<PAGE>   1


                                  UNITED STATES
                       SECURITIES AND EXCHANGE COMMISSION
                             WASHINGTON, D.C. 20549

                                   FORM 10-KSB

                ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF
                       THE SECURITIES EXCHANGE ACT OF 1934
                   FOR THE FISCAL YEAR ENDED DECEMBER 31, 1998

Commission File Number 1-11922

                              MEDICALCONTROL, INC.
                  --------------------------------------------  
                 (Name of small business issuer in its charter)

            Delaware                                        75-2297429 
 --------------------------------                      -------------------
 (State or other jurisdiction of                        (I.R.S.  Employer 
  incorporation or organization)                      Identification Number)

     8625 King George Drive, Suite 300
              Dallas, Texas                                   75235 
   --------------------------------------                   ----------  
  (Address of principal executive offices)                  (Zip Code)

Issuer's telephone number:          (214) 630-6368

Securities registered under Section 12(b) of the Exchange Act:    None.

Securities registered under Section 12(g) of the Exchange Act:

                          Common Stock, $.01 Par Value
                          ----------------------------    
                                (Title of Class)

                         Common Stock Purchase Warrants
                         ------------------------------ 
                                (Title of Class)

Check whether the issuer (1) filed all reports required to be filed by Section
13 or 15 (d) of the Exchange Act during the past 12 months (or for such shorter
period that the registrant was required to file such reports), and (2) has been
subject to such filing requirements for the past 90 days. YES [X]   NO [ ]

Check if there is no disclosure of delinquent filers in response to Item 405 of
Regulation S-B contained in this form, and no disclosure will be contained, to
the best of registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-KSB or any
amendment to this Form 10-KSB. [ ]

State issuer's revenues for its most recent fiscal year: $14,571,673.

State the aggregate market value of the voting stock held by non-affiliates of
the Registrant: As of March 26, 1999: $11,634,240*

State the number of shares outstanding of each of the issuer's classes of common
equity, as of the latest practicable date: 4,163,487 shares of Common Stock,
$.01 par value as of March 26, 1999.






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                      DOCUMENTS INCORPORATED BY REFERENCE

           Portions of the Proxy Statement for 1999 Annual Meeting of
            Shareholders of MedicalControl, Inc. are incorporated by
                  reference into Part III of this Form 10-KSB.

Transitional Small Business Disclosure Format:       Yes [ ]       No [X]  
                                                                         

*The aggregate market value was determined by multiplying the number of
outstanding shares (excluding those shares held of record by officers, directors
and greater than five percent shareholders) by $9.13, the last sales price of
the Registrant's common stock as of March 26, 1999, such date being within 60
days prior to the date of filing.





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CAUTIONARY STATEMENT FOR PURPOSES OF THE "SAFE HARBOR" PROVISIONS OF THE PRIVATE
SECURITIES LITIGATION REFORM ACT OF 1995

         The Company desires to take advantage of the "safe harbor" provisions
contained in Section 27A of the Private Securities Litigation Reform Act and is
including this statement in its Annual Report on Form 10-KSB in order to do so.
From time to time the Company's management may wish to make forward-looking
statements based upon management expectations, to inform more fully existing and
potential shareholders regarding various matters, including without limitation,
projections regarding future income, completion of networks, future growth, as
well as predictions as to the timing and success of specific projects. Such
forward looking statements are generally accompanied by words such as
"believes," "anticipates," "estimate," "predict" or "expect" and similar
expressions that convey the uncertainty of future events or outcomes.

         The factors identified in this Form 10-KSB under "Risk Factors" are
believed to be important factors (but not necessarily all of the important
factors) that could cause actual results to differ materially from those
expressed in any forward-looking statement made by or on behalf of the Company.
Such statements are subject to certain risks and uncertainties, over which the
Company has no control, which could cause actual results to differ materially
from those projected. Such forward looking information could be affected by
changes in laws and regulations, interest rates, liquidity issues, the rate of
sales growth, price and product competition, new product introduction and social
and economic conditions, such as increased competition in the managed care or
healthcare industry and the amount, type and cost of financing available to the
Company. Unpredictable or unknown factors not discussed herein could also have
material adverse effects on forward-looking projections. Readers are cautioned
not to place undue reliance on these forward-looking statements that speak only
as of the date hereof. The Company undertakes no obligation to republish revised
forward-looking statements to reflect events or circumstances after the date
thereof or to reflect the occurrence of unanticipated events. Readers are also
urged to carefully review and consider the various disclosures made by the
Company, in this report, as well as the Company's periodic reports on Forms
10-QSB and 8-KSB filed with the Securities and Exchange Commission.



                                     PART I

ITEM 1.  DESCRIPTION OF BUSINESS.

GENERAL

         MedicalControl, Inc. (the "Company") is a holding company comprised of
related operating companies serving the managed care industry and providing
health benefit plan administration services. The Company's four major
subsidiaries are MedicalControl Network Solutions, Inc. ("MedicalControl"),
providing managed care services primarily through its preferred provider
networks, ValueCheck, Inc. ("ValueCheck"), providing utilization review and case
management, Diversified Group Administrators, Inc. ("Diversified"), providing
third party administration ("TPA") services, and ppoONE.com, inc. (formerly PPO
Management Solutions, Inc.) ("ppoONE.com"), providing network management and
repricing software and services for provider network organizations ("PPO"). Each
subsidiary is accounted for as a separate segment of the Company. For financial
information on each segment see Note 3 to the Consolidated Financial Statements.

DESCRIPTION OF OPERATING COMPANIES

         MedicalControl, acting as a preferred provider organization ("PPO"),
contracts with hospitals, physicians and ancillary providers providing access to
comprehensive healthcare services on behalf of its clients and their employees
or members at negotiated, discounted rates. MedicalControl reprices resulting
network provider claims to reflect negotiated terms as well as providing
healthcare data analyses, reporting and related healthcare cost containment
programs.

         ValueCheck, a utilization review and case management company, began
doing business January 1, 1999. Utilization review and case management
represents a complementary product for both MedicalControl's PPO and
Diversified's TPA businesses and has potential value for many of the same target
clients and market segments. Diversified and MedicalControl began marketing
ValueCheck services in the Fall of 1998 to their clients.

         Diversified provides a comprehensive range of administration services
to self-funded benefit plans, insurance companies, provider-based organizations
and other benefit management organizations. Diversified provides complete
benefit plan review, design and administrative services in the administration of
comprehensive employee benefit programs and risk management activities.
Diversified currently administers over 300 self-funded benefit plans, two
fully-insured plans and over 50 risk management plans with clients ranging from
50 to 4,000 employees. Current total covered lives exceed 100,000 members
located in 49 states. In 1998, Diversified entered the Taft-Hartley and student
accident markets.

         ppoONE.com, using its proprietary application software, provides
software leasing, Internet-based data center and claims processing services for
PPOs and other network organizations that enable such entities and their clients
to reprice provider claims to reflect negotiated rates and to produce data
analyses, and other cost containment information. ppoONE.com began service to
its first client in the fall of 1997. During the first quarter of 1998,
ppoONE.com began formally marketing its software, Internet-based data center and
administrative services. ppoONE.com recently licensed its software to a large
insurance conglomerate.

         The Company was incorporated in October 1989 as a Delaware corporation.
Unless the context otherwise requires, the term the "Company" refers to
MedicalControl, Inc. and its direct and indirect wholly-owned subsidiaries.
Effective January 1, 1998, the Company established MedicalControl and




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ppoONE.com as subsidiaries and transferred its managed care operations to
MedicalControl and its repricing and administrative services operations to
ppoONE.com. All references to the operations of MedicalControl or ppoONE.com
prior to January 1, 1998, are to operations of the Company. The Company's
executive offices are located at 8625 King George Drive, Suite 300, Dallas,
Texas 75235 and its telephone number is (214) 630-6368.

INDUSTRY OVERVIEW

         The managed care industry has experienced tremendous growth and change
over the past fifteen years. Primary among the available managed care solutions
offering access to healthcare services at reduced rates are Health Maintenance
Organizations ("HMOs") and PPOs. Among other factors, HMOs are distinguished
from PPOs in that HMOs are responsible for the delivery of medical services to
their members and assume the financial risk for the costs associated with that
healthcare. PPOs, including MedicalControl, instead offer employers and
healthcare purchasers access to a network of contracted facilities and providers
who have agreed to provide services for discounted rates from their standard
fees. In such PPO arrangements, the self-insured employer or benefit plan
typically remains responsible for the cost of care. Currently, approximately 85%
of all Americans with private insurance are enrolled in an HMO, PPO or other
form of managed care. A growing number of health insurance carriers, HMOs, TPAs
and provider groups have also established their own PPO networks.

         Employers and other healthcare purchasers have encouraged the
development or expansion of alternative forms of healthcare delivery and
financing. Currently, over 78% of employers have opted for some type of
self-insurance. Under a self-funded benefit program, an employer retains the
obligation of funding claims, frequently acquiring reinsurance to provide
protection against claims exceeding specific or aggregate amounts. By adopting
self-funding programs and using the plan administration services of TPAs and
other managed care services, employers may experience lower costs and obtain
other advantages over traditional insurance.

         A trend in the managed care industry is the development or expansion of
provider-owned networks. In some areas, these provider-owned or operated
organizations require a plan or PPO to access their network exclusively in a
service area. Such situations limit the ability of the PPO to provide the
broadest network offering or limits access altogether.

MANAGED CARE BUSINESS

         MedicalControl provides access to preferred provider networks for its
clients and their enrolled plan members. It also provides clients with
healthcare data analyses, reporting and related healthcare cost containment
programs. MedicalControl principally markets its managed healthcare services to
self-insured employers, insurance companies, third party administrators and
managed care organizations with large concentrations of employees or
participants within the southwestern United States. MedicalControl has
established and continues to enhance networks of healthcare providers providing
medical services to clients' plan members at negotiated, discounted rates. After
the provider renders service, MedicalControl, its client or its client's third
party administrator reviews and reprices the provider's bill to apply the PPO's
negotiated rates prior to adjudication and payment. MedicalControl also offers a
variety of management reports to clients designed to measure and evaluate the
cost-effectiveness and quality of the employers' healthcare benefit programs.
These reports provide summary and detailed information on network utilization,
services provided, claims processing activity, accounting data and cost savings.

         In September 1998, MedicalControl purchased Business Health Companies,
Inc. ("BHC"), a leading Houston, Texas-based managed care organization that
enhanced significantly MedicalControl's Texas network offering. BHC owns the
Houston Healthcare Purchasing Organization ("HHPO")




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preferred provider organization. The HHPO network currently includes 68
hospitals, over 6,000 contracted physicians in addition to ancillary providers.
In addition to managing its provider network, the HHPO issues an annual Quality
Data Study of Houston hospitals which evaluates the quality performance of 46
Houston area hospitals in 4 categories: mortality rates, medical complications,
length of stay and average charge per patient. Since the acquisition, BHC
operates as a subsidiary of MedicalControl providing its greater Houston PPO
network and as the Houston component of MedicalControl's Texas network.

         As of December 31, 1998, MedicalControl had over 75 clients comprising
more than 270,000 employees or plan members and representing over 621,000
covered lives. Through the Company's directly-contracted and affiliate provider
networks, the Company's clients have access to more than 2,400 hospitals and
185,000 physicians and other healthcare providers nationwide. Significant
concentrations of covered employees or plan members reside in Dallas, Fort
Worth, San Antonio and Houston, Texas in addition to the States of Louisiana,
New Mexico, California, Florida, Illinois, Ohio, Oklahoma and Pennsylvania.

         Products and Services. MedicalControl provides a variety of managed
care products including quality, cost effective PPO networks, provider claims
repricing, and healthcare data analyses and reports. MedicalControl is also
exploring ways to expand service offerings by selling third party services
complementing the PPO such as prescription drug card, dental PPO or vision
program.

         MedicalControl offers the following types of PPO networks:

         MedicalControl Hospital Network -- a network of more than 2,400 acute
care hospitals and 5,000 ancillary facilities available through both direct
agreements and affiliate network agreements in 43 states.

         MedicalControl Physician Network -- a network of more than 185,000
physicians, chiropractors, physical therapists and other healthcare
professionals through both direct agreements and affiliate network agreements.

         MedicalControl Behavioral Network -- a network of mental health,
alcohol and substance abuse treatment facilities.

         Contracted network providers have agreed to accept, as payment in full,
negotiated fee schedules in place of the current charges providers bill to
non-network patients for the same procedures and services. As a result of the
Company's negotiated fee schedules available through its Texas hospital network,
the Company's clients achieve average savings of over 30% between billed charges
and MedicalControl's negotiated, discounted rates. In addition to hospitals and
facilities, MedicalControl also contracts with physicians. MedicalControl
evaluates and verifies the credentials of physicians in MedicalControl's
directly contracted Texas and New Mexico networks in accordance with established
standards and its credentialing process is accredited by the American
Accreditation HealthCare Commission/URAC.

         MedicalControl reprices network provider claims based on negotiated fee
schedules and provides clients the option to reprice their own claims. In
providing in-house claims repricing services for the year-ended December 31,
1998, the Company processed over 450,000 claims in an average of 1.8 calendar
days with an accuracy rate of over 97% for all errors and 99% for those errors
affecting repriced amounts. MedicalControl uses ppoONE.com's proprietary
software system, IMPULSE(TM), to reprice network provider claims. This system
allows claims payors to reprice claims and perform customer service functions
remotely via direct-dial modem or Internet access to the system, provides faster




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response times and requires fewer keystrokes, therefore reducing errors while
increasing efficiency. ppoONE.com's system also has the ability to track claims
status for improved customer service.

         MedicalControl provides extensive client specific healthcare reports to
its clients. ppoONE.com's system automatically produces a variety of
comprehensive utilization and savings reports on a scheduled basis.
MedicalControl can also create efficient ad hoc and custom reports with advanced
report writing tools. Clients have access to a catalog of over 200 standard
reports identifying information related to services and network utilization,
savings analyses, provider networks and claims production activity.
MedicalControl can produce these reports and other needed data in hard copy or
electronically, providing it to clients via diskette, direct modem access or the
Internet.

         MedicalControl works with clients to design cost-effective benefit
programs or other healthcare management programs and to adopt appropriate cost
containment controls. Through benefit plan design, MedicalControl assists
clients in maximizing in-network utilization through the client's implementation
of co-pay differentials, waiver or reduction of deductible amounts for
in-network hospitalization or similar incentive programs for in-network use.
Greater utilization of in-network providers decreases the average cost per claim
and the costs to the client's employee benefit plan.

         Although MedicalControl is expanding its product portfolio to include
other services for the benefit of its clients, MedicalControl expects its core
business and primary revenue source to continue to be its PPO networks.

         Provider Arrangements and Services. MedicalControl provides clients
with savings on hospital, physician and related healthcare expenditures through
geographically tailored networks of quality, cost-effective providers.
MedicalControl's strategy is to create a network of healthcare providers that
meet the healthcare needs of their covered employees or plan members and the
financial needs of clients. MedicalControl uses the group purchasing leverage of
multiple clients to negotiate competitive discounts with such providers.
Healthcare providers join MedicalControl's PPO network to maintain or increase
patient volumes as members are directed to them through the client's health
benefit plans, identification cards, utilization review oversight and other
channeling mechanisms.

         The network development process begins with evaluation of
MedicalControl's current client needs, projected future needs and the supply of
and demand for healthcare providers in a given geographic area in
MedicalControl's southwestern United States target market. Other demographic and
environmental information gathered in the development process, such as the
economic condition of the area and major businesses in the community, assists in
identifying essential factors that can impact network development and the
negotiating process.

         In addition, MedicalControl contracts with other PPO networks to
provide PPO network access, as needed, in many regions outside of Texas and New
Mexico. MedicalControl also maintains affiliate relationships in the
southwestern United States to supplement its own network. MedicalControl has
such affiliate network relationships in the States of Alabama, Arizona,
Arkansas, California, Colorado, Florida, Georgia, Illinois, Indiana, Louisiana,
Nevada, Michigan, Mississippi, New Jersey, North Carolina, Ohio, Oklahoma,
Oregon, Pennsylvania, South Carolina, Tennessee, Virginia, Washington and
Wisconsin.



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         As of December 31, 1998, the approximate number of MedicalControl's
contracted providers were:

<TABLE>
<CAPTION>
                                                                         Primary Car   Specialists    Total
                                              Hospitals    Ancillaries  Physicians(1)  Physicians   Physicians
                                              ---------    -----------  -------------  ----------   ---------- 
<S>                                           <C>          <C>          <C>            <C>          <C>    
Directly Contracted                              650         1,800         9,300        13,700        23,000
Contracted through Affiliates                  1,750         3,200        64,700        97,300       162,000
Total                                          2,400         5,000        74,000       111,000       185,000
</TABLE>

---------------
(1) Primary care physicians include general practitioners, family practitioners,
pediatricians and internal medicine physicians.

