**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 September 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 principal executive offices and zip  code)                  |
| **(914) 934-5200**                                                 |
| (Registrant’s telephone number, including area code)               |

 

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Indicate by checkmark whether the registrant (1) hasfiled all reports required to be filed by Section 13 or 15 (d) of theSecurities Exchange Act of 1934 during the preceding 12 months (or forsuch shorter period that the registrant was required to file such reports), and(2) has been subject to such filing requirements for the past90 days. Yes x   No o

Indicate by check mark whether the registrant is alarge accelerated filer, an accelerated filer, or a non-accelerated filer. Seedefinition of “accelerated filer and large accelerated filer” in Rule 12b-2of the Exchange Act. (Check one):

Large accelerated filer  o                     Acceleratedfiler  x                     Non-acceleratedfiler  o

Indicate by check mark whether the registrant is ashell company (as defined in Rule 12b-2 of the ExchangeAct). Yes o   No x

Asof November 3, 2006, 58,990,385 shares of the registrant’s common stockwere issued 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—Nine 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       |       |   | 33 |   |   |
|         |       |     | 3          |            |       | Quantitative  and Qualitative Disclosures About Market Risk                                                                     |       |   | 60 |   |   |
|         |       |     | 4          |            |       | Controls  and Procedures                                                                                                        |       |   | 62 |   |   |
| PART II |       |     |       |            |       | Other Information                                                                                                               |       |   |   |   |   |
|         |       |     | 1          |            |       | Legal Proceedings                                                                                                               |       |   | 64 |   |   |
|         |       |     | 1A         |            |       | Risk Factors                                                                                                                    |       |   | 66 |   |   |
|         |       |     | 2          |            |       | Unregistered Sales of Equity  Securities and Use of Proceeds                                                                    |       |   | 68 |   |   |
|         |       |     | 3          |            |       | Defaults Upon Senior  Securities                                                                                                |       |   | 69 |   |   |
|         |       |     | 4          |            |       | Submission of Matters to a  Vote of Security Holders                                                                            |       |   | 69 |   |   |
|         |       |     | 5          |            |       | Other Information                                                                                                               |       |   | 69 |   |   |
|         |       |     | 6          |            |       | Exhibits                                                                                                                        |       |   | 70 |   |   |
|         |       |     |       |            |       | Signatures                                                                                                                      |       |   | 71 |   |   |

 

2

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

**DISCLOSURE REGARDINGFORWARD 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 (the “Exchange Act”), and the Private SecuritiesLitigation Reform Act of 1995. The Company intends such forward-lookingstatements to be covered by the safe harbor provisions for forward-lookingstatements contained in Section 21E of the Exchange Act and the PrivateSecurities Litigation Reform Act of 1995. Such forward-looking statementsrelate to, without limitation, the Company’s future economic performance, plansand objectives for future operations and projections of revenue and otherfinancial items. Forward-looking statements can be identified by the use ofwords such as “prospects,” “outlook,” “believes,” “estimates,” “intends,” “may,”“will,” “should,” “anticipates,” “expects” or “plans,” or the negative or othervariation of these or similar words, or by discussion of trends and conditions,strategy or risks and uncertainties. Forward-looking statements are inherentlysubject to risks, trends and uncertainties, many of which are beyond theCompany’s ability to control or predict with accuracy and some of which theCompany might not even anticipate. Although the Company believes that theexpectations reflected in such forward-looking statements are based uponreasonable 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 factors that may cause actual results todiffer materially from the results discussed in the forward-looking statementsinclude, but are not limited to, the risks and uncertainties set forth in ourAnnual Report on Form 10-K for the fiscal year ended December 31,2005, and in our subsequently filed Quarterly Reports on Form 10-Q.The Company assumes no obligation to update or supplement any forward-lookingstatements that may become untrue because of subsequent events, whether as aresult of new information, future events or otherwise.

3

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**PART I**

**ITEM 1—FINANCIALSTATEMENTS (Unaudited)**

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

| ** **                                                                                                     | ** ** | **September 30,  2006** | ** ** | **December 31,  2005** | ** ** |
|----------------------------------------------------------------------------------------------------------------|------------|------------------------------|------------|-----------------------------|------------|
| ** **                                                                                                     | ** ** | **(Unaudited)**              | ** ** | ** **                  | ** ** |
| ASSETS                                                                                                         |       |                         |       |                        |       |   |   |   |   |
| Investments (Note 5):                                                                                          |       |                         |       |                        |       |   |   |   |   |
| Fixed maturities  available for sale, at fair value (amortized cost: 2006, $1,118,394; 2005,  $1,101,209) |       |                         | $          | 1,120,986                   |       |   |   | $ | 1,109,745 |   |   |
| Policy loans                                                                                                   |       |                         | 22,376     |                        |       |   | 23,493 |   |   |
| Other invested  assets                                                                                         |       |                         | 1,702      |                        |       |   | 2,175 |   |   |
| Total investments                                                                                              |       |                         | 1,145,064  |                        |       |   | 1,135,413 |   |   |
| Cash and cash  equivalents                                                                                     |       |                         | 341,097    |                        |       |   | 136,930 |   |   |
| Accrued investment  income                                                                                     |       |                         | 11,807     |                        |       |   | 12,482 |   |   |
| Deferred policy  acquisition costs                                                                             |       |                         | 257,826    |                        |       |   | 243,300 |   |   |
| Amounts due from  reinsurers                                                                                   |       |                         | 266,658    |                        |       |   | 220,944 |   |   |
| Due and unpaid  premiums                                                                                       |       |                         | 15,108     |                        |       |   | 6,025 |   |   |
| Present value of  future profits and other amortizing intangible assets (Note 4)                               |       |                         | 56,517     |                        |       |   | 50,724 |   |   |
| Goodwill and other  indefinite lived intangible assets (Note 4)                                                |       |                         | 71,332     |                        |       |   | 73,000 |   |   |
| Income taxes  receivable                                                                                       |       |                         | —     |                        |       |   | 3,481 |   |   |
| Other assets                                                                                                   |       |                         | 162,923    |                        |       |   | 53,985 |   |   |
| Assets of  discontinued operations (Note 16)                                                                   |       |                         | 304,074    |                        |       |   | 277,695 |   |   |
| Total assets                                                                                                   |       |                         | $          | 2,632,406                   |       |   |   | $ | 2,213,979 |   |   |
| LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                      |       |                         |       |                        |       |   |   |   |   |
| LIABILITIES                                                                                                    |       |                         |       |                        |       |   |   |   |   |
| Policyholder  account balances                                                                                 |       |                         | $          | 492,898                     |       |   |   | $ | 495,751 |   |   |
| Reserves for  future policy benefits                                                                           |       |                         | 593,761    |                        |       |   | 585,934 |   |   |
| Policy and  contract claims—life                                                                          |       |                         | 13,053     |                        |       |   | 14,081 |   |   |
| Policy and  contract claims—health                                                                        |       |                         | 168,654    |                        |       |   | 107,156 |   |   |
| Advance Premiums                                                                                               |       |                         | 25,303     |                        |       |   | 17,878 |   |   |
| CMS contract  deposits for amounts not at risk                                                                 |       |                         | 155,357    |                        |       |   | — |   |   |
| Loan payable (Note  9)                                                                                         |       |                         | 91,875     |                        |       |   | 95,813 |   |   |
| Other long term  debt (Note 10)                                                                                |       |                         | 75,000     |                        |       |   | 75,000 |   |   |
| Amounts due to  reinsurers                                                                                     |       |                         | 80,856     |                        |       |   | 6,028 |   |   |
| Income taxes  payable                                                                                          |       |                         | 3,294      |                        |       |   | — |   |   |
| Deferred income  tax liability                                                                                 |       |                         | 1,565      |                        |       |   | 4,820 |   |   |
| Other liabilities                                                                                              |       |                         | 107,313    |                        |       |   | 67,364 |   |   |
| Liabilities of  discontinued operations (Note 16)                                                              |       |                         | 231,661    |                        |       |   | 212,270 |   |   |
| Total liabilities                                                                                              |       |                         | 2,040,590  |                        |       |   | 1,682,095 |   |   |
| 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                                                                                    |       |                         | 246,961    |                        |       |   | 242,433 |   |   |
| Accumulated other  comprehensive income (Notes 6 and 13)                                                       |       |                         | 39,353     |                        |       |   | 39,896 |   |   |
| Retained earnings                                                                                              |       |                         | 315,538    |                        |       |   | 260,205 |   |   |
| Less: Treasury  stock (2006, 0.7 million shares; 2005, 0.8 million shares)                                     |       |                         | (10,628    | )                           |       |   | (11,240 | ) |   |
| Total  stockholders’ equity                                                                               |       |                         | 591,816    |                        |       |   | 531,884 |   |   |
| Total liabilities  and stockholders’ equity                                                               |       |                         | $          | 2,632,406                   |       |   |   | $ | 2,213,979 |   |   |

 

See notes to unaudited consolidated financial statements.

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

| ** **                                                                                 | ** ** | **2006**       | ** ** | **2005**       | ** ** |
|--------------------------------------------------------------------------------------------|------------|----------------|------------|----------------|------------|
| Revenues:                                                                                  |       |           |       |           |       |
| Direct premium and policyholder  fees earned                                               |       | $              | 466,714    |           | $          | 307,348 |   |
| Reinsurance premiums  assumed                                                              |       | 7,694          |       | 8,463          |       |
| Reinsurance premiums  ceded                                                                |       | (173,141       | )          | (118,565       | )          |
| Net premiums and  policyholder fees earned                                                 |       | 301,267        |       | 197,246        |       |
| Net investment income                                                                      |       | 19,578         |       | 15,735         |       |
| Fee and other income                                                                       |       | 7,304          |       | 4,538          |       |
| Net realized (losses)  gains on investments                                                |       | (26            | )          | 260            |       |
| Total revenues                                                                             |       | 328,123        |       | 217,779        |       |
| Benefits, Claims and Expenses:                                                             |       |           |       |           |       |
| Claims and other benefits                                                                  |       | 212,773        |       | 139,996        |       |
| Increase in future policy  benefits                                                        |       | 1,913          |       | 1,352          |       |
| Interest credited to  policyholders                                                        |       | 4,503          |       | 5,096          |       |
| Increase in deferred  acquisition costs                                                    |       | (3,863         | )          | (13,299        | )          |
| Amortization of present  value of future profits                                           |       | 1,810          |       | 2,047          |       |
| Commissions                                                                                |       | 28,566         |       | 34,602         |       |
| Reinsurance commissions  and expense allowances                                            |       | (18,199        | )          | (15,241        | )          |
| Interest expense                                                                           |       | 3,670          |       | 2,826          |       |
| Other operating costs and  expenses                                                        |       | 68,210         |       | 41,119         |       |
| Total benefits, claims  and expenses                                                       |       | 299,383        |       | 198,498        |       |
| Income from continuing  operations, before equity in earnings of unconsolidated subsidiary |       | 28,740         |       | 19,281         |       |
| Equity in earnings (loss)  of unconsolidated subsidiary (Note 14)                          |       | 13,971         |       | (224           | )          |
| Income from continuing  operations before taxes                                            |       | 42,711         |       | 19,057         |       |
| Provision for income  taxes                                                                |       | 15,983         |       | 7,182          |       |
| **Income  from continuing operations**                                                     | ** ** | **26,728**     | ** ** | **11,875**     | ** ** |
| Income from discontinued  operations, net of taxes (Note 16)                               |       | 3,474          |       | 3,413          |       |
| **Net  income**                                                                            | ** ** | **$**          | **30,202** | ** **     | **$**      | **15,288** | ** ** |
| **Earnings per common share**                                                              |       |           |       |           |       |
| **Basic:**                                                                                 |       |           |       |           |       |
| Income from continuing  operations                                                         |       | $              | 0.46       |           | $          | 0.20 |   |
| Income from discontinued  operations, net of taxes (Note 16)                               |       | 0.06           |       | 0.06           |       |
| Net income                                                                                 |       | $              | 0.52       |           | $          | 0.26 |   |
| **Diluted:**                                                                               |       |           |       |           |       |
| Income from continuing  operations                                                         |       | $              | 0.44       |           | $          | 0.19 |   |
| Income from discontinued  operations, net of taxes (Note 16)                               |       | 0.06           |       | 0.06           |       |
| Net income                                                                                 |       | $              | 0.50       |           | $          | 0.25 |   |
| **Weighted average shares outstanding:**                                                   |       |           |       |           |       |
| Weighted average shares  outstanding                                                       |       | 59,191,384     |       | 58,568,131     |       |
| Less weighted average  treasury shares                                                     |       | (707,648       | )          | (52,718        | )          |
| **Basic  weighted shares outstanding**                                                     | ** ** | **58,483,736** | ** ** | **58,515,413** |       |
| Effect of dilutive  securities                                                             |       | 1,434,330      |       | 2,096,420      |       |
| **Diluted weighted shares outstanding**                                                    | ** ** | **59,918,066** | ** ** | **60,611,833** |       |

 

See notes to unaudited consolidated financial statements.

5

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

| ** **                                                                                 | ** ** | **2006**       | ** ** | **2005**       | ** ** |
|--------------------------------------------------------------------------------------------|------------|----------------|------------|----------------|------------|
| Revenues:                                                                                  |       |           |       |           |       |
| Direct premium and policyholder fees earned                                                |       | $              | 1,412,205  |           | $          | 779,819 |   |
| Reinsurance premiums assumed                                                               |       | 24,240         |       | 25,659         |       |
| Reinsurance premiums ceded                                                                 |       | (540,440       | )          | (232,693       | )          |
| Net premiums and policyholder fees earned                                                  |       | 896,005        |       | 572,785        |       |
| Net investment income                                                                      |       | 55,244         |       | 44,950         |       |
| Fee and other income                                                                       |       | 20,570         |       | 13,160         |       |
| Net realized gains on investments                                                          |       | 21             |       | 4,363          |       |
| Total revenues                                                                             |       | 971,840        |       | 635,258        |       |
| Benefits, Claims and  Expenses:                                                            |       |           |       |           |       |
| Claims and other benefits                                                                  |       | 684,342        |       | 407,451        |       |
| Increase in future policy benefits                                                         |       | 7,820          |       | 5,204          |       |
| Interest credited to policyholders                                                         |       | 13,713         |       | 14,271         |       |
| Increase in deferred acquisition costs                                                     |       | (12,350        | )          | (44,355        | )          |
| Amortization of present value of future profits                                            |       | 6,288          |       | 4,918          |       |
| Commissions                                                                                |       | 90,533         |       | 102,459        |       |
| Reinsurance commissions and expense allowances                                             |       | (55,307        | )          | (43,873        | )          |
| Interest expense                                                                           |       | 9,898          |       | 8,007          |       |
| Other operating costs and expenses                                                         |       | 189,248        |       | 116,048        |       |
| Total benefits, claims and expenses                                                        |       | 934,185        |       | 570,130        |       |
| Income from continuing operations, before equity in earnings of  unconsolidated subsidiary |       | 37,655         |       | 65,128         |       |
| Equity in earnings (loss) of unconsolidated subsidiary (Note 14)                           |       | 36,645         |       | (400           | )          |
| **Income from continuing operations before taxes**                                         | ** ** | **74,300**     | ** ** | **64,728**     | ** ** |
| Provision for income taxes                                                                 |       | 27,278         |       | 22,715         |       |
| **Income from continuing operations**                                                      | ** ** | **47,022**     | ** ** | **42,013**     | ** ** |
| Income from discontinued operations, net of taxes (Note 16)                                |       | 8,311          |       | 7,995          |       |
| **Net income**                                                                             | ** ** | **$**          | **55,333** | ** **     | **$**      | **50,008** | ** ** |
| **Earnings per common  share**                                                             |       |           |       |           |       |
| **Basic:**                                                                                 |       |           |       |           |       |
| Income from continuing operations                                                          |       | $              | 0.81       |           | $          | 0.74 |   |
| Income from discontinued operations, net of taxes (Note 16)                                |       | 0.14           |       | 0.14           |       |
| Net income                                                                                 |       | $              | 0.95       |           | $          | 0.88 |   |
| **Diluted:**                                                                               |       |           |       |           |       |
| Income from continuing operations                                                          |       | $              | 0.78       |           | $          | 0.72 |   |
| Income from discontinued operations, net of taxes (Note 16)                                |       | 0.14           |       | 0.13           |       |
| Net income                                                                                 |       | $              | 0.92       |           | $          | 0.85 |   |
| **Weighted average shares  outstanding:**                                                  |       |           |       |           |       |
| Weighted average shares outstanding                                                        |       | 59,121,776     |       | 56,694,196     |       |
| Less weighted average treasury shares                                                      |       | (718,677       | )          | (67,546        | )          |
| **Basic weighted shares outstanding**                                                      | ** ** | **58,403,099** | ** ** | **56,626,650** | ** ** |
| Effect of dilutive securities                                                              |       | 1,482,847      |       | 2,050,371      |       |
| **Diluted weighted shares outstanding**                                                    | ** ** | **59,885,946** | ** ** | **58,677,021** | ** ** |

 

See notes to unaudited consolidated financial statements.

6

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**UNIVERSAL AMERICAN FINANCIAL CORP. AND SUBSIDIARIES**

**CONSOLIDATEDSTATEMENTS OF STOCKHOLDERS’ EQUITY AND COMPREHENSIVEINCOME**

**For the Nine Months Ended September 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                                   |       |              | —     |                             |       | —                                        |       |                   | —     |                |       | 50,008    |       | — |   | 50,008 |   |
| Other  comprehensive income  (Note 13)       |       |              | —     |                             |       | —                                        |       |                   | 691        |                |       | —    |       | — |   | 691 |   |
| Comprehensive income                         |       |              |       |                             |       |                                          |       |                   |       |                |       |      |       |   |   | 50,699 |   |
| Issuance of common stock                     |       |              | 36         |                             |       | 66,396                                        |       |                   | —     |                |       | —    |       | — |   | 66,432 |   |
| Stock-based  compensation                    |       |              | —     |                             |       | 1,678                                         |       |                   | —     |                |       | —    |       | — |   | 1,678 |   |
| Repayments of  loans to officers             |       |              | —     |                             |       | 20                                            |       |                   | —     |                |       | —    |       | — |   | 20 |   |
| Treasury shares  purchased, at cost (Note 6) |       |              | —     |                             |       | —                                        |       |                   | —     |                |       | —    |       | (45 | ) | (45 | ) |
| Treasury shares  reissued (Note 6)           |       |              | —     |                             |       | 598                                           |       |                   | —     |                |       | —    |       | 577 |   | 1,175 |   |
| Balance,  September 30, 2005            |       |              | $          | 589                              |       |                                          | $          | 241,217                |       |                | $          | 41,674    |       |   | $ | 256,337 |   | $ | (437 | ) | $ | 539,380 |   |
| **2006**                                     |       |              |       |                             |       |                                          |       |                   |       |                |       |      |       |   |   |   |   |
| Balance,  January 1, 2006               |       |              | $          | 590                              |       |                                          | $          | 242,433                |       |                | $          | 39,896    |       |   | $ | 260,205 |   | $ | (11,240 | ) | $ | 531,884 |   |
| Net income                                   |       |              | —     |                             |       | —                                        |       |                   | —     |                |       | 55,333    |       | — |   | 55,333 |   |
| Other  comprehensive loss (Note 13)          |       |              | —     |                             |       | —                                        |       |                   | (543       | )                   |       | —    |       | — |   | (543 | ) |
| Comprehensive income                         |       |              |       |                             |       |                                          |       |                   |       |                |       |      |       |   |   | 54,790 |   |
| Issuance of common stock                     |       |              | 2          |                             |       | 2,050                                         |       |                   | —     |                |       | —    |       | — |   | 2,052 |   |
| Stock-based  compensation                    |       |              | —     |                             |       | 2,456                                         |       |                   | —     |                |       | —    |       | — |   | 2,456 |   |
| Treasury shares  purchased, at cost (Note 6) |       |              | —     |                             |       | —                                        |       |                   | —     |                |       | —    |       | (209 | ) | (209 | ) |
| Treasury shares  reissued (Note 6)           |       |              | —     |                             |       | 22                                            |       |                   | —     |                |       | —    |       | 821 |   | 843 |   |
| Balance,  September 30, 2006            |       |              | $          | 592                              |       |                                          | $          | 246,961                |       |                | $          | 39,353    |       |   | $ | 315,538 |   | $ | (10,628 | ) | $ | 591,816 |   |

 

See notes to unaudited consolidated financial statements.

