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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D. C. 20549
FORM 10-K

þ ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the Fiscal Year Ended December 31, 2004
OR
¨  TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934

COMMISSION FILE NUMBER 1-16477

COVENTRY HEALTH CARE, INC.
(Exact name of registrant as specified in its charter)

6705 Rockledge Drive, Suite 900, Bethesda, Maryland 20817
(Address of principal executive offices) (Zip Code)

Registrant’s telephone number, including area code: (301)581-0600

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

Securities registered pursuant to Section 12(g) of the Act:
Common Stock, $.01 par value
Common Stock purchase rights

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

        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. ¨

        Indicate by check mark whether the registrant is an accelerated filer (as defined in the Securities Exchange Act of 1934 Rule 12b - 2) Yes þ No ¨

        The aggregate market value of the registrant’s voting Common Stock held by non - affiliates of the registrant as of June 30, 2004 (computed by reference to the closing sales price of such stock on the NYSE® stock market on such date) was $4,381,325,720.

        As of February 28, 2005, there were 107,006,167 shares of the registrant’s voting Common Stock outstanding.

DOCUMENTS INCORPORATED BY REFERENCE

        Parts of the registrant’s Proxy Statement for its 2005 Annual Meeting of Shareholders to be filed with the Commission pursuant to Regulation 14A subsequent to the filing of this Form 10-K Report are incorporated by reference in Items 10 through 14 of Part III hereof.

COVENTRY HEALTH CARE, INC.
FORM 10-K
TABLE OF CONTENTS

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PART I

Cautionary Statement Regarding Forward-Looking Statements

        This Form 10-K contains forward-looking statements which are subject to risks and uncertainties in accordance with the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Forward-looking statements, typically include assumptions, estimates or descriptions of our future plans, strategies and expectations, and are generally identifiable by the use of the words “anticipate,” “will,” “believe,” “estimate,” “expect,” “intend,” “seek,” or other similar expressions. Examples of these include discussions regarding our operating and growth strategy, projections of revenue, income or loss and future operations. Unless this Form 10-K indicates otherwise or the context otherwise requires, the terms “we,” “our,” “our Company,” “the Company” or “us” as used in this Form 10-K refer to Coventry Health Care, Inc. and its subsidiaries as of December 31, 2004 and exclude First Health Group Corp (“First Health”).

        These forward-looking statements may be affected by a number of factors, including, but not limited to, the “Risk Factors” contained in Management’s Discussion and Analysis of Financial Condition and Results of Operations in this Form 10-K. Actual operations and results may differ materially from those expressed in this Form 10-K. Among the factors that may materially affect our business are increases in medical costs, difficulties in increasing premiums due to competitive pressures, unanticipated revenue short falls in recently acquired companies, price restrictions under Medicaid and Medicare, problems in integrating or realizing efficiencies in acquired companies, issues related to product marketing and imposition of regulatory restrictions, costs, or penalties. Other factors that may materially affect the Company’s business include issues related to the inability in obtaining or maintaining favorable contracts with health care providers, credit risks on global capitation arrangements, financing costs and contingencies, the ability to increase membership and premium rates, issues relating to our recent acquisition of First Health, and litigation risk.

Item 1: Business

General

        We are a leading publicly traded managed health care company with 2.5 million members as of December 31, 2004. We operate a diversified portfolio of local market health plans serving 15 markets, primarily in the Mid-Atlantic, Midwest and Southeast United States. Our health plans are operated under the names Altius Health Plans, Carelink Health Plans, Coventry Health Care, Coventry Health and Life, Group Health Plan, HealthAmerica, HealthAssurance, HealthCare USA, OmniCare, PersonalCare, SouthCare, Southern Health and WellPath. Our health plans generally are located in small to mid-sized metropolitan areas.

        Coventry was incorporated under the laws of the State of Delaware on December 17, 1997 and is the successor to Coventry Corporation, which was incorporated on November 21, 1986. Our Annual Report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to these reports, and recent press releases can be found, within one week of being filed with or furnished to the Securities and Exchange Commission and free of charge, on the Internet at www.coventryhealth.com.

        We offer a broad range of managed care products to a broad cross-section of employers including federal, state, and local governments. In addition, in selected markets, we participate in Medicaid and Medicare Advantage programs. Our products include traditional health maintenance organization (HMO) products, preferred provider organizations (PPOs) and point of service products (POS). We offer these products on an underwritten or “risk” basis where we receive a monthly premium in exchange for assuming underwriting risks including all medical and administrative costs, as well as on a self-funded basis where we perform administrative services only for a fee and the customer assumes the risk for all medical costs. Within these products, we also offer consumer-directed benefit options including health reimbursement accounts (HRAs) and health savings accounts (HSAs). Our Medicare Advantage and Medicaid products are risk products.

        In late January 2005, we acquired First Health Group Corp, which operates one of the largest national preferred provider organization networks and is a major national provider of non risk administrative and medical management services to commercial, governmental and third party payor customers.

Products

        Commercial Risk

        Our health plans and insurance companies offer employer groups a full range of commercial risk products, including HMO, PPO and POS products. We design our products to meet the needs and objectives of a wide range of employers and members and to comply with the regulatory requirements in the markets in which we operate. We had 1.5 million commercial risk members as of December 31, 2004 that accounted for $4.0 billion of revenue in 2004.

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        Our products vary with respect to the level of benefits provided, the costs to be paid by employers and members, including deductibles and co-payments, and our members’ access to providers without referral or preauthorization requirements.

Health Maintenance Organizations

        Our HMO products provide comprehensive health care benefits to members, including ambulatory and inpatient physician services, hospitalization, pharmacy, mental health and ancillary diagnostic and therapeutic services. In general, a fixed monthly membership fee covers all HMO services although some benefit plans require co-payments or deductibles in addition to the basic membership fee. A primary care physician assumes overall responsibility for the care of a member, including preventive and routine medical care and referrals to specialists and consulting physicians. While an HMO member’s choice of providers is limited to those within the health plan’s HMO network, the HMO member is typically entitled to coverage of a broader range of health care services than is covered by typical reimbursement or indemnity policies. Furthermore, many of our HMO plans have added features to more easily allow “direct access” to providers.

Preferred Provider Organizations and Point of Service

        Our risk-based PPO and POS products also provide comprehensive managed health care benefits to members, but allow members to choose their health care providers at the time medical services are required and allow members to use providers that do not participate in our managed care networks. If a member chooses a non-participating provider, deductibles, co-payments and other out-of-pocket costs to the member generally are higher than if the member chooses a participating provider. Premiums for our PPO and POS products typically are lower than HMO premiums due to the increased out-of-pocket costs borne by the members.

        Medicare Advantage

        As of December 31, 2004, we operated three Medicare Advantage (“Medicare”) HMOs in four states covering 65,000 members. We also operated four Medicare demonstration PPOs in six states covering 4,000 members. These demonstrations will continue through 2005. In addition, we managed one Medicare alternative payment demonstration HMO in two states covering 3,000 members, for which we assumed no underwriting risk. This demonstration terminated on December 31, 2004. The Medicare Advantage line of business accounted for $564.8 million of revenue in 2004.

        Under the Medicare contracts, we receive a county-specific fixed premium per member per month (“PMPM”) from the Centers for Medicare and Medicaid Services (“CMS”). In 2004, 70% of this premium was based on certain demographic adjusters of the Medicare population and 30% reflected individually determined health risk adjusters. In 2005, 2006 and 2007, fifty, seventy-five and one hundred percent, respectively, of the CMS premium will be based on individually determined health risk adjusters. The average increase of the CMS rates for Coventry service area counties in 2004 was 3.2%. The Medicare Prescription Drug, Improvement and Modernization Act of 2003 provided for an additional 4.5% increase to the CMS premium for 2004. The additional revenue was applied to reducing member cost sharing, increasing benefits and/or provider stabilization as required by law. An additional 3% revenue increase was the result of changes in risk scores and the change in the blend from 10% to 30%. These increases resulted in a total average increase in 2004 for all of our markets of 10.7%. In the HMO alternative payment demonstration, we provide only administrative services to an employer retiree account for a fixed administrative fee with 10% of that fee at risk as part of an agreement among CMS, the employer and Coventry. PPO products in all markets benefit from a risk sharing arrangement with CMS.

        Medicaid

        We offer health care coverage to Medicaid recipients in eight states which, as of December 31, 2004, covered 397,000 members and accounted for $609.6 million of revenue in 2004. The Medicaid Management Care agreement is a contract with each individual state. Under a Medicaid contract, the participating state pays a monthly premium per member based on the age, sex, eligibility category and in some states, county or region of the Medicaid member enrolled. In some states, these premiums are adjusted according to the health risk associated with the individual member. The majority of the Medicaid members are in the Michigan, Missouri and Pennsylvania markets, representing 86.7% of our total Medicaid membership.

        Financial Information

        Required financial information related to our business segments is set forth in Note N of our consolidated financial statements.

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        Management Services

        We offer management services and access to our provider networks to employers that self-insure their employee health benefits. The management services we provide typically include network management, claims processing, utilization review and quality assurance. For our management services, we receive a fixed fee for the access to our provider networks and the management services we provide and assume no underwriting risk. As of December 31, 2004, we had approximately 560,000 non-risk members.

        We offer a product to third-party payors under which we provide access to our provider networks for members of self-insured employers, as well as the benefits of our provider pricing arrangements, claims repricing and utilization review services. We do not assume underwriting risk for these services.

        These management services accounted for $113.4 million of revenue for the year ended December 31, 2004.

Markets

        The geographic markets in which we operate are described as follows:

• Delaware — commercial products in Delaware and eastern Maryland; Medicaid products in the Baltimore metropolitan area and northeast Maryland counties.
• Georgia — commercial products in the Atlanta metropolitan area.
• Illinois — commercial products, primarily in the Central, Western (exclusive of the Chicago Metropolitan area) and Southern areas.
• Iowa — commercial products to members primarily in the Des Moines metropolitan area with additional networks in Sioux City, Waterloo and rural Iowa; and Medicaid products in the Waterloo area.
• Kansas — commercial and Medicare products in the Kansas City and Wichita metropolitan areas, including portions of Western Missouri.
• Louisiana — commercial products, primarily in the New Orleans and Baton Rouge metropolitan areas.
• Michigan — Medicaid products in Wayne County, Michigan.
• Missouri— commercial and Medicare products to members in the St. Louis metropolitan area, including portions of Southern Illinois; Medicaid products also in the St. Louis metropolitan area and Central and Western Missouri.
• Nebraska — commercial products primarily in the Omaha metropolitan area with additional networks in Lincoln and rural Nebraska.
• North Carolina — commercial and Medicaid products primarily in the Charlotte and Raleigh — Durham metropolitan areas.
• Pennsylvania — commercial products primarily in Harrisburg and the State College metropolitan areas comprising the Central Eastern Pennsylvania market; commercial products in the Philadelphia metropolitan area comprising the Eastern Pennsylvania market; commercial products in Pittsburgh, and portions of Eastern Ohio comprising the Western Pennsylvania market; Medicaid products in the Harrisburg metropolitan area; and Medicare in the Pittsburgh and State College metropolitan areas.
• Utah — commercial products primarily in the Ogden, Salt Lake City and Provo metropolitan areas.
• Virginia — commercial and Medicaid products primarily in the Richmond, Roanoke and Charlottesville metropolitan areas and the Shenandoah Valley.
• West Virginia — commercial, Medicaid and Medicare products to a service area covering a majority of the state’s population.

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Membership

        The following tables show the total number of members as of December 31, 2004 and 2003 (in thousands) and the percentage change in membership between these dates.

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Provider Networks

        Our health plans maintain provider networks that furnish health care services through contractual arrangements with physicians, hospitals and other health care providers. All of our health plans currently offer an open panel delivery system. In an open panel structure, individual physicians or physician groups contract with the health plans to provide services to members but also maintain independent practices in which they provide services to individuals who are not members of our health plans.

        We have capitation arrangements for certain ancillary health care services, such as mental health care, and a small percentage of our membership is covered by global capitation arrangements. Under the typical arrangement, the provider receives a fixed percentage of premium to cover all the medical costs provided to the globally capitated members. Under some capitated arrangements, physicians may also receive additional compensation from risk sharing and other incentive arrangements. Global capitation arrangements limit our exposure to the risk of increasing medical costs, but expose us to risk as to the adequacy of the financial and medical care resources of the provider organization. We are ultimately responsible for the coverage of our members pursuant to the customer agreements. To the extent that the respective provider organization faces financial difficulties or otherwise is unable to perform its obligations under the capitation arrangements, we will be required to perform such obligations. Consequently, we may have to incur costs in excess of the amounts we would otherwise have to pay under the original global or ancillary capitation arrangements. Medical costs associated with capitation arrangements made up approximately 7.1%, 9.9%, and 8.9% of our total medical costs for the years ended December 31, 2004, 2003 and 2002, respectively. Membership associated with global capitation arrangements was approximately 127,000, 145,000 and 116,000 as of December 31, 2004, 2003 and 2002, respectively. We consider the risk associated with these arrangements to be insignificant.

        Most contracted primary care and specialist physicians are compensated under a discounted fee-for-service arrangement. The majority of our contracts with hospitals provide for inpatient per diem or per case hospital rates. Outpatient services are contracted on a discounted fee-for-service, a per case basis or in some instances a discount from charges basis. We pay ancillary providers on a fixed fee schedule or a capitation basis. Prescription drug benefits are provided through a formulary comprised of an extensive list of drugs. Drug prices are negotiated through a network of pharmacies in the markets in which we operate at discounted rates.

Medical Management

        We have established systems to monitor the availability, appropriateness and effectiveness of the patient care we provide. We collect utilization data in each of our markets that we use to analyze over-utilization or under-utilization of services and to assist our health plans in providing appropriate care for their members and improving patient outcomes in a cost efficient manner. Our corporate office monitors the medical management policies of our health plans and assists our health plans in implementing disease management programs, quality assurance programs and other medical management tools. In addition, our health plans have internal quality assurance review committees made up of practicing physicians and staff members whose responsibilities include periodic review of medical records, development and implementation of standards of care based on current medical literature and the collection of data relating to results of treatment.

        We have developed a comprehensive disease management program that identifies those members having certain chronic diseases, such as asthma and diabetes. Our case managers proactively work with members and their physicians to facilitate appropriate treatment, help to ensure compliance with recommended therapies and educate members on lifestyle modifications to manage the disease. We believe that our disease management program promotes the delivery of efficient care and helps to improve the quality of health care delivered.

        Each of our health plans either employs or contracts with physicians as medical directors who monitor the quality and appropriateness of the medical services provided to our members. The medical directors supervise medical managers who review and approve requests by physicians to perform certain diagnostic and therapeutic procedures, using nationally recognized clinical guidelines developed based on nationwide benchmarks that maximize efficiency in health care delivery and InterQual, a nationally recognized evidence-based set of criteria developed through peer review medical literature. Medical managers also continually review the status of hospitalized patients and compare their medical progress with established clinical criteria, make hospital rounds to review patients’ medical progress and perform quality assurance and utilization functions.

        Medical directors also monitor the utilization of diagnostic services and encourage the use of outpatient surgery and testing where appropriate. Data showing each physician’s utilization profile for diagnostic tests, specialty referrals and hospitalization are collected by each health plan and presented to the health plan’s physicians. The medical directors monitor these results in an attempt to ensure the use of cost-effective, medically appropriate services.

        We also focus on the satisfaction of our members. We monitor appointment availability, member-waiting times, provider environments and overall member satisfaction. Our health plans continually conduct membership surveys of existing employer groups concerning the quality of services furnished and suggestions for improvement.

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Information Technology

        We believe that integrated and reliable information technology systems are critical to our success. We have implemented advanced information systems to improve the operating efficiency of our health plans, support medical management, underwriting and quality assurance decisions and effectively service our employer customers, members and providers. Each of our health plans operates on a single financial reporting system along with a common, fully integrated application which encompasses all aspects of our commercial, government and non-risk business, including enrollment, provider referrals, claims processing and premium billing.

        We have dedicated in-house teams providing infrastructure and application support services to our members. Our data warehouse collects information from all of our health plans and uses it in medical management to support our underwriting, product pricing, quality assurance, rates, marketing and contracting functions. Our centralized data center processes approximately 21 million claims annually. We have dedicated in-house teams that convert acquired health plans to our information systems as soon as possible following the closing of the acquisition.

        Approximately 65% of all claim transactions are processed via electronic data interface which supports our ability to auto adjudicate 80% of all claims.

        The Health Insurance Portability and Accountability Act (“HIPAA”) of 1996 imposed new requirements relating to the standardization of electronic healthcare transactions, privacy and security. Dedicated HIPAA project teams, along with a senior management steering committee, have been created to ensure that we have satisfied all applicable requirements. The HIPAA projects for privacy and for transaction and code sets were delivered on schedule by the mandatory compliance dates. We are continuing to work on HIPAA security and expect to complete all remaining security required enhancements to our systems and business processes by the mandatory compliance date.

Marketing

        Our health plans market commercial HMO, POS and PPO products to employer group purchasers in our local markets on both a fully insured and self-funded basis. Among small and medium size employers, our commercial products are most commonly offered on an exclusive basis. In the large group segment, our products may be made available to employees as one option among multiple carriers. In all size segments, employers generally pay a large part of their employees’ health care premiums, although we have witnessed a trend toward a growing portion of that cost being assumed by employees. Typically our employer group contracts are renewed annually.

        To respond to market demand, our health plans have expanded the number of lower cost product options made available to employee group purchasers. These include our FlexChoice products, a family of products whereby the employer bears a substantially greater proportion of healthcare costs through mechanisms such as health reimbursement accounts. In addition, we offered Health Savings Accounts, which are tax-advantage employee savings accounts for healthcare expenses, in most markets effective January 2005.

        We maintain an active presence in the communities served by our health plans through participation in health fairs, special children’s programs and other community activities, which we believe enhances our visibility and reputation in these communities. We market our managed care products and services through our own sales staff and a network of several thousand independent brokers and agents. Our local direct sales staff and independent brokers and agents market our health plans, seeking to attract new employer customers and members and retain our existing employer customers and members. We compensate our direct sales staff through a combination of base salary and incentive arrangements. We compensate our independent brokers and agents on a commission basis.

        Our direct sales staff and independent brokers and agents typically market our managed care products and services to employers in a two-step process in which presentations are made first to employers to secure contracts to provide health benefits. In most instances, our sales are made on a complete replacement basis. If we are co-existing in an employer account with another carrier, our direct sales staff will then be involved in the solicitation of members from the employee base during periodic open enrollments during which employees are permitted to change health care programs. In some markets, we use workplace presentations, direct mail and radio and television advertisements to market to prospective members.

        Our Medicaid products are marketed to Medicaid recipients by state Medicaid authorities. We market our Medicare products to both individuals and retirees of employer groups that provide benefits to retirees through television, radio, newspaper and billboard advertising and direct mail. Our Medicaid and Medicare contracts are renewable annually. Medicare enrollees may disenroll monthly. Medicaid enrollees may disenroll monthly or annually, depending on the jurisdiction.

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Significant Customers

        Our commercial business is diversified across a large customer base and there are no commercial groups that make up 10% or more of our managed care premiums. We received 10.9%, 10.8% and 12.3% of our managed care premiums for the years ended December 31, 2004, 2003 and 2002, respectively, from the Federal Medicare program throughout our various markets. We also received 11.7%, 11.8% and 13.1% of our managed care premiums for the years ended December 31, 2004, 2003 and 2002, respectively, from our state-sponsored Medicaid programs throughout our various markets. In 2004, the State of Missouri accounted for over half our Medicaid premiums.

Competition

        The managed care industry is highly competitive, both nationally and in the individual markets we serve. Generally, in each market, we compete against local Blue Cross Blue Shield affiliated health plans, locally-owned plans and provider sponsored plans. In certain markets, we also compete with national health plans. We compete for employer groups and members primarily on the basis of the price of the benefit plans offered, locations of the health care providers, reputation for quality care, financial stability, comprehensiveness of coverage, diversity of product offerings and access to care. We also compete with other managed care organizations and indemnity insurance carriers in obtaining and retaining favorable contracts for health care services and supplies.

Corporate Governance

        Our Board of Directors has adopted a Code of Business Conduct and Ethics applicable to the members of our Board of Directors and our officers, including our Chief Executive Officer, Chief Financial Officer, Controller and our employees. In addition, the Board of Directors has adopted Corporate Governance Guidelines and committee charters for our Audit Committee, Compensation Committee and Nominating/Corporate Governance Committee. Our Code of Business Conduct and Ethics, Corporate Governance Guidelines and current committee charters can be accessed on our website at www.coventryhealth.com or may be requested by writing to the following address: Coventry Health Care, Inc., Attn: Corporate Secretary, 6705 Rockledge Drive, Suite 900, Bethesda, Maryland, 20817.

Government Regulation

        As a managed health care company, we are subject to extensive government regulation of our products and services. The laws and regulations affecting our industry generally give state and federal regulatory authorities broad discretion in their exercise of supervisory, regulatory and administrative powers. These laws and regulations are intended primarily for the benefit of the members of the health plans. Managed care laws and regulations vary significantly from jurisdiction to jurisdiction and changes are frequently considered and implemented.

        State Regulation

        The states served by our health plans provide the principal legal and regulatory framework for the commercial risk products offered by our insurance companies and HMO subsidiaries. One of our insurance company subsidiaries, Coventry Health and Life Insurance Company (“CH&L”), offers managed care products, primarily PPO and POS products, in conjunction with our HMO subsidiaries in states where HMOs are not permitted to offer these types of health care benefits. CH&L does not currently offer traditional health indemnity insurance.

        Our regulated subsidiaries are required by state law to file periodic reports and to meet certain minimum capital and deposit and/or reserve requirements and may be restricted from paying dividends to the parent or making other distributions or payments under certain circumstances. They also are required to provide their members with certain mandated benefits. Our HMO subsidiaries are required to have quality assurance and educational programs for their professionals and enrollees. Certain states’ laws further require that representatives of the HMOs’ members have a voice in policy making. Most states impose requirements regarding the prompt payment of claims and several states permit “any willing provider” to join our network. Compliance with “any willing provider” laws could increase our costs of assembling and administering provider networks.

        We also are subject to the insurance holding company regulations in the states in which our regulated subsidiaries operate. These laws and associated regulations generally require registration with the state department of insurance and the filing of reports describing capital structure, ownership, financial condition, certain inter-company transactions and business operations. Most state insurance holding company laws and regulations require prior regulatory approval or, in some states, prior notice, of acquisitions or similar transactions involving regulated companies, and of certain transactions between regulated companies and their parents. In connection with obtaining regulatory approvals of acquisitions, we may be required to agree to maintain capital of regulated subsidiaries at specified levels, to guarantee the solvency of such subsidiaries or to other conditions. Generally, our regulated subsidiaries are limited in their ability to pay dividends to their parent due to the requirements of state regulatory agencies that the subsidiaries maintain certain minimum capital balances.

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        Most states now impose risk-based or other net worth-based capital requirements on our regulated entities. These requirements assess the capital adequacy of the regulated subsidiary based upon the investment asset risks, insurance risks, interest rate risks and other risks associated with the subsidiary’s business. If a subsidiary’s capital level falls below certain required capital levels, it may be required to submit a capital corrective plan to regulatory authorities, and at certain levels may be subjected to regulatory orders, including regulatory control through rehabilitation or liquidation proceedings. See Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources” for more information.

        Federal Regulation

Health Insurance Portability and Accountability Act of 1996

        The Health Insurance Portability and Accountability Act of 1996 (“HIPAA”) imposes requirements relating to a variety of issues that affect the Company’s business, including the privacy and security of medical information, limits on exclusions based on preexisting conditions for certain plans, guaranteed renewability of health care coverage for most employers and individuals and administrative simplification procedures involving the standardization of transactions and the establishment of uniform health care provider, payor and employer identifiers. Various agencies of the federal government have issued regulations to implement certain sections of HIPAA.

        For example, the Department of Health and Human Services issued a final rule that establishes the standard data content and format for the electronic submission of claims and other administrative health transactions. We are compliant with the electronic data standards established by the final rule.

        Further, the Department of Health and Human Services has issued a final privacy rule that applies to individually identifiable health information. The primary purposes of the privacy rule are to protect and enhance the rights of consumers by providing them access to their health information and controlling the inappropriate use of that information, and to improve the efficiency and effectiveness of health care delivery by creating a national framework for health privacy protection that builds on efforts by states, health systems, individual organizations and individuals. We are compliant with the final rule.

        On January 5, 2001, the U.S. Department of Labor’s Pension and Welfare Benefits Administration, the IRS and the Department of Health and Human Services issued two regulations that provide guidance on the nondiscrimination provisions under the HIPAA as they relate to health factors and wellness programs. These nondiscrimination provisions prohibit a group health plan or group health insurance issuer from denying an individual eligibility for benefits or charging an individual a higher premium based on a health factor. We currently do not believe that these regulations will have a material adverse effect on our business.

        On February 20, 2003, the Department of Health and Human Services issued its final rule for security standards under the HIPAA. This rule establishes minimum standards for the security of electronic individually identifiable health information. The compliance date for the security standards rule is April 20, 2005. We have implemented a plan of action to achieve compliance with the final security standards rule by the compliance date.

Employee Retirement Income Security Act of 1974

        The provision of services to certain employee health benefit plans is subject to the Employee Retirement Income Security Act of 1974 (“ERISA”). ERISA regulates certain aspects of the relationships between us and employers who maintain employee benefit plans subject to ERISA. Some of our administrative services and other activities may also be subject to regulation under ERISA. In addition, some states require licensure or registration of companies providing third party claims administration services for benefit plans. We provide a variety of products and services to employee benefit plans that are covered by ERISA.

        The U.S. Department of Labor adopted federal regulations that establish claims procedures for employee benefit plans under ERISA (insured and self-insured). The regulations shorten the time allowed for health and disability plans to respond to claims and appeals, establishes requirements for plan responses to appeals and expands required disclosures to participants and beneficiaries. These regulations have not had a material adverse effect on our business.

        Medicare and Medicaid

        Some of our health plans contract with the Centers for Medicare and Medicaid Services (“CMS”) to provide services to Medicare beneficiaries pursuant to the Medicare program. Some of our health plans also contract with states to provide health benefits to Medicaid recipients. As a result, we are subject to extensive federal and state regulations. CMS may audit any health plan operating under a Medicare contract to determine the plan’s compliance with federal regulations and contractual obligations.

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        CMS and the appropriate state regulatory agency have the right to audit any health plan operating under a Medicaid managed care contract to determine the plan’s compliance with state and federal law. In some instances, states engage peer review organizations to perform quality assurance and utilization review oversight of Medicaid managed care plans. Our health plans are required to abide by the peer review organizations’ standards.

        CMS rules require Medicaid managed care plans to have beneficiary protections and protect the rights of participants in the Medicaid program. Specifically, states must assure continuous access to care for beneficiaries with ongoing health care needs who transfer from one health plan to another. States and plans must identify enrollees with special health care needs and assess the quality and appropriateness of their care. These requirements have not had a material adverse effect on our business.

        The federal anti-kickback statute imposes criminal and civil penalties for paying or receiving remuneration (which is deemed to include a kickback, bribe or rebate) in connection with any federal health care program, including the Medicare, Medicaid and Federal Employees Health Benefits Programs. The law and related regulations have been interpreted to prohibit the payment, solicitation, offering or receipt of any form of remuneration in return for the referral of federal health care program patients or any item or service that is reimbursed, in whole or in part, by any federal health care program. Similar anti-kickback provisions have been adopted by many states, which apply regardless of the source of reimbursement.

        With respect to the federal anti-kickback statute, there exists a statutory exception and two safe harbors addressing certain risk-sharing arrangements. A safe harbor is a regulation that describes relationships and activities that are deemed not to violate the federal anti-kickback statute. However, failure to satisfy each criterion of an applicable safe harbor does not mean that the arrangement constitutes a violation of the law; rather the arrangement must be analyzed on the basis of its specific facts and circumstances. We believe that our risk agreements satisfy the requirements of these safe harbors. In addition, the Office of the Inspector General has adopted other safe harbor regulations that relate to managed care arrangements. We believe that the incentives offered by our health plans to Medicare and Medicaid beneficiaries and the discounts our plans receive from contracting health care providers satisfy the requirements of these safe harbor regulations. We believe that our arrangements do not violate the federal or similar state anti-kickback laws.

        CMS has promulgated regulations that prohibit health plans with Medicare contracts from including any direct or indirect payment to physicians or other providers as an inducement to reduce or limit medically necessary services to a Medicare beneficiary. These regulations impose disclosure and other requirements relating to physician incentive plans such as bonuses or withholds that could result in a physician being at “substantial financial risk” as defined in Medicare regulations. Our ability to maintain compliance with such regulations depends, in part, on our receipt of timely and accurate information from our providers. Although we believe we are in compliance with all such Medicare regulations, we are subject to future audit and review.

        Federal Employees Health Benefits Program

        We contract with the Office of Personnel Management (“OPM”) to provide managed health care services under the Federal Employee Health Benefits Program (“FEHBP”). These contracts with the OPM and applicable government regulations establish premium rating arrangements for this program. The OPM conducts periodic audits of its contractors to, among other things, verify that the premiums established under its contracts are in compliance with the community rating and other requirements under FEHBP. The OPM may seek premium refunds or institute other sanctions against health plans that participate in the program.

        Managed Care Legislative Proposals

        Numerous proposals have been introduced in the U.S. Congress and various state legislatures relating to managed health care reform. The provisions of legislation that may be adopted at the state level cannot be accurately and completely predicted at this time, and we therefore cannot predict the effect of proposed legislation on our operations. On the federal level, it is possible that some form of managed health care reform may be enacted. At this time, it is unclear as to when any legislation might be enacted or the content of any new legislation, and we cannot predict the effect on our operations of the proposed legislation or any other legislation that may be adopted.

        The Medicare Prescription Drug, Improvement and Modernization Act of 2003

        On December 8, 2003, President George W. Bush signed into law the Medicare Prescription Drug, Improvement and Modernization Act of 2003. This Act makes changes to the existing Medicare law, including the creation of a new outpatient drug benefit beginning in 2006 and an immediate drug discount card for the interim period until January 1, 2006. The Act makes managed care organizations eligible to be sponsors of both the drug card and drug benefit plan programs. Our members have access to a CMS endorsed prescription drug discount card throughout 2004 and 2005. We are currently monitoring the implementation of the law to determine how it will impact our offerings in 2006 and will continue to monitor this issue as new regulations are released.

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Risk Management

        In the normal course of business, we have been named as a defendant in various legal actions such as actions seeking payments for claims denied by the Company, medical malpractice actions, employment related claims and other various claims seeking monetary damages. The claims are in various stages of proceedings and some may ultimately be brought to trial. Incidents occurring through December 31, 2004 may result in the assertion of additional claims. We maintain general liability, professional liability and employment practices liability insurances in amounts that we believe are appropriate, with varying deductibles for which we maintain reserves. The professional liability and employment practices liability insurances are carried through our captive subsidiary.

Employees

        At February 28, 2005, we employed approximately 10,280 persons, including First Health, none of whom are covered by a collective bargaining agreement.

Acquisition Growth

        We began operations in 1987 with the acquisition of the American Service Companies entities, including Coventry Health and Life Insurance Company. We have grown substantially through acquisitions. The table below summarizes all of our significant acquisitions through December 31, 2004. See Note B to the consolidated financial statements for additional information on the most recent acquisitions.

First Health Acquisition

        On January 28, 2005, we completed the acquisition of First Health, our largest acquisition to date. First Health operates a national preferred-provider network of over 450,000 physicians and 4,300 hospitals in all 50 states, District of Columbia and Puerto Rico and specializes in providing large payors with integrated managed care solutions, including network access, administrative services and medical and disease management. We believe the combination of Coventry and First Health creates a leading health benefits company with the size, scale and product breadth to be a market leader with significant growth opportunities. First Health’s strengths and business mix are highly complementary to our existing business, enabling the following benefits, among others:

• significantly expands our geographic presence, creating a national healthcare platform with substantial growth opportunities;
• diversifies our product offerings and client base and enables us to serve a full spectrum of healthcare clients nationwide, ranging from national accounts to small businesses and including corporate, federal government, state government, Medicaid and Medicare clients;
• significantly increases our fee-based, non-regulated cash flows; and
• leverages our existing operating expertise and administrative infrastructure.

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Service Marks and Trademarks

        We have the following federally registered service marks: “Advantra,” “Altius Health Plans” blue logo, “Be Sure,” “Carelink,” “CCN,” “CCN” with shadow logo, “CCN” logo without shadow, “Compare,” “ConfidentCare,” “Coventry,” “Coventry FlexChoice,” “Coventry Healthy Choices Program,” “Coventry USA,” “DirectorEase,” “First Claim,” “First Health,” “First Health Services Corporation,” “First Health” with stylized heart logo, “GHP,” “GHP” logo, “GHP Network Connection,” “HealthAmerica,” “HealthAssurance,” “HealthAssurance Flex,” heart logo, “It’s That Simple,” “Making Health Care as Simple as 1, 2, 3,” “Mid America Health” logo, “PersonalCare What you want in a health plan” and design, “POW,” “POW-Providers on the Web,” “POW Providers on the Web” logo, “Sensicare,” “SouthCare,” “SouthCare Medical Alliance” logo, “True to Life,” sun design logo, “Strong Starts,” “WellPath 65,” “Senior Life Management,” “The Answer To Your Health Care Needs,” “With You When It Matters,” and our torch logo. We have the right in perpetuity to use the federally registered name “HealthCare USA” in Missouri, Illinois, Kansas and Florida.

        We are currently in the process of perfecting our ownership interest in the following federal service mark registrations: “Babylove Program,” cross design, “Mid-America Health Network,” “OmniCare,” “OmniCare Health Plan,” “OmniCare Plus,” “OmniMedCare” logo, and “Omni “Perks.””

         We have pending applications for federal registration of the following service marks: “Advantra Advantage,” “Advantra Freedom,” “Coventry Healthy Decisions Program,” Doc Bear character, “HealthAmericaOne,” “Mid America Health Access,” “Mid America Health Access +,” “Powered by People,” “Tested. True,” and “WellPath.”

Executive Officers of Our Company

        The following table sets forth information with respect to our executive officers as of January 1, 2005:

        Dale B. Wolf was elected Chief Executive Officer of our Company effective January 2005. Prior to that he served as Executive Vice President, Chief Financial Officer and Treasurer of our Company from April 1998 to December 2004. He was elected Senior Vice President, Chief Financial Officer and Treasurer in December 1996. From August 1995 to December 1996, he was Executive Vice President of SpectraScan Health Services, Inc., a women’s health care services company. From January 1995 to August 1995, Mr. Wolf was Senior Vice President, Business Development of MetraHealth Companies, Inc., a managed health care company. From August 1988 to December 1994, Mr. Wolf was Vice President, Specialty Operations of the Managed Care and Employee Benefits Operations of The Travelers, an insurance company. He is a director and a member of the audit committee of HealthExtras, Inc., a provider of pharmacy benefit management services and supplemental benefits. Mr. Wolf is a Fellow of the Society of Actuaries.

        Thomas P. McDonough was elected President of our Company effective January 2005. Prior to that he served as Executive Vice President of our Company from April 1998 to December 2004 and Chief Operating Officer from July 1998 to December 2004. He was Chief Executive Officer of Uniprise, a subsidiary of UnitedHealth Group, Incorporated, a diversified health and well being company, from November 1997 until April 1998; Executive Vice President, Customer Services Group from February 1997 to November 1997; and Senior Vice President, Claim Services from August 1995 through February 1997. Prior to 1995, he was the President of Harrington Service Corporation, an insurance services company, and the Chief Operating Officer of Jardine Group Services Corporation, an insurance brokerage company and third party administrator.

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        Harvey C. DeMovick, Jr. was elected Executive Vice President of our Company effective January 2005. Prior to that he served as Senior Vice President of our Company from April 1998 to December 2004. He has served as our Chief Information Officer since April 2001 and as our Senior Vice President, Customer Service Operations since September 2001. From April 2001 to September 2001, he served as our Senior Vice President, Organizational Development, Human Resources and Compliance. From April 1998 to April 2001, he was Senior Vice President, Government Programs, Compliance, Information Systems and Human Resources of our Company. He was Senior Vice President, Medical and Government Programs of Coventry Corporation from July 1997 to April 1998. From October 1995 to July 1997, Mr. DeMovick was Senior Vice President, Customer Administrative Services, of UnitedHealth Group, Incorporated, a diversified health and well being company, and from October 1994 through October 1995 he was Vice President, Managed Care Operations, of MetraHealth Companies, Inc., a managed health care company.

        Shawn M. Guertin was elected Executive Vice President and Chief Financial Officer of our Company effective January 2005. Prior to that he served as Senior Vice President of our Company from February 2003 to December 2004. He has served as President of Coventry Health and Life Insurance Company since February 2002. From April 1998 to February 2003, he was Vice President of Finance of our Company. Prior to that date, he was Vice President of Finance of Coventry Corporation from January 1998. From October 1995 to January 1998, he was a Vice President of UnitedHealth Group, Incorporated, a diversified health and well being company. Prior to that time, from 1993 to 1995, he served as a Vice President for The MetraHealth Companies, Inc., a Connecticut managed health care company, and for The Travelers, a Connecticut insurance company. Mr. Guertin is a Fellow of the Society of Actuaries and a Member of the American Academy of Actuaries.

        Francis S. Soistman, Jr. was elected Executive Vice President, Health Plan Operations, effective January 2005. Prior to that he served as Senior Vice President of our Company from April 1998 to December 2004. He was named President and Chief Executive Officer of HealthAmerica Pennsylvania, Inc. and HealthAssurance Pennsylvania, Inc., our Pennsylvania subsidiaries, in May 1998 and July 2001, respectively. He was Regional Vice President of Principal Health Care, Inc., from December 1994 to March 1998. From April 1994 to December 1994, he was Executive Director of Principal Health Care of the Mid-Atlantic, Inc., a wholly owned managed health care subsidiary of one of Principal’s subsidiaries. From January 1983 until March 1994, Mr. Soistman held various positions with Blue Cross Blue Shield of Maryland and its subsidiary companies.

        Bernard J. Mansheim, M.D. was elected Senior Vice President and Chief Medical Officer of our Company in April 1998. From August 1997 to April 1998, he was the Chief Operating Officer of United HealthCare of the Mid-Atlantic, a managed health care company, and, from August 1996 to July 1997, was its Chief Medical Officer. In April 1995, he became President and Chief Executive Officer of HealthSpring, Inc., a pre-paid, primary care group medical practice and subsidiary of MetraHealth Companies, Inc. Following the acquisition of MetraHealth Companies, Inc. by UnitedHealth Group, Incorporated, a diversified health and well being company, in October 1995. Dr. Mansheim continued as the President and Chief Executive Officer of HealthSpring, Inc. until its divestiture in August 1996 and also served as National Medical Director of UnitedHealth Group, Incorporated. From August 1994 to April 1995, he was President and Chief Executive Officer of Triangle HealthCare Group, a primary care group medical practice, and Medical Director of Prudential Health Care System of the Triangle in Raleigh-Durham-Chapel Hill, North Carolina, a managed health care company.

        Richard J. Gilfillan, M.D. was elected Senior Vice President of our Company in August 2001. Prior to that time, from October 2000 to August 2001, he was an independent health care consultant. From June 1989 to October 2000, he held various positions with Independence Blue Cross, a health care insurance company in southeastern Pennsylvania, including most recently Senior Vice President and General Manager of AmeriHealth New Jersey, a managed health care plan and subsidiary of Independence Blue Cross. Prior to that, he was Senior Vice President and Chief Medical Officer of Independence Blue Cross. Prior to that time, from 1985 to 1989, he served as Medical Director for Medigroup Central Health Plan, a managed health care plan, and from 1980 to 1985, he served as Medical Director and practicing physician with The Winchendon Community Health Center, a health care clinic.

        Thomas C. Zielinski was elected Senior Vice President and General Counsel of our Company in August 2001. Prior to that time, Mr. Zielinski worked for 19 years in various capacities for the law firm of Cozen and O’Connor, P.C., including as a senior member, shareholder and Chair of the firm’s Commercial Litigation Department.

        Patrisha L. Davis was elected Vice President and Chief Human Resources Officer of our Company in March 2005, and has served in that position since November 2000. Ms. Davis has been a Human Resources executive with our Company since April 1998. Prior to that time, she held various Human Resources management positions with Principal Health Care, Inc., a health maintenance organization holding company and subsidiary of Principal Financial Group, Inc., a global financial institution.

        John J. Ruhlmann was elected Vice President and Corporate Controller of our Company in November 1999. From December 1993 to September 1999, Mr. Ruhlmann was Vice President of Accounting of Integrated Health Services, Inc., a national provider of health services that owned and managed hospitals, nursing homes and clinics.

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Item 2: Properties

        As of December 31, 2004, we leased approximately 60,000 square feet of space for our corporate office in Bethesda, Maryland. We also leased approximately 832,000 aggregate square feet for office space, subsidiary operations and customer service centers for the various markets where our health plans operate, of which 7% is subleased. Our leases expire at various dates from 2005 through 2013. We also own a building in Richmond, Virginia with approximately 45,000 square feet, which is used for administrative services related to our health plan in that state, of which 16% is subleased. We believe that our facilities are adequate for our operations.

Item 3: Legal Proceedings

        See Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Legal Proceedings” which is incorporated herein by reference.

Item 4: Submission of Matters to a Vote of Security Holders

        No matters were submitted to a vote of security holders during the fourth quarter of the fiscal year 2004.

PART II

Item 5: Market for the Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.

Price Range of Common Stock

        Our common stock is traded on the New York Stock Exchange (NYSE) stock market under the ticker symbol “CVH.” On December 23, 2003, our Board of Directors approved a three-for-two stock split of our common stock. The stock split, in the form of a stock dividend, was effective January 30, 2004 for stockholders of record on January 9, 2004. The stock split is reflected retroactively in our price per share for all periods presented. The following table sets forth the quarterly range of the high and low sales prices of the common stock on the NYSE stock markets during the calendar period indicated. Such quotations represent inter-dealer prices without retail markup, markdown or commission and may not necessarily represent actual transactions:

        On February 28, 2005, we had approximately 400 stockholders of record, not including beneficial owners of shares held in nominee name. On February 28, 2005, our closing price was $63.10.

        We have not paid any cash dividends on our common stock and expect for the foreseeable future to retain all of our earnings to finance the development of our business. Our ability to pay dividends is limited by certain covenants and restrictions contained in our debt obligations and by insurance regulations applicable to our subsidiaries. Subject to the terms of such insurance regulations and debt covenants, any future decision as to the payment of dividends will be at the discretion of our Board of Directors and will depend on our earnings, financial position, capital requirements and other relevant factors. See Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources.”

        Our Board of Directors has approved a program to repurchase up to 10% of our outstanding common stock. Stock repurchases may be made from time to time at prevailing prices on the open market, by block purchase or in private transactions. We purchased 2.0 million shares under this program in 2004 at an aggregate cost of $84.6 million. We did not purchase any shares of our common stock in 2003 under this program. The total remaining common shares we are authorized to repurchase under the program is approximately 1.8 million as of December 31, 2004.

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Issuer Purchases of Equity Securities

        The following table shows our purchases of our common stock during the quarter ended December 31, 2004 (in thousands, except per share information).

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Item 6: Selected Financial Data

      (in thousands, except per share and membership data)

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Item 7: Management’s Discussion and Analysis of Financial Condition and Results of Operations

        The following discussion should be read in conjunction with the accompanying audited consolidated financial statements and notes thereto. The organization of our Management’s Discussion and Analysis of Financial Condition and Results of Operations is as follows.

• Executive-Level Overview
• Critical Accounting Policies
• New Accounting Standards
• Acquisitions
• Membership
• Results of Operations
• Liquidity and Capital Resources
• Other Disclosures
• Risk Factors

Executive-Level Overview

        General Operations

        We are a leading publicly traded managed health care company with approximately 2.5 million members as of December 31, 2004. We operate a diversified portfolio of local market health plans, insurance companies and provider networks serving 15 markets. Our operations are based in Bethesda, Maryland with our local markets primarily covering the Mid-Atlantic, Midwest and Southeast regions of the United States. Our primary focus has been owning and operating health plans with a concentration on risk business with mid-sized employer groups.

        On January 28, 2005, we acquired First Health which operates one of the largest national preferred provider organization networks. First Health is a major national provider of non-risk administrative and medical management services to commercial, governmental and third party payor customers. Since the acquisition was consummated in 2005, First Health’s financial position and operating results are not included in this discussion. We believe the combination of Coventry and First Health creates a leading health benefits company with the size, scale and product breadth to be a market leader with significant growth opportunities. First Health’s strengths and business mix are highly complementary to our existing business, enabling the following benefits, among others:

• significantly expands our geographic presence, creating a national healthcare platform with substantial growth opportunities;
• diversifies our product offerings and client base and enables us to serve a full spectrum of healthcare clients nationwide, ranging from national accounts to small businesses and including corporate, federal government, state government, Medicaid and Medicare clients;
• significantly increases our fee-based, non-regulated cash flows; and
• leverages our existing operating expertise and administrative infrastructure.

        Highlights of 2004 Performance

• Membership increased 5% over the prior year.
• Revenue increased 17% over the prior year.
• Medical loss ratio of 80.5% improved 70 basis points over the prior year.
• Selling, general and administrative expenses were 11.5% of operating revenue, a 50 basis point improvement over the prior year.
• Operating margin of 9.4% improved 130 basis points over the prior year.
• Diluted earnings per share increased 35% over the prior year.
• Cash flows from operations was $453.9 million, a 41% improvement over the prior year.
• Total cash and investments was $1.7 billion, a 23% increase over the prior year.

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        Operating Revenue and Products

        We generate our operating revenues from premiums for a broad range of managed care and management service products. Premiums for our commercial risk products, for which we assume full underwriting risk, can vary. For example, premiums for our preferred provider organization (“PPO”) and point of service (“POS”) products are typically lower than our health maintenance organization (“HMO”) premiums due to medical underwriting and higher deductibles and co-payments that are typically required of the PPO and POS members. Premium rates for our government programs, Medicare and state-sponsored managed Medicaid, are established by governmental regulatory agencies. These government products are offered in selected markets where we believe we can achieve profitable growth based upon favorable reimbursement levels, provider costs and regulatory climates.

        Revenue for our management services products (“non-risk”) is generally a fixed administrative fee for access to our provider networks and management services, for which we do not assume underwriting risk. The management services we provide typically include network management, claims processing, utilization review and quality assurance. In addition, we rent our network of providers, including claims repricing and utilization review, to other managed care plans or non-risk employers and assume no underwriting risk.

        During the three years ended December 31, 2004, we experienced substantial growth in operating revenues due in part to membership increases from acquisitions. Acquisitions must have a manageable regulatory and business climate and have the ability to add value to our company. Additionally, membership growth was achieved organically through marketing efforts, geographic expansion and increased product offerings. Our ability to introduce products quickly to each market has helped us to expand our customer base. In particular, we have been able to add a large variety of lower cost products, which has proven especially attractive to customers.

        Operating Expenses

        Our medical costs include medical claims paid under contractual relationships with a wide variety of providers and capitation arrangements. Medical costs also include an estimate of claims incurred but not reported.

        Our health plans maintain provider networks that furnish health care services through contractual arrangements with physicians, hospitals and other health care providers. Prescription drug benefits are provided through a formulary comprised of an extensive list of drugs. Drug prices are negotiated through a national network of pharmacies at discounted rates.

        We have capitation arrangements for certain ancillary heath care services, such as mental health care, and a small percentage of our membership is covered by global capitation arrangements. Under the typical arrangement, the provider receives a fixed percentage of premium to cover costs of all medical care or of the specified ancillary services provided to the globally capitated members. Under some capitated arrangements, physicians may also receive additional compensation from risk sharing and other incentive arrangements. Global capitation arrangements limit our exposure to the risk of increasing medical costs, but expose us to risk as to the adequacy of the financial and medical care resources of the provider organization. We are ultimately responsible for the coverage of our members pursuant to the customer agreements. To the extent that the respective provider organization faces financial difficulties or otherwise is unable to perform its obligations under the capitation arrangements, we will be required to perform such obligations. Consequently, we may have to incur costs in doing so in excess of the amounts we would otherwise have to pay under the original global or ancillary capitation arrangements.

        We have established systems to monitor the availability, appropriateness and effectiveness of the patient care we provide. We collect utilization data in each of our markets that we use to analyze over-utilization or under-utilization of services and assist our health plans in providing appropriate care for their members and improving patient outcomes in a cost efficient manner. Medical directors also monitor the utilization of diagnostic services and encourage the use of outpatient surgery and testing where appropriate. Each health plan collects data showing each physician’s utilization profile for diagnostic tests, specialty referrals and hospitalization and presents such data to the health plan’s physicians. The medical directors monitor these results in an effort to ensure the use of cost-effective, medically appropriate services.

        We operate four regional service centers that perform claims processing, premium billing and collection, enrollment and customer service functions for our health plans. Our regional service centers enable us to take advantage of economies of scale, implement standardized management practices at each of our plans and capitalize on the benefits of our integrated information technology systems. We centralize the underwriting and product pricing functions for our health plans, which allows us to utilize our underwriting expertise and a disciplined pricing strategy at each of our health plans.

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        Cash Flows

        We generate cash through operations. As a profitable company in an industry that is not capital equipment intensive, we have not needed to use financing methods to fund operations. We have a low debt to capital ratio and while we did issue senior notes in 2002 (as described in Note H to our consolidated financial statements in this Form 10-K), the entire proceeds were used to repurchase a portion of our common stock and were not used to fund operations. Our primary use of cash is to pay medical claims. Any excess cash has historically been used for acquisitions and for repurchases of our common stock.

        In late January 2005, in connection with the First Health merger, we incurred approximately $865 million of indebtedness in order to finance the acquisition of all of First Health’s outstanding common stock, refinance the existing indebtedness of First Health and pay related transaction fees and expenses. We do not anticipate that any of the proceeds of such indebtedness will be used to fund operations.

Critical Accounting Policies

        We consider the accounting policies described below critical in preparing our consolidated financial statements. Critical accounting policies are ones that require difficult, subjective, or complex judgments, often as a result of the need to make estimates about the effect of matters that are inherently uncertain. The judgments and uncertainties affecting the application of these policies include significant estimates and assumptions made by us using information available at the time the estimates are made. Actual results could differ materially from those estimates.

        Revenue Recognition

        Managed care premiums are recorded as revenue in the month in which members are entitled to service. Premiums are based on both a per subscriber contract rate and the number of subscribers in our records at the time of billing. Premium billings are generally sent to employers in the month preceding the month of coverage. Premium billings may be subsequently adjusted to reflect changes in membership as a result of retroactive terminations, additions, or other changes. Due to early timing of the premium billing, we are able to identify the retroactive adjustments for two subsequent months billings. Current period revenues are adjusted to reflect these retroactive adjustments.

        Based on information received subsequent to generating premium billings, historical trends, bad debt write-offs and the collectibility of specific accounts, we estimate, on a monthly basis, the amount of bad debt and future membership retroactivity and adjust our revenue and allowances accordingly.

        As of December 31, 2004, we maintained allowances for retroactive billing adjustments of approximately $6.7 million compared with approximately $7.2 million at December 31, 2003. We also maintained allowances for doubtful accounts of approximately $0.9 million and $1.4 million as of December 31, 2004 and 2003, respectively. The calculation for these allowances is based on a percentage of the gross accounts receivable with the allowance percentage increasing for the older receivables. The allowances have declined as a result of an improvement in the aging of our premium receivables.

        We also receive premium payments from the Centers for Medicare and Medicaid Services (“CMS”) on a monthly basis for our Medicare membership. Membership and category eligibility are periodically reconciled with CMS and could result in adjustments to revenue. Premiums collected in advance are recorded as deferred revenue.

        We contract with the Office of Personnel Management (“OPM”) to provide managed health care services under the Federal Employee Health Benefits Program (“FEHBP”). These contracts with the OPM and applicable government regulations establish premium rating arrangements for this program. The OPM conducts periodic audits of its contractors to, among other things, verify that the premiums established under its contracts are in compliance with the community rating and other requirements under FEHBP. The OPM may seek premium refunds or institute other sanctions against health plans that participate in the program. We periodically reconcile our contracts with the OPM and such reconciliations could result in adjustments to revenue. Premiums for services to federal employee groups are subject to audit and review by the OPM on a periodic basis. Such audits are usually a number of years in arrears. We record reserves, on an estimated basis annually, based on appropriate guidelines. Any differences between actual results and estimates are recorded in the year the audits are finalized.

        We enter into performance guarantees with employer groups where we pledge that we will meet certain standards. These standards vary widely and could involve customer service, member satisfaction, claims processing, claims accuracy, telephone on-hold time, etc. Under these performance guarantees, we could be at risk and may incur penalties for not maintaining the standards established in the contracts. The risk level varies by agreement with penalties based on a variety of calculations including per member per month, percentage of premium, or percentage of administration fees. Risk levels are evaluated at least quarterly. We estimate our potential exposure and record appropriate reserves. The penalties that we have incurred have been immaterial and, although, we can not predict with precision the future effect on our results of operations of these penalties, we expect them to remain immaterial.

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        Medical Claims Expense and Liabilities

        Medical liabilities consist of actual claims reported but not paid and estimates of health care services incurred but not reported. Medical liabilities estimates are developed using actuarial principles and assumptions that consider, among other things, historical claims payment patterns, provider reimbursement changes, historical utilization trends, current levels of authorized inpatient days, other medical cost inflation factors, membership levels, benefit design changes, seasonality, demographic mix change and other relevant factors.

        We employ a team of actuaries that have developed, refined and used the same set of reserve models over the past several years. These reserve models do not calculate separate amounts for reported but not paid and incurred but not reported, but rather a single estimate of medical claims liabilities. These reserve models make use of both historical claim payment patterns as well as emerging medical cost trends to project our best estimate of claim liabilities. Within these models, historical data of paid claims is formatted into claim triangles which compare claim incurred dates to the claim payment dates. This information is analyzed to create “completion factors” that represent the average percentage of total incurred claims that have been paid through a given date after being incurred. Completion factors are applied to claims paid through the financial statement date to estimate the ultimate claim expense incurred for the current period. Actuarial estimates of claim liabilities are then determined by subtracting the actual paid claims from the estimate of the ultimate incurred claims.

        For the more recent incurred months, the percentage of claims paid to claims incurred in those months is generally low. As a result, the completion factor methodology is less reliable for such months. For that reason, incurred claims for recent months are not projected solely from historical completion and payment patterns. Instead, they are projected by estimating the claims expense for those months based upon recent claims expense levels and health care trend levels, or “trend factors.” As these months mature over time, the two estimates (completion factor and trend) are blended with completion factors being used exclusively for older months.

        Within the reserve setting methodologies for inpatient and non-inpatient services, we use certain assumptions. For inpatient services, authorized days are used for utilization factors, while cost trend assumptions are incorporated into per diem amounts. The per diem estimates reflect anticipated effects of changes in reimbursement structure and severity mix. For non-inpatient services, a composite trend assumption is applied which reflects anticipated changes in cost per service, provider contracts, utilization, and other factors.

        Changes in the completion factors, trend factors and utilization factors can have a significant effect on the claim liability. The following example provides the estimated effect to our December 31, 2004 unpaid claims liability assuming hypothetical changes in the completion, trend, and inpatient day factors. While we believe the selection of factors and ranges provided are reasonable, certain factors and actual results may differ.

        We also establish reserves, if required, for the probability that anticipated future health care costs and contract maintenance costs under the group of existing contracts will exceed anticipated future premiums and reinsurance recoveries on those contracts.

        Accruals are continually monitored and reviewed, and as settlements are made or accruals adjusted, differences are reflected in current operations. Changes in assumptions for medical costs caused by changes in actual experience could cause these estimates to change in the near term. Certain situations require judgment in setting reserves, such as system conversions, processing interruptions, environmental changes or other factors.

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        Actuarial standards of practice generally require the actuarial developed medical claims estimates to cover obligations under an assumption of moderately adverse conditions. Adverse conditions are situations in which the actual claims are expected to be higher than the otherwise estimated value of such claims. In many situations, the claims paid amount experienced will be less than the estimate that satisfies the actuarial standards of practice. Medical claims liabilities are recorded at an amount we estimate to be appropriate. Adjustments of prior years estimates may result in additional medical costs or, as we have experienced during the last several years, a reduction in medical costs in the period an adjustment was made. Our reserve models have historically developed favorably suggesting that the accrued liabilities calculated from the models were more than adequate to cover our ultimate liability for unpaid claims. We believe that this favorable development is a result of good communications between our health plans and our actuarial staff regarding medical utilization, mix of provider rates and other components of medical cost trend.

        The following table presents the components of the change in medical claims liabilities for the years ended December 31, 2004, 2003 and 2002, respectively (in thousands).

        Acquisition balances represent medical liabilities of the acquired company as of the applicable acquisition date. Subsequent changes in estimates related to the acquired balances are recorded as adjustments to the settlement account with the acquired entity’s previous owner.

        The negative amounts noted as “prior year” medical costs are favorable adjustments for claim estimates being settled for amounts less than originally anticipated. As noted above, these favorable restatements from original estimates occur due to changes in medical utilization, mix of provider rates and other components of medical cost trends. Medical claim liabilities are generally paid within several months of the member receiving service from the provider. Accordingly, the 2004 prior year medical costs relate almost entirely to claims incurred in calendar year 2003.

        We believe that the amount of medical liabilities is adequate to cover our ultimate liability for unpaid claims as of December 31, 2004; however, actual claim payments and other items may differ from established estimates.

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        Investments

        We account for investments in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 115 - “Accounting for Certain Investments in Debt and Equity Securities.” We invest primarily in fixed income securities and classify all of our investments as available-for-sale. Investments are evaluated at least quarterly to determine if declines in value are other-than-temporary. In making that determination, we consider all available evidence relating to the realizable value of a security. This evidence includes, but is not limited to, the following:

• adverse financial conditions of a specific issuer, segment, industry, region or other variables;
• the length of the time and the extent to which the fair value has been less than cost;
• the financial condition and near-term prospects of the issuer;
• our intent and ability to retain our investment in the issuer for a period of time sufficient to allow for any anticipated recovery in fair value;
• elimination or reduction in dividend payments, or scheduled interest and principal;
• rating agency downgrade of a debt security; and
• expected cash flows of a debt security.

        Temporary declines in value of investments classified as available-for-sale are netted with unrealized gains and reported as a net amount in a separate component of stockholders’ equity. A decline in fair value below amortized cost that is judged to be other-than-temporary is accounted for as a realized loss and the write down is included in earnings. Realized gains and losses on the sale of investments are determined on a specific identification basis.

        The following table shows our investments’ gross unrealized losses and fair value, at December 31, 2004, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position (in thousands).

        The securities presented in this table do not meet the criteria for an other-than-temporarily impaired investment. These securities have an investment grade credit rating. The current unrealized loss is the result of interest rate increases and not unfavorable changes in the credit ratings associated with these securities. These investments are not in high risk industries or sectors and we intend to hold these investments for a period of time sufficient to allow for a recovery in market value.

        Investments with original maturities in excess of three months and less than one year are classified as short-term investments and generally consist of corporate bonds, U.S. treasury notes and commercial paper. Long-term investments have original maturities in excess of one year and primarily consist of fixed income securities.

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        Goodwill and Other Intangible Assets

        Goodwill and other intangible assets that have indefinite lives are subject to a periodic assessment for impairment by applying a fair-value-based test. We use three approaches to identifying the fair value of our goodwill and other intangible assets: a market approach, a market capitalization approach and an income approach. The market approach estimates a business’s fair value by analyzing the recent sales of similar companies. The market capitalization approach is based on the market value of our total shares outstanding. The income approach is based on the present value of expected future cash flows. All three approaches are reviewed together for consistency and commonality. Any impairment charges that may result will be recorded in the period in which the impairment took place as recalculated on October 1, our annual impairment test date. We have not incurred an impairment charge related to goodwill or indefinite intangibles. See Note C to the consolidated financial statements for additional disclosure related to intangible assets.

New Accounting Standards

        In December 2004, the Financial Accounting Standards Board (“FASB”) issued FASB Statement No. 123 (revised 2004), Share-Based Payment, which is a revision of SFAS No. 123 “Accounting for Stock-Based Compensation.” SFAS No. 123(R) supersedes Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees,” and amends SFAS No. 95, “Statement of Cash Flows.” Generally, the approach in SFAS No. 123(R) is similar to the approach described in SFAS No. 123. However, SFAS No. 123(R) requires all share-based payments to employees, including grants of employee stock options, to be recognized in the income statement based on their fair values. Pro forma disclosure is no longer an alternative.

        SFAS No. 123(R) must be adopted no later than July 1, 2005. Early adoption will be permitted in periods in which financial statements have not yet been issued. We expect to adopt SFAS No. 123(R) on July 1, 2005 using the modified-prospective method.

        Under the modified-prospective method, compensation cost is recognized beginning with the effective date based on the requirements of SFAS No. 123(R) for all share-based payments granted after the effective date and based on the requirements of SFAS No. 123 for all awards granted to employees prior to the effective date of SFAS No. 123(R) that remain unvested on the effective date.

