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FORM 10-K

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Commission file number 1-12996

ADVOCAT INC.

(Exact name of registrant as specified in its charter)

Registrant’s telephone number, including area code: (615) 771-7575

Securities registered pursuant to Section 12(b) of the Act:

None.

Securities registered pursuant to Section 12(g) of the Act:

Common Stock, par value $0.01 per share

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 the 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 Registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.   [X]

Indicate by check mark whether the registrant is an accelerated filer as defined in Exchange Act Rule 12b-2.   Yes   [   ]      No   [X] .

The aggregate market value of Common Stock held by non-affiliates on March 21, 2003 (based on the closing price of such shares on the NASD OTC Market) was $616,689. For purposes of the foregoing calculation only, all directors, named executive officers and persons known to the Registrant to be holders of 5% or more of the Registrant’s Common Stock have been deemed affiliates of the Registrant.

On March 21, 2003, 5,493,287 shares of the registrant’s $0.01 par value Common Stock were outstanding.

Documents Incorporated by Reference:

The following documents are incorporated by reference into Part III, Items 10, 11, 12, and 13 of this Form 10-K: The Registrant’s definitive proxy materials for its 2003 annual meeting of stockholders.

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PART I

Forward-Looking Statements.

Certain statements made by or on behalf of Advocat Inc. (together with its subsidiaries, “Advocat” or the “Company”), including those contained in this Annual Report on Form 10-K and elsewhere, are forward-looking statements as defined in the Private Securities Litigation Reform Act of 1995. These statements involve risks and uncertainties including, but not limited to, changes in governmental reimbursement, government regulation and health care reforms, the increased cost of borrowing under the Company’s credit agreements, covenant waivers from the Company’s lenders, possible amendments to the Company’s credit agreements, ability to control ultimate professional liability costs, the impact of future licensing surveys, changing economic conditions as well as others. Investors also should refer to the risks identified in “Item 1: Business — Material Corporate Developments and Risk Factors” and “Item 7: Management’s Discussion and Analysis of Financial Condition and Results of Operations” for a discussion of various risk factors of the Company and that are inherent in the health care industry. Given these risks and uncertainties, the Company can give no assurances that these forward-looking statements will, in fact, transpire and, therefore, cautions investors not to place undue reliance on them. Actual results may differ materially from those described in such forward-looking statements. Such cautionary statements identify important factors that could cause the Company’s actual results to materially differ from those projected in forward-looking statements. In addition, the Company disclaims any intent or obligation to update these forward-looking statements.

Introductory Summary.

The Company provides long-term care services to nursing home patients and residents of assisted living facilities in 10 states, primarily in the Southeast, and three Canadian provinces.

The Company’s objective is to become the provider of choice of health care and related services to the elderly in the communities in which it operates. Advocat will continue to implement its operating strategy of (i) providing a broad range of cost-effective elder care services; (ii) forming strategic alliances with other health care providers to expand the Company’s continuum of care; and (iii) clustering its operations on a regional basis. Key elements of the Company’s growth strategy are to increase revenue and profitability at existing facilities, emphasize development of joint ventures in Canada, and pursue additional management contract opportunities. The Company’s financial position significantly limits its strategic opportunities to non-capital intensive opportunities.

The Company’s principal executive offices are located at 277 Mallory Station Road, Suite 130, Franklin, Tennessee 37067. The Company’s telephone number at that address is (615) 771-7575, and its facsimile number is (615) 771-7409. The Company’s web-site is located at www.irinfo.com/AVC. The information on the Company’s web-site does not constitute part of this Annual Report on Form 10-K.

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Material Corporate Developments and Risk Factors.

There have been a number of material developments both within the Company and the long-term care industry. These developments have had and are likely to continue to have a material impact on the Company. This section summarizes these developments as well as other risks, that should be considered by stockholders and prospective investors in the Company.

Self-Insured Professional Liability Exposure

The entire long-term care profession in the United States has experienced a dramatic increase in claims related to alleged negligence in providing care to its patients and the Company is no exception in this regard. The Company, as the rest of the industry, has numerous liability claims and disputes outstanding for professional liability and other related issues. As of December 31, 2002, the Company is engaged in 58 professional liability lawsuits, including 17, 20, and 6 in the states of Florida, Arkansas and Texas, respectively. The Company and its subsidiaries carry professional liability insurance up to certain limits for coverage of such claims. However, the coverage available to the Company declined significantly, beginning in 1999. On June 22, 2001, a jury in Mena, Arkansas, issued a verdict in a professional liability lawsuit against the Company totaling $78.425 million. The Company appealed the verdict to the Arkansas Supreme Court in a hearing that took place March 13, 2003. As of March 17, no ruling has been issued by the Court. The Company believes that the $78.425 million, if upheld by the Arkansas Supreme Court, verdict will be covered by insurance pursuant to the 1997 and 1998 insurance programs. Based on the insurance coverage in effect at the time of the Mena claim, the verdict amount has not been accrued. However, the ultimate resolution of the Company’s professional liability claims and disputes are unknown at the present time. There can be no assurance that verdicts against the Company will not exceed the policy limits of the Company’s insurance policies or that the Company will be able to fund its self-insured portion. For more information regarding the Mena, Arkansas, verdict and the Company’s insurance coverage, see Note 14 to the Company’s financial statements, “Item 7: Management’s Discussion and Analysis of Financial Condition — Liquidity and Capital Resources.” and “Item 1: Business — Insurance.”

In addition, due to the increasing cost of claims against the Company and throughout the long-term care industry, the Company’s professional liability insurance premiums and deductible amounts increased substantially and insurance coverage limits have decreased significantly during 1999 through 2002 and continuing for policy year 2003. As a result of the substantial premium and deductible increases and insurance coverage decreases, effective March 9, 2002, the Company has obtained professional liability insurance coverage for its United States nursing homes and assisted living facilities that, based on historical claims experience, is likely to be substantially less than the claims that could be incurred during the policy periods from March 9, 2002 through March 9, 2004. As a result, the Company is effectively self-insured. See “Item 1: Business — Insurance.”

Operating Losses

The Company has incurred operating losses during the years ended December 31, 2002, 2001 and 2000 and has limited resources available to meet its operating, capital expenditure and debt service requirements during 2003. The Company has a working capital deficit of $58.8 million as of December 31, 2002. No assurance can be given that the Company will achieve profitable operations during 2003.

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The Company cannot assure that internally generated cash flows from earnings and existing cash balances will be sufficient to fund existing debt obligations or future capital and working capital requirements through fiscal year 2003. At a minimum, the Company’s cash requirements during 2003 include funding operations (including potential payments related to professional liability claims), capital expenditures, scheduled debt service, and working capital requirements. See “Item 7: Management’s Discussion and Analysis of Financial Condition and Results of Operations — Liquidity and Financial Resources.”

Current Debt Maturities and Financial Covenant Non-Compliance

The Company has $23.6 million of matured debt as of December 31, 2002 and $18.2 million of scheduled debt maturities in 2003. In addition, certain of the Company’s debt agreements contain various financial covenants, the most restrictive of which relate to current ratio requirements, tangible net worth, cash flow, net income (loss), required insurance coverage and limits on the payment of dividends to shareholders. As of December 31, 2002, the Company was not in compliance with certain of these financial covenants. The Company has not obtained waivers of the non-compliance. Cross-default or material adverse change provisions contained in the debt agreements allow the holders of substantially all of the Company’s debt to demand immediate repayment. The Company would not be able to repay this indebtedness if the applicable lenders demanded repayment. Although the Company does not anticipate that such demands will be made, the continued forbearance on the part of the Company’s lenders cannot be assured at this time. Given that events of default exist under the Company’s working capital line of credit, there can be no assurance that the lender will continue to provide working capital advances. Any demands for repayment by lenders or the inability to obtain waivers or refinance the related debt would have a material adverse impact on the financial position, results of operations and cash flows of the Company. See “Item 7: Management’s Discussion and Analysis of Financial Condition and Results of Operations — Liquidity and Financial Resources.”

Cross-Defaults Under Debt, Leases and Management Agreements.

As noted above, as of December 31, 2002, the Company was not in compliance with certain of its debt covenants. An event of default under the Company’s debt agreements could lead to actions by the lenders that could result in an event of default under the Company’s lease agreements covering a majority of its United States nursing facilities. In addition, the Company has obtained professional liability insurance coverage for its United States nursing homes that is less than amounts required in the Omega Master Lease. The Company has not obtained waivers of the non-compliance. The Master Lease provides that a default with respect to one facility is a default with respect to the entire Master Lease. The Company also leases eight facilities and manages nine facilities owned by Counsel Corporation or its affiliates. A default under any one of these agreements constitutes a default under all of the leases and management agreements with Counsel Corporation. Finally, three management contracts that cover two, four and seven nursing homes, respectively, provide that a default with respect to any facility under any one of the management contracts is a default with respect to all facilities under such management contracts. In addition, certain of the Company’s debt agreements provide that a default under any of the Company’s leases or management agreements constitutes a default under the debt agreements. Should such a default occur in the related lease agreements, the lessor would have the right to terminate the lease agreements.

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Health Care Industry

The health care industry is subject to numerous laws and regulations of federal, state and local governments. These laws and regulations include, but are not necessarily limited to, matters such as licensure, accreditation, government health care program participation requirements, reimbursement for patient services, quality of resident care and Medicare and Medicaid fraud and abuse (collectively the “Health Care Laws”). Changes in these laws and regulations, such as reimbursement policies of Medicare and Medicaid programs as a result of budget cuts by federal and state governments or other legislative and regulatory actions, have had a material adverse effect on the profession and the Company’s consolidated financial position, results of operations, and cash flows. Future federal budget legislation and federal and state regulatory changes may negatively impact the Company. See “Item 1: Business — Government Regulation and Reimbursement”.