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

| ** **                                                                                                    | ** ** | **2006** | ** ** | **2005** | ** ** |
|---------------------------------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|
| Cash flows from operating activities:                                                                         |       |     |       |     |       |
| Net income                                                                                                    |       | $        | 55,333     |     | $          | 50,008 |   |
| Adjustments to reconcile  net income to net cash provided by operating activities, net of balances  acquired: |       |     |       |     |       |
| Income from  discontinued operations                                                                          |       | (8,311   | )          | (7,995   | )          |
| Equity in the  (earnings) loss of unconsolidated subsidiary                                                   |       | (36,645  | )          | 401      |       |
| Distribution from  unconsolidated subsidiary                                                                  |       | 30,500   |       | —   |       |
| Deferred income  taxes                                                                                        |       | (1,884   | )          | 16,007   |       |
| Realized gains on  investments                                                                                |       | (21      | )          | (4,363   | )          |
| Amortization of  present value of future profits and other intangibles                                        |       | 6,288    |       | 4,918    |       |
| Net amortization  of bond premium                                                                             |       | 1,688    |       | 2,464    |       |
| Change in deferred  policy acquisition costs                                                                  |       | (12,350  | )          | (44,355  | )          |
| Change in reserves  for future policy benefits                                                                |       | 7,827    |       | 10,797   |       |
| Change in policy  and contract claims payable                                                                 |       | 60,470   |       | 15,207   |       |
| Change in  reinsurance balances                                                                               |       | 27,944   |       | (9,468   | )          |
| Change in advanced  premium                                                                                   |       | (1,820   | )          | 18,442   |       |
| Change in income  taxes payable                                                                               |       | 6,775    |       | 1,141    |       |
| Change in  Part D receivables                                                                            |       | (89,323  | )          | —   |       |
| Change in  Part D payables                                                                               |       | 31,941   |       | —   |       |
| Other, net                                                                                                    |       | 8,640    |       | 8,142    |       |
| Cash from  operating activities—continuing operations                                                    |       | 87,052   |       | 61,346   |       |
| Cash from  operating activities—discontinued operations                                                  |       | 10,411   |       | 12,169   |       |
| Cash from  operating activities                                                                               |       | 97,463   |       | 73,515   |       |
| Cash flows from investing activities:                                                                         |       |     |       |     |       |
| Proceeds from sale  or redemption of fixed maturities                                                         |       | 70,979   |       | 197,620  |       |
| Cost of fixed  maturities purchased                                                                           |       | (89,798  | )          | (315,306 | )          |
| Purchase of  business                                                                                         |       | (10,407  | )          | (1,611   | )          |
| Purchase of fixed  assets                                                                                     |       | (10,249  | )          | (2,793   | )          |
| Other investing  activities                                                                                   |       | 956      |       | 29,340   |       |
| Cash used for  investing activities—continuing operations                                                |       | (38,519  | )          | (92,750  | )          |
| Cash used for  investing activities—discontinued operations                                              |       | (4,562   | )          | (8,365   | )          |
| Cash used for  investing activities                                                                           |       | (43,081  | )          | (101,115 | )          |
| Cash flows from financing activities:                                                                         |       |     |       |     |       |
| Net proceeds from  issuance of common stock                                                                   |       | 2,053    |       | 63,848   |       |
| Cost of treasury  stock purchases                                                                             |       | (209     | )          | (45      | )          |
| Receipts from CMS  contract deposits                                                                          |       | 663,054  |       | —   |       |
| Withdrawals from  CMS contract deposits                                                                       |       | (507,697 | )          | —   |       |
| Deposits and  interest credited to policyholder account balances, net of reinsurance                          |       | 37,803   |       | 53,625   |       |
| Policyholder  account balance surrenders and other withdrawals                                                |       | (39,805  | )          | (36,879  | )          |
| Distribution from  discontinued operations                                                                    |       | 4,372    |       | 2,706    |       |
| Principal  repayment on loan payable                                                                          |       | (3,938   | )          | (3,938   | )          |
| Cash from  financing activities—continuing operations                                                    |       | 155,633  |       | 79,317   |       |
| Cash from  financing activities—discontinued operations                                                  |       | (4,372   | )          | (2,706   | )          |
| Cash from  financing activities                                                                               |       | 151,261  |       | 76,611   |       |
| Net increase in  cash and cash equivalents                                                                    |       | 205,643  |       | 49,011   |       |
| Cash and cash equivalents  at beginning of year                                                               |       | 138,899  |       | 181,257  |       |
| Cash and cash  equivalents at end of period                                                                   |       | 344,542  |       | 230,268  |       |
| Less cash and cash  equivalents of discontinued operations at end of period                                   |       | 3,445    |       | 3,460    |       |
| Cash and cash  equivalents of continuing operations at end of period                                          |       | $        | 341,097    |     | $          | 226,808 |   |

 

See notes to unaudited consolidated financial statements.

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

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

Universal American Financial Corp. (“we,” the “Company,”or “Universal American”) is a specialty health and life insurance holdingcompany with an emphasis on providing a broad array of health insurance andmanaged care products and services to the growing senior population. UniversalAmerican was incorporated in the State of New York in 1981. Collectively, ourinsurance company subsidiaries are licensed to sell life and accident andhealth insurance and annuities in all fifty states, the District of Columbia,and Puerto Rico. The principal insurance products currently sold by the Companyare Medicare Supplement and Select, fixed benefit accident and sicknessdisability insurance and senior life insurance. The Company distributes theseproducts through an independent general agency system and a career agencysystem. The career agents focus on sales for Pennsylvania Life InsuranceCompany (“Pennsylvania Life”) and The Pyramid Life Insurance Company (“PyramidLife”) while the independent general agents sell for American Pioneer LifeInsurance Company (“American Pioneer”), American Progressive Life & HealthInsurance Company of New York (“American Progressive”), Constitution LifeInsurance Company (“Constitution”), Marquette National Life Insurance Company (“Marquette”)and Union Bankers Insurance Company (“Union Bankers”). Heritage Health Systems, Inc.(“Heritage”) operates Medicare Advantage plans in Houston and Beaumont Texasthrough SelectCare of Texas, L.L.C., in Oklahoma through SelectCare of Oklahoma, Inc.(formerly Eagle Life Insurance Company), and in Florida through AmericanPioneer and our Medicare Advantage private fee-for-service plans (“PFFS”)through American Progressive and Pyramid Life. CHCS Services, Inc. (“CHCS”),the Company’s administrative services company, acts as a service provider forboth affiliated and unaffiliated insurance companies for senior market insuranceand non-insurance programs.

In 2006, we began offering prescription drug benefitplans (“PDPs”) pursuant to Medicare Part D (“Part D”) through astrategic alliance with PharmaCare Management Services, Inc. (“PharmaCare”),a third party pharmacy benefits manager (“PBM”) and wholly-owned subsidiary ofCVS Corporation (“CVS”).

On August 31, 2006,the Company entered into a definitive agreement to sell Penncorp Life InsuranceCompany (“PennCorp Life Canada”), its Canadian subsidiary. The Companyanticipates that the closing of the transaction, which is subject to thereceipt of applicable regulatory approvals and other customary conditions, willoccur during the fourth quarter of 2006. Consequently, theCompany has accounted for the operations of PennCorp Life Canada as discontinuedoperations, beginning in the third quarter. All prior period amounts have beenreclassified to conform to this presentation. See Note 16—DiscontinuedOperations.

**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 and its subsidiaries (collectively, the “Company”),American Progressive, American Pioneer, American Exchange Life InsuranceCompany (“American Exchange”), Pennsylvania Life, Peninsular Life InsuranceCompany (“Peninsular”), Union Bankers, Constitution, Marquette, 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 us and 50% owned by PharmaCare. We do not control PDMS andtherefore PDMS is not consolidated in our financial statements. PDMS principallyperforms marketing and risk management services on behalf of our 

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PDPs and PharmaCare Re,for which it receives fees and other remuneration from our PDPs and PharmaCare.As noted above, the operations ofPennCorp Life Canada are reported as discontinued operations.

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 (including normal,recurring adjustments) necessary to present fairly the financial position andresults of operations for such periods. The results of operations for the threeor nine months ended September 30, 2006 and 2005 are not necessarilyindicative of the results to be expected for the full year. The accompanyingconsolidated financial statements and notes should be read in conjunction withthe Company’s Annual Report on Form 10-K for the fiscal 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 quarter.

***Supplemental Cash Flow Information:  ***Supplementalcash flow information for interest and income taxes paid for continuing anddiscontinued operations is as follows:

| ** **                                                        | ** ** | **Nine months ended  September 30,** | ** ** |
|-------------------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                        | ** ** | **2006**                                            | ** ** | **2005** | ** ** |
| ** **                                                        | ** ** | **(in thousands)**                             | ** ** |
| Supplemental cash flow  information from continuing operations:   |       |                                                |       |   |   |
| Cash paid for interest                                            |       | $                                                   | 9,499      |   | $ | 7,950 |   |
| Cash paid for income taxes                                        |       | $                                                   | 20,800     |   | $ | 4,768 |   |
| Supplemental cash flow  information from discontinued operations: |       |                                                |       |   |   |
| Cash paid for  income taxes                                       |       | $                                                   | 5,118      |   | $ | 2,767 |   |

 

***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 for the fiscal year ended December 31,2005.

***Accounting for Prescription Drug Benefits underMedicare Part D***

On January 1, 2006, we began offeringprescription drug coverage in accordance with Part D as a stand-alonebenefit to Medicare-eligible beneficiaries under 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 

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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 a percentage of revenues, as reflectedin their bids (“target amount’). Variances exceeding, or below, certainthresholds may result in CMS making additional payments to us or requiring usto refund to CMS a portion of the payments we received. Actual prescriptiondrug costs subject to risk sharing with CMS are limited to the costs that are,or would have been, incurred under the CMS defined “standard” benefit plan. Weestimate and recognize an adjustment to premium revenues related to the riskcorridor payment adjustment based upon prescription drug claims experience todate, net of manufacturer rebates and other Part D revenues, at the end ofeach reporting period. Accordingly, this estimate does not consider futureprescription 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 through the reinsurance subsidy for PDPs offeringthe standard coverage. Low-income cost subsidies represent reimbursements fromCMS for all or a portion of the deductible, the coinsurance and the co-paymentamounts for low-income beneficiaries. We account for these subsidies as adeposit in our balance sheet and as a financing activity in our statement ofcash flows. We do not recognize premium revenue or claims expense for thesesubsidies. Receipt and payment activity is accumulated at the contract leveland recorded in the balance sheet as a CMS contract deposit account asset orliability depending on the net contract balance at the end of the reportingperiod.

We recognize pharmacy benefit costs as incurred. Wehave subcontracted the pharmacy claims administration to PharmaCare, a thirdparty PBM. Certain of our PDPs receive all or a portion of the rebates fromdrug manufacturers on prescriptions filled. A significant portion of these rebatesare reflected as a reduction in pharmacy benefit costs with the balance offsetagainst the catastrophic claims reimbursed by CMS, for which we are not at risk.Pharmacy benefit costs are based on rates as contracted with PharmaCare.

The PDPs sponsored by subsidiaries of UniversalAmerican are reinsured, on a 50% quota share basis, to PharmaCare Captive Re,Ltd (“PharmaCare Re”) a wholly-owned subsidiary of PhamaCare, which itself is awholly-owned subsidiary of CVS. Our insurance company subsidiaries also assume,on a 33.3% quota share basis, risks of an unaffiliated prescription drug plan.

For the nine months ended September 30, 2006, webased our membership for Part D on enrollment information provided by CMSwhich indicated that, as of September 30, 2006, approximately 445,000members were enrolled in our PDPs for which we were paid by CMS. This includesapproximately 422,000 members in our PDPs that we participate in on a 50% basisand 23,000 members in the unaffiliated PDP that we participate in on a 33.3%basis. Our revenues and claims expense are based on earned premium and incurredpharmacy benefits for the reported enrolled membership. The membershipinformation continues to be reconciled and refined by CMS with respect to theallocation among all plans participating in the Part D program. As aresult, it is likely that the membership data upon which we based our resultsfor the first nine months of 2006 will change, with a corresponding change inthe financial results for the 

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segment. We are unable toprecisely quantify the impact of any potential change until the membership datais fully reconciled with CMS; however, we do not believe that any change fromthe amounts reported as of September 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 New Accounting 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 FASB issued FASB Staff Position No. 115-1,“The Meaning of Other-Than-Temporary Impairment and Its Application to CertainInvestments” (“FSP 115-1”). FSP 115-1 modifies certain existingguidance and establishes a framework for the evaluation of whether animpairment of an investment is other-than-temporary. The evaluation is based onthe intent and ability to hold the security to recovery, and should beconsidered on an individual security basis, not on a portfolio basis. FSP 115-1also clarifies 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 September 30, 2006, the Company had $10.2 million oftotal gross unrealized losses. The amount of impairments to be recognized, ifany, will depend on market conditions and management’s intent and ability tohold securities with unrealized losses at the time of the impairmentevaluation.

***Future Adoption of Accounting Standards:***

***DeferredAcquisition Costs—******In***September 2005,the American Institute of Certified Public Accountants issued Statement ofPosition 05-1, “Accounting by Insurance Enterprises for DeferredAcquisition Costs (“DAC”) in Connection with Modifications or Exchanges ofInsurance Contracts” (“SOP 05-1”). SOP 05-1 provides guidance onaccounting by insurance enterprises for DAC on internal replacements ofinsurance and investment contracts. An internal replacement is a modificationin product benefits, features, rights or coverages that occurs by the exchangeof a contract for a new contract, or by amendment, endorsement, or rider to acontract, or by the election of a feature or coverage within a contract.Modifications that result in a replacement contract that is substantiallychanged from the 

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replaced contract shouldbe accounted for as an extinguishment of the replaced contract. UnamortizedDAC, unearned revenue liabilities and deferred sales inducements from thereplaced contract must be written-off. Modifications that result in a contractthat is substantially unchanged from the replaced contract should be accountedfor as a continuation of the replaced contract. SOP 05-1 is effective forinternal replacements occurring in fiscal years beginning after December 15,2006, with earlier adoption encouraged. Initial application of SOP 05-1should be as of the beginning of the entity’s fiscal year. The Company expectsto adopt SOP 05-1 effective January 1, 2007. Adoption of this statementis expected to have an effect on the Company’s consolidated financialstatements; however, the effect has not yet been determined.

***Income Taxes—******In***July 2006,the FASB issued FASB Interpretation No. 48, “Accounting for Uncertainty inIncome Taxes-an Interpretation of FASB Statement 109” (“FIN 48”). FIN 48prescribes a comprehensive model for how a company should recognize, measure,present, and disclose in its financial statements uncertain tax positions thatthe company has taken or expects to take on a tax return. The interpretationrequires public companies to recognize the tax benefits of uncertain taxpositions only where the position is “more likely than not” to be sustainedassuming examination by tax authorities. The amount recognized would be theamount that represents the largest amount of tax benefit that is greater than50% likely of being realized upon ultimate settlement with the taxing authority.A liability 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. FIN48 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 willchange significantly in the next 12 months. FIN 48 is effective for fiscalyears beginning after December 15, 2006. We currently are evaluating theimpact of adopting FIN 48.

**4.**                 *INTANGIBLE ASSETS*

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

| ** **                                    | ** ** | **Weighted  Average** | ** ** | **September 30, 2006** | ** ** | **December 31, 2005** | ** ** |
|-----------------------------------------------|------------|-----------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                    | ** ** | **Life  (Years)**     | ** ** | **Value  Assigned**              | ** ** | **Accumulated  Amortization**   | ** ** | **Value  Assigned** | ** ** | **Accumulated  Amortization** | ** ** |
| ** **                                    | ** ** | ** **            | ** ** | **(In thousands)**          | ** ** |
| Senior Health  Insurance:                     |       |                  |       |                             |       |                            |       |   |   |   |   |   |   |   |   |   |   |
| Policies in force                             |       |                  | 9          |                             |       | $                               | 18,473     |   |   | $ | 9,270 |   |   | $ | 18,473 |   |   | $ | 6,761 |   |   |
| Distribution Channel                          |       |                  | 30         |                             |       | 22,055                          |       |   | 2,573 |   |   | 22,055 |   |   | 2,022 |   |   |
| Life Insurance  and Annuity—PVFP         |       |                  | 7          |                             |       | 4,127                           |       |   | 1,825 |   |   | 4,127 |   |   | 1,577 |   |   |
| Senior Managed  Care—Medicare Advantage: |       |                  |       |                             |       |                            |       |   |   |   |   |   |   |   |   |   |   |
| Membership Base                               |       |                  | 7          |                             |       | 15,381                          |       |   | 4,960 |   |   | 15,381 |   |   | 3,558 |   |   |
| Provider Contracts                            |       |                  | 10         |                             |       | 15,539                          |       |   | 1,842 |   |   | 3,458 |   |   | 635 |   |   |
| Senior  Administrative Services               |       |                  |       |                             |       |                            |       |   |   |   |   |   |   |   |   |   |   |
| Administrative service contracts              |       |                  | 6          |                             |       | 7,671                           |       |   | 7,360 |   |   | 7,671 |   |   | 7,240 |   |   |
| Hospital network contracts                    |       |                  | 10         |                             |       | 1,797                           |       |   | 696 |   |   | 1,797 |   |   | 445 |   |   |
| Total                                         |       |                  | 17         |                             |       | $                               | 85,043     |   |   | $ | 28,526 |   |   | $ | 72,962 |   |   | $ | 22,238 |   |   |

 

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Changesin the present value of future profits and other amortizing intangible assetsare presented below:

| ** **                     | ** ** | **Three months ended  September 30,** | ** ** | **Nine months ended  September 30,** | ** ** |
|--------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                     | ** ** | **2006**                                             | ** ** | **2005**                                            | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                     | ** ** | **(In thousands)**                              | ** ** |
| Balance,  beginning of period  |       | $                                                    | 58,327     |                                                | $          | 54,760 |   | $ | 50,724 |   | $ | 60,804 |   |
| Additions and  adjustments     |       | —                                               |       | —                                              |       | 12,081 |   | (3,173 | ) |
| Amortization, net  of interest |       | (1,810                                               | )          | (2,047                                              | )          | (6,288 | ) | (4,918 | ) |
| Balance, end of period         |       | $                                                    | 56,517     |                                                | $          | 52,713 |   | $ | 56,517 |   | $ | 52,713 |   |

 

During the first quarter of 2006, Heritage acquired anadditional interest in the earnings of one of its risk pools, effective as of January 1,2006, for $12.1 million. The purchase price was allocated to the amortizingintangible asset—Provider Contracts and represents the present value of theestimated future cash flows related to the additional interest, and will beamortized over ten years. The adjustments in 2005 relate to changesin the valuation of the amortizing intangible assets from the acquisition ofHeritage.

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

| 2006 (remainder  of year) |   | $      | 1,923  |   |
|---------------------------|--------|--------|--------|--------|
| 2007                      |   | 6,967  |   |
| 2008                      |   | 6,601  |   |
| 2009                      |   | 6,220  |   |
| 2010                      |   | 5,600  |   |
| Thereafter                |   | 29,206 |   |
|                      |   | $      | 56,517 |   |

 

Changesin the carrying amounts of goodwill and intangible assets with indefinite livesare shown below:

| ** **                                                | ** ** | **December 31,**   | ** ** | ** **    | ** ** | ** **      | ** ** | **September 30,** | ** ** |
|-----------------------------------------------------------|------------|-------------------------|------------|---------------|------------|-----------------|------------|------------------------|------------|
| ** **                                                | ** ** | **2005**                | ** ** | **Additions** | ** ** | **Adjustments** | ** ** | **2006**               | ** ** |
| ** **                                                | ** ** | **(In thousands)** | ** ** |
| Senior Market Health  Insurance                           |       |                    |       |          |       |            |       |                   |       |   |   |   |   |   |   |   |   |
| Goodwill                                                  |       |                    | $          | 3,893         |       |            |       | $                      | —     |   |   |   | $ | — |   |   |   | $ | 3,893 |   |   |
| Other                                                     |       |                    | 4,867      |          |       |            | —     |                   |       |   | — |   |   |   | 4,867 |   |   |
| Subtotal—Senior Market Health Insurance              |       |                    | 8,760      |          |       |            | —     |                   |       |   | — |   |   |   | 8,760 |   |   |
| Senior Managed  Care—Medicare Advantage              |       |                    |       |          |       |            |       |                   |       |   |   |   |   |   |   |   |   |
| Goodwill                                                  |       |                    | 54,720     |          |       |            | —     |                   |       |   | (1,668 | ) |   |   | 53,052 |   |   |
| Other                                                     |       |                    | 5,163      |          |       |            | —     |                   |       |   | — |   |   |   | 5,163 |   |   |
| Subtotal—Senior Managed Care—Medicare Advantage |       |                    | 59,883     |          |       |            | —     |                   |       |   | (1,668 | ) |   |   | 58,215 |   |   |
| Senior  Administrative Services—Goodwill             |       |                    | 4,357      |          |       |            | —     |                   |       |   | — |   |   |   | 4,357 |   |   |
| Total                                                     |       |                    | $          | 73,000        |       |            |       | $                      | —     |   |   |   | $ | (1,668 | ) |   |   | $ | 71,332 |   |   |

 

Other non-amortizingintangible assets consist primarily of trademarks and licenses. The reductionin goodwill for Senior Managed Care—Medicare Advantage was the result of apurchase price adjustment for the acquisition of Heritage.

