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UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Form 10-K

Commission file number 000-21949

PACIFICARE HEALTH SYSTEMS, INC.

5995 Plaza Drive, Cypress, California 90630

(714) 952-1121

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 þ          No o

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 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.     þ

Indicate by check mark whether the Registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2)     Yes þ          No o

Non-affiliates of the Registrant held approximately $737,800,000 of the aggregate market value of common stock on June 28, 2002.

There were approximately 36,099,000 shares of common stock outstanding on February 28, 2003.

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PACIFICARE HEALTH SYSTEMS, INC.

INDEX TO ANNUAL REPORT ON FORM 10-K

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PART I

ITEM 1.     BUSINESS

Company Overview

We offer managed care and other health insurance products to employer groups and Medicare beneficiaries in eight Western states and Guam. Our commercial and senior plans are designed to deliver quality health care and customer service to members cost-effectively. These programs include health maintenance organizations, or HMOs, preferred provider organizations, or PPOs, and Medicare Supplement products. We also offer a variety of specialty managed care products and services that employees can purchase as a supplement to our basic commercial and senior medical plans or as stand-alone products. These products include pharmacy benefit management, or PBM, behavioral health services, group life and health insurance and dental and vision benefit plans. As of December 31, 2002, we had approximately 3.1 million HMO and other commercial and senior product members and approximately 9.1 million members in our PBM, dental and behavioral plans, including both members covered by our commercial or senior HMOs, and members that are unaffiliated with our HMOs.

Industry Overview

Managed Care

Managed care plans develop health care provider networks by entering into contracts with independent hospitals, physicians and other health care professionals to deliver health care services to their members cost effectively. Unlike conventional indemnity insurance, managed care plans generally credential network providers and incorporate medical management and other measures to control costs and encourage the delivery of medically necessary health care services. Managed care plans promote the maintenance of good health of their members as critical to managing health care costs. To that end, managed care plans typically cover preventive medicine and common diagnostic screening, and conduct member education campaigns on common health issues aimed at improving the health of their members. Conventional indemnity insurance usually allows insured parties substantial freedom of choice in selecting health care providers and requires satisfaction of an annual deductible before insured parties are reimbursed for health care costs on a full or partial basis. Such reimbursement is often limited to the insurer’s assessment of the reasonable and customary charges for the particular health care procedure.

A network-model HMO is a managed health care organization that combines aspects of a health care insurer with those of a health care provider by arranging for health care services for its members through a defined health care provider network at a reduced deductible or a fixed copayment for services received. Members generally select one primary care physician from the network who is responsible for coordinating health care services for the member. A PPO is a network of physicians, hospitals and other health care providers organized by an insurer to facilitate the delivery of health care to its insured enrollees on a discounted fee-for-service basis. Enrollees have broad access to a wide range of providers without the requirement of referral from a primary care physician. PPO enrollees generally have higher deductible, coinsurance or copayment requirements than their HMO counterparts, in exchange for increased freedom of choice.

We expect health care costs to continue to rise for many reasons, including:

•	an aging population that has greater medical needs;
•	the availability of more costly diagnostic and therapeutic procedures;
•	new laws and regulations specifying covered services for managed care plans;
•	increased unit prices for prescription drugs and other medications and the introduction of new, more expensive medications;
•	increased utilization of health care services;

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•	defensive medical practices due to physicians’ fear of lawsuits; and
•	significant investments by pharmaceutical companies in advertising campaigns for branded drugs, which may increase consumer demand for these drugs, including lifestyle-enhancing prescription drugs.

As health care costs have risen, managed care plans have become a lower-cost option for employers and governmental entities that provide health care coverage for their employees and constituents. Given the number of factors that will impact future health care costs and their unpredictability, we expect managed care plans to continue to remain a lower-cost option for employers and governmental entities that desire to access quality health care services for their employees and constituents on a cost-effective basis.

Medicare

Medicare is a federal program that provides persons age 65 and over and some disabled persons a variety of hospital and medical insurance benefits. Most individuals eligible for Medicare are entitled to receive inpatient hospital care under Part A without the payment of any premium, but are required to pay a premium to the federal government, which is adjusted annually, to be eligible for physician care and other services under Part B. Even though they participate in both Part A and Part B of the traditional Medicare program, beneficiaries are still required to pay deductible and coinsurance amounts. They may, if they choose, supplement their Medicare coverage by purchasing Medicare Supplement policies, which pay all or a portion of these deductibles and coinsurance amounts. Many of these policies also cover other services such as prescription drugs, which are not included in Medicare coverage.

Under the Medicare+Choice program, managed care plans can contract with the Centers for Medicare and Medicaid Services, or CMS, to provide health insurance coverage in exchange for a fixed monthly payment per member that varies based on the geographic areas in which the members reside. The fixed monthly payment per member is subject to periodic adjustments determined by CMS based upon a number of factors, including retroactive changes in members’ status, such as Medicaid eligibility, and risk measures based on demographic factors, such as age, gender, county of residence and health status. The weighting of the risk measures on the amount of the periodic adjustments to the fixed monthly payments is being phased in over time, and these measures will have their full impact on the calculation of those adjustments by 2007. Individuals who elect to participate in the Medicare+Choice program are relieved of the obligation to pay some or all of the deductible or coinsurance amounts, but are generally required to use the services provided by the HMO exclusively and are required to pay a Part B premium to the Medicare program. These individuals also may be required to pay a monthly premium to the HMO.

Rules intended to limit the number of enrollment changes from traditional Medicare to a Medicare+Choice Plan or among Medicare+Choice plans by Medicare beneficiaries with individual Medicare coverage were originally scheduled to be effective January 1, 2002. However, legislation passed in June 2002 delayed the implementation of these rules until 2005.

Pharmacy Benefit Management

One of the most significant components of rising health care costs in the United States has been increased utilization of and rising costs for prescription drugs. As part of their overall efforts to control health care costs, employers, insurers, governmental entities and health care providers have sought means to ensure the efficacy of prescription drug treatments while controlling their costs, resulting in a demand for PBM services that can accomplish both objectives. This demand has created a market opportunity for PBM companies that are committed to medical management as a means to control prescription drug costs, especially through managed care principles such as formulary management. Formulary management entails using lists of physician-recommended drugs in different therapeutic classes that have been reviewed for safety, effectiveness and value to ensure that drugs prescribed are the lowest cost option among equally effective alternatives.

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Contracting Arrangements with Physicians and Hospitals

Managed care plans generally contract with physicians and hospitals under three methods:

Fee-for-service Contracts. Managed care plans contract with health care providers to provide services to members based on discounted or other fee schedules, such as the Medicare fee schedule, for the services provided. Consistent with industry practice, certain fee-based hospital contracts contain “stop-loss provisions” where the level of payment increases once a minimum amount of billed charges is exceeded. Due to the variable nature of these payment methodologies, contracts containing “stop-loss” provisions are generally more complex to administer and to predict than payments made under a fixed fee schedule.

Risk-based Contracts. Managed care plans contract with health care providers to provide services to members based on modified discounted fee schedules, like the Medicare fee schedule, for the services provided with elements of risk-sharing through the development of, and adherence to agreed-on budgets. Under risk-based contracts, managed care plans partially share the risk of health care costs with hospitals and physicians. For example, the managed care plan may share hospital costs in excess of a specified target or budget with the physician group only or with both the physician group and the hospital.

Capitated Contracts. Less frequently, managed care plans contract with hospitals and physicians on a prepaid, capitated fixed-fee per-member per-month basis, regardless of the services provided to each member. Capitation payments to physicians and hospitals may be based on a percentage of the premiums received or a fixed per-member per-month amount that is often adjusted to reflect membership age, sex and benefit plan variation. In some cases, providers may be capitated for certain services and paid on a fee-for-service basis for other services. Under capitated contracts, medical groups and hospitals may assume administrative functions, including medical management and claims processing, to support management of health care services. Generally, under capitated contracts, if a member utilizes services that cost more than the capitated fee, the health care provider is responsible for the payment of the excess, while if a member’s utilization cost is less than the capitated fee, the provider keeps the difference.

Historically, the managed care industry has relied primarily on risk-based or fee-for-service contracts except in California, where capitation was used by a few large managed care plans, including us, as the prevailing contracting model. With the continuing consolidation of hospitals, especially in less populated areas, and the insolvency of several prominent physician groups in California and Texas, the industry is reducing its reliance on capitated contracts and using more fee-for-service and risk-based contracts, especially for hospital services. Risk-based contracts generally present managed care plans with greater challenges in accurately estimating and reserving for claims and controlling health care costs than capitated contracts, where the risk of excess health care costs is borne by the health care provider.

Business Strategy

Our mission is to create long-term stockholder value as a health and consumer services company committed to making people’s lives healthier and more secure. Our strategy to achieve this mission is to continue to strengthen our core HMO business, become a full-service managed care organization by expanding our health services portfolio, and ultimately evolve into a consumer health organization that focuses on the financial, health and wellness needs of our members.

