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UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-K

FOR ANNUAL AND TRANSITION REPORTS PURSUANT TO SECTIONS 13

OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

(Mark One)

or

Commission file number 001-31700

PACIFICARE HEALTH SYSTEMS, INC.

(Exact name of registrant as specified in its charter)

(714) 952-1121

(Registrant’s telephone number, including area code)

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

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

Common Stock, par value $0.01

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

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§229.405 of this chapter) is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. x

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

Non-affiliates of the Registrant held approximately $2,809,800,000 of the aggregate market value of common stock on June 30, 2004.

There were approximately 86,665,000 shares of common stock outstanding on January 31, 2005.

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DOCUMENTS INCORPORATED BY REFERENCE

The following sections of the definitive Proxy Statement for the 2005 Annual Meeting of Stockholders are incorporated by reference under Parts II and III of this Form 10-K:

With the exception of the portions of the definitive Proxy Statement that are incorporated by reference under Parts II and III of this Form 10-K, the definitive Proxy Statement is not deemed filed as part of this Form 10-K.

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PACIFICARE HEALTH SYSTEMS, INC.

INDEX TO ANNUAL REPORT ON FORM 10-K

For the Year Ended December 31, 2004

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PART I

ITEM 1.  BUSINESS

Introduction

In this Annual Report on Form 10-K, we refer to PacifiCare Health Systems, Inc. as “PacifiCare,” “the Company,” “we,” “us,” or “our.”

We offer managed care and other health insurance products to employer groups, individuals and Medicare beneficiaries throughout most of the United States and Guam. Our commercial and senior plans are designed to deliver quality health care and customer service to members cost-effectively. These products include health insurance, health benefits administration and indemnity insurance products such as Medicare Supplement products offered through health maintenance organizations, or HMOs, and preferred provider organizations, or PPOs. We also offer a variety of specialty managed care products and services that employees and individuals can purchase as a supplement to our basic commercial and senior medical plans or as stand-alone products. These products include pharmacy benefit management, or PBM, services, behavioral health services, group life and health insurance and dental and vision benefit plans. As of December 31, 2004, we had approximately 3.3 million HMO and other commercial and senior product members and approximately 10.4 million members in our PBM, dental and behavioral plans, including both members covered by our commercial or senior HMOs, and members who are unaffiliated with our HMOs.

We were formed in 1996 as a Delaware corporation and are the successor to a California corporation that was formed in 1983 and reincorporated as a Delaware corporation in 1985. Our principal executive offices are located at 5995 Plaza Drive, Cypress, California 90630, and our telephone number is (714) 952-1121.

Our Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and all amendments to those reports that we file with the Securities and Exchange Commission, or SEC, are currently available free of charge to the general public through our website at www.pacificare.com. These reports are accessible on our website as soon as reasonably practicable after being filed with the SEC. These reports are also available at the SEC’s public reference room at 450 Fifth Street, N.W., Washington, D.C. 20549. The public may obtain information on the operation of the public reference room by calling the SEC at 1-800-SEC-0330. The SEC also maintains a website at www.sec.gov that contains reports, proxy and information statements and other information regarding issuers that file electronically with the SEC.

This Annual Report on Form 10-K contains both historical and forward-looking information. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and “Cautionary Statements” for a description of a number of factors that could adversely affect our results.

Business Strategy

Our mission is to create long-term stockholder value as a consumer health organization committed to making people’s lives healthier and more secure. Our strategy to achieve this mission is to continue the innovative expansion of our health care services portfolio, increase membership in our commercial and specialty businesses, including our small group and individual business and maintain and grow our Medicare Advantage, formerly Medicare+Choice, business. We intend to accomplish this by taking advantage of opportunities in some markets to compete with the standard government Medicare program for new members, and by aligning our organization to meet the financial, health and wellness needs of our members.

We believe that employers and consumers desire innovative health care products that provide flexible network benefit design and financing components. We are continuing to design and offer new products such as our self-directed health plan product, a low cost plan which offers incentives to consumers to help contain costs through a broad based PPO network, as well as tiered network products and value network products that allow consumers to make trade-offs based upon breadth of network, quality measures and costs.

