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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549



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FORM 10-K



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|x | ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
|- | ------------------------------------------------------------------------------------



For the fiscal year ended December 31, 2004



OR



| ̈ | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
|- | ----------------------------------------------------------------------------------------



For the transition period from
 to



Commission File Number 0-31014



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HEALTHEXTRAS, INC.

(Exact name of registrant as specified in its charter)



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|                                                               |  |                                        
|-------------------------------------------------------------- |  | ---------------------------------------
|Delaware                                                       |  | 52-2181356                             
|(State or other jurisdiction of incorporation or organization) |  | (I.R.S. Employer Identification Number)



800 King Farm
Boulevard, Rockville, Maryland 20850

(Address of principal executive offices, zip code)



Registrants phone number, including area code (301) 548-2900



|                    |  |                                          
|------------------- |  | -----------------------------------------
|Title of each class |  | Name of each exchange on which registered
|Common Stock        |  | NASDAQ National Market                   



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

Securities registered pursuant to 12(g) of the Act: Common Stock, $0.01 par value



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Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the
preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No ̈



Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be
contained, to the best of the registrants knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K: ̈



Indicate
by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act)    Yes  x    No ̈



The
aggregate market value of the voting and non-voting common equity held by non-affiliates was $241,957,040 based on the closing price of $14.60 at which the common equity was last sold by the registrant. Solely for the purposes of this calculation,
directors and officers of the registrant are deemed to be affiliates.



Documents incorporated by reference:



The Companys Proxy
Statement for its annual meeting of stockholders to be held on June 7, 2005, a definitive copy of which will be filed within 120 days of December 31, 2004, is incorporated by reference in Part III of this Report on Form 10-K.



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TABLE OF CONTENTS



|           |  |                                                                                                              |  |     
|---------- |  | ------------------------------------------------------------------------------------------------------------ |  | ----
|           |  |                                                                                                              |  | Page
|PART I     |  |                                                                                                              |  |     
|           |  |                                                                                                             
|Item 1.    |  | Business                                                                                                     |  | 3   
|Item 2.    |  | Properties                                                                                                   |  | 19  
|Item 3.    |  | Legal Proceedings                                                                                            |  | 20  
|Item 4.    |  | Submission of Matters for a Vote of Security Holders                                                         |  | 20  
|           |  |                                                                                                             
|PART II    |  |                                                                                                              |  |     
|           |  |                                                                                                             
|Item 5.    |  | Market for Registrants Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities |  | 21  
|Item 6.    |  | Selected Financial Data                                                                                      |  | 22  
|Item 7.    |  | Managements Discussion and Analysis of Financial Condition and Results of Operations                        |  | 23  
|Item 7A.   |  | Quantitative and Qualitative Disclosures About Market Risk                                                   |  | 41  
|Item 8.    |  | Financial Statements and Supplementary Data                                                                  |  | 41  
|Item 9.    |  | Changes in and Disagreements with Accountants on Accounting and Financial Disclosure                         |  | 41  
|Item 9A.   |  | Controls and Procedures                                                                                      |  | 41  
|Item 9B.   |  | Other Information                                                                                            |  | 42  
|           |  |                                                                                                             
|PART III   |  |                                                                                                              |  |     
|           |  |                                                                                                             
|Item 10.   |  | Directors and Executive Officers of the Registrant                                                           |  | 43  
|Item 11.   |  | Executive Compensation                                                                                       |  | 43  
|Item 12.   |  | Security Ownership of Certain Beneficial Owners and Management                                               |  | 43  
|Item 13.   |  | Certain Relationships and Related Transactions                                                               |  | 43  
|Item 14.   |  | Principal Accountant Fees and Services                                                                       |  | 43  
|           |  |                                                                                                             
|PART IV    |  |                                                                                                              |  |     
|           |  |                                                                                                             
|Item 15.   |  | Exhibits and Financial Statement Schedules                                                                   |  | 44  
|           | 
|SIGNATURES |  |                                                                                                             



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Special Note Regarding Forward Looking Statements



This Form 10-K, including the documents incorporated by reference, contains certain forward-looking statements, including without
limitation, statements concerning HealthExtras, Inc.s operations, economic performance and financial condition. These forward-looking statements are made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of
1995. The words believe, expect, anticipate and other similar expressions generally identify forward-looking statements. Readers are cautioned not to place undue reliance on these forward-looking statements, which
speak only as of their dates. These forward-looking statements are based largely on HealthExtras, Inc.s current expectations and are subject to a number of risks and uncertainties, including, without limitation, those identified under
Managements Discussion and Analysis of Financial Condition and Results of Operations and elsewhere in this Form 10-K, including the documents incorporated by reference. Actual results could differ materially from results referred
to in the forward-looking statements. In addition, important factors to consider in evaluating such forward-looking statements include changes in external market factors, changes in HealthExtras, Inc.s business or growth strategy or an
inability to execute its strategy due to changes in its industry or the economy generally. In light of these risks and uncertainties, there can be no assurances that the results referred to in the forward-looking statements contained in this Form
10-K will in fact occur. HealthExtras, Inc. undertakes no obligation to publicly revise these forward-looking statements to reflect any future events or circumstances.



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PART I



THE COMPANY



ITEM 1. BUSINESS



The following description of
our business should be read in conjunction with the information included elsewhere in this Form 10-K for the year ended December 31, 2004. This description contains forward-looking statements that involve risks and uncertainties. Our actual results
could differ significantly from the results discussed in the forward-looking statements due to the factors set forth in Risk Factors and elsewhere in this Form 10-K. References in this Form 10-K to we, our,
us, or the Company, refer to HealthExtras, Inc.



OVERVIEW



HealthExtras, Inc. provides
pharmacy benefit management, PBM, services and supplemental benefit programs. Our PBM segment, which operates under the brand name Catalyst Rx, accounted for 91%, 86% and 73% of our revenue in 2004, 2003 and 2002, and is
expected to be the primary source of our growth and profits in the future. Our PBM clients include more than 1,000 self-insured employers, including state and local governments, third-party administrators, TPAs, and managed care
organizations, who contract with us to administer the prescription drug component of their overall health benefit programs. Total claims processed increased to 12.8 million in 2004 from 9.0 million in 2003, respectively and our PBM segment revenue
increased by 43.3% from 2003 to 2004.



We also offer supplemental benefit
programs developed by us under the brand name HealthExtras, which include lump sum accidental disability benefits, accidental death and dismemberment benefits, and emergency accident and sickness medical benefits. We contract with
insurance companies to underwrite the insurance components of these programs. As a result, the financial responsibility for the payment of claims resulting from a qualifying event covered by the insurance features of our programs is borne by the
third-party insurers. Our supplemental benefits segment accounted for 9%, 14% and 27% of our revenue in 2004, 2003 and 2002, respectively. Individuals are the major purchasers of these programs.



The Company is incorporated in Delaware. Our principal executive offices are located at 800
King Farm Boulevard, 4thFloor, Rockville, Maryland 20850. Our telephone number is 301-548-2900.



Our Internet website is www.healthextras.com. We make available free of charge on or
through the website our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and any amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934 as
soon as reasonably practicable after we electronically file such material with, or furnish it to, the Securities and Exchange Commission (SEC). This reference to the Companys website is for the convenience of shareholders as
required by the Securities and Exchange Commission and shall not be deemed to incorporate any information on the website into this Form 10-K or the Companys other filings with the SEC.



PHARMACY BENEFIT MANAGEMENT



The Companys PBM segment, Catalyst Rx, provides its clients access to a contracted,
non-exclusive national network of more than 53,000 pharmacies. Catalyst Rxs services provide our clients members with timely and accurate benefit adjudication, while controlling pharmacy spending trends through customized plan designs,
physician orientation programs, and member education. Catalyst Rx maintains an electronic point-of-sale system of eligibility verification and plan design information, and offers access to rebate arrangements for certain branded pharmaceuticals.
When a member of one of our clients presents a prescription or health plan identification card to a retail pharmacist in our network, our system provides the pharmacist with access to online information regarding eligibility, patient history, health
plan formulary listings, and contractual reimbursement rates. The member generally pays a co-payment to the retail pharmacy and the pharmacist fills the prescription. We electronically aggregate pharmacy benefit claims, which include prescription
costs plus our claims processing fees for consolidated billing and payment. We receive payments from clients, make payments of amounts owed to the retail pharmacies pursuant to our negotiated rates, and retain the difference, including claims
processing fees.



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On June 18, 2004, we acquired 100% of the common stock of Managed Healthcare Systems, Inc. (MHS). We believe
our acquisition of MHS allows us to offer an improved range of services to our existing clients, facilitates the expansion of our business development initiatives in Florida, and increases our revenue and cash flow. We believe that the integration
of MHS into our existing operations should be fully and successfully completed by the third quarter of 2005.



On July 1, 2004, we began providing PBM services to employees, dependents and retirees under a contract with the State of Louisiana, which covers approximately 180,000 lives and has a three-year term. It is the
largest contract ever awarded to us in terms of revenue and covered lives. This contract generated 13.0% of our PBM revenue in 2004. This contract is important not only for its size but because it was awarded in a highly competitive and thorough
selection process. The award and successful implementation of the contract should position us favorably for additional growth opportunities in both the public and private sectors.



The Industry



The PBM industry has developed and grown in response to the increased utilization of pharmaceuticals, increasing unit costs and broader application of prescription drugs
to various conditions. These factors have combined to create a significant and recurring escalation in the cost of drug coverage offered by managed-care organizations, self-insured employers and third party administrators. In order to understand,
manage and mitigate these trends, many of these payor organizations have contracted for the specialized services offered by PBMs.



According to 2004 survey data from national benefits consultants, employer sponsored pharmacy benefit costs increased between 16.3% and 14.3% annually in each of the four
years ended in 2003. Current projections generally anticipate that increases for 2005 will be in excess of 15%. In the context of overall employer-sponsored health care cost increases, pharmacy costs have been escalating at a rate approximately 40%
higher than that of overall spending. The persistence of these trends has resulted in an increasing willingness on the part of payors to embrace plan design changes and other options to curb these levels of cost escalation.



The factors contributing to the increase in pharmacy spending include:



| |  |  | The introduction of new and expensive drug therapies and greater reliance on drug therapy by the physician community,
| | - |  | ---------------------------------------------------------------------------------------------------------------------



| |  |  | Increased preventative prescribing to manage high cholesterol levels and digestive disorders,
| | - |  | -----------------------------------------------------------------------------------------------



| |  |  | Efforts by drug manufacturers to increase market share and extend single-source brand use,
| | - |  | ------------------------------------------------------------------------------------------



| |  |  | The introduction of improvements over existing therapies, which normally carry higher unit prices than existing formulations,
| | - |  | -----------------------------------------------------------------------------------------------------------------------------



| |  |  | Increased patient demand and education as a result of direct-to-consumer advertising and other pharmaceutical marketing or promotional efforts,
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | An aging workforce,
| | - |  | -------------------



| |  |  | Increased obesity among all age groups, and
| | - |  | -------------------------------------------



| |  |  | Improved techniques and technology to detect and diagnose diseases.
| | - |  | -------------------------------------------------------------------



PBMs are responsible for implementing and administering benefit plans that seek to lower overall prescription spending by encouraging generic utilization, increasing the
proportion of brand drugs dispensed from the preferred category and encouraging, where appropriate, non-prescription therapy and treatment alternatives. These objectives are accomplished through a combination of administrative, educational and
technology initiatives directed towards pharmacies, physicians and members.



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Over the past several years, plan design has increasingly focused on the use of three-tier co-payment structures.
Co-payments represent that portion of the cost of a prescription paid for by the member at the time the drug is dispensed. The purpose of these designs and the use of drug specific formulary lists is to create financial incentives for members to
utilize generic drugs where available and to select the most cost-effective brand drugs indicated for a specific diagnosis or condition. In general, these plans incorporate the lowest member co-payments for generic drugs, with increases for
preferred brand drugs and reaching their highest level for non-preferred brands. Typically these categories might require member co-payments of $10, $20 and $35 respectively. The use of these tiered plans has increased significantly over the past
several years and now applies to approximately 70% of employer-sponsored members. As importantly, both the levels of member co-payment and the differential between tiers has continued to increase.



Competition



We believe the primary competitive factors in our PBM business are price, quality of service and scope of available services. Scale is an
important factor in negotiating prices with pharmacies and manufacturers. Though we have other advantages to offset our comparatively small scale, we could face more pricing competition in the future.



There are a number of national and regional PBMs in the United States, several of which have
significantly greater financial, marketing and technological resources at their disposal to expand their client base and grow their businesses. The largest national companies include Medco, Express Scripts and Caremark. There are also large health
insurers and certain HMOs which have their own PBM capabilities. Our competitors also include drug retailers and physician practice management companies.



Some of our PBM services, such as disease management services, informed decision counseling services and medical information management services, compete with those being
offered by pharmaceutical manufacturers, other PBMs, specialized disease management companies and information service providers.



Market share for PBM services in the U.S. is highly concentrated, with a few firms controlling over 70% of prescription volume. We have demonstrated our ability to serve
a broad range of clients from large managed care organizations to employer groups with fewer than a thousand members. We believe the following are our principal competitive strengths:



Flexible and Customized Services.Because we are not affiliated with any pharmaceutical manufacturer, and because we do not own a
full-service mail-order facility, the formulary and plan designs we suggest to clients are highly flexible and not subject to influence from manufacturer relationships. Our larger competitors that have manufacturer affiliations or mail order assets
are often in a position where they may benefit from increasing the volume of drug utilization generally or that of certain specific drugs. These conflicts arise where revenues from pharmaceutical manufacturers may support the inclusion of certain
drugs on formulary which would not otherwise be included or may result from mail order utilization serving as an important source of profit for the PBM.



Local Market Presence.Our local market presence in Florida, Georgia, Louisiana, Nevada, New Mexico, Oklahoma, Texas and the Carolinas allows us to offer
attractive benefit pricing based on local pharmacy network rates and formulary design. We support our local markets from our primary operating facilities in Rockville, Maryland, Las Vegas, Nevada and Raleigh, North Carolina. These offices provide
account management, customer service and clinical support programs including dedicated clinical pharmacists with expertise in plan design, treatment protocols and various cost management initiatives.



Information-Based Cost-Containment Methods.Through the use of our customized
information technology systems, we believe that we provide our clients and members with access to information on a rapid basis that allows us to work with our clients to manage the costs of prescription drugs. For example, our Web-based systems
allow our clients to choose which metrics are most important to them for the purposes of evaluating their pharmacy benefit management program. We then provide customized reporting solutions for these key performance indicators. In addition, members
can access our Web-based programs to evaluate the costs and benefits of the options for prescription drugs, including over-the-counter alternatives, to which they have access through our benefit programs. We believe these services allow us to
further differentiate ourselves from our competitors.



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Our Business Strategy



We seek to continue to increase our client base, revenue and profits. We intend to accomplish this by capitalizing on our competitive strengths and helping to address the
challenges confronting payors.



Increasing our PBM Client Base by Targeting
Certain Market Segments.



We have identified four segments of the market
that provide us with the greatest opportunity for growth. We intend to focus our sales and marketing efforts to target these segments in order to gain new clients and increase our membership base and revenues. Our analysis of our market opportunity
by segment is as follows:



| |  |  | Large Employer Groups (Self-Insured):Representing over 12 million lives, employers in this segment are large enough to need a full-service PBM solution to manage their
increasing prescription benefits costs, but are not Fortune 500-size companies that typically are only served by the largest PBMs. By utilizing our information-based cost containment strategies, we offer these clients favorable results compared to
larger PBMs, and a greater level of customer service.
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | State and Local Governments:State and local governments are also employers who provide health benefits to their employees and retirees. Some state governments have a
workforce and retiree population that rivals a Fortune 1000 employer. These clients are seeking the same customer service, attention to detail, and bottom line results as private sector employers. Because the vast majority of members in this market
segment are geographically concentrated, we can analyze the prescribing and utilization trends associated with a state and local government entity and actively influence physicians prescribing practices in a particular region. These physician
interactions draw on peer-reviewed clinical studies, generic drug utilization patterns, and the insights offered by the physicians themselves to deliver better care at lower costs.
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Third-Party Administrators (TPAs):There are hundreds of TPAs in the U.S. that focus primarily on administering the health benefits of their clients. TPAs provided services
to over 17 million employees, dependents, and retirees, paying over $17 billion annually in total health claims. As the TPA market continues to consolidate, and TPA clients increasingly seek out complete health benefits solutions from their TPA, we
believe an increasing number of TPAs will be seeking a PBM partner to administer the prescription benefits of their clients.
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Mid-Tier Managed Care Organizations (MCOs):There are hundreds of MCOs that each provide coverage to fewer than 200,000 lives. These MCOs collectively represent more than 20
million lives and $8.5 billion in annual drug spending. We believe that MCOs of this size are increasingly dissatisfied with the level of service and results they are receiving from larger PBM companies that devote most of their attention to MCOs
that have more than one million members. We have demonstrated that we can provide these MCOs with a complete, full-service PBM that includes all of the features that larger PBMs offer, with superior customer service, market-specific retail networks
and customized benefit plans.
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



Leveraging Local Market
Dynamics to Build Customized Networks and Manage Drug Spending.



Although
clients contract with us to provide PBM services nationwide, capitalizing on local and regional market dynamics is an effective way to manage drug spending and differentiate our PBM services from those offered by our competitors.



| |  |  | Customized Pharmacy Networks:In order to obtain greater pharmacy discounts for our clients, we work with clients to identify pharmacies that will agree to deeper
prescription discounts in a specific locality, based on the concentration of client members in that area, and the resulting store traffic those members represent to a drug, grocery, or retail chains non-pharmacy business. We have established
customized pharmacy networks in Florida, Georgia, Louisiana, Nevada, New Mexico, Oklahoma, Texas, and the Carolinas and intend to develop similar networks in other parts of the country.
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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| |  |  | Data Analysis and Reporting to Improve Cost Management and Quality of Care:We perform client-specific data analysis to monitor trends and develop insights and conclusions
that result in improved care while reducing costs. Many PBMs offer a variety of data analysis techniques from both a clinical and financial perspective. We differentiate ourselves by using the information we derive from our systems to obtain
regionally favorable prescription pricing, to actively influence the drivers of prescription drug utilization and to monitor clinical formulary and disease management trends.
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Extensive Use of Internet Facilities to Enhance Account Management Effectiveness:We provide our clients Web-enabled decision support for prescription benefit plan
management, clinical evaluations, disease management, and compliance monitoring. These data analysis and reporting capabilities allow clients to assess top-level trend information for total population management and to analyze detail for a
particular drug, physician, member, or pharmacy. This functionality enables our clients to measure successes relative to formulary and disease management initiatives and assists in the identification of specific patient populations that may benefit
from specialty pharmacy programs.
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



Offering Our Clients a
Variety of Specialized Services Focused On Improving Health Outcomes.



Clinical and Other Services.Our clinical service teams work closely with clients to design and administer pharmacy benefit plans that use formularies and other techniques to promote clinically appropriate and cost-effective drug
usage. We are often able to influence physician prescribing patterns by comparing individual behavior to physician peer groups and encouraging change where practices differ from peer group norms and medical best practices. Because we operate with
significant geographic focus, the consultations between our clinical pharmacists and local physicians tend to have higher levels of effectiveness compared with less concentrated initiatives. Similarly, our programs with retail pharmacies support
therapeutic interchange programs that encourage the evaluation of cost-effective drug alternatives where appropriate. We also offer consulting services to assist clients in designing education and communication programs designed to support
cost-effective prescription drug programs.



Disease Management.We
assist clients in managing the cost and treatment of specific chronic diseases in order to improve medical outcomes and lower the overall cost of health care. These disease management programs monitor the contracted population and intervene when
individuals demonstrate symptoms of a specific disease or high risk indications.



Our disease management programs are the responsibility of a dedicated team of clinicians and have been developed around three-key approaches:



| |  |  | Data Analysis and Integration.We evaluate and identify medical, laboratory, pharmacy and other relevant data within an identified population.
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Case Identification.We identify patients who have a specific disease and evaluate the appropriateness of targeted interventions.
| | - |  | --------------------------------------------------------------------------------------------------------------------------------



| |  |  | Clinical and Program Interventions.We communicate with identified patients and offer enhanced education about their condition and effective management tools. We also
integrate our recommendations with those of physicians, including treatment guidelines, patient profiles and patient management tools. Case management intervention programs are coordinated with other care-givers to monitor outcomes and improve
overall care.
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



Pursuing Selective Acquisitions.



Consolidation has been, and may continue to be, an important factor in
all aspects of the pharmaceutical industry, including the PBM segment. We will continue to evaluate additional acquisition and joint venture opportunities to enhance our business strategy.



We have successfully integrated three strategic acquisitions over the last four years. Our
acquisitions have provided us with a more diverse and complete set of products and services to sell to a larger customer base. For example, Catalysts previously developed demand management, generic substitution and other clinical programs have
significantly enhanced our ability to serve larger and more sophisticated customers. The acquisitions have also



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allowed us to better capture efficiencies in corporate overhead and information technology investments. In each of these acquisitions, we achieved our
objectives by integrating operations, realizing operating efficiencies, improving profitability and growing the revenue base of the acquired businesses. We acquired MHS in June 2004 and are in the process of integrating its operations. We will
continue to look for acquisition opportunities that complement our existing operations and have characteristics similar to the companies previously acquired. These characteristics include geographic membership concentrations, opportunities to
improve profitability and a base from which to generate revenue growth.



Customers.



One of our customers, the State of Louisiana,
accounted for 13.0% of our PBM segment revenues and 11.8% of our consolidated revenues in 2004. Also, our ten largest customers accounted for 51.0% of our PBM segment revenues and 46.5% of our consolidated revenues in 2004.



PBM Services



We provide our clients the tools, information, and specialized expertise needed to offer the best drug therapy to their membership, while
simultaneously working to lower the costs associated with a pharmacy benefit plan. Our PBM services involve managing member prescription drug utilization to ensure high-quality, cost-effective pharmaceutical care through a combination of managed
care principles, advanced data analysis and technologies, and the management of client specific cost control initiatives. Our PBM services include:



| |  |  | Benefit plan design and consultation:Our pharmacy professionals work in conjunction with our clients to design benefit plans that meet the needs of our clients and their
members. We seek to maximize the quality of care members receive while controlling the cost of providing prescription pharmaceutical coverage by, among other efforts, creating financial incentives and reimbursement limitations on the drugs covered
by our plan, offering generic utilization incentives, and imposing reimbursement limitations on the amount of a drug that can be obtained in a specific period.
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Formulary administration:We seek to maximize the clinical appropriateness of all drugs covered by our plans. In doing so, we actively seek to promote the use of drugs that
our clients identify as the preferred prescription alternative for certain clinical conditions, thereby reducing unnecessary overuse of new drugs or reformulations of old drugs in inappropriate conditions.
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Formulary compliance and therapeutic intervention programs:We seek to encourage compliance with the formularies established in conjunction with our clients for our plans by
instituting guidelines that create financial incentives both for our clients members and our pharmacy networks to comply with the formulary. For example, we design plan features such as tiered co-payments that require a member to pay more for
a non-formulary drug. At the same time, we also encourage the appropriate use of prescription drugs through prescriber education programs. Finally, we seek to encourage the use of generic formulations of branded pharmaceuticals, thereby lowering the
cost of prescription pharmaceuticals without compromising efficacy.
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Retail pharmacy network contracting and administration:We contract with more than 53,000 retail pharmacies nationwide at competitive discount rates which allows our members
to access their benefits at a broad array of locations. We may offer clients access to sub-networks where higher discounts are available when offering a limited network of retail pharmacies to their members. We work with our retail pharmacy network
providers to achieve the goals of our clients: quality, responsible, and cost-effective prescription drug coverage for their members.
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Advanced decision support and data analysis services:We are able to help manage the expansion in the cost of providing prescription drug coverage through intensive analysis
and review of utilization data of our clients members. By recognizing inappropriate use or dispensing of certain prescription drugs for certain member groups or at certain network pharmacies, we are able to help limit rapid inflation in
prescription expenses.
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Flexible, customized reporting available via secure Internet connection:We provide our clients members the ability to compare options available to them for certain
prescription drugs through our comprehensive Web site. For example, on our Web site members can compare the various options available to them for allergy medication, such as branded prescription pharmaceuticals, a generic alternative, or an
over-the-counter formulation.
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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| |  |  | Contracted mail order pharmacy:We are able to help control the costs of providing prescription drug coverage for our clients through the use of mail order distribution
capabilities to which we have access through contractual arrangements. We have negotiated favorable rates for our clients that allow them to maintain desired clinical outcomes while limiting prescription drug costs.
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



SUPPLEMENTAL BENEFITS



Supplemental Benefit Programs



We currently offer under the brand name, HealthExtras, supplemental benefit
programs developed by us, which include lump sum accidental disability benefits, accidental death and dismemberment benefits, and emergency accident and sickness medical benefits. Our supplemental benefits segment accounted for approximately 9% and
14% of our revenue in 2004 and 2003, respectively. We have an agreement to use certain endorsements and likenesses of former actor and advocate Christopher Reeve to promote our supplemental benefit programs.



In recent periods, our supplemental benefit programs have been marketed and sold to
individuals primarily by American Express, Citibank and Stonebridge who incur the marketing expenses. Accordingly, the generation of supplemental benefit program revenue from new members is primarily dependent on the extent and timing of marketing
campaigns funded by these three companies and the success they achieve.



We
contract with insurance companies to underwrite the insurance components of these programs. As a result, the financial responsibility for the payment of claims resulting from a qualifying event covered by the insurance features of our programs is
borne by the third-party insurers. All of the insurance and service features included in our programs are supplied by third-party insurance companies or other vendors, and the programs are distributed through an independent, licensed and
non-affiliated insurance agency.



Our agreements with the program marketers are
typically for a term of 12 months, with automatic annual renewals unless cancelled upon written notice 30 or 90 days prior to an anniversary date. Some contracts also provide for termination by either party without cause upon 30 or 90 days prior
written notice.



Competition



Our supplemental benefit programs compete with the traditional distributors of disability
and accident insurance, such as captive agents, independent brokers and agents, and direct distributors of insurance, and with banks, securities firms and mutual fund companies that sell insurance or alternative products to similar consumers. We
believe that the principal competitive factors in our supplemental disability and accident benefits markets are price, brand recognition, marketing expenditures and customer service. Many of our current and potential competitors have longer
operating histories, larger consumer bases, greater brand recognition and significantly greater financial, marketing, technical and other resources than our own. Certain of these competitors may be able to secure products and services on more
favorable terms than we can obtain.



Any of the distributors described above
could seek to compete against us in providing supplemental benefits through traditional channels or by copying our products or business model. Increased competition may result in reduced operating margins, loss of market share and damage to our
brand.



GOVERNMENT REGULATION



Various aspects of our business are governed by federal and state laws and regulations.
Because sanctions may be imposed for violations of these laws, compliance is a significant operational requirement. We believe we are in substantial compliance with all existing legal requirements material to the operation of our business. There
are, however, significant uncertainties involving the application of many of these legal requirements to our business. In addition, there are numerous proposed health care laws and regulations at the federal and state levels, many of which could
adversely affect our business, results of operations and financial condition. We are unable to predict what additional federal or state legislation or regulatory initiatives may be enacted in the future relating to our business, or the health care
industry in general, or what effect any such legislation or regulations might have on us. We also



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cannot provide any assurance that federal or state governments will not impose additional restrictions or adopt interpretations of existing laws or
regulations that could have a material adverse effect on our business or financial performance.



Some of the state laws described below may be preempted in whole or in part by the Employee Retirement Income Security Act of 1974, ERISA, which provides for comprehensive federal regulation of employee
benefit plans. However, the scope of ERISA preemption is uncertain and is subject to conflicting court rulings. We also provide services to certain clients, such as governmental entities, that are not subject to the preemption provisions of ERISA.



Federal Laws and Regulations Affecting the PBM Segment



The following descriptions identify various federal laws and regulations that affect or may
affect aspects of our PBM business:



Medicare Prescription Drug,
Improvement, and Modernization Act of 2003.



On December 8, 2003,
President Bush signed the Medicare Prescription Drug, Improvement, and Modernization Act of 2003, referred to as MMA. MMA created an endorsed Medicare voluntary prescription drug discount card and transitional assistance program that took effect in
the spring of 2004 and a new voluntary outpatient prescription drug benefit that is scheduled to take effect on January 1, 2006. The MMA also created new guidelines for Medicare HMOs (termed Medicare Advantage Plans) which offer both an outpatient
prescription drug benefit and health care coverage.



The drug discount card and
transitional assistance program was created as an interim program until the commencement of the new Medicare drug benefit in 2006. The voluntary drug discount card program enables Medicare beneficiaries to pay a fixed fee to access discounts on
drugs. On March 26, 2004, the Center for Medicare and Medicaid Services, CMS, approved 28 private sponsors for the transitional drug discount card program. While we were selected as a national voluntary drug discount card program
sponsor, we opted not to participate in this transitional prescription drug discount program. Endorsed card sponsors must offer the drug discount card program until the end of the transition period. The transition period will be from January 1, 2006
until the effective date of the individuals enrollment in the new Medicare drug benefit or the last day that individuals may enroll in the new Medicare drug benefit through the open enrollment process.



