and $7.9 million for three monthsended June 30, 2005.

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Our health plans receive premiums primarily from CMS.As of June 30, 2006, there were 32,778 members in these health plans.Membership is based on enrollment information provided by CMS, which enrollmentinformation is subject to reconciliation with CMS. The health plans makecapitated risk payments to the IPA’s or other medical groups in the Houston andBeaumont regions, two of which are affiliated IPA’s. In addition, the healthplans retain the risk for certain other types of care, primarily out of area emergencyand transplants. In August 2005, we began enrolling members in a MedicareAdvantage special needs program. Beginning January 1, 2006, we beganenrolling members in our Medicare Advantage coordinated care plan in SouthFlorida. During the second quarter of 2006, the health plans had revenues of$82.7 million and reported a medical loss ratio of 81.1% versus revenues of$52.9 million and a medical loss ratio of 82.6% in the second quarter of 2005.

We participate in the profits from the two affiliatedIPA’s that receive capitated payments from SelectCare of Texas. As ofJune 30, 2006, the affiliated IPA’s managed the care for 17,320 members.During the second quarter of 2006, the IPA’s earned $3.0 million on $35.3million in revenues. For the second quarter of 2005, the IPA’s earned $2.8million on $28.9 million in revenues.

Our MSO’s provide comprehensive management services toour health plans and affiliated IPA’s as part of long-term managementagreements. Services provided include strategic planning, provider networkservices, marketing, finance and accounting, enrollment, claims processing,information systems, utilization review, credentialing and quality management.For the second quarter of 2006, these MSO’s earned $0.5 million on $11.4million of fees collected. For the second quarter of 2005, these MSO’s earned$1.7 million of income on $8.1 million of fees collected. The reduction inearnings from MSO’s and Corporate is primarily due to the cost of marketing,development and expansion initiatives relating to our Medicare Advantageprograms.

Starting inJune 2004, we began enrolling members in our PFFS product, a MedicareAdvantage program that allows its members to have more flexibility in thedelivery of their health care services than other Medicare Advantage plans. Inaddition to premium received from CMS, we receive modest premium payments fromthe members. Beginning September 1, 2005, we expanded our PFFS productoffering to Medicare eligibles in 258 counties in seven new states. OnJanuary 1, 2006, we expanded the PFFS product to an additional 152counties in six states for a total service area of 459 counties in 15 states.As of June 30, 2006, we had 15,446 members enrolled in our PFFS plans.During the second quarter of 2006, we collected $28.1 million of premium fromCMS and the members, and reported a medical loss ratio of 73.7%. For the secondquarter of 2005, we collected $4.6 million of premium from CMS and the members,and reported a medical loss ratio of 68.9%.

***Six months ended June 30, 2006 and 2005***

*Revenues.*   Netpremiums for the Senior Managed Care segment increased by $90.1 million, or82%, compared to the first six months of 2005. Approximately $84.4 million ofthe increase was due to growth in membership. Pursuant to the MMA, we began toreceive incremental revenue from CMS for the Part D prescription drugbenefit in 2006. For the first six months of 2006, our health plans received$14.4 million from CMS for the Part D prescription drug benefit. Those increaseswere partially offset by the reduction in the average premium per member permonth (“PMPM”) due to an increase in the percentage of members in our PFFSplans which have a lower PMPM than our health plans. Net investment incomeincreased by $1.3 million, due primarily to growth in invested assets as aresult of growth in business, as well as increased yields.

*Benefits,Claims and Expenses.*   Medical expenses increasedby $67.9 million, or 86%, compared to the first six months of 2005. Growth inmembership added approximately $51.1 million. The enhanced prescription drugbenefit increased pharmacy benefit costs by $7.3 million to $12.1 million. Thebalance of $9.5 million was due to an increase in the loss ratio. Overall lossratios for the segment increased by 150 

36

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basis points to 73.4% forthe first six months of 2006 from 71.9% for the first six months of 2005.Commissions and general expenses increased by $17.1 million compared to thefirst six months of 2005, due primarily to the growth in business, includingmarketing costs for new service areas and other development activities, as wellas an increase in commissions, as more of the Medicare Advantage product isbeing sold by our agents.

Thecomponents of the revenues and results within the segment are as follows:

| ** **                | ** ** | **Six months ended June 30,** | ** ** |
|---------------------------|------------|---------------------------------------------------|------------|
| ** **                | ** ** | **2006**                                          | ** ** | **2005** | ** ** |
| ** **                | ** ** | **Revenue**                                       | ** ** | **Segment Income** | ** ** | **Revenue** | ** ** | **Segment Income** | ** ** |
| ** **                | ** ** | **(In thousands)**                           | ** ** |
| Health Plans              |       | $                                                 | 156,824    |   |   | $ | 5,459 |   |   | $ | 102,576 |   |   | $ | 4,865 |   |   |
| Affiliated IPA’s     |       | 70,963                                            |       |   | 6,517 |   |   | 57,655 |   |   | 5,556 |   |   |
| MSO’s and  Corporate |       | 21,773                                            |       |   | 1,615 |   |   | 15,830 |   |   | 3,413 |   |   |
| Private Fee-for  Service  |       | 44,471                                            |       |   | 6,012 |   |   | 7,963 |   |   | 296 |   |   |
| Eliminations              |       | (91,699                                           | )          |   | — |   |   | (72,895 | ) |   | — |   |   |
| Total                     |       | $                                                 | 202,332    |   |   | $ | 19,603 |   |   | $ | 111,129 |   |   | $ | 14,130 |   |   |

 

Intra-segment revenues are reported on a gross basisin each of the above components of the Medicare Advantage segment. Theseintra-segment revenues are eliminated in the consolidation for the segmenttotals. The eliminations include premiums received by the IPA’s from our healthplans amounting to $70.5 million for the first six months of 2006 and $57.4million for the first six months of 2005 and management fees received by theMSO’s from the health plans and the IPA’s amounting to $21.2 million for thefirst six months of 2006 and $15.5 million for the first six months of 2005.

During the first six months of 2006, our health planshad revenues of $156.8 million and reported a medical loss ratio of 82.3%versus revenues of $102.6 million and a medical loss ratio of 82.0% for thefirst six months of 2005.

During the first six months of 2006, the IPA’s earned$6.5 million on $71.0 million in revenues. For the first six months of 2005,the IPA’s earned $5.6 million on $57.7 million in revenues.

For the first six months of 2006, our MSO’s earned $1.6million of income on $21.8 million of fees collected. For the first six monthsof 2005, these MSO’s earned $3.4 million of income on $15.8 million of feescollected.

During the first six months of 2006, we collected$44.5 million of premium from CMS and the members for our PFFS product, andreported a medical loss ratio of 72.8%. For the first six months of 2005, wecollected $8.0 million of premium from CMS and the members for our PFFSproduct, and reported a medical loss ratio of 71.5%.

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**Segment Results—Senior Market Health Insurance**

| ** **                                           | ** ** | **Three months endedJune 30,** | ** ** | **Six months ended  June 30,** | ** ** |
|------------------------------------------------------|------------|-----------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                           | ** ** | **2006**                                      | ** ** | **2005**                                      | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                           | ** ** | **(In thousands)**                       | ** ** |
| **Premiums:**                                        | ** ** | ** **                                    | ** ** | ** **                                    | ** ** | ** ** | ** ** | ** ** | ** ** |
| Direct and assumed                                   |       | $                                             | 257,787    |                                          | $          | 141,134 |   | $ | 531,822 |   | $ | 289,589 |   |
| Ceded                                                |       | (100,109                                      | )          | (44,474                                       | )          | (207,643 | ) | (95,066 | ) |
| Net premiums                                         |       | 157,678                                       |       | 96,660                                        |       | 324,179 |   | 194,523 |   |
| Other Part D  revenue                           |       | 12,867                                        |       | —                                        |       | 22,674 |   | — |   |
| Net investment  income                               |       | 2,631                                         |       | 1,147                                         |       | 4,601 |   | 2,363 |   |
| Other income                                         |       | 799                                           |       | 176                                           |       | 1,311 |   | 328 |   |
| Total revenue                                        |       | 173,975                                       |       | 97,983                                        |       | 352,765 |   | 197,214 |   |
| Policyholder  benefits                               |       | 129,155                                       |       | 69,891                                        |       | 274,734 |   | 141,160 |   |
| Change in  deferred acquisition costs                |       | (1,713                                        | )          | (10,365                                       | )          | (4,501 | ) | (18,983 | ) |
| Amortization of  intangible assets                   |       | 994                                           |       | 725                                           |       | 2,289 |   | 1,431 |   |
| Commissions and  general expenses, net of allowances |       | 37,223                                        |       | 29,283                                        |       | 72,787 |   | 58,327 |   |
| Total benefits, claims and other deductions          |       | 165,659                                       |       | 89,534                                        |       | 345,309 |   | 181,935 |   |
| Segment income                                       |       | $                                             | 8,316      |                                          | $          | 8,449 |   | $ | 7,456 |   | $ | 15,279 |   |

 

Our Senior Market HealthInsurance segment historically has included our Medicare Supplement businessand other health insurance products designed for the senior market. On January 1,2006, we began covering prescription drug benefits in accordance with Medicare Part Das a stand-alone benefit to Medicare eligible beneficiaries under PDPs. Wereinsure 50% of the business of our PDPs to PharmaCare Re. The total resultsfor the segment are presented above. Results for our Medicare Supplementbusiness are separately presented below on a comparative basis. Additionally,we have also separately presented the results for our Part D business.

***Three months ended June 30, 2006 and 2005***

The Senior Market HealthInsurance segment income declined by $0.1 million to $8.3 million for thesecond quarter of 2006, compared to $8.4 million for the second quarter of 2005.Results for our Medicare Supplement business declined by $8.4 million, comparedto the second quarter of 2005, as a result of increased loss ratios and thecontinued effect of higher than expected lapsation of our Medicare Supplementin force business, which resulted in an acceleration of the amortization ofdeferred acquisition costs and present value of future profits. This wassubstantially offset by the segment income of $7.9 million generated byour Part D business for the second quarter of 2006, compared to a loss of$0.4 million for the second quarter of 2005. 

***Six months ended June 30, 2006 and 2005***

The Senior Market HealthInsurance segment income declined by $7.8 million to $7.5 million for the firstsix months of 2006, compared to segment income of $15.3 million for the firstsix months of 2005. Results for our Medicare Supplement business declined by$21.6 million, compared to the first six months of 2005, as a result ofincreased loss ratios and the continued effect of higher than expectedlapsation of our Medicare Supplement in force business, which resulted in anacceleration of the amortization of deferred acquisition costs and presentvalue of future profits. This was offset, in part, by the segment income of$13.3 million generated by our Part D business for the first six months of2006, compared to a loss of $0.4 million for the first six months of 2005.. 

