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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

For the quarterly period ended: June 30, 2004

or

For the transition period from                  to                

Commission File Number: 1-12718

HEALTH NET, INC.

(Exact name of registrant as specified in its charter)

(818) 676-6000

(Registrant’s telephone number, including area code)

(Former name, former address and former fiscal year, if changed since last report)

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.    x  Yes    ¨  No

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

Indicate the number of shares outstanding of each of the issuer’s classes of common stock as of the latest practicable date:

The number of shares outstanding of the registrant’s Common Stock as of August 5, 2004 was 111,966,737 (excluding 21,457,429 shares held as treasury stock).

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HEALTH NET, INC.

INDEX TO FORM 10-Q

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PART I—FINANCIAL INFORMATION

Item 1. Financial Statements.

HEALTH NET, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(Amounts in thousands)

(Unaudited)

See accompanying notes to condensed consolidated financial statements.

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HEALTH NET, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(Amounts in thousands, except per share data)

(Unaudited)

See accompanying notes to condensed consolidated financial statements.

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HEALTH NET, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(Amounts in thousands, except per share data)

(Unaudited)

See accompanying notes to condensed consolidated financial statements.

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HEALTH NET, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Amounts in thousands)

(Unaudited)

See accompanying notes to condensed consolidated financial statements.

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HEALTH NET, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

1. BASIS OF PRESENTATION

Health Net, Inc. (referred to hereafter as the Company, we, us or our) prepared the condensed consolidated financial statements following the rules and regulations of the Securities and Exchange Commission (SEC) for interim reporting. As permitted under those rules and regulations, certain notes or other financial information that are normally required by accounting principles generally accepted in the United States of America (GAAP) have been condensed or omitted if they substantially duplicate the disclosures contained in the annual audited financial statements.

We are responsible for the accompanying unaudited condensed consolidated financial statements. These condensed consolidated financial statements include all normal and recurring adjustments that are considered necessary for the fair presentation of our financial position and operating results in accordance with GAAP. In accordance with GAAP, we make certain estimates and assumptions that affect the reported amounts. Actual results could differ from estimates. As these are condensed financial statements, you should also read our 2003 consolidated financial statements and notes included in our Annual Report on Form 10-K for the year ended December 31, 2003.

Revenues, expenses, assets and liabilities can vary during each quarter of the year. Therefore, the results and trends in these interim financial statements may not be indicative of those for the full year.

2. SIGNIFICANT ACCOUNTING POLICIES

Comprehensive Income

Our comprehensive income is as follows (amounts in thousands):

Earnings Per Share

Basic earnings per share excludes dilution and reflects net income divided by the weighted average shares of common stock outstanding during the periods presented. Diluted earnings per share is based upon the weighted average shares of common stock and dilutive common stock equivalents (stock options and restricted stock) outstanding during the periods presented. Common stock equivalents arising from dilutive stock options and restricted common stock are computed using the treasury stock method. There were 886,000 and 1,328,000 shares of dilutive common stock equivalents for the three and six months ended June 30, 2004, respectively, and 2,185,000 and 1,892,000 shares of dilutive common stock equivalents for the three and six months ended June 30, 2003, respectively. Included in the dilutive common stock equivalents for the three and six months ended June 30, 2004 are 91,000 and 79,000 shares of dilutive restricted common stock, respectively, and 39,000 and 32,000 shares of dilutive restricted common stock for the three and six months ended June 30, 2003, respectively.

Options to purchase an aggregate of 4,831,000 and 4,104,000 shares of common stock during the three and six months ended June 30, 2004, respectively, and 1,158,000 and 1,934,000 shares of common stock during the

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three and six months ended June 30, 2003, respectively, were not included in the computation of diluted earnings per share because the options’ exercise prices were greater than the average market price of the common stock for each respective period. These options expire through June 2014.

In April 2002, our Board of Directors authorized us to repurchase up to $250 million (net of exercise proceeds and tax benefits from the exercise of employee stock options) of our common stock. In August 2003, our Board of Directors authorized us to repurchase up to an additional $200 million (net of exercise proceeds and tax benefits from the exercise of employee stock options) of our common stock. As of June 30, 2004, we had repurchased an aggregate of 17,807,155 shares of our common stock under this repurchase program (see Note 6).

Stock-Based Compensation

As permitted under Statement of Financial Accounting Standards (SFAS) No. 123, “Accounting for Stock-Based Compensation” (SFAS No. 123), we have elected to continue accounting for stock-based compensation under the intrinsic value method prescribed in APB Opinion No. 25, “Accounting for Stock Issued to Employees” (APB Opinion No. 25). Under the intrinsic value method, compensation cost for stock options is measured at the date of grant as the excess, if any, of the quoted market price of our common stock over the exercise price of the option. We apply APB Opinion No. 25 and related Interpretations in accounting for our plans. Had compensation cost for our plans been determined based on the fair value at the grant dates of options and employee purchase rights consistent with the method of SFAS No. 123, our net income and earnings per share would have been reduced to the pro forma amounts indicated below (amounts in thousands, except per share data):

The weighted average fair value for options granted during the three and six months ended June 30, 2004 was $6.46 and $6.93, respectively. The weighted average fair value for options granted during the three and six months ended June 30, 2003 was $7.83 and $7.96, respectively. The fair values were estimated using the Black-Scholes option-pricing model.

The weighted average assumptions used in the fair value calculation for the following periods were:

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As fair value criteria were not applied to option grants and employee purchase rights prior to 1995, and additional awards in future years are anticipated, the effects on net income and earnings per share in this pro forma disclosure may not be indicative of future amounts.

Restricted Stock

During the six months ended June 30, 2004 and 2003, we entered into restricted stock agreements with certain employees and awarded 6,000 and 190,000 shares, respectively, of nonvested common stock under those agreements. The shares issued pursuant to the agreements are subject to restrictions on transfers, voting rights and certain other conditions. Upon issuance of the restricted shares pursuant to the agreements, an unamortized compensation expense equivalent to the market value of the shares on the date of grant was charged to stockholders’ equity as unearned compensation. This unearned compensation will be amortized over the respective restricted periods. Compensation expense recorded for these restricted shares was $503,000 and $497,000 during the three months ended June 30, 2004 and 2003, respectively, and $1,015,000 and $823,000 during the six months ended June 30, 2004 and 2003, respectively.

We become entitled to an income tax deduction in an amount equal to the taxable income reported by the holders of the restricted shares when the restrictions are released and the shares are issued. Restricted shares are forfeited if the employees terminate prior to the lapsing of restrictions. We record forfeitures of restricted stock, if any, as treasury share repurchases and any compensation cost previously recognized is reversed in the period of forfeiture.

Goodwill and Other Intangible Assets

Effective January 1, 2002, we adopted SFAS No. 142, “Goodwill and Other Intangible Assets” which, among other things, eliminates amortization of goodwill and other intangibles with indefinite lives. Intangible assets, including goodwill, that are not subject to amortization will be tested for impairment annually or more frequently if events or changes in circumstances indicate that we might not recover the carrying value of these assets.

We identified the following six reporting units within our businesses: Health Plans, Government Contracts, Behavioral Health, Dental & Vision, Subacute and Employer Services Group. In accordance with the transition requirements of SFAS No. 142, we completed an evaluation of goodwill at each of our reporting units at January 1, 2002. We also re-assessed the useful lives of our other intangible assets and determined that they properly reflect the estimated useful lives of these assets. We perform our annual impairment test as of June 30 in each year. During the fourth quarter ended December 31, 2003, we sold our dental, vision and employer services group subsidiaries. During the first quarter ended March 31, 2004, we sold our subacute subsidiaries (see Note 5). As a result of our 2003 and 2004 divestitures, Health Plans is our only reporting unit with goodwill as of June 30, 2004. All goodwill balances related to the reporting units sold in 2003 and the three months ended March 31, 2004 were recovered and written off as part of the sale transactions.

We performed our annual impairment test on our goodwill and other intangible assets as of June 30, 2004 at our Health Plans reporting unit and also re-evaluated the useful lives of our other intangible assets with the assistance of the same independent third-party professional services firm that assisted us in the impairment testing and measurement process in the prior year. No goodwill impairment was identified in our Health Plans reporting unit. We also determined that the estimated useful lives of our other intangible assets properly reflected the current estimated useful lives.