As stated above, the MMA also created a new voluntary outpatient prescription drug benefit
under Medicare to begin January 1, 2006. Medicare beneficiaries who elect such coverage will pay a monthly premium for the covered outpatient drug benefit. Assistance with premiums and cost sharing are provided to eligible low-income beneficiaries.
The voluntary outpatient prescription drug benefit requires coverage of essentially the same pharmaceuticals that are approved for the Medicaid program, although selection may be restricted through a formulary. The new outpatient prescription drug
benefit will be offered on an insured basis by Prescription Drug Plans, PDPs, in 34 regions across the United States and by Medicare Advantage Plans, along with health care coverage, in 26 regions across the United States.



In order to qualify as a regional PDP, a plan needs to be licensed as a risk bearing entity
in the state(s) in which it offers the plan(s) or meet other solvency and financial standards created by the Secretary of the Department of Health and Human Services, DHHS. In addition, there are extensive requirements that will need to
be met, including maintaining an adequate network of community pharmacies and providing beneficiaries with access to negotiated prices. Regional PDPs and Medicare Advantage Plans will be selected through a competitive bidding process in 2005.



The MMA also provides a provision for fallback plans in regions where less
than two plans from two different sponsors, one of which must be a PDP, are offered. Fallback plans are not risk bearing entities like PDPs; rather such plans are paid a set administrative fee and also reimbursed by Medicare for the actual cost of a
beneficiarys prescriptions. Fallback plans, like PDPs, will be selected through a competitive bidding process in 2005.



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We are considering bidding to become either a PDP or a fallback plan in one or more regions. If chosen as a PDP or as a
fallback plan, it will be the first time that we will be a direct contractor with the federal government and subject directly to the rules, regulations and enforcement authority of the federal government over contractors. PDPs and fallback plans are
also subject to extensive requirements, including reporting certain rebate information and providing beneficiaries and CMS access to negotiated prices.



Federal Anti-Remuneration/Fraud And Abuse Laws.



The federal healthcare Anti-Kickback Statute prohibits, among other things, an entity from paying or receiving, subject to certain exceptions and safe
harbors, any remuneration, directly or indirectly, to induce the referral of individuals covered by federally funded health care programs, including Medicare, Medicaid and the Civilian Health and Medical Program of the Uniformed Services,
CHAMPUS, or the purchase, or the arranging for or recommending of the purchase, of items or services for which payment may be made in whole or in part under Medicare, Medicaid, CHAMPUS or other federally funded health care programs.
Sanctions for violating the Anti-Kickback Statute may include imprisonment, criminal and civil fines, and exclusion from participation in the federally funded health care programs.



The Anti-Kickback Statute has been interpreted broadly by courts, the Office of Inspector General within the DHHS, the OIG, and
other administrative bodies. Because of the statutes broad scope and the limited statutory exceptions, federal regulations establish certain safe harbors from liability. For example, safe harbors exist for certain properly disclosed and
reported discounts received from vendors, certain investment interests, certain properly disclosed payments made by vendors to group purchasing organizations, certain personal services arrangements, and certain discount and payment arrangements
between PBMs and HMO risk contractors serving Medicaid and Medicare members. A practice that does not fall within an exception or a safe harbor is not necessarily unlawful, but may be subject to scrutiny and challenge. In the absence of an
applicable exception or safe harbor, a violation of the statute may occur even if only one purpose of a payment arrangement is to induce patient referrals or purchases of products or services that are reimbursed by federal health care programs.
Among the practices that have been identified by the OIG as potentially improper under the statute are certain product conversion programs in which benefits are given by drug manufacturers to pharmacists or physicians for changing a prescription, or
recommending or requesting such a change, from one drug to another. The Anti-Kickback Statute has been cited as a partial basis, along with state consumer protection laws discussed below, for investigations and multi-state settlements relating to
financial incentives provided by drug manufacturers to retail pharmacies in connection with such programs.



Additionally, it is a crime under the Public Contractor Anti-Kickback Statute, for any person to knowingly and willfully offer or provide any remuneration to a prime contractor to the United States, including a
contractor servicing federally funded health programs, in order to obtain favorable treatment in a subcontract. Violators of this law also may be subject to civil monetary penalties.



In April 2003, the OIG published Final OIG Compliance Program Guidance for Pharmaceutical Manufacturers, referred to as
Compliance Guidance. The Compliance Guidance is voluntary and is directly aimed at the compliance efforts of pharmaceutical manufacturers. This Compliance Guidance highlights several transactions as potential risks, including
the provision of grants to PBMs to support disease management programs and therapeutic interchanges. The Compliance Guidance recognizes that formulary development is unlikely to raise significant anti-remuneration issues as long as the
decision-making process places clinical efficacy and drug appropriateness before cost considerations.



To our knowledge, these anti-remuneration laws and regulations have not been interpreted to prohibit PBMs from receiving payments from drug manufacturers in connection with certain drug purchasing and formulary
management programs, certain therapeutic intervention programs conducted by independent PBMs, or other contractual relationships, such as those we have with certain of our clients. Furthermore, we believe that we are in substantial compliance with
the legal requirements imposed by such anti-remuneration laws and regulations. However, there can be no assurance that we will not be subject to scrutiny or challenge under such laws or regulations. Any such challenge could have a material adverse
effect on our business, results of operations and financial condition.



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Federal Statutes Prohibiting False Claims.



The Federal False Claims Act imposes civil penalties for knowingly making or causing to be made false claims with respect to governmental
programs, such as Medicare and Medicaid, for services not rendered, or for misrepresenting actual services rendered, in order to obtain higher reimbursement. Private individuals may bring qui tamor whistle blower suits against providers
under the Federal False Claims Act, which authorizes the payment of a portion of any recovery to the individual bringing suit. Such actions are initially required to be filed under seal pending their review by the Department of Justice. A few
federal district courts have recently interpreted the Federal False Claims Act as applying to claims for reimbursement that violate the anti-kickback statute or federal physician self-referral law under certain circumstances. The Federal False
Claims Act generally provides for the imposition of civil penalties and for treble damages, resulting in the possibility of substantial financial penalties for small billing errors that are replicated in a large number of claims, as each individual
claim could be deemed to be a separate violation of the Federal False Claims Act. Criminal provisions that are similar to the Federal False Claims Act provide that a corporation may be fined if it is convicted of presenting to any federal agency a
claim or making a statement that it knows to be false, fictitious or fraudulent to any federal agency.



There are currently two qui tamactions filed under the Federal False Claims Act and similar state laws pending in U.S. District Court for the Eastern District of Pennsylvania against Medco Health Solutions,
Inc., Medco, for alleged violations of the Federal False Claims Act. The U.S. Attorneys Office for the Eastern District of Pennsylvania has intervened. The complaint alleges, among other things, that Medco favored the products of
certain pharmaceutical manufacturers, including Merck & Co., Inc., over less expensive products and engaged in improper pharmacy practices in its mail order pharmacy. In December 2003, the initial complaint was amended to include allegations of
violations of the Public Contractor Anti-Kickback Statute in connection with Medcos role as a PBM for federally funded health care programs. In September 2004, the court denied Medcos motion to dismiss the Federal False Claims Act and
Public Contractor Anti-Kickback Statute claims. In April 2004, Medco entered into a settlement with the U.S. Attorneys Office with regard to the governments claims for injunctive relief. There has been no settlement of the
governments monetary claims.



Currently, we do not directly contract with
the federal government to provide services to beneficiaries of federally funded health programs. Therefore, we do not directly submit claims to the federal government. However, we may contract with and provide services to entities or organizations
that are federal government contractors. There can be no assurance that the government would not potentially view one or more of our actions in providing services to federal government contractors as causing or assisting in the presentment of a
false claim. We do not believe we are in violation of the Federal False Claims Act and we have a corporate compliance and ethics program, policies and procedures and internal controls in place to help maintain an organizational culture of honesty
and integrity.



ERISA Regulation.



The Employee Retirement Income Security Act of 1974, ERISA, regulates certain
aspects of employee pension and health benefit plans, including self-funded corporate health plans. We have agreements with self-funded corporate health plans to provide PBM services, and therefore, are a service provider to ERISA plans. ERISA
imposes duties on any person or entity that is a fiduciary with respect to the ERISA plan. We administer pharmacy benefits for ERISA plans in accordance with plan design choices made by the ERISA plan sponsors. Therefore, we believe that the conduct
of our business generally is not subject to the fiduciary obligations of ERISA. However, there can be no assurance that the U.S. Department of Labor, which is the agency that enforces ERISA, or a private litigant would not assert that the fiduciary
obligations imposed by the statute apply to certain aspects of our operations.



On May 25, 2004, the U.S. District Court for the Southern District of New York accepted a class action settlement proposed by Medco in a lawsuit that alleged that Medco was a functional fiduciary under ERISA and violated its fiduciary
obligations by, among other things, failing to make adequate disclosures regarding certain rebates from pharmaceutical manufacturers and steering clients toward more expensive pharmaceuticals with higher rebates benefiting Medco and its parent
company, Merck & Co., Inc. Pursuant to the settlement, Medco will pay $42.5 million into a settlement fund to be distributed to plan participants. In addition, Medco will implement and continue certain business practices aimed at increasing
transparency around formulary decisions and therapeutic interchanges. Medco has not admitted, and the settlement does not require Medco to admit, any wrongdoing under ERISA or otherwise.



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On July 26, 2004, private litigants filed suit against Caremark, Inc. in the U.S. District Court for the Middle District
of Tennessee alleging that Caremark, Inc. was a fiduciary under ERISA and violated its ERISA fiduciary duties by, among other things, failing to disclose the existence and extent of manufacturer rebates, concealing the spread on pharmacy
claims to the detriment of ERISA plans and conspiring with pharmaceutical manufacturers to inflate AWP.



In addition to the cases discussed above, numerous other lawsuits have been filed against various PBMs by private litigants, whether a Plan participant on behalf of an ERISA plan or by the ERISA Plan sponsor, alleging
that the PBMs are ERISA fiduciaries and that, in such capacity, they allegedly violated ERISA fiduciary duties in connection with certain business practices related to their respective contracts with retail pharmacy networks and/or pharmaceutical
manufacturers.



ERISA also imposes civil and criminal liability on service
providers to health plans and certain other persons if certain forms of illegal remuneration are made or received. These provisions of ERISA are similar, but not identical, to the federal health care anti-kickback statute discussed above. In
particular, ERISA does not provide the statutory and regulatory safe harbor exceptions incorporated into the federal healthcare anti-kickback statute. Like the health care anti-kickback laws, the corresponding provisions of ERISA are written broadly
and their application to particular cases is often uncertain. We have implemented policies regarding, among other things, disclosure to health plan sponsors with respect to any commissions paid by or to us that might fall within the scope of such
provisions and accordingly believe we are in substantial compliance with these provisions of ERISA. However, we can provide no assurance that our policies in this regard would be found by the appropriate enforcement authorities and potential private
litigants to meet the requirements of ERISA.



FDA Regulation.



The U.S. Food and Drug Administration, the FDA, generally has
authority to regulate drug promotional materials that are disseminated by or on behalf of a drug manufacturer. In January 1998, the FDA issued a Notice and Draft Guidance regarding its intent to regulate certain drug promotion and
switching activities of PBMs that are controlled, directly or indirectly, by drug manufacturers. After extending the comment period due to numerous industry objections to the proposed draft, the FDA has taken no further action on the Notice and
Draft Guidance. However, there can be no assurance that the FDA will not attempt again to assert jurisdiction over aspects of our PBM business in the future and, although we are not controlled directly or indirectly by any drug manufacturer, the
impact future FDA regulation could materially adversely affect our business, results of operations, or financial condition.



Antitrust Regulation.



The federal antitrust laws regulate trade and commerce and prohibit unfair competition as defined by those laws. Section One of the Sherman Antitrust Act prohibits contracts, combinations or conspiracies in restraint
of trade or commerce. Despite its sweeping language, however, Section One of the Sherman Act has been interpreted to prohibit only unreasonable restraints on competition. Section Two of the Sherman Act prohibits monopolization and attempts at
monopolization. Similarly, Section Seven of the Clayton Act prohibits unlawful mergers and acquisitions. In addition, the Robinson Patman Act, which is part of the Clayton Act, prohibits a variety of conduct relating to the sale of goods, including
prohibiting practices the statute defines as price discrimination. One section of the Robinson Patman Act prohibits a seller from selling goods of like grade or quality to different customers at different prices if the favorable prices are not
available to all customers competing in the same class of trade. Successful plaintiffs in antitrust actions are allowed to recover treble damages for the damage sustained as a result of the violation.



On October 1, 2003, several independent pharmacies throughout the United States filed suit as
a class against Express Scripts, Inc. in the U.S. District Court for the Northern District of Alabama. The same plaintiffs filed similar suits against Caremark, Inc., Advance PCS, and Medco, also on October 1, 2003, in the U.S. District Court for
the Northern District of Alabama. The complaints allege that the defendant PBMs conspired with other PBMs to fix prices in violation of the Sherman Antitrust Act. The suits seek unspecified monetary damages (including treble damages) and injunctive
relief. Motions to dismiss are pending in all cases.



We believe that we are in
substantial compliance with the legal requirements imposed by such antitrust laws. However, there can be no assurance that we will not be subject to scrutiny or challenge under such legislation. Any such challenge could have a material adverse
effect on our business, results of operations and financial condition.



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State Laws and Regulations Affecting the PBM Segment



The following descriptions identify various state laws and regulations that affect or may
affect aspects of our PBM business.



State Anti-Remuneration/False Claims
Laws.



Several states have laws and/or regulations similar to the federal
anti-remuneration and Federal False Claims Act described above. Such state laws are not necessarily limited to services or items for which federally funded health care program payments may be made. Such state laws may be broad enough to include
improper payments made in connection with services or items that are paid by commercial payors. Sanctions for violating these state anti-remuneration and false claims laws may include injunction, imprisonment, criminal and civil fines and exclusion
from participation in the state Medicaid programs.



We believe that we are in
substantial compliance with the legal requirements imposed by such laws and regulations. However, there can be no assurance that we will not be subject to scrutiny or challenge under such laws or regulations. Any such challenge could have a material
adverse effect on our business, results of operations and financial condition.



State Consumer Protection Laws.



Most states have enacted
consumer protection and deceptive trade laws that generally prohibit payments and other broad categories of conduct deemed harmful to consumers. These statutes may be enforced by states and/or private litigants. Such laws have been and continue to
be the basis for state investigations and prosecutions of PBMs.



| |  |  | On April 26, 2004, Medco settled allegations that it engaged in unfair or deceptive acts and practices in violation of trade practice laws with twenty (20) states for $29 million.
In addition to the monetary settlement, Medco agreed to several business practice changes, primarily aimed at increasing transparency as to the existence and extent of manufacturer rebates and the reasons for therapeutic interchanges.
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | On August 4, 2004, the New York Attorney General brought suit against Express Scripts in New York Supreme Court. The complaint alleges that Express Scripts breached its contract
with the state and violated the states Executive and General Business Laws by concealing manufacturer rebates and maximizing the difference between client payments for pharmacy services and payments made to pharmacies.
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



In addition to the lawsuits discussed above, there have been
numerous additional actions filed by private litigants against PBMs asserting state consumer protection law claims.



We do not believe that we maintain contractual relationships that include the features that have been identified as problematic in the Medco settlement agreement or that
have been alleged as improper in other actions against PBMs under state consumer protection statutes. However, no assurance can be given that we will not be subject to scrutiny or challenge under one or more of these laws, or under similar consumer
protection theories.



State Comprehensive PBM Regulation.



States continue to introduce legislation to regulate PBM activities in a comprehensive
manner. Legislation seeking to impose fiduciary duties or disclosure obligations on PBMs has been proposed on some states. Both Maine and the District of Columbia have enacted statutes imposing fiduciary obligations on PBMs. However, both the U.S.
District Court for Maine and for the District of Columbia have preliminarily enjoined enforcement of these statutes on the grounds that the statutes may cause PBMs to disclose proprietary trade secrets and may be preempted by ERISA.



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In addition, certain quasi-regulatory organizations, such as the National Association of Boards of Pharmacy,
NABP, an organization of state boards of pharmacy, the National Association of Insurance Commissioners, NAIC, an organization of state insurance regulators, and the National Committee on Quality Assurance, NCQA,
an accreditation organization, are considering proposals to regulate PBMs and/or PBM activities, such as formulary development and utilization management. While the actions of the NABP and NAIC would not have the force of law, they may influence
states to adopt any requirements or model acts they promulgate. In addition, standards established by NCQA could materially impact us directly as a PBM, and indirectly through the impact on our health plan clients, where applicable.



Many states have licensure or registration laws governing certain types of ancillary health
care organizations, including preferred provider organizations, TPAs, companies that provide utilization review services, and companies that engage in the practices of a pharmacy. The scope of these laws differs significantly from state to state,
and the application of such laws to the activities of PBMs often is unclear.



We believe that we are in substantial compliance with all such laws and requirements where required, and continue to monitor legislative and regulatory developments. There can be no assurance, however, regarding the future interpretation of
these laws and their applicability to the activities of our PBM business. Future legislation or regulation, or interpretations by regulatory and quasi-regulatory authorities of existing laws and regulations, could materially affect the cost and
nature of our business as currently conducted.



State Network Access
Legislation.



A majority of states now have some form of legislation
affecting our ability to limit access to a pharmacy provider network, referred to as any willing provider legislation, or removal of a network provider, referred to as due process legislation. Such legislation may require us or our
clients to admit any retail pharmacy willing to meet the plans price and other terms for network participation, or may provide that a provider may not be removed from a network except in compliance with certain procedures. These statutes have
not materially affected our business.



State Legislation Affecting Plan Or
Benefit Design.



Some states have enacted legislation that prohibits
certain types of managed care plan sponsors from implementing certain restrictive design features, and many states have legislation regulating various aspects of managed care plans, including provisions relating to the pharmacy benefits. For
example, some states, under so-called freedom of choice legislation, provide that members of the plan may not be required to use network providers, but must instead be provided with benefits even if they choose to use non-network
providers. Other states have enacted legislation purporting to prohibit health plans from offering members financial incentives for use of mail service pharmacies. Legislation has been introduced in some states to prohibit or restrict therapeutic
intervention, to require coverage of all FDA-approved drugs or to require coverage for off-label uses of drugs where those uses are recognized in peer-reviewed medical journals or reference compendia. Other states mandate coverage of certain
benefits or conditions and require health plan coverage of specific drugs, if deemed medically necessary by the prescribing physician. Such legislation does not generally apply to us directly, but may apply to certain of our clients, such as HMOs
and health insurers. If legislation were to become widely adopted, it could have the effect of limiting the economic benefits achievable through PBMs. This development could have a material adverse effect on our business, results of operations and
financial condition.



State Regulation Of Financial Risk Plans.



Fee-for-service prescription drug plans are generally not subject to
financial regulation by the states. However, if a PBM offers to provide prescription drug coverage on a capitated basis or otherwise accepts material financial risk in providing the benefit, laws in various states may regulate the plan. Such laws
may require that the party at risk establish reserves or otherwise demonstrate financial responsibility. Laws that may apply in such cases include insurance laws, HMO laws or limited prepaid health service plan laws. Currently, we do not believe
that our PBM business currently incurs financial risk of the type subject to such regulation. However, as discussed above, if we choose to become a regional PDP for the Medicare outpatient prescription drug benefit we would need to comply with state
laws governing risk-bearing entities in the states where we operate a PDP.



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State Discount Drug Card Regulation.



Numerous states have recently enacted laws and/or promulgated or proposed regulations regulating the selling, marketing, promoting,
advertising or distributing of commercial discount drug cards for cash purchases. Such laws and regulations provide, generally, that any person may bring an action for damages or seek an injunction for violations. We administer a limited commercial
discount drug card program that we do not consider material to our business. We believe our administration of the commercial discount drug card program is in compliance with various state laws. However, there can be no assurance that the existence
of such laws will not materially impact our ability to offer certain new commercial products and/or services in the future.



Combined Federal and State Laws, Regulations and Other Standards Affecting the PBM Segment



Certain aspects of our PBM business are or may be affected by bodies of law that exist at both the federal and state levels and by other
standard setting entities. Among these are the following:



Privacy And
Confidentiality Legislation.



Our activities involve the receipt or use of
confidential medical information concerning individual members. In addition, we use aggregated and anonymized data for research and analysis purposes. Many states laws restrict the use and disclosure of confidential medical information, and
similar new legislative and regulatory initiatives are underway in several states. To date, no such laws adversely impact our ability to provide our services, but there can be no assurance that federal or state governments will not enact such
legislation, impose restrictions or adopt interpretations of existing laws that could have a material adverse effect on our business, results of operations and financial condition.



As of April 14, 2003, the final privacy regulations, the Privacy Rule, issued by the DHHS pursuant to the Health Information
Portability and Accountability Act, HIPAA, became effective, and began imposing extensive restrictions on the use and disclosure of individually identifiable health information by certain entities known under the Privacy Rule as covered
entities. PBMs, in general, are not considered covered entities. However, our clients are covered entities, and are required to enter into business associate agreements with vendors, such as PBMs, that perform a function or activity for
the covered entity that involves the use or disclosure of individually identifiable health information. The business associate agreements mandated by the Privacy Rule create a contractual obligation for the PBM to perform its duties for the covered
entity in compliance with the Privacy Rule.



As of October 16, 2002, or October
16, 2003 for those covered entities that filed for an extension, compliance with the final transactions and code sets regulation, the Transaction Rule, promulgated under HIPAA became effective. The Transaction Rule requires that all
covered entities that engage in electronic transactions use standardized formats and code sets. It is incumbent upon PBMs to conduct all such transactions in accordance with the Transaction Rule to satisfy the obligations of their covered entity
clients. In July 2003, CMS issued guidance that, at least for the short term, as long as covered entities were making good faith efforts toward testing for the standard transactions, CMS would not act affirmatively to enforce the Transaction Rule
against covered entities for non-compliance. We have made the necessary arrangements to offer compliant electronic transactions to our clients.



In February 2003, the final security regulations, the Security Rule, issued pursuant to HIPAA, were published. The Security Rule mandates the use of
administrative, physical and technical safeguards to protect the confidentiality of electronic health care information. Compliance with the Security Rule is not required until April 21, 2005. Similarly to the other two rules issued pursuant to
HIPAA, the Security Rule applies to covered entities. We have made the necessary arrangements to ensure compliance with the Security Rule, as we will be subject to many of its requirements as a result of our contracts with covered entities.



While implementation of the Privacy Rule, Transaction Rule and the Security
Rule, the HIPAA Regulations, is just beginning and future regulatory interpretations could alter our assessment, we currently believe that compliance with the HIPAA Regulations should not have a material adverse effect on our business
operations. Also, pursuant to HIPAA, state laws that are more protective of medical information are not pre-empted by HIPAA. Therefore, to the extent states enact more protective legislation, we could be required to make significant changes to our
business operations.



Independent of any regulatory restrictions, individual
health plan sponsor clients could increase limitations on our use of medical information, which could prevent us from offering certain services.



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Legislation Affecting Drug Prices.



Various federal and state Medicaid agencies, as well as legislators and private litigants have raised the issue of how average wholesale
price, AWP, is determined. AWP is a standard pricing unit published by third party data sources and currently used throughout the PBM industry as the basis for determining drug pricing under contracts with clients, pharmacies and
pharmaceutical manufacturers. Under MMA, effective January 1, 2005, AWP will no longer serve as the basis for Medicare Part B Drug reimbursement, except for certain vaccines, infusion drugs furnished through durable medical equipment and for blood
and blood products (other than clotting factors). Rather, with certain exceptions, Part B drugs generally will be reimbursed on an average sales price, ASP, methodology. ASP means a manufacturers total dollar sales of a product in
the United States to all purchasers (excluding certain sales exempted from Medicaid Best Price reporting and nominal sales) divided by the total number of such units of such drug or biological products sold by the manufacturer in such
quarter. Manufacturers are required to include in ASP calculations all volume discounts, prompt pay discounts, cash discounts, free goods that are contingent on any purchase requirement, chargebacks, and rebates (other than Medicaid rebates).
Additionally, beginning in 2005, DHHS may include other price concessions in the ASP calculation. Drugs that will be reimbursed on an ASP reimbursement system by Medicare do not represent a significant portion of our business and we therefore do not
believe that ASP reimbursement for such drugs will have a material adverse effect on our business, results of operations or financial condition.



The extent to which ASP will be used in pricing outside the Medicare Part B context or changes to how AWP is determined and reported to state and federal programs could
alter the calculation of drug prices for federal and/or state programs. We are unable to predict whether any such changes will be adopted, and whether such changes would have a material adverse effect on our business, results of operations and
financial condition.



The federal Medicaid rebate statute provides that
pharmaceutical manufacturers must provide rebates on all drugs purchased by the Medicaid program. Manufacturers of brand-name pharmaceuticals must provide the Medicaid program a rebate equivalent to the greater of (1) 15.1% of average manufacturer
price, AMP, the average price for products sold to wholesalers, or (2) the difference between AMP and the best price given to customers other than the Medicaid program. Some pharmaceutical manufacturers may view the Medicaid
rebate statute as a disincentive to offer rebates and discounts to private parties, including PBMs.



Additionally, some states have adopted so-called most favored nation legislation providing that a pharmacy participating in the state Medicaid program must give the state the lowest price that the pharmacy
makes available to any third-party plan. Such legislation may adversely affect our ability to negotiate discounts in the future from network pharmacies.



Voluntary Industry Ethical Guidelines.



In June 2002, the Pharmaceutical Research and Manufacturers of Americas voluntary code for its members titled PhRMA Code On Interactions with Healthcare
Professionals took effect. Although it does not have the force of law, this code, which has been updated since its original publication, provides guidance relating to several facets of pharmaceutical manufacturers marketing practices,
particularly with respect to payments to providers. We believe that these ethical guidelines will not have a material adverse effect on our financial operations.



Future Regulation.



We are unable to predict accurately what additional federal or state legislation or regulatory initiatives may be enacted in the future relating to our businesses or the
health care industry in general, or what effect any such legislation or regulations might have on us. For example, the federal government and several state governments have proposed Patients Bill of Rights or other similar legislation aimed
primarily at improving quality of care provided to individuals in managed care plans. Some of the initiatives propose providing greater access to drugs not included on health plan formularies, giving participants the right to sue their health plan
for malpractice, and mandating an



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appeals or grievance process. There can be no assurance that federal or state governments will not impose additional restrictions, via a Patients Bill
of Rights or otherwise, or adopt interpretations of existing laws that could have a material adverse effect on our business, results of operations and financial condition.



Regulations Affecting Mail Order Pharmacies



We operate a facility in Fort Lauderdale, Florida that provides limited mail order services to certain of our PBM customers. This facility principally fills
workers compensation and hospice-related prescriptions. Nonetheless, we are subject to state and federal statutes and regulations governing the operation of pharmacies, repackaging of drug products and dispensing of controlled substances.



Regulation of Controlled Substances



Our mail order facility must register with the United States Drug Enforcement
Administration, the DEA, and individual state controlled substance authorities in order to dispense controlled substances. Federal law requires us to comply with the DEAs security, recordkeeping, inventory control, and labeling
standards in order to dispense controlled substances. State controlled substance law requires registration and compliance with state pharmacy licensure, registration or permit standards promulgated by the state pharmacy licensing authority.



State Licensure Laws



Our mail order facility is located in Florida, and we are licensed to do business as a
pharmacy there. Furthermore, many states require out-of-state mail order pharmacies to register with the state board of pharmacy or similar governing body when pharmaceuticals are delivered by mail into the state. Also, some states require that an
out-of-state pharmacy employ a pharmacist that is licensed in the state into which pharmaceuticals are shipped. We believe we are in substantial compliance with state licensure and registration requirements.



Other Regulations



The FTC regulates advertising by mail order pharmacies and requires such facilities to stock a reasonable supply of a product sold, to fill
mail orders within 30 days and to provide customer refunds where appropriate. In addition, the FDA sets standards for the packaging of prescription drugs. Federal and state anti-remuneration laws also apply to our mail order pharmacy.



Regulations Affecting the Supplemental Benefits Segment



Because our supplemental benefit programs include insurance benefits, distribution of our
programs must satisfy applicable legal requirements relating, among other things, to policy form and rate approvals, the licensing laws for insurance agents and insurance brokers, and the satisfaction by a HealthExtras member who receives the
insurance benefit of requisite criteria, for example being a resident of a state which has approved the insurance policy. We believe we satisfy applicable requirements. The underwriter of the insurance benefits included in our supplemental benefit
programs is responsible for obtaining regulatory approvals for those benefits. Independent licensed insurance agencies are responsible for the solicitation of insurance benefits involved in those programs.