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**Medicare Supplement**

| ** **                                           | ** ** | **Three months endedJune 30,** | ** ** | **Six months ended  June 30,** | ** ** |
|------------------------------------------------------|------------|-----------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                           | ** ** | **2006**                                      | ** ** | **2005**                                      | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                           | ** ** | **(In thousands)**                       | ** ** |
| Premiums:                                            |       |                                          |       |                                          |       |   |   |   |   |
| Direct and assumed                                   |       | $                                             | 127,782    |                                          | $          | 141,134 |   | $ | 267,002 |   | $ | 289,589 |   |
| Ceded                                                |       | (36,221                                       | )          | (44,474                                       | )          | (77,068 | ) | (95,066 | ) |
| Net premiums                                         |       | 91,561                                        |       | 96,660                                        |       | 189,934 |   | 194,523 |   |
| Net investment  income                               |       | 1,995                                         |       | 1,147                                         |       | 3,483 |   | 2,363 |   |
| Other income                                         |       | 781                                           |       | 176                                           |       | 1,276 |   | 328 |   |
| Total revenue                                        |       | 94,337                                        |       | 97,983                                        |       | 194,693 |   | 197,214 |   |
| Policyholder  benefits                               |       | 65,722                                        |       | 69,891                                        |       | 144,435 |   | 141,160 |   |
| Change in  deferred acquisition costs                |       | (1,713                                        | )          | (10,365                                       | )          | (4,501 | ) | (18,983 | ) |
| Amortization of  intangible assets                   |       | 994                                           |       | 725                                           |       | 2,289 |   | 1,431 |   |
| Commissions and  general expenses, net of allowances |       | 28,878                                        |       | 28,848                                        |       | 58,315 |   | 57,892 |   |
| Total benefits, claims and other deductions          |       | 93,881                                        |       | 89,099                                        |       | 200,538 |   | 181,500 |   |
| Segment income (loss)                                |       | $                                             | 456        |                                          | $          | 8,884 |   | $ | (5,845 | ) | $ | 15,714 |   |

 

***Three months ended June 30, 2006 and 2005***

*Revenues.**  *Net premiums for our Medicare Supplement businessdeclined by $5.1 million, compared to the second quarter of 2005, due to thecontinued effect of higher than expected lapsation of our Medicare Supplementin force business, offset in part by increased retention of our MedicareSupplement business, rate increases and new sales. 

Net investment income increased by approximately $0.8million, compared to the second quarter of 2005, due to an increase in investedassets as well as an increase in portfolio yields.

*Benefits,Claims and Expenses.**  *Policyholderbenefits incurred decreased by $4.2 million, or 6%, compared to the secondquarter of 2005. The reduction in business, as noted above, resulted in adecline of $3.7 million. Improved loss ratios resulted in a decline of $0.5million. Overall loss ratios declined 50 basis points to 71.8% for the secondquarter of 2006 compared to 72.3% for the second quarter of 2005, as a resultof the rate increases we have implemented in the past year. We anticipate thatwe will see seasonal reductions in the overall loss ratio for this segmentduring the third and fourth quarters of 2006. After consideration of certainadjustments made at the end of 2005 to increase claim reserves, the loss ratiofor the quarter ended June 30, 2005 was 73.4%, or 160 basis points higherthan the second quarter of 2006.

The increase in deferred acquisition costs was $8.7million less for the second quarter of 2006 than the increase for the secondquarter of 2005. Two factors contributed to the decrease. First, we incurredlower commissions and other acquisition costs as a result of lower production,resulting in a decrease in the costs capitalized of $3.5 million. Second,amortization increased by approximately $5.0 million as a result of higherlapsation of our Medicare Supplement business, compared to the second quarterof 2005. We began to experience higher than expected lapsation in our MedicareSupplement business in the third quarter of 2005 that continued and worsened inthe first quarter of 2006. This excess lapsation moderated somewhat in thesecond quarter of 2006, but not as much as we anticipated. We believe thatthere are a number of factors contributing to the lapsation, primarilycompetitive pressure from Medicare Advantage products, as well as increasedcompetition from other Medicare Supplement carriers. This increase in lapsationhas accelerated the amortization of the deferred acquisition cost and presentvalue of future profits assets associated with the business that lapsed. 

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The amortization of intangibles relates primarily tointangibles recorded from the acquisition of Pyramid Life, and increased by$0.3 million compared to the second quarter of 2005, due to the increase inlapsation of in force business noted above.

Commissionsand general expenses, net of reinsurance allowances, were level with the secondquarter of 2005. The following table details the components of commission andother operating expenses:

| ** **                                           | ** ** | **2006**                | ** ** | **2005** | ** ** |
|------------------------------------------------------|------------|-------------------------|------------|----------|------------|
| ** **                                           | ** ** | **(In thousands)** | ** ** |
| Commissions                                          |       | $                       | 17,312     |     | $          | 20,622 |   |
| Other operating  costs                               |       | 18,308                  |       | 17,801   |       |
| Reinsurance  allowances                              |       | (6,742                  | )          | (9,575   | )          |
| Commissions and general  expenses, net of allowances |       | $                       | 28,878     |     | $          | 28,848 |   |

 

The ratio of commissionsto gross premiums decreased to 13.4% for the second quarter of 2006, from 14.6%for the second quarter of 2005, as a result of lower overall commission ratesassociated with the continued growth of our in force renewal premium and lessnew business production that has higher commission rates. Other operating costsas a percentage of gross premiums were 14.3% for the second quarter of 2006,compared to 12.6% for the second quarter of 2005 due to lower premium revenues,the ratio of fixed to variable costs, and certain non-recurring legal andconsulting costs incurred. Commission and expense allowances received fromreinsurers as a percentage of the premiums ceded decreased to 18.6% for thesecond quarter of 2006 from 21.5% for the second quarter of 2005, primarily dueto the reduction in new business ceded and the effects of normal lowercommission allowances on our aging base of ceded renewal business.

***Six months ended June 30, 2006 and 2005***

*Revenues.**  *Net premiums for our Medicare Supplement businessdeclined by $4.6 million, compared to the first six months of 2005, due to thecontinued effect of higher than expected lapsation of our Medicare Supplementin force business, offset in part by increased retention of our MedicareSupplement business, rate increases and new sales. 

Net investment income increased by approximately $1.1million, compared to the first six months of 2005, due to an increase ininvested assets as well as an increase in portfolio yields.

*Benefits,Claims and Expenses.**  *Policyholderbenefits incurred increased by $3.3 million, or 2%, compared to the first sixmonths of 2005. Overall loss ratios for the first six months of 2006 increased340 basis points to 76.0% for the first six months of 2006 compared to 72.6%for the first six months of 2005. The increase in our Medicare Supplement lossratio was primarily as a result of the federally prescribed increase in the Part Bdeductible. The increase in the loss ratio added $6.6 million to benefitsduring the first six months of 2006 and was offset by the reduction inbusiness, as noted above, that resulted in a reduction in benefits of $3.7million.

The increase in deferred acquisition costs was $14.5million less for the first six months of 2006 than the increase for the firstsix months of 2005. Two factors contributed to the decrease. First, we incurredlower commissions and other costs of acquisition as a result of lowerproduction, resulting in a decrease in the costs capitalized of $5.5 million. Second,amortization increased by approximately $10.6 million, primarily as a result ofhigher lapsation of our Medicare Supplement business, compared to the first sixmonths of 2005. We began to experience higher than expected lapsation in ourMedicare Supplement business in the third quarter of 2005 that continued andworsened in the first quarter of 2006. This excess lapsation moderated somewhatin the second quarter of 2006, but not as much as we anticipated. We believethat there are a number of factors contributing to the lapsation, primarilycompetitive pressure from Medicare Advantage products, as well as increasedcompetition from other Medicare Supplement 

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carriers. This increase inlapsation has accelerated the amortization of the deferred acquisition cost andpresent value of future profits assets associated with the business thatlapsed. 

The amortization of intangibles relates primarily tointangibles recorded from the acquisition of Pyramid Life, and increased by$0.9 million compared to the first six months of 2005, due to the increase inlapsation of in force business noted above.

Commissionsand general expenses, net of reinsurance allowances, increased by $0.4 million,or 1%, compared to the first six months of 2005. The following table detailsthe components of commission and other operating expenses:

| ** **                                           | ** ** | **2006**                | ** ** | **2005** | ** ** |
|------------------------------------------------------|------------|-------------------------|------------|----------|------------|
| ** **                                           | ** ** | **(In thousands)** | ** ** |
| Commissions                                          |       | $                       | 36,022     |     | $          | 41,435 |   |
| Other operating  costs                               |       | 36,868                  |       | 36,111   |       |
| Reinsurance  allowances                              |       | (14,575                 | )          | (19,654  | )          |
| Commissions and general  expenses, net of allowances |       | $                       | 58,315     |     | $          | 57,892 |   |

 

The ratio of commissionsto gross premiums decreased to 13.5% for the first six months of 2006, from14.3% for the first six months of 2005, as a result of lower overall commissionrates associated with the continued growth of our in force renewal premium andless new business production that has higher commission rates. Other operatingcosts as a percentage of gross premiums were 13.8% for the first six months of2006, compared to 12.5% for the first six months of 2005 due to lower premiumrevenues, the ratio of fixed to variable costs, and certain non-recurring legaland consulting costs incurred. Commission and expense allowances received fromreinsurers as a percentage of the premiums ceded decreased to 18.9% for thefirst six months of 2006 from 20.7% for the first six months of 2005, primarilydue to the reduction in new business ceded and the effects of normal lowercommission allowances on our aging base of ceded renewal business.

**Part D**

| ** **                                           | ** ** | **Three months endedJune 30,** | ** ** | **Six months endedJune 30,** | ** ** |
|------------------------------------------------------|------------|-----------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                           | ** ** | **2006**                                      | ** ** | **2005**                                    | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                           | ** ** | **(In thousands)**                       | ** ** |
| Part D Revenue                                  |       |                                          |       |                                        |       |   |   |   |   |
| CMS and Member premium                               |       | $                                             | 130,005    |                                        | $          | — |   | $ | 264,820 |   | $ | — |   |
| Ceded premiums                                       |       | (63,888                                       | )          | —                                      |       | (130,575 | ) | — |   |
| Net premiums                                         |       | 66,117                                        |       | —                                      |       | 134,245 |   | — |   |
| Other Part D revenue                            |       | 12,867                                        |       | —                                      |       | 22,674 |   | — |   |
| Total Part D  Revenue                           |       | 78,984                                        |       |                                        |       | 156,919 |   |   |   |
| Net investment  and other income                     |       | 654                                           |       | —                                      |       | 1,153 |   | — |   |
| Total revenue                                        |       | 79,638                                        |       | —                                      |       | 158,072 |   | — |   |
| Pharmacy benefits                                    |       | 63,433                                        |       | —                                      |       | 130,299 |   | — |   |
| Commissions and  general expenses, net of allowances |       | 8,345                                         |       | 435                                         |       | 14,472 |   | 435 |   |
| Total benefits, claims and other deductions          |       | 71,778                                        |       | 435                                         |       | 144,771 |   | 435 |   |
| Segment income                                       |       | $                                             | 7,860      |                                        | $          | (435 | ) | $ | 13,301 |   | $ | (435 | ) |

 

A discussion of the accounting for Part D isincluded in Notes 2 and 15 included in the notes to the consolidated financialstatements in this Form 10-Q. For the six months ended June 30, 2006,we based our membership for Part D on enrollment information provided byCMS which indicated that, as of June 30, 2006, approximately 440,000members were enrolled in our PDPs for which we were paid by CMS. This 

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includes approximately418,000 members in our PDPs that we participate in on a 50% basis and 22,000members in an unaffiliated PDP that we participate in on a 33% basis. Ourrevenues and claims expenses are based on premium earned and incurred pharmacybenefits for the reported enrolled membership. The membership informationcontinues to be reconciled and refined by CMS with respect to the allocationamong all plans participating in the Part D program. As a result, it islikely that the membership data upon which we based our results for the firstsix months of 2006 will change, with a corresponding change in the financialresults for the segment. We are unable to precisely quantify the impact of anypotential change until the membership data is fully reconciled with CMS,however, we do not believe that any change from the amounts reported as of June 30,2006 is likely to be material.

Other Part D revenue represents our equity in theearnings of PDMS, a strategic alliance we formed with PharmaCare. PDMSprincipally performs marketing and risk management services on behalf of ourPDPs and PharmaCare for which it receives fees and other remuneration from ourPDPs and PharmaCare.

The ratio of incurredprescription drug benefits to Part D revenue for the second quarter of2006 was 80.3% and for the first six months of 2006 was 83.0%. Based on thecoverage provided by our PDPs, we anticipate that results for our Part Dbusiness will be seasonal, with higher benefit ratios in the first and secondquarters, decreasing in the third and fourth quarters. Changes in the benefitratios are partially offset as a result of the risk corridor adjustments. 