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The changes in the carrying amount of goodwill by reporting unit are as follows (amounts in millions):

The intangible assets that continue to be subject to amortization using the straight-line method over their estimated lives are as follows (amounts in millions):

Estimated annual pretax amortization expense for other intangible assets for the current year and each of the next four years ending December 31 is as follows (amounts in millions):

Restricted Cash and Investments

We and our consolidated subsidiaries are required to set aside certain funds for restricted purposes pursuant to state regulatory requirements. We have discretion as to whether we invest such funds in cash and cash equivalents or other investments. As of June 30, 2004 and December 31, 2003, the restricted cash and cash

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equivalents balances totaled $55.8 million and $62.4 million, respectively, and are included in other noncurrent assets. Long-term debt investments held by trustees or agencies pursuant to state regulatory requirements totaled $0.6 million and $0.8 million as of June 30, 2004 and December 31, 2003, respectively, and are included in other noncurrent assets. Short-term investments held by trustees or agencies pursuant to state regulatory requirements were $90.4 million and $72.7 million as of June 30, 2004 and December 31, 2003, respectively, and are included in investments available for sale. In addition, in connection with the expiration of our current TRICARE contracts, we have set aside $129.9 million and $53.5 million in cash as of June 30, 2004 and March 31, 2004, respectively, as required under the current TRICARE contracts to pay the run-out claims. These amounts are included in other noncurrent assets on the accompanying condensed consolidated balance sheets.

Interest Rate Swap Contracts

The interest rate swap contracts are reflected at fair value in our consolidated balance sheet and the related senior notes payable are reflected at an amount equal to the sum of their carrying value plus or minus an adjustment representing the change in fair value of the senior notes payable attributable to the interest risk being hedged. Because the terms of the swap contracts match the terms of our senior notes payable, the changes in the fair value of the swap contracts offset the changes in the adjusted carrying value of our senior notes payable being hedged. The net effect on our operating results is that the interest expense on our senior notes payable is recorded based on variable interest rates. See Note 5 for additional information on our interest rate swap contracts.

Recently Issued Accounting Pronouncements

In March 2004, the Emerging Issues Task Force (EITF) reached consensus on the remaining issues for Issue No. 03-1 “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments” and as a result reached a final consensus on an other-than-temporary impairment model for debt and equity securities within the scope of SFAS No. 115, “Accounting for Certain Investments in Debt and Equity Securities,” certain debt and equity securities within the scope of SFAS No. 124, “Accounting for Certain Investments Held by Not-for-Profit Organizations,” and equity securities that are not subject to the scope of SFAS No. 115 and not accounted for under the equity method of accounting (i.e., cost method investments). The EITF has also reached a consensus that the three-step model used to determine other-than-temporary impairments shall be applied prospectively to all current and future investments, in interim or annual reporting periods beginning after June 15, 2004. The adoption of the three-step model had no impact on our consolidated financial position or results of operations as of June 30, 2004. Quantitative and qualitative disclosure requirements for investments accounted for under SFAS No. 115 and SFAS No. 124 were effective for the first annual reporting period ending after December 15, 2003. We disclosed such quantitative and qualitative information in the notes to our consolidated financial statements as of December 31, 2003. All new disclosure requirements related to cost method investments are effective for the annual reporting periods ending after June 15, 2004. Comparative information for the periods prior to the period of initial application is not required.

In May 2003, the Financial Accounting Standards Board (FASB) issued SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity” (SFAS No. 150). SFAS No. 150 addresses the issuer’s accounting for certain freestanding financial instruments. The provisions of SFAS No. 150 are effective for financial instruments entered into or modified after May 31, 2003 and pre-existing instruments as of the beginning of the first interim period that commences after June 15, 2003. As of June 30, 2004, the adoption of SFAS No. 150 had no impact on our financial position or results of operations.

In April 2003, the FASB issued SFAS No. 149, “Amendment of Statement 133 on Derivative Instruments and Hedging Activities” (SFAS No. 149). SFAS No. 149 amends and clarifies accounting for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities under SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities” (SFAS No. 133). SFAS No. 149 is effective for contracts entered into or modified after June 30, 2003, except as stated as follows, and for hedging relationships designated after June 30, 2003. The guidance will be applied prospectively. The provisions of SFAS No. 149 that relate to SFAS No. 133 Implementation Issues that have been effective for fiscal quarters

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that began prior to June 15, 2003 will continue to be applied in accordance with their respective effective dates. In addition, certain provisions relating to forward purchases or sales of when-issued securities or other securities that do not yet exist will be applied to existing contracts as well as new contracts entered into after June 30, 2003. As of June 30, 2004, the adoption of SFAS No. 149 has had no impact on our consolidated financial position or results of operations.

In January 2003, the FASB issued Interpretation No. 46, “Consolidation of Variable Interest Entities,” and subsequently revised the interpretation in December 2003 (FIN 46R). FIN 46R requires an investor with a majority of the variable interests in a variable interest entity to consolidate the entity and also requires majority and significant variable interest investors to provide certain disclosures. A variable interest entity is an entity in which the equity investors do not have a controlling interest or the equity investment at risk is insufficient to finance the entity’s activities without receiving additional subordinated financial support from the other parties. The maximum exposure of any investment that may be determined to be a variable interest entity is limited to the amount invested. As revised, FIN 46R is now generally effective for financial statements for interim or annual periods ending after March 31, 2004. As of June 30, 2004, the adoption of FIN 46R has had no impact on our consolidated financial position or results of operations.

3. SEGMENT INFORMATION

We operate within two reportable segments: Health Plan Services and Government Contracts. Our Health Plan Services reportable segment includes the operations of our health plans in the states of Arizona, California, Connecticut, New Jersey, New York and Oregon, the operations of our health and life insurance companies and our behavioral health and pharmaceutical services subsidiaries. Coverage for all members enrolled in our Pennsylvania health plan was discontinued on January 11, 2004.

Our Government Contracts reportable segment includes government-sponsored multi-year managed care plans through the TRICARE program and other government contracts.

We evaluate performance and allocate resources based on profit or loss from operations before income taxes. The accounting policies of the reportable segments are the same as those described in the summary of significant accounting policies in Note 2 to the consolidated financial statements included in our Annual Report on Form 10-K for the year ended December 31, 2003, except that intersegment transactions are not eliminated.

Our segment information is as follows (amounts in millions):

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A reconciliation of the total reportable segments’ measures of profit to the Company’s consolidated income before income taxes is as follows (amounts in millions):

Loss from other corporate entities and our employer services group division, which are not part of our Health Plan Services and Government Contracts reportable segments, are excluded from our measurement of segment performance. Other corporate entities include our facilities, warehouse, reinsurance and surgery center subsidiaries. Severance and related benefits related to an involuntary workforce reduction (see Note 4) and gain on sale of businesses are excluded from our measurement of segment performance since they are not part of our core operations and are not managed within either of our reportable segments.

4. SEVERANCE AND RELATED BENEFIT COSTS

On May 4, 2004, we announced that, in order to enhance efficiency and reduce administrative costs, we would commence an involuntary workforce reduction of approximately 500 positions, which includes reductions resulting from an intensified performance review process, throughout many of our functional groups and divisions, most notably in the Northeast (the May 2004 Plan). During the three months ended June 30, 2004, we recorded pretax severance and benefit related costs of $17.4 million in connection with the May 2004 Plan. As of June 30, 2004, 244 positions had been eliminated and $3.4 million of the severance and benefit related costs had been paid out. We currently anticipate that we will record additional severance and benefit related costs of $7.7 million during the six months ending December 31, 2004. We expect that an additional $15.1 million and $6.6 million will be paid out during the six months ending December 31, 2004 and three months ending March 31, 2005, respectively. We plan to use cash flows from operations to fund these payments. Elimination of the remaining identified 261 positions covered by the involuntary workforce reduction will be completed during the six months ending December 31, 2004.

Severance and benefit related costs expected to be incurred in connection with the May 2004 Plan as of June 30, 2004 are as follows (amounts in millions):

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A reconciliation of our liability balances for severance and benefit related costs incurred in connection with the May 2004 Plan is as follows (amounts in millions):

5. TRANSACTIONS AND DIVESTITURES

Hospital Subsidiaries

In 1999, we sold our two hospital subsidiaries to Health Plus, Inc. As part of the sale, we received cash and a note for $12 million due on August 31, 2003 including any unpaid interest. Prior to August 31, 2003, we had established an $8.2 million allowance on the note. On August 31, 2003, Health Plus defaulted on the note. As a result, we increased the allowance on the note by $3.4 million and recorded it in general and administrative (G&A) expenses in our condensed consolidated statements of operations for the three months ended September 30, 2003. The note was fully reserved as of September 30, 2003. On June 16, 2004, we and Health Plus restructured and settled all outstanding issues relating to the note default for $4 million in cash. We have recorded the $4 million settlement as a reduction in G&A expense in our condensed consolidated statements of operations for the three and six months ended June 30, 2004.

American VitalCare and Managed Alternative Care Subsidiaries

On March 1, 2004, we completed the sale of two subsidiaries, American VitalCare, Inc. and Managed Alternative Care, Inc., to a subsidiary of Rehabcare Group, Inc. We received a payment of approximately $11 million, subject to certain post-closing adjustments, and a $3 million subordinated promissory note for which we recorded a full reserve. We retained an interest in certain accounts receivable of the subsidiaries and have reserved for all except $0.2 million of these accounts receivable. In addition, we are contingently liable for the accounts receivable balances of $3.0 million, net of an allowance for uncollectible accounts of $0.7 million, purchased by Rehabcare Group, Inc. and not collected within six months after the sale. These subsidiaries were reported as part of our Government Contracts reportable segment. We recorded a pretax gain of $1.9 million related to the sale of these subsidiaries during the first quarter ended March 31, 2004.