Dependence on Reimbursement by Third-Party Payors.

Substantially all of the Company’s nursing home revenues, including management fees, are directly or indirectly dependent upon reimbursement from third-party payors, including the Medicare and Medicaid programs, the Ontario Government Operating Subsidy program, and private insurers. For the year ended December 31, 2002, approximately 61.3%, 21.4%, and 17.3% of the Company’s patient and resident revenues were derived from Medicaid, Medicare and private pay sources. Changes in the mix of the Company’s patients among Medicare, Medicaid and private pay categories and among different types of private pay sources may affect the Company’s net revenues and profitability. The net revenues and profitability of the Company are also affected by the continuing efforts of all payors to contain or reduce the costs of health care. Efforts to impose reduced payments, greater discounts and more stringent cost controls by government and other payors are expected to continue.

Under the current law, Medicare reimbursements for nursing facilities were reduced following the October 1, 2002 expiration of two temporary payment increases enacted as part of earlier Medicare enhancement bills. Beginning October 1, 2002, the Company’s Medicare reimbursement has been reduced by an estimated $368,000 per month, as a result of the expiration of temporary add-on legislation. Partially offsetting this decrease, the Centers for Medicare and Medicaid Services (“CMS”) implemented a Medicare rate increase of approximately 2.6% effective October 1, 2002. There are two additional payment increases that were originally scheduled to expire October 1, 2002. CMS has announced that the expiration of these payment increases has been postponed to October 1, 2004.

A number of state governments, including several of the Company’s operating states, have announced projected budget shortfalls and/or deficit spending situations. Possible actions by these states include reductions of Medicaid reimbursement to providers such as the Company or the failure to increase Medicaid reimbursements to cover increased operating costs.

Any changes in reimbursement levels or in the timing of payments under Medicare, Medicaid or private pay programs and any changes in applicable government regulations could have a material adverse effect on the Company’s net revenues and net income. The Company is unable to predict what reform proposals or reimbursement limitations will be adopted in the future or the effect such changes will have on its operations. No assurance can be given that such reforms will not have a material adverse effect on the Company. See “Item 1: Business — Government Regulation and Reimbursement.”

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Government Regulation.

The United States government, the Canadian government, and all states and provinces in which the Company operates regulate various aspects of its business. Various federal, state and provincial laws regulate relationships among providers of services, including employment or service contracts and investment relationships. The operation of long-term care facilities and the provision of services are also subject to extensive federal, state, provincial and local laws relating to, among other things, the adequacy of medical care, distribution of pharmaceuticals, equipment, personnel, operating policies, environmental compliance, ADA compliance, fire prevention and compliance with building codes. Long-term care facilities are also subject to periodic inspection to assure continued compliance with various standards and licensing requirements under state law, as well as with Medicare and Medicaid conditions of participation. The failure to obtain or renew any required regulatory approvals or licenses could adversely affect the Company’s growth and could prevent it from offering its existing or additional services. In addition, health care is an area of extensive and frequent regulatory change. Changes in the laws or new interpretations of existing laws can have a significant effect on methods and costs of doing business and amounts of payments received from governmental and other payors. The Company’s operations could be adversely affected by, among other things, regulatory developments such as mandatory increases in the scope and quality of care to be afforded patients and revisions in licensing and certification standards. The Company at all times attempts to comply with all applicable laws; however, there can be no assurance that new legislation or administrative or judicial interpretation of existing laws or regulations will not have a material adverse effect on the Company’s operations or financial condition. See “Item 1: Business — Government Regulation and Reimbursement.”

Increased Regulatory Scrutiny.

The Office of Inspector General (“OIG”), the enforcement arm of the Medicare program, announced in its work plan for 2002 that it intended to increase scrutiny of nursing homes. Compliance review has focused on quality of care, medical necessity of mental health services, and documentation of therapy services, among other concerns. The OIG’s 2003 work plan indicates that quality, survey deficiencies and constraints will continue to be an investigative focus in 2003. The Company cannot predict the likelihood, scope or outcome of any such investigations on its facilities.

Self-Referral and Anti-Kickback Legislation.

The health care industry is highly regulated at the state, provincial and federal levels. In the United States, various state and federal laws regulate the relationships between providers of health care services, physicians, and other clinicians. These self-referral laws impose restrictions on physician referrals for designated health services to entities with which they have financial relationships. These laws also prohibit the offering, payment, solicitation or receipt of any form of remuneration in return for the referral of Medicare or state health care program patients or patient care opportunities for the purchase, lease or order of any item or service that is covered by the Medicare and Medicaid programs. To the extent that the Company, any facility with which it does business, or any of their owners or directors have a financial relationship with each other or with other health care entities providing services to long-term care patients, such relationships could be subject to increased scrutiny. There can be no assurance the Company’s operations will not be subject to review, scrutiny, penalties or enforcement actions under these laws, or that these laws will not change in the future. Violations of these laws may result in substantial civil or criminal penalties for individuals or entities, including large

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civil monetary penalties and exclusion from participation in the Medicare or Medicaid programs. Such exclusion or penalties, if applied to the Company, could have a material adverse effect on the profitability of the Company.

Third-Party Indebtedness Secured By Assets Leased or Managed By Company.

The Company, through leases and management agreements, operates facilities that secure the indebtedness of the owners of the facilities. As a result, the Company’s leases at such facilities are subject to cancellation upon the default of these third-party owners under their credit agreements. In addition, the payment of management fees to the Company at these facilities is subordinated to the payment of the owners’ debt obligations. To the extent that the owners of the Company’s managed facilities experience financial difficulty or otherwise are unable to meet their obligations, the ability of the Company to receive management fees or continue as manager of such facility is jeopardized.

Liquidity.

During 1999, the New York Stock Exchange de-listed the Company’s Common Stock. Trading of the Company’s Common Stock is currently conducted on the over-the-counter market (“OTC”) or, on application by broker-dealers, in the NASD’s Electronic Bulletin Board using the Company’s current trading symbol, AVCA. As a result of the de-listing, the liquidity of the Company’s Common Stock and its price have been adversely affected, which may limit the Company’s ability to raise additional capital.

Guarantees of Partnership Cash Flows.

A subsidiary of the Company has provided guarantees of certain cash flow deficiencies and quarterly return obligations of Diversicare VI Limited Partnership (“Diversicare VI”), which may obligate the subsidiary to make interest-free loans to Diversicare VI. Such cash flow obligations have never been called upon; however, no assurance can be given that such obligations will not arise in the future. If any such loans are made, there is no assurance that all, or any portion, of any such loans made to Diversicare VI will be repaid.

Competition.

The long-term care industry generally, and the nursing home and assisted living center businesses particularly, are highly competitive. The Company faces direct competition for the acquisition or management of facilities. In turn, its facilities face competition for employees, patients and residents. Some of the Company’s present and potential competitors are significantly larger and have or may obtain greater financial and marketing resources than those of the Company. Some hospitals that provide long-term care services are also a potential source of competition to the Company. In addition, the Company may encounter substantial competition from new market entrants. Consequently, there can be no assurance that the Company will not encounter increased competition in the future, which could limit its ability to attract patients or residents or expand its business, and could materially and adversely affect its business or decrease its market share.

Anti-takeover Considerations.

The Company is authorized to issue up to 400,000 shares of preferred stock, the rights of which may be fixed by the Board of Directors without shareholder approval. In November 2000, the Company issued 393,658 shares of the Company’s Series B Redeemable Convertible Preferred Stock to Omega

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Healthcare Investors, Inc. in connection with the Settlement and Restructuring Agreement. In March 1995, the Board of Directors approved the adoption of a Shareholder Rights Plan (the “Plan”). The Plan is intended to encourage potential acquirors to negotiate with the Company’s Board of Directors and to discourage coercive, discriminatory and unfair proposals. The Company’s stock incentive plans provide for the acceleration of the vesting of options in the event of certain changes in control (as defined in such plans). The Company’s Certificate of Incorporation (the “Certificate”) provides for the classification of its Board of Directors into three classes, with each class of directors serving staggered terms of three years. The Company’s Certificate requires the approval of two-thirds of the outstanding shares to amend certain provisions of the Certificate. Section 203 of the Delaware General Corporate Law restricts the ability of a Delaware corporation to engage in any business combination with an interested stockholder. Provisions in the executive officers’ employment agreements provide for post-termination compensation, including payment of amounts up to 2 times their annual salary, following certain changes in control. Certain changes in control of the Company also constitute an event of default under the Company’s bank credit facility. The foregoing matters may, together or separately, have the effect of discouraging or making more difficult an acquisition or change of control of the Company.

Business.

Advocat provides a broad range of long-term care services to the elderly including assisted living, skilled nursing and ancillary health care services. As of December 31, 2002, Advocat’s portfolio includes 98 facilities composed of 62 nursing homes containing 7,138 licensed beds and 36 assisted living facilities containing 3,499 units. In comparison, at December 31, 2001, the Company operated 116 facilities composed of 62 nursing homes containing 6,992 licensed beds and 54 assisted living facilities containing 5,319 units. Within the current portfolio, 28 facilities are managed on behalf of other owners, 22 of which are on behalf of unrelated owners and six in which the Company holds a minority equity interest. The remaining facilities, consisting of 42 leased and 28 owned facilities, are operated for the Company’s own account. In the United States, the Company operates 48 nursing homes and 16 assisted living facilities, and in Canada, the Company operates 14 nursing homes and 20 assisted living facilities.

The Company’s facilities provide a range of health care services to its residents. In addition to the nursing and social services usually provided in long-term care facilities, the Company offers a variety of rehabilitative, nutritional, respiratory, and other specialized ancillary services. As of December 31, 2002, the Company operates facilities in Alabama, Arkansas, Florida, Kentucky, North Carolina, Ohio, South Carolina, Tennessee, Texas, West Virginia, and the Canadian provinces of Ontario, British Columbia and Alberta.