**Segment Results—Specialty Health Insurance**

| ** **                                           | ** ** | **Three months endedJune 30,** | ** ** | **Six months ended  June 30,** | ** ** |
|------------------------------------------------------|------------|-----------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                           | ** ** | **2006**                                      | ** ** | **2005**                                      | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                           | ** ** | **(In thousands)**                       | ** ** |
| Premiums:                                            |       |                                          |       |                                          |       |   |   |   |   |
| Direct and assumed                                   |       | $                                             | 115,076    |                                          | $          | 42,398 |   | $ | 224,868 |   | $ | 85,508 |   |
| Ceded                                                |       | (78,043                                       | )          | (5,632                                        | )          | (150,362 | ) | (11,315 | ) |
| Net premiums                                         |       | 37,033                                        |       | 36,766                                        |       | 74,506 |   | 74,193 |   |
| Net investment  income                               |       | 7,446                                         |       | 6,608                                         |       | 14,793 |   | 12,997 |   |
| Other income                                         |       | 136                                           |       | 339                                           |       | 270 |   | 637 |   |
| Total revenue                                        |       | 44,615                                        |       | 43,713                                        |       | 89,569 |   | 87,827 |   |
| Policyholder  benefits                               |       | 25,127                                        |       | 25,150                                        |       | 54,058 |   | 50,532 |   |
| Change in  deferred acquisition costs                |       | (1,651                                        | )          | (2,158                                        | )          | (3,498 | ) | (4,127 | ) |
| Commissions and  general expenses, net of allowances |       | 13,122                                        |       | 13,923                                        |       | 26,295 |   | 29,050 |   |
| Total benefits, claims and other deductions          |       | 36,598                                        |       | 36,915                                        |       | 76,855 |   | 75,455 |   |
| Segment income                                       |       | $                                             | 8,017      |                                          | $          | 6,798 |   | $ | 12,714 |   | $ | 12,372 |   |

 

***Three months ended June 30, 2006 and 2005***

Our Specialty Health Insurance segment incomeincreased by $1.2 million, or 18%, compared to the second quarter of 2005,primarily as a result of the underwriting fees earned on the reinsurancearrangement with PharmaCare Re and the strengthening of the Canadian dollar.The operations of Penncorp Life (Canada), which are included in our SpecialtyHealth segment results, are transacted using the Canadian dollar as thefunctional currency. The Canadian dollar strengthened relative to theU.S. dollar during the second quarter of 2006. The average conversion rateincreased 10%, to C$0.8984 per U.S. $1.00 for the second quarter of 2006, fromC$0.8028 per U.S. $1.00 for the second quarter of 2005. This strengtheningadded approximately $0.5 million of pre-tax income to the Specialty Healthsegment results compared to the second quarter of 2005. See discussion belowunder the heading “Quantitative and Qualitative Disclosures about Market Risk”for additional information.

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*Revenues.**  *Both direct and ceded premium for the SpecialtyHealth Insurance segment increased approximately $72.8 million, compared to thesecond quarter of 2005, in connection with the PharmaCare Re reinsuranceagreement discussed above. Net premiums were approximately the same as thesecond quarter of 2005. Canadian business accounted for approximately 47% ofthe net premiums of this segment for the second quarter of 2006 and 42% of thenet premiums for the second quarter of 2005. The stronger Canadian dollar andincreased sales in Canada generated an increase in premiums of approximately$1.7 million, which was offset by reductions of $0.9 million in our U.S. fixedbenefit accident and sickness line and $0.4 million in our long term care line.

Net investment income increased by approximately $0.8million, or 13%, compared to the second quarter of 2005. The increase is dueprimarily to investing cash that we had been accumulating in anticipation ofrising interest rates.

*Benefits,Claims and Expenses.**  *Policyholderbenefits incurred were level with the second quarter of 2005. Overall lossratios for the segment were 67.9% for the second quarter of 2006 compared to68.4% for the second quarter of 2005. Improvements in the loss ratios for ourlong term care line and our Canadian business were offset by an increase in theloss ratio on our U.S. disability line.

Commissions and generalexpenses decreased by $0.7 million, or 6%, compared to the second quarter of2005. The reinsurance allowance for the underwriting fees earned on the newreinsurance arrangement with PharmaCare Re of $1.5 million was offset by anincrease in commissions, primarily for our Canadian business.

***Six months ended June 30, 2006 and 2005***

Our Specialty Health Insurance segment income increasedby $0.3 million, or 3%, compared to the first six months of 2005. Theunderwriting fees earned on the reinsurance arrangement with PharmaCare Re andthe strengthening of the Canadian dollar were offset by higher claim costs inour runoff block of long term care business. The operations of Penncorp Life(Canada), which are included in our Specialty Health segment results, aretransacted using the Canadian dollar as the functional currency. The Canadiandollar strengthened relative to the U.S. dollar during the first six months of2006. The average conversion rate increased 9%, to C$0.8788 per U.S. $1.00 forthe first six months of 2006, from C$0.8097 per U.S. $1.00 for the first sixmonths of 2005. This strengthening added approximately $0.7 million of pre-taxincome to the Specialty Health segment results compared to the first six monthsof 2005. See discussion below under the heading “Quantitative and QualitativeDisclosures about Market Risk” for additional information.

*Revenues.**  *Both direct and ceded premium for the SpecialtyHealth Insurance segment increased approximately $140.3 million, compared tothe first six months of 2005, in connection with the PharmaCare Re reinsuranceagreement discussed above. Net premiums were approximately the same as thefirst six months of 2005. Canadian business accounted for approximately 46% ofthe net premiums of this segment for the first six months of 2006 and 43% ofthe net premiums for the first six months of 2005. The stronger Canadian dollarand increased sales in Canada generated an increase in premiums ofapproximately $2.8 million, which was offset by reductions of $1.7 millionin our U.S. fixed benefit accident and sickness line and $0.7 million in ourlong term care line.

Net investment income increased by approximately $1.8million, or 14%, compared to the first six months of 2005. The increase is dueprimarily to investing cash that we had been accumulating in anticipation ofrising interest rates.

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*Benefits,Claims and Expenses.**  *Policyholderbenefits incurred increased by $3.5 million, or 7%, compared to the first sixmonths of 2005. Overall loss ratios for the segment increased to 72.6% for thefirst six months of 2006 compared to 68.1% for the first six months of 2005,primarily as a result of higher loss ratios for our long term care line. Longterm care loss ratios increased to 131.9% for the first six months of 2006 from106.1% for the first six months of 2005.

Commissions and generalexpenses decreased by $2.8 million, or 10%, compared to the first six months of2005, primarily as a result of the reinsurance allowance of $2.8 million forthe underwriting fees earned on the new reinsurance arrangement with PharmaCareRe.

**Segment Results—Life Insurance and Annuity**

| ** **                                           | ** ** | **Three months endedJune 30,** | ** ** | **Six months ended  June 30,** | ** ** |
|------------------------------------------------------|------------|-----------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                           | ** ** | **2006**                                      | ** ** | **2005**                                      | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                           | ** ** | **(In thousands)**                       | ** ** |
| **Premiums :**                                       | ** ** | ** **                                    | ** ** | ** **                                    | ** ** | ** ** | ** ** | ** ** | ** ** |
| Direct and assumed                                   |       | $                                             | 19,385     |                                          | $          | 19,074 |   | $ | 38,582 |   | $ | 37,052 |   |
| Ceded                                                |       | (4,268                                        | )          | (4,684                                        | )          | (8,093 | ) | (8,522 | ) |
| Net premiums                                         |       | 15,117                                        |       | 14,390                                        |       | 30,489 |   | 28,530 |   |
| Net investment  income                               |       | 9,815                                         |       | 8,908                                         |       | 19,396 |   | 17,598 |   |
| Other income                                         |       | 67                                            |       | 70                                            |       | 156 |   | 73 |   |
| Total revenue                                        |       | 24,999                                        |       | 23,368                                        |       | 50,041 |   | 46,201 |   |
| Policyholder  benefits                               |       | 10,209                                        |       | 10,093                                        |       | 21,530 |   | 19,081 |   |
| Interest credited  to policyholders                  |       | 4,740                                         |       | 4,630                                         |       | 9,210 |   | 9,175 |   |
| Change in  deferred acquisition costs                |       | (2,183                                        | )          | (5,047                                        | )          | (2,933 | ) | (10,146 | ) |
| Amortization of  intangible assets                   |       | 122                                           |       | 269                                           |       | 198 |   | 529 |   |
| Commissions and  general expenses, net of allowances |       | 8,353                                         |       | 10,018                                        |       | 17,236 |   | 20,117 |   |
| Total benefits, claims and other deductions          |       | 21,241                                        |       | 19,963                                        |       | 45,241 |   | 38,756 |   |
| Segment income                                       |       | $                                             | 3,758      |                                          | $          | 3,405 |   | $ | 4,800 |   | $ | 7,445 |   |

 

***Three months ended June 30, 2006 and 2005***

Segment income from our Life Insurance and Annuitysegment increased by $0.4 million, compared to the second quarter of 2005,primarily as a result of a decrease in claim costs

*Revenues.*   Net premiumsfor the segment increased by $0.7 million, or 5%, compared to the secondquarter of 2005, primarily due to growth in renewal premiums for our seniorlife product of $0.8 million.

Our agents sold $7.7 million of fixed annuities duringthe second quarter of 2006 and $10.1 million during the second quarter of 2005.Annuity deposits are not considered premiums for reporting in accordance withgenerally accepted accounting principles. The reduction in annuity sales wasthe result of lower interest crediting rates offered and our reduced emphasison this business as we continue our focus more on providing health insurancealternatives to the growing senior market.

Net investment income increased by approximately $0.9million, or 10%, compared to the second quarter of 2005, primarily as a resultof the increase in policyholder account balances as well as an increase inportfolio yields.

*Benefits, Claims andExpenses.**  *Policyholderbenefits incurred increased by $0.1 million, or 1%, compared to the secondquarter of 2005. The increase in business added approximately $0.5 million topolicyholder benefits during the second quarter of 2006, but was offset by areduction in claim costs of $0.4 million as a result of improvedmortality, as compared to the second quarter of 2005. The increase in deferredacquisition costs was $2.9 million less during the second quarter of 2006, ascompared to the 

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increase during thesecond quarter of 2005. This was primarily due to lower production of new lifeinsurance and annuity business during the second quarter of 2006, resulting ina lower level of acquisition costs to capitalize, and aging of the block ofbusiness as compared to the second quarter of 2005. Commissions and generalexpenses, net of allowances decreased by $1.8 million, or 18%, compared to thefirst quarter of 2005, due to the lower production levels of new life insurancean annuity business, as noted above.

***Six months ended June 30, 2006 and 2005***

Segment income from our Life Insurance and Annuitysegment decreased by $2.6 million, compared to the first six months of 2005,primarily as a result of an increase in claim costs and an increase in theamortization of deferred acquisition costs.

*Revenues.*   Net premiumsfor the segment increased by $2.0 million, or 7%, compared to the first sixmonths of 2005, as a result of the growth in renewal premiums for our seniorlife product.

Our agents sold $18.5 million of fixed annuities duringthe first six months of 2006 and $25.6 million during the first six months of2005. Annuity deposits are not considered premiums for reporting in accordancewith generally accepted accounting principles. The reduction in annuity saleswas the result of lower interest crediting rates offered and our reducedemphasis on this business as we continue our focus more on providing healthinsurance alternatives to the growing senior market.

Net investment income increased by approximately $1.8million, or 10%, compared to the first six months of 2005, primarily as aresult of the increase in policyholder account balances as well as an increasein portfolio yields.