        As permitted by SFAS No. 123, we currently account for share-based payments to employees using APB No. 25’s intrinsic value method and, as such, have recognized no compensation cost for employee stock options. Accordingly, the adoption of SFAS No. 123(R)’s fair value method will have an effect on our results of operations, although it will have no material effect on our overall financial position. The effect of adoption of SFAS No. 123(R) cannot be predicted at this time because it will depend on levels of share-based payments granted in the future. However, had we adopted SFAS No. 123(R) in prior periods using the Black-Scholes method of valuation, the effect of that standard would have approximated the effect of SFAS No. 123 as described in the disclosure of pro forma net income and earnings per share in Note A to our consolidated financial statements. SFAS No. 123(R) also requires the benefits of tax deductions in excess of recognized compensation cost to be reported as a financing cash flow, rather than as an operating cash flow as required under current literature. This requirement will reduce net operating cash flows and increase net financing cash flows in periods after adoption. While we cannot estimate what those amounts will be in the future (as it is dependent upon, among other things, when employees exercise stock options), the amount of operating cash flows that would have been recognized under SFAS No. 123 in 2004, 2003 and 2002 for such excess tax benefits were $15.8 million, $15.6 million, and $12.9 million, respectively.

Acquisitions

        During the three years ended December 31, 2004, we completed several business combinations and membership purchases. These business combinations are all accounted for using the purchase method of accounting and, accordingly, the operating results of each acquisition have been included in our consolidated financial statements since their effective date of acquisition. The purchase price for each business combination was allocated to the assets, including the identifiable intangible assets, and liabilities based on estimated fair values. The excess of the purchase price over the net identifiable assets acquired was allocated to goodwill. The purchase price of our membership purchases is allocated to identifiable intangible assets and is being amortized over a useful life of ten to twenty years.

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        The following table summarizes all business combinations and membership purchases for the three years ended December 31, 2004. The purchase price of each business combination includes the payment for net worth and estimated transition costs. The estimated transition costs may be adjusted as actual expenses are incurred, thereby affecting the final purchase price of the acquisition. In addition, most of our acquisition agreements contain a provision for a final retroactive balance sheet settlement which may result in adjustments to the purchase price. The purchase price shown for recent acquisitions, in thousands, is inclusive of all retroactive balance sheet settlements to date and transaction cost adjustments.

Membership

        The following table presents our membership as of December 31, 2004 and 2003 (in thousands) and the percentage change in membership between these dates.

        Medicaid membership increased primarily as a result of the acquisition of OmniCare in the fourth quarter of 2004. The increase in non-risk membership was influenced by three large groups changing from a risk product to a non-risk product effective January 1, 2004, as well as from additional organic membership obtained in the Missouri market.

        In January 2005, we lost a large commercial insured account to an administrative services only (“ASO”) bid and a large existing ASO account to another third party administrator. Because of the loss of this membership, organic growth was negative in January but currently is expected to be one to three percent for all of 2005.

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Results of Operations

        The following table is provided to facilitate a more meaningful discussion regarding the comparison of our operations for each of the three years in the period ended December 31, 2004.

Comparison of 2004 to 2003

        Managed care premium revenue increased as a result of rate increases that occurred throughout all markets, acquisitions and organic growth. Commercial yields (premium per member per month) increased as a result of rate increases on renewals that occurred throughout all markets. Medicare yields increased as a result of the rate increases from the annual Adjusted Community Rating filings and from the Medicare Modernization Act. The rate increases from the Medicare Modernization Act were required to be used for enhanced member benefits and/or network access and thus did not affect profitability. The acquisition of Altius effective September 1, 2003 and OmniCare effective October 1, 2004 accounted for $208.7 million of the increase in managed care premium revenue over the prior year.

        Management services revenue increased due to the increase in non-risk membership discussed earlier.

        Medical costs have increased due to medical trend, acquisitions and organic growth. However, total medical expense as a percentage of managed care premium revenue has improved to 80.5% over the prior year. This favorable change was attributable mostly to our commercial business and is a result of the commercial premium rate increases mentioned above outpacing commercial medical trend. Reported commercial medical trend, net of benefit buy downs, was 8.9%. Our Medicare business medical loss ratio improved compared to the prior year as a result of the increase in premium yields discussed above. Our overall Medicaid medical loss ratio was essentially flat compared to prior year. Excluding OmniCare, the Medicaid medical loss ratio would have improved to 86.9%. The same store improvement is as a result of rate increases across our markets and as a result of much improved performance in our Medicaid Virginia market. The Virginia market benefited from lower utilization, lower drug costs and favorable provider contract renegotiations.

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        Selling, general and administrative expense increased primarily due to normal operating costs of recent acquisitions, an increase in broker commissions and an increase in salary expenses. Broker commissions, excluding acquisitions, have increased due to the growth in both organic membership and in premium rates. Salary expenses, excluding acquisitions, have increased due to annual compensation increases, additional amortization expense related to restricted shares of common stock granted in 2003 and 2004, and incremental compensation expense related to our organic membership growth. Selling, general and administrative expenses as a percentage of revenue have improved as a result of continuing revenue growth and success in controlling customer service costs.

        Other income increased due to an increase in interest income as a result of higher interest rates and as a result of a larger investment portfolio in 2004. Additionally, 2003 other income included a gain from sale of our single derivative investment which partially offsets the current year increase.

        Our provision for income taxes increased due to an increase in earnings before taxes. The effective tax rate decreased to 36.0% in 2004 from 36.4% in 2003.

        Days in total medical claims liabilities decreased from the prior year due primarily to faster claim receipts and continually improved processing cycle times.

Comparison of 2003 to 2002

        Managed care premium revenue increased as a result of rate increases on renewals that occurred throughout all markets, acquisitions and organic membership growth. Rate increases on commercial risk renewals averaged 13.5% for the year 2003. Commercial yields increased by an average of 12.1% on a per member per month (“PMPM”) basis. Excluding the Altius acquisition, the commercial yield increased 12.8%. Medicare yields increased as a result of changes being made to rate structures, as well as changes in demographics. The acquisitions of Mid-America, PersonalCare, and Altius resulted in an increase in managed care premium revenue of approximately $325 million. Organic membership growth resulted in an increase to managed care premiums of approximately $265 million.

        Management services revenue increased due to the increase in non-risk membership discussed earlier.

        Medical costs have increased due to acquisitions, organic growth and medical trend. Our total medical costs as a percentage of managed care premiums for all products improved 2.1%. This favorable change was attributable mostly to our commercial business and is a result of the commercial premium rate increases mentioned above outpacing commercial medical trend. Reported commercial medical trends, net of benefit buy downs, have been below 10% for each of the last two years. Our Medicare business medical loss ratio improved as a result of an increase in premium yields discussed above and exiting three counties in the Kansas City market on January 1, 2003. Our Medicaid medical loss ratio increased as a result of changes in the geographical markets in which we operate, and an increase in membership in a capitated service. We exited the Delaware Medicaid market on July 1, 2002. Within our Pennsylvania market, membership in our capitated Medicaid behavioral health program has increased significantly during 2002 and 2003. This program has a high medical loss ratio, but is lower in risk to our Company. Our days in total medical claims liabilities have decreased 10.1 days from prior year due to faster claim receipts and processing cycle times as well as efforts to reduce claim inventories.

        Selling, general and administrative expense increased primarily due to increased costs associated with acquisitions, an increase in broker commissions and an increase in salary expenses. Broker commissions, excluding acquisitions, have increased due to the growth in both organic membership and in premium yields. Salary expenses, excluding acquisitions, have increased due to annual salary increases, additional amortization expense related to restricted shares of common stock granted in 2003, additional management and sales incentive accruals and incremental salary expense related to our organic membership growth. As a percentage of revenue, selling, general and administrative expense decreased by 0.2%.

        Senior notes interest and amortization expense has increased in 2003. Due to the issuance of the notes on February 1, 2002, the prior year period represented eleven months of interest compared to twelve months in 2003. Also contributing to the increase is a $0.5 million loss on the repurchase of a portion of our senior notes at a premium in the third quarter of 2003.

        Other income increased due to a larger investment portfolio in 2003 offset by a decrease in interest income as a result of lower interest rates. Additionally, the current year included a gain from our single derivative investment compared to a loss in the prior year. This derivative investment was sold during the second quarter of 2003.

        Our provision for income taxes increased primarily due to an increase in earnings before taxes. The effective tax rate increased to 36.4% in 2003 from 35.5% in 2002.

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Liquidity and Capital Resources

        Liquidity

        The nature of our operations is such that cash receipts from premium revenues are typically received up to two months prior to the expected cash payment for related medical costs. Premium revenues are typically received at the beginning of the month in which they are earned, and the corresponding incurred medical expenses are paid in a future time period, typically 30 to 60 days after the date such medical services are rendered. The lag between premium receipts and claims payments creates positive cash flow and overall cash growth. As a result, we typically hold approximately two months of “float”. In addition, accumulated earnings provide further positive cash flow. In addition to ample current liquidity, our long-term investment portfolio is available for further liquidity needs.

        Our investment guidelines emphasize investment grade fixed income instruments in order to provide liquidity to meet future payment obligations and minimize the risk to the principal. The fixed income portfolio includes government and corporate securities with an average quality rating of “AA” and an average contractual duration of 2.5 years, as of December 31, 2004. Typically, the amount and duration of our short-term assets are more than sufficient to pay for our short-term liabilities, and we do not anticipate that sales of our long-term investment portfolio will be necessary to fund our claims liabilities.

        Our total cash and investments, consisting of cash and cash equivalents and short-term and long-term investments, but excluding deposits of $23.1 million restricted under state regulations, increased $321.8 million to $1.7 billion at December 31, 2004 from $1.4 billion at December 31, 2003.

        We will continue to fund our working capital requirements from our cash flow from operations. We believe that because our long-term investments are available-for-sale, the amount of such investments should be considered when assessing our liquidity. On such basis, current assets plus long-term investments available-for-sale less current liabilities increased to $1.0 billion at December 31, 2004 from $730.5 million at December 31, 2003.

        The demand for our products and services are subject to many economic fluctuations, risks and uncertainties that could materially affect the way we do business. Please refer to the section entitled “Risk Factors” in this Form 10-K for more information. Management believes that the combination of our ability to generate cash flows from operations, cash and investments on hand and the excess funds held in certain of our regulated subsidiaries will be sufficient to fund continuing operations, capital expenditures, debt interest costs and any other reasonably likely future cash requirements.

Cash Flows

        Net cash from operating activities is primarily driven by net earnings. For the year ended December 31, 2004, operating cash flow was positively affected by an increase in medical claims liabilities and an increase in accounts payable and other liabilities. Medical liabilities were unusually low at December 31, 2003 due to an effort to pay down medical claims inventory at year-end. The medical liabilities increased in 2004 as claim inventory levels returned to more normal levels and due to medical liabilities recorded for the new members brought on with the OmniCare membership purchase in October of 2004. Accounts payable and other liabilities increased as a result of an increase in taxes payable and an increase in the deferred compensation liability. Offsetting these operating cash inflows was a decrease in deferred revenue. As a result of the timing of CMS payments for Medicare beneficiaries, we only received eleven monthly CMS payments in 2004 versus twelve monthly CMS payments in 2003. Partially offsetting the one less CMS payment was an increase in commercial deferred revenue collections. Cash flow from operating activities has improved over the prior year as a result of higher earnings, an increase in unpaid medical liabilities and a larger increase in accounts payable and other accrued liabilities. Offsetting these improvements was a change in deferred revenue, the reasons for which are noted above. Prior year operating cash flows included a decrease in other receivables due to accelerated collections of our pharmacy rebate receivable as a result of improved procedures implemented in 2003. The pharmacy rebate receivable remained consistent at December 31, 2004 compared to December 31, 2003 and thus did not change operating cash flow year over year.

        Financing and Investing Activities

        Our Board of Directors has approved a program to repurchase up to 10% of our outstanding common stock. Stock repurchases may be made from time to time at prevailing prices on the open market, by block purchase or in private transactions. As a part of this program, we purchased 3.3 million shares of our common stock in 2002 at an aggregate cost of $65.5 million, no shares in 2003 and 2.0 million shares during the first quarter of 2004 at an aggregate cost of $84.6 million. As of December 31, 2004, the total remaining common shares we are authorized to repurchase under the program is approximately 1.8 million. Excluded from these amounts are shares purchased in exchange for employee payroll taxes on vesting of restricted stock awards as these purchases are not part of the program.

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        On February 1, 2002 we issued $175.0 million in aggregate principal amount of 8.125% senior notes due 2012. The proceeds from the sale were used to purchase, from Principal Health Care, Inc., 7.1 million shares of our common stock and a warrant exercisable, at that time, for 3.1 million shares of our common stock. The aggregate purchase price for the shares of common stock and warrant was $176.1 million. Interest on our senior notes is payable on February 15 and August 15 each year. The 2002 notes mature on February 15, 2012.

        In August 2003, we repurchased a portion of our senior notes with a face value of $4.5 million and a weighted average premium of 8.9%. We recorded a loss on the repurchase in accordance with SFAS No. 145 which requires gains and loses on extinguishments of debt to be classified as income or loss from continuing operations. The loss of $0.5 million was included as additional interest expense. The carrying value of our senior notes is equal to the face value and the fair value is based on the quoted market prices. As of December 31, 2004, the carrying value was $170.5 million and the fair value was $185.2 million.

        Our senior notes contain certain covenants and restrictions regarding incurring additional debt, limiting dividends or other restricted payments, and restricting transactions with affiliates, sales of assets and consolidations or mergers. We have complied with all covenants under the senior notes.

        During January 2005, we incurred approximately $865 million of additional indebtedness related to the acquisition of First Health. The additional indebtedness includes new senior, unsecured credit facilities consisting of a $300 million five-year term loan, all of which was drawn at closing, and a $150 million five-year revolving credit facility, of which $65 million was drawn at closing.

        Loans under the new senior credit facilities bear interest at a margin or spread in excess of either (1) the one-, two-, three- or six-month rate for the Eurodollar deposits (the “Eurodollar Rate”) or (2) the greater of the federal funds rate plus 0.5% or the prime rate of the Administrative Agent (“ABR”), as selected by us. The margin or spread depends on the debt ratings assigned to the new credit facilities and our consolidated leverage ratio and varies from 0.75% to 2% for Eurodollar Rate loans and from 0% to 1.0% for ABR loans. Commitment fees will accrue and be payable quarterly in arrears at an initial rate of 0.375% per annum, and subsequently at a rate ranging from 0.25% to 0.5% depending on the debt ratings assigned to the new credit facilities and our consolidated leverage ratio, multiplied by the daily average undrawn portion of the revolving credit facility.

        The term loan has a maturity of five years and will amortize in 20 consecutive quarterly installments in an aggregate annual amount equal to 10.0% of the original principal amount of the term loan during the first two years thereof, 20% of the original principal amount of the term loan during the next two years, with the balance payable in four equal installments in year five. Unless terminated earlier, the revolving credit facility terminates five years after closing and is payable in full upon its maturity on the termination date.

        The credit agreement contains covenants, including, among other things, covenants that restrict our ability and the ability of our subsidiaries to: incur additional indebtedness; incur guarantee obligations; create or permit liens on assets, engage in mergers or consolidations; dispose of assets; pay dividends or other distributions, purchase or redeem our equity securities or those of our subsidiaries and make other restricted payments; make loans, advances or other investments (including acquisitions); engage in certain transactions with affiliates; agree with others to limit their ability to grant liens on assets; agree with others to limit the ability of the our subsidiaries to pay dividends or other restricted payments or to make loans or transfer assets to us or another of our subsidiaries. The new senior credit facilities also require compliance with specified financial ratios and tests, including a maximum leverage ratio, a minimum fixed charge coverage ratio and a minimum net worth requirement.

        The additional indebtedness also includes the private placement of $250 million aggregate principal amount of 5 7/8% senior notes due 2012 and $250 million aggregate principal amount of 6 1/8% senior notes due 2015. These senior notes have since been registered with the Securities and Exchange Commission. The senior notes are general unsecured obligations of ours and rank equal in right of payment to all of our existing and future senior debt, including our existing 8.125% senior notes due 2012 and our new credit facilities.