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**5.**                 *INVESTMENTS*

Theamortized cost and fair value of fixed maturity investments are as follows:

| ** **                                                        | ** ** | **September 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 |       | $                                | 120,415    |   |   | $ | 375 |   |   |   | $ | (1,193 | ) |   | $ | 119,597 |   |
| Corporate debt  securities                                        |       | 444,161                          |       |   | 8,511 |   |   |   | (4,544 | ) |   | 448,128 |   |
| Foreign debt  securities                                          |       | 33,128                           |       |   | 497 |   |   |   | (448 | ) |   | 33,177 |   |
| Mortgage-backed  and asset-backed securities                      |       | 520,690                          |       |   | 3,375 |   |   |   | (3,981 | ) |   | 520,084 |   |
|                                                              |       | $                                | 1,118,394  |   |   | $ | 12,758 |   |   |   | $ | (10,166 | ) |   | $ | 1,120,986 |   |
|                                                                   |            |                                  |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

| ** **                                                        | ** ** | **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                                        |       |                            | 448,564    |   |   |   | 12,946 |   |   |   | (3,786 | ) |   | 457,724 |   |
| Foreign debt  securities                                          |       |                            | 31,588     |   |   |   | 813 |   |   |   | (178 | ) |   | 32,223 |   |
| Mortgage-backed  and asset-backed securities                      |       |                            | 508,200    |   |   |   | 3,148 |   |   |   | (3,411 | ) |   | 507,937 |   |
|                                                              |       |                            | $          | 1,101,209 |   |   |   | $ | 17,169 |   |   |   | $ | (8,633 | ) |   | $ | 1,109,745 |   |
|                                                                   |            |                                 |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Theamortized cost and fair value of fixed maturity investments at September 30,2006 by contractual maturity are shown below. Expected maturities will differfrom contractual maturities because borrowers may have the right to call orprepay obligations with or without call or prepayment penalties.

| ** **                                   | ** ** | **Amortized**           | ** ** | **Fair**  | ** ** |
|----------------------------------------------|------------|-------------------------|------------|-----------|------------|
| ** **                                   | ** ** | **Cost**                | ** ** | **Value** | ** ** |
| ** **                                   | ** ** | **(In thousands)** | ** ** |
| Due in 1 year or  less                       |       | $                       | 53,571     |      | $          | 54,329 |   |
| Due after 1 year  through 5 years            |       | 248,581                 |       | 251,406   |       |
| Due after 5 years  through 10 years          |       | 224,326                 |       | 225,270   |       |
| Due after 10  years                          |       | 71,226                  |       | 69,898    |       |
| Mortgage-backed  and asset-backed securities |       | 520,690                 |       | 520,083   |       |
|                                         |       | $                       | 1,118,394  |      | $          | 1,120,986 |   |

 

**6.**                 *STOCKHOLDERS’ EQUITY*

*Preferred Stock*

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

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*Common Stock*

TheCompany has 100 million shares of common stock, par value $0.01 per share,authorized for issuance. Changes in the number of shares of common stock issuedwere as follows:

| ** **                                                                               | ** ** | **Nine months ended  September 30,** | ** ** |
|------------------------------------------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                                               | ** ** | **2006**                                            | ** ** | **2005** | ** ** |
| Common stock  issued, beginning of year                                                  |       | 59,042,685                                          |       | 55,326,092 |   |
| Equity offering                                                                          |       | —                                              |       | 2,660,000 |   |
| Stock options  exercised                                                                 |       | 200,480                                             |       | 811,824 |   |
| Agent stock award                                                                        |       | (507                                                | )          | 78,167 |   |
| Stock purchases  pursuant to agents’ stock purchase and deferred compensation plans |       | 4,500                                               |       | 6,951 |   |
| Common stock issued, end  of period                                                      |       | 59,247,158                                          |       | 58,883,034 |   |

 

*Treasury Stock*

TheCompany currently has 984,339 shares of common stock available to purchasepursuant to share repurchase programs approved by the Company’s Board ofDirectors in November 2005 and December 2003. Changes in the numberof shares of treasury stock were as follows:

| ** **                                          | ** ** | **Nine months ended September 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                                 |       | 16,429                                                  |       | 209 |   |   | 12.74 |   |   | 2,277 |   |   | 45 |   |   |   | 19.82 |   |   |
| Shares  distributed in the form of employee bonuses |       | (54,901                                                 | )          | (821 | ) |   | 15.34 |   |   | (74,081 | ) |   | (577 | ) |   |   | 15.87 |   |   |
| Treasury stock, end of  period                      |       | 713,001                                                 |       | $ | 10,628 |   |   | $ | 14.91 |   |   | 53,137 |   |   | $ | 437 |   |   |   | $ | 8.22 |   |   |

 

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*Accumulated OtherComprehensive Income*

Thecomponents of accumulated other comprehensive income are as follows:

| ** **                                                           | ** ** | **September 30,  2006** | ** ** | **December 31,  2005** | ** ** |
|----------------------------------------------------------------------|------------|------------------------------|------------|-----------------------------|------------|
| ** **                                                           | ** ** | **(In thousands)**      | ** ** |
| Continuing Operations:                                               |       |                         |       |                        |       |   |   |   |   |
| Net unrealized appreciation on  investments                          |       |                         | $          | 2,597                       |       |   |   | $ | 8,515 |   |   |
| Deferred  acquisition cost adjustment                                |       |                         | 911        |                        |       |   | (1,265 | ) |   |
| Foreign currency  translation gains                                  |       |                         | 282        |                        |       |   | 242 |   |   |
| Fair value of  cash flow swap                                        |       |                         | 1,328      |                        |       |   | 1,544 |   |   |
| Deferred tax                                                         |       |                         | (1,791     | )                           |       |   | (3,163 | ) |   |
| Accumulated other comprehensive income—continuing  operations   |       |                         | 3,327      |                        |       |   | 5,873 |   |   |
| Discontinued  Operations:                                            |       |                         |       |                        |       |   |   |   |   |
| Net unrealized  appreciation on investments                          |       |                         | 43,454     |                        |       |   | 42,116 |   |   |
| Foreign currency  translation gains                                  |       |                         | 11,970     |                        |       |   | 10,227 |   |   |
| Deferred tax                                                         |       |                         | (19,398    | )                           |       |   | (18,320 | ) |   |
| Accumulated other comprehensive income—discontinued  operations |       |                         | 36,026     |                        |       |   | 34,023 |   |   |
| Total accumulated  other comprehensive income                        |       |                         | $          | 39,353                      |       |   |   | $ | 39,896 |   |   |

 

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

The Company has variousstock-based incentive plans for its employees, non-employee directors andagents. The Company issues new shares upon the exercise of options grantedunder such stock-based incentive plans. Detailed information for activity inthe Company’s stock-based incentive plans can be found in Note 8—Stock-BasedCompensation to the financial statements in our Annual Report on Form 10-Kfor the year ended December 31, 2005.

*Stock Option Awards*

Beginning January 1, 2006, the Company adoptedFAS 123-R using the modified prospective method, and began recognizingcompensation cost for share-based payments to employees and non-employeedirectors based on the grant date fair value of the award, which is amortizedover the grantees’ service period. The Company has elected to use theBlack-Scholes valuation model to value employee stock options, as it had donefor its previous pro forma stock compensation disclosures. The adoption of FAS 123-Rdid not have a material effect on the Company’s method of computingcompensation costs for options as compared to the method the Company used toprepare the pro forma disclosures in prior periods.

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

| ** **                                             | ** ** | **Three months  ended  September 30,  2006**            | ** ** | **Nine months  ended  September 30,  2006** | ** ** |
|--------------------------------------------------------|------------|-------------------------------------------------------------------|------------|-------------------------------------------------------|------------|
| ** **                                             | ** ** | **(In thousands, except  per share amounts)** | ** ** |
| Stock option  expense                                  |       |                                                              | $          | 501                                                   |       |   |   | $ | 1,997 |   |   |
| Income from  continuing operations before taxes        |       |                                                              | (501       | )                                                     |       |   | (1,997 | ) |   |
| Provision for  (benefit from) income taxes             |       |                                                              | (175       | )                                                     |       |   | (699 | ) |   |
| Net income                                             |       |                                                              | (326       | )                                                     |       |   | (1,298 | ) |   |
| Cash flows from  operations—continuing operations |       |                                                              | —     |                                                  |       |   | (563 | ) |   |
| Cash flows from  financing—continuing operations  |       |                                                              | —     |                                                  |       |   | 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 expensemay vary based upon factors such as the number of awards granted by the Companyand the 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 the adoption of FAS 123-R by the Companyare not reflected in the financial statements of those periods. The followingtable illustrates the effect on net income and earnings per share if the fairvalue based method had been applied to those periods.****

| ** **                                                                                                   | ** ** | **Three months  ended  September 30,  2005**            | ** ** | **Nine months  ended  September 30,  2005** | ** ** |
|--------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------|------------|-------------------------------------------------------|------------|
| ** **                                                                                                   | ** ** | **(In thousands, except  per share amounts)** | ** ** |
| Reported net  income                                                                                         |       |                                                              | $          | 15,288                                                |       |   |   | $ | 50,008 |   |   |
| Add back:  Stock-based compensation expense included in reported net income, net of  tax                |       |                                                              | 547        |                                                  |       |   | 1,299 |   |   |
| Less: Stock-based  compensation expense determined under fair value based method for all awards,  net of tax |       |                                                              | (942       | )                                                     |       |   | (2,639 | ) |   |
| Pro forma net  income                                                                                        |       |                                                              | $          | 14,893                                                |       |   |   | $ | 48,668 |   |   |
| Net income per  share:                                                                                       |       |                                                              |       |                                                  |       |   |   |   |   |
| Basic, as reported                                                                                           |       |                                                              | $          | 0.26                                                  |       |   |   | $ | 0.88 |   |   |
| Basic, pro forma                                                                                             |       |                                                              | $          | 0.25                                                  |       |   |   | $ | 0.86 |   |   |
| Diluted, as reported                                                                                         |       |                                                              | $          | 0.25                                                  |       |   |   | $ | 0.85 |   |   |
| Diluted, pro  forma                                                                                          |       |                                                              | $          | 0.25                                                  |       |   |   | $ | 0.83 |   |   |

 

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       |   |

 

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Asummary of option activity for the nine months ended September 30, 2006 ispresented below:

| **Stock Options**            | ** ** | ** **              | ** ** | **Options** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Weighted  Average  Remaining  Contractual  Term  (in years)** | ** ** | **Aggregate  Intrinsic  Value** | ** ** |
|-----------------------------------|------------|-------------------------|------------|-------------|------------|----------------------------------------|------------|----------------------------------------------------------------------|------------|---------------------------------|------------|
| ** **                        | ** ** | **(in thousands)** | ** ** | ** **  | ** ** | ** **                             | ** ** | **(in thousands)**                                              | ** ** |
| Outstanding at  beginning of year |       |                    | 4,823      |        |       |                                   | $          | 6.81                                                                 |       |                            |       | 5.2 |   |   |   |   |   |   |
| Granted                           |       |                    | 430        |        |       |                                   | 15.37      |                                                                 |       |                            |       |   |   |   |   |   |   |
| Exercised                         |       |                    | (200       | )           |       |                                   | 7.35       |                                                                 |       |                            |       |   |   |   |   |   |   |
| Forfeited or  expired             |       |                    | (97        | )           |       |                                   | 11.10      |                                                                 |       |                            |       |   |   |   |   |   |   |
| Outstanding at  end of period     |       |                    | 4,956      |        |       |                                   | $          | 7.39                                                                 |       |                            |       | 4.1 |   |   |   | $ | 31,799 |   |   |
| Exercisable at end of  period     |       |                    | 3,754      |        |       |                                   | $          | 6.38                                                                 |       |                            |       | 4.0 |   |   |   | $ | 27,006 |   |   |

 

The weighted-averagegrant-date fair value was $5.30 for options granted during the nine monthsended September 30, 2006 and was $6.07 for options granted during the ninemonths ended September 30, 2005. The total intrinsic value of optionsexercised during the nine months ended September 30, 2006 was $1.5 millionand the total intrinsic value of options exercised during the nine months endedSeptember 30, 2005 was $10.8 million.

As of September 30,2006, the total compensation cost related to non-vested awards not yetrecognized was $3.4 million, which is expected to be recognized over a weightedaverage period of 1.2 years.

Cash received from theexercise of stock options was $1.5 million for the first nine months of 2006and was $4.9 million for the first nine months of 2005. FAS 123-R alsorequires the benefits of tax deductions in excess of recognized compensationcost to be reported as a financing cash flow, rather than as an operating cashflow as required under the prior statement. The amount of financing cash flowsrecognized for such excess tax deductions was $0.6 million for the nine monthsended September 30, 2006. The amount of operating cash flows recognizedfor such excess tax deductions was $2.6 million for the nine months ended September 30,2005.

*Employee Stock Awards*

Inaccordance with the Company’s 1998 Incentive Compensation Plan, the Company maygrant restricted stock to its officers and non-officer employees. Suchrestricted stock vest upon issuance. Executive officers may be grantedrestricted stock in connection with their bonuses. This restricted stock vestsratably over four years. Restricted stock awards are valued equal to the marketprice of the Company’s common stock on the date of grant and are generallyissued out of treasury shares. Compensation expense for restricted stock awardsis recognized on a straight line basis over the vesting period. A summary ofthe status of the Company’s non-vested restricted stock awards as of September 30,2006, and changes during the nine months ended September 30, 2006, ispresented 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                                |       |                    | (11        | )          |       |                                               | 11.78      |   |   |
| Nonvested at end of  period              |       |                    | 149        |       |       |                                               | $          | 13.60 |   |   |

 

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The total fair value ofshares of restricted stock vested during the nine months ended September 30,2006 was $0.8 million and the total fair value of shares of restricted stockvested during the nine months ended September 30, 2005 was $0.5 million.

**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 regulatoryrisk-based capital (“RBC”) requirements on life insurance enterprises. At September 30,2006, all of our U.S. insurance subsidiaries maintained ratios of total adjustedcapital to RBC in excess of the “authorized control level.” The combinedstatutory capital and surplus, including asset valuation reserve, of our U.S.insurance subsidiaries totaled $175.6 million at September 30, 2006 and$158.4 million at December 31, 2005. For the nine months ended September 30,2006, our U.S. insurance subsidiaries generated statutory net income of $18.9million and for the nine months ended September 30, 2005, our U.S.insurance subsidiaries generated statutory net income of $4.5 million.

Our health plans also are required by regulatoryauthorities to maintain minimum amounts of capital and surplus, and also aresubject to RBC requirements. At September 30, 2006, the statutory capitaland surplus of each of our health plans exceeded minimum requirements and theirRBCs are in excess of the “authorized control level”. The statutory capital andsurplus for our health plan was $38.0 million at September 30, 2006 and$26.0 million at December 31, 2005. Statutory net income for our healthplans was $12.0 million for the nine months ended September 30, 2006 and$7.4 million for the nine months ended September 30, 2005.

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$65.6 million(US$58.7 million) as of September 30, 2006 and were C$62.3 million(US$53.6 million) as of December 31, 2005. PennCorp Life Canadamaintained a Minimum Continuing Capital and Surplus Requirement Ratio (“MCCSR”)in excess of the minimum requirement at September 30, 2006. Net income forPennCorp Life Canada based on Canadian generally accepted accounting principleswas C$8.2 million (US$7.2 million) for the nine months ended September 30,2006, C$8.7 million (US$7.1 million) for the nine months ended September 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 asof September 30, 2006. Under the Amended Credit Agreement, the spread overLIBOR was reduced to 225 basis points. Effective October 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 $80.1 milliondue upon maturity on March 31, 2009.

20

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The Company made regularly scheduled principalpayments of $3.9 million during the nine months ended September 30, 2006and $3.9 million during the nine months ended September 30, 2005, inconnection with its credit facilities. The Company paid interest of $5.2million during the nine months ended September 30, 2006 and $4.0 millionduring the nine months ended September 30, 2005, in connection with itscredit facilities.

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

| 2006 (remainder  of the year) |   | $      | 1,312  |   |
|-------------------------------|--------|--------|--------|--------|
| 2007                          |   | 5,250  |   |
| 2008                          |   | 5,250  |   |
| 2009                          |   | 80,063 |   |
|                          |   | $      | 91,875 |   |

** **

**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 $4.3million in interest in connection with the Junior Subordinated Debt during thenine months ended September 30, 2006, and $4.0 million during the ninemonths ended September 30, 2005.

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

Effective September 4,2003, the Company entered into a swap agreement whereby it pays a fixed rate of6.7% on a $15.0 million notional amount relating to the December 2002trust preferred securities issuance, in exchange for a floating rate of LIBORplus 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 agreementwhereby it pays a fixed rate of 6.98% on a $20.0 million notional amountrelating to the October 2003 trust preferred securities issuance, inexchange for a floating rate of LIBOR plus 395 basis points, capped at 12.45%.The swap contract expires in October 2008. The swaps are designated ascash flow hedges, and changes in their fair value are recorded in accumulatedother comprehensive income. The combined fair value of the swaps was $1.3million at September 30, 2006 and $1.5 million at December 31, 2005and 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.

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The Kemp Action is apurported class action asserted on behalf of those shareholders of the Companywho acquired the Company’s common stock between February 16, 2005 and October 28,2005. Plaintiffs in the Kemp Action seek unspecified damages under Section 10(b) and20(a) of the Securities Exchange Act of 1934 based upon allegedly falsestatements by the Company and Richard A. Barasch, Robert A. Waegelein and GaryW. Bryant (hereinafter, the “Officer Defendants”) in press releases, financialstatements and analyst conferences during 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 1934on grounds 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. On August 14, 2006, defendants served amotion to dismiss the Amended Complaint in the Kemp Action. The lead plaintiffserved opposition papers to the motion on October 17, 2006. Defendants arescheduled to serve a reply in further support of their motion to dismiss thecomplaint later in November, and the motion will be argued before the Court on December 13,2006.

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 “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. On September 8,2006, defendants served a motion to dismiss the GM Amended 

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Complaint. On October 26,2006 (prior to the response date for plaintiff), the Court entered an orderstaying the case for 90 days.

The second derivativeaction was filed by plaintiff Arthur Tsutsui (the “Tsutsui Action”) on December 30,2005, in The Supreme Court for New York State, Westchester County. Thedefendants in the Tsutsui Action are the three Officer Defendants named in theother actions, as well as all of the directors sitting on the Company’s Boardof Directors as of the time the complaint was filed. The Tsutsui Action allegesthat the same alleged misstatements that are the subject of the Kemp Actionconstituted a breach of fiduciary duty by the Officer Defendants and thedirectors that caused the Company to sustain damages. The Tsutsui Action alsoseeks recovery of any proceeds derived by the Officer Defendants from the saleof Company stock that was in breach of their fiduciary duties. Defendants inthe Tsutsui Action filed a motion to dismiss the complaint on June 9, 2006.On August 17, 2006, the Court issued an order staying the case until suchtime (i) as the Kemp Action is fully and finally resolved or settled, or (ii) theGreen Meadows Action is fully and finally resolved, or shareholders in thatcase receive notice of a proposed settlement. Each of the Officer Defendantsdenies the allegations and has indicated that he intends to vigorously defendagainst the allegations. Management believes that after liability insurancerecoveries, none of these actions will have a material adverse effect on theCompany.

***Class Action Litigation Relating to AcquisitionProposal***

Four actions have recently been commenced in New Yorkstate courts against the Company and other defendants concerning theacquisition proposal received by the Company on October 24, 2006, frommembers of management led by Richard A. Barasch, the Company’s Chairman andChief Executive Officer, and private equity firms Capital Z Partners, Ltd., LeeEquity Partners, LLC, Perry Capital, LLC and Welsh, Carson, Anderson &Stowe X, L.P. to acquire all of the Company’s publicly held common stock for$18.15 per share in cash (the “Offer”). Two of these actions are pending in theSupreme Court for New York County, and are known as Stellato v. UniversalAmerican Financial Corp., et al. (06-116006) (“Stellato”) and GreenMeadows Partners LLP v. Barasch, et al. (603724-06) (“Green Meadows II”).

The Stellato action names as defendants the Company, Mr. Baraschand the other sponsors of the offer, including Capital Z Partners Ltd. (“CapitalZ”), as well as eight other members of the Company’s board of directors. Stellatoalleges that the offer was made at an “unfair price, under unfair terms andthrough improper means.” The action seeks an injunction preventing the offerfrom being consummated, or in the alternative, monetary damages.

The Green Meadows II action names the Company, Mr. Baraschand directors Bradley Cooper, Eric Leathers and Robert Spass as defendants. Thecomplaint alleges that these defendants dominate the board of directors of theCompany, and have breached their fiduciary duties by, among other things,making a buyout proposal that “fails to take into account the value of UHCO,its improving financial results and its value in comparison to other similarcompanies.” The action seeks, among other things, an injunction preventingdefendants from carrying out an unfair transaction, and monetary damages.

A third and a fourth action pertaining to the Offerare pending in the Supreme Court for Westchester County and are known asConolly v. Universal American Financial Corp, et al (“Conolly”) and McCormackv. Averill et al. (06-21365) (“McCormack”). The Conolly action names asdefendants Mr. Barasch and other sponsors of the Offer, including CapitalZ, as well as the Company and all of its directors. The complaint alleges thatthe shareholder agreement to which Mr. Barasch and Capital Z are parties “deter[s]potential bids for the Company at a premium to the presently offered price,”and that the sponsors of the offer (excluding Mr. Barasch) are members ofa “club” of elite private equity funds under investigation for violations ofthe anti-trust laws that have resulted in “driv[ing] down the prices ofpotential acquisition targets.” The Conolly action further asserts that thedirector defendants have breached their fiduciary duties to maximizeshareholder value by, among other things, failing immediately 

23

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to reject the Offer. Thecomplaint seeks an injunction prohibiting consummation of the Offer, or in thealternative, monetary damages.

The complaint in McCormack names as defendants theCompany and all of its directors, and alleges, among other things, that theOffer is unfair and grossly inadequate. The complaint also asserts that thebuyout offer is “the product of unfair dealing” by the management of theCompany and its largest shareholder, Capital Z. The action seeks an injunctionordering the directors to fulfill their fiduciary duties, and/or enjoining anytransaction based upon the Offer, as well as monetary damages.

All four actionspertaining to the Offer are currently being reviewed by counsel for defendants.Therefore, management cannot yet ascertain the impact that these complaints mayhave, if any, on the Company’s financial statements. The defendants are notrequired to respond to any of the actions until later in November 2006.