*Benefits, Claims andExpenses.**  *Policyholderbenefits incurred increased by $2.4 million, or 13%, compared to the first sixmonths of 2005. The increase in business added approximately $1.4 million topolicyholder benefits and other claim costs were higher by approximately $1.1million as a result of increased mortality in the first six months of 2006, ascompared to the first six months of 2005. The increase in deferred acquisitioncosts was $7.2 million less during the first six months of 2006, as compared tothe increase during the first six months of 2005. This was primarily due tolower production of new life insurance and annuity business during the firstsix months of 2006, resulting in a lower level of acquisition costs tocapitalize, as well as increased levels of amortization (primarily in the firstquarter of 2006) as compared to the first six months of 2005 as a result ofhigher lapsation and aging of the block of business. Commissions and generalexpenses, net of allowances decreased by $3.2 million, or 16%, compared to thefirst six months of 2005, due to the lower production levels of new lifeinsurance an annuity business, as noted above.

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**Segment Results—Senior Administrative Services**

| ** **                                                                              | ** ** | **Three months endedJune 30,** | ** ** | **Six months ended  June 30,** | ** ** |
|-----------------------------------------------------------------------------------------|------------|-----------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                                                              | ** ** | **2006**                                      | ** ** | **2005**                                      | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                                                              | ** ** | **(In thousands)**                       | ** ** |
| Affiliated Service Fee  Revenue                                                         |       |                                          |       |                                          |       |   |   |   |   |
| Medicare Supplement                                                                     |       | $                                             | 6,905      |                                          | $          | 7,585 |   | $ | 14,627 |   | $ | 15,551 |   |
| Part D                                                                             |       | 5,970                                         |       | —                                        |       | 9,899 |   | — |   |
| Long term care                                                                          |       | 765                                           |       | 673                                           |       | 1,520 |   | 1,269 |   |
| Life insurance                                                                          |       | 524                                           |       | 886                                           |       | 1,065 |   | 1,730 |   |
| Other                                                                                   |       | 645                                           |       | 694                                           |       | 1,426 |   | 1,491 |   |
| Total Affiliated Revenue                                                                |       | 14,809                                        |       | 9,838                                         |       | 28,537 |   | 20,041 |   |
| Unaffiliated Service Fee  Revenue                                                       |       |                                          |       |                                          |       |   |   |   |   |
| Medicare Supplement                                                                     |       | 1,734                                         |       | 2,124                                         |       | 3,591 |   | 4,158 |   |
| Long term care                                                                          |       | 1,963                                         |       | 2,077                                         |       | 3,990 |   | 4,100 |   |
| Non-insurance products                                                                  |       | 364                                           |       | 374                                           |       | 644 |   | 758 |   |
| Part D                                                                             |       | 402                                           |       | —                                        |       | 730 |   | — |   |
| Other                                                                                   |       | 2,486                                         |       | 290                                           |       | 4,470 |   | 554 |   |
| Total Unaffiliated Revenue                                                              |       | 6,949                                         |       | 4,865                                         |       | 13,425 |   | 9,570 |   |
| Total revenue                                                                           |       | 21,758                                        |       | 14,703                                        |       | 41,962 |   | 29,611 |   |
| Amortization of  present value of future profits                                        |       | 123                                           |       | 120                                           |       | 246 |   | 239 |   |
| General expenses                                                                        |       | 16,860                                        |       | 11,542                                        |       | 34,514 |   | 22,716 |   |
| Total expenses                                                                          |       | 16,983                                        |       | 11,662                                        |       | 34,760 |   | 22,955 |   |
| Segment income                                                                          |       | 4,775                                         |       | 3,041                                         |       | 7,202 |   | 6,656 |   |
| Depreciation,  amortization and interest                                                |       | 817                                           |       | 542                                           |       | 1,628 |   | 1,074 |   |
| Earnings before  interest, taxes, depreciation and amortization (“EBITDA”)(1) |       | $                                             | 5,592      |                                          | $          | 3,583 |   | $ | 8,830 |   | $ | 7,730 |   |

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       (1) In addition to segment income, we also evaluate the results of ourSenior Administrative Services segment based on earnings before interest,taxes, depreciation and amortization (“EBITDA”). EBITDA is a common alternativemeasure of performance used by investors, financial analysts and ratingagencies. It is also a measure that is included in the fixed charge ratiorequired by the covenants for our outstanding bank debt. Accordingly, thesegroups use EBITDA, along with other measures, to estimate the value of a companyand evaluate the Company’s ability to meet its debt service requirements. Whilewe consider EBITDA to be an important measure of comparative operatingperformance, it should not be construed as an alternative to segment income orcash flows from operating activities (as determined in accordance withgenerally accepted accounting principles).

Included in unaffiliatedrevenue are fees received to administer certain business of our insurancesubsidiaries that is 100% reinsured to an unaffiliated reinsurer, which amountedto $0.8 million for the six months ended June 30, 2006, and$1.0 million for the six months ended June 30, 2005 and $1.7 millionfor the six months ended June 30, 2006, and $2.1 million for the sixmonths ended June 30, 2005. These fees, together with the affiliatedrevenue, were eliminated in consolidation.

***Three months ended June 30, 2006 and 2005***

Segment income for our Senior Administrative Servicessegment increased by $1.7 million, or 57%, to $4.8 million for the secondquarter of 2006, as compared to the same period of 2005. This increase isprimarily the result of new business administered.

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Service fee revenueincreased by $7.1 million, or 48%, during the second quarter of 2006 comparedto the second quarter of 2005. Affiliated service fee revenue increased by $5.0million primarily as a result of fees for the administration of our Part Dprescription drug plans on behalf of our insurance subsidiaries which commencedon January 1, 2006, offset, in part, by a decline in revenues for administrationof affiliated Medicare supplement and life insurance business. Unaffiliatedservice fee revenue increased by $2.1 million, due primarily to an increase infees for the administration of agency services, including licensing andcommission payments, for unaffiliated clients. General expenses for the segmentincreased by $5.3 million, or 46%, due primarily to the administration of theaffiliated Part D business, beginning in 2006. During the second quarterof 2005, approximately $0.6 million of expenses were incurred in this segmentrelating to our implementation of Part D.

***Six months ended June 30, 2006 and 2005***

Segment income for our Senior Administrative Servicessegment increased by $0.5 million, or 8%, to $7.2 million for the first sixmonths of 2006, as compared to the same period of 2005. This increase isprimarily the result of new business administered, offset in part by the $1.2million incremental increase in expenses incurred in this segment relating to Part Das compared to 2005.

Service fee revenueincreased by $12.4 million, or 42%, during the first six months of 2006compared to the first six months of 2005. Affiliated service fee revenueincreased by $8.5 million primarily as a result of fees for the administrationof our Part D prescription drug plans on behalf of our insurancesubsidiaries which commenced on January 1, 2006, offset, in part, by adecline in revenues for administration of affiliated Medicare supplement andlife insurance business. Unaffiliated service fee revenue increased by $3.9million, due primarily to an increase in fees for the administration of agencyservices, including licensing and commission payments, for unaffiliatedclients. General expenses for the segment increased by $11.8 million, or 52%,primarily to the administration of the affiliated Part D business,beginning in 2006. During the six months ended June 30, 2006,approximately $1.8 million of expenses were incurred in this segment relatingto Part D compared to approximately $0.6 million of expenses that wereincurred during the first six months of 2005.

**Segment Results—Corporate**

Thefollowing table presents the primary components comprising the loss from thesegment:

| ** **                                         | ** ** | **Three months endedJune 30,**            | ** ** | **Six months ended  June 30,**            | ** ** |
|----------------------------------------------------|------------|----------------------------------------------------------|------------|----------------------------------------------------------|------------|
| ** **                                         | ** ** | **    2006    ** | ** ** | **    2005    ** | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                         | ** ** | **(In thousands)**                                  | ** ** |
| Interest                                           |       |                                                     | $          | 3,186                                                    |       |   |   | $ | 2,670 |   |   | $ | 6,228 |   | $ | 5,181 |   |
| Amortization of  capitalized loan origination fees |       |                                                     | 229        |                                                     |       |   | 227 |   |   | 458 |   | 444 |   |
| Stock-based  compensation expense                  |       |                                                     | 780        |                                                     |       |   | — |   |   | 1,495 |   | 2 |   |
| Other parent  company expenses, net                |       |                                                     | 2,193      |                                                     |       |   | 1,237 |   |   | 3,688 |   | 2,023 |   |
| Segment loss                                       |       |                                                     | $          | 6,388                                                    |       |   |   | $ | 4,134 |   |   | $ | 11,869 |   | $ | 7,650 |   |

 

***Three months ended June 30, 2006 and 2005***

The loss from ourCorporate segment increased by $2.3 million, or 55%, for the three months endedJune 30, 2006 compared to the three months ended June 30, 2005. Theincrease was due primarily to the increase in stock-based compensation expenseas a result of the adoption of FAS 123-R, costs of due diligence andhigher interest cost. During the three months ended June 30, 2006, werecognized $0.8 million of stock-based compensation expense relating tooptions vesting during the period. We also incurred $0.7 million of costsassociated with due diligence for a potential acquisition that we determined wewill not pursue at this time. Our combined outstanding debt was $168.2 millionat June 30, 2006 

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comparedto $173.4 million at June 30, 2005. The weighted average interest rate onour loan payable increased to 7.2% for the three months ended June 30,2006 from 5.3% for the three months ended June 30, 2005. The weightedaverage interest rate on our other long term debt increased to 7.8% for thethree months ended June 30, 2006 from 7.1% for the three months ended June 30,2005. See “Liquidity and Capital Resources” for additional informationregarding our loan payable and other long term debt.

***Six months ended June 30, 2006 and 2005***

The loss from ourCorporate segment increased by $4.2 million, or 55%, for the six months ended June 30,2006 compared to the six months ended June 30, 2005. The increase was dueprimarily to the increase in stock-based compensation expense as a result ofthe adoption of FAS 123-R, costs of due diligence and higher interestcost. During the six months ended June 30, 2006, we recognized $1.5million of stock-based compensation expense relating to options vesting duringthe period. We also incurred $0.7 million of costs associated with duediligence for a potential acquisition that we determined we will not pursue atthis time. The weighted average interest rate on our loan payable increased to7.0% for the six months ended June 30, 2006 from 5.0% for the six monthsended June 30, 2005. The weighted average interest rate on our other longterm debt increased to 7.7% for the six months ended June 30, 2006 from7.0% for the six months ended June 30, 2005. See “Liquidity and CapitalResources” for additional information regarding our loan payable and other longterm debt.

**Liquidity andCapital Resources**

Our capital is used primarily to support the retainedrisks and growth of our insurance company subsidiaries and health plan and tosupport our parent company as an insurance holding company. In addition, we usecapital to fund our growth through acquisitions of other companies, blocks ofinsurance or administrative service business.

We require cash at our parent company to meet ourobligations under our credit facility. We also require cash to pay theoperating expenses necessary to function as a holding company (applicableinsurance department regulations require us to bear our own expenses), and tomeet the costs of being a public company.

We believe that ourcurrent cash position, the availability of our $15.0 million revolving creditfacility, the expected cash flows of our administrative service company and managementservice organizations (acquired in the acquisition of Heritage) and the surplusnote interest and principal payments from American Exchange (as explainedbelow) can support our parent company obligations for the foreseeable future.However, there can be no assurance as to our actual future cash flows or to thecontinued availability of dividends from our insurance company subsidiaries.

*Credit Facility, asAmended in May 2004*

In connection with the acquisition of Heritage on May 28,2004, the Company amended the Credit Agreement by increasing the facility to$120 million from $80 million (the “Amended Credit Agreement”), including anincrease in the term loan portion to $105 million from $36.4 million (thebalance outstanding at May 28, 2004) and maintaining the $15 millionrevolving loan facility. None of the revolving loan facility was drawn as of June 30,2006. Under the Amended Credit Agreement, the spread over LIBOR was reduced to225 basis points from 275 basis points. Effective July 1, 2006, theinterest rate on the term loan was 7.6%. Principal repayments are scheduled at$5.3 million per year over a five-year period with a final payment of $80.1million due upon maturity on March 31, 2009.

The Company incurred additional loan origination fees ofapproximately $2.1 million, which were capitalized and are being amortized on astraight-line basis over the life of the Amended Credit Agreement along withthe continued amortization of the origination fees incurred in connection withthe 

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Credit Agreement. TheCompany pays an annual commitment fee of 50 basis points on the unutilizedrevolving loan facility.