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Strengthen Our Core HMO Business

The first priority of our multiple-year turnaround plan was to strengthen our core HMO business by improving our operational capabilities and profitability. We intend to continue to focus on the efficiency of our operations as we pursue a growth strategy:

•	We have implemented initiatives to stabilize both our commercial and senior medical loss ratios, while addressing the significant increases in health care costs that we have experienced over the last three years, including:

—	Increasing commercial premium rates, and continuing efforts to tailor pricing and benefit designs to increase commercial membership in our larger, more profitable market segments;
—	Redesigning Medicare+Choice benefits, charging higher senior member monthly premiums, and exiting or freezing enrollment in underperforming Medicare+Choice markets to increase the profitability of our Medicare+Choice operations; and
—	Enhancing our medical management capabilities, and continuing to implement chronic disease management programs that focus on prevention, member education, and evidence-based best practices to improve our members’ health and reduce costs;

•	We have centralized several company operations, including accounting, customer service, large and small group underwriting and advertising, to improve operational efficiency; and
•	We have outsourced our information technology, or IT, infrastructure, including our voice and data networks and our servers and software maintenance services to move toward a more simplified technology platform and to focus internally on moving toward a state-of-the-art IT infrastructure.

Become a Full-Service Managed Care Organization

Since 2001, we have been expanding our health services portfolio to support our strategy of becoming a full service managed care organization and diversifying our revenue sources. In connection with this objective, we have taken or are taking the following actions:

•	In January 2003, we announced an affordable and flexible benefits package, combining our dental PPO plans, dental indemnity plans and vision PPO plans with our health insurance plans for large employers. This integrated benefit solution is offered in all of the states where we currently offer our medical HMO;
•	In 2002, we expanded the offering of our PPO products to employers in all of the states where we currently offer our medical HMO products, and also launched a new Administrative Services Only, or ASO PPO product to support employer groups that self-fund their benefit plans;
•	In 2000, we launched our group retiree Senior Supplement plan, which provides employers a new option for their Medicare-eligible retirees, and in 2002 we expanded our individual offerings to include Medicare Supplement plans;
•	In October 2002, we began offering life, accidental death and dismemberment and short-term and long-term disability products to our commercial employer groups under a private label arrangement with Continental Assurance Company, Continental Casualty Company and CNA Group Life Assurance Company;
•	We are continuing to grow our PBM business, Prescription Solutions, by increasing sales of its services to unaffiliated health plans and employer groups and by expanding its mail-order business;
•	We are continuing to grow our behavioral health services business and diversify its revenue base, by increasing sales of our services and products to unaffiliated health plans and employer groups. We have also increased sales of our service-oriented products, which include disease management and health improvement programs as well as employee and member assistance programs; and

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•	We are continuing to grow our dental and vision services business by cross-selling these products and services with our medical HMO and indemnity products.

Evolve into a Consumer Health Services Organization

Our ultimate strategy is to evolve into a consumer health services organization that gives our members more responsibility for health care spending, and expands our product offerings to focus on the financial, health and wellness needs of our members. We plan to accomplish this strategy by structuring employer-purchased plans to increase consumer involvement in purchasing decisions, increasing consumer-funded optional coverage and offering wellness and lifestyle enhancing products and services. To build a consumer-focused organization, quality of care and quality of service are essential. Examples of the steps we have taken or are taking to support this evolution are the following:

•	We are offering consumers more freedom in health care spending by introducing new products such as self-directed health plans, our new Secure Horizons Prescription Advantages Plan, which is an indemnity prescription drug program for seniors, and our health care debit cards;
•	We are offering wellness-enhancing products and services through our Women’s Health Solutions initiative. To date we have designed more than 30 programs related to women’s health, including expansion of our obstetrics and gynecology networks and our pediatric networks, adding a 24-hour nurse advice line and adding educational programs targeted at women’s health issues;
•	We have established a proprietary quality measurement profile, the QUALITY INDEX®, that rates our contracting medical groups’ performance, and we are developing a similar profile for our contracting hospitals, to assist consumers in making better informed health care provider decisions. See “Health Care Quality — Physician and Hospital Quality Reviews” for further discussion; and
•	We are extending the hours of our customer service centers, making welcome calls to new members, and adding service quality incentive plans for our customer service representatives.

Products

We have developed products and services to meet the needs of our commercial and senior customers. In developing our products and marketing plans, we take into account the differing needs of our customers and believe that we create cost effective, quality health care service options.

Commercial Products

Our commercial products accounted for $5 billion, or 45% of our consolidated revenue, for the year ended December 31, 2002. Our commercial HMO and PPO products may be bundled with our specialty products and services, including PBM, behavioral health services, group life and health insurance products, and dental and vision services, providing employer groups and individuals with more benefit options from a single source and the ability to design tailored benefit programs. We also sell our specialty products and services on a stand-alone basis to unaffiliated health plans and employer groups.

Health Maintenance Organizations. Our PacifiCare HMO plans provide health care benefits to commercial members through a defined provider network at a reduced deductible or a nominal copayment. We believe we have developed one of the largest health care provider networks among managed care companies in the Western United States. As of December 31, 2002, this network included approximately 700 hospitals and 59,000 primary care and specialty physicians. As of December 31, 2002, we had approximately 2.3 million commercial HMO members.

We target a variety of plan sponsors including employer groups and other purchasing coalitions, as well as state and federal government agencies. We categorize our target markets for the commercial HMO product into four groups, including small group/ individual markets, mid-market groups, major/ national accounts and labor and trust organizations. We provide consolidated billing, eligibility, centralized sales, account management and underwriting for larger customers. We also have contracts with the United

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Our strategy is to grow profitable commercial HMO membership by focusing on product innovation and quality management. For example, effective in 2003, we launched our Value Network Plan. This plan is our first HMO network where participating California members may choose from a list of medical groups, and access their affiliated or referring hospitals, that are in our Value Network. The Value Network comprises medical groups and their affiliated or referring hospitals that have been selected based on their affordability and their scores on our QUALITY INDEX® profile. The QUALITY INDEX® profile is a proprietary report that we publish in California, Oregon, and Washington on our contracting medical groups’ performance in the areas of clinical, service and administrative data quality. We also now publish a report for contracted hospitals in California.

We have, and will continue to develop commercial HMO products that provide lower price points for corporate customers through the use of alternative benefit plans and tiered access to health care provider networks. Under these alternative benefit plans, members may select more expensive health care options only if they are willing to bear an increased share of the expense.

Preferred Provider Organizations. As customers continue to desire choice and flexibility in health care, we believe that there is a substantial demand for competitively priced PPO products. Our PPO network supplements our existing HMO network with additional health care providers and generally includes a majority of all available providers in any given geographic area, providing our PPO members with substantial choice. Additionally, access is extended to health care providers located outside of a given geographic area through out-of-network benefits that allow choice beyond the organized PPO network in exchange for reduced coverage or higher coinsurance or copayments.

Our PPO product provides members open access to network providers, with no primary care physician coordinating care and simplified medical management practices. The PPO product is designed around an administrative platform that streamlines the members’ interactions with employers and providers.

Effective January 1, 2003, we began offering self-directed health plans to employers with 250 or more employees. A self-directed health plan is a high-deductible PPO plan, combined with an employee-controlled spending account that the employer funds. In addition to paying the premiums for the high-deductible plan, an employer deposits a certain amount per year into each employee’s spending account. The employee can use the money to pay health care expenses incurred, and if money is left over at the end of the year, the balance can be rolled over to the following year. A portion of the balance can be used for health care expenses typically covered through insurance or eligible health-related expenses that are traditionally excluded from insurance coverage such as nutritional counseling or smoking-cessation programs.

On January 1, 2003, we also launched our health care debit card and Flexible Spending Account service, or FSA. Tailored to meet the needs of employers and health care consumers, our new service includes a stored-value card that charges health care services directly to an employee’s FSA, much like a bank-issued debit card. The debit card works off the Cirrus® network so that fees for eligible medical expenses are immediately deducted from the employee’s account, eliminating the necessity of filing a paper claim for later reimbursement.

During 2002, we also introduced our new ASO PPO product to support employer groups whom self-fund their benefit plans.

As of December 31, 2002, we had over 73,000 enrollees in our PPO product. We are actively marketing these products to employers in all of the states where we currently offer our commercial HMO products.

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Specialty Products

We use our existing employer group and senior relationships to offer our specialty products and services in conjunction with our commercial and senior products. These specialty products and services include PBM, behavioral health services, group life and health insurance products, and dental and vision services. In addition, we sell our specialty products and services to unaffiliated health plans and employer groups. These specialty products and services provide employer groups and individuals with more benefit options from a single source and the ability to design tailored benefit programs for their employees and themselves.

Prescription Solutions®. Founded in 1993, Prescription Solutions provided integrated PBM services to more than 4.6 million people, including approximately 0.8 million seniors, as of December 31, 2002. For the year ended December 31, 2002, Prescription Solutions processed 48.1 million claims, filled 3.4 million mail service prescriptions and accounted for $173 million of our consolidated revenue, net of intercompany transactions. Prescription Solutions offers a broad range of innovative programs, products and services designed to improve, enhance and increase clinical and financial outcomes. Prescription Solutions employs tools such as quality initiatives, utilization management, targeted disease intervention, programs that assess the interaction and efficacy of drugs prescribed to an individual member, active formulary management, prior-authorization review, health outcomes research and real-time audits that are designed so that its members are receiving the most appropriate medications in a cost-effective manner. Prescription Solutions also offers a comprehensive, fully integrated injectable program, which targets one of the most rapidly growing and high cost categories of pharmacy benefits today.