***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.

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**13.****          *OTHER COMPREHENSIVE INCOME***

The components of othercomprehensive income, and the related tax effects for each component, are asfollows:

| ** **                                                                              | ** ** | **Three months ended September 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)**                                  | ** ** |
| ***From continuing operations:***                                             |       |                                                     |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Net  unrealized (loss) gain arising during the year (net of deferred acquisition costs) |       |                                                     | $          | 16,671 |   |   |   | $ | 5,835 |   |   |   | $ | 10,836 |   |   |   | $ | (13,898 | ) |   |   | $ | (4,864 | ) |   |   | $ | (9,034 | ) |   |
| Reclassification  adjustment for losses (gains) included  in net income                 |       |                                                     | 26         |   |   |   | 9 |   |   |   | 17 |   |   |   | (260 | ) |   |   | (91 | ) |   |   | (169 | ) |   |
| Net  unrealized (loss) gain                                                             |       |                                                     | 16,697     |   |   |   | 5,844 |   |   |   | 10,853 |   |   |   | (14,158 | ) |   |   | (4,955 | ) |   |   | (9,203 | ) |   |
| Cash  Flow Hedge                                                                        |       |                                                     | (442       | ) |   |   | (155 | ) |   |   | (287 | ) |   |   | 375 |   |   |   | 131 |   |   |   | 244 |   |   |
| Foreign  currency translation adjustment                                                |       |                                                     | (1         | ) |   |   | — |   |   |   | (1 | ) |   |   | 49 |   |   |   | 17 |   |   |   | 32 |   |   |
| Other  comprehensive (loss) income from continuing operations                      |       |                                                     | 16,254     |   |   |   | 5,689 |   |   |   | 10,565 |   |   |   | (13,734 | ) |   |   | (4,807 | ) |   |   | (8,927 | ) |   |
| ***From discontinued  operations:***                                                    | ** ** |                                                     |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Net  unrealized gain arising during the  year (net of deferred acquisition costs)       |       |                                                     | 17,290     |   |   |   | 6,051 |   |   |   | 11,239 |   |   |   | 1,144 |   |   |   | 401 |   |   |   | 743 |   |   |
| Reclassification  adjustment for gains included in  net income                          |       |                                                     | (630       | ) |   |   | (220 | ) |   |   | (410 | ) |   |   | (722 | ) |   |   | (253 | ) |   |   | (469 | ) |   |
| Net  unrealized gain                                                                    |       |                                                     | 16,660     |   |   |   | 5,831 |   |   |   | 10,829 |   |   |   | 422 |   |   |   | 148 |   |   |   | 274 |   |   |
| Foreign  currency translation adjustment                                                |       |                                                     | (43        | ) |   |   | (15 | ) |   |   | (28 | ) |   |   | 2,134 |   |   |   | 747 |   |   |   | 1,387 |   |   |
| Other  comprehensive income from discontinued operations                           |       |                                                     | 16,617     |   |   |   | 5,816 |   |   |   | 10,801 |   |   |   | 2,556 |   |   |   | 895 |   |   |   | 1,661 |   |   |
| Total  other comprehensive (loss) income                                           |       |                                                     | $          | 32,871 |   |   |   | $ | 11,505 |   |   |   | $ | 21,366 |   |   |   | $ | (11,178 | ) |   |   | $ | (3,912 | ) |   |   | $ | (7,266 | ) |   |

 

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| ** **                                                                                   | ** ** | **Nine months ended September 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)**                                 | ** ** |
| ***From continuing operations:***                                                            |       |                                                    |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Net unrealized (loss) gain arising during the year (net of deferred acquisition  costs) |       |                                                    | $          | (3,721 | ) |   |   | $ | (1,303 | ) |   |   | $ | (2,418 | ) |   |   | $ | (12,655 | ) |   |   | $ | (4,429 | ) |   | $ | (8,226 | ) |
| Reclassification adjustment for losses (gains) included in net income                        |       |                                                    | (21        | ) |   |   | (7 | ) |   |   | (14 | ) |   |   | (4,363 | ) |   |   | (1,527 | ) |   | (2,836 | ) |
| Net unrealized (loss) gain                                                                   |       |                                                    | (3,742     | ) |   |   | (1,310 | ) |   |   | (2,432 | ) |   |   | (17,018 | ) |   |   | (5,956 | ) |   | (11,062 | ) |
| Cash Flow Hedge                                                                              |       |                                                    | (215       | ) |   |   | (75 | ) |   |   | (140 | ) |   |   | 595 |   |   |   | 208 |   |   | 387 |   |
| Foreign currency translation adjustment                                                      |       |                                                    | 40         |   |   |   | 14 |   |   |   | 26 |   |   |   | 24 |   |   |   | 8 |   |   | 16 |   |
| Other comprehensive (loss) income from continuing operations                                 |       |                                                    | (3,917     | ) |   |   | (1,371 | ) |   |   | (2,546 | ) |   |   | (16,399 | ) |   |   | (5,740 | ) |   | (10,659 | ) |
| ***From discontinued operations:***                                                          |       |                                                    |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Net unrealized (loss) gain arising during the year (net of deferred acquisition  costs) |       |                                                    | 1,968      |   |   |   | 688 |   |   |   | 1,280 |   |   |   | $ | 16,645 |   |   |   | $ | 5,826 |   |   | $ | 10,819 |   |
| Reclassification adjustment for gains included in net income                                 |       |                                                    | (630       | ) |   |   | (220 | ) |   |   | (410 | ) |   |   | (722 | ) |   |   | (253 | ) |   | (469 | ) |
| Net unrealized (loss) gain                                                                   |       |                                                    | 1,338      |   |   |   | 468 |   |   |   | 870 |   |   |   | 15,923 |   |   |   | 5,573 |   |   | 10,350 |   |
| Foreign currency translation adjustment                                                      |       |                                                    | 1,743      |   |   |   | 610 |   |   |   | 1,133 |   |   |   | 1,539 |   |   |   | 539 |   |   | 1,000 |   |
| Other comprehensive (loss) income from discontinued operations                               |       |                                                    | 3,081      |   |   |   | 1,078 |   |   |   | 2,003 |   |   |   | 17,462 |   |   |   | 6,112 |   |   | 11,350 |   |
| Total other comprehensive (loss) income                                                 |       |                                                    | $          | (836 | ) |   |   | $ | (293 | ) |   |   | $ | (543 | ) |   |   | $ | 1,063 |   |   |   | $ | 372 |   |   | $ | 691 |   |

 

**14.****          *UNCONSOLIDATED SUBSIDIARY***

During 2005, we entered into a strategic alliance withPharmaCare and created PDMS, which is 50% owned by Universal American and 50%owned by PharmaCare. PDMS principally performs marketing and risk managementservices on behalf of our PDPs and PharmaCare for which it receives fees andother remuneration from our PDPs and PharmaCare. We do not control PDMS andtherefore PDMS is not consolidated in our financial statements. Our investmentin PDMS is accounted for on an equity basis and is included in other assets. AtSeptember 30, 2006, our investment in the equity in PDMS was $6.4 millionand at December 31, 2005, our share of the deficit of PDMS was $1.0million. Our share in the net income of PDMS was $36.6 million for the ninemonths ended September 30, 2006 and is included in “equity in earnings ofunconsolidated subsidiary.” During the nine months ended September 30,2006, PDMS made distributions to its owners aggregating $61.0 million. Ourshare of these distributions was $30.5 million.

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

| ** **                    | ** ** | **September 30,  2006** | ** ** | **December 31,  2005** | ** ** |
|-------------------------------|------------|------------------------------|------------|-----------------------------|------------|
| ** **                    | ** ** | **(in thousands)**      | ** ** |
| *Assets*                      |       |                         |       |                        |       |   |   |   |   |
| Cash and  investments         |       |                         | $          | 4,724                       |       |   |   | $ | 131 |   |   |
| Other                         |       |                         | 9,123      |                        |       |   | 2,353 |   |   |
| Total Assets                  |       |                         | $          | 13,847                      |       |   |   | $ | 2,484 |   |   |
| *Liabilities*                 |       |                         |       |                        |       |   |   |   |   |
| Accrued expenses  and other   |       |                         | $          | 1,021                       |       |   |   | $ | 4,444 |   |   |
| Equity                        |       |                         | 12,826     |                        |       |   | (1,960 | ) |   |
| Total liabilities  and equity |       |                         | $          | 13,847                      |       |   |   | $ | 2,484 |   |   |

 

| ** **     | ** ** | **Three months ended  September 30,** | ** ** | **Nine months ended  September 30,** | ** ** |
|----------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **     | ** ** | **2006**                                             | ** ** | **2005**                                            | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **     | ** ** | **(In thousands)**                              | ** ** |
| Total revenue  |       | $                                                    | 29,186     |                                                | $          | — |   | $ | 78,002 |   | $ | — |   |
| Total expenses |       | 1,247                                                |       | 447                                                 |       | 4,716 |   | 801 |   |
| Net income     |       | $                                                    | 27,939     |                                                | $          | (447 | ) | $ | 73,286 |   | $ | (801 | ) |

 

**15.****          *BUSINESS SEGMENT INFORMATION***

The Company’s principal business segments are based onproduct and include: Senior Managed Care—Medicare Advantage, Senior MarketHealth Insurance, Specialty Health Insurance, Life Insurance and Annuity andSenior Administrative Services. The Company also reports the activities of ourholding company in a separate segment. Reclassifications have been made toconform prior year amounts to the current year presentation. A description ofthese segments follows:

**SeniorManaged Care—Medicare Advantage—****The******Senior Managed Care—Medicare Advantage segment includes theoperations of our initiatives in managed care for seniors. We operate varioushealth plans, including SelectCare of Texas, that offer coverage to Medicarebeneficiaries under a contract with CMS in Southeastern Texas, Oklahoma andFlorida. The health plans are sold by our career and independent agents anddirectly by employee representatives. In connection with the health plans, weoperate separate Management Service Organizations (“MSO’s”) that manage thatbusiness and affiliated Independent Physician Associations (“IPA’s”). We participatein the net results derived from these affiliated IPA’s. Our Medicare Advantageprivate fee-for-service plans, also under a contract with CMS, are sold by ourcareer and independent agents. We currently market PFFS products in 459counties throughout 15 states. Beginning November 15, 2006, we will marketPFFS products in 2,600 counties throughout 35 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 Medicare Part D plans thatbegan offering prescription drug coverage for seniors on January 1, 2006.The inclusion of the operating results from our Medicare Part D businesswith those of our Medicare Supplement business has resulted in an increase inthe level of seasonality in our reported results during a given calendar year. Thesebusinesses generally see higher claim experience in the early quarters of theyear, with lower claims experience in the later quarters of the year, resultingin a pattern of increasing reported net income attributable to thosebusinesses.

**SpecialtyHealth Insurance—****This**segment includes specialtyhealth insurance products, primarily fixed benefit accident and sicknessdisability insurance sold to the middle income self-employed market in 

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the United States. Thissegment also includes certain products that we no longer sell such as long termcare and major medical insurance. This segment’s products are distributedprimarily by our career agents. The results for this segment exclude theresults for PennCorp Life Canada,  sinceit is now classified as discontinued operations. Prior period amounts have beenconformed to this presentation.

**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 administrative servicessubsidiary acts as a third party administrator and service provider of seniormarket insurance products and geriatric care management for both affiliated andunaffiliated insurance companies. The services provided include policyunderwriting 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. The significantitems eliminated include intersegment revenue and expense 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 from continuingoperations and segment income (loss) from continuing operations before incometaxes to total revenue and income from continuing operations in accordance withgenerally accepted accounting principles is as follows:

| ** **                                   | ** ** | **Three months ended September 30,** | ** ** |
|----------------------------------------------|------------|----------------------------------------------------------|------------|
| ** **                                   | ** ** | **2006**                                                 | ** ** | **2005** | ** ** |
| ** **                                   | ** ** | **Revenue**                                              | ** ** | **Income  (Loss)  Before  Income  Taxes** | ** ** | **Revenue** | ** ** | **Income  (Loss)  Before  Income  Taxes** | ** ** |
| ** **                                   | ** ** | **(In thousands)**                                  | ** ** |
| Senior Managed  Care—Medicare Advantage |       | $                                                        | 126,373    |   | $ | 4,008 |   | $ | 62,707 |   | $ | 7,467 |   |
| Senior Market  Health Insurance              |       | 145,274                                                  |       | 30,217 |   | 100,054 |   | 5,563 |   |
| Specialty Health  Insurance                  |       | 24,652                                                   |       | 3,828 |   | 25,536 |   | 2,566 |   |
| Life Insurance  and Annuity                  |       | 25,467                                                   |       | 6,045 |   | 24,869 |   | 4,304 |   |
| Senior  Administrative Services              |       | 21,073                                                   |       | 4,630 |   | 14,573 |   | 2,846 |   |
| Corporate                                    |       | 388                                                      |       | (5,991 | ) | 497 |   | (3,949 | ) |
| Intersegment  revenues                       |       | (15,078                                                  | )          | — |   | (10,717 | ) | — |   |
| Adjustments to segment  amounts:             |       |                                                     |       |   |   |   |   |   |   |
| Net realized (losses) gains(1)               |       | (26                                                      | )          | (26 | ) | 260 |   | 260 |   |
| Total                                        |       | $                                                        | 328,123    |   | $ | 42,711 |   | $ | 217,779 |   | $ | 19,057 |   |

 

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| ** **                                   | ** ** | **Nine months ended September 30,** | ** ** |
|----------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                   | ** ** | **2006**                                                | ** ** | **2005** | ** ** |
| ** **                                   | ** ** | **Revenue**                                             | ** ** | **Income  (Loss)  Before  Income  Taxes** | ** ** | **Revenue** | ** ** | **Income  (Loss)  Before  Income  Taxes** | ** ** |
| ** **                                   | ** ** | **(In thousands)**                                 | ** ** |
| Senior Managed  Care—Medicare Advantage |       | $                                                       | 328,705    |   | $ | 23,611 |   | $ | 173,836 |   | $ | 21,597 |   |
| Senior Market  Health Insurance              |       | 475,365                                                 |       | 37,673 |   | 297,268 |   | 20,841 |   |
| Specialty Health  Insurance                  |       | 73,867                                                  |       | 8,179 |   | 76,843 |   | 8,274 |   |
| Life Insurance  and Annuity                  |       | 75,508                                                  |       | 10,845 |   | 71,071 |   | 11,749 |   |
| Senior  Administrative Services              |       | 63,035                                                  |       | 11,832 |   | 44,184 |   | 9,502 |   |
| Corporate                                    |       | 738                                                     |       | (17,861 | ) | 606 |   | (11,598 | ) |
| Intersegment  revenues                       |       | (45,399                                                 | )          | — |   | (32,913 | ) | — |   |
| Adjustments to segment  amounts:             |       |                                                    |       |   |   |   |   |   |   |
| Net realized gains(1)                        |       | 21                                                      |       | 21 |   | 4,363 |   | 4,363 |   |
| Total                                        |       | $                                                       | 971,840    |   | $ | 74,300 |   | $ | 635,258 |   | $ | 64,728 |   |

----

(1)          We evaluate the resultsof operations of our segments based on income before realized gains and lossesand income taxes. Management believes that realized gains and losses are notindicative of overall operating trends.

Identifiableassets by segment are as follows:

| ** **                                   | ** ** | **September 30,2006** | ** ** | **December 31,2005** | ** ** |
|----------------------------------------------|------------|----------------------------|------------|---------------------------|------------|
| ** **                                   | ** ** | **(In thousands)**    | ** ** |
| Senior Managed  Care—Medicare Advantage |       |                       | $          | 272,428                   |       |   |   | $ | 182,754 |   |   |
| Senior Market  Health Insurance              |       |                       | 781,486    |                      |       |   | 426,180 |   |   |
| Specialty Health  Insurance                  |       |                       | 478,283    |                      |       |   | 533,459 |   |   |
| Life Insurance and  Annuity                  |       |                       | 748,541    |                      |       |   | 744,185 |   |   |
| Senior  Administrative Services              |       |                       | 34,008     |                      |       |   | 26,149 |   |   |
| Corporate                                    |       |                       | 761,406    |                      |       |   | 705,409 |   |   |
| Intersegment  assets(1)                      |       |                       | (747,820   | )                         |       |   | (681,852 | ) |   |
| Assets of  discontinued operations           |       |                       | 304,074    |                      |       |   | 277,695 |   |   |
| Total Assets                                 |       |                       | $          | 2,632,406                 |       |   |   | $ | 2,213,979 |   |   |

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(1)          Intersegmentassets include the elimination of the parent holding company’s investment inits subsidiaries as well as the elimination of other intercompany balances.

**16.**          *DISCONTINUEDOPERATIONS*

On August 31, 2006, the Company entered into a Share PurchaseAgreement (the “Purchase Agreement”) with La Capitale Civil Service InsurerInc. (“La Capitale”), a subsidiary of La Capitale Financial Group Inc., and GMFAssurances, S.A., a French mutual insurance company (“GMF,” and, together withLa Capitale, the “Purchaser”).

Pursuant to the Purchase Agreement, the Company will sell all of theoutstanding shares of UAFC (Canada) Inc., owner of the Company’s Canadianinsurance subsidiary, PennCorp Life Canada, to a venture 70% owned by LaCapitale and 30% owned by GMF, for an aggregate purchase price of approximately$131 million (C$147 million) in cash, on the terms and conditions set forth inthe Purchase Agreement (the “Sale”). The purchase price is comprised of$121.9 million (C $137.0 million) in cash, plus 

29

 

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an amount equal to the balance of netearnings generated by PennCorp Life during the period from January 1, 2006through the closing date, which the Company estimates to equal approximately$8.9 million (CAD $10 million). Under the terms of the PurchaseAgreement, the aggregate purchase price is subject to adjustment for alldividends paid by PennCorp Life Canada to the Company with respect to netearnings for 2006, none of which has been paid to date.

The closing of the Sale, which is expected to occur in the fourth calendarquarter of 2006, is subject to a number of conditions, including receipt ofregulatory approvals and permits, and other customary conditions.

The Purchase Agreement includes representations, covenants, Companynon-competition arrangements and indemnification obligations customary fortransactions of this nature, as well as an escrow for the benefit of thePurchaser, consisting of $2.7 million (CAD $3.0 million) of the purchaseprice. The escrow amount is expected to be released to the Company at thesecond anniversary of the closing date, subject to any claims. The PurchaseAgreement may be terminated upon the occurrence of certain events, includingthe failure to complete the Sale on or before February 28, 2007.

Universal American anticipates that its equity in PennCorp Life Canada willincrease to $74.9 million, which includes both the earnings through theearliest anticipated closing date of November 30, 2006, and unrealizedforeign exchange gains and losses and unrealized investment gains and losses of$36 million, net of tax, as of September 30, 2006.

Based on after-tax proceeds of approximately $96** **million (comprised of approximately $93 million ofcash at closing, plus an additional $2.7 million in two years if certainconditions are satisfied), the Sale is expected to result in a net gain to bookvalue of $21 million, or $0.36 per diluted share. Universal Americananticipates that the transaction will generate an after-tax realized gain of$57 million, or approximately $0.95 per diluted share, that will bereported in its income statement.

PennCorp Life Canada is a Canadian insurance company.Canadian law provides that a life insurer may pay a dividend after suchdividend declaration has been approved by its board of directors and upon atleast 10 days prior notification to the Superintendent of FinancialInstitutions. Such a dividend is limited to retained net income (based onCanadian GAAP) for the preceding two years, plus net income earned for thecurrent year. In considering approval of a dividend, the board of directorsmust consider whether the payment of such dividend would be in contravention ofthe Insurance Companies Act of Canada. During the nine months ended September 30,2006, PennCorp Life Canada paid dividends of C$4.9 million (approximatelyUS$4.4 million) to Universal American. During 2005, PennCorp Life Canada becamesubject to a 5% withholding tax on dividends paid to Universal American. Thewithholding tax paid on the dividends from PennCorp Life Canada in 2006 wasC$0.2 million (approximately US$0.2 million). During the nine months ended September 30,2005, PennCorp Life Canada paid dividends of C$3.2 million (approximatelyUS$2.7 million) to Universal American. Due to limitations resulting from thetiming of prior dividend payments by PennCorp Life Canada and the effect ofreducing the proceeds from the Sale, we do not anticipate that PennCorp LifeCanada will make any dividend payments to its parent company during theremainder of 2006.

As Universal American previously stated in its AnnualReport on Form 10-K, changes in the exchange rate between the U.S.dollar and the Canadian dollar may impact our results. Thus, the Company’sexpected revenue from the Sale could fluctuate with the value of the U.S.dollar as compared to the Canadian dollar. In order to mitigate this risk inconnection with the sale of PennCorp Life Canada, on September 5, 2006,Universal American entered into a financial hedging currency collar, which setthe upper value of the exchange rate at C$0.9124 per U.S. $1.00 and the lowervalue of the exchange rate at C$0.8900 per U.S. $1.00. The spot exchange ratewas C$0.8993 per U.S. $1.00 at the time Universal American entered into thehedging transaction. At September 30, 2006, the value of the financialhedging 

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currency collar wasapproximately $0.4 million, and is included in Assets of discontinuedoperations. The change in the value of the collar is included in income fromdiscontinued operations.

At September 30,2006, PennCorp Life Canada was classified as discontinued operations and itsresults of operations, financial position and cash flows are separatelyreported for all periods presented. Summarized financial information for ourdiscontinued operations is presented below.

| ** **                                                     | ** ** | **Three months ended  September 30,** | ** ** | **Nine months ended  September 30,** | ** ** |
|----------------------------------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                     | ** ** | **2006**                                             | ** ** | **2005**                                            | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                                     | ** ** | **(In thousands)**                              | ** ** |
| Total revenue                                                  |       | $                                                    | 20,025     |                                                | $          | 18,651 |   | $ | 60,379 |   | $ | 55,170 |   |
| Total expenses                                                 |       | 15,563                                               |       | 14,381                                              |       | 47,554 |   | 44,236 |   |
| Income before  realized gains, gain on collar and income taxes |       | 4,462                                                |       | 4,270                                               |       | 12,825 |   | 10,934 |   |
| Realized gains                                                 |       | 630                                                  |       | 722                                                 |       | 630 |   | 722 |   |
| Gain on financial  hedging currency collar                     |       | 396                                                  |       | —                                              |       | 396 |   | — |   |
| Income before  provision for taxes                             |       | 5,488                                                |       | 4,992                                               |       | 13,851 |   | 11,656 |   |
| Provision for  income taxes                                    |       | 2,013                                                |       | 1,579                                               |       | 5,540 |   | 3,660 |   |
| Income from discontinued  operations                           |       | $                                                    | 3,475      |                                                | $          | 3,413 |   | $ | 8,311 |   | $ | 7,996 |   |

 

Totalassets and liabilities of PennCorp Life Canada, located entirely in Canada, areas follows:

| ** **                         | ** ** | **September 30,  2006** | ** ** | **December 31,  2005** | ** ** |
|------------------------------------|------------|------------------------------|------------|-----------------------------|------------|
| ** **                         | ** ** | **(In thousands)**      | ** ** |
| **Assets**                         |       |                         |       |                        |       |   |   |   |   |
| Cash and  investments              |       |                         | $          | 259,981                     |       |   |   | $ | 236,999 |   |   |
| Deferred policy  acquisition costs |       |                         | 34,039     |                        |       |   | 29,242 |   |   |
| Other assets                       |       |                         | 10,054     |                        |       |   | 11,454 |   |   |
| Total assets                       |       |                         | $          | 304,074                     |       |   |   | $ | 277,695 |   |   |
| **Liabilities**                    | ** ** |                         |       |                        |       |   |   |   |   |
| Policyholder  liabilities          |       |                         | $          | 227,652                     |       |   |   | $ | 207,165 |   |   |
| Other liabilities                  |       |                         | 4,009      |                        |       |   | 5,105 |   |   |
| Total liabilities                  |       |                         | $          | 231,661                     |       |   |   | $ | 212,270 |   |   |

 

**17.**          *SUBSEQUENTEVENT*

On October 25, 2006, the Company announced thatits Board of Directors had received a proposal from members of management ledby Richard A. Barasch, Universal American’s Chairman and Chief ExecutiveOfficer, and private equity firms Capital Z Partners, Ltd., Lee EquityPartners, LLC, Perry Capital, LLC and Welsh, Carson, Anderson & StoweX, L.P. to acquire all of Universal American’s publicly held common stock for$18.15 per share in cash.