        The indentures under which the new notes have been issued, among other things, restrict our ability and the ability of our restricted subsidiaries to: make investments; incur or guarantee additional indebtedness; pay dividends or make other distributions on capital stock or redeem or repurchase capital stock; create liens; incur dividend or other payment restrictions affecting subsidiaries; and merge or consolidate with other entities. From and after the date on which the notes receive investment grade ratings from two designated rating agencies, certain covenants related to the notes will terminate.

        We used the proceeds from the new credit facilities and senior notes, together with approximately $221 million of cash on hand, to fund the First Health acquisition, including the repayment of First Health’s outstanding bank debt and related transaction expenses.

        Projected cash payments for the final payment for the OmniCare purchase are $6.2 million in the first quarter of 2005.

        Projected capital payments in 2005 of approximately $65 million to $80 million consist primarily of computer hardware, software and related equipment costs associated with the development and implementation of improved operational and communication systems.

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        Health Plans

        Our regulated HMO and insurance company subsidiaries are required by state regulatory agencies to maintain minimum surplus balances, thereby limiting the dividends the parent may receive from our regulated entities. During 2004, we received $173.6 million in dividends and $12.6 million for note repayments from our regulated subsidiaries.

        The National Association of Insurance Commissioners (“NAIC”) has proposed that states adopt risk-based capital (“RBC”) standards that, if adopted, would generally require higher minimum capitalization requirements for HMOs and other risk-bearing health care entities. RBC is a method of measuring the minimum amount of capital appropriate for a managed care organization to support its overall business operations in consideration of its size and risk profile. The managed care organization’s RBC is calculated by applying factors to various assets, premiums and reserve items. The factor is higher for those items with greater underlying risk and lower for less risky items. The adequacy of a managed care organization’s actual capital can then be measured by a comparison to its RBC as determined by the formula. Our health plans are required to submit an RBC report to the NAIC and their domiciled state’s department of insurance with their annual filing.

        Regulators will use the RBC results to determine if any regulatory actions are required. Regulatory actions that could take place, if any, range from filing a financial action plan explaining how the plan will increase its statutory net worth to the approved levels, to the health plan being placed under regulatory control.

        The majority of states in which we operate health plans have adopted a risk-based capital (“RBC”) policy that recommends the health plans maintain statutory reserves at or above the ‘Company Action Level’ which is currently equal to 200% of their RBC. We have adopted an internal policy to maintain all of our regulated subsidiaries’ statutory capital and surplus at or above 250% of their RBC and a level of 300% in aggregate (referred to below as “300% of RBC”). Some states in which our regulated subsidiaries operate require deposits to be maintained with the respective states’ departments of insurance. The table below summarizes our statutory reserve information, as of December 31, 2004 and 2003 (in millions, except percentage data).

        The increase in capital and surplus for our regulated subsidiaries is a result of income from 2004 offset by dividends paid to the parent company.

        We believe that all subsidiaries which incur medical claims maintain more than adequate liquidity and capital resources to meet these short-term obligations as a matter of both Company policy and multiple Department of Insurance regulations.

        Excluding funds held by entities subject to regulation, we had cash and investments of approximately $383.1 million and $209.5 million at December 31, 2004 and December 31, 2003, respectively. The increase in non-regulated cash and investments is primarily a result of dividends received from our regulated subsidiaries, as mentioned above, and ordinary operating activities offset by stock repurchases made and payments for acquisitions. During the year ended December 31, 2004, we made capital contributions of approximately $20.0 million to our HMO subsidiaries. Of this total, $16.0 million was made to our newly formed Michigan subsidiary to meet statutory capital requirements.

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        Other

        The United States Department of Health and Human Services has issued rules, as mandated by the Health Insurance Portability and Accountability Act of 1996, which, among other things, impose security and privacy requirements with respect to individually identifiable patient data, including a member’s transactions with health care providers and payors, as well as requirements for the standardization of certain electronic transaction code sets and provider identifiers. We have spent approximately $2.2 million, $4.2 million and $4.1 million on compliance matters for the years ended December 31, 2004, 2003 and 2002, respectively. We do not anticipate future spending related to these rules to be material.

        As of December 31, 2004, we were contractually obligated to make the following payments within the next five years and thereafter (in thousands):

        Refer to Note I to our consolidated financial statement for disclosure related to our operating leases.

        We have typically paid 90% to 95% of medical claims within 6 months of the date incurred and approximately 99% of medical claims within 9 months of the date incurred. Accordingly, we believe medical claims liabilities are short-term in nature and therefore do not meet the listed criteria for classification as contractual obligations and have been excluded from the table above.

        After giving effect to the new senior notes and new credit facilities in January 2005, we will be contractually obligated to make the following payments, in addition to the payments shown in the table above, within the next five years and thereafter (in thousands):

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Other Disclosure

        Legal Proceedings

        In the normal course of business, we have been named as a defendant in various legal actions such as actions seeking payments for claims denied by the Company, medical malpractice actions, employment related claims and other various claims seeking monetary damages. The claims are in various stages of proceedings and some may ultimately be brought to trial. Incidents occurring through December 31, 2004 may result in the assertion of additional claims. We maintain general liability, professional liability and employment practices liability insurances in amounts that we believe are appropriate, with varying deductibles for which we maintain reserves. The professional liability and employment practices liability insurances are carried through our captive subsidiary.

        We are a defendant in the provider track in the Managed Care Litigation filed in the United States District Court for the Southern District of Florida, Miami Division, Multi-District Litigation (“MDL”), styled In re: Managed Care Litigation, MDL No. 1334. This lawsuit was filed by a group of physicians as a class action against Coventry and twelve other companies in the managed care industry. The plaintiffs have alleged violations of the Racketeer Influenced and Corrupt Organizations Act (“RICO”), conspiracy to violate RICO and aiding and abetting a scheme to violate RICO. In addition to these federal law claims, the complaint includes state law claims for breach of contract, violations of various state prompt payment laws and equitable claims for unjust enrichment and quantum meruit. The trial court has dismissed several of the state law claims and ordered that all physicians who have an arbitration provision in their provider contracts must submit their direct RICO claims and all of their remaining state law claims to arbitration. As a consequence of this ruling, all the plaintiffs who have arbitration provisions voluntarily dismissed all of their claims that are subject to arbitration. The trial court however has ordered that the plaintiffs’ claims of conspiracy, conspiracy to violate RICO and aiding and abetting violations of RICO are not subject to arbitration. The defendants’ appeal to the 11th Circuit challenging the trial court’s arbitration decision was denied. The trial court has certified various subclasses of physicians; however, we are not subject to the class certification order because the motion to certify was filed before we were joined as a defendant. The plaintiffs have now filed a motion to certify various subclasses as to Coventry. We have filed our opposition to that motion which remains pending before the trial court. The defendants who were subject to the class certification order filed an appeal to the 11th Circuit Court of Appeals. The Court of Appeals has overturned the class certification order as to the plaintiffs’ state law claims but affirmed the certification with respect to the plaintiffs’ federal law claims. The U.S. Supreme Court has denied the defendants’ petition to review the 11th Circuit’s class certification decision. Two defendants have entered into settlement agreements with the plaintiffs. Both settlement agreements have been filed with the Court and have received final approval. This MDL lawsuit has triggered the filing of copycat class action complaints by other health care providers such as chiropractors, podiatrists, acupuncturists and other licensed health care professionals. Each of these actions has been transferred to the MDL and has been designated as “tag-along” actions. The court has entered an order which stays all proceedings in the tag-along actions until all pre-trial proceedings in the MDL action have been concluded. Although we can not predict the outcome, management believes that the MDL lawsuit and tag-along actions will not have a material adverse effect on its financial position or its results of operations. Management also believes that the claims asserted in these lawsuits are without merit, and we intend to defend our position.

        Several companies in the insurance industry have received subpoenas for information from the New York Attorney General and the Connecticut Attorney General with respect to an industrywide investigation into certain insurance brokerage practices, including broker compensation arrangements, bid quoting practices and potential antitrust violations. As of the filing of this Annual Report on Form 10-K, Coventry has not been served with any such subpoenas.

        As a consequence of the Attorney General investigations in New York and Connecticut, Coventry, like most other companies in the insurance industry, has received Letters of Inquiry from the departments of insurance in several states in which it does business. These Letters, which are very similar, if not identical, seek information regarding broker compensation arrangements, bid quoting practices and conduct which may potentially constitute antitrust violations. Coventry has provided the information requested by these Letters and currently does not anticipate any additional follow up or requests for additional information.

        Legislation and Regulation

        As a managed health care company, we are subject to extensive government regulation of our products and services. The laws and regulations affecting our industry generally give state and federal regulatory authorities broad discretion in their exercise of supervisory, regulatory and administrative powers. These laws and regulations are intended primarily for the benefit of the members of the health plans. Managed care laws and regulations vary significantly from jurisdiction to jurisdiction and changes are frequently considered and implemented. Likewise, interpretations of these laws and regulations are also subject to change.

        Although the provisions of any legislation adopted at the state or federal level can not be accurately predicted at this time, management believes that the ultimate outcome of currently proposed legislation should not have a material adverse effect on the results of our operations in the short-term. Nevertheless, it is possible that future legislation or regulation could have a significant effect on our operations.

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        Inflation

        In recent years, health care cost inflation has exceeded the general inflation rate. To reduce the effect of health care cost inflation on our business operations we have, where possible, increased premium rates and implemented cost control measures in our patient care management and provider contracting. We can not be certain that we will be able to increase future premium rates at a rate that equals or exceeds the health care cost inflation rate or that our other cost control measures will be effective.

        2005 Outlook

        Our health plans operate in highly competitive markets, but we believe that the pricing environment is rational in our existing markets, thus creating the opportunity for reasonable price increases. We will continue to obtain adequate premium increases and expect premium rates to continue to rise at a rate equal to or greater than medical trend in 2005. Management believes that existing markets have potential for premium growth for our commercial and governmental products.

        In 2005, we have received Medicare premium rate increases of seven to ten percent. Additionally, we have received a Medicaid rate increase of 6.5% effective January 1, 2005 in Missouri, our largest Medicaid market.

        The acquisition of First Health will provide significant growth opportunities. For 2005, we will pursue achievement of synergies, the alignment business operations, accountabilities, and people toward future success, and the establishment of a foundation for future growth in each of the businesses.

Risk Factors

        The risks described below are not the only ones that we face. Additional risks not presently known to us or that we currently deem immaterial may also impair our business operations.

        Our business, financial condition or results of operations could be materially adversely affected by any of these risks. Further, the trading price of our common stock could decline due to any of these risks, and you may lose all or part of your investment.

        Our results of operations may be adversely affected if we are unable to accurately estimate and control future health care costs.

        Most of the premium revenue we receive is based upon rates set months before we deliver services. As a result, our results of operations largely depend on our ability to accurately estimate and control future health care costs. We base the premiums we charge, at least in part, on our estimate of expected health care costs over the applicable premium period. Factors that may cause health care costs to exceed our estimates include:

• an increase in the cost of health care services and supplies, including pharmaceuticals;
• higher than expected utilization of health care services;
• periodic renegotiations of hospital, physician and other provider contracts;
• the occurrence of epidemics and catastrophic events;
• changes in the demographics of our members and medical trends affecting them;
• general inflation or economic downturns;
• new mandated benefits or other regulatory changes that increase our costs; and
• other unforeseen occurrences.

        In addition, medical liabilities in our financial statements include our estimated reserves for incurred but not reported and reported but not paid claims. The estimates for medical liabilities are made on an accrual basis. We believe that our reserves for medical liabilities are adequate, but we can not assure you of this. Any adjustments to our medical liabilities could adversely affect our results of operations.

        Our results of operations will be adversely affected if we are unable to increase premiums to offset increases in our health care costs.

        Our results of operations depend on our ability to increase premiums to offset increases in our health care costs. Although we attempt to base the premiums we charge on our estimate of future health care costs, we may not be able to control the premiums we charge as a result of competition, government regulations and other factors. Our results of operations could be adversely affected if we are unable to set premium rates at appropriate levels or adjust premium rates in the event our health care costs increase.

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        A reduction in the number of members in our health plans could adversely affect our results of operations.

        A reduction in the number of members in our health plans could adversely affect our results of operations. Factors that could contribute to the loss of membership include:

• competition in premium or plan benefits from other health care benefit companies;
• reductions in the number of employers offering health care coverage;
• reductions in work force by existing customers;
• our increases in premiums or benefit changes;
• our exit from a market or the termination of a health plan; and
• negative publicity and news coverage relating to our company or the managed health care industry generally.

        We do not currently anticipate additional growth through acquisitions in 2005

        Part of our growth strategy historically has been to grow through the acquisition of additional health plans. During the last several years, we have significantly increased our membership through a number of acquisitions. Because of the size of the First Health acquisition, we anticipate that our management will focus on the integration of First Health and we do not currently intend to acquire additional health plans in 2005.

        Competition in our industry may limit our ability to attract new members or to increase or maintain our premium rates, which would adversely affect our results of operations.

        We operate in a highly competitive environment that may affect our ability to attract new members and increase premium rates. We compete with other health plans for members. We believe the principal factors influencing the choice among health care options are:

• price of benefits offered and cost and risk of alternatives such as self-insurance;
• location and choice of health care providers;
• quality of customer service;
• comprehensiveness of coverage offered;
• reputation for quality care;
• financial stability of the plan; and
• diversity of product offerings.

        We face competition from other managed care companies that may have broader geographical coverage, more established reputations in our markets, greater market share, larger contracting scale, lower costs and/or greater financial and other resources. We also may face increased rate competition from certain Blue Cross plan competitors that might be required by state regulation to reduce capital surpluses that may be deemed excessive.

        Competition in the Federal Employees Benefit Plan and recent plan design changes in the Mail Handlers Benefit Plan may reduce membership and revenues.

        The Mail Handlers Benefit Plan, which is administered by First Health, competes against a number of national carriers and local health plans for Federal employee membership. First Health has sought through plan design changes, including premium increases, changes in employee cost-sharing and benefit changes, to create a more attractive and competitive Mail Handlers product offering to attract new members as well as retain existing members. As these new products are introduced for 2005, it is expected that there will be some loss of existing membership as the new benefit plans may be more attractive to potential members than existing members. In addition, the new plan design changes for the 2005 benefit plan year may result in a greater than expected loss of membership if these products are not as attractive or competitive as we anticipate.

        Competition in the multi-site, national account business may limit our ability to grow revenues which could adversely affect our results of operations.

        First Health competes in a highly competitive environment against other major national managed care companies in its Corporate line of business to provide administrative, network access, and medical management services to large, multi-site, self-insured employers. Among these competitors are Aetna, United Healthcare and “Blue Card” (a joint venture of major Blue Cross plans), all of which have greater resources, brand identity and contracting scale compared to First Health or Coventry.

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        We depend on the services of non-exclusive independent agents and brokers to market our products to employers, and we can not assure you that they will continue to market our products in the future.

        We depend on the services of independent agents and brokers to market our managed care products and services, particularly to small employer group members. We do not have long term contracts with independent agents and brokers, who typically are not dedicated exclusively to us and frequently market the health care products of our competitors. We face intense competition for the services and allegiance of independent agents and brokers, and we can not assure you that agents and brokers will continue to market our products in a fair and consistent manner.

        Our failure to obtain cost-effective agreements with a sufficient number of providers may result in higher medical costs and a decrease in our membership.

        Our future results largely depend on our ability to enter into cost-effective agreements with hospitals, physicians and other health care providers. The terms of those provider contracts will have a material effect on our medical costs and our ability to control these costs. In addition, our ability to contract successfully with a sufficiently large number of providers in a particular geographic market will impact the relative attractiveness of our managed care products in those markets.

        In some of our markets, there are large provider systems that have a major presence. Some of these large provider systems have operated their own health plans in the past or may choose to do so in the future. These provider systems could adversely affect our product offerings and results of operations if they refuse to contract with us, place us at a competitive disadvantage or use their market position to negotiate contracts that are less favorable to us. Provider agreements are subject to periodic renewal and renegotiations. We can not assure you that these large provider systems will continue to contract with us or that they will contract with us on terms that are favorable to us.

        Negative publicity regarding the managed health care industry generally or our company in particular could adversely affect our results of operations or business.

        Over the last several years, the managed health care industry has been subject to negative publicity. Negative publicity regarding the managed health care industry generally or our company in particular may result in increased regulation and legislative review of industry practices further increase our costs of doing business and adversely affect our results of operations by:

• requiring us to change our products and services;
• increasing the regulatory burdens under which we operate; or
• adversely affecting our ability to market our products or services.

        Negative publicity relating to our company or the managed care industry generally also may adversely affect our ability to attract and retain members.

        A failure of our information technology systems could adversely affect our business.

        We depend on our information technology systems for timely and accurate information. Failure to maintain effective and efficient information technology systems or disruptions in our information technology systems could cause disruptions in our business operations, loss of existing customers, difficulty in attracting new customers, disputes with customers and providers, regulatory problems, increases in administrative expenses and other adverse consequences.

        The anticipated benefits of acquiring First Health may not be realized.

        We anticipate our acquisition of First Health will result in various benefits including, among other things, benefits relating to enhanced revenues, a strengthened market position, cross selling opportunities, technology, cost savings and operating efficiencies. Achieving the anticipated benefits of the First Health acquisition is subject to a number of uncertainties, including whether we integrate First Health in an efficient and effective manner, and general competitive factors in the marketplace. Failure to achieve these anticipated benefits could result in increased costs, decreases in the amount of expected revenues and diversion of management’s time and energy and could materially impact our business, financial condition and operating results.

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        We may face substantial difficulties, costs and delays in integrating First Health. These factors may include:

• potential difficulty in leveraging the value of the separate technologies of the combined company;
• perceived adverse changes in product offerings available to customers and customer services standards, whether or not these changes do, in fact, occur;
• managing customer and provider overlap and potential pricing conflicts;
• costs and delays in implementing common systems and procedures;
• potential charges to earnings resulting from the application of purchase accounting to the transaction;
• difficulty comparing financial reports due to differing management systems;
• diversion of management resources from the business of the combined company;
• the retention of existing customers of each company, including, with respect to First Health, the Mail Handlers Benefit Plan (a nationally offered health plan for federal employees);
• reduction or loss of customer orders due to the potential for market confusion, hesitation and delay;
• retaining and integrating management and other key employees of the combined company; and
• coordinating infrastructure operations in an effective and efficient manner.

        After the First Health acquisition, we may seek to combine certain operations and functions using common information and communication systems, operating procedures, financial controls and human resource practices, including training, professional development and benefit programs. We may be unsuccessful in implementing the integration of these systems and processes. For its fiscal year 2003, First Health’s revenues were approximately $891 million. While we believe that the companies share certain similar cultural characteristics and philosophies, the differences in size and scope of operations may affect our management processes.

        Any one or all of these factors, many of which are outside of our control, may cause increased operating costs, worse than anticipated financial performance or the loss of customers and employees. Many of these factors are also outside the control of either company.

        We conduct business in a heavily regulated industry and changes in laws or regulations or violations of regulations could adversely affect our business and results of operations.

        Our business is heavily regulated by federal, state and local authorities. Legislation or other regulatory reform that increases the regulatory requirements imposed on us or that changes the way we currently do business may in the future adversely affect our business and results of operations. Legislative or regulatory changes that could significantly harm us and our subsidiaries include changes that:

• impose increased liability for adverse consequences of medical decisions;
• limit premium levels;
• increase minimum capital, reserves and other financial viability requirements;
• impose fines or other penalties for the failure to pay claims promptly;
• impose fines or other penalties as a result of market conduct reviews;
• prohibit or limit rental access to health care provider networks;
• prohibit or limit provider financial incentives and provider risk-sharing arrangements;
• require health plans to offer expanded or new benefits;
• limit the ability of health plans to manage care and utilization due to “any willing provider” and direct access laws that restrict or prohibit product features that encourage members to seek services from contracted providers or through referral by a primary care provider;
• limit contractual terms with providers, including audit, payment and termination provisions;
• implement mandatory third party review processes for coverage denials; and
• impose additional health care information privacy or security requirements.

        We also may be subject to governmental investigations or inquiries from time to time. For example, several companies in the insurance industry have received subpoenas for information from the New York Attorney General and the Connecticut Attorney General with respect to an industry wide investigation into certain insurance brokerage practices, including broker compensation arrangements, bid quoting practices and potential antitrust violations. Insurance regulators in several states, including states in which our subsidiaries are domiciled, have sent letters of inquiry concerning similar matters to the companies subject to this jurisdiction, including our subsidiaries. We have furnished the information requested and have cooperated with the insurance regulatory authorities. The existence of such investigations in our industry could negatively impact the market value of all companies in our industry including our stock price. Any similar governmental investigations of Coventry could have a material adverse effect on our financial condition, results of operations or business or result in significant liabilities to the Company, as well as adverse publicity.

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        In addition, we are required to obtain and maintain various regulatory approvals to market many of our products. Delays in obtaining or failure to obtain or maintain these approvals could adversely impact our results of operations. Federal, state and local authorities frequently consider changes to laws and regulations that could adversely affect our business. We can not predict the changes that government authorities will approve in the future or assure you that those changes will not have an adverse effect on our business or results of operations.

        We face periodic reviews, audits and investigations under our contracts with federal and state government agencies, and these audits could have adverse findings that may negatively impact our business.

        We contract with various federal and state governmental agencies to provide managed health care services. Pursuant to these contracts, we are subject to various governmental reviews, audits and investigations to verify our compliance with the contracts and applicable laws and regulations. Any adverse review, audit or investigation could result in:

• refunding of amounts we have been paid pursuant to our government contracts;
• imposition of fines, penalties and other sanctions on us;
• loss of our right to participate in various federal programs;
• damage to our reputation in various markets;
• increased difficulty in selling our products and services; and
• loss of one or more of our licenses to act as an insurer or HMO or to otherwise provide a service.

        We are subject to litigation in the ordinary course of our business, including litigation based on new or evolving legal theories, that could adversely affect our results of operations.

        Due to the nature of our business, we are subject to a variety of legal actions relating to our business operations including claims relating to:

• our denial of non-covered benefits;
• vicarious liability for our actions or medical malpractice claims;
• disputes with our providers over alleged violations of RICO;
• disputes with our providers over compensation and termination of provider contracts;
• disputes related to our non-risk business, including actions alleging breach of fiduciary duties, claim administration errors and failure to disclose network rate discounts and other fee and rebate arrangements;
• disputes over our co-payment calculations;
• customer audits of our compliance with our plan obligations; and
• disputes over payments for out-of-network benefits.

        In addition, plaintiffs continue to bring new types of legal claims against managed care companies. Recent court decisions and legislative activity increase our exposure to these types of claims. In some cases, plaintiffs may seek class action status and substantial economic, non-economic or punitive damages. The loss of even one of these claims, if it resulted in a significant damage award, could have an adverse effect on our financial condition or results of operations. In the event a plaintiff were to obtain a significant damage award it may make reasonable settlements of claims more difficult to obtain. We can not determine with any certainty what new theories of recovery may evolve or what their impact may be on the managed care industry in general or on us in particular.

        We have, and expect to maintain, liability insurance coverage for some of the potential legal liabilities we may incur. Currently, professional liability and employment practices liability insurance is covered through our captive subsidiary. Potential liabilities that we incur may not, however, be covered by insurance, our insurers may dispute coverage or may be unable to meet their obligations or the amount of our insurance coverage may be inadequate. We can not assure you that we will be able to obtain insurance coverage in the future, or that insurance will continue to be available on a cost effective basis, if at all.

      Our stock price and trading volume may be volatile.

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        From time to time, the price and trading volume of our common stock, as well as the stock of other companies in the health care industry may experience periods of significant volatility. Company-specific issues and developments generally in the health care industry (including the regulatory environment) and the capital markets may cause this volatility. Our stock price and trading volume may fluctuate in response to a number of events and factors, including:

• variations in our operating results;
• changes in the market’s expectations about our future operating results;
• changes in financial estimates and recommendations by securities analysts concerning our company or the health care industry generally;
• operating and stock price performance of other companies that investors may deem comparable;
• news reports relating to trends in our markets;
• changes in the laws and regulations affecting our business;
• acquisitions and financings by us or others in our industry; and
• sales of substantial amounts of our common stock by our directors and executive officers or principal stockholders, or the perception that such sales could occur.

        Our indebtedness imposes restrictions on our business and operations.

        The indentures for our senior notes and bank credit agreement impose restrictions on our business and operations. These restrictions limit our ability to, among other things:

• incur additional debt;
• pay dividends or make other restricted payments;
• create or permit certain liens on our assets;
• sell assets;
• create or permit restrictions on the ability of certain of our restricted subsidiaries to pay dividends or make other distributions to us;
• enter into transactions with affiliates;
• enter into sale and leaseback transactions; and
• consolidate or merge with or into other companies or sell all or substantially all of our assets.

        Our ability to generate sufficient cash to service our indebtedness will depend on numerous factors beyond our control.

        Our ability to service our indebtedness will depend on our ability to generate cash in the future. Our ability to generate the cash necessary to service our indebtedness is subject to general economic, financial, competitive, legislative, regulatory and other factors that are beyond our control. We cannot assure you that our business will generate sufficient cash flow from operations or that future borrowings will be available in an amount sufficient to enable us to service our indebtedness or to fund other liquidity needs. In addition, we will be more vulnerable to economic downturns, adverse industry conditions and competitive pressures as a result of our significant indebtedness. We may need to refinance all or a portion of our indebtedness before maturity. We cannot assure you that we will be able to refinance any of our indebtedness or that we will be able to refinance our indebtedness on commercially reasonable terms.

        Our stockholder rights plan, certificate of incorporation and bylaws and Delaware law could delay, discourage or prevent a change in control of our company that our stockholders consider favorable.

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        We have a stockholder rights plan that may have the effect of discouraging unsolicited takeover proposals. The rights issued under the stockholder rights plan would cause substantial dilution to a person or group that attempts to acquire us on terms not approved in advance by our board of directors. In addition, provisions in our certificate of incorporation and bylaws and Delaware law may delay, discourage or prevent a merger, acquisition or change in control involving our company that our stockholders may consider favorable. These provisions could also discourage proxy contests and make it more difficult for stockholders to elect directors and take other corporate actions. Among other things, these provisions:

• authorize us to issue preferred stock, the terms of which may be determined at the sole discretion of our board of directors and may adversely affect the voting or economic rights of our common stockholders;
• provide for a classified board of directors with staggered three-year terms so that no more than one-third of our directors can be replaced at any annual meeting;
• provide that directors may be removed without cause only by the affirmative vote of the holders of two-thirds of our outstanding shares;
• provide that any amendment or repeal of the provisions of our certificate of incorporation establishing our classified board of directors must be approved by the affirmative vote of the holders of three-fourths of our outstanding shares; and
• establish advance notice requirements for nominations for election to the board of directors or for proposing matters that can be acted on by stockholders at a meeting.

        These provisions of our stockholder rights plan, certificate of incorporation and bylaws and Delaware law may discourage transactions that otherwise could provide for the payment of a premium over prevailing market prices for our common stock and also could limit the price that investors are willing to pay in the future for shares of our common stock.

      General economic conditions

        Changes in economic conditions could adversely affect our business and results of operations. The state of the economy could adversely affect our employer group renewal prospects and our ability to collect or increase premiums. The state of the economy could also adversely affect the states’ budgets, which could result in the states attempting to reduce payments to Medicaid plans in those states in which we offer Medicaid plans, and increase taxes and assessments on our activities. Although we could attempt to mitigate or cover our exposure from such increased costs through, among other things, increases in premiums, there can be no assurance that we will be able to mitigate or cover all of such costs resulting from any budget cuts in states in which we operate. Although we have attempted to diversify our product offerings to address the changing needs of our membership, the effects of economic conditions could cause our existing membership to seek health coverage alternatives that we do not offer or could result in significant membership loss, lower average premium yields or decreased margins on continuing membership.

Item 7A: Quantitative and Qualitative Disclosures About Market Risk

        Under an investment policy approved by our Board of Directors, we invest primarily in marketable U.S. government and agency, state, municipal, mortgage-backed and asset-backed securities and corporate debt obligations that are investment grade. The investment policy specifically prohibits purchasing investments in any equities or in fixed income securities that are below investment grade. We have classified all of our investments as available-for-sale. We are exposed to certain market risks including interest rate risk and credit risk.

        We have established policies and procedures to manage our exposure to changes in the fair value of our investments. Our policies include an emphasis on credit quality and the management of our portfolio’s duration and mix of securities. We believe our investment portfolio is diversified and currently expect no material loss to result from the failure to perform by the issuers of the debt securities we hold. The mortgage-backed securities are insured by several associations, including Government National Mortgage Administration, Federal National Mortgage Administration and the Federal Home Loan Mortgage Corporation.

        We invest primarily in fixed income securities and classify all our investments as available-for-sale. Investments are evaluated at least quarterly to determine if declines in value are other-than-temporary. In making that determination, we consider all available evidence relating to the realizable value of a security. This evidence includes, but is not limited to, the following:

• adverse financial conditions of a specific issuer, segment, industry, region or other variables;
• the length of the time and the extent to which the fair value has been less than cost;
• the financial condition and near-term prospects of the issuer;
• our intent and ability to retain our investment in the issuer for a period of time sufficient to allow for any anticipated recovery in fair value;
• elimination or reduction in dividend payments, or scheduled interest and principal;
• rating agency downgrade of a debt security; and
• expected cash flows of a debt security.

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        Temporary declines in value of investments classified as available-for-sale are netted with unrealized gains and reported as a net amount in a separate component of stockholders’ equity. A decline in fair value below amortized cost that is judged to be other-than-temporary is accounted for as a realized loss and the write down is included in earnings. Realized gains and losses on the sale of investments are determined on a specific identification basis. See Note E to our consolidated financial statements in this Form 10-K for more information concerning other-than-temporary impaired investments.

        Our investments at December 31, 2004 mature according to their contractual terms, as follows, in thousands (actual maturities may differ because of call or prepayment rights):

        Our projections of hypothetical net gains in fair value of our market rate sensitive instruments, should potential changes in market rates occur, are presented below. The projection is based on a model, which incorporates effective duration, convexity and price to forecast hypothetical instantaneous changes in interest rates of positive and negative 100, 200 and 300 basis points. The model only takes into account the fixed income securities in the portfolio and excludes all cash. While we believe that the potential market rate change is reasonably possible, actual results may differ.

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Item 8: Financial Statements and Supplementary Data

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Board of Directors and Shareholders of Coventry Health Care, Inc.:

        We have audited the accompanying consolidated balance sheets of Coventry Health Care, Inc. and subsidiaries as of December 31, 2004 and 2003, and the related consolidated statements of operations, shareholders’ equity, and cash flows for each of the three years in the period ended December 31, 2004. Our audits also included the financial statement schedule listed in the Index at Item 15(a)(2). These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.