We believe Prescription Solutions’ strength lies in its ability to influence medical outcomes and reduce overall health care costs by focusing on appropriate prescription drug use. For example, through its formulary management program, Prescription Solutions uses lists of physician-recommended drugs in different therapeutic classes that have been reviewed for safety, efficacy and value to ensure that drugs prescribed are the lowest cost option among equally effective alternatives. Medically necessary drugs not included in the formulary can be obtained through Prescription Solutions’ prior authorization process provided they are not specifically excluded from coverage or for the treatment of excluded benefits. Prescription Solutions operates independently of pharmaceutical or retail drug organizations, which allows it to focus primarily on improving clinical outcomes while managing and controlling costs. This focus on pharmacy management is part of what differentiates Prescription Solutions from its competitors. As part of its pharmacy management, Prescription Solutions funds clinical outcomes research programs aimed at measuring the health outcomes of patients using commercially available prescription drugs.

We believe that Prescription Solutions’ mail service capabilities also differentiate it from its competitors. Prescription Solutions operates an 84,000-square-foot, fully automated facility in Carlsbad, California. We believe we have the ability to increase the number of mail service prescriptions we process, which was 3.4 million in 2002, by adding more work shifts and hours or days of operation. Prescription Solutions is aggressively promoting mail-service pharmacy services and is developing other business opportunities for its mail service pharmacy, such as offering over-the-counter medications and health and beauty products.

Prescription Solutions’ PBM services are offered as a standard part of most of our commercial health plans and are sold in conjunction with our other commercial and Medicare products and to unaffiliated health plans, employer groups, union trusts and third party administrators.

Behavioral Health Services. We provide behavioral health care services to our HMO members in California, Colorado, Oklahoma, Oregon, Texas and Washington, and unaffiliated health plans in California, Oregon and Pennsylvania. Our behavioral health care services include managed mental health, employee assistance, care management and chemical dependency benefit programs. As of December 31, 2002, we provided these behavioral health care services to approximately 3.9 million members through our provider network of approximately 14,500 providers and approximately 760 facilities. For the year ended December 31, 2002, our behavioral health care subsidiaries accounted for $160 million of our consolidated revenue, of which $52 million was generated from unaffiliated health plans and employer groups.

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Managed mental health and chemical dependency services are offered as a standard part of most of our commercial health plans and are sold in conjunction with our other commercial and Medicare products, and are offered on a stand-alone basis, to unaffiliated health plans and employer groups.

Group Life and Health Insurance. We are licensed to issue life and health care insurance in 40 states, including each of the states where our HMOs operate, the District of Columbia and Guam. By marketing our HMO commercial product line in conjunction with indemnity health care products, we are able to offer multi-option health benefits programs. Other supplementary benefits offered to employer groups include basic life insurance, group term life insurance, indemnity dental and indemnity behavioral health benefits. In October 2002, we began offering life, accidental death and dismemberment and short-term and long-term disability products to our commercial employer groups under a private label arrangement with Continental Assurance Company, Continental Casualty Company and CNA Group Life Assurance Company. For the year ended December 31, 2002, our life and health insurance subsidiaries accounted for $292 million of our consolidated revenue, substantially all of which was generated from our health plan customers.

Dental and Vision Services. We provide HMO, PPO and indemnity fee-for-service dental, and PPO vision benefits to individuals and employer groups, and to seniors through Secure Horizons. We offer these products in all of the states where we currently offer our commercial HMO products.

We provide a complete range of dental and vision product offerings for small, mid-size and large employers, regardless of their existing medical plan offering. With December 31, 2002 membership of approximately 0.7 million, our dental and vision plans accounted for $39 million of our consolidated revenue of which $27 million was generated from unaffiliated health plans and employer groups.

Senior Products

We offer eligible seniors access to Medicare+Choice and Medicare Supplement products though our Secure Horizons programs.

Medicare+Choice HMO. Medicare+Choice accounted for $5.9 billion, or 53% of our consolidated revenue for the year ended December 31, 2002. We are one of the largest Medicare+Choice HMOs in the United States as measured by membership with approximately 0.8 million members as of December 31, 2002. Since March 2001, our Medicare+Choice membership has declined by approximately 280,000, primarily due to voluntary disenrollment and county exits. We will continue to reduce our participation in the Medicare+Choice program if federal funding does not increase. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations-Forward-Looking Statements.” To the extent that we continue to reduce our participation in the Medicare+Choice program, our revenue will decline unless lost revenue from our Medicare+Choice products is replaced with revenue from other sources, such as our new Medicare Supplement product offerings or other lines of business.

We regularly review our product design to include appropriate cost sharing with plan members and we make annual benefit changes to mitigate increases in health care costs that exceed the rate of increase in our CMS reimbursement under Medicare+Choice contracts. We have also adopted a political and legislative strategy designed to encourage the federal government to reimburse Medicare+Choice payers on a basis that more accurately reflects health care service costs and inflation and to lessen the administrative burdens placed on Medicare+Choice payers by CMS.

Medicare Indemnity Products. In 2000, we introduced a new product under the PacifiCare brand, the group retiree Senior Supplement product. The group retiree Senior Supplement plan is offered in 13 states, and provides employers with a new option for their Medicare-eligible retirees. We plan to continue to increase the marketing of this group retiree product within the mid-size, large-size and national account market segments. In 2002, we introduced an individual Medicare Supplement product under the Secure Horizons brand. For individuals who are not covered by benefits offered by a former employer, we offer four standardized Medicare Supplement plans, which are A, C, F and G. These plans are currently offered in seven states and we are working on expanding to as many as 20 additional states by the third

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These products are designed to fill gaps left by traditional Medicare coverage. For example, the Supplement products pay for hospital deductibles, physician copayments and coinsurance for which an individual enrolled in the traditional Medicare program would otherwise be responsible. The Secure Horizons Prescription Advantages Plan has no annual deductible, no annual maximums, and provides unlimited coverage for approximately 400 generic medications covering many chronic conditions and ailments. This plan offers discounts on most other drugs depending on how the drugs are purchased.

We believe that these new products will increase our capabilities in the indemnity insurance business, strengthen and expand our Secure Horizons brand recognition on a national level, and replace revenues and profits from the reduction in Medicare+Choice membership. We expect that these products will also establish an additional distribution channel and revenue source for Prescription Solutions and our other specialty businesses.

Physician and Hospital Relationships

Contracting Arrangements with Physicians and Hospitals

We maintain a network of qualified physicians, hospitals and other health care providers in each geographic area we serve. Our contracting strategy is to base the type of contract utilized on our assessment of the underlying structure and strengths of the medical communities within the applicable geographic markets. For example, in markets with large medical groups that we believe are able to assume financial risk, we may continue to use capitation contracts effectively. In other markets, where there are fewer of such large medical groups, we may instead use fee-for-service or other shared risk arrangements. In the past few years, and going forward, we have experienced and expect to continue to experience a trend away from capitation contracts. Many of our physician and hospital contracts have one-year terms. However, we also have a number of multiple-year contracts with physician groups and hospitals to create greater stability of our network.

Our provider contracting processes include analysis and modeling of underlying cost and utilization assumptions. Through these processes, we continually seek to identify strategies to better manage health care costs. We also focus on provider consultation and management tools, including thorough data reporting and financial analysis of expected performance of our contracts.

Underwriting

In establishing premium rates for our health care plans, we use underwriting criteria based upon our accumulated actuarial data, with adjustments for factors such as the physicians and hospitals utilized, claims experience, member mix and industry differences. Predictive models using pharmacy data and health status are also used to identify health care costs that are likely to emerge. Our underwriting practices are filed and approved in states requiring those actions and in all states in which we operate in the individual, small group and Medicare supplement markets. Because our members are in multiple states, our underwriting practices, especially in the individual, small group and Medicare Supplement markets, are subject to a variety of legislative and regulatory requirements and restrictions unique to the state in which a member resides.

Medical Management

Our profitability depends, in part, on our ability to control health care costs while providing quality care. To reduce the financial risk associated with risk-based contracts, we remain focused on the ongoing enhancement of our internal medical management programs. Our medical management staff consists of doctors and nurses who monitor the medical treatment of our members in need of hospital and specialist care. In some cases, our medical managers are located on-site at some of our key hospitals.

