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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

For the fiscal year ended December 31, 2000

OR

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

For the transition period from ____________ to ____________ .

Commission file number 000-21949

PACIFICARE HEALTH SYSTEMS, INC.

3120 Lake Center Drive, Santa Ana, California 92704

(Registrant’s telephone number, including area code) (714) 825-5200

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

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

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

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of 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.  [   ]

Non-affiliates of the Registrant held approximately $964,800,000 of the aggregate market value of common stock on February 28, 2001.

There were approximately 33,500,000 shares of common stock outstanding on February 28, 2001.

PACIFICARE HEALTH SYSTEMS, INC.

INDEX TO ANNUAL REPORT ON FORM 10-K
For the Year Ended December 31, 2000

				Page
		PART I
Item 1.		Business			1
Item 2.		Properties			13
Item 3.		Legal Proceedings			14
Item 4.		Submission of Matters to a Vote of Security Holders			15
		PART II
Item 5.		Market for the Company’s Common Equity and Related Stockholder Matters			16
Item 6.		Selected Financial Data			17
Item 7.		Management’s Discussion and Analysis of Financial Condition and Results of Operations			19
Item 7A.		Quantitative and Qualitative Disclosures About Market Risk			33
Item 8.		Consolidated Financial Statements and Supplementary Data			34
Item 9.		Changes in and Disagreements with Accountants and Accounting and Financial Disclosure			34
		PART III
Item 10.		Directors and Executive Officers of the Registrant			35
Item 11.		Executive Compensation			39
Item 12.		Security Ownership of Certain Beneficial Owners and Management			47
Item 13.		Certain Relationships and Related Transactions			48
		PART IV
Item 14.		Exhibits, Financial Statement Schedules and Reports on Form 8-K			49

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PART I

ITEM 1. BUSINESS

Overview. Committed to making people’s lives healthier and more secure, PacifiCare Health Systems, Inc. is one of the nation’s largest health care services companies. Primary operations include managed care products for employer groups and Medicare beneficiaries in eight states and Guam, serving approximately four million members. We operate health maintenance organizations (“HMOs”) and offer HMO-related products and services. Our commercial and Medicare programs are designed to deliver quality health care and customer service to members cost-effectively. We also offer a variety of specialty HMO managed care and HMO-related products and services that employers can purchase to supplement our basic commercial plans, or as stand-alone products. Other specialty products include pharmacy benefit management, behavioral health services, life and health insurance and dental and vision services. We generally provide these specialty services to our members through subcontracts or referral relationships with physicians and hospitals.

Our single largest customer is the federal government. Sources of federal government revenues include revenues from Federal Employee Health Benefits Program (“FEHBP”) members as well as Medicare beneficiaries. Federal government revenues were $6.7 billion in 2000, $6.2 billion in 1999 and $5.9 billion in 1998.

Events During 2000. On February 1, 2000, we completed our acquisition of Harris Methodist Texas Health Plan, Inc. and Harris Methodist Health Insurance Company, Inc. (together, “Harris”), a health plan and insurance company in Texas, for an approximate purchase price of $122 million. This acquisition added approximately 250,000 commercial members and 50,000 Medicare members to our Texas HMO and was accounted for as a purchase. The related goodwill and acquired intangible assets are being amortized over periods ranging from three to 30 years. The operating results of these entities are included in our consolidated financial statements from the acquisition date. See Note 4 of the Notes to Consolidated Financial Statements.

We completed the exit of all HMO operations in Ohio. This exit affected approximately 35,000 commercial members and 3,500 Medicare members located in Ohio and Kentucky who were enrolled in our plans during 2000. See Note 4 of the Notes to Consolidated Financial Statements.

See Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations for additional business events.

BUSINESS OPERATIONS

Business Strategy

Our goal is to create long-term stockholder value by becoming a full service health care insurer and consumer services company, committed to making people’s lives healthier and more secure. To meet this goal, we plan to:

Take actions to strengthen our existing operations. We are focusing on implementing programs to strengthen our physician and hospital networks, and to reduce our medical care ratios and marketing, general and administrative expenses to improve our operating margins for our HMO business. We intend to:

•		Stabilize our medical care ratios through the pricing and design of our products and through our contracts with physicians and hospitals;
•		Continue to evaluate our product offerings and service areas to exit unprofitable Medicare or commercial markets, invest in expanding membership in profitable markets and make market-driven changes to product offerings;
•		Continue to market our Secure Horizons products to new members in Medicare markets in which we choose to remain;
•		Continue to manage aggressively our marketing, general and administrative expenses by reducing overall employee population, while investing in key capabilities such as underwriting and claims processing;
•		Continue to build key capabilities to operate in a risk-based environment, including our underwriting, medical management and claims processing systems;

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•		Outsource some functions in the information technology and medical management areas where we believe we can improve performance while reducing our costs; and

•

Continue to develop incentive programs to recruit, reward and retain key employees.

Expand the health insurance portfolio. Responding to the desires of consumers to have more choice and flexibility in health care coverage, we intend to evolve beyond our current HMO product lines to offer a broader array of health insurance products. We intend to:

•		Launch a broader Preferred Provider Organization (“PPO”) product on a stand-alone basis as the first step toward broadening into non-HMO products;

•		Launch other health care insurance products with a hybrid of managed care and PPO features, including Medicare Supplements and defined contribution plans;

•		Develop a program to sell Medicare Supplement products to disenrolling Medicare+Choice members to diversify our Medicare risk; and

•

Grow our pharmacy benefit management business, Prescription Solutions, by increasing sales of our services to third-party health plans, expanding our mail-order business and, if Congress approves a prescription drug benefit for the Medicare fee-for-service program, participating in that program.

Move beyond traditional health insurance. We believe that consumers want products and services that go beyond basic health insurance and extend to areas such as lifestyle, senior independent living and financial security. Over time, we plan to evolve into a health and consumer services company offering health insurance, lifestyle products, health technology services and other consumer products aimed at making people feel healthier and more secure. During 2001, we intend to assess and pilot potential product offerings.

Membership

Our commercial and Medicare membership at December 31, 2000 was as follows:

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Commercial Programs

General. Our commercial membership has grown from approximately 1.3 million members at December 31, 1995 to 3.1 million members at December 31, 2000. For the commercial employer market, we offer a range of products and benefit plan designs that vary in the amount of member copayments. These options allow employers flexibility in selecting cost-effective benefit packages for their employees. Our employer group and individual products include HMO, PPO, point-of-service (“POS”) and employer self-funded plans.

•		An HMO is a health care organization that combines aspects of a health care insurer with those of a health care provider by arranging for health care services for its members through a defined provider network at a reduced deductible or a nominal copayment.
•		A PPO is a selected group of providers, such as physician groups, that offers discounted fee-for-service health care.
•		POS plans combine the features of an HMO with the features of a traditional indemnity insurance product, allowing members to choose from a network of providers at a lower cost, or from physicians outside of the network at a higher deductible or copayment.
•		Under employer self-funded plans, we administer claims on behalf of employers, but do not assume the risk of these claims.