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

        In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Coventry Health Care, Inc. and subsidiaries at December 31, 2004 and 2003, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 2004, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein.

        We have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of Coventry Health Care, Inc.’s internal control over financial reporting as of December 31, 2004, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations for the Treadway Commission and our report dated February 15, 2005 expressed an unqualified opinion thereon.

ERNST & YOUNG LLP

Baltimore, Maryland
February 15, 2005

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Coventry Health Care, Inc. and Subsidiaries
Consolidated Balance Sheets
(in thousands)

See accompanying notes to the consolidated financial statements.

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Coventry Health Care, Inc. and Subsidiaries
Consolidated Statements of Operations
(in thousands, except per share data)

See accompanying notes to the consolidated financial statements.

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Coventry Health Care, Inc. and Subsidiaries
Consolidated Statements of Stockholders’ Equity
Years Ended December 31, 2004, 2003 and 2002
(in thousands)

See accompanying notes to the consolidated financial statements.

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Coventry Health Care, Inc. and Subsidiaries
Consolidated Statements of Cash Flows
(in thousands)

See accompanying notes to the consolidated financial statements.

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COVENTRY HEALTH CARE, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2004, 2003 and 2002

A. ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

        Coventry Health Care, Inc. (together with its subsidiaries, the “Company” or Coventry) is a managed health care company operating health plans under the names Altius Health Plans, Carelink Health Plans, Coventry Health Care, Coventry Health and Life, Group Health Plan, HealthAmerica, HealthAssurance, HealthCare USA, OmniCare, PersonalCare, SouthCare, Southern Health and WellPath. The Company provides a full range of managed care products and services including health maintenance organization (“HMO”), preferred provider organization (“PPO”) and point of service (“POS”) products. The Company also administers self-insured plans for large employer groups and rents its provider networks to various third parties.

        Since the Company began operations in 1987 with the acquisition of the American Service Companies entities, including Coventry Health and Life Insurance Company (“CH&L”), the Company has grown substantially through acquisitions. The table below lists all of the Company’s acquisitions. See Note B to consolidated financial statements for additional information on the most recent acquisitions.

Significant Accounting Policies

        Principles of Consolidation - The consolidated financial statements include the accounts of the Company and its subsidiaries, all of which are 100% owned. All significant inter-company transactions have been eliminated.

        Use of Estimates - The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those amounts.

        Reclassifications - Certain 2003 and 2002 amounts have been reclassified to conform to the 2004 presentation.

        Stock Split - On December 23, 2003, the Company’s Board of Directors approved a three-for-two stock split of the Company’s common stock. The stock split, in the form of a stock dividend, was distributed January 30, 2004 for stockholders of record on January 9, 2004. The stock split is reflected retroactively in the Company’s consolidated financial statements and notes thereto for all periods presented.

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        Significant Customers - The Company’s commercial business is diversified across a large customer base and there are no commercial groups that make up 10% or more of Coventry’s managed care premiums. The Company received 10.9%, 10.8% and 12.3% of its managed care premiums for the years ended December 31, 2004, 2003 and 2002, respectively, from the federal Medicare program throughout its various markets. The Company also received 11.7%, 11.8% and 13.1% of its managed care premiums for the years ended December 31, 2004, 2003 and 2002, respectively, from its state-sponsored Medicaid programs throughout its various markets. For the year ended December 31, 2004, the State of Missouri accounted for over half the Company’s Medicaid premiums.

        Cash and Cash Equivalents - Cash and cash equivalents consist principally of money market funds, commercial paper and certificates of deposit. The Company considers all highly liquid securities purchased with an original maturity of three months or less to be cash equivalents. The carrying amounts of cash and cash equivalents reported in the accompanying consolidated balance sheets approximate fair value.

        Investments - - The Company accounts for investments in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 115 - “Accounting for Certain Investments in Debt and Equity Securities.” The Company invests primarily in fixed income securities and classifies all of its investments as available-for-sale. Investments are evaluated at least quarterly to determine if declines in value are other-than-temporary. In making that determination, the Company considers all available evidence relating to the realizable value of a security. This evidence includes, but is not limited to, the following:

• adverse financial conditions of a specific issuer, segment, industry, region or other variables;
• the length of the time and the extent to which the fair value has been less than cost;
• the financial condition and near-term prospects of the issuer;
• the Company’s intent and ability to retain its investment in the issuer for a period of time sufficient to allow for any anticipated recovery in fair value;
• elimination or reduction in dividend payments, or scheduled interest and principal;
• rating agency downgrade of a debt security; and
• expected cash flows of a debt security.

        Temporary declines in value of investments classified as available-for-sale are netted with unrealized gains and reported as a net amount in a separate component of stockholders’ equity. A decline in fair value below amortized cost that is judged to be other-than-temporary is accounted for as a realized loss and the write down is included in earnings. Realized gains and losses on the sale of investments are determined on a specific identification basis.

        Investments with original maturities in excess of three months and less than one year are classified as short-term investments and generally consist of corporate bonds, U.S. Treasury notes and commercial paper. Long-term investments have original maturities in excess of one year and primarily consist of fixed income securities.

        Other Receivables - Other receivables include interest receivables, pharmacy rebate receivables, receivables from providers and suppliers and any other receivables that do not relate to premiums.

        Property and Equipment - Property, equipment and leasehold improvements are recorded at cost. Depreciation is computed using the straight-line method over the estimated lives of the related assets or, if shorter, over the terms of the respective leases.

        Long-term Assets - Long-term assets primarily include assets associated with the Supplemental Executive Retirement Plan (“SERP” ) and deferred tax assets.

        Business Combinations, Accounting for Goodwill and Other Intangibles - The Company accounts for business combinations, goodwill and other intangibles in accordance with SFAS No. 141 - - “Business Combinations” and SFAS No. 142 - “Goodwill and Other Intangible Assets.” Acquired intangible assets are separately recognized upon meeting certain criteria. Such intangible assets include, but are not limited to, trade and service marks, non-compete agreements, customer lists and licenses. Goodwill and other intangible assets that have indefinite lives are subject to a periodic assessment for impairment by applying a fair-value-based test. The Company uses three approaches to identifying the fair value of its goodwill and other intangible assets: the market approach, the market capitalization approach and the income approach. The market approach estimates a business’s fair value by analyzing the recent sales of similar companies. The market capitalization approach is based on market value of the Company’s total shares outstanding. The income approach is based on the present value of expected future cash flows. As impairment charges occur, write-down charges will be recorded in the period in which the impairment took place. See Note C to consolidated financial statements for disclosure related to intangible assets.

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        Medical Liabilities and Expense - Medical liabilities consist of actual claims reported but not paid and estimates of health care services incurred but not reported. The estimated claims incurred but not reported are based on historical data, current enrollment, health service utilization statistics and other related information. In determining medical liabilities, the Company employs standard actuarial reserve methods that are specific to each market’s membership, product characteristics, geographic territories and provider network. The Company also considers utilization frequency and unit costs of inpatient, outpatient, pharmacy and other medical expenses, as well as claim payment backlogs and the timing of provider reimbursements. The Company also establishes reserves, if required, for the probability that anticipated future health care costs and contract maintenance costs under the group of existing contracts will exceed anticipated future premiums and reinsurance recoveries on those contracts. These accruals are continually monitored and reviewed, and as settlements are made or accruals adjusted, differences are reflected in current operations. Changes in assumptions for medical costs caused by changes in actual experience could cause these estimates to change in the near term.

        The following table shows the components of the change in medical liabilities for the years ended December 31, 2004, 2003 and 2002, respectively:

        Acquisition balances represent medical liabilities as of the applicable acquisition date. Subsequent changes in estimates related to the acquired balances are recorded as adjustments to the settlement account with the acquired entity’s previous owner.

        The negative amounts noted as “prior year” medical costs are favorable adjustments for claim estimates being settled for amounts less than originally anticipated. As noted above, these favorable changes from original estimates occur due to changes in medical utilization, mix of provider rates and other components of medical cost trends.

        Other Long-term Liabilities - Other long-term liabilities consist primarily of liabilities associated with the SERP and the deferred tax liability associated with the net unrealized gains on investments.

        Revenue Recognition - Managed care premiums are recorded as revenue in the month in which members are entitled to service. Premiums are based on a per subscriber contract rate and the subscribers in the Company’s records at the time of billing. Premium billings are generally sent to employers in the month preceding the month of coverage. Premium billings may be subsequently adjusted to reflect changes in membership as a result of retroactive terminations, additions, or other changes. The Company also receives premium payments from the Centers for Medicare and Medicaid Services (“CMS”) on a monthly basis for its Medicare membership. Membership and category eligibility are periodically reconciled with CMS and such reconciliations could result in adjustments to revenue. Premiums collected in advance are recorded as deferred revenue. Employer contracts are typically on an annual basis, subject to cancellation by the employer group or by the Company upon 30 days notice.

        Based on information received subsequent to premium billings being sent, historical trends, bad debt write-offs and the collectibility of specific accounts, the Company estimates, on a monthly basis, the amount of bad debt and future retroactivity and adjusts its revenue and reserves accordingly.

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        Premiums for services to federal employee groups are subject to audit and review by the Office of Personnel Management (“OPM”) on a periodic basis. Such audits are usually a number of years in arrears. Adjustments are recorded as additional information regarding the audits and reviews becomes available. Any differences between actual results and estimates are recorded in the year the audits are finalized.

        The Company enters into performance guarantees with employer groups where the Company guarantees that it will meet certain standards. These standards vary widely and could involve customer service, member satisfaction, claims processing, claims accuracy and telephone on-hold time. Under these performance guarantees, the Company could be at risk for not maintaining the standards agreed upon in the contracts. The risk level varies by agreement with penalties based on a variety of calculations including per member per month, percentage of premium, or percentage of administration fees. Performance levels are evaluated at least quarterly. The Company estimates its potential exposure and records the appropriate reserves.

        Stock-based Compensation - The Company accounts for stock-based compensation to employees under Accounting Principles Board (“APB”) No. 25 - “Accounting for Stock Issued to Employees,” and complies with the disclosure requirements for Statement of Financial Accounting Standards (“SFAS”) No. 123 - “Accounting for Stock-Based Compensation” and SFAS No. 148 - “Accounting for Stock-Based Compensation - Transition and Disclosure.” Had stock-based compensation cost been determined consistent with SFAS No. 123, the Company’s net earnings and earnings per share (“EPS”) would have been reduced to the following pro-forma amounts (in thousands, except per share data):

        The fair value of the stock options included in the pro-forma amounts shown above was estimated as of the grant date using the Black-Scholes option-pricing model with the following weighted-average assumptions:

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        In December 2004, the Financial Accounting Standards Board (“FASB”) issued FASB Statement No. 123 (revised 2004), Share-Based Payment, which is a revision of SFAS No. 123. SFAS No. 123(R) supersedes Accounting Principles Board (“APB”) Opinion No. 25, and amends SFAS No. 95, “Statement of Cash Flows.” Generally, the approach in SFAS No. 123(R) is similar to the approach described in SFAS No. 123. However, SFAS No. 123(R) requires all share-based payments to employees, including grants of employee stock options, to be recognized in the income statement based on their fair values. Pro forma disclosure is no longer an alternative.

        SFAS No. 123(R) must be adopted no later than July 1, 2005. Early adoption will be permitted in periods in which financial statements have not yet been issued. The Company expects to adopt SFAS No. 123(R) on July 1, 2005 using the modified-prospective method.

        Under the modified-prospective method, compensation cost is recognized beginning on the adoption date based on the requirements of SFAS No. 123(R) for all share-based payments granted after the effective date and based on the requirements of SFAS No. 123 for all awards granted to employees prior to the effective date of SFAS No. 123(R) that remain unvested on the effective date.

        As permitted by SFAS No. 123, the Company currently accounts for share-based payments to employees using APB No. 25’s intrinsic value method and, as such, has recognized no compensation cost for employee stock options. Accordingly, the adoption of SFAS No. 123(R)’s fair value method will have an effect on its results of operations, although it will have no material effect on its overall financial position. The effect of adoption of SFAS No. 123(R) cannot be predicted at this time because it will depend on levels of share-based payments granted in the future. However, had the Company adopted SFAS No. 123(R) in prior periods using the Black-Scholes method of valuation, the effect of that standard would have approximated the effect of SFAS No. 123 as described in the disclosure of pro forma net income and earnings per share above. SFAS No. 123(R) also requires the benefits of tax deductions in excess of recognized compensation cost to be reported as a financing cash flow, rather than as an operating cash flow as required under current literature. This requirement will reduce net operating cash flows and increase net financing cash flows in periods after adoption. While the Company cannot estimate what those amounts will be in the future (as it is dependent upon, among other things, when employees exercise stock options), the amounts of operating cash flows that would have been recognized under SFAS No. 123 in prior periods for such excess tax benefits were $15.8 million, $15.6 million, and $12.9 million in 2004, 2003 and 2002, respectively.

        See Note G to consolidated financial statements for disclosure related to stock-based compensation.

        Contract Acquisition Costs - Costs related to the acquisition of customer contracts, such as commissions paid to outside brokers, are expensed as incurred.

        Income Taxes - The Company files a consolidated federal tax return for the Company and its subsidiaries. The Company accounts for income taxes in accordance with SFAS No. 109 - “Accounting for Income Taxes.” The deferred tax assets and/or liabilities are determined by multiplying the differences between the financial reporting and tax reporting bases for assets and liabilities by the enacted tax rates expected to be in effect when such differences are recovered or settled. The effect on deferred taxes of a change in tax rates is recognized in income in the period that includes the enactment date. See Note F to consolidated financial statements for disclosures related to income taxes.

        Earnings Per Share - Basic earnings per share are based on the weighted average number of common shares outstanding during the year. Diluted earnings per share assume the exercise of all options and warrants and the vesting of all restricted stock using the treasury stock method.

B. ACQUISITIONS

        During the three years ended December 31, 2004, the Company completed several business combinations and membership purchases. The Company’s business combinations are all accounted for using the purchase method of accounting and, accordingly, the operating results of each acquisition have been included in the Company’s consolidated financial statements since their effective date of acquisition. The purchase price for each business combination was allocated to the assets, including the identifiable intangible assets, and liabilities based on estimated fair values. The excess of the purchase price over the net identifiable assets acquired was allocated to goodwill. The purchase price of the Company’s membership purchases is allocated to identifiable intangible assets and is being amortized over a useful life of ten to twenty years.

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        The following table summarizes all business combinations and membership purchases for the three years ended December 31, 2004. The purchase price of each business combination includes the payment for net worth and estimated transition costs. The estimated transition costs may be adjusted as actual expenses are incurred, thereby affecting the final purchase price of the acquisition. In addition, most of the Company’s acquisition agreements contain a provision for a final retroactive balance sheet settlement which may result in adjustments to the purchase price. The purchase price, inclusive of all retroactive balance sheet settlements to date and transaction cost adjustments, is presented below (in thousands):

C. GOODWILL AND OTHER INTANGIBLE ASSETS

        Goodwill and other intangible assets consist of costs in excess of the fair value of the net tangible assets of subsidiaries or operations acquired through December 31, 2004.

Goodwill

        As described in the Company’s segment disclosure, assets are not allocated to specific products, and, accordingly, goodwill can not be reported by segment. The Company has completed its impairment test of goodwill and has determined that there was no impairment of goodwill as of October 1, 2004, the Company’s annual impairment test date. The changes in the carrying amount of goodwill for the years ended December 31, 2004 and 2003 were as follows (in thousands):

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Other Intangible Assets

        The other intangible asset balances are as follows (in thousands):