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Our medical management programs include:

•	Precertification of Admission. In the precertification stage, our medical managers are responsible for determining whether requests for hospitalization and specified health care procedures meet specific clinical criteria and are approved in advance;
•	Concurrent Review. Our concurrent review process begins once our member has been admitted to the hospital for care, and our on-site or telephonic medical managers become responsible for providing administrative oversight of the hospital process. The medical manager is also responsible for monitoring the discharge process, and coordinating any outpatient services needed by the patient, including skilled nursing facility, home nursing care and rehabilitation therapy;
•	Retrospective Review. Our retrospective review process involves confirming our certifications of services provided to our members when our medical management staff has not been concurrently involved in the hospitalization of our members. This process can occur when our members receive emergency care at an out-of-area hospital or when medical claims may be disputed;
•	Case Management. Our case management department provides multi-disciplinary coordination of personalized care for patients with complex medical conditions, including arranging access to appropriate medical and social services, to improve the health status and manage health care costs for these patients; and
•	Chronic Disease Management. A small percentage of our members with chronic diseases continue to account for a significant majority of our health care costs. Our emphasis on disease management focuses on prevention, member education, and evidence-based care to improve our members’ health and reduce costs. Our analysis has shown that during 2001, 5% of our California Secure Horizons members consumed more than 73% of our California Medicare+Choice plan’s hospital expenses within the year, and six chronic diseases accounted for 62% of these costs. As a result, we have supplemented our in-house programs by contracting with third parties who provide complementary disease management programs for coronary artery disease and stroke, congestive heart failure, end stage renal disease, chronic obstructive pulmonary disease and cancer. During the fourth quarter of 2002, we added care management services for members admitted to neonatal intensive care units. These voluntary programs assist patients with intensive care management services, and better coordinate care among health care providers with the objectives of preventing disease exacerbation and the need for hospitalization and managed utilization of medical procedures. We actively identify members who would benefit from these disease management programs and seek to enroll them in these programs.

Health Care Quality

We believe that providing our members access to continually improving health care services leads to improved health for our members. To achieve this desired result, we focus on physician peer reviews, physician and hospital quality reviews, member quality initiatives and national industry measures.

Physician Peer Reviews

We have established a comprehensive peer review procedure at each health plan, governed by a quality improvement committee. The medical director for each health plan chairs that health plan’s committee. Each committee consists of health plan clinical professionals that may include contracted physicians. All network physicians are initially credentialed and periodically re-credentialed by that health plan’s quality improvement committee. The quality assessment includes evaluating the education, training and performance of that physician, as well as the quality of the providers’ medical facilities, medical records, laboratory and x-ray licenses and their capacity to handle membership demands.

Physician and Hospital Quality Reviews

We also engage in ongoing quality reviews of our existing physicians and hospitals to ensure that members are receiving quality medical care. For example, a highlight of our physician and hospital management

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Member Quality Initiatives

To improve the quality of service and health for our members, we have developed a comprehensive quality improvement program that includes:

•	Conducting preventive health programs, cancer screening, immunization programs, smoking cessation, and senior health risk assessments;
•	Implementing comprehensive health management programs in diabetes, coronary artery disease, congestive heart failure, end stage renal disease, cancer and other chronic diseases;
•	Enhancing and expanding our national pre-certification of procedures, concurrent medical review and case management services for those with serious and complex medical conditions;
•	Offering independent external review programs to members in which members can have a service or treatment denial of coverage decision reviewed by a physician or panel of physicians outside their health plan;
•	Decreasing inappropriate denials and improving the appeals process for our members;
•	Participating in the Coalition for Affordable Quality Health Care’s voluntary quality initiative whereby we, along with 21 other organizations, have committed to enabling consumers to have access to quality coverage and information, improving administrative simplicity for doctors and consumers, and working with doctors to improve overall health care quality and patient safety;
•	Participating with five other health plans in California to agree on common quality measures by which to reward better performing provider groups;
•	Developing provider contracts with tiered compensation in California, whereby providers are compensated at higher levels when certain quality measures are achieved;
•	Monitoring member satisfaction through surveys and internal operational report cards compared to our current established benchmarks; and
•	Providing members with free access to in-depth health information on thousands of topics and guided self-care tools, such as personalized diaries, medication logs, exercise and diet records and reminder calendars, via our website.

National Industry Measures

The National Committee for Quality Assurance, or NCQA, is an independent, non-profit organization that reviews and accredits HMOs. The NCQA performs site reviews to determine if an HMO complies with over 270 standards it has established for quality improvement, effectiveness of care, member satisfaction, utilization management, physician and hospital credentialing and a commitment to members’ rights and preventive health services. HMOs that comply with NCQA’s review requirements and quality standards receive NCQA accreditation. As of March 2003, our commercial HMOs in Arizona, California, Colorado, Oklahoma, Oregon, Texas and Washington have all earned “excellent” accreditation status, while our plan

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Marketing

We believe that we have developed strong brand recognition with our PacifiCare and Secure Horizons members. Our commercial products are marketed under the PacifiCare brand, which we believe has a reputation for quality and value. Our senior products are marketed under the Secure Horizons brand, which we believe is the premier brand in health care services among seniors in our markets in the Western United States. We market our specialty products under the PacifiCare brand and our PBM services under our Prescription Solutions brand.

We have expanded the marketing of our PBM services by building a dedicated sales force targeting other health care payors and other unaffiliated channels. For example, in September 2002, Prescription Solutions contracted with MedE America Corporation of Ohio, a subsidiary of WebMD Corporation, to become the preferred mail service provider to MedE America’s clients. MedE America provides pharmacy claims processing for its clients and services four million lives.

We are increasing and intensifying marketing efforts to enhance and reposition our PacifiCare and Secure Horizons brands to increase our commercial market share in our existing markets. While we believe our brands are perceived positively by our customers and providers, we understand the importance of strengthening our brands and marketing directly to consumers as the final health care decision makers. We launched a new brand campaign in 2002 and expect to continue this campaign in 2003.

Marketing to our commercial customers is a two-step process in which we first market to employer groups, then provide information directly to employees, primarily during their open enrollment periods, once the employer has selected our plan. Open enrollment periods typically occur during the fourth quarter of the calendar year. We use various techniques to attract commercial members, including work site presentations, direct mail, medical group tours and local advertising. We also use television, radio, billboard and print media to market our programs to potential commercial members. Further, we utilize multiple distribution channels such as general agents, a proprietary on-line price quoting service, and insurance brokers and consultants who represent many employer groups. These brokers and consultants work directly with employers to recommend or design employee benefits packages. We pay insurance brokers commissions over the life of the contract, if designated by the employer, while employers generally pay consultants directly. Our new commercial business is a result of new customers, as well as greater penetration in existing employer groups. With each open enrollment, we identify a specific approach for each employer group with the objective of increasing the number of members from each employer.

We believe that our understanding of the senior population and our attention to customer service differentiates our Secure Horizons program from competing products. We market our Secure Horizons programs to Medicare beneficiaries and caregivers for Medicare beneficiaries primarily through direct mail, telemarketing, our website, television, radio and community-based events with participating physician groups. Most Secure Horizons members enroll directly in a plan, generally without the involvement of insurance brokers, except when enrolling as part of an employer group retiree offering. However, in late 2002, we began the development of a national broker channel for our individual Medicare Supplement and Prescription Advantages products.

The primary focus of our individual Medicare Supplement marketing efforts is directed toward those individuals just turning age 65 and becoming eligible for Medicare for the first time. The product is distributed both directly to the consumer as well as through a network of insurance agents that began

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Customer Service

We provide customer service to members and providers contracting with our health plans. Our customer service centers support all of our commercial and Secure Horizons products. Each year we receive approximately 21 million calls. Customer service representatives handle approximately 14 million calls and approximately seven million calls are processed by our Interactive Voice Response System. We also provide customer service on our member and provider websites.

We have three regionally based customer service centers in Phoenix, Arizona; Cypress, California; and San Antonio, Texas. These customer service centers handle all HMO health plan claims in the continental United States. Our customer service center in Cypress, California also supports our PPO, indemnity and Medicare Supplement products. We also have stand-alone customer service and claims processing centers to support our specialty products companies and our HMO operations in Guam.

Management Information Systems

We use computer-based information systems for various purposes, including e-commerce, marketing and sales tracking, underwriting, billing, claims processing, medical management, medical cost and utilization trending, financial and management accounting, reporting, planning and analysis. These systems also support on-line customer service functions, provider and member administration functions, and support our tracking and extensive analyses of health care costs and outcome data.

We established corporate goals to have our IT systems operate under one business platform and improve operational efficiency. Simplification and integration of the systems servicing our business are important components of controlling health care and administrative expenses and improving member satisfaction. To accomplish these goals, in late 2001 and early 2002 we established a strategic outsourcing arrangement with two suppliers: International Business Machines Corporation, or IBM, and Keane, Inc., or Keane. We entered into a 10-year contract with IBM to outsource our IT infrastructure functions, including data center operations, support services and information distribution. We also entered into a 10-year contract with Keane to outsource our applications maintenance and enhancement activities. In connection with these outsourcing arrangements we transitioned approximately 550 employee positions to IBM and Keane in March 2002.

Our internal IT team interacts with internal business staff to build strategy, translate business requirements into technical solutions, develop systems architecture that promotes consistent processes and reduces total cost of ownership, and perform project demand management, prioritization and oversight. The IT team manages our outsourcing suppliers for support of operations and systems enhancements and maintenance. Our suppliers interact directly with internal business staff in day-to-day support and project activities.

Our ongoing IT investments include projects to consolidate system platforms, enhance existing application software and implement new financial system software and new pre-adjudication system software to create a more robust EDI architecture. We are also making other investments to ensure that our systems comply with the Health Insurance Portability and Accountability Act of 1996, or HIPAA.