The Company, in its role as owner, lessee, or manager, is responsible for the day-to-day operations of all operated facilities. These responsibilities include recruiting, hiring, and training all nursing and other personnel, and providing resident care, nutrition services, marketing, quality improvement, accounting, and data processing services for each facility. The lease agreements pertaining to the Company’s 42 leased facilities are “triple net” leases, requiring the Company to maintain the premises, pay taxes and pay for all utilities. The leases typically provide for an initial term of 10 to 15 years with renewal options up to 10 years. The average remaining term of the Company’s lease agreements, including renewal options, is approximately 14 years.

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As compensation for providing management services, the Company earns a management fee, which in 2002 averaged approximately 3.1% of the facilities’ net patient revenues. Of the Company’s 28 management agreements, 4 have more than five years remaining on their current terms, 20 have from one to four years remaining on their current terms and 4 have a current term expiring within one year, with an average remaining life of approximately 3.2 years for all contracts.

Industry Background.

The long-term care profession encompasses a broad range of non-institutional and institutional services. For those among the elderly requiring temporary or limited special services, a variety of home care options exist. As needs for assistance in activities of daily living develop, assisted living facilities become the most viable and cost effective option. For those among the elderly requiring much more intensive care, skilled nursing facility care becomes the only viable option. The Company, through its assisted living facilities and nursing homes, is actively involved in the continuum of care and believes that it has, through its history of operating such facilities, developed the expertise required to serve the varied needs of its elderly residents.

Since the enactment of the Balanced Budget Act (“BBA”) in 1997, numerous changes affecting government funding levels of the nursing home industry have resulted. See “Item 1: Business — Government Regulation and Reimbursement - Material Corporate Developments — Medicare Reimbursement Changes.” While the ultimate impact of the BBA on nursing homes is presently unknown, management believes there are a number of significant trends that will support the continued growth of the assisted living and nursing home segments of the long-term care industry, including:

	Demographic Trends. The primary market for the Company’s long-term health care services is comprised of persons aged 75 and older. This age group is one of the fastest growing segments of the United States population. As the number of persons aged 75 and over continues to grow, the Company believes that there will be corresponding increases in the number of persons who need skilled nursing care or who want to reside in an assisted living facility for assistance with activities of daily living.
	Cost Containment Pressures. In response to rapidly rising health care costs, governmental and other third-party payors have adopted cost-containment measures to reduce admissions and encourage reduced lengths of stays in hospitals and other acute care settings. The federal government had previously acted to curtail increases in health care costs under Medicare by limiting acute care hospital reimbursement for specific services to pre-established fixed amounts. Other third-party payors have begun to limit reimbursement for medical services in general to predetermined reasonable charges, and managed care organizations (such as health maintenance organizations) are attempting to limit hospitalization costs by negotiating for discounted rates for hospital and acute care services and by monitoring and reducing hospital use. In response, hospitals are discharging patients earlier and referring elderly patients, who may be too sick or frail to manage their lives without assistance, to nursing homes and assisted living facilities where the cost of providing care is typically lower than hospital care. In addition, third-party payors are increasingly becoming involved in determining the appropriate health care settings for their insureds or clients based primarily on cost and quality of care.
	Limited Supply of Facilities. As the nation’s elderly population continues to grow, life expectancy continues to expand, and there continues to be limitations on granting Certificates of Need (“CON’s”) for new skilled nursing facilities, management believes that there will be continued

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	demand for skilled nursing beds in the markets in which the Company operates. The majority of states have adopted CON, or similar statutes, requiring that prior to the addition of new skilled beds, any new services, or making certain capital expenditures, a state agency must determine that a need exists for the new beds or proposed activities. The Company believes that this CON process tends to restrict the supply and availability of licensed skilled nursing facility beds. High construction costs, limitations on state and federal government reimbursement for the full costs of construction, and start-up expenses also act to restrict growth in the supply for such facilities. At the same time, skilled nursing facility operators are continuing to focus on improving occupancy and expanding services to include high acuity subacute patients, that require significantly higher levels of skilled nursing personnel and care. Although many states do not require CON’s for assisted living facilities, some states impose additional limitations on the supply of these facilities. For example, North Carolina has imposed a moratorium on any addition of new beds unless there is a demonstrated need based on several criteria, such as those items noted in the original language of the law stating that county vacancy rates are less than 15%, as well as other specific factors.
	Reduced Reliance on Family Care. Historically, the family has been the primary provider of care for seniors. Management of the Company believes that the increase in the percentage of women in the work force, the reduction of average family size, and the increased mobility in society will reduce the role of the family as the traditional care-giver for aging parents. Management believes that this trend will make it necessary for many seniors to look outside the family for assistance as they age.

Nursing Home and Assisted Living Facility Services.

Operations. As of December 31, 2002, the Company operates 62 nursing homes with 7,138 licensed beds and 36 assisted living facilities with 3,499 units as set forth below:

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For the year ended December 31, 2002, the Company’s net patient and resident revenues were $195.9 million, or 98.4% of total net revenues. For the year ended December 31, 2002, the Company’s net revenues from the provision of management services were $2.9 million, or 1.4% of the total net revenues. See Note 16 of the Company’s Consolidated Financial Statements for more information on the Company’s operating segments.

Nursing Home Services. The nursing homes operated by the Company provide skilled nursing health care services, including room and board, nutrition services, recreational therapy, social services, and housekeeping and laundry services. The Company’s nursing homes range in size from 48 to 247 licensed beds. The nursing homes dispense medications prescribed by the patients’ physicians. In addition, a plan of care is developed by professional nursing staff for each resident. In an effort to increase revenues by attracting patients with more complex health care needs, the Company also provides for the delivery of ancillary medical services at the nursing homes it operates. These specialty services include rehabilitation therapy services, such as speech therapy, audiology, and occupational, physical therapies, which are provided through licensed therapists and registered nurses, and the provision of medical supplies, nutritional support, infusion therapies, and related clinical services. On October 1, 2001 the Company entered into an agreement with a regional rehabilitation company to provide financial and clinical management of the Company’s therapists. The Company believes that the rehabilitation company provides better management of the therapy function, including an emphasis on better utilization of available therapists, while containing the total cost. The Company has historically contracted with third parties for a fee to assist in the provision of various ancillary services to the Company’s patients. The Company owns an ancillary service supply business through which it provides medical supplies and enteral nutritional support services directly to patients.

Assisted Living Facility Services. Services and accommodations at assisted living facilities include central dining facilities, recreational areas, social programs, housekeeping, laundry and maintenance service, emergency call systems, special features for handicapped persons and transportation to shopping and special events. The Company’s assisted living facilities range in size from 12 to 323 units. The Company believes that assisted living services will continue to increase as an attractive alternative to nursing home care because a variety of supportive services and supervision can be obtained in a far more independent and less institutional setting. Generally, basic care and support services can be offered more economically in an assisted living facility than either in a nursing home or through home health care assistance. On average, the Company provides 45 to 90 minutes of nursing care per resident per day in its Canadian assisted living facilities.

Operating and Growth Strategy.

The Company’s objective is to be the provider of choice of health care and related services to the elderly in the communities in which it operates. The Company achieves this objective by:

Provide a Broad Range of Cost-Effective Services. The Company’s objective is to provide a variety of services in a broad continuum of care which will meet the ever changing needs of the elderly. The Company’s expanded service offering currently includes assisted living, skilled nursing (including Alzheimer and Dementia Care), comprehensive rehabilitation services and medical supply and nutritional support services. By addressing varying levels of acuity, the Company is able to meet the needs of the elderly population it serves for a longer period of time and can establish a reputation as the provider of choice in a particular market. Furthermore, the

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		Company believes it is able to deliver quality services cost-effectively, thereby expanding the elderly population base that can benefit from the Company’s services, including those not otherwise able to afford private-pay assisted living services.
		Form Strategic Alliances or Joint Ventures with Other Health Care Providers. Through strategic alliances or joint ventures with other health care providers, the Company is able to offer additional services to its customers in a cost-effective, specialized manner. By entering into such agreements for services such as rehabilitation, the Company believes that it can continue to leverage the expertise of other providers in order to expand its continuum of care on a cost-effective basis. On October 1, 2001 the Company entered into an agreement with a regional rehabilitation company to provide financial and clinical management of the Company’s therapists. The Company believes that the rehabilitation company provides better management of the therapy function, including an emphasis on better utilization of available therapists, while containing the total cost.
		Cluster Operations on a Regional Basis. The Company has developed regional concentrations of operations in order to achieve operating efficiencies, generate economies of scale and capitalize on marketing opportunities created by having multiple operations in a regional market area.

Key elements of the Company’s growth strategy are to:

		Increase Revenues and Profitability at Existing Facilities. The Company’s strategy includes increasing facility revenues and profitability levels through increasing occupancy levels, maximizing reimbursement rates and containing costs. In 2002, the Company has added more intensive corporate support for local facility based marketing efforts and in 2003 the Company hired a marketing vice president. In addition, regional marketing coordinators have been added to support the overall marketing program in each local facility, in order to promote higher occupancy levels and improved payor and case mixes at its nursing homes and assisted living facilities.
		Emphasize Development of Joint Ventures in Canada. During 1999 and 1998, the Company entered into five Canadian joint ventures, each of which has developed a new assisted living facility. The Company has a minority equity interest in each development and has received a long-term contract to manage each facility. Four of these facilities opened during 1999 and the fifth began operations in January 2000. The Company currently has no capital resources to further execute this strategy.
		Pursue Additional Opportunities for Management Agreements. Management believes that the Company can attract additional management agreements in Canada. Further, it is management’s belief that the Company is a recognized provider of quality care in Canada and has established financial and operational control systems, extensive reimbursement expertise, and access to purchasing economies. The Company has the ability to provide an array of services ranging from total operational management for passive investors in nursing homes and assisted living facilities to the provision of unbundled consulting services. In certain cases, the Company has the opportunity to share in the profits of a managed facility and/or has a right of first refusal or an option to purchase the managed facility.
		Consider Divestiture of Selected Facilities. Management is currently evaluating certain facilities for possible divestiture. There are no agreements in place, nor can there be any assurance that any divestitures will occur, though the Company will evaluate any options that could improve liquidity and/or operating results. The Company terminated the leases on two Florida nursing homes during

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2001 and sold another owned Florida nursing home during 2002. In 2002, the Company terminated leases on 16 assisted living facilities. The Company continues to evaluate the other leased and owned facilities for possible divestiture.