These subsidiaries had $0 and $3.7 million of total revenues for the three months ended June 30, 2004 and 2003, respectively, and $2.3 million and $7.2 million of total revenues for the six months ended June 30, 2004 and 2003, respectively. These subsidiaries had $0 and $0.8 million of income before income taxes for the three months ended June 30, 2004 and 2003, respectively, and $0.2 million and $1.6 million of income before income taxes for the six months ended June 30, 2004 and 2003, respectively. As of the date of sale, these subsidiaries had a combined total of approximately $2.3 million in net equity which we fully recovered through the sales proceeds.

The divestitures of our American VitalCare and Managed Alternative Care subsidiaries during the first quarter ended March 31, 2004 are not presented as discontinued operations since they are collectively not material to the accompanying condensed consolidated financial statements as of December 31, 2003 and June 30, 2004 and for the three and six months ended June 30, 2004 and 2003.

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Pennsylvania Health Plan

Effective September 30, 2003, we withdrew our commercial health plan from the commercial market in the Commonwealth of Pennsylvania. Coverage for our members enrolled in the Federal Employee Health Benefit Plan was discontinued on January 11, 2004; however, we have maintained our network of providers in Pennsylvania to service our New Jersey members and TRICARE eligibles. As of June 30, 2004, we had no members enrolled in our commercial health plan in Pennsylvania. Our Pennsylvania health plan had been reported as part of our Health Plan Services reportable segment.

Our Pennsylvania health plan had $0.5 million and $19.2 million of total revenues for the three months ended June 30, 2004 and 2003, respectively, and $0.7 million and $39.6 million of total revenues for the six months ended June 30, 2004 and 2003, respectively. Our Pennsylvania health plan had $1.1 million and $(3.3) million of income (loss) before income taxes for the three months ended June 30, 2004 and 2003, respectively, and $1.0 million and $(3.9) million of income (loss) before income taxes for the six months ended June 30, 2004 and 2003, respectively. As of June 30, 2004, our Pennsylvania health plan had net equity of $11.2 million. The net equity is comprised of cash, cash equivalents and investments available for sale and is required by the Pennsylvania Department of Insurance to meet minimum capital requirements until all claims have been paid or discharged.

Florida Health Plan

Effective August 1, 2001, we sold our Florida health plan, known as Foundation Health, a Florida Health Plan, Inc. (the Plan), to Florida Health Plan Holdings II, L.L.C. In connection with the sale, we received $23 million in cash and approximately $26 million in a secured six-year note bearing 8% interest per annum for which we recorded a full reserve. We also sold the corporate facility building used by our Florida health plan to DGE Properties, LLC for $15 million, payable by a secured five-year note bearing 8% interest per annum. We estimated and recorded a $72.4 million pretax loss on the sales of our Florida health plan and the related corporate facility building during the three months ended June 30, 2001.

Under the Stock Purchase Agreement that evidenced the sale (as amended, the SPA), we, through our subsidiary FH Assurance Company (FHAC), entered into a reinsurance agreement (the Reinsurance Agreement) with the Plan. Under the terms of the Reinsurance Agreement, FHAC will reimburse the Plan for certain medical and hospital expenses arising after the Florida health plan sale. The Reinsurance Agreement covers claims arising from all commercial and governmental health care contracts or other agreements in force as of July 31, 2001 and any renewals thereof up to 18 months after July 31, 2001. The Reinsurance Agreement provides that the Plan will be reimbursed for medical and hospital expenses relative to covered claims in excess of certain baseline medical loss ratios.

The maximum liability under the Reinsurance Agreement of $28 million was reported as part of loss on assets held for sale as of June 30, 2001, since this was our best estimate of our probable obligation under this arrangement. As the reinsured claims are submitted to FHAC, the liability is reduced by the amount of claims paid. We have paid the maximum amount of $28 million under this agreement.

The SPA included an indemnification obligation for all pending and threatened litigation as of the closing date and certain specific provider contract interpretation or settlement disputes. We have paid $5.7 million in settlements on certain indemnified items. At this time, we believe that the estimated liability related to the remaining indemnified obligations on any pending or threatened litigation and the specific provider contract disputes will not have a material impact on the financial condition, results of operations or liquidity of the Company.

The SPA provides for the following true-up adjustments that could result in an adjustment to the loss on the sale of the Plan:

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The true-up process has not been finalized as to the post-closing settlement of statutory equity and the settlement of unpaid provider claims, and we do not have sufficient information regarding the true-up adjustments to assess the probability or estimate any adjustment to the recorded loss on the sale of the Plan as of June 30, 2004. However, based on the information we have to date, we believe that the true-up adjustments would not have a material impact on the financial condition, results of operations or liquidity of the Company.

Pharmacy Benefit Services

Effective April 1, 2003, we amended our existing ten-year pharmacy benefit services agreement that we had entered into in 1999 with an external third-party service provider (the Pharmacy Benefit Services Agreement). The amendment provided for (1) the termination of certain service and performance provisions and the modification of certain other service and performance provisions of the Pharmacy Benefit Services Agreement, (2) our payment of approximately $11.5 million in May 2003 (the Amendment Payment) to the external third-party service provider, (3) our ability to terminate the Pharmacy Benefit Services Agreement on April 1, 2004, subject to certain termination provisions and (4) one year of consulting services (which ended March 31, 2004) on specialty pharmacy strategic planning, benefit design strategy and e-prescribing services from the external third-party service provider for a fee of $5 million. In April 2003, we paid $2.9 million to this external third-party service provider for amounts previously accrued under another provision of the Pharmacy Benefit Services Agreement.

As part of the original 1999 transactions with this external third-party service provider, we sold our non-affiliate health plan pharmacy benefit management operations and received a warrant to acquire 800,000 shares of common stock (as adjusted for stock splits) of the external third-party service provider. In April 2003, we exercised the vested portion of the warrants (640,000 shares) and, following a 30-day holding period, sold the underlying common stock for a gain of approximately $11.5 million. We recorded the Amendment Payment as well as the gain realized on the sale of the underlying common stock in G&A expenses in May 2003. The remaining 160,000 shares were scheduled to vest on April 1, 2004. During the three months ended March 31, 2004, this external third-party service provider was acquired by Caremark Rx, Inc. (CMX), whereupon our warrant to acquire the remaining 160,000 shares of common stock was converted into a warrant to acquire 301,425 shares of CMX common stock. The CMX warrant vested on April 1, 2004. During April 2004, we exercised the warrant and sold the underlying 301,425 shares of common stock for approximately $10.2 million.

On September 2, 2003, we terminated the Pharmacy Benefit Services Agreement effective April 1, 2004. Concurrent with this termination, we entered into a new three-year agreement with this external third-party service provider for it to provide pharmacy claims processing services for all of our health plans beginning April 1, 2004. As a result of terminating the Pharmacy Benefit Services Agreement, on April 28, 2004, we paid a termination fee in an amount equal to the approximately $10.2 million gain realized on the exercise of the CMX warrant and the sale of the underlying 301,425 shares of CMX common stock in April 2004. We recorded the termination fee as well as the fair value of the CMX warrant in G&A expenses as of March 31, 2004. We may terminate the new pharmacy claims processing services agreement prior to April 1, 2007, subject to certain termination provisions which include liquidated damages of $3.6 million; provided, that the liquidated damages are reduced by $100,000 per month through the termination date.

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Interest Rate Swap Contracts

We use interest rate swap contracts (swap contracts) as a part of our hedging strategy to manage certain exposures related to changes in interest rates on the fair value of our outstanding $400 million in aggregate principal amount of 8.375% Senior Notes due on April 15, 2011 (Senior Notes). On February 20, 2004, we entered into four swap contracts on our Senior Notes. Under these swap contracts, we agree to pay an amount equal to a specified variable rate of interest times a notional principal amount and to receive in return an amount equal to a specified fixed rate of interest times the same notional principal amount. The swap contracts are entered into with four major financial institutions in order to minimize counterparty credit risk.

The swap contracts have an aggregate notional principal amount of $400 million and effectively convert the 8.375% fixed rate on the Senior Notes to a variable rate of six-month London Interbank Offered Rate (LIBOR) plus 399.625 basis points. As of June 30, 2004, the expected effective variable rate on the Senior Notes was 5.94%. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Liquidity and Capital Resources” for additional information regarding the Senior Notes. As of June 30, 2004, the swap contracts were reflected at negative fair value of $14.8 million in our condensed consolidated balance sheet and the related Senior Notes were reflected at an amount equal to the sum of their carrying value plus or minus an adjustment representing the change in fair value of the Senior Notes attributable to the interest risk being hedged. Because the terms of the swap contracts match the terms of our Senior Notes, the changes in the fair value of the swap contracts of $22.4 million from March 31, 2004 offset the changes in the adjusted carrying value of our Senior Notes being hedged.