Claims Processing Systems

We use computer-based information systems as an important component of claims processing. We receive medical claims from physicians and hospitals for services to our members. Claims are reviewed to determine member eligibility, the quantity and kind of services performed and whether services were authorized, then adjudicated against pricing, claims rules and benefits. To ensure timely and accurate payments, we regularly review reports on inventory levels and claims statistics that focus on claims turn-around and accuracy of payment. We also perform a variety of claim audits and cost containment

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Claims are processed through our customer service centers or through our claims processing center in Letterkenney, Ireland, which is electronically connected to each of our customer service centers. This connectivity allows us to efficiently route claims to sites that have excess capacity or can provide lower cost services. We will continue to take advantage of lower cost operations in production areas such as the Ireland claims center, increasing automation through technology while continuing to evaluate the most efficient and effective ways of supporting our health plans.

Government Regulation

We are subject to extensive federal and state regulations that govern the scope of benefits provided to our members, including regulations relating to:

•	Financial solvency requirements;
•	Mandated benefits;
•	Claims processing and payment;
•	Quality assurance and utilization review procedures;
•	Member grievance procedures;
•	Physician and hospital contracts; and
•	Marketing and advertising.

Our HMOs and indemnity insurance subsidiaries are also required to maintain minimum statutory capital. The cash necessary to satisfy our corporate obligations and our subsidiaries’ needs is facilitated through intercompany dividends and advances, which are regulated by state laws.

Medicare+Choice

Background. Our Medicare+Choice program is subject to regulation by CMS, the Department of Health and Human Services, or DHHS, and state regulatory entities. These agencies govern the benefits provided, premiums paid, quality assurance procedures, marketing and advertising for our Medicare+Choice products. CMS has promulgated regulations, operational policy letters and contracts implementing Medicare+Choice, including the Balanced Budget Act of 1997, Balanced Budget Refinement Act of 1999 and the Benefits Improvement and Protection Act of 2000, or BIPA, and the Public Health Security and Bioterrorism Response Act of 2002. These contracts and regulations established new and expanded requirements for Medicare+Choice organizations. They also establish new or expanded standards for quality assurance, beneficiary protection, coordinated open enrollment, program payment and audits, information disclosure and physician and hospital participation. Compliance with Medicare+Choice regulations has and will continue to increase our Medicare administration costs. Under BIPA, Medicare+Choice receives increased government funding over the five years beginning March 2001. The changes for 2001 - 2006 include increases to the monthly minimum payment floors, increases in the minimum annual payment from 2% to 3% and modifications to the risk adjuster.

It is possible that future legislation may create additional changes in the payment formula or risk adjuster. However, it is not certain that efforts to revise the laws governing the Medicare+Choice program will succeed in increasing the level of reimbursement to Medicare+Choice plan products.

Adjusted Community Rate Filings. As a result of the Balanced Budget Act of 1997 and related CMS rules and regulations, our HMO subsidiaries are required to submit separate adjusted community rate proposals for every Medicare+Choice product that they offer to Medicare beneficiaries. These rates are based upon our average commercial rate for non-Medicare enrollees modified by a factor that represents the difference in utilization characteristics between Medicare and non-Medicare enrollees within each

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In the normal course of business, all information submitted as part of the adjusted community rate process is subject to audit by CMS or any person or organization designated by CMS. Our adjusted community rate proposal is based on historical data and information available to us at the time of the filing. During 2002, none of our health plans were selected for audit. Our adjusted community rate proposals for the contract year 2003 have been filed and approved.

Office of Personnel Management

We have commercial contracts with OPM to provide managed health care services to federal employees, annuitants and their dependents under the FEHBP. As of December 31, 2002, we provided managed health care services to approximately 191,000 members under these contracts. Rather than negotiating rates with us, OPM requires us to provide the FEHBP with rates comparable to the rates charged to the two employer groups with enrollment closest in size to the FEHBP in the applicable community after making required adjustments. OPM further requires us to certify each year that its rates meet these requirements. Periodically, the Office of Inspector General, or OIG, audits us to verify that the premiums charged are calculated and charged in compliance with these regulations and guidelines. OPM has the right to audit the premiums charged during any period for up to five years following the end of that contract year. The final resolution and settlement of audits have historically taken more than three years and as many as seven years. We could become subject to actions under the False Claims Act if, as a result of the audit process, OPM believes that we knowingly overcharged the government or otherwise submitted false documentation or certifications.

In late 1997, we established a formal compliance program to specifically address potential issues that may arise from the FEHBP rating process, to work with OPM to understand its interpretation of the rules and guidelines prior to completion of the rating process, to standardize the FEHBP rating process among all of our HMOs, and to help reduce the likelihood that future government audits will result in any significant findings. Based on the results of the audits that have been conducted since the compliance program was implemented, we believe that this program has been effective.

Health Insurance Portability and Accountability Act of 1996

As a result of the HIPAA federal standards apply to both the group and individual health insurance markets. HIPAA includes administrative simplification provisions directed at standardizing transactions and codes, establishing uniform health care provider, payer, employer and patient identifiers and seeking protections for confidentiality and security of patient data. We are currently working on modifications to our information systems and business processes to comply with HIPAA regulations.

In addition, we continue to work with various industry groups to find a common way to work with external business associates, such as physicians, hospitals and vendors, to ensure their compliance with the HIPAA rules. Our 2002 HIPAA compliance costs were approximately $16 million as well as $2 million in capital expenditures. We estimate that our HIPAA compliance costs will approximate $19 million in 2003 as well as $1 million in capital expenditures.

Employee Retirement Income Security Act of 1974

Pursuant to the Employee Retirement Income Security Act of 1974, or ERISA, the federal government regulates insured and self-insured health coverage plans offered by employers. There have been recent highly publicized legislative attempts to amend ERISA to remove the current limitation on the ability of states to regulate employer health plans and the limitations on an employee’s ability to sue a health plan under state law. If such proposals were enacted, states may have the ability to regulate other aspects of our business operations, and increase our exposure to state law claims that relate to employee health benefits.

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Required Statutory Capital

By law, regulation and governmental policy, our HMO, indemnity and regulated specialty product subsidiaries, which we refer to as our regulated subsidiaries, are required to maintain minimum levels of statutory net worth. The minimum statutory net worth requirements differ by state and are generally based on a percentage of annualized premium revenue, a percentage of annualized health care costs or risk-based capital, or RBC, requirements. The RBC requirements are based on guidelines established by the National Association of Insurance Commissioners, or NAIC. If adopted, the RBC requirements may be modified as each state legislature deems appropriate for that state. The RBC formula, based on asset risk, underwriting risk, credit risk, business risk and other factors, generates the authorized control level, or ACL, which represents the amount of net worth believed to be required to support the regulated entity’s business. For states in which the RBC requirements have been adopted, the regulated entity typically must maintain the greater of the required ACL or the minimum statutory net worth requirement calculated pursuant to pre-RBC guidelines. In addition to the foregoing requirements, our regulated subsidiaries are subject to restrictions on their ability to make dividend payments, loans and other transfers of cash.

The statutory framework for our regulated subsidiaries’ statutory net worth requirements may change over time. These subsidiaries are also subject to their state regulators’ overall oversight powers. Those regulators could require our subsidiaries to maintain minimum levels of statutory net worth in excess of the amount required under the applicable state laws if the regulators determine that maintaining such additional statutory net worth is in the best interest of our members.

Pharmacy Regulations

Our PBM business is subject to state and federal statutes and regulations governing the operation of pharmacies, labeling, packaging and repackaging of drug products, dispensing of controlled substances, disposal, advertising, security, recordkeeping and inventory control.

Many states have laws and regulations that require out-of-state internet and mail service pharmacies to register with, or be licensed by, the board of pharmacy or a similar regulatory body in the state. Other states generally permit the dispensing pharmacy to follow the laws of the state within which the dispensing pharmacy is located. Various other states, however, have enacted laws requiring, among other things, the hiring of a pharmacist licensed by that state or compliance with all laws of the states into which the out-of-state pharmacy dispenses medications, whether or not those laws conflict with the laws of the state in which the pharmacy is located. If these laws are applicable to us, they could restrict or prevent us from providing prescription internet or mail service in those states.

Other specific laws or regulations that may affect our PBM business include:

•	Laws that constrain our ability to limit access to a pharmacy provider network or remove network providers, such as those that require us to admit any retail pharmacy willing to meet the plan’s price and other terms for network participation, prohibit the removal of a provider except in compliance with “due process” procedures, or that prohibit supply limitations or co-payment differentials between mail service and retail pharmacy providers;
•	Plan design or benefit mandates such as those that prohibit or restrict therapeutic substitution, require coverage of all drugs approved by the Food and Drug Administration, or FDA, or prohibit denial of coverage for “off-label” or non-FDA approved uses;
•	Federal anti-remuneration laws and state consumer protection laws that could prevent us from seeking or accepting discounts from drug manufacturers or participating in “product conversion programs” in which benefits are given by drug manufacturers for changing a prescription or recommending or requesting such a change from one drug to another unless we fit within a specific exemption or safe harbor of those laws;
•	Medicaid laws requiring that a pharmacy participating in the Medicaid program give the best price that the pharmacy makes available to any third party payor, even if the payors are in different states, which

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	may limit our ability to negotiate discounts in the future from network pharmacies and on the reimbursement we receive from state Medicaid programs; and
•	Specific regulations of the FDA regarding the conduct of clinical trials for drugs, if we participate in clinical trials and assume some or all of the sponsors’ obligations related to the clinical trials.