Specialty Products. In addition to our HMO operations, we provide a range of specialty managed care products that supplement our HMO products and are primarily sold with our commercial plans. These products include:

•		Pharmacy Benefit Management. RX Solutions, Inc., d.b.a. Prescription Solutions is one of the industry’s largest pharmacy benefit management companies. Prescription Solutions offers pharmacy benefit management services primarily to our HMOs and employer groups that are self-insured for prescription drugs. Prescription Solutions’ clients have access to a pharmacy provider network that features independent and chain pharmacies and a variety of cost and quality management capabilities. Prescription Solutions also provides its clients with an array of fully integrated services, including mail-order distribution, claims processing and sophisticated drug utilization reporting. Prescription Solutions launched its e-commerce initiative in 1999 as a means of improving member services and moving more medications to its mail-service operation. Our mail-order prescription volume has increased in excess of 100 percent over the last three years. To support the increased consumer demand, Prescription Solutions opened a new 84,000 square foot facility in Carlsbad, California in August 2000. Nearly four times larger than our current facility in Mira Mesa, California, the Carlsbad facility is able to fill nearly three times as many prescriptions as the Mira Mesa facility. With the addition of this new facility, we believe Prescription Solutions can aggressively promote mail-service and pursue new business opportunities such as offering over-the-counter medications.
•		Behavioral Health Services. PacifiCare Behavioral Health of California, Inc. is a California-licensed specialized health care service plan that provides behavioral health care services, including chemical dependency benefit programs, primarily to our California and other HMO commercial members. Outside of California, PacifiCare Behavioral Health, Inc. contracts with our HMOs and employers to manage their respective mental health and chemical dependency benefit programs.
•		Life and Health Insurance. We are licensed through our subsidiaries, PacifiCare Life and Health Insurance Company and PacifiCare Life Assurance Company, to issue life and health care insurance in 38 states, including each of the states where our HMOs operate, the District of Columbia and Guam. When our sales and marketing representatives promote our HMO commercial product line, they offer managed health care insurance products to employer groups at the same time. This allows us to form multi-option health benefits programs, including our PPO and POS plans. In addition, other supplementary insurance products offered to employer groups include group term life, indemnity dental and indemnity behavioral health benefits.
•		Dental and Vision Services. PacifiCare Dental, a California licensed HMO dental plan, PacifiCare Dental of Colorado, Inc., a Colorado licensed HMO dental plan, and a third-party administrator of indemnity and PPO dental and vision plans, provide HMO, PPO and fee-for-service dental and PPO vision benefits directly to individuals and employer groups and indirectly to seniors through Secure Horizons. In 2000, we offered these products in five states: California, Colorado, Nevada, Oregon and Washington.

Premiums. When pricing our commercial programs, we use underwriting criteria as an integral part of our commercial risk management efforts. Underwriting is the process by which a health plan assesses the risk of enrolling employer groups (or

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individuals) and establishes appropriate or necessary premium rates. The setting of premium rates directly affects a health plan’s profitability and marketing success. See “Health Care Costs and Physician and Hospital Relationships.”

Marketing. Commercial marketing is a two-step process in which we first market to employer groups, then provide information directly to employees once the employer has selected our plan. We use various techniques to attract commercial members, including work site presentations, direct mail, medical group tours and local advertising. We also use television, radio, billboard and print media to market our programs. Insurance brokers and consultants represent many employer groups under contract with us. These brokers and consultants work directly with employers to recommend or design employee benefits packages. We pay insurance brokers commissions over the life of the contract, while employers generally pay consultants directly. Our commercial membership growth is a result of in-market acquisitions as well as greater penetration in existing employer groups. With each open enrollment, we identify a specific approach for each employer group with the objective of increasing the number of members from each employer to increase our penetration.

Federal Employees. Our HMOs also have commercial contracts with the United States Office of Personnel Management (“OPM”) to provide managed health care services to approximately 173,000 members under the FEHBP for federal employees, annuitants and their dependents. See “Government Regulation and Proposed Legislation — OPM” and Note 10 of the Notes to Consolidated Financial Statements.

Retiree Product. In response to the needs of employers to provide cost-effective health care coverage to their retired employees who may or may not be currently entitled to Medicare, we offer the commercial retiree product. This product draws on our Medicare expertise by offering physician and hospital networks that are similar to those offered to our Secure Horizons enrollees. We set our premiums generally based on the same revenue requirements needed to provide services to Secure Horizons members. The retiree product gives us access to individuals who, once familiar with our services and delivery system, may enroll in Secure Horizons when they become eligible for Medicare benefits.

Small Group and Individual. An employer with 50 or fewer employees is considered a small group. We now consider small groups as unique markets managed independently within each of our regions. Since September 1999, we have established agreements with several e-commerce distribution partners, making our small group and individual products accessible from hundreds of sites on the Internet to provide free health insurance quotes. We began by offering individual health products at InsWeb in California, and have since expanded to individual and small group offerings in our other states. In February 2000, we announced the launch of our Premier plans in California, a new line of small group products sold through the Internet. This product’s pricing reflects the reduced distribution costs of doing business online. The Premier plans are currently available to our California customers through electronic brokers via online insurance channels, our website (www.pacificare.com) and through traditional insurance brokers.

Secure Horizons Program

General. For Medicare beneficiaries, we offer access to health care services through our Secure Horizons program. The Secure Horizons program is the largest Medicare+Choice program in the United States (as measured by membership). Secure Horizons membership has grown from approximately 0.6 million members at December 31, 1995 to approximately 1.1 million members at December 31, 2000.

Premiums. As a general rule, our Medicare+Choice contracts entitle us to per-member per-month payments on behalf of each enrolled Medicare beneficiary. In addition, we, and all participants in the Medicare+Choice program, are subject to periodic adjustments to premiums based upon retroactive changes in members’ status, such as Medicaid eligibility and risk adjustments. These periodic adjustments can be positive or negative. Effective January 1, 2000, our payments from the Health Care Financing Administration (“HCFA”) were adjusted for each individual based upon demographic factors including the age, gender, county of residence and Medicaid status, as well as certain health status information relating to each enrollee. Under the provisions of HCFA’s risk adjusted methodology, plans with enrollees who were hospitalized for more than one day in the previous year for select disease conditions, including certain cancers, cardiovascular problems, diabetes, and neurological disorders are paid more than for enrollees without these conditions. These higher payments are determined from data that we, and all other Medicare+Choice contracting organizations, are required to submit to HCFA. The current risk adjuster, which is used to calculate 10 percent of the plan’s payment, will continue to be used through 2003. Beginning in 2004, the risk adjuster will be based on both inpatient hospitalization and ambulatory data. The risk adjuster will continue to be modified according to the phase-in schedule, and is expected to be at 100 percent by 2007. See “Government Regulation and Proposed Legislation — HCFA” and “Government Regulation and Proposed Legislation — Adjusted Community Rate Filings.”

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Our Medicare+Choice contracts are renewed every 12 months unless HCFA or the Medicare+Choice plan elects to terminate or not to renew the contract. HCFA may also terminate Medicare+Choice contracts if a plan fails to meet specified compliance standards. Termination of our Medicare+Choice contracts would have a material effect on our financial position, results of operations or cash flows of a future period. Under our Medicare+Choice contracts, we also have the ability to close enrollment to new members with limited exceptions through either a formal capacity limit or a voluntary closure. In general, closing enrollment requires a 30 day advance public notice.

Marketing. We market our Secure Horizons programs to Medicare beneficiaries primarily through direct mail, telemarketing, our website, television, radio and community based events with participating physician groups. Most Secure Horizons members enroll directly in a plan, generally without the involvement of insurance brokers, except when enrolling as part of an employer group retiree offering.

Health Care Costs and Physician and Hospital Relationships

General. The cost of prescription drugs and health care services has been rising over the past few years and we expect this trend to continue for the foreseeable future, leading to an increase in premiums. The reasons for these increases have been numerous, including:

•		An aging population that has greater medical needs;
•		The availability of more costly diagnostic and therapeutic procedures;
•		New laws and regulations specifying covered services;
•		Increased prices for medications and the introduction of more expensive medications;
•		Growth in the number of hospitals and medical specialists under non-capitated contracts;
•		Increased utilization of services;
•		Defensive medical practices due to physicians’ fear of lawsuits;
•		Significant investments by pharmaceutical companies in advertising campaigns for branded drugs, in turn driving consumer demand for these drugs;
•		Increased instability in hospital and specialty networks, contributing to increased medical costs. Many hospitals have merged with larger hospital systems resulting in increased contract negotiating leverage with HMOs; and
•		Consumer demand for easy access to and choice of physicians and hospitals, low out-of-pocket costs and coverage of lifestyle prescription drugs.

Contracting Arrangements with Physicians and Hospitals. We use contracting processes that include analysis and modeling of underlying cost and utilization assumptions. Through these processes, we expect to identify strategies to better manage health care costs. We provide incentives to the physician or medical groups for improving the quality of care, as well as to encourage appropriate utilization of hospital inpatient, outpatient surgery and emergency room services. We believe improved business consultation and management tools, including more thorough data reporting and financial analysis of expected performance of our contracts, will enable us to create more financially successful physician and hospital networks. We primarily focus on securing cost-effective physician, hospital and other health care provider contracts to maintain a qualified network of providers in each geographic area we serve, as well as improving the medical management of health services to achieve both better quality and cost-effective care. Many of our physician and hospital contracts have one-year terms. However, we also have a number of multiple-year contracts with physician groups and hospitals to ensure the quality and stability of our network.

•

Capitation Arrangements. Traditionally, we have contracted with physician organizations as well as many hospitals and ancillary providers on a prepaid, capitated fixed-fee per-member per-month basis, regardless of the services provided to each member. Capitation payments to physicians and hospitals may be based on a percentage of the premium we receive, which is especially true for our Secure Horizons contracts, or a fixed per-member per-month amount that is adjusted to reflect membership age, sex and benefit variation. Under our capitated contracts, medical groups may assume administration functions, including physician

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management and claims processing, to support management of health care services. We continue to believe that delegation of agreed upon functions empowers our physicians and hospitals to provide quality service and care.

		Provider Delegated Administration. Most of our capitated physician and hospital networks have qualified through our assessment processes to perform some or all of the administrative functions associated with operating in a capitated environment, such as paying claims and providing medical management. In those situations, we provide support for their administrative functions to help them achieve greater levels of efficiency. Moreover, we only delegate medical management duties to physicians and hospitals with demonstrated and consistent acceptable performance of these functions.
		HMO Direct Administration. We perform all the direct management functions, such as claims payment and medical management, mainly on behalf of physician networks that do not have the capability to manage the administrative functions associated with operating in a capitated environment. In addition, we work with those physicians to assist them in developing the capability to assume a greater share of the administrative functions. We continue to develop our own expertise in this area to ensure that we can continue to build strong networks for our members in both existing and new markets where physicians may not be capable of performing these functions.

•		Risk-based Arrangements. We share the risk of health care costs with parties not covered by capitation arrangements. Under the majority of our risk-based arrangements, the physician group is capitated for physician services only. Therefore, our risk-based contracts generally include budgeted amounts for hospital inpatient, outpatient surgery, and emergency room service utilization. In some cases, if member utilization for hospital services exceeds the agreed upon budgeted amount, we share these excess costs with the physician group based on provisions specified in the contract. Depending on how the contract is arranged, health care costs may be apportioned between two or more entities. For example, we may share excess hospital costs with the physician group only or with both the physician group and the hospital provider.
•		Fee-for-Service Arrangements (including Directly Contracted Network Model). We contract with other hospitals and ancillary providers, as well as some individual physicians or physician organizations, to provide services to our members based on modified discounted fee schedules (such as the Medicare fee schedule) for the services provided. Where the provider community is not organized around aggregate physician groups or if it requires more extensive medical management and/or administrative services, we contract with physicians through our directly contracted network model. This model allows individual physicians to serve our members through a program that generally compensates physicians on a discounted fee-for-service basis and incorporates some elements of risk-sharing through the development and adherence to agreed-upon budgets. Under these arrangements, we perform all administrative functions required for effective management of quality, medical costs and claims payment.

The trend away from capitated contracts to risk-based and fee-for-service agreements continues, especially for hospital services. The percentages of membership by contract type at December 31, 2000 and 1999 were as follows:

Physician and Hospital Contracting Risk. Our profitability depends, in part, on our ability to control health care costs while providing quality care. As we shift from our capitation model to a risk-based environment, we face the risk that we will not be able to control our health care costs to the same degree as was possible under fully capitated contracts. The following are risks associated with our physician and hospital contracting arrangements:

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•		Insolvency Risk. Under capitated arrangements, we face the risk of a physician group or physician association becoming insolvent. Depending on state law, we may be held liable for unpaid health care claims that were previously the responsibility of the capitated physician and for which we have already paid capitation. To reduce this insolvency risk, we have developed contingency plans that include shifting members to other physicians and reviewing operational and financial plans to monitor and maximize financial and network stability. Some of our physicians require more frequent monitoring. We may incur additional health care costs in the event of physician instability where we are unable to reach an agreement that is mutually beneficial. These costs may be incurred when we need to contract with other physicians at less than cost-effective rates to continue providing health care to our members.
•		Utilization Risk. Under fee-for-service and risk-based contracts, we risk incurring higher than expected health care costs due to increased utilization of hospital and physician services. To reduce the risk of higher than medically warranted utilization, we are focused on developing medical management programs to manage health care costs and investing in the development of systems to monitor and manage the utilization of health care services, while maintaining quality of care.

Medical Management. In efforts to reduce the financial risk associated with risk-based and fee-for-service arrangements, we are focusing on enhancing our internal medical management programs. Our medical management staff consists of doctors and nurses who monitor the medical treatment of our members in need of hospital care. In some cases, our medical managers are located on-site for some of our key hospitals.

Our medical management programs are composed of:

•		a precertification of admission process;
•		a concurrent review process; and
•		a retrospective review.

In the precertification stage, our medical managers are responsible for determining that requests for hospitalization and specified health care procedures meet specific clinical criteria and are approved in advance. Our concurrent review process begins once our member has been admitted to the hospital for care with our medical managers responsible for providing administrative oversight of the hospital process. The medical manager is also responsible for monitoring the discharge process, and coordinating any outpatient services needed by the patient, including skilled nursing facility, home nursing care and rehabilitation therapy.

Finally, our retrospective review process occurs when our medical management staff is not directly involved in the hospitalization of our members. This can occur when our members receive emergency care at an out-of-area hospital.

With our increased number of risk-based and fee-for-service arrangements, we have an increased need for medical management. To meet this need, we plan to increase medical management staffing by 20 percent to more than 800 full-time employees in 2001.

A small number of our members with chronic diseases continue to drive a significant portion of our health care costs. Our emphasis on disease management focuses on member education and prevention to improve our members’ health and reduce costs. Our analysis has shown that five percent of seniors consume more than 50 percent of health care expenses within a year and four diseases account for 90 percent of the costs within that subset. As a result, we are developing programs in coronary artery disease, congestive heart failure, chronic obstructive pulmonary disease and end stage renal disease to better address the health needs of those patients. We are also entering into contracts with outside parties to assist us with our disease management programs.

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Health Care Quality

General. We are convinced that providing our members access to continually improved health care services leads to improved health for our members. To assure this, we focus on physician peer review procedures, physician and hospital quality reviews, member quality initiatives and national industry measures.

Physician Peer Review Procedures. We have established a comprehensive peer review procedure at each HMO, governed by a quality improvement committee. The medical director for each HMO chairs that HMO’s committee. Each committee consists of health plan clinical professionals and physician representatives from the contracted physician groups. All physicians are initially credentialed and approved by that HMO’s quality improvement committee. The quality assessment includes evaluating the performance of that physician, as well as the quality of the providers’ medical facilities, medical records, laboratory and x-ray licenses and their capacity to handle membership demands.

Physician and Hospital Quality Reviews. We also engage in ongoing quality reviews of our existing physicians and hospitals to ensure that members are receiving quality medical care. A highlight of our physician and hospital management program is our provider profile, which is a comprehensive, quarterly risk-adjusted report card of over 80 measures, which helps physicians and hospitals manage their performance in the areas of clinical quality, utilization management, service quality and administrative efficiency. In addition, the provider profile serves as the data source for the Quality Index, which is a public report on our contracting medical groups’ performance in the areas of clinical, service and administrative data quality. This report provides consumers with information to help them become more active participants in their health care, beginning with their selection of health care providers. In addition, the Quality Index has statistically proven to significantly improve performance and consistency in virtually all indicators that have been continually measured. Our member information materials highlight best performing physician groups, so that members have credible and relevant information by which to select physicians.

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

•		Implementing comprehensive health management programs in diabetes, congestive heart failure, cardiovascular risk reduction and depression, aimed at improving health outcomes;
•		Conducting preventive health programs, cancer screening, smoking cessation, and senior health risk assessments;
•		Offering independent external review programs to members in which members can have a service or treatment denial of coverage decision reviewed by a physician or panel of physicians outside their health plan;
•		Decreasing inappropriate denials and improving the appeals process for our members;
•		Standardizing and streamlining our specialty provider referral process;
•		Utilizing our “JustOne/Ready Reply” approach in California, Oklahoma and Texas, which is designed to resolve members’ issues and answer questions with a single phone call by the member. We handle all necessary contact between the plan, physicians, hospitals and medical groups through the final resolution of the issue, and then report the outcome to the member;
•		Participating in the Coalition for Affordable Quality Health Care’s voluntary quality initiative. Along with 21 other organizations, we have committed to enabling consumers to have access to quality coverage and information; improving administrative simplicity for doctors and consumers; and working with doctors to improve overall health care quality and patient safety;
•		Monitoring member satisfaction through surveys and internal operational report cards compared to our current established benchmarks; and
•		Providing members free access to in-depth health information on thousands of topics via the Internet at www.pacificare.com.

National Industry Measures. The National Committee for Quality Assurance (“NCQA”) is an independent, non-profit organization that reviews and accredits HMOs. Our HMOs provide quality and service information under NCQA’s Health Plan Employer Data Information Set program. NCQA also performs site reviews to determine if an HMO complies with standards it has established for

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quality improvement, utilization management, physician and hospital credentialing and a commitment to members’ rights and preventive health services. HMOs that comply with NCQA’s review requirements and quality standards receive NCQA accreditation. We have improved our NCQA scores by implementing our membership and physician and hospital quality programs. At December 31, 2000, our HMOs in Arizona, California, Colorado, Nevada, Oklahoma, Oregon, Texas and Washington (covering approximately 98 percent of our membership) have received either “commendable” or “excellent” three-year NCQA accreditation.

Risk Management

We shift part of our risk of catastrophic losses by maintaining reinsurance coverage for specified hospital costs incurred in the treatment of catastrophic illnesses. We require contracting physicians, physician groups and hospitals to maintain individual malpractice insurance coverage. We also maintain general liability, property, managed care errors and omissions and medical malpractice insurance coverage in amounts that we believe to be adequate.

Government Regulation and Proposed Legislation

General. Our HMOs are subject to extensive federal and state regulations that govern the scope of benefits provided to our members, financial solvency requirements, claims processing, quality assurance and utilization review procedures, member grievance procedures, physician and hospital contracts, marketing and advertising. Our HMOs are also required to maintain restricted cash reserves represented by interest-bearing investments that are held by trustees or state regulatory agencies. These requirements, which limit the ability of our subsidiaries to transfer funds, may also limit their ability to pay dividends. From time to time, we advance funds to our subsidiaries to assist them in satisfying federal or state financial requirements. Our behavioral health, insurance and dental subsidiaries are also subject to extensive federal and state regulation.

HCFA. Our Secure Horizons program is subject to regulations by HCFA, the United States Department of Health and Human Services and state regulatory entities. These agencies govern the benefits provided, premiums paid, quality assurance procedures, marketing and advertising for our Medicare+Choice products. See “Business Operations — Secure Horizons Program.” Congress enacted the Balanced Budget Act of 1997 (“BBA”), which required the creation of the Medicare+Choice program as a replacement to the Medicare Risk program. HCFA has since promulgated regulations, operational policy letters and contracts implementing Medicare+Choice, including the Balanced Budget Refinement Act of 1999 and the Benefits Improvement and Protection Act of 2000 (“BIPA”). These contracts and regulations established new and expanded requirements for Medicare+Choice organizations. They also establish new or expanded standards for quality assurance, beneficiary protection, coordinated open enrollment, program payment and audits, information disclosure and physician and hospital participation. Compliance with Medicare+Choice regulations has and will continue to increase our Medicare administration costs. BIPA was passed by Congress in December 2000, effective for 2001. Under the new law, Medicare+Choice will receive increased government funding over the next five years beginning in March 2001. The changes for 2001 include increases to the monthly minimum payment floors, increases in the minimum annual payment update from two percent to three percent and modifications to the risk adjuster. See “Secure Horizons Program — Premiums.”

It is possible that future legislation may create additional changes in the payment formula or risk adjuster. However, it is not certain that efforts to revise the laws governing the Medicare+Choice program will succeed. The loss of Medicare contracts or changes in the program could have a material effect on our financial position, results of operations or cash flows of a future period.

Adjusted Community Rate Filings. As a result of the Balanced Budget Act of 1997 and related HCFA rules and regulations, our HMO subsidiaries are required to submit separate adjusted community rate (“ACR”) proposals for every Medicare+Choice plan they offer to Medicare beneficiaries. These rates are based upon our average commercial rate (for non-Medicare enrollees) modified by a factor that represents the difference in utilization characteristics between Medicare and non-Medicare enrollees within each geographic area. In effect, our benefits structure for Secure Horizons is established based on these rates.

Each of our subsidiaries must submit the ACR proposals, generally by county or service area, to HCFA by July 1 for each Medicare+Choice plan offered in the subsequent year. In the normal course of business, all information submitted as part of the ACR process is subject to audit by HCFA or any person or organization designated by HCFA. Our ACR proposal is based on historical data and information available to us at the time of the filing. Potential changes to physician and hospital contracts and market and/or competitive conditions may cause actual results to vary from the projections submitted. In January 2000, HCFA contracted with the Office of Inspector General of the United States Department of Health and Human Services to conduct more comprehensive audits on one-third of all ACR filings as mandated by law. During 2000, audits were conducted in Colorado, Nevada and Texas. No violations were noted as a result of the audits. In addition to the regular ACR proposals submitted in 2000, Medicare+Choice plans were required to re-submit ACR proposals in January 2001 in accordance with BIPA. In our ACR resubmission, BIPA required that we

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use increased funding to do one or a combination of the following: to reduce member premiums or cost sharing; to enhance benefits; to contribute to a benefits stabilization fund; or to stabilize or enhance beneficiary access to physicians and hospitals (so long as such action does not result in increased beneficiary premiums, cost-sharing, or reduced benefits). Our January 2001 ACR submission has been filed in accordance with BIPA and accompanying ACR instructions, and has been accepted by HCFA.

Employee Retirement Income Security Act of 1974 (“ERISA”). Pursuant to ERISA, the federal government regulates insured and self-insured health coverage plans offered by employers. There have been recent highly publicized legislative attempts to amend ERISA to remove the current limitation on the ability of states to regulate employer health plans and the limitations on an employee’s ability to sue a health plan under state law. If such proposals were enacted, states may have the ability to regulate other aspects of our business operations, and increase our exposure to state law claims that relate to employee health benefits. If such proposals were enacted, the federal government may propose rules on claims payment and appeals processes which accomplish the intent of the proposed Patient Bill of Rights. Additionally, if such proposals were enacted, they may result in increased operating costs.

Health Insurance Portability and Accountability Act of 1996 (“HIPAA”). HIPAA’ s federal standards apply to both the group and individual health insurance markets. HIPAA requires us to:

•		Guarantee the availability and renewability of health insurance for certain employers, employees and individuals;
•		Limit the use of preexisting condition exclusions;
•		Disclose prior coverage; and
•		Make it easier for members to continue coverage in cases where an employee is terminated or changes employers.

HIPAA also prohibits us from discriminating against potential enrollees on the basis of health status. HIPAA includes administrative simplification provisions directed at standardizing transactions and codes, establishing uniform health care provider, payor, employer and patient identifiers and seeking protections for confidentiality and security of patient data. Publication of the HIPAA proposed and final rules has occurred in phases. The first set of final rules, which focus on data standards and code sets, were published in August 2000. Given the 26-month implementation window (from final rule publication date), compliance is required for the data standards and code sets by October 2002. We have reviewed our systems and processes for compliance with the data standard requirements, and are planning 2001 activities to implement the new data requirements. We are also working with various groups to find a common way to work with external business associates, such as physicians and hospitals, to ensure their compliance with the HIPAA rules. We estimate that our HIPAA compliance costs will approximate $20 million in 2001. Our estimate of HIPAA compliance costs may change as current HIPAA rules evolve and additional rules are released or as we continue to evaluate the work required to modify our existing information technology and development systems.

Both federal and state regulators have enforcement responsibilities for HIPAA. As a result, we may encounter different interpretations of HIPAA’s provisions in the different states, as well as varying enforcement philosophies in states where we operate HMOs. These differences may inhibit our ability to standardize our products and services across state lines. Ultimately, under HIPAA and other state laws, cost control through physician and hospital contracting and coordinating care may become more important, and we believe our experience in these areas will allow us to compete effectively.

OPM. We have commercial contracts with OPM to provide managed health care services to federal employees, annuitants and their dependents under the FEHBP. Rather than negotiating rates with us, OPM requires us to provide the FEHBP with rates comparable to the rates charged to the two employer groups with enrollment closest in size to the FEHBP in the applicable community after making required adjustments. OPM further requires us to certify each year that its rates meet these requirements.

Periodically, OPM’s Office of Inspector General (“OIG”) audits us to verify that the premiums charged are calculated and charged in compliance with these regulations and guidelines. Each audit encompasses a period of up to six years. Following the government’s initial on-site audit, OPM will provide us with a post-audit briefing indicating its preliminary results. Interpretations of the rating regulations and audit findings often raise complex issues. The final resolution and settlement of audits have historically taken more than three years and as many as seven years. We have a number of pending audits that we are seeking to resolve with the United States Department of Justice (“DOJ”).

During the audit process, OPM may refer its findings to the DOJ if it believes that we knowingly overcharged the government or otherwise submitted false documentation or certifications in violation of the False Claims Act. Under the False Claims Act, an action

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can be considered knowingly committed if the government contractor acted with actual knowledge, or with reckless disregard or deliberate ignorance of the government’s rules and regulations. If the government were to win a False Claims Act lawsuit against us, the government could obtain trebled damages, a civil penalty of not less than $5,000 nor more than $10,000 for each separate alleged false claim, and the government could permanently disqualify us from participating in all federal government programs.

In late 1997, we established a formal compliance program to specifically address potential issues that may arise from the FEHBP rating process, to work with OPM to understand its interpretation of the rules and guidelines prior to completion of the rating process, to standardize the FEHBP rating process among all of our HMOs, and to help reduce the likelihood that future government audits will result in any significant findings. Based on the results of a limited number of audits that have been conducted for contract years 1998 and later, we believe that this program has been effective. See Item 3. Legal Proceedings — OPM Litigation and Note 10 of the Notes to Consolidated Financial Statements for a further discussion of OPM matters referred to the DOJ.

Management Information Systems

General. We use computer-based management information systems for various purposes, including e-commerce, marketing and sales tracking, underwriting, billing, claims processing, medical management, medical cost and utilization trending, financial and management accounting, reporting, planning and analysis. These systems also support member, employer group and physician and hospital service functions, including on-line access to membership verification, claims and referral status and information regarding hospital admissions and lengths of stay. In addition, these systems support our tracking and extensive analyses of cost and outcome data.

We continually enhance and upgrade our computer information systems to preserve our investment in existing systems, embrace new technologies, improve the cost effectiveness and quality of our services, introduce new products, and continue to meet legal and regulatory requirements. Ongoing system investments include upgrading system platforms, enhancing existing software, implementing purchased software, migrating to more suitable software database environments and making other investments required to make our systems comply with HIPAA. Simplification, integration and expansion of the systems servicing our business are important components of controlling health care and administrative expenses and improving member and physician and hospital satisfaction. We selectively outsource some technical functions and employ third-party data collection agencies for electronic data interfaces (“EDI”) to receive claims electronically. We have recovery plans in place to mitigate the effect of information systems outages, if necessary. To the extent that these systems fail to operate, however, it could have a material effect on results of operations or cash flows of a future period.

Claims Processing Systems. We use computer based information systems as an important component of claims processing. We receive medical claims from physicians and hospitals for services to our members. Claims are reviewed to determine member eligibility, the quantity and kind of services performed and whether services were authorized. To ensure accuracy, we regularly review reports on inventory levels and claims statistics that focus on claims turn-around and accuracy of payment.

Under our capitated contracts, most of our physicians and hospitals have qualified through our assessment processes to perform administration functions, including claims processing. Under our risk-based contracts, we perform administrative functions, including claims processing. Due to the trend away from capitated contracts to risk-based and fee-for-service arrangements, we have increasing financial and regulatory risk for the accurate and timely processing of claims.

The California Department of Managed Health Care issued a censure against us for late payment of claims to physicians and hospitals. In March of 2001, we reached a settlement with the Department of Managed Health Care, whereby related interest and penalties will not exceed $3 million. We expect to complete payment for the claims and interest by the end of March 2001, bringing us in full compliance. The late payments were caused by the rapid shift from capitation contracts to risk-based and fee-for-service arrangements. Because of the shift, we experienced a dramatic increase in claims volume in California. We have taken steps to correct the situation.

As part of our efforts, we upgraded our claims processing software and enhanced our EDI submission and batch processing capabilities. To further reduce our financial and regulatory risk associated with the accurate and timely processing of claims, we intend to:

•		Eliminate retroactive provider contracts to better manage our costs and claims volume fluctuations;
•		Streamline medical management practices to improve administration;

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•		Increase claims processing staff to support the higher level of claims volume associated with risk-based arrangements; and
•		When necessary, consider using third-party administrators to leverage our existing claims processing capabilities.

Competition

In general, the health care industry has experienced significant consolidation. Acute care hospitals have consolidated, increasing their leverage in the market place. Continued consolidation of insurance carriers, other HMOs, employer self-funded programs and PPOs, some of which have substantially larger enrollments or greater financial resources than ours, have created competition for physicians, hospitals and members, impacting profitability and the ability to influence medical management. Pharmacy benefit management companies have continued to consolidate, competing with the pharmacy cost management capability of our wholly owned subsidiary, Prescription Solutions.

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

We have the highest Medicare membership in the nation, both in absolute terms and as a percentage of overall membership, offering competitive advantages and economies of scale in the Medicare+Choice market. Many health plans have exited the Medicare HMO market due to changes in federal law that reduced Medicare reimbursement rates. While we have benefited in certain regions from our competitors’ market exits, the long-term impact of reduced federal funding on enrollment trends in Medicare+Choice HMO programs is uncertain.

Other competitors include hospitals, health care facilities and other health care providers. These competitors have combined to form their own networks to contract directly with employer groups, and other prospective customers for the delivery of health care services.

Our pharmacy benefit management company, Prescription Solutions, is an integral part of our commercial and Medicare products; however, Prescription Solutions is also sold as a stand-alone product supporting members of other health plans and employer groups. Competitors include Merck-Medco Managed Care, WellPoint Pharmacy Management, Med Impact, Express Scripts and Advance PCS. We believe, when aligned with an HMO, Prescription Solutions differentiates itself from other pharmacy benefit organizations by managing prescription costs and outcomes for the HMO members. Our mail-order prescription drug service competes with national, regional and local pharmacies and other mail-order prescription drug companies.

PacifiCare Behavioral Health of California, Inc. and PacifiCare Behavioral Health, Inc. serve our HMO members in California, Colorado, Oklahoma, Oregon, Texas and Washington, as well as non-PacifiCare HMO members in Arizona and New Mexico. California is among many states that have adopted parity legislation, requiring employers to offer equal coverage for mental health benefits, which we believe enhances our behavioral health business’ future growth potential. Competitors may include other behavioral health plans and employers that move to self-insurance.

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

•		Our significant existing market position in our geographic areas of operation;
•		Our long-term operating experience in managed care;
•		Our generally favorable marketplace reputation with physicians, hospitals, members and employers;
•		A strong brand identity for Secure Horizons;
•		Our emphasis on providing high quality customer service; and

•

Our continual improvement of the quality of care provided to our members.

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Trademarks

We own the federally registered service marks PacifiCare®, SecureHorizons® and Prescription Solutions®. These service marks are material to our business.

Employees

At February 28, 2001, we had approximately 9,200 full and part-time employees. None of our employees are presently covered by a collective bargaining agreement. We consider relations with our employees to be good and have never experienced any work stoppage.

ITEM 2. PROPERTIES

As of December 31, 2000, we leased approximately 178,000 aggregate square feet of space for its principal corporate headquarters and executive offices in Costa Mesa and Santa Ana, California. In connection with our operations, as of December 31, 2000, we leased approximately 1.9 million aggregate square feet for office space, subsidiary operations, customer service centers and space for computer facilities. Such space corresponds to areas in which our HMOs or specialty managed care products and services operate, or where we have satellite administrative offices. Our leases expire at various dates from 2001 through 2010.

We own seven buildings encompassing approximately 367,000 aggregate square feet of space. Two of the buildings, representing approximately 225,000 aggregate square feet of space, are primarily used for administrative operations and are located in California and Guam. The remaining five buildings are medical office buildings, of which four are leased to third parties under a master lease agreement. All five medical buildings are being marketed for sale. We also own one parcel of vacant land for a total of two acres, which is being marketed for sale.

Our facilities are in good working condition, are well maintained and are adequate for our present and currently anticipated needs. We believe that we can rent additional space at competitive rates when current leases expire, or if we need additional space.

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ITEM 3. LEGAL PROCEEDINGS

OPM Litigation. We have contracts that were audited by the OIG, that we acquired through our merger with FHP International Corporation (“FHP”) in 1997. The OIG is alleging that the former FHP Arizona, California, Colorado, Guam and Ohio HMO subsidiaries as well as former FHP Illinois, New Mexico and Utah HMO subsidiaries that we sold in 1997 and 1998, overcharged the government from 1990 through 1997. Several of these contract years have already been audited, but are yet to be settled. We responded to the audit reports, challenging many of the auditors’ assertions. OIG’s allegations were referred to the DOJ for review of potential claims under the False Claims Act. We do not believe there is any evidence that we engaged in any action that would violate the False Claims Act.

The OIG conducted an audit of our Oregon HMO subsidiary. The OIG issued a draft audit report in July 1997, alleging that we overcharged the government for contract years 1991 through 1996. We responded to this draft audit report in April 1998, strongly disagreeing with OIG’s claims. In March 2000, we were notified that the auditors had referred the above-mentioned audit report to the DOJ for review of potential claims under the False Claims Act. We do not believe there is any evidence that we engaged in any action that would violate the False Claims Act. When our legal counsel met with the U.S. Attorney in May 2000, the U.S. Attorney stated that a letter would be sent specifying additional information that was needed. No letter has been received to date. The DOJ has until June 1, 2001 to decide whether to file a claim.

The OIG conducted an audit of our California HMO subsidiary. The OIG issued a draft audit report in January 1998, alleging that we overcharged the government for contract years 1993 through 1996. We responded to this draft audit report in May 1998, strongly disagreeing with OIG’s claims. In January 2001, we were notified that the auditors had referred the above-mentioned audit report to the DOJ for review of potential claims under the False Claims Act. We do not believe there is any evidence that we engaged in any action that would violate the False Claims Act.

We intend to continue to negotiate with OPM on any existing or future unresolved matters to attain a mutually satisfactorily result. We cannot be certain that any ongoing future negotiations will be concluded satisfactorily, that additional audits will not be referred to the DOJ or that additional, possibly material, liabilities will not be incurred. Such liability could have a material effect on our results of operations or cash flows of a future period if resolved unfavorably.

Class Action Legal Proceedings. On November 21, 2000, Michael Russ filed a purported class action complaint against PacifiCare and several of our present and former directors and executive officers in the Central District of California. At least four other complaints have been filed against PacifiCare and several present and former directors and executive officers in the same court. Each of these complaints relates to the same subject matter and will likely be consolidated. The complaints relate to the period between October 27, 1999 and October 10, 2000. The complaints primarily allege that we made false projections about our financial performance in 2000. We deny all material allegations and intend to defend the actions vigorously.

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

On November 22, 1999, Debbie Hitsman filed a purported class action complaint against PacifiCare in the United States District Court for the Southern District of Mississippi, Hattiesburg Division. The complaint relates to the period from November 22, 1995 to the present and purports to be on behalf of all enrollees in our health care plans other than Medicare and Medicaid enrollees. The complaint alleges causes of action for violations of the Racketeer-Influenced and Corrupt Organizations Act and ERISA. The complaint seeks an unspecified amount of compensatory and treble damages, injunctive and restitutionary relief, attorneys’ fees, the imposition of a constructive trust and interest. On June 23, 2000, Hitsman filed and served an additional complaint in the United States District Court for the Southern District of Miami as a purported part of a multi-district litigation proceeding against another managed care company, Humana. Subsequently, Dr. Dennis Breen and other doctors joined the Florida proceeding making

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allegations similar to those from other providers. These providers, including the California Medical Association, accuse us of imposing unfair contract terms, unnecessarily denying health care for our members, delaying payments for authorized health care and reimbursing physicians at rates that are not sufficient to cover the physician’s cost of providing the health care.

In October 2000, the multi-district litigation panel consolidated the Hitsman cases, the Breen case, the California Medical Association case and certain provider cases in the Southern District of Florida. In December 2000, the court granted our motion to compel arbitration of all of the Hitsman claims and all of Dr. Breen’s claims except for his claims for violations of the Racketeer-Influenced and Corrupt Organizations Act and conspiracy and aiding and abetting claims that stem from contractual relationships with other managed care companies. We have appealed the denial of the arbitration of these claims. Our motion to dismiss the Breen claims was granted, with permission to amend. An amended complaint is anticipated. We deny all material allegations and intend to defend the actions vigorously.

In 1997, William Madruga and another individual filed a purported class action suit against PacifiCare and several of our directors and officers in the United States District Court for the Central District of California. The complaint relates to the period from the date of proxy statement for the FHP acquisition through our November 1997 announcement that earnings for the fourth quarter of 1997 would be lower than expected. The complaint primarily alleges that we previously omitted and/or misrepresented material facts with respect to our costs, earnings and profits. In November 1999, May 2000 and again in January 2001, the court dismissed the Madruga case in part without permission to amend and in part with permission to amend the complaint. The plaintiffs filed a fourth amended complaint in March 2001. We deny all material allegations and intend to defend the actions vigorously.

Industry Litigation. In 2000, Aetna U.S. Healthcare, Inc. and affiliated entities (“Aetna”) settled claims brought by the Attorney General of Texas by consenting to modify some of its business practices in Texas. The Attorney General of Texas has filed similar claims against our Texas HMO and has proposed to settle the lawsuit on the same terms as the Aetna settlement. The business practices in question relate primarily to our Texas HMO’s commercial operations. Resolution of a proposed settlement is still pending. We are unable to predict whether we will ultimately reach a settlement with the Attorney General on these or other terms or the impact that the ultimate settlement could have on our operations. These changes ultimately could adversely affect the HMO industry and could have a material effect on our financial position, results of operations or cash flows of a future period.

We are involved in legal actions in the normal course of business, some of which seek monetary damages, including claims for punitive damages which are not covered by insurance. Based on current information and review, including consultation with our lawyers, we believe any ultimate liability that may arise from these actions (including all OPM litigation, class action legal proceedings and industry litigation) would not materially affect our consolidated financial position, results of operations or cash flows. However, our evaluation of the likely impact of these actions could change in the future and an unfavorable outcome, depending upon the amount and timing, could have a material effect on our results of operations or cash flows of a future period.

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

No matter was submitted to a vote of security holders during the three months ended December 31, 2000.

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PART II

ITEM 5. MARKET FOR THE COMPANY’S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS

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

We have never paid cash dividends on our common stock. We do not expect to declare dividends on our common stock in the future, retaining all earnings for business development. Any possible future dividends will depend on our earnings, financial condition, and regulatory requirements. If we decide to declare common stock dividends in the future, such dividends may only be made in shares of our common stock, according to the terms of our credit facility. See Note 6 of the Notes to Consolidated Financial Statements.

As of February 28, 2001 there were 287 stockholders of record of our common stock.

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ITEM 6. SELECTED FINANCIAL DATA

In February 1997, our board of directors approved a change in our fiscal year end from September 30 to December 31. This resulted in a transition period for October 1, 1996 through December 31, 1996. The following selected financial and operating data are derived from our audited consolidated financial statements, or from our unaudited internal financial data. For clarity of presentation and comparability, the following selected financial and operating data includes the unaudited period for the twelve months ended December 31, 1996. The selected financial and operating data should be read in conjunction with “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations,” and also with “Item 8. Consolidated Financial Statements and Supplementary Data.”

INCOME STATEMENT DATA

See footnotes following “Balance Sheet Data.”
Continued on next page.

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

Results of Operations

Overview. We sell HMO and HMO-related products primarily to members in two groups: the commercial programs for employer-group members and individuals and the Secure Horizons program for Medicare beneficiaries. Our specialty managed care HMOs and HMO-related products and services supplement our commercial and Secure Horizons programs. These include pharmacy benefit management, behavioral health services, life and health insurance and dental and vision services.

Events significant to our business in 2000 included the following:

•		2000 results include impairment, disposition, restructuring, OPM and other net pretax charges totaling $9 million ($5 million or $0.15 diluted loss per share, net of tax). See Note 9 of the Notes to Consolidated Financial Statements.
•		In December 2000, we limited the enrollment of new members in our Medicare+Choice health plan, Secure Horizons, through a combination of capacity waivers and voluntary closure notices. This plan affected a total of 42 counties in California, Colorado, Oregon, Texas and Washington. Voluntary closures, did not affect current or recently enrolled members in these counties, nor did they affect newly eligible Medicare beneficiaries (those turning 65 or becoming disabled). Retiree enrollment with January 1, 2001 effective dates were accepted, except for those areas affected by the capacity waivers in the Houston, Texas and Washington State areas.
•		In October 2000, we announced our intention to withdraw our commercial HMO and POS products from 15 Colorado counties. This plan affects approximately 25,000 commercial HMO and POS members. The effective date for this withdrawal is May 1, 2001. We will retain our commercial HMO products in other Colorado counties where the vast majority of our members reside. Qualified employers may apply for our PPO, which is not affected by this service area change.
•		In June 2000, we submitted our 2001 proposed Medicare benefit plan changes to HCFA for approval. These changes include exiting (or partially exiting) Medicare operations in a total of 15 counties in Arizona, Colorado, Ohio, Texas and Washington. This proposal will affect approximately 20,500 Medicare members.
•		We completed the exit of all HMO operations in Ohio. This exit affected approximately 35,000 commercial members and 3,500 Medicare members located in Ohio and Kentucky who were enrolled in our plans during 2000. (These 3,500 Medicare members were included in our 2001 proposed Medicare benefits plan changes submitted to HCFA as discussed above.) We entered into an agreement with Anthem Blue Cross and Blue Shield to assist in transitioning Ohio’s commercial membership. Medicare members were provided a choice of another Medicare+Choice HMO or traditional fee-for-service Medicare. See Note 4 of the Notes to Consolidated Financial Statements.
•		During the first half of 2000, we assumed approximately 18,000 members in Colorado and 21,000 members in Washington as a result of transition agreements signed with QualMed Plans for Health of Colorado and with QualMed Washington Health Plans, Inc. (together, “QualMed”), each a subsidiary of Health Net, Inc. See Note 4 of the Notes to Consolidated Financial Statements.
•		On February 1, 2000, we completed our acquisition of Harris Methodist Texas Health Plan, Inc. and Harris Methodist Health Insurance Company Inc. (together, “Harris”), a health plan and insurance company in Texas with approximately 250,000 commercial and 50,000 Medicare members. See Note 4 of the Notes to Consolidated Financial Statements.

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2000 Compared With 1999

Membership. Total HMO membership increased 10 percent to approximately 4.0 million members at December 31, 2000 from approximately 3.7 million members at December 31, 1999. Our total HMO membership excludes employer self-funded members and PPO and indemnity members.

Commercial HMO membership increased approximately 12 percent at December 31, 2000 compared to the prior year due to:

•		Net membership increases from acquired membership in Colorado, Texas and Washington, partially offset by membership decreases in Colorado attributable to premium rate increases that averaged 14 percent in 2000; and
•		Growth in California primarily from marketing efforts to retain membership and renew major employer accounts.

Medicare membership increased four percent at December 31, 2000 compared to the prior year due to:

•		Members acquired primarily in Washington and Texas; and
•		Competitor exits in markets where Secure Horizons will remain, primarily in Arizona, Nevada and Texas; partially offset by
•		Membership decreases primarily in California due to disenrollment resulting from reduced benefits, increased copayments and instituted or increased member-paid supplemental premiums in some counties; and
•		Membership decreases as a result of our January 2000 county exits in California, Ohio, Oregon and Washington.

Employer self-funded membership increased approximately 18 percent at December 31, 2000 compared to the same period in the prior year primarily due to additional membership from the Harris acquisition, partially offset by membership losses in Colorado. PPO and indemnity membership increased approximately 44 percent at December 31, 2000 compared to the prior year primarily due to additional Harris membership.

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Commercial Premiums. Commercial premiums increased 23 percent or $918 million for the year ended December 31, 2000 compared to the prior year as follows:

Medicare Premiums. Medicare premiums increased nine percent or $540 million for the year ended December 31, 2000 compared to the prior year as follows:

Other Income. Other income increased approximately 17 percent or $21 million for the year ended December 31, 2000 compared to the prior year. The increases were primarily due to increased mail-service revenues of Prescription Solutions, including mail-service revenues from the acquired Harris business. Prescription Solutions generates mail-service revenues, where we, rather than network retail pharmacies, collect the member copayments.

Consolidated Medical Care Ratio. The consolidated, commercial and Medicare medical care ratios (health care services as a percentage of premium revenue), including favorable changes in estimates for the first quarter, increased for the year ended December 31, 2000 compared to the prior year primarily due to:

•		Higher physician, hospital, outpatient, emergency service utilization and higher cost of claims under fee-for-service or risk-based contracts; and
•		Higher prescription drug costs; partially offset by
•		Premium rate increases.

The commercial medical care ratio includes the specialty HMOs and indemnity insurance results.

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Health care costs for the year ended December 31, 2000, were reduced by $9 million ($5 million or $0.14 diluted earnings per share, net of tax), of which $6 million is related to our commercial product line. These reductions were a result of our favorable first quarter 2000 resolution of prior period estimates relating to a provider contract. Excluding the effects of these favorable changes in estimates, the medical care ratios were as follows:

Marketing, General and Administrative Expenses. For the year ended December 31, 2000, marketing, general and administrative expenses as a percentage of operating revenue decreased compared to the prior year due to higher operating revenue in 2000.

Impairment, Disposition, Restructuring, Office of Personnel Management (“OPM”) and Other Charges (Credits). We recognized net pretax charges of $9 million ($5 million or $0.15 diluted loss per share, net of tax) for the year ended December 31, 2000. See Note 9 of the Notes to Consolidated Financial Statements.

Operating Income. Factors contributing to the changes are discussed above.

Net Investment Income. Net investment income increased approximately 29 percent for the year ended December 31, 2000 compared to the prior year due to:

•		Higher average invested balances; and
•		Increases in short- and long-term interest rates combined with the gradual shift of tax-exempt investments to higher yielding taxable securities.

Interest Expense. Interest expense increased approximately 85 percent for the year ended December 31, 2000 compared to the prior year due to:

•		Increased borrowings on our credit facility to fund our share repurchase program; and
•		Higher short-term interest rates combined with a higher interest fee structure in the credit facility agreement.

Provision for Income Taxes. The effective income tax rate was 44.1 percent for the year ended December 31, 2000, compared with 42.2 percent in 1999. Because of lower 2000 earnings, the non-deductible goodwill amortization expense is a higher percentage of pretax income, increasing our 2000 effective tax rate.

Significant Fourth Quarter Items. During the fourth quarter of 2000, our claims incurred but not reported increased by $21 million for periods prior to September 30, 2000, primarily due to increased utilization and cost of claims under risk-based hospital arrangements. This increase was partially offset by $15 million of reductions in related ancillary reserves, such as reserves for claims backlog and vision and mental health claims. Additionally, during the fourth quarter of 2000, our marketing, general and administrative expenses decreased by $11 million, related to incentive compensation and other accruals.

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1999 Compared with 1998

Membership. Total HMO membership increased four percent to approximately 3.7 million members at December 31, 1999 from approximately 3.5 million members at December 31, 1998.