         In the event that current contracts with providers are not continued,
MedicalControl believes that in most areas there are other physician groups,
hospitals and other providers sufficient to serve its clients' employees and
members adequately. MedicalControl believes that its relationships with its
providers are generally good; however, there is increasing competition for
physicians and other healthcare providers from other PPOs, HMOs, provider-owned
networks and other healthcare plans. There can be no assurance that
MedicalControl will in all cases be successful in maintaining existing
relationships or attracting necessary healthcare providers with adequate
discounts.

         In order to promote effective, long-term and positive business
relationships with network providers, the Company also considers its providers
to be clients of MedicalControl and has established a provider services program.
A dedicated staff performs a variety of activities including responding to
hospital and physician claims inquiries and conducting site visits.

         MedicalControl was the first PPO in the nation to have its physician
credentialing process accredited by the American Accreditation HealthCare
Commission/URAC as applied to its Texas and New Mexico directly-contracted
networks. Management believes that MedicalControl's credential standards are
more stringent than many other PPOs. In the credentialing process,
MedicalControl, using primary source verification, confirms that a physician
meets the established MedicalControl standards. In instances when contracting
with larger physician or provider groups, having confirmed that a provider group
credentials to MedicalControl's standards, MedicalControl may choose to delegate
the credentialing function to that provider group.

         Marketing. MedicalControl principally markets its managed healthcare
services to self-insured employers, insurance companies, third party
administrators and managed care organizations with large concentrations of
employees or participants within the southwestern United States. MedicalControl
markets its products and services through an employed sales staff, independent
sales agents and third parties such as TPAs and insurance companies.
MedicalControl plans to place greater emphasis on marketing to TPAs, insurance
companies and other third parties that, in turn, market MedicalControl's PPO to
their clients. MedicalControl has developed marketing programs designed to
emphasize the unique aspects of its network products, other managed care
services and its reputation for quality service. MedicalControl provides
marketing services through its corporate office in Dallas, Texas and in its
Houston, Texas office.

         As is customary in the PPO industry, clients generally offer
MedicalControl's PPO to their employees or members as an alternative to either
traditional indemnity insurance coverage or an HMO. MedicalControl believes that
the most significant factors in the selection of MedicalControl's PPO by
employers and employees include the location and size of the provider network,
provider choice, depth of negotiated discounts, quality of services,
administrative support services, access fees, market presence and reputation.
MedicalControl believes its clients' employees and members select
MedicalControl's




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PPO rather than an HMO due to the significantly greater freedom of choice of
providers offered by MedicalControl in addition to other factors.

         MedicalControl believes the costs incurred by its clients for
healthcare services rendered, along with the fees paid to MedicalControl, result
in significant net savings to the client, and are competitive with like
PPOs/managed care companies. In addition, MedicalControl believes that its
proprietary PPO networks tend to be more extensive than its competitors in
certain geographic regions, providing greater access for a client's employees or
members.

         MedicalControl charges its clients for access to its PPO network or
networks on either a percentage of savings or a per employee per month ("PEPM")
basis. For the fiscal years ending December 31, 1998, 1997 and 1996,
MedicalControl derived 67%, 72% and 72%, respectively, of its PPO revenue from
access fees based on the percentage of savings method. For percentage of savings
clients, the actual savings upon which MedicalControl's fees are based is the
difference between what the client or payor would have paid without
MedicalControl's intervention and the final bill (reflecting the discounted
adjustment) actually paid. The percentage and aggregate revenue recognized by
MedicalControl varies depending on the number of enrollees, their levels of
utilization of PPO provider services and the networks selected by the client.
The PEPM fee basis provides MedicalControl with an expected level of payment
that is not contingent or dependent upon utilization levels or savings. The
number of clients that use the PEPM basis has increased during the past three
years. MedicalControl believes that its pricing is competitive with the market.

UTILIZATION REVIEW AND CASE MANAGEMENT

         ValueCheck began providing utilization review and case management as of
January 1, 1999. The Company launched ValueCheck because of what management
believes is an unmet market need for effective, basic and cost-effective
utilization review and case management services. In addition, utilization review
and case management is a complementary product for PPO services. MedicalControl
and ValueCheck products can be sold to the same customer and ValueCheck adds
value to the PPO offering. ValueCheck products are also sold to Diversified's
customers. ValueCheck's management team brings over 50 years of sales, product,
operations and Medical Director experience in the utilization review and case
management industry to this business.

         ValueCheck's basic utilization review program combines review of
medical necessity and the appropriateness of inpatient setting. High-risk
medical cases are identified for special tracking because such cases have the
greatest potential for financial impact. According to data derived from more
than 500,000 hospital admissions, more than 50% of all inpatient admissions
generally follow a consistent treatment course, therefore, outcomes are not
significantly influenced by aggressive utilization review. ValueCheck monitors
these medically uncomplicated cases from pre-certification through discharge to
ensure they do not become complicated or deviate from their expected treatment
course. However, in cases where treatments and outcomes are not consistent,
ValueCheck employs intensive management techniques to optimize patient outcomes
and maximize cost savings. ValueCheck incorporates three components to its
utilization review process: review of procedure and medical necessity,
length-of-stay determination and negotiation of the treatment plan and
alternative care.

         Throughout the utilization review process, ValueCheck nurses review the
medical necessity of an inpatient stay using nationally accepted medical
guidelines. In instances where the treating physician requests days that are
unsupported by these guidelines, a ValueCheck physician advisor will review and
discuss the case with the treating physician.



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         This process continues until the patient is discharged or until medical
guidelines are no longer met by the patient's condition or treatment plan.
ValueCheck's review specialists maintain on-going contact with the attending
physician to ensure the patient stay in an acute care setting lasts only as long
as medically necessary.

         ValueCheck uses a range of medical guidelines to support the
utilization review process. They are designed to promote discussion and
negotiation with the patient's attending physician, ensure consistent case
reviews, enhance review nurses' cross-discipline clinical knowledge and
establish proactive information exchange and negotiation capabilities. These
guidelines are screening tools used by ValueCheck's review specialists that
allow consistent evaluation of the appropriate level of care and treatment
planning. The use of such guidelines does not, however, replace the expertise
and important contribution of ValueCheck's nurses or physicians. ValueCheck uses
the following guidelines for evaluation and decision making during the review
process:

MILLIMAN AND ROBERTSON OPTIMAL RECOVERY GUIDELINES (ORGS): ORGs provide
day-by-day treatment plans for patients under age 65 with no significant
co-morbidities or complications. They are based on the CPT (procedure) and ICD-9
(diagnosis) codes relevant to the patient's condition and planned treatment.
ORGs provide the equivalent of medical guidelines, length-of-stay guidelines,
and outpatient procedure/treatment alternatives for uncomplicated medical,
surgical, and pediatric admissions. They also include guidelines for extending
an admission.

HCIA LENGTH-OF-STAY (LOS) TABLES: HCIA LOS standards are based on all-payor data
gathered from nearly 11 million actual inpatient records, representing 1 of
every 3 discharges from hospitals in the United States annually. These standards
provide norms for both simple and more complex patients. Each patient is unique,
and HCIA's LOS tables are sensitive to those differences.

         ValueCheck's case management program targets cases requiring more
attention which can result in better medical outcomes for patients and greater
cost savings for plan sponsors. ValueCheck's early identification of and
intervention in case management candidates gives ValueCheck the greatest
opportunity to impact outcomes. ValueCheck's criteria and systems are
specifically designed not only to identify catastrophic and chronic illness or
injury cases, but also to prompt our reviewer to ask questions about seemingly
routine, uncomplicated cases that may reveal additional factors indicating
increased risk. Once cases are identified, ValueCheck matches the level and
method of case management services to the intensity of the case to improve
outcomes in the most cost-efficient manner possible.

         Case managers identify, coordinate, and negotiate alternative treatment
plans and related costs. Nurses help expedite discharge from costly inpatient
settings to a patient's home or outpatient care facility, placing the patient in
the most appropriate setting possible. Nurses interface with the patient,
family, treating providers, and facilities in addition to a variety of ancillary
vendors such as home health aid and local support groups to coordinate
patient-focused, caring treatment plans that incorporate effective use of
benefit dollars.

         Our case managers will direct patients to network providers whenever
possible. If the patient does not participate in a PPO plan or there is not a
network provider available, the case manager will negotiate a discounted fee
with the service provider with the goal of securing high-quality, lower-cost
outpatient and home health care services.

THIRD PARTY ADMINISTRATION BUSINESS

         Diversified provides a comprehensive range of administration services
to self-funded benefit plans, insurance companies, provider-based organizations
and other benefit management organizations.




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<PAGE>   10

Diversified provides complete benefit plan review, design and administration
services to administer comprehensive employee benefit programs and risk
management activities. Diversified currently administers over 300 self-funded
benefit plans, two fully insured plans and over 50 risk management plans with
clients ranging from 50 to 4,000 employees. Current total covered lives exceed
100,000 members located in 49 states. Student Accident policies cover an
additional 200,000 participants.

         Products and Services. Diversified's services include placement of
insurance products, design of benefit programs, composition of plan documents
and summary plan descriptions, employee enrollment and orientation services,
claim processing and payment reporting, total plan or policy reporting,
collection and disbursement of premiums, fees and commissions. Diversified also
manages and interacts with auxiliary service providers such as utilization
review firms, prescription drug firms, employee assistance programs, subrogation
recovery firms, PPOs and other related entities on behalf of its clients. Other
services provided include COBRA continuation, portability certification,
Internal Revenue Service and Department of Labor reporting, Section 125/129
programs and medical savings account plans.

         Diversified also maintains and manages the relationships and interfaces
with insurance carriers who provide risk taking products for Diversified's
clients. Diversified files claims with carriers on behalf of clients in many
lines of coverage including specific and aggregate stop loss, life and
accidental death, disability income and insured medical, dental and vision
products.

         In 1996, Diversified entered into a joint venture arrangement with The
Initial Group, a Knoxville, Tennessee provider-owned PPO. St. Mary's Health
System and Baptist Health System of Knoxville, both of whom are clients of
Diversified, own The Initial Group. The Initial Group contracts with hospitals
and doctors in an eight-county area of Northeastern Tennessee. Diversified and
the Initial Group formed the joint venture, known as East Tennessee
Administrative Services ("ETAS"), to develop and market in Knoxville, Tennessee
and surrounding areas both self-funded programs and a fully-insured managed care
program underwritten by an insurance company. Diversified and The Initial Group
each own 50% of the joint venture and share equally in revenues and expenses.
ETAS introduced a fully-insured product, the Initial Advantage, in July 1997.
This product is designed for small and medium sized employer groups in eastern
Tennessee. Diversified recently received notice from the insurance company
underwriting these products that it is terminating Diversified in September
1999. Revenue from this product in 1998 was approximately $114,000. Management
believes that other related customers of Diversified may also terminate their
agreement with Diversified.

         In November 1998, Diversified acquired certain assets located in
Harrisburg, Pennsylvania, and opened a TPA office in Harrisburg. Harrisburg is
important to attracting potential new TPA clients on the East Coast. This new
office also administers Taft-Hartley plans and a fully-insured student accident
plan, which are new markets for Diversified.

         Marketing. Diversified markets its products and services directly
through in-house personnel and through a national network of licensed/approved
brokers. Over 95% of new revenues are generated through relationships with
existing brokers and clients.

         Diversified believes that clients select Diversified's TPA services for
a variety of reasons including flexibility, data processing and claims
administration system capabilities, personalized client services, competitive
pricing, reputation, market presence and longevity in the industry.
Diversified's TPA operations have been in existence for 17 years - significantly
longer than most TPAs.

         Diversified believes that future opportunities will be concentrated in
marketing risk assumption products of insurance companies and other
risk-assumers such as fully-insured managed care programs and provider-based
risk assumption organizations. Diversified is constantly reviewing auxiliary
suppliers




                                       8
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for quality products to supplement offerings to clients. As a TPA, Diversified
currently offers auxiliary service providers to its clients in the form of 18
insurance carriers, seven utilization review firms, 36 managed care or PPO
networks, two Employee Assistance Programs, nine prescription drug plans and
various other services.

         TPA revenues are derived from administrative fees, auxiliary service
provider fees, consulting fees, commission income from insurance contracts,
override and bonus arrangements with insurance carriers, override arrangements
with auxiliary service providers and fee-for-service arrangements with brokerage
firms. Administrative fees are based upon capitation, percentage or periodic
basis. Insurance policy administration and commissions are based upon a
percentage of total premiums. Overrides and bonuses are based upon
profitability, volume and persistency. Other fees are on a negotiated basis.

         Diversified maintains full client service offices in Canonsburg and
Harrisburg, Pennsylvania, Dallas, Texas and Knoxville, Tennessee. In addition to
sales and marketing, client service personnel interact with clients on an
ongoing basis related to problem resolution, plan modifications and
communications with other Company personnel.

         Management Information Systems and Software Systems. Effective
September 30, 1996, Diversified entered into an agreement with Resource
Information Management Systems ("RIMS") for the use of their most current
version of software through access to the RIMS Data Center located in
Naperville, Illinois. RIMS offers application software serving TPAs and claims
administrators performing benefit plan administration, claims adjudication and
related functions. Conversion from its former systems to the RIMS Data Center is
substantially completed. Using frame relay telephone lines, each TPA location
accesses the RIMS Data Center. Diversified's agreement with RIMS provides
continuous access to the most current software versions as may be available and
requires that RIMS ensure satisfactory response time and system support,
including a disaster recovery program. In addition, Diversified, as a
third-party administrator, benefits from improved functionality and productivity
through the enhanced software programs. The full array of standard as well as ad
hoc reporting capabilities is available to Diversified's clients and it is
easier to exchange data with clients and vendors. RIMS' software includes
features allowing electronic claim submission, automatic batch adjudication, PPO
repricing and point-of-service plan administration and adjudication, among
others, that are considered essential in today's managed care marketplace.
Diversified believes that its systems are equal or superior to those offered by
like size TPAs operating on a national basis.

PPO MANAGEMENT SOFTWARE, INTERNET DATA CENTER AND CLAIMS ADMINISTRATION BUSINESS

         ppoONE.com is dedicated to providing other PPOs and provider network
organizations with PPO administration software, data center services and
complete administration and claims outsourcing. ppoONE.com offers three types of
products: (i) lease of its proprietary PPO management software referred to as
IMPULSETM (Information Management Processing & UtiLization SystEm) (ii) lease of
proprietary PPO management software and Internet-based data center and (iii)
outsourcing of PPO claims administrative services including claims repricing,
customer service and PPO data management. Target markets for ppoONE.com products
are PPOs, medical provider groups, insurance carriers, third party
administrators and other managed care companies offering provider networks.
During the fall of 1997, ppoONE.com began servicing its first client, Business
Health Companies, Inc., which the Company subsequently purchased in September
1998. In April 1998, Florida Health L.C., a state-wide Florida PPO, began
outsourcing its repricing needs to ppoONE.com. Those services have since been
expanded to cover complete information system outsourcing. In March 1999,
ppoONE.com signed a license agreement to license its software to a large
insurance conglomerate.





                                       9
<PAGE>   12

         At its core, ppoONE.com's PPO management and repricing software is a
comprehensive PPO claims processing and customer service system based on
client/server technology. The system employs an OracleTM relational database
engine and state-of-the-art Microsoft Visual BasicTM user interface. IMPULSE's
advanced technology allows clients to reprice claims and perform customer
service functions remotely via direct dial modem or Internet access to the
system. IMPULSE provides faster response times and requires fewer keystrokes
than most systems therefore reducing errors while increasing efficiency. The
system also has the ability to track claims status for improved customer
service.

         ppoONE.com is continuing the development and improvement of its data
processing systems, proprietary software and administrative services serving
MedicalControl and its clients as well as software which is marketed to
prospective clients. Through continuing development of its advanced, proprietary
client/server software and relational database, ppoONE.com plans to strengthen
and expand its current client base as well as broaden its revenue sources
through entry into new markets. Although there can be no assurance that such
products or services will be successfully developed, management believes that
these new administrative services and products provide superior administrative
services relating to healthcare management network and cost management.

         Among many other state-of-the-art features, IMPULSETM allows the
electronic transmission and receipt of provider claims. ppoONE.com can receive
electronic claims from facilities and physicians which reduce the costs
associated with manual input of claims data. Once ppoONE.com receives the claims
data electronically, certain claims can be automatically repriced without human
intervention, again reducing manual input costs.

         ppoONE.com has no patents and relies on a combination of trademarks,
trade secrets and copyright protection to establish and protect its proprietary
technology. ppoONE.com routinely enters into confidentiality agreements with its
employees and clients, however, there can be no assurance that the legal
protections and precautions taken will be adequate to prevent misappropriation
of ppoONE.com's technology. In addition, these protections and precautions do
not prevent independent third party development of competitive technology.