Complex laws, rules and regulations of each of the 50 states and the District of Columbia
pertaining to insurance impose strict and substantial requirements on insurance coverage sold to consumers and businesses. Compliance with these laws, rules and regulations can be arduous and imposes significant costs. Each jurisdictions
insurance regulator typically has the power, among other things, to:



| |  |  | administer and enforce the laws and promulgate rules and regulations applicable to insurance, including the quotation of insurance premiums;
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | approve policy forms and regulate premium rates;
| | - |  | ------------------------------------------------



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| |  |  | regulate how, by which personnel and under what circumstances an insurance premium can be quoted and published; and
| | - |  | -------------------------------------------------------------------------------------------------------------------



| |  |  | regulate the solicitation of insurance and license insurance companies, agents and brokers who solicit insurance.
| | - |  | -----------------------------------------------------------------------------------------------------------------



State insurance laws and regulations are complex and broad in scope and are subject to
periodic modification, as well as differing interpretations. There can be no assurance that insurance regulatory authorities in one or more states will not determine that the nature of our business requires us to be licensed under applicable
insurance laws. A determination to that effect or that we or the distributors are otherwise not in compliance with applicable regulations could result in fines, additional licensing requirements or our inability to market the products in particular
jurisdictions. Such penalties could significantly increase our general operating expenses and harm our business. In addition, even if the allegations in any regulatory or legal action against us turn out to be false, negative publicity relating to
any such allegation could result in a loss of consumer confidence and significant damage to our brand.



One of the primary means by which our programs are marketed is telemarketing, which the marketers may outsource to third parties. The Federal Telemarketing and Consumer Fraud and Abuse Prevention Act of 1994, related
state laws and FTC regulations prohibit deceptive, unfair or abusive practices in telemarketing sales. Both the FTC and state attorneys general have authority to prevent certain telemarketing activities deemed by them to violate consumer protection.



In 2003, the FTC established the national Do-Not-Call Registry. Both the FTC
and the Federal Communications Commission, the FCC, have adopted rules to enforce restrictions on companies marketing their goods and services to consumers by telephone. Subject to certain exemptions (such as an existing business
relationship with the called party), telemarketers may not initiate telephone solicitations to individuals that have registered their numbers on the national Do-Not-Call Registry. Those who disregard the national Do-Not-Call Registry can be fined up
to $11,000 per call. Companies are also required to maintain their own lists of consumers that have stated that they do not wish to receive future marketing calls, and must not solicit such consumers by telephone, even if the call falls within the
scope of one of the exemptions to the national do-not-call rules.



The Do-Not-Call Registry has not had a material adverse effect on the sale of our supplemental benefit programs. We have continued to meet our enrollment targets.



There can be no assurance that federal or state laws regulating telemarketing will not materially impact our business in the future. In
addition, some states have enacted laws, and others are considering enacting laws, targeted directly at regulating telemarketing practices. There can be no assurance that any such laws will not adversely affect or limit our current or future
operations. While compliance with these laws and regulations is generally the responsibility of the marketers and subcontractors, there can be no assurance that we would have no exposure to liability.



EMPLOYEES



As of December 31, 2004, we had 227 employees whose services are devoted full time to HealthExtras and its subsidiaries. We have never had a
work stoppage. Our personnel are not represented by any collective bargaining unit. We consider our relations with our personnel to be good. Our future success will depend, in part, on our ability to continue to attract, integrate, retain and
motivate highly qualified technical and managerial personnel, for whom competition is intense.



|ITEM | 2. PROPERTIES
|---- | -------------



In June 2004, we entered into a ten-year lease in a new office building located in Rockville, Maryland for approximately 37,000 square feet of office space and moved our headquarters to the new location in the third
quarter of 2004. Annual basic rent for the first year is approximately $1.0 million. The lease provides for annual escalations. We have clinical and sales offices in Florida, Georgia, Louisiana, Minnesota, Nevada, North Carolina, and Texas.



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Six of the seven clinical and sales offices, with a total of 22,000 square feet, are under leases that expire over terms
through October 2011 and the other office is under a month-to-month lease. We believe that suitable space on commercially reasonable terms will be available as required.



|ITEM | 3. LEGAL PROCEEDINGS
|---- | --------------------



From time to time we become subject to legal proceedings and claims in the ordinary course of business. Such claims, even if without merit, could result in the
significant expenditure of our financial and managerial resources. We are not aware of any legal proceedings or claims that we believe will, individually or in the aggregate, materially harm our business, financial condition or results of
operations.



|ITEM | 4. SUBMISSION OF MATTERS FOR A VOTE OF SECURITY HOLDERS
|---- | -------------------------------------------------------



There were no matters submitted to a vote of security holders during the quarter ended December 31, 2004.



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PART II



ITEM 5. MARKET FOR REGISTRANTS COMMON EQUITY AND RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES



The common stock has been quoted on the NASDAQ National Market under the symbol HLEX since the Companys initial public offering on December 14, 1999.
The following table sets forth for the period indicated the high and low sales closing prices for the common stock:



|               |  |      |       |     |   |      
|-------------- |  | ---- | ----- | --- | - | -----
|               |  | High |       | Low
|2003           |  |      |       |     |   |      
|First quarter  |  | $    | 4.30  |     | $ | 3.40 
|Second quarter |  | $    | 8.15  |     | $ | 3.96 
|Third quarter  |  | $    | 9.59  |     | $ | 7.15 
|Fourth quarter |  | $    | 14.50 |     | $ | 8.88 
|2004           |  |      |       |     |   |      
|First quarter  |  | $    | 13.22 |     | $ | 9.21 
|Second quarter |  | $    | 16.84 |     | $ | 11.03
|Third quarter  |  | $    | 16.28 |     | $ | 11.81
|Fourth quarter |  | $    | 16.80 |     | $ | 13.22



On March 11, 2005, the closing
sale price of the common stock, as reported by the Nasdaq National Market was $16.64 per share. As of March 11, 2005, the Company had approximately 448 stockholders of record.



Dividend Policy



We have never paid a dividend on our common stock and have no present intention on commencing the payment of cash dividends. It is possible
that the Board could determine in the future, based on the Companys financial and other relevant circumstances at that time, to pay dividends.



Recent Sales of Unregistered Securities



On May 5, 2004, the Company issued 15,000 shares of its common stock to a non-employee in exchange for consulting services. This issuance was made in reliance upon
Section 4(2) of the Securities Act of 1933.



On June 18, 2004, the Company
issued 100,739 shares of its common stock to the sellers of Managed Healthcare Services, Inc. Refer to Form 8-K, filed with the SEC on June 23, 2004 for additional information.



On June 24, 2004, the Company issued 74,250 shares of its common stock to the seller of Diabetic Sense. Refer to Form 10-Q, filed with the
SEC on August 9, 2004.



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|ITEM | 6. SELECTED FINANCIAL DATA
|---- | --------------------------



The following selected financial data has been derived from the audited financial statements of the Company. The selected financial data should be read in conjunction
with Managements Discussion and Analysis of Financial Condition and Results of Operations and the audited consolidated financial statements, including notes thereto.



|                                                             |  |      |         |   |                                      |   |         |      |  |   |         |   |  |      |         |   |  |   |         |  
|------------------------------------------------------------ |  | ---- | ------- | - | ------------------------------------ | - | ------- | ---- |  | - | ------- | - |  | ---- | ------- | - |  | - | ------- | -
|                                                             |  |      |         |   | For the Years Ended December 31,     |   |         |      | 
|                                                             |  |      |         |   | (In thousands except per share data) |   |         |      | 
|                                                             |  | 2000 |         |   | 2001                                 |   |         | 2002 |  |   | 2003    |   |  | 2004 |        
|Statement of Operations Data:                                |  |      |         |   |                                      |   |         |      |  |   |         |   |  |      |         |   |  |   |         |  
|Revenue                                                      |  | $    | 43,924  |   |                                      | $ | 118,226 |      |  | $ | 248,407 |   |  | $    | 384,094 |   |  | $ | 521,325 |  
|                                                             |  |      |         |   |                                      |   |         |      |  |   |         |   |  |      |         |   |  |   |         |  
|Direct expenses                                              |  |      | 24,049  |   |                                      |   | 87,543  |      |  |   | 209,523 |   |  |      | 341,201 |   |  |   | 460,783 |  
|Selling, general and administrative                          |  |      | 39,669  |   |                                      |   | 38,454  |      |  |   | 35,484  |   |  |      | 25,865  |   |  |   | 35,583  |  
|                                                             |  |      |         |   |                                      |   |         |      |  |   |         |   |  |      |         |   |  |   |         |  
|Total operating expenses                                     |  |      | 63,718  |   |                                      |   | 125,997 |      |  |   | 245,007 |   |  |      | 367,066 |   |  |   | 496,366 |  
|                                                             |  |      |         |   |                                      |   |         |      |  |   |         |   |  |      |         |   |  |   |         |  
|Operating income (loss)                                      |  |      | (19,794 | ) |                                      |   | (7,771  | )    |  |   | 3,400   |   |  |      | 17,028  |   |  |   | 24,959  |  
|Interest income (expense), net                               |  |      | 2,069   |   |                                      |   | 1,092   |      |  |   | (82     | ) |  |      | (443    | ) |  |   | (762    | )
|Other income (expense), net                                  |  |      | 499     |   |                                      |   |        |      |  |   |        |   |  |      |        |   |  |   | 2,100   |  
|                                                             |  |      |         |   |                                      |   |         |      |  |   |         |   |  |      |         |   |  |   |         |  
|Income (loss) before income taxes and minority interest      |  |      | (17,226 | ) |                                      |   | (6,679  | )    |  |   | 3,318   |   |  |      | 16,585  |   |  |   | 26,297  |  
|Minority interest                                            |  |      |        |   |                                      |   | (96     | )    |  |   | (45     | ) |  |      |        |   |  |   |        |  
|                                                             |  |      |         |   |                                      |   |         |      |  |   |         |   |  |      |         |   |  |   |         |  
|Income (loss) before income taxes                            |  |      | (17,226 | ) |                                      |   | (6,775  | )    |  |   | 3,273   |   |  |      | 16,585  |   |  |   | 26,297  |  
|Income tax (credit) provision                                |  |      |        |   |                                      |   |        |      |  |   | (10,205 | ) |  |      | 6,268   |   |  |   | 9,914   |  
|                                                             |  |      |         |   |                                      |   |         |      |  |   |         |   |  |      |         |   |  |   |         |  
|Net income (loss)                                            |  | $    | (17,226 | ) |                                      | $ | (6,775  | )    |  | $ | 13,478  |   |  | $    | 10,317  |   |  | $ | 16,383  |  
|                                                             |  |      |         |   |                                      |   |         |      |  |   |         |   |  |      |         |   |  |   |         |  
|Net income (loss) per share, basic                           |  | $    | (0.62   | ) |                                      | $ | (0.23   | )    |  | $ | 0.42    |   |  | $    | 0.32    |   |  | $ | 0.49    |  
|Net income (loss) per share, diluted                         |  | $    | (0.62   | ) |                                      | $ | (0.23   | )    |  | $ | 0.42    |   |  | $    | 0.30    |   |  | $ | 0.45    |  
|Weighted average shares of common stock outstanding, basic   |  |      | 28,010  |   |                                      |   | 29,731  |      |  |   | 32,234  |   |  |      | 32,447  |   |  |   | 33,642  |  
|Weighted average shares of common stock outstanding, diluted |  |      | 28,010  |   |                                      |   | 29,731  |      |  |   | 32,420  |   |  |      | 34,454  |   |  |   | 36,407  |  
|                                                             |  |      |         |   |                                     
|Balance Sheet Data:                                          |  |      |         |   |                                      |   |         |      |  |   |         |   |  |      |         |   |  |   |         |  
|Cash and cash equivalents                                    |  | $    | 28,921  |   |                                      | $ | 33,009  |      |  | $ | 17,531  |   |  | $    | 28,877  |   |  | $ | 67,068  |  
|Total assets                                                 |  |      | 52,044  |   |                                      |   | 88,153  |      |  |   | 120,002 |   |  |      | 141,768 |   |  |   | 244,252 |  
|Long term debt                                               |  |      |        |   |                                      |   |        |      |  |   | 18,000  |   |  |      | 10,000  |   |  |   | 20,500  |  
|Total liabilities                                            |  |      | 15,806  |   |                                      |   | 42,372  |      |  |   | 60,477  |   |  |      | 70,790  |   |  |   | 96,602  |  
|Total stockholders equity                                   |  |      | 36,238  |   |                                      |   | 45,237  |      |  |   | 59,525  |   |  |      | 70,978  |   |  |   | 147,650 |  



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



This Form 10-K may contain forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended. These forward-looking
statements involve a number of risks and uncertainties. We undertake no obligation to revise any forward-looking statements in order to reflect events or circumstances that may arise after the date of this report. Readers are urged to carefully
review and consider the various disclosures made in this report and in our other filings with the Securities and Exchange Commission that attempt to advise interested parties of the risks and factors that may affect our business.



OVERVIEW



The Company



HealthExtras provides pharmacy benefit management (PBM) services and supplemental benefit programs. Our PBM segment, which operates under the brand name
Catalyst Rx, accounted for approximately 91%, 86% and 73% of our revenue in the years ended 2004, 2003 and 2002, respectively, and is expected to be the primary source of our growth and profits in the future. Our PBM clients include more
than 1,000 self-insured employers, including state and local governments, third-party administrators (TPAs), and managed care organizations, who contract with us to administer the prescription drug component of their overall health
benefit programs. Total claims processed increased to 12.8 million in 2004 from 9.0 million in 2003, respectively and our PBM segment revenue increased by 43.3% from 2003 to 2004.



We also offer supplemental benefit programs developed by us under the brand name HealthExtras, which include lump sum accidental
disability benefits, accidental death and dismemberment benefits, and emergency accident and sickness medical benefits. We contract with insurance companies to underwrite the insurance components of these programs. As a result, the financial
responsibility for the payment of claims resulting from a qualifying event covered by the insurance features of our programs is borne by the third-party insurers. Our supplemental benefits segment accounted for approximately 9%, 14% and 27% of our
revenue in the years ended 2004, 2003 and 2002, respectively. Individuals are the major purchasers of these programs.



PHARMACY BENEFIT MANAGEMENT



Catalyst Rx



Catalyst Rx provides its clients access to a contracted, non-exclusive national network of more than 53,000 pharmacies. Catalyst Rxs services provide our clients members with timely and accurate benefit
adjudication, while controlling pharmacy spending trends through customized plan designs, physician orientation programs, and member education. Catalyst Rx uses an electronic point-of-sale system of eligibility verification and plan design
information, and offers access to rebate arrangements for certain branded pharmaceuticals. When a member of one of our clients presents a prescription or health plan identification card to a retail pharmacist in our network, the system provides the
pharmacist with access to online information regarding eligibility, patient history, health plan formulary listings, and contractual reimbursement rates. The member generally pays a co-payment to the retail pharmacy and the pharmacist fills the
prescription. We electronically aggregate pharmacy benefit claims, which include prescription costs plus our claims processing fees for consolidated billing and payment. We receive payments from clients, make payments of amounts owed to the retail
pharmacies pursuant to our negotiated rates, and retain the difference, including claims processing fees.



Pharmacy benefit claim payments from our clients are recorded as revenue, and prescription costs to be paid to pharmacies are recorded as direct expenses. Under our network contracts, we generally have an independent
obligation to pay pharmacies for the drugs dispensed and, accordingly, have assumed that risk independent of our clients. When we administer pharmacy reimbursement contracts and do not assume a credit risk, we record only our administrative or
processing fees as revenue. Rebates earned under arrangements with manufacturers are recorded as a reduction of direct expenses. The portion of manufacturer rebates due to clients is recorded as a reduction of revenue.



Member co-payments are not recorded as revenue. The Company incurs no obligations for
co-payments to pharmacies and has never made such payments. Under our pharmacy agreements, the pharmacy is solely obligated to collect the co-payments from the members.



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Under our client contracts, we do not assume liability for member co-payments in pharmacy transactions. As such, we do
not include member co-payments to pharmacies in revenue or operating expenses.



To provide additional information to investors, we have disclosed the specific amounts of member payments excluded from both revenue and operating expenses. If the Company had included co-payments in its reported revenue and operating
expenses, it would have resulted in an increase in reported PBM revenue and operating expenses for years ended 2004, 2003 and 2002 of $213.0 million, $141.0 million and $71.6 million, respectively. Our operating and net income, consolidated balance
sheets and statements of cash flows would not be affected.



The following
tables illustrate the effects on the reported PBM revenue and operating expenses if Catalyst Rx had included the actual member co-payments as indicated by our claims processing system (in thousands):



|                     |  |                  |         |                  |   |                  |  |   |        
|-------------------- |  | ---------------- | ------- | ---------------- | - | ---------------- |  | - | -------
|                     |  | December 31,2004 |         | December 31,2003 |   | December 31,2002
|Reported PBM revenue |  | $                | 475,229 |                  | $ | 331,530          |  | $ | 182,276
|Member co-payments   |  |                  | 213,014 |                  |   | 141,020          |  |   | 71,617 
|                     |  |                  |         |                  |   |                  |  |   |        
|Total                |  | $                | 688,243 |                  | $ | 472,550          |  | $ | 253,893
|                     |  |                  |         |                  |   |                  |  |   |        



|                                |  |                  |         |                  |   |                  |  |   |        
|------------------------------- |  | ---------------- | ------- | ---------------- | - | ---------------- |  | - | -------
|                                |  | December 31,2004 |         | December 31,2003 |   | December 31,2002
|Reported PBM operating expenses |  | $                | 451,388 |                  | $ | 317,760          |  | $ | 173,905
|Member co-payments              |  |                  | 213,014 |                  |   | 141,020          |  |   | 71,617 
|                                |  |                  |         |                  |   |                  |  |   |        
|Total                           |  | $                | 664,402 |                  | $ | 458,780          |  | $ | 245,522
|                                |  |                  |         |                  |   |                  |  |   |        



ACQUISITIONS



We have supported the growth of our PBM segment through acquisitions.



On June 18, 2004, we acquired 100% of the common stock of MHS for a cash
payment of $37.3 million and 100,739 shares of our common stock valued at $1.5 million. In addition, we agreed to issue $4.0 million principal amount of non-negotiable promissory notes, warrants to purchase up to 300,000 shares of our common stock
at an exercise price of $15.45 per share, and to pay $2.0 million in cash, all subject to performance-based standards and certain revenue and gross profit criteria attributable to MHS. The acquisition of MHS was accounted for using the purchase
method of accounting, and we have recorded goodwill of approximately $30.4 million and intangible assets of $8.4 million.



On December 1, 2002, we acquired 100% of the common stock of Pharmacy Network National Corporation (PNNC) for $20.2 million in cash. The acquisition of PNNC
was accounted for using the purchase method of accounting. The acquisition resulted in goodwill of approximately $10.6 million and intangible assets of approximately $8.0 million.



On November 14, 2001, we acquired an 80% interest in Catalyst for an aggregate purchase price of approximately $14.3 million, consisting of
$10.4 million in cash, the assumption of $1.6 million in liabilities and the issuance of 366,730 shares of common stock valued at $2.3 million. The acquisition of Catalyst was accounted for using the purchase method of accounting and resulted in
$9.1 million of goodwill and $4.0 million of intangible assets.



During the
first quarter of 2002, we purchased the remaining 20% minority interest in Catalyst for $5.3 million, consisting of 319,033 shares of our common stock valued at $1.1 million and notes in the principal amount of $4.2 million. This minority interest
purchase resulted in additional goodwill of $3.2 million and intangible assets of $1.7 million. The stock was transferred to the seller on April 1, 2002, $3.1 million in cash was paid in 2002, and the final cash installment of $1.1 million was paid
on March 1, 2003.



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Effective November 1, 2000, we acquired International Pharmacy Management (IPM) for an aggregate purchase
price of approximately $9.2 million, consisting of approximately 95% cash and the remainder in common stock. The acquisition of IPM was accounted for using the purchase method of accounting and resulted in $9.2 million of goodwill.



We have successfully integrated IPM, Catalyst, and PNNC into our financial, organizational,
management and technology structure. As a result, we achieved cost savings from the consolidation of certain corporate activities and the elimination of certain duplicate components of our corporate operations. We are in the process of integrating
MHS.



SUPPLEMENTAL BENEFITS



Our supplemental benefits segment generates revenue from the sale of supplemental benefit
programs, which include lump sum accidental disability benefits, accidental death and dismemberment benefits, and emergency accident and sickness medical benefits. In recent periods, our supplemental benefits programs have been marketed and sold to
individuals primarily by three nationally-recognized companies, which incur the marketing expenses. Accordingly, our supplemental benefit revenue from new members is primarily dependent on the extent and timing of marketing campaigns funded by these
three companies and the success they achieve. Correspondingly, these companies are compensated with an increasing percentage of total program revenue, which is accounted for as direct expenses by HealthExtras. All of the insurance and service
features included in our programs are supplied by third-party insurance companies or other vendors, and the programs are distributed through an independent, licensed and non-affiliated insurance agency.



The primary determinant of revenue recognition for the supplemental benefits segment is
monthly program enrollment. In general, program revenue is recognized based on the number of members enrolled in each reporting period multiplied by the applicable monthly fee for their specific membership program. The program revenue recognized by
the Company includes the cost of membership features supplied by others, including the insurance components. Revenue from program payments received, and related direct expenses, is deferred to the extent that they are applicable to future periods or
to any refund guarantee we offer.



Direct program expenses consist of the costs
that are a direct function of a period of membership and a specific set of program features. The coverage obligations of our benefit suppliers and the related expense are determined monthly, as are the remaining direct expenses.



RESULTS OF OPERATIONS



Year Ended December 31, 2004 Compared to Year Ended December 31, 2003



Revenue. Revenue from operations for year ended December 31, 2004 was $521.3 million,
consisting of $475.2 million generated from the PBM segment and $46.1 million from the supplemental benefits segment. The PBM revenue increased by $143.7 million, including $131.0 million of revenue from increased prescription volume, $8.9 million
from the acquisition of MHS, and $16.2 million in increased unit prices, slightly offset by a reduction in revenue of $12.4 million due to increased member co-payments. Total claims processed increased to approximately 12.8 million in 2004 from
approximately 9.0 million in 2003. A significant contributor to the increase in revenue and prescription volume was a new contract with the State of Louisiana, covering about 180,000 members, which commenced on July 1, 2004. This contract generated
13.0% and 11.8% of the Companys PBM and total revenue, respectively. The supplemental benefits revenue decreased by $6.5 million, largely as a result of lower levels of coverage purchased and decreased membership. Revenue for year ended
December 31, 2003 was $384.1 million, consisting of approximately $331.5 million and $52.6 million attributable to the PBM and supplemental benefits segments, respectively.



Direct Expenses.Direct expenses for year ended December 31, 2004 were $460.8 million, consisting of $427.0 million in direct
expenses from the PBM segment and $33.8 million in direct expenses from the supplemental benefits segment. PBM segment direct expenses increased by $124.8 million, while the supplemental benefits segment direct expenses decreased by approximately
$5.2 million. The PBM segments $124.8 million increase in direct expenses are a direct function of the $143.7 million increase in PBM revenue. The net $119.6 million increase is consistent with our anticipated gross margin contribution from
increased prescription volume, the acquisition of MHS and



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increased unit prices, offset by increased member co-payments. The decrease in direct expenses in the supplemental benefits segment was largely a result of a
modest decrease in membership and the negotiation of lower costs for certain of the benefits in our programs.



Direct expenses for year ended December 31, 2003 were $341.2 million, consisting of approximately $302.2 million and $39.0 million attributable to the PBM and supplemental benefit segments, respectively. The direct
expenses of $460.8 million and $341.2 million for years ended December 31, 2004 and 2003 represented 92.8% and 93.0% of operating expenses for the respective periods.



Gross margins in the PBM segment for year ended December 31, 2004 were 10.2%, or $48.3 million, compared to 8.8%, or $29.3 million, for year
ended December 31, 2003. Gross margins for the supplemental benefits segment for year ended December 31, 2004 were 26.6%, or $12.3 million, compared to 25.8%, or $13.6 million for year ended December 31, 2003.



Gross margins in the PBM segment are generally predictable based on client contract terms and
vendor/supplier contracts. Factors that can result in changes in gross margins include generic substitution rates, changes in the utilization of preferred drugs with higher discounts and changes in the volume of prescription dispensing at lower cost
network pharmacies. None have materially changed in 2004 in a manner that would meaningfully affect current or anticipated results. In the current year, gross margins were improved by an increased volume of higher margin workers compensation
business resulting from the acquisition of the MHS business. This increase was largely offset in percentage terms by the addition of the State of Louisiana contract that has lower percentage margin contributions than our historical averages.
Excluding these changes, there were no other significant factors that influenced reported gross margins in 2004 or indicate likely changes in the near future.



Gross margins in the supplemental benefits segment are generally consistent on a per transaction basis. Gross dollar margins have been declining as new enrollments,
with lower gross dollar margins, offset attrition in membership under more profitable prior marketing arrangements. This gradual shift in business mix is likely to continue in the future but is not anticipated to accelerate.



Selling, General and Administrative.For the year ended December 31, 2004, selling,
general and administrative expenses increased by approximately $9.7 million over the prior year to $35.6 million or 7.2% of operating expenses. This increase was primarily associated with PBM segment growth, several significant marketing
initiatives, and new client implementations.



Of the $35.6 million in selling,
general and administrative expenses for the year ended December 31, 2004, $24.9 million related to the PBM segment, $4.5 million related to the supplemental benefits segment, and $6.2 million related to corporate overhead. Selling, general and
administrative expenses included approximately $16.7 million in compensation and benefits, $5.5 million in commissions, other professional services, and insurance, $4.1 million in other expenses, $3.0 million in depreciation and amortization, $2.1
million for creative development, product endorsement and market research, $2.6 million in facility costs, and $1.6 million in travel expenses.



Selling, general and administrative expenses for year ended December 31, 2003 were approximately $25.9 million or 7.0% of total operating expenses, $15.6 million of which
related to the PBM segment, $4.9 million related to the supplemental benefits segment, while the remaining $5.4 million related to corporate overhead. These expenses included approximately $10.7 million in compensation and benefits, $4.8 million in
commissions, other professional fees, and insurance, $3.2 million in other expenses, $2.4 million in depreciation and amortization, $1.8 million for creative development, product endorsement and market research, $1.8 million in facility costs, and
$1.2 million in travel expenses.



Other Income. In the second quarter of
2004, we reached a legal settlement related to litigation initiated by us on December 3, 2002. The terms of the settlement are confidential; however, the net proceeds from the settlement constitute the significant portion of the $2.1 million in
other income reported in the 2004 statement of operations.



Interest
Income. Interest income increased to $383,000 in the year ended December 31, 2004 from $155,000 in the prior year. The increase was primarily due to our higher average cash and cash equivalents balance during 2004 due to increased operating
income and our sale of common stock in the fourth quarter of 2004.



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Interest Expense.Interest expense increased to $1.1 million in the year ended December 31, 2004 from $598,000 in
the year ended December 31, 2003. With our acquisition of MHS on June 18, 2004, we entered into a $20.0 million term loan and increased our current line of credit. As a result, the increase in interest expense was attributable to significantly
larger amounts of outstanding debt in the year ended December 31, 2004 compared to 2003.



Income Tax Expense.The effective income tax rates of 37.7% for both 2004 and 2003 represent the combined federal and state income tax rates adjusted as necessary based on the particular jurisdictions where the
Company operates.



Net Income.Net income for year ended
December 31, 2004 increased by approximately $6.1 million over the same period in 2003. The increase in net income was primarily a function of increased gross margins in the PBM segment and an increase in other income. PBM segment gross margins
increased to $48.3 million in 2004 from $29.3 million in 2003, largely attributable to the $143.7 million increase in PBM revenues from the year ended December 31, 2003 to the year ended December 31, 2004. Segment operating information for 2004 and
2003 is as follows (in thousands):



|                           |  |     |         |                      |   |        |  |   |        
|-------------------------- |  | --- | ------- | -------------------- | - | ------ |  | - | -------
|                           |  | PBM |         | SupplementalBenefits |   | Total 
|December 31, 2004          |  |     |         |                      |   |        |  |   |        
|Revenue                    |  | $   | 475,229 |                      | $ | 46,096 |  | $ | 521,325
|Segment operating expenses |  |     | 451,388 |                      |   | 38,735 |  |   | 490,123
|Segment operating income   |  |     | 23,841  |                      |   | 7,361  |  |   | 31,202 



|                           |  |     |         |                      |   |        |  |   |        
|-------------------------- |  | --- | ------- | -------------------- | - | ------ |  | - | -------
|                           |  | PBM |         | SupplementalBenefits |   | Total 
|December 31, 2003          |  |     |         |                      |   |        |  |   |        
|Revenue                    |  | $   | 331,530 |                      | $ | 52,564 |  | $ | 384,094
|Segment operating expenses |  |     | 317,760 |                      |   | 43,959 |  |   | 361,719
|Segment operating income   |  |     | 13,770  |                      |   | 8,605  |  |   | 22,375 



Operating expenses of the segments
exclude $6.2 million and $5.4 million in corporate overhead that was not allocated by management in assessing segment performance for the years ended December 31, 2004 and 2003, respectively.



RESULTS OF OPERATIONS



Year Ended December 31, 2003 Compared to Year Ended December 31, 2002



Revenue. The increase in revenue for 2003 was primarily related to the ongoing growth
of our PBM revenue. Revenue growth in the PBM segment in 2003 was primarily attributable to a full year consolidation of the results of our acquired subsidiary, PNNC, and a significant overall increase in the number of pharmacy claim transactions
processed. Total claims processed increased from approximately 4.8 million in 2002 to approximately 9.0 million in 2003. Revenue also increased due to modest increases in unit prices.



Revenue decreases in the supplemental benefits segment were a function of contractual changes in the economic terms of our marketing
arrangements. While net membership levels were largely unchanged from 2002 to 2003, our marketers began to incur the direct marketing costs for new members added during the year and we recognized lower revenue levels accordingly. The reduction in
revenue of approximately $13.5 million in the supplemental benefits segment in 2003 was more than offset by the $15.4 million decrease in the segments combined marketing and creative development expenses recorded in selling, general and
administrative expenses. The decrease in combined marketing and creative development expenses was primarily attributable to the restructured distribution arrangements under which the distributor became responsible for marketing expenses.



Revenue for the year ended December 31, 2003 was $384.1 million, consisting of $331.5
million generated from the PBM segment and $52.6 million from the supplemental benefits segment. PBM revenue increased by $149.3 million, including a $99.2 million increase from PNNC. Of the $99.2 million increase from PNNC, $17.8 million was
attributable to revenue from new clients signed by PNNC in 2003. The remaining



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increase of $50.1 million was attributable to $55.5 million of revenue from prescription volume increases and $2.2 million to increased unit prices, offset
by a $7.6 million reduction in revenue due to increased member co-payments. Supplemental benefits revenue decreased by $13.5 million. Revenue for the year ended December 31, 2002 was $248.4 million, consisting of approximately $182.3 million and
$66.1 million attributable to the PBM and supplemental benefits segments, respectively.



Direct Expenses. Operating margins in the PBM segment were improved in 2003 through an increase in more profitable generic drug dispensing rates, consolidation of our claims processing systems to a single more cost-effective
platform, the introduction of standardized pharmacy reimbursement contract rates across all our business units and more effective formulary compliance programs which result in increased margins from the use of preferred drugs.



The decrease in direct expenses in the supplemental benefits segment was largely a result of
lower levels of coverage being purchased by new members. A modest decrease in membership and the negotiation of lower costs paid by us for certain of the benefits included in our programs (available for the first time in 2003) also contributed to
the decrease.



Direct expenses for the year ended December 31, 2003 were $341.2
million, consisting of $302.2 million in direct expenses from the PBM segment and $39.0 million in direct expenses from the supplemental benefits segment. PBM segment direct expenses increased by $134.2 million, including a $89.1 million increase
from PNNC. The remaining $45.1 million increase was directly related to the $50.1 million increase in revenue in 2003. This $45.1 million increase in related direct expenses was consistent with our anticipated PBM segment gross margin contribution
of approximately 10% from increased prescription volume during 2003. Direct expenses for the year ended 2002 were $209.5 million, consisting of approximately $168.0 million and $41.5 million attributable to the PBM and supplemental benefit segments,
respectively. The direct expenses of $341.2 million and $209.5 million for the years ended December 31, 2003 and 2002 represented 93.0% and 85.5% of operating expenses for the respective periods.



Selling, General and Administrative. From 2002 to 2003, selling, general and
administrative expenses decreased by approximately $9.6 million. This decrease, as discussed above, was primarily a result of changing our marketing arrangements. In 2003, Company-funded direct marketing expenses for supplemental benefits were
eliminated and resulted in an expense reduction of approximately $12.6 million. The offsetting increase in selling, general and administrative expenses was primarily associated with PNNCs operations, personnel costs and other expenses being
consolidated for the full calendar year.



Selling, general and administrative
expenses for the year ended December 31, 2003 totaled $25.9 million or 7.0% of operating expenses, $15.6 million of which was related to the PBM segment, $4.9 million was related to the supplemental benefits segment, while the remaining $5.4 million
was related to corporate overhead. These expenses include $10.7 million in compensation and benefits, $4.8 million in commissions, other professional services and insurance, $3.2 million in other expenses, $2.4 million in depreciation and
amortization, $1.8 million for creative development, product endorsement and market research, $1.8 million in facility costs, and $1.2 million in travel expenses. We had no supplemental benefits direct marketing expense in 2003, as direct marketing
expenses were paid by the distributor.



Selling, general and administrative
expenses for the year ended December 31, 2002, were approximately $35.5 million or 14.5% of total operating expenses, $5.9 million of which related to the PBM segment, $23.1 million related to the supplemental benefits segment, while the remaining
$6.5 million related to corporate overhead. These expenses included $4.1 million for creative development, product endorsements and market research, $12.6 million in direct marketing, $8.2 million in compensation and benefits, $1.6 million in
commissions, professional fees and other insurance, $2.4 million in other expenses, $1.4 in facility costs, $826,000 in travel expenses, $1.7 million in depreciation and amortization, and $2.7 million related to the impairment of and write-off of
property and equipment.



Interest Income. Interest income decreased to
$155,000 in the year ended December 31, 2003 from $286,000 in the prior year. The decrease in 2003 was due to lower interest rates in 2003 and increased average cash and cash equivalent balances in 2002 resulting from the sale of Company stock in
the fourth quarter of 2001.



Interest Expense. Interest expense
increased to $598,000 in the year ended December 31, 2003 from $368,000 in the year ended December 31, 2003. The increase was primarily due to the acquisition of PNNC and increased borrowings under the line of credit commencing in the fourth quarter
of 2002.



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Minority Interest. There was no minority interest charge in 2003. The $45,000 charge in 2002 represents the net
income attributable to the 20% minority interest in Catalyst for the months of January and February 2002.



Income Tax (Benefit) Expense.Through the third quarter of 2002, we maintained a full valuation allowance against our deferred tax assets due to the uncertainly as to their ultimate realization.Due to
the recording of the full valuation allowance, no provision for income taxes was recorded in the first nine months of 2002. In the fourth quarter of 2002, as a result of our 2002 and projected profitability, we recognized a $10.2 million tax credit
principally resulting from releasing the valuation allowance against our deferred tax assets. In 2003, our effective tax rate was 37.7% and the provision for income taxes was $6.3 million.



Net Income. Net income in 2003 decreased by $3.1 million from 2002 despite a $13.6
million improvement in operating income. The decrease was attributable in large part to the recognition of a $10.2 million tax benefit in 2002 versus a $6.3 million tax expense in 2003. The increase in operating income was primarily a function of
increased gross margins in the PBM segment. PBM segment gross margins increased from $14.2 million in 2002 to $29.3 million in 2003, an increase largely attributable to a comparable percentage increase in revenues.



In the supplemental benefits segment, the increase in net income was attributable to reduced
marketing expenses, and increases in fees charged to vendors. Net income also increased from 2002 to 2003 because results for 2002 reflected a $2.6 million charge for software impairment.



Net income for the year ended December 31, 2003, was $10.3 million compared to $13.5 million in 2002. The $13.5 million net income in 2002
included a tax benefit of $10.2 million, while the $10.3 net income for 2003 included a $6.3 million provision for income taxes, as discussed above. As a percentage of revenue, pre-tax income increased from 1.3% to 4.3%.



Segment operating information for 2003 and 2002 is as follows (in thousands):



|                           |  |     |         |                      |   |        |  |   |        
|-------------------------- |  | --- | ------- | -------------------- | - | ------ |  | - | -------
|                           |  | PBM |         | SupplementalBenefits |   | Total 
|December 31, 2003          |  |     |         |                      |   |        |  |   |        
|Revenue                    |  | $   | 331,530 |                      | $ | 52,564 |  | $ | 384,094
|Segment operating expenses |  |     | 317,760 |                      |   | 43,959 |  |   | 361,719
|Segment operating income   |  |     | 13,770  |                      |   | 8,605  |  |   | 22,375 



|                           |  |     |         |                      |   |        |  |   |        
|-------------------------- |  | --- | ------- | -------------------- | - | ------ |  | - | -------
|                           |  | PBM |         | SupplementalBenefits |   | Total 
|December 31, 2002          |  |     |         |                      |   |        |  |   |        
|Revenue                    |  | $   | 182,276 |                      | $ | 66,131 |  | $ | 248,407
|Segment operating expenses |  |     | 173,905 |                      |   | 64,645 |  |   | 238,550
|Segment operating income   |  |     | 8,371   |                      |   | 1,486  |  |   | 9,857  



Operating expenses of the segments
exclude $5.4 million and $6.5 million in corporate overhead that was not allocated by management in assessing segment performance for the years ended December 31, 2003 and 2002, respectively.



LIQUIDITY AND CAPITAL RESOURCES



Our sources of funds are usually the capital markets through the sale of equity, bank debt,
and cash flows from operations. In November 2004, we received $54.8 million in net proceeds from the sale of shares in a public offering. During 2004 and 2003, we generated positive cash flow from operations and anticipate similar results in 2005
and thereafter. Cash and cash equivalents at December 31, 2004 were $67.1 million, an increase of $38.2 million from the end of 2003.



Net Cash Provided by Operating Activities.Our operating activities generated $12.0 million of cash from operations during 2004, a $11.4 million decrease from the
$23.4 million of net cash provided in 2003. The decrease was primarily due to the timing of payments to vendors included in accounts payable, the timing of receipts from clients against accounts receivable, and a $6.3 million decrease in deferred
tax assets in 2003.



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Net Cash Used in Investing Activities.Net cash used in investing activities for year ended December 31, 2004 was
$46.3 million compared to $4.8 million in 2003. This increase reflects the $37.7 million we paid to acquire MHS and $9.7 million in capital expenditures, largely associated with our new headquarters office space.



Net Cash Provided by (Used in) Financing Activities.Net cash provided by financing
activities for year ended December 31, 2004 was $72.4 million compared to cash used in financing activities of $7.2 million in 2003. In 2004, we received $54.8 million in net proceeds from the sale of shares in a public offering. We made payments
totaling $21.8 million on our line of credit in 2004 compared to payments of $8.0 million in 2003. We also increased borrowings by $37.3 million to finance the acquisition of MHS and received approximately $2.2 million in proceeds from the exercise
of stock options.



We anticipate continuing to generate positive operating cash
flow which, combined with available cash resources, should be sufficient to meet our planned working capital, capital expenditures and operating expenses. However, there can be no assurance that we will not require additional capital. Even if such
funds are not required, we may seek additional equity or debt financing. We cannot be assured that such financing will be available on acceptable terms, if at all, or that such financing will not be dilutive to our stockholders.



The Company has no off-balance-sheet transactions. The following table reflects our current
contractual commitments as of December 31, 2004 (in thousands):



|                            |  |                        |        |          |   |           |  |           |        |           |   |       |  |   |      
|--------------------------- |  | ---------------------- | ------ | -------- | - | --------- |  | --------- | ------ | --------- | - | ----- |  | - | -----
|                            |  | Payments Due by Period
|                            |  | Total                  |        | < 1 year |   | 1-3 years |  | 4-5 years |        | > 5 years
|Notes payable               |  | $                      | 25,500 |          | $ | 5,000     |  | $         | 18,000 |           | $ | 2,500 |  | $ |     
|Operating leases            |  |                        | 14,706 |          |   | 1,706     |  |           | 3,410  |           |   | 3,149 |  |   | 6,441
|Other long-term obligations |  |                        | 1,000  |          |   | 1,000     |  |           |       |           |   |      |  |   |     
|                            |  |                        |        |          |   |           |  |           |        |           |   |       |  |   |      
|                            |  | $                      | 41,206 |          | $ | 7,706     |  | $         | 21,410 |           | $ | 5,649 |  | $ | 6,441
|                            |  |                        |        |          |   |           |  |           |        |           |   |       |  |   |      



Using the December 31, 2004 effective
interest rates and outstanding balances, and factoring the required future payments on the term loan, the Company estimates its interest payments on its notes payable to be $1.1 million, $866,000, $626,000 and $215,000 for 2005, 2006, 2007 and 2008,
respectively.



CRITICAL ACCOUNTING POLICIES AND ESTIMATES



Critical Accounting Policies and Estimates



Managements Discussion and Analysis of the Financial Condition and Results of
Operations discusses our consolidated financial statements. Preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that
affect the amounts reported in the consolidated financial statements and accompanying notes. Actual results could differ from those estimates. The most significant estimates included in these financial statements include the following: the value of
intangible assets acquired in business combinations and related amortization periods, income tax provisions and related valuation allowances, rebates due from pharmaceutical manufacturing companies, and, in years prior to 2004, the estimate of the
value and number of common stock warrants to be issued to a distributor under a marketing compensation agreement.



Revenue and direct expense recognition



We recognize revenues from PBM services, which include sales of prescription drugs by pharmacies in our nationwide network and related claims processing fees, provided to
our clients. Revenue is recognized when the claims are adjudicated. Pharmacy claims are adjudicated at the point-of-sale using an on-line claims processing system. When we have a contractual obligation to pay a network pharmacy provider for benefits
provided to our clients members, total payments from these clients are recorded as revenue and payments to the network pharmacy provider are recorded as direct expenses. Generally, these contracts require us to assume the credit risk of our
clients abilities to pay. In addition, under the vast majority of our client contracts, we are at risk for the difference between the payments we receive from our clients and the negotiated reimbursements we pay to the pharmacies. When we
administer pharmacy reimbursement contracts and do not assume credit risk, we record only the net revenue and the administrative or processing fees. Rebates earned under arrangements with manufacturers are recorded as a reduction to direct expenses.
The portion of such rebates due to plan sponsors is recorded as a reduction of revenue. Manufacturers rebates are based on estimates, which are subject to final settlement with the contracted party.



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Member co-payments are not recorded as revenue. Under our client contracts, the pharmacy is solely obligated to collect
the co-payments from the members. Under client contracts, we do not assume liability for member co-payments in pharmacy transactions. As such, we do not include member co-payments to pharmacies in revenue or operating expenses.



The primary determinant of revenue recognition for the supplemental benefits segment is
monthly program enrollment and, prior to October 2002, payments from certain distributors related to new member enrollments. In general, program revenue is recognized based on the number of members enrolled in each reporting period multiplied by the
applicable monthly fee for their specific membership program. The program revenue we recognize includes the cost of membership features supplied by others, including the insurance components. Direct program expenses consist of the costs that are a
direct function of a period of membership and a specific set of program features. The coverage obligations of our benefit suppliers and the related expense are determined monthly, as are the remaining direct expenses.



Prior to October 2002, payments from distributors related to new member enrollments were
recorded as revenue to the extent of related direct expenses, which cumulatively exceeded payments from distributors.



Revenue from supplemental benefit programs and related direct expenses (principally marketing and processing fees and the cost of the benefits provided to program
members) are initially deferred during the period in which a program member is entitled to obtain a refund (generally 90 days). If a member requests a refund, we retain any interest earned on funds held during the refunded membership period. Total
revenue and direct expenses attributable to the initial deferral are recognized subsequent to the end of the initial deferral period. After the initial deferral period, revenue is recognized as earned and direct expenses as incurred.



We have historically maintained a prepaid balance for the cost of insurance benefits included
in its programs. The carrying value of the prepayment was adjusted at the end of each quarter based on factors including enrollment levels in each product, enrollment trends, and the remaining portion of the unexpired prepayment period.



Pharmacy Benefit Management Rebates



Rebates earned under arrangements with manufacturers are recorded as a reduction of direct
expenses. The portion of such rebates due to clients is recorded as a reduction of revenue. Manufacturer rebates are based on estimates, which are subject to final settlement with the contracted party on an annual basis. Resulting adjustments
historically have not been significant.



Allowance for Doubtful Accounts



Trade accounts receivable are recorded at the invoiced amount and do
not bear interest. The allowance for doubtful accounts is our best estimate of the amount of probable credit losses in our existing accounts receivable. We determine the allowance based on historical write-off experience by industry and regional
economic data. We review our allowance for doubtful accounts monthly. Past due balances over 90 days and over a specified amount are reviewed individually for collectibility. All other balances are reviewed on a pooled basis by type of receivable.
Account balances are charged off against the allowance when we feel it is probable the receivable will not be recovered. We do not have any off-balance-sheet credit exposure related to our customers.



Assets Acquired and Liabilities Assumed in Business Combinations



In our acquisitions, we are required to make judgments regarding the fair values of the
assets acquired and the liabilities assumed. For significant acquisitions, management engages independent consultants to assist it in estimating the fair values of acquired intangible assets.



Intangible Assets



The Company accounts for its intangible assets under Statement of Financial Accounting
Standards (SFAS) No. 142, Goodwill and Other Intangible Assets. Under SFAS No. 142, the Company does not have any intangible assets with indefinite lives. The Company does have other intangible assets subject to amortization
and these assets are amortized over 5 months to 20 years, depending on each intangible assets estimated useful life.



The estimated fair value and the weighted average useful-life of the intangible assets are based on income-method valuation calculations, performed by an independent
consulting firm. The remaining useful life of intangible assets is evaluated periodically and adjusted as necessary to match the period that the assets are expected to provide economic benefits. We concluded that no impairment of intangible assets
existed at December 31, 2004 and 2003.



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Goodwill



The Company accounts for its goodwill under SFAS No. 142, Goodwill and Other Intangible Assets. Under SFAS No. 142, goodwill is not amortized, but it is
tested for impairment at least annually. Each year, the Company tests for impairment of goodwill according to a two-step approach. In the first step, the Company tests for impairment of goodwill by estimating the fair values of its reporting units
using the present value of future cash flows approach, subject to a comparison for reasonableness to its market capitalization at the date of valuation. If the carrying amount exceeds the fair value, the second step of the goodwill impairment test
is performed to measure the amount of the impairment loss, if any. In the second step the implied fair value of the goodwill is estimated as the fair value of the reporting unit used in the first step less the fair values of all other net tangible
and intangible assets of the reporting unit. If the carrying amount of the goodwill exceeds its implied fair market value, an impairment loss is recognized in an amount equal to that excess, not to exceed the carrying amount of the goodwill. In
addition, goodwill of a reporting unit is tested for impairment between annual tests if an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying value.



Income Taxes



In 2001, we recorded a full valuation allowance against our deferred tax assets due to the uncertainty as to their ultimate realization. In
the fourth quarter of 2002, as a result of our profitability, we recognized $10.2 million in tax benefits principally resulting from releasing the full valuation allowance for our deferred tax asset. In 2004 and 2003, we recorded income tax expense
of $9.9 million and $6.3 million, respectively. As we now have achieved sustained profitability, no additional valuation allowances are expected in the foreseeable future.



Common Stock Warrants



From time to time we have issued warrants to purchase shares of our common stock under arrangements with our business partners or as consideration in acquisitions. We are
required to estimate the fair value of such warrants for purposes of recording these transactions in our financial statements upon achieving a measurement date. Such estimates require judgments regarding, among other things, expected term, risk-free
interest rates and common stock volatility.



RECENT
ACCOUNTING PRONOUNCEMENTS



In January 2003, the FASB issued Interpretation
No. 46, Consolidation of Variable Interest Entities (FIN 46). Until this interpretation, a company generally included another entity in its consolidated financial statements only if it controlled the entity through voting
interests. FIN 46 requires a variable interest entity, as defined, to be consolidated by a company if that company is subject to a majority of the risk of loss from the variable interest entitys activities or entitled to receive a majority of
the entitys residual returns. Certain provisions of FIN 46 were deferred until the period ending after March 15, 2004. The impact of FIN 46 and certain provisions effective after March 15, 2004, are not applicable to the accounting of our
business and had no impact on the Companys financial statements.



In
December 2004, the FASB issued SFAS No. 123, Revised 2004 (Statement 123(R)), Share-Based Payment, which revised SFAS No. 123, Accounting for Stock-Based Compensation. This statement supercedes APB 25. The revised
statement addresses the accounting for share-based payment transactions with employees and other third parties, eliminates the ability to account for share-based compensation transactions using APB 25 and requires that the compensation costs
relating to such transactions be recognized in the consolidated statement of operations. The revised statement is effective as of the first interim period beginning after June 15, 2005. The Company will adopt the statement as required. Effective
with the implementation of SFAS 123(R), the Company anticipates accelerating the vesting of certain options with little or no intrinsic value prior to July 1, 2005. Therefore, these options will not be expensed in the periods subsequent to July 1,
2005. It is estimated that the acceleration of the vesting of these options will eliminate approximately $5.0 million before income taxes on a prospective basis and that the Company will incur a one-time charge associated with the acceleration of
vesting of approximately $1.5 million before income taxes. The Company expects to execute the indicated restructuring of its option plans no later than June 30, 2005.



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INTEREST RATE AND EQUITY PRICE SENSITIVITY



We are subject to interest rate risk on our short-term investments. We have determined that a
10% move in the current weighted average interest rate of our short-term investments would not have a material effect in our financial position, results of operations and cash flows in the next year.



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RISK FACTORS



Risks Related To Our Pharmacy Benefits Management Segment



Competition in our industry is intense and could reduce or eliminate our profitability.



The PBM industry is very competitive. If we do not compete effectively, our business,
results of operations and financial condition could suffer. The industry is highly consolidated and dominated by a few large companies with significant resources, purchasing power and other competitive advantages, which we do not have. A limited
number of firms, including national PBM companies such as Medco, Medco, Express Scripts, Inc., Express Scripts and Caremark Rx, Inc., Caremark, have an aggregate market share of approximately 70% of prescription
volume. Our competitors also include drug retailers, physician practice management companies, and insurance companies/health maintenance organizations. We may also experience competition from other sources in the future. PBM companies compete
primarily on the basis of price, service, reporting capabilities and clinical services. In most cases, our competitors are large, profitable and well-established companies with substantially greater financial and marketing resources than our
resources.



If we lose key clients as a result of competitive bidding for
contracts, consolidation of clients or otherwise, our business, profitability and growth prospects could suffer.



We depend on a limited number of clients for a significant portion of our revenue. Our top ten clients generated approximately 47%, and our top twenty clients generated
approximately 58%, of the claims we processed in 2004, although no single client accounted for greater than 15% of all revenue. Our business, results of operations and financial condition could suffer if we were to lose one or more of our
significant clients.



Many of our clients put their contracts out for
competitive bidding prior to expiration. Competitive bidding requires costly and time-consuming efforts on our behalf and, even after we have won such bidding processes, we can incur significant expense in proceedings or litigation contesting the
adequacy or fairness of these bidding processes. We could lose clients if they cancel their agreements with us, if we fail to win a competitive bid at the time of contract renewal, if the financial condition of any of our clients deteriorates or if
our clients are acquired by, or acquire, companies with which we do not have contracts. Over the past several years, self-funded employers, TPAs and other managed care companies have experienced significant consolidation. Consolidations by their
very nature reduce the number of clients who may need our services. A client involved in a merger or acquisition by a company that is not a client of ours may not renew, and in some instances may terminate, its contract with us. Our clients have
been and may continue to be, subject to consolidation pressures.



If we
lose pharmacy network affiliations, our business, results of operations and financial condition could suffer.



Our PBM operations are dependent to a significant extent on our ability to obtain discounts on prescription purchases from retail pharmacies that can be utilized by our
clients and their members. Our contracts with retail pharmacies, which are non-exclusive, are generally terminable by either party on short notice. If one or more of our top pharmacy chains elects to terminate its relationship with us or if we are
only able to continue our relationship on terms less favorable to us, access to retail pharmacies by our clients and their health plan members, and our business, results of operations and financial condition could suffer. In addition, some large
retail pharmacy chains either own or have strategic alliances with PBMs or could attempt to acquire or enter into these kinds of relationships in the future. Ownership of, or alliances with, PBMs by retail pharmacy chains, particularly large
pharmacy chains which together control 45% of retail pharmacy business, could have material adverse effects on our relationships with those retail pharmacy chains, particularly the discounts they are willing to make available, and on our business,
results of operations and financial condition.



If we lose relationships
with one or more key pharmaceutical manufacturers or if rebate payments we receive from pharmaceutical manufacturers decline, our business, results of operations and financial condition could suffer.



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We receive rebates from numerous pharmaceutical manufacturers based on the use of selected drugs by members of health
plans sponsored by our clients, as well as fees for other programs and services. We believe our business, results of operations and financial condition could suffer if:



| |  |  | we lose relationships with one or more key pharmaceutical manufacturers;
| | - |  | ------------------------------------------------------------------------



| |  |  | rebates decline due to the failure of our health plan sponsors to meet market share or other thresholds;
| | - |  | --------------------------------------------------------------------------------------------------------



| |  |  | legal restrictions are imposed on the ability of pharmaceutical manufacturers to offer rebates or purchase our programs or services; or
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------



| |  |  | pharmaceutical manufacturers choose not to offer rebates or purchase our programs or services.
| | - |  | ----------------------------------------------------------------------------------------------



Over the next few years, as patents expire covering many brand name drugs that currently have substantial market share, generic products
will be introduced that may substantially reduce the market share of these brand name drugs. Historically, manufacturers of generic drugs have not offered formulary rebates on their drugs. Our profitability could be adversely affected if the use of
newly approved, brand name drugs added to formularies, does not offset any decline in use of brand name drugs whose patents expire.



If our business continues to grow rapidly and we are unable to manage this growth, our business, results of operations and financial condition could suffer.



Our business has grown rapidly since 2000, in part due to
acquisitions, with total annual PBM revenue increasing from $4.9 million in 2000 to $475.2 million in 2004. Our business strategy is to continue to seek to expand our PBM operations, including through possible acquisitions. If we are unable to
finance continued growth, manage future expansion or hire and retain the personnel needed to manage our business successfully, then our business, results of operations and financial condition could be adversely affected. Our growth in operations has
placed significant demands on our management and other resources, which is likely to continue. Our acquisition of MHS in June 2004 gives us specialized PBM capabilities for workers compensation and hospice care, which we did not previously
have. Under these conditions, it is important for us to retain our existing management, including those from MHS, Catalyst and PNNC, and to attract, hire and retain additional highly skilled and motivated officers, managers and employees.



If we are unable to manage potential problems and risks related to
future acquisitions, our business, results of operations and financial condition could suffer.



Part of our growth strategy includes making acquisitions involving new markets and complementary products, services, technologies and businesses. If we are unable to overcome the potential problems and inherent risks
related to such future acquisitions, our business, results of operations and financial condition could suffer. Our ability to continue to expand successfully through acquisitions depends on many factors, including our ability to identify acquisition
prospects and negotiate and close transactions. Even if we complete future acquisitions:



| |  |  | we could fail to successfully integrate the operations, services and products of an acquired company;
| | - |  | -----------------------------------------------------------------------------------------------------



| |  |  | there could be inconsistencies in standards, controls, procedures and policies among the companies being combined or assimilated which would make it more difficult to implement and
harmonize company-wide financial, accounting, billing, information technology and other systems;
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | we may experience difficulties maintaining the quality of products and services that acquired companies have historically provided;
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------



| |  |  | we would be required to amortize the identifiable intangible assets of an acquired business, which will reduce our net income in the years following its acquisition, and we also
would be required to reduce our net income in future years if we were to experience an impairment of goodwill or other intangible assets attributable to an acquisition.
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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| |  |  | we could be exposed to unanticipated liabilities of acquired businesses;
| | - |  | ------------------------------------------------------------------------



| |  |  | our managements attention could be diverted from other business concerns; and
| | - |  | ------------------------------------------------------------------------------



| |  |  | we could lose key employees or customers of the acquired business.
| | - |  | ------------------------------------------------------------------



In June 2004, we acquired MHS, which we are in the process of integrating into our business operations. There are risks associated with integrating and operating newly
acquired businesses. We can give no assurance that we will successfully operate this new business in the future.



Many companies compete for acquisition opportunities in the PBM industry. Most of our competitors are companies that have significantly greater financial and management
resources than we do. This may reduce the likelihood that we will be successful in completing acquisitions necessary to the future success of our business.



If we become subject to liability claims that are not covered by our insurance policies, we may be liable for damages and other expenses that could have a material
adverse effect on our business, results of operations and financial condition.



Various aspects of our business may subject us to litigation and liability for damages, for example, the performance of PBM services and the operation of our call centers and Web site. A successful product or professional liability claim in
excess of our insurance coverage where we are required to pay damages, incur legal costs or face negative publicity could have a material adverse effect on our business, results of operations and financial condition, our business reputation and our
ability to attract and retain clients, network pharmacies, and employees. While we intend to maintain professional and general liability insurance coverage at all times, we cannot provide assurances that we will be able to maintain insurance in the
future, that insurance will be available on acceptable terms or that insurance will be adequate to cover any or all potential product or professional liability claims.



Disruption of our point of sale information system and transaction processing system, which relies on third parties, could have a
material adverse effect on our business, results of operations and financial condition.



Our operations utilize an electronic network connecting approximately 53,000 retail pharmacies to process third-party claims. This system is provided by a third-party adjudication vendor. Because claims are
adjudicated in real time, systems availability and reliability are key to meeting customers service expectations. Any interruption in real time service, either through systems availability or telecommunications disruptions can significantly
damage the quality of service we provide. Our PBM services also depend on third-party proprietary software to perform automated transaction processing. There can be no assurance that our business will not be harmed by service interruptions or
software performance problems.



The failure by our health plan clients to
pay for prescription claims or a delay in payment of those claims could have a material adverse effect on our business, results of operations and financial condition.



Our contracts with retail pharmacies which participate in our network generally obligate us to make payments for prescription claims even if
we are not reimbursed by our clients. If our clients delay their reimbursement payments or fail to make payments for prescription claims, it could have a material adverse effect on our business, results of operations and financial condition.



If we fail to comply with complex and rapidly evolving laws and
regulations, we could suffer civil and/or criminal penalties, lose clients, be required to pay substantial damages or make significant changes to our operations.



During the past several years, the U.S. health care industry has been subject to an increase in governmental regulation at both the federal
and state levels. We are subject to numerous federal and state regulations. If we fail to comply with existing or future applicable laws and regulations, we could suffer civil or criminal penalties. We must devote significant operational and
managerial resources to comply with these laws and regulations. Although we believe that we substantially comply with all existing statutes and regulations applicable to our business, different interpretations and enforcement policies of these laws
and regulations could subject our current practices to allegations of impropriety or illegality, or could require us to make significant changes to our operations. In addition, we cannot predict the impact of future legislation and regulatory
changes on our business or assure you that we will be able to obtain or maintain the regulatory approvals required to operate our business.



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Among the legislation and government regulations that could affect us as a provider of PBM services are the following:



Network Access Legislation.A majority of states now have some form of
legislation, referred to as any willing provider legislation, which affects our ability to limit access to a pharmacy provider network or remove a network provider. Such legislation may require us or our clients to admit any retail
pharmacy willing to meet a health plans price and other terms for network participation or may restrict or prevent removal of a provider from a network except in compliance with certain procedures, referred to as due process
legislation.



Anti-Remuneration Legislation.Anti-kickback statutes at
the federal and state level prohibit an entity from paying or receiving any compensation to induce the referral of healthcare plan beneficiaries or the purchase of items or services for which payment may be made under healthcare plans. To our
knowledge, these laws have not been applied to prohibit PBM companies from receiving amounts from pharmaceutical manufacturers in connection with pharmaceutical purchasing and formulary management programs or in connection with therapeutic
substitution programs conducted by independent PBM companies nor have such laws been interpreted as prohibiting contractual relationships, such as we have with certain of our clients. However, we can make no assurances that such laws will not, in
the future, be applied to restrict PBM activities and affect the way in which we conduct our business.



ERISA Regulation.The Employee Retirement Income Security Act of 1974, ERISA, regulates certain aspects of employee pension and health benefit plans, including self-funded corporate health plans
with which we have agreements to provide PBM services. We believe that the conduct of our business generally is not subject to the fiduciary obligations of ERISA. However, other PBMs have disclosed publicly that they are defending private litigant
lawsuits alleging that they are ERISA fiduciaries. On May 25, 2004, the U.S. District Court for the Southern District of New York accepted a class action settlement proposed by Medco. Pursuant to the settlement, Medco will pay $42.5 million into a
settlement fund to be distributed to plan participants. Medco also agreed to change certain business practices aimed at increasing transparency around formulary decisions and therapeutic interchanges. There can be no assurance that the U.S.
Department of Labor, which is the agency that enforces ERISA, or a private litigant would not assert that the fiduciary obligations imposed by ERISA apply to certain aspects of our operations.



In addition to its fiduciary provisions, ERISA imposes civil and criminal liability on
service providers to health plans and certain other persons if certain forms of illegal remuneration are made or received. These provisions of ERISA are similar, but not identical, to the health care anti-remuneration laws discussed above. We have
implemented policies regarding, among other things, disclosure to health plan sponsors, with respect to any commissions paid by or to us that might fall within the scope of those provisions, and accordingly believe we are in substantial compliance
with these provisions of ERISA. However, we can provide no assurance that our policies in this regard would be found by the appropriate enforcement authorities and potential private litigants to meet the requirements of ERISA.



Plan or Benefit Design Regulations.Some states have enacted legislation that
prohibits a health care plan sponsor from implementing certain restrictive design features, and many states have introduced legislation to regulate various aspects of managed care plans, including provisions relating to PBMs. Legislation has been
introduced in some states to prohibit or restrict therapeutic substitution, or to require coverage of all FDA approved drugs. Other states mandate coverage of certain benefits or conditions. This type of legislation does not generally apply to us,
but it may apply to certain of our clients, such as HMOs and health insurers. If this type of legislation were to become widespread and broad in scope, it could have the effect of limiting the economic benefits achievable through PBMs and
consequently make our services less attractive.



Legislation Affecting Drug
Prices.Some states have adopted so-called most favored nation legislation providing that a pharmacy participating in the state Medicaid program must give the state the lowest price that the pharmacy makes available to any
third-party plan. This type of legislation may adversely affect our ability to negotiate discounts in the future from network pharmacies. In addition, under the MMA, effective January 1, 2005, AWP will no longer serve as the basis for Medicare Part
B drug reimbursement, except for certain enumerated products. Part B drugs will be reimbursed based on average sales price, ASP. Drugs that will be reimbursed under an ASP reimbursement system by Medicare do not represent a significant
portion of our business and we therefore do not expect ASP reimbursement for such drugs to have a material effect on our business.



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Consumer Protection Legislation.Most states have consumer protection laws that generally prohibit payments and
other broad categories of conduct deemed harmful to consumers. States and/or private litigants may enforce these statutes and both have put such statutes to use initiating lawsuits against PBMs. On April 26, 2004, Medco settled allegations that it
engaged in unfair and deceptive acts with 20 states for $29 million. In addition, Medco agreed to change several of its business practices aimed at increasing transparency as to the existence and extent of manufacturer rebates and the reasons for
therapeutic interchanges. We do not believe that we engage in conduct that has been identified as problematic in the Medco settlement agreement or that has been alleged as improper in other actions against PBMs under state consumer protection
statutes. However, no assurance can be given that we will not be subject to scrutiny or challenge under one or more of these laws by the government enforcers or private litigants.



State Discount Drug Card Regulation.Several states recently have enacted laws and/or promulgated or proposed regulations regarding
the selling, marketing, promoting, advertising or distributing of commercial discount drug cards for cash purchases. These laws and regulations provide generally that any person may bring an action for damages or injunction for violations. While we
offer a very limited commercial discount drug card program which we do not consider material to our business, there can be no assurance that the existence of such laws will not materially impact our ability to offer certain new products and/or
services in the future.



Licensure.Many states have licensure or
registration laws governing certain types of ancillary healthcare organizations, including preferred provider organizations, third party administrators and utilization review organizations. Laws requiring registration and regulating the operations
of PBMs meeting certain criteria have also begun to appear. These laws differ significantly from state to state, and the application of these laws to the activities of PBMs is often unclear. We have registered under these laws in those states in
which we have concluded that registration is required.



Confidential
Information.Most of our activities involve the receipt or use by us of confidential medical information concerning individual members, including the transfer of the confidential information to the members health benefit plan. In addition,
we use aggregated population data for research and analysis purposes. The Health Insurance Portability and Accountability Act, HIPAA, requires our PBM clients to enter into business associate agreements with us that require us to assure
confidential treatment of health care information, to only use or disclose that information as needed to provide our services, to use certain standard codes and data sets in processing claims and to safeguard and protect confidential information. We
currently believe that compliance with the HIPAA regulations should not have a material adverse effect on our business operations.



State laws that are more protective of medical information are not pre-empted by HIPAA. Therefore, to the extent states enact more protective legislation, we could be
required to make significant changes to our business operations.



Antitrust
Legislation.Federal and state antitrust laws regulate trade and commerce and prohibit unfair competition as defined by those laws. Sanctions for failing to comply with these antitrust laws can result in criminal penalties and civil sanctions.
Antitrust challenges can be brought either by government agencies or by private plaintiffs, and such actions generally raise very complex issues. Private litigants have become active in bringing suits against PBMs alleging violations of these laws.
We do not believe that we have business relationships that include the features that would be viewed adversely by government antitrust enforcement authorities or private litigants. However, no assurance can be given that we will not be subject to
scrutiny or challenge under one or more of these laws by the government enforcers or private litigants.



Government efforts to reduce health care costs and alter health care financing practices could lead to a decreased demand for our services or to reduced rebates from manufacturers.



Efforts to control health care costs, including prescription drug costs, are underway at the
federal and state government levels. Congress is also currently considering proposals to reform the U.S. health care system. These proposals may increase governmental involvement in health care and PBM services and may otherwise change the way our
clients do business. Our clients and prospective clients may react to these proposals and the uncertainty surrounding them by cutting back or delaying the purchase of our PBM services, and manufacturers may react by reducing rebates or reducing
supplies of certain products. These proposals could lead to a decreased demand for our services or to reduced rebates from manufacturers.



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In addition, both Congress and state legislatures are expected to consider legislation to increase governmental
regulation of managed care plans. Some of these initiatives would, among other things, require that health plan members have greater access to drugs not included on a plans formulary and give health plan members the right to sue their health
plans for malpractice when they have been denied care. The scope of the managed care reform proposals under consideration by Congress and state legislatures and enacted by states to date vary greatly, and we cannot predict the extent of future
legislation. However, these initiatives could greatly limit our business practices and impair our ability to serve our clients.



MMA creates a voluntary outpatient prescription drug benefit, which will provide both new risks and opportunities for PBMs to participate in the Medicare program,
and possible increased competition.



There are many uncertainties
presented by the Medicare Modernization Act, MMA, which is one of the reasons we opted not to participate under the interim endorsed drug discount card program, despite being selected as a national sponsor. We are considering bidding to
become either a Prescription Drug Plan, PDP, or a fallback plan in one or more regions for the outpatient prescription drug benefit to begin January 1, 2006. Possible effects of the MMA include:



| |  |  | New opportunities for PBMs created by MMA may bring new entrants into the PBM industry, thereby increasing competition and impacting profitability.
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | PDPs will be risk-bearing entities, paid on a capitated basis, which may impact profitability.
| | - |  | ----------------------------------------------------------------------------------------------



| |  |  | The implicit role PBMs will play in the outpatient prescription drug benefit program will increase governmental scrutiny on the industry.
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------



| |  |  | If we are chosen as a PDP or fallback plan, this will be the first time we are a direct contractor to the federal government and subject to the rules, regulations and enforcement
authority of the federal government over its contractors.
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



Risks Related To Our Supplemental Benefits Segment



The
National Do Not Call Registry under FTC rules may have a material adverse effect on the marketing of our supplemental benefit programs.



Over 50 million consumers have registered on the Do-Not-Call Registry established by the Federal Trade Commission FTC, which became effective on
October 1, 2003. This Registry limits the ability to telemarket our supplemental benefit programs. Although we do not believe the Registry has had a material adverse effect on sales of our supplemental benefit programs to date, it could have such an
effect in the future.



We have experienced a greater reliance on monthly
rather than annual sales and a reduction in program renewals as a result of reliance on telemarketing.



A significant percentage of our sales of supplemental benefit programs is attributable to telemarketing sales. These sales involve a much higher percentage of monthly
rather than annual sales than was our previous experience. This has resulted in higher initial cancellation rates and a reduction in program renewals.



The passing of Christopher Reeve, a key promoter of our supplemental benefit programs, could significantly impair our brand recognition and, thus, our ability to
sell our programs.



The management and staff at HealthExtras were
deeply saddened by the loss of Christopher Reeve in October 2004. Our relationship with him has allowed us to share in his optimism, energy and convictions over the past eight years. Mr. Reeve was an integral part of the development and marketing of
the programs offered in our supplemental benefits segment. We believe that the benefits of these programs can still be communicated effectively in the market with a less direct personal association. Should the marketing affiliations be discontinued,
or should our alternative marketing efforts produce disappointing results, our revenues and earnings could be adversely affected.



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If we lose one or more of our marketing relationships, our access to potential customers would decline, and our
business, results of operations and financial condition could suffer.



A significant majority of all of our supplemental benefit program sales is attributable to our marketing relationships with Stonebridge Life Insurance Company, the successor to JC Penney Life Insurance Company, a member of the AEGON Group
of Companies, Stonebridge, American Express Travel Related Services Company, Inc., Amex and Citibank N.A. If we lose one or more of these relationships and are unable to replace them with other marketing outlets, our access
to potential customers would decline and our business, results of operations and financial condition could suffer.



If we lose our relationships with the providers of the benefits under our programs, we could have difficulty meeting demand for our programs.



We are dependent on third party providers for the benefits included in our supplemental
benefit programs. Those benefits are provided pursuant to arrangements with The Chubb Group of Insurance Companies, National Union Fire Insurance Company of Pittsburgh, a subsidiary of American International Group Inc., Unum Life Insurance Company
of America, and others, which may be terminated on relatively short notice. If we were to lose these relationships and were unable to replace them quickly and cost effectively, we would not be able to satisfy consumer demand for our programs.



If the providers of the benefits included in our programs fail to pay or
otherwise provide accrued benefits, or the extent of those benefits is deemed to be greater than the providers are obligated to pay, we could become subject to liability claims by program members.



The benefits included in the member programs are provided by other firms. If the firms with
which we have contracted to provide those benefits fail to pay or otherwise provide them as required, or are negligent or otherwise culpable in providing them, or if it is determined that the level of benefits to which members are entitled exceeds
the obligations of the providers, we could become involved in any resulting claim or litigation.



If we fail to comply with all of the various and complex laws and regulations governing our products and marketing, we could be subject to fines or additional licensing requirements or lose the ability to market
in particular jurisdictions.



Complex laws, rules and regulations of
each of the 50 states and the District of Columbia pertaining to insurance impose strict and substantial requirements on insurance coverage sold to consumers and businesses. Compliance with these laws, rules and regulations can be arduous and
imposes significant costs. The underwriters of the insurance benefits included in our programs are responsible for obtaining and maintaining regulatory approvals for those benefits. If the appropriate regulatory approvals for those insurance
benefits are not maintained, we would have to stop including them. An independent licensed insurance agency is responsible for solicitations regarding the insurance benefits involved in our programs.



State insurance laws and regulations are complex and broad in scope and are subject to
periodic modification as well as differing interpretations. There can be no assurance that insurance regulatory authorities in one or more states will not determine that the nature of our business requires us to be licensed under applicable
insurance laws. A determination to that effect or that we or our business partners are not in compliance with applicable regulations could result in fines, additional licensing requirements or the inability to market our programs in particular
jurisdictions. Such penalties could significantly increase our general operating expenses and harm our business, results of operations and financial condition. In addition, even if the allegations in any regulatory or legal action against us turn
out to be false, negative publicity relating to any such allegation could result in a loss of consumer confidence and significant damage to our brand.



Telemarketing is one of the primary means by which our programs are marketed. Telemarketing has become subject to an increasing amount of Federal and state regulation in
the past several years. For example, such regulation limits the hours during which telemarketers may call consumers and prohibits the use of automated telephone dialing equipment to call certain telephone numbers. The Federal Telemarketing and
Consumer Fraud and Abuse Prevention Act of 1994 and FTC regulations prohibit deceptive, unfair or abusive practices in telemarketing sales.



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Both the FTC and state attorneys general have authority to prevent certain telemarketing activities deemed by them to
violate consumer protection. The FTC has adopted regulations which, beginning October 1, 2003, prohibit most telemarketers from calling a number listed on a National Do Not Call Registry. Violators are subject to a fine of up to $11,000 per
violation. Under those FTC regulations, telemarketers can continue to call consumers with whom a company has an existing business relationship and consumers who request information about a companys products can be called for three months. In
addition, some states have enacted laws and others are considering enacting laws targeted directly at regulating telemarketing practices, and there can be no assurance that any such laws, if enacted, will not adversely affect or limit our current or
future operations. While compliance with these regulations is generally the responsibility of the marketers and subcontractors, there can be no assurance that we would have no exposure to liability.



ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK



|Included | in Part II, Item 7, Managements Discussion and Analysis of Financial Condition and Results of operations
|-------- | ---------------------------------------------------------------------------------------------------------



ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA



Our audited Financial Statements are contained in a separate section of this Annual Report on Form 10-K on pages F-1 through F-22 and Financial Statement Schedule on page S-1 attached hereto.



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



|None. | 
|----- | 



ITEM 9A. CONTROLS AND PROCEDURES



Managements Responsibility for Financial Statements



Our
management is responsible for the integrity and objectivity of all information presented in this annual report. The consolidated financial statements were prepared in conformity with accounting principles generally accepted in the United States of
America and include amounts based on managements best estimates and judgments. Management believes the consolidated financial statements fairly reflect the form and substance of transactions and that the financial statements present fairly, in
all material respects, the Companys financial position, results of operations and cash flows.



The Audit Committee of the Board of Directors, which is composed solely of independent directors, meets regularly with the independent auditors and representatives of management to review accounting, financial
reporting, internal control and audit matters, as well as the nature and extent of the audit effort. The Audit Committee is responsible for the engagement of the independent auditors. The independent auditors have free access to the Audit Committee.



Conclusion Regarding the Effectiveness of Disclosure Controls and
Procedures



The Companys management, with the participation of its
Chief Executive Officer and Chief Financial Officer, evaluated the effectiveness of the Companys disclosure controls and procedures. Based on their evaluation, as of the end of the period covered by this Annual Report on Form 10-K, the
Companys Chief Executive Officer and Chief Financial Officer have concluded that the Companys disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended) were
effective.



Managements Report on Internal Control Over Financial
Reporting



The Companys management is responsible for establishing
and maintaining adequate internal control over financial reporting, as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Securities and Exchange Act of 1934.



Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of
any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.



The Companys management, with the participation of its Chief Executive Officer and
Chief Financial Officer, assessed the effectiveness of the Companys internal control over financial reporting as of December 31, 2004. In making this assessment, the Companys management used the criteria set forth by the Committee of
Sponsoring Organizations of the Treadway Commission in Internal Control - Integrated Framework.



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Based on its assessment, management has concluded that, as of December 31, 2004, the Companys internal control over
financial reporting was effective based on those criteria.



Management has
excluded Managed Healthcare Systems, Inc. (MHS) from its assessment of internal control over financial reporting as of December 31, 2004 because it was acquired by the Company in a purchase business combination during 2004. MHS is a wholly-owned
subsidiary whose total assets and total revenues represent 19% and 2%, respectively, of the related consolidated financial statement amounts as of and for the year ended December 31, 2004.



Managements assessment of the effectiveness of its internal control over financial
reporting as of December 31, 2004 has been audited by PricewaterhouseCoopers LLP, an independent registered public accounting firm, as stated in their report, which is included herein.



ITEM 9B. OTHER INFORMATION



Not applicable.



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PART III



|ITEM | 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
|---- | ------------------------------------------------------



| | (a) | Information required under this item will be contained in the sections entitled Executive Officers and Directors and Audit Committee Report in our Proxy
Statement for our 2005 Annual Meeting of Stockholders and is incorporated herein by reference.
| | --- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | (b) | The Company has developed a Code of Business conduct. The Company will provide to any person free of charge a copy of the Code of Business Conduct upon request.
| | --- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------



|ITEM | 11. EXECUTIVE COMPENSATION
|---- | --------------------------



Information required under this item will be contained in the sections entitled Directors Compensation and Executive Compensation in our Proxy
Statement for our 2005 Annual Meeting of Stockholders and is incorporated herein by reference.



ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS



Information required under this item by Item 403 of Regulation SK will be contained in the section entitled Stock Ownership in our Proxy Statement for our
2005 Annual Meeting of Stockholders and is incorporated herein by reference. Equity Compensation Plan Information (share data in thousands):



|                                                           |  |                                                                                             |  |                                                                             |      |                                                             |      
|---------------------------------------------------------- |  | ------------------------------------------------------------------------------------------- |  | --------------------------------------------------------------------------- | ---- | ----------------------------------------------------------- | -----
|Plan category                                              |  | Number of securities tobe issued upon exerciseof outstanding options,warrants and rights(a) |  | Weighted averageexercise price ofoutstanding options,warrants and rights(b) |      | Number ofsecuritiesremainingavailable for futureissuance(c)
|Equity compensation plans approved by security holders     |  | 5,264                                                                                       |  | $                                                                           | 6.65 |                                                             | 1,088
|Equity compensation plans not approved by security holders |  |                                                                                            |  |                                                                             |     |                                                             |     
|Total                                                      |  | 5,264                                                                                       |  | $                                                                           | 6.65 |                                                             | 1,088



ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS



Information concerning certain relationships and related transactions is set forth in our proxy statement and is incorporated by reference.



ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES



Information concerning principal accountant fees and services is set forth in our proxy statement and is incorporated by reference.



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PART IV



ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES



|    |  |                                        |  |                                                                                                      
|--- |  | -------------------------------------- |  | -----------------------------------------------------------------------------------------------------
|(a) |  | Documents filed as part of this report
|    |  |                                       
|    |  | (1)                                    |  | Financial Statements                                                                                 
|    |  |                                        |  | Report of Independent Registered Public Accounting Firm                                              
|    |  |                                        |  | Consolidated Balance Sheets as of December 31, 2004 and 2003                                         
|    |  |                                        |  | Consolidated Statements of Operations for the years ended December 31, 2004, 2003, and 2002          
|    |  |                                        |  | Consolidated Statements of Stockholders Equity for the years ended December 31, 2004, 2003, and 2002
|    |  |                                        |  | Consolidated Statements of Cash Flows for the years ended December 31, 2004, 2003 and 2002           
|    |  |                                        |  | Consolidated Statements of Comprehensive Income for the years ended December 31, 2004, 2003 and 2002 
|    |  |                                        |  | Notes to Comprehensive Financial Statements                                                          
|    |  |                                       
|    |  | (2)                                    |  | Financial statement schedule:                                                                        
|    |  |                                        |  | Schedule II  Valuation and Qualifying Accounts                                                      



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| | b) | Exhibits
| | -- | --------



The following exhibits are filed as part of this report unless noted otherwise:



|            |  |                                                                                                                                                                                                       
|----------- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit No. |  | Description                                                                                                                                                                                           
|2.1         |  | Form of Reorganization Agreement by and among HealthExtras, Inc., HealthExtras, LLC and Capital Z Healthcare Holding Corp(1)                                                                          
|            | 
|2.2         |  | Catalyst Rx, Inc. Securities Purchase Agreement Dated as of November 14, 2001 by and among HealthExtras, Inc. as the Purchaser, Catalyst Rx, Inc. and Kevin C. Hooks as the Seller(2)                 
|            | 
|2.3         |  | Catalyst Consultants, Inc. Securities Purchase Agreement Dated as of November 4, 2001 by and among HealthExtras, Inc. as the purchaser, Catalyst Consultants, Inc. and Kevin C. Hooks as the
Seller(2)
|            | 
|2.4         |  | Stock Purchase Agreement by and among HealthExtras, Inc. and Kenneth J. Sack and The Sack Family Trust, dated as of June 18, 2004(3)                                                                  
|            | 
|3.1         |  | Amended and Restated Certificate of Incorporation(1)                                                                                                                                                  
|            | 
|3.2         |  | Bylaws of HealthExtras, Inc.(1)                                                                                                                                                                       
|            | 
|4.1         |  | Specimen Stock Certificate of HealthExtras, Inc.(1)                                                                                                                                                   
|            | 
|4.2         |  | Form of Warrant to Purchase Common Stock of the Registrant(3)                                                                                                                                         
|            | 
|4.2         |  | Form of Common Stock Warrant(4)                                                                                                                                                                       
|            | 
|4.3         |  | Financing and Security Agreement dated June 18, 2004 by and between HealthExtras, Inc. and Wachovia Bank, National Association(5)                                                                     
|            | 
|4.4         |  | Registration Rights Agreement by and among HealthExtras, Inc. and Kenneth J. Sack and the Sack Family Trust, dated as of June 18, 2004(4)                                                             
|            | 
|10.1        |  | Form of Employment Agreement between HealthExtras, Inc. and David T. Blair(1)                                                                                                                         
|            | 
|10.2        |  | Form of Employment Agreement between HealthExtras, Inc. and certain Executive Officers(1)                                                                                                             
|            | 
|10.3        |  | Agreement by and between Cambria Productions, Inc. f/s/o Christopher Reeve and HealthExtras, Inc.(1) (6)                                                                                              
|            | 
|10.4        |  | Form of HealthExtras, Inc. 1999 Stock Option Plan(1)                                                                                                                                                  
|            | 
|10.5        |  | Securities Purchase Agreement by and among HealthExtras, Inc., as the Purchaser, and TD Javelin Capital Fund, L.P., Meriken Nominees, LTD, et. al, as the Sellers(7)                                  
|            | 
|10.6        |  | Form of HealthExtras, Inc. 2000 Stock Option Plan(8)                                                                                                                                                  
|            | 
|10.7        |  | Form of HealthExtras, Inc. 2000 Directors Stock Option Plan(8)                                                                                                                                       
|            | 
|10.8        |  | Amended Agreement by and between Cambria Productions, Inc. f/s/o Christopher Reeve and HealthExtras, Inc.(8)                                                                                          
|            | 
|10.9        |  | Securities Purchase Agreement, dated September 25, 2001 by and between HealthExtras, Inc. and Investors Signatory thereto.(3)                                                                         
|            | 
|10.10       |  | Form of 2003 HealthExtras, Inc. Equity Incentive Plan(9)                                                                                                                                              
|            | 
|10.11       |  | Employment Agreement by and between CatalystRx and Kevin C. Hooks(5)                                                                                                                                  
|            | 
|11.1        |  | Statement re: Computation of Per Share Earnings (see Note 2 of the Notes to Consolidated Financial Statements)                                                                                        
|            | 
|21.1        |  | Subsidiaries                                                                                                                                                                                          
|            | 
|23.1        |  | Consent of Independent Registered Public Accounting Firm                                                                                                                                              
|            | 
|31.1        |  | Rule 13a-14(a)/15d-14(a) Certification of Chief Executive Officer                                                                                                                                     
|            | 
|31.2        |  | Rule 13a-14(a)/15d-14(a) Certification of Chief Financial Officer                                                                                                                                     
|            | 
|32.1        |  | Certification Pursuant to 18 U.S.C. Section 1350                                                                                                                                                      

---

|(1) | Incorporated herein by reference into this document from the Exhibits to the Form S-1 Registration Statement, as amended, Registration No. 333-83761, initially filed on July 26,
1999.
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(2) | Incorporated herein by reference into this document from the Exhibits to the Form 8-K, initially filed on November 29, 2001.
|--- | ----------------------------------------------------------------------------------------------------------------------------

|(3) | Incorporated herein by reference into this document from the Exhibits to the Form S-3 Registration Statement, as amended, Registration No. 333-72430, initially filed on November 29,
2001.
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(4) | Incorporated herein by reference into this document from the Exhibits to the Form 8-K, initially filed on June 23, 2004.
|--- | ------------------------------------------------------------------------------------------------------------------------

|(5) | Incorporated herein by reference into this document from the Exhibits to the Form S-3, initially filed on October 15, 2004.
|--- | ---------------------------------------------------------------------------------------------------------------------------

|(6) | Confidential treatment requested for portion of agreement pursuant to Section 406 of Regulation C. promulgated under the Securities Act of 1933, as amended.
|--- | ------------------------------------------------------------------------------------------------------------------------------------------------------------

|(7) | Incorporated herein by reference into this document from the Exhibits to the Form 8-K initially filed on November 21, 2000.
|--- | ---------------------------------------------------------------------------------------------------------------------------

|(8) | Incorporated herein by reference into this document from the Exhibits to the Form 10-K filed on April 2, 2001.
|--- | --------------------------------------------------------------------------------------------------------------

|(9) | Incorporated herein by reference into this document from the Exhibit to the Registrants proxy statement for the annual meeting of shareholders filed on April 30, 2003.
|--- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------



45



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SIGNATURES



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



|               |  |                    |  |                                                    
|-------------- |  | ------------------ |  | ---------------------------------------------------
|               |  | HEALTHEXTRAS, INC.
|               |  |                   
|March 16, 2005 |  | By:                |  | /s/ David T. Blair                                 
|               |  |                    |  | David T. Blair Chief Executive Officer and
Director



Pursuant to the
requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated:



|               |  |     |  |                                                                                              
|-------------- |  | --- |  | ---------------------------------------------------------------------------------------------
|March 16, 2005 |  | By: |  | /s/ Thomas L. BlairThomas L. Blair Chairman of The Board                                     
|               |  |    
|March 16, 2005 |  | By: |  | /s/ David T. BlairDavid T. Blair Chief Executive Officer and Director                        
|               |  |    
|March 16, 2005 |  | By: |  | /s/ Michael P. DonovanMichael P. Donovan Chief Financial Officer and Chief Accounting Officer
|               |  |    
|March 16, 2005 |  | By: |  | /s/ William E. BrockWilliam E. Brock Director                                                
|               |  |    
|March 16, 2005 |  | By: |  | /s/ Edward S. CiveraEdward S. Civera Director                                                
|               |  |    
|March 16, 2005 |  | By: |  | /s/ Steven B. EpsteinSteven B. Epstein Director                                              
|               |  |    
|March 16, 2005 |  | By: |  | /s/ Frederick H. GraefeFrederick H. Graefe Director                                          
|               |  |    
|March 16, 2005 |  | By: |  | /s/ Thomas J. GrafThomas J. Graf Director                                                    
|               |  |    
|March 16, 2005 |  | By: |  | /s/ Carey G. JuryCarey G. Jury Director                                                      
|               |  |    
|March 16, 2005 |  | By: |  | /s/ Deanna D. Strable-SoethoutDeanna D. Strable-Soethout Director                            
|               |  |    
|March 16, 2005 |  | By: |  | /s/ Dale B. WolfDale B. Wolf Director                                                        



---

##### Table of Contents

HEALTHEXTRAS, INC.

and Subsidiaries



CONSOLIDATED FINANCIAL STATEMENTS



at
December 31, 2004 and 2003



AND REPORT THEREON



---

##### Table of Contents

Report of Independent Registered Public Accounting Firm



To Board of Directors and Stockholders of HealthExtras,
Inc.:



We have completed an integrated audit of HealthExtras, Inc.s 2004
consolidated financial statements and of its internal control over financial reporting as of December 31, 2004 and audits of its 2003 and 2002 consolidated financial statements in accordance with the standards of the Public Company Accounting
Oversight Board (United States). Our opinions, based on our audits, are presented below.



Consolidated financial statements and financial statement schedule



In our opinion, the consolidated financial statements listed in the index appearing under Item 15(a)(1) present fairly, in all material
respects, the financial position of HealthExtras, Inc. and its subsidiaries at December 31, 2004 and 2003, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2004 in conformity with
accounting principles generally accepted in the United States of America. In addition, in our opinion, the financial statement schedule listed in the index appearing under Item 15(a)(2) presents fairly, in all material respects, the information set
forth therein when read in conjunction with the related consolidated financial statements. These financial statements and financial statement schedule are the responsibility of the Companys management. Our responsibility is to express an
opinion on these financial statements and financial statement schedule based on our audits. We conducted our audits of these statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). 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 of financial statements includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.



Internal
control over financial reporting



Also, in our opinion, managements
assessment, included in Managements Report on Internal Control Over Financial Reporting appearing under Item 9A, that the Company maintained effective internal control over financial reporting as of December 31, 2004 based on criteria
established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), is fairly stated, in all material respects, based on those criteria. Furthermore, in our opinion,
the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2004, based on criteria established in Internal Control - Integrated Framework issued by the COSO. The Companys
management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express opinions on managements
assessment and on the effectiveness of the Companys internal control over financial reporting based on our audit. We conducted our audit of internal control over financial reporting in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. An audit
of internal control over financial reporting includes obtaining an understanding of internal control over financial reporting, evaluating managements assessment, testing and evaluating the design and operating effectiveness of internal
control, and performing such other procedures as we consider necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinions.



A companys internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability
of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A companys internal control over financial reporting includes those policies and procedures
that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (ii) provide reasonable assurance that transactions are recorded as necessary to
permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made



---

##### Table of Contents

only in accordance with authorizations of management and directors of the company; and (iii) provide reasonable assurance
regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the companys assets that could have a material effect on the financial statements.



Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of
any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.



As described in Managements Report on Internal Control Over Financial Reporting under
Item 9A, management has excluded Managed Healthcare Systems, Inc. (MHS) from its assessment of internal control over financial reporting as of December 31, 2004 because it was acquired by the Company in a purchase business combination during 2004.
We have also excluded MHS from our audit of internal control over financial reporting. MHS is a wholly-owned subsidiary whose total assets and total revenues represent 19% and 2%, respectively, of the related consolidated financial statement amounts
as of and for the year ended December 31, 2004.



PricewaterhouseCoopers LLP

McLean, VA

March 11, 2005



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##### Table of Contents

HEALTHEXTRAS, INC.

and Subsidiaries



CONSOLIDATED BALANCE SHEETS

(In thousands, except per share data)



|                                                                                                                                                                   |  |              |         |      |   |         |  
|------------------------------------------------------------------------------------------------------------------------------------------------------------------ |  | ------------ | ------- | ---- | - | ------- | -
|                                                                                                                                                                   |  | December 31, |        
|                                                                                                                                                                   |  | 2004         |         | 2003 |  
|ASSETS                                                                                                                                                             |  |              |         |      |   |         |  
|Current assets:                                                                                                                                                    |  |              |         |      |   |         |  
|Cash and cash equivalents                                                                                                                                          |  | $            | 67,068  |      | $ | 28,877  |  
|Accounts receivable, net of allowance for doubtful accounts of $917 and $889 in 2004 and 2003, respectively                                                        |  |              | 68,238  |      |   | 51,670  |  
|Income taxes receivable                                                                                                                                            |  |              | 2,025   |      |   |        |  
|Inventory, net of allowance for obsolescence of $50 in 2004                                                                                                        |  |              | 464     |      |   |        |  
|Deferred income taxes                                                                                                                                              |  |              |        |      |   | 1,225   |  
|Deferred charges                                                                                                                                                   |  |              | 1,871   |      |   | 1,835   |  
|Other current assets                                                                                                                                               |  |              | 2,151   |      |   | 1,447   |  
|                                                                                                                                                                   |  |              |         |      |   |         |  
|Total current assets                                                                                                                                               |  |              | 141,817 |      |   | 85,054  |  
|Property and equipment, net                                                                                                                                        |  |              | 9,881   |      |   | 2,848   |  
|Intangible assets, net of accumulated amortization of $2,780 and $1,287 in 2004 and 2003, respectively                                                             |  |              | 22,307  |      |   | 14,324  |  
|Goodwill                                                                                                                                                           |  |              | 68,947  |      |   | 37,764  |  
|Restricted cash                                                                                                                                                    |  |              | 1,000   |      |   | 1,000   |  
|Other assets                                                                                                                                                       |  |              | 300     |      |   | 778     |  
|                                                                                                                                                                   |  |              |         |      |   |         |  
|Total assets                                                                                                                                                       |  | $            | 244,252 |      | $ | 141,768 |  
|                                                                                                                                                                   |  |              |         |      |   |         |  
|LIABILITIES AND STOCKHOLDERS EQUITY                                                                                                                               |  |              |         |      |   |         |  
|Current liabilities:                                                                                                                                               |  |              |         |      |   |         |  
|Accounts payable                                                                                                                                                   |  | $            | 55,691  |      | $ | 50,863  |  
|Accrued expenses and other current liabilities                                                                                                                     |  |              | 5,321   |      |   | 2,699   |  
|Note payable                                                                                                                                                       |  |              | 5,000   |      |   |        |  
|Deferred income taxes                                                                                                                                              |  |              | 967     |      |   |        |  
|Deferred revenue                                                                                                                                                   |  |              | 4,580   |      |   | 4,717   |  
|                                                                                                                                                                   |  |              |         |      |   |         |  
|Total current liabilities                                                                                                                                          |  |              | 71,559  |      |   | 58,279  |  
|                                                                                                                                                                   |  |              |         |      |   |         |  
|Deferred income taxes                                                                                                                                              |  |              | 4,543   |      |   | 2,511   |  
|Notes payable                                                                                                                                                      |  |              | 20,500  |      |   | 10,000  |  
|                                                                                                                                                                   |  |              |         |      |   |         |  
|Total liabilities                                                                                                                                                  |  |              | 96,602  |      |   | 70,790  |  
|                                                                                                                                                                   |  |              |         |      |   |         |  
|Stockholders equity:                                                                                                                                              |  |              |         |      |   |         |  
|Preferred stock, $0.01 par value, 5,000 shares authorized, none issued                                                                                             |  |              |        |      |   |        |  
|Common stock, $0.01 par value, 100,000 shares authorized, 37,714 and 32,603 shares issued and outstanding at December 31, 2004 and December
31, 2003, respectively |  |              | 377     |      |   | 326     |  
|Additional paid-in capital                                                                                                                                         |  |              | 131,756 |      |   | 71,578  |  
|Accumulated other comprehensive income                                                                                                                             |  |              | 60      |      |   |        |  
|Retained earnings (Accumulated deficit)                                                                                                                            |  |              | 15,457  |      |   | (926    | )
|                                                                                                                                                                   |  |              |         |      |   |         |  
|Total stockholders equity                                                                                                                                         |  |              | 147,650 |      |   | 70,978  |  
|                                                                                                                                                                   |  |              |         |      |   |         |  
|Total liabilities and stockholders equity                                                                                                                         |  | $            | 244,252 |      | $ | 141,768 |  
|                                                                                                                                                                   |  |              |         |      |   |         |  



The accompanying notes
are an integral part of these consolidated financial statements.



F-1



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##### Table of Contents

HEALTHEXTRAS, INC.

and Subsidiaries



CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands, except per share data)



|                                                                                                              |  |                                  |         |   |      |   |         |      |  |   |         |  
|------------------------------------------------------------------------------------------------------------- |  | -------------------------------- | ------- | - | ---- | - | ------- | ---- |  | - | ------- | -
|                                                                                                              |  | For the years ended December 31, |        
|                                                                                                              |  | 2004                             |         |   | 2003 |   |         | 2002 | 
|Revenue (excludes member co-payments of $213,014, $141,020 and $71,617, in 2004, 2003 and 2002, respectively) |  | $                                | 521,325 |   |      | $ | 384,094 |      |  | $ | 248,407 |  
|                                                                                                              |  |                                  |         |   |      |   |         |      |  |   |         |  
|Direct expenses                                                                                               |  |                                  | 460,783 |   |      |   | 341,201 |      |  |   | 209,523 |  
|Selling, general and administrative expenses                                                                  |  |                                  | 35,583  |   |      |   | 25,865  |      |  |   | 35,484  |  
|                                                                                                              |  |                                  |         |   |      |   |         |      |  |   |         |  
|Total operating expenses                                                                                      |  |                                  | 496,366 |   |      |   | 367,066 |      |  |   | 245,007 |  
|                                                                                                              |  |                                  |         |   |      |   |         |      |  |   |         |  
|Operating income                                                                                              |  |                                  | 24,959  |   |      |   | 17,028  |      |  |   | 3,400   |  
|Interest income                                                                                               |  |                                  | 383     |   |      |   | 155     |      |  |   | 286     |  
|Interest expense                                                                                              |  |                                  | (1,145  | ) |      |   | (598    | )    |  |   | (368    | )
|Other income                                                                                                  |  |                                  | 2,100   |   |      |   |        |      |  |   |        |  
|                                                                                                              |  |                                  |         |   |      |   |         |      |  |   |         |  
|Income before income taxes and minority interest                                                              |  |                                  | 26,297  |   |      |   | 16,585  |      |  |   | 3,318   |  
|Minority interest                                                                                             |  |                                  |        |   |      |   |        |      |  |   | (45     | )
|                                                                                                              |  |                                  |         |   |      |   |         |      |  |   |         |  
|Income before income taxes                                                                                    |  |                                  | 26,297  |   |      |   | 16,585  |      |  |   | 3,273   |  
|Income tax (benefit) expense                                                                                  |  |                                  | 9,914   |   |      |   | 6,268   |      |  |   | (10,205 | )
|                                                                                                              |  |                                  |         |   |      |   |         |      |  |   |         |  
|Net income                                                                                                    |  | $                                | 16,383  |   |      | $ | 10,317  |      |  | $ | 13,478  |  
|                                                                                                              |  |                                  |         |   |      |   |         |      |  |   |         |  
|Net income per share, basic                                                                                   |  | $                                | 0.49    |   |      | $ | 0.32    |      |  | $ | 0.42    |  
|Net income per share, diluted                                                                                 |  | $                                | 0.45    |   |      | $ | 0.30    |      |  | $ | 0.42    |  
|Weighted average shares of common stock outstanding, basic                                                    |  |                                  | 33,642  |   |      |   | 32,447  |      |  |   | 32,234  |  
|Weighted average shares of common stock outstanding, diluted                                                  |  |                                  | 36,407  |   |      |   | 34,454  |      |  |   | 32,420  |  



The accompanying notes
are an integral part of these consolidated financial statements.



F-2



---

##### Table of Contents

HEALTHEXTRAS, INC.

and Subsidiaries



CONSOLIDATED STATEMENTS OF STOCKHOLDERS EQUITY

for the years ended December 31, 2002, 2003, and 2004

(In thousands)



|                                                                                             |  |              |  |                           |     |  |                                     |         |                                      |  |   |                      |  |   |         |   |  |   |      |   |  |   |         |  
|-------------------------------------------------------------------------------------------- |  | ------------ |  | ------------------------- | --- |  | ----------------------------------- | ------- | ------------------------------------ |  | - | -------------------- |  | - | ------- | - |  | - | ---- | - |  | - | ------- | -
|                                                                                             |  | Common Stock |  | Additional Paid-inCapital |     |  | AccumulatedOtherComprehensiveIncome |         | RetainedEarnings(AccumulatedDeficit) |  |   | DeferredCompensation |  |   | Total   |  
|                                                                                             |  | Shares       |  | Amount                    |     |  |                                     |         |                                     
|Balance at December 31, 2001                                                                 |  | 31,868       |  | $                         | 319 |  | $                                   | 69,747  |                                      |  | $ |                     |  | $ | (24,721 | ) |  | $ | (108 | ) |  | $ | 45,237  |  
|                                                                                             |  |              |  |                           |     |  |                                     |         |                                      |  |   |                      |  |   |         |   |  |   |      |   |  |   |         |  
|Exercise of stock options                                                                    |  | 9            |  |                           |    |  |                                     | 33      |                                      |  |   |                     |  |   |        |   |  |   |     |   |  |   | 33      |  
|Shares issued pursuant to stock grants                                                       |  | 82           |  |                           | 1   |  |                                     | (1      | )                                    |  |   |                     |  |   |        |   |  |   |     |   |  |   |        |  
|Shares issued pursuant to Catalyst acquisition                                               |  | 319          |  |                           | 3   |  |                                     | 1,053   |                                      |  |   |                     |  |   |        |   |  |   |     |   |  |   | 1,056   |  
|Shares issued in exchange for services                                                       |  | 17           |  |                           |    |  |                                     | 236     |                                      |  |   |                     |  |   |        |   |  |   |     |   |  |   | 236     |  
|Reversal for warrants issued or expected to be issued in connection with marketing agreement |  |             |  |                           |    |  |                                     | (1,008  | )                                    |  |   |                     |  |   |        |   |  |   |     |   |  |   | (1,008  | )
|Issuance of common stock warrants                                                            |  |             |  |                           |    |  |                                     | 400     |                                      |  |   |                     |  |   |        |   |  |   |     |   |  |   | 400     |  
|Amortization of deferred compensation                                                        |  |             |  |                           |    |  |                                     |        |                                      |  |   |                     |  |   |        |   |  |   | 93   |   |  |   | 93      |  
|Net income for the year                                                                      |  |             |  |                           |    |  |                                     |        |                                      |  |   |                     |  |   | 13,478  |   |  |   |     |   |  |   | 13,478  |  
|                                                                                             |  |              |  |                           |     |  |                                     |         |                                      |  |   |                      |  |   |         |   |  |   |      |   |  |   |         |  
|Balance at December 31, 2002                                                                 |  | 32,295       |  | $                         | 323 |  | $                                   | 70,460  |                                      |  | $ |                     |  | $ | (11,243 | ) |  | $ | (15  | ) |  | $ | 59,525  |  
|                                                                                             |  |              |  |                           |     |  |                                     |         |                                      |  |   |                      |  |   |         |   |  |   |      |   |  |   |         |  
|Exercise of stock options                                                                    |  | 171          |  |                           | 2   |  |                                     | 815     |                                      |  |   |                     |  |   |        |   |  |   |     |   |  |   | 817     |  
|Shares issued pursuant to stock grants                                                       |  | 82           |  |                           | 1   |  |                                     | (1      | )                                    |  |   |                     |  |   |        |   |  |   |     |   |  |   |        |  
|Shares issued in exchange for services                                                       |  | 55           |  |                           |    |  |                                     | 24      |                                      |  |   |                     |  |   |        |   |  |   |     |   |  |   | 24      |  
|Expense related to stock options granted to employees                                        |  |             |  |                           |    |  |                                     | 17      |                                      |  |   |                     |  |   |        |   |  |   |     |   |  |   | 17      |  
|Expense related to stock options granted in exchange for services                            |  |             |  |                           |    |  |                                     | 263     |                                      |  |   |                     |  |   |        |   |  |   |     |   |  |   | 263     |  
|Amortization of deferred compensation                                                        |  |             |  |                           |    |  |                                     |         |                                      |  |   |                     |  |   |        |   |  |   | 15   |   |  |   | 15      |  
|Net income for the year                                                                      |  |             |  |                           |    |  |                                     |        |                                      |  |   |                     |  |   | 10,317  |   |  |   |     |   |  |   | 10,317  |  
|                                                                                             |  |              |  |                           |     |  |                                     |         |                                      |  |   |                      |  |   |         |   |  |   |      |   |  |   |         |  
|Balance at December 31, 2003                                                                 |  | 32,603       |  | $                         | 326 |  | $                                   | 71,578  |                                      |  | $ |                     |  | $ | (926    | ) |  | $ |     |   |  | $ | 70,978  |  
|                                                                                             |  |              |  |                           |     |  |                                     |         |                                      |  |   |                      |  |   |         |   |  |   |      |   |  |   |         |  
|Shares issued in public offering                                                             |  | 4,025        |  |                           | 40  |  |                                     | 54,742  |                                      |  |   |                     |  |   |        |   |  |   |     |   |  |   | 54,782  |  
|Exercise of stock options, including tax benefits                                            |  | 300          |  |                           | 3   |  |                                     | 1,832   |                                      |  |   |                     |  |   |        |   |  |   |     |   |  |   | 1,835   |  
|Exercise of stock warrants                                                                   |  | 584          |  |                           | 6   |  |                                     | 1,009   |                                      |  |   |                     |  |   |        |   |  |   |     |   |  |   | 1,015   |  
|Shares issued pursuant to acquisition                                                        |  | 175          |  |                           | 2   |  |                                     | 2,248   |                                      |  |   |                     |  |   |        |   |  |   |     |   |  |   | 2,250   |  
|Shares issued in exchange for services                                                       |  | 15           |  |                           |    |  |                                     |        |                                      |  |   |                     |  |   |        |   |  |   |     |   |  |   |        |  
|Expense related to stock options granted to employee                                         |  |             |  |                           |    |  |                                     | 41      |                                      |  |   |                     |  |   |        |   |  |   |     |   |  |   | 41      |  
|Expense related to stock options granted in exchange for services                            |  |             |  |                           |    |  |                                     | 158     |                                      |  |   |                     |  |   |        |   |  |   |     |   |  |   | 158     |  
|Shares issued pursuant to employee stock purchase plan                                       |  | 12           |  |                           |    |  |                                     | 148     |                                      |  |   |                     |  |   |        |   |  |   |     |   |  |   | 148     |  
|Valuation of interest rate swap, net of tax                                                  |  |             |  |                           |    |  |                                     |        |                                      |  |   | 60                   |  |   |        |   |  |   |     |   |  |   | 60      |  
|Net income for the year                                                                      |  |             |  |                           |    |  |                                     |        |                                      |  |   |                     |  |   | 16,383  |   |  |   |     |   |  |   | 16,383  |  
|                                                                                             |  |              |  |                           |     |  |                                     |         |                                      |  |   |                      |  |   |         |   |  |   |      |   |  |   |         |  
|Balance at December 31, 2004                                                                 |  | 37,714       |  | $                         | 377 |  | $                                   | 131,756 |                                      |  | $ | 60                   |  | $ | 15,457  |   |  | $ |     |   |  | $ | 147,650 |  
|                                                                                             |  |              |  |                           |     |  |                                     |         |                                      |  |   |                      |  |   |         |   |  |   |      |   |  |   |         |  



The accompanying notes
are an integral part of these consolidated financial statements.



F-3



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##### Table of Contents

HEALTHEXTRAS, INC.

and Subsidiaries



CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)



|                                                                     |  |                                  |         |   |      |   |         |      |  |   |         |  
|-------------------------------------------------------------------- |  | -------------------------------- | ------- | - | ---- | - | ------- | ---- |  | - | ------- | -
|                                                                     |  | For the years ended December 31, |        
|                                                                     |  | 2004                             |         |   | 2003 |   |         | 2002 | 
|Cash flows from operating activities:                                |  |                                  |         |   |      |   |         |      |  |   |         |  
|Net income                                                           |  | $                                | 16,383  |   |      | $ | 10,317  |      |  | $ | 13,478  |  
|Depreciation and amortization expense                                |  |                                  | 1,538   |   |      |   | 1,537   |      |  |   | 1,295   |  
|Impairment of and loss on disposal of property and equipment         |  |                                  | 38      |   |      |   |        |      |  |   | 2,680   |  
|Provision for bad debts                                              |  |                                  | 210     |   |      |   | 189     |      |  |   | 91      |  
|Deferred income taxes                                                |  |                                  | 4,521   |   |      |   | 6,268   |      |  |   | (10,205 | )
|Noncash charges (credits)                                            |  |                                  | 199     |   |      |   | 190     |      |  |   | (680    | )
|Amortization of intangibles and other assets                         |  |                                  | 1,550   |   |      |   | 885     |      |  |   | 548     |  
|Minority interest                                                    |  |                                  |        |   |      |   |        |      |  |   | 45      |  
|Changes in assets and liabilities, net of effects from acquisitions: |  |                                  |         |   |      |   |         |      |  |   |         |  
|Accounts receivable                                                  |  |                                  | (15,847 | ) |      |   | (10,076 | )    |  |   | (577    | )
|Income tax receivable                                                |  |                                  | (1,671  | ) |      |   | 2,606   |      |  |   |        |  
|Inventory                                                            |  |                                  | (74     | ) |      |   |        |      |  |   |        |  
|Other assets                                                         |  |                                  | (166    | ) |      |   | (98     | )    |  |   | (795    | )
|Deferred charges                                                     |  |                                  | (36     | ) |      |   | 53      |      |  |   | 198     |  
|Accounts payable, accrued expenses, and other liabilities            |  |                                  | 5,502   |   |      |   | 11,596  |      |  |   | (6,405  | )
|Deferred revenue                                                     |  |                                  | (137    | ) |      |   | (97     | )    |  |   | 305     |  
|                                                                     |  |                                  |         |   |      |   |         |      |  |   |         |  
|Net cash provided by (used in) operating activities                  |  |                                  | 12,010  |   |      |   | 23,370  |      |  |   | (22     | )
|                                                                     |  |                                  |         |   |      |   |         |      |  |   |         |  
|Cash flows from investing activities:                                |  |                                  |         |   |      |   |         |      |  |   |         |  
|Capital expenditures                                                 |  |                                  | (9,655  | ) |      |   | (324    | )    |  |   | (1,991  | )
|Business acquisitions and related payments, net of cash acquired     |  |                                  | (37,650 | ) |      |   | (4,517  | )    |  |   | (31,648 | )
|Purchase of intangible assets                                        |  |                                  |        |   |      |   |        |      |  |   | (450    | )
|Proceeds from sale of property and equipment                         |  |                                  | 1,045   |   |      |   |        |      |  |   |        |  
|Deposits, restricted cash and other                                  |  |                                  |        |   |      |   |        |      |  |   | 600     |  
|                                                                     |  |                                  |         |   |      |   |         |      |  |   |         |  
|Net cash used in investing activities                                |  |                                  | (46,260 | ) |      |   | (4,841  | )    |  |   | (33,489 | )
|                                                                     |  |                                  |         |   |      |   |         |      |  |   |         |  
|Cash flows from financing activities:                                |  |                                  |         |   |      |   |         |      |  |   |         |  
|Proceeds from borrowings                                             |  |                                  | 37,338  |   |      |   |        |      |  |   | 30,500  |  
|Repayment of line of credit                                          |  |                                  | (21,838 | ) |      |   | (8,000  | )    |  |   | (12,500 | )
|Proceeds received from exercise of stock options and warrants        |  |                                  | 2,159   |   |      |   | 817     |      |  |   | 33      |  
|Net proceeds from sale of common stock                               |  |                                  | 54,782  |   |      |   |        |      |  |   |        |  
|                                                                     |  |                                  |         |   |      |   |         |      |  |   |         |  
|Net cash provided by (used in) financing activities                  |  |                                  | 72,441  |   |      |   | (7,183  | )    |  |   | 18,033  |  
|                                                                     |  |                                  |         |   |      |   |         |      |  |   |         |  
|Net (decrease) increase in cash and cash equivalents                 |  |                                  | 38,191  |   |      |   | 11,346  |      |  |   | (15,478 | )
|Cash and cash equivalents at the beginning of year                   |  |                                  | 28,877  |   |      |   | 17,531  |      |  |   | 33,009  |  
|                                                                     |  |                                  |         |   |      |   |         |      |  |   |         |  
|Cash and cash equivalents at the end of year                         |  | $                                | 67,068  |   |      | $ | 28,877  |      |  | $ | 17,531  |  
|                                                                     |  |                                  |         |   |      |   |         |      |  |   |         |  
|Supplemental disclosure:                                             |  |                                  |         |   |      |   |         |      |  |   |         |  
|Cash paid for interest                                               |  | $                                | 968     |   |      | $ | 600     |      |  | $ | 319     |  
|Cash paid for taxes                                                  |  | $                                | 7,063   |   |      | $ | 35      |      |  | $ |        |  



The accompanying notes
are an integral part of these consolidated financial statements.



F-4



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##### Table of Contents

HEALTHEXTRAS, INC.

and Subsidiaries



CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(In thousands)



|                                      |  |                                  |        |      |   |        |  |   |       
|------------------------------------- |  | -------------------------------- | ------ | ---- | - | ------ |  | - | ------
|                                      |  | For the years ended December 31,
|                                      |  | 2004                             |        | 2003 |   | 2002  
|Comprehensive income:                 |  |                                  |        |      |   |        |  |   |       
|Net income                            |  | $                                | 16,383 |      | $ | 10,317 |  | $ | 13,478
|Other comprehensive income:           |  |                                  |        |      |   |        |  |   |       
|Unrealized gain on interest rate swap |  |                                  | 60     |      |   |       |  |   |      
|                                      |  |                                  |        |      |   |        |  |   |       
|Total comprehensive income            |  | $                                | 16,443 |      | $ | 10,317 |  | $ | 13,478
|                                      |  |                                  |        |      |   |        |  |   |       



The accompanying notes
are an integral part of these consolidated financial statements.



F-5



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##### Table of Contents

HEALTHEXTRAS, INC.



and Subsidiaries



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS



1. COMPANY



HealthExtras, Inc. and subsidiaries (the Company) is a provider of pharmacy benefit management (PBM) services and supplemental benefit programs.
The Companys PBM segment, which operates under the brand name Catalyst Rx, accounted for approximately 91% and 86% of the Companys revenue in 2004 and 2003, respectively. The Companys PBM clients include more than 1,000
self-insured employers, including state and local governments, third-party administrators, and managed care organizations (payors), who contract with Catalyst Rx to administer the prescription drug component of their overall health
benefit programs. Catalyst Rx provides its clients access to a contracted, non-exclusive national network of more than 53,000 pharmacies. Catalyst Rxs services provide its clients members with timely and accurate benefit adjudication,
while controlling pharmacy spending trends through customized plan designs, physician orientation programs and member education. Catalyst Rx maintains an electronic point-of-sale system of eligibility verification and plan design information, and
offers access to rebate arrangements for certain branded pharmaceuticals.



The
Company also offers supplemental benefit programs developed by it under the brand name HealthExtras, which include lump sum accidental disability benefits, accidental death and dismemberment benefits, and emergency accident and sickness
medical benefits. HealthExtras contracts with insurance companies to underwrite the insurance components of these programs. As a result, the financial responsibility for the payment of claims resulting from a qualifying event covered by the
insurance features of its programs is borne by the third-party insurers. The supplemental benefits segment accounted for approximately 9% and 14% of the Companys revenue in 2004 and 2003, respectively. Individuals are the major purchasers of
these programs.



2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES



Principles of consolidation



The accompanying consolidated financial statements include the accounts of the Company and
all its wholly owned subsidiaries. All intercompany accounts and transactions have been eliminated.



Use of estimates



Preparation of
financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and
accompanying notes. Actual results could differ from those estimates. The most significant estimates included in these financial statements include the following: rebates due from pharmaceutical manufacturing companies, the value of intangible
assets acquired in business combinations and related amortization periods, income tax provisions and related valuation allowances, and, in years prior to 2004, the estimate of the value and number of common stock warrants to be issued to a
distributor under a marketing compensation agreement.



Concentration of
Credit Risk



Financial instruments that potentially subject the Company to
significant concentrations of credit risk consist principally of cash and cash equivalents and accounts receivable.



The Company maintains its cash and cash equivalents in financial institutions with high credit ratings; however, at times the balances may exceed federally insured
amounts. The Company has not experienced any losses related to its cash or cash equivalents and believes it is not exposed to any significant credit risk on its cash or cash equivalents.



Accounts receivable consists principally of amounts due from the Companys PBM customers. The Company holds no collateral for accounts
receivable. Concentration of risks with respect to receivables is mitigated based on the geographical dispersion of customers, the Companys communications with clients, and the Companys continuous review of outstanding receivables.
Management also performs ongoing credit evaluations of its customers and



F-6



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##### Table of Contents

HEALTHEXTRAS, INC.



and Subsidiaries



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS



provides allowances as deemed necessary. The Company has not experienced significant losses related to receivables in the past. The Companys collection
experience indicates limited loss exposure due to the nature of the benefits involved and the necessity of benefit continuity for plan sponsor employees.



Cash and cash equivalents



All highly liquid investments purchased with an original maturity date of three months or less when purchased are classified as cash and cash equivalents. At December 31,
2004, the Company had $1,000,000 on deposit in a restricted account with the State of Nevada as security for performance of its pharmacy benefit management obligations and this amount is excluded from cash and cash equivalents.



Accounts Receivable



Based on the Companys revenue recognition policies discussed below, certain rebates are estimated and unbilled at the end of the
period. Receivables for rebates are calculated monthly based on an estimate of rebatable prescriptions and the rebate per prescription. These estimates are adjusted to actual when the number of rebatable prescriptions and the rebate per prescription
have been determined. Historically, adjustments to original estimates have been immaterial.



The allowance for doubtful accounts is determined based on historical write-off experience. Account balances are charged off against the allowance when we feel it is more than likely that the receivable will not be
recovered. We do not have any off-balance-sheet credit exposure related to our customers.



Inventory



Inventory consists of
prescription drugs and medical supplies that are stated at the lower or cost of market determined by the first-in, first-out method.



Property and Equipment



Property and equipment is stated at cost and depreciated over their estimated useful lives using the straight-line method. The estimated useful lives range from 3-5 years for the Companys equipment and computer
software while leasehold improvements are amortized over the shorter of the estimated lives of the assets or the lease term.



Internally developed software



The Company capitalizes costs associated with software developed or obtained for internal use in accordance with American Institute of Certified Public Accountants
Statement of Position 98-1, Accounting for the Costs of Computer Software Developed or Obtained for Internal Use. Capitalized internal use software development costs include only (1) external direct costs of materials and services
consumed in developing and obtaining software, (2) payroll and payroll-related costs for employees who are directly associated with and who devote time to the project, and (3) interest costs incurred, when material, while developing the software.
Capitalization of these costs ceases when the project is substantially complete and ready for its intended purpose.



Impairment of long-lived assets



The Company investigates potential impairments of its long-lived assets when evidence exists that events or changes in circumstances may have made recovery of an
assets carrying value unlikely. Long-lived assets are measured for impairment when the sum of the expected undiscounted future net cash flows is less than the carrying amount of the asset. Any related impairment loss is calculated based upon
comparison of the fair value to the carrying value of the asset. No such impairment existed as of December 31, 2004 and 2003.



F-7



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##### Table of Contents

HEALTHEXTRAS, INC.



and Subsidiaries



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS



Intangible Assets



The Company accounts for its intangible assets under Statement of Financial Accounting Standards (SFAS) No. 142, Goodwill and Other Intangible
Assets. Under SFAS No. 142, the Companys other intangible assets with indefinite lives, including trademarks, tradenames, and in-place distributor networks, are not amortized, but are tested for impairment annually. Currently the Company
does not have any intangible assets with indefinite lives. The Company does have other intangible assets subject to amortization and these assets are amortized over 5 months to 20 years, depending on each intangible assets estimated useful
life.



The estimated fair value and the weighted average useful-life of the
intangible assets are based on income-method valuation calculations, performed by an independent consulting firm. The remaining useful life of intangible assets is evaluated periodically and adjusted as necessary to match the period that the assets
are expected to provide economic benefits. We concluded that no impairment of intangible assets existed at December 31, 2004 and 2003.



Goodwill



The Company accounts for its goodwill under SFAS No. 142, Goodwill and Other Intangible Assets. Under SFAS No. 142, goodwill is not amortized, but it is tested for impairment at least annually. Each year,
the Company tests for impairment of goodwill according to a two-step approach. In the first step, the Company tests for impairment of goodwill by estimating the fair values of its reporting units using the present value of future cash flows
approach, subject to a comparison for reasonableness to its market capitalization at the date of valuation. If the carrying amount exceeds the fair value, the second step of the goodwill impairment test is performed to measure the amount of the
impairment loss, if any. In the second step the implied fair value of the goodwill is estimated as the fair value of the reporting unit used in the first step less the fair values of all other net tangible and intangible assets of the reporting
unit. If the carrying amount of the goodwill exceeds its implied fair market value, an impairment loss is recognized in an amount equal to that excess, not to exceed the carrying amount of the goodwill. In addition, goodwill of a reporting unit is
tested for impairment between annual tests if an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying value.



Revenue and direct expense recognition



The Company recognizes revenues from PBM services, which include sales of prescription drugs by pharmacies in the Companys nationwide network and related claims
processing fees, provided to its clients. Revenue is recognized when the claims are adjudicated. Pharmacy claims are adjudicated at the point-of-sale using an on-line claims processing system. When the Company has a contractual obligation to pay its
network pharmacy providers for benefits provided to its clients members, total payments from these clients are recorded as revenue and payments to the network pharmacy provider are recorded as direct expenses. Generally, these contracts
require the Company to assume the credit risk of its clients abilities to pay. In addition, under a vast majority of its client contracts, the Company is at risk for the difference between the payments the Company receives from its clients and
the negotiated reimbursements the Company pays to its pharmacies. When the Company administers pharmacy reimbursement contracts and does not assume credit risk, the Company records only the net revenue and the administrative or processing fees.
Rebates earned under arrangements with drug manufacturers are recorded as a reduction of direct expenses. The portion of such rebates due to plan sponsors is recorded as a reduction of revenue. Manufacturers rebates are based on estimates, which are
subject to final settlement with the contracted party.



Member co-payments are
not recorded as revenue. Under the Companys client contracts, the pharmacy is solely obligated to collect the co-payments from the members. Under client contracts, the Company does not assume liability for member co-payments in pharmacy
transactions. As such, the Company does not include member co-payments to pharmacies in revenue or operating expenses.



The primary determinant of revenue recognition for the supplemental benefits segment is monthly program enrollment and, prior to October 2002, payments from certain
distributors related to new member enrollments. In general, program revenue is recognized based on the number of members enrolled in each reporting period



F-8



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##### Table of Contents

HEALTHEXTRAS, INC.



and Subsidiaries



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS



multiplied by the applicable monthly fee for their specific membership program. The program revenue recognized by the Company includes the cost of membership
features supplied by others, including the insurance components. Direct program expenses consist of the costs that are a direct function of a period of membership and a specific set of program features. The coverage obligations of our benefit
suppliers and the related expense are determined monthly, as are the remaining direct expenses.



Prior to October 2002, payments from distributors related to new member enrollments were recorded as revenue to the extent of related direct expenses, which cumulatively exceeded payments from distributors.



Revenue from supplemental benefit programs and related direct expenses
(principally marketing and processing fees and the cost of the benefits provided to program members) are initially deferred during the period in which a program member is entitled to obtain a refund (generally 90 days). If a member requests a
refund, the Company retains any interest earned on funds held during the refunded membership period. Total revenue and direct expenses attributable to the initial deferral are recognized subsequent to the end of the initial deferral period. After
the initial deferral period, revenue is recognized as earned and direct expenses as incurred.



The Company has historically maintained a prepaid balance for the cost of insurance benefits included in its programs. The carrying value of the prepayment was adjusted at the end of each quarter based on factors
including enrollment levels in each product, enrollment trends, and the remaining portion of the unexpired prepayment period.



Other Income



In April 2004, the Company reached a legal settlement related to litigation initiated by the Company on December 3, 2002. The terms of the settlement are confidential; however, the net proceeds from the settlement
constitute the significant portion of the $2.1 million of other income reported in the consolidated statement of operations for the period ended December 31, 2004.



Income taxes



Deferred tax assets and liabilities are recognized for the expected future tax consequences of events that have been included in the financial statements or tax returns.
Deferred income taxes reflect the net effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes measured using the enacted tax rates and laws
that will be in effect when the differences are expected to reverse.



Net
income per share



Basic net income per common share excludes dilution and
is computed by dividing net income available to common stockholders by the weighted average number of common shares outstanding for the period. Diluted net income per common share reflects the potential dilution that could occur (using the treasury
stock method) if options and warrants to issue common stock were exercised.



The following represents a reconciliation of the number of shares used in the basic and diluted net income per share computations (amounts in thousands except per share data):



|                                                    |  |      |        |      |   |        |  |   |       
|--------------------------------------------------- |  | ---- | ------ | ---- | - | ------ |  | - | ------
|                                                    |  | 2004 |        | 2003 |   | 2002  
|Net income                                          |  | $    | 16,383 |      | $ | 10,317 |  | $ | 13,478
|                                                    |  |      |        |      |   |        |  |   |       
|Calculation of shares:                              |  |      |        |      |   |        |  |   |       
|Weighted average common shares outstanding, basic   |  |      | 33,642 |      |   | 32,447 |  |   | 32,234
|Dilutive effect of stock options and warrants       |  |      | 2,765  |      |   | 2,007  |  |   | 186   
|                                                    |  |      |        |      |   |        |  |   |       
|Weighted average common shares outstanding, diluted |  |      | 36,407 |      |   | 34,454 |  |   | 32,420
|                                                    |  |      |        |      |   |        |  |   |       
|Net income per common share, basic                  |  | $    | 0.49   |      | $ | 0.32   |  | $ | 0.42  
|                                                    |  |      |        |      |   |        |  |   |       
|Net income per common share, diluted                |  | $    | 0.45   |      | $ | 0.30   |  | $ | 0.42  
|                                                    |  |      |        |      |   |        |  |   |       



F-9



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##### Table of Contents

HEALTHEXTRAS, INC.



and Subsidiaries



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS



The following options and warrants were not included in the computation of diluted net income per share because the
exercise prices were greater than the average market price of the common shares:



|                                                                       |  |      |  |      |  |      
|---------------------------------------------------------------------- |  | ---- |  | ---- |  | -----
|                                                                       |  | 2004 |  | 2003 |  | 2002 
|Options and warrants to purchase shares of common stock (in thousands) |  | 412  |  | 48   |  | 5,292



Comprehensive income



The Company records comprehensive income for its interest rate swap
arrangement. See Footnote 7 for further details.



Stock-based compensation



The Company accounts for stock-based compensation in accordance with
Financial Accounting Standards Board (FASB) Statement No. 123, Accounting for Stock-Based Compensation, as amended by FASB Statement No. 148, Accounting for Stock-Based Compensation-Transition and Disclosure, an
Amendment of FASB No. 123. These statements establish financial accounting and reporting standards for stock-based compensation, including employee stock option plans.



As allowed by FASB Statement No. 123, the Company continues to measure compensation expense under Accounting Principles Board Opinion No.
25, Accounting for Stock Issued to Employees (APB 25), and related interpretations. Accordingly, no compensation cost has been recognized for the Companys employee and director stock option plans. Had compensation cost
for the Companys stock-based compensation plans been determined under the fair value method included in FASB Statement No. 123, as amended by FASB Statement No. 148, the Companys net income and earnings per share would have been reduced
to the pro forma amounts as indicated below. Amounts in thousands, except per share data.



|                        |  |                                                                                                                                                                  |        |      |       |        |  |       |        |  |      
|----------------------- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------- | ------ | ---- | ----- | ------ |  | ----- | ------ |  | -----
|                        |  |                                                                                                                                                                  |        | 2004 |       | 2003   |  | 2002 
|Net income, as reported |  | $                                                                                                                                                                | 16,383 |      | $     | 10,317 |  | $     | 13,478
|Add:                    |  | Stock-based compensation expense included in net income (net of related taxes in 2004 and 2003)                                                                  |        |      | 26    |        |  | 11    |        |  |     
|Deduct:                 |  | Total stock-based employee and director compensation expense determined under the fair value method for all awards (net of related taxes in 2004, 2003 and 2002) |        |      | 2,673 |        |  | 1,512 |        |  | 1,766
|                        |  |                                                                                                                                                                  |        |      |       |        |  |       |        |  |      
|Pro forma net income    |  | $                                                                                                                                                                | 13,736 |      | $     | 8,816  |  | $     | 11,712
|                        |  |                                                                                                                                                                  |        |      |       |        |  |       |        |  |      
|Net income per share:   |  |                                                                                                                                                                  |        |      |       |        |  |       |       
|Basic  as reported     |  | $                                                                                                                                                                | 0.49   |      | $     | 0.32   |  | $     | 0.42  
|Basic  pro forma       |  | $                                                                                                                                                                | 0.41   |      | $     | 0.27   |  | $     | 0.36  
|Diluted  as reported   |  | $                                                                                                                                                                | 0.45   |      | $     | 0.30   |  | $     | 0.42  
|Diluted  pro forma     |  | $                                                                                                                                                                | 0.38   |      | $     | 0.26   |  | $     | 0.36  



The fair value for these options was
estimated at the date of the grants using the modified American Black-Scholes economic option-pricing model with the following assumptions for the years ended 2004, 2003, and 2002.



|                        |  |              |  |            |  |         
|----------------------- |  | ------------ |  | ---------- |  | --------
|                        |  | 2004         |  | 2003       |  | 2002    
|Expected term           |  | 5 years      |  | 5 years    |  | 5 years 
|Volatility factor       |  | 74.65-79.87% |  | 80.787.3% |  | 87.0%   
|Risk free interest rate |  | 2.76-4.04%   |  | 2.33.3%   |  | 2.95.1%
|Dividend yield          |  |             |  |           |  |        
|Fair value              |  | $8.20        |  | $4.67      |  | $3.72   



F-10



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##### Table of Contents

HEALTHEXTRAS, INC.



and Subsidiaries



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS



3. RECENT ACCOUNTING PRONOUNCEMENTS



In January 2003, the FASB issued Interpretation No. 46, Consolidation of Variable Interest Entities (FIN 46). Until
this interpretation, a company generally included another entity in its consolidated financial statements only if it controlled the entity through voting interests. FIN 46 requires a variable interest entity, as defined, to be consolidated by a
company if that company is subject to a majority of the risk of loss from the variable interest entitys activities or entitled to receive a majority of the entitys residual returns. Certain provisions of FIN 46 were deferred until the
period ending after March 15, 2004. The impact of FIN 46 and certain provisions effective after March 15, 2004, are not applicable to the accounting of our business and had no impact on the Companys financial statements.



In December 2004, the FASB issued SFAS No. 123, Revised 2004 (Statement 123(R)),
Share-Based Payment, which revised SFAS No. 123, Accounting for Stock-Based Compensation. This statement supercedes APB 25. The revised statement addresses the accounting for share-based payment transactions with employees
and other third parties, eliminates the ability to account for share-based compensation transactions using APB 25 and requires that the compensation costs relating to such transactions be recognized in the consolidated statement of operations. The
revised statement is effective as of the first interim period beginning after June 15, 2005. The Company will adopt the statement as required. Effective with the implementation of SFAS 123(R), the Company anticipates accelerating the vesting of
certain options with little or no intrinsic value prior to July 1, 2005. Therefore, these options will not be expensed in the periods subsequent to July 1, 2005. It is estimated that the acceleration of the vesting of these options will eliminate
approximately $5.0 million before income taxes on a prospective basis and that the Company will incur a one-time charge associated with the acceleration of vesting of approximately $1.5 million before income taxes. The Company expects to execute the
indicated restructuring of its option plans no later than June 30, 2005.



4.
PROPERTY AND EQUIPMENT



Property and
equipment consists of the following (in thousands):



|                                          |  |      |        |   |      |   |        |  
|----------------------------------------- |  | ---- | ------ | - | ---- | - | ------ | -
|                                          |  | 2004 |        |   | 2003 |  
|Computer equipment and software           |  | $    | 4,246  |   |      | $ | 2,461  |  
|Internally developed software             |  |      | 372    |   |      |   | 67     |  
|Furniture, fixtures and office equipment  |  |      | 3,139  |   |      |   | 1,291  |  
|Leasehold improvements                    |  |      | 3,509  |   |      |   | 1,901  |  
|Transportation equipment                  |  |      | 2,256  |   |      |   | 1,666  |  
|Fixed assets in progress                  |  |      | 65     |   |      |   |       |  
|                                          |  |      |        |   |      |   |        |  
|Total property and equipment              |  |      | 13,587 |   |      |   | 7,386  |  
|Accumulated depreciation and amortization |  |      | (3,706 | ) |      |   | (4,538 | )
|                                          |  |      |        |   |      |   |        |  
|Total property and equipment, net         |  | $    | 9,881  |   |      | $ | 2,848  |  
|                                          |  |      |        |   |      |   |        |  



Depreciation expense for the years
ended December 31, 2004, 2003, and 2002 was $1.5 million, $1.5 million and $1.3 million, respectively.



In 2002, the Company purchased a fractional interest in two aircraft used for corporate business purposes at a cost of $1.7 million. The carrying value of these assets was approximately $1.3 million at December 31,
2003. In July 2004, the Company sold its fractional interests for approximately $1.0 million in cash and recognized a loss of approximately $38,000. Simultaneously, the Company purchased a fractional interest in two other aircraft for approximately
$2.3 million. The carrying value of these assets was $2.1 million at December 31, 2004.



In June 2004, the Company entered into a ten-year lease in a new office building in Rockville, Maryland for approximately 37,000 square feet of office space and moved its headquarters to the new location in the third quarter of 2004. The
Company purchased approximately $5.0 million in equipment, furniture, and leasehold improvements for the new office space.



F-11



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##### Table of Contents

HEALTHEXTRAS, INC.



and Subsidiaries



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS



5. INTANGIBLE ASSETS



Catalyst Rx (Catalyst), Pharmacy Network National Corporation (PNNC) and Managed Healthcare Systems, Inc. (MHS) customer contracts
represent the estimated fair value of customer contracts held by Catalyst, PNNC and MHS at the dates of acquisition. This estimated fair value and the weighted average useful-lives are based on incomemethod valuation calculations. Other PBM
contracts allow the Company to provide PBM services, which are amortized over the future cash flow, based on managements best estimate.



As of December 31, 2004 and 2003, intangible assets consisted of the following (in thousands):



|                            |  |      |        |   |      |   |        |                     |  |                   
|--------------------------- |  | ---- | ------ | - | ---- | - | ------ | ------------------- |  | ------------------
|                            |  | 2004 |        |   | 2003 |   |        | Amortization Period
|Catalyst customer contracts |  | $    | 5,700  |   |      | $ | 5,700  |                     |  | 20 years          
|PNNC customer contracts     |  |      | 8,000  |   |      |   | 8,000  |                     |  | 20 years          
|MHS customer contracts      |  |      | 8,289  |   |      |   |       |                     |  | 15 years          
|Non-compete agreements      |  |      | 118    |   |      |   |       |                     |  | 2 years           
|Other PBM contracts         |  |      | 2,980  |   |      |   | 1,911  |                     |  | 5 months 20 years
|                            |  |      |        |   |      |   |        |                     |  |                   
|Total intangible assets     |  | $    | 25,087 |   |      | $ | 15,611 |                     |  |                   
|Accumulated amortization    |  |      | (2,780 | ) |      |   | (1,287 | )                   |  |                   
|                            |  |      |        |   |      |   |        |                     |  |                   
|                            |  | $    | 22,307 |   |      | $ | 14,324 |                     |  |                   
|                            |  |      |        |   |      |   |        |                     |  |                   



The estimated aggregate amortization
expense of intangible assets through 2009 is as follows (in thousands):



|      |  |        |      
|----- |  | ------ | -----
|Year  |  | Amount
|2005  |  | $      | 1,831
|2006  |  |        | 1,799
|2007  |  |        | 1,395
|2008  |  |        | 1,357
|2009  |  |        | 1,346
|      |  |        |      
|Total |  | $      | 7,728
|      |  |        |      



Amortization expense for the years
ended 2004, 2003 and 2002 was $1.5 million, $828,000 and $414,000 respectively.



6. GOODWILL



The changes in goodwill for the years ended
December 31, 2004 and 2003 are as follows (in thousands):



|                                  |  |      |        |      |   |       
|--------------------------------- |  | ---- | ------ | ---- | - | ------
|                                  |  | 2004 |        | 2003
|Balance as of January 1           |  | $    | 37,764 |      | $ | 33,538
|Goodwill acquired in acquisitions |  |      | 31,183 |      |   | 4,226 
|                                  |  |      |        |      |   |       
|Balance as of December 31         |  | $    | 68,947 |      | $ | 37,764
|                                  |  |      |        |      |   |       



Goodwill represents the excess of the
purchase price over the fair value of the net assets of acquired businesses. The Company adopted SFAS No. 142, and discontinued the amortization of goodwill and indefinite-lived intangible assets, effective January 1, 2002. The Company performed its
annual impairment testing at December 31, 2004 and December 31, 2003 and concluded that no impairment of goodwill exists. All goodwill is recorded in the PBM segment. The increase to goodwill in 2004 and 2003 results from the acquisitions in those
years.



F-12



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##### Table of Contents

HEALTHEXTRAS, INC.



and Subsidiaries



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS



7. NOTES PAYABLE



At December 31, 2003, the Company had a $25.0 million revolving credit facility with a commercial bank. The credit facility had an expiration date of May 2005 and an
interest rate of LIBOR plus 2.75% payable in arrears on the fifth day of each month. The outstanding balance on the revolving credit facility at December 31, 2003 was $10.0 million.



In June 2004, the revolving credit facility was increased to $30.0 million and the term was extended to June 2006. The new interest rate is
LIBOR plus 2.00% payable in arrears on the first day of each month. The effective rate at December 31, 2004 was 4.42%. The outstanding balance on the credit facility on December 31, 2004 was $8.0 million.



In June 2004, the Company entered into a $20.0 million, forty-eight month term loan facility
with a commercial bank. Commencing July 1, 2004, principal is payable monthly in equal installments, together with accrued interest on the outstanding balance. The interest rate is LIBOR plus 2.00%. The outstanding balance on the term loan facility
at December 31, 2004 was $17.5 million.



The table below outlines the
Companys outstanding notes payable balances (in thousands):



|                                   |  |                     |        |   |      |   |       
|---------------------------------- |  | ------------------- | ------ | - | ---- | - | ------
|                                   |  | Outstanding balance
|Description                        |  | 2004                |        |   | 2003
|Line of credit                     |  | $                   | 8,000  |   |      | $ | 10,000
|Term loan                          |  |                     | 17,500 |   |      |   |      
|                                   |  |                     |        |   |      |   |       
|Total notes payable                |  |                     | 25,500 |   |      |   | 10,000
|Less: Current portion of term loan |  |                     | (5,000 | ) |      |   |      
|                                   |  |                     |        |   |      |   |       
|Long-term notes payable            |  | $                   | 20,500 |   |      | $ | 10,000
|                                   |  |                     |        |   |      |   |       



The revolving credit facility and the
term loan facility are collateralized by substantially all of the Companys assets. Both facilities contain affirmative and negative covenants related to indebtedness, EBITDA, cash and accounts receivable.



The Company manages its interest rate risk by balancing the amount of fixed and variable rate
debt. In August 2004, the Company entered into an interest rate swap for the purpose of converting the interest payable on the term loan from a variable rate to a fixed rate. Under the agreement, the Company has agreed to receive interest from the
counter party on the $17.5 million notional amount at a variable rate of LIBOR plus 2.00% and pay interest at a fixed rate of 5.23%. The interest rate swap met the criteria to qualify for the shortcut method of accounting for cash flow hedges under
SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities as amended. Based on this shortcut method of accounting, no ineffectiveness in the hedging relationship was assumed. The changes in the fair value of the interest
rate swap agreement are exactly offset by changes in the fair value of the underlying long-term debt; therefore, the adjustments are recorded on the balance sheet as comprehensive gain and do not impact income.



Interest expense for notes payable for the years ended December 31, 2004 and 2003 was $1.0
million and $595,000, respectively.





F-13



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##### Table of Contents

HEALTHEXTRAS, INC.



and Subsidiaries



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS



8. INCOME TAXES



The components of income tax (benefit) expense at December 31, 2004, 2003 and 2002 are as follows (in thousands):



|                  |  |      |       |      |   |       |  |   |         |  
|----------------- |  | ---- | ----- | ---- | - | ----- |  | - | ------- | -
|                  |  | 2004 |       | 2003 |   | 2002  | 
|Current: Federal  |  | $    | 4,457 |      | $ |      |  | $ |        |  
|State             |  |      | 936   |      |   |      |  |   |        |  
|                  |  |      |       |      |   |       |  |   |         |  
|Total             |  | $    | 5,393 |      | $ |      |  | $ |        |  
|                  |  |      |       |      |   |       |  |   |         |  
|Deferred: Federal |  | $    | 3,867 |      | $ | 5,478 |  | $ | (8,979  | )
|State             |  |      | 654   |      |   | 790   |  |   | (1,226  | )
|                  |  |      |       |      |   |       |  |   |         |  
|Total             |  | $    | 4,521 |      | $ | 6,268 |  | $ | (10,205 | )
|                  |  |      |       |      |   |       |  |   |         |  
|Total: Federal    |  | $    | 8,324 |      | $ | 5,478 |  | $ | (8,979  | )
|State             |  |      | 1,590 |      |   | 790   |  |   | (1,226  | )
|                  |  |      |       |      |   |       |  |   |         |  
|Total             |  | $    | 9,914 |      | $ | 6,268 |  | $ | (10,205 | )
|                  |  |      |       |      |   |       |  |   |         |  



In 2002, as a result of the
Companys profitability, the Company recognized $10.2 million in tax benefit principally resulting from the release of the full valuation allowance for its deferred tax assets. A summary of the components of deferred income taxes at December
31, 2004 and 2003 is as follows (in thousands):



|                                                   |  |      |        |   |      |   |        |  
|-------------------------------------------------- |  | ---- | ------ | - | ---- | - | ------ | -
|                                                   |  | 2004 |        |   | 2003 |  
|Deferred tax assets (liabilities):                 |  |      |        |   |      |   |        |  
|Allowance for doubtful accounts                    |  | $    | 162    |   |      | $ | 182    |  
|Deferred charges                                   |  |      | (542   | ) |      |   | (515   | )
|Rebates receivable, net                            |  |      | (548   | ) |      |   | (740   | )
|Property and equipment                             |  |      | (742   | ) |      |   | (127   | )
|Customer-based and other intangibles               |  |      | (4,729 | ) |      |   | (4,828 | )
|Goodwill                                           |  |      | (428   | ) |      |   |       |  
|Deferred revenue                                   |  |      |       |   |      |   | 1,821  |  
|Federal and state net operating loss carryforwards |  |      | 1,299  |   |      |   | 2,724  |  
|Other                                              |  |      | 16     |   |      |   | 197    |  
|                                                   |  |      |        |   |      |   |        |  
|Net deferred tax liability                         |  | $    | (5,510 | ) |      | $ | (1,286 | )
|                                                   |  |      |        |   |      |   |        |  



At December 31, 2004 the Company had
net operating loss carryforwards of $1.4 million and $19.3 million, which are available to offset future federal and state taxable income respectively. The federal carryforwards are subject to an annual limitation of $467,000 under Internal Revenue
Code Section 382. The carryforwards expire at various times between 2010 and 2021.



The effective tax rate varies from the U.S. Federal Statutory tax rate principally due to the following:



|                                     |  |      |   |  |      |   |  |        |   
|------------------------------------ |  | ---- | - |  | ---- | - |  | ------ | --
|                                     |  | 2004 |   |  | 2003 |   |  | 2002   |   
|U.S. Federal Statutory tax rate      |  | 35.0 | % |  | 34.0 | % |  | 34.0   | % 
|State taxes, net of federal benefits |  | 3.2  |   |  | 4.4  |   |  | 4.6    |   
|Non-deductible expenses              |  | 0.1  |   |  | 0.1  |   |  | (0.5   | ) 
|Valuation allowance (release)        |  |     |   |  |     |   |  | (345.7 | ) 
|Other                                |  | (0.6 | ) |  | (0.8 | ) |  |       |   
|                                     |  |      |   |  |      |   |  |        |   
|Effective tax rate                   |  | 37.7 | % |  | 37.7 | % |  | (307.6 | )%
|                                     |  |      |   |  |      |   |  |        |   





F-14



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##### Table of Contents

HEALTHEXTRAS, INC.



and Subsidiaries



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS



9. STOCKHOLDERS EQUITY



Stock option plans



In 1999, the Company established the HealthExtras, Inc. 1999 Stock Option Plan (1999 SOP). The 1999 SOP provides for a maximum of 4,000,000 common shares of
the Company to be issued as option grants. A Committee of the Board of Directors determines award amounts, option prices and vesting periods, subject to the provisions of the 1999 SOP. All option grants expire in ten years. All officers, employees
and independent contractors of the Company are eligible to receive option awards at the discretion of the Committee.



In 2000, the shareholders approved and the Company adopted the HealthExtras, Inc. 2000 Stock Option Plan (2000 SOP). The 2000 SOP provides for a maximum of
1,000,000 common shares of the Company to be issued as option grants. A Committee of the Board of Directors determines award amounts, option prices and vesting periods, subject to the provisions of the 2000 SOP. All option grants expire in ten
years. All officers, employees and independent contractors of the Company are eligible to receive option awards at the discretion of the Committee.



In 2000, the shareholders approved and the Company adopted the HealthExtras, Inc. Directors Stock Option Plan. (Directors SOP). The Directors SOP
provides for a maximum of 200,000 common shares of the Company to be issued as option grants. The Board of Directors determines award amounts, option prices and vesting periods, subject to the provisions of the Directors SOP. All option grants
expire in ten years. All non-employee Directors of the Company are eligible to receive option awards at the discretion of the Board of Directors. The Directors SOP provided for an option grant of 15,000 shares to each non-Employee Director
upon approval of the plan and subsequent annual grants of 5,000 shares.



In
2003, the shareholders approved and the Company adopted the HealthExtras, Inc. 2003 Equity Incentive Plan (2003 EIP). The 2003 EIP provides for a maximum of 1,500,000 common shares of the Company to be issued as option grants or
restricted shares. A Committee of the Board of Directors determines award amounts, option prices, vesting periods, and restrictions, subject to the provisions of the 2003 EIP. All option grants expire in ten years. All officers, employees and
independent contractors of the Company are eligible to receive option and restricted stock awards at the discretion of the Committee.



In 2001, the Board of Directors approved a voluntary plan by which qualified individuals were offered an opportunity to surrender their 1999 stock option awards, and
receive, at a future grant date, six months and one day beyond the surrender date, up to two-thirds of the number of options surrendered; 2.8 million options were surrendered in 2001 and 1.6 million options were granted in 2002 under this voluntary
plan.





F-15



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##### Table of Contents

HEALTHEXTRAS, INC.



and Subsidiaries



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS



The following table summarized stock option activity under all plans for the three years ended December 31, 2004 (in
thousands, except price per share and weighted-average exercise price):



|                               |  |                                |   |  |                |  |                                |      
|------------------------------ |  | ------------------------------ | - |  | -------------- |  | ------------------------------ | -----
|                               |  | Number of Sharesof CommonStock |   |  | PricePer Share |  | Weighted -AverageExercisePrice
|Balance, December 31, 2001     |  | 2,239                          |   |  | 3.509.65      |  |                                | 5.02 
|                               |  |                                |   |  |                |  |                                |      
|Granted                        |  | 2,957                          |   |  | 2.426.62      |  |                                | 5.23 
|Exercised                      |  | (9                             | ) |  | 3.57           |  |                                | 3.57 
|Forfeited                      |  | (320                           | ) |  | 3.317.15      |  |                                | 4.51 
|                               |  |                                |   |  |                |  |                                |      
|Balance, December 31, 2002     |  | 4,867                          |   |  | 2.427.15      |  |                                | 5.16 
|                               |  |                                |   |  |                |  |                                |      
|Granted                        |  | 295                            |   |  | 3.639.65      |  |                                | 5.52 
|Exercised                      |  | (201                           | ) |  | 2.756.62      |  |                                | 4.65 
|Forfeited                      |  | (303                           | ) |  | 3.316.62      |  |                                | 4.65 
|                               |  |                                |   |  |                |  |                                |      
|Balance, December 31, 2003     |  | 4,658                          |   |  | 2.429.65      |  |                                | 5.19 
|                               |  |                                |   |  |                |  |                                |      
|Granted                        |  | 981                            |   |  | 9.15-16.36     |  |                                | 12.57
|Exercised                      |  | (308                           | ) |  | 2.42-9.65      |  |                                | 3.87 
|Forfeited                      |  | (67                            | ) |  | 3.57-13.55     |  |                                | 7.96 
|                               |  |                                |   |  |                |  |                                |      
|Balance, December 31, 2004     |  | 5,264                          |   |  | $2.4216.36    |  | $                              | 6.65 
|                               |  |                                |   |  |                |  |                                |      
|Exercisable, December 31, 2002 |  | 827                            |   |  | $ 3.259.65    |  | $                              | 5.40 
|Exercisable, December 31, 2003 |  | 1,858                          |   |  | $ 2.429.65    |  | $                              | 5.08 
|Exercisable, December 31, 2004 |  | 2,763                          |   |  | $2.42-16.36    |  | $                              | 5.29 



The following table summarizes
information about the outstanding options at December 31, 2004 (in thousands, except for weighted-average exercise price):



|                         |  |                     |  |                                                  |  |                                 |      
|------------------------ |  | ------------------- |  | ------------------------------------------------ |  | ------------------------------- | -----
|                         |  | Options Outstanding
|Range of Exercise Prices |  | Number              |  | Weighted-AverageRemainingContractualLife (years) |  | Weighted -AverageExercise Price
|$2.42 3.60              |  | 412                 |  | 7.13                                             |  | $                               | 2.90 
|$3.63 5.00              |  | 1,910               |  | 6.33                                             |  | $                               | 4.49 
|$5.45 7.78              |  | 1,976               |  | 7.36                                             |  | $                               | 6.60 
|$9.65 13.99             |  | 726                 |  | 9.38                                             |  | $                               | 11.56
|$14.20 16.36            |  | 240                 |  | 9.53                                             |  | $                               | 15.86
|                         |  |                     |  |                                                  |  |                                 |      
|$2.42  16.36            |  | 5,264               |  | 7.82                                             |  | $                               | 6.65 
|                         |  |                     |  |                                                  |  |                                 |      



Stock (member interests) grants



In February 1999, certain management employees were granted effective
member interests aggregating 1.87% (equivalent to 413,333 common shares of the Company), after giving effect to an existing commitment to sell a 20% interest in the Company to a third party for $5.0 million. Such grants vested over a four-year
period commencing March 1, 1999. The Company recorded the estimated fair value of these interests of $467,573 ($1.13 per common share) as stockholders equity and deferred compensation expense.



During 2004, 2003 and 2002, amortization of deferred compensation expense was zero, $15,000
and $92,000, respectively. As such grants were 100% vested and distributed in the first quarter of 2003, no additional deferred compensation expense relating to these stock grants has been recorded after the first quarter of 2003.



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##### Table of Contents

HEALTHEXTRAS, INC.



and Subsidiaries



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS



Common Stock Warrants



In 2001, in accordance with EITF 01-9, Accounting Consideration Given by a Vendor to a Customer or Reseller of the Vendors
Products, the Company recorded a reduction of revenue of $1.0 million related to common stock warrants expected to be issued to a distributor with respect to the annualized revenue threshold for the year ending June 30, 2002. Annualized
revenues under the contract for the year ending June 30, 2002 were estimated based on the performance of the distributor through December 31, 2001. Due to the lower fair value of the warrants in the first quarter of 2002, the Company recognized a
non-cash credit of approximately $477,000 in the first quarter of 2002. In the second quarter of 2002, it was determined that the distributor had not exceeded the specific annualized revenue thresholds; thus, the Company reversed the remaining
charge of approximately $531,000 for the warrant agreement. To comply with EITF 01-9, the $1.0 million of total non-cash credits was recorded as revenue during 2002. This arrangement will result in no further issuance of warrants beyond the
originally issued 750,000 warrants.



In January 2004, pursuant to an exchange
agreement entered into between the distributor and the Company the distributor surrendered the 750,000 warrants in exchange for 394,773 shares of common stock to be issued by the Company. The Company agreed to accept such surrender and exchange and
issued the 394,773 shares of common stock to be registered in the name of the distributor. The distributor then sold the 394,773 shares through a broker transaction.



In September of 2001, the Company issued warrants to third parties to acquire 845,816 shares of the Companys common stock in a private
placement with an exercise price of $5.37, which were vested immediately and expire on September 26, 2005.



During 2002, the Company issued common stock warrants to Health Care Horizons Inc., d/b/a Cimarron Health Plan (Cimarron) that grant Cimarron the right to purchase 250,000 shares of the
Companys common stock for $5.22 per share. The warrants are exercisable at any time after the grant date, with a condition that the Company must be the exclusive provider of PBM services to Cimarron on the date of exercise. The term of the PBM
contract is from July 1, 2002, to September 30, 2009. In accordance with EITF 96-18, Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring or in Conjunction With Selling Goods or Services, the
measurement date was determined to be the grant date of April 1, 2002. Using an equity-pricing model, the value of the 250,000 warrants was estimated to be $400,000 and was recorded as a deferred charge and additional paid-in capital at April 1,
2002. This deferred charge is being recognized over the life of the seven-year contract beginning July 2002, on a straight-line basis. The Company recorded approximately $57,000, $57,000 and $29,000 of contra-revenue related to amortization of the
cost of the warrants in 2004, 2003 and 2002, respectively.



The following table
summarizes the outstanding stock options and warrants at December 31, 2004 and 2003 (in thousands, except for weighted-average exercise price):



|                                                              |  |                      |  |                               |      |                      |       |                               |   |     
|------------------------------------------------------------- |  | -------------------- |  | ----------------------------- | ---- | -------------------- | ----- | ----------------------------- | - | ----
|                                                              |  | 2004                 |  | 2003                         
|                                                              |  | Numberof derivatives |  | Weightedaverageexercise price |      | Numberof derivatives |       | Weightedaverageexercise price
|Options issued through the Companys stock option plans       |  | 5,264                |  | $                             | 6.65 |                      | 4,658 |                               | $ | 5.19
|Warrants issued to a distributor                              |  |                     |  |                               |     |                      | 750   |                               |   | 5.21
|Warrants issued in Private Placement                          |  | 657                  |  |                               | 5.37 |                      | 846   |                               |   | 5.37
|Warrants issued to Health Care Horizons, Inc. d/b/a Cimarron |  | 250                  |  |                               | 5.22 |                      | 250   |                               |   | 5.22
|                                                              |  |                      |  |                               |      |                      |       |                               |   |     
|Total options and warrants outstanding                        |  | 6,170                |  | $                             | 6.45 |                      | 6,504 |                               | $ | 5.22
|                                                              |  |                      |  |                               |      |                      |       |                               |   |     



F-17



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##### Table of Contents

HEALTHEXTRAS, INC.



and Subsidiaries



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS



10. BUSINESS COMBINATIONS



Acquisition of Catalyst



During the first quarter of 2002, the Company purchased the remaining 20% minority interest in Catalyst for 319,033 shares of the Companys stock valued at $1.1
million and notes payable of $4.2 million. This purchase resulted in the Company owning 100% of Catalyst. The stock was transferred to the seller on April 1, 2002, $3.1 million in cash was paid in 2002, and the final installment of $1.1 million was
paid on March 1, 2003.



Acquisition of MHS



On June 18, 2004, the Company acquired 100% of the common stock of MHS.



Total consideration for MHS stock consisted of:



| |  |  | An aggregate cash payment of $37.3 million to the seller;
| | - |  | ---------------------------------------------------------



| |  |  | 100,739 shares of the Companys common stock, valued at $1.5 million to the seller; and
| | - |  | ---------------------------------------------------------------------------------------



| |  |  | Transaction costs incurred by the Company of $1.5 million.
| | - |  | ----------------------------------------------------------



The Company also issued:



| |  |  | two non-negotiable promissory notes, having an aggregate maximum principal amount of $4.0 million payable pursuant to and subject to certain revenue and gross profit criteria
attributable to MHS for the twelve months ending June 30, 2005;
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | warrants to purchase, for up to ten years, up to an aggregate of 300,000 shares of the Companys common stock at a purchase price of $15.45 per share, subject to the provisions
in the warrant, including performance-based standards;
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | a contingent earn-out provision which could require an additional payment of up to $2.0 million, subject to certain revenue and gross profit criteria attributable to MHS for the
twelve months ending September 30, 2005.
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



Given the contingent
nature of the non-negotiable promissory notes and warrants, the cost of the acquisition will be increased as the contingencies are resolved.



The Companys management has reviewed the specific criteria set forth in EITF 95-8, Accounting for Contingent Consideration Paid to the Shareholders of an
Acquired Enterprise in a Purchase Business Combination, to determine whether the contingent consideration that is based on certain revenue and gross profit measures should be accounted for as an adjustment to the purchase price of MHS or as
compensation for services. Management believes that the contingent consideration meets the criteria stated in Paragraph 27, SFAS No. 141, Business Combination, of being accounted for as an adjustment to the purchase price of MHS.



The acquisition resulted in the recording of goodwill of approximately $30.4
million and intangible assets (customer contracts and non-compete agreements) of $8.4 million.



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##### Table of Contents

HEALTHEXTRAS, INC.



and Subsidiaries



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS



The following table summarizes the estimated fair values of the assets acquired and liabilities assumed at the date
of acquisition. The acquisition was accounted for as a purchase. Amounts are in thousands.



|                                       |  |                  |        |  
|-------------------------------------- |  | ---------------- | ------ | -
|Description                            |  | At June 18, 2004 |       
|Current assets, including cash of $769 |  | $                | 2,106  |  
|Intangible assets                      |  |                  | 8,407  |  
|Goodwill                               |  |                  | 30,433 |  
|                                       |  |                  |        |  
|Total assets acquired                  |  |                  | 40,946 |  
|                                       |  |                  |        |  
|Current liabilities assumed            |  |                  | (662   | )
|                                       |  |                  |        |  
|Net assets acquired                    |  | $                | 40,284 |  
|                                       |  |                  |        |  



Pro forma consolidated results



The following unaudited pro forma consolidated results of operations for
the years ended December 31, 2004 and 2003 are presented as though MHS had been acquired at the beginning of each year, after giving effect to purchase accounting adjustments relating to the amortization and intangible assets. Results are in
thousands, except for per share data.



|                                 |  |      |         |      |   |        
|-------------------------------- |  | ---- | ------- | ---- | - | -------
|                                 |  | 2004 |         | 2003
|Revenue                          |  | $    | 528,216 |      | $ | 402,569
|Net income                       |  |      | 17,473  |      |   | 13,682 
|Net income per share, basic      |  | $    | 0.52    |      | $ | 0.42   
|Net income per share, diluted    |  | $    | 0.48    |      | $ | 0.40   
|Weighted average shares, basic   |  |      | 33,688  |      |   | 32,548 
|Weighted average shares, diluted |  |      | 36,453  |      |   | 34,555 



The pro forma results of operations
are not necessarily indicative of the results that would have occurred had the Company owned 100% of MHS at January 1, 2004, nor are these results indicative of future operating results.



In addition, to support its geographic expansion and growth, the Company has periodically completed various insignificant business
acquisitions to secure local operating assets, new pharmacy network contracts and local market executive offices. None of these transactions has had any significant impact on the Companys reported revenues, assets or results of operations.



11. LEASE COMMITMENTS



The Company maintains non-cancelable lease agreements for office space in its six main
operating locations. These agreements provide for annual escalations and payment by the Company of its proportionate share of the increase in the costs of operating the buildings. The Company also leases certain office equipment. The Company
recognizes rent expense on a straight-line basis over the terms of the leases.



The future minimum payments due under non-cancelable leases are as follows (in thousands):



|           |  |   |       
|---------- |  | - | ------
|2005       |  | $ | 1,706 
|2006       |  |   | 1,666 
|2007       |  |   | 1,744 
|2008       |  |   | 1,567 
|2009       |  |   | 1,582 
|Thereafter |  |   | 6,441 
|           |  |   |       
|           |  | $ | 14,706
|           |  |   |       



Rent expense for the years ended
December 31, 2004, 2003 and 2002 was $1.5 million, $1.2 million, and $797,000 respectively.



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##### Table of Contents

HEALTHEXTRAS, INC.



and Subsidiaries



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS



12. COMMITMENTS AND CONTINGENCIES



In 2000, the Company extended a marketing agreement for a five-year term, whereby the Company committed to total non-refundable payments of
$5.0 million due in equal annual installments for an individuals participation in various marketing campaigns. As of December 31, 2004, installments totaling $1.0 million remained committed under this agreement. The Company has the option to
extend this agreement for another five-year period, which would result in an additional commitment of $7.7 million.



In the ordinary course of business, the Company may become subject to legal proceedings and claims. The Company is not aware of any legal proceedings or claims, which, in
the opinion of management, will have a material adverse effect on the financial condition or results of operations of the Company.



13. SEGMENT REPORTING



The Company operates in two business segments, PBM and supplemental benefits. The following table presents financial data by segment for the years ended December 31, 2004, 2003 and 2002. PBM services operating results
include the results for Catalyst, PNNC and MHS from their respective dates of acquisition.



Segment information for 2004, 2003 and 2002 is as follows (in thousands):



|                           |  |     |         |                      |   |        |  |   |        
|-------------------------- |  | --- | ------- | -------------------- | - | ------ |  | - | -------
|December 31, 2004          |  |     |         |                      |   |        |  |   |        
|                           |  | PBM |         | SupplementalBenefits |   | Total 
|Revenue                    |  | $   | 475,229 |                      | $ | 46,096 |  | $ | 521,325
|Segment operating expenses |  |     | 451,388 |                      |   | 38,735 |  |   | 490,123
|Segment operating income   |  |     | 23,841  |                      |   | 7,362  |  |   | 31,203 
|Total assets               |  |     | 236,836 |                      |   | 7,416  |  |   | 244,252
|Accounts receivable        |  |     | 68,082  |                      |   | 156    |  |   | 68,238 
|Accounts payable           |  |     | 54,292  |                      |   | 1,399  |  |   | 55,691 



|                           |  |     |         |                      |   |        |  |   |        
|-------------------------- |  | --- | ------- | -------------------- | - | ------ |  | - | -------
|December 31, 2003          |  |     |         |                      |   |        |  |   |        
|                           |  | PBM |         | SupplementalBenefits |   | Total 
|Revenue                    |  | $   | 331,530 |                      | $ | 52,564 |  | $ | 384,094
|Segment operating expenses |  |     | 317,760 |                      |   | 43,959 |  |   | 361,719
|Segment operating income   |  |     | 13,770  |                      |   | 8,605  |  |   | 22,375 
|Total assets               |  |     | 132,532 |                      |   | 9,236  |  |   | 141,768
|Accounts receivable        |  |     | 51,414  |                      |   | 256    |  |   | 51,670 
|Accounts payable           |  |     | 49,612  |                      |   | 1,251  |  |   | 50,863 



|                           |  |     |         |                      |   |        |  |   |        
|-------------------------- |  | --- | ------- | -------------------- | - | ------ |  | - | -------
|December 31, 2002          |  |     |         |                      |   |        |  |   |        
|                           |  | PBM |         | SupplementalBenefits |   | Total 
|Revenue                    |  | $   | 182,276 |                      | $ | 66,131 |  | $ | 248,407
|Segment operating expenses |  |     | 173,905 |                      |   | 64,645 |  |   | 238,550
|Segment operating income   |  |     | 8,371   |                      |   | 1,486  |  |   | 9,857  
|Total assets               |  |     | 104,403 |                      |   | 15,599 |  |   | 120,002
|Accounts receivable        |  |     | 37,527  |                      |   | 273    |  |   | 37,800 
|Accounts payable           |  |     | 33,864  |                      |   | 588    |  |   | 34,452 



The Company does not allocate to
separate segments certain general expenses not directly related to the business segments, such as insurance and public company costs. The Company believes this segment disclosure, which



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##### Table of Contents

HEALTHEXTRAS, INC.



and Subsidiaries



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS



excludes corporate overhead, allows management to more accurately assess each segments operating performance without an arbitrary allocation of
non-operating expenses. Operating expenses of the segments exclude $6.2 million, $5.3 million, and $6.5 million in corporate overhead that was not allocated by management in assessing segment performance for the years ended December 31, 2004, 2003
and 2002, respectively.



The reconciliation of segment operating income to
income before taxes as disclosed in the financial statements is as follows (amounts in thousands):



|                                                 |  |      |        |   |      |   |        |      |  |   |       |  
|------------------------------------------------ |  | ---- | ------ | - | ---- | - | ------ | ---- |  | - | ----- | -
|                                                 |  | 2004 |        |   | 2003 |   |        | 2002 | 
|Segment operating income                         |  | $    | 31,203 |   |      | $ | 22,375 |      |  | $ | 9,857 |  
|Less: Corporate overhead expenses:               |  |      | 6,244  |   |      |   | 5,347  |      |  |   | 6,457 |  
|                                                 |  |      |        |   |      |   |        |      |  |   |       |  
|Operating income                                 |  | $    | 24,959 |   |      | $ | 17,028 |      |  | $ | 3,400 |  
|Interest income                                  |  | $    | 383    |   |      | $ | 155    |      |  | $ | 286   |  
|Interest expense                                 |  | $    | (1,145 | ) |      | $ | (598   | )    |  | $ | (368  | )
|Other income                                     |  |      | 2,100  |   |      |   |       |      |  |   |      |  
|                                                 |  |      |        |   |      |   |        |      |  |   |       |  
|Income before income taxes and minority interest |  | $    | 26,297 |   |      | $ | 16,585 |      |  | $ | 3,318 |  
|Minority interest                                |  |      |       |   |      |   |       |      |  |   | (45   | )
|                                                 |  |      |        |   |      |   |        |      |  |   |       |  
|Income before income taxes                       |  | $    | 26,297 |   |      | $ | 16,585 |      |  | $ | 3,273 |  
|                                                 |  |      |        |   |      |   |        |      |  |   |       |  



14. 401(k) SAVINGS PLAN



In April 2000, the Company authorized the establishment of an employee
401(k) Savings Plan (the Plan). The Plan benefit is available to all Company employees, subject to certain service requirements. Since Plan inception, the Company has matched the first $1,000 of the employees contribution and 50%
thereafter subject to statutory limits. The Companys matching contribution vests ratably over 5 years for each employee. For the years ended December 31, 2004, 2003 and 2002, the Company incurred expense of $377,000, $259,000 and $165,000
respectively, under the Plan.



15. RELATED PARTY TRANSACTIONS



During 2004 and 2003, the Company paid legal fees to a law firm in which
a member of the Board of Directors is a shareholder and member of the executive committee of $157,000 and $78,000, respectively.



In March of 2004, the Company entered into an agreement to purchase all of the assets of Diabetic Sense, a company specializing in diabetes management programs, from an
executive vice president of the Company in exchange for 74,250 shares of the Companys common stock. The 74,250 shares of stock were valued at $749,925 on the date of the agreement. Diabetic Sense provides specialty services to certain enrolled
members who participate in arrangements for discounted purchasing of diabetes test meters, insulin and other related supplies. The programs are offered to existing client groups of HealthExtras, as well as to other clients who do not otherwise
contract with HealthExtras or its affiliates for pharmacy benefit management services. The transaction closed on June 24, 2004.



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##### Table of Contents

HEALTHEXTRAS, INC.



and Subsidiaries



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS



16. SUPPLEMENTAL DISCLOSURE OF QUARTERLY RESULTS OF OPERATIONS (UNAUDITED)



Quarterly results of operations for the years ended December 31, 2004 and 2003 (in
thousands, except per share amounts):



|                                                                                                                                                                            |  |               |         |                |   |               |  |                |         |  |   |        
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ------------- | ------- | -------------- | - | ------------- |  | -------------- | ------- |  | - | -------
|                                                                                                                                                                            |  | First Quarter |         | Second Quarter |   | Third Quarter |  | Fourth Quarter
|2004 Quarterly Operating Results                                                                                                                                            |  |               |         |                |   |               |  |                |         |  |   |        
|Revenue (excludes member co-payments of $42,449, $43,206, $62,069, and $65,290 for the four quarterly periods ended March 31, June 30,
September 30, and December 31, 2004) |  | $             | 110,520 |                | $ | 114,201       |  | $              | 143,193 |  | $ | 153,411
|Operating income                                                                                                                                                            |  |               | 5,552   |                |   | 4,735         |  |                | 7,215   |  |   | 7,457  
|Income before income taxes                                                                                                                                                  |  |               | 5,520   |                |   | 6,618         |  |                | 6,904   |  |   | 7,255  
|Net income                                                                                                                                                                  |  | $             | 3,439   |                | $ | 4,123         |  | $              | 4,301   |  | $ | 4,520  
|Net income per common share, basic                                                                                                                                          |  | $             | 0.10    |                | $ | 0.12          |  | $              | 0.13    |  | $ | 0.13   
|Net income per common share, diluted                                                                                                                                        |  | $             | 0.10    |                | $ | 0.11          |  | $              | 0.12    |  | $ | 0.12   



|                                                                                                                                                                            |  |               |        |                |   |               |  |                |        |  |   |        
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ------------- | ------ | -------------- | - | ------------- |  | -------------- | ------ |  | - | -------
|                                                                                                                                                                            |  | First Quarter |        | Second Quarter |   | Third Quarter |  | Fourth Quarter
|2003 Quarterly Operating Results                                                                                                                                            |  |               |        |                |   |               |  |                |        |  |   |        
|Revenue (excludes member co-payments of $33,897, $33,650, $35,238, and $38,235 for the four quarterly periods ended March 31, June 30,
September 30, and December 31, 2003) |  | $             | 91,735 |                | $ | 94,115        |  | $              | 95,003 |  | $ | 103,241
|Operating income                                                                                                                                                            |  |               | 3,206  |                |   | 3,759         |  |                | 4,666  |  |   | 5,397  
|Income before income taxes                                                                                                                                                  |  |               | 3,057  |                |   | 3,645         |  |                | 4,568  |  |   | 5,315  
|Net income                                                                                                                                                                  |  | $             | 1,874  |                | $ | 2,238         |  | $              | 2,805  |  | $ | 3,400  
|Net income per common share, basic                                                                                                                                          |  | $             | 0.06   |                | $ | 0.07          |  | $              | 0.09   |  | $ | 0.10   
|Net income per common share, diluted                                                                                                                                        |  | $             | 0.06   |                | $ | 0.07          |  | $              | 0.08   |  | $ | 0.09   



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##### Table of Contents

HEALTHEXTRAS, INC.

and Subsidiaries



HEALTHEXTRAS, INC.

SCHEDULE II  VALUATION AND QUALIFYING ACCOUNTS



|                                   |  |                           |       |                            |   |                             |  |            |     |  |                      |         |   |  |   |    
|---------------------------------- |  | ------------------------- | ----- | -------------------------- | - | --------------------------- |  | ---------- | --- |  | -------------------- | ------- | - |  | - | ---
|Description                        |  | BalanceBeginning ofPeriod |       | AdditionsCharged toExpense |   | Additions DuetoAcquisitions |  | Deductions |     |  | Balance Endof Period
|Deduction from asset account:      |  |                           |       |                            |   |                             |  |            |     |  |                      |         |   |  |   |    
|Allowance for doubtful accounts:   |  |                           |       |                            |   |                             |  |            |     |  |                      |         |   |  |   |    
|Year ended December 31, 2004       |  | $                         | 889   |                            | $ | 210                         |  | $          | 199 |  | $                    | (381    | ) |  | $ | 917
|Year ended December 31, 2003       |  |                           | 425   |                            |   | 189                         |  |            | 391 |  |                      | (116    | ) |  |   | 889
|Year ended December 31, 2002       |  |                           | 457   |                            |   | 91                          |  |            | 145 |  |                      | (268    | ) |  |   | 425
|Deduction from asset account:      |  |                           |       |                            |   |                             |  |            |     |  |                      |         |   |  |   |    
|Allowance for deferred tax assets: |  |                           |       |                            |   |                             |  |            |     |  |                      |         |   |  |   |    
|Year ended December 31, 2004       |  | $                         |      |                            | $ |                            |  | $          |    |  | $                    |        |   |  | $ |   
|Year ended December 31, 2003       |  |                           |      |                            |   |                            |  |            |    |  |                      |        |   |  |   |   
|Year ended December 31, 2002       |  |                           | 9,926 |                            |   | 279                         |  |            |    |  |                      | (10,205 | ) |  |   |   



Additions to the valuation allowance
in 2002 represent the net increases in the Companys deferred tax asset before the decision was made to release the reserve in the fourth quarter of 2002.



S-1