In early 2000, we received a subpoena from an Assistant United States Attorney in Boston relating to a pharmaceutical product. We were advised that we were not a target of the investigation, and fully cooperated with the Assistant US Attorney. In the second and third quarters of 2002, the same Assistant US Attorney in Boston requested additional documents and served additional subpoenas relating to pharmaceutical marketing contracts. The Assistant US Attorney has reaffirmed that we are not a target of the investigation, and we are fully cooperating with these subpoenas.

Risk Management

We maintain general liability, property, and managed care errors and omissions, which includes medical malpractice insurance coverage. Policies typically include varying and increasing levels of self-insured retention or deductibles that increase our risk of loss. We operate a wholly owned captive insurance company designed to assist us in managing this risk of loss. We require contracting physicians, physician groups and hospitals to maintain individual malpractice insurance coverage.

Competition

In general, the health care industry has experienced significant consolidation. Acute care hospitals have consolidated and excess bed capacity has been reduced, increasing their leverage in the marketplace. Continued consolidation of insurance carriers, other HMOs, employer self-funded programs and PPOs, some of which have substantially larger enrollments or greater financial resources than ours, has created competition for physicians, hospitals and members, impacting profitability and the ability to influence medical management. The cost of providing benefits is in many instances the controlling factor in obtaining and retaining employer groups as clients and some of our competitors have set premium rates at levels below our rates for comparable products. The cost of pharmaceuticals, a significant component of benefits, continues to increase, and the development of high cost therapeutic agents that are expected as part of commercial formularies and the desire by employers for more choice in formulary design impacts the ability of Prescription Solutions, our PBM, to manage costs. We anticipate that premium pricing will continue to be highly competitive.

In offering HMOs, PPOs and related products, we compete with CIGNA Corporation, Aetna Inc., WellPoint Health Networks Inc. and UnitedHealth Group Incorporated for membership from national employers. We also compete with regional HMOs and small group employers, which vary depending on the geographic market. Regional competitors include Kaiser Foundation Health Plan Inc., Health Net, Inc., WellPoint Health Networks Inc., Humana Inc., and the member companies of the Blue Cross and Blue Shield Association. We also offer a regional alternative for national employers who are willing to support multiple health plans to maintain plans that best suit the needs of employees within a specific region.

We have among the highest Medicare+Choice membership in the nation, both in absolute terms and as a percentage of overall membership, offering competitive advantages and economies of scale in the Medicare+Choice market. Beginning in 2002, we have reduced our benefits, raised member copays and deductibles, and replaced coverage of brand name prescription drugs with generic drugs in most of the counties where we participate in Medicare+Choice. This is in response to the rising health care costs of treating the senior population and the inadequate rate of increase in levels of Medicare reimbursement from the government. These changes have caused members to leave our plans for competing plans or traditional Medicare coverage. Many competing health plans have also reduced their participation in the Medicare+Choice program and reduced benefits coverage. In the markets where we have remained and structured our benefits to offset rising costs, exits and benefit reductions made by competitors may result in increased membership in our program.

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The Medicare Supplement product market is highly fragmented with few large competitors. Our primary competition in this market is the Medicare Supplement product marketed by the American Association of Retired Persons, and underwritten by UnitedHealth Group Incorporated. We believe that our product offerings and distribution channels differentiate our Medicare Supplement products from competing products. For example, in 2002, we introduced Prescription Advantages, one of the nation’s first stand-alone, insured pharmacy products being marketed exclusively to individual Medicare beneficiaries. Additionally in 2002, we entered into a strategic marketing partnership with Reader’s Digest Financial Services Inc. Under this partnership, Reader’s Digest Financial Services Inc. will exclusively endorse our Medicare Supplement plans to its customer base.

Prescription Solutions’ PBM services are sold as part of our commercial and Medicare products and on a stand-alone basis to unaffiliated health plans and employer groups. Competitors include Medco Health, WellPoint Pharmacy Management, MedImpact Healthcare Systems, Inc., Caremark Rx, Inc., Express Scripts and Advance PCS. We believe, when aligned with a managed care organization, Prescription Solutions differentiates itself from other pharmacy benefit organizations by managing prescription costs and outcomes for managed care organization members. Our mail-order prescription drug service competes with national, regional and local pharmacies and other mail-order prescription drug companies. Prescription Solutions also competes with firms offering prescription discount cards, such large drugstore chains.

In 2001, we began offering behavioral health services to members who are not affiliated with our commercial health plans. The managed behavioral health care industry is dominated by a few large companies, principally Magellan Health Services, Inc. and ValueOptions, Inc., as well as the behavioral health divisions of health insurers such as UnitedHealth Group Incorporated and CIGNA Corporation. Our ability to compete is affected by a limited national supply of providers, particularly psychiatrists and psychiatric hospital units. Our behavioral health subsidiary has a core competency in managing at-risk contracts, which we believe differentiate us competitively in states with mental health parity laws that mandate equal coverage for mental health benefits.

We believe that to retain our health plans’ competitive advantages we should continue to focus on developing additional products and services and eliminate or limit growth of unprofitable products. We believe that consumers want products and services that go beyond basic necessity, extending to areas such as lifestyle and wellness enhancing products. The factors that we believe give us competitive advantages are:

•	our existing market position in our geographic areas of operation;
•	our long-term operating experience in managed care;
•	our marketplace reputation with physicians, hospitals, members and employers;
•	a strong brand identity for PacifiCare, Secure Horizons and Prescription Solutions;
•	our benefit design and flexibility of features for employers;
•	our QUALITY INDEX® profile, which provides customers with certain provider performance quality measures;
•	our emphasis on providing high quality customer service; and
•	our continual improvement of the quality of care provided to our members.

Intellectual Property

We own federally registered trademarks and other trademarks, which include PacifiCare®, SecureHorizons®, Prescription Solutions® and QUALITY INDEX®. There is also a patent pending for certain methods used in creating the QUALITY INDEX®.

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Employees

At February 28, 2003, we had approximately 7,800 full and part-time employees. None of our employees is presently covered by a collective bargaining agreement. We consider relations with our employees to be good and have never experienced any work stoppage.

Available Information

Our electronically-filed reports with the Securities Exchange Commission, or SEC, such as the annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and all amendments to those reports, are currently available free of charge to the general public through our company website at www.pacificare.com. These reports are accessible at a reasonably practicable time after being filed with the SEC.

ITEM 2.     PROPERTIES

As of December 31, 2002, we leased approximately 214,000 aggregate square feet of space for our principal corporate headquarters and executive offices in Cypress and Santa Ana, California. In connection with our operations, as of December 31, 2002, we leased approximately 1.7 million aggregate square feet for office space, subsidiary operations, customer service centers and space for computer facilities. Such space corresponds to areas in which our HMOs or specialty managed care products and services operate, or where we have satellite administrative offices. Our leases expire at various dates from 2003 through 2012.

In California and Guam, we own 2 buildings encompassing approximately 225,000 aggregate square feet of space primarily used for administrative operations. All of our facilities are in good working condition, are well maintained and are adequate for our present and currently anticipated needs. We believe that we can rent additional space at competitive rates when current leases expire, or if we need additional space.

ITEM 3.     LEGAL PROCEEDINGS

Class Action Legal Proceedings

On November 2, 1999, Jose Cruz filed a purported class action complaint against us, our California subsidiary, and FHP International Corporation, or FHP, in the San Francisco Superior Court. On November 9, 1999, Cruz filed a first amended purported class action complaint that omitted FHP as a defendant. The amended complaint relates to the period from November 2, 1995 to the present and purports to be filed on behalf of all enrollees in our health care plans operating in California other than Medicare and Medicaid enrollees. The amended complaint alleges that we have engaged in unfair business acts in violation of California law, engaged in false, deceptive and misleading advertising in violation of California law and violated the California Consumer Legal Remedies Act. It also alleges that we have received unjust payments as a result of our conduct. The amended complaint seeks injunctive and declaratory relief, an order requiring the defendants to inform and warn all California consumers regarding our financial compensation programs, unspecified monetary damages for restitution of premiums and disgorgement of improper profits, attorneys’ fees and interest. We moved to compel arbitration and the Superior Court denied our motion. We filed an appeal from this denial, and the Court of Appeal affirmed the Superior Court’s decision. Thereafter, we filed a petition asking the California Supreme Court to review the Court of Appeal’s decision, and the California Supreme Court granted the petition. Oral argument before the California Supreme Court occurred on February 4, 2003. We expect a ruling from the California Supreme Court in May 2003. We deny all material allegations in the amended complaint and intend to defend the action vigorously.

In mid-2000, various federal actions against managed care companies, including us, were joined in a multi-district litigation that was coordinated for pretrial proceedings only in the United States District Court for the Southern District of Florida. This litigation is known as “In re Managed Care Litigation.” Thereafter, Dr. Dennis Breen, Dr. Leonard Klay, Dr. Jeffrey Book and several other health care providers, along with

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The District Court granted our motion to compel arbitration of all of Dr. Breen’s and Dr. Book’s claims against us, except for their claims for violations of the Racketeer Influenced and Corrupt Organizations Act, or RICO, and for their conspiracy and aiding and abetting claims that stem from contractual relationships with other managed care companies. The District Court denied our motion to compel arbitration by several other doctors because the District Court concluded that they were only pursuing conspiracy and aiding and abetting claims against us. We appealed from the District Court’s arbitration rulings to the extent they denied sending claims to arbitration. The Court of Appeals affirmed the District Court’s arbitration rulings in their entirety. We filed a petition asking the United States Supreme Court to review the Court of Appeals’ decision, and on October 15, 2002 the United States Supreme Court granted our petition. Oral argument before the United States Supreme Court occurred on February 24, 2003. We expect a ruling by the United States Supreme Court in or before June 2003.