In the aggregate, the management and investor groupmaking the proposal currently holds approximately 48% of the outstanding sharesof Universal American’s common stock. The proposal is subject to a number ofconditions, including, among other things, (i) obtaining financing for theproposed transaction as contemplated by the “highly confident” letterssubmitted with the proposal, and (ii) the negotiation and execution ofdefinitive transaction agreements on mutually acceptable terms.

Universal American’s Board of Directors hasestablished a Special Committee consisting of four independent directors toreview and evaluate the proposal and any strategic alternatives to the proposalthat may be available to Universal American. In establishing the SpecialCommittee, the Board determined 

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that it would not approvethe proposal unless it receives a prior favorable recommendation from theSpecial Committee. The Special Committee has retained Citigroup Global Markets, Inc.as its financial advisor and Willkie Farr & Gallagher LLP as its legaladvisor.

Universal American cautions its shareholders andothers considering trading in its securities that its Board of Directors hasjust received the proposal, and that the process of considering the proposal isonly in its beginning stages. The Special Committee will proceed in an orderlyand timely manner to consider the proposal and its implications. The SpecialCommittee has not made a determination whether a transaction is in the bestinterests of Universal American and its shareholders or whether UniversalAmerican should pursue any available alternative to the proposal. Accordingly,there is no assurance that Universal American will enter into this or any othertransaction. Shareholders are not now being asked to take any action withrespect to the proposal.

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**ITEM2—**MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITIONAND RESULTS OFOPERATIONS

**Introduction**

The following discussionand analysis presents a review of the Company as of September 30, 2006 andits results of operations for the three and nine months ended September 30,2006, and 2005. The following analysis of our consolidated results ofoperations and financial condition should be read in conjunction with theconsolidated financial statements and related consolidated footnotes as well asthe Management’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 businesssegments are based on our products and include: Senior Managed Care—MedicareAdvantage, Senior Market Health Insurance, Specialty Health Insurance, LifeInsurance and Annuity and Senior Administrative Services. We also report theactivities of our holding company in a separate segment. Reclassifications havebeen made to conform prior year amounts to the current year presentation. See “Note15—Business Segment Information” in our consolidated financial statementsincluded in this Quarterly Report on Form 10-Q for a description ofour 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 Accounting Policies**

Our consolidated financialstatements have been prepared in accordance with 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 financialstatements and the revenues and expenses reported during the reporting period.As additional information becomes available or actual amounts becomedeterminable, the recorded estimates may be revised and reflected in operatingresults. Actual results could differ from those estimates. Accounts that, inour judgment, 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 related liabilities***

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 could materially exceed our reserves and have amaterial adverse effect on our results of operations and 

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financialcondition. Our net income depends significantly upon the extent to which ouractual claims experience is consistent with the assumptions we used in settingour reserves and pricing our policies. If our assumptions with respect tofuture claims are incorrect, and our reserves are insufficient to cover ouractual losses and expenses, we would be required to increase our liabilitiesresulting in reduced net income and shareholders’ 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,“Accounting and Reporting by Insurance Enterprises.” Amortization of deferredacquisition costs for Medicare Supplement policies is periodically adjusted forsignificant changes in benefit structures and differences in assumed premiumrates on a prospective basis, consistent with assumptions used in the relatedreserves for future policy benefits. During 2005, the Company determined thatthe historical actual approved rate increases and persistency were higher thanassumed levels. The prospective unlocking of these assumptions resulted in aslower amortization of Medicare Supplement deferred acquisition costs.

The determination of expectedgross profits for interest-sensitive products is an inherently uncertainprocess that relies on assumptions including projected interest rates, thepersistency of the policies issued as well as anticipated benefits, commissionsand expenses. It is possible that the actual profits from the business may varymaterially from the assumptions used in the determination and amortization ofdeferred acquisition costs. Deferred policy acquisition costs are written offto the extent that it is determined that future policy premiums and investmentincome or expected gross profits would not be adequate to recover theunamortized 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 could relate to purchaseprice adjustments, resolution of pre-acquisition contingencies and refinementsmade to estimates of fair value in 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.

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 

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carryingvalue of such assets is not recoverable, in which case an impairment chargewould be recognized. Management believes that no impairments of present valueof future profits, goodwill or other identified intangibles existed as of September 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 longernecessary are reflected as deferred tax benefits. To the extent that valuationallowances were established in conjunction with acquisitions, changes in thoseallowances are first applied to increasing or decreasing the goodwill (but notbelow zero) or other intangibles related to the acquisition and then applied asan increase or decrease in income tax expense.

**SignificantTransactions and Initiatives**

***Pending Sale of Canadian Subsidiary***

On August 31, 2006,we entered into an agreement to sell our Canadian operations for approximately$131 million cash. The closing of the Sale, which is expected to occur in thefourth calendar quarter of 2006, is subject to a number of conditions,including receipt of regulatory approvals and permits, and other customaryconditions. We expect that the Sale will generate approximately $96 million ofafter tax proceeds. As a result, our Canadian Subsidiary will be reported asdiscontinued operations. See “Note 16—Discontinued Operations” in ourconsolidated financial statements included in this Quarterly Report on Form 10-Qfor a more detailed description of the Sale.

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***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 coverage doesnot cover prescription drugs except as required in the course of a coveredhospital stay. According to the U.S. Census Bureau, more than 2 millionAmericans turn 65 in the United States each year, and this number is expectedto grow as the so-called baby boomers begin to turn 65. In addition, manylarge employers who traditionally provided medical and prescription drugcoverage to their retirees have begun to curtail these benefits. Finally, thepassage of the Medicare Modernization Act of 2003 (the “MMA”) demonstrated theFederal government’s commitment to expand the healthcare options available toMedicare beneficiaries through the expansion of Medicare managed care plans (“MedicareAdvantage”) and the authorization of a subsidized prescription drug insurancebenefit pursuant to Part D. Taken together, these conditions presentsignificant opportunities for us to increase the sale of our products.

***Medicare Advantage***

We entered the Medicare Advantage business in 2004with the acquisition of Heritage Health Systems, Inc. which operatesMedicare Advantage coordinated care plans in Southeastern Texas. As of January 2006,we are marketing PFFS plans in a total of 15 states.

As a result of theincreased reimbursement rates from CMS, the Federal agency that administers theMedicare Advantage program, Medicare Advantage plans are able to offer moreattractive benefits including enhanced prescription drug coverage pursuant toPart D. Consequently, we believe that enrollment in Medicare Advantageprograms is likely to increase in the coming years. For 2007, we have expandedinto new Part D and Medicare HMO markets and, through our insurancesubsidiaries American Progressive and Pyramid Life, we will offer our PFFSproducts in 35 states, up from 15 states in 2006 and we will be expanding withnew Medicare Advantage coordinated care plans in 3 new markets; in Florida,Texas and Wisconsin in 2007. We anticipate that we will incur approximately $19million to $23 million of additional costs in order to execute these expansion initiatives,of which approximately $5.5 million was expensed in the third quarter.

***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 lose similarcoverage that had previously been offered to them as a retiree benefit by theirformer 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.

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***Medicare Part D***

Effective January 1, 2006, private insurers werepermitted to sponsor insured stand-alone PDPs pursuant to Part D, whichwas established by the MMA. A portion of the premium for this insurance is paidby the Federal government, and the balance, if any, is paid by the individualswho enroll. The Federal government will also provide additional subsidies inthe form of premium support and coverage of the cost-sharing elements of theplan to certain low income Medicare beneficiaries. We have been approved tooffer these programs in 32 of the 34 regions that have been established forthis program for the 2006 plan year and had bids below the benchmark in 26regions. As a result, we were auto-assigned approximately 328,000 Medicare andMedicaid eligible (dual eligible) and facilitated enrollees by CMS for the 2006plan year. For the 2007 plan year, the Company has again been approved to offer, through its insurance subsidiaries, itsPrescription PathwaySM prescription drug plans in all 32 of the 34 regionsdesignated by CMS in which we bid, which excludes only Hawaii and Alaska. Inaddition, the Company is entitled to receive auto assignment of dual eligiblesand low income subsidy (“LIS”) beneficiaries who are dually eligible forMedicare and Medicaid in 28 of the 32 CMS regions. These regions include all ofthe 26 regions for which Universal American was eligible to receive autoassignees in 2006, plus two new regions. We believe that this newprogram provides increased opportunities to offer a much needed coverage and tofurther serve our target markets.

Through our strategicalliance with PharmaCare, we retain 50% of the Medicare Part D business ofour PDPs. The remainder is reinsured PharmaCare Re on a 50% quota share basis. Additionally,as part of the strategic alliance, we created PDMS, which is 50% owned byUniversal American and 50% owned by PharmaCare. PDMS principally performsmarketing and risk management services on behalf of our PDPs and PharmaCare Re.

***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 Re on a 100% first dollarquota share basis. We receive an underwriting fee of two percent of premium. Asa result of this arrangement, both direct and ceded premium increased byapproximately $70 million per quarter, with no impact on net premium.

**Results ofOperations—Consolidated Overview**

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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The following table reflectsincome from each of our segments(1) and contains a reconciliation toreported net income:

| ** **                                   | ** ** | **Three months endedSeptember 30,** | ** ** | **Nine months endedSeptember 30,** | ** ** |
|----------------------------------------------|------------|----------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                   | ** ** | **2006**                                           | ** ** | **2005**                                          | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                   | ** ** | **(In thousands)**                            | ** ** |
| Senior Managed Care-Medicare  Advantage(1)   |       |                                               | $          | 4,008                                             |       |   | $ | 7,467 |   | $ | 23,611 |   | $ | 21,597 |   |
| Senior Market Health  Insurance(1)           |       |                                               | 30,217     |                                              |       | 5,563 |   | 37,673 |   | 20,841 |   |
| Specialty Health  Insurance(1)               |       |                                               | 3,828      |                                              |       | 2,566 |   | 8,179 |   | 8,274 |   |
| Life Insurance and  Annuity(1)               |       |                                               | 6,045      |                                              |       | 4,304 |   | 10,845 |   | 11,749 |   |
| Senior Administrative  Services(1)           |       |                                               | 4,630      |                                              |       | 2,846 |   | 11,832 |   | 9,502 |   |
| Corporate(1)                                 |       |                                               | (5,991     | )                                                 |       | (3,949 | ) | (17,861 | ) | (11,598 | ) |
| Realized gains                               |       |                                               | (26        | )                                                 |       | 260 |   | 21 |   | 4,363 |   |
| Income before provision  for income taxes(1) |       |                                               | 42,711     |                                              |       | 19,057 |   | 74,300 |   | 64,728 |   |
| Income taxes, excluding  realized gains      |       |                                               | 15,992     |                                              |       | 7,091 |   | 27,271 |   | 22,281 |   |
| Income taxes on realized  gains              |       |                                               | (9         | )                                                 |       | 91 |   | 7 |   | 435 |   |
| Total income taxes                           |       |                                               | 15,983     |                                              |       | 7,182 |   | 27,278 |   | 22,716 |   |
| Income from continuing  operations           |       |                                               | 26,728     |                                              |       | 11,875 |   | 47,022 |   | 42,012 |   |
| Income from discontinued  operations         |       |                                               | 3,474      |                                              |       | 3,413 |   | 8,311 |   | 7,996 |   |
| Net income                                   |       |                                               | $          | 30,202                                            |       |   | $ | 15,288 |   | $ | 55,333 |   | $ | 50,008 |   |
| Per Share Data (Diluted):                    |       |                                               |       |                                              |       |   |   |   |   |   |   |
| Income from continuing  operations           |       |                                               | $          | 0.44                                              |       |   | $ | 0.19 |   | $ | 0.78 |   | $ | 0.72 |   |
| Income from discontinued  operations         |       |                                               | $          | 0.06                                              |       |   | $ | 0.06 |   | $ | 0.14 |   | $ | 0.13 |   |
| Net income                                   |       |                                               | $          | 0.50                                              |       |   | $ | 0.25 |   | $ | 0.92 |   | $ | 0.85 |   |

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(1)          Weevaluate the results of operations of our segments based on income beforerealized gains and income taxes. Management believes that realized gains andlosses are not indicative of overall operating trends. This differs fromgenerally accepted accounting principles, which includes the effect of realizedgains in the determination of net income. The schedule above reconciles oursegment income to net income in accordance with generally accepted accountingprinciples.

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

Net income for the third quarter of 2006 increased to$30.2 million, or $0.50 per diluted share, compared to $15.3 million, or $0.25per diluted share for the third quarter of 2005. Income from continuingoperations, after taxes, was $26.7 million, or $0.44 per diluted share comparedincome from continuing operations, after taxes, of $11.9 million, or $0.19 perdiluted share. Income from discontinued operations, after taxes, was $3.5million or $0.06 per diluted share, for the third quarter of 2006, compared to$3.4 million, or $0.06 per diluted share, for the third quarter of 2005. Ouroverall effective tax rate was 37.3% for the third quarter of 2006, and 36.4%for the third quarter of 2005.

Our Senior Managed Care—Medicare Advantage segmentgenerated segment income of $4.0 million during the third quarter of 2006, adecrease of $3.5 million, compared to $7.5 million for the third quarter of2005, primarily due to expansion costs of $5.5 million incurred in the thirdquarter of 2006, offset in part by 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. The SeniorMarket Health Insurance segment income increased by $24.7 million to $30.2million for the third quarter of 2006, compared to $5.6 million for the 

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third quarter of 2005. Resultsfor our Medicare Supplement business was level with the third quarter of 2005. Segmentincome for our Part D business increased by $24.6 million to $24.3million, for the third quarter of 2006 compared to a loss of $0.3 million forthe third 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.

Segment income from our Life Insurance and Annuitysegment increased by $1.7 million, compared to the second quarter of 2005,primarily as a result of an increase in net investment income and a decrease inclaim costs.

Segment income for our Senior Administrative Servicessegment increased by $1.8 million, or 63%, to $4.6 million for the thirdquarter 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 $2.0 million, or 52%, for the three months endedSeptember 30, 2006 compared to the three months ended September 30,2005. The increase was due primarily to the increase in stock-basedcompensation expense as a result of the adoption of FAS 123-R, costs ofdue diligence and higher interest cost.

***Nine months ended September 30, 2006 and 2005***

Net income for the first nine months 2006 increased to$55.3 million, or $0.92 per diluted share, compared to $50.0 million, or $0.85per diluted share for the first nine months of 2005. Income from continuingoperations, after taxes, was $47.0 million, or $0.78 per diluted share comparedincome from continuing operations, after taxes, of $42.0 million, or $0.72 perdiluted share. Income from discontinued operations, after taxes, was $8.3million or $0.14 per diluted share, for the first nine months of 2006, comparedto $8.0 million, or $0.13 per diluted share, for the first nine months of 2005.

Net income for the first nine months of 2005 includesrealized investment gains, net of tax, of $3.9 million, or $0.07 perdiluted share, which reflects the benefit from a $1.1 million release of a taxvaluation allowance relating to net capital loss carryforwards

Our overall effective tax rate was 37.2% for the firstnine months of 2006, and 34.5% for the first nine months of 2005, reflectingthe release of the valuation allowance noted above.

Our Senior Managed Care—Medicare Advantage segmentgenerated segment income of $23.6 million during the first nine months of2006, an increase of $2.0 million, compared to $21.6 million for the first ninemonths of 2005, primarily due to the continued growth in membership in ourMedicare Advantage plans.

The Senior Market Health Insurance segment incomeincreased by $16.8 million to $37.7 million for the first nine months of 2006,compared to segment income of $20.8 million for the first nine months of 2005. Segmentincome for our Part D business increased by $38.4 million, to $37.6million, for the first nine months of 2006, compared to a loss of $0.8 millionfor the first nine months of 2005. This was offset, in part, by the results forour Medicare Supplement business, which declined by $21.5 million, compared tothe first nine 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.

Our Specialty Health Insurance segment incomedecreased by $0.1 million, or 1%, compared to the first nine months of 2005.

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Segment income from our Life Insurance and Annuitysegment decreased by $0.9 million, compared to the first nine 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 $2.3 million, or 25%, to $11.8 million for the first ninemonths 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 $6.3 million, or 54%, for the nine months ended September 30,2006 compared to the nine months ended September 30, 2005. The increasewas due primarily to the increase in stock-based compensation expense as aresult of the adoption of FAS 123-R, costs of due diligence and higherinterest cost.

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

| ** **                                  | ** ** | **Three months endedSeptember 30,** | ** ** | **Nine months ended  September 30,** | ** ** |
|---------------------------------------------|------------|----------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                  | ** ** | **2006**                                           | ** ** | **2005**                                            | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                  | ** ** | **(In thousands)**                            | ** ** |
| Net premiums                                |       | $                                                  | 124,719    |                                                | $          | 61,967 |   | $ | 324,714 |   | $ | 171,897 |   |
| Net investment  and other income            |       | 1,654                                              |       | 740                                                 |       | 3,991 |   | 1,939 |   |
| Total revenue                               |       | 126,373                                            |       | 62,707                                              |       | 328,705 |   | 173,836 |   |
| Medical expenses                            |       | 94,389                                             |       | 44,564                                              |       | 241,269 |   | 123,579 |   |
| Amortization of  intangible assets          |       | 870                                                |       | 644                                                 |       | 2,610 |   | 1,647 |   |
| Commissions and  general expenses           |       | 27,106                                             |       | 10,032                                              |       | 61,215 |   | 27,013 |   |
| Total benefits, claims and other deductions |       | 122,365                                            |       | 55,240                                              |       | 305,094 |   | 152,239 |   |
| Segment income                              |       | $                                                  | 4,008      |                                                | $          | 7,467 |   | $ | 23,611 |   | $ | 21,597 |   |

 

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 MSO’s that manage thatbusiness and affiliated IPA’s. We participate in the net results derived fromthese affiliated IPA’s. Our Medicare Advantage PFFS plans, also under acontract with CMS, are sold by our career and independent agents throughAmerican Progressive and Pyramid Life.

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

*Revenues.*   Netpremiums for the Senior Managed Care segment increased by $62.8 million, or101%, compared to the third quarter of 2005. Approximately $57.9 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 third quarter of 2006, our health plans received $8.6million 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 $0.9 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 $49.8 million, or 112%, compared to the third quarter of 2005. Growth inmembership added approximately $36.5 million. The enhanced prescription drugbenefit increased pharmacy benefit costs by $4.4 million to $7.2 million. Thebalance of $8.9 million was due to an increase in the loss ratio. Overall lossratios for the segment increased by 

40

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380 basis points to75.7% for the third quarter of 2006 from 71.9% for the third quarter of 2005. Commissionsand general expenses increased by $17.1 million compared to the third quarterof 2005, due primarily to the growth in business, including $5.5 million formarketing 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:

| ** **                | ** ** | **Three months ended September 30,** | ** ** |
|---------------------------|------------|----------------------------------------------------------|------------|
| ** **                | ** ** | **2006**                                                 | ** ** | **2005** | ** ** |
| ** **                | ** ** | **Revenue**                                              | ** ** | **Segment Income** | ** ** | **Revenue** | ** ** | **Segment Income** | ** ** |
| ** **                | ** ** | **(In thousands)**                                  | ** ** |
| Health Plans              |       | $                                                        | 91,757     |   |   | $ | 4,330 |   |   | $ | 56,560 |   |   | $ | 2,552 |   |   |
| Affiliated IPA’s     |       | 36,988                                                   |       |   | 3,009 |   |   | 30,335 |   |   | 3,526 |   |   |
| MSO’s and  Corporate |       | 13,239                                                   |       |   | (1,638 | ) |   | 8,630 |   |   | 1,317 |   |   |
| Private Fee-for  Service  |       | 33,928                                                   |       |   | (1,693 | ) |   | 5,852 |   |   | 72 |   |   |
| Eliminations              |       | (49,539                                                  | )          |   | — |   |   | (38,670 | ) |   | — |   |   |
| Total                     |       | $                                                        | 126,373    |   |   | $ | 4,008 |   |   | $ | 62,707 |   |   | $ | 7,467 |   |   |

 

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 $36.7 million for three months ended September 30, 2006and $30.2 million for three months ended September 30, 2005 and managementfees received by the MSO’s from the health plans and the IPA’s amounting to$12.8 million for three months ended September 30, 2006 and $8.5 millionfor three months ended September 30, 2005.

Our health plans receive premiums primarily from CMS.As of September 30, 2006, there were 34,038 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 areaemergency and transplants. In August 2005, we began enrolling members in aMedicare Advantage special needs program. Beginning January 1, 2006, webegan enrolling members in our Medicare Advantage coordinated care plan in SouthFlorida. During the third quarter of 2006, the health plans had revenues of$91.8 million and reported a medical loss ratio of 81.0% versus revenues of$56.6 million and a medical loss ratio of 82.2% in the third quarter of 2005.

We participate in the profits from the two affiliatedIPA’s that receive capitated payments from SelectCare of Texas. As of September 30,2006, the affiliated IPA’s managed the care for 16,822 members. During thethird quarter of 2006, the IPA’s earned $3.0 million on $37.0 million inrevenues. For the third quarter of 2005, the IPA’s earned $3.5 million on $30.3million 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 third quarter of 2006, these MSO’s incurred a loss of $1.6 million on$13.2 million of fees collected. For the third quarter of 2005, these MSO’searned $1.3 million of income on $8.6 million of fees collected.

Starting in June 2004,we began enrolling members in our PFFS product, a Medicare Advantage programthat allows its members to have more flexibility in the delivery of theirhealth care services than other Medicare Advantage plans. In addition topremium received from CMS, we receive modest premium 

41

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paymentsfrom the members. Beginning September 1, 2005, we expanded our PFFSproduct offering to Medicare eligibles in 258 counties in 7 new states. On January 1,2006, we expanded the PFFS product to an additional 152 counties in 6 statesfor a total service area of 459 counties in 15 states. As of September 30,2006, we had 17,616 members enrolled in our PFFS plans. During the thirdquarter of 2006, we collected $33.9 million of premium from CMS and themembers, and reported a medical loss ratio of 83.1%, which included adversedevelopment of prior period reserves for these plans of approximately $1.3 million.For the third quarter of 2005, we collected $5.9 million of premium from CMSand the members, and reported a medical loss ratio of 75.5%.

***Nine months ended September 30, 2006 and 2005***

*Revenues.*   Netpremiums for the Senior Managed Care segment increased by $152.8 million, or89%, compared to the first nine months of 2005. Approximately $142.6 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 nine months of 2006, our health plans received$23.0 million from CMS for the Part D prescription drug benefit. Thoseincreases were partially offset by $12.8 million related to the reductionin the average premium PMPM due to an increase in the percentage of members inour PFFS plans which have a lower PMPM than our health plans. Net investmentincome increased by $2.1 million, due primarily to growth in investedassets as a result of growth in business, as well as increased yields.

*Benefits,Claims and Expenses.*   Medical expenses increasedby $117.7 million, or 95%, compared to the first nine months of 2005. Growth inmembership added approximately $87.6 million. The enhanced prescription drugbenefit increased pharmacy benefit costs by $11.7 million to $19.3 million. Thebalance of $18.4 million was due to an increase in the loss ratio. Overall lossratios for the segment increased by 240 basis points to 74.3% for the firstnine months of 2006 from 71.9% for the first nine months of 2005. Commissionsand general expenses increased by $34.2 million compared to the first ninemonths of 2005, due primarily to the growth in business, including $5.5 millionfor marketing costs for new service areas and other development activities, aswell as an increase in commissions, as more of the Medicare Advantage productis being sold by our agents.

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

| ** **                | ** ** | **Nine months ended September 30,** | ** ** |
|---------------------------|------------|---------------------------------------------------------|------------|
| ** **                | ** ** | **2006**                                                | ** ** | **2005** | ** ** |
| ** **                | ** ** | **Revenue**                                             | ** ** | **Segment Income** | ** ** | **Revenue** | ** ** | **Segment Income** | ** ** |
| ** **                | ** ** | **(In thousands)**                                 | ** ** |
| Health Plans              |       | $                                                       | 248,580    |   |   | $ | 9,790 |   |   | $ | 159,135 |   |   | $ | 7,416 |   |   |
| Affiliated IPA’s     |       | 107,951                                                 |       |   | 9,526 |   |   | 87,990 |   |   | 9,083 |   |   |
| MSO’s and  Corporate |       | 35,013                                                  |       |   | (23 | ) |   | 24,461 |   |   | 4,730 |   |   |
| Private Fee-for  Service  |       | 78,399                                                  |       |   | 4,318 |   |   | 13,815 |   |   | 368 |   |   |
| Eliminations              |       | (141,238                                                | )          |   | — |   |   | (111,565 | ) |   | — |   |   |
| Total                     |       | $                                                       | 328,705    |   |   | $ | 23,611 |   |   | $ | 173,836 |   |   | $ | 21,597 |   |   |

 

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 $107.2 million for the first nine months of 2006 and $87.6million for the first nine months of 2005 and management fees received by theMSO’s from the health plans and the IPA’s amounting to $34.0 million for thefirst nine months of 2006 and $23.9 million for the first nine months of 2005.

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During the first nine months of 2006, our health planshad revenues of $248.6 million and reported a medical loss ratio of 81.8%versus revenues of $159.1 million and a medical loss ratio of 82.1% for thefirst nine months of 2005.

During the first nine months of 2006, the IPA’s earned$9.5 million on $108.0 million in revenues. For the first nine months of 2005,the IPA’s earned $9.1 million on $88.0 million in revenues.

For the first nine months of 2006, our MSO’s brokeeven on $35.0 million of fees collected. For the first nine months of 2005,these MSO’s earned $4.7 million of income on $24.5 million of fees collected.

During the first ninemonths of 2006, we collected $78.4 million of premium from CMS and the membersfor our PFFS product, and reported a medical loss ratio of 77.3%. For the firstnine months of 2005, we collected $13.8 million of premium from CMS and themembers for our PFFS product, and reported a medical loss ratio of 73.2%.

**Segment Results—Senior Market Health Insurance**

| ** **                                           | ** ** | **Three months endedSeptember 30,** | ** ** | **Nine months ended  September 30,** | ** ** |
|------------------------------------------------------|------------|----------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                           | ** ** | **2006**                                           | ** ** | **2005**                                            | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                           | ** ** | **(In thousands)**                            | ** ** |
| **Premiums:**                                        | ** ** | ** **                                         | ** ** | ** **                                          | ** ** | ** ** | ** ** | ** ** | ** ** |
| Direct and assumed                                   |       | $                                                  | 227,375    |                                                | $          | 142,952 |   | $ | 759,197 |   | $ | 432,540 |   |
| Ceded                                                |       | (85,721                                            | )          | (44,292                                             | )          | (293,363 | ) | (139,357 | ) |
| Net premiums                                         |       | 141,654                                            |       | 98,660                                              |       | 465,834 |   | 293,183 |   |
| Other Part D  income (PDMS)                     |       | 13,969                                             |       | (224                                                | )          | 36,643 |   | (400 | ) |
| Net investment  income                               |       | 2,915                                              |       | 1,145                                               |       | 7,516 |   | 3,507 |   |
| Other income                                         |       | 705                                                |       | 249                                                 |       | 2,015 |   | 578 |   |
| Total revenue                                        |       | 159,243                                            |       | 99,830                                              |       | 512,008 |   | 296,868 |   |
| Policyholder  benefits                               |       | 96,495                                             |       | 70,752                                              |       | 371,228 |   | 211,913 |   |
| Change in  deferred acquisition costs                |       | (1,789                                             | )          | (7,919                                              | )          | (6,289 | ) | (26,902 | ) |
| Amortization of  intangible assets                   |       | 764                                                |       | 1,262                                               |       | 3,053 |   | 2,694 |   |
| Commissions and  general expenses, net of allowances |       | 33,556                                             |       | 30,172                                              |       | 106,343 |   | 88,322 |   |
| Total benefits, claims and other deductions          |       | 129,026                                            |       | 94,267                                              |       | 474,335 |   | 276,027 |   |
| Segment income                                       |       | $                                                  | 30,217     |                                                | $          | 5,563 |   | $ | 37,673 |   | $ | 20,841 |   |

 

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. We reinsure50% of the business of our PDPs to PharmaCare Re. The total results for thesegment are presented above. Results for our Medicare Supplement business areseparately presented below on a comparative basis. Additionally, we have alsoseparately presented the results for our Part D business.

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

The Senior Market HealthInsurance segment income increased by $24.7 million to $30.2 million for thethird quarter of 2006, compared to $5.6 million for the third quarter of 2005. Resultsfor our Medicare Supplement business was level with the third quarter of 2005. Segmentincome for our Part D business increased by $24.6 million to $24.3million, for the third quarter of 2006 compared to a loss of $0.3 million forthe third quarter of 2005.

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***Nine months ended September 30, 2006 and 2005***

The Senior Market HealthInsurance segment income increased by $16.8 million to $37.7 million for thefirst nine months of 2006, compared to segment income of $20.8 million for thefirst nine months of 2005. Segment income for our Part D businessincreased by $38.4 million, to $37.6 million, for the first nine months of2006, compared to a loss of $0.8 million for the first nine months of 2005. Thiswas offset, in part, by the results for our Medicare Supplement business, whichdeclined by $21.5 million, compared to the first nine months of 2005, as aresult of increased loss ratios and the continued effect of higher thanexpected lapsation of our Medicare Supplement in force business, which resultedin an acceleration of the amortization of deferred acquisition costs andpresent value of future profits.

| ** **                                           | ** ** | **Three months endedSeptember 30,** | ** ** | **Nine months ended  June 30,** | ** ** |
|------------------------------------------------------|------------|----------------------------------------------------|------------|------------------------------------------------|------------|
| ** **                                           | ** ** | **2006**                                           | ** ** | **2005**                                       | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                           | ** ** | **(In thousands)**                            | ** ** |
| **Medicare Supplement**                              |       |                                               |       |                                           |       |   |   |   |   |
| Premiums:                                            |       |                                               |       |                                           |       |   |   |   |   |
| Direct and assumed                                   |       | $                                                  | 124,916    |                                           | $          | 142,952 |   | $ | 391,917 |   | $ | 432,540 |   |
| Ceded                                                |       | (35,330                                            | )          | (44,292                                        | )          | (112,397 | ) | (139,357 | ) |
| Net premiums                                         |       | 89,586                                             |       | 98,660                                         |       | 279,520 |   | 293,183 |   |
| Net investment  income                               |       | 2,055                                              |       | 1,145                                          |       | 5,538 |   | 3,507 |   |
| Other income                                         |       | 690                                                |       | 249                                            |       | 1,965 |   | 578 |   |
| Total revenue                                        |       | 92,331                                             |       | 100,054                                        |       | 287,023 |   | 297,268 |   |
| Policyholder  benefits                               |       | 61,705                                             |       | 70,752                                         |       | 206,139 |   | 211,913 |   |
| Change in  deferred acquisition costs                |       | (1,789                                             | )          | (7,919                                         | )          | (6,289 | ) | (26,902 | ) |
| Amortization of  intangible assets                   |       | 764                                                |       | 1,262                                          |       | 3,053 |   | 2,694 |   |
| Commissions and  general expenses, net of allowances |       | 25,718                                             |       | 30,063                                         |       | 84,032 |   | 87,955 |   |
| Total benefits, claims and other deductions          |       | 86,398                                             |       | 94,158                                         |       | 286,935 |   | 275,660 |   |
| Segment income (loss)                                |       | $                                                  | 5,933      |                                           | $          | 5,896 |   | $ | 88 |   | $ | 21,608 |   |

 

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

*Revenues.**  *Net premiums for our Medicare Supplement businessdeclined by $9.1 million, compared to the third quarter of 2005, due to thecontinued effect of higher lapsation of our Medicare Supplement in force business,offset in part by a decrease in the level of our Medicare Supplement premiumsreinsured, rate increases and new sales.

Net investment income increased by approximately $0.9million, compared to the third 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 $9.0 million, or 13%, compared to the thirdquarter of 2005. The reduction in business, as noted above, resulted in adecline of $6.3 million. Improved loss ratios resulted in a decline of $2.8million. Overall loss ratios declined approximately 30 basis points to 68.9%for the third quarter of 2006 compared to 71.7% for the third quarter of 2005,as a result of the rate increases we have implemented in the past year. Theincreased loss ratios in the third quarter of 2005 related primarily tohigher-than-anticipated outpatient doctor (Part B) and skilled nursingfacility incidence. After consideration of certain adjustments made at the endof 2005 to increase claim reserves, the loss ratio for the quarter ended September 30,2005 was 70.4%, or 150 basis points higher than the third quarter of 2006. We anticipate thatour Medicare Supplement loss ratio will continue to decrease during the fourthquarter and for the full year 2006, will be in the range of 71.5% to 73.5%.

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The increase in deferred acquisition costs was $6.1million less for the third quarter of 2006 than the increase for the thirdquarter 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 $1.1 million. Second,amortization increased by approximately $5.0 million as a result of higherlapsation of our Medicare Supplement business, compared to the third quarter of2005. 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 and third quarters of 2006, but not as much as we anticipated. Webelieve that there are a number of factors contributing to the increasedlapsation, including competitive pressure from new Medicare Advantage productsand increased competition from other Medicare Supplement carriers. Thisincrease in lapsation has accelerated the amortization of the deferredacquisition cost and present value of future profits assets associated with thebusiness that lapsed.

The amortization of intangibles relates primarily tointangibles recorded from the acquisition of Pyramid Life and decreased by $0.5million, compared to the third quarter of 2005, due to the moderation of thelapsation of in force business of Pyramid.

Commissionsand general expenses, net of reinsurance allowances, declined by $4.3 million ,or 15%, compared to the third quarter of 2005. The following table details thecomponents of commission and other operating expenses:

| ** **                                           | ** ** | **2006**                | ** ** | **2005** | ** ** |
|------------------------------------------------------|------------|-------------------------|------------|----------|------------|
| ** **                                           | ** ** | **(In thousands)** | ** ** |
| Commissions                                          |       | $                       | 16,684     |     | $          | 20,531 |   |
| Other operating  costs                               |       | 15,267                  |       | 18,788   |       |
| Reinsurance  allowances                              |       | (6,233                  | )          | (9,256   | )          |
| Commissions and general  expenses, net of allowances |       | $                       | 25,718     |     | $          | 30,063 |   |

 

The ratio of commissionsto gross premiums decreased to 13.4% for the third quarter of 2006, from 14.4%for the third 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 12.2% for the third quarter of 2006,compared to 13.1% for the third quarter of 2005 as a result of loweracquisition expenses due to lower new business production and lower fixedcosts. Commission and expense allowances received from reinsurers as a percentageof the premiums ceded decreased to 17.6% for the third quarter of 2006 from20.9% for the third quarter of 2005, primarily due to the reduction in newbusiness ceded and the effects of normal lower commission allowances on ouraging base of ceded renewal business.

***Nine months ended September 30, 2006 and 2005***

*Revenues.**  *Net premiums for our Medicare Supplement businessdeclined by $13.7 million, compared to the first nine months of 2005, due tothe continued effect of higher lapsation of our Medicare Supplement in forcebusiness, offset in part by increased retention of our Medicare Supplementbusiness, rate increases and new sales.

Net investment income increased by approximately $2.0million, compared to the first nine months of 2005, due to an increase ininvested assets as well as an increase in portfolio yields.

*Benefits,Claims and Expenses.**  *Policyholderbenefits incurred declined by $5.8 million, or 3%, compared to the first ninemonths of 2005. Overall loss ratios for the first nine months of 2006 increased140 basis points to 73.7% compared to 72.3% for the first nine months of 2005. Theincrease in our Medicare Supplement loss ratio was primarily as a result of theincrease in the federally prescribed Part B deductible. The reduction inbusiness, as noted above, resulted in a reduction in benefits of $9.9 million, 

45

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this was offset by an increasein the loss ratio, which added $4.1 million to benefits during the first nine monthsof 2006.

The increase in deferred acquisition costs was $20.6million less for the first nine months of 2006 than the increase for the firstnine months of 2005. Two factors contributed to the decrease. First, weincurred lower commissions and other acquisition costs as a result of lowerproduction, resulting in a decrease in the costs capitalized of $6.5 million. Second,amortization increased by approximately $14.1 million, primarily as a result ofhigher lapsation of our Medicare Supplement business, compared to the firstnine months of 2005. We began to experience higher than expected lapsation inour Medicare Supplement business in the third quarter of 2005 that continuedand worsened in the first quarter of 2006. This excess lapsation moderatedsomewhat in the second and third quarters of 2006, but not as much as weanticipated. We believe that there are a number of factors contributing to theincreased lapsation, including competitive pressure from new Medicare Advantageproducts and increased competition from other Medicare Supplement carriers.This increase in lapsation has accelerated the amortization of the deferredacquisition costs and present value of future profits assets associated withthe business that lapsed.

The amortization of intangibles relates primarily tointangibles recorded from the acquisition of Pyramid Life, and increased by$0.4 million compared to the first nine months of 2005, due to the increase inlapsation of in force business at Pyramid.

Commissionsand general expenses, net of reinsurance allowances, decreased by $3.9 million,or 5%, compared to the first nine months of 2005. The following table detailsthe components of commission and other operating expenses:

| ** **                                           | ** ** | **2006**                | ** ** | **2005** | ** ** |
|------------------------------------------------------|------------|-------------------------|------------|----------|------------|
| ** **                                           | ** ** | **(In thousands)** | ** ** |
| Commissions                                          |       | $                       | 52,706     |     | $          | 61,966 |   |
| Other operating  costs                               |       | 52,134                  |       | 54,899   |       |
| Reinsurance  allowances                              |       | (20,808                 | )          | (28,910  | )          |
| Commissions and general  expenses, net of allowances |       | $                       | 84,032     |     | $          | 87,955 |   |

 

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Theratio of commissions to gross premiums decreased to 13.4% for the first ninemonths of 2006, from 14.3% for the first nine months of 2005, as a result oflower overall commission rates associated with the continued growth of our inforce renewal premium and less new business production that has highercommission rates. Other operating costs as a percentage of gross premiums were13.3% for the first nine months of 2006, compared to 12.7% for the first ninemonths of 2005 as a result of lower acquisition expenses due to lower newbusiness production and lower fixed costs.. Commission and expense allowancesreceived from reinsurers as a percentage of the premiums ceded decreased to18.5% for the first nine months of 2006 from 20.7% for the first nine months of2005, primarily due to the reduction in new business ceded and the effects ofnormal lower commission allowances on our aging base of ceded renewal business.

| ** **                                                 | ** ** | **Three months endedSeptember 30,** | ** ** | **Nine months endedSeptember 30,** | ** ** |
|------------------------------------------------------------|------------|----------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                                 | ** ** | **2006**                                           | ** ** | **2005**                                          | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                                 | ** ** | **(In thousands)**                            | ** ** |
| **Part D**                                            |       |                                               |       |                                              |       |   |   |   |   |
| Direct and assumed premium after risk corridor  adjustment |       | $                                                  | 102,459    |                                              | $          | — |   | $ | 367,280 |   | $ | — |   |
| Ceded premiums                                             |       | (50,391                                            | )          | —                                            |       | (180,966 | ) | — |   |
| Net premiums                                               |       | 52,068                                             |       | —                                            |       | 186,314 |   | — |   |
| Other Part D income (PDMS)                            |       | 13,984                                             |       | (224                                              | )          | 36,693 |   | (400 | ) |
| Total Part D  Revenue                                 |       | 66,052                                             |       | (224                                              | )          | 223,007 |   | (400 | ) |
| Net investment  and other income                           |       | 860                                                |       | —                                            |       | 1,978 |   | — |   |
| Total revenue                                              |       | 66,912                                             |       | (224                                              | )          | 224,985 |   | (400 | ) |
| Pharmacy benefits                                          |       | 34,790                                             |       | —                                            |       | 165,089 |   | — |   |
| Commissions and  general expenses, net of allowances       |       | 7,838                                              |       | 109                                               |       | 22,311 |   | 367 |   |
| Total benefits, claims and other deductions                |       | 42,628                                             |       | 109                                               |       | 187,400 |   | 367 |   |
| Segment income                                             |       | $                                                  | 24,284     |                                              | $          | (333 | ) | $ | 37,585 |   | $ | (767 | ) |

 

A discussion of the accounting for Part D isincluded in Notes 2 and 14 included in the notes to the consolidated financialstatements in this Form 10-Q. For the nine months ended September 30,2006, we based our membership for Part D on enrollment informationprovided by CMS which indicated that, as of September 30, 2006,approximately 445,000 members were enrolled in our PDPs for which we were paidby CMS. This includes approximately 422,000 members in our PDPs that weparticipate in on a 50% basis and 23,000 members in an unaffiliated PDP that weparticipate in on a 33% basis. Our revenues and claims expenses are based onpremium earned and incurred pharmacy benefits for the reported enrolledmembership. The membership information continues to be reconciled and refinedby CMS with respect to the allocation among all plans participating in the Part Dprogram. As a result, it is likely that the membership data upon which we basedour results for the first nine months of 2006 will change, with a correspondingchange in the financial results for the segment. We are unable to preciselyquantify the impact of any potential change until the membership data is fullyreconciled with CMS, however, we do not believe that any change from theamounts reported as of September 30, 2006 is likely to be material. Other Part Drevenue represents our equity in the earnings of PDMS.

The ratio of incurredprescription drug benefits to Part D revenue for the third quarter of 2006was 52.7% and for the first nine months of 2006 was 74.0%. 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.

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**Segment Results—Specialty Health Insurance**

| ** **                                           | ** ** | **Three months endedSeptember 30,** | ** ** | **Nine months ended  September 30,** | ** ** |
|------------------------------------------------------|------------|----------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                           | ** ** | **2006**                                           | ** ** | **2005**                                            | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                           | ** ** | **(In thousands)**                            | ** ** |
| Premiums:                                            |       |                                               |       |                                                |       |   |   |   |   |
| Direct and assumed                                   |       | $                                                  | 100,217    |                                                | $          | 90,934 |   | $ | 289,975 |   | $ | 144,106 |   |
| Ceded                                                |       | (80,612                                            | )          | (70,051                                             | )          | (230,303 | ) | (80,663 | ) |
| Net premiums                                         |       | 19,605                                             |       | 20,883                                              |       | 59,672 |   | 63,443 |   |
| Net investment  income                               |       | 4,792                                              |       | 4,364                                               |       | 13,846 |   | 12,561 |   |
| Other income                                         |       | 255                                                |       | 289                                                 |       | 349 |   | 839 |   |
| Total revenue                                        |       | 24,652                                             |       | 25,536                                              |       | 73,867 |   | 76,843 |   |
| Policyholder  benefits                               |       | 15,830                                             |       | 17,474                                              |       | 50,134 |   | 49,417 |   |
| Change in  deferred acquisition costs                |       | (541                                               | )          | (1,682                                              | )          | (1,594 | ) | (3,609 | ) |
| Commissions and  general expenses, net of allowances |       | 5,535                                              |       | 7,178                                               |       | 17,148 |   | 22,761 |   |
| Total benefits, claims and other deductions          |       | 20,824                                             |       | 22,970                                              |       | 65,688 |   | 68,569 |   |
| Segment income                                       |       | $                                                  | 3,828      |                                                | $          | 2,566 |   | $ | 8,179 |   | $ | 8,274 |   |

 

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

Our Specialty Health Insurance segment incomeincreased by $1.2 million, or 18%, compared to the third quarter of 2005,primarily as a result of the underwriting fees earned on the reinsurancearrangement with PharmaCare Re. The operations of PennCorp Life Canada, whichhave previously been included in our Specialty Health segment results, are nowclassified as discontinued operations and are not reflected in the above table.

*Revenues.**  *Both direct and ceded premium for the SpecialtyHealth Insurance segment increased approximately $10.8 million, compared to thethird quarter of 2005, as a result of the premiums relating to the PharmaCareRe reinsurance agreement discussed above. Net premiums declined by $1.3million, or 6%, compared to the third quarter of 2005 as a result of lowersales and renewals in our U.S. fixed benefit accident and sickness line and ournon-marketed long term care line.

Net investment income increased by approximately $0.4million, or 10%, compared to the third 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 declined by $1.6 million, or 9%, compared to the thirdquarter of 2005. Overall loss ratios for the segment were 67.9% for the thirdquarter of 2006 compared to 68.4% for the third quarter of 2005. Improvementsin the loss ratios for our fixed benefit accident and sickness line and majormedical lines were offset by an increase in the loss ratio on our long termcare line.

Commissions and generalexpenses decreased by $1.6 million, or 23%, compared to the third quarter of2005. Commissions and general expenses declined by approximately $0.8 millioneach, primarily as a result of the reduction in new business produced.

***Nine months ended September 30, 2006 and 2005***

Our Specialty Health Insurance segment incomedecreased by $0.1 million, or 1%, compared to the first nine months of 2005.

*Revenues.**  *Both direct and ceded premium for the SpecialtyHealth Insurance segment increased approximately $151.1 million, compared tothe first nine months of 2005, as a result of the premiums 

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relating to the PharmaCareRe reinsurance agreement discussed above. Net premiums declined byapproximately $3.8 million, or 6%, compared to the first nine months of 2005. Netpremiums declined by approximately $2.6 million in our U.S. fixed benefitaccident and sickness line and $1.4 million in our long term care line.

Net investment income increased by approximately $1.3million, or 10%, compared to the first nine months of 2005. The increaseis due primarily to investing cash that we had been accumulating inanticipation of rising interest rates.

*Benefits,Claims and Expenses.**  *Policyholderbenefits incurred increased by $0.7 million, or 2%, compared to the first ninemonths of 2005. Overall loss ratios for the segment increased to 84.0% for thefirst nine months of 2006 compared to 77.9% for the first nine months of 2005,primarily as a result of higher loss ratios for our long term care line. Longterm care loss ratios increased to 135.2% for the first nine months of 2006from 108.5% for the first nine months of 2005.

Commissions and generalexpenses decreased by $5.6 million, or 25%, compared to the first nine monthsof 2005, primarily as a result of the $3.0 million increase in the reinsuranceallowance earned on the reinsurance arrangement with PharmaCare Re, as comparedto the first nine months of 2005, due to the arrangement beginning on July 1,2005. Commissions declined by $0.8 million and general expenses declined byapproximately $2.0 million, primarily as a result of the reduction in newbusiness and renewal premium.

**Segment Results—Life Insurance and Annuity**

| ** **                                           | ** ** | **Three months endedSeptember 30,** | ** ** | **Nine months ended  September 30,** | ** ** |
|------------------------------------------------------|------------|----------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                           | ** ** | **2006**                                           | ** ** | **2005**                                            | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                           | ** ** | **(In thousands)**                            | ** ** |
| **Premiums :**                                       |       |                                               |       |                                                |       |   |   |   |   |
| Direct and assumed                                   |       | $                                                  | 19,677     |                                                | $          | 20,111 |   | $ | 58,259 |   | $ | 57,164 |   |
| Ceded                                                |       | (4,407                                             | )          | (4,459                                              | )          | (12,499 | ) | (12,982 | ) |
| Net premiums                                         |       | 15,270                                             |       | 15,652                                              |       | 45,760 |   | 44,182 |   |
| Net investment  income                               |       | 10,054                                             |       | 9,183                                               |       | 29,450 |   | 26,780 |   |
| Other income                                         |       | 143                                                |       | 34                                                  |       | 298 |   | 109 |   |
| Total revenue                                        |       | 25,467                                             |       | 24,869                                              |       | 75,508 |   | 71,071 |   |
| Policyholder  benefits                               |       | 7,953                                              |       | 8,476                                               |       | 29,483 |   | 27,557 |   |
| Interest credited  to policyholders                  |       | 4,503                                              |       | 5,096                                               |       | 13,713 |   | 14,271 |   |
| Change in  deferred acquisition costs                |       | (1,534                                             | )          | (3,698                                              | )          | (4,467 | ) | (13,844 | ) |
| Amortization of  intangible assets                   |       | 50                                                 |       | 18                                                  |       | 248 |   | 210 |   |
| Commissions and  general expenses, net of allowances |       | 8,450                                              |       | 10,673                                              |       | 25,686 |   | 31,128 |   |
| Total benefits, claims and other deductions          |       | 19,422                                             |       | 20,565                                              |       | 64,663 |   | 59,322 |   |
| Segment income                                       |       | $                                                  | 6,045      |                                                | $          | 4,304 |   | $ | 10,845 |   | $ | 11,749 |   |

 

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

Segment income from ourLife Insurance and Annuity segment increased by $1.7 million, compared to thethird quarter of 2005, primarily as a result of an increase in net investmentincome and a decrease in claim costs

*Revenues.*   Net premiumsfor the segment declined by $0.4 million, or 2%, compared to the third quarterof 2005. Declines in premiums for our non-marketed traditional life insuranceand interest sensitive products of approximately $1.0 were offset by growth inrenewal premiums for our senior life product.

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Our agents sold $2.4 million of fixed annuities duringthe third quarter of 2006 and $9.3 million during the third 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 third 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 decreased by $0.5 million, or 6%, compared to the thirdquarter of 2005. Improved mortality resulted in a reduction in claim costs of$0.5 million, as compared to the third quarter of 2005. The increase indeferred acquisition costs was $2.2 million less during the third quarter of2006, as compared to the increase during the third quarter of 2005. This wasprimarily due to lower production of new life insurance and annuity businessduring the third quarter of 2006, resulting in a lower level of acquisitioncosts to capitalize, and aging of the block of business as compared to thethird quarter of 2005. Commissions and general expenses, net of allowancesdecreased by $2.2 million, or 21%, compared to the third quarter of 2005, dueto the lower production levels of new life insurance an annuity business, asnoted above.

***Nine months ended September 30, 2006 and 2005***

Segment income from our Life Insurance and Annuitysegment decreased by $0.9 million, compared to the first nine months of 2005,primarily as a result of an increase in benefits incurred and an increase inthe amortization of deferred acquisition costs.

*Revenues.*   Net premiumsfor the segment increased by $1.6 million, or 4%, compared to the first ninemonths of 2005, as a result of the growth in renewal premiums for our seniorlife product of approximately $2.6 million, offset by declines in ourtraditional life insurance and interest sensitive products of approximately$1.0 million.

Our agents sold $20.9 million of fixed annuitiesduring the first nine months of 2006 and $35.0 million during the first ninemonths of 2005. Annuity deposits are not considered premiums for reporting inaccordance with generally accepted accounting principles. The reduction inannuity sales was the result of lower interest crediting rates offered and ourreduced emphasis on this business as we continue our focus more on providinghealth insurance alternatives to the growing senior market.

Net investment income increased by approximately $2.7million, or 10%, compared to the first nine 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 $1.9 million, or 7%, compared to the first ninemonths of 2005. The increase in business added approximately $1.0 million topolicyholder benefits and claim costs were higher by approximately $0.9 millionas a result of increased mortality in the first nine months of 2006, ascompared to the first nine months of 2005. The increase in deferred acquisitioncosts was $9.4 million less during the first nine months of 2006, as comparedto the increase during the first nine months of 2005. This was primarily due tolower production of new life insurance and annuity business during the firstnine months of 2006, resulting in a lower level of acquisition costs to capitalize,as well as increased levels of amortization (primarily in the first quarter of2006) as compared to the first nine months of 2005 as a result of higherlapsation and aging of the block of business. Commissions and general expenses,net of allowances decreased by $5.4 million, or 18%, compared to the first ninemonths of 2005, due to the lower production levels of new life insurance anannuity business, as noted above.

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**Segment Results—Senior Administrative Services**

| ** **                                       | ** ** | **Three months endedSeptember 30,** | ** ** | **Nine months ended  September 30,** | ** ** |
|--------------------------------------------------|------------|----------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                       | ** ** | **2006**                                           | ** ** | **2005**                                            | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                       | ** ** | **(In thousands)**                            | ** ** |
| Affiliated Service Fee  Revenue                  |       |                                               |       |                                                |       |   |   |   |   |
| Medicare Supplement                              |       | $                                                  | 6,897      |                                                | $          | 7,484 |   | $ | 21,524 |   | $ | 23,035 |   |
| Part D                                      |       | 5,398                                              |       | —                                              |       | 15,297 |   | — |   |
| Long term care                                   |       | 698                                                |       | 687                                                 |       | 2,218 |   | 1,957 |   |
| Life insurance                                   |       | 599                                                |       | 760                                                 |       | 1,664 |   | 2,489 |   |
| Other                                            |       | 707                                                |       | 825                                                 |       | 2,133 |   | 2,316 |   |
| Total Affiliated Revenue                         |       | 14,299                                             |       | 9,756                                               |       | 42,836 |   | 29,797 |   |
| Unaffiliated Service Fee  Revenue                |       |                                               |       |                                                |       |   |   |   |   |
| Medicare Supplement                              |       | 1,614                                              |       | 1,938                                               |       | 5,205 |   | 6,096 |   |
| Long term care                                   |       | 2,133                                              |       | 2,082                                               |       | 6,123 |   | 6,182 |   |
| Non-insurance products                           |       | 306                                                |       | 363                                                 |       | 950 |   | 1,121 |   |
| Part D                                      |       | 405                                                |       | —                                              |       | 1,135 |   | — |   |
| Other                                            |       | 2,316                                              |       | 434                                                 |       | 6,786 |   | 988 |   |
| Total Unaffiliated Revenue                       |       | 6,774                                              |       | 4,817                                               |       | 20,199 |   | 14,387 |   |
| Total revenue                                    |       | 21,073                                             |       | 14,573                                              |       | 63,035 |   | 44,184 |   |
| Amortization of present  value of future profits |       | 124                                                |       | 119                                                 |       | 370 |   | 358 |   |
| General expenses                                 |       | 16,319                                             |       | 11,608                                              |       | 50,833 |   | 34,324 |   |
| Total expenses                                   |       | 16,443                                             |       | 11,727                                              |       | 51,203 |   | 34,682 |   |
| Segment income                                   |       | $                                                  | 4,630      |                                                | $          | 2,846 |   | 11,832 |   | $ | 9,502 |   |
|                                                  |            |                                                    |            |                                                     |            |  |  |  |  |  |  |  |  |

 

Included in unaffiliatedrevenue are fees received to administer certain business of our insurancesubsidiaries that is 100% reinsured to an unaffiliated reinsurer, whichamounted to $0.8 million for the three months ended September 30, 2006,and $1.0 million for the three months ended September 30, 2005 and$2.5 million for the nine months ended September 30, 2006, and$3.1 million for the nine months ended September 30, 2005. Thesefees, together with the affiliated revenue, were eliminated in consolidation.

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

Segment income for our Senior Administrative Servicessegment increased by $1.8 million, or 63%, to $4.6 million for the thirdquarter of 2006, as compared to the same period of 2005. This increase isprimarily the result of new business administered.

Service fee revenueincreased by $6.5 million, or 45%, during the third quarter of 2006 compared tothe third quarter of 2005. Affiliated service fee revenue increased by $4.5million primarily as a result of fees for the administration of our PDPs onbehalf of our insurance subsidiaries which commenced on January 1, 2006,offset, in part, by a decline in revenues for administration of affiliatedMedicare Supplement and life insurance business. Unaffiliated service feerevenue increased by $2.0 million, due primarily to an increase in additionaladministrative services performed for unaffiliated clients. General expensesfor the segment increased by $4.7 million, or 41%, due primarily to theadministration of the affiliated Part D business, beginning in 2006.

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***Nine months ended September 30, 2006 and 2005***

Segment income for our Senior Administrative Servicessegment increased by $2.3 million, or 25%, to $11.8 million for the first ninemonths of 2006, as compared to the same period of 2005. This increase is primarilythe result of new business administered.

Service fee revenueincreased by $18.9 million, or 43%, during the first nine months of 2006compared to the first nine months of 2005. Affiliated service fee revenueincreased by $13.0 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 $5.8million, due primarily to an increase in additional administrative servicesperformed for unaffiliated clients. General expenses for the segment increasedby $16.5 million, or 48%, primarily to the administration of the affiliated Part Dbusiness, beginning in 2006.

**Segment Results—Corporate**

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

| ** **                                         | ** ** | **Three months endedSeptember 30,** | ** ** | **Nine months ended  September 30,** | ** ** |
|----------------------------------------------------|------------|----------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                         | ** ** | **   2006   **       | ** ** | **   2005   **        | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                         | ** ** | **(In thousands)**                            | ** ** |
| Interest                                           |       |                                               | $          | 3,320                                               |       |   |   | $ | 2,826 |   |   | $ | 9,548 |   | $ | 8,007 |   |
| Amortization of  capitalized loan origination fees |       |                                               | 230        |                                                |       |   | 230 |   |   | 688 |   | 674 |   |
| Stock-based  compensation expense                  |       |                                               | 491        |                                                |       |   | — |   |   | 1,986 |   | 2 |   |
| Other parent  company expenses, net                |       |                                               | 1,950      |                                                |       |   | 893 |   |   | 5,639 |   | 2,915 |   |
| Segment loss                                       |       |                                               | $          | 5,991                                               |       |   |   | $ | 3,949 |   |   | $ | 17,861 |   | $ | 11,598 |   |

 

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

The loss from ourCorporate segment increased by $2.0 million, or 52%, for the three months endedSeptember 30, 2006 compared to the three months ended September 30,2005. The increase was due primarily to the increase in stock-basedcompensation expense as a result of the adoption of FAS 123-R, costs ofdue diligence and higher interest cost. During the three months ended September 30,2006, we recognized $0.5 million of stock-based compensation expense relatingto options vesting during the period. We also incurred $0.4 million of costsassociated with our board of directors’ review of the proposed buyout offer. Ourcombined outstanding debt was $166.9 million at September 30, 2006compared to $172.1 million at September 30, 2005. The weighted averageinterest rate on our loan payable increased to 7.7% for the three months endedSeptember30, 2006 from 5.8% for the three months ended September 30, 2005.The weighted average interest rate on our other long term debt increased to8.0% for the three months ended September 30, 2006 from 7.4% for the threemonths ended September 30, 2005. See “Liquidity and Capital Resources” foradditional information regarding our loan payable and other long term debt.

***Nine months ended September 30, 2006 and 2005***

The loss from ourCorporate segment increased by $6.3 million, or 54%, for the nine months ended September 30,2006 compared to the nine months ended September 30, 2005. The increasewas due primarily to the increase in stock-based compensation expense as aresult of the adoption of FAS 123-R, costs of due diligence and higherinterest cost. During the nine months ended September 30, 2006, werecognized $2.0 million of stock-based compensation expense relating to optionsvesting during the period. We also incurred $0.7 million of costs associatedwith due diligence for a potential acquisition that we 

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determinedwe will not pursue at this time and we incurred $0.4 million of costsassociated with our board of directors’ review of the proposed buyout offer. Theweighted average interest rate on our loan payable increased to 7.2% for thenine months ended September 30, 2006 from 5.3% for the nine months ended September 30,2005. The weighted average interest rate on our other long term debt increasedto 7.8% for the nine months ended September 30, 2006 from 7.3% for thenine months ended September 30, 2005. See “Liquidity and Capital Resources”for additional information regarding our loan payable and other long term 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 andmanagement service organizations (acquired in the acquisition of Heritage) andthe surplus note interest and principal payments from American Exchange (asexplained below) can support our parent company obligations for the foreseeablefuture. However, there can be no assurance as to our actual future cash flowsor to the continued availability of dividends from our insurance companysubsidiaries.

*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 September 30,2006. Under the Amended Credit Agreement, the spread over LIBOR was reduced to225 basis points from 275 basis points. Effective October 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 feesof approximately $2.1 million, which were capitalized and are being amortizedon a straight-line basis over the life of the Amended Credit Agreement alongwith the continued amortization of the origination fees incurred in connectionwith the Credit Agreement. The Company pays an annual commitment fee of 50basis points on the unutilized revolving 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 

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company and partnershipinterests, all of their respective rights, title and interest under any serviceor management contract entered into between or among any of their respectivesubsidiaries and all proceeds of any and all of the foregoing.

The Amended Credit Facility requires the Company andits subsidiaries to meet certain financial tests, including a minimum fixedcharge coverage ratio, a minimum risk based capital test and a minimumconsolidated net worth test. The Amended Credit Facility also containscovenants, which among other things, limit the incurrence of additional indebtedness,dividends, capital expenditures, transactions with affiliates, asset sales,acquisitions, mergers, prepayments of other indebtedness, liens andencumbrances and other matters customarily restricted in such agreements. TheAmended Credit Facility contains customary events of default, including, amongother things, payment defaults, breach of representations and warranties,covenant defaults, cross-acceleration, cross-defaults to certain otherindebtedness, certain events of bankruptcy and insolvency and judgmentdefaults. During the fourth quarter of 2005, the Company was in default with acovenant regarding limitations on treasury stock repurchases. The Companyrequested and received, from the administrative agent for the bank group, awaiver of the event of default and an amendment to the Amended Credit Facilityto increase the limitation for treasury stock purchases to $30.0 million in theaggregate after January 1, 2006.

We made regularly scheduled principal payments of $3.9million during the nine months ended September 30, 2006 and $3.9 millionduring the nine months ended September 30, 2005, in connection with ourcredit facilities. We paid interest of $5.2 million during the nine monthsended September 30, 2006 and $4.0 million during the nine months ended September 30,2005, in connection 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) |   | $      | 1,312  |   |
|-------------------------------|--------|--------|--------|--------|
| 2007                          |   | 5,250  |   |
| 2008                          |   | 5,250  |   |
| 2009                          |   | 80,063 |   |
|                          |   | $      | 91,875 |   |

 

*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  September 30, 2006** | ** ** |
|------------------------|------------|-------------------------|------------|------------------------|------------|-------------------------|----------------|-----------------------------|------------|--------------------------------------------------------|------------|
| ** **             | ** ** | **(In thousands)** | ** ** | ** **             | ** ** | **(Basis points)** | ** **     | ** **                  | ** ** |
| December 2032     |       |                    | $          | 15,000                 |       |                    | Fixed/Floating |                        |       | 400                                                    | (1)        |   |   | 6.7 | % |   |
| March 2033        |       |                    | 10,000     |                   |       | Floating                |           |                        | 400        |                                                   |       |   | 9.5 | % |   |
| May 2033          |       |                    | 15,000     |                   |       | Floating                |           |                        | 420        |                                                   |       |   | 9.6 | % |   |
| 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 whereby it will pay a fixed rate of 6.7%in exchange for a floating rate of LIBOR plus 400 basis points. The swapcontract expires in December 2007.

(2)          The rate on this issueis fixed at 7.4% for the first five years. On May 15, 2008 it will beconverted to a floating rate equal to LIBOR plus 410 basis points.

(3)          Effective April 29,2004, we entered into a swap agreement whereby it will pay a fixed rate of6.98% in exchange for a floating rate of LIBOR plus 395 basis points. The swapcontract 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.

Our Company has the right at any time, and from timeto time, to defer payments of interest on the Junior Subordinated Debt for aperiod not exceeding 20 consecutive quarters up to each debenture’s maturitydate. During any such period, interest will continue to accrue and our parentholding company may not declare or pay any cash dividends or distributions on,or purchase, our common stock nor make any principal, interest or premiumpayments on or repurchase any debt securities that rank equally with or juniorto the Junior Subordinated Debt. Our parent holding company has the right atany time to dissolve the Trusts and cause the Junior Subordinated Debt to bedistributed to the holders of the Capital Securities. We have guaranteed, on asubordinated basis, all of the Trusts’ obligations under the Capital Securitiesincluding payment of the redemption price and any accumulated and unpaiddistributions to the extent of available funds and upon dissolution, winding upor liquidation but only to the extent the Trusts have funds available to makesuch payments. The Capital Securities have not been and will not be 

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registered under theSecurities Act of 1933, as amended (the “Securities Act”), and will only beoffered and sold under an applicable exemption from registration requirementsunder the Securities Act.

We paid $4.3 million ininterest in connection with the Junior Subordinated Debt during the nine monthsended September 30, 2006, and $4.0 million during the nine months ended September 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) |   | $      | 1,048  |   |
|-------------------------------|--------|--------|--------|--------|
| 2007                          |   | 4,151  |   |
| 2008                          |   | 4,011  |   |
| 2009                          |   | 3,619  |   |
| 2010 and thereafter           |   | 10,220 |   |
| Totals                        |   | $      | 23,049 |   |

 

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, our largestshareholder. The shelf registration statement 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. A more detailed descriptionof the use of proceeds will be included in any specific offering of securitiesin 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.

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*Sources ofLiquidity to Universal American*

We anticipatefunding the obligations of Universal American and the capital required to growour business from the four distinct and uncorrelated sources of cash flowwithin the organization as follows:

·       the expected cash flows ofCHCS, our senior administrative services company;

·       the expected cash flows ofour senior managed care company (acquired in the acquisition of Heritage);

·       dividend payments andproceeds from sale of Penncorp Life (Canada); and

·       surplus note principal andinterest 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.

*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.

*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 September 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 ninemonths ended September 30, 2006, and $8.4 million during the nine monthsended September 30, 2005. American Exchange paid interest on the surplusnote of $2.1 million during the nine months ended September 30, 2006and $1.9 million during the nine months ended September 30, 2005.

Universal American made capital contributions toAmerican Exchange amounting to $3.5 million during the first nine months of2006. 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 Lifedeclared and paid a dividend in the amount of $10.8 million to PennsylvaniaLife. American Exchange made capital contributions of $2.5 million toConstitution during the first nine 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 

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requirementsand approval processes vary significantly from state to state. PennsylvaniaLife is able to pay ordinary dividends of up to $9.8 million to AmericanExchange 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,which mitigates the risk of unexpected increases in claim payments due toepidemics and events of a catastrophic nature. These accident and healthpolices are not interest-sensitive and therefore are not subject to unexpectedpolicyholder redemptions due to investment yield changes.

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 September 30, 2006 we held reserves that exceeded theunderlying cash surrender values of our net retained in force life insuranceand annuities by $33.3 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 process adequatelycovers the expected payment of benefits related to these liabilities.

As of September 30, 2006, our U.S. insurancecompany subsidiaries and health plans held cash and cash equivalents totaling$154.7 million, as well as fixed maturity securities that could readily beconverted to cash with carrying values (and fair values) of $1.1 billion. Inaddition, our U.S. insurance company subsidiaries have approximately $162.4million of cash for the operations of our PDPs.

The net yields on our cash and invested assetsincreased to 5.0% for the nine months ended September 30, 2006, from 4.8%for the nine months ended September 30, 2005. A portion of thesesecurities are held to support the liabilities for policyholder accountbalances, which liabilities are subject to periodic adjustments to theircredited interest rates. The credited interest rates of the interest-sensitivepolicyholder account balances are determined by us based upon factors such asportfolio rates of return 

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and prevailing marketrates and typically follow the pattern of yields on the assets supportingthese 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’ statutory capitaland surplus exceeds its respective minimum statutory requirement at levels webelieve are sufficient to support their current levels of operation. Additionally,the NAIC imposes RBC requirements on life insurance enterprises. At September 30,2006, all of our U.S. insurance subsidiaries maintained ratios of totaladjusted capital to RBC in excess of the “authorized control level”. Thecombined statutory capital and surplus, including asset valuation reserve, ofour U.S. insurance subsidiaries totaled $175.6 million at September 30,2006, and $158.4 million at December 31, 2005. For the nine months ended September 30,2006, our U.S. insurance subsidiaries generated statutory net income of $18.9 million.Our U.S. insurance companies generated statutory net income of $4.5 million forthe nine months ended September 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 September 30, 2006, the statutorycapital and surplus of each of our health plan affiliates exceeds its minimumrequirement and its RBC is in excess of the “authorized control level”. Thestatutory capital and surplus for our health plans was $38.0 million at September 30,2006, and $26.0 million at December 31, 2005. Statutory net income for ourhealth plans was $12.0 million for the nine months ended September 30, 2006and $7.4 million for the nine months ended September 30, 2005.

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$65.6 million (US$58.7 million) as of September 30,2006, and C$62.3 million (US$53.6 million) as of December 31, 2005.Net income based on Canadian generally accepted accounting principles wasC$8.2 million (US$7.2 million) for the nine months ended September 30,2006 and C$8.7 million (US$7.1 million) for the nine months ended September 30,2005. Penncorp Life (Canada) maintained a Minimum Continuing Capital andSurplus Requirement Ratio (“MCCSR”) in excess of the minimum requirement at September 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, andcertain floating rate portfolios, which are managed by Hyperion Capital. MFCGlobal Investment Management manages our Canadian portfolio. We investprimarily in fixed maturity securities of the U.S. Government and its agenciesand in corporate fixed maturity securities with investment grade ratings of “BBB-”(Standard & Poor’s Corporation), “Baa3” (Moody’s Investor Service) orhigher.

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As of September 30,2006, approximately 99% of our fixed maturity investments had investment graderatings from Standard & Poor’s Corporation or Moody’s Investor Service.There were no non-income producing fixed maturities as of September 30,2006. During the nine months ended September 30, 2006 and 2005, we did notwrite down the value of any fixed maturity securities. These write-downs wouldrepresent our estimate of other than temporary declines in value and would beincluded in net realized gains on investments in our consolidated statements ofoperations.

*Effects of RecentlyIssued and Pending Accounting Pronouncements*

There was no materialimpact on our consolidated financial condition or results of operations as aresult of our adoption of the recently issued accounting pronouncements. We donot anticipate 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 forshare-based payments to employees based on the grant-date fair value of theaward for financial statements. Refer to Consolidated Financial Statements Note2—Recent and Pending Accounting Pronouncements and Note 8—Stock-basedCompensation.

**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.

*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.

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The sensitivity analysis of interest rate risk assumesan instantaneous shift in a parallel fashion across the yield curve, withscenarios of interest rates increasing and decreasing 100 and 200 basis pointsfrom their levels as of September 30, 2006, and with all other variablesheld constant. For our investments held to support our continuing operations, a100 basis point increase in market interest rates would result in a pre-taxdecrease in the market value of our fixed income investments of $37.8 millionand a 200 basis point increase in market interest rates would result in $76.5million decrease. Similarly, a 100 basis point decrease in market interestrates would result in a pre-tax increase in the market value of our fixedincome investments of $37.8 million and a 200 basis point decrease in marketinterest rates would result in a $72.6 million increase.

For our investments heldby our discontinued operations, a 100 basis point increase in market interestrates would result in a pre-tax decrease in the market value of our fixedincome investments of $29.0 million and a 200 basis point increase inmarket interest rates would result in $53.8 million decrease. Similarly, a 100basis point decrease in market interest rates would result in a pre-tax increasein the market value of our fixed income investments of $34.2 million and a 200basis point decrease in market interest rates would result in a $74.9 millionincrease.

*Debt*

We pay interest on our term loan and a portion of ourtrust preferred securities based on LIBOR for one, two or three months. Due tothe variable interest rate, the Company would be subject to higher interestcosts if short-term interest rates rise. We have attempted to mitigate ourexposure to adverse interest rate movements by fixing the rate on $15.0 millionof the trust preferred securities for a five year period through thecontractual terms of the security at inception and an additional $35.0 millionthrough 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.

Thesensitivity analysis of interest rate risk assumes scenarios increases ordecreases in LIBOR of 100 and 200 basis points from their levels as of and forthe nine months ended September 30, 2006, and with all other variablesheld constant. The following table summarizes the impact of changes in LIBOR.

| ** **                                                | ** ** | ** **             | ** ** | **Weighted**                              | ** ** | **Effect of Change in LIBOR on Pre-tax Income  for the nine months ended September 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                                              |       |                   | 7.2        | %                                         |       |                                                                                                                                                                | $          | 94.5 |   |   |   | $ | 1.4 |   |   |   | $ | 0.7 |   |   |   | $ | (0.7 | ) |   |   | $ | (1.4 | ) |   |
| Other long term  debt                                     |       |                   | 9.2        | %                                         |       |                                                                                                                                                                | $          | 25.0 |   |   |   | 0.4 |   |   |   | 0.2 |   |   |   | (0.2 | ) |   |   | (0.4 | ) |   |
| Total                                                     |       |                   |       |                                      |       |                                                                                                                                                                |       |   |   |   | $ | 1.8 |   |   |   | $ | 0.9 |   |   |   | $ | (0.9 | ) |   |   | $ | (1.8 | ) |   |
|                                                           |            |                        |            |                                           |            |                                                                                                                                                                     |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

As noted above, we havefixed the interest rate on $50 million of our $167 million of total debtoutstanding, leaving $117 million of the debt exposed to rising interest rates.As of September 30, 2006 we had approximately $179 million of cash andcash equivalents and $151 million in short duration floating rate investmentsecurities. We anticipate that the net investment income on this $330 millionwill be positively impacted by rising interest rates and will mitigate thenegative impact of rising interest rates on our debt.

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*Currency ExchangeRate Sensitivity*

Our discontinued operations are transacted using theCanadian dollar as the functional currency. As of and for the nine months endedSeptember 30, 2006, approximately 12% of our assets, 6% of our revenues,excluding realized gains, and 15% of our income before realized gains and taxeswere derived from our discontinued Canadian operations. As of and for the ninemonths ended September 30, 2005, approximately 12% of our assets, 8% ofour revenues, excluding realized gains, and 15% of our income before realizedgains and taxes were derived from our discontinued Canadian operations.Accordingly, our earnings and shareholder’s equity are affected by fluctuationsin the value of the U.S. dollar as compared to the Canadian dollar. Althoughthis risk is somewhat mitigated by the fact that both the assets andliabilities for our foreign operations are denominated in Canadian dollars, weare 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 ninemonths ended September 30, 2006, would have resulted in a decrease in ourincome from discontinued operations before realized gains and taxes ofapproximately $1.2 million for the nine months ended September 30, 2006and a decrease in our shareholders’ equity of approximately $6.6 million at September 30,2006. A 10% weakening of the U.S. dollar relative to the Canadian dollar wouldhave resulted in an increase in our income from discontinued operations beforerealized gains and taxes of approximately $1.4 million for the nine monthsended September 30, 2006 and an increase in shareholders’ equity ofapproximately $8.0 million at September 30, 2006. Our sensitivityanalysis of the effects of changes in foreign currency exchange rates does notfactor in any potential change in sales levels, local prices or any othervariables.

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.

**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 

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befaulty and that breakdowns can occur because of simple error or mistake.Controls can also be circumvented by the individual acts of some persons or bycollusion of two or more people. The design of any system of controls is basedin part on certain assumptions about the likelihood of future events, and therecan be no assurance that any design will succeed in achieving its stated goalsunder all potential future conditions. Projections of any evaluation ofcontrols effectiveness to future periods are subject to risks. Over time,controls may become inadequate because of changes in conditions ordeterioration in the degree 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, includingour Chief Executive Officer and Chief Financial Officer, of the effectivenessof the design and operation of our disclosure controls and procedures as of September 30,2006. Based on this evaluation, our Chief Executive Officer and Chief FinancialOfficer concluded that our disclosure controls and procedures were effective asof September 30, 2006, at a reasonable assurance level, to timely alertmanagement to material information required to be included in our periodicfilings with the Securities and Exchange Commission.

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

There were no significant changes in our internalcontrol over financial reporting that occurred during the quarter ended September 30,2006 that have materially affected, or are reasonably likely to materiallyaffect, our internal control over financial reporting.

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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,two of which have been consolidated.

In the first action, Robert Kemp filed a purportedclass action complaint (the “Kemp Action”) on November 22, 2005, in the UnitedStates District Court for the Southern District of New York. The Kemp Action isa purported class action asserted on behalf of those shareholders of theCompany who acquired the Company’s common stock between February 16, 2005and 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 1934on grounds 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. On August 14, 2006, defendants served amotion to dismiss the Amended Complaint in the Kemp Action. The lead plaintiffserved opposition papers to the motion on October 17, 2006. Defendants arescheduled to serve a reply in further support of their motion to dismiss thecomplaint later in November, and the motion will be argued before the Court on December 13,2006.

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 theOfficer Defendants.

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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. On September 8,2006, defendants served a motion to dismiss the GM Amended Complaint. On October 26,2006 (prior to the response date for plaintiff), the Court entered an orderstaying the case for 90 days.

The second derivativeaction was filed by plaintiff Arthur Tsutsui (the “Tsutsui Action”) on December 30,2005, in The Supreme Court for New York State, Westchester County. Thedefendants in the Tsutsui Action are the three Officer Defendants named in theother actions, as well as all of the directors sitting on the Company’s Boardof Directors as of the time the complaint was filed. The Tsutsui Action allegesthat the same alleged misstatements that are the subject of the Kemp Actionconstituted a breach of fiduciary duty by the Officer Defendants and thedirectors that caused the Company to sustain damages. The Tsutsui Action alsoseeks recovery of any proceeds derived by the Officer Defendants from the saleof Company stock that was in breach of their fiduciary duties. Defendants inthe Tsutsui Action filed a motion to dismiss the complaint on June 9, 2006.On August 17, 2006, the Court issued an order staying the case until suchtime (i) as the Kemp Action is fully and finally resolved or settled, or (ii) theGreen Meadows Action is fully and finally resolved, or shareholders in thatcase receive notice of a proposed settlement. Each of the Officer Defendantsdenies the allegations and has indicated that he intends to vigorously defendagainst the allegations. Management believes that after liability insurancerecoveries, none of these actions will have a material adverse effect on theCompany.

***Class Action Litigation Relating to AcquisitionProposal***

Four actions have recently been commenced in New Yorkstate courts against the Company and other defendants concerning theacquisition proposal received by the Company on October 24, 2006, frommembers of management led by Richard A. Barasch, the Company’s Chairman andChief Executive Officer, and private equity firms Capital Z Partners, Ltd., LeeEquity Partners, LLC, Perry Capital, LLC and Welsh, Carson, Anderson &Stowe X, L.P. to acquire all of the Company’s publicly held common stock for $18.15per share in cash (the “Offer”). Two of these actions are pending in theSupreme Court for New York County, and are known as Stellato v. UniversalAmerican Financial Corp., et al. (06-116006) (“Stellato”) and Green MeadowsPartners LLP v. Barasch, et al. (603724-06) (“Green Meadows II”)

The Stellato action names as defendants the Company, Mr. Baraschand the other sponsors of the offer, including Capital Z, as well as eightother members of the Company’s board of directors. Stellato alleges that the offerwas made at an “unfair price, under unfair terms and through improper means.”The action seeks an injunction preventing the offer from beingconsummated, or in the alternative, monetary damages.

The Green Meadows II action names the Company, Mr. Baraschand directors Bradley Cooper, Eric Leathers and Robert Spass as defendants.The complaint alleges that these defendants dominate the board of directors ofthe Company, and have breached their fiduciary duties by, among other things,making a buyout proposal that “fails to take into account the value of UHCO,its improving financial results and its value in comparison to other similarcompanies.” The action seeks, among other things, an injunction preventingdefendants from carrying out an unfair transaction, and monetary damages.

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A third and a fourth action pertaining to the Offerare pending in the Supreme Court for Westchester County and are known asConolly v. Universal American Financial Corp, et al (“Conolly”) and McCormackv. Averill et al.(06-21365) (“McCormack”). The Conolly action names asdefendants Mr. Barasch and other sponsors of the Offer, including CapitalZ, as well as the Company and all of its directors. The complaint alleges thatthe shareholder agreement to which Mr. Barasch and Capital Z are parties “deter[s]potential bids for the Company at a premium to the presently offered price,”and that the sponsors of the offer (excluding Mr. Barasch) are members ofa “club” of elite private equity funds under investigation for violations ofthe anti-trust laws that have resulted in “driv[ing] down the prices ofpotential acquisition targets.” The Conolly action further asserts that thedirector defendants have breached their fiduciary duties to maximizeshareholder value by, among other things, failing immediately to reject theOffer. The complaint seeks an injunction prohibiting consummation of the Offer,or in the alternative, monetary damages.

The complaint in McCormack names as defendants theCompany and all of its directors, and alleges, among other things, that theOffer is unfair and grossly inadequate. The complaint also asserts that thebuyout offer is “the product of unfair dealing” by the management of theCompany and its largest shareholder, Capital Z. The action seeks an injunctionordering the directors to fulfill their fiduciary duties, and/or enjoining anytransaction based upon the Offer, as well as monetary damages.

All four actionspertaining to the Offer are currently being reviewed by counsel for defendants.Therefore, management cannot yet ascertain the impact that these complaints mayhave, if any, on the Company’s financial statements. The defendants are notrequired to respond to any of the actions until later in November 2006.

***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 theseactions will have a material adverse effect on us.

**ITEM 1A—RISKFACTORS**

In addition to the other information set forth in thisreport, you should consider carefully the risks and uncertainties describedunder the caption “Part I- Item 1A. Risk Factors” in our Annual Report on Form 10-Kfor the fiscal year ended December 31, 2005, the occurrence of any ofwhich could materially adversely affect our business, prospects, financialcondition or results of operations. We also could be materially adverselyaffected by additional risks and uncertainties of which we are not currentlyaware, or which we currently consider to be immaterial.

The following risk factorsupdate and supplement the risks and uncertainties described in our AnnualReport on Form 10-K for the fiscal year ended December 31, 2005.

***Our reliance uponthird party data in connection with our Part D and Private Fee-For-ServicePlans may continue to disrupt or adversely affect our operations.***

We are reliant upon datafrom our joint venture partner PharmaCare, our third party administrator TMG Health(“TMG”) and CMS for information relating to Part D and Medicare Advantagemembership and claims administration. Incorrect information from these entitiescould generate inaccurate or incomplete membership and payment reportsconcerning our Medicare eligibility and enrollment. These developments havecaused, and could continue to cause, us to utilize additional information,communications and administrative resources and to incur additional expense. Whilewe believe that we have adequate monitoring and review controls in place includingreview of SAS 70 reports for those providers that have them, we have notbeen able to independently test and verify these third party systems 

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and data.Although we believe the current conditions are temporary and improving, therecan be no assurance that future third party data will not disrupt or adverselyaffect our plans’ relationships with our members or our results of operations. Additionally,beginning in 2006, we will no longer utilize TMG to manage our PFFS claims, butwill bring this function in house to our Heritage offices. This, too, could putnew administrative burdens on us.

***Our inability to collect receivables owed to us byother Part D prescription drug plans may disrupt or adversely affect ourprescription drug plans.***

Upon the direction of CMS,we have paid approximately $64.1 million of prescription drug benefits forMedicare beneficiaries who were, in fact, members of another PDP plan, otherthan our Prescription Pathway plans. We have recorded a receivable of $64.1 millionfor these payments. We believe that we may have a liability of approximately$3.8 million to other PDPs for our Prescription Pathway members whose drugcosts have been borne by other plans. Although CMS has initiated a process forreconciling these errors in membership and drug costs, there can be noassurance that we will receive reimbursement of these costs from CMS or anotherPDP plan sponsor. Therefore, we have booked a $5.6 million reserveallowance for uncollectible amounts relating to this receivable. Although weintend to actively pursue amounts due us in the CMS reconciliation process, wecannot assure you that we will receive reimbursements from any other plan.

***Reductions infunding for Medicare programs could materially reduce our profitability.***

Approximately 51% of ourtotal revenue for the nine months ended September 30, 2006 are premiumsgenerated by the operation of our Medicare Advantage and Part Dprescription drug plans. As a result, our revenue and profitability aredependent on government funding levels for these programs. The premium ratespaid to Medicare Advantage health plans like ours are established by contract,although the rates differ depending on a combination of factors, includingupper payment limits established by CMS, a member’s health profile and status,age, gender, county or region, benefit mix, member eligibility categories, andthe plan’s risk scores. Future Medicare premium rate levels may be affected bycontinuing government efforts to contain medical expense, includingprescription drug costs, and other federal budgetary constraints. Changes inthe Medicare program, including with respect to funding, may affect our abilityto operate under the Medicare program and/or lead to reductions in the amountof reimbursement, elimination of coverage for certain benefits, or reductionsin the number of persons enrolled in or eligible for Medicare. 

***We contract with the Centers for Medicare &Medicaid Services to provide Medicare Part D Prescription Drug benefits.***

EffectiveJanuary 1, 2006, we began offering Medicare approved prescription drugplans to Medicare eligible individuals. While we believe we have adequatelyreviewed our assumptions regarding the Medicare Part D program, our actualresults may differ from our assumptions. Risks associated with the Medicareprescription drug plans include:

·       anincrease in the cost of pharmaceuticals;

·       inabilityto receive and process information;

·       higherthan expected utilization;

·       potentialuncollectability of receivables;

·       newmandated benefits or other regulatory changes that increase our costs;

·       otherregulatory changes such as restructuring of the Medicare Part D programthereby affecting our ability to operate under the program or increase ourcosts or reduce our reimbursement; and

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·       otherunforeseen occurrences.

***Our strategic alliance with our pharmacybenefits manager, PharmaCare Management Services, Inc., could beterminated after 2007.***

On March 21, 2005, we entered into a strategicalliance in the ordinary course of business with PharmaCare Management Services, Inc.,a pharmacy benefits manager that is a wholly-owned subsidiary of CVSCorporation, pursuant to which PharmaCare performs pharmacy benefits managementservices for our Medicare Part D Plans. Under the strategic alliance, we shareequally with PharmaCare in the results of the Part D business, includingthrough (i) a 50% quota share reinsurance agreement with PharmaCare’swholly-owned subsidiary, PharmaCare Captive Re, Ltd., and (ii) Part DManagement Services, L.L.C., or PDMS, the joint venture owned equally byUniversal American and PharmaCare, which principally performs Part Dmarketing and risk management services for which it receives fees and otherremuneration from our Part D plans and PharmaCare Re.

The strategic alliance continues in effect through December 2007,and, thereafter, automatically renews annually for successive Part Dcoverage years beginning in January 2008, unless either we or PharmaCaredeliver to the other party a notice of offer to purchase all of such otherparty’s equity interest in one or more of the CMS-approved regions in which wesell our Part D plans. The receiving party of the offer notice may electto (a) sell its equity interest to the initiating party for the pricestated in the offer notice or (b) buy the equity interest of theinitiating party for the price stated in the offer notice. To be effective, theoffer notice must be delivered at least 11 months prior to the beginning of thePart D coverage year to which the offering applies.

The strategic alliancewith PharmaCare will continue to be effective through 2007, and although wepresently expect the strategic alliance to continue after 2007, we cannot makeassurances of that expectation given the option of either party to deliver tothe other party an offer notice, which, only if timely delivered by PharmaCareand accepted by us, could interrupt our Part D operations for a period oftime. If an offer notice is timely delivered by us and accepted by PharmaCare,or if an offer notice is timely delivered by PharmaCare and we exercise ourright to buy PharmaCare’s equity interest, we expect our Part D operationsto continue uninterrupted, other than the replacement of PharmaCare withanother pharmacy benefits manager, which we believe can be effected seamlessly,although possibly on varying terms from the PharmaCare arrangement

**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** | ** ** |
|------------------------------------------------------|------------|------------|------------|-----------------------------------------------------|------------|----------------------------------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------------------------------------------------------------|------------|
| July 1,  2006—July 31, 2006           |       |       | —     |                                                |       |                                         | —     |                                                                                                                                   |       |                                                                                                                                | —     |   |   |   | 997,729 |   |   |
| August 1,  2006—August 31, 2006       |       |       | 12,465     |                                                |       |                                         | $          | 12.07                                                                                                                                  |       |                                                                                                                                |       | 12,465 |   |   |   | 985,269 |   |   |
| September 1,  2006—September 30, 2006 |       |       | 925        |                                                |       |                                         | $          | 16.47                                                                                                                                  |       |                                                                                                                                |       | 925 |   |   |   | 984,339 |   |   |
| Total                                                |       |       | 13,390     |                                                |       |                                         |       |                                                                                                                                   |       |                                                                                                                                | 13,390     |   |   |   |   |   |   |

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(1)          Allshares were purchased in private transactions.

**Recent Sales ofUnregistered Securities**

None.

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**ITEM 3—DEFAULTSUPON SENIOR SECURITIES**

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

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

None.

**ITEM 5—OTHERINFORMATION**

None.

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**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 Consolidated Statements of Operations 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 orfurnished 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.** |
|-----------------------|----------------------------------------|
| November 9, 2006 | /s/ RICHARD A. BARASCH                 |   |
|                  | Richard A. Barasch                     |   |
|                  | *Chief Executive Officer*              |   |
| November 9, 2006 | /s/ ROBERT A. WAEGELEIN                |   |
|                  | Robert A. Waegelein                    |   |
|                  | *Executive Vice President and*         |   |
|                  | *Chief Financial Officer*              |   |
|                  | *(Principal Accounting Officer)*       |   |

 

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