6. STOCK REPURCHASE PROGRAM

In April 2002, our Board of Directors authorized us to repurchase up to $250 million (net of exercise proceeds and tax benefits from the exercise of employee stock options) of our common stock under our stock repurchase program. In August 2003, our Board of Directors authorized us to repurchase up to an additional $200 million (net of exercise proceeds and tax benefits from the exercise of employee stock options) of our common stock under our stock repurchase program. Share repurchases are made under our stock repurchase program from time to time through open market purchases or through privately negotiated transactions. As of June 30, 2004, we had repurchased an aggregate of 17,807,155 shares of our common stock under our stock repurchase program for aggregate consideration of approximately $484.4 million before taking into account exercise proceeds and tax benefits from the exercise of employee stock options. We repurchased 1,007,900 shares of common stock during the six months ended June 30, 2004 for $31.5 million.

During the six months ended June 30, 2004, we received approximately $7 million in cash and recognized $1 million in tax benefits as a result of option exercises. During 2003 and 2002, we received approximately $42 million and $48 million in cash, respectively, and recognized $15 million and $18 million in tax benefits, respectively, as a result of option exercises. As a result of the $8 million (in the six months ended June 30, 2004), $57 million (in 2003) and $66 million (in 2002) in realized and estimated benefits, our total authority under our stock repurchase program is estimated at $581 million based on the authorization we received from our Board of Directors to repurchase an aggregate of up to $450 million (net of exercise proceeds and tax benefits from the exercise of employee stock options) of our common stock. The remaining authorization under our stock repurchase program as of June 30, 2004 was $97 million.

7. HEALTH CARE SERVICES AND GOVERNMENT CONTRACT EXPENSES

Health care services and government contract expenses include changes in reserves for claims and other settlements and health care and other costs payable under government contracts. These reserves include amounts for claims which consist of incurred but not reported claims (IBNR), received but unprocessed claims, claims in course of settlement and other liabilities. We estimate the amount of our reserves for claims primarily by using standard actuarial developmental methodologies. An extensive degree of actuarial judgment is used in this estimation process, considerable variability is inherent in such estimates, and the estimates are highly sensitive to changes in medical claims submission and payment patterns and medical cost trends.

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Our health care costs for the three and six months ended June 30, 2004 include approximately $14 million and $78 million, respectively, of higher than previously estimated health care costs, amounts for provider settlements and reconciliations and other related costs for 2003 and prior periods. Of these amounts, approximately $0.5 million and $45.6 million for the three and six months ended June 30, 2004, respectively, were for higher than previously estimated health care costs for 2003 and prior periods. In addition, our health care costs for the three and six months ended June 30, 2004 include approximately $13 million for higher than previously estimated health care costs for the three months ended March 31, 2004. These prior period health care costs resulted primarily from a large number of hospital claims that were paid during the six months ended June 30, 2004 for dates of service that occurred in 2003 and prior and reflect our having underestimated the underlying health care cost trend.

8. FINANCING ARRANGEMENTS

Revolving Credit Facility

On June 30, 2004, we entered into a new five year revolving Credit Agreement with Bank of America, N.A., as Administrative Agent, Swing Line Lender and L/C Issuer, JP Morgan Chase Bank, as Syndication Agent, and the other lenders party thereto (Credit Agreement). This Credit Agreement refinanced and replaced our previous $175 million 364-day credit facility (which matured June 22, 2004) and $525 million revolving five-year credit facility (which was scheduled to mature June 28, 2006). Maximum availability under the Credit Agreement continues to be $700 million.

Under the Credit Agreement, we can obtain letters of credit in an aggregate amount of $200 million. No amounts were outstanding under the Credit Agreement as of June 30, 2004. See “—Letters of Credit” below for information on our letters of credit. We are also able to obtain swingline loans in an aggregate amount of $50 million, but any such swingline loans must be repaid within no more than seven days. The borrowings under the Credit Agreement also may be used for general corporate purposes, including acquisitions, and to service our working capital needs. We must repay all borrowings, if any, under the Credit Agreement by June 30, 2009, unless the maturity date under the Credit Agreement is extended. Interest on any amount outstanding under the Credit Agreement is payable monthly at a rate per annum of (a) LIBOR plus a margin ranging from 50 to 112.5 basis points or (b) the higher of (1) the Bank of America prime rate and (2) the federal funds rate plus 0.5%, plus a margin of up to 12.5 basis points. We have also incurred and will continue to incur customary fees in connection with the Credit Agreement. The Credit Agreement requires us to comply with certain covenants that impose restrictions on our operations, including the maintenance of a maximum leverage ratio, a minimum fixed charge coverage ratio and minimum net worth and a limitation on dividends and distributions. If our long-term credit rating by Standard & Poors or Moody’s Investors Service is reduced to below investment grade, the Credit Agreement prohibits us from making dividends, distributions or redemptions in respect of our capital stock in excess of $75 million in any consecutive four-quarter period, subjects us to a different minimum coverage ratio standard and additional reporting requirements to the lenders and will increase the interest and fees applicable to any outstanding borrowings and any letters of credit issued under the Credit Agreement.

Letters of Credit

Under the Credit Agreement, we can obtain letters of credit in an aggregate amount of $200 million. We have issued letters of credit to guarantee workers’ compensation claim payments to certain external third-party insurance companies in the event that we do not pay our portion of the workers’ compensation claims. As of June 30, 2004, these letters of credit totaled $13.2 million in the aggregate. We have also issued a letter of credit to guarantee an intercompany note with our California health plan subsidiary. As of June 30, 2004, this letter of credit totaled $100 million. No amounts had been drawn on any of these letters of credit as of June 30, 2004. As a result of issuing these letters of credit, the maximum amount available for borrowing under the Credit Agreement was $586.8 million as of June 30, 2004.

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9. LEGAL PROCEEDINGS

Superior National Insurance Group, Inc.

We and our former wholly-owned subsidiary, Foundation Health Corporation (FHC), which merged into Health Net, Inc. in January 2001, were named in an adversary proceeding, Superior National Insurance Group, Inc. v. Foundation Health Corporation, Foundation Health Systems, Inc. and Milliman & Robertson, Inc. (M&R), filed on April 28, 2000, in the United States Bankruptcy Court for the Central District of California, case number SV00-14099GM. The lawsuit related to the 1998 sale of Business Insurance Group, Inc. (BIG), a holding company of workers’ compensation insurance companies operating primarily in California, by FHC to Superior National Insurance Group, Inc. (Superior).

On October 22, 2003, we entered into an agreement with SNTL Litigation Trust, successor-in-interest to Superior, to settle all outstanding claims under the Superior National Insurance Group, Inc. v. Foundation Health Corporation, et. al. litigation. As part of the settlement agreement, we agreed to pay the SNTL Litigation Trust $137 million and receive a release of all of the SNTL Litigation Trust’s claims against us.

However, following the announcement of the settlement, we learned that, on or about October 28, 2003, Capital Z Financial Services Fund II, L.P. and certain related parties (referred to collectively as Cap Z) had filed suit against us in the Supreme Court of the State of New York, County of New York (case index number 03 603375), asserting claims arising out of the same BIG transaction that is the subject of the settlement agreement with the SNTL Litigation Trust. Cap Z previously had participated as a creditor in the Superior bankruptcy and is a beneficiary of the SNTL Litigation Trust. The Cap Z complaint alleges at least $250 million in damages and seeks unspecified punitive damages and the costs of the action, including attorneys’ fees. Following the commencement of the Cap Z proceeding, we and the SNTL Litigation Trust entered into a revised settlement agreement to, among other things, require the Trust to obtain bankruptcy court approval of the revised settlement agreement and reduce the amount payable to the SNTL Litigation Trust to $132 million. As more fully described below, there are various procedural motions pending in the Cap Z lawsuit that we expect to be ruled upon in mid-2004. We will reassess our position after such rulings. The Bankruptcy Court approved the revised settlement agreement on December 29, 2003. Following that approval, District Court action brought by Superior was dismissed with prejudice on December 31, 2003. Cap Z has appealed the District Court’s order approving the settlement. On March 18, 2004, pursuant to the stipulation of Cap Z and the SNTL Trust, the District Court dismissed with prejudice Cap Z’s appeal from the Bankruptcy Court Order approving the revised settlement. Accordingly, the Bankruptcy Court’s approval of the settlement is final.

Cap Z’s complaint alleges that we made certain misrepresentations and/or omissions, relating to the sufficiency of BIG’s reserves, the nature of its internal financial condition (including its accounts receivable) and the status of certain of its “captive” insurance programs. Cap Z claims that in reliance thereon it voted its shares in favor of the BIG acquisition and provided financing to Superior for that transaction. Cap Z alleges at least $250 million in damages and seeks unspecified punitive damages and the costs of the action, including attorneys’ fees. We removed the action from New York state court to the District Court for the Southern District of New York. Presently before that court is Cap Z’s motion to remand the action to state court and our motion to dismiss the action. No hearing date for those motions has been scheduled. We intend to defend ourselves vigorously against Cap Z’s claims. Based on the information we have to date, we believe that the final outcome of this case would not have a material adverse effect upon our financial condition, results of operations or liquidity; however, our belief regarding the likely outcome could change in the future and an unfavorable outcome could have a material adverse effect upon our financial condition, results of operations or liquidity.

In Re Managed Care Litigation

The Judicial Panel on Multidistrict Litigation (JPML) has transferred various class action lawsuits against managed care companies, including us, to the United States District Court for the Southern District of Florida for coordinated or consolidated pretrial proceedings in In re Managed Care Litigation, MDL 1334. This proceeding

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is divided into two tracks, the subscriber track, which includes actions brought on behalf of health plan members, and the provider track, which includes suits brought on behalf of health care providers. As described below, each of the subscriber track actions against Health Net-affiliated entities has been dismissed with prejudice, either pursuant to a settlement agreement or on the merits, and the subscriber track has been closed.

Subscriber Track

The subscriber track included four actions involving us, three of which sought certification of nationwide class actions for unspecified damages and injunctive relief.

On September 26, 2002, the Court denied the motion for class certification in the lead action against us in the subscriber track. In the interest of avoiding the further expense and burden of continued litigation, we resolved all three actions which had sought nationwide class certification for immaterial amounts ($5,000 in the aggregate), and the actions have been dismissed with prejudice, with no admission of liability. As a result of these settlements, the Romero and Pay actions were dismissed with prejudice on March 28, 2003 and the Albert action was dismissed with prejudice on July 22, 2003, all with no admission of liability.

On September 19, 2003, the Court dismissed the fourth and final subscriber track action involving us, The State of Connecticut v. Physicians Health Services of Connecticut, Inc. (filed in the District of Connecticut on September 7, 2000), on grounds that the State of Connecticut lacks standing to bring the ERISA claims asserted in the complaint. That same day, the Court ordered that the subscriber track is closed “in light of the dismissal of all cases in the Subscriber Track.” The State of Connecticut has appealed the dismissal order to the Eleventh Circuit Court of Appeals and oral argument is scheduled for August 12, 2004.

Provider Track

The provider track includes the following actions involving us: Shane v. Humana, Inc., et al. (including Health Net, Inc.) (filed in the Southern District of Florida on August 17, 2000 as an amendment to a suit filed in the Western District of Kentucky), California Medical Association v. Blue Cross of California, Inc., PacifiCare Health Systems, Inc., PacifiCare Operations, Inc. and Foundation Health Systems, Inc. (filed in the Northern District of California in May 2000), Klay v. Prudential Ins. Co. of America, et al. (including Foundation Health Systems, Inc.) (filed in the Southern District of Florida on February 22, 2001 as an amendment to a case filed in the Northern District of California), Connecticut State Medical Society v. Physicians Health Services of Connecticut, Inc. (filed in Connecticut state court on February 14, 2001), Lynch v. Physicians Health Services of Connecticut, Inc. (filed in Connecticut state court on February 14, 2001), Sutter v. Health Net of the Northeast, Inc. (D. N.J.) (filed in New Jersey state court on April 26, 2002), Medical Society of New Jersey v. Health Net, Inc., et al., (D. N.J.) (filed in New Jersey state court on May 8, 2002), Knecht v. Cigna, et al. (including Health Net, Inc.) (filed in the District of Oregon in May 2003), Solomon v. Cigna, et. al. (including Health Net, Inc.) (filed in the Southern District of Florida on October 17, 2003), Ashton v. Health Net, Inc., et al. (filed in the Southern District of Florida on January 20, 2004), and Freiberg v. UnitedHealthcare, Inc., et al. (including Health Net, Inc.) (filed in the Southern District of Florida on February 24, 2004).

On March 2, 2001, the District Court for the Southern District of Florida issued an order in the lead provider action (Shane) granting the dismissal of certain claims with prejudice and the dismissal of certain other claims without prejudice, and denying the dismissal of certain claims.

On March 26, 2001, a consolidated amended complaint was filed in the lead provider action, which adds new plaintiffs, including Leonard Klay and the California Medical Association (who, as set forth below, had previously filed claims against the Company), and has, in addition to revising the pleadings of the original claims under the federal Racketeer Influenced and Corrupt Organizations Act (RICO), ERISA and various state laws, added a claim under the California Business and Professions Code. On May 1, 2001, we filed a motion to compel arbitration in Shane of the claims of all individual plaintiffs that allege to have treated persons insured by us. On that same date, we filed a motion to dismiss this action.

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On September 26, 2002, the Court granted plaintiffs’ motion for class certification and granted plaintiffs’ request for leave to amend their complaint. The new complaint adds another managed care company as a defendant, adds the Florida Medical Society and the Louisiana Medical Society as plaintiffs, withdraws Dennis Breen as a named plaintiff, and adds claims under the New Jersey Consumer Fraud Act and the Connecticut Unfair Trade Practices Act against defendants other than Health Net. The court has referred the case to mediation and has entered a scheduling order with a trial date set for March 2005. While fact discovery ended by Court order on June 1, 2004, expert discovery is ongoing in the case.

On November 20, 2002, the Eleventh Circuit granted the defendants’ petition for review of the district court’s certification decision. Oral argument on defendants’ appeal of the class certification decision took place before the Eleventh Circuit on September 11, 2003.

On August 21, 2003, the District Court ordered that “[a]ll Provider Track tag-along cases are hereby stayed until ten calendar days after the Court issues its omnibus opinions on the Main Track motions to compel arbitration and motions to dismiss. At such time, the Court will set briefing schedules for all tag-along motions to compel arbitration and motions to dismiss.”

On September 15, 2003, the District Court entered an order in the lead action granting in part and denying in part the defendants’ motions to compel arbitration. In this order, the Court ruled that certain claims must be arbitrated and that others may proceed in court. The defendants, including Health Net, have appealed to the Eleventh Circuit portions of the Court’s order denying their motions to compel arbitration. The Eleventh Circuit will hear oral arguments on August 12, 2004.

On December 8, 2003, the Court entered an order granting in part and denying in part defendants’ joint motion to dismiss the Shane complaint. The Court dismissed plaintiffs’ causes of action under ERISA and certain state law claims but refused to dismiss plaintiffs’ other causes of action, including those under RICO. We filed our answer and affirmative defenses on December 22, 2003.

On January 15, 2004, the Court issued an order granting defendants’ motion for a suggestion of remand and informing the MDL Panel that pretrial proceedings shall be completed and the MDL Panel may remand the lead provider track case on or before August 17, 2004. On March 23, 2004 oral argument took place regarding whether to remand the lead provider track case and to what court it should be remanded. On April 7, 2004, the MDL Panel issued an order deferring a decision on the remand issues until the Eleventh Circuit rules on the class certification appeal.

The CMA action alleges violations of RICO, certain federal regulations and the California Business and Professions Code and seeks declaratory and injunctive relief, as well as costs and attorneys’ fees. As set forth above, on March 26, 2001, the California Medical Association was named as an additional plaintiff in the consolidated amended complaint filed in the Shane action.

The Klay suit is a purported class action allegedly brought on behalf of individual physicians in California who provided health care services to members of the defendants’ health plans. The complaint alleges violations of RICO, ERISA, certain federal regulations, the California Business and Professions Code and certain state common law doctrines, and seeks declaratory and injunctive relief and damages. As set forth above, on March 26, 2001, Leonard Klay was named as an additional plaintiff in the consolidated amended complaint filed in the Shane action.

The CSMS case was originally brought in Connecticut state court against Physicians Health Services of Connecticut, Inc. (PHS-CT) alleging violations of the Connecticut Unfair Trade Practices Act. The complaint alleges that PHS-CT engaged in conduct that was designed to delay, deny, impede and reduce lawful reimbursement to physicians who rendered medically necessary health care services to PHS-CT health plan members. The complaint, which is similar to others filed against us and other managed care companies, seeks

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declaratory and injunctive relief. On March 13, 2001, PHS-CT removed this action to federal court. Before this case was transferred to MDL 1334, the plaintiffs moved to remand the action to state court and the federal District Court of Connecticut consolidated this action and Lynch v. Physicians Health Services of Connecticut, Inc., along with similar actions against Aetna, CIGNA and Anthem, into one case entitled CSMS v. Aetna Health Plans of Southern New England, et al. PHS-CT has not yet responded to the complaint. In August 2003, the MDL 1334 Court denied without prejudice CSMS’s motion to remand.

The Lynch case was also originally filed in Connecticut state court. This case was brought by J. Kevin Lynch, M.D. and Karen Laugel, M.D. purportedly on behalf of physician members of the Connecticut State Medical Society who provide health care services to PHS-CT health plan members pursuant to provider service contracts. The complaint alleges that PHS-CT engaged in improper, unfair and deceptive practices by denying, impeding and/or delaying lawful reimbursement to physicians. The complaint seeks declaratory and injunctive relief and damages. On March 13, 2001, PHS-CT removed this action to federal court. Before this case was transferred to MDL 1334, the plaintiffs moved to remand the action to state court and the case was consolidated as described above. PHS-CT has not yet responded to the complaint. On July 24, 2003, PHS-CT moved to compel to arbitration the claims of plaintiffs Lynch and Laugel. In August 2003, the MDL 1334 Court denied without prejudice plaintiffs’ motion to remand.

On April 26, 2002, plaintiff John Ivan Sutter, M.D., P.A. filed an amended complaint in New Jersey state court joining Health Net of the Northeast, Inc. (Health Net of the Northeast), a subsidiary of ours, in an action originally brought against Horizon Blue Cross Blue Shield of New Jersey, Inc., CIGNA Healthcare of New Jersey, Inc. and CIGNA Corp, United Healthcare of New Jersey, Inc. and United Healthcare Insurance Company and Oxford Health Plans, Inc. The complaint seeks certification of a statewide class of health care providers who render or have rendered services to patients who are members of healthcare plans sponsored by the defendants.

Plaintiff alleges that the defendants engage in unfair and deceptive acts and practices which are designed to delay, deny, impede and reduce compensation to physicians. The complaint seeks unspecified damages and sets forth various causes of action under New Jersey law. On May 22, 2002, the New Jersey state court severed the action into five separate cases. On May 24, 2002, Health Net of the Northeast removed the case against it to federal court. Plaintiff moved to remand, which motion was denied without prejudice. On July 18, 2002, the JPML transferred this action to MDL 1334 for coordinated or consolidated pretrial proceedings. On September 23, 2002, plaintiff filed in the MDL proceeding a motion to remand to state court. On July 24, 2003, the Health Net defendants moved to compel to arbitration the claims of plaintiff Sutter. In August 2003, the MDL 1334 Court denied plaintiff Sutter’s motion to remand.

On May 8, 2002, the Medical Society of New Jersey filed a complaint in New Jersey state court against us and our subsidiaries, Health Net of the Northeast, Inc., First Option Health Plan of New Jersey, Inc., and Health Net of New Jersey, Inc. (the Health Net defendants). Plaintiff brought this action on its own behalf and purportedly on behalf of its physician members and alleges that the Health Net defendants engage in practices which are designed to delay, deny, impede and reduce compensation to physicians. Plaintiff has requested declaratory and injunctive relief and has set forth causes of action for violation of public policy, violations of the New Jersey Consumer Fraud Act, violations of the Healthcare Information Networks and Technologies Act (the HINT Act) and tortious interference with prospective economic relations. On June 14, 2002, the Health Net defendants removed this case to federal court. On July 3, 2002, the Health Net defendants filed a motion to stay this action pending ruling by the JPML on whether to transfer this case to MDL 1334. On July 15, 2002, plaintiff filed a motion in the New Jersey District Court to remand this case to state court. On August 2, 2002, the JPML transferred this case to MDL 1334 for coordinated or consolidated pretrial proceedings. In August 2003, the MDL 1334 Court denied without prejudice the plaintiff’s motion to remand.

The Knecht case was originally brought in the United States District Court for the District of Oregon in May 2003 by five individual chiropractors, a chiropractic clinic, and a professional association of about 130 chiropractors in Arizona against us and several other managed care organizations. The plaintiffs have brought

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this action on their own behalf and putatively on behalf of a nationwide class of non-medical and non-osteopathic chiropractors. The Knecht plaintiffs allege that each defendant has engaged in a “common scheme” to deny, delay, and diminish the payments due to chiropractors. Plaintiffs contend that the defendants’ alleged practices constitute RICO and state prompt pay violations and give rise to common law claims, including breach of contract and constructive contract/unjust enrichment. Plaintiffs seek unspecified treble damages, declaratory and injunctive relief, and attorneys’ fees.

The Solomon case was filed on October 17, 2003 in the United States District for the Southern District of Florida (and has been transferred to MDL 1334) against us and several other managed care organizations by two individual podiatrists, three podiatric associations and a chiropractic association. The plaintiffs have brought this action on their own behalf and putatively on behalf of a nationwide class of similarly situated health care providers. The plaintiffs allege that each defendant has been engaged in a “common scheme” to deny, delay, and diminish payments due to health care providers. Plaintiffs contend that the defendants’ alleged practices constitute RICO, ERISA, and state prompt pay violations, and give rise to common law claims, including breach of contract and constructive contract/unjust enrichment. Plaintiffs seek unspecified treble damages, declaratory and injunctive relief and attorneys’ fees.

On January 20, 2004, a suit, Ashton v. Health Net, Inc., et. al., was filed in the Southern District of Florida against us and several other managed care organizations by a podiatrist, a physical therapist and two chiropractors. The plaintiffs have brought this action on their own behalf and on behalf of a nationwide class of similarly situated healthcare professionals. The plaintiffs allege that the defendants have been engaged in a “common scheme” to deny, delay and diminish payments due to healthcare providers. Plaintiffs contend that the defendants’ alleged practices constitute RICO, ERISA and state prompt pay violations, and give rise to common law claims, including breach of contract and constructive contract/unjust enrichment. Plaintiffs seek unspecified treble damages, declaratory and injunctive relief and attorney’s fees. On March 8, 2004, this case was transferred to MDL 1334, where it was closed for statistical purposes and placed in a civil suspense file.

On February 24, 2004, Freiberg v. UnitedHealthcare, Inc., et al., was filed in the Southern District of Florida against us and several other managed care organizations by an acupuncturist and the Acupuncture and Oriental Medicine National Coalition, Corp. The plaintiffs have brought this action on their own behalf and purportedly on behalf of a nationwide class of similarly situated healthcare professionals. The plaintiffs allege that each defendant has been engaged in a “common scheme” to deny, delay, and diminish payments due to healthcare providers. Plaintiffs contend that the defendants’ alleged practices constitute RICO and ERISA violations, give rise to common law claims, including breach of contract and constructive contract/unjust enrichment. Plaintiffs seek unspecified treble damages, declaratory and injunctive relief and attorneys’ fees. On March 8, 2004, this case was also transferred to MDL 1334, where it was closed for statistical purposes and placed in a civil suspense file.

We intend to defend ourselves vigorously in this litigation. While the final outcome of these proceedings cannot be determined at this time, based on information presently available, we believe that the final outcome of such proceedings will not have a material adverse effect upon our financial condition, results of operations or liquidity. However, our belief regarding the likely outcome of such proceedings could change in the future and an unfavorable outcome could have a material adverse effect upon our financial condition, results of operations or liquidity.

Miscellaneous Proceedings

In the ordinary course of our business operations we and certain of our subsidiaries are also parties to various other legal proceedings, including, without limitation, claims brought by members and providers seeking coverage or additional reimbursement for services allegedly rendered to our members, but which allegedly were either underpaid or not paid. We are also subject to claims relating to the performance of contractual obligations to providers, members and others, including the alleged failure to properly pay claims and challenges to the manner in which we process claims. In particular, a number of arbitrations and cases related to our review and

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adjustment of provider claims are pending, predominately in California, and have not yet been resolved. While the final outcome of these proceedings cannot be determined at this time we believe, based on information presently available, that the final outcome of any such proceeding will not have a material adverse effect upon our financial condition, results of operations or liquidity. However, our belief regarding the likely outcome of such proceedings could change in the future and an unfavorable outcome could have a material adverse effect upon our financial condition, results of operations or liquidity. In addition, the loss of any claim that results in a significant punitive damage award could have a material adverse effect on the Company, and the risk of potential liability under punitive damage theories may increase significantly the difficulty of obtaining reasonable settlements of such claims.

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

Cautionary Statements

This discussion and analysis and other portions of this Quarterly Report on Form 10-Q contain “forward-looking statements” within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended, and Section 27A of the Securities Act of 1933, as amended, regarding our business, financial condition and results of operations. These forward-looking statements involve risks and uncertainties. All statements other than statements of historical information provided or incorporated by reference herein may be deemed to be forward-looking statements. Without limiting the foregoing, the words “believes,” “anticipates,” “plans,” “expects,” “may,” “should,” “could,” “estimate” and “intend” and other similar expressions are intended to identify forward-looking statements. Managed health care companies operate in a highly competitive, constantly changing environment that is significantly influenced by, among other things, aggressive marketing and pricing practices of competitors and regulatory oversight. Factors that could cause our actual results to differ materially from those reflected in forward-looking statements include, but are not limited to, the factors set forth under the heading “Risk Factors” in our Annual Report on Form 10-K for the year ended December 31, 2003 and the risks discussed in our other filings from time to time with the SEC.

We wish to caution readers that these factors, among others, could cause our actual financial or enrollment results to differ materially from those expressed in any projections, estimates or forward-looking statements relating to us. In addition, those factors should be considered in conjunction with any discussion of operations or results by us or our representatives, including any forward-looking discussion, as well as comments contained in press releases, presentations to securities analysts or investors or other communications by us. You should not place undue reliance on any forward-looking statements, which reflect management’s analysis, judgment, belief or expectation only as of the date thereof. Except as may be required by law, we undertake no obligation to publicly update or revise any forward-looking statements to reflect events or circumstances that arise after the date of this report.

This Management’s Discussion and Analysis of Financial Conditions and Results of Operations should be read in its entirety since it contains detailed information that is important to understanding Health Net, Inc. and its subsidiaries’ results of operations and financial condition. The Executive Summary below is qualified in its entirety by the full Management’s Discussion and Analysis of Financial Condition and Results of Operations and the information contained in the Executive Summary is as of August 9, 2004.

Executive Summary

We are an integrated managed care organization that delivers managed health care services through health plans and government sponsored managed care plans. Our health plans and government contracts subsidiaries provide health benefits through our health maintenance organizations (HMOs), preferred provider organizations (PPOs) and point-of-service (POS) plans to approximately 5.2 million individuals in 14 states. We also offer managed health care products related to behavioral health and prescription drugs. In addition, we own health and life insurance companies licensed to sell exclusive provider organizations, PPO, POS and indemnity products, as well as auxiliary non-health products in 36 states and the District of Columbia.

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We operate health plans in six states (Arizona, California, Connecticut, New Jersey, New York and Oregon) and offer our products to commercial, Medicare and Medicaid members. We have sold or otherwise disposed of a number of health plans over the past several years to focus our sales and marketing efforts on these six plans in populous and contiguous markets, most notably Southern California and the New York metropolitan area, which we believe offer sustained growth opportunities.

Operating Highlights and Outlook for 2004

Our overall operating performance in the three months ended June 30, 2004 did not reach the levels achieved in the three months ended June 30, 2003. The primary cause of this year-over-year decline was higher health care costs in the three months ended June 30, 2004. These higher costs are primarily the result of higher than expected inpatient and outpatient hospital costs, continuing a trend first seen in the three months ended March 31, 2004. Higher health care costs caused the medical care ratio (MCR) for our Health Plans segment to reach 86.0% for the three months ended June 30, 2004, compared with 83.6% for the three months ended June 30, 2003.

To address the higher health care cost trend, we are, among other things, raising premiums for employer groups and individuals who renew their coverage through the balance of 2004, strengthening medical management practices such as pre-authorization and concurrent review of hospital stays, employing new provider contracting strategies and employing our new Decision Power services. Decision Power is designed to more directly involve patients in their health care decisions. It allows our members to access a wealth of information and health coaches as they deal with health care issues. Just now underway, this program is being met with great acceptance around the country and we expect that it will be recognized as a meaningful differentiator for our health plans. To help ensure our claims payment patterns lead to greater predictability of health care cost trends and to allow time for claims inventories to reach optimal levels, we have delayed implementation of our Health Net One systems conversion project until the first half of 2005.

As a result of instituting higher premiums, commercial enrollment declined by 51,000, or 1.8%, at June 30, 2004 compared with March 31, 2004 and 18,000, or less than 1%, compared with June 30, 2003. We expect commercial enrollment to further decline through the remainder of 2004 as a result of instituting higher premiums. Medicare enrollment was essentially flat at June 30, 2004, compared with March 31, 2004 but down approximately 2,000, or 1.2%, from June 30, 2003. Medicare enrollment is expected to grow slightly through the balance of 2004. Medicaid enrollment fell during the three months ended June 30, 2004, as California sustained more stringent eligibility requirements. We expect Medicaid enrollment to climb in the second half of 2004 with the addition of two new counties to the California program.

For the three months ended June 30, 2004, our Government Contracts cost ratio, which includes both health care and administrative costs, improved by 20 basis points to 95.0% compared to the three months ended June 30, 2003. Our debt-to-capital ratio was 22.6% as of June 30, 2004, well below our target of 30% and down from 23.9% as of March 31, 2004. Our administrative ratio (G&A expenses plus depreciation) was 9.4% for the three months ended June 30, 2004, a 90 basis point improvement from the three months ended June 30, 2003 and a 60 basis point improvement from the three months ended March 31, 2004. Reducing the administrative ratio is a key part of our strategy. Part of the G&A expense savings were achieved through an involuntary workforce reduction affecting approximately 500 employees that was commenced in May 2004 (the May 2004 Plan). During the three months ended June 30, 2004, we recorded pretax severance and benefit related costs of $17.4 million in connection with the May 2004 Plan. As of June 30, 2004, 244 positions had been eliminated. We currently anticipate that we will record additional severance and benefit related costs of $7.7 million during the six months ending December 31, 2004. We plan to use cash flows from operations to fund these payments. We expect that the remaining positions to be eliminated in connection with the May 2004 Plan will be completed by December 31, 2004. See Note 4 to the condensed consolidated financial statements for additional information regarding the May 2004 Plan. The G&A savings that stem from the May 2004 Plan will, we believe, contribute to improved earnings in the second half of 2004 compared to the first half of 2004. We continue to expect to reduce our administrative ratio by approximately 150 basis points in the next two to three years.

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For the three months ended June 30, 2004, our net margin was 1.4% and was impacted by the higher MCR in our health plans. For the three months ended June 30, 2004, cash provided by operating activities was $12.5 million, which was lower than cash provided by operating activities over the past several quarters. An $8 million increase in the amounts receivable under government contracts and a $16 million decrease in health care and other costs payable under government contracts also contributed to operating cash flow performance in the three months ended June 30, 2004. We expect that operating cash flow for the full year 2004 will be less than the levels achieved in 2003. The primary cause of this expected decline is related to changing payment patterns from the Department of Defense related to our transition to the new TRICARE contract for the North region. Our operating cash flow has, in part, been used to repurchase shares of our common stock and we expect to continue using cash flow to repurchase shares in the future. In the three months ended June 30, 2004, we repurchased 127,800 shares of our common stock. Since the inception of our stock repurchase program in May 2002, we have repurchased 17,807,155 shares at an average price of $27.20 per share.

Our success in 2004 and beyond will depend, in part, on our ability to price our health plan products at a level equal to or greater than the growth in health care costs, as well as our ability to contain growth in our health care costs, especially hospital costs, by employing a range of medical management, pharmaceutical management and provider contracting strategies. In addition, we must successfully implement our new TRICARE contract for the North Region, complete our Health Net One systems consolidation project, continue to foster and improve our provider relations and continue growing and solidifying our presence in all of the markets in which we do business. It is also important that we introduce new products and variations on existing products and continue to focus on competitively differentiating our products so that we can compete on factors other than price alone. In 2004, we began the rollout of a new branding initiative called the “Rosetta Stone,” which we believe could provide us with a differentiated position in the health care marketplace.

Health Plan Operations. While we believe that a long-term enrollment growth target of 3% to 5% per year is possible to achieve, enrollment in commercial health plans at December 31, 2004 will be down compared with enrollment at December 31, 2003. We expect to continue pursuing small group business (generally defined as an employer group with 2 to 50 employees) in the future, as we believe this is where most job growth will occur over the next several years in the markets we serve. However, we expect small group and individual enrollment to decline through the balance of 2004, as a result of higher premiums. Small group and individual enrollment at June 30, 2004 was higher by only 3.0% compared with small group and individual enrollment at June 30, 2003—a lower rate of growth than seen in previous quarters. Large group enrollment declined at June 30, 2004 due to premium increases, deletion of members from existing accounts that commonly occurs in the second quarter and our efforts to improve profitability in the Northeast. Large group enrollment will continue to decline through the balance of 2004 as a result of higher premiums.

We have expanded our Medicare marketing efforts in 2004 in response to the Medicare reform legislation that was passed in December 2003. We believed that the improved funding provided through this legislation would provide a basis for us to reverse Medicare enrollment declines from recent years which were caused by inadequate funding from the Centers for Medicare & Medicaid Services. These expected increases have not, as yet, materialized as we believe that Medicare beneficiaries are confused about the wide range of offerings in both basic Medicare and the new prescription drug cards. Thus, Medicare enrollment declined in the three months ended June 30, 2004, compared with June 30, 2003. We continue to develop strategies and tactics to improve Medicare enrollment, and we expect enrollment to increase through the balance of this year. In particular, Oregon Medicare enrollment was again a high point, increasing by approximately 70%, or approximately 5,000 members, at June 30, 2004 compared with March 31, 2004. Our Oregon health plan participates in a Medicare PPO demonstration project and we believe this product is proving to be especially popular among certain segments of Oregon’s Medicare population. On April 1, 2004, we announced that we will offer a Medicare Drug Discount Card to our Medicare enrollees.

We participate in state Medicaid programs in three states, California, Connecticut and New Jersey. California Medicaid membership, where the program is known as Medi-Cal, comprised 82% of our Medicaid

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membership at June 30, 2004. Despite ongoing concerns about the states’ ability to adequately fund these Medicaid programs, we believe that the significant savings generated by Medicaid managed care will provide ongoing future growth opportunities, as states may move more Medicaid enrollees into managed care plans. We will add two counties for California Medi-Cal in the third quarter ending September 30, 2004 and believe the addition of these new counties will help counteract enrollment declines resulting from the State of California tightening eligibility requirements. Medi-Cal enrollment dropped by approximately 64,000 members at June 30, 2004 compared to June 30, 2003 as a result of the more stringent eligibility requirements. The new California state budget includes no rate increases for the benefit year beginning October 1, 2004. In the prior two benefit years, the premiums we receive from the State had been reduced from the prior year’s levels.

Our product line in our health plan operations has begun to change over the past few years. Enrollment in our PPOs has been growing at a faster rate than enrollment in our HMOs, which have historically accounted for the largest portion of our enrollment. At June 30, 2004, PPO enrollment comprised 13% of our commercial enrollment, from 11% at June 30, 2003. In response to growing demand from employers for more flexible product lines, we are developing and plan to introduce Consumer Directed Health Plan products in the next several years. In 2003, we test marketed one such product in our Oregon health plan.

We expect commercial per member per month (PMPM) premium yields to increase at a slower rate in 2004 compared to the 11.9% yield achieved in 2003. For the three months ended June 30, 2004, PMPM commercial premium yields increased 7.7% compared with the three months ended June 30, 2003, as a result of a change in the geographic mix of our business, product and mix shifts to lower cost, lower benefit products and employers continuing to buy down benefits. In Medicare, we expect that PMPM premium revenues will rise at a faster pace due to increased funding from the December 2003 Medicare reform legislation. Medicare PMPM premium revenues rose by 10.6% for the three months ended June 30, 2004 compared with the prior-year period when the year-over-year increase was 5.1%. We expect that Medicaid premiums will again rise at slower rates than health care costs. This expectation is consistent with our ongoing overall strategic approach to participate selectively in the Medicaid market. Since much of our Medi-Cal membership is serviced by medical groups to which we make capitation payments, our revenues and profit margin are expected to remain relatively stable and predictable.

We believe that managing health care costs is an essential function for a managed care company. Among the medical management techniques we utilize to contain the growth of health care costs are pre-authorization or certification for outpatient and inpatient hospitalizations and a concurrent review of active inpatient hospital stays and discharge planning. We also contract with third parties to manage certain conditions such as neonatal intensive care unit admissions and stays, as well as chronic conditions such as asthma, diabetes and congestive heart failure. These techniques are widely used in the managed care industry and are accepted practice in the medical profession.

For the three months ended June 30, 2004, our PMPM physician costs increased by 4.4%, consistent with expectations. Pharmaceutical costs on a PMPM basis for all lines rose by 1.9%, as employers continued to purchase plans with higher pharmaceutical co-payments. In addition, increased use of generic drugs and the impact of certain prescription medications moving to over-the-counter status continue to be factors helping to contain the growth in pharmaceutical costs. We have implemented a number of techniques to contain the growth of pharmaceutical costs, including, without limitation, pre-authorization or certification for the use of certain high cost pharmaceuticals.

TRICARE. In August 2003, we were awarded a new five-year contract for the TRICARE North Region that supports nearly 2.8 million Military Health System eligible participants. The new North Region contract covers Connecticut, Delaware, Illinois, Indiana, Kentucky, Maine, Maryland, Massachusetts, Michigan, New Hampshire, New Jersey, New York, North Carolina, Ohio, Pennsylvania, Rhode Island, Vermont, Virginia, West Virginia, Wisconsin and the District of Columbia. In addition, the contract covers small portions of Tennessee, Missouri and Iowa. Health care delivery began under the new contract on July 1, 2004 for the area that was previously Regions 2 and 5 and will begin September 1, 2004 for the area that was previously Region 1. The transition program developed for the new contracts was on schedule as of June 30, 2004.

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We incur administrative and health care expenses in connection with our administration of the TRICARE program in the regions we manage on behalf of the Department of Defense. Health care expenses are directly related to the use of civilian providers by TRICARE eligible beneficiaries and have risen in recent quarters as a direct result of increased military activity. Increased military activity results in increased enrollment and the deployment of military medical personnel overseas that reduces beneficiaries’ access to military treatment facilities. We expect that for the duration of the current contracts we will continue to experience elevated levels of costs due to reservist call-ups and higher utilization of civilian providers. However, as part of our contract with the Department of Defense, we are reimbursed for costs related to this heightened military activity. As noted above, we expect our Government Contracts cost ratio to remain relatively stable in 2004 compared with 2003, even with the transition to our new TRICARE contract for the North Region. There are differences in the economic structure of our existing TRICARE contract and our new contract for the North Region. We believe that the differences in the economic structure of the new contract, when compared to our expiring contract, should reduce our risk related to the ability to accurately project our profitability over the term of the new contract. In addition, on a quarterly basis, revenues will decline to reflect the new contract’s exclusion of pharmacy benefits and the TRICARE for Life program, a change from the existing contract. A description of the differences in the contracts is contained in our Annual Report on Form 10-K for the year ended December 31, 2003.

Health Net One Systems Consolidation Project. We are in the process of converting a number of information systems in our health plan business to a single information system. This system is currently in use in our Northeast and Arizona health plans and project completion is now scheduled for the first half of 2005. This project, known as Health Net One, also includes consolidation initiatives for other functional areas, such as claims handling, customer service and product development. We believe Health Net One will produce administrative cost savings and improved service capability over the next several years. We believe that using a single information technology platform for all of our health plans will permit us to develop and deploy new products more rapidly, thus producing a competitive advantage in our markets.

Provider Network. We maintain a large network of providers to service our members in the six states in which we have health plans. These networks include a broad range of hospitals, including academic medical centers and community hospitals. We maintain contracts with large integrated physician groups, independent practice associations and individual primary care specialty physicians. Overall, we believe that our provider relations are generally good. In recent years, we have implemented a number of techniques specifically aimed at the review of very high cost hospital claims, a problem that has plagued the entire managed care industry as well as hospitals. Some of these techniques, including reviews of individual claims, create differences of interpretation between us and hospitals. We have been able to resolve these differences through negotiation or, in some cases, through arbitration. However, a number of arbitrations and cases related to our review and adjustment of provider claims are pending, predominately in California, and have not yet been resolved. Given the high rate of growth in hospital costs, we believe we must continue to be vigilant in our review of these costs, though we have modified some of these review processes in response to provider feedback.

Recent and Other Developments

Credit Agreement

On June 30, 2004, we entered into a new five year revolving Credit Agreement with Bank of America, N.A., as Administrative Agent, Swing Line Lender and L/C Issuer, JP Morgan Chase Bank, as Syndication Agent, and the other lenders party thereto. The Credit Agreement refinanced and replaced our previous $175 million 364-day credit facility (which matured June 22, 2004) and $525 million revolving five-year credit facility (which was scheduled to mature June 28, 2006). Maximum availability under the Credit Agreement is $700 million. See Note 8 to our condensed consolidated financial statements for additional information regarding the Credit Agreement.

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Results of Operations

Consolidated Operating Results

Our net income for the three months ended June 30, 2004 was $41.4 million, or $0.37 per basic share and $0.36 per diluted share, compared to net income for the same period in 2003 of $74.8 million, or $0.64 per basic share and $0.63 per diluted share. Our net income for the six months ended June 30, 2004 was $56.4 million, or $0.50 per basic share and $0.49 per diluted share, compared to net income for the same period in 2003 of $146.9 million, or $1.25 per basic share and $1.23 per diluted share. Our results for the three and six months ended June 30, 2004 include severance and related benefit costs of $17.4 million recorded in the three months ended June 30, 2004 in connection with the involuntary workforce reduction we commenced on May 4, 2004 (the May 2004 Plan). See Note 4 to the condensed consolidated financial statements for further information on the May 2004 Plan. Our results for the six months ended June 30, 2004 include gain on sale of businesses of $1.9 million recorded in the three months ended March 31, 2004. See the disclosure under the heading “American VitalCare and Managed Alternative Care Subsidiaries” in Note 5 to the condensed consolidated financial statements for further information on the gain on sale of businesses.

The table below and the discussion that follows summarize our results of operations for the three and six months ended June 30, 2004 and 2003.