The obligations of the Company under the AmendedCredit Facility are guaranteed by our subsidiaries, CHCS Services Inc., QuincyCoverage Corporation, Universal American Financial Services, Inc.,Heritage, HHS-HPN Network, Inc., Heritage Health Systems of Texas, Inc.,PSO Management of Texas, LLC, HHS Texas Management, Inc. and HHS TexasManagement LP (collectively the “Guarantors”) and secured by substantially allof the assets of each of the Guarantors. In addition, as security for theperformance by the Company of its obligations under the Amended CreditFacility, the Company, CHCS Services Inc., Heritage and HHS Texas Management, Inc.,have each pledged and assigned substantially all of their respective securities(but not more than 65% of the issued and outstanding shares of voting stock ofany foreign subsidiary), all of their respective limited liability company andpartnership interests, all of their respective rights, title and interest underany service or management contract entered into between or among any of theirrespective subsidiaries and all proceeds of any and all of the foregoing.

The Amended Credit Facility requires the Company and itssubsidiaries to meet certain financial tests, including a minimum fixed chargecoverage ratio, a minimum risk based capital test and a minimum consolidatednet worth test. The Amended Credit Facility also contains covenants, whichamong other things, limit the incurrence of additional indebtedness, dividends,capital expenditures, transactions with affiliates, asset sales, acquisitions,mergers, prepayments of other indebtedness, liens and encumbrances and othermatters customarily restricted in such agreements. The Amended Credit Facilitycontains customary events of default, including, among other things, paymentdefaults, breach of representations and warranties, covenant defaults,cross-acceleration, cross-defaults to certain other indebtedness, certainevents of bankruptcy and insolvency and judgment defaults. During the fourthquarter of 2005, the Company was in default with a covenant regardinglimitations on treasury stock repurchases. The Company requested and received,from the administrative agent for the bank group, a waiver of the event ofdefault and an amendment to the Amended Credit Facility to increase thelimitation for treasury stock purchases to $30.0 million in the aggregate afterJanuary 1, 2006.

We made regularly scheduled principal payments of $2.6million during the six months ended June 30, 2006 and $2.6 millionduring the six months ended June 30, 2005, in connection with our creditfacilities. We paid interest of $3.4 million during the six months ended June 30,2006 and $2.5 million during the six months ended June 30, 2005, inconnection with our credit facilities.

Thefollowing table shows the schedule of principal payments (in thousands)remaining on the Amended Credit Agreement, with the final payment in March 2009:

| 2006 (remainder  of the year) |   | $      | 2,625  |   |
|-------------------------------|--------|--------|--------|--------|
| 2007                          |   | 5,250  |   |
| 2008                          |   | 5,250  |   |
| 2009                          |   | 80,063 |   |
|                          |   | $      | 93,188 |   |

 

*Other Long TermDebt*

We formed statutory business trusts, which exist forthe exclusive purpose of issuing trust preferred securities representingundivided beneficial interests in the assets of the trust, investing the grossproceeds of the trust preferred securities in junior subordinated deferrableinterest debentures of our parent holding company (the “Junior SubordinatedDebt”) and engaging in only those activities necessary or incidental thereto.In accordance with the adoption of FIN 46R, we have deconsolidated the trusts.

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Separatesubsidiary trusts of our parent holding company (the “Trusts”) have issued acombined $75.0 million in thirty year trust preferred securities (the “CapitalSecurities”) as detailed in the following table:

| **Maturity Date** | ** ** | ** **              | ** ** | **Amount Issued** | ** ** | **Term**                | ** **     | **Spread Over  LIBOR** | ** ** | **Rate as of  June 30, 2006** | ** ** |
|------------------------|------------|-------------------------|------------|------------------------|------------|-------------------------|----------------|-----------------------------|------------|---------------------------------------------------|------------|
| ** **             | ** ** | **(In thousands)** | ** ** | ** **             | ** ** | **(Basis points)** | ** **     | ** **                  | ** ** |
| December 2032     |       |                    | $          | 15,000                 |       |                    | Fixed/Floating |                        |       | 400                                               | (1)        |   |   | 6.7 | % |   |
| March 2033        |       |                    | 10,000     |                   |       | Floating                |           |                        | 400        |                                              |       |   | 9.1 | % |   |
| May 2033          |       |                    | 15,000     |                   |       | Floating                |           |                        | 420        |                                              |       |   | 9.4 | % |   |
| May 2033          |       |                    | 15,000     |                   |       | Fixed/Floating          |           |                        | 410        | (2)                                               |       |   | 7.4 | % |   |
| October 2033      |       |                    | 20,000     |                   |       | Fixed/Floating          |           |                        | 395        | (3)                                               |       |   | 7.0 | % |   |
|                   |       |                    | $          | 75,000                 |       |                    |           |                        |       |                                              |       |   |   |   |   |   |

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       (1) Effective September, 2003, we entered into a swap agreement wherebyit will pay a fixed rate of 6.7% in exchange for a floating rate of LIBOR plus400 basis points. The swap contract expires in December 2007.

       (2) The rate on this issue is fixed at 7.4% for the first five years. OnMay 15, 2008 it will be converted to a floating rate equal to LIBOR plus410 basis points.

       (3) Effective April 29, 2004, we entered into a swap agreementwhereby it will pay a fixed rate of 6.98% in exchange for a floating rate ofLIBOR plus 395 basis points. The swap contract expires in October 2008.

The Trusts have the right to call the CapitalSecurities at par after five years from the date of issuance (which ranged fromDecember 2002 to October 2003).

The Capital Securities represent an undividedbeneficial interest in the Trusts’ assets, which consist solely of the JuniorSubordinated Debt. Holders of the Capital Securities have no voting rights. Ourparent holding company owns all of the common securities of the Trusts. Holdersof both the Capital Securities and the Junior Subordinated Debt are entitled toreceive cumulative cash distributions accruing from the date of issuance, andpayable quarterly in arrears at a floating rate equal to the three-month LIBORplus a spread. The floating rate resets quarterly and is limited to a maximumof 12.5% during the first sixty months. Due to the variable interest rate forthese securities, we may be subject to higher interest costs if short-terminterest rates rise. The Capital Securities are subject to mandatory redemptionupon repayment of the Junior Subordinated Debt at maturity or upon earlierredemption. The Junior Subordinated Debt is unsecured and ranks junior andsubordinate in right of payment to all present and future senior debt of ourparent holding company and is effectively subordinated to all existing andfuture obligations of the Company’s subsidiaries. Our parent holding companyhas the right to redeem the Junior Subordinated Debt after five years from thedate of issuance.

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Our parent holding company has the right at any time,and from time to time, to defer payments of interest on the Junior SubordinatedDebt for a period not exceeding 20 consecutive quarters up to each debenture’smaturity date. During any such period, interest will continue to accrue and ourparent holding company may not declare or pay any cash dividends ordistributions on, or purchase, our common stock nor make any principal,interest or premium payments on or repurchase any debt securities that rank equallywith or junior to the Junior Subordinated Debt. Our parent holding company hasthe right at any time to dissolve the Trusts and cause the Junior SubordinatedDebt to be distributed to the holders of the Capital Securities. We haveguaranteed, on a subordinated basis, all of the Trusts’ obligations under theCapital Securities including payment of the redemption price and anyaccumulated and unpaid distributions to the extent of available funds and upondissolution, winding up or liquidation but only to the extent the Trusts havefunds available to make such payments. The Capital Securities have not been andwill not be registered under the Securities Act of 1933, as amended (the “SecuritiesAct”), and will only be offered and sold under an applicable exemption fromregistration requirements under the Securities Act.

We paid $2.8 million ininterest in connection with the Junior Subordinated Debt during the six monthsended June 30, 2006, and $2.6 million during the six months ended June 30,2005.

*Lease Obligations*

We areobligated under certain lease arrangements for our executive and administrativeoffices in New York, Florida, Indiana, Texas, and Ontario, Canada. Annualminimum rental commitments, subject to escalation, under non-cancelableoperating leases (in thousands) are as follows:

| 2006 (remainder  of the year) |   | $      | 2,095  |   |
|-------------------------------|--------|--------|--------|--------|
| 2007                          |   | 4,151  |   |
| 2008                          |   | 4,011  |   |
| 2009                          |   | 3,619  |   |
| 2010 and  thereafter          |   | 10,220 |   |
| Totals                        |   | $      | 24,096 |   |

 

In addition to the above,Pennsylvania Life and Penncorp Life (Canada) are the named lessees on 69 propertiesoccupied by Career Agents for use as field offices. The Career Agents reimbursePennsylvania Life and Penncorp Life (Canada) the actual rent for these fieldoffices. The total annual rent paid by the Company and reimbursed by the CareerAgents for these field offices during 2005 was approximately $1.7 million.

*Shelf Registration*

On November 3, 2004, we filed a universal shelfregistration statement on Form S-3 with the U.S. Securities andExchange Commission (“SEC”), pursuant to which we may issue common stock,warrants and debt securities from time to time, up to an aggregate offering of$140 million. The registration statement also covers five million shares ofcommon stock that may be offered for sale by Capital Z Financial Services FundII, L.P. (“Capital Z”), our largest shareholder. The shelf registrationstatement was declared effective in December, 2004.

The shelf registration statement enables us to raisefunds from the offering of any individual security covered by the shelfregistration statement, as well as any combination thereof, through one or moremethods of distribution, subject to market conditions and our capital needs.The terms of any offering pursuant to this shelf will be established at thetime of the offering. We plan to use the proceeds from any future offeringunder the registration statement for general corporate purposes, including, butnot limited to, working capital, capital expenditures, investments insubsidiaries, acquisitions and refinancing of debt. 

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A more detaileddescription of the use of proceeds will be included in any specific offering ofsecurities in the prospectus supplement relating to the offering.

On June 22, 2005, weissued 2.0 million shares of our common stock in connection with a publicoffering pursuant to the shelf registration, generating proceeds to us of $44.2million, net of underwriters discount and other issuance costs. On July 20,2005, the underwriters exercised their over-allotment option and we issued anadditional 660,000 shares of our common stock generating additional netproceeds of $14.8 million. The aggregate amount that remains available foroffering under the shelf registration statement is $77.2 million.

*Sources ofLiquidity to the Parent Company*

We anticipate fundingthe obligations of the parent company and the capital required to grow ourbusiness from the four distinct and uncorrelated sources of cash flow withinthe organization as follows:

·       theexpected cash flows of our senior administrative services company;

·       theexpected cash flows of our senior managed care company (acquired in theacquisition of Heritage);

·       dividendpayments received from Penncorp Life (Canada); and

·       surplusnote principal and interest payments from American Exchange.

In addition, we have access to the $15.0 millionavailable under the revolving portion of our credit facility. Finally, we havethe ability, from time to time, to access the capital markets for additionalcapital. There can be no assurance as to our actual future cash flows, from thecontinued availability of dividends from our insurance company subsidiaries orfrom access to the capital markets.

*SeniorAdministrative Services Company.*   Liquidity forour Senior Administrative Services subsidiary is measured by its ability to payoperating expenses and pay dividends to our parent company. The primary sourceof liquidity is fees collected from clients. We believe that the sources ofcash for our Senior Administrative Services company exceed scheduled uses ofcash and results in amounts available to dividend to our parent holdingcompany. We measure the ability of the Senior Administrative Services companyto pay dividends based on its earnings before interest, taxes, depreciation andamortization (“EBITDA”). EBITDA for our Senior Administrative Services segmentwas $8.8 million for the six months ended June 30, 2006, and $7.7 millionfor the six months ended June 30, 2005.