In March 2001, the plaintiffs in the Breen lawsuit filed an amended complaint, and we filed a motion to dismiss the amended complaint. On September 26, 2002, the District Court granted plaintiffs’ motion to amend their complaint further and denied our pending motion to dismiss as moot. On September 26, 2002, the District Court also certified three classes of physicians on the claims asserted against us in the plaintiffs’ complaint. Of the three classes of physicians that were certified, two were nationwide classes and one class was limited to California physicians. On October 18, 2002, we filed a new motion to dismiss directed at the plaintiffs’ second amended complaint. That motion remains pending. Discovery in this litigation has recently commenced. We deny all material allegations and intend to defend the action vigorously.

PacifiCare of Texas v. The Texas Department of Insurance and the State of Texas. In November 2001, our Texas subsidiary, PacifiCare of Texas, filed a lawsuit against the Texas Department of Insurance, or TDI, and the State of Texas challenging the TDI’s interpretation and enforcement of state statutes and regulations that would make Texas a “double-pay” state. The lawsuit relates to the financial insolvency of three physician groups that had capitation contracts with PacifiCare of Texas. Under these contracts, the responsibility for claims payments to health care providers was delegated to the contracted physician groups. We made capitation payments to each of these physician groups, but each of these physician groups failed to pay all of the health care providers who provided health care services covered by the capitation payments. On February 11, 2002, subsequent to the filing of our lawsuit, the Attorney General of Texas, or AG, on behalf of the State of Texas and the TDI, filed a civil complaint against PacifiCare of Texas in the District Court of Travis County, Texas alleging violations of the Texas Health Maintenance Organization Act, Texas Insurance Code and regulations under the Code and the Texas Deceptive Trade Practices Consumer Protection Act. The AG’s complaint primarily alleges that despite its capitation payments to the physician groups, PacifiCare of Texas is still financially responsible for the failure of the delegated providers to pay health care providers. The AG is seeking an injunction requiring us to comply with state laws plus unspecified damages, civil penalties and restitution. The AG also claimed that its subsequent lawsuit, not ours, should govern the dispute. In March 2002, we submitted a motion to be recognized as the plaintiff in the lawsuit rather than the AG. In June 2002, the District Court granted this motion. On September 11, 2002, the Texas Medical Association, various providers and the bankruptcy trustee for an affiliate of one of the physician groups intervened, without our opposition, in the lawsuit.

On March 21, 2003, without the admission of any wrongdoing, our Texas subsidiary entered into a binding memorandum of understanding, or MOU, with the Sate of Texas, the AG and the TDI setting forth the principal terms of a settlement of all of the pending litigation between the parties and related civil investigations by the TDI. Under the MOU, the parties have agreed to enter into a definitive settlement

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As part of the settlement, we agree to make payments totaling $4.25 million, including attorneys fees totaling $1.25 million to the AG, and administrative services reimbursements totaling $1.5 million and administrative penalties totaling $1.5 million to the TDI. Of the $4.25 million payment, $2.45 million will be paid upon execution of the settlement, and the remaining $1.8 million will be paid upon the satisfaction of the conditions for the settlement. All amounts paid upon execution of the settlement will be held in trust pending the effectiveness of the settlement. The settlement will become effective upon us completing our settlements in the two bankruptcies in accordance with the MOU, timely completion of the HPN claims process, payment of all settlement amounts to the AG and TDI, and compliance with certain Texas prompt payment obligations with respect to members enrolled in our commercial HMO plans. Concurrent with the settlement becoming effective: (i) the parties would enter into a permanent injunction with a term of one year that will require PacifiCare of Texas to comply with applicable provisions of the Texas prompt payment obligations with respect to members enrolled in our commercial HMO plans; (ii) all of the pending litigation between the parties will be dismissed with prejudice or with specified final judgements; and (iii) the parties will enter into mutual releases. We cannot provide any assurances that we will be able to meet the conditions required to cause the settlement to become effective. If we cannot reach the settlement, then we are prepared to resume the litigation. We believe that we have adequate reserves for this matter, including the satisfaction of all the terms and conditions of the settlement, or any liabilities that may arise if we are required to resume the litigation.

OPM and Other Litigation

OPM Litigation. On April 12, 2002, we resolved issues raised in various audits of our health plans by the Office of Inspector General, or OIG, as well as the False Claims investigations of the United States Department of Justice, or DOJ and a private lawsuit under the False Claims Act. The settlement primarily related to contracts we acquired through our merger with FHP in 1997. As previously disclosed, the OIG and others alleged that the former FHP Arizona, California, Colorado, Guam and Ohio HMO subsidiaries, as well as the former FHP Illinois, New Mexico and Utah HMO subsidiaries that we sold in 1997 and 1998, substantially overcharged the government for premiums from 1990 through 1997. The allegations were referred to the DOJ for review of potential claims under the False Claims Act. In addition, a private individual filed a complaint under the False Claims Act in 1998 that remained under seal until the settlement. The OIG also conducted audits of our Oregon HMO for contract years 1991 through 1996 and our California HMO for contract years 1993 through 1996 and referred these audits to the DOJ for potential claims under the False Claims Act. The settlement resolved issues raised in OIG’s various audits of these 10 health plans, as well as the False Claims investigations of the DOJ and the private lawsuit under the False Claims Act. See Note 11 of the Notes to Consolidated Financial Statements for further discussion.

Other Litigation. We are involved in legal actions in the normal course of business, including claims from our members and providers arising out of decisions to deny or restrict reimbursement for services and claims that seek monetary damages, including claims for punitive damages that are not covered by insurance. Our establishment of drug formularies, support of clinical trials and PBM services may increase our exposure to product liability claims associated with pharmaceuticals and medical devices. Based on current information, including consultation with our lawyers, we believe any ultimate liability that may arise from these actions, including all class action legal proceedings and the settlement or resumption of the State of Texas litigation, would not materially affect our consolidated financial position, results of

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

No matter was submitted to a vote of security holders during the three months ended December 31, 2002.

PART II

Our common stock is listed on the Nasdaq National Market under the symbol PHSY. The following table indicates the high and low reported sale prices per share as furnished by Nasdaq.

We have never paid cash dividends on our common stock. We do not expect to declare dividends on our common stock in the future, retaining all earnings for business development. Any possible future dividends will depend on our earnings, financial condition, and regulatory requirements. If we decide to declare common stock dividends in the future, such dividends may only be made in shares of our common stock, according to the terms of our credit facility.

As of February 28, 2003 there were 313 stockholders of record of our common stock.

On November 22, 2002, we issued and sold $125 million of 3% convertible subordinated debentures due 2032 in a private placement to two accredited investors, Morgan Stanley & Co. Incorporated and Goldman, Sachs and Co., which we refer to as the initial purchasers, in reliance on Section 4(2) of and Rule 506 under the Securities Act of 1933, as amended, or the Securities Act. On December 20, 2002, we issued an additional $10 million of the debentures in connection with the exercise in part by the initial purchasers of their option to purchase additional debentures. The initial purchasers resold the debentures in offerings in reliance on an exemption from registration under Rule 144A of the Securities Act. The aggregate discount received by the initial purchasers in connection with their purchase of the debentures from us was approximately $4 million. The debentures are convertible into our common stock under certain conditions, including satisfaction of a market price condition for our common stock, satisfaction of a trading price condition relating to the debentures, upon notice of redemption, or upon specified corporate transactions. Each $1,000 of the debentures is convertible into 23.8095 shares of our common stock.

Information regarding our securities authorized for issuance under equity incentive plans is included in this report in Item 12 under the caption “Equity Compensation Plan Information.”

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ITEM 6.     SELECTED FINANCIAL DATA

The following selected financial and operating data are derived from our audited consolidated financial statements, or from our unaudited internal financial data. The selected financial and operating data should be read in conjunction with “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations,” and also with “Item 15. Exhibits, Financial Statement Schedules and Reports on Form 8-K.”

Income Statement Data

See footnotes following “Balance Sheet Data.”