Marketing.

At a local level, the Company’s sales and marketing efforts are designed to promote higher occupancy levels and optimal payor mix. Management believes that the long-term care industry is fundamentally a local industry in which both patients and residents and the referral sources for them are based in the immediate geographic area in which the facility is located. The Company’s marketing plan and support activities emphasize the role and performance of administrators, admissions coordinators and social services directors of each nursing home and the administrator of each assisted living facility, all of whom are responsible for contacting various referral sources such as doctors, hospitals, hospital discharge planners, churches, and various community organizations. Administrators are evaluated based on their ability to meet specific goals and performance standards that are tied to compensation incentives. The Company’s regional managers and marketing coordinators assist local marketing personnel and administrators in establishing relationships and follow-up procedures with such referral sources. In addition to soliciting admissions from these sources, management emphasizes involvement in community affairs in order to promote a public awareness of the Company’s nursing homes and assisted living facilities and their services. The Company also promotes effective customer relations and seeks feedback through family and employee surveys. Also, the Company has ongoing family councils and community based “family night” functions where organizations come to the facility to educate the public on various topics such as Medicare benefits, powers of attorney, and other matters of interest. In 2002, the Company added more intensive corporate support for local facility based marketing efforts and in 2003 the Company hired a marketing vice president. In addition, regional marketing coordinators have been added to support the overall marketing program in each local facility, in order to promote higher occupancy levels and improved payor and case mixes at its nursing homes and assisted living facilities.

The Company has an internally-developed marketing program that focuses on the identification and provision of services needed by the community. The program assists each facility administrator in analysis of local demographics and competition with a view toward complementary service development. The Company believes that the primary referral area in the long-term care industry generally lies within a five-to-fifteen-mile radius of each facility depending on population density; consequently, local marketing efforts are more beneficial than broad-based advertising techniques.

Description of Management Services and Agreements.

Of the Company’s 98 facilities, 28 are operated as managed facilities, where the Company’s responsibilities include recruiting, hiring and training all nursing and other personnel, and providing quality assurance, resident care, nutrition services, marketing, accounting and data processing services. Services performed at the corporate level include group contract purchasing, employee training and development, quality assurance oversight, human resource management, assistance in obtaining third-party reimbursement, financial and accounting functions, policy and procedure development, system design and development and marketing support. The Company’s financial reporting system monitors certain key data for each managed facility, such as payroll, admissions and discharges, cash collections, net patient care revenues, rental revenues, staffing trend analysis and measurement of operational data on a per patient basis.

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The Company’s management fee is subordinated to debt payments at 11 facilities. The Company has the potential to earn incentive management fees over its base management fees at 25 facilities and is obligated to provide cash flow support at two facilities. The Company receives a base management fee for the management of long-term care facilities ranging generally from 3.5% to 6.0% of the net revenues of each facility. Total management fees as a percentage of the managed facilities’ patient and resident revenues were 3.1% in 2002. Management fees with respect to four United States facilities were reduced in 2001 and 2002 because of the failure to meet defined operational thresholds. Other than certain corporate and regional overhead costs, the services provided at the facility are the facility owner’s expense. The facility owner also is obligated to pay for all required capital expenditures. The Company generally is not required to advance funds to the owner. However, with respect to one management agreement covering two facilities, the Company has advanced $190,000 as of December 31, 2002; this advance carries 7.5% interest, with maturity in 2004. See Note 10 of the Company’s Consolidated Financial Statements for more information on these advances.

Based upon the initial term and any renewal terms over which the Company holds the option, the Company’s remaining management contracts expire in the following years:

The Company currently anticipates that all of the management agreements coming due for renewal in 2003 will be renewed. However, there can be no assurance that any of these agreements will be renewed.

The following table summarizes the Company’s net revenues derived from management services and the net revenues of the managed facilities during the years indicated (in thousands):

Description of Lease Agreements.

The Company operates 42 long-term care facilities under operating leases, including 31 owned by Omega Healthcare Investors, Inc. (“Omega”), 8 owned by Counsel Corporation (together with its affiliates, “Counsel”), and three owned by other parties. The Company’s operating leases generally require the Company to pay stated rent, subject to increases based on changes in the Consumer Price

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Index, a minimum percentage increase, or increases in the net revenues of the leased properties. Certain of the leases require the Company to pay certain scheduled rent increases. The Company’s leases are “triple-net,” requiring the Company to maintain the premises, pay taxes, and pay for all utilities. The Company generally grants its lessor a security interest in the Company’s personal property located at the leased facility. The leases generally require the Company to maintain a minimum tangible net worth and prohibit the Company from operating any additional facilities within a certain radius of each leased facility. The Company is generally required to maintain comprehensive insurance covering the facilities it leases as well as personal and real property damage insurance and professional liability insurance. Effective March 9, 2002, the Company has obtained professional liability insurance coverage for its United States nursing homes that is less than amounts required in the Omega Master Lease. The Company has not obtained a waiver. The failure to pay rentals within a specified period or to comply with the required operating and financial covenants, including insurance coverage, generally constitutes a default, which default, if uncured, permits the lessor to terminate the lease and assume the property and the contents within the facilities. In all cases where mortgage indebtedness exists with respect to a leased facility, the Company’s interest in the premises is subordinated to that of the lessors’ mortgage lenders.

Omega Leases. On November 8, 2000, the Company entered into a 10-year restructured lease agreement (the “Settlement and Restructuring Agreement”) with Omega. The Settlement and Restructuring Agreement, effective as of October 1, 2000, provides for reduced future lease costs under an amended lease agreement covering all nursing homes leased from Omega (the “Omega Master Lease”). All of the accounts receivable, equipment, inventory and other assets of the facilities leased pursuant to the Omega Master Lease have been pledged as security under the Omega Master Lease. The initial term of the Omega Master Lease is ten years, expiring September 30, 2010, with an additional ten-year renewal term at the option of the Company, assuming no defaults. Effective March 9, 2002, the Company obtained professional liability insurance coverage that is less than the coverage required by the Omega Master Lease. Lease payments of $10,875,000 were required during the first two years of the Omega Master Lease. During subsequent years, increases in the lease payments are equal to the lesser of two times the consumer price index or 3.0%. The Company is recording all scheduled rent increases, including the 3.0% rent increases, as additional lease expense on a straight-line basis over the initial lease term.

The Omega Master Lease also required the Company to fund capital expenditures related to the leased facilities totaling $1,000,000 during the first two years of the initial lease term. The Company is also required to fund annual capital expenditures equal to $325 per licensed bed over the initial lease term (annual required capital expenditures of $994,000), subject to adjustment for increases in the Consumer Price Index. Total required capital expenditures over the initial lease term are $10,940,000. These required capital expenditures are being depreciated on a straight-line basis over the initial lease term beginning October 1, 2000.

Upon expiration of the Omega Master Lease or in the event of a default under the Omega Master Lease, the Company is required to transfer all of the leasehold improvements, equipment, furniture and fixtures of the leased facilities to Omega. In the event that the Company does not transfer all of the facility assets to Omega, the Company will be required to pay Omega $5,000,000 plus accrued interest at 11.00% from the effective date of the Settlement and Restructuring Agreement. The Company’s management intends to transfer the facility assets to Omega at the end of the lease term.

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As of December 31, 2002, the Company is not in compliance with certain debt covenants. Such events of default under the Company’s debt agreements could lead to actions by the lenders that could result in an event of default under the Omega Master Lease. In addition, effective March 9, 2002, the Company obtained professional liability insurance coverage that is less than the coverage required by the Omega Master Lease. Upon a default in the Omega Master Lease, the lessor has the right to terminate the lease agreements and assume operating rights with respect to the leased properties. The net book value of property and equipment, including leasehold improvements, related to these facilities total approximately $4.6 million as of December 31, 2002.

Counsel Leases. The Company leases three facilities from Counsel with an initial term of ten years through April 2004 and one ten-year renewal option. The Company leases five additional facilities from Counsel with a remaining term expiring in April 2004. With respect to all of these facilities, the Company has a right of first refusal and a purchase option at the end of the lease term.

Prior to September 2001, the Company leased three additional facilities from Counsel. Omega was Counsel’s mortgage lender on the three facilities. Pursuant to the Settlement and Restructuring Agreement with Omega, Counsel was required to transfer one of the facilities to Omega in exchange for the outstanding mortgage balance, at which time the facility would be leased by the Company from Omega in accordance with the terms of the Omega Master Lease. The transfer of this facility occurred during 2001. Also pursuant to the Settlement and Restructuring Agreement, the Company had the right to require Counsel to transfer the remaining two facilities to Omega in exchange for the related outstanding mortgage balances, at which time the facilities were expected to be sold or leased by Omega to a third party. Effective September 30, 2001, both facilities were transferred to Omega. Effective October 1, 2001 and December 31, 2001, respectively, Omega leased these two facilities to a third party. Pursuant to the Settlement and Restructuring Agreement with Omega, the Company will receive 20% of the lease proceeds (net of costs associated with the leasing transaction) throughout the term of the lease and 20% of any sales proceeds. The Company is recording these proceeds as a reduction of lease expense as they are received.

Assisted Living Leases. Effective April 30, 2002, the Company entered into a Lease Termination and Operations Transfer Agreement (the “Pierce Agreement”) with Pierce Management Group and related persons (collectively, “Pierce”), pursuant to which the 13 leases for assisted living facilities with the former principal owners or affiliates of Pierce were terminated. Effective May 31, 2002, the leases on two additional assisted living facilities were assumed by Pierce. As a result, the Company was relieved of its future obligations with respect to these 15 leases. Effective June 30, 2002, the Company terminated the lease on one additional assisted living facility. The Company is in a dispute with the owner of this property which will be the subject of an arbitration hearing currently scheduled in 2003. The Company has accrued for the estimated costs associated with this arbitration hearing. The Company incurred lease termination charges of approximately $750,000 in 2002, consisting of the remaining net book value of these facilities, approximately $470,000, and approximately $280,000 for legal fees and other costs of completing the transactions.

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Facilities.

The following table summarizes certain information with respect to the nursing homes and assisted living facilities owned, leased and managed by the Company as of December 31, 2002:

Organization.

The Company’s long-term care facilities are currently organized into nine regions, seven in the United States and two in Canada, each of which is supervised by a regional vice president or manager. The regional vice president or manager is generally supported by nursing and human resource personnel, and clerical personnel, all of whom are employed by the Company. The day-to-day operations of each owned, leased or managed nursing home are supervised by an on-site, licensed administrator. The administrator of each nursing home is supported by other professional personnel, including a medical director, who assists in the medical management of the facility, and a director of nursing, who supervises a staff of registered nurses, licensed practical nurses, and nurses aides. Other personnel include dietary staff, activities and social service staff, housekeeping, laundry and maintenance staff, and a business office staff. Each assisted living facility owned, leased or managed by the Company is supervised by an on-site administrator, who is supported by a director of resident care, a director of food services, a director of maintenance, an activities coordinator, dietary staff and housekeeping, laundry and maintenance staff. With respect to the managed facilities, the majority of the administrators are

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employed by the Company, and the Company is reimbursed for their salaries and benefits by the respective facilities. All other personnel at managed facilities are employed and paid by the owner of the nursing home or assisted living facility, not by the Company. All personnel at the leased or owned facilities, including the administrators, are employed by the Company.

The Company has in place a Continuous Quality Improvement (“CQI”) program, which is focused on identifying opportunities for improvement, as well as overseeing the initiation and effectiveness of interventions. The Company conducts monthly audits to monitor adherence to the standards of care established by the CQI program at each facility which it owns, leases or manages. The facility administrator, with assistance from regional nursing personnel, is primarily responsible for adherence to the Company’s quality improvement standards. In that regard, the annual operational objectives established by each facility administrator include specific objectives with respect to quality of care. Performance of these objectives is evaluated quarterly by the regional vice president or manager, and each facility administrator’s incentive compensation is based, in part, on the achievement of the specified quality objectives. Issues regarding quality of care and resident care outcomes are addressed routinely by senior management. The Company also has established a quality improvement committee consisting of nursing representatives from each region. This committee periodically reviews the Company’s quality improvement programs and conducts facility audits. The Company and its predecessor have operated a medical advisory committee in Ontario for more than 14 years and has developed similar committees in some of the other jurisdictions in which it operates. It is the Company’s view that these committees provide a vehicle for ensuring greater physician involvement in the operations of each facility with resulting improved focus on CQI and resident care plans. In addition, the Company has provided membership for all of its United States medical directors in the American Medical Directors Association. All of the nursing homes operated by the Company in Ontario have been accredited by the Canadian Council on Health Facilities Accreditation. The CQI program used at all locations was designed to meet accreditation standards and to exceed state and federal government regulations.

Competition.

The long-term care business is highly competitive. The Company faces direct competition for additional facilities and management agreements, and the facilities operated by the Company face competition for employees, patients and residents. Some of the Company’s present and potential competitors for acquisitions and management agreements are significantly larger and have or may obtain greater financial and marketing resources. Competing companies may offer new or more modern facilities or new or different services that may be more attractive to patients, residents or facility owners than some of the services offered by the Company.

The nursing homes and assisted living facilities operated by the Company compete with other facilities in their respective markets, including rehabilitation hospitals, other “skilled” and personal care residential facilities. In the few urban markets in which the Company operates, some of the long-term care providers with which the Company’s operated facilities compete are significantly larger and have or may obtain greater financial and marketing resources than the Company’s operated facilities. Some of these providers are not-for-profit organizations with access to sources of funds not available to the facilities operated by the Company. Construction of new long-term care facilities near the Company’s existing operated facilities could adversely affect the Company’s business. Management believes that the most important competitive factors in the long-term care business are: a facility’s local reputation with referral sources, such as acute care hospitals, physicians, religious groups, other community organizations, managed care organizations, and a patient’s family and friends; physical plant condition;

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the ability to identify and meet particular care needs in the community; the availability of qualified personnel to provide the requisite care; and the rates charged for services. There is limited, if any, price competition with respect to Medicaid and Medicare patients, since revenues for services to such patients are strictly controlled and are based on fixed rates and cost reimbursement principles. Although the degree of success with which the Company’s operated facilities compete varies from location to location, management believes that its operated facilities generally compete effectively with respect to these factors.

Government Regulation and Reimbursement.

The health care industry is subject to numerous laws and regulations of federal, state and local governments. These laws and regulations include, but are not necessarily limited to, matters such as licensure, accreditation, government health care program participation requirements, reimbursement for patient services, quality of resident care and Medicare and Medicaid fraud and abuse (collectively the “Health Care Laws”). Changes in these laws and regulations, such as reimbursement policies of Medicare and Medicaid programs as a result of budget cuts by federal and state governments or other legislative and regulatory actions, have had a material adverse effect on the industry and the Company’s consolidated financial position, results of operations, and cash flows. Future federal budget legislation and federal and state regulatory changes may further negatively impact the Company.

All of the Company’s facilities are required to obtain annual licensure renewal and are subject to annual surveys and inspections in order to be certified for participation in the Medicare and Medicaid programs. In order to maintain their state operating license and their certification for participation in Medicare and Medicaid programs, the nursing facilities must meet certain statutory and administrative requirements at both the state and Federal level. These requirements relate to the condition of the facilities, the adequacy and condition of the equipment used therein, the quality and adequacy of personnel, and the quality of resident care. Such requirements are both subjective and subject to change. There can be no assurance that, in the future, the Company will be able to maintain such licenses and certifications for its facilities or that the Company will not be required to expend significant sums in order to comply with regulatory requirements.

The Company’s assisted living facilities in the United States are also subject to state and local licensing requirements.

Reimbursement. A significant portion of the Company’s revenues is derived from government-sponsored health insurance programs. The nursing homes operated by the Company derive revenues under Medicaid, Medicare, the Ontario Government Operating Subsidy program, and private pay sources. The United States assisted living facilities located in North Carolina derive revenues from Medicaid and similar programs as well as from private pay sources. The Company’s assisted living facilities in Canada derive virtually all of their revenues from private pay sources. The Company employs specialists in reimbursement at the corporate level to monitor regulatory developments, to comply with reporting requirements, and to maximize payments to its operated nursing homes. It is generally recognized that all government-funded programs have been and will continue to be under cost containment pressures, but the extent to which these pressures will affect the Company’s future reimbursement is unknown.

Under the current law, Medicare reimbursements for nursing facilities were reduced following the October 1, 2002 expiration of two temporary payment increases enacted as part of earlier Medicare enhancement bills. As a result, beginning October 1, 2002, the Company’s Medicare reimbursement has

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been reduced by an estimated $368,000 per month, as a result of the expiration of temporary add-on legislation. Partially offsetting this decrease, CMS implemented a Medicare rate increase of approximately 2.6% effective October 1, 2002. There are two additional payment increases that were originally scheduled to expire October 1, 2002. CMS has announced that the expiration of these payment increases has been postponed to October 1, 2004.

Medicare and Medicaid. Medicare is a federally-funded and administered health insurance program for the aged and for certain chronically disabled individuals. Part A of the Medicare program covers inpatient hospital services and certain services furnished by other institutional providers such as skilled nursing facilities. Part B covers the services of doctors, suppliers of medical items, various types of outpatient services, and certain ancillary services of the type provided by long term and acute care facilities. Medicare payments under Part A and Part B are subject to certain caps and limitations, as provided in Medicare regulations. Medicare benefits are not available for intermediate and custodial levels of nursing home care, nor for assisted living facility arrangements.

Medicaid is a medical assistance program for the indigent, operated by individual states with financial participation by the federal government. Criteria for medical indigence and available Medicaid benefits and rates of payment vary somewhat from state to state, subject to certain federal requirements. Basic long-term care services are provided to Medicaid beneficiaries, including nursing, dietary, housekeeping and laundry and restorative health care services, room and board, and medications. Previously, under legislation known as the Boren Amendment, federal law required that Medicaid programs pay to nursing home providers amounts adequate to enable them to meet government quality and safety standards. However, the Balanced Budget Act enacted during 1997 (the “BBA”) repealed the Boren Amendment, and the BBA requires only that a state Medicaid program must provide for a public process for determination of Medicaid rates of payment for nursing facility services. Under this process, proposed rates, the methodologies underlying the establishment of such rates, and the justification for the proposed rates are published. This public process gives providers, beneficiaries and concerned state residents a reasonable opportunity for review and comment. Certain of the states in which the Company now operates are actively seeking ways to reduce Medicaid spending for nursing home care by such methods as capitated payments and substantial reductions in reimbursement rates.

The BBA contains numerous Medicare and Medicaid cost-saving measures. The BBA requires that nursing homes transition to a prospective payment system (“PPS”) under the Medicare program during a three-year “transition period,” commencing with the first cost reporting period beginning on or after July 1, 1998. The BBA also contains certain measures that have led and could lead to further future reductions in Medicare therapy reimbursement and Medicaid payment rates. Revenues and expenses have both been reduced significantly from the levels prior to PPS. The BBA has negatively impacted the entire long-term care industry.

During 1999 and 2000, certain amendments to the BBA were enacted, including the Balanced Budget Reform Act of 1999 (“BBRA”) and the Benefits Improvement and Protection Act of 2000 (“BIPA”). The BBRA provided legislative relief in the form of increases in certain Medicare payment rates during 2000. The BIPA continued to provide additional increases in certain Medicare payment rates during 2001. In July 2001, CMS published a final rule updating payment rates for skilled nursing facilities under PPS.

Although refinements resulting from the BBRA and the BIPA have been well received by the United States nursing home industry, it is the Company’s belief that the resulting revenue enhancements are still significantly less than the losses sustained by the industry due to the BBA. Current levels of or further

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reductions in government spending for long-term health care would continue to have an adverse effect on the operating results and cash flows of the Company. The Company will attempt to maximize the revenues available from governmental sources within the changes that have occurred and will continue to occur under the BBA. In addition, the Company will attempt to increase revenues from non-governmental sources, including expansion of its assisted living operations, to the extent capital is available to do so, if at all.

Under the current law, Medicare reimbursements for nursing facilities were reduced following the October 1, 2002 expiration of two temporary payment increases enacted as part of earlier Medicare enhancement bills. As a result, beginning October 1, 2002, the Company’s Medicare reimbursement has been reduced by an estimated $368,000 per month, as a result of the expiration of temporary add-on legislation. Partially offsetting this decrease, CMS implemented a Medicare rate increase of approximately 2.6% effective October 1, 2002. There are two additional payment increases that were originally scheduled to expire October 1, 2002. CMS has announced that the expiration of these payment increases has been postponed to October 1, 2004.

During 2002, 2001 and 2000, the Company experienced certain regulatory actions with respect to certain facilities, including a decertification of one facility from the Medicare and Medicaid programs during 2000. The Company also experiences regulatory scrutiny that can result in fines and penalties. The Company incurred expenses of $210,000, $324,000 and $570,000 for fines and penalties in 2002, 2001 and 2000, respectively.

Reduction in health care spending has become a national priority in the United States, and the field of health care regulation and reimbursement is a rapidly evolving one. For the fiscal year ended December 31, 2002, the Company derived 21.4% and 61.3% of its total patient and resident revenues from the Medicare and Medicaid programs, respectively. Any health care reforms that significantly limit rates of reimbursement under these programs could, therefore, have a material adverse effect on the Company’s profitability. The Company is unable to predict which reform proposals or reimbursement limitations will be adopted in the future, or the effect such changes would have on its operations. In addition, private payors, including managed care payors, are increasingly demanding that providers accept discounted fees or assume all or a portion of the financial risk for the delivery of health care services. Such measures may include capitated payments, which can result in significant losses to health care providers if patients require expensive treatment not adequately covered by the capitated rate.

HIPAA Compliance. The Health Insurance Portability and Accountability Act of 1996 (“HIPAA”) has mandated an extensive set of regulations to standardize electronic patient health, administrative and financial data transactions, and to protect the privacy of individually identifiable health information. In October 2002, the Company filed for an extension of the deadline for compliance with the electronic patient health information requirements, and has until October 2003 to be in compliance with these requirements. Compliance with the privacy regulations is required by April 14, 2003. The Company has created a HIPAA Compliance Committee, appointed a privacy officer and a security officer, and is currently conducting training at each of its facilities on the privacy requirements. The Company is in the process of identifying information inflow and outflow throughout the organization in order to determine the appropriate security safeguards the Company will need to put in place to be HIPAA-compliant. The Company is unable to definitively assess the full cost of compliance with HIPAA’s electronic transactions, privacy, and security standards at this time. Expenditures for any substantial changes to the Company’s information management systems required for HIPAA compliance could have a material financial impact on the Company.

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Ontario Government Operating Subsidy Program. The Ontario Government Operating Subsidy program (“OGOS”) regulates both the total charges allowed to be levied by a licensed nursing home and the maximum amount that the OGOS program will pay on behalf of nursing home residents. The maximum amounts that can be charged to residents for ward, semi-private and private accommodation are established each year by the Ontario Ministry of Health. Regardless of actual accommodation, at least 40% of the beds in each home must be filled at the ward rate. Generally, amounts received from residents should be sufficient to cover the accommodation costs of a nursing home, including food, laundry, housekeeping, property costs and administration. In addition, the Ontario government partially subsidizes each individual, and funds each nursing home for the approximate care requirements of its residents. This funding is based upon an annual assessment of the levels of care required in each home, from which “caps” are determined and funding provided on a retrospective basis. The Ontario government funds from 35.0% to 70.0% of a resident’s charges, depending on the individual resident’s income and type of accommodation. The Company receives payment directly from OGOS by virtue of its ownership of two nursing homes in Canada. Additionally, the Company earns management fees from Canadian nursing homes, which derive significant portions of their revenues from OGOS.

Self-Referral and Anti-Kickback Legislation. The health care industry is subject to state and federal laws which regulate the relationships of providers of health care services, physicians, and other clinicians. These self-referral laws impose restrictions on physician referrals to any entity with which they have a financial relationship, which is a broadly defined term. The Company believes its relationships with physicians are in compliance with the self-referral laws. Failure to comply with self-referral laws could subject the Company to a range of sanctions, including civil monetary penalties and possible exclusion from government reimbursement programs. There are also federal and state laws making it illegal to offer anyone anything of value in return for referral of patients. These laws, generally known as “anti-kickback” laws, are broad and subject to interpretations that are highly fact dependent. Given the lack of clarity of these laws, there can be no absolute assurance that any health care provider, including the Company, will not be found in violation of the anti-kickback laws in any given factual situation. Strict sanctions, including fines and penalties, exclusion from the Medicare and Medicaid programs and criminal penalties, may be imposed for violation of the anti-kickback laws.

Licensure and Certification. All the Company’s nursing homes must be licensed by the state in which they are located in order to accept patients, regardless of payor source. In most states, nursing homes are subject to certificate of need laws, which require the Company to obtain government approval for the construction of new nursing homes or the addition of new licensed beds to existing homes. The Company’s nursing homes must comply with detailed statutory and regulatory requirements on an ongoing basis in order to qualify for licensure, as well as for certification as a provider eligible to receive payments from the Medicare and Medicaid programs. Generally, the requirements for licensure and Medicare/Medicaid certification are similar and relate to quality and adequacy of personnel, quality of medical care, record keeping, dietary services, resident rights, and the physical condition of the facility and the adequacy of the equipment used therein. Each facility is subject to periodic inspections, known as “surveys” by health care regulators, to determine compliance with all applicable licensure and certification standards. If the survey concludes that there are deficiencies in compliance, the facility is subject to various sanctions, including but not limited to monetary fines and penalties, suspension of new admissions, non-payment for new admissions and loss of licensure or certification. Generally, however, once a facility receives written notice of any compliance deficiencies, it may submit a written plan of correction and is given a reasonable opportunity to correct the deficiencies.

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A Company leased facility, located in Texas, was decertified from the Medicaid and Medicare programs during 2000. During the fourth quarter of 2001, the Company concluded that relicensure of this facility was not a worthwhile investment given a lease expiration date in May 2004. As a result, the Company wrote-off the remaining net book value associated with this facility and accrued for the future operating costs, including rent, maintenance, taxes and insurance.

Recently, government activity has increased with respect to investigations and allegations concerning possible violations by health care providers of fraud and abuse statutes and regulations and quality of care issues in the skilled nursing profession in general. Violations of these laws and regulations could result in exclusion from government health care programs together with the imposition of significant fines and penalties, as well as significant repayments for patient services previously billed. Compliance with such laws and regulations is subject to ongoing government review and interpretation, as well as regulatory actions which may be unknown or unasserted at this time. The Company has been a defendant in one such false claims action as described under “Item 3: Legal Proceedings.”

Privately owned nursing homes in Ontario are licensed by the Ministry of Health under the Ontario Nursing Homes Act. The legislation, together with program manuals, establishes the minimum standards that are required to be provided to the patients of the home, including staffing, space, nutrition and activities. Patients can only be admitted and subsidized if they require at least 1.5 hours per day of care, as determined by a physician. Retirement centers in Canada are generally regulated at the municipal government level in the areas of fire safety and public health and at the provincial level in the areas of employee safety, pay equity, and, in Ontario, rent control.

Licensure and regulation of assisted living facilities varies considerably from state to state, although the trend is toward increased regulation in the United States. In North Carolina, the Company’s facilities must pass annual surveys and the state has established base-level requirements that must be maintained. Such requirements include or relate to staffing ratios, space, food service, activities, sanitation, proper medical oversight, fire safety, resident assessments and employee training programs. In Canada, assisted living facilities are generally not required to be licensed and are subject to only minor regulations. However, assisted living facilities in Canada undergo a voluntary certification process through the Ontario Residential Care Association. This certification validates proper care and services through an on-site review process of two to three years.

Payor Sources.

The Company classifies its revenues from patients and residents into three major categories: Medicaid, Medicare and private pay. In addition to traditional Medicaid revenues, the Company includes within the Medicaid classification revenues from other programs established to provide benefits to those in need of financial assistance in the securing of medical services. Examples include the OGOS and North Carolina state and county special assistance programs. Medicare revenues include revenues received under both Part A and Part B of the Medicare program. The Company classifies payments from individuals who pay directly for services without government assistance as private pay revenue. The private pay classification also includes revenues from commercial insurers, HMOs, and other charge-based payment sources. Veterans Administration payments are included in private pay and are made pursuant to renewable contracts negotiated with these payors.

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The following table sets forth net patient and resident revenues by payor source for the Company for the years presented:

     Patient and residential service is generally provided and charged in daily service units, commonly referred to as patient and resident days. The following table sets forth patient and resident days by payor source for the Company for the years presented:

The above tables include net patient revenues and the patient days of the six facilities comprising TDLP. See Note 5 of the Company’s Consolidated Financial Statements.

Consistent with the nursing home industry in general, changes in the mix of a facility’s patient population among Medicaid, Medicare, and private pay can significantly affect the profitability of the facility’s operations.

For information about revenue, operating income (loss) and identifiable assets attributable to the Company’s United States and Canadian operations, see Note 16 of the Company’s Consolidated Financial Statements.

Supplies and Equipment.

The Company purchases drugs, solutions and other materials and leases certain equipment required in connection with the Company’s business from many suppliers. The Company has not experienced, and management does not anticipate that the Company will experience, any significant difficulty in purchasing supplies or leasing equipment from current suppliers. In the event that such suppliers are unable or fail to sell supplies or lease equipment to the Company, management believes that other suppliers are available to adequately meet the Company’s needs at comparable prices. National purchasing contracts are in place for all major supplies, such as food, linens, and medical supplies. These contracts assist in maintaining quality, consistency and efficient pricing.

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Insurance.

The increasing cost of claims against both the Company and throughout the long-term care profession in general have caused the Company’s professional liability insurance premiums and deductible amounts to increase substantially and insurance coverage limits have decreased substantially during 1999 through 2002 and continuing or policy year 2003. As a result of the substantial premium and deductible increases and insurance coverage decreases, effective March 9, 2002, the Company has obtained professional liability insurance coverage for its United States nursing homes and assisted living facilities that is likely to be substantially less than the claims that could be incurred during the policy periods from March 9, 2002 through March 9, 2004. As a result, the Company is effectively self-insured. For claims made after March 9, 2002, the Company maintains general and professional liability insurance with coverage limits of $250,000 per medical incident and total aggregate policy coverage limits of $1,000,000 for its long-term care services. The 2002 and 2003 policies are on a claims made basis and the Company is self-insured for the first $25,000 per occurrence with no aggregate limit. The Company provides reserves on an actuarial basis for known and expected claims incurred during the policy period.

For claims made during the period March 9, 2001 through March 9, 2002, the Company is self-insured for the first $50,000 per occurrence with no aggregate limit for the Company’s United States nursing homes. The policy has coverage limits of $2,000,000 per occurrence and $3,000,000 in the aggregate. The Company provides reserves on an actuarial basis for known and expected claims incurred during the policy period. This policy is on a claims made basis. Effective October 1, 2001, the Company’s United States assisted living properties were added to the Company’s insurance program for United States nursing home properties.

For claims made during the period March 9, 2000 through March 9, 2001, the Company is self-insured for the first $500,000 per occurrence with no aggregate limit for the Company’s United States nursing homes. The policy has coverage limits of $1,000,000 per occurrence, $3,000,000 per location and $12,000,000 in the aggregate. The Company also maintains umbrella coverage of $15,000,000 in the aggregate for claims made during the period March 9, 2000 through March 9, 2001. The Company provides reserves on an actuarial basis for known and expected claims incurred during the policy period. This policy is on a claims made basis.

Prior to March 9, 2000, all of these policies are on an occurrence basis. For the policy periods January 1, 1998 through February 1, 1999, the Company is self-insured for the first $250,000 per occurrence and $2,500,000 in the aggregate per year with respect to the majority of its United States nursing homes. Effective February 1, 1999, all United States nursing homes became part of the $250,000/$2,500,000 deductible program, including the six TDLP facilities.

For the policy years 2000 and 1999, the Company expects to ultimately fully incur the aggregate deductible amount and has established reserves based on this expectation.

The Company’s United States assisted living facilities are self-insured, with respect to each location, for the first $50,000 per occurrence through September 2001. Effective October 1, 2001, the Company’s United States assisted living properties were added to the Company’s insurance program for United States nursing home properties. The Company also maintains a $15,000,000 aggregate umbrella liability policy for claims in excess of the foregoing limits for these assisted living operations through September 30, 2001.

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In Canada, the Company’s professional liability claims experience and associated costs have been dramatically less than that in the United States. The Canadian facilities owned or leased by the Company are self-insured for the first $3,000 ($5,000 Canadian) per occurrence. The Company’s aggregate primary coverage limit with respect to Canadian operations is $1,269,000 ($2,000,000 Canadian). The Company also maintains a $3,172,000 ($5,000,000 Canadian) aggregate umbrella policy for claims in excess of the foregoing limits for these facilities.

The Company has recorded total liabilities for reported professional liability claims and estimates for incurred but unreported claims of $33,745,000 as of December 31, 2002. Such liabilities include estimates of legal costs. The Company believes that the $78.425 million monetary judgment, if upheld by the Arkansas Supreme Court (to which it is currently on appeal) will be covered by insurance pursuant to the 1997 and 1998 insurance programs. Based on the expected insurance coverage in effect at the time of the Mena claim, the verdict amount has not been accrued. However, the ultimate results of the Company’s professional liability claims and disputes are unknown at the present time.

In addition, the payment of professional liability claims by the Company’s insurance carriers is dependent upon the financial solvency of the individual carriers. The Company is aware that two of its insurance carriers providing coverage for prior years claims have either been declared insolvent or are currently under rehabilitation proceedings. Any future judgments or settlements above the Company’s per occurrence, per location or umbrella coverage or not covered by insurance due to the insolvency of the insurance carrier could have a material adverse impact on the Company’s financial position, cash flows and results of operations. In addition, the ultimate payment of professional liability claims accrued as of December 31, 2002 and claims that could be incurred during 2003 could require cash resources during 2003 that would be in excess of the Company’s available cash or other resources. These potential future payments could have a material adverse impact on the Company’s financial position and cash flows.

With respect to workers’ compensation insurance, substantially all of the Company’s employees became covered under either an indemnity insurance plan or state-sponsored programs in May 1997. Prior to that time, the Company was self-insured for the first $250,000, on a per claim basis, for workers’ compensation claims in a majority of its United States nursing facilities. However, the insurance carrier providing coverage above the Company’s self insured retention has been declared insolvent by the applicable state insurance agency. As a result, the Company is completely self insured for workers compensation exposures prior to May 1997. The Company has been and remains a non-subscriber to the Texas workers’ compensation system and is, therefore, completely self-insured for employee injuries with respect to its Texas operations. Effective July 1, 2002, the Company entered into a “high deductible” workers compensation insurance program covering the majority of the Company’s United States employees. Under the high deductible policy, the Company is self insured for the first $25,000 per claim, subject to an aggregate maximum out of pocket cost of $1,600,000 for the 12 month policy period. The Company has a letter of credit of $1,252,000 securing its self insured obligations under this program. The letter of credit is secured by a certificate of deposit of $1,252,000, which is reflected as “restricted cash” in the accompanying balance sheet. The reserve for the high deductible policy is based known claims incurred and an estimate of incurred by not reported claims determined by an analysis of historical claims incurred. The Company has provided reserves for the settlement of outstanding self-insured claims at amounts believed to be adequate. The liability recorded by the Company for its

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obligations under these plans is $1,127,000 as of December 31, 2002. The differences between actual settlements and reserves are included in expense in the year finalized.

The Company is self-insured for health insurance benefits for certain employees and dependents for amounts up to $150,000 per individual annually. The Company provides reserves for the settlement of outstanding self-insured health claims at amounts believed to be adequate. The liability for reported claims and estimates for incurred but unreported claims is $869,000 at December 31, 2002. The differences between actual settlements and reserves are included in expense in the year finalized.

Employees.

As of February 28, 2003, the Company employed a total of approximately 5,333 individuals. Management believes that the Company’s employee relations are good. Approximately 264 of the Company’s United States employees are represented by a labor union and approximately 413 of the Company’s Canadian employees are represented by various unions. With the exception of some administrators of managed facilities (whose salaries are reimbursed by the owners), the staff of the managed nursing homes and assisted living facilities are not employees of the Company. The Company’s managed facilities employ approximately 2,854 individuals, approximately 2,076 of whom are Canadians represented by various unions.

A major component of the Company’s CQI program is employee empowerment initiatives, with particular emphasis placed on selection, recruitment, retention and recognition programs. Administrators and managers of the Company include employee retention and turnover goals in the annual facility, regional and personal objectives.

Although the Company believes it is able to employ sufficient nurses and therapists to provide its services, a shortage of health care professional personnel in any of the geographic areas in which the Company operates could affect the ability of the Company to recruit and retain qualified employees and could increase its operating costs. The Company competes with other health care providers for both professional and non-professional employees and with non-health care providers for non-professional employees. During 2002, the Company faced increased competition for workers due to tight labor markets in most of the areas in which the Company operates in the United States and the nursing shortage that is affecting the United States and Canada.

The Company owns 28 and leases 42 long-term care facilities. See “Item 1. Business — Description of Lease Agreements” and “- Facilities.” The Company leases approximately 19,000 square feet of office space in Franklin, Tennessee, that houses the executive offices of the Company, centralized management support functions, and the ancillary services supply operations. In addition, the Company leases its regional office for Canadian operations with approximately 10,800 square feet of office space in Mississauga, Ontario, its regional office with approximately 3,400 square feet of office space in Kernersville, North Carolina, and its regional office with approximately 3,000 square feet of office space in Ashland, Kentucky. Lease periods on these facilities generally range up to seven years, although the Kernersville lease runs through 2022 including renewal options. Regional executives for Alabama, Arkansas, Florida, Tennessee and Texas work from offices of up to 1,000 square feet each. Management believes that the Company’s leased properties are adequate for its present needs and that suitable additional or replacement space will be available as required.