*SeniorManaged Care Company.**  *Liquidityfor our managed care company is measured by its ability to pay operatingexpenses and pay dividends to our parent company. The primary source ofliquidity is management fees for administration of SCOT and services providedto the IPA’s. Dividend payments by SCOT to Heritage are subject to the approvalof the insurance regulatory authorities of the state of Texas, SCOT’s state ofdomicile. SCOT is not able to pay dividends during 2006 without prior approval.However, we believe that the sources of cash to our managed care holdingcompany exceed scheduled uses of cash which will result in funds available todividend to our parent holding company. We measure the ability of the seniormanaged care holding company to pay dividends based on its EBITDA. EBITDA forour senior managed care holding company was $21.7 million for the six monthsended June 30, 2006 and $15.4 million for the six months ended June 30,2005.

*PenncorpLife (Canada) Dividends.**  *PenncorpLife (Canada) is a Canadian insurance company. Canadian law provides that alife insurer may pay a dividend after such dividend declaration has beenapproved by its board of directors and upon at least 10 days prior notificationto the Superintendent of Financial Institutions. Such a dividend is limited toretained net income (based on Canadian GAAP) for the preceding two years, plusnet income earned for the current year. In considering approval of a dividend,the board of directors must consider whether the payment of such dividend wouldbe in 

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contravention of theInsurance Companies Act of Canada. During the six months ended June 30,2006, Penncorp Life (Canada) paid dividends of C$4.9 million (approximatelyUS$4.4 million) to Universal American. During 2005, Penncorp Life (Canada)became subject to a 5% withholding tax on dividends paid to Universal American.The withholding tax paid on the dividends from Penncorp Life (Canada) in 2006was C$0.2 million (approximately US$0.2 million). No dividends were paid byPenncorp Life (Canada) during the six months ended June 30, 2005. Due tolimitations resulting from the timing of prior dividend payments by PennCorpLife (Canada), we do not anticipate that Penncorp Life (Canada) will be able topay dividends in 2006 without prior approval.

*InsuranceSubsidiaries—Surplus Note, Dividends and Capital Contributions.*   Cash**generated by our insurance company subsidiaries will bemade available to our holding company, principally through periodic payments ofprincipal and interest on the surplus note owed to our holding company by oursubsidiary, American Exchange, the intermediate parent of our U.S. insurancesubsidiaries. As of June 30, 2006, the principal amount of thesurplus note was $32.6 million. The note bears interest to our parent holdingcompany at LIBOR plus 325 basis points. We anticipate that the surplus notewill be primarily serviced by dividends from Pennsylvania Life, and bytax-sharing payments among the insurance companies that are included in theconsolidated Federal income tax return that is filed by American Exchange.American Exchange made principal payments of $7.5 million during the six monthsended June 30, 2006, and $4.3 million during the six months ended June 30,2005. American Exchange paid interest on the surplus note of $1.4 millionduring the six months ended June 30, 2006 and $1.0 million during thethree months ended June 31, 2005.

Our parent holding company made capital contributionsto American Exchange amounting to $3.5 million during the first six monthsof 2006. During May, 2006, our parent holding company also contributed itsinterest in PDMS to American Exchange. On the date of the contribution, ourinterest in PDMS was $4.1 million. In January 2006, Pyramid Life declaredand paid a dividend in the amount of $10.8 million to Pennsylvania Life.American Exchange made capital contributions of $2.5 million to Constitutionduring the first six months of 2006.

Dividend payments by ourU.S. insurance companies are limited by, or subject to the approval of, theinsurance regulatory authorities of each insurance company’s state of domicile.Such dividend requirements and approval processes vary significantly from stateto state. Pennsylvania Life is able to pay ordinary dividends of up to $9.8million to American Exchange during 2006, without prior approval.

*InsuranceSubsidiaries—Liquidity*

Liquidity for our insurance company subsidiaries ismeasured by their ability to pay scheduled contractual benefits, pay operatingexpenses, fund investment commitments, and pay dividends to their parentcompany. The principal sources of cash for our insurance operations includescheduled and unscheduled principal and interest payments on investments,premium payments, annuity deposits, and the sale or maturity of investments.Both the sources and uses of cash are reasonably predictable and we believethat these sources of cash for our insurance company subsidiaries exceedscheduled uses of cash.

Liquidity is also affected by unscheduled benefitpayments including benefits under accident and health insurance policies, deathbenefits and interest-sensitive policy surrenders and withdrawals.

Our accident and health insurance policies generallyprovide for fixed-benefit amounts and, in the case of Medicare Supplementpolicies, for supplemental payments to Medicare provider rates. Some of thesebenefits are subject to medical-cost inflation and we have the capability tofile for premium rate increases to mitigate rising medical costs. Our healthinsurance business is widely dispersed in the United States and Canada, whichmitigates the risk of unexpected increases in claim payments due to epidemicsand events of a catastrophic nature. These accident and health polices are notinterest-sensitive and therefore are not subject to unexpected policyholderredemptions due to investment yield changes.

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Some of our life insurance and annuity policies areinterest-sensitive in nature. The amount of surrenders and withdrawals isaffected by a variety of factors such as credited interest rates for similarproducts, general economic conditions and events in the industry that affectpolicyholders’ confidence. Although the contractual terms of substantially allof our in force life insurance policies and annuities give the holders theright to surrender the policies and annuities, we impose penalties for earlysurrenders. As of June 30, 2006 we held reserves that exceeded theunderlying cash surrender values of our net retained in force life insuranceand annuities by $33.4 million. Our insurance subsidiaries, in our view, havenot experienced any material changes in surrender and withdrawal activity inrecent years.

Changes in interest rates may affect the incidence ofpolicy surrenders and withdrawals. In addition to the potential impact onliquidity, unanticipated surrenders and withdrawals in a changed interest rateenvironment could adversely affect earnings if we were required to sellinvestments at reduced values in order to meet liquidity demands. We manage ourasset and liability portfolios in order to minimize the adverse earnings impactof changing market rates. We have segregated a portion of our investmentportfolio in order to match liabilities that are sensitive to interest ratemovements with fixed income securities containing similar characteristics tothe related liabilities, most notably the expected duration and requiredinterest spread. We believe that this asset/liability management processadequately covers the expected payment of benefits related to these liabilities.

As of June 30, 2006, our insurance companysubsidiaries held cash and cash equivalents totaling $186.8 million, as well asfixed maturity securities that could readily be converted to cash with carryingvalues (and fair values) of $1.3 billion.

The net yields on our cash and invested assetsincreased to 5.1% for the six months ended June 30, 2006, from 4.8%for the six months ended June 30, 2005. A portion of these securities areheld to support the liabilities for policyholder account balances, whichliabilities are subject to periodic adjustments to their credited interestrates. The credited interest rates of the interest-sensitive policyholderaccount balances are determined by us based upon factors such as portfoliorates of return and prevailing market rates and typically follow the pattern ofyields on the assets supporting these liabilities.

Our U.S. insurance subsidiaries are required tomaintain minimum amounts of statutory capital and surplus as required byregulatory authorities. However, substantially more than the statutory minimumamounts are needed to meet statutory and administrative requirements ofadequate capital and surplus to support the current level of our U.S. insurancesubsidiaries’ operations. Each of our U.S. insurance subsidiaries’ statutorycapital and surplus exceeds its respective minimum statutory requirement atlevels we believe are sufficient to support their current levels of operation.Additionally, the National Association of Insurance Commissioners (“NAIC”) imposesregulatory risk-based capital (“RBC”) requirements on life insuranceenterprises. At June 30, 2006, all of our U.S. insurance subsidiariesmaintained ratios of total adjusted capital to RBC in excess of the “authorizedcontrol level”. The combined statutory capital and surplus, including assetvaluation reserve, of our U.S. insurance subsidiaries totaled $169.4 million atJune 30, 2006, and $158.4 million at December 31, 2005. For the sixmonths ended June 30, 2006, our U.S. insurance subsidiaries generatedstatutory net income of $9.2 million. Our U.S. insurance companies generatedstatutory net income of $0.3 million for the six months ended June 30,2005.

Our health plans are also required to maintain minimumamounts of capital and surplus, as required by regulatory authorities and arealso subject to RBC requirements. At June 30, 2006, the statutory capitaland surplus of each of our health plan affiliates exceeds its minimumrequirement and its RBC is in excess of the “authorized control level”. The statutorycapital and surplus for our health plans was $33.7 million at June 30,2006, and $23.0 million at December 31, 2005. Statutory net income for ourhealth plans was $7.7 million for the six months ended June 30, 2006and $4.9 million for the six months ended June 30, 2005.

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Penncorp Life (Canada)reports to Canadian regulatory authorities based upon Canadian statutoryaccounting principles that vary in some respects from U.S. statutory accountingprinciples. Penncorp Life (Canada)’s net assets based upon Canadian statutoryaccounting principles were C$62.8 million (US$56.3 million) as of June 30,2006, and C$62.3 million (US$53.6 million) as of December 31, 2005. Netincome based on Canadian generally accepted accounting principles was C$5.4million (US$4.7 million) for the six months ended June 30, 2006 and C$5.6million (US$4.5 million) for the six months ended June 30, 2005. PenncorpLife (Canada) maintained a Minimum Continuing Capital and Surplus RequirementRatio (“MCCSR”) in excess of the minimum requirement at June 30, 2006.

*Investments*

Our investment policy is to balance the portfolioduration to achieve investment returns consistent with the preservation ofcapital and maintenance of liquidity adequate to meet payment of policybenefits and claims. We invest in assets permitted under the insurance laws ofthe various states in which we operate. Such laws generally prescribe thenature, quality of and limitations on various types of investments that may bemade. We do not currently have investments in partnerships, special purposeentities, real estate, commodity contracts, or other derivative securities. Wecurrently engage the services of three investment advisors under the directionof the management of our insurance company subsidiaries and in accordance withguidelines adopted by the Investment Committees of their respective boards ofdirectors. Conning Asset Management Company manages the portfolio of all of ourUnited States subsidiaries, except for the portfolio of Pyramid Life, and certainfloating rate portfolios, which are managed by Hyperion Capital. MFC GlobalInvestment Management manages our Canadian portfolio. We invest primarily infixed maturity securities of the U.S. Government and its agencies and incorporate fixed maturity securities with investment grade ratings of “BBB-”(Standard & Poor’s Corporation), “Baa3” (Moody’s Investor Service) orhigher.

As of June 30, 2006,approximately 99% of our fixed maturity investments had investment graderatings from Standard & Poor’s Corporation or Moody’s InvestorService. There were no non-income producing fixed maturities as of June 30,2006. During the six months ended June 30, 2006 and 2005, we did not writedown the value of any fixed maturity securities. These write-downs would representour estimate of other than temporary declines in value and would be included innet realized gains on investments in our consolidated statements of operations.

*Effects of RecentlyIssued and Pending Accounting Pronouncements*

There was no material impacton our consolidated financial condition or results of operations as a result ofour adoption of the recently issued accounting pronouncements. We do notanticipate any material impact from the adoption of the recently issued orpending accounting pronouncements, other than the adoption of Statement ofFinancial Accounting Standards No. 123-Revised, “Share-Based Payment”(“FAS 123-R”). FAS 123-R was adopted effective January 1,2006, and requires all companies to recognize compensation costs for share-basedpayments to employees based on the grant-date fair value of the award forfinancial statements. Refer to Consolidated Financial Statements Note 2—Recentand Pending Accounting Pronouncements and Note 8—Stock-based Compensation.

**ITEM 3—QUANTITATIVEAND QUALITATIVE DISCLOSURES ABOUT MARKET RISK**

In general, market riskrelates to changes in the value of financial instruments that arise fromadverse movements in interest rates and foreign exchange rates. We are exposedprincipally to changes in interest rates that affect the market prices of ourfixed income securities as well as the cost of our variable rate debt.Additionally, we are exposed to changes in the Canadian dollar that affects thetranslation of the financial position and the results of operations of ourCanadian subsidiary from Canadian dollars to U.S. dollars.

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*Investment InterestRate Sensitivity*

Our profitability could be affected if we wererequired to liquidate fixed income securities during periods of rising and/orvolatile interest rates. However, we attempt to mitigate our exposure toadverse interest rate movements through a combination of active portfoliomanagement and by staggering the maturities of our fixed income investments toassure sufficient liquidity to meet our obligations and to address reinvestmentrisk considerations. Our insurance liabilities generally arise over relativelylong periods of time, which typically permits ample time to prepare for theirsettlement.

Certain classes of mortgage-backed securities aresubject to significant prepayment risk due to the fact that in periods ofdeclining interest rates, individuals may refinance higher rate mortgages totake advantage of the lower rates then available. We monitor and adjust ourinvestment portfolio mix to mitigate this risk.

We regularly conduct various analyses to gauge thefinancial impact of changes in interest rate on our financial condition. Theranges selected in these analyses reflect our assessment as being reasonablypossible over the succeeding twelve-month period. The magnitude of changesmodeled in the accompanying analyses should not be construed as a prediction offuture economic events, but rather, be treated as a simple illustration of thepotential impact of such events on our financial results.

The sensitivity analysisof interest rate risk assumes an instantaneous shift in a parallel fashionacross the yield curve, with scenarios of interest rates increasing anddecreasing 100 and 200 basis points from their levels as of June 30, 2006,and with all other variables held constant. A 100 basis point increase inmarket interest rates would result in a pre-tax decrease in the market value ofour fixed income investments of $65.9 million and a 200 basis point increase inmarket interest rates would result in $127.9 million decrease. Similarly,a 100 basis point decrease in market interest rates would result in a pre-taxincrease in the market value of our fixed income investments of $70.7 millionand a 200 basis point decrease in market interest rates would result in a$144.9 million increase.

*Debt*

We pay interest on our term loan and a portion of ourtrust preferred securities based on the London Inter Bank Offering Rate (“LIBOR”)for one, two or three months. Due to the variable interest rate, the Companywould be subject to higher interest costs if short-term interest rates rise. Wehave attempted to mitigate our exposure to adverse interest rate movements byfixing the rate on $15.0 million of the trust preferred securities for a fiveyear period through the contractual terms of the security at inception and anadditional $35.0 million through the use of interest rate swaps.

We regularly conduct various analyses to gauge thefinancial impact of changes in interest rate on our financial condition. Theranges selected in these analyses reflect our assessment as being reasonablypossible over the succeeding twelve-month period. The magnitude of changesmodeled in the accompanying analyses should not be construed as a prediction offuture economic events, but rather, be treated as a simple illustration of thepotential impact of such events on our financial results.

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The sensitivity analysisof interest rate risk assumes scenarios increases or decreases in LIBOR of 100 and200 basis points from their levels as of and for the six months ended June 30,2006, and with all other variables held constant. The following tablesummarizes the impact of changes in LIBOR.

| ** **                                                | ** ** | ** **             | ** ** | **Weighted**                              | ** ** | **Effect of Change in LIBOR on Pre-tax Income  for the six months ended June 30, 2006** | ** ** |
|-----------------------------------------------------------|------------|------------------------|------------|-------------------------------------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| **Description of Floating Rate Debt** | ** ** | ** **             | ** ** | **Weighted  Average  Interest Rate** | ** ** | **Average  Balance  Outstanding**                                                                                                                             | ** ** | **200 Basis  Point  Decrease** | ** ** | **100 Basis  Point  Decrease** | ** ** | **100 Basis  Point  Increase** | ** ** | **200 Basis  Point  Increase** | ** ** |
| ** **                                                | ** ** | **(In millions)** | ** ** |
| Loan Payable                                              |       |                   | 7.0        | %                                         |       |                                                                                                                                                          | $          | 95.1 |   |   |   | $ | 1.0 |   |   |   | $ | 0.5 |   |   |   | $ | (0.5 | ) |   |   | $ | (1.0 | ) |   |
| Other long term  debt                                     |       |                   | 9.0        | %                                         |       |                                                                                                                                                          | $          | 25.0 |   |   |   | 0.2 |   |   |   | 0.1 |   |   |   | (0.1 | ) |   |   | (0.2 | ) |   |
| Total                                                     |       |                   |       |                                      |       |                                                                                                                                                          |       |   |   |   | $ | 1.2 |   |   |   | $ | 0.6 |   |   |   | $ | (0.6 | ) |   |   | $ | (1.2 | ) |   |
|                                                           |            |                        |            |                                           |            |                                                                                                                                                               |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

As noted above, we havefixed the interest rate on $50 million of our $168 million of total debtoutstanding, leaving $118 million of the debt exposed to rising interest rates.As of June 30, 2006 we had approximately $208 million of cash and cashequivalents and $149 million in short duration floating rate investmentsecurities. We anticipate that the net investment income on this $357 millionwill be positively impacted by rising interest rates and will mitigate thenegative impact of rising interest rates on our debt.

*Currency ExchangeRate Sensitivity*

Portions of our operations are transacted using theCanadian dollar as the functional currency. As of and for the six months ended June 30,2006, approximately 11% of our assets, 6% of our revenues, excluding realizedgains, and 23% of our income before realized gains and taxes were derived fromour Canadian operations. As of and for the six months ended June 30, 2005,approximately 12% of our assets, 8% of our revenues, excluding realized gains,and 14% of our income before realized gains and taxes were derived from ourCanadian operations. Accordingly, our earnings and shareholder’s equity areaffected by fluctuations in the value of the U.S. dollar as compared to theCanadian dollar. Although this risk is somewhat mitigated by the fact that boththe assets and liabilities for our foreign operations are denominated inCanadian dollars, we are still subject to translation gains and losses.

We periodically conduct various analyses to gauge thefinancial impact of changes in the foreign currency exchange rate on ourfinancial condition. The ranges selected in these analyses reflect ourassessment of what is reasonably possible over the succeeding twelve-monthperiod.

A 10% strengthening of the U.S. dollar relative to theCanadian dollar, as compared to the actual average exchange rate for the sixmonths ended June 30, 2006, would have resulted in a decrease in ourincome before realized gains and taxes of approximately $0.8 million for thesix months ended June 30, 2006 and a decrease in our shareholders’equity of approximately $5.3 million at June 30, 2006. A 10%weakening of the U.S. dollar relative to the Canadian dollar would haveresulted in an increase in our income before realized gains and taxes ofapproximately $0.9 million for the six months ended June 30, 2006 andan increase in shareholders’ equity of approximately $6.4 million at June 30,2006. Our sensitivity analysis of the effects of changes in foreign currencyexchange rates does not factor in any potential change in sales levels, localprices or any other variables.

The magnitude of changesreflected in the above analysis regarding interest rates and foreign currencyexchange rates should, in no manner, be construed as a prediction of futureeconomic events, but rather as a simple illustration of the potential impact ofsuch events on our financial results.

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**ITEM 4—Controls andprocedures**

***Disclosure Controls and Procedures***

The Company maintainsdisclosure controls and procedures that are designed to ensure that informationrequired to be disclosed in the reports that we file or submit under theExchange Act, is recorded, processed, summarized and reported within the timeperiods specified in the SEC’s rules and forms, and that such informationis accumulated and communicated to management, including the Company’s ChiefExecutive Officer and Chief Financial Officer, as appropriate, to allow timelydecisions regarding required disclosures.

***Inherent Limitations on Effectiveness of Controls***

Our disclosure controlsand procedures and our internal controls over financial reporting may notprevent or detect all errors and all fraud. A control system, no matter howwell designed and operated, can provide only reasonable, not absolute,assurance that the objectives of the control system are met. The design of acontrol system must reflect the fact that there are resource constraints, andthe benefits of controls must be considered relative to their costs. Further,because of the inherent limitations in all control systems, no evaluation ofcontrols can provide absolute assurance that misstatements due to error orfraud will not occur or that all control issues and instances of fraud, if any,within Universal American have been detected. These inherent limitationsinclude the realities that judgments in decision-making can be faulty and thatbreakdowns can occur because of simple error or mistake. Controls can also becircumvented by the individual acts of some persons or by collusion of two ormore people. The design of any system of controls is based in part on certainassumptions about the likelihood of future events, and there can be noassurance that any design will succeed in achieving its stated goals under allpotential future conditions. Projections of any evaluation of controlseffectiveness to future periods are subject to risks. Over time, controls maybecome inadequate because of changes in conditions or deterioration in thedegree of compliance with policies or procedures.

***Evaluation of Effectiveness of Controls***

An evaluation was carriedout under the supervision and with the participation of our management,including our Chief Executive Officer and Chief Financial Officer, of theeffectiveness of the design and operation of our disclosure controls andprocedures as of June 30, 2006. Based on this evaluation, our ChiefExecutive Officer and Chief Financial Officer concluded that our disclosurecontrols and procedures were effective as of June 30, 2006, at areasonable assurance level, to timely alert management to material informationrequired to be included in our periodic filings with the Securities andExchange Commission.

***Changes in Internal Control Over Financial Reporting***

There were no significantchanges in our internal control over financial reporting that occurred duringthe quarter ended June 30, 2006 that have materially affected, or arereasonably likely to materially affect, our internal control over financialreporting.

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**PART II**

**ITEM 1—LEGALPROCEEDINGS**

***Securities Class Action and Derivative Litigation***

Five actions containing related factual allegationswere filed against the Company and certain of its officers and directorsbetween November 22, 2005 and February 2, 2006. One of these actionswas voluntarily withdrawn by plaintiffs, and four actions are now pending, twoof which have been consolidated.

In the first action, Robert Kemp filed a purportedclass action complaint (the “Kemp Action”) on November 22, 2005, in theUnited States District Court for the Southern District of New York. The KempAction is a purported class action asserted on behalf of those shareholders ofthe Company who acquired the Company’s common stock between February 16,2005 and October 28, 2005. Plaintiffs in the Kemp Action seek unspecifieddamages under Section 10(b) and 20(a) of the Securities ExchangeAct of 1934 based upon allegedly false statements by the Company and Richard A.Barasch, Robert A. Waegelein and Gary W. Bryant (hereinafter, the “OfficerDefendants”) in press releases, financial statements and analyst conferencesduring the class period.

Another purported class action was filed by WesternTrust Laborers-Employers Pension Trust (the “Western Trust Action”), a putativeclass member in the Kemp Action who had filed a motion to be named as leadplaintiff in that action, on February 2, 2006, in the United StatesDistrict Court for the Southern District of New York. The factual and legalallegations in the Western Trust Action, which also purports to be a classaction, are similar to those in the Kemp Action. By order dated May 1,2006, the Kemp Action and the Western Trust Action were consolidated.

On June 26, 2006, a consolidated amended classaction complaint was filed in the Kemp Action (the “Amended Complaint”), whichwill now subsume the Western Trust Action. The Amended Complaint asserts thesame legal claims as in the original Kemp and Western Trust Actions, but alsonames an additional defendant and includes additional allegations. Theadditional defendant is William E. Wehner, a former director and formerpresident of Pennsylvania Life Insurance Company, a subsidiary of the Company.The Amended Complaint alleges that Mr. Wehner is liable for violations ofSections 10(b) and 20(a) of the Securities Exchange Act of 1934 ongrounds similar to those asserted against the Officer Defendants. Theadditional assertions are supposedly based in part upon information from sixformer employees and agents of the Company and its subsidiaries concerning,among other things, the Company’s medical loss ratio. Like the originalcomplaints in the Kemp and Western Trust Actions, the Amended Complaint seeksdamages in an unspecified amount. Under a scheduling order entered by theCourt, defendants will file a motion to dismiss the Amended Complaint on orbefore August 14, 2006.

Two additional actions have been brought derivativelyby shareholders purporting to act on behalf of the Company, and not as classactions. One of these was filed by Green Meadows Partners LLP (the “GreenMeadows Action”) on December 13, 2005, in the United States District Courtfor the Southern District of New York, and has been assigned to the same judgepresiding over the Kemp Action and the Western Trust Action. In the GreenMeadows Action, plaintiffs seek contribution under Section 10(b) and21D of the Exchange Act on the ground that if the Company is found liable tohave violated the securities laws in the Kemp Action, then the OfficerDefendants are liable for contribution. The Green Meadows Action also assertsthree claims under state law for breach of fiduciary duty against the OfficerDefendants.