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Other Financial and Operating Data

(1)	The 2002 results include impairment, disposition, restructuring, OPM and other net pretax charges totaling $3.8 million ($2.4 million or $0.07 diluted loss per share, net of tax). See Note 10 of the Notes to Consolidated Financial Statements. Operating income before net pretax charges as a percentage of operating revenue was 2.7%. The 2002 results include a cumulative effect of a change in accounting principle in connection with the goodwill impairment recognized upon the adoption of Statement of Financial Accounting Standards (SFAS) No. 142, Goodwill and Other Intangible Assets, totaling $929 million ($897 million or $25.46 diluted loss per share, net of tax). See Note 7 of the Notes to Consolidated Financial Statements.
(2)	The 2001 results include impairment, disposition, restructuring, OPM and other net pretax charges totaling $61 million ($39 million or $1.13 diluted loss per share, net of tax). See Note 10 of the Notes to Consolidated Financial Statements. Operating income before net pretax charges as a percentage of operating revenue was 1.6%.
(3)	The 2000 results include impairment, disposition, restructuring, OPM and other net pretax charges totaling $9 million ($5 million or $0.15 diluted loss per share, net of tax). See Note 10 of the Notes to Consolidated Financial Statements. Operating income before net pretax charges as a percentage of operating revenue was 3.2%.
(4)	The 1999 results include impairment, disposition, restructuring and other net pretax credits totaling $2 million ($2 million or $0.04 diluted loss per share, net of tax). The after tax and per share amounts were losses because the goodwill impairment was not deductible for income tax purposes. Operating income before net pretax credits as a percentage of operating revenue was 5.2%.
(5)	The 1998 results include $11 million of net pretax charges ($6 million or $0.12 diluted loss per share, net of tax). Operating income before net pretax charges as a percentage of operating revenue was 4.8%.
(6)	Effective income tax rate includes the effect of nondeductible pretax charges, primarily goodwill amortization for the years ended December 31, 1998 through 2001.

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Results of Operations

Overview. We offer managed care and other health insurance products to employer groups and Medicare beneficiaries in eight Western states and Guam. Our commercial and senior plans are designed to deliver quality health care and customer service to members cost-effectively. These programs include health maintenance organizations, or HMOs, preferred provider organizations, or PPOs, and Medicare Supplement products. We also offer a variety of specialty managed care products and services that employees can purchase as a supplement to our basic commercial and senior medical plans or as stand-alone products. These products include pharmacy benefit management, or PBM, behavioral health services, group life and health insurance and dental and vision benefit plans.

Revenue

Commercial and Medicare Premiums. We receive per-member per-month payments on behalf of each member enrolled in our commercial HMOs and our behavioral health services, life and health insurance and dental and vision services plans. Generally, our Medicare+Choice contracts entitle us to per-member per-month payments from the Centers for Medicare and Medicaid Services, or CMS, on behalf of each enrolled Medicare beneficiary. We report prepaid health care premiums received from our commercial plans’ enrolled groups, CMS, and our Medicare plans’ members as revenue in the month that members are entitled to receive health care. We record premiums received in advance as unearned premium revenue.

Premiums for our commercial products and Medicare+Choice products are generally fixed in advance of the periods covered. Of our commercial business, more than 50% of our membership renews on January 1 of each year, with premiums that are generally fixed for periods up to one year. In addition, each of our subsidiaries that offers Medicare+Choice products must submit adjusted community rate proposals, generally by county or service area, to CMS by September 9 for each such product that will be offered in a subsequent year. As a result, increases in the costs of health care service in excess of the estimated future health care costs reflected in the premiums or the adjusted community rate proposals generally cannot be recovered in the applicable contract year through higher premiums or benefit designs.

Generally, since the Balanced Budget Act of 1997 went into effect, annual premium increases for Medicare+Choice members have not kept pace with increases in the costs of health care. CMS announced that federal payments to Medicare+Choice managed care organizations are projected to increase only 2%, the guaranteed minimum required by law, in calendar year 2003. These shortfalls in Medicare+Choice premiums compared to our health care service expenses in some of our operating areas contributed to our decision to cease offering, close enrollment, or obtain capacity limits in our Medicare+Choice plans in various counties in 2003, 2002 and 2001. These premium trends also contributed to changes in our benefits, copayments and deductibles. The following table provides information on the number of counties where we did offer or currently offer our Medicare+Choice plans for new member enrollment as of the dates indicated. Additionally, it provides information on the number of counties for which we contracted with CMS to offer our Medicare+Choice plans, as of the beginning of each calendar year indicated. The change in the number of counties from 2002 to 2003 for which we contracted with CMS to offer our

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Other Income. Other income consists of revenue we receive from administrative services we offer through our specialty products companies, primarily from our pharmacy benefit management company. Our pharmacy benefit management company generates mail-service revenue where we, rather than network retail pharmacies, collect the member copayments, for both affiliated and unaffiliated members. Additionally, we record revenues for prescription ingredient costs on prescriptions dispensed by our mail-service pharmacy. For prescription drugs dispensed through retail pharmacies, we record administrative services fees when a prescription claim is reviewed and approved, and the prescription is shipped or filled. For prescription drugs dispensed through retail pharmacies, we do not record revenues for drugs dispensed or the network pharmacies’ dispensing fees; nor do we record revenues for copayments our members make to the retail pharmacies.

Net Investment Income. Net investment income consists of interest income, gross realized gains and losses experienced based on the level of cash invested over each period. As we have increased the number of our contracts that are risk-based rather than capitated contracts, our net investment income has become, and will continue to be an important component to results of operations. Under risk-based contracts, cash disbursements to health care providers for services provided to members are made after the related claim has been submitted and adjudicated. Under capitated contracts, health care providers are prepaid on a fixed-fee per-member per-month basis for the agreed-upon schedule of services, without regard to the volume of services provided to a given member.

Expenses

Commercial and Senior Health Care Services. Health care services expenses for our commercial plans and our senior plans primarily comprise payments to physicians, hospitals and other health care providers under capitated or risk-based contracts for services provided to our members. Health care services expenses also include expenses for health care provided and administrative services performed under our specialty products and services companies.

Our risk-based health care services expenses consist mostly of four cost of care components: outpatient care, inpatient care, professional services (primarily physician care) and pharmacy benefit costs. All four components are affected both by unit costs and utilization rates. Unit costs, for example, are the cost of outpatient medical procedures, inpatient hospital stays, physician fees for office visits and prescription drug prices. Utilization rates represent the volume of consumption of health services and vary with the age and health of our members and broader social and lifestyle patterns of the population as a whole.

The cost of health care provided is accrued in the month services are provided to members, based in part on estimates for hospital services and other health care costs that have been incurred but not yet reported. We develop these estimates using actuarial methods based on historical data for payment patterns, cost trends, product mix, seasonality, utilization of health care services and other relevant factors. These estimates are adjusted in future periods as we receive actual claims data, and can either increase or reduce our accrued health care costs. The cost of prescription drugs covered under our commercial and senior plans is expensed when the prescription drugs are dispensed. Our commercial and senior plans also provide incentives, through a variety of programs, for health care providers that participate in those plans to control

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The following table illustrates our shift from capitated contracts to risk-based contracts since 2000. We expect this shift to continue in 2004. The percentages of HMO membership by contract type at December 31, 2002, 2001 and 2000 were as follows:

2002 Compared with 2001

Membership. Total HMO and other membership decreased 10% to approximately 3.1 million members at December 31, 2002 from approximately 3.5 million members at December 31, 2001.

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(1)	Pharmacy benefit management PacifiCare HMO membership represents members that are in our commercial or senior HMO. All of these members either have a prescription drug benefit or are able to purchase their prescriptions utilizing our retail network contracts or our mail service.
(2)	Behavioral health and dental PacifiCare HMO membership represents members that are in our commercial HMO that are also enrolled in our behavioral health or dental plan.

Commercial HMO membership decreased approximately 8% at December 31, 2002 compared to the prior year due to decreases of 79,300 members in Texas, 36,000 members in California, 25,200 members in Oregon and 24,000 members in Colorado. These decreases were primarily due to elimination of unprofitable commercial business and the termination of contracts with network providers. As previously announced, our contract with the California Public Employee Retirement System was not renewed for 2003, resulting in the loss of approximately 185,000 commercial HMO members effective January 1, 2003.

Senior HMO membership decreased approximately 20% at December 31, 2002 compared to the prior year due to a decrease of 150,100 members in California and Texas. This decrease primarily resulted from county exits and member disenrollments attributable to reduced benefits and increased premiums effective January 1, 2002. As previously announced, we exited five counties in California and Texas resulting in the loss of approximately 37,000 senior HMO members effective January 1, 2003.

PPO and indemnity membership increased approximately 96% at December 31, 2002 compared to the prior year due to enhanced marketing and new product initiatives primarily in California and Texas.

Pharmacy benefit management unaffiliated membership at December 31, 2002 increased approximately 45% compared to the prior year due to increased marketing efforts. Pharmacy benefit management HMO membership at December 31, 2002 decreased approximately 11% compared to the prior year as a result of county exits and member disenrollments attributable to reduced benefits and increased premiums effective January 1, 2002.

PacifiCare behavioral health HMO membership at December 31, 2002 decreased approximately 6% compared to the prior year due to declines in commercial HMO membership resulting from renewal premium rate increases primarily in Texas. Behavioral health unaffiliated membership at December 31, 2002 increased approximately 22% compared to the prior year due to the addition of one large employer group in the Eastern United States.

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PacifiCare dental HMO membership at December 31, 2002 decreased approximately 36% compared to the prior year primarily due to senior membership losses in California, attributable to dental benefit changes effective January 1, 2002. Dental unaffiliated membership at December 31, 2002 increased approximately 7% compared to the prior year due to membership from new PPO product offerings.

Commercial Premiums. Commercial premiums increased 4% or $214 million for the year ended December 31, 2002 compared to the prior year as follows: