EXTENDICARE HEALTH SERVICES INC - 10-K Annual Report

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

FORM 10-K
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[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934 FOR THE FISCAL YEAR ENDED DECEMBER 31, 2002

OR

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

COMMISSION FILE NUMBERS 333-43549; 333-97293

EXTENDICARE HEALTH SERVICES, INC.
(Exact Name of Registrant as Specified in its Charter)

DELAWARE 98-0066268
(State or Other Jurisdiction of (I.R.S. Employer
Incorporation or Organization) Identification Number)
111 WEST MICHIGAN STREET (414) 908-8000
MILWAUKEE, WI 53203 (Registrant's Telephone Number,
(Address of Principal Executive Office Including Area Code)
Including Zip code)

Securities Registered Pursuant to Section 12(b) of the Act: None

Securities Registered Pursuant to Section 12(g) of the Act: None

Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days.

Yes [X] No __

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

Indicate by check mark whether the registrant is an accelerated filer (as
defined by Rule 12b-2 of the Act)

Yes __ No [X]

Common Stock -- authorized 1,000 shares, $1.00 par value; issued and
outstanding 947 shares as of March 15, 2003. All issued and outstanding shares
of Common Stock were, on June 28, 2002, and continue to be held indirectly by
Extendicare Inc., a publicly traded Canadian company.

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TABLE OF CONTENTS

i

CAUTIONARY STATEMENT REGARDING FORWARD LOOKING STATEMENTS

This Form 10-K report contains forward-looking statements that are intended
to qualify for the safe harbors from liability established by the Private
Securities Litigation Reform Act of 1995. All statements other than statements
of historical fact, including statements regarding anticipated financial
performance, business strategy and management's plans and objectives for future
operations, are forward-looking statements. These forward-looking statements can
be identified as such because the statements generally include words such as
"expect," "intend," "believe," "anticipate," "estimate," "plan" or "objective"
or other similar expressions. These forward-looking statements are subject to
risks and uncertainties that could cause actual results to differ materially
from those expressed in, or implied by, these statements. Some, but not all, of
the risks and uncertainties include those described in the "Risk Factors of the
Industry" section of this Form 10-K and include the following:

- Medicare and Medicaid reimbursement policies;

- resident care litigation, including exposure for punitive damage claims
and increased insurance costs, which among other things caused us to exit
Florida and Texas markets;

- the shortage of, and related costs of hiring and retraining qualified
staff and employees;

- federal and state regulation of our business;

- actions by our competitors; and

- fee pressures and slow payment practices by health maintenance
organizations and preferred provider organizations.

All forward-looking statements contained in this report are based upon
information available at the time the statement is made and the Company assumes
no obligation to update any forward-looking statement.

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PART I

ITEM 1. BUSINESS

GENERAL

Extendicare Health Services Inc. was incorporated in Delaware in 1984 and
is an indirect wholly owned subsidiary of Extendicare Inc. (hereafter referred
to as "Extendicare"), a Canadian publicly traded company. As used herein, unless
the context otherwise specifies or requires, the "Company", "we", or "us" refers
to Extendicare Health Services, Inc. and its subsidiaries on a combined basis.
We are subject to certain of the informational requirements of the Securities
Exchange Act due to our public offerings of 9.35% Senior Subordinated Notes Due
2007, and 9.5% Senior Notes Due 2010, which have been registered under the
Securities Act of 1933, as amended.

Based upon number of beds, we are one of the largest providers of long-term
care and related services in the United States. Through our network of
geographically clustered facilities, we offer a continuum of healthcare
services, including skilled nursing care, assisted living and related medical
specialty services, such as subacute care and rehabilitative therapy. As of
December 31, 2002, we operated or managed 197 long-term care facilities with
18,269 beds in 15 states, of which 156 were skilled nursing facilities with
16,357 beds and 41 were assisted living and retirement facilities with 1,912
units. In addition, we operated 22 outpatient rehabilitation clinics in four
states. We also provided consulting services to 39 facilities with 4,213 beds in
two states. We receive payment for our services from Medicare, Medicaid, private
insurance, self pay residents and other third party payors.

We focus on our core skilled nursing facility operations, while continuing
to grow our complementary long-term care services. By emphasizing quality care
of patients and by clustering several long-term care facilities together within
the geographic areas we serve, our goal is to build upon our reputation as a
leading provider of a full range of long-term care services in our communities.

The principal elements of our business strategy are to:

- provide quality, clinically based services;

- increase our total and Medicare census through strategies such as focused
marketing efforts, standardized admissions protocols and streamlined
admitting procedures.

- leverage presence in small urban markets to improve operating
efficiencies and to offer our customers a broad range of long-term care
and related health services, including assisted living facilities;

- expand management and consulting services;

- increase our operating efficiency; and

- proactively manage our asset portfolio so that we upgrade our facilities
to meet the demands of the local market and customer base, or exit
markets or sell facilities which do not meet our performance goals.

THE LONG-TERM CARE INDUSTRY

The long-term care industry is changing as a result of several fundamental
factors, which we believe we can capitalize on. The factors include:

Aging Population. According to the Health Care Industry Market Update
report issued in February 2002 by the Centers for Medicare and Medicaid
Services, or CMS (formerly the Health Care Financing Administration), long-term
care spending related to nursing facilities was estimated at approximately $92.2
billion in 2000. The aging of the U.S. population is a leading driver of demand
for long-term care services. According to the U.S. Census Bureau, there are
approximately 35 million Americans aged 65 or older, representing 12.4% of the
total U.S. population. CMS has projected the annual growth rate through 2020 for
persons over 65 will be 1.8%, and 2.6% for persons over 85. In 2000,
approximately 1.6 million or 4.5%

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of all persons aged 65 and over were living in a nursing facility. The long-term
care industry is fragmented, with the 10 largest nursing facility companies
accounting for 18.5% of the total facility beds.

Supply/Demand Imbalance. Acquisition and construction of additional nursing
facilities are subject to certain restrictions on supply, including government
legislated moratoriums on new capacity or licensing restrictions limiting the
growth of services. Such restrictions on supply, coupled with an aging
population, are causing a decline in the availability of long-term beds per
person 85 years of age or older. Additionally, advances in medical technology
are enabling the treatment of certain medical conditions outside the hospital
setting. As a result, patients requiring a higher degree of monitoring, more
intensive and specialized medical care, 24-hour per day nursing, and a
comprehensive array of rehabilitative therapies are increasing, resulting in a
need for long-term care. We believe that such specialty care can be provided in
nursing homes at a significantly lower cost than in traditional acute care and
rehabilitation hospitals.

Cost Containment Pressures. As the number of people over age 65 continues
to grow and as advances in medicine and technology continue to increase life
expectancies, healthcare costs are expected to rise faster than the availability
of resources from government-sponsored healthcare programs. In response to such
rising costs, governmental and private pay sources in the United States have
adopted cost containment measures that encourage reduced lengths of stay in
acute care hospitals. As a result, average acute care hospital stays have been
shortened, and many patients are discharged despite a continuing need for
nursing or specialty healthcare services, including therapy. An increasing
number of patients require a high degree of monitoring, intensive and
specialized medical care, 24-hour per day nursing services and a comprehensive
array of rehabilitative therapies. This trend has increased demand for long-term
care, home healthcare, outpatient facilities, hospices and assisted living
facilities. We believe that long-term care companies with information systems to
process clinical and financial data, and an integrated network and a broad range
of services will be in a good position to contract with managed care or other
payers.

Changing Family Dynamics. As a result of the growing number of two-income
families, immediate family has become a less primary source of care-giving for
the elderly. Women, who under more traditional roles were viewed as the primary
caretakers of the family, have moved back into the workforce in increasing
numbers as evidenced through their labor participation rates increasing from 38%
in 1963 to 59% in 1998. At the same time, two-income families are better able to
provide financial support for elderly parents to receive the care they need in a
nursing or assisted living facility. The parent support ratio (the ratio of
individuals over 85 to those 50 to 64 years of age has increased from 3 to 100
in 1950 to 10 to 100 in 2000 and is expected to reach 29 to 100 by the year
2050. The expected increase is partly due to the fact that, by 1990,
approximately 26% of the baby boom was childless.

COMPETITIVE STRENGTHS

Our major competitive strengths are:

Leading Provider of Long-term Care Services. We are among the largest
providers of long-term care services in the United States. As of December 31,
2002, we owned, leased or managed 197 long-term care facilities with 18,269
beds. Our scope of operations allows us to achieve economies of scale in
purchasing and contracting with suppliers and customers. For example, through
our subsidiary, United Professional Services, Inc., we purchase for nursing
facilities in numerous states in addition to the facilities we operate or
manage. Through our affiliate, Virtual Care Provider, Inc., we also provide
technology support services to unaffiliated long-term care facilities.

Significant Facility Ownership. We own rather than lease a majority of our
properties, unlike a number of other long-term care providers. As of December
31, 2002, we owned 164 facilities, or 93.7% of the total number of facilities we
operated. We believe that owning properties increases our operating flexibility
by allowing us to:

- refurbish facilities to meet changing consumer demands;

- add assisted living and retirement facilities adjacent to our skilled
nursing facilities;

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- adjust licensed capacity to avoid occupancy-based rate penalties;

- divest facilities and exit markets at our discretion; and

- more directly control our occupancy costs.

Focus on Core Business. Over the past five years, we have successfully
identified and disposed of business segments that did not fit within our core
business and facilities located in states with unacceptable litigation risks.
These dispositions included the 1998 sale of our institutional pharmacy
operation, the 1999 and 2000 sale or lease of all of our facilities in Florida
and the 2001 lease or sublease of all our skilled nursing operations in Texas.
We intend to continue to focus on owning and managing long-term care facilities.
In addition, we will continue to review the performance of our current
facilities and exit markets or sell facilities that do not meet our performance
goals. At the present time, we have no significant divestiture plans.

Dual Medicare and Medicaid Certification. We have certified substantially
all of our beds for the provision of care to both Medicare and Medicaid
patients. We believe that dual certification increases the likelihood of higher
occupancy rates by increasing the availability of beds to patients who require a
specific bed certification. In addition, dual certification allows our
facilities to easily shift patients from one level of care and reimbursement to
another without physically moving the patient.

Management Focus on Key Performance Drivers. We believe that our senior
management, as well as our field personnel, are proficient at focusing on the
key areas that drive revenues, profits and cash flows. Our senior management has
identified three critical drivers of operating and financial performance:

- improving census, particularly increasing our Medicare census;

- expediting billing and collections; and

- controlling labor costs.

Every level of management, starting with our Chief Executive Officer,
devotes a significant portion of its time to improving these drivers. We believe
that this attention has resulted in substantial improvement in several of our
key operating metrics.

For 2002, the occupancy rate for our skilled nursing facilities was 90.3%,
or 2.8 percentage points higher than the 87.5% occupancy rate for 2001. For
2002, the percentage of Medicare residents to total residents was 13.4%, or 2.0
percentage points higher than the comparable percentage for 2001, which was
11.4%.

Through consistent emphasis on admissions protocols, attention to older and
larger account balances and proactive collection efforts at regional and head
offices, we have improved our accounts receivable management. Days of revenues
outstanding have dropped from approximately 59 days in 1998 to 47 days as of
December 31, 2002.

We have employed a variety of strategies to control labor costs and
minimize the use of temporary staff. Our strategies include adjusting wage
scales, offering greater flexibility in staffing and improving overall job
satisfaction. Regular wages as a percent of revenues have declined to 46.5% for
2002 from 46.8% for 2001, while temporary wages as a percent of revenues in the
same periods decreased to 1.2% from 2.5%.

Geographic Diversity. We operate or manage facilities located in specific
markets across 15 states throughout the Northeast, Midwest, South and Northwest
regions of the United States. No state contains more than 18% of our facilities
or 19% of our beds. Each state is unique in terms of its competitive dynamics as
well as political and regulatory environment. Each state administers its own
Medicaid program, which constitutes a significant portion of our revenue. Our
diversified market scope limits our exposure to events or trends that may occur
in any individual state, including changes in any state's Medicaid reimbursement
program and in regional and local economic conditions and demographics.

Experienced and Proven Management Team. Our management has demonstrated
competency in dealing with major changes in the reimbursement environment
resulting from the shift to the prospective payment system, or PPS. In addition,
management determined that the best way to address the extremely litigious

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environments in Florida and Texas was to cease operating in those markets.
During these challenging times, we have retained substantially all of our
executive and operating management team.

BUSINESS STRATEGY

The principal elements of our business strategy are to:

Provide Quality, Clinically Based Services. We engage in outcomes
management, forecasting and continuous quality improvement processes at the
facility, regional and corporate level. In recognition of increased state
regulatory oversight, we have an internal team of field-based quality validation
specialists who are responsible for mirroring the regulatory survey process and
regularly communicating with our outcomes management specialists in our
corporate office. On-site data is integrated with clinical indicators, facility
human resource data and state regulatory outcomes to provide a detailed picture
of problems, challenges and successes in achieving performance at all levels of
our organization. This information pool allows us to determine best practices
for duplication in similarly situated facilities. We emphasize these programs
when marketing our services to acute care providers, community organizations and
physicians in the communities we serve.

Increase Medicare Census. We continue to develop and implement strategies
and capabilities to attract residents, with a focus on increasing Medicare
census. In 2002, Medicare payments represented approximately 26% of our total
net revenues, up from 22% in 1999. Senior management has worked with our
regional and local management teams to develop strategies to continue to
increase this percentage. Strategies, such as focused marketing efforts,
standardized admissions protocols, streamlined admitting procedures, the dual
certification of beds and improved management communication have driven this
improvement. In addition to increasing the profitability of our nursing
facilities, the increased Medicare census expands the market for our service
related businesses as Medicare patients utilize significant ancillary services.

Leverage Presence in Small Urban Markets. We geographically cluster our
long-term care facilities and services in small urban markets in order to
improve operating efficiencies and to offer our customers a broad range of
long-term care and related health services, including assisted living
facilities. Future expansion of our owned nursing facility operations is
anticipated to be through the selective acquisition and construction of new
facilities in areas that are in close proximity to existing facilities, where
management is experienced in dealing with the regulatory and reimbursement
environments, where the facility can participate as an active member of the
nursing facility association and where the facility's reputation is established.

Expand Management and Consulting Services. We seek to increase the number
of management and consulting contracts with third party operators. We have
knowledge and expertise in both the operational and administrative aspects of
the long-term care sector. We believe that the increasingly complex and
administratively burdensome nature of the long-term care sector, coupled with
our commitment and reputation as a leading, high-quality operator, will drive
demand for new contracts. We believe this strategy is a logical extension of our
business model and competencies and will drive growth without requiring
substantial capital expenditures.

Increase Operating Efficiency. We are focused on reducing operating costs
by improving our communications systems, streamlining documentation and
strengthening the formalization of procedures to approve expenditures. We are
reducing duplication of roles at the corporate and regional levels. We continue
to seek to improve our utilization of regional resources by adding management
and consulting contracts to our existing regions, thereby enabling us to spread
the semi-fixed costs of our regional structure over a wider base of facilities.

Proactively Manage Our Asset Portfolio. We continually review our asset
portfolio in terms of its physical condition, the facility meeting the needs of
the marketplace, its financial performance and long-term outlook. When
facilities do not meet our performance criteria, risks within the marketplace
increase or litigation risk increases beyond acceptable limits, we exit the
marketplace or sell facilities. Over the past four years, we have disposed of a
number of facilities and exited two states, while improving the performance of
the balance of our asset portfolio.

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RISK FACTORS IN THE INDUSTRY

The risk factors and uncertainties facing us and our industry include:

We depend upon reimbursement for our services by third-party payors, and
changes in their reimbursement levels could adversely affect our revenues,
results of operations and financial position. Substantially all, or 76%, of our
long-term and rehabilitation revenues are derived from governmental third-party
payors with the remainder being derived from commercial insurers, managed care
plans, the Department of Veteran Affairs and private individuals. In 2002,
approximately 26% of our revenues were derived from Medicare and 50% from
Medicaid. There are ongoing pressures from many payors to control health care
costs and to reduce or limit increases in reimbursement rates for medical
services. Governmental payment programs are subject to statutory and regulatory
changes, retroactive rate adjustments, administrative or executive orders and
government funding restrictions, all of which may materially change the amount
of payments to us for our services. Medicare funding levels have changed
significantly over the past few years. For example, in 1998 and 1999, the
industry experienced a decline in revenues primarily attributable to declines in
government reimbursement as a result of the Balanced Budget Act of 1997, or BBA.
The revenue rate reductions from the BBA are being partially offset by the
Balanced Budget Refinement Act of 1999, or BBRA, and the Benefits Improvement
Protective Act of 2000, or BIPA. We cannot assure you that payments from
governmental or private payors will remain at levels comparable to present
levels or will, in the future, be sufficient to cover the costs allocable to
patients eligible for reimbursement pursuant to such programs. See "Management's
Discussion and Analysis of Financial Condition and Results of
Operations -- Overview -- Legislative Actions Affecting Revenues" and
"Business -- Government Regulation" for additional information.

Effective October 1, 2002, our revenues were adversely affected by expiring
Medicare provisions with no assurance from Congress that lost Medicare revenues
may be restored. The incremental Medicare relief packages received from BBRA and
BIPA provided a total $2.7 billion in temporary Medicare funding enhancements to
the long-term care industry. The funding enhancements implemented by the BBRA
and BIPA fall into two categories. The first category is "Legislative Add-ons"
which included a 16.66% add-on to the nursing component of the Resource
Utilization Groupings, or RUGs rate and a 4% base adjustment. The second
category is "RUGs Refinements" which involved an initial 20% add-on for 15 RUGs
categories identified as having high intensity, non-therapy ancillary services,
which, for three RUGs categories, the 20% add-ons were later redistributed to 14
Rehab categories at 6.7%.

The Legislative Add-ons expired on September 30, 2002 and the Company's
Medicare funding has been reduced. Based on the Medicare case mix and census
over the nine month period ended September 30, 2002 we received an estimated
average rate of $31.22 per resident day relating to Legislative Add-ons, or 9.2%
of our total average Medicare rate of $338 per resident day. Offsetting this, on
October 1, 2002 long-term care providers received a 2.6% market basket increase
in Medicare rates. The impact of these two items in the fourth quarter of 2002
was a net decline in our average rate of $23.64 per patient day, which, based
upon the Medicare case mix and patient days for the year ended December 31,
2002, amounts to lower annualized revenue of approximately $14.7 million going
forward.

With respect to the RUGs Refinements, on April 23, 2002 CMS announced that
it would delay the refinement of the RUGs categories thereby extending the
related funding enhancements for at least one additional year to September 30,
2003. Further to this, in the budget report released in February 2003, President
Bush proposed additional funding to extend the RUGs Refinements to September 30,
2004 and though the President's budget has not been passed, CMS has agreed
verbally with the extension of the RUGs refinements to September 30, 2004. Based
upon the Medicare case mix and census for the year ended December 31, 2002, we
estimate that it received an average $24.40 per resident day, which on an
annualized basis amounts to $15.1 million related to the RUGs Refinements. A
decision to discontinue all or part of the enhancement could have a significant
impact on us.

In the February 2003 budget, President Bush proposed plans for reductions
in the annual market basket increase for skilled nursing facilities from October
1, 2003 to October 1, 2007. If this budget is passed, it will mean reductions in
the market basket increase for the industry of $60 million starting in October
2003;

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$140 million in October 2004; $240 million in October 2005; $350 million in
October 2006; and $470 million in October 2007.

In January, 2003 CMS announced that the moratorium on implementing payment
caps for outpatient Part B therapy services, which were scheduled to take effect
on January 1, 2003, would be extended for six months, until July 1, 2003. The
impact of a payment cap cannot be reasonably estimated based on information
available at this time, however such a cap would reduce therapy revenues.

In February 2003, CMS announced its plan to reduce its level of
reimbursement for uncollectible Part A co-insurance. Under current law, skilled
nursing facilities are reimbursed 100% of bad debts incurred. Over the next
three years, The Department of Health and Human Services, or HHS, plans to
reduce the reimbursement level to 70% as follows: 90% effective for the
government fiscal year commencing October 1, 2003; 80% effective for the
government fiscal year commencing October 1, 2004; and 70% effective for
government fiscal years commencing on or after October 1, 2005. This plan is
consistent with the Part A co-insurance reimbursement plan applicable to
hospitals. We estimate that should this plan be implemented the impact on our
net earnings would be $1.0 million in 2004, increasing to $2.5 million in 2006.

Financial pressures on state budgets will directly impact the level of
available Medicaid fundings and hence the level of available funding for
inflationary increases. In addition, these pressures have caused the states to
take initiatives to reduce the level of funding to long-term care providers. A
study issued by the Kaiser Commission on Medicaid and the Uninsured in January
2003, indicates that 49 of the states have made or plan to make Medicaid cuts in
fiscal year 2003 and 32 states have made or are planning a second round of cuts
to the programs. It is likely that long-term care providers will be affected by
these cuts. Of the states in which we operate, Ohio, Kentucky, Indiana,
Wisconsin, and Washington have announced plans to limit or reduce funding in
2003. Since Medicaid revenues account for 50% of our revenues, and 69% of our
costs are wages and associated benefits to our staff, Medicaid funding
restraints could have a significant negative impact on our results from
operations, and cash flow.

Legislative and regulatory actions have resulted in continuing changes to
Medicare and Medicaid reimbursement programs. Medicare and Medicaid
reimbursement programs are complicated and constantly changing as CMS continues
to refine its programs. There are considerable administrative costs incurred in
monitoring the changes made within the programs, determining the appropriate
actions to be taken to respond to those changes, and implementing the required
actions to meet the new requirements and minimize the repercussions of the
changes to our organization, reimbursement rates and costs. Examples of changes
adopted by either CMS or certain states, which have impacted our industry,
include:

- the repeal of the Boren Amendment federal payment standard for Medicaid
payments, which required states to provide skilled nursing facilities
with reasonable and adequate reimbursement rates to cover the costs of
efficiently and economically operated healthcare facilities. As a result,
budget constraints may cause states to reduce Medicaid reimbursement to
skilled nursing facilities or delay payments to providers;

- the limitation of costs being reimbursed under Medicaid reimbursement
programs when operators use a certain level of agency staffing, or incur
leasing costs, which have an imputed lease interest cost greater than the
current market rate;

- the establishment of a minimum occupancy requirement in certain Medicaid
programs, which effectively reduces the eligible Medicaid reimbursement
rate that a skilled nursing facility can receive; and

- an increasing number of states have adopted policies to discontinue the
reimbursement of Part A co-insurance payments for dually eligible
residents.

In January 2003, the President outlined his budget plans for Medicaid
modernization which allows states the flexibility to design innovative programs
without waivers, including increased use of consumer-directed services and home
and community based care. The President wants to improve coverage for low-income
Americans and allow people who might be cut from Medicaid coverage to keep it.
By giving states more

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flexibility to tailor coverage to the needs of recipients, the President would
give states both flexibility and federal fiscal relief over the first seven
years. The President has offered an extra $12.7 billion above what is currently
projected, including an additional $3.25 billion in fiscal year 2004. States
that chose this new option would be subject to an entirely new financing
structure. The program is designed to be budget neutral over a 10-year period so
state allotments in years 8 to 10 would be reduced by $12.7 billion.

The cost of general and professional liability claims are significant. We
have experienced an increasing trend in the number and severity of litigation
claims asserted against us, including personal injury and wrongful death claims.
We believe that this trend is endemic to the long-term care industry and is a
result of the increasing number of large judgments, including large punitive
damage awards, against long-term care providers in recent years resulting in an
increased awareness by plaintiff's lawyers of potentially large recoveries. This
has been particularly the case in Florida and Texas where we have ceased to
operate skilled nursing facilities. Industry sources report the average cost of
a claim in Florida in 2000 was three times higher than most of the rest of the
United States. Florida health care providers experienced four times the number
of claims as providers in most other states experienced. We ceased all
operations in Florida as of December 31, 2000 and all skilled nursing facility
operations in Texas as of September 30, 2001. As a result of the litigious
environment, insurance coverage for general and professional liability claims
has increased and in certain states become unavailable to skilled nursing
facility operators, as insurance companies have refrained from providing
insurance in certain states. We continually review requests for medical records
and claims by facility and by state, and use that information, along with
operational performance measures, to assess whether we should dispose of
additional facilities. At the present time, we have no significant divestiture
plans.

As of December 31, 2002, we have provided for $55.1 million in accruals for
known or potential general and professional liability claims based on claims
experience and an independent actuarial review; however, we may need to increase
our accruals in excess of the amounts we have accrued as a result of future
actuarial reviews and claims that may develop. An adverse determination in legal
proceedings, whether currently asserted or arising in the future, could have a
material adverse effect on us. See "Business -- Insurance."

The shortage of qualified registered nursing staff and other healthcare
workers could adversely affect our ability to attract, train and retain
qualified personnel and could increase operating costs. A national shortage of
nurses and other trained personnel, and general inflationary pressures have
forced us to enhance our wage and benefits packages in order to compete for
qualified personnel. The shortage of nurses is documented by the U.S. Labor
Department, which reports that there will be a 1.0 million shortfall of
professional nurses by 2010. In some of the markets where we operate, there are
shortages of healthcare workers. This is supported by a report by the North
Carolina Medical Journal in March/April, 2002 which reported that between 2000
and 2010 there will be 874,000 more care workers needed in the long-term care
industry. As a result, our wages increased 6.9% in 2002 over 2001, 5.4% between
2001 and 2000. In order to supplement staffing levels, though we attempt to
limit the use of temporary help from staffing agencies to maintain a higher
quality of care, we periodically are forced to utilize costly temporary help
from staffing agencies, which results in wage premiums of 25% to 60%. In 2002,
we incurred temporary agency costs of $10.2 million compared to $18.4 million in
2001.

We conduct our business in a heavily regulated industry and our failure to
comply with laws and government regulation could lead to fines and penalties. We
must comply with complex laws and regulations at the federal, state and local
government levels relating to, among other things:

- licensure and certification;

- qualifications of healthcare and support personnel;

- maintenance of physical plant and equipment;

- staffing levels and quality of healthcare services;

- maintenance, confidentiality and security issues associated with medical
records;

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- relationships with physicians and referral sources;

- billing for services;

- operating policies and procedures; and

- additions or changes to facilities and services.

There are ongoing initiatives at the federal and state levels for
comprehensive reforms affecting the payment for and availability of healthcare
services. In addition, regulations and policies of regulatory agencies are
subject to change. Aspects of some of these healthcare initiatives, such as the
termination of Medicare funding improvements and limitations on Medicare
coverage, other pressures to contain healthcare costs by Medicare, Medicaid and
other payors, as well as increased operational requirements in the
administration of Medicaid, could adversely affect our financial condition or
our results of operations. Revisions to regulatory requirements, changes in
scope and quality of care to residents and revisions to licensure and
certification standards also could potentially have a material impact on us. In
the future, different interpretations or enforcement of existing, new or amended
laws and regulations could result in allegations of impropriety or illegality or
could result in changes requiring capital expenditure programs and operating
expenses.

If we do not comply with applicable laws and regulations, then we could be
subject to liabilities, including criminal penalties and civil penalties and
exclusion of one or more of our facilities from participation in Medicare,
Medicaid and other federal and state healthcare programs. If one of our
facilities lost its certification under either the Medicare or Medicaid program,
then it would have to cease future admissions and displace residents funded by
the programs from the facility. In order to become re-certified, a facility must
rectify all identified deficiencies and, over a specified period of time, pass a
survey conducted by representatives of the respective programs through
demonstrated care and operations for residents in the facility. Until the
appropriate agency has verified through the "reasonable assurance" process that
the facility can achieve and maintain substantial compliance with all applicable
participation requirements, the facility will not be admitted back into either
the Medicare or Medicaid programs. Medicare and Medicaid re-certification
processes are similar, but different, and are conducted separately.
Re-certification requires considerable staff resources. The loss of
certification from either program can have potentially significant financial
consequences. In 1998, we operated one facility in Maryland that lost its
certification under the Medicare program, and we subsequently closed the
facility. In November 2000, we operated one facility in Indiana that lost its
certification under the Medicare and Medicaid programs but has since been
re-certified under both programs.

If we do not achieve and maintain competitive quality of care ratings from
the CMS our business may be negatively affected. CMS launched the Nursing Home
Quality Initiative pilot program in April 2002 in Colorado, Florida, Maryland,
Ohio, Rhode Island and Washington. This program, which is designed to provide
consumers with comparative information about nursing home quality measures, will
rate every nursing home operating in these states on nine quality of care
indicators. These quality of care indicators include such measures as
percentages of patients with infections, bedsores and unplanned weight loss.
This comparative data is available to the public on CMS's web site. Based upon
the success of the pilot, CMS has announced its intention to roll out the
program nationwide to all other states. If we are unable to achieve quality of
care ratings that are comparable or superior to those of our competitors, our
ability to attract and retain patients could be affected and, as a result, our
occupancy levels could decline.

Changes in the case mix of residents, the mix of residents by payor type
and payment methodologies may significantly affect our profitability. The
sources and amounts of our patient revenues will be determined by a number of
factors, including licensed bed capacity and occupancy rates of our skilled
nursing facilities, average length of stay of our residents, the mix of
residents by payor type (for example, Medicare versus Medicaid or private), and,
within the Medicare and certain Medicaid programs , the distribution of
residents assessed within the RUGs. Changes which increase the percentage of
Medicaid residents within our facilities can have a material adverse effect on
our financial operations, especially in states whose reimbursement levels are
below the cost of the provision of care.

If we fail to cultivate new or maintain existing relationships with the
physicians in the communities in which we operate, our patient base may
decrease. Our success depends in part upon the admissions and
9

referral practices of the physicians in the communities in which we operate and
our ability to cultivate and maintain relationships with these physicians.
Physicians referring patients to our facilities are not our employees and are
free to refer their patients to other providers. If we are unable to
successfully cultivate and maintain strong relationships with these physicians,
our patient population may decline.

We face national, regional and local competition. Our nursing and assisted
living facilities compete on a local and regional basis with other long-term
care providers. The number of competing centers in the local market, the types
of services available, quality of care, reputation, age and appearance of each
center and the cost of care in each locality all affect our ability to compete
successfully. The availability and quality of competing facilities significantly
influence occupancy levels in assisted living facilities. There are relatively
few barriers to entry in the assisted living industry and, therefore, future
development of assisted living facilities in the markets we serve could limit
our ability to attract and retain residents, to maintain or increase resident
service fees or to expand our business. See "Business -- Competition."

State efforts to regulate the construction or expansion of healthcare
providers could impair our ability to expand through construction and
redevelopment. Most of the states in which we currently operate have adopted
laws to regulate expansion of skilled nursing facilities. Certificate of need
laws generally require that a state agency approve certain acquisitions or
physical plant changes and determine that a need exists prior to the addition of
beds or services, the implementation of the physical plant changes or the
incurrence of capital expenditures exceeding a prescribed amount. Some states
also prohibit, restrict or delay the issuance of certificates of need. Many
states have established similar certificate of need processes to regulate the
expansion of assisted living facilities.

If certificates of need or other similar approvals are required in order to
expand our operations, our failure or inability to obtain the necessary
approvals, changes in the standards applicable to such approvals and possible
delays and expenses associated with obtaining such approvals could adversely
affect our ability to expand and, accordingly, to increase our revenues and
earnings. We cannot assure you that we will be able to obtain a certificate of
need or other regulatory approval for all future projects requiring such
approval.

Many states in which we operate have implemented moratoriums on the
granting of licenses for any additional skilled nursing facility beds. In these
states we may only expand by acquiring existing operations and licensure rights
from other skilled nursing care providers. We cannot guarantee that we will be
able to find acceptable acquisition targets in these states and, as a result, we
may not be able to expand in these states.

We face periodic reviews, audits and investigations under our contracts
with federal and state government agencies, and these audits could have adverse
findings that may negatively impact our business. As a result of our
participation in the Medicare and Medicaid programs, we are subject to various
governmental reviews, audits and investigations to verify our compliance with
these programs and applicable laws and regulations. Private pay sources also
reserve the right to conduct audits. An adverse review, audit or investigation
could result in:

- refunding amounts we have been paid pursuant to the Medicare or Medicaid
programs or from private payors;

- state or federal agencies imposing fines, penalties and other sanctions
on us;

- loss of our right to participate in the Medicare or Medicaid programs or
one or more private payor networks; or

- damages to our reputation in various markets.

Both federal and state government agencies have heightened and coordinated
civil and criminal enforcement efforts as part of numerous ongoing
investigations of healthcare companies and, in particular, skilled nursing
facilities. The investigations include:

- cost reporting and billing practices;

- quality of care;

10

- financial relationships with referral sources; and

- medical necessity of services provided.

We also are subject to potential lawsuits under a federal whistleblower
statute designed to combat fraud and abuse in the healthcare industry. These
lawsuits can involve significant monetary and award bounties to private
plaintiffs who successfully bring these suits.

We are required to comply with laws governing the transmission and privacy
of health information. The Health Insurance Portability and Accountability Act
of 1996, or HIPAA, requires us to comply with standards for the exchange of
health information within our company and with third parties. The Department of
Health and Human Services has released three rules to date mandating the use of
new standards with respect to certain healthcare transactions and health
information. The first rule establishes uniform standards for common healthcare
transactions, including:

- healthcare transactions, such as claims information, plan eligibility,
payment information and the use of electronic signatures;

- plan eligibility, enrollment and disenrollment, referral certification
and authorization;

- claims status, payment and remittance advice; and

- plan premium payments and coordination of benefits.

The second rule relates to the privacy of individually identifiable health
information. These standards not only require our compliance with rules
governing the use and disclosure of protected health information, but they also
require us to impose those rules, by contract, on any business associate to whom
we disclose information. We generally must comply with the privacy standards by
April 2003 and the transaction standards by October 2003.

The third rule, issued in 2003, governs the security of health information.
Compliance with the security regulations is required by April 21, 2005. The
security regulations apply only to electronic protected health information, and
have four main objectives to:

- ensure the confidentiality, integrity and availability of protected
health information that a covered entity creates, receives, maintains or
transmits electronically;

- protect against any reasonably anticipated hazards that might threaten
the security or integrity of electronic protected health information;

- protect against any unauthorized use or disclosure of electronic
protected health information that can be reasonably anticipated; and

- ensure that the covered entity's workforce complies with the full range
of security measures.

Although HIPAA was intended to ultimately reduce administrative expenses
and burdens faced within the healthcare industry, it is generally agreed that
the implementation of this law will result in additional costs to all healthcare
organizations in the short term. The cost of implementing the new standards is
estimated at $0.5 million. We have established a HIPAA task force consisting of
clinical, legal, financial and information services professionals to work on the
project, and commenced implementation of the standards and procedural changes
within our organization. At this time, we anticipate to be able to fully comply
with the HIPAA privacy and transactions standards by the required implementation
dates. However, our ability to comply with the transactions standards is
dependent upon other third parties, including the fiscal intermediaries and
state program providers also complying with the HIPAA requirements and
timetables. If we fail to comply with the new standards, we could be subject to
criminal penalties and civil sanctions.

We may make acquisitions and undertake management and consulting contracts
that could subject us to a number of operating risks. We anticipate that we may
continue to make acquisitions of, investments in, and strategic alliances with,
complementary businesses to enable us to add services for our customer base and
for adjacent markets and to expand each of our businesses geographically. In
addition, we may undertake

11

management and consulting service arrangements with other organizations.
However, implementation of these strategies entails a number of risks including:

- inaccurate assessment of undisclosed liabilities;

- entry into markets in which we may have limited or no experience;

- diversion of management's attention from our core business;

- difficulties in assimilating the operations of an acquired business or in
realizing projected efficiencies and cost savings; and

- increasing our indebtedness and limiting our ability to access additional
capital when needed.

Certain changes may be necessary to integrate the acquired businesses into our
operations, to assimilate new employees and to implement reporting, monitoring,
compliance and forecasting procedures.

If we are unable to control operating costs and generate sufficient cash
flow to meet operational and financial requirements, including servicing our
indebtedness, our business operations may be adversely affected. Cost
containment and lower reimbursement levels by third party payors, including
federal and state governments, have had a significant impact on the healthcare
industry as a whole and on our cash flows. Our operating margins continue to be
under pressure because of continuing regulatory scrutiny and growth in operating
expenses, such as labor costs and insurance premiums. In addition, as a result
of competitive pressures, our ability to maintain operating margins through
price increases to private patients is limited. If we are unable to generate
sufficient cash flow to service our indebtedness, our business operations will
be materially adversely affected. Although, as of December 31, 2002, we are in
compliance with the financial covenants of our credit facility, Subordinated
Notes and Senior Notes, and management has a strategy to remain in compliance,
there can be no assurance that we can meet future debt covenant requirements. If
we are unable to do so, our business operations may be materially adversely
affected.

OPERATIONS

ORGANIZATIONAL STRUCTURE OF OPERATIONS

Our operations are organized into a number of different direct and indirect
wholly owned subsidiaries primarily for legal and tax purposes. We manage our
operations as a single unit. Operating policies and procedures are substantially
the same in each subsidiary. Several of our subsidiaries own and operate a
significant number of our total portfolio of facilities. No single facility
generates more than 2% of total revenues.

NURSING CARE

We provide a broad range of long-term nursing care, including skilled
nursing services, subacute care and rehabilitative therapy services, to assist
patients in the recovery from acute illness or injury. We provide nursing care
and therapy services to persons who do not require the more extensive and
specialized services of a hospital. Our nursing facilities employ registered
nurses, licensed practical nurses, therapists, certified nursing assistants and
qualified healthcare aides who provide care as prescribed by each resident's
attending physician. All of our nursing facilities provide daily dietary
services, social services and recreational activities, as well as basic services
such as housekeeping and laundry.

ASSISTED LIVING AND RETIREMENT FACILITIES

In our assisted living facilities, we provide residential accommodations,
activities, meals, security, housekeeping and assistance in the activities of
daily living to seniors who require some support, but not the level of nursing
care provided in a nursing facility. Our retirement communities provide
activities, security, transportation, special amenities, comfortable apartments,
housekeeping services and meals. Our assisted living facilities enhance the
value of an existing nursing facility in situations where the two facilities
operate

12

side by side. This allows us to better serve the communities in which we operate
by providing a broader continuum of services. Most of our assisted living
facilities are within close proximity to our nursing facilities.

MANAGEMENT AND SELECTED CONSULTING SERVICES

We apply our operating expertise and knowledge in long-term care by
providing either full management services or selected consulting services to
third parties.

Through our wholly owned subsidiary, Partners Health Group, LLC, we provide
full management services utilizing our experienced professionals who have
considerable knowledge and expertise in both the operational and administrative
aspects of the long-term care industry. For full management contracts, we
consult on all aspects of operating a long-term care facility, including the
areas of nursing, dietary, laundry and housekeeping. Contracts are structured as
fee-for-service contracts, with the fees sometimes being based on a percentage
of revenues. The contracts generally have terms ranging from one to five years.

Through our wholly owned subsidiary, Fiscal Services Group, LLC, we provide
selected consulting services, which include selected accounting or cost
reimbursement services. Accounting services can include billing, accounts
receivable tracking, payroll, invoice processing, financial reporting, tax and
cost reimbursement services. Contracts are structured as fee-for-service
contracts, with the fees sometimes being based on a percentage of revenues. The
contracts generally have terms ranging from one to five years.

In addition, Virtual Care Provider, Inc., a wholly owned subsidiary of our
parent, Extendicare Inc., provides information technology services to us and
unrelated third parties on a fee-for-services basis.

GROUP PURCHASING

Through United Professional Services, Inc., one of our wholly owned
subsidiaries, we provide purchasing services for nursing facilities in numerous
states in addition to the facilities we own or manage. We offer substantial cost
reductions for members of the purchasing group through the contractual
volume-based arrangements made with a variety of industry suppliers for food,
supplies and capital equipment.

REHABILITATIVE THERAPY

We operate rehabilitative therapy clinics within our wholly owned
subsidiary, The Progressive Step Corporation. As of December 31, 2002, we
operated 22 clinics: ten in Pennsylvania, one in Ohio, two in Texas and nine in
Wisconsin. These clinics provide services to outpatients requiring physical,
occupational and/or speech-language therapy. In addition, our Pennsylvania
clinics provide respiratory and psychological and social services.

We provide rehabilitative therapy services on an inpatient and outpatient
basis. We have expanded all of our nursing facilities' therapy units, with some
facilities offering 1,500 to 5,000 square feet of therapy space. We have
developed therapy programs to provide patient-centered, outcome-oriented
subacute and rehabilitative care. At the majority of our facilities, we employ
physical, occupational and/or speech-language therapists who provide
rehabilitative therapy services to both inpatient and outpatient clients.

EXPANSION

Plans for expanding our operations are developed from sources such as:

- personal contacts that we have in the long-term care industry;

- information made available to us and that we make available to others
through state and nationally based associations; and

- investment and financing firms and brokers.

All acquisitions and the undertaking of new contracts for management and
consulting services involve a process of due diligence in which the operational,
building and financial aspects of the undertaking are investigated.
13

SOURCES OF REVENUE

SKILLED NURSING FACILITIES

The principal reimbursement sources for our nursing services are:

- Medicaid, a state-administered program financed by state funds and
matching federal funds, providing health insurance coverage for certain
persons in financial need, regardless of age, and which may supplement
Medicare benefits for financially needy persons aged 65 or older.
Medicaid reimbursement formulas are established by each state with the
approval of the federal government in accordance with federal guidelines.
The states in which we operate currently use cost-based or price-based
reimbursement systems. These formulas may be categorized as prospective
or retrospective in nature. Under a prospective cost-based system, per
diem rates are established based upon the historical cost of providing
services during a prior year, adjusted to reflect factors such as
inflation and any additional service required to be performed. Many of
the prospective payment systems under which we operate contain an acuity
measurement system, which adjusts rates based on the care needs of the
resident. Retrospective systems operate similar to the pre-PPS Medicare
program where nursing facilities are paid on an interim basis for
services provided, subject to adjustments based on allowable costs, which
are generally submitted on an annual basis. The price-based or modified
price-based systems pay a provider at a certain payment rate irrespective
of the provider's cost to deliver the care;

- Medicare, which is a federally funded health-insurance program providing
health insurance coverage for persons aged 65 or older and certain
disabled persons, which provides reimbursement for inpatient services for
hospitals, nursing facilities and certain other healthcare providers and
patients requiring daily professional skilled nursing and other
rehabilitative care (Part A Medicare) and services for suppliers of
certain medical items, outpatient services and doctors' services (Part B
Medicare). Medicare pays for the first 20 days of stay in a skilled
nursing facility in full and the next 80 days above a daily coinsurance
amount, after the individual has qualified for Medicare coverage by a
three day hospital stay; and

- private pay, which consist of individuals, private insurance companies,
HMOs, PPOs, other charge-based payment sources, HMO Medicare risk plans,
Blue Cross and the Department of Veterans Affairs.

We estimate that Medicare and Medicaid accounted for approximately 26% and
50% of our revenues, respectively, for 2002, as compared to 24% and 51% of
revenues for 2001. These payors have set maximum reimbursement levels for
payments for nursing services and products. The healthcare policies and programs
of these agencies have been subject to changes in payment methodologies during
the past several years. There can be no assurance that future changes will not
reduce reimbursements for nursing services from these sources.

ASSISTED LIVING FACILITIES

Assisted living facilities revenue is primarily derived from private pay
residents at rates we establish based upon the services we provide and market
conditions in the area of operation. Approximately 38 states provide or have
approval to provide Medicaid reimbursement for services in assisted living
facilities covering board and care. An additional six states plan to add
Medicaid coverage of services in the near future.

QUALITY OF CARE AND EMPLOYEE TRAINING

Our "Commitment to Residents" emphasizes our corporate philosophy of
treating residents with dignity and respect, a philosophy which we implement and
monitor through rigorous standards that we periodically assess and update. At a
regional level, our area directors of care management lead a department that is
primarily responsible for establishing care and service standards, policies and
procedures and auditing care and service delivery systems. They also provide
direction and training for all levels of the staff within the nursing facilities
and assisted living facilities. Our area directors of care management develop
programs and standards for all professional disciplines and services provided to
our customers, including nursing, dietary, social
14

services, activities, ethical practices, mental health services, behavior
management, quality validation and continuous quality improvement.

Employee training at all levels is an integral part of our on-going efforts
to improve and maintain our service quality. Each new nursing facility
administrator and assisted living facility manager or director of nursing is
required to attend a week of company-provided training to ensure that he or she
understands all aspects of nursing facility operations, including clinical,
management and business operations. We conduct additional training for these
individuals and all other staff on a regional or local basis.

MARKETING

Most of our long-term care facilities are located in smaller urban
communities. We focus our marketing efforts predominantly at the local level. We
believe that residents selecting a long-term care facility are strongly
influenced by word-of-mouth and referrals from physicians, hospital discharge
planners, community leaders, neighbors and family members. The administrator of
each long-term care facility is, therefore, a key element of our marketing
strategy. Each administrator is responsible for developing relationships with
potential referral sources. Administrators are supported through a regional team
of marketing personnel, which establish the overall marketing strategy, develop
relationships with HMO and PPO organizations and provide marketing direction
with training and community specific promotional materials. We aim to be the
provider of choice in the communities we serve.

COMPETITION

The long-term care industry in the United States is highly competitive with
companies offering a variety of similar services. We face local and regional
competition from other healthcare providers, including for-profit and
not-for-profit organizations, hospital-based nursing units, rehabilitation
hospitals, home health agencies, medical supplies and services agencies and
rehabilitative therapy providers. Newer assisted living facilities can attract
an element of the former private pay nursing facility admissions that require a
lesser degree of care. Significant competitive factors affecting the placement
of residents in nursing and assisted living facilities include quality of care,
services offered, reputation, physical appearance, location and, in the case of
private-pay residents, cost of the services. We focus our marketing efforts on
word-of-mouth reputation and referrals from each community's medical and
healthcare professionals.

Our medical services and supplies operation and our group purchasing
operation compete with other similar operations ranging from small local
operators to companies that have a national scope and distribution capability.

We also compete with other providers in the acquisition and development of
additional facilities. Other competitors may accept a lower rate of return and
therefore, present significant price competition. Also, tax-exempt
not-for-profit organizations may finance acquisitions and capital expenditures
on a tax-exempt basis or receive charitable contributions unavailable to us.

GOVERNMENT REGULATION

Various federal, state and local governmental authorities in the United
States regulate the provision of institutional care through nursing facilities.
Though we believe our operations comply with the laws governing our industry, we
cannot guarantee that we will be in absolute compliance with all regulations at
all times. Failure to comply may result in significant penalties, including
exclusion from the Medicare and Medicaid programs, which could have a material
adverse effect on our business. We cannot assure you that governmental
authorities will not impose additional restrictions on our activities that might
adversely affect our business. In addition to the information presented below,
please see "Risk Factors -- Risks Relating to Us and Our Business" and
"Management's Discussion and Analysis of Financial Condition and Results of
Operations -- Significant Events -- Asset Divestitures."

15

GENERAL REGULATORY REQUIREMENTS

Nursing facilities, assisted living facilities and other healthcare
businesses are subject to licensure and other state and local regulatory
requirements. In addition, in order for a nursing facility to be approved for
payment under the Medicare and Medicaid reimbursement programs, it must meet the
participation requirements of the Social Security Act and related regulations.
The regulatory requirements for nursing facility licensure and participation in
Medicare and Medicaid generally prescribe standards relating to provision of
services, resident rights, staffing, employee training, physical environment and
administration. Nursing and assisted living facilities are generally subject to
unannounced annual inspections by state or local authorities for purposes of
licensure and for purposes of certification under Medicare and Medicaid, in the
case of nursing facilities. These surveys will also confirm that nursing
facilities continue to meet Medicare and Medicaid participation standards. All
of our nursing facilities are licensed under applicable state laws. In addition,
all of our nursing facilities are certified to participate in either the
Medicare program, the Medicaid program, or both.

ENVIRONMENTAL LAWS AND REGULATIONS

Some federal and state laws govern the handling and disposal of medical,
infectious and hazardous waste. If an entity fails to comply with those laws or
the related regulations, the entity could be subject to fines, criminal
penalties and other enforcement actions. Federal regulations established by the
Occupational Safety and Health Administration impose additional requirements on
us with regard to protecting employees from exposure to blood borne pathogens.
We have developed policies for the handling and disposal of medical, infectious
and hazardous waste to assure that each of our facilities complies with those
laws and regulations. We incur ongoing operational costs to comply with
environmental laws and regulations. However, we have not had to make material
capital expenditures to comply with those laws and regulations. We believe that
we substantially comply with applicable laws and regulations governing these
requirements.

HEALTH INSURANCE PORTABILITY AND ACCOUNTABILITY ACT

The administrative simplification provisions of the Health Insurance
Portability and Accountability Act mandate a set of interlocking regulations
that will establish the uniform coding conventions and record formats across all
payor types for all electronic transactions central to the processing of all
healthcare claims and health plan enrollments. These standards will allow
entities within the healthcare system to exchange medical, billing and other
information and to process transactions in a more timely and cost effective
manner. These new transactions and code sets must be implemented by October
2003. Also, new privacy standards will go into effect on April 14, 2003 that
will require operational changes throughout the healthcare industry in the
handling of all patient information. The privacy standards are designed to
protect the privacy of patients' medical information. The security standards,
issued in February 2003, will require compliance by April 21, 2005. All
standards are required to be fully implemented within two years of final
issuance, with civil and criminal penalties established for noncompliance. We
have established a work task force to review and implement the standards
required by the legislation and we are currently on schedule to comply with the
requirements.

NURSING FACILITY REGULATION

The Centers for Medicare and Medicaid Services has established regulations
to implement survey, certification and enforcement procedures. The survey
process is intended to review the actual provision of care and services, with an
emphasis on resident outcomes to determine whether the care provided meets the
assessed needs of the individual residents. Surveys are generally conducted on
an unannounced annual basis by state survey agencies. Remedies are assessed for
deficiencies based upon the scope and severity of the cited deficiencies. The
regulations specify that the remedies are intended to motivate facilities to
return to

16

compliance and to facilitate the removal of chronically poor performing
facilities from the program. Remedies range from:

- directed plans of correction, directed in-service training and state
monitoring for minor deficiencies;

- denial of Medicare or Medicaid reimbursement for existing residents or
new admissions and civil money penalties up to $3,000 per day for
deficiencies that do not immediately jeopardize resident health and
safety; and

- appointment of temporary management, termination from the program and
civil money penalties of up to $10,000 for one or more deficiencies that
immediately jeopardize resident health or safety.

The regulations allow state survey agencies to identify alternative
remedies that must be approved by the Centers for Medicare and Medicaid Services
prior to implementation.

Facilities with acceptable regulatory histories generally are given an
opportunity to correct deficiencies by a date certain, usually within six
months. The Centers for Medicare and Medicaid Services will continue payments
and refrain from imposing sanctions, unless the facility does not return to
compliance. Facilities with deficiencies that immediately jeopardize resident
health and safety and those that are classified as poor performing facilities
are not given an opportunity to correct their deficiencies prior to the
assessment of remedies. From time to time, we receive notices from federal and
state regulatory agencies alleging deficiencies for failing to comply with all
components of the regulations. While we do not always agree with the positions
taken by the agencies, we review all such notices and take corrective action
when appropriate. Due to the fact that the regulatory process provides us with
limited appeal rights, many alleged deficiencies are not challenged even if we
do not agree with the allegation.

While we try to comply with all applicable regulatory requirements, from
time to time some of our nursing facilities have been sanctioned as a result of
deficiencies alleged by the Centers for Medicare and Medicaid Services or state
survey agencies. In November 2000, we operated one facility in Indiana that lost
its certification under the Medicare and Medicaid programs, but that facility
has since been recertified under both programs. We cannot assure you that we
will not be sanctioned and penalized in the future.

The Centers for Medicare and Medicaid Services has launched the Nursing
Home Quality Initiative pilot program with the states of Colorado, Florida,
Maryland, Ohio, Rhode Island and Washington. This program, which is designed to
provide consumers with comparative information about nursing home quality
measures, will rate every nursing home operating in these states on nine quality
of care indicators. These quality of care indicators include such measures as
percentages of patients with infections, bedsores and unplanned weight loss.
This comparative data is available to the public on the Centers' web site and is
expected to be published in local newspapers. Based upon the success of the
pilot, CMS has announced its intention to roll out the program nationwide to all
other states. We believe that we have appropriate systems and mechanisms in
place to monitor care and service delivery. We expect that our facilities that
may not substantially comply with the regulations will ultimately substantially
comply. We cannot predict whether we will comply in the future and we could be
adversely affected if a substantial portion of our facilities were determined to
not comply with applicable regulations. We currently operate nursing homes in
Ohio and Washington.

RESTRICTIONS ON ACQUISITIONS AND CONSTRUCTION

Acquisition and construction of additional nursing facilities are subject
to state regulation. Most of the states in which we currently operate have
adopted laws to regulate expansion of skilled nursing facilities. Certificate of
need laws generally require that a state agency approve certain acquisitions or
physical plant changes and determine that a need exists prior to the addition of
beds or services, the implementation of the physical plant changes or the
incurrence of capital expenditures exceeding a prescribed amount. Some states
also prohibit, restrict or delay the issuance of certificates of need. In
addition, in most states the reduction of beds or the closure of a facility
requires the approval of the appropriate state regulatory agency. Our nursing
facility expansions comply with all state regulations regarding expansion. Prior
to engaging in any regulated expansion project, we have obtained certificates of
need, if required by law. If we decide to reduce beds or close a facility, we
could be adversely affected by a failure to obtain or a delay in obtaining such
approval. To
17

the extent that a certificate of need or other similar approvals are required
for expansion of our operations, either through facility acquisitions,
construction of new facilities or additions to existing facilities, or expansion
or provision of new services or other changes, our expansion proposals could be
adversely affected by an inability to obtain the necessary approvals, changes in
the standards applicable to such approvals and possible delays and expenses
associated with obtaining such approvals.

Acquisition, construction and operation of assisted living facilities are
subject to less stringent regulation than nursing facilities and, in the absence
of uniform federal regulations, states develop their own regulations. However,
since 1999 the term "assisted living facility" has been defined in 29 state
regulations and statutes, and approximately half of the remaining states have
regulations currently in effect or have proposed regulations regarding assisted
living facilities. Virtually every state has a licensure process, registration
process or some other form of regulation that may apply to assisted living
providers. If an assisted living provider supplies services that meet the
definition of a licensed level of care in the state, the provider must be
licensed. Licensure regulations can apply to admission and discharge criteria
and the variety and type of services provided. Many states require that buyers
submit building plans and receive state approval prior to construction. However,
the approval process is different from the certificate of need procedure, as it
is more of a clearance process than a demand formula. Assisted living facilities
must meet a stringent set of building construction and design regulations
including the Life Safety Code (NFPA101). State regulators conduct inspections
of assisted living facilities on a periodic basis similar to their inspections
of nursing facilities in most cases. Our assisted living facilities are
compliant in all material respects with applicable state licensure, building
construction and design regulations.

REGULATION OF FRAUD AND RELATED MATTERS

Because we participate in federal and state health care programs, we are
subject to a variety of federal and state laws that are intended to prevent
health care fraud and abuse. These laws are punishable by criminal and/or civil
sanctions, including, in some instances, exclusion from participation in federal
health programs, including Medicare, Medicaid and Department of Veterans Affairs
health programs. These laws, which include, but are not limited to,
anti-kickback laws, false claims laws, physician self-referral laws and federal
criminal health care fraud laws, are discussed in further detail below.
Management believes that both we and our subsidiaries have been and continue to
be in substantial compliance with all of these laws as they apply to us.

We believe our billing practices, operations and compensation and financial
arrangements with referral sources and others materially comply with applicable
federal and state requirements. However, we cannot assure you that a
governmental authority will not interpret such requirements in a manner
inconsistent with our interpretation and application. If we fail to comply, even
inadvertently, with any of these requirements, we could be required to alter our
operations and/or refund payments to the government. In addition, we could be
subject to significant penalties. Even if we successfully defend against any
action against us for violating these laws or regulations, we would likely be
forced to incur significant legal expenses and divert our management's attention
from the operation of our business. Any of these actions, individually or in the
aggregate, could have a material adverse effect on our business and financial
results. We cannot reasonably predict whether enforcement activities will
increase at the federal or state level or the effect of any such increase on our
business.

The illegal remuneration provisions of the Social Security Act make it a
felony to solicit, receive, offer to pay or pay any kickback, bribe or rebate in
return for referring a resident for any item or service or in return for
purchasing, leasing, ordering, recommending or arranging for any good, facility,
service or item, for which payment may be made under the federal healthcare
programs. A violation of the illegal remuneration statute may result in the
imposition of criminal penalties, including imprisonment for up to five years,
the imposition of a fine of up to $25,000, civil penalties and exclusion from
participating in federal health programs.

Recognizing that the law is broad and may technically prohibit beneficial
arrangements, the Office of Inspector General of the Department of Health and
Human Services developed regulations addressing those types of business
arrangements that will not be subject to scrutiny under the law. These safe
harbors describe

18

activities that may technically violate the act, but which are not to be
considered illegal when carried on in conformance with the regulations. For
example, the safe harbors cover activities such as contracting with physicians
or other individuals that have the potential to refer business to us that would
ultimately be billed to a federal health program. Failure to qualify for safe
harbor protection does not mean that an arrangement is illegal. Rather, the
arrangement must be analyzed under the anti-kickback statute to determine
whether there is an intent to pay or receive remuneration in return for
referrals. Conduct and business arrangements that do not fully satisfy one of
the safe harbors may result in increased scrutiny by government enforcement
authorities. In addition, some states have anti-kickback laws that may apply
regardless of whether a federal health care program is involved. Although our
business arrangements may not always satisfy all the criteria of a safe harbor,
we believe that our operations are in material compliance with federal and state
anti-kickback laws.

Under the federal "Stark II" law, physicians are prohibited from making a
referral to an entity for the furnishing of designated health services,
including therapy services, for which Medicare or Medicaid may pay, if the
physician, or an immediate family member of the physician, has a financial
relationship, including ownership interests and compensation arrangements, with
that entity, and the relationship fails to meet a statutory or regulatory
exception to the rule. The penalties for violating this act include denial of
payment, additional financial penalties and exclusion from participating in
federal health programs. In addition, a number of states have enacted their own
versions of self-referral laws.

The Federal False Claims Act and similar state statutes prohibit
presenting, a false or misleading claim for payment under a federal program.
Violations can result in significant civil penalties, treble damages and
exclusion from participation in federal programs. Liability arises, primarily,
when an entity knowingly submits a false claim for reimbursement to the federal
government. However, enforcement over the past few years has expanded the
traditional scope of this act to cover quality of care issues, especially in the
skilled nursing facility context. In addition to the civil provisions of the
False Claims Act, the federal government can use several other criminal statutes
to prosecute persons who submit false or fraudulent claims for payment to the
federal government.

Federal law provides that practitioners, providers and related persons may
not participate in most federal healthcare programs, including the Medicare and
Medicaid programs, if the individual or entity has been convicted of a criminal
offense related to the delivery of an item or service under these programs or if
the individual or entity has been convicted, under state or federal law, of a
criminal offense relating to neglect or abuse of residents in connection with
the delivery of a healthcare item or service. Other individuals or entities may
be, but are not required to be, excluded from such programs under certain
circumstances, including the following:

- conviction related to fraud;

- conviction relating to obstruction of an investigation;

- conviction relating to a controlled substance;

- licensure revocation or suspension;

- exclusion or suspension from state or federal healthcare programs;

- filing claims for excessive charges or unnecessary services or failure to
furnish medically necessary services;

- ownership or control by an individual who has been excluded from the
Medicaid and/or Medicare programs, against whom a civil monetary penalty
related to the Medicaid and/or Medicare programs has been assessed or who
has been convicted of the crimes described in this paragraph; and

- the transfer of ownership or control interest in an entity to an
immediate family or household member in anticipation of, or following, a
conviction, assessment or exclusion.

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CROSS DECERTIFICATION AND DE-LICENSURE

In some circumstances, if one facility is convicted of abusive or
fraudulent behavior, then other facilities under common control or ownership may
be decertified from participating in Medicaid or Medicare programs. Executive
Order 12549 prohibits any corporation or facility from participating in federal
contracts if it or its principals have been barred, suspended or are ineligible
or have been voluntarily excluded from participating in federal contracts. In
addition, some state regulations provide that all facilities under common
control or ownership licensed within a state may be de-licensed if any one or
more of the facilities are de-licensed. To date, neither we nor our subsidiaries
have experienced any cross-decertifications and none of our or our subsidiaries
facilities have been de-licensed.

OFFICE OF THE INSPECTOR GENERAL

In 1995, a major anti-fraud demonstration project, "Operation Restore
Trust" was announced by the Office of the Inspector General, which guaranteed
funding for fraud and abuse activities and coordinated efforts among multiple
federal and state agencies. A primary purpose for the operation is to scrutinize
the activities of healthcare providers who are reimbursed under the Medicare and
Medicaid programs. Initial investigation efforts have focused on skilled nursing
facilities, home health and hospice agencies and durable medical equipment
suppliers in Texas, Florida, New York, Illinois and California. In May 1997, The
Department of Health and Human Services announced that the operation would be
expanded in the future to include several other types of healthcare services and
several additional states, with the intent that it will ultimately be a
nationwide operation. Over the longer term, the operation's enforcement actions
could include criminal prosecutions, suit for civil penalties and/or Medicare,
Medicaid or federal healthcare program exclusions. Prior to our November 1997
acquisition of Arbor Health Care Company, one of its subsidiary's facilities was
charged with inadequately documented therapy services. Following this
investigation, Arbor adopted measures to strengthen its documentation relating
to reimbursable services. While we do not believe that we are the target of any
such investigation under operation restore trust, we cannot assure you that we
will not expend substantial amounts to cooperate with any such investigation or
to defend allegations that may arise from an investigation. If a government
agency finds that any of our practices failed to comply with the anti-fraud
provisions, we could be materially adversely affected.

NEW INITIATIVES

There are ongoing initiatives at the federal and state levels for
comprehensive reforms affecting the payment for and availability of health care
services. Aspects of some of these health care initiatives, such as the
termination of Medicare funding improvements and limitations on Medicare
coverage, other pressures to contain health care costs by Medicare, Medicaid and
other payors, as well as increased operational requirements in the
administration of Medicaid, could adversely affect us. We cannot predict the
ultimate content, timing or effect of any health care reform legislation, nor
can we estimate the impact of potential legislation on us.

CORPORATE COMPLIANCE PROGRAM

Our Corporate Compliance Program was developed to assure that we achieve
our goal of providing a level of service in a manner consistent with all
applicable state and federal laws and regulations, and our internal standards of
conduct. Our Corporate Compliance Program incorporates the elements included in
the guidance issued by the Office of the Inspector General. As part of our
Corporate Compliance Program, our employees must acknowledge their
responsibility to comply with relevant laws, regulations and policies, including
our Corporate Compliance Program. We have a Corporate Compliance Officer
responsible for administering our Corporate Compliance Program who reports to
the Board of Extendicare and our Chief Executive Officer.

INSURANCE

We currently maintain insurance policies for property coverage, workers'
compensation and employer's liability insurance in amounts and with such
coverage and deductibles as we believe adequate, based on

20

availability, the nature and risks of our business, historical experience and
industry standards. These policies are obtained through both affiliated
subsidiaries of Extendicare Inc. and third-party insurers. We self-insure for
health and dental claims, workers' compensation and employer's liability in
certain states. Management believes that our skilled nursing facilities,
assisted living facilities and rehabilitation therapy clinics are adequately
insured.

As a result of limited availability from third party insurers or
availability at an excessive cost or deductible, since January 2000, we
generally self insure for comprehensive general and professional liability
(including malpractice insurance for our health providers, assistants and other
staff, as it relates to their respective duties performed on our behalf) up to a
certain amount per incident. In January 2000, our retained risk for general and
professional liability coverage increased significantly resulting in us
providing accruals based upon past claims and actuarial estimates of the
ultimate cost to settle claims. Those risks were significantly reduced when we
ceased operations of all Florida facilities in 2000 and Texas nursing facilities
in the fourth quarter of 2001. As of December 31, 2002, we have provided for
$55.1 million in accruals for known or potential general and professional
liability claims based on claims experience and an independent actuarial review.
Based upon such claims experience and independent actuarial review, we believe
that our accrual is adequate to cover any losses from general and professional
liability claims. General and professional liability claims are the most
volatile and significant of the risks that we self-insure.

LEGAL PROCEEDINGS

For information regarding legal proceedings, please see Item 1 -- "Risk
Factors in the Industry", Item 3 -- "Legal Proceedings" and Item
7 -- "Management Discussion and Analysis of Financial Condition and Results of
Operations."

EMPLOYEES

As of December 31, 2002, we employed approximately 19,300 people, including
approximately 3,600 registered and licensed practical nurses, 7,900 nursing
assistants, 1,700 therapists, 4,400 dietary, domestic, maintenance and other
staff and 1,300 administrative employees who work at our corporate offices and
facilities. We have approximately 36 collective bargaining agreements, 15 of
which expire within 12 months of March 31, 2003, among seven unions covering
approximately 2,200 employees. As of December 31, 2002 we were in the process of
negotiating two of these collective bargaining agreements. As of March 22, 2003
we are still in the process of negotiating one of these collective bargaining
agreements. We believe that we have a good relationship with all of our
employees.

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ITEM 2. PROPERTIES

At December 31, 2002, we owned, leased or managed 197 long-term care
facilities with 18,269 beds in 15 states, of which 156 were nursing facilities
with 16,357 beds and 41 were assisted living facilities with 1,912 units. In
addition, we own long-term care properties of which 10 were nursing properties
with 1,065 beds that were leased and operated by unrelated nursing home
providers. We also retain an interest in, but do not operate, 11 nursing
properties with 1,435 beds and four assisted living properties with 135 units.
At December 31, 2002, we also operated 22 rehabilitative therapy clinics: ten in
Pennsylvania, one in Ohio, two in Texas and nine in Wisconsin. The following
table lists by state, the nursing, assisted living and retirement facilities
that we owned, leased or managed at December 31, 2002:

- ---------------
(1) The remaining life of the leases, including renewal options exercisable
solely by us, ranges from one to ten years, the average being four years. We
retain an option to purchase the leased property for 5 of the 11

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leased properties. For lease payment information, please see Note 14 to our
consolidated financial statements.

(2) In October 2002, we completed the purchase of seven previously-leased
facilities in Ohio and Indiana.

(3) Consulting services provided to the facilities listed include billing,
accounts receivable tracking, invoice processing, payroll, financial
reporting and cost reimbursements services.

(4) We own 10 skilled nursing properties held under lease arrangements with two
unrelated long-term care operators whose terms include an option to purchase
the properties. Senior Health Properties -- South leases six properties
whose term matures on December 31, 2006. Senior Health Properties,
Texas -- Inc. leases 4 properties whose term matures on September 30, 2006.
In addition, Senior Health Properties, Texas -- Inc. subleases 12 leased
facilities whose term matures in February 2012. The facilities we lease to
Senior Health Properties -- South, Inc. and Senior Health
Properties -- Texas, Inc. are included in the facilities for which we
provide consulting services.

(5) We retain an interest in 11 nursing facilities with 1,435 beds and four
assisted living facilities with 135 units in Florida pursuant to the
Greystone divestiture agreement. Pursuant to this agreement we retain
contingent consideration in the form of a series of interest bearing notes
which have an aggregate potential value of up to $30.0 million plus
interest. See "Management's Discussion and Analysis of Financial Condition
and Results of Operations -- Significant Events -- Asset Divestitures."

The number of skilled nursing beds and assisted living units identified in
the above table and throughout this report represents the approximate number of
operational beds and units that we currently use. The number of operational beds
and units is subject to periodic changes and can be less than the licensed
number of beds approved by the state due to market and other factors.

ITEM 3. LEGAL PROCEEDINGS

We and our subsidiaries are defendants in actions against us or them from
time to time in connection with our operations and due to the nature of our
business. These actions may include civil or criminal actions from personal
injury and wrongful death suits arising out of allegation of professional
malpractice brought against us, one or more of our facilities, or the
individuals who work at particular facilities. We are unable to predict the
ultimate outcome of pending litigation and other investigations. We cannot
assure you that claims will not arise that are in excess of our insurance
coverage, are not covered by our insurance coverage or result in punitive damage
being assessed against us. In addition, we cannot assure you that the United
States Department of Justice, the Centers for Medicare and Medicaid or other
regulatory agencies will not initiate investigations related to our businesses
in the future. A successful claim against us that is not covered by, or is in
excess of, our insurance could have a material adverse effect on our financial
condition and results of operation. Claims against us, regardless of their merit
or eventual outcome, would require management to devote time to matters
unrelated to the operation of our business and, due to publicity, may also have
a material adverse effect on our ability to attract residents or expand our
business.

We have experienced an increasing trend in the number and severity of
litigation claims asserted against us. We believe that this trend is endemic to
the long-term care industry and is a result of the increasing number of large
judgments, including large punitive damage awards, against long-term care
providers in recent years resulting in an increased awareness by plaintiff's
lawyers of potentially large recoveries. This has been particularly the case in
the states of Florida and Texas where the Company has ceased to operate skilled
nursing facilities within. As a result of the litigious environment, insurance
coverage for general and professional liability claims has increased and in
certain states become unavailable to operators, as insurance companies have
refrained from providing insurance in certain states. There can be no assurance
that we will not be liable for claims in excess of the amounts provided or for
punitive damages awarded in such litigation cases. We also believe that there
has been, and will continue to be, an increase in governmental investigations of
long-term care providers, particularly in the area of Medicare/Medicaid false
claims as well as an increase in enforcement actions resulting from these
investigations. Adverse determination in legal proceedings or governmental
investigations, whether currently asserted or arising in the future, could have
a material adverse effect on us.

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As referred to in the Management's Discussion and Analysis of Financial
Condition and Results of Operation, Item 7, pursuant to the disposition of our
pharmacy operations in 1998, we entered into a Preferred Provider Agreement with
Omnicare, Inc. The terms of the Preferred Provider Agreement enabled Omnicare to
execute Pharmacy Service Agreements and Consulting Service Agreements with all
of our skilled nursing facilities. In 2001, we and Omnicare brought a matter to
arbitration involving "per diem" pricing rates billed for managed care
residents. This matter was subsequently settled and amounts reflected within the
financial results. We are currently negotiating the pricing of drugs for
Medicare residents and should this matter not be settled, the matter will be
taken to arbitration. In addition, in connection with its agreements to provide
pharmacy services, Omnicare has requested arbitration for an alleged lost
profits claim related to our disposition of assets, primarily in Florida. Damage
amounts, if any, cannot be reasonably estimated based on information available
at this time. We and Omnicare continue to discuss the claim and should we fail
to resolve the matter, the claim will be taken to an arbitration hearing. An
arbitration hearing has not been scheduled. We believe that we have interpreted
correctly and complied with the terms of the agreement, however there can be no
assurance that other claims will not be made with respect to the agreement.

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

Not applicable

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PART II

ITEM 5. MARKET FOR REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS

Extendicare Inc. owns all of our outstanding common stock.

ITEM 6. SELECTED FINANCIAL DATA

The following table summarizes our selected financial data, which is
derived from our consolidated financial statements as audited by KPMG LLP, our
independent certified public accountants. You should read the following
information in conjunction with our consolidated financial statements included
at Item 8 and Management's Discussion and Analysis of Financial Condition and
Results of Operation included at Item 7 of this Annual Report on Form 10-K.

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ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATION

OVERVIEW

Based on number of beds, we are one of the largest providers of long-term
care and related services in the United States. As of December 31, 2002, we
operated 139 nursing facilities with 14,101 beds and 36 assisted living and
retirement facilities with 1,756 units that we owned or leased in 13 states. In
addition, we managed 17 nursing facilities with 2,256 beds and five assisted
living and retirement facilities with 156 units and provided selected consulting
services to 38 nursing facilities with 4,097 beds and one assisted living
facility with 116 beds owned by third parties. In total, we operated, managed or
provided selected consulting services to 236 long-term care facilities with
22,482 beds in 16 states, of which 194 were nursing facilities with 20,454 beds
and 42 were assisted living and retirement facilities with 2,028 units.

REVENUES

We derive revenues by providing healthcare services in our network of
facilities, including long-term care services such as nursing care, assisted
living and related medical services such as subacute care and rehabilitative
therapy. We derive nursing and assisted living facility revenues by providing
routine and ancillary services for our facilities' residents. We derive
outpatient therapy revenues by providing such services to outside third parties
at our clinics.

We generate our revenue from Medicare, Medicaid and private pay sources.
The following table sets forth our Medicare, Medicaid and private pay sources of
revenue by percentage of total revenue:

LEGISLATIVE ACTIONS AFFECTING REVENUES

Prior to October 1, 2002, the incremental Medicare relief packages received
from the Balanced Budget Refinement Act, or BBRA, and the Benefits Improvement
and Protection Act, or BIPA, provided a total of $2.7 billion in temporary
Medicare funding enhancements to the long-term care industry. The funding
enhancements implemented by the BBRA and BIPA fall into two categories. The
first category is "Legislative Add-ons," which includes a 16.66% add-on to the
nursing component of the Resource Utilization Groupings, or RUGs rate and a 4%
base adjustment. The second category is "RUGs Refinements" which involved an
initial 20% add-on for 15 RUGs categories identified as having high intensity,
non-therapy ancillary services. Twenty percent add-ons from three RUGs
categories were later redistributed to 14 rehabilitation categories at an add-on
rate of 6.7% each.

The Legislative Add-ons expired on September 30, 2002 and the Company's
Medicare funding has been reduced. Based on the Medicare case mix and census
over the nine months ended September 30, 2002 we received an estimated average
rate of $31.22 per resident day relating to the Legislative Add-ons. Offsetting
this, on October 1, 2002 long-term care providers received a 2.6% market basket
increase in Medicare rates. The impact of these two items in the fourth quarter
of 2002 was a net decline in our average rate of $23.64 per patient day, which
based upon the Medicare case mix and patient days for the year ended December
31, 2002, amounts to lower annualized revenues of approximately $14.7 million
going forward.

With respect to the RUGs Refinements, on April 23, 2002 CMS announced that
it would delay the refinement of the RUGs categories thereby extending the
related funding enhancements for at least one additional year to September 30,
2003. Further to this, in the budget report released in February 2003, President
Bush proposed additional funding to extend the RUGs Refinements to September 30,
2004 and though the President's budget has not been passed, CMS has agreed
verbally with the extension of the RUGs

26

refinements to September 30, 2004. Based upon the Medicare case mix and census
for the year ended December 31, 2002, we estimate that we received an average
$24.40 per resident day, which on an annualized basis amounts to $15.1 million
related to the RUGs Refinements. A decision to discontinue all or part of the
enhancement could have a significant impact on us.

In the February 2003 budget, President Bush proposed plans for reductions
in the annual market basket increase for skilled nursing facilities from October
1, 2003 to October 1, 2007. If this budget is passed, it will mean reductions in
the market basket increase for the industry of $60 million starting in October
2003; $140 million in October 2004; $240 million in October 2005; $350 million
in October 2006; and $470 million in October 2007.

In January 2003, CMS announced that the moratorium on implementing payment
caps for outpatient Part B therapy services, which were scheduled to take effect
on January 1, 2003, would be extended for six months until July 1, 2003. The
impact of a payment cap cannot be reasonably estimated based on the information
available at this time, however such a cap would reduce therapy revenues.

In February 2003, CMS announced its plan to reduce its level of
reimbursement for uncollectible Part A co-insurance. Under current law, skilled
nursing facilities are reimbursed 100% of bad debts incurred. Over the next
three years, HHS plans to reduce the reimbursement level to 70% as follows: 90%
effective for the government fiscal year commencing October 1, 2003; 80%
effective for the government fiscal year commencing October 1, 2004; and 70%
effective for government fiscal years commencing on or after October 1, 2005.
This plan is consistent with the Part A co-insurance reimbursement plan
applicable to hospitals. We estimate that, should this plan be implemented, the
impact to net earnings would be $1.0 million in 2004, increasing to $2.5 million
in 2006.

INCOME TAXES

Income tax expense in 2002 was $4.3 million compared to an income tax
benefit of $12.5 million in 2001. Our effective tax rate was 46.3% in 2002 as
compared to 31.2% in 2001. In assessing the realizability of deferred tax
assets, we consider whether it is more likely than not that all or some portion
of the deferred tax assets will not be realized. The ultimate realization of
deferred tax assets depends upon us generating future taxable income during the
periods in which temporary differences become deductible. We consider the
scheduled reversal of deferred tax liabilities, projected future taxable income
and tax planning strategies in making this assessment. In 2002 and 2001 we
increased our valuation allowance by $0.8 million and $2.8 million,
respectively. The amount of the deferred tax assets considered realizable could
be reduced if estimates of future taxable income during the carryforward period
are reduced.

ASSET IMPAIRMENT COSTS

We are required to accrue for asset impairment costs when indicators of
impairment are present and the undiscounted cash flows from the assets do not
appear to be sufficient to recover the assets' carrying value. The impairment
loss is measured by comparing the fair value of the asset to its carrying
amount. Accordingly, we have estimated the future cash flows of each facility
and reduced the corresponding carrying value to the estimated fair value, where
appropriate. Such estimates are subject to change due to factors both within and
outside our control. If those changes reduce estimated future cash flows, we may
be required to record further impairment provisions in subsequent periods. We
recorded provisions of $1.7 million in 2001 and $20.7 million in 2000, related
to the impairment of assets.

CRITICAL ACCOUNTING POLICIES

Our consolidated financial statements have been prepared in conformity with
accounting principles generally accepted in the United States, or GAAP. For a
full discussion of our accounting policies as required by GAAP, refer to the
accompanying notes to the consolidated financial statements. We consider the
accounting policies discussed below to be critical to an understanding of our
financial statements because their application requires significant judgment and
reliance on estimations of matters that are inherently uncertain. Specific risks
related to these critical accounting policies are described below.
27

REVENUE RECOGNITION AND ACCOUNTS RECEIVABLE

We derive our revenues primarily from providing long-term healthcare
services in the nursing and assisted living facilities we operate. Nursing
facility revenue results from the payment for services and products from federal
and state-funded cost reimbursement programs as well as private pay residents.
More than 75% of our revenues are derived from services provided under various
federal or state medical assistance programs.

We recognize nursing home revenues in the period in which we provide
services and or deliver products at established rates less contractual
adjustments. Contractual adjustments include differences between our established
billing rates and amounts estimated by management as reimbursable under various
reimbursement formulas or contracts in effect. Estimation differences between
final settlements and amounts recorded in previous years are reported as
adjustments to revenues in the period such settlements are determined. Due to
the complexity of the laws and regulations governing the federal and state
reimbursement programs, there is a possibility that recorded estimates may
change by a material amount.

We derive assisted living facility revenue primarily from private pay
residents in the period in which we provide services and at rates we establish
based upon the services provided and market conditions in the area of operation.

We record accounts receivable at the net realizable value we expect to
receive from federal and state reimbursement programs, other third-party payors
or individual residents. We also estimate which receivables may be collected
within one year and reflect those not expected to be collected within one year
as non-current. We continually monitor and adjust our allowances associated with
these receivables. We record allowances for bad debts from other third-party
payors or from individual patients based upon a specific assessment of an
account's collection risk and our historical experience by payor type. If
circumstances change, for instance due to economic downturn, resulting in higher
than expected defaults or denials, our estimates of the recoverability of our
receivables could be reduced by a material amount. Our allowance for doubtful
accounts for current accounts receivable totaled $9.3 million and $14.5 million
at December 31, 2002 and 2001, respectively. Our allowance for doubtful accounts
for non-current accounts receivable totaled $15.4 million at December 31, 2002
and 2001.

Prior to the implementation of the Prospective Payment System in 1999,
Medicare was a cost-based reimbursement program, and in the ordinary course of
business we continue to have ongoing discussions with the fiscal intermediary
regarding the treatment of various items related to prior years' cost reports.
Normally disputes are resolved in the audit process; however, we record general
provisions for disagreements that require settlement through a formal appeal
process.

VALUATION OF ASSETS AND ASSET IMPAIRMENT

We record property and equipment at cost less accumulated depreciation and
amortization. We depreciate and amortize these assets using a straight-line
method based upon the estimated lives of the assets. Goodwill represents the
cost of the acquired net assets in excess of their fair market values. Effective
January 1, 2002, we adopted SFAS No. 142 and no longer amortize goodwill and
intangible assets with indefinite useful lives. Instead we test for impairment
at least annually; whereas prior to 2002, these assets were amortized using a
straight-line method over a period of no more than forty years. Other intangible
assets, consisting of the cost of leasehold rights, are deferred and amortized
over the term of the lease including renewal options. We periodically assess the
recoverability of long-lived assets, including property and equipment, goodwill
and other intangibles, when there are indications of potential impairment based
upon the estimates of undiscounted future cash flows. The amount of any
impairment is calculated by comparing the estimated fair market value with the
carrying value of the related asset. We consider such factors as current
results, trends and future prospects, current market value and other economic
and regulatory factors in performing these analyses.

A substantial change in the estimated future cash flows for these assets
could materially change the estimated fair values of these assets, possibly
resulting in an additional impairment. In response to the

28

implementation of the Medicare Prospective Payment System, increased litigation,
insurance costs in certain states and increased operational costs resulting from
changes in legislation and regulatory scrutiny, over the past several years we
have focused on divesting under-performing nursing and assisted living
facilities and non-core healthcare assets. As detailed in Footnote 4 to our
consolidated financial statements, losses from asset impairments and disposals
and provisions for closure and exit costs and other items have totaled $1.3
million, $25.9 million and $27.4 million in 2002, 2001 and 2000, respectively.

SELF-INSURED LIABILITIES

Insurance coverage for patient care liability and other risks has become
increasingly difficult to obtain. We insure certain risks with affiliated
insurance subsidiaries of Extendicare Inc. and third-party insurers. The
insurance policies cover comprehensive general and professional liability,
property coverage, workers' compensation and employer's liability insurance in
amounts and with such coverage and deductibles as we deem appropriate, based on
the nature and risks of our business, historical experiences, availability and
industry standards. We self-insure for health and dental claims, in certain
states for workers' compensation and employer's liability, and since January
2000, for general and professional liability claims.

We accrue our self-insured liabilities based upon past trends and
information received from an independent actuary. We regularly evaluate the
appropriateness of the carrying value of the self-insured liabilities through an
independent actuarial review. Our estimate of the accrual for general and
professional liability costs is significantly influenced by assumptions, which
are limited by the uncertainty of predicting future events, and assessments
regarding expectations of several factors. Such factors include, but are not
limited to: the frequency and severity of claims, which can differ materially by
jurisdiction; coverage limits of third-party reinsurance; the effectiveness of
the claims management process; and the outcome of litigation.

Changes in our level of retained risk, and other significant assumptions
that underlie our estimate of self-insured liabilities, could have a material
effect on the future carrying value of the self-insured liabilities. For
example, in 2000, we experienced adverse claims development. In 2000 our per
claim retained risk increased significantly for general and professional
liability coverage mainly due to the level of risks associated with our Florida
and Texas operations. We no longer operate nursing or assisted living facilities
in Florida or nursing operations in Texas. However, as a result of the increase
in the frequency and severity of claims, in 2001 we recorded a provision of
$29.2 million for resident care liability including an $11.0 million provision
relating to disposed operations included in provision for closure and exit costs
and in 2002 we recorded a provision of $5.3 million. Our accrual for
self-insured liabilities totaled $55.1 million and $70.3 million at December 31,
2002 and 2001, respectively.

DEFERRED TAX ASSETS

Our results of operations are included in the consolidated federal tax
return of our U.S. parent company. Accordingly, federal current and deferred
income taxes payable (or receivable) are transferred to our parent company.
Deferred tax assets and liabilities are recognized to reflect the expected
future tax consequences attributed to differences between the financial
statement carrying amounts of existing assets and liabilities and their
respective tax bases and operating loss and tax credit carryforwards. We measure
deferred tax assets and liabilities using enacted tax rates expected to apply to
taxable income in the years in which we expect those temporary differences to be
recovered or settled. We establish a valuation allowance based upon our estimate
of whether it is more likely than not that some portion or all of the deferred
tax assets will not be realized. The ultimate realization of deferred tax assets
depends upon us generating future taxable income during the periods in which
those temporary differences become deductible. We consider the scheduled
reversal of deferred tax liabilities, projected future taxable income and tax
planning strategies in making this assessment. Our valuation allowance for net
state deferred tax assets totaled $21.0 million and $20.2 million at December
31, 2002 and 2001, respectively.

29

SIGNIFICANT EVENTS

ISSUANCE OF SENIOR NOTES

On June 28, 2002 we completed a private placement of $150 million of our
9.5% Senior Notes due July 1, 2010, which were issued at a discount of 0.25% of
par to yield 9.54%. In January 2003, we completed the offer to exchange our 9.5%
Senior Notes due 2010 that have been registered under the Securities Act of 1933
for the Notes issued in June 2002. The terms of the new Senior Notes are
identical to the terms of the Senior Notes issued in June 2002 and are
guaranteed by all of our existing and future active subsidiaries.

We used the proceeds of $149.6 million to pay $8.3 million of related fees
and expenses, retire $130.8 million of debt (consisting of $124.5 million
outstanding under the previous credit facility and $6.3 million of other debt),
and the remainder for general corporate purposes. We had hedged a portion of our
previous variable-rate long-term debt through an interest rate swap with a
notional amount of $25 million maturing in February 2003. Upon refinancing of
the debt, we terminated this swap with a cash payment of $0.6 million. This
amount and other deferred financing costs related to the previous credit
facility, totaling $2.8 million, were written off in June 2002 and reported on
the income statement as an extraordinary item. The after-tax amount of this item
was $1.7 million.

PURCHASE OF PREVIOUSLY-LEASED FACILITIES

In October 2002, we purchased three skilled nursing facilities in Ohio and
four skilled nursing facilities in Indiana that we previously leased for an
aggregate purchase price of $17.9 million. The purchase price consisted of $7.4
million in cash and a $10.5 million ten-year note, which bears interest at a
rate to be determined by arbitration (currently being accrued at 10.5%).

LOSS ON DISPOSAL OF ASSETS, PROVISION FOR CLOSURE AND EXIT COSTS, AND IMPAIRMENT
OF LONG-LIVED ASSETS

A number of significant factors adversely affected our industry and us over
the past few years, which resulted in losses on disposal of assets, provisions
for closure and exit costs, and impairment of long-lived assets. These factors
include the following:

- Increased Litigation Settlements and Insurance Costs for General and
Professional Liability Claims. A report issued by AON Risk Consultants
for the American Health Care Association in February 2002 indicates that
the average insurance cost for general liability and professional
liability increased at an average of 24% per year from 1990, when the
average cost was $240 per bed, to $2,360 per bed in 2001. The report
further states that the increased cost for general and professional
liability coverage has absorbed approximately 20% of the average Medicaid
reimbursement rate increase from 1995 to 2000. Increased litigation
settlement and insurances costs have particularly occurred in the states
of Florida, Texas and California.

- Inadequate Funding Levels in Some States or Resident Classifications in
Both the Medicaid and Medicare Programs. For example, in 2002 we received
on average $331 per day for a Medicare resident, while care for similar
residents funded under the Medicaid program averaged $125 per day.
According to the Health Care Industry Market Update dated February 6,
2002, which is published by the Centers for Medicare and Medicaid
Services, Medicaid programs inadequately fund our industry.

- Increased Costs Incurred as a Result of Increased Regulatory
Requirements. For example, we have estimated that the cost of compliance
with the Health Insurance Portability and Accountability Act regulations
that come into effect in 2002 and 2003, including upgrading computer
software, modifying operating practices, purchasing equipment and
training employees, will exceed $500,000.

- Increased Wages and Premiums Paid to Nursing Assistants, Domestic Staff
and Temporary Agencies for Professional Nursing Staff. These increases
are mainly due to increased competition for service level staffing and a
national shortage of qualified nurses. Our wages increased 6.9% in 2002
over 2001 and we incurred temporary agency costs of $10.2 million in
2002, which includes an agency margin of approximately 25% to 30%,
compared to $18.4 million in 2001. Medicaid rates increased only 5.0% in

30

this same period. According to an article published in the March/April
2002 Volume of the North Carolina Medical Journal, between 2000 and 2010
there will be 874,000 more care workers needed in the long-term care
industry. According to the U.S. Labor Department, there will be a 1.0
million shortfall of professional nurses by 2010.

In response to the above challenges, we identified, planned and implemented
actions involving the divestiture of non-core health care assets, the exiting of
all skilled nursing facilities in specific states, and the divestiture of other
under-performing facilities. As a result, we recorded significant:

- loss (gain) on the disposal of assets;

- provisions for closure and exit costs; and

- loss on the impairment of long-lived assets

Below is a summary of the significant transactions which resulted in the
above provisions, gains and losses.

In May 2002, Tandem Health Care, Inc. exercised its option to purchase
seven properties that it leased from us in Florida for gross proceeds of $28.6
million, consisting of cash of $15.6 million and $13.0 million in 8.5% five-year
notes. The carrying value of the seven facilities was $25.3 million. We applied
$12.4 million of the proceeds to reduce our bank debt and, as a result, we
recorded a gain on the sale of assets of $4.0 million, inclusive of the deferred
gain of $2.2 million from the April 2001 transaction described below.

In 2001, we transferred all of our Texas nursing home operations to
affiliates of Senior Health Properties-Texas, Inc. The transaction involved 17
nursing homes, with a capacity of 1,421 residents. We now lease four of these
facilities to Senior Health-Texas under a five-year lease, which will expire in
September 2006, and sublease 12 of these facilities to Senior Health-Texas under
an eleven-year sublease, which will expire in February 2012. The final property
was sublet for one month to a Senior Health-Texas affiliate until October 31,
2001, the remainder of the lease term. The Senior Health-Texas affiliate
transferred the operations of this final property to an unrelated third party
and terminated its leasehold interest on November 1, 2001. We receive annual
rental income from the properties of approximately $3.8 million, which is $1.8
million more than our current annual lease costs. Our annual rental income will
escalate in alignment with the increases in rent expense under the existing
leases and in alignment with improvements in operating income for the owned
facilities. Senior Health-Texas has a right of first refusal with respect to any
offer to purchase one or more of the four owned facilities.

In April 2001, Tandem exercised its option to purchase two leased
properties in Florida. Upon Tandem's exercise of its option, we received gross
proceeds of $11.4 million, consisting of cash of $7.0 million, a $2.5 million
8.5% interest-bearing five-year note and $1.9 million in 9% cumulative dividend
preferred shares, mandatorily redeemable after five years. The carrying value of
the two facilities on our books was $9.2 million. We deferred a potential gain
on the sale of these assets of $2.2 million because a significant portion of the
proceeds had not been received (FASB 66) and the ultimate determination of the
gain was dependent on Tandem exercising some or all of the remaining purchase
options available to it. We applied $4.0 million of the net proceeds to reduce
our term bank debt.

In 2000, we disposed of or leased all 32 of our facilities with 3,427 beds
in Florida through a series of transactions. We sold two Florida nursing
facilities in separate transactions in July and December 2000. In September
2000, we entered into an agreement involving 15 facilities with Greystone
Tribeca Acquisition LLC in which we retain an interest in the properties in the
form of a series of interest bearing notes, which have an aggregate value of up
to $30.0 million. The notes have a maximum term of three and one half years and
may be retired at any time out of the proceeds from the sale or refinancing of
the facilities by Greystone. During the term of the notes, the Company retains
an interest in these facilities by way of a right of first refusal and an option
to repurchase the facilities in March 2004, which if not accepted, will trigger
repayment of the balance of the notes. The option to repurchase, along with the
significant portion of the sales price being contingent, results in the
disposition being accounted for as a deferred sale. This particular transaction,
while not accounted for as a sale, resulted in initial net cash proceeds of
$30.0 million in addition to the contingent

31

notes. In December 2000, we transferred the operations and leased the properties
of nine Florida facilities to Tandem and of six Florida facilities to Senior
Health Properties-South, Inc. Under the leases, the Tandem and Senior Health
Properties-South have options to purchase their respective properties. We also
sold two formerly closed facilities, which together with the Florida
divestitures, resulted in total cash proceeds of $37.7 million, of which $33.1
million was used to reduce our bank debt. The dispositions, in addition to
provisions for the closure of two nursing and one assisted living facilities and
provisions for other non-core assets, resulted in a total loss from the
disposition of assets of $6.7 million in 2000, including a loss on disposal of
assets of $3.3 million and a provision for closure and exit costs of $3.4
million.

We have recorded provisions for all estimated future costs related to
operations that we disposed of. Those estimates were made at the time of
disposition and can be subject to revisions which may impact our future
earnings.

As a result of the divestiture programs in Florida and Texas, we received
cash proceeds and notes and we retained ownership of certain nursing home
properties and entered into on-going consulting service agreements with
operators in these two states. As of December 31, 2002, we:

- held $21.6 million in notes from Tandem;

- owned six leased nursing home properties in Florida and four leased
nursing home properties in Texas with a net book value of $17.0 million;
and

- subleased 12 properties in Texas to another long-term care operator.

The six remaining Florida leases expire in December 2005. The Texas leases
expire in September 2006 and the Texas subleases expire in February 2012. In
addition, we provide on-going management and consulting services to and earn
rental income from the operators of these facilities. As of December 31, 2002,
we had $9.6 million in accounts receivable from long-term care operators for
whom we provided management and consulting services, which included interim
working capital advances related to the transfer of ownership. As a result, our
earnings and cash flow can be influenced by the financial stability of these
unrelated companies.

OTHER ITEMS

On an ongoing basis we review the levels of our overall reserves for losses
related to our Florida and Texas operations, which reserves were initially
established when we decided to exit these states. See footnote 4 to our
consolidated financial statements. During 2002, as a result of events which
became known to us in 2002, we concluded that we should increase our overall
reserves by $5.3 million for cost report and other settlements with the state of
Florida and other Medicare fiscal intermediaries, collection of receivables, and
settlement of claims with suppliers and employees.

As of December 2002, we are pursuing settlement of a number of outstanding
Medicaid and Medicare receivable balances. Due to the length of the settlement
process, some of those receivables are not expected to be collected within one
year and, as a result, are classified as long-term other assets. Normally such
issues are resolved during the audit process; however we record general
provisions for disagreements that require settlement through a formal appeal
process. For one specific issue involving the allocation of overhead costs
totaling $14.8 million, the first of three specific claim years was presented to
the Provider Reimbursement Review Board, or PRRB, at a hearing on January 30,
2003. The hearing procedures were discontinued after the parties negotiated a
methodology for resolution of the claim, and an administrative resolution has
been signed by the Fiscal Intermediary, or FI, and us to settle the amount,
which will be determined later in 2003. For another specific issue involving a
staffing cost issue totaling $7.3 million, a settlement of the first year of
seven specific claim years was settled prior to the PRRB hearing, and an
agreement has been reached with the FI to continue to negotiate the remaining
years in dispute. No adjustment to the amounts reflected as of December 31, 2002
is determinable at this time. Further negotiations on the remaining years under
appeal are to occur during 2003. No adjustment to the receivable amount can be
determined until negotiations are concluded on a majority of the remaining claim
years under appeal. As of December 31, 2002, we had $61.7 million of gross
Medicare and Medicaid settlement receivables with a related allowance for
doubtful
32

accounts of $15.4 million. The net receivable balance represents our estimate of
the amounts collectible for prior period Medicare and Medicaid cost reports.

We entered into a preferred provider agreement with Omnicare, Inc. pursuant
to the disposition of our pharmacy operations in 1998. The terms of the
Preferred Provider Agreement enabled Omnicare to execute Pharmacy Service
Agreements and Consulting Service Agreements with all of our skilled nursing
facilities. In 2001, we and Omnicare brought a matter to arbitration involving
the "per diem" pricing rates billed for managed care residents. This matter was
subsequently settled and the amount of the settlement is reflected within our
financial results. We and Omnicare are currently negotiating the pricing of
drugs for Medicare residents and should this matter not be settled, the matter
will be taken to arbitration. In addition, in connection with its agreements to
provide pharmacy services, Omnicare has requested arbitration for an alleged
lost profits claim related to our disposition of assets, primarily in Florida.
Damage amounts, if any, cannot be reasonably estimated based on information
available at this time. An arbitration hearing for this matter has not yet been
scheduled. We believe we have interpreted correctly and complied with the terms
of the preferred provider agreement; however, we cannot assure you that other
claims will not be made with respect to the agreement.

RESULTS FROM OPERATIONS:

The following table sets forth details of our revenues and earnings as a
percentage of total revenues:

Average occupancy in our long-term care facilities was as follows:

YEAR ENDED DECEMBER 31, 2002 COMPARED WITH YEAR ENDED DECEMBER 31, 2001

REVENUES

Revenues in the year ended December 31, 2002 were $815.1 million,
representing an increase of $21.0 million, or 2.6%, from $794.1 million in the
year ended December 31, 2001. The increase in revenues

33

includes a $56.1 million increase in revenues from nursing and assisted living
facilities and other businesses operated during both 2002 and 2001 ("same
facility operations") and an increase of $0.5 million from other revenue,
partially offset by a decrease of $35.6 million in revenues from divested
nursing facilities.

Revenues from same-facility operations increased $56.1 million due to:

- an increase in the average daily Medicaid rate from $121 in 2001 to $127
in 2002, which resulted in additional revenue of $19.2 million;

- an increase in Medicare residents from 11.4% of total residents in 2001
to 13.4% in 2002, which resulted in additional revenue of $16.8 million;

- a 1.9% increase in resident census from an average daily census of 13,928
in 2001 to 14,200 in 2002, which resulted in additional revenue of $14.3
million;

- other rate increases, which resulted in additional revenue of $10.2
million; and

- an increase of $0.8 million when comparing periods due to more favorable
Medicaid cost settlements in 2002.

These increases were offset by a decrease of $5.2 million in Medicare
revenue ($31.22 per day) relating to the expiration of the Legislative Add-ons
as of October 1, 2002 (referred to as the "Medicare Cliff").

Our key Medicare and Medicaid results and statistics for our nursing
operations on a same-facility basis for 2002 and 2001 are summarized as follows:

OPERATING AND GENERAL AND ADMINISTRATIVE COSTS

Operating and general and administrative costs increased $6.8 million, or
1.0%, between years, of which $11.6 million was a decrease in expenses for
general liability insurance and liability claims (primarily related to our
divestiture of our Texas nursing facilities) and $32.9 million related to
reduced operating costs attributable to nursing facilities divested during 2001.
Operating and general and administrative costs on a same-facility basis
increased $51.3 million, or a 7.8% increase on a same-facility basis, and
included increases of:

- wages and benefits of $23.1 million and contracted staffing for food and
laundry services of $10.4 million totaling $33.5 million, or a 7.1%
increase;

- workers compensation of $4.6 million due to prior year actuarial
adjustments recorded in 2001;

- drug expense of $3.4 million due to higher resident census and higher
drug prices;

- outside therapy services of $3.2 million primarily relating to increased
use of therapy services and higher Medicare census;

- bad debt expense of $2.7 million;

- supplies expense of $1.4 million primarily due to higher occupancy; and

- other operating and general and administrative expenses of $2.5 million.

LEASE COSTS, DEPRECIATION AND AMORTIZATION

Depreciation and amortization decreased $3.2 million to $37.6 million for
2002 compared to $40.8 million for 2001. This decrease was primarily a result of
a $2.4 million decrease relating to the adoption of SFAS

34

No. 142, "Goodwill and Other Intangible Assets," which requires that goodwill no
longer be amortized to earnings. The remaining $0.8 million decrease was
primarily a result of divestitures.

Lease costs decreased $3.9 million when comparing periods, including $2.0
million as a result of divestitures, $0.5 million as a result of the purchase of
previously leased facilities and $1.4 million relating to other facilities that
we continue to operate.

INTEREST

Interest expense, net of interest income, decreased $3.3 million to $32.3
million for 2002 compared to $35.6 million for 2001. This decrease was primarily
due to (1) net interest income of $2.1 million from interest rate swaps, and (2)
lower market interest rates during 2002 prior to the issuance, on June 28, 2002,
of our 9.5% Senior Notes due 2010, the proceeds of which were used to refinance
floating-rate debt. The decrease was also due to a reduction in the average debt
level to $387.2 million during 2002 compared to $406.5 million during 2001,
resulting from our use of divestiture proceeds and an income tax refund during
2001 to reduce bank debt balances. The weighted average interest rate of all
long-term debt decreased to 7.81% during 2002 compared to 8.44% during 2001.

LOSS ON IMPAIRMENT OF LONG-LIVED ASSETS

When our management commits us to a plan for disposal of assets, we adjust
assets held for disposal to the lower of the assets' carrying value or the fair
value less selling costs. In September 2001, we formally decided to lease all
owned, and sublease all leased, nursing facilities in Texas. As a result of the
transaction, and based on the terms of the lease with Senior Health-Texas, we
recorded in 2001 a provision of $1.7 million for impairment of Texas nursing
properties in accordance with Statement of Financial Accounting Standards No.
121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived
Assets to Be Disposed Of."

LOSS (GAIN) ON DISPOSAL OF ASSETS AND PROVISION FOR CLOSURE AND EXIT COSTS AND
OTHER ITEMS

For 2002, we recorded a gain on disposal of assets of $4.0 million relating
to the sale of seven properties in Florida to Tandem Health Care, Inc. and a
provision for closure and exit costs of $5.3 million. The gain of $4.0 million
includes a deferred gain of $2.2 million from the April 2001 sale of two other
properties to Tandem. The provision for closure and exit costs relates to an
increase in the overall disposition reserve for cost report and other
settlements with the states of Florida and Texas and other Medicare fiscal
intermediaries, collection of receivables, and settlement of claims with
suppliers and employees.

For 2001, we recorded a loss on disposal of assets of $1.0 million and a
provision for closure and exit costs and other items of $23.2 million. On
September 30, 2001, we transferred all Texas nursing homes to Senior
Health-Texas. As a result of the Texas transaction, as well as the closure and
sale of one nursing home and two other properties in Wisconsin, we provided $3.7
million for related disposal and closure costs. We also made additional
provisions of $20.5 million relating to previously ceased operations, including
$19.0 million related to the nursing facilities in Florida. This $19.0 million
consists of an $11.0 million provision related to Florida claims for years prior
to 2001 based upon an actuarial review of resident liability costs, and an $8.0
million provision for Florida closure and exit costs.

INCOME TAXES

Income tax expense for 2002 was $4.3 million compared to an income tax
benefit of $12.5 million for 2001. Our effective tax rate was 46.3% for 2002 as
compared to 31.2% for 2001. The increase in the effective tax rate results from
the impact of certain permanent adjustments which increased the effective rate
when applied to pre-tax earnings compared to decreasing the effective rate when
applied to pre-tax loss for 2001 and the reversal of current and prior year
state deferred income tax benefits. When we assess the realizability of deferred
tax assets, we consider whether it is more likely than not that some portion or
all of the deferred tax assets will not be realized and record a valuation
allowance if required. The ultimate realization of deferred tax assets depends
upon us generating future taxable income during the periods in which those
temporary
35

differences become deductible. We consider the scheduled reversal of deferred
tax liabilities, projected future taxable income and tax planning strategies
when we make this assessment.

EXTRAORDINARY ITEM

The extraordinary loss in 2002 of $1.7 million, net of income tax, was due
to the early extinguishment in June 2002 of our debt using proceeds from the
issuance of the 9.5% Senior Notes due 2010. The extraordinary loss in 2001 of
$45,000, net of income tax effect, was related to the write-off of deferred
financing costs in connection with debt reduction upon the sale of nursing
facilities.

NET EARNINGS (LOSS)

Net earnings for 2002 were $3.2 million compared to a net loss of $27.5
million for 2001. Net earnings prior to loss (gain) on disposal of assets,
provision for closure and exit costs and other items, loss on impairment of
long-lived assets and extraordinary items, after applicable income tax effect,
was $5.6 million for 2002 compared to a net loss of $11.0 million for 2001. The
fluctuation was caused by the reasons noted above.

RELATED PARTY TRANSACTIONS

We insure certain risks, including comprehensive general liability,
property coverage and excess workers' compensation/employer's liability
insurance, with Laurier Indemnity Company and Laurier Indemnity Ltd., affiliated
insurance subsidiaries of Extendicare Inc.. We recorded approximately $9.9
million of expenses for this purpose for 2002 and $5.7 million for 2001.

We purchase computer hardware and software support services from Virtual
Care Provider, Inc., an affiliated subsidiary of Extendicare Inc.. Expenses
related to these services were $7.9 million for 2002 and $6.6 million for 2001.

YEAR ENDED DECEMBER 31, 2001 COMPARED WITH YEAR ENDED DECEMBER 31, 2000

REVENUES

Revenues for the year ended December 31, 2001 were $794.1 million,
representing a decrease of $129.0 million, or 14.0%, from $923.1 million for the
year ended December 31, 2000. The decrease in revenues is attributable to:

- divestiture of nursing and assisted living facilities primarily in
Florida and Texas resulting in a decrease of $154.6 million of revenue;

- the one-time recovery of $8.9 million in revenue in 2000 on a
same-facility basis pertaining to the settlement of the workers
compensation issue through the Provider Reimbursement Review Board and
the staffing cost issue with the fiscal intermediary; and

- a decline of $0.4 million from outpatient therapy divestitures in 2000,

offset in part by an increase of $3.6 million from new management services
contracts and an increase of $31.3 million in revenue from nursing and assisted
living facilities and other businesses operated during both 2001 and 2000.

Revenues from same-facility operations increased $31.3 million in 2001 due
to:

- a $33.5 million increase, or a 4.8% increase on a same-facility basis,
from increased rates, partially offset by a 0.9% decline in overall
resident census from an average daily census of 14,055 in 2000 to an
average daily census of 13,928 in 2001;

- a $1.5 million decrease due to more favorable Medicaid cost settlements
in 2000;

36

- a $1.4 million decrease as a result of the accrual in 2000 for blood
glucose revenue for the period of October 1, 1997 through December 31,
2000 due to favorable rulings regarding reimbursement litigation with our
fiscal intermediary; and

- a $0.7 million increase from other business operations.

Our key Medicare and Medicaid results and statistics for our nursing
operations on a same-facility basis in 2001 and 2000 are summarized as follows:

Overall, our average daily Medicare rate increased 3.7% to $333 during 2001
compared to $321 during 2000, and our average daily Medicaid rate increased 4.5%
to $117 in 2001 compared to $112 in 2000.

OPERATING AND GENERAL AND ADMINISTRATIVE COSTS

Operating and general and administrative costs in 2001 decreased $154.5
million, or 17.7%, as compared to 2000. The decrease was caused by a $49.5
million decrease in expenses for insurance and liability claims, primarily
relating to our disposal of our Florida operations, and a $134.7 million
reduction in operating costs, other than insurance and liability claims,
attributable to operations closed or nursing facilities divested during 2001 and
2000. The increase in operating and general and administrative costs on a
same-facility basis, excluding expenses for insurance and liability claims, was
$29.7 million, a 4.7% increase on a same-facility basis. The increase is
attributable to:

- wage and benefit costs of $29.8 million, representing a 6.9% increase on
a same-facility basis;

- drug expense of $2.4 million primarily due to settlement of 1999
contracted drug charges in 2001;

- utility costs of $1.1 million due to higher rates in 2001; and

- a net increase in other operating and administrative expenses of $1.9
million, or a 0.3% increase on a same-facility basis.

These increases are partially offset by a decrease in:

- workers' compensation costs of $3.1 million due to favorable actuarial
adjustments for prior years in 2001; and

- bad debt expense of $2.4 million.

We had $70.3 million in accruals for known or potential general and
professional liability claims at December 31, 2001 based upon claims experience
and actuarial estimates. Based upon such claims experience and independent
actuarial review, we believe that our accrual is adequate to cover any losses
from general and professional liability claims. Though we regularly evaluate
these accruals and we believe they are adequate and fairly stated, the accruals
are subject to adjustment, which could have a material impact on our earnings.
The timing of the settlement of the claims could influence cash flow and our
ability to meet financial covenants under our credit facility.

In 1998, we sold our pharmacy operations to Omnicare, Inc. In connection
with that sale, we entered into a preferred provider agreement with Omnicare.
Under the terms of this preferred provider agreement, Omnicare pharmacies are
required to execute pharmacy service agreements and pharmacy consulting
agreements to provide pharmacy supplies and services to all of our skilled
nursing facilities. Pricing under the agreement is to be competitive within the
local marketplace. Omnicare may not charge us rates that are higher than the
most favorable rates that Omnicare charges for similarly situated beneficiaries
in the same marketplace. We secured per diem pricing arrangements for pharmacy
supplies provided to residents with

37

managed care and Medicare payor sources for the first four years of the
agreement, which period expires in December 2002. The preferred provider
agreement contains a number of provisions that involve sophisticated
calculations to determine the per diem pricing during this first four-year
period. Under a per diem pricing agreement pharmacy costs fluctuate based upon
occupancy levels in the facilities. The per diem rates were established assuming
a declining per diem value over the initial four years of the contract to
coincide with the phase-in of the Medicare prospective payment system rates.

Subsequent to December 31, 2001, Omnicare made claims regarding per diem
pricing rates billed for Medicare residents for 2001 and 2002. Provisions for
settlement of the claims are included within the financial statements. We
believe we have interpreted correctly and complied with the terms of the
preferred provider agreement; however, we cannot assure you that other claims
will not be made with respect to the agreement.

We record a provision for bad debts in relation to revenues recorded based
upon our past experience and we believe our reserves are adequate. We
continually review and refine our reserve estimation process and the adequacy of
our reserve, but we cannot guarantee that our estimates accurately reflect the
future credit losses that we may incur and therefore our estimates can be
subject to future adjustments.

LEASE COSTS, DEPRECIATION AND AMORTIZATION

Lease costs decreased $1.2 million from 2000 to 2001.

Depreciation and amortization decreased $4.7 million to $40.8 million in
2001 compared to $45.5 million in 2000. This decrease included a $1.4 million
decrease as a result of divestitures and a $3.3 million decrease from
same-facility operations as a result of assets becoming fully depreciated and
reduced depreciation relating to losses recorded in 2001 and 2000 for impairment
of depreciable assets.

INTEREST

Interest expense, net of interest income, decreased $9.6 million to $35.6
million in 2001 compared to $45.2 million in 2000. The decrease was primarily
due to a reduction in our average debt level to $406.5 million during 2001
compared to $478.3 million during 2000, resulting from our use of divestiture
proceeds and income tax refunds during both years to reduce our bank debt. The
weighted average interest rate of all long-term debt decreased to approximately
9.31% during 2001 compared to approximately 9.73% during 2000 due to an overall
decline in interest rates.

LOSS ON IMPAIRMENT OF LONG-LIVED ASSETS

When we commit to a plan for disposal of assets, assets held for disposal
are adjusted to the lower of the assets' carrying value or the fair value less
selling costs. In September 2001, we decided to lease all owned, and sublease
all leased, nursing facilities in Texas. As a result of the transaction and
based on the terms of the lease with Senior Health-Texas, in 2001 we recorded a
provision of $1.7 million for impairment of Texas nursing properties in
accordance with SFAS No. 121, "Accounting for the Impairment of Long-Lived
Assets and for Long-Lived Assets to Be Disposed Of."

In December 2000, we decided to sell or lease all of our remaining
operations in Florida and completed two transactions to accomplish that
decision. Both transactions resulted in providing the two operators with an
option to purchase the properties within the lease term. In December 2000, we
recorded a provision of $15.9 million for impairment of Florida properties and
reported a provision for closure and exit costs of $1.1 million related to the
termination of our Florida operational staff. In addition, in December 2000, we
determined that a $4.8 million adjustment was required for non-Florida
properties resulting in a total impairment provision for 2000 of $20.7 million.

LOSS ON DISPOSAL OF ASSETS AND PROVISION FOR CLOSURE AND EXIT COSTS AND OTHER
ITEMS

For 2001, we recorded a loss on disposal of assets of $1.0 million and a
provision for closure and exit costs and other items of $23.2 million. On
September 30, 2001, we transferred all Texas nursing homes to Senior
Health-Texas. As a result of the Texas transaction, as well as the closure and
sale of one nursing home and
38

two other properties in Wisconsin, we provided $3.7 million for related disposal
and closure costs. We also made additional provisions of $20.5 million relating
to previously ceased operations, including $19.0 million related to the nursing
facilities in Florida. This $19.0 million consists of an $11.0 million provision
related to Florida claims for years prior to 2001 based upon an actuarial review
of resident liability costs, and an $8.0 million provision for Florida closure
and exit costs.

In 2000, we disposed or leased all of our operations in Florida consisting
of 32 facilities with 3,427 beds through a series of transactions, two of which
involved lease agreements with operators who have an option to purchase the
properties and one in which we retain an interest in the properties through the
contingent consideration terms of the agreement. In addition, we sold two
formerly closed facilities. In the aggregate these five transactions, along with
other asset sales, resulted in cash proceeds of $37.7 million, of which $33.1
million was applied to reduce our debt. The sale of the Florida facilities
resulted in a pre-tax provision for closure and exit costs of $1.6 million. In
addition, in states other than Florida, we recorded provisions for closure and
exit costs of $1.7 million for the closure of two nursing and one assisted
living facilities and $0.6 million for the disposition of other non-core assets.
For 2000, the total loss from the disposal of assets was $3.3 million and the
total provision for closure and exit costs and other items was $3.4 million.

INCOME TAXES

We have recorded a financial statement benefit for federal and state tax
losses and other deferred tax assets based upon our future anticipated taxable
earnings. As of December 31, 2001, the valuation allowance was $20.2 million,
primarily relating to state net operating losses to reflect limited carry
forward periods and reductions in various states apportionment. The allowance
was increased by $2.8 million in 2001 and $3.2 million in 2000.

EXTRAORDINARY ITEM

The extraordinary loss in 2001 of $45,000, net of income tax effect, is
related to the write-off of deferred financing costs in connection with debt
reduction with the proceeds of sales of nursing facilities. The extraordinary
loss in 2000 of $0.4 million, net of income tax effect, is related to the
write-off of deferred financing costs in connection with the repayment of debt.

NET LOSS

The net loss in 2001 was $27.5 million compared to a net loss of $55.1
million in 2000. The net loss prior to loss on disposal of assets, provision for
closure and exit costs and other items, loss on impairment of long-lived assets
and extraordinary item, after applicable income tax effect, was $11.0 million
for 2001 compared to a comparable net loss of $37.1 million for 2000 due to the
changes noted above.

LIQUIDITY AND CAPITAL RESOURCES

We had cash and cash equivalents of $27.0 million at December 31, 2002 and
$1.0 million at December 31, 2001. We generated cash flow of $37.5 million from
operating activities in 2002 compared with $75.9 million in 2001. The $38.4
million reduction in cash flow from operations was primarily the result of the
2001 tax refund of $22.5 million and increased payments in 2002 of self-insured
general liability claims of $12.0 million.

Our working capital, excluding cash and borrowings included in current
liabilities, decreased $1.5 million from $15.8 million at December 31, 2001 to
$14.3 million at December 31, 2002. The decrease resulted primarily from a $43.8
million increase in accounts payable, accrued liabilities and current portion of
accrual for self-insurance liability. These decreases in working capital were
partially offset by a $8.7 million decrease in amounts due to shareholder and
affiliates and a $25.5 million increase in amounts due from shareholder and
affiliates, primarily relating to changes in deferred federal income taxes.

Accounts receivable at December 31, 2002 were $104.1 million compared with
$104.2 million at December 31, 2001, representing a decrease of $0.1 million.
The reduction in accounts receivable included a

39

$1.0 million decrease within the nursing operations, an increase of $0.1 million
within the outpatient therapy operations and a $0.8 million increase in
receivables from long-term care operators for which we provide management and
consulting services. The $0.8 million increase was primarily attributable to
transitional working capital advances to the nursing facilities transferred to
Senior Health-Texas and Senior Health-South. Within the nursing operations,
billed patient care and other receivables decreased $5.8 million while
third-party payor settlement receivables, based on Medicare and Medicaid cost
reports, increased $4.8 million. The decrease in billed patient care receivables
of $5.8 million included a decrease of $9.4 million due to our improved
collection efforts. The remaining increase of $3.6 million reflects an increase
of $11.9 million due to rate increases, partially offset by a decrease of $8.3
million due to the sale or closure of nursing facilities and assisted living
facilities.

The increase in settlement receivables of $4.8 million from December 31,
2001 to December 31, 2002 included an increase of $5.4 million in revenue
recorded in 2002 for anticipated Medicare reimbursement for uncollectible
co-insurance amounts and an increase of $6.7 million as a result of the
reclassification of settlements from long-term accounts receivable to current.
These increases were partially offset by decreases of $1.6 million from
collections of Medicare settlements, $3.3 million for collections from Medicare
of co-insurance amounts recorded as revenue in 2002 and 2001 and $2.4 million
for collection of Medicaid cost report settlements.

Property and equipment decreased $24.7 million from December 31, 2001 to a
total of $453.1 million at December 31, 2002. The decrease was the result of
depreciation expense of $33.7 million and asset disposals of $27.6 million
primarily relating to the sale of seven formerly leased Florida properties to
Tandem. These decreases were partially offset by capital expenditures of $18.7
million, an increase of $17.9 million as a result of the acquisition of seven
previously leased nursing facilities in October 2002.

Total borrowings, including bank indebtedness and both current and
long-term maturities of debt, totaled $400.8 million at December 31, 2002. This
represents an increase of $14.9 million from December 31, 2001. This increase is
due to:

- proceeds of $149.6 million from issuance in June 2002 of our 9.5% Senior
Notes due 2010;

- issuance of $10.5 million of 10-year notes relating to the purchase of
seven previously leased facilities;

- increases in our borrowings under the former line of credit of $11.0
million; and

- a net increase of $2.1 million in current bank indebtedness, relating to
outstanding checks.

These increases were partially offset by:

- early repayment of $130.8 million in debt using proceeds from the
issuance of our 9.5% Senior Notes due 2010;

- decreases in the former line of credit of $19.0 million; and

- other repayments of $8.5 million.

The weighted average interest rate of all of our long-term debt was 8.80%
at December 31, 2002 and such debt had maturities ranging from 2002 to 2014.

As of December 31, 2002, our parent, Extendicare Inc., held $27.9 million,
or 14.0%, of our outstanding Senior Subordinated Notes.

Cash used in investing activities increased $10.9 million to $21.0 million
for 2002 compared to $10.1 million for 2001. The increase was primarily due to
the acquisition of seven previously leased nursing facilities in October 2002
for $17.9 million and an increase of $2.3 million in purchases of property and
equipment. These increases in cash used were partially offset by an additional
$6.7 million in proceeds from the sale of property and equipment in 2002, $1.0
million from the collection of notes receivable in 2002 and $1.6 million from
changes in other non-current assets.

40

Cash provided from financing activities was $9.6 million for 2002 compared
to $66.5 million used in financing activities in 2001. The increase of $76.1
million is primarily due to:

- proceeds of $171.1 million from issuance of long-term debt;

- a $2.6 million increase in cash from other liabilities; and

- a $2.0 million increase from cash from bank indebtedness;

These increases were offset by:

- increased payments of $92.5 million of long-term debt; and

- payments for deferred financing costs of $7.1 million associated with the
issuance of our 9.5% Senior Notes.

On June 28, 2002, we refinanced all outstanding indebtedness under our then
existing credit facility with the proceeds from the issuance of our 9.5% Senior
Notes due 2010 and we entered into a new credit facility that provides senior
secured financing of up to $105.0 million on a revolving basis. As of December
31, 2002, we did not have any borrowings outstanding under this new credit
facility, but we had $38.8 million of letters of credit outstanding thereunder.
The new credit facility will terminate on June 28, 2007. Borrowings drawn during
the first four fiscal quarters following closing of the new credit facility will
initially bear interest, at our option, at an annual rate equal to:

- LIBOR, plus 3.50%; or

- the Base Rate, as defined in our new credit facility, plus 2.50%;

thereafter, in each case, subject to adjustments based on financial performance.
Our obligations under the new credit facility are guaranteed by:

- Extendicare Holdings, Inc., our direct parent;

- each of our current and future domestic subsidiaries excluding certain
inactive subsidiaries; and

- any other current or future foreign subsidiaries that guarantee or
otherwise provide direct credit support for any U.S. debt obligations of
ours or any of our domestic subsidiaries.

Our obligations are secured by a perfected first priority security interest
in certain of our tangible and intangible assets and all of our and our
subsidiary guarantors' capital stock. The new credit facility is also secured by
a pledge of 65% of the voting stock of our and our subsidiary guarantors'
foreign subsidiaries, if any. Our new credit facility contains customary
covenants and events of default and is subject to various mandatory prepayments
and commitment reductions. The new credit facility requires that we comply with
various financial covenants, on a consolidated basis including:

- a minimum fixed charge coverage ratio starting at 1.10 to 1 and
increasing to 1.20 to 1 in 2005;

- a minimum tangible net worth starting at 85% of our tangible net worth at
March 31, 2002 and increasing by 50% of our net income for each fiscal
quarter plus 100% of any additional equity we raise;

- a maximum senior leverage ratio starting at 4.25 to 1 and reducing to
4.00 to 1 in 2005; and

- a maximum senior secured leverage ratio starting at 1.75 to 1 and
reducing to 1.50 to 1 in 2005.

We are in compliance with these financial covenants as of December 31,
2002.

To hedge our exposure to fluctuations in the market value of the Senior
Notes, we entered into a five-year interest rate swap contract with a notional
amount of $150 million. The contract effectively converted up to $150 million of
our fixed interest rate indebtedness into variable interest rate indebtedness.

Also in June 2002, we entered into a five-year interest rate cap with a
notional amount of $150 million. Under this cap, we pay a fixed rate of interest
equal to 0.24% and receive a variable rate of interest equal to the excess, if
any, of the one-month LIBOR rate, adjusted monthly, over the cap rate of 7%. We
use the interest

41

rate cap to offset possible increases in interest payments under the interest
rate swap caused by increases in market interest rates over a certain level and
also as a cash flow hedge to effectively limit increases in interest payments
under our variable-rate debt obligations.

We believe that our cash from operations and anticipated growth, together
with other available sources of liquidity, including borrowings available under
our new credit facility, will be sufficient for the foreseeable future to fund
anticipated capital expenditures and make required payments of principal and
interest on our debt, including payments due on the notes and obligations under
our new credit facility.

Principal payments on long-term debt due within the next five years and
thereafter are as follows (dollars in thousands):

2003........................................................ $ 716
2004........................................................ 756
2005........................................................ 733
2006........................................................ 698
2007........................................................ 203,491
After 2007.................................................. 191,756
--------
$398,150
========

At December 31, 2002, we were committed to making the following minimum
rental payments under non-cancelable operating leases (dollars in thousands):

2003........................................................ $ 7,964
2004........................................................ 7,285
2005........................................................ 7,069
2006........................................................ 4,472
2007........................................................ 3,225
After 2007.................................................. 18,460
-------
Total minimum payments................................. $48,475
=======

ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

QUALITATIVE DISCLOSURES

We use interest rate swaps to hedge the fair value of our debt obligations
and interest rate caps as a cash flow hedge of our variable-rate debt and also
to offset possible increases in variable-rate payments under our interest rate
swap related to increases in market interest rates.

We also have market risk relating to investments in stock and stock
warrants that we obtained in connection with the 1998 sale of our pharmacy
operations. In effect, these holdings can be considered contingent purchase
price proceeds whose value, if any, may not be realized for several years. These
stock and warrant holdings are subject to various trading and exercise
limitations. We intend to hold them until we believe the market opportunity is
appropriate to trade or exercise the holdings.

We monitor the markets to adequately determine the appropriate market
timing to sell or otherwise act with respect to our stock and warrant holdings
in order to maximize their value. With the exception of the above holdings, we
do not enter into derivative instruments for any purpose other than cash flow
hedging purposes. That is, we do not speculate using derivative instruments and
do not engage in trading activity of any kind.

42

QUANTITATIVE DISCLOSURES

The table below presents principal, or notional, amounts and related
weighted average interest rates by year of maturity for our debt obligations and
interest rate swaps as of December 31, 2002 (dollars in thousands):

The above table incorporates only those exposures that existed as of
December 31, 2002 and does not consider those exposures or positions which could
arise after that date or future interest rate movements. As a result, the
information presented above has limited predictive value. Our ultimate results
with respect to interest rate fluctuations will depend upon the exposures that
occur, our hedging strategies at the time and interest rate movements.

43

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

INDEPENDENT AUDITORS' REPORT

The Board of Directors
Extendicare Health Services, Inc.:

We have audited the accompanying consolidated balance sheets of Extendicare
Health Services, Inc. and subsidiaries (the Company) as of December 31, 2002 and
2001, and the related consolidated statements of operations, shareholder's
equity, and cash flows for each of the years in the three-year period ended
December 31, 2002. These consolidated financial statements are the
responsibility of the Company's management. Our responsibility is to express an
opinion on these consolidated financial statements based on our audits.

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

In our opinion, the consolidated financial statements referred to above
present fairly, in all material respects, the financial position of Extendicare
Health Services, Inc. and subsidiaries as of December 31, 2002 and 2001, and the
results of their operations and their cash flows for each of the years in the
three-year period ended December 31, 2002 in conformity with accounting
principles generally accepted in the United States of America.

As discussed in Note 2 of the consolidated financial statements, the
Company changed its method of accounting for goodwill effective January 1, 2002.

[KPMG LLP LOGO]

Milwaukee, Wisconsin
February 10, 2003

44

EXTENDICARE HEALTH SERVICES, INC.

CONSOLIDATED BALANCE SHEETS
DECEMBER 31, 2002 AND 2001
(IN THOUSANDS EXCEPT SHARE DATA)

The accompanying notes are an integral part of these consolidated financial
statements.
45

EXTENDICARE HEALTH SERVICES, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS
FOR THE YEARS ENDED DECEMBER 31, 2002, 2001 AND 2000
(IN THOUSANDS)

The accompanying notes are an integral part of these consolidated financial
statements.
46

EXTENDICARE HEALTH SERVICES, INC.

CONSOLIDATED STATEMENTS OF SHAREHOLDER'S EQUITY
(IN THOUSANDS EXCEPT SHARE DATA)

The accompanying notes are an integral part of these consolidated financial
statements.
47

EXTENDICARE HEALTH SERVICES, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS
FOR THE YEARS ENDED DECEMBER 31, 2002, 2001 AND 2000
(IN THOUSANDS)

The accompanying notes are an integral part of these consolidated financial
statements.
48

EXTENDICARE HEALTH SERVICES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1. BUSINESS

Extendicare Health Services, Inc. and its subsidiaries (hereafter referred
to as the "Company") operates, in one reporting segment, nursing and assisted
living facilities, throughout the United States. The Company is an indirect
wholly owned subsidiary of Extendicare Inc. ("Extendicare"), a Canadian publicly
traded company.

At December 31, 2002, the Company operated 156 nursing facilities with
capacity for 16,357 beds and 41 assisted living facilities with 1,912 units.
Through its nursing centers, the Company provides nursing, rehabilitative and
other specialized medical services and, in the assisted living facilities, the
Company provides varying levels of assistance with daily living activities to
residents. The Company also provides consulting services to 38 nursing
facilities (4,097 beds) and one assisted living facility (116 units).

In addition, at December 31, 2002, the Company owned 10 nursing facilities
(1,065 beds), which were leased to and operated by two unrelated nursing home
providers, and retained an interest in (but did not operate) 11 nursing
facilities (1,435 beds) and 4 assisted living facilities (135 units) under a
Divestiture Agreement (see Note 4).

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

a) Principles of Consolidation

The consolidated financial statements of the Company have been prepared in
accordance with accounting principles generally accepted in the United States of
America. The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amount of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenues and expenses during the
reporting period. Management's most significant estimates include provision for
bad debts, provision for Medicaid and Medicare revenue rate settlements,
recoverability of long-lived assets, provision for general liability, facility
closure accruals, workers' compensation accruals and self-insured health and
dental claims. Actual results could differ from those estimates.

The consolidated financial statements include those of the Company and its
subsidiaries and partnerships the Company controls. All significant intercompany
accounts and transactions with subsidiaries have been eliminated from the
consolidated financial statements.

b) Cash Equivalents

For purposes of the consolidated statements of cash flows, the Company
considers all highly liquid investments with original maturities of three months
or less to be cash equivalents.

c) Accounts Receivable

Accounts receivable are recorded at the net realizable value expected to be
received from federal and state assistance programs, other third-party payors or
from individual patients. Receivables from government agencies represent the
only concentrated group of accounts receivable for the Company.

The Company had approximately 24%, 25% and 30% as of December 31, 2002,
2001 and 2000, respectively, in accounts receivable derived from services
provided under various federal (Medicare) programs and 41%, 38% and 36% as of
the same dates derived from services provided under various state (Medicaid)
medical assistance programs. Management does not believe there are any credit
risks associated with these government agencies other than possible funding
delays. Accounts receivable other than from government agencies consist of
receivables from various payors that are subject to differing economic
conditions and do not represent any concentrated credit risks to the Company.

49

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)

The Company periodically evaluates the adequacy of its allowance for
doubtful accounts by conducting a specific account review of amounts in excess
of predefined target amounts and aging thresholds, which vary by payor type.
Provisions are considered based upon the evaluation of the circumstances for
each of these specific accounts. In addition, the Company has established a
standard allowance requirement percentage which is based upon historical
collection trends for each payor type, and its understanding of the nature and
collectibility of these receivables. Accounts receivable that the Company
specifically estimates to be uncollectible, based upon the above process, are
fully reserved for in the allowance for doubtful accounts until they are
written-off or collected.

d) Property and Equipment

Property and equipment are stated at cost less accumulated depreciation and
amortization. Provisions for depreciation and amortization are computed using
the straight-line method at rates based upon the following estimated useful
lives:

Land improvements..................... 10 to 25 years
Buildings............................. 30 to 40 years
Building improvements................. 5 to 30 years
Furniture and equipment............... Varying periods not exceeding 15 years
Leasehold improvements................ The shorter of the term of the
applicable leases or the useful life
of the Improvement

Leased nursing home assets held under Option Agreements are stated at cost
less accumulated depreciation. Provisions for depreciation are computed as
outlined above.

Maintenance and repairs are charged to expense as incurred. When property
or equipment is retired or disposed, the cost and related accumulated
depreciation and amortization are removed from the accounts and the resulting
gain or loss is included in the results of operations. Approximately $739,000,
$1,118,000 and $395,000 of costs included in furniture and equipment associated
with developing or obtaining internal-use software were capitalized during the
years ended December 31, 2002, 2001 and 2000, respectively, and are being
amortized over three years.

e) Leases

Leases that substantially transfer all of the benefits and risks of
ownership of property to the Company, or otherwise meet the criteria for
capitalizing a lease under generally accepted accounting principles, are
accounted for as capital leases. An asset is recorded at the time a capital
lease is entered into together with its related long-term obligation to reflect
its purchase and financing. Property and equipment recorded under capital leases
are depreciated on the same basis as previously described. Rental payments under
operating leases are expensed as incurred.

f) Goodwill and Other Intangible Assets

Goodwill represents the cost of acquired net assets in excess of their fair
market values. As of January 1, 2002, the Company adopted SFAS No. 142,
"Goodwill and Other Intangible Assets" which requires that goodwill and
intangible assets with indefinite useful lives no longer be amortized but
instead tested for impairment at least annually in accordance with the
provisions of SFAS No. 142. As a result, the amortization of goodwill and
intangible assets with an indefinite life ceased upon adoption of the Statement.
SFAS No. 142 also requires that intangible assets with estimable useful lives be
amortized over their respective estimated useful lives to their estimated
residual values, and reviewed for impairment in accordance with SFAS No. 144. If
an intangible asset is identified as having an indefinite useful life, the
Company is required to test the intangible asset for impairment in accordance
with the provisions of SFAS No. 142 (see paragraph (g) below for more
information).

50

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)

Prior to January 2002, goodwill and other intangible assets were amortized
using the straight-line method over a period of no more than forty years in
connection with the acquisitions of long-term care facilities. As of January 1,
2002 the Company had unamortized goodwill in the amount of $72.1 million (cost
of $83.3 million less accumulated amortization of $11.2 million) which were
subject to the provisions of SFAS No. 142. Upon adoption of SFAS No. 142 and in
December 2002, the Company reviewed goodwill for impairment and these tests
indicated that no impairment existed. No assurance can be given that impairment
will not exist in the future.

The following table shows what net income would have been had SFAS No. 142
been applied in the comparable prior year periods:

Other intangible assets, consisting of the costs of acquiring leasehold
rights are deferred and amortized over the term of the lease including renewal
options.

g) Long-lived Assets

The Company periodically assesses the recoverability of long-lived assets,
including property and equipment, in accordance with the provisions of SFAS No.
144, "Accounting for the Impairment or Disposal of Long-Lived Assets". This
statement requires that all long-lived assets be reviewed for impairment
whenever events or changes in circumstances indicate the carrying amount of an
asset may not be recoverable. Recoverability of assets to be held and used is
measured by comparison of the carrying value of an asset to the undiscounted
future cash flows expected to be generated by the asset. If the carrying value
of an asset exceeds its estimated undiscounted future cash flows, an impairment
provision is recognized to the extent of the excess amount. Assets to be
disposed of are reported at the lower of the carrying amount or the fair value
of the asset, less all associated costs of disposition. In addition, SFAS No.
144 requires companies to separately report discontinued operations and extends
that reporting to a component of an entity that either has been disposed of (by
sale, abandonment, or in a distribution to owners) or is classified as held for
sale. Management considers such factors as current results, trends and future
prospects, current market value, and other economic and regulatory factors, in
performing these analyses.

h) Other Assets

Assets held under Divestiture Agreement (see Note 8) are stated at cost
less accumulated depreciation. Provisions for depreciation are computed as
outlined above in Note 2(d).

In the normal course of business, the Company has accounts receivable due
from both the federal Medicare program and from various states under their
respective Medicaid programs. Prior to January 1, 1999 and the implementation of
Prospective Payment System ("PPS"), the Medicare program was a cost-based
reimbursement program under which skilled nursing facilities received interim
payments for each facility's respective reimbursable costs, which could be
subject to adjustment based upon the submission of a year-end cost report and
certain cost limits. The year-end cost report would be subject to audit by the
Company's Fiscal Intermediary ("FI") and could lead to ongoing discussions with
the FI regarding the treatment of various items related to prior years' cost
reports. Normally items are resolved during the audit process and no provisions
are required. For items involving differences of opinion between the Company and
the FI regarding cost report methods, such items can be settled through a formal
appeal process. Should this occur, a general provision for Medicare receivables
may be provided for disagreements, which result in the provider filing an appeal
with the Provider Reimbursement Review Board ("PRRB") of the Centers for
Medicare and

51

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)

Medicaid Services ("CMS"). Similarly, for states which operate under a
retrospective reimbursement system under which interim payments are subject to
audits, settlement accounts receivable or payable are determined by the Company.
The Company periodically reviews the accounts receivable and the general
provision for settlement of amounts in dispute, and adjusts its balances
accordingly based upon known facts at the time. In addition, the Company
estimates the portion of the Medicaid and Medicare accounts receivable that are
collectible within the next 12 months and classifies this amount as a current
asset.

Notes receivables are stated at the face value of the note. The Company
monitors the payment of interest due on the notes and, where provided within the
terms of the notes, reviews the financial statements of the company owing the
amount to assess the ultimate collectibility of the notes. Should circumstances
arise that the collectibility of the note is doubtful, an allowance will be
reflected against the note receivable.

Direct loan origination costs are recorded as deferred financing costs and
amortized over the life of the related debt using the effective interest method.

Debt service and capital expenditure trust funds and other investment
holdings, which are comprised of fixed interest securities, equity securities,
and liquid money market investments, are considered to be available-for-sale and
accordingly, are reported at fair value. Fair values are based on quoted market
prices. Unrealized gains and losses, net of related tax effects, are reported
within Accumulated Other Comprehensive Income (AOCI) as a separate component of
shareholder's equity. A decline in the market value of any security below cost
that is deemed other than temporary is charged to earnings, resulting in the
establishment of a new cost basis for the security. The cost basis of the debt
service trust funds approximates fair value. Realized gains and losses for
securities classified as available-for-sale are included in the results of
operations and are derived using the specific identification method for
determining the cost of securities sold. Interest income is recognized when
earned.

i) Revenue Recognition

Nursing facility revenue results from the payment for services and products
from federal and state-funded cost reimbursement programs as well as private pay
residents. Revenues are recorded in the period in which services and products
are provided at established rates less contractual adjustments. Contractual
adjustments include differences between the Company's established billing rates
and amounts estimated by management as reimbursable under various reimbursement
formulas or contracts in effect. Estimation differences between final
settlements and amounts recorded in previous years are reported as adjustments
to revenues in the period such settlements are determined. Refer also to Note
13.

Assisted living facility revenue is primarily derived from private pay
residents in the period in which the services are provided and at rates
established by the Company based upon the services provided and market
conditions in the area of operation.

j) Derivative Instruments and Hedging Activities

In June 1998 the Financial Accounting Standards Board (FASB) issued
Statement of Financial Accounting Standards (SFAS) No. 133, "Accounting for
Derivative Instruments and Certain Hedging Activities." In June 2000 the FASB
issued SFAS No. 138, "Accounting for Certain Derivative Instruments and Certain
Hedging Activity, an Amendment of SFAS 133." SFAS No. 133 and SFAS No. 138
require that all derivative instruments be recorded on the balance sheet at
their respective fair values. The Company adopted SFAS No. 133 and SFAS No. 138
on January 1, 2001. In accordance with the transition provisions of SFAS 133,
the Company recorded a net-of-tax cumulative-effect-type adjustment of $195,000
in AOCI to recognize at fair value all derivatives that are designated as
cash-flow hedging instruments.

All derivatives are recognized on the balance sheet at their fair value. On
the date the derivative contract is entered into, the Company designates the
derivative as either a hedge of the fair value of a recognized asset or
liability ("fair value hedge") or a hedge of the variability of cash flows to be
received or paid related to a recognized asset or liability ("cash flow hedge").
The Company assesses, both at the hedge's inception and on
52

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)

an ongoing basis, whether the derivatives that are used in hedging transactions
are highly effective in offsetting changes in fair values or cash flows of hedge
items. When it is determined that a derivative is not highly effective as a
hedge or that it has ceased to be a highly effective hedge, the Company
discontinues the hedge accounting prospectively.

Changes in the fair value of a derivative that is highly effective and that
is designated and qualifies as a fair-value hedge, along with the loss or gain
on the hedged asset or liability of the hedged item that is attributable to the
hedged risk are recorded in earnings. Changes in the fair value of a derivative
that is highly effective and that is designated and qualifies as a cash-flow
hedge are recorded in other comprehensive income, until earnings are affected by
the variability in cash flows of the designated hedged item.

The Company discontinues hedge accounting prospectively when it is
determined that the derivative is no longer effective in offsetting changes in
the fair value or cash flows of the hedged item, the derivative expires or is
sold, terminated, or exercised, or because management determines that
designation of the derivative as a hedging instrument is no longer appropriate.
When hedge accounting is discontinued because it is determined that the
derivative no longer qualifies as an effective fair-value hedge, the Company
continues to carry the derivative on the balance sheet at its fair value, and no
longer adjusts the hedged asset or liability for changes in fair value. In all
other situations in which hedge accounting is discontinued, the Company
continues to carry the derivative at its fair value on the balance sheet, and
recognizes any changes in its fair value in earnings.

For years before 2001, prior to the adoption of SFAS No. 133, the Company
entered into interest rate swap agreements to reduce its exposure to market
risks from changing interest rates. For interest rate swaps, the differential to
be paid or received is accrued and recognized in interest expense and may change
as market interest rates change. If a swap was terminated prior to its maturity,
the gain or loss is recognized over the remaining original life of the swap if
the item hedged remains outstanding, or immediately, if the item hedged does not
remain outstanding.

k) Income Taxes

Income taxes are accounted for under the asset and liability method.
Deferred tax assets and liabilities are recognized for the expected future tax
consequences attributable to differences between the financial statement
carrying amounts of existing assets and liabilities and their respective tax
bases and operating loss and tax credit carryforwards. Deferred tax assets and
liabilities are measured using enacted tax rates expected to apply to taxable
income in the years in which those temporary differences are expected to be
recovered or settled. The effect on deferred tax assets and liabilities of a
change in tax rates is recognized in income in the period that includes the
enactment date.

l) Reclassifications

Certain reclassifications have been made to the 2001 and 2000 consolidated
financial statements to conform to the presentation for 2002.

3. NEW ACCOUNTING PRONOUNCEMENTS

In June 2001, the FASB issued SFAS No. 143, "Accounting for Asset
Retirement Obligations." This Statement addresses financial accounting and
reporting for obligations associated with the retirement of tangible long-lived
assets and the associated asset retirement costs. It applies to legal
obligations associated with the retirement of long-lived assets that result from
the acquisition, construction, development and/or the normal operation of a
long-lived asset, except for certain obligations of lessees. Under SFAS No. 143,
a legal obligation is an obligation that a party is required to settle as a
result of an existing or enacted law, statute, ordinance, or written or oral
contract or by legal construction of a contract under the doctrine of promissory
estoppel. SFAS No. 143 requires that the fair value of a liability for an asset
retirement obligation be recognized in the period in which it is incurred if a
reasonable estimate of fair value can be made. The associated asset retirement
costs are capitalized as part of the carrying amount of the long-lived asset.
The

53

3. NEW ACCOUNTING PRONOUNCEMENTS (CONTINUED)

liability is discounted and accretion expense is recognized using the
credit-adjusted risk-free interest rate in effect when the liability was
initially recognized. This Statement is effective for financial statements
issued for fiscal years beginning after June 15, 2002

In May 2002, the FASB issued SFAS No. 145, "Rescission of FASB Statements
No. 4, 44, and 64, Amendment of FASB Statement No. 13 and Technical
Corrections." The most significant provision of SFAS No. 145 addresses the
termination of extraordinary item treatment for gains and losses on early
retirement of debt. The Company will be required to adopt the provisions of this
standard beginning on January 1, 2003. The Company plans to adopt the provisions
of this standard in the first quarter of 2003 and will be required to modify the
presentation of its year 2002, 2001 and 2000 results by recording the loss on
early retirement of debt in earnings before income taxes.

In July 2002, the FASB issued SFAS No. 146, "Accounting for Exit and
Disposal Activities." The provisions of SFAS No. 146 modify the accounting for
the costs of exit and disposal activities by requiring that liabilities for
these activities be recognized when the liability is incurred. Previous
accounting literature permitted recognition of some exit and disposal
liabilities at the date of commitment to an exit plan. The provisions of this
statement will be effective for exit or disposal activities initiated after
December 31, 2002.

4. LOSS ON DISPOSAL OF ASSETS, PROVISION FOR CLOSURE AND EXIT COSTS, AND
IMPAIRMENT OF LONG-LIVED ASSETS

In response to the implementation of Medicare Prospective Payment System
(PPS), increased litigation and insurance costs in certain states, and increased
operational costs resulting from changes in legislation and regulatory scrutiny,
over the past several years the Company has focused on the divestiture of under-
performing nursing and assisted living facilities and the divestiture of
non-core health care assets. As a result, the Company has recorded significant:

- loss (gain) on the disposal of assets;

- provisions for closure and exit costs; and

- loss on the impairment of long-lived assets

Below is a summary of the significant transactions which resulted in the
above provisions, gains and losses.

In May 2002, Tandem Health Care, Inc. ("Tandem") exercised its option to
purchase seven leased properties in Florida from the Company for gross proceeds
of $28.6 million, consisting of cash of $15.6 million and $13.0 million in 8.5%
five-year notes (net proceeds of $25.5 million). Until this date, Tandem
operated these facilities under a lease agreement with a purchase option. The
carrying value of the seven facilities was $21.5 million. The Company applied
$12.4 million of the proceeds to reduce bank debt and, as a result recorded a
gain on the sale of the asset of $4.0 million, inclusive of the deferred $2.2
million from the April, 2001 sales transaction described below. The transaction
also involved the conversion of $1.9 million in preferred shares received in the
April 2001 transaction into $1.9 million 8.5% notes, due in April 2006. In
addition, in May 2002, the Company recorded a provision for closure and exit
costs relating to the divested Florida operations of $5.3 million relating to
cost report settlement issues, and the settlement of claims with suppliers and
employees.

In 2001, the Company recorded a loss on disposal of assets of $1.0 million
and a provision for closure and exit costs and other items of $23.2 million, as
discussed below. In September 2001, the Company transferred all nursing
facilities in Texas to Senior Health Properties-Texas, Inc. ("Senior
Health-Texas") resulting in a pre-tax loss of $1.8 million. In addition, the
Company recorded provisions totaling $2.0 million relating to the closure and/or
sale of three nursing properties. The Company made additional provisions of
$20.2 million relating to previously sold operations, of which $19.0 million
relates to the nursing facilities in Florida. This $19.0 million consists of an
$11.0 million provision related to Florida claims for years prior to 2001 based
upon an actuarial review of resident liability costs and an $8.0 million
provision for Florida closure and exit costs.
54

4. LOSS ON DISPOSAL OF ASSETS, PROVISION FOR CLOSURE AND EXIT COSTS, AND
IMPAIRMENT OF LONG-LIVED ASSETS (CONTINUED)

The $11.0 million provision was the result of an increase in the estimate of the
incurred but not yet reported claims and an increase in the frequency and
severity of claims incurred by the Company.

In September 2001, the Company transferred (via license transfer) the
operations of all its Texas nursing facilities to Senior Health-Texas. The
transaction involved 17 skilled nursing facilities, with a capacity of 1,421
residents, of which 13 facilities are subleased to Senior Health-Texas and the
remainder leased to Senior Health-Texas on a five-year term from the Company.
Senior Health-Texas will operate the subleased facilities for their remaining
lease terms, one of which expired in October 2001, and the remainder expiring
through February 2012. In November 2001, the landlord of the subleased nursing
facility for which the lease term expired in October 2001 assumed operational
responsibility for the facility and the Company provided consulting services to
the landlord for a five month period. The annual rental income from Senior
Health-Texas is approximately $3.8 million per annum, or $1.8 million in excess
of the Company's current annual lease costs, and will escalate in alignment to
the existing lease and in alignment with Medicaid rate increases for the owned
facilities. Senior Health-Texas has the right to first refusal on the purchase
of the four owned facilities.

In April 2001, Tandem exercised its option to purchase two leased nursing
properties in Florida for gross proceeds of $11.4 million. Proceeds consisted of
cash of $7.0 million, a $2.5 million interest-bearing five-year note and $1.9
million in cumulative dividend preferred shares, redeemable after five years.
The Company's carrying value of the two facilities was $9.2 million. Tandem
continued to operate seven nursing facilities under a lease agreement with the
Company, with an option to purchase these facilities at any time until May 2002.
In accordance with Statement of Financial Accounting Standards No. 66 (SFAS No.
66), the Company deferred a potential gain on the sale of these assets of $2.2
million because a significant portion of the proceeds had not been received and
the ultimate determination of the gain was dependent on Tandem exercising some
or all of the remaining purchase options available to it. For these reasons, the
Company did not record any gain or loss on the sale until May 2002 as described
above. The Company applied $4.0 million of the net cash proceeds to further
reduce its term bank debt.

In 2000, the Company was successful in the disposition or lease of all of
its operations in Florida consisting of 32 facilities (3,427 beds) through a
series of transactions, two of which involved lease agreements with operators
who have an option to purchase the properties, and one in which the Company
retains an interest in the properties through the contingent consideration terms
of the agreement. In addition, the Company sold two formerly closed facilities.
In aggregate these five transactions, along with other asset sales, resulted in
cash proceeds of $37.7 million, of which $33.1 million was applied to reduce
debt. The sale of Florida facilities resulted in a pre-tax provision for closure
and exit costs of $1.6 million. In addition, in states other than Florida, the
Company recorded provisions for closure and exit costs of $1.7 million for the
closure of two nursing and one assisted living facilities and $0.6 million for
the disposition of other non-core assets. For 2000, the total loss from the
disposal of assets was $3.3 million and the total provision for closure and exit
costs and other items was $3.4 million.

In December 2000, the Company leased nine Florida nursing facilities (1,033
beds) to Tandem for an 18-month term. In April 2001, Tandem exercised its right
to acquire two of the facilities and in May 2002, Tandem exercised its option to
purchase the remaining seven facilities.

In December 2000, the Company leased six nursing facilities (585 beds) to
Senior Health Properties-South, Inc. ("Senior Health-South") for a 60-month
term. Under the terms of the transaction, Senior Health-South has an option to
purchase the properties for $10.7 million. The Company will earn rental income
based upon the net operating cash flow of the properties, which cannot exceed on
average $2.0 million per annum and has entered into a specific services
consulting agreement over the term of the lease with Senior Health-South. Under
the terms of transaction, the Company has retained a commitment to fund any cash
flow deficiencies for one of the six properties, which the Company anticipates
would not exceed $300,000 per annum. All operations and assets, other than the
land, building and equipment, were transferred to the lessees at the
commencement of the leases at no cost to the lessees. Refer to Note 14.
55

4. LOSS ON DISPOSAL OF ASSETS, PROVISION FOR CLOSURE AND EXIT COSTS, AND
IMPAIRMENT OF LONG-LIVED ASSETS (CONTINUED)

In December 2000, the Company sold one Florida nursing facility (120 beds)
for $3.8 million. Consideration was comprised of notes totaling $1.2 million
(before prepayment discounts) and $2.6 million in cash, of which $932,000 is
held in escrow for settlement for potential claims. The two promissory notes
contain certain prepayment discounts totaling $324,000, which the Company has
assumed will be exercised and therefore the sale resulted in a pre-tax loss of
$2.5 million. The Company applied the net proceeds from this transaction of $1.6
million to reduce debt. In December 2001, the Company sold the two promissory
notes for $825,000 in cash, which was held in escrow until January 2002.

In September 2000, the Company disposed of eleven Florida nursing
facilities (1,435 beds) and four Florida assisted living facilities (135 units)
to Greystone Tribeca Acquisition L.L.C. ("Greystone") for initial cash proceeds
of $30.0 million and contingent consideration in the form of a series of
interest bearing notes, which have an aggregate potential value of up to $30.0
million plus interest. The notes have a maximum term of three and one half years
and may be retired at any time out of the proceeds from the sale or refinancing
of the facilities by Greystone. During the term of the notes, the Company
retains the right of first refusal and an option to repurchase the facilities in
March 2004, which if not accepted, will trigger repayment of the balance of the
notes. The option to repurchase, along with the significant portion of the sales
price being contingent, results in the disposition being accounted for as a
deferred sale in accordance with SFAS No. 66. There was no gain or loss recorded
on the initial transaction, and the Company will continue to depreciate the
fixed assets on its records, which as of December 31, 2002 had a net book value
of $36.2 million and have been classified under "Other Assets" as "Assets held
under Divestiture Agreement". The initial cash proceeds have been classified
within "Other Long-term Liabilities" in the balance sheet as "Deposits held
under Divestiture Agreement". Additional payments received, including interest,
will increase the deposits net of carrying costs paid. The Company applied the
net after tax proceeds from this transaction of $27.5 million to reduce debt.

In July 2000, the Company sold one Florida nursing facility (119 beds) for
$2.8 million. The sale resulted in a pre-tax gain of $940,000. The Company
applied the net after tax proceeds from this transaction of $2.0 million to
reduce debt.

In May and June, 2000 the Company sold two previously closed nursing
facilities for $2.0 million and $700,000 respectively resulting in pre-tax
losses of $453,000 and $1.1 million, respectively. In June and October 2000,
leases at two of the Company's nursing homes in Oregon (135 operational beds)
expired and were not renewed. Certain equipment assets of these Oregon homes
were sold for $168,000, resulting in no gain or loss. In February 2000, the
Company sold seven outpatient therapy facilities resulting in a pre-tax loss of
$71,000.

a) Loss (Gain) on the Sale of Assets

The following summarizes the components of the loss (gain) on the sale of
assets:

56

4. LOSS ON DISPOSAL OF ASSETS, PROVISION FOR CLOSURE AND EXIT COSTS, AND
IMPAIRMENT OF LONG-LIVED ASSETS (CONTINUED)

b) Provision for Closure and Exit Costs and Other items

The provision for closure and exit costs and other items is summarized as
follows:

c) Impairment of Long-lived Assets

The Company records impairment losses recognized for long-lived assets used
in operations when indicators of impairment are present and the estimated
undiscounted future cash flows do not appear to be sufficient to recover the
assets' carrying amounts. The impairment loss is measured by comparing the fair
value of the asset to its carrying amount. In addition, once management has
committed the organization to a plan for disposal, assets held for disposal are
adjusted to the lower of the assets' carrying value and the fair value less
costs to sell. Accordingly, management has estimated the future cash flows of
each facility and reduced the carrying value to the estimated fair value less
costs to sell, where appropriate.

In September 2001 the Company made a formal decision to divest of its
nursing facilities (but not assisted living facilities) in Texas and completed a
transaction through which the Company ceased operating these facilities. This
transaction resulted in the Company leasing all four owned facilities and
subleasing the remaining 13 nursing facilities to a third party operator. As a
result of the transaction, the Company recorded a provision of $1.7 million for
impairment of these remaining Texas properties of which all related to leasehold
rights and leasehold improvements on the facilities. Refer to discussion in
"Loss on Disposal of Assets and Other Items".

In December 2000 the Company made a formal decision to divest of all
remaining operations in Florida and completed two transactions through which the
Company leased all of its remaining operations. Both transactions resulted in
providing two operators with a first right to purchase the properties within the
lease term. The Company recorded a provision of $15.9 million for impairment of
these remaining Florida properties including a provision of $1.1 million for
costs related to the termination of its Florida operational staff. In addition,
in December 2000, the Company determined that a $4.8 million adjustment was
required for non-Florida properties, resulting in a total impairment provision
for 2000 (including Florida) of $20.7 million applicable to goodwill, property
and equipment, of which $2.0 million related to goodwill.

57

4. LOSS ON DISPOSAL OF ASSETS, PROVISION FOR CLOSURE AND EXIT COSTS, AND
IMPAIRMENT OF LONG-LIVED ASSETS (CONTINUED)

(d) Reconciliation to cash flow statement

The following reconciles the loss from asset impairment, disposals and
other items to that reported in the cash flow statements. The provision for
general and professional liability costs is removed as it is already reflected
in the line item provision for self-insured liabilities as an item not involving
cash.

5. ACQUISITION OF PREVIOUSLY-LEASED FACILITIES

On October 1, 2002 the Company completed a transaction which exercised its
right to acquire seven previously-leased nursing facilities in the states of
Ohio and Indiana for $17.9 million. The purchase included cash of $7.4 million
and a $10.5 million interest bearing 10-year note. Negotiation on the interest
rate continues with the vendor who holds the note and, failing any agreement,
will be settled through arbitration.

6. PROPERTY AND EQUIPMENT

Property and equipment and related accumulated depreciation and
amortization as of December 31 is as follows:

Included within property and equipment are properties leased to unrelated
operators (refer to Note 14).

58

7. GOODWILL AND OTHER INTANGIBLE ASSETS

Goodwill and other intangible assets consisted of the following at December
31:

Aggregate amortization expense for leasehold rights for the years ended
December 31, 2002 and 2001 was $1.3 million and $1.3 million, respectively.
Estimated amortization expense for the next five years is $1.1 million in 2003,
$1.1 million in 2004, $1.1 million in 2005, $577,000 in 2006 and $194.000 in
2007.

8. OTHER ASSETS

Other assets consisted of the following at December 31:

For Medicare revenues earned prior to the implementation of PPS, and
Medicaid programs with a retrospective reimbursement system, differences between
revenues that the Company ultimately expects to be realized from these programs
and amounts received are reflected as accounts receivable; or as accrued
liabilities when payments have exceeded revenues that the Company ultimately
expects to be realized. Accounts receivable from both Medicare and Medicaid
state programs at December 31, 2002 totaled $46.3 million (2001 -- $48.2
million), of which $16.6 million (2001 -- $11.8 million) are expected to be
substantially collected within one year.

59

8. OTHER ASSETS (CONTINUED)

As of December 2002, the Company is pursuing settlement of a number of
outstanding Medicaid and Medicare receivables. Due to the length of the
settlement process, some of those receivables are not expected to be collected
within one year and, as a result, are classified as long-term other assets. For
one specific issue involving the allocation of overhead costs totaling $14.8
million, the first of three specific claim years was presented to the Provider
Reimbursement Review Board ("PRRB") at a hearing on January 30, 2003. The
hearing procedures were discontinued after the parties negotiated a methodology
for resolution of the claim, and an administrative resolution has been signed by
the Fiscal Intermediary ("FI") and the Company to settle the amount, which will
be determined later in 2003. For another specific issue involving a staffing
cost issue totaling $7.3 million, a settlement of the first year of seven
specific claim years was settled prior to the PRRB hearing, and an agreement has
been reached with the FI to continue to negotiate the remaining years in
dispute. No adjustment to the amounts reflected as of December 31, 2002 is
determinable at this time. Further negotiations on the remaining years under
appeal are to occur during 2003. No adjustment to the receivable amount can be
determined until negotiations are concluded on a majority of the remaining claim
years under appeal.

Accumulated amortization of deferred financing costs as of December 31,
2002 and 2001 was $4.5 million and $8.8 million, respectively.

9. LINE OF CREDIT AND LONG-TERM DEBT

Long-term debt consisted of the following at December 31:

On June 28, 2002, the Company completed a private placement of $150 million
of its 9.5% Senior Notes due July 1, 2010 (the "Senior Notes") which were issued
at a discount of 0.25% of par to yield 9.54%. In January 2003, the Company
completed its offer to exchange new 9.5% Senior Notes due 2010 that have been
registered under the Securities Act of 1933 for the Notes issued in June 2002.
The terms of the new Senior Notes are identical to the terms of the Senior Notes
issued in June 2002 and are guaranteed by all existing and future active
subsidiaries of the Company.

The Company used the proceeds of $149.6 million from the Senior Notes to
pay related fees and expenses of $8.3 million, to retire $124.5 million of
indebtedness outstanding under its previous credit facility and Term Loans, to
refinance $6.3 million of other debt, and for general corporate purposes. The
retirement of the previous credit facility resulted in an extraordinary loss on
early retirement of debt (net of income taxes)

60

9. LINE OF CREDIT AND LONG-TERM DEBT -- (CONTINUED)

of $1.7 million. Also on June 28, 2002, the Company entered into an interest
rate swap agreement and an interest rate cap agreement. See Note 15 for the
terms of the swap and cap agreements.

Concurrent with the sale of the Senior Notes, the Company established a new
five-year $105 million senior secured revolving credit facility (the "Credit
Facility") that is used to back letters of credit and for general corporate
purposes. Borrowings under the Credit Facility bear interest, at the Company's
option, at the Eurodollar rate or the prime rate, plus applicable margins,
depending upon the Company's leverage ratio. As of December 31, 2002 the Company
had no borrowings from the Revolving Credit Facility. The unused portion of the
Revolving Credit Facility, that is available for working capital and corporate
purposes, after reduction for outstanding letters of credit of $38.8 million,
was $66.2 million as of December 31, 2002.

The Senior Notes and the Credit Facility contain a number of covenants,
including: restrictions on the payment of dividends by the Company; limitations
on capital expenditures, investments, redemptions of the Company's common stock
and changes of control of the Company; as well as financial covenants, including
fixed charge coverage, debt leverage, and tangible net worth ratios. The Company
is required to make mandatory prepayments of principal upon the occurrence of
certain events, such as certain asset sales and certain issuances of securities.
The Company is permitted to make voluntary prepayments at any time under the
Credit Facility. The Senior Notes are redeemable at the option of the Company
starting on July 1, 2006. The redemption prices, if redeemed during the 12-month
period beginning on July 1 of the year indicated, are as follows:

The Company is in compliance with the financial covenants as of December
31, 2002.

The Company has no independent assets or operations, the guarantees of the
Senior Notes are full and unconditional, and joint and several, and any of the
Company's subsidiaries that do not guarantee the Senior Notes are minor.

On December 2, 1997, the Company issued $200 million of 9.35% Senior
Subordinated Notes due 2007 (the "Senior Subordinated Notes"). The Senior
Subordinated Notes are unsecured senior subordinated obligations of the Company
subordinated in right of payment to all existing and future senior indebtedness
of the Company, which includes all borrowings under the Credit Facility as well
as all indebtedness not refinanced by the Credit Facility. At December 31, 2002,
Extendicare Inc. held $27.9 million of the Senior Subordinated Notes.

The Senior Subordinated Notes are unsecured senior subordinated obligations
of the Company subordinated in right of payment to all existing and future
senior indebtedness of the Company, which includes all borrowings under the
Credit Facility as well as all indebtedness not refinanced by the Credit
Facility. The Senior Subordinated Notes mature on December 15, 2007. Interest on
the Senior Subordinated Notes is payable semi-annually.

The Revolving Credit Facility, the Tranche A Term Loan and the Tranche B
Term Loan ("previous credit facility") bore interest at the Company's option at
rates equal to the prime rate or LIBOR, plus applicable margins, depending upon
the Company's leverage ratios. Applicable margins under the Revolving Credit
Facility and Tranche A Term Loan were 1.50% for prime rate loans and 2.25% for
LIBOR based borrowings. The applicable margin under the Tranche B Term Loan was
2.25% for prime rate borrowings and 3.00% for LIBOR based borrowings. The
average interest rates outstanding for the Revolving Credit Facility, Tranche A
Term Loan and Tranche B Term Loan at December 31, 2001 were 4.41%, 5.16%, and
4.19%, respectively. The Company paid a commitment fee on the unused portion of
the Credit Facility at an annual rate of 0.50%.

61

9. LINE OF CREDIT AND LONG-TERM DEBT -- (CONTINUED)

Principal payments on long-term debt due within the next five years and
thereafter are as follows (dollars in thousands):

2003........................................................ $ 716
2004........................................................ 756
2005........................................................ 733
2006........................................................ 698
2007........................................................ 203,491
After 2007.................................................. 191,756
--------
$398,150
========

Interest paid in 2002, 2001 and 2000 was $26.2 million, $35.5 million and
$47.2 million, respectively.

10. ACCRUED LIABILITIES

Accrued liabilities consisted of the following at December 31:

Below is a summary of activity of the accrued liabilities balance relating
to divested operations and facility closures:

- ---------------
(1) The liability for other expenses consists of amounts reserved for cost
report and other settlements with the states of Florida and Texas and other
Medicare fiscal intermediaries, collection of receivables, and settlement of
claims with suppliers and employees.

62

10. ACCRUED LIABILITIES -- (CONTINUED)

(2) The provision of $6,407 for 2002 includes the provision for closure and exit
costs of $5,293, selling expenses of $1,200 relating to the sale of assets
to Tandem less other items of $86.

11. ACCRUAL FOR SELF-INSURED LIABILITIES

The Company insures certain risks with affiliated insurance subsidiaries of
Extendicare, and certain third-party insurers. The insurance policies cover
comprehensive general and professional liability, workers' compensation and
employer's liability insurance in amounts and with such coverage and deductibles
as the Company deems appropriate, based on the nature and risks of its business,
historical experiences, availability and industry standards. The Company also
self-insures for health and dental claims, in certain states for workers'
compensation and employer's liability. As a result of limited availability from
third party insurers or availability at an excessive cost or deductible, since
January 2000, we self-insure for comprehensive general and professional
liability (including our malpractice exposure arising from duties performed on
our behalf by our professional staff, assistants and other staff) up to a
certain amount per incident. Self-insured liabilities with respect to general
and professional liability claims are included within the Accrual for
Self-insured Liabilities. The Company's accrual for self-insured health and
dental claims, and workers' compensation are included in accrued liabilities
(see Note 10).

Management regularly evaluates the appropriateness of the carrying value of
the self-insured liability through an independent actuarial review. General and
professional liability claims are the most volatile and significant of the risks
for which the Company self-insures. Management's estimate of the accrual for
general and professional liability costs is significantly influenced by
assumptions, which are limited by the uncertainty of predicting future events,
and assessments regarding expectations of several factors. Such factors include,
but are not limited to: the frequency and severity of claims, which can differ
materially by jurisdiction; coverage limits of third-party reinsurance; the
effectiveness of the claims management process; and the outcome of litigation.
In addition, the Company estimates the amount of general and professional
liability claims it will pay in the subsequent year and classifies this amount
as a current liability. Prior to 2002, the Company was unable to estimate a
current liability amount due to the lack of historical experience with the
self-insurance program.

In 2000, the Company experienced adverse claims development resulting in an
increase in the accrual for self-insured liabilities. Consequently, as of
January 1, 2000 the Company's per claim retained risk increased significantly
for general and professional liability coverage mainly due to the level of risk
associated with Florida and Texas operations. As of January 1, 2001, the Company
no longer operated nursing and assisted living facilities in Florida and as of
October 1, 2001 ceased nursing operations in Texas, thereby reducing the level
of exposure to future litigation in these litigious states. However, as a result
of an increase in the frequency and severity of claims the Company recorded an
additional $11.0 million provision (refer to Note 4) to increase its accrual for
resident care liability in the third quarter of 2001. This additional accrual
was based upon an independent actuarial review and was largely attributable to
potential claims for incidents in Florida and Texas prior to the Company's
cessation of operations in those states. Changes in the Company's level of
retained risk, and other significant assumptions that underlie management's
estimates of self-insured liabilities, could have a material effect on the
future carrying value of the self-insured liabilities as well as the Company's
operating results and liquidity.

63

11. ACCRUAL FOR SELF-INSURED LIABILITIES (CONTINUED)

Following is a summary of activity in the accrual for self-insured
liabilities:

12. OTHER LONG-TERM LIABILITIES

Other long-term liabilities consisted of the following at December 31:

As noted in Note 4, the Company disposed of eleven Florida nursing
facilities (1,435 beds) and four Florida assisted living facilities (135 units)
to Greystone for initial cash proceeds of $30.0 million and contingent
consideration in the form of a series of interest bearing notes which have an
aggregate potential value of up to $30.0 million plus interest. The disposition
is being accounted for as a deferred sale in accordance with SFAS 66 and
therefore, the initial cash proceeds have been classified as "Deposits held
under the Divestiture Agreement". Greystone has not sold or refinanced the
properties and therefore has not triggered the determination and payment of the
contingent notes.

The Company maintains an unfunded deferred compensation plan offered to all
corporate employees defined as highly compensated by the Internal Revenue
Service Code in which participants may defer up to 10% of their base salary. The
Company will match up to 50% of the amount deferred. The Company also maintains
non-qualified deferred compensation plans covering certain executive employees.
Expense incurred for Company contributions under such plans were $361,000,
$278,000 and $91,000 in 2002, 2001 and 2000, respectively.

The Company maintains defined contribution retirement 401(k) savings plans,
which are made available to substantially all of the Company's employees. The
Company pays a matching contribution of 17% to 25% of every qualifying dollar
contributed by plan participants, net of any forfeitures. Expenses incurred by
the Company related to the 401(k) savings plans were $1.3 million, $1.3 million
and $1.4 million in 2002, 2001 and 2000, respectively. The Company also
maintains a money purchase plan for three facilities in which the Company pays
amounts based upon the plan participants worked hours and an agreed fixed hourly
rate. Expenses incurred by the Company related to the money purchase plan were
$96,000, $54,000 and $65,000 in 2002, 2001 and 2000, respectively.

64

13. REVENUES

The Company derived approximately 26%, 24% and 24% of its revenues from
services provided under various federal (Medicare) and approximately 50%, 51%
and 51% of its revenues from services provided under various state (Medicaid)
medical assistance programs in 2002, 2001 and 2000, respectively. The Medicare
program and most state Medicaid programs pay each participating facility on a
prospectively-set per diem rate for each resident, which is based on the
resident's acuity. Most Medicaid programs fund participating facilities using a
case-mix system, paying prospectively set rates. Prior to 1999, the Medicare
program was a cost-based reimbursement program.

a) Balanced Budget Act and the Prospective Payment System

The Balanced Budget Act ("BBA"), signed into law in August 1997, made
numerous changes to the Medicare and Medicaid programs. With respect to the
Medicare program, the BBA established a Prospective Payment System ("PPS") for
skilled nursing facility funding certified under the Medicare program. The PPS
establishes a federal per diem rate for virtually all covered services and the
provisions of the BBA provided that for skilled nursing facilities in operation
prior to 1996, the federal per diem rate would be phased in over a four-year
period. In November 1999, the Balanced Budget Relief Act ("BBRA") was passed to
allow each skilled nursing facility to apply to adopt the full federal rate
effective January 1, 2000 or to continue to phase in to the federal rate over
the next three years. An evaluation was completed by the management of the
Company, to determine the skilled nursing facilities that would benefit from
adoption of the full federal rate, and where appropriate the Company applied and
later received approval to have these facilities placed on the full federal
rate. Effective January 2002, all skilled nursing facilities are reimbursed at
the full federal rate.

With respect to the Medicaid program, the BBA repealed the federal payment
standard which required state Medicaid programs to pay rates that were
reasonable and adequate to meet the costs necessary to efficiently and
economically operate skilled nursing facilities. As a result, states have
considerable flexibility in establishing payment rates for Medicaid services
provided after October 1, 1997.

b) Balanced Budget Refinement Act of 1999 ("BBRA") and Benefits Improvement and
Protection Act of 2000 ("BIPA")

As a result of the industry coming under financial pressure due to the
implementation of PPS and other BBA of 1997 provisions, Congress passed two acts
to provide some relief to the industry, namely the BBRA of 1999 and the BIPA of
2000. These laws contained additional funding provisions to assist providers as
they adjusted to PPS for an interim period. The BBRA of 1999 increased the rate
by 20% for 15 Resource Utilization Groups III ("RUGs") categories identified as
having intensity non-therapy ancillary services deemed to be underfunded. The
BBRA of 1999 also provided for a 4% increase to all RUGs categories on October
1, 2000. The BIPA of 2000 increased the nursing component of the federal rate by
16.66% and replaced the 20% add-on to the three RUGs categories with a 6.7%
add-on for all 14 rehabilitative RUGs categories.

The funding enhancements implemented by the BBRA and BIPA fall into two
categories. The first category is "Legislative Add-ons" which included a 16.66%
add-on to the nursing component of the RUGs rate and a 4% base adjustment. The
second category is "RUGs Refinements" which involved an initial 20% add-on for
15 RUGs categories identified as having high intensity, non-therapy ancillary
services (later redistributed the 20% add-ons from three RUGs categories to 14
Rehab categories at 6.7%).

The Legislative Add-ons expired on September 30, 2002 and the Company's
Medicare funding has been reduced. Based on the Medicare case mix and census
over the nine months ended September 30, 2002 the Company estimates that it
received an average rate of $31.22 per resident day relating to the Legislative
Add-ons. Offsetting this, on October 1, 2002 long-term care providers received a
2.6% market basket increase in Medicare rates. The impact of these two items in
the fourth quarter of 2002 was a net decline in our average rate of $23.64 per
patient day, which based upon the Medicare case mix and patient days for the
year ended December 31, 2002, amounts to lower annualized revenues of
approximately $14.7 million going forward.

65

13. REVENUES (CONTINUED)

With respect to the RUGs Refinements, on April 23, 2002 CMS announced it
would delay the refinement of the RUGs categories thereby extending the related
funding enhancements for at least one additional year to September 30, 2003.
Further to this, in the budget report released in February, 2003 President Bush
proposed additional funding to extend the RUGs Refinements to September 30, 2004
and though the President's budget has not been passed, CMS has agreed verbally
with the extension of the RUGs refinements to September 30, 2004. Based upon the
Medicare case mix and census for the year ended December 31, 2002, the Company
has estimated that it received an average $24.40 per resident day, which on an
annualized basis amounts to $15.1 million related to the RUGs Refinements. A
decision to discontinue all or part of the enhancement could have a significant
negative impact on the Company.

c) Provision (Recovery) for Outstanding Medicare Receivable

In the normal course of business, the Company has ongoing discussions with
its FI regarding the treatment of various items related to prior years' cost
reports. Normally items are resolved during the audit process and no provisions
are required. For items involving differences of opinion between the Company and
the FI regarding cost report methods, such items can be settled through a formal
appeal process. Should this occur, a general provision for Medicare receivables
may be provided for disagreements, which result in the provider filing an appeal
with the PRRB of the CMS.

During 1999, the FI notified the Company of several adjustments for
services rendered from 1995 through 1998. In the fourth quarter of 1999, the
Company made a decision to file a formal appeal to the PRRB and based upon this
decision, a general provision of $27.4 million was recorded as a reduction of
revenues in 1999. In April 2000, the PRRB heard the Company's first appeal
involving the reimbursement of workers' compensation costs and during September
2000, issued a decision that supported the Company's position. In December 2000,
the Administrator for CMS confirmed the PRRB's decision resulting in a favorable
settlement of $12.4 million, including a recovery recorded in revenue of $10.3
million of the general provision recorded in 1999. In addition, the Company
reached a settlement on another staffing cost issue resulting in a recovery of
$2.4 million including a recovery of $1.7 million of the general provision
recorded in 1999. In total, a recovery of $12.0 million before tax was recorded
in 2000 relating to the general provision recorded in 1999.

14. LEASE COMMITMENTS

As a lessee, the Company, at December 31, 2002, was committed under
non-cancelable operating leases requiring future minimum rentals as follows
(dollars in thousands):

2003........................................................ $ 7,964
2004........................................................ 7,285
2005........................................................ 7,069
2006........................................................ 4,472
2007........................................................ 3,225
After 2007.................................................. 18,460
-------
Total minimum payments...................................... $48,475
=======

Operating lease costs were $10.6 million, $14.6 million and $18.0 million
in 2002, 2001 and 2000, respectively. These leases expire on various dates
extending to the year 2013 and in many cases contain renewal options.

As a lessor, at December 31, 2002, the Company leases 10 nursing properties
(1,065 beds) to two unrelated operators in Florida and in Texas under the terms
outlined in Note 4. The leases are accounted for as operating leases and both
operators have an option to purchase the facilities during the term. The lease
of six nursing properties to Senior Health-South expires in December 2005, and
the Company earns rental income (based upon the net operating cash flow of the
properties) which on average cannot exceed

66

14. LEASE COMMITMENTS (CONTINUED)

$2.0 million per annum. Rental income earned during 2002 totaled $523,000 under
this lease. Senior Health-Texas leases four nursing properties for a term which
expires in October 2006, and subleases another 12 properties until February
2012, all in Texas. The annual rental income during 2002 totaled $3.8 million or
$1.8 million in excess of the Company's annual lease cost. The cost and
accumulated depreciation of facilities under operating lease arrangements
included in Property and Equipment (refer to Note 6) as of December 31, 2002 are
as follows (dollars in thousands):

Land and land improvements.................................. $ 2,147
Buildings and improvements.................................. 32,748
Furniture and equipment..................................... 8,062
-------
42,957
Less accumulated depreciation and amortization.............. 25,987
-------
Property and equipment...................................... $16,970
=======

15. DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES

OBJECTIVES AND STRATEGIES PRIOR TO ISSUANCE OF SENIOR NOTES

Prior to the issuance of the Senior Notes in June 2002, the Company had
variable-rate long-term debt of approximately $124.5 million, which it used to
finance its operations. These debt obligations exposed the Company to
variability in interest payments due to changes in interest rates. The Company
hedged a portion of its variable-rate debt through interest rate swaps
designated as cash-flow hedges with a notional amount of $25 million maturing in
February 2003 under which the Company received variable interest rate payments
and made fixed-rate interest payments. When the Company issued the fixed-rate
Senior Notes, the proceeds were used to payoff the variable-rate debt which was
being hedged by the interest rate swaps. These interest rate swaps were
terminated by the Company in June 2002 with a cash payment of $635,000 and
charged to extraordinary loss.

OBJECTIVES AND STRATEGIES AFTER ISSUANCE OF SENIOR NOTES

After the issuance of the Senior Notes, all but $32 million of the
Company's outstanding debt obligations have fixed interest rates. The market
value of these fixed-rate debt obligations vary based on changes in interest
rates.

Management believes that it is prudent to limit the variability of the
market value of its fixed-rate debt obligations. To meet this objective, the
Company entered into an interest rate swap in June 2002. This swap effectively
changes the fixed-rate cash flows on fixed-rate long-term debt to variable-rate
cash flows. Under the interest rate swap, the Company pays variable interest
rate payments and receives fixed interest rate payments. In addition, the
Company uses an interest rate cap to offset possible increases in interest
payments under the interest rate swap caused by increases in market interest
rates over a certain level and also as a cash flow hedge to effectively limit
increases in interest payments under its variable-rate debt obligations.

The Company does not speculate using derivative instruments.

RISK MANAGEMENT POLICIES

The Company assesses interest rate cash flow risk by continually
identifying and monitoring changes in interest rate exposures that may adversely
impact expected future cash flows and by evaluating hedging opportunities. The
Company maintains risk management control systems to monitor interest rate cash
flow risk attributable to both the Company's outstanding or forecasted debt
obligations as well as the Company's offsetting hedge positions. The risk
management control systems involve the use of analytical techniques, including
cash flow sensitivity analysis, to estimate the expected impact of changes in
interest rates on the Company's future cash flows.

67

15. DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES (CONTINUED)

QUANTITATIVE DISCLOSURES

In June 2002, the Company entered into an interest rate swap (used to hedge
the fair value of fixed-rate debt obligations) with a notional amount of $150
million maturing in December 2007. Under this swap, the Company pays a variable
rate of interest equal to the one-month London Interbank Borrowing rate
("LIBOR") (1.42% as of December 31, 2002), adjustable monthly, plus a spread of
4.805% and receives a fixed rate of 9.35%. This swap is designated as a fair
value hedge and changes in the market value of the swap had no impact on the
income statement during 2002.

Also in June 2002, the Company entered into an interest rate cap with a
notional amount of $150 million maturing in December 2007. Under this cap, the
Company pays a fixed rate of interest equal to 0.24% and receives a variable
rate of interest equal to the excess, if any, of the one-month LIBOR rate,
adjusted monthly, over the cap rate of 7%. A portion of the interest rate cap
with a notional amount of $32 million is designated as a hedging instrument
(cash-flow hedge) to effectively limit possible increases in interest payments
under variable-rate debt obligations. The remainder of the interest rate cap
with a notional amount of $118 million is used to offset increases in
variable-rate interest payments under the interest rate swap to the extent
one-month LIBOR exceeds 7%. This portion of the interest rate cap is not
designated as a hedging instrument under SFAS 133.

Changes in the fair value of a derivative that is highly effective and that
is designated and qualifies as a fair-value hedge, along with the loss or gain
on the hedged asset or liability of the hedged item that is attributable to the
hedged risk, are recorded in earnings. Changes in the fair value of cash flow
hedges are reported as Accumulated Other Comprehensive Income ("AOCI") as a
component of Shareholder's Equity. Changes in the fair value of the portion of
the interest rate cap not designated as a hedging instrument is reported in
earnings. As of December 31, 2002, the fair value of the interest rate swap
designated as a fair value hedge is an asset of $5.5 million and is offset by a
liability of $5.5 million relating to the change in market value of the hedged
item (long-term debt obligations). The fair value of the cash-flow hedges is a
liability recorded in other long-term liabilities of $0.2 million as of December
31, 2002 and the gain credited to AOCI (net of income tax effect) for 2002 was
$1.0 million. The fair value of the portion of the interest rate cap not
designated as a hedging instrument is a liability recorded in other long-term
liabilities as of December 31, 2002 of $0.7 million. During 2003, none of the
gains or losses in AOCI (net of income tax effect) related to the interest rate
cap are expected to be reclassified into interest expense as a yield adjustment
of the hedged debt obligation.

16. COMMITMENTS AND CONTINGENCIES

CAPITAL EXPENDITURES

The Company as of December 31, 2002 had capital expenditure purchase
commitments outstanding of approximately $5.4 million.

INSURANCE AND SELF-INSURED LIABILITIES

As discussed in Note 11, the Company insures certain risks with affiliated
insurance subsidiaries of Extendicare and third party insurers. The insurance
policies cover comprehensive general and professional liability (including
malpractice insurance) for the Company's health providers, assistants and other
staff as it relates to their respective duties performed on the Company's
behalf, property coverage, workers' compensation and employers' liability in
amounts and with such coverage and deductibles as determined by the Company,
based on the nature and risk of its businesses, historical experiences,
availability and industry standards. The Company also self insures for health
and dental claims, in certain states for workers' compensation and employers'
liability and for general and professional liability claims. Self-insured
liabilities with respect to general and professional liability claims are
included within the accrual for self-insured liabilities.

68

16. COMMITMENTS AND CONTINGENCIES (CONTINUED)

LITIGATION

The Company and its subsidiaries are defendants in actions brought against
them from time to time in connection with their operations. While it is not
possible to estimate the final outcome of the various proceedings at this time,
such actions generally are resolved within amounts provided. Refer to Note 11
which describes the nature and accrual for litigation settlements.

The U.S. Department of Justice and other federal agencies are increasing
resources dedicated to regulatory investigations and compliance audits of
healthcare providers. The Company is diligent to address these regulatory
efforts.

OMNICARE PREFERRED PROVIDER AGREEMENT

In 1998, the Company disposed of its pharmacy operations to Omnicare, Inc.
In addition, the Company entered into a Preferred Provider Agreement, the terms
of which enabled Omnicare to execute Pharmacy Service Agreements and Consulting
Service Agreements with all of the Company's skilled nursing facilities. Under
the terms of the agreement, the Company secured "per diem" pricing arrangements
for pharmacy supplies for the first four years of the Agreement, which period
expired December 2002. The Preferred Provider Agreement contains a number of
provisions which involve sophisticated calculations to determine the "per diem"
pricing during this first four-year period. Under the "per diem" pricing
arrangement, pharmacy costs fluctuate based upon occupancy levels in the
facilities. The "per diem" rates were established assuming a declining "per
diem" value over the initial four years of the contract to coincide with the
phase-in of the Medicare PPS rates. Omnicare has subsequently asserted that "per
diem" rates for managed care and Medicare beneficiaries are subject to an upward
adjustment based upon a comparison of per diem rates to pricing models based on
Medicaid rates.

In 2001, the Company and Omnicare brought a matter to arbitration,
involving a "per diem" pricing rate billed for managed care residents. This
matter was subsequently settled and amounts reflected in the financial results.
The parties are currently negotiating the pricing of drugs for Medicare
residents and should this matter not be settled, the matter will be taken to
arbitration. Provisions for settlement of this claim is included within the
financial statements.

In 2002, in connection with its agreements to provide pharmacy services to
the Company, Omnicare, Inc. has requested arbitration for an alleged lost
profits claim related to the Company's disposition of assets, primarily in
Florida. Damage amounts, if any, cannot be reasonably estimated based on
information available at this time. An arbitration hearing has not yet been
scheduled. The Company believes it has interpreted correctly and has complied
with the terms of the Preferred Provider Agreement; however, there can be no
assurance that other claims will not be made with respect to the agreement.

17. TRANSACTIONS WITH SHAREHOLDER AND AFFILIATES

The following is a summary of the Company's transactions with Extendicare
and its affiliates in 2002, 2001 and 2000:

INSURANCE

The Company insures certain risks with affiliated insurance subsidiaries of
Extendicare. The cost of general and professional liability premiums was the
most significant insurance expense charged to the Company by the affiliates. The
consolidated statements of operations for 2002, 2001 and 2000 include
intercompany insurance premium expenses of $9.9 million, $5.7 million and $20.7
million, respectively. These figures are net of favorable actuarial adjustments
for prior years under its retroactively-rated workers' compensation coverage in
the amounts of $0.9 million and $1.3 million in 2001 and 2000, respectively. The
Company's departure from the State of Florida and the State of Texas reduced
general and professional liability coverage expenditures in 2002 and 2001
compared to 2000.

69

17. TRANSACTIONS WITH SHAREHOLDER AND AFFILIATES (CONTINUED)

COMPUTER SERVICES

In January 2001, the Company established an agreement for computer hardware
and software support services with an affiliated subsidiary of Extendicare. The
annual cost of services was $6.8 million and $6.5 million for 2002 and 2001,
respectively.

LEASES

In 1999, the Company entered into a capital lease relating to computer
equipment with an affiliated subsidiary of Extendicare. In the first quarter of
2000, the Company exercised its option to purchase the equipment for $1.3
million. The consolidated statement of operations includes interest expense of
$319,000 related to this lease for 2000.

DUE TO SHAREHOLDERS AND AFFILIATES

Transactions affecting these accounts were general and professional
liability insurance charges, accrued liability claims from an affiliate and
working capital advances to an affiliate in 2002, 2001 and 2000, and charges
(payments) from (to) shareholder and affiliates for income taxes in each of the
three years.

At December 31, 2002, 2001 and 2000 the Company had a $3.5 million
non-interest bearing payable with no specific due date to a subsidiary company
of Extendicare.

CAPITAL AND OTHER TRANSACTIONS

During 2001 and 2000, Extendicare and/or one of its wholly owned
subsidiaries acquired $19.0 million and $8.9 million, respectively of the
Company's Senior Subordinated Notes. As of December 31, 2002, Extendicare held
$27.9 million (14.0%) of the outstanding Senior Subordinated Notes.

18. INCOME TAXES

The Company's results of operations are included in the consolidated
federal tax return of its U.S. parent company. Accordingly, federal current and
deferred income taxes payable are transferred to the Company's parent company.
The provisions for income taxes have been calculated as if the Company was a
separately taxed entity for each of the periods presented in the accompanying
consolidated financial statements.

Total income taxes for the years ended December 31, 2002, 2001 and 2000
were allocated as follows:

70

18. INCOME TAXES (CONTINUED)

The income tax expense (benefit) on income (loss) before income taxes and
extraordinary item consists of the following for the year ended December 31:

During 2002, the Company reported a reclassification of $5.9 million from
deferred to current income tax benefit, reflecting a new federal tax law enacted
in March 2002 retroactive to 2001, which extended the net operating loss
carryback period to five years from two years.

The differences between the effective tax rates on earnings before
provision for income taxes and extraordinary items, and the United States
federal income tax rate are as follows:

The Company received payments of $0.7 million, $22.5 million and $47.3
million for federal income taxes from its U.S. parent in 2002, 2001 and 2000,
respectively.

71

18. INCOME TAXES (CONTINUED)

The components of the net state deferred tax assets and liabilities as of
December 31 are as follows:

The Company paid state income taxes of $699,000, $326,000 and $98,000 in
2002, 2001 and 2000, respectively. As of December 31, 2002 the Company had $84.5
million of total net operating loss carryforwards available for state income tax
financial reporting purposes, which expire from 2003 to 2022. As of December 31,
2002, the Company had $164 million of capital loss carryforwards for state
income tax purposes which expire in 2004. Because the realizability of these
losses is uncertain, the operating loss and capital loss carryforwards are
offset by a valuation allowance.

The valuation allowance for state deferred tax assets as of December 31,
2002 and 2001 was $21.0 million and $20.2 million, respectively. The net change
in the total valuation allowance for the years ended December 31, 2002 and 2001
was an increase of $0.8 million and an increase of $2.8 million, respectively.
In assessing the realizability of deferred tax assets, management considers
whether it is more likely than not that some portion or all of the deferred tax
assets will not be realized. The ultimate realization of deferred tax assets is
dependent upon the generation of future taxable income during the periods in
which those temporary differences become deductible. Management considers the
scheduled reversal of deferred tax liabilities, projected future taxable income,
and tax planning strategies in making this assessment. Management believes it is
more likely than not the Company will realize the benefits of these deductible
differences, net of the valuation allowances.

72

19. COMPREHENSIVE INCOME

The accumulated balances for each classification of comprehensive income
are as follows:

The related tax effects allocated to each component of other comprehensive
income are as follows:

20. UNCERTAINTIES AND CERTAIN SIGNIFICANT RISKS

The Company's earnings are highly contingent on Medicare and Medicaid
funding rates, and the effective management of staffing and other costs of
operations which are strictly monitored through state and federal regulatory
authorities. The Company is unable to predict whether the federal or any state
government will adopt changes in their reimbursement systems, or if adopted and
implemented, what effect such initiatives would have on the Company. Limitations
on Medicare and Medicaid reimbursement for health care services are continually
proposed. Changes in applicable laws and regulations could have an adverse
effect on the levels of reimbursement from governmental, private and other
sources.

As outlined in Note 13(b), the incremental Medicare relief packages
received from BBRA and BIPA provided a total $2.7 billion in temporary Medicare
funding enhancements to the long-term care industry. The funding enhancements
implemented by the BBRA and BIPA fall into two categories. The first category is
"Legislative Add-ons" which included a 16.66% add-on to the nursing component of
the RUGs rate and the 4% base adjustment. The second category is "RUGs
Refinements" which involved an initial 20% add-on for 15 RUGs categories
identified as having high intensity, non-therapy ancillary services (later
redistributed the 20% add-ons from 3 RUGs categories to 14 Rehab categories at
6.7%).

The Legislative Add-ons expired on September 30, 2002 and the Company's
Medicare funding has been reduced. Based on the Medicare case mix and census
over the nine months ended September 30, 2002 the Company estimates that it
received an average rate of $31.22 per resident day relating to the Legislative
Add-ons. Offsetting this, on October 1, 2002 long-term care providers received a
2.6% market basket increase in Medicare rates. The impact of these two items in
the fourth quarter of 2002 was a net decline in the Company's average rate of
$23.64 per patient day, which based upon the Medicare case mix and patient days

73

20. UNCERTAINTIES AND CERTAIN SIGNIFICANT RISKS (CONTINUED)

for the year ended December 31, 2002, amounts to lower annualized revenues of
approximately $14.7 million going forward.

With respect to the RUGs Refinements, on April 23, 2002 CMS announced that
it would delay the refinement of the RUGs categories thereby extending the
related funding enhancements for at least one additional year to September 30,
2003. Further to this, in the budget report released in February 2003, President
Bush proposed additional funding to extend the RUGs Refinements to September 30,
2004 and though the President's budget has not been passed, CMS has agreed
verbally with the extension of the RUGs refinements to September 30, 2004. Based
upon the Medicare case mix and census for the year ended December 31, 2002, the
Company has estimated that it received an average $24.40 per resident day, which
on an annualized basis amounts to $15.1 million related to the RUGs Refinements.
A decision to discontinue all or part of the enhancement could have a
significant impact on the Company.

In the budget report released in February 2003, President Bush proposed
plans for a reduction in the inflationary increase ("market basket increase")
for skilled nursing facilities effective the government fiscal year commencing
on October 1, 2003 and in the subsequent years through to October 1, 2007. If
this budget is passed, it will mean reductions in the market basket increase of
$60 million starting in October 2003; $140 million in October 2004; $240 million
in October 2005; $350 million in October 2006; and $470 million in October 2007.

In January 2003, CMS announced that the moratorium on implementing payment
caps for outpatient Part B therapy services, which were scheduled to take effect
on January 1, 2003, would be extended for six months until July 1, 2003. The
impact of a payment cap cannot be reasonably estimated based on the information
available at this time, however, such a cap would reduce therapy revenues.

In February 2003, CMS announced its plan to reduce its level of
reimbursement for uncollectible Part A co-insurance. Under current law, skilled
nursing facilities are reimbursed 100% for any bad debts incurred. Over the next
three years, CMS plans to phase down the reimbursement level to 70% as follows:
90% effective for the government fiscal year commencing October 1, 2003; 80% for
the government fiscal year commencing October 1, 2004; and 70% for the
government fiscal year commencing October 1, 2005 and thereafter. This plan is
consistent with the bad debt reimbursement plan for hospitals. The Company
estimates that should this plan be implemented, the impact on net earnings would
be $1.0 million in 2004, increasing to $2.5 million in 2006.

Through the divestiture program in Texas and Florida, the Company has
assumed notes from the purchasers and retained ownership of certain nursing home
properties, which the Company leases to other unrelated long-term care
providers. In aggregate, as of December 31, 2002, the Company has $21.5 million
in notes and owns $17.0 million in nursing home properties in Texas and Florida.
In 2002, the Company earned $5.7 million in annual management and consulting
fees, and $3.7 million in rental revenue from properties owned as at December
31, 2002 from unrelated long-term operators. As a result, the earnings and cash
flow of the Company can be influenced by the financial stability of these
unrelated long-term operators.

The Company is attempting to settle a number of outstanding Medicare and
Medicaid receivables. Normally such items are resolved during an annual audit
process and no provision is required. However, where differences exist between
the Company and the Fiscal Intermediary, the Company may record a general
provision. For one specific issue involving the allocation of overhead costs
totaling $14.8 million, the first of three specific claim years was settled
prior to the the Provider Reimbursement Review Board ("PRRB") hearing on January
30, 2003. The hearing procedures were discontinued after the parties negotiated
a methodology for resolution of the claim, and an administrative resolution has
been signed by the Fiscal Intermediary and the Company to settle the amount,
which will be determined later in 2003. For another specific issue involving a
staffing cost issue totaling $7.3 million, a settlement of the first year of
seven specific claim years was settled prior to the PRRB hearing, and an
agreement has been reached with the Fiscal Intermediary to continue to negotiate
the remaining years in dispute. No adjustment to the amounts reflected as of
December 31, 2002 is determinable at this time. Further negotiations on the
remaining years under

74

20. UNCERTAINTIES AND CERTAIN SIGNIFICANT RISKS (CONTINUED)

appeal are to occur during 2003. No adjustment to the receivable amount can be
determined until negotiations are concluded on a majority of the remaining claim
years under appeal. Though the Company remains confident that it will
successfully settle the issues, an unsuccessful conclusion could negatively
impact the Company's earnings and cash flow. As of December 31, 2002 the Company
had $61.7 million in gross Medicare and Medicaid settlement receivables with a
related allowance for doubtful accounts of $15.4 million. The net amounts
receivable represents the Company's estimate of the amount collectible on
Medicare and Medicaid prior period cost reports.

The Company entered into a Preferred Provider Agreement with Omnicare, Inc.
pursuant to the divestiture of its pharmacy operation in 1998. In connection
with its agreement to provide pharmacy services, Omnicare has requested
arbitration for an alleged lost profits claim relating to the Company's
disposition of assets, primarily in Florida. Damage amounts, if any cannot be
reasonably estimated based on information available at this time. An arbitration
hearing for this matter has not been scheduled. The Company believes that it has
interpreted correctly and complied with the terms of the Preferred Provider
Agreement; however there can be no assurances that this claim will not be
successful or other claims arise.

The Company has $55.1 million in accruals for self-insured liabilities as
of December 31, 2002. Though the Company has been successful in exiting from the
states of Texas and Florida and limiting future exposure to general liability
claims in these states, the timing and eventual settlement costs for these
claims cannot be precisely defined.

The Company has a high level of indebtedness with debt service obligations
totaling $398.2 million in borrowings at December 31, 2002 representing 63.8% of
total capitalization, compared to a similar ratio of 63.4% at December 31, 2001.
As a result, the degree to which the Company is leveraged could have important
consequences, including, but not limited to the following:

- a substantial portion of the Company's cash flow from operations would be
dedicated to the payment of principal and interest on the Company's
indebtedness, thereby reducing the funds available for other purposes;

- the Company's ability to obtain additional financing within its current
Credit Facility for working capital, capital expenditures, acquisitions
or other purposes may be limited; and

- certain of the Company's borrowings are at variable rates of interest,
which exposes the Company to the risk of higher interest rates.

The Company expects to satisfy the required payments of principal and
interest on indebtedness from cash flow from operations. However, the Company's
ability to generate sufficient cash flow from operations depends on a number of
internal and external factors, including factors beyond the Company's control
such as prevailing industry conditions. There can be no assurance that cash flow
from operations will be sufficient to enable the Company to service its debt and
meet other obligations.

The Company is in compliance with the financial covenants as of December
31, 2002. While management has a strategy to remain in compliance, there can be
no assurance that the Company will meet future covenant requirements. The
Company's available bank lines can be affected by its ability to remain in
compliance, or if not, would depend upon management's ability to amend the
covenant or refinance the debt.

75

21. DISCLOSURES ABOUT FAIR VALUES OF FINANCIAL INSTRUMENTS

The estimated fair values of the Company's financial instruments at
December 31 are as follows:

The fair value of non-current accounts receivable, which are anticipated to
be collected beyond one year, are estimated based on discounted cash flows at
estimated current borrowing rates.

Other assets consist of debt service and capital expenditure trust funds
and other financial instruments, the fair values of which are estimated based on
market prices from the same or similar issues of the underlying investments.

The fair value of long-term debt is estimated based on approximate
borrowing rates currently available to the Company for debt equal to the
existing debt maturities. For other long-term liabilities, principally
refundable escrows, it is not practicable to estimate fair value.

The fair values of the interest rate swap and cap are based on the quoted
market prices as provided by the financial institution which is a counter-party
to the arrangements.

The fair value of deferred compensation, other long-term liabilities and
long-term due to affiliate are estimated to be equal to their carrying value.

22. SUPPLEMENTARY QUARTERLY FINANCIAL DATA (UNAUDITED)

The following is a summary of the quarterly results of operations for the
years ended December 31, 2002 and 2001 (in thousands):

76

22. SUPPLEMENTARY QUARTERLY FINANCIAL DATA (UNAUDITED) -- (CONTINUED)

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

None

77

PART III

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

The following table sets forth information with respect to our executive
officers and directors:

MEL RHINELANDER is our Chairman and Chief Executive Officer and one of our
directors. He has been with us and our affiliated companies since 1977 and has
served in a number of senior management positions. Mr. Rhinelander has been
President of Extendicare Inc. since August 1999, a director since May 2000 and
its Chief Executive Officer since August 2000. He has been an officer of our
company since 1989 and a director since 1998. He has been our Chief Executive
Officer since December 1999 and Chairman of our Board of Directors since August
2000.

MARK W. DURISHAN has been our Chief Financial Officer, Treasurer and one of
our Vice Presidents and directors since joining us in August 1999. At that time
he also joined Extendicare Inc. Prior to joining us, Mr. Durishan was Senior
Vice-President of Finance and Operations for Blue Cross and Blue Shield of
Minnesota where he served in such capacity from 1995 to 1998. From 1991 to 1995,
Mr. Durishan was Chief Financial Officer of Graduate Health System of
Philadelphia, a healthcare corporation encompassing seven hospitals, a
100,000-member HMO, a captive insurance company and a home health agency. During
his career, Mr. Durishan was a partner at Coopers & Lybrand responsible for the
Philadelphia and Washington healthcare consulting offices. Mr. Durishan has over
33 years of experience in the healthcare industry.

RICHARD L. BERTRAND is our Senior Vice President, Development. Mr. Bertrand
joined EHSI in 1983 as our Vice President of Finance. From 1983 to 1995 he
served as our Vice President of Finance and later as our Senior Vice President
of Finance and Chief Financial Officer. Beginning in 1995, Mr. Bertrand served
as our Senior Vice President, Reimbursement and later as our Senior Vice
President, Development. Prior to joining us, Mr. Bertrand served as Vice
President and Controller of Extendicare Inc. from 1977 to 1983. Prior to that,
he was a staff accountant and supervisor with the accounting firm of Thorne
Riddell from 1972 to 1976.

PHILIP W. SMALL joined us in June 2001 as our Senior Vice President,
Strategic Planning and Investor Relations. At that time he also joined
Extendicare Inc. He was appointed to our Board of Directors on December 31,
2001. Prior to joining us, Mr. Small served 15 years at Beverly Enterprises
Corporation, Fort Smith, Arkansas, in various financial capacities, the most
recent being Executive Vice President, Strategic Planning and Operations Support
and acting Chief Financial Officer. His prior experience includes serving as
Director, Reimbursement for HCA Management Company of Atlanta, Georgia. Mr.
Small has over 21 years of experience in the healthcare industry.

ROCH CARTER was appointed our Vice President, General Counsel and Assistant
Secretary in January 1998. He joined us in 1974 as Legal Counsel and he was
subsequently appointed our General Counsel in 1985. Prior to joining us, Mr.
Carter was an attorney with the United States Attorney's office in Milwaukee.
Mr. Carter was also an attorney with the City of Milwaukee and was in practice
with Young and McManus, S.C. Mr. Carter has over 28 years of experience in
healthcare law and practice.

DOUGLAS J. HARRIS joined us in December 1999 as our Controller and one of
our Vice Presidents. From 1994 through 1999, Mr. Harris was the Managing
Director of Extendicare (U.K.) Limited. Mr. Harris has been with us and our
affiliated companies since 1981 and has held positions in various financial
capacities. Prior to joining us, Mr. Harris was an audit supervisor with KPMG.

78

L. WILLIAM WAGNER joined us in 1987 as Vice President of Human Resources.
Prior to joining us, Mr. Wagner was Vice President of Human Resources for ARA
Living Centers and Director of Personnel for General Foods Corp. Mr. Wagner has
19 years of experience in the healthcare industry and over 25 years of human
resources experience.

79

ITEM 11. EXECUTIVE COMPENSATION

COMPENSATION OF NAMED EXECUTIVE OFFICERS

The following summary compensation table details compensation information
for the three fiscal years ended December 31, 2002, 2001 and 2000 for each of
our Chief Executive Officer and the four other most highly compensated executive
officers (collectively, the "named executive officers").

SUMMARY COMPENSATION TABLE

- ---------------
NOTES:
(1) The aggregate amount of perquisites and other benefits for each named
executive officer is less than the lesser of $50,000 or 10% of total annual
salary and bonus. In the case of M.A. Rhinelander, the amount is comprised
of car allowance and flexible account.

(2) For M.A. Rhinelander these amounts reflect premiums paid by the Company for
term life insurance and long-term disability. All other compensation, in the
case of M.W. Durishan, R.L. Bertrand, P.W. Small and J.A. Karoleski,
includes payments for life insurance and long-term disability premiums and
contributions to a deferred compensation plan and a defined contribution
retirement plan. The amount of salary and/or bonus deferred by the named
executive officer is included within the figures set forth in the "Salary"
and/or "Bonus" columns in the above table. EHSI's contribution is included
within the "All

80

Other Compensation" column. The amounts contributed by the officer and
EHSI's matching portion contributed to the deferred compensation plan are as
follows:

(3) P.W. Small commenced employment with the Company in June 2001.

(4) No EHSI contribution for deferred compensation was made in 2002 for J.A.
Karoleski because she chose other benefit options which disqualified her
from this benefit. J.A. Karoleski resigned on February 7, 2003.

DEFERRED COMPENSATION PLAN

We maintain a non-qualified, deferred compensation plan (consisting of
individual agreements), which is offered to all highly compensated employees as
prescribed by the Internal Revenue Service. The maximum amount of annual
compensation that may be deferred is 10% of the employee's base salary,
excluding any bonus. We match up to 50% of the amount deferred, and the combined
amount earns interest at the prime rate. Our matching payment, plus interest,
vests to the employee over eight years. Amounts deferred and vested matching
amounts are payable upon the death, disability or termination of the employee.
Amounts deferred are not guaranteed, are "at risk" and are subject to our
ability to make the scheduled payments. Our deferred compensation liabilities
are unfunded and unsecured.

EXECUTIVE RETIREMENT PLAN

We provide an executive retirement program for certain of our key officers
and executives. Under the program we contribute 10% of the participant's base
salary into an account to be invested in certain mutual funds at the
participant's discretion. The amounts in the executive retirement program vest
upon certain events which are specified in the participant's executive
retirement program plan, and by discretionary actions by the Board of Directors
of Extendicare Inc. A graduated vesting schedule applies for some program
participants if we terminate the participant. Any funds that we invest or assets
that we acquire pursuant to the program continue to be a part of our general
funds. No party, other than EHSI, has any interest in such funds. To the extent
that any participant acquires a right to receive payment from us under the
executive retirement program, such right shall be no greater than the right of
any unsecured general creditor of ours. We expense the amounts we fund into the
executive retirement program on a monthly basis.

STOCK OPTION PLAN

Extendicare Inc.'s stock option plan provides for the grant, from time to
time, at the discretion of Extendicare Inc.'s board of directors, to certain
directors, officers and employees of the Extendicare Inc. group of companies, of
options to purchase subordinate voting shares of Extendicare Inc. for cash. The
plan provides

81

that the exercise price of any options granted not be less than the closing
price (or, if there is no closing price, the simple average of the bid and ask
price) for the subordinate voting shares as quoted on the Toronto Stock Exchange
on the trading day prior to the date of grant. It also permits options to be
exercised for a period not to exceed either five or ten years from the date of
grant, as determined by the Extendicare Inc. board of directors at the time the
option is granted. The options vest equally over the first four years and the
plan contains provisions for appropriate adjustments in the event of corporate
reorganizations of Extendicare Inc.

At December 31, 2002, a total of 4,747,475 subordinate voting shares of
Extendicare Inc. were reserved under the plan, of which 2,514,750 subordinate
voting shares were subject to outstanding options and 2,232,725 were available
for grant.

The following table summarizes stock options granted during 2002 to our
named executive officers under the Extendicare Inc. stock option plan:

OPTION/SAR GRANTS IN FISCAL YEAR 2002

These amounts do not represent the present value of the options. The
amounts shown represent what would be received upon exercise five years after
the date of grant, assuming certain rates of stock price appreciation during the
entire period. Actual gains, if any, on stock option exercises are dependent on
future performance of the Extendicare Inc. common stock and overall market
conditions. In addition, actual gains depend upon whether, and the extent to
which, the options actually vest.

The following table summarizes options exercised during 2002 and option
values at December 31, 2002 for our named executive officers.

AGGREGATED OPTION/SAR EXERCISED IN FISCAL YEAR 2002
AND FISCAL YEAR-END OPTION/SAR VALUES

- ---------------
Note: The closing price of the Extendicare Inc. subordinate voting shares on the
Toronto Stock Exchange on December 31, 2002 was Cdn $4.20.

RETIREMENT ARRANGEMENTS

M.A. Rhinelander and R.L. Bertrand are covered by retirement arrangements
established by Extendicare Inc. The arrangements provide for a benefit of 4% of
the best three consecutive years of base salary for each
82

year of service to a maximum of 15 years and 1% per year thereafter. These
arrangements provide a maximum benefit guarantee of 60% of base salary after 15
years of service and 70% after 25 years of service. Normal retirement age is 60
years, or 55 years with our consent. We have consented to Mr. Rhinelander
retiring with full benefits at age 55. Retirement benefits are payable as an
annuity over the lifetime of the executive with a portion continuing to be paid
to the executive's spouse after the death of the executive. As of December 31,
2002, projected years of credited service at retirement for each of Messrs.
Rhinelander and Bertrand is 34 years.

Estimated annual benefits payable upon retirement of the specified
compensation and years of credited service classifications are as shown in the
following table:

PENSION PLAN TABLE

M.W. Durishan, P.W. Small and J.A. Karoleski are not participants in these
arrangements, but rather, are participants in a money purchase, 401(K) plan and
a deferred compensation plan established for U.S. executives.

TERMINATION OF EMPLOYMENT ARRANGEMENTS

M.A. Rhinelander has a termination of employment arrangement with
Extendicare Inc. that provides for one month of salary for each year of service
up to a maximum of 24 months' severance.

COMPENSATION COMMITTEE INTERLOCKS & INSIDER PARTICIPATION

Our Board of Directors is comprised solely of our executive officers and
the executive officers of our parent company, Extendicare Inc.. The Human
Resources Committee of the Extendicare Inc. Board of Directors is comprised of
six directors. The Committee determines compensation matters for Extendicare
Inc. and its subsidiaries, including us, and consists of: Derek H.L. Buntain,
Sir Graham Day, David M. Dunlap, Michael J.L. Kirby, Frederick B. Ladly and J.
Thomas MacQuarrie, Q.C. None of these committee members are our directors or
officers, or directors or officers of any our subsidiaries.

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

We are an indirect wholly owned subsidiary of Extendicare. Extendicare's
principal executive offices are located at 3000 Steeles Avenue East, Markham,
Ontario, Canada L3R 9W2.

We have no equity compensation plans that provide for the issuance of our
common stock.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

We are an indirect wholly owned subsidiary of Extendicare Inc. Certain
operating expenses are allocated between Extendicare Inc. and its subsidiaries.
We insure certain risks, including comprehensive general liability, property
coverage and excess workers' compensation/employer's liability insurance, with
Laurier Indemnity Company and Laurier Indemnity Ltd., affiliated insurance
subsidiaries of Extendicare Inc. We recorded approximately $9.9 million, $5.7
million and $20.7 million of expenses for this purpose in the fiscal years ended
December 31, 2002, 2001 and 2000, respectively.

83

We entered into a capital lease in 1999 relating to computer equipment with
Laurier Indemnity Company. In the first quarter of 2000, we exercised our option
to purchase the equipment for $1.3 million. The consolidated statement of
operations includes interest expense related to this lease of $0.1 million in
2000.

In January 2001, we established an arrangement for computer hardware and
software support services with Virtual Care Provider, Inc., an affiliated
subsidiary of Extendicare Inc. The annual cost of services was $7.9 million and
$6.5 million in 2002 and 2001, respectively.

At December 31, 2002, 2001 and 2000, we had a non-interest bearing loan
payable to Extendicare Holdings, Inc., our immediate parent, in the amount of
approximately $3.5 million with no specific due date. We used the proceeds of
the loan for working capital.

For federal tax purposes we file as part of a consolidated group of
companies, of which Extendicare Holdings is the parent. Extendicare Holdings (a
subsidiary of Extendicare Inc.) holds all of Extendicare Inc.'s U.S. operations,
including EHSI. We have a tax sharing arrangement with Extendicare Holdings
pursuant to which we had a payable of $1.4 million at December 31, 2002 and
receivables of $1.0 million at December 31, 2001 and $10.0 million at December
31, 2000. Under this tax sharing arrangement, a U.S. consolidated income tax
return is filed by Extendicare Holdings and, for purposes of determining each
member's share of the tax liability in such return, each member of the
affiliated group computes its separate U.S. income tax liability for regular
income tax purposes (but not for alternative minimum tax purposes) as if it had
filed a separate U.S. income tax return. Such amount is reflected as a federal
income tax expense and as an intercompany payable to Extendicare Holdings on
each member's separate financial statements. If a member incurs a net operating
loss, such net operating loss is tax benefited (for regular tax purposes only)
in the year the net operating loss is incurred. Such amount is reflected as a
reduction in federal income tax expense and as an intercompany receivable from
Extendicare Holdings on each member's separate financial statements. Similarly,
the federal income tax receivable and payable is recorded on the separate
financial statement of Extendicare Holdings. Each member's separate intercompany
balances are transferred to Extendicare Holdings through the intercompany
payable and receivable account.

In addition to the amounts discussed in the preceding two paragraphs, we
had non-interest bearing current amounts due to (from) affiliates as follows:

As of December 31, 2002, Extendicare Inc. and/or one of its wholly-owned
subsidiaries held $27.9 million, or 14.0%, of our outstanding Senior
Subordinated Notes.

ITEM 14. CONTROLS AND PROCEDURES

EVALUATION OF DISCLOSURE CONTROL AND PROCEDURES

Within 90 days of the date of this report, an evaluation was conducted
under the supervision and participation of our management, including the Chief
Executive Officer and Chief Financial Officer, of the effectiveness of the
design and operation of our disclosure controls and procedures (as defined in
Rules 13a - 14 (c) and 15d-14(c) under the Securities and Exchange Act of 1934).
Based upon that evaluation, the Chief Executive Officer and Chief Financial
Officer concluded that the design and operation of

84

these disclosure controls and procedures were effective, as of the date of such
evaluation, in timely alerting them to material information relating to us
(including our consolidated subsidiaries) required to be included in our
periodic SEC filings.

CHANGES IN INTERNAL CONTROLS

No significant changes were made in our internal controls or were there
other factors that could significantly affect these controls subsequent to the
date we carried out this evaluation.

85

PART IV

ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K

(A) DOCUMENTS FILED AS PART OF THIS REPORT:

1. FINANCIAL STATEMENTS

The following reports and financial statements are filed herewith on the
pages indicated and incorporated herein by reference:

2. FINANCIAL STATEMENT SCHEDULE

Schedule II -- Valuation and Qualifying Accounts is filed herewith as
Exhibit 99.4 and incorporated herein by reference.

3. EXHIBITS

See (c) below.

(B) REPORTS ON FORM 8-K:

None

(C) EXHIBITS:

See the exhibits listed on the Exhibit Index accompanying this Annual
Report on Form 10-K, which are incorporated herein by reference.

(D) FINANCIAL STATEMENTS EXCLUDED FROM ANNUAL REPORT TO SHAREHOLDERS:

Not applicable.

86

SIGNATURES

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

EXTENDICARE HEALTH SERVICES, INC.

By: /s/ MARK W. DURISHAN
------------------------------------
Mark W. Durishan
Vice President, Chief Financial
Officer,
Treasurer and Director
(Principal Financial and Accounting
Officer)

Date: March 25, 2003

Pursuant to the requirements of the Securities Exchange of 1934, this
report has been signed below by the following persons on behalf of the
Registrant and on the date indicated.

87

CERTIFICATION

I, Mel Rhinelander, Chairman of the Board and Chief Executive Officer of
Extendicare Health Services, Inc., certify that:

1. I have reviewed this annual report on Form 10-K of Extendicare Health
Services, Inc.;

2. Based on my knowledge, this annual report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to make
the statements made, in light of the circumstances under which such statements
were made, not misleading with respect to the period covered by this annual
report;

3. Based on my knowledge, the financial statements, and other financial
information included in this annual report, fairly present in all material
respects the financial condition, results of operations and cash flows of the
registrant as of, and for, the periods presented in this annual report;

4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-14 and 15d-14) for the registrant and have:

(a) designed such disclosure controls and procedures to ensure that
material information relating to the registrant, including its consolidated
subsidiaries, is made known to us by others within those entities,
particularly during the period in which this annual report is being
prepared;

(b) evaluated the effectiveness of the registrant's disclosure
controls and procedures as of a date within 90 days prior to the filing
date of this annual report (the "Evaluation Date"); and

(c) presented in this annual report our conclusions about the
effectiveness of the disclosure controls and procedures based on our
evaluation as of the Evaluation Date;

5. The registrant's other certifying officers and I have disclosed, based
on our most recent evaluation, to the registrant's auditors and the audit
committee of registrant's board of directors (or persons performing the
equivalent functions):

(a) all significant deficiencies in the design or operation of
internal controls which could adversely affect the registrant's ability to
record, process, summarize and report financial data and have identified
for the registrant's auditors any material weaknesses in internal controls;
and

(b) any fraud, whether or not material, that involves management or
other employees who have a significant role in the registrant's internal
controls; and

6. The registrant's other certifying officers and I have indicated in this
annual report whether there were significant changes in internal controls or in
other factors that could significantly affect internal controls subsequent to
the date of our most recent evaluation, including any corrective actions with
regard to significant deficiencies and material weaknesses.

/s/ MEL RHINELANDER
--------------------------------------
Mel Rhinelander
Chairman of the Board and Chief
Executive Officer
March 25, 2003

88

CERTIFICATION

I, Mark W. Durishan, Vice-President, Chief Financial Officer and Treasurer of
the Extendicare Health Services, Inc., certify that:

1. I have reviewed this annual report on Form 10-K of Extendicare Health
Services, Inc.;

2. Based on my knowledge, this annual report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to make
the statements made, in light of the circumstances under which such statements
were made, not misleading with respect to the period covered by this annual
report;

3. Based on my knowledge, the financial statements, and other financial
information included in this annual report, fairly present in all material
respects the financial condition, results of operations and cash flows of the
registrant as of, and for, the periods presented in this annual report;

4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-14 and 15d-14) for the registrant and have:

(a) designed such disclosure controls and procedures to ensure that
material information relating to the registrant, including its consolidated
subsidiaries, is made known to us by others within those entities,
particularly during the period in which this annual report is being
prepared;

(b) evaluated the effectiveness of the registrant's disclosure
controls and procedures as of a date within 90 days prior to the filing
date of this annual report (the "Evaluation Date"); and

(c) presented in this annual report our conclusions about the
effectiveness of the disclosure controls and procedures based on our
evaluation as of the Evaluation Date;

5. The registrant's other certifying officers and I have disclosed, based
on our most recent evaluation, to the registrant's auditors and the audit
committee of registrant's board of directors (or persons performing the
equivalent functions):

(a) all significant deficiencies in the design or operation of
internal controls which could adversely affect the registrant's ability to
record, process, summarize and report financial data and have identified
for the registrant's auditors any material weaknesses in internal controls;
and

(b) any fraud, whether or not material, that involves management or
other employees who have a significant role in the registrant's internal
controls; and

6. The registrant's other certifying officers and I have indicated in this
annual report whether there were significant changes in internal controls or in
other factors that could significantly affect internal controls subsequent to
the date of our most recent evaluation, including any corrective actions with
regard to significant deficiencies and material weaknesses.

/s/ MARK W. DURISHAN
--------------------------------------
Mark W. Durishan
Vice President, Chief Financial
Officer and Treasurer
March 25, 2003

89

SUPPLEMENTAL INFORMATION TO BE FURNISHED WITH REPORTS FILED PURSUANT TO
SECTION 15(D) OF THE ACT BY REGISTRANTS WHICH HAVE NOT REGISTERED SECURITIES
PURSUANT TO SECTION 12 OF THE ACT.

The Company has not sent to security holders any annual report covering its
last fiscal year or any proxy soliciting material with respect to any annual or
other meeting of security holders and does not intend to do so.

90

EXHIBIT INDEX

- ---------------
* Represents a management contract or compensatory plan or arrangement.