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The provision of health care services entails an inherent risk of liability. In recent years, participants in the health care industry have become subject to an increasing number of lawsuits alleging malpractice, product liability, or related legal theories, many of which involve large claims and significant defense costs. The entire long-term care profession in the United States has experienced a dramatic increase in claims related to alleged negligence in providing care to its patients — the Company is no exception in this regard. The Company, as with the rest of the industry, has numerous liability claims and disputes outstanding for professional liability and other related issues. It is expected that the Company will continue to be subject to such suits as a result of the nature of its business. Further, as with all health care providers, the Company is potentially subject to the increased scrutiny of regulators for issues related to compliance with health care fraud and abuse laws.

As of December 31, 2002, the Company is engaged in 58 professional liability lawsuits, including 17, 20, and 6 in the states of Florida, Arkansas and Texas, respectively. On June 22, 2001, a jury in Mena, Arkansas, issued a verdict in a professional liability lawsuit against the Company totaling $78.425 million. The Company appealed the verdict to the Arkansas Supreme Court in a hearing that took place March 13, 2003. As of March 17, no ruling has been issued by the Court. The Company believes that the $78.425 million verdict, if upheld by the Arkansas Supreme Court, will be covered by insurance pursuant to the Company’s professional liability insurance. Based on the insurance coverage in effect at the time of the claim, the verdict amount has not been accrued. However, to the extent the Company’s professional liability insurance pays large amounts with respect to this verdict, there may not be sufficient insurance coverage for other claims during the same time period. The ultimate results of all of the Company’s professional liability claims and disputes are unknown at the present time. There can be no assurance that verdicts against the Company will not exceed the policy limits of the Company’s insurance policies.

On October 17, 2000, the Company was served with a civil complaint by the Florida Attorney General’s office, in the case of State of Florida ex rel. Mindy Myers v. R. Brent Maggio, et al. In this case, the State of Florida accused multiple defendants of violating Florida’s False Claims Act. The Company, in its capacity as the manager of four nursing homes owned by Emerald Coast Healthcare, Inc. (“Emerald”), was named in the complaint, as amended, which accused the Company of making illegal kickback payments to R. Brent Maggio, Emerald’s sole shareholder, and fraudulently concealing such payments in the Medicaid cost reports filed by the nursing homes. During the first quarter of 2003, the State of Florida granted a voluntary dismissal with prejudice of all claims related to this incident against the Company and its subsidiaries. In addition, a settlement agreement was executed between the State of Florida, R. Brent Maggio and Emerald, pursuant to which the State of Florida has dropped its prosecution of this matter. The Company has been informed that the whistle blower in this action will object to the settlement as executed by the State of Florida. Under Florida’s False Claims Act, a whistle blower may object in court to a settlement but must demonstrate that the State’s settlement is manifestly unjust. In the event the settlement is determined to be manifestly unjust, the Company believes that it has meritorious defenses in this matter and intends to vigorously pursue these defenses in litigation.

In addition to the false claims actions described above, the Company has also received notices from CMS concerning post-payment medical reviews of claims for several of the Company’s Texas facilities. The reviews have resulted in the denial of previously paid claims for infusion therapy and certain other therapy services rendered by outside providers to patients at the Company’s facilities for the years 1996 through 1999. The government has recovered $374,000 as of December 31, 2002, and may continue to recover, some of the alleged overpayment amounts by offset against current amounts due the facilities.

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The Company believes that the medical reviews were imposed as the result of a governmental investigation of Infusion Management Services (“IMS”), an unrelated company that provided infusion therapy services to residents at the Company’s facilities and which some time ago entered into a settlement agreement with the government regarding allegations of violations of applicable laws. The Company has appealed many of the denied claims. The Company’s intermediary has indicated it will no longer pursue the denial of claims related to the provision of infusion therapy although it is still denying other therapy services on the same claims. The Company cannot at this time predict whether its efforts to recover the recouped money and obtain payment of the denied claims will be successful, and the denial of these claims could have a material adverse impact on the Company’s financial condition, cash flows or results of operations.

On August 5, 2002, the Company was served notice that the State of Arkansas was suing the Company and certain subsidiaries, including a nursing home operated in Eureka Springs, Arkansas. The State of Arkansas’ allegations against the Company and certain subsidiaries includes violation of the Arkansas Abuse of Adults Act and violation of the Arkansas Medicaid False Claims Act. These allegations are made with respect to a resident (designated in the complaint as “Resident #1”) of the Eureka Springs facility. The Company believes that it has meritorious defenses in this case and will vigorously defend itself. The Company further notes that the Arkansas Department of Human Services — Office of Long Term Care conducted a thorough investigation of the care of Resident #1 and that the Office of Long Term Care issued no citations as a result of their investigation of Resident #1.

The Company cannot currently predict with certainty the ultimate impact of the above cases on the Company’s financial condition, cash flows or results of operations. An unfavorable outcome in any of the lawsuits or any state or Federal False Claims Act case could subject the Company to fines, penalties and damages. Moreover, the Company could be excluded from the Medicare, Medicaid or other federally-funded health care programs, which could have a material adverse impact on the Company’s financial condition, cash flows or results of operations.

There have been no matters submitted to a vote of security holders during the fourth quarter (October 1, 2002 through December 31, 2002) of the fiscal year covered by this Annual Report on Form 10-K.

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PART II

The Common Stock of the Company was listed on the New York Stock Exchange under the symbol “AVC” through November 9, 1999. Since that time, the Company’s Common Stock has been traded on NASD’s OTC Bulletin Board under the symbol “AVCA.” The following table sets forth the high and low prices of the common stock for each quarter in 2001 and 2002:

The Company’s Common Stock has been traded since May 10, 1994. On March 21, 2003, the closing price for the Common Stock was $0.19, as reported by PCQuote.com.

On March 21, 2003, there were 334 holders of record of the common stock. Most of the Company’s shareholders have their holdings in the street name of their broker/dealer.

The Company has not paid cash dividends on its Common Stock and anticipates that, for the foreseeable future, any earnings will be retained for use in its business and no cash dividends will be paid. The Company is currently prohibited from issuing dividends under certain debt instruments.

The following table sets forth certain information regarding the Company’s Equity Compensation Plans:

Equity Compensation Plan Information

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The selected financial data of Advocat as of December 31, 2002, 2001, 2000, 1999 and 1998 and for the years ended December 31, 2002, 2001, 2000, 1999 and 1998 have been derived from the audited financial statements of the Company, and should be read in conjunction with the audited financial statements and related Notes and Management’s Discussion and Analysis of Financial Condition and Results of Operations.

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Overview

Advocat Inc. (together with its subsidiaries, “Advocat” or the “Company”) provides long-term care services to nursing home patients and residents of assisted living facilities in ten states, primarily in the Southeast, and three Canadian provinces. The Company’s facilities provide a range of health care services to their patients and residents. In addition to the nursing, personal care and social services usually provided in long-term care facilities, the Company offers a variety of comprehensive rehabilitation services as well as medical supply and nutritional support services.

As of December 31, 2002, the Company operates 98 facilities, consisting of 62 nursing homes with 7,138 licensed beds and 36 assisted living facilities with 3,499 units. In comparison, at December 31, 2001, the Company operated 116 facilities composed of 62 nursing homes containing 6,992 licensed beds and 54 assisted living facilities containing 5,319 units. As of December 31, 2002, the Company owns 12 nursing homes, leases 34 others and manages the remaining 16 nursing homes. Additionally, the Company owns 16 assisted living facilities, leases 8 others and manages the remaining 12 assisted

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living facilities. The Company holds a minority interest in six of these managed assisted living facilities. The Company operates 48 nursing homes and 16 assisted living facilities in the United States and 14 nursing homes and 20 assisted living facilities in Canada.

Effective April 30, 2002, the Company entered into a Lease Termination and Operations Transfer Agreement (the “Pierce Agreement”) with Pierce Management Group and related persons (collectively, “Pierce”), pursuant to which the 13 leases with the former principal owners or affiliates of Pierce were terminated. Effective May 31, 2002, the leases on two additional assisted living facilities were assumed by Pierce. As a result, the Company was relieved of its future obligations with respect to these 15 leases. Effective June 30, 2002, the Company terminated the lease on one additional assisted living facility. The Company is in a dispute with the owner of this property which will be the subject of an arbitration hearing currently scheduled in 2003. The Company has accrued for the estimated costs associated with this arbitration hearing. The Company incurred lease termination charges of approximately $750,000 in 2002, consisting of the remaining net book value of these facilities, approximately $470,000, and approximately $280,000 for legal fees and other costs of completing the transactions.

During the fourth quarter of 2001, the Company terminated the leases on two Florida nursing homes, and sold another owned Florida nursing home during the fourth quarter of 2002. The Company recorded impairment provisions of approximately $482,000 and $95,000 in 2001 and 2002, respectively, to write-off the remaining net book value of these properties in connection with these transactions.

Basis of Financial Statements. The Company’s patient and resident revenues consist of the fees charged for the care of patients in the nursing homes and residents of the assisted living facilities owned and leased by the Company. Management fee revenues consist of the fees charged to the owners of the facilities managed by the Company. The management fee revenues are based on the respective contractual terms of the Company’s management agreements, which generally provide for management fees ranging from 3.5% to 6.0% of the net revenues of the managed facilities. As a result, the level of management fees is affected positively or negatively by the increase or decrease in the average occupancy level rates of the managed facilities. The Company’s operating expenses include the costs, other than lease, depreciation and amortization expenses, incurred in the operation of the nursing homes and assisted living facilities owned and leased by the Company. The Company’s general and administrative expenses consist of the costs of the corporate office and regional support functions, including the costs incurred in providing management services to other owners. The Company’s depreciation, amortization and interest expenses include all such expenses across the range of the Company’s operations.

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Operating Data

The following table presents the Advocat statements of operations for the years ended December 31, 2002, 2001 and 2000, and sets forth this data as a percentage of revenues for the same years.