         During 1998 and 1997, the Company incurred approximately $243,000 and
$286,000 of software development costs, respectively, all of which were expensed
as incurred.

OTHER SERVICES

         The Company also provided large healthcare claims negotiation services
for clients who incur out-of-network hospital claims through a subsidiary called
Genesis/ValueCheck, Inc. ("G/VC"). Discounts achieved by G/VC vary depending on
the size of the claim, the nature of the services, the specific facility and
other factors. The Company achieved the savings or complete removal of certain
charges based upon nurse reviews for medical necessity and appropriateness,
comparison and negotiation based on the Company's database of usual and
customary charges and other factors. G/VC may also negotiate a prompt pay
discount with the provider. Company-developed software provides G/VC with data
regarding reasonable and customary rates for use in negotiating discounts on
bills from out-of-network providers. The Company intends to outsource this
business beginning in the spring of 1999. This outsourced product will be sold
to clients of MedicalControl and Diversified.

CUSTOMERS

         For the fiscal years ended December 31, 1998, 1997 and 1996, two
customers, American Airlines, Inc., and the National Rural Electric Cooperative
Association, in the aggregate, accounted for approximately 13%, 18%, and 17%,
respectively, of the consolidated net revenues of the Company. 




                                       10
<PAGE>   13

Individually, each of the foregoing major customers of the Company accounted for
the following respective approximate percentages of the consolidated net
revenues of the Company for the fiscal years ended December 31, 1998, 1997 and
1996: American Airlines, Inc., 4%, 9% and 9%, and the National Rural Electric
Cooperative Association, 9%, 9% and 8%. Based on current services provided to
American Airlines, the Company expects the revenues of American Airlines to
decrease further during 1999.

         The loss of any principal customers could have a material adverse
effect on the Company and its business. No customer accounted for as much as 10%
of the Company's consolidated net revenues for the fiscal years ended December
31, 1998 and 1997.

         Clients representing approximately $700,000 of 1998 revenues have
terminated or amended their contracts with the Company during 1998 and the first
two months of 1999. Certain PPO clients also changed from a percentage of
savings fee arrangement to a PEPM fee arrangement, representing a loss of
approximately $658,000 of 1998 revenues. In addition, Diversified's revenues
relating to its fully-insured product may cease. Revenues from that product in
1998 were $114,000. Management believes that the Company will be able to replace
this revenue loss in 1999 by increased penetration of other current clients, new
PPO and TPA business development, marketing of its PPO management and repricing
services business and new utilization review and case management business as
well as through potential acquisitions.

COMPETITION

         The Company competes with national and local organizations that have
developed PPOs, TPAs, Utilization Review and Case Management companies as well
as with HMOs and insurance carriers. The industry is highly competitive and
significant consolidation has occurred within the industry, creating stronger
competitors. The Company's managed care division also faces competition from
hospitals, healthcare facilities and other healthcare providers who have
combined and formed their own networks to contract directly with employer groups
and other prospective customers for the delivery of healthcare services. Large
employer groups have demanded a variety of healthcare options, such as
traditional indemnity insurance, HMOs, point-of-service plans and PPOs, offered
either through self-funding or third parties. The Company competes with
providers of all of these products, many of which have substantially greater
financial resources than the Company. The Company believes that a limited number
of companies provide all of the services offered by the Company within the
geographic areas in which the Company presently operates. The Company's managed
care subsidiary may encounter competition from companies with broader networks,
narrower networks (which allow for greater cost control and lower prices),
greater market share or more established marketplace name or reputation. These
competitive factors could adversely affect the Company's financial results. The
current competitive markets may also limit the Company's ability to price its
products at levels the Company believes are appropriate.

         There are nearly 100 million lives enrolled in indemnity and PPO plans
in the United States today, and 95% of those covered lives are required to
comply with utilization review procedures as defined in their benefit plan. This
mature market is dominated by a handful of national firms that together control
about 40% of the market. The remaining market is fragmented among a variety of
smaller competitors. Most of the larger national firms have built products for
the high-end Fortune 500 company market, and product design tends to feature a
great deal of customization, product enhancements, ad hoc reporting
capabilities, and corresponding premium pricing at or above $1.50 PEPM. Smaller
vendors fall into several categories including software vendors, disease and
demand management specialty boutiques who have entered the utilization review
business, and turn-key consultants. Few vendors, large or small, offer both
Utilization Management and PPO provider discounts, the two managed care tools
necessary to effectively manage both the utilization of health care and the unit
cost of services rendered. ValueCheck,




                                       11
<PAGE>   14

when integrated with the MedicalControl PPO network offering, addresses both
critical components of the cost of health care. The integration of both services
in one location, with one toll-free number for members and providers, offers
seamless delivery, a key advantage in a market that seeks administrative ease of
doing business and one-stop shopping. ValueCheck was not designed to be
all-things-to-all-buyers. Rather, ValueCheck's target markets are TPAs,
Taft-Hartley plans, associations, and select self-insured employers who value
customer service, and early identification of high dollar claims - all at a
price that is generally 40% or more below market pricing.

         The Company's TPA subsidiary may encounter competition from larger TPAs
with greater resources and regional TPAs with greater market penetration. The
Company will be subject to significant competition in any new geographic areas
it may enter.

         PPOs and other network managers obtain network management and claims
repricing software or services through a variety of means including
internally-developed, proprietary systems, use of claims adjudication systems
through specific modules designed for such purpose, as well as through a few
vendors selling PPO claims outsourcing services or software. Management believes
there is no competitive software developed exclusively for PPOs with all of the
advanced features, functionality or productivity tools of the IMPULSETM system.
Continuous investments and improvements will be required to retain this
competitive advantage. There can be no assurance that such competitive advantage
will be maintained.

GOVERNMENT REGULATION AND LEGISLATION

         Since 1993, many competing proposals introduced in Congress and various
state legislatures have called for general healthcare market reforms aimed at
increasing access and availability of group health insurance and to require that
all businesses offer health insurance coverage to their employees. It is
uncertain what additional healthcare reform legislation will ultimately be
implemented or whether other changes in the administration or interpretation of
governmental healthcare programs will occur. At both the federal and state
level, there is also growing interest in legislation to regulate how managed
care companies interact with providers and health plan members. Such proposed
legislation is primarily aimed at the practices of HMOs but could effect the
operations expense structure of PPOs as well. The Company cannot predict what
effect federal or state healthcare legislation or private sector initiatives
will have on its PPO or TPA operations. There can be no assurance that future
health care reforms or PPO regulations will not be adopted which would have a
material adverse effect on the Company.

         The Employee Retirement Income Security Act of 1974 ("ERISA"),
governing employee benefit plans, among other mandates, permitted employers to
self-insure their health insurance by acting as a quasi-insurer. Employers
viewed the ability to underwrite their own health claims as a result of ERISA as
an opportunity to better control health costs. Regulation of such self-insured
benefit plans falls under the auspices of the United States Department of Labor,
which has strict, enforceable guidelines relative to the operation of TPAs in
the administration of such plans. In addition, TPAs and utilization review and
case management businesses are subject to licensing and regulation on the state
level. Typically, the only state requirements for TPA are a completed
application, errors and omissions coverage and proof of a fidelity bond in the
amount of $500,000. Diversified is licensed as a TPA in the states of Texas,
Pennsylvania, Tennessee, California, Illinois, Kentucky, West Virginia and New
Mexico and has filed for ERISA exemptions where required. ValueCheck's license
in Texas is pending and expected to be completed soon. Many states merely
require accreditation. ValueCheck has applied for accreditation.



                                       12
<PAGE>   15


EMPLOYEES

         As of December 31, 1998, the Company and its wholly owned subsidiaries
had 233 full-time employees and 12 part-time employees. The Company believes
that it has a good relationship with its employees. None of the Company's
employees are covered by collective bargaining agreements.

RISK FACTORS

         This report contains forward-looking statements which involve risks and
uncertainties. These forward-looking statements can be identified by the use of
predictive, future-tense or forward-looking terminology, such as "believes,"
"anticipates," "expects," "estimates," "may," "will" or similar terms.
Forward-looking statements also include projections of financial performance,
statements regarding management's plans and objectives and statements concerning
any assumptions relating to the foregoing. The Company's actual results could
differ materially from those anticipated in these forward-looking statements as
a result of certain factors, including those set forth in the following risk
factors and elsewhere in this Form 10-KSB.

RECENT REVENUE DECLINE

         Exclusive of revenues associated with BHC, the Company experienced a
16% decline in its PPO revenues for the year ended December 31, 1998, as
compared to the prior year. We cannot assure you that revenue will not further
decline or that profitable operations can be sustained on a quarterly or annual
basis in the future.

INTEGRATION OF ACQUIRED OPERATIONS

         The Company, through MedicalControl, a wholly owned subsidiary,
completed the acquisition of BHC in September 1998. As a result of this
acquisition, BHC became an indirect, wholly owned subsidiary of the Company, and
the Company began the integration of the operations and management of BHC into
the Company's existing business. We expect to continue the integration of
marketing, client services and related support activities of BHC into our
operations throughout fiscal 1999. We may not be able to complete this
integration successfully. The operating history of BHC on a stand-alone basis
cannot necessarily be regarded as indicative of our prospects on a consolidated
basis. Accordingly, we cannot assure you that the Company and BHC will achieve
the growth in revenues or sustain revenues at a level consistent with the
historical results achieved by the Company and BHC on a stand-alone basis.

DEPENDENCE ON KEY CLIENTS

         The Company has contracts with several key clients, which account for a
substantial portion of its total revenues. The Company's two largest clients, in
the aggregate, accounted for approximately 13%, 18% and 17%, respectively, of
the Company's net revenues for the fiscal years ended December 31, 1998, 1997
and 1996. The loss of any principal customer could have a material adverse
effect on the operating results of the Company. Subject to anticipated
fluctuations in the relative contribution of each of these clients, we expect
that the combined volume of these clients as a percentage of revenues through
1999 will be comparable with prior periods. Although we cannot assure you for
certain, we do not expect the net results of the change in volumes of these
clients to have a material effect on our results from operation.



                                       13
<PAGE>   16

COMPETITION

         We compete with national, regional and local organizations who have
developed PPOs and TPAs as well as with major insurance carriers. The industry
is highly competitive and significant consolidation has occurred within the
industry, creating stronger competitors. The current competitive environment may
limit our ability to price our products at levels we believe are appropriate.
The Company's managed care subsidiaries also face competition from hospitals,
healthcare facilities and other healthcare providers who have combined and
formed their own networks to contract directly with employer groups and other
prospective customers for the delivery of healthcare services. Large employer
groups have demanded a variety of healthcare options, such as traditional
indemnity insurance, health maintenance organizations ("HMOs"), point-of-service
plans and PPOs, offered either through self-funding or third parties. We compete
with providers of all of these products, many of which have substantially
greater financial resources than we do. We believe that a limited number of
companies provide all of the services offered by us within the geographic areas
in which we presently operate. The Company's managed care subsidiaries may
encounter competition from companies with broader networks, narrower networks
(which allow for greater cost control and lower prices), greater market share or
more established marketplace name or reputation. These competitive factors could
adversely affect the Company's financial results. The Company's TPA subsidiary
may encounter competition from larger TPAs with greater resources and regional
TPAs with greater market penetration. All subsidiaries of the Company will be
subject to significant competition in any new geographic areas they may enter.

         "Indemnity insurance" is the "traditional" insurance plan that pays
specific benefits to an insured individual to reimburse them for a portion of
the cost of medical care. Reimbursement for medical care in this situation is
based on the providers' regular charges to the public and the insureds are not
limited with regard to choice of providers. HMOs are managed healthcare plans
that require their members, with the exception of certain medical emergency
situations, to use the services of specific designated physicians, hospitals or
other providers for their healthcare needs. Restriction of access to a limited
number of providers allows the HMO to control the utilization of services and
resources in the delivery of care. One method used by HMOs to reward providers
with cost-effective management of care is through "capitation." "Capitation" is
a provider payment method that reimburses each provider a fixed monthly fee per
member per month for the total cost of all care for enrolled patients regardless
of use. "Point of service" plans offer an individual the choice of seeking
services from a participating provider or any other provider of their choice
each time services are rendered. Patients who choose a participating provider to
provide healthcare services will receive a higher level of reimbursement than
patients choosing a non-participating provider. "Preferred provider
organizations", including our PPO subsidiary, offer employers and healthcare
purchasers access to a broad network of facilities and physicians who have
agreed, by contract, to provide services at a fixed rate or at discounted rates
from their standard fees. In such PPO arrangements, the cost of care is borne by
the self-insured employer or benefit plan and not the PPO.

         The major competitors of the Company vary depending on the product or
services or the market served by the Company on behalf of its particular
clients. In general, the Company typically encounters competition from large
insurance companies, national and local TPAs, national, regional and local PPOs
and Blue Cross plans when the Company solicits new clients for business.

GOVERNMENT REGULATION AND HEALTHCARE REFORM

         PPOs are currently not highly regulated. Since 1993, many competing
proposals have been introduced in Congress and various state legislatures have
called for general healthcare market reforms to insure access to quality
healthcare services. These reforms relate to certain "patient rights," network
or healthcare quality and the measurement and reporting of certain quality
indicators. These reforms could



                                       14
<PAGE>   17

have a negative impact on limiting certain practices, introducing new liability
exposures and increasing cost as a result of required quality measures or
reporting. We cannot predict what additional healthcare reform legislation, if
any, will ultimately be implemented or whether other changes in the
administration or interpretation of governmental healthcare programs will occur.
We cannot predict if proposals calling for broad insurance market reform will be
reintroduced in Congress or in any state legislature in the future, or if any
such proposals may be enacted. At both the federal and state levels, interest is
growing in legislation to regulate how managed care companies interact with
providers and health plan members. We cannot predict what effect federal or
state healthcare legislation or private sector initiatives will have on our PPO
or TPA operations, although we believe we may benefit from some proposals that
favor the growth of managed care. We cannot assure you that future healthcare
reforms or PPO regulations will not be adopted which would have a material
adverse effect on us.

         ERISA, governing employee benefit plans, permitted employers, among
other mandates, to self-insure their health insurance by acting as a
quasi-insurer. The courts are narrowing the application of ERISA, which limits
its protections for our TPA subsidiary. Employers viewed the ability to
underwrite their own health claims as a result of ERISA as an opportunity to
better control healthcare costs. The United States Department of Labor regulates
TPAs and has adopted strict, enforceable guidelines for the operation of TPAs.
In addition, TPAs are subject to licensing and regulation on the state level.
Typically, the only state requirements are a completed application and proof of
a fidelity bond in the amount of $500,000. The Company's wholly owned
subsidiary, Diversified is licensed as a TPA in the states of Texas,
Pennsylvania, Tennessee, California, Illinois, Kentucky, West Virginia and New
Mexico and has filed for ERISA exemptions where required.

         We anticipate that federal and state legislatures will continue to
review and consider alternative healthcare solutions and payment methods. We are
unable to determine to what extent PPOs and TPAs will be subject to any managed
care initiatives of the federal and state governments or private sector
initiatives, as there is increasing emphasis on market-driven modifications.
Also, we are unable to determine the favorable or unfavorable impact, if any,
such initiatives would have on our operations.

DEPENDENCE ON HEALTHCARE PROVIDERS

         The Company's PPO profitability and long-range business plans are
dependent upon attracting and retaining qualified physicians, hospitals and
other healthcare providers under contract and preferred pricing terms which
permit the Company to compete with other managed care companies and insurance
companies on favorable terms. We believe there is increasing competition from
HMOs, PPOs and other healthcare plans for physicians, hospitals and other
healthcare providers. We cannot assure you that we will be successful in
maintaining existing relationships or attracting necessary healthcare providers.

CANCELLATION RIGHTS ON CONTRACTS

         Although the Company generally enters into written contracts with its
clients, the majority of such contracts, including the contracts with the
Company's major clients, permit cancellation upon 30 to 90 days' notice.
Additionally, the Company's contracts with its clients do not require minimum
payments or minimum levels of services. The exercise of these cancellation
rights or a significant reduction in the volume of services by the Company's
largest clients or by a number of the Company's other clients could have a
material adverse effect on the Company. See "Risk Factors - Dependence on Key
Clients." Clients representing approximately $3,000,000 of 1996 and 1997
revenues and $700,000 of 1998 revenues have terminated their contracts with the
Company during 1997 and 1998. In addition, certain clients in 1998 have
converted to a different fee arrangement resulting in a loss of approximately
$658,000 of 1998 revenues. We believe that we will be able to replace this
revenue through increased penetration of current



                                       15
<PAGE>   18

clients, new PPO and TPA business development in 1998 and marketing of our
repricing and administrative services business and external growth. We cannot
assure you that we will maintain our current client relationships or that our
clients will not decrease their volume or change their fee structure.

POSSIBLE DELISTING OF COMMON STOCK ON THE NASDAQ NATIONAL MARKET

         In November 1998, the Company received notification from The Nasdaq
National Market that the Company did not have the minimum net tangible assets
required for listed companies. As of December 31, 1998, the Company's net
tangible assets were approximately $114,000 and The Nasdaq National Market's
minimum requirement for listed companies is at least $4 million in net tangible
assets. The Company filed a proposal with The Nasdaq National Market that, if
successful, would cause the Company to comply with The Nasdaq National Market's
listing criteria. The Nasdaq National Market initially rejected the Company's
plan. The Company met with a panel from The Nasdaq National Market on March 25,
1999, to appeal this decision.

         If the Company's Common Stock is no longer traded on The Nasdaq
National Market, the Company intends to apply for listing its Common Stock on
the American Stock Exchange or on a regional exchange, such as the Boston Stock
Exchange. If the Company's Common Stock is not approved for listing on The
American Stock Exchange or a regional exchange, trading, if any, on the
Company's Common Stock would be conducted in the over-the-counter market in the
"pink sheets" or the electronic bulletin board administered by the National
Association of Securities Dealers, Inc. In such an event, the market price of
the Company's Common Stock may be adversely impacted. As a result, an investor
may find it difficult to dispose of or obtain accurate quotations as to the
market value of the Company's Common Stock.

DEPENDENCE ON COMPANY'S SENIOR MANAGEMENT

         The Company's success depends to a significant extent upon J. Ward
Hunt, President and Chief Executive Officer, and Robert O. Brooks, Executive
Vice President and Chief Operating Officer. Neither Mr. Hunt nor Mr. Brooks is
currently subject to an employment agreement and we cannot assure you that
either of them will remain our employees in the future. The loss of Mr. Hunt's
or Mr. Brooks' services could have a material adverse effect on us. We do not
carry key man life insurance on the life of Mr. Hunt or Mr. Brooks. We believe
that our future success will also depend on our ability to continue to attract
and retain key employees. Competition for qualified personnel in our industry is
intense.

MANAGEMENT INFORMATION SYSTEMS; PROPRIETARY TECHNOLOGY

         Our management information systems are critical to our operations
because the information from our information systems allow us to negotiate price
discounts for provider services, monitor network utilization and perform other
client services. In addition, these systems are critical to the timely,
efficient processing and/or review of provider claims. We rely on a combination
of trade secrets and copyright protections to establish and protect our
proprietary rights to these information systems. We cannot assure you, however,
that the legal protections and the precautions taken by us will be adequate to
prevent misappropriation of our technology. In addition, these protections and
precautions will not prevent development by independent third parties of
competitive technology or products, and some companies have already developed
products which, to some extent, perform functions similar to those performed by
our information systems.



                                       16
<PAGE>   19

RELIANCE ON DATA PROCESSING AND YEAR 2000 COMPLIANCE

         Certain aspects of our business are dependent upon our ability to
store, retrieve, process and manage data and to maintain and upgrade our data
processing capabilities. Interruption of data processing capabilities for any
extended length of time, loss of stored data, programming errors or other
computer problems could have a material adverse effect on our business.

         We recognize the need to ensure that our operations will not be
adversely impacted by Year 2000 software failures. Accordingly, we have been
evaluating the impact of the Year 2000 on our services offerings as well as our
internal systems and hardware. Relative to our services offerings, all current
versions of our products are designed to be "Year 2000" compliant. Accordingly,
we do not currently believe that the effects of any Year 2000 non-compliance in
our installed services offerings will result in any material adverse impact on
our business or financial condition. As to our own internal software systems and
hardware, we have identified and are currently reviewing all key applications
and systems. We believe there is no significant exposure to us related to the
Year 2000 issue.

         We cannot assure you that the Company will not be exposed to potential
claims resulting from system problems associated with the century change. In
addition, we cannot know for certain that unknown issues will not arise or that
any costs will not exceed current. Any difficulties in reviewing claims in a
timely manner may adversely affect the Company's ability to attract and retain
clients and/or healthcare providers and may also adversely affect the Company's
ability to monitor its financial and operational performance. Further, we cannot
know for certain our providers, customers and vendors are Year 2000 compliant
and the effect of such non-compliance on the Company.

CONTROL OF THE COMPANY

         Currently, The Answer Partnership, Ltd. owns 2,640,000 shares, or 64%,
of the Company's Common Stock. As a result, The Answer Partnership, Ltd. in
essence elects the entire Board of Directors of the Company and controls the
direction and operations of the Company. J. Ward Hunt, President of the Company,
controls The Answer Partnership, Ltd. due to his position as its managing
partner.

CONFLICTS OF INTEREST

         The Company is a party to a loan arrangement with Mr. Hunt, the
Company's Chairman of the Board, principal shareholder, President and Chief
Executive Officer. From time to time during the term and course of such
arrangement, the officers and directors of the Company may be faced with
potential conflicts of interest between the Company and Mr. Hunt. The officers
and directors of the Company are limited only by their fiduciary duty under
Delaware law to conduct themselves in a manner that is fair to the shareholders
of the Company, the requirements under Delaware law of disclosure to the Board
of Directors of transactions that involve interested director(s) and approval by
a majority of the disinterested directors, and disclosure of interested
transactions to shareholders (for transactions that require shareholder
approval) and approval by a majority of the disinterested shareholders (for
transactions that require shareholder approval). Management undertakes to abide
by Delaware law and its fiduciary duty of fairness to shareholders if faced with
conflicts in this ongoing relationship with Mr. Hunt. We have established no
other guidelines or procedures for resolving potential conflicts. Failure by
management to resolve conflicts of interest in favor of the Company may have a
materially adverse affect on the Company.



                                       17
<PAGE>   20

POSSIBLE ANTI-TAKEOVER EFFECTS OF CERTAIN CERTIFICATE OF INCORPORATION AND BYLAW
PROVISIONS

         The Company's Certificate of Incorporation and Bylaws contain
provisions that may discourage acquisition bids for the Company. The Company has
substantial authorized but unissued capital stock available for issuance. The
Company's Certificate of Incorporation contains provisions which authorize the
Board of Directors, without the consent of stockholders, to issue additional
shares of Common Stock and issue shares of Preferred Stock in series, including
establishment of the rights, powers and preferences, including voting rights, of
holders of the Preferred Stock, and grant authority to the Board to amend the
Company's Bylaws. Additionally, the Company's Bylaws empower the Board to
increase or decrease the number of directors, subject to certain limitations,
and specify that directors will generally hold office until the next annual
meeting of stockholders. These provisions may have the effect, either alone or
in combination with each other, of (i) limiting the price that certain investors
might be willing to pay in the future for the Common Stock, (ii) delaying,
deferring or otherwise discouraging an acquisition or change in control of the
Company deemed undesirable by the Board of Directors or (iii) adversely
affecting the voting power of stockholders who own Common Stock.

ITEM 2.  DESCRIPTION OF PROPERTY.

         In August 1996, the Company signed a ten-year lease for 8,000 square
feet for its TPA operations in Dallas. In January 1997, the Company exercised an
option to lease an additional 20,200 square feet in the same building complex
for its executive offices and PPO operations. The total monthly rental was
approximately $20,800. In connection with the Company's relocation of its
corporate offices and operations for its PPO in January 1997, management secured
a purchase option on their new office facility. During September 1997, the
Company sold this option to a third party for $910,000 cash, who subsequently
exercised the option. Concurrent with the sale, the Company executed a ten-year
lease extension at a fixed monthly rental of approximately $26,500.

         The Company also leases approximately 5,000 square feet in Canonsburg,
Pennsylvania at a monthly rent of approximately $2,750 plus all maintenance and
repairs. The Company owns a 9,100 square foot building in Canonsburg,
Pennsylvania with an outstanding mortgage in the principal amount of
approximately $250,000 and monthly principal payments of approximately $2,100.
The Company leases approximately 400 square feet in Knoxville, Tennessee and
5,000 square feet in Houston, Texas.

         The Company does not invest in, and has not adopted any policy with
respect to investments in, real estate or interests in real estate, real estate
mortgages or securities of or interests in persons primarily engaged in real
estate activities. It is not the Company's policy to acquire assets primarily
for possible capital gain or primarily for income.

ITEM 3.  LEGAL PROCEEDINGS.

         There are no material pending legal proceedings, other than routine
litigation incidental to the Company's business, to which the Company is a party
or of which any of its property is the subject, and no such proceedings are
known by the Company to be contemplated.

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

         No matter was submitted during the fourth quarter of the fiscal year
covered by this report to a vote of security holders, through the solicitation
of proxies or otherwise.




                                       18
<PAGE>   21
                                     PART II

ITEM 5.  MARKET FOR COMMON EQUITY AND RELATED STOCKHOLDER MATTERS.

         (a) The Common Stock is traded in the over-the-counter market and is
quoted on The Nasdaq National Market under the symbol "MDCL." The following
table sets forth the high and low bid prices of the Common Stock for the last
two fiscal years as reported to the Company by the National Association of
Securities Dealers, Inc.:

<TABLE>
<CAPTION>

 Quarter Ended                                  High Bid          Low Bid
 -------------                                  --------          -------  
<S>                                             <C>              <C> 
March 31, 1998                                   6                5 1/8
June 30, 1998                                    5 3/4            5 1/8
September 30, 1998                               7 1/2            3 3/4
December 31, 1998                                8 5/8            5 3/8

March 31, 1997                                   5 5/8            5
June 30, 1997                                    5 1/4            3 1/2
September 30, 1997                               5 7/8            3 1/4
December 31, 1997                                5 5/8            5 1/4
</TABLE>

         The over-the-counter quotations set forth herein reflect inter-dealer
prices, without retail mark-up, mark-down or commission and may not represent
actual transactions.

         (b) As of March 21, 1999, there were approximately 800 record and
beneficial holders of the Company's Common Stock.

         (c) The Company has not paid cash dividends on its Common Stock in the
last two years and in any subsequent interim period. The Company's bank
agreement with its senior lender prohibits the payment of dividends.

         (d) In September 1998, the Company in a private transaction acquired
all of the outstanding stock of BHC. The Company paid to the three former
stockholders of BHC consideration consisting of cash, 270,900 shares of the
Company's Common Stock and convertible promissory notes in the aggregate
principal amount of $1,000,000 convertible into shares of the Company's Common
Stock at the conversion rate of $5.25 per share. The Company relied on the
exemption from the registration requirements provided by Section 4(2) of the
Securities Act of 1933, as amended.

ITEM 6.  MANAGEMENT'S DISCUSSION AND ANALYSIS OR PLAN OF OPERATION.

FISCAL YEAR ENDED DECEMBER 31, 1998, COMPARED TO DECEMBER 31, 1997

         Total revenues for the year ended December 31, 1998, were $14.6
million, $300,000 (2%) higher than the $14.3 million reported in 1997. Excluding
revenues generated by BHC which was purchased effective September 1998, revenues
declined by approximately $600,000. This net decrease resulted from reduced PPO
revenues of approximately $1.4 million (primarily due to client turnover,
reduced revenues from existing clients caused by conversion to capitated fee
arrangements and fluctuations in the relative mix of hospital versus physician
claims volumes), offset by increased TPA revenues of approximately $800,000
(primarily derived from claims administration fees on incremental covered lives
and twelve months of revenues from a new fully-insured product introduced during
1997). Diversified has received notice that it is being terminated from its
fully insured products as of September 1999. Revenue from this product in 1998
was approximately $114,000. Management believes that other related customers of
Diversified may also terminate their agreement with Diversified during 1999 as a
result.

         The Company has experienced declining PPO revenues in recent periods.
This decline is largely attributable to industry-wide trends associated with PPO
access service fees migrating towards less profitable capitated rates and client
turnover driven by consolidations and mergers of large clients and client
benefit plans typically beyond the control of management. Medical Control
derived 67% of its PPO revenues from percentage of savings business in 1998 
versus 72% in 1997. Management believes this trend can be reversed through
increased market penetration with current PPO clients, new PPO and TPA business
development, marketing of its PPO management and repricing business.




                                       19
<PAGE>   22
         For the year ended December 31, 1998, the Company generated a net loss
of $1.2 million ($.30 per share) versus net income of $289,000 ($.07 per share)
in 1997. Operating results for 1998 were in part adversely impacted by post
acquisition charges associated with the BHC acquisition more fully discussed
below. Included in the 1998 operating results is approximately $127,000 of net
income generated by BHC. Included in the prior year's operating results were
approximately $285,000 of non-recurring costs associated with the Company's
relocation of its principal operations and corporate offices, the implementation
of a new claims processing system for its subsidiary, certain separation costs
associated with a former employee, and accelerated software development cost
amortization. Exclusive of these prior year nonrecurring costs, and the impact
of BHC net income and the post acquisition charges included in 1998 operating
results, net income declined approximately $1.5 million between periods. This
decline was due primarily to reduced PPO revenues and increases in personnel
costs and operating expenses more fully discussed below.

         Salaries and wages increased 22% between years, to $9.3 million in 1998
from $7.7 million in 1997. Exclusive of personnel costs associated with BHC
operations, salaries and wages increased approximately $1.3 million. Of this
amount, approximately $345,000 was attributable to merit increases and the
recruitment and retention of key management personnel effective between periods,
approximately $821,000 was attributable to incremental new staffing requirements
in both the PPO and TPA operations, and $120,000 related to temporary labor
costs associated with year-end backlog and systems conversion efforts in the TPA
operations.

         Other operating expenses were $5.7 million for 1998, $262,000 (4%)
higher than in 1997. Exclusive of approximately $228,000 of operating expenses
associated with BHC operations and $253,000 of non-recurring charges included in
1997 operating results associated with the Company's relocation and systems
conversion costs, other operating expenses increased approximately $287,000
between periods. This increase was due primarily to incremental access fees paid
to affiliate PPO networks, increased telephone expenses associated with higher
customer service call volumes, and increased postage costs due to increased
claims volumes.

         Depreciation and amortization expense decreased to approximately
$826,000 in 1998 from $885,000 in 1997, or 7% for the year. This decrease
resulted from the reduction in capitalized software development cost
amortization due to such remaining costs being written off during the third
quarter, offset by increased amortization expense associated with intangible
assets recorded in conjunction with the BHC acquisition. See discussion of post
acquisition charges below for further information.

         In connection with the BHC acquisition discussed above, the Company
recognized certain post acquisition charges of approximately $648,000. These
charges consisted of a $483,000 write-off of certain historically capitalized
software development costs, $125,000 of special management bonuses related to
the acquisition, and $40,000 of severance related costs. Due to the Company's
requirement to consolidate database administration, network access, and like
product offerings of the separate entities, certain existing capitalized
information management applications of the Company no longer had an economic
value. The Company has and continues to develop new database and network
administration applications to accommodate combined product offerings of the
consolidated entity and such development costs are being expensed as incurred.

         Other income and expense decreased to income of approximately $94,000
from $120,000 for the years ended December 31, 1998 and 1997, respectively. This
decrease resulted primarily from incremental interest expense on acquisition
notes payable to fund the BHC acquisition.



                                       20
<PAGE>   23

 (2)  LIQUIDITY AND CAPITAL REQUIREMENTS

         The Company had net working capital of approximately $253,000 at
December 31, 1998, compared to $2,583,000 at December 31, 1997. Unrestricted
cash and cash equivalents were approximately $1,113,000 at December 31, 1998,
compared to $2,032,000 at December 31, 1997. Cash provided by operations during
1998 was approximately $197,000 as compared to $923,000 during 1997. This 
decrease is primarily due to cash used as purchase consideration for the BHC
acquisition, a reduction in PPO revenue, increased personnel costs, increased
current obligations from the purchase of BHC, and the timing of third party
insurance premium payments, offset by increased collections of accounts
receivable.

         Capital expenditures for the purchase of tangible property and
equipment were approximately $388,000 for the twelve months ended December 31,
1998. These expenditures were primarily for data processing equipment for the
Company's PPO and TPA operations. During 1998, the Company also acquired certain
other data processing equipment totaling approximately $70,000, which were
financed under terms of an operating lease.

         In connection with the 1994 acquisition of Diversified, the Company
incurred certain acquisition note obligations. The final $100,000 of these
obligations, subject to an option to convert this note into 25,000 shares of
common stock, was due on June 30, 1998. At maturity, $40,000 of this obligation
was converted to Company stock with the remaining $60,000 being paid in cash.

         In connection with the separation agreement with a former employee, the
Company is required to make eight quarterly installments of $13,750, plus
interest at 8%, which began on September 30, 1997. Three installments were made
during 1998, with a fourth payment being made immediately subsequent to
year-end. Two quarterly payments remain to be made in 1999.

         Effective September 1, 1998, the Company purchased BHC for
approximately $4,500,000. The purchase consideration consisted of $500,000 cash,
a $1,600,000 term note with a bank, an aggregate of $1,000,000 in convertible
notes from the previous shareholders of BHC, and common stock of the Company
valued at approximately $1,400,000. The bank note bears interest at the bank's
prime rate plus 1% (8.75% at December 31, 1998) and is payable in sixty monthly
principal installments plus interest through October 2003. The convertible
seller notes bear interest at 8.5% and are payable in quarterly principal
installments of $50,000 plus interest through October 2003. The notes are
convertible into common stock of the Company at any time, in $25,000 increments,
at a conversion rate of $5.25 per share.

         At December 31, 1998, the Company had $325,000 of outstanding
borrowings under its line of credit arrangement. In conjunction with the bank
financing above, the Company's existing $1,000,000 line of credit was terminated
and a new revolving credit facility was obtained. This credit facility, secured
by accounts receivable, allows for maximum borrowings of $500,000 and bears
interest at the bank's prime rate plus 1% (8.75% at December 31, 1998).
Availability under this credit facility was $175,000 at December 31, 1998. As of
December 31, 1998, the Company was not in compliance with certain debt covenants
and, in March 1999, it restructured these covenants and certain other terms of
the bank agreement and received the necessary waivers. Under the revised terms
of the bank agreement, the Company is required to make principal reductions in
the amount of $200,000 on March 31, 1999 and $350,000 on or before August 1,
1999. The revised term note includes certain revised financial covenants,
including minimum cash flow, stockholders' equity and working capital
requirements, and is secured by a pledge of certain shares of the Company's
wholly owned subsidiaries. Concurrently, maximum borrowings under the Company's
revolving credit facility were reduced from




                                       21
<PAGE>   24
 $500,000 to $400,000. As of March 1999, the Company has no availability under
its line of credit. Although there can be no assurance, the Company believes
that it will be in compliance with its debt covenants through 1999. In January
1999, the Company eliminated certain positions and reduced certain expenses that
resulted in approximately $70,000 in salary and other cost savings per month.

         In October 1998, the Mr. Hunt gave notice of his intent to repay his
promissory note in the amount of approximately $414,000 by transferring to the
Company certain of his shares of common stock of the Company. This transfer
would require the consent of the Company's bank lender. Such consent was not
received and the transaction was not completed.

         During the first half of 1998, the Company purchased a total of 88,000
shares of Company stock at $5.13 per share under terms of a stock repurchase
agreement announced during January 1997. The purchases were financed with
advances under this credit facility.

         Management believes that cash flows from operations and cash on hand
will be sufficient to fund liquidity needs and capital requirements in 1999.

         The Company has not paid dividends in the past and does not anticipate
the payment of such in the future.

RELIANCE ON DATA PROCESSING

         The Company's management has recognized the need to ensure that its
operations and relationships with vendors and other third parties will not be
adversely impacted by software processing errors arising from calculations using
the year 2000 and beyond ("Year 2000"). Management recognizes that failure by
the Company to timely resolve internal Year 2000 issues could result, in the
worst case, in an inability of the Company to store, retrieve, process, and
manage data in support of its claims repricing and third party administration
services. However, Company management believes that scenario is unlikely based
on the progress made in its Year 2000 remediation plan. Failure of one or more
third party service providers on whom the Company relies to address Year 2000
issues could also result, in a worst case scenario, in some business
interruption. The lost revenues, if any, resulting from a worst case scenario
such as those examples described above would depend on the time period during
which the failure goes uncorrected and on how widespread the impact.

         The Company began a formal program in 1998 to evaluate, assess and make
the needed changes to its core information technology ("IT") systems and
applications to comply with Year 2000 issues. Management has completed its
review of all essential IT systems and believes that they are Year 2000
compliant. The Company's primary IT systems and applications have been developed
and placed into production within the past eighteen to twenty-four months.
Accordingly, such systems and applications were developed employing contemporary
software tools to be Year 2000 compliant from their initial design phase.
Management is continuing to inventory and evaluate all non-essential software
programs and hardware used in the Company's business. Management expects this
process to be complete by September 30, 1999. Non-compliant systems are being
replaced, modified, or outsourced as they are reviewed. The Company has
communicated, and will continue to communicate, with its suppliers, financial
institutions and others with which it does business to monitor and evaluate Year
2000 conversion progress.

         With regard to non-IT systems, such as general office security systems
and phone systems, the Company is currently evaluating the compliance of such
systems. Systems that are not compliant, if any, will be remediated, upgraded or
replaced by September 30, 1999. Management anticipates that expenditures related
to these activities will not exceed $20,000.



                                       22
<PAGE>   25

         Direct expenditures associated with Year 2000 issues, excluding costs
associated with the development of the underlying core IT systems, have been
immaterial to date and have been funded through the Company's normal IT
operations budget.

         The Company has had each of its departments or divisions develop basic
contingency plans to restore the material functions of each of its material
systems or activities in the case of a Year 2000 related failure. The
contingency plans cover all material levels of activity within each business
location. The Company plans to continually refine these plans and to make them
more comprehensive, as more information becomes available from testing and third
party suppliers.

         Although there can be no assurance that the Company will be able to
complete all of the modifications in the required time frame, nor that
unanticipated events will occur, or that the Company will be able to identify
all Year 2000 issues before problems manifest themselves, it is management's
belief that the Company is taking adequate action to address Year 2000 issues.
Management does not expect the Year 2000 compliance efforts or related
expenditures to be material to the Company's consolidated financial position,
results of operations or cash flows.


                                       23
<PAGE>   26

ITEM 7. FINANCIAL STATEMENTS.

MEDICALCONTROL, INC. AND SUBSIDIARIES
INDEX TO FINANCIAL STATEMENTS

HISTORICAL FINANCIAL STATEMENTS

<TABLE>
<CAPTION>

         MedicalControl, Inc. and Subsidiaries                                                                     Page 
                                                                                                                   ----
<S>                                                                                                                <C>
  Report of Independent Public Accountants......................................................................   F-1
  Consolidated Balance Sheets as of December 31, 1998 and 1997  ................................................   F-2
  Consolidated Statements of Operations for the years ended December 31, 1998 and 1997..........................   F-3
  Consolidated Statements of Changes in Stockholders' Equity for the years
     ended December 31, 1998 and 1997...........................................................................   F-4
  Consolidated Statements of Cash Flows for the years ended December 31, 1998 and 1997..........................   F-5
  Notes to Consolidated Financial Statements....................................................................   F-6
</TABLE>

The Financial Statements are located after the signature page.

ITEM 8. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE

None

                                    PART III

ITEM 9. DIRECTORS, EXECUTIVE OFFICERS, PROMOTERS AND CONTROL PERSONS; COMPLIANCE
WITH SECTION 16(A) OF THE EXCHANGE ACT.

         The information called for by this Item is incorporated by reference
from the Company's definitive Proxy Statement, which involves, among other
things, the election of the Board of Directors, to be filed pursuant to
Regulation 14A and which the Company intends to file with the Securities and
Exchange Commission not later than 120 days after December 31, 1998, the end of
the year covered by this Form 10-KSB.

ITEM 10.  EXECUTIVE COMPENSATION.

         The information called for by this Item is incorporated by reference
from the Company's definitive Proxy Statement, which involves, among other
things, the election of the Board of Directors, to be filed pursuant to
Regulation 14A and which the Company intends to file with the Securities and
Exchange Commission not later than 120 days after December 31, 1998, the end of
the year covered by this Form 10-KSB.

ITEM 11.  SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT.

         The information called for by this Item is incorporated by reference
from the Company's definitive Proxy Statement, which involves, among other
things, the election of the Board of Directors, to be filed pursuant to
Regulation 14A and which the Company intends to file with the Securities and
Exchange Commission not later than 120 days after December 31, 1998, the end of
the year covered by this Form 10-KSB.




                                       24
<PAGE>   27

ITEM 12.  CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.

         The information called for by this Item is incorporated by reference
from the Company's definitive Proxy Statement, which involves, among other
things, the election of the Board of Directors, to be filed pursuant to
Regulation 14A and which the Company intends to file with the Securities and
Exchange Commission not later than 120 days after December 31, 1998, the end of
the year covered by this Form 10-KSB.

ITEM 13.  EXHIBITS AND REPORTS ON FORM 8-K.

         (a) EXHIBITS

3.1      Restated Certificate of Incorporation of the Registrant - incorporated
         by reference to the Exhibits to the Registration Statement on Form
         SB-2, file number 33-58334-FW, declared effective May 13, 1993.

3.2      Amended and Restated Corporate Bylaws of the Registrant - incorporated
         by reference to the Exhibits to the Registration Statement on Form
         SB-2, file number 33-58334-FW, declared effective May 13, 1993.

10.1     Amended and Restated Non-Qualified Stock Option Agreement -
         incorporated by reference to the Exhibits to the Registration Statement
         on Form SB-2, file number 33-58334-FW, declared effective May 13, 1993.

10.2     Outside Directors Stock Option Plan of MedicalControl, Inc., -
         incorporated by reference to the Exhibits to the Registration Statement
         on Form SB-2, file number 33-58334-FW, declared effective May 13, 1993.

10.3     First Amendment to the Outside Directors Stock Option Plan of
         MedicalControl, Inc. - incorporated by reference to the Exhibits to the
         Registration Statement on Form SB-2, file number 33-58334-FW, declared
         effective May 13, 1993.

10.4     Amendment to the Outside Directors Stock Option Plan of MedicalControl,
         Inc. dated August 20, 1996 - incorporated by reference to the Company's
         Annual Report on Form 10-KSB for the year ended December 31, 1997.

10.5     Amended and Restated Non-Qualified Stock Option Agreement (Issued Under
         Outside Directors Stock Option Plan). - incorporated by reference to
         the Exhibits to the Registration Statement on Form SB-2, file number
         33-58334-FW, declared effective May 13, 1993.

10.6     Qualified Employee Stock Purchase Plan of MedicalControl, Inc. -
         incorporated by reference to the Exhibits to Post Effective Amendment
         Number 1 to the Registration Statement on Form SB-2, file number
         33-58334-FW, dated January 30, 1995.

10.7     Amendment to Qualified Employee Stock Purchase Plan of MedicalControl,
         Inc. dated as of March 18, 1997 - incorporated by reference to the
         Company's Annual Report on Form 10-KSB for the year ended December 31,
         1997.




                                       25
<PAGE>   28

10.8     1993 Stock Compensation Plan of MedicalControl, Inc. - incorporated by
         reference to the Exhibits to Post Effective Amendment Number 1 to the
         Registration Statement on Form SB-2, file number 33-58334-FW, dated
         January 30, 1995.

10.9     Amendment to 1993 Stock Compensation Plan of MedicalControl, Inc. dated
         as of August 20, 1996 - incorporated by reference to the Company's
         Annual Report on Form 10-KSB for the year ended December 31, 1997.

10.10    Stock Purchase Agreement, dated as of June 30, 1994, between Robert H.
         Soleau and David C. Bramer (as Sellers) and MedicalControl, Inc., a 
         Delaware corporation (as Purchaser) - incorporated by reference to
         the Current Report on Form 8-K dated August 15, 1994, file number
         1-11922.

10.11    Asset Purchase Agreement, dated as of October 3, 1994, between Group 
         Administrators, Inc., a Texas corporation (as Seller) and 
         MedicalControl Administrators, Inc., a Texas corporation (as 
         Purchaser) - incorporated by reference to the Current Report on Form 
         8-K dated October 31, 1994, file number 1-11922.

10.12    Agreement and Plan of Reorganization, dated as of November 28, 1994,
         between Group Administrators - San Antonio, Inc., a Texas corporation,
         and MedicalControl Administrators San Antonio, Inc., a Texas 
         corporation and wholly-owned subsidiary of MedicalControl, Inc. - 
         incorporated by reference to the Current Report on Form 8-K dated 
         November 30, 1994, file number 1-11922.

10.13    Form of Agreement by and between the Company and each of its directors
         and officers - incorporated by reference to Registrant's Annual Report
         on Form 10-KSB for the year ended December 31, 1996.

10.14    Commercial Lease, dated March 1, 1993, by and among Diversified and 
         David C. and Janice L. Bramer - incorporated by reference to 
         Registrant's Annual Report on Form 10-KSB for the year ended 
         December 31, 1996.

10.15    Letter Agreement, dated September 29, 1994, by and between Registrant 
         and David C. Bramer - incorporated by reference to Registrant's Annual
         Report on Form 10-KSB for the year ended December 31, 1996.

10.16    Transfer Agreement, dated as of January 1, 1998, by and among the
         Registrant, MedicalControl Network Solutions, Inc., PPO Management
         Solutions, Inc., Genesis/ValueCheck, Inc., MedicalControl Holdings,
         Inc., and its direct and indirect wholly-owned subsidiaries. (All
         exhibits have been omitted and will be provided to the Commission upon
         request.) - incorporated by reference to Registrant's Annual Report on 
         Form 10-KSB for the year ended December 31, 1997.

10.17    Stock Purchase Agreement, dated September 10, 1998, by and between 
         MedicalControl Network Solutions, Inc., Business Health Companies, 
         Inc., Ralph T. Smith, Donald Richard Huntington and Douglas Elden. -
         incorporated by reference to Registrant's Special Report on Form 8-K
         filed October 9, 1998.

10.18    Employment, Confidentiality and Non-Competition Agreement, dated
         September 25, 1998, by and among MedicalControl Network Solutions,
         Inc., registrant and Donald Richard Huntington

10.19    Employment, Confidentiality and Non-Competition Agreement, dated
         September 25, 1998, by and among MedicalControl Network Solutions,
         Inc., registrant and Ralph T. Smith

10.20    Loan Agreement, dated September 25, 1998, by and between the registrant
         and Bank One, Texas, N.A.

10.21    First Amendment to Loan Agreement, dated as of March 31, 1999, by and 
         between Bank One, Texas N.A. and the registrant.

21       Subsidiaries of the Registrant.






                                       26
<PAGE>   29

23.7     Consent of Arthur Andersen LLP, independent public accountants.

27       Financial Data Schedule.

(b)      Reports on Form 8-K. The Company filed a Current Report on
         Form 8-K and 8-K/A on October 9, 1998 and November 12, 1998, 
         respectfully, relating to the BHC acquisition.







                                       27
<PAGE>   30





                                   SIGNATURES

         In accordance with Section 13 or 15(d) of the Exchange Act, the
registrant caused this report to be signed on its behalf by the undersigned,
thereunto duly authorized.

Registrant:

Date: March 31, 1999                         MedicalControl, Inc.



                                             By: /s/ John Ward Hunt
                                                 ------------------------------
                                                 John Ward Hunt,
                                                 President and Chief Executive 
                                                 Officer

In accordance with the Exchange Act, this report has been signed below by the
following persons on behalf of the registrant and in the capacities and on the
dates indicated.

<TABLE>
<CAPTION>

    Name                                            Title                                  Date
    ----                                            -----                                  ---- 

<S>                                   <C>                                               <C> 
 /s/ John Ward Hunt                   President, Chief Executive Officer                March 31, 1999
---------------------------           and Chairman of the Board of Directors  
John Ward Hunt                        (principal executive officer)  
                          

/s/ David A. Hanson                   Vice President, Finance and Accounting            March 31, 1999
---------------------------           (principal accounting officer)
David A. Hanson                     

                                      Director
---------------------------
Robert W. Philip

/s/ William L. Amos, Jr.              Director                                          March 31, 1999
---------------------------
William L. Amos, Jr., M.D.

/s/ D. Samuel Coats
---------------------------
D.  Samuel Coats                      Director                                          March 31, 1999
</TABLE>






                                       28
<PAGE>   31





                    REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS

To the Stockholders and Board of Directors of MedicalControl, Inc.:

We have audited the accompanying consolidated balance sheets of MedicalControl,
Inc. (a Delaware corporation) and subsidiaries as of December 31, 1998 and 1997,
and the related consolidated statements of operations, stockholders' equity, and
cash flows for the years then ended. These financial statements are the
responsibility of the Company's management. Our responsibility is to express an
opinion on these financial statements based on our audits.