On July 19, 2006, the plaintiff in the GreenMeadows Action filed a Verified Amended Shareholder Derivative Complaint (the“GM Amended Complaint”). The GM Amended Complaint adds as new defendantsMr. Wehner, Capital Z Financial Services Fund II, L.P. (“Capital Z”) andthree directors of the Company who are affiliated with Capital Z, namelyBradley E. Cooper, Robert A. Spass and Eric W. 

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Leathers. Capital Z is thelargest shareholder of the Company. The GM Amended Complaint carries forwardthe legal claims asserted in the original complaint against the originaldefendants (with additional allegations), and adds new claims (i) againstthe new director defendants for alleged breach of fiduciary duty in connectionwith a secondary offering in June 2005 that included 5 million shares ofthe Company’s common stock that had been owned by Capital Z and(ii) against Capital Z for alleged unjust enrichment with respect to theproceeds Capital Z realized from the sale of the 5 million shares it formerlyowned in the secondary offering. Under an order entered by the Court,defendants are scheduled to file a motion to dismiss the GM Amended Complainton or before September 8, 2006.

The second derivative action was filed by plaintiffArthur Tsutsui (the “Tsutsui Action”) on December 30, 2005, in The SupremeCourt for New York State, Westchester County. The defendants in the TsutsuiAction are the three Officer Defendants named in the other actions, as well asall of the directors sitting on the Company’s Board of Directors as of the timethe complaint was filed. The Tsutsui Action alleges that the same allegedmisstatements that are the subject of the Kemp Action constituted a breach offiduciary duty by the Officer Defendants and the directors that caused theCompany to sustain damages. The Tsutsui Action also seeks recovery of anyproceeds derived by the Officer Defendants from the sale of Company stock thatwas in breach of their fiduciary duties. Defendants in the Tsutsui Action fileda motion to dismiss the complaint on June 9, 2006. Plaintiff has not yetresponded to that motion, and counsel for the parties are discussing a proposedstipulation under which the Tsutsui Action would be stayed pending developmentsin the federal case.

Each of the OfficerDefendants and Mr. Wehner denies the allegations in the above-describedcases and has indicated that he intends to vigorously defend against theallegations. Management believes that after liability insurance recoveries,none of these actions will have a material adverse effect on us.

***Other Litigation***

We have litigation in theordinary course of our business, including claims for medical, disability andlife insurance benefits, and in some cases, seeking punitive damages.Management believes that after liability insurance recoveries, none of these actionswill have a material adverse effect on us. In addition, our insurance companysubsidiaries and health plan affiliates are subject to the regulations of, andsupervision by, the insurance departments of each of the jurisdictions in whichthey are admitted and authorized to transact business.  Periodically, these insurance departmentsconduct examinations and/or investigations of our insurance companysubsidiaries and health plan affiliates, which could result in adversefindings, monetary fines or disciplinary action, as more fully described in“Item 1—Business—Regulation” of our Annual Report on Form 10-K.

**ITEM 1A—RISKFACTORS**

Please refer to theCompany’s Annual Report on Form 10-K for the year endedDecember 31, 2005 for disclosures with respect to the Company’s riskfactors. There have been no material changes since year-end 2005 in thespecified risk factors disclosed in the Company’s Annual Report on Form 10-K.

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**ITEM 2—UNREGISTEREDSALES OF EQUITY SECURITIES AND USE OF PROCEEDS**

**Issuer purchases of Equity securities**

| **Period**                                   | ** ** | ** ** | ** ** | **Total Number  of Shares  Purchased(1)** | ** ** | **Average  Price Paid  Per Share** | ** ** | **Total Number of   Shares Purchased as  Part of Publicly  Announced Plans or  Programs** | ** ** | **Maximum Number  of Shares That May  Yet Be Purchased  Under the Plans or  Programs** | ** ** |
|----------------------------------------------|------------|------------|------------|-----------------------------------------------------|------------|----------------------------------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------------------------------------------------------------|------------|
| April 1,  2006—April 30, 2006 |       |       | —     |                                                |       |                                         | —     |                                                                                                                                   |       |                                                                                                                                | —     |   |   |   | 1,000,255 |   |   |
| May 1,  2006—May 31, 2006     |       |       | 155        |                                                |       |                                         | $          | 13.74                                                                                                                                  |       |                                                                                                                                |       | 155 |   |   |   | 1,000,100 |   |   |
| June 1,  2006—June 30, 2006   |       |       | 2,371      |                                                |       |                                         | $          | 14.24                                                                                                                                  |       |                                                                                                                                |       | 2,371 |   |   |   | 997,729 |   |   |
| Total                                        |       |       | 2,526      |                                                |       |                                         |       |                                                                                                                                   |       |                                                                                                                                | 2,526      |   |   |   |   |   |   |

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  (1) All shares were purchasedin private transactions.

**Recent Sales ofUnregistered Securities**

None.

**ITEM 3—DEFAULTSUPON SENIOR SECURITIES**

There were no defaultsupon senior securities during the first quarter of 2006.

**ITEM 4—SUBMISSIONOF MATTERS TO A VOTE OF SECURITY HOLDERS**

The Annual Meeting of Shareholders of the Company (the“Annual Meeting”) was held on May 25, 2006. The following describes theactions taken at the Annual Meeting.

*Election of Directors.**  *At the Annual Meeting, ten nominees were re-electedto serve as members of the Company’s Board of Directors until the Company’s2007 annual meeting of shareholders, or until their successors are duly electedand qualified. The tabulation of votes for each of the nominees was as follows:

| ** **             | ** ** | **Number of Votes** | ** ** |
|------------------------|------------|-------------------------------|------------|
| **Nominee**            | ** ** | ** **                    | ** ** | **For** | ** ** | **Withheld** | ** ** |
| Barry W. Averill       |       |                          | 35,651,271 |   |   | 297,503 |   |
| Richard A.  Barasch    |       |                          | 35,071,737 |   |   | 877,037 |   |
| Bradley E. Cooper      |       |                          | 34,478,087 |   |   | 1,470,687 |   |
| Mark M. Harmeling      |       |                          | 35,567,954 |   |   | 380,820 |   |
| Bertram Harnett        |       |                          | 33,912,399 |   |   | 2,036,375 |   |
| Linda H. Lamel         |       |                          | 35,645,081 |   |   | 303,693 |   |
| Eric W. Leathers       |       |                          | 35,583,829 |   |   | 364,945 |   |
| Patrick J.  McLaughlin |       |                          | 35,628,896 |   |   | 319,878 |   |
| Robert A. Spass        |       |                          | 34,419,742 |   |   | 1,529,032 |   |
| Robert F. Wright       |       |                          | 34,464,118 |   |   | 1,484,656 |   |
|                        |            |                               |            |  |  |  |  |  |  |

* *

*Ratification of theElection of Independent Auditors.**  *Atthe Annual Meeting, the proposal to ratify the appointment of Ernst &Young LLP as the Company’s independent auditors for the fiscal year ending December 31,2006 was approved. Tabulation of the votes for the proposal was as follows: 

| **Number of Votes  For** | ** ** | **Number of Votes  Against** | ** ** | **Number of  Abstentions** | ** ** | **Number of  Broker Non-Votes** | ** ** |
|------------------------------------|------------|----------------------------------------|------------|---------------------------------|------------|-------------------------------------------|------------|
| 35,901,113                         |       | 41,686                                 |       | 5,975                           |       | —                                    |       |

 

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**ITEM 5—OTHERINFORMATION**

None.

**ITEM6—EXHIBITS**

| 2.1   |   | Agreement and Plan of Merger, dated as of  March 9, 2004, among Universal American Financial Corp., HHS Acquisition  Corp., Heritage Health Systems, Inc. and Carlyle Venture Partners, L.P.,  as the stockholder representative, incorporated by reference to Form 8-K  dated March 9, 2004.                                                                        |
|-------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.1   |   | Restated Certificate of Incorporation of Universal  American Financial Corp. incorporated by reference to Exhibit 3.1 to the  registrant’s Amendment No. 2 to the Registration Statement (No. 333-62036)  on Form S-3 filed on July 11, 2001.                                                                                                                        |
| 3.2   |   | Amendment No. 1 to  the Restated Certificate of Incorporation of Universal American Financial  Corp., incorporated by reference to Exhibit 3 to Form 10-Q  (File No. 0-11321) for the quarter ended June 30, 2004, filed  with the SEC on August 9, 2004.                                                                                                            |
| 3.3   |   | Amended and Restated By-Laws  of Universal American Financial Corp., incorporated by reference to  Exhibit A to Form 8-K (File No. 0-11321) dated  August 13, 1999.                                                                                                                                                                                                            |
| 4.1   |   | Form of Indenture  dated as of December 2004 between Universal American Financial Corp. and  U.S. Bank National Association, as Trustee, incorporated by reference to  Exhibit 4.01 to Amendment No. 1 to the Company’s Registration  Statement on Form S-3 (File No. 333-120190) filed with  the Securities and Exchange Commission on December 10, 2004. |
| 4.2   |   | Form of Indenture  dated as of December 2004 between Universal American Financial Corp. and  U.S. Bank National Association, as Trustee, incorporated by reference to  Exhibit 4.02 to Amendment No. 1 to the Company’s Registration  Statement on Form S-3 (File No. 333-120190) filed with  the Securities and Exchange Commission on December 10, 2004. |
| 4.3   |   | Shareholders Agreement  dated July 30, 1999, among the Company, Capital Z Financial Services  Fund II, L.P., UAFC, L.P., AAM Capital Partners, L.P., Chase Equity  Associates, L.P., Richard A. Barasch and others, incorporated by  reference to Exhibit A of Form 8-K dated August 13, 1999.                                                                       |
| 4.4   |   | Registration Rights  Agreement, dated July 30, 1999, among the Company, Capital Z Financial  Services Fund II, L.P., Wand/Universal American Investments L.P.I.,  Wand/Universal American Investments L.P. II, Chase Equity Associates, L.P.,  Richard A. Barasch and others, incorporated by reference to Exhibit A to  Form 8-K dated August 13, 1999.                       |
| 11.1* |   | Computation of Per Share  Earnings Data, (contained in Note 4 to the Consolidated Financial Statements  in this Report).                                                                                                                                                                                                                                                                           |
| 31.1* |   | Certification of Chief  Executive Officer, as required by Rule 13a-14(a) of the  Securities Exchange Act of 1934.                                                                                                                                                                                                                                                                        |
| 31.2* |   | Certification of Chief  Financial Officer, as required by Rule 13a-14(a) of the  Securities Exchange Act of 1934.                                                                                                                                                                                                                                                                        |
| 32.1* |   | Certification of the  Chief Executive Officer and Chief Financial Officer, as required by  Rule 13a-14(b) of the Securities Exchange Act of 1934 and 18  U.S.C. Section 1350, as adopted pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002.                                                                                                                           |

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      * Filed or furnished herewith.

 

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**SIGNATURES**

Pursuantto the requirements of Section 13 or 15(d) of the Securities ExchangeAct of 1934, the Registrant has duly caused this report to be signed on itsbehalf by the undersigned, thereunto duly authorized.

|                     | **UNIVERSAL AMERICAN FINANCIAL  CORP.** |
|---------------------|-----------------------------------------|
| August 9, 2006 | /s/ RICHARD A. BARASCH                  |   |
|                | Richard A. Barasch                      |
|                | *Chief Executive Officer*               |
| August 9, 2006 | /s/ ROBERT A. WAEGELEIN                 |   |
|                | Robert A. Waegelein                     |
|                | *Executive Vice President and*          |
|                | *Chief Financial Officer*               |
|                | *(Principal Accounting Officer)*        |

 

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