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

In our opinion, the financial statements referred to above present fairly, in
all material respects, the financial position of MedicalControl, Inc. and
subsidiaries as of December 31, 1998 and 1997, and the results of their
operations and their cash flows for the years then ended in conformity with
generally accepted accounting principles.




         ARTHUR ANDERSEN LLP

Dallas, Texas
March 31, 1999



   
                                       F-1





<PAGE>   32

                      MEDICALCONTROL, INC. AND SUBSIDIARIES

                           CONSOLIDATED BALANCE SHEETS

                           DECEMBER 31, 1998 AND 1997



<TABLE>
<CAPTION>
                                   ASSETS                                    
                                                                             1998          1997  
                                                                        ------------   ------------
<S>                                                                     <C>            <C>         
CURRENT ASSETS
       Cash and cash equivalents                                        $  1,112,653   $  2,031,550
       Restricted cash                                                       308,002      1,203,757
       Accounts receivable - trade, net of allowance
             for doubtful accounts of $119,000 and
             $135,000 in 1998 and 1997, respectively                       1,312,043      1,979,875
       Accounts receivable - premium                                         466,980        741,345
       Accounts receivable - other                                            90,671         87,099
       Income tax receivable                                                 472,691           --
       Prepaid expenses and other current assets                             227,391        276,105
       Deferred income taxes                                                 169,028        168,838
                                                                        ------------   ------------
          Total current assets                                             4,159,459      6,488,569

NOTE RECEIVABLE - OFFICER, including accrued interest                        421,175        394,654
PROPERTY AND EQUIPMENT, NET                                                1,697,698      1,661,290
GOODWILL, NET                                                              7,772,833      3,451,348
INTANGIBLE AND OTHER ASSETS, NET                                              97,991        691,563
DEFERRED TAXES                                                                85,270           --
                                                                        ------------   ------------

       TOTAL ASSETS                                                     $ 14,234,426   $ 12,687,424
                                                                        ============   ============

             LIABILITIES AND STOCKHOLDERS' EQUITY
CURRENT LIABILITIES
       Accounts payable - trade                                         $    916,826   $    643,249
       Accounts payable - premium                                            774,982      1,945,102
       Accrued liabilities                                                   773,749        852,095
       Income taxes payable                                                     --          291,927
       Borrowings under revolving bank line of credit                        325,000           --
       Current portion of long-term debt                                   1,115,515        173,072
                                                                        ------------   ------------
          Total current liabilities                                        3,906,072      3,905,445

NON-CURRENT LIABILITIES
       Long-term debt, net of current portion                              1,554,484        111,514
       Deferred gain on sale of option on real estate                        789,417        880,417
       Deferred income taxes                                                    --          116,489

COMMITMENTS AND CONTINGENCIES

STOCKHOLDERS' EQUITY
       Preferred stock - $.10 par; 4,000,000
          shares authorized, no shares issued or outstanding                    --             --
       Common stock - $.01 par: 8,000,000 shares
          authorized, 4,115,409 and 3,908,635 issued
           in 1998 and 1997, respectively                                     41,154         39,086
       Additional paid-in capital                                          6,210,002      5,231,265
       Retained earnings                                                   1,733,297      2,922,104
                                                                        ------------   ------------
                                                                           7,984,453      8,192,455

       Less: Treasury stock (83,612 shares at December 31,1997)                 --         (518,896)
                                                                        ------------   ------------
          Total stockholders' equity                                       7,984,453      7,673,559
                                                                        ------------   ------------
          TOTAL  LIABILITIES AND STOCKHOLDERS' EQUITY                   $ 14,234,426   $ 12,687,424
                                                                        ============   ============
</TABLE>




                                      F-2

        The accompanying notes are an integral part of these statements.
<PAGE>   33



                      MEDICALCONTROL, INC. AND SUBSIDIARIES

                      CONSOLIDATED STATEMENTS OF OPERATIONS

                     YEARS ENDED DECEMBER 31, 1998 AND 1997



<TABLE>
<CAPTION>

                                                               1998           1997
                                                          ------------    ------------
<S>                                                       <C>             <C>         
NET REVENUES                                              $ 14,571,673    $ 14,313,101
                                                          ------------    ------------

OPERATING EXPENSES
       Salaries and wages                                    9,302,168       7,648,757
       Other operating expenses                              5,690,897       5,429,208
       Depreciation and amortization                           825,659         884,800
       Post acquisition charges                                648,098            --
                                                          ------------    ------------

          Total operating expenses                          16,466,822      13,962,765
                                                          ------------    ------------

INCOME (LOSS) FROM OPERATIONS                               (1,895,149)        350,336
                                                          ------------    ------------

OTHER INCOME (EXPENSE)
       Interest expense                                        (56,604)        (10,704)
       Investment income                                       121,479         108,356
       Other income                                             29,391          21,923
                                                          ------------    ------------

          Total other income                                    94,266         119,575
                                                          ------------    ------------

INCOME (LOSS) BEFORE INCOME TAXES                           (1,800,883)        469,911

Provision (benefit) for income taxes                          (612,076)        180,660
                                                          ------------    ------------

NET INCOME (LOSS)                                         $ (1,188,807)   $    289,251
                                                          ============    ============


Basic earnings (loss) per share                           $      (0.30)   $       0.08
                                                          ============    ============

Diluted earnings (loss) per share                         $      (0.30)   $       0.07
                                                          ============    ============

Weighted average common shares outstanding                   3,900,439       3,840,478
                                                          ============    ============

Weighted average common and dilutive shares outstanding      3,900,439       3,907,961
                                                          ============    ============

</TABLE>



                                      F-3

        The accompanying notes are an integral part of these statements.



<PAGE>   34

                     MEDICALCONTROL, INC. AND SUBSIDIARIES

          CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY

                    YEARS ENDED DECEMBER 31, 1998 AND 1997


<TABLE>
<CAPTION>
                                        Common Stock
                                       ---------------------     Additional                                Total                
                                           Shares                 Paid-in     Retained      Treasury    Stockholders' Comprehensive
                                        Outstanding   Amount      Capital      Earnings      Stock        Equity         Income
                                       --------------------------------------------------------------------------------------------
<S>                                    <C>           <C>         <C>          <C>         <C>          <C>            <C>           
Balance at December 31, 1996            3,873,578    $ 39,072   $ 5,224,979  $ 2,632,853  $ (268,896)  $ 7,628,008      $     --   

Acquisition of treasury stock             (50,000)         --            --           --    (250,000)     (250,000)           --

Exercise of stock options                   1,445          14         6,286           --          --         6,300            --  

Comprehensive income:
     Net income                                --          --            --      289,251          --       289,251       289,251  
                                       ------------------------------------------------------------------------------- ============
Balance at December 31, 1997            3,825,023      39,086     5,231,265    2,922,104    (518,896)    7,673,559            --

Acquisition of treasury stock             (88,000)         --            --           --    (451,000)     (451,000)           --

Exercise of stock options                  97,486         975       424,322           --          --       425,297            --

Issuance of treasury stock upon
conversion of note payable                 10,000          --       (12,500)          --      52,500        40,000            --

Issuance of common stock in
connection with BHC acquisition           270,900       1,093       503,737           --     917,396     1,422,226            --

Tax benefit of stock option exercises          --          --        63,178           --          --        63,178            --

Comprehensive income:
     Net loss                                  --          --            --   (1,188,807)         --    (1,188,807)   (1,188,807)
                                       ----------------------------------------------------------------------------    ============
Balance at December 31, 1998            4,115,409    $ 41,154   $ 6,210,002  $ 1,733,297  $       --   $ 7,984,453          
                                       ===========================================================================
</TABLE>


        The accompanying notes are an integral part of these statements.

                                      F-4
<PAGE>   35


                      MEDICALCONTROL, INC. AND SUBSIDIARIES

                      CONSOLIDATED STATEMENTS OF CASH FLOWS

                     YEARS ENDED DECEMBER 31, 1998 AND 1997

<TABLE>
<CAPTION>
                                                                           1998             1997
                                                                      -------------    -------------
<S>                                                                   <C>              <C>          
CASH FLOWS RELATED TO OPERATING ACTIVITIES
Net income                                                            $  (1,188,807)   $     289,251
Adjustments to reconcile net income
to net cash provided by operations (less balances acquired)
       Depreciation and amortization                                        825,659          884,800
       Amortization of deferred gain on real estate transaction             (91,000)         (29,583)
       Post acquisition charges                                             483,097             --
       Deferred tax provision                                              (251,755)        (196,101)
       Net changes in certain assets and liabilities
             Accounts receivable - trade                                    963,372         (371,033)
             Current income taxes, net                                     (792,552)         214,763
             Prepaid expenses and other current assets                       75,888          (69,438)
             Other assets                                                    47,851             --
             Accounts payable - trade                                       159,297           65,599
             Accrued expenses                                              (427,780)         135,164
                                                                      -------------    -------------
Net cash provided by (used in) operating activities                        (196,730)         923,422
                                                                      -------------    -------------

CASH FLOWS RELATED TO INVESTING ACTIVITIES
       Purchases of property and equipment                                 (387,889)        (495,736)
       Proceeds from sale of property and equipment                            --             34,273
       Acquisition, net of cash acquired                                   (495,645)            --
       Proceeds from sale of option on real estate                             --            910,000
                                                                      -------------    -------------
Net cash provided by (used in) investing activities                        (883,534)         448,537
                                                                      -------------    -------------

CASH FLOWS RELATED TO FINANCING ACTIVITIES
       Loan to officer, including accrued interest                          (26,521)         (29,433)
       Net borrowings on revolving bank line of credit                      325,000             --
       Payments on long-term debt                                          (174,587)        (610,165)
       Proceeds from issuance of common stock                               488,475            6,300
       Acquisition of treasury stock                                       (451,000)        (250,000)
                                                                      -------------    -------------
Net cash provided by (used in) financing activities                         161,367         (883,298)
                                                                      -------------    -------------

NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS                       (918,897)         488,661
Cash and cash equivalents at beginning of year                            2,031,550        1,542,889
                                                                      -------------    -------------
Cash and cash equivalents at end of year                              $   1,112,653    $   2,031,550
                                                                      =============    =============

SUPPLEMENTAL CASH FLOW DISCLOSURES
Interest paid                                                         $      56,638    $      49,253
                                                                      =============    =============
Income taxes paid                                                     $     464,774    $     162,008
                                                                      =============    =============

SUPPLEMENTAL SCHEDULE OF NONCASH INVESTING AND FINANCING ACTIVITIES
       Fair value of assets acquired                                  $  (5,087,246)   $        --
       Liabilities assumed                                                  419,375             --
       Acquisition debt                                                   2,600,000             --
       Common stock issued                                                1,422,226             --
       Accrued acquisition costs                                            150,000             --
                                                                      -------------    -------------
       Cash paid for acquisition of Business Health Companies, Inc.   $    (495,645)   $        --
                                                                      =============    =============

       Restricted cash at period end date                             $     308,002    $   1,203,757
                                                                      =============    =============
</TABLE>








                                       F-5

        The accompanying notes are an integral part of these statements.

<PAGE>   36


                      MEDICALCONTROL, INC. AND SUBSIDIARIES
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                           December 31, 1998 and 1997



NOTE 1 - BACKGROUND AND ORGANIZATION

MedicalControl, Inc. ("Company"), a Delaware corporation, is a holding company
of healthcare cost management and administrative services companies. The Company
is comprised of three main subsidiaries: MedicalControl Network Solutions, Inc.,
providing managed care services, primarily through its preferred provider
organization ("PPO") networks, Diversified Group Administrators, Inc., providing
third party administration ("TPA") services, and ppoONE.com, inc., providing
repricing and administrative services for PPO's and certain network healthcare
providers. The Company's contracts with its customers are renewable annually and
permit cancellation upon 30 to 60 days' notice.

In September 1998, the Company acquired all the outstanding shares of Business
Health Companies, Inc. ("BHC"). See Note 4 for further discussion.


NOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Principles of Consolidation

The consolidated financial statements are prepared in accordance with generally
accepted accounting principles and include the accounts of the Company and its
wholly owned subsidiaries. All significant intercompany balances and
transactions have been eliminated.

Cash and Cash Equivalents

Cash equivalents consist of certificates of deposit and other highly liquid
investments with original maturities of three months or less. Restricted cash
represents cash collected from customers for the payment of insurance premiums
and other ancillary fees to third parties.

Accounts Receivable - Trade

In the normal course of business, the Company extends unsecured credit to
virtually all of its customers that are located throughout the United States.
Because of the credit risk involved, management has provided an allowance for
doubtful accounts, which reflects its estimate of amounts that will eventually
become uncollectible.

Accounts Receivable - Premium and Accounts Payable - Premium

Accounts receivable - premium represent amounts owed by customers for insurance
premiums and related ancillary fees. The Company bears no substantial collection
risk, as nonpayment of premiums constitutes grounds for cancellation of
insurance coverage. As a result, the Company does not provide an allowance for
doubtful accounts on these accounts receivable. Premiums and fees owed to
insurance carriers and service providers are classified as accounts payable -
premium.

Property and Equipment

Property and equipment are recorded at cost and are depreciated on a
straight-line basis, over their estimated useful lives (generally 3 to 40
years). Major additions and betterments are capitalized and depreciated over


                                      F-6
<PAGE>   37

                      MEDICALCONTROL, INC. AND SUBSIDIARIES
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                           December 31, 1998 and 1997


the remaining estimated useful lives of the related assets. Maintenance, repairs
and minor improvements are expensed as incurred.

Software Development Costs

Software development costs (included in intangible and other assets) consisted
of outside services and incremental salaries and wages incurred to develop
discrete proprietary software for internal use. These assets were being
amortized over their remaining estimated useful lives (12 to 36 months). As a
result of the acquisition discussed in Note 4, the Company had a requirement to
consolidate database administration, network access and like product offerings
of the separate entities. As a result of this requirement, the Company
determined that it would not be able to recover its investment in certain
capitalized software development costs over their remaining economic life, and
accordingly, recognized an impairment in accordance with Statement of Financial
Accounting Standards No. 121, "Accounting for the Impairment of Long-Lived
Assets and for Long-Lived Assets to be Disposed Of" ("SFAS No. 121"). As a
result of this impairment, approximately $483,000 of remaining capitalized
software costs were written off effective September 1, 1998, and are included in
the post acquisition charges in the accompanying consolidated statements of
operations. Maintenance and other minor updates to all of the Company's various
software programs are expensed as incurred.

Goodwill

Goodwill is being amortized under the straight-line method over periods ranging
from 25 - 30 years.

Long-Lived Assets

Subsequent to its initial recording, the Company periodically evaluates whether
later events and circumstances have occurred that indicate the remaining
estimated useful life of long-lived assets (including property and equipment,
software development costs and goodwill) may warrant revision or that the
remaining balance of the assets may not be recoverable. When factors indicate
these assets should be evaluated for possible impairment, the Company uses an
estimate of the related operating unit's or specific asset's undiscounted future
cash flows in determining whether an impairment has occurred, and the operating
unit's or specific asset's fair value in measuring the impairment.

Income Taxes

Deferred income taxes are provided for temporary differences between the tax
bases of assets and liabilities and their financial reporting amounts. Deferred
taxes are recorded for temporary differences based upon enacted tax rates
anticipated to be in effect when the temporary differences are expected to
reverse.

Revenue Recognition

Revenue is recognized (i) at the completion of the processing of a customer's
hospital or physician claim (regardless of the period in which the underlying
hospital charge was incurred) for cost management services, (ii) per month based
upon a fixed fee per employee in a customer's benefit plan for TPA services or
PPO services or (iii) at the time commissions are earned for the placement of
insurance coverage. Although no one customer accounts for greater than 10% of
the Company's revenues, two customers accounted for 13% and 18% of consolidated
revenues in 1998 and 1997, respectively. The loss of one of these customers
could have a material effect on the Company.



                                      F-7
<PAGE>   38


                      MEDICALCONTROL, INC. AND SUBSIDIARIES
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                           December 31, 1998 and 1997

Earnings Per Share

Basic earnings per share are computed by dividing net income by the weighted
average common shares outstanding during the period. Diluted earnings per share
are computed by dividing net income by the weighted average common shares and
dilutive shares outstanding during the period. The impact of the dilutive common
equivalent shares was 0 and 67,483 for 1998 and 1997, respectively.

In 1998 and 1997, 1,544,528 and 1,355,425 common equivalent shares were excluded
from the calculation of diluted earnings per share because the effect would have
been anti-dilutive for the periods presented.

Use of Estimates

Preparation of the consolidated financial statements in conformity with
generally accepted accounting principles requires management to make certain
estimates and assumptions that affect the reported amounts of assets and
liabilities and disclosures of contingent assets and liabilities and the
reported amounts of revenues and expenses. Actual results could differ from
these estimates.

Stock Based Compensation

The Company has adopted the footnoted disclosure approach of Statement of
Financial Accounting Standards No. 123, "Accounting for Stock-Based
Compensation" (SFAS No. 123"). The Company's pro forma disclosure can be found
in Note 13 to the consolidated financial statements.

Reclassifications

Certain reclassifications have been made to the 1997 financial statements to
conform them to the 1998 presentation.


NOTE 3 - NEW ACCOUNTING PRONOUNCEMENTS

Comprehensive Income

Effective January 1, 1998, the Company adopted Statement of Financial Accounting
Standards No. 130, "Reporting Comprehensive Income" ("SFAS No. 130"), which
requires companies to report all changes in equity during the period, except
those resulting from investments by and distributions to owners in a financial
statement. The Company has chosen to disclose comprehensive income, which
includes only net income in the consolidated statements of stockholders' equity.
Prior years have been restated to conform to SFAS No. 130 requirements.

Business Segment Reporting

During 1998, the Company adopted Statement of Financial Accounting Standards No.
131, "Disclosure About Segments of an Enterprise and Related Information" ("SFAS
No. 131"). SFAS No. 131 supersedes SFAS No. 14, "Financial Reporting for
Segments of an Enterprise," replacing the "industry segment" approach with the
"management" approach. The management approach designates the internal reporting
that is used by management for making operating decisions and assessing
performance as the source of the Company's reportable segments. SFAS No. 131
also requires disclosures about products and services,



                                      F-8
<PAGE>   39

                      MEDICALCONTROL, INC. AND SUBSIDIARIES
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                           December 31, 1998 and 1997


geographic areas and major customers. The adoption of SFAS No. 131 did not
affect results of operations or the financial position of the Company but did
affect the disclosure of segment information.

The Company manages its business segments primarily on a products and services
basis. The Company's reportable segments are comprised of managed care services,
primarily through its preferred provider organization ("PPO"), third party
administration services ("TPA"), and repricing and administrative products and
services offered through its wholly-owned subsidiary, ppoONE.com ("ppoONE.com").
Other segments include large claim negotiation services and utilization review
and case management services.

The accounting policies of the various business segments are the same as those
described in "Summary of Significant Accounting Policies" in Note 2. The Company
evaluates the performance of its business units based on segment operating
profit. Segment revenues include an intercompany allocation for services
performed by ppoONE.com for the PPO segment. Segment operating profit includes
personnel, sales and marketing expenses and other operating expenses directly
attributable to the segment and excludes certain expenses that are managed
outside the segment. Costs excluded from the segment operating profit consist of
corporate expenses, including income taxes, amortization expense and interest
income and interest expense. Corporate expenses are comprised primarily of
executive compensation, post acquisition charges and other general and
administrative expenses that are separately managed. Corporate assets are not
included in segment assets. Corporate assets consist primarily of cash and cash
equivalents, deferred taxes, and intangible assets.

Summary information by segment as of and for the years ended December 31, 1998
and 1997, are as follows:


<TABLE>
<CAPTION>
                                                1998             1997
                                           --------------   --------------
<S>                                        <C>              <C>           
     PPO Segment:
     Revenues                              $    5,863,553   $    7,488,649
     Operating expenses                         5,571,360        3,990,543
                                           --------------   --------------
         Operating profit                         292,193        3,498,106

     Depreciation                                  27,423           21,539
     Segment assets                             1,825,806        2,343,721

TPA Segment:
     Revenues                              $    6,538,289   $    5,738,674
     Operating expenses                         5,915,657        5,121,187
                                           --------------   --------------
         Operating profit                         622,632          617,487

  Depreciation                             $      133,303   $       80,083
  Segment assets                                2,112,915        3,112,848

ppoONE.com Segment:
  Revenues                                 $    2,788,898    $   1,036,186
  Operating expenses                            3,409,826        2,246,307
                                           --------------    --------------
    Operating loss                               (620,928)      (1,210,121)

  Depreciation                                     91,312           51,404
  Segment assets                                  313,676          251,430
</TABLE>






                                      F-9
<PAGE>   40


                      MEDICALCONTROL, INC. AND SUBSIDIARIES
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                           December 31, 1998 and 1997

<TABLE>
<CAPTION>
                                                1998             1997
                                           --------------   --------------
<S>                                        <C>              <C>           
Other Segments:
     Revenues                              $      493,319   $      504,528
     Operating expenses                           193,129          315,573
                                           --------------   --------------
         Operating profit                         300,190          188,955

     Depreciation                                   4,093            9,834
     Segment assets                                56,950          192,116
</TABLE>


A reconciliation of the Company's segment revenues, operating profit (loss) and
segment assets to the corresponding consolidated amounts as of and for the years
ended December 31, 1998 and 1997 are as follows:

<TABLE>
<CAPTION>
                                               1998               1997 
                                           --------------    --------------
<S>                                        <C>               <C>           
Segment revenues                           $   15,684,059    $   14,768,037
Intercompany revenues                          (1,112,386)         (454,936)
                                           --------------    --------------
    Consolidated revenues                  $   14,571,673    $   14,313,101
                                           ==============    ==============

Segment operating profit                   $      594,087    $    3,094,427
Corporate expenses, net                        (2,489,236)       (2,744,091)
                                           --------------    --------------
     Consolidated operating profit (loss)  $   (1,895,149)   $      350,336
                                           ==============    ==============
Operating profit


Segment assets                             $    4,309,347    $    5,900,115
Corporate assets                                9,925,079         6,787,309
                                           --------------    --------------
     Consolidated assets                   $   14,234,426    $   12,687,424
                                           ==============    ==============
</TABLE>




NOTE 4 - ACQUISITION

Effective September 1, 1998, a wholly owned subsidiary of the Company acquired
all of the issued and outstanding common stock of Business Health Companies,
Inc. ("BHC") for approximately $4,500,000 plus liabilities assumed of $264,138
and accrued acquisition costs of $150,000. BHC provides managed care services,
primarily through its PPO networks within the 15-county Houston, Texas market.
The purchase consideration consisted of $2,150,000 in cash, 270,900 shares of
Company stock, valued at approximately $1,422,000, and an aggregate of
$1,000,000 in subordinated convertible notes to the previous shareholders of
BHC. The acquisition was accounted for under the purchase method of accounting.
The purchase price exceeded the fair value of assets acquired and liabilities
assumed which resulted in the recording of goodwill of approximately $4,500,000,
which will be amortized over 25 years. Liabilities assumed included $110,000 for
severance related expenses for certain employees and other identified
contingencies.

In connection with the acquisition discussed above, the Company recognized 
certain post acquisition charges of approximately $648,000. These charges 
consisted of a $483,000 write-off of certain capitalized software development 
costs, $125,000 of special bonuses payable to the CEO and COO of the Company, 
related to the acquisition, and $40,000 of severance related costs. Due to the 
acquisition of BHC, the Company has a requirement to consolidate database 
administration, network access, and like product offerings of the separate 
entities. As a result of this requirement, the Company has determined that it 
will not be able to recover its investment in certain capitalized software 
development costs over their remaining economic life, and accordingly, has 
recognized an impairment in accordance with Statement of Financial Accounting 
Standards No. 121.


                                      F-10
<PAGE>   41

                      MEDICALCONTROL, INC. AND SUBSIDIARIES
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                           December 31, 1998 and 1997



Pro Forma Results of Operations (Unaudited)

The following unaudited pro forma information is presented to illustrate the
estimated effects of the BHC acquisition as if it had occurred on January 1,
1997, and is not necessarily indicative of what operations would have been if
the acquisition had been consummated at the assumed date, nor is it indicative
of future results of operations. The pro forma information does not include the
post acquisition charges included in the accompanying consolidated statement of
operations for 1998.

<TABLE>
<CAPTION>
                                                                    For the Year Ended    For the Year Ended
                                                                    December 31, 1998     December 31, 1997
                                                                   ------------------   -------------------
     <S>                                                              <C>               <C>
     Net revenues                                                     $   15,912,691    $   15,877,794
     Operating income                                                 $   (1,347,691)   $      180,490
     Net income                                                       $     (659,192)   $      (21,246)
     Earnings per share                                               $        (0.16)   $        (0.01)
     Weighted average shares outstanding                                   4,081,039         4,111,378
</TABLE>


NOTE 5 - PROPERTY AND EQUIPMENT, NET

Property and equipment at December 31, 1998 and 1997, consisted of the
following:

<TABLE>
<CAPTION>
                                                    Estimated                         
                                                   Useful Life          1998                 1997
                                                   ------------    --------------      --------------                    
<S>                                                <C>             <C>                 <C>   
     Land                                               -          $       60,000      $       60,000
     Buildings                                       40 years             240,000             240,000
     Furniture and fixtures                         5-10 years            714,731             624,070
     Data processing equipment                      3-6 years           1,368,345           1,253,213
     Leasehold improvements                          40 years             116,343              66,407
                                                                   --------------      --------------
                                                                        2,499,419           2,243,690
     Less - accumulated depreciation                                     (801,721)           (582,400)
                                                                   --------------      --------------
          Property and equipment, net                              $    1,697,698      $    1,661,290
                                                                   ==============      ==============
</TABLE>





                                      F-11
<PAGE>   42


                      MEDICALCONTROL, INC. AND SUBSIDIARIES
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                           December 31, 1998 and 1997



NOTE 6 - GOODWILL, NET

Goodwill at December 31, 1998 and 1997, consisted of the following:

    
  
<TABLE>
<CAPTION>
                                                        1998              1997
                                                   --------------    --------------
<S>                                                <C>               <C>           
     Goodwill                                      $    8,374,303    $    3,871,953
     Less - accumulated amortization                     (601,470)         (420,605)
                                                   --------------    --------------
          Goodwill, net                            $    7,772,833    $    3,451,348
                                                   ==============    ==============
</TABLE>


NOTE 7 - INTANGIBLE AND OTHER ASSETS, NET

Intangible and other assets at December 31, 1998 and 1997, consisted of the
following:

<TABLE>
<CAPTION>
                                                        1998              1997
                                                   --------------    --------------
<S>                                                <C>               <C>           
     Software development costs                    $            -    $    1,354,771
     Covenants not to compete                             210,000           210,000
     Organization costs                                    49,038            44,977
     Other                                                 31,731            20,808
                                                   --------------    --------------
                                                          290,769         1,630,556
     Less - accumulated amortization                     (192,778)         (938,993)
                                                   --------------    --------------
          Intangible and other assets, net         $       97,991    $      691,563
                                                   ==============    ==============
</TABLE>



NOTE 8 - DEBT

During 1997, the Company had a revolving line of credit with a bank providing
for maximum borrowings of $1,000,000, secured by accounts receivable. Advances
under this credit facility accrued interest at the bank's prime rate plus 1%.
There were no outstanding borrowings under this line of credit as of December
31, 1997.

In connection with the acquisition of BHC, the Company obtained bank financing
in the form of a $1,600,000 term loan. The Company also issued an aggregate of
$1,000,000 in subordinated convertible notes to the selling shareholders of BHC.
The bank note bears interest at the bank's prime rate plus 1% (8.75% at December
31, 1998) and is payable in monthly installments of principal and interest
through October 2003. The subordinated convertible seller notes bear interest at
8.5% and are payable in quarterly installments of principal and interest through
October 2003. The notes are convertible into common stock of the Company at any
time, in $25,000 increments, at a conversion rate of $5.25 per share.

In conjunction with the bank financing above, the Company's existing $1,000,000
line of credit was terminated and a new revolving credit facility was obtained.
This credit facility, secured by accounts receivable, allows for maximum
borrowings of $500,000 and bears interest at the bank's prime rate plus 1%
(8.75% at December 31, 1998). Availability under this credit facility was
$175,000 at December 31, 1998. The credit facility contains certain affirmative
financial covenants, such as minimum net worth and financial statement ratios.
The Company was not in compliance with such covenants as of December 31, 1998, 
and received the necessary waivers.

During March 1999, the Company restructured the terms and financial covenants of
its existing bank term note and revolving line of credit. Under the revised
terms of the note agreement, the Company is required to make principal
reductions in the amount of $200,000 on March 31, 1999 and $350,000 on or before
August



                                      F-12
<PAGE>   43
                      MEDICALCONTROL, INC. AND SUBSIDIARIES
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                           December 31, 1998 and 1997

 1, 1999. The revised new term note includes certain revised financial
covenants, including minimum cash flow, stockholders' equity and working capital
requirements, and is secured by a pledge of certain shares of the Company's
wholly owned subsidiaries. The Company is required to make monthly payments of
principal and interest, as described above. Concurrently, maximum borrowings
under the Company's revolving credit facility were reduced from $500,000 to
$400,000. The Company had no availability under its line of credit as of March 
1999. No other modifications were made to this credit facility.

Although there can be no assurance, the Company believes that it will be in
compliance with its debt covenants through 1999.

Management believes that cash flows from operations and cash on hand will be 
sufficient to fund liquidity needs and capital requirements in 1999.

Long-Term Debt

Long-term debt consisted of the following at December 31, 1998 and 1997:

<TABLE>
<CAPTION>
                                                                         1998                 1997
                                                                     ----------------   ---------------
<S>                                                                  <C>                <C>            
     Mortgage note payable, monthly installments of                  $         84,071   $       102,086
     approximately $1,500, plus interest at a bank's prime rate
     plus .25% (8.0% at December 31, 1998) through September 2003

     Note payable, due in quarterly  installments of $13,750 plus              27,500            82,500
     interest at 8% through June 1999


     Note payable to previous stockholders of subsidiary,                           -           100,000
     $100,000 due on June 30, 1998, with balance due on June 30,
     1998, plus interest at 9.5% due quarterly 

     Subordinated convertible notes payable to previous                     1,000,000                 -
     stockholders of subsidiary, principal payable in quarterly
     installments of $50,000, interest at 8.5% due monthly through 
     September 2003

     Note payable to bank, secured by essentially all assets of             1,558,428                 -
     the Company, monthly installments of approximately $26,700,
     plus interest at bank's prime rate plus 1% (8.75% at
     December 31, 1998) through 2003
                                                                     ----------------   ---------------
                                                                            2,669,999           284,586
     Less - current portion                                                (1,115,515)         (173,072)
                                                                     ----------------   ---------------
     Total long-term debt, net of current portion                    $      1,554,484   $       111,514
                                                                     ================   ===============

</TABLE>






                                      F-13
<PAGE>   44

                      MEDICALCONTROL, INC. AND SUBSIDIARIES
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                           December 31, 1998 and 1997



Scheduled future principal maturities of long-term debt at December 31, 1998,
are as follows:

<TABLE>
<CAPTION>
          Year ended
          December 31,                                   Amount
          ------------                                ----------
<S>                                                   <C>       
          1999                                        $1,115,515
          2000                                           538,015
          2001                                           538,015
          2002                                           266,443
          2003                                           212,011
          Thereafter                                          --
                                                      ---------- 
                                                      $2,669,999
                                                      ==========
</TABLE>
      
In connection with the notes payable to previous shareholders of subsidiary
discussed above, the Company agreed to permit one of the former shareholders the
option to convert up to $100,000 of debt owed to him by the Company into 25,000
shares of common stock at a price of $4.00 per share. During 1998, $40,000 of
the note was converted into common stock of the Company, with the remainder of
the note being paid in cash.


NOTE 9 - BENEFIT PLANS

Profit Sharing Plan

The Company has a 401(k) profit sharing plan that covers all employees of the
Company who have one year of service, as defined, and have reached age 21.
Company contributions are discretionary based upon determinations made by the
plan trustees. Employees become 100% vested in employer contributions after 5
years of service (accruing 20% per year of service, as defined). The Company
recorded expense of $103,965 and $85,428 for plan contributions for the years
ended December 31, 1998 and 1997, respectively.

Salary Continuation Benefits

The Company has a salary continuation plan, whereby an officer shall continue to
receive a stated monthly salary for 120 months following his normal retirement
date upon reaching age 65. In the event of premature death or disability, his
beneficiaries are entitled to certain benefits. The Company reserves the right
in its sole discretion to terminate this plan and/or funding at any time. The
Company has financed this potential obligation with a corporate-owned life
insurance policy. Premiums expended on this policy were $24,000 and $29,316 in
1998 and 1997, respectively.

Other than stated above, the Company does not provide any post-retirement or
post-employment benefits to any of its employees.





                                      F-14
<PAGE>   45

                      MEDICALCONTROL, INC. AND SUBSIDIARIES
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                           December 31, 1998 and 1997



NOTE 10 - INCOME TAXES

The provision (benefit) for income taxes at December 31, 1998 and 1997,
consisted of the following:

<TABLE>
<CAPTION>
                                                      1998             1997
                                                --------------    --------------
<S>                                             <C>               <C>           
Current:
     Federal                                    $     (320,805)   $      390,127
     State                                             (39,516)          (13,366)

Deferred:
     Federal                                          (222,329)         (173,178)
     State                                             (29,426)          (22,923)
                                                --------------    --------------
Total                                           $     (612,076)   $      180,660
                                                ==============    ==============
</TABLE>


The differences between the statutory federal income tax rate and the Company's
effective income tax rate are as follows:

<TABLE>
<CAPTION>
                                                     1998               1997
                                                --------------     --------------
<S>                                             <C>                <C>  
Statutory federal income tax rate                        (34.0)%             34.0%
State income taxes, net of federal benefit                (2.6)              (5.1)
Meals and entertainment expenses                           0.8                3.3
Goodwill amortization                                      2.4                5.5
Other                                                      (.5)               0.7
                                                --------------     --------------
     Total                                               (33.9)%           38.4 %
                                                ==============     ==============
</TABLE>


The components of and changes in net deferred tax assets (liabilities) as of
December 31, 1998 and 1997, are as follows:


<TABLE>
<CAPTION>
                                                     1998              1997
                                                --------------    --------------
<S>                                             <C>               <C>           
Current Deferred Taxes:
Assets:
     Nondeductible reserves                     $      169,028    $      168,838
                                                --------------    --------------

Noncurrent Deferred Taxes:
Assets:
     Other                                              50,800            26,757
     Deferred gain from sale of option on
         real estate                                   303,926           338,680

Liabilities:
     Excess tax over book depreciation and
     amortization                                     (269,456)         (267,074)
     Software development costs                           --            (214,852)
                                                --------------    --------------
Noncurrent deferred taxes, net                          85,270          (116,489)
                                                --------------    --------------

Total deferred taxes                            $      254,298    $       52,349
                                                ==============    ==============
</TABLE>



                                      F-15
<PAGE>   46

                      MEDICALCONTROL, INC. AND SUBSIDIARIES
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                           December 31, 1998 and 1997



A valuation allowance must be provided when it is more likely than not that some
portion of the deferred tax asset will not be realized. The Company has not
established a valuation allowance because, in the opinion of management, the
Company will fully realize its deferred tax asset.


NOTE 11 - DEFERRED GAIN ON SALE OF OPTION ON REAL ESTATE

In connection with the Company's relocation of its corporate offices and
principal operations in January 1997, management secured a purchase option on
their new office facility. During September 1997, the Company sold this option
for $910,000 cash to a third party, who subsequently exercised the option.
Concurrent with the sale, the Company executed a ten-year lease extension. The
gain from this transaction will be recognized on a straight-line basis over the
life of the lease extension and is reflected as a deferred gain on the
accompanying balance sheet. The amount of gain amortization included in
operating results for the year ended December 31, 1998 and 1997 was $91,000 and
$29,583, respectively.


NOTE 12 - COMMITMENTS AND CONTINGENCIES

Leases

The Company leases certain office space, automobiles, furniture, and equipment
under noncancelable operating leases that expire at various dates through 2007.
During 1997, the Company relocated its principal operations and corporate
offices and executed a ten-year extension of its operating lease. In connection
with this move, the Company leased approximately $300,000 of certain furniture
and fixtures under terms of a 5-year operating lease. These commitments are
reflected in the table of future minimum lease payments.

At December 31, 1998, scheduled future minimum payments for operating leases
with initial terms in excess of one year are as follows:

<TABLE>
<CAPTION>
          Year ended
          December 31,                                   Amount
          ------------                                ------------
<S>                                                   <C>         
          1999                                        $    618,008
          2000                                             566,980
          2001                                             495,239
          2002                                             367,954
          2003                                             332,597
          Thereafter                                     1,212,480
                                                      ------------
                                                      $  3,593,258
                                                      ============
</TABLE>
 

Rental expense for all operating leases for the years ended December 31, 1998
and 1997, was $530,803 and $451,585, respectively.

During 1996, a subsidiary of the Company entered into a service agreement,
commencing January 1997, with a third party for use of their claims adjudication
software via on-line access to a data center. The term of this service agreement
is ten years and fees paid to the third party will be $1.00 per month for each
individual plan member served by the Company's subsidiary. Fees paid under this
agreement were $170,065 and $178,236 in 1998 and 1997, respectively.



                                      F-16
<PAGE>   47


                      MEDICALCONTROL, INC. AND SUBSIDIARIES
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                           December 31, 1998 and 1997


Litigation

The Company is involved in certain legal actions and claims arising in the
ordinary course of business. Management believes that such litigation and claims
will be resolved without material effect on the Company's financial position or
results of operations.


NOTE 13 - STOCKHOLDERS' EQUITY

Common Stock

In May 1993, the Company completed a stock offering consisting of 920,000 units
at a price per unit of $5.00. Each unit contained one share of common stock and
one warrant. The warrants were exercisable at a price of $7.50. The warrants
were redeemable by the Company at $.10 upon certain conditions, as defined. The
917,000 warrants that were outstanding as of December 31, 1996, expired during
April 1997.

In connection with the offering discussed above, the Company sold 80,000
warrants (the "Underwriter's Warrants") to the underwriter and its designees for
$100. Each Underwriter's Warrant enabled the holder to purchase one unit of the
Company's securities (one share of common stock and one warrant) for $6.00,
subject to adjustments and other conditions, as defined. The Underwriter's
Warrants were exercisable for a 48-month period commencing one year from their
date of issue and contained various registration rights. All of these warrants
expired during April 1997.

Stock Options

The Company has a nonqualified stock option agreement with the then sole
stockholder whereby the stockholder was granted options to purchase up to
300,000 additional shares of the Company's common stock at a price of $4.25. The
agreement expires on August 18, 1999 (subject to extension under certain
circumstances as defined). The options vest in 20% increments on each of the
first five anniversary dates of the agreement. Under certain specified events,
the vesting of the options may be accelerated.

The Company has stock option plans adopted in 1992 and 1993 which provide that
options for shares of the Company common stock may be granted to officers,
directors, and key employees of the Company at the fair market value on the date
of grant. The options expire 10 years from the date of grant (or earlier if
specified in the grant) and generally vest over a five year period. In 1993, the
Company also adopted a qualified stock option plan under Section 423 of the
Internal Revenue Code which provides that options for shares of the Company
stock may be granted to eligible employees of the Company at 85% of the fair
market value on the date of grant. The options vest one year from the date of
grant and expire 27 months thereafter. During 1998, the qualified plan was
terminated by the Company's Board of Directors. The following table sets forth
summarized information regarding the plans:




                                      F-17
<PAGE>   48

                      MEDICALCONTROL, INC. AND SUBSIDIARIES
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                           December 31, 1998 and 1997



<TABLE>
<CAPTION>
                                                                                                    Weighted
                                                                                                     Average
                                                           Shares               Option Price       Option Price
                                                       --------------        ------------------     -----------
<S>                                                    <C>                   <C>                    <C>        
     Outstanding at December 31, 1996                       1,202,139        $ 3.30   to $ 9.00     $      6.52
         Granted                                              230,994          3.38   to   5.13     $      3.82
         Exercised                                             (1,445)         4.36   to   4.36            4.36
         Forfeited                                            (33,780)         4.36   to   7.86            5.78
                                                       --------------        ------------------     -----------
     Outstanding at December 31, 1997                       1,397,908        $ 3.30   to $ 9.00     $      6.10
                                                       --------------        ==================     ===========
         Granted                                              286,995          4.46   to   7.81     $      6.39
         Exercised                                            (96,835)         3.38   to   5.13            4.40
         Forfeited                                            (43,540)         3.38   to   4.50            3.81
                                                       --------------       ------------------      -----------
     Outstanding at December 31, 1998                       1,544,528       $  3.38   to $ 9.00     $      6.30
                                                       ==============       ===================     ===========

     Exercisable options                                      946,551
                                                       ============== 
     Options available for future grants                      400,050
                                                       ============== 
</TABLE>


In 1994, the Company granted a stock option to a third party for financial
advisory services whereby the third party has the option to purchase up to
100,000 shares of the Company common stock at prices ranging from $6.00 to $9.00
per share. The option became fully vested as of November 12, 1994, and expires
over various dates through 1999.

Accounting for Stock-Based Compensation 

The Company has three stock option plans, a qualified plan, a non-qualified
plan, and directors' plan. The Company accounts for these plans under APB
Opinion No. 25, under which no compensation cost has been recognized. Had
compensation cost for these plans been determined consistent with SFAS No. 123,
the Company's pro-forma net income and diluted earnings per share would have
been the amounts shown below:

<TABLE>
<CAPTION>
                                               1998               1997
                                          --------------      -------------
<S>                                       <C>                 <C>          
      Pro-forma net income                $   (1,400,254)     $     165,001
      Pro-forma earnings per share        $         (.36)     $         .04
</TABLE>

The fair value of each option grant was estimated on the grant date using the
Black-Scholes option pricing model with the following weighted average
assumptions:

<TABLE>
<CAPTION>
                                              1998            1997
                                          ------------    ------------
<S>                                       <C>             <C> 
      Risk free interest rate                   5.1%             6.0%
      Expected dividend yield                   0.0%             0.0%
      Expected volatility                      43.9%            45.1%
      Expected lives                              5                5
</TABLE>

The weighted average fair value of options granted in 1998 and 1997 was $3.03
and $1.83, respectively.




                                      F-18
<PAGE>   49

                      MEDICALCONTROL, INC. AND SUBSIDIARIES
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                           December 31, 1998 and 1997

Because the SFAS No. 123 method of accounting has not been applied to options
granted prior to January 1, 1995, the resulting pro forma compensation cost may
not be representative of that to be expected in future years.


NOTE 13 - RELATED PARTY TRANSACTIONS

In October 1994, the Company loaned $300,000 to its chief executive officer. The
loan is secured by the pledge of 70,000 shares of the Company's common stock
held by the majority stockholder and is also guaranteed by the majority
stockholder. The loan accrues interest at a bank's prime rate plus 1% (9.5% at
December 31, 1998). The principal and any unpaid accrued interest are due in its
entirety by October 27, 2000. Accrued interest on this note was $121,175 and
94,654 at December 31, 1998 and 1997, respectively.

During April 1998, the Company filed a registration statement with the
Securities and Exchange Commission to register certain existing outstanding
shares of common stock owned by the majority shareholder of the Company. The
stock registered serves as collateral for certain loans of the majority
shareholder. During December 1998, the Company filed a second registration
statement to register shares of common stock issued in connection with the BHC
acquisition. In connection with these registration statements, the Company paid
approximately $6,500 of legal and accounting expenses.





                                      F-19

<PAGE>   50
                                 EXHIBIT INDEX

Exhibit 
Number                            Description  
-------                           -----------

3.1      Restated Certificate of Incorporation of the Registrant - incorporated
         by reference to the Exhibits to the Registration Statement on Form
         SB-2, file number 33-58334-FW, declared effective May 13, 1993.

3.2      Amended and Restated Corporate Bylaws of the Registrant - incorporated
         by reference to the Exhibits to the Registration Statement on Form
         SB-2, file number 33-58334-FW, declared effective May 13, 1993.

4.1      Form of Warrant Agreement - incorporated by reference to the Exhibits
         to the Registration Statement on Form SB-2, file number 33-58334-FW,
         declared effective May 13, 1993.

10.1     Amended and Restated Non-Qualified Stock Option Agreement -
         incorporated by reference to the Exhibits to the Registration Statement
         on Form SB-2, file number 33-58334-FW, declared effective May 13, 1993.

10.2     Outside Directors Stock Option Plan of MedicalControl, Inc., -
         incorporated by reference to the Exhibits to the Registration Statement
         on Form SB-2, file number 33-58334-FW, declared effective May 13, 1993.

10.3     First Amendment to the Outside Directors Stock Option Plan of
         MedicalControl, Inc. - incorporated by reference to the Exhibits to the
         Registration Statement on Form SB-2, file number 33-58334-FW, declared
         effective May 13, 1993.

10.4     Amendment to the Outside Directors Stock Option Plan of MedicalControl,
         Inc. dated August 20, 1996 - incorporated by reference to the Company's
         Annual Report on Form 10-KSB for the year ended December 31, 1997.

10.5     Amended and Restated Non-Qualified Stock Option Agreement (Issued Under
         Outside Directors Stock Option Plan). - incorporated by reference to
         the Exhibits to the Registration Statement on Form SB-2, file number
         33-58334-FW, declared effective May 13, 1993.

10.6     Qualified Employee Stock Purchase Plan of MedicalControl, Inc. -
         incorporated by reference to the Exhibits to Post Effective Amendment
         Number 1 to the Registration Statement on Form SB-2, file number
         33-58334-FW, dated January 30, 1995.

10.7     Amendment to Qualified Employee Stock Purchase Plan of MedicalControl,
         Inc. dated as of March 18, 1997 - incorporated by reference to the
         Company's Annual Report on Form 10-KSB for the year ended December 31,
         1997.




                                      
<PAGE>   51

10.8     1993 Stock Compensation Plan of MedicalControl, Inc. - incorporated by
         reference to the Exhibits to Post Effective Amendment Number 1 to the
         Registration Statement on Form SB-2, file number 33-58334-FW, dated
         January 30, 1995.

10.9     Amendment to 1993 Stock Compensation Plan of MedicalControl, Inc. dated
         as of August 20, 1996 - incorporated by reference to the Company's
         Annual Report on Form 10-KSB for the year ended December 31, 1997.

10.10    Stock Purchase Agreement, dated as of June 30, 1994, between Robert H.
         Soleau and David C. Bramer (as Sellers) and MedicalControl, Inc., a 
         Delaware corporation (as Purchaser) - incorporated by reference to
         the Current Report on Form 8-K dated August 15, 1994, file number
         1-11922.

10.11    Asset Purchase Agreement, dated as of October 3, 1994, between Group
         Administrators, Inc., a Texas corporation (as Seller) and 
         MedicalControl Administrators, Inc., a Texas corporation (as 
         Purchaser) - incorporated by reference to the Current Report on Form 
         8-K dated October 31, 1994, file number 1-11922.

10.12    Agreement and Plan of Reorganization, dated as of November 28, 1994,
         between Group Administrators - San Antonio, Inc., a Texas corporation,
         and MedicalControl Administrators San Antonio, Inc., a Texas 
         corporation and wholly-owned subsidiary of MedicalControl, Inc. - 
         incorporated by reference to the Current Report on Form 8-K dated 
         November 30, 1994, file number 1-11922.

10.13    Form of Agreement by and between the Company and each of its directors
         and officers - incorporated by reference to Registrant's Annual Report
         on Form 10-KSB for the year ended December 31, 1996.

10.14    Commercial Lease, dated March 1, 1993, by and among Diversified and 
         David C. and Janice L. Bramer - incorporated by reference to 
         Registrant's Annual Report on Form 10-KSB for the year ended 
         December 31, 1996.

10.15    Letter Agreement, dated September 29, 1994, by and between Registrant 
         and David C. Bramer - incorporated by reference to Registrant's Annual
         Report on Form 10-KSB for the year ended December 31, 1996.

10.16    Transfer Agreement, dated as of January 1, 1998, by and among the
         Registrant, MedicalControl Network Solutions, Inc., PPO Management
         Solutions, Inc., Genesis/ValueCheck, Inc., MedicalControl Holdings,
         Inc., and its direct and indirect wholly-owned subsidiaries. (All
         exhibits have been omitted and will be provided to the Commission upon
         request.) - incorporated by reference to Registrant's Annual Report on 
         Form 10-KSB for the year ended December 31, 1997.

10.17    Stock Purchase Agreement, dated September 10, 1998, by and between 
         MedicalControl Network Solutions, Inc., Business Health Companies, 
         Inc., Ralph T. Smith, Donald Richard Huntington and Douglas Elden. -
         incorporated by reference to Registrant's Special Report on Form 8-K
         filed October 9, 1998.

10.18    Employment Confidentiality and Non-Competition Agreement, dated
         September 25, 1998, by and among MedicalControl Network Solutions,
         Inc., registrant and Donald Richard Huntington

10.19    Employment, Confidentiality and Non-Competition Agreement, dated
         September 25, 1998, by and among MedicalControl Network Solutions,
         Inc., registrant and Ralph T. Smith

10.20    Loan Agreement, dated September 25, 1998, by and between the registrant
         and Bank One, Texas, N.A.

10.21    First Amendment to Loan Agreement, dated as of March 31, 1999, by and 
         between Bank One, Texas N.A. and the registrant.

21       Subsidiaries of the Registrant.






<PAGE>   52

23.7     Consent of Arthur Andersen LLP, independent public accountants.

27       Financial Data Schedule.