We operate one of the largest Medicare Advantage programs in the United States as measured by membership and we have used our long experience in working with seniors to operate our program cost-effectively in what was a declining

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Medicare funding environment. On December 8, 2003, the President signed the new Medicare Prescription Drug, Improvement, and Modernization Act of 2003, or MMA, into law. This law increases the Medicare Advantage reimbursement payment formula, creates a prescription drug discount card program in 2004-2005 and establishes a new Part D Medicare prescription drug benefit beginning in 2006. This law also requires us to pass through, in 2005, 100% of the incremental funding to our members in the form of enhanced benefits, or to providers for increased network stabilization. With the changes in Medicare funding, beginning in 2004 we were able to increase our membership in Medicare Advantage beginning in 2004 for the following reasons:

One of our primary areas of focus has been servicing large employer groups. In recent years, we have concentrated on small employer groups and individuals as demonstrated by our acquisition of American Medical Security Group, Inc., or AMS, and our pending acquisition of the group health insurance business of Pacific Life Insurance Company, or Pacific Life.

Health Plans

We have developed products and services in order to meet the needs of our commercial and senior customers. In developing our products and marketing plans, we take into account the differing needs of our customers and believe that we create cost-effective, quality health care service options.

Commercial Products

Our commercial HMO, PPO and Self Directed Health Plan, or SDHP, products may be offered on a stand-alone basis or may be bundled with our specialty products and services, including PBM, behavioral health services, group life and health insurance products, and dental and vision services. This provides employer groups and individuals with more benefit options from a single source and the ability to design tailored benefit programs. We also sell our specialty products and services on a stand-alone basis to unaffiliated health plans, employer groups and individuals.

Our HMO plans provide health care benefits to commercial members through a defined provider network in which members typically pay a fixed copayment for services accessed. We have a broad network that as of December 31, 2004 included approximately 700 hospitals and 68,000 primary care and specialty physicians.

Our PPO network supplements our existing HMO network with additional health care providers. We also contract with commercial PPO networks in geographic areas where we do not have HMOs. The PPOs generally enable members to have a broad selection of providers in any given geographic area. Additionally, access is extended to health care providers located outside of a given geographic area through out-of-network benefits that allow choice beyond the organized PPO network in exchange for reduced coverage or higher coinsurance or copayments. Our PPO products give members open access to network providers, with no primary care physician coordinating care and simplified medical management practices.

Our SDHP product, which was introduced in 2004, offers our members a self directed account, or SDA, that covers certain health care expenses coupled with a PPO plan for expenses incurred that are outside of the coverage of the SDA, and after the applicable deductibles have been met. Unused amounts in the SDA can roll over from year to year and accumulate for future use (up to a plan maximum). The SDA feature gives members control over their health care spending, provides greater personal choice in health care services and encourages members to budget and plan for health care expenses.

We also offer an exclusive provider organization, or EPO, product that combines all of our proprietary networks in each state where we offer PPOs. This allows members to receive more cost-effective benefits on an in-network basis as

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long as they receive services from a contracted EPO provider. The EPO plan is an open-access product within the combined network and there is no primary care physician gatekeeper. This makes the EPO an excellent option for providing members with broader access to network physicians.

We target a variety of plan sponsors including employer groups and other purchasing coalitions, as well as state and federal government agencies. We offer commercial products in a broad spectrum of customer segments ranging from individuals and small groups to large employers. We also have contracts with the United States Office of Personnel Management, or OPM, to provide HMO services to members under the Federal Employee Health Benefit Program, or FEHBP, for federal employees, annuitants and their dependents.

As of December 31, 2004, we had approximately 1.9 million commercial HMO members and approximately 583,000 enrollees in our PPO products.

Group Life and Health Products

We are licensed to issue life and health care insurance in 47 states, including each of the states where our HMOs operate, the District of Columbia and Guam. By marketing our commercial health care product line in conjunction with supplemental insurance products, we are able to offer multi-option health and financial benefit programs. Other supplementary benefits offered to employer groups include basic life insurance, group term life insurance, indemnity dental and indemnity behavioral health benefits. Indemnity dental and behavioral health benefits are specialty products. We also offer life, accidental death and dismemberment and short-term and long-term disability products to our commercial employer groups through AMS or under a private label arrangement with the Hartford Life Group.

Senior Products

We offer eligible Medicare beneficiaries access to Medicare Advantage and Medicare Supplement products through our Secure Horizons programs.

Medicare Advantage Plans.  We are one of the largest Medicare Advantage organizations in the United States as measured by membership with approximately 705,000 members as of December 31, 2004. Medicare is a federal program that provides persons age 65 and over and eligible disabled persons under the age of 65 a variety of hospital and medical insurance benefits. Most individuals eligible for Medicare are entitled to receive inpatient hospital care under Part A without the payment of any premium, but are required to pay a premium to the federal government, which is adjusted annually, to be eligible for physician care and other services under Part B. Beneficiaries are required to pay out-of-pocket deductibles and coinsurance in both Part A and Part B of the traditional Medicare program.

We contract with the Centers for Medicare and Medicaid Services, or CMS, under the Medicare Advantage program to provide health insurance coverage in exchange for a fixed monthly payment per member that varies based on geographic and risk factors. Individuals who elect to participate in the Medicare Advantage program may receive benefits greater than the government program, such as pharmacy drug coverage and reduced deductibles and coinsurance, but are generally required to use the services provided by the HMO exclusively and are required to pay a Part B premium to the Medicare program. These individuals also may be required to pay a monthly premium to the HMO.

Medicare Supplement Products.  We are licensed in 48 states to offer group and individual senior supplement products and have licenses pending in two states and Puerto Rico. These products are designed to fill gaps left by traditional Medicare coverage. For example, the Individual Supplement products pay for hospital deductibles, physician copayments and coinsurance for which an individual enrolled in the traditional Medicare program would otherwise be responsible. The Senior Supplement product provides employer groups with similar coverage options for their Medicare eligible retirees. The Secure Horizons Prescription Advantages Plan has no annual deductible, no annual maximums, and provides unlimited coverage for approximately 400 generic medications covering many chronic conditions and ailments. This plan offers discounts on most other drugs depending on how the drugs are purchased.

Specialty

We use our existing employer group and senior relationships to offer our specialty products and services in conjunction with our commercial and senior products. These specialty products and services include PBM, behavioral health

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services, group life and health insurance products, and dental and vision services. In addition, we sell our specialty products and services to unaffiliated health plans, union trusts, third party administrators and employer groups.

Prescription Solutions^®.  Prescription Solutions offered integrated PBM services (including mail order pharmacy services) to approximately 5.6 million people, including approximately 743,000 seniors, as of December 31, 2004. Prescription Solutions offers a broad range of innovative programs, products and services designed to enhance clinical outcomes with appropriate financial results for employers and members.

We believe Prescription Solutions’ strength lies in its ability to influence medical outcomes and reduce overall health care costs by focusing on appropriate prescription drug use. For example, through its formulary management program, Prescription Solutions uses lists of physician-recommended drugs in different therapeutic classes that have been reviewed for safety, efficacy and value to ensure that drugs prescribed are the lowest cost option among equally effective alternatives. Prescription Solutions operates independently of pharmaceutical or retail drug organizations, which allows it to focus primarily on improving clinical outcomes.

We believe that Prescription Solutions’ mail order capabilities also differentiate us from our health insurance competitors who do not have captive PBMs. Prescription Solutions operates an 84,000 square foot, fully automated facility in Carlsbad, California, which we believe can support our projected internal growth for the foreseeable future. Prescription Solutions aggressively promotes mail order pharmacy services as a convenient and cost-effective service for our members.

Behavioral Health Services.  We provide behavioral health care services including managed behavioral health, employee assistance, care management and chemical dependency benefit programs. As of December 31, 2004, we provided these behavioral health care services to approximately 3.8 million affiliated and unaffiliated members through our provider network. Managed behavioral health and chemical dependency services are offered as a standard part of most of our commercial health plans and are sold in conjunction with our other commercial and Medicare products, and are sold on a stand-alone basis to unaffiliated health plans and employer groups.

Dental and Vision Services.  We provide a broad range of dental and vision insurance and discount services to individuals and employer groups. Commercial plans include dental HMO, dental PPO, dental fee-for-service, vision PPO, and dental and vision discount programs. We also provide dental services to seniors through Secure Horizons. We provide our commercial dental and vision products to small, mid-size and large employers, regardless of their existing medical carrier. As of December 31, 2004, we provided these dental and vision services to approximately 1.0 million affiliated and unaffiliated members.

Physician and Hospital Relationships

Contracting Arrangements with Physicians and Hospitals

We maintain a network of qualified physicians, hospitals and other health care providers in every geographic area where we offer managed care products and services. Our contracting strategy is to base the type of contract utilized on our assessment of the underlying structure and strengths of the medical communities within the applicable geographic markets. In HMO markets with physicians and hospitals that we believe have the necessary infrastructure and financial strength to accept delegation for certain administrative services and prepayment for health care services, we may elect to use delegation and capitation contracts. In other circumstances, we may elect to use fee-for-service or other shared risk arrangements. Most of our physician and hospital contracts have a one-year term, however, we may also enter into multiple-year contracts with physician groups and hospitals to enhance network stability or provide greater predictability of future health care costs. Contracts for our PPO products are all fee-for-service.

Our provider contracting processes include analysis and modeling of underlying cost and utilization assumptions. Through these processes, we continually seek to identify strategies to better manage health care costs. We also focus on provider consultation and management tools, including thorough data reporting and financial analysis of expected performance of our contracts.

Underwriting

In establishing premium rates for our health care plans, we use underwriting criteria based upon our accumulated actuarial data, with adjustments for factors such as the physicians and hospitals utilized, claims experience, member

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demographic mix and industry differences. Predictive models using pharmacy data and health status are also used to identify health care costs that are likely to emerge. Our underwriting practices are filed and approved in states in which we operate and require those actions. Because our members are in multiple states, our underwriting practices, especially in the individual, small group and Medicare Supplement markets, are subject to a variety of legislative and regulatory requirements and restrictions unique to the state in which a member resides.

Medical Management

Our profitability depends, in part, on our ability to control health care costs while providing quality care. Our medical management staff consists of doctors and nurses who monitor the medical treatment of our members in need of hospital and specialist care. In some cases, our medical managers are located on-site at some of our key contracted hospitals.

Our medical management programs include:

Marketing

Our commercial products are marketed under the PacifiCare and AMS brands, which we believe have a reputation for quality and value. Our senior products are marketed under the Secure Horizons name, which we believe is one of the premier service marks in health care services among seniors in our markets in the western United States. We market our specialty products under the PacifiCare brand and our third-party unaffiliated PBM services under our Prescription Solutions service mark.

Marketing to our small group, large group and National Account commercial customers is typically handled primarily through the broker and consultant channels. After a large group or National Account is sold we market directly to employees, primarily during their open enrollment periods. For many of our larger commercial accounts, the open enrollment periods typically occur for 30 days during the fourth quarter of the calendar year. For some employer groups, we are the exclusive provider of health care products for their employees on a full-replacement basis. We also offer individual commercial products directly to consumers.

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We use various techniques to attract commercial members, including work site presentations, direct mail, medical group tours and local advertising. We also use television, radio, billboard and print media to market our programs to potential commercial members. Further, we utilize multiple distribution channels such as general agents, an on-line price quoting service, and insurance brokers and consultants who represent many employer groups. These brokers and consultants work directly with employers to recommend or design employee benefits packages and select carriers to provide these services. Commercial marketing provides brokers with kits containing information about our products and programs. We engage in Broker Advisory Councils and conferences to provide brokers with education on our products and services. We send communications to our brokers on a regular basis to update them on new products or changes.

We believe that our commitment to service and offering of health programs, such as, HealthCredits, depression, diabetes, Pregnancy to Preschool and special programs including Women’s Health Solutions and Latino Health Solutions differentiates us from other carriers. Also, our product offering, including our SDHP product, provides solutions to commercial customers.

We believe that our understanding of the senior population and our attention to customer service differentiates our Secure Horizons program from competing products. We market our Secure Horizons programs to Medicare beneficiaries and caregivers for Medicare beneficiaries primarily through direct mail, newspaper, television, telemarketing, our website, and community-based events. We also have a national broker channel for delivery of all of our products.

Management Information Systems and Claims Processing

We use computer-based information systems for various purposes, including e-commerce, marketing and sales tracking, underwriting, billing, claims processing, medical management, medical cost and utilization trending, financial and management accounting, reporting, planning and analysis. These systems also support on-line customer service functions, provider and member administration functions, and support our tracking and extensive analyses of health care costs and outcome data.

We have established corporate goals to have our information technology, or IT, systems operate under an integrated business platform and improve operational efficiency. Simplification and integration of the systems servicing our business are important components of controlling health care and administrative expenses and improving member satisfaction. To accomplish these goals, we have outsourced data processing operations and maintenance of older software applications so we can focus internally on new technologies. Additionally, we are opportunistically insourcing data center operations and software development as part of our long-term sourcing strategy.

We use these computer-based information systems as an important component of claims processing. We receive medical claims from physicians and hospitals for services to our members. Claims are reviewed to determine member eligibility, the quantity and kind of services performed and whether services were authorized, then adjudicated against pricing, claims rules and benefits. To help ensure timely and accurate payments, we regularly review reports on inventory levels and claims statistics that focus on claims turn-around time and accuracy of payment processing. We also perform a variety of claim audits and cost containment programs. We have significantly increased the number and percentage of claims processed electronically to improve claims turnaround times and accuracy.

Government Regulation

General HMO and Indemnity Regulation

We are subject to extensive federal and state regulations that govern the scope of benefits provided to our members. These regulations can vary significantly from jurisdiction to jurisdiction. Broad latitude is given to the agencies administering these regulations. Changes in applicable laws and regulations are continually being considered, and the interpretation of existing laws and rules also may change periodically. Existing and future laws and rules could force us to change how we do business, restrict revenue and enrollment growth, increase our health care and administrative costs and capital requirements and increase our liability in federal and state courts for coverage determinations, contract interpretation and other actions. We must obtain and maintain regulatory approvals to market our products, to increase prices for certain regulated products and to consummate acquisitions and dispositions of health plans.

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We participate in federal, state and local government health care coverage programs. These programs generally are subject to frequent change, including changes that may reduce the number of persons enrolled or eligible, reduce the amount of reimbursement or payment levels, or increase our administrative or health care costs under such programs. Such changes have adversely affected our financial results and willingness to participate in such programs in the past and may do so in the future.

State legislatures and Congress continue to focus on health care issues. Bills and regulations at state and federal levels may affect certain aspects of our business, including:

Office of Personnel Management

We have commercial contracts with OPM to provide managed health care services to federal employees, annuitants and their dependents under FEHBP. Rather than negotiating rates, OPM requires health plans to provide the FEHBP with rates comparable to the rates charged to the two employer groups with enrollment closest in size to the FEHBP in the applicable community after making required adjustments. OPM further requires health plans to certify each year that rates meet these requirements. Periodically, the Office of the Inspector General, or OIG, audits health plans to verify that the premiums charged are calculated and charged in compliance with these regulations and guidelines. OPM has the right to audit the premiums charged during any period for up to five years following the end of that contract year. The final resolution and settlement of audits have historically taken more than three years and as many as seven years. We have a formal compliance program to specifically address potential issues that may arise from the FEHBP rating process, to work with OPM to understand its interpretation of the rules and guidelines prior to completion of the rating process, to standardize the FEHBP rating process among all of our HMOs, and to help reduce the likelihood that future government audits will result in any significant findings.

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Required Statutory Capital

By law, regulation and governmental policy, our HMO, indemnity and regulated specialty product subsidiaries, which we refer to as our regulated subsidiaries, are required to maintain minimum levels of statutory net worth. The minimum statutory net worth requirements differ by state and are generally based on a percentage of annualized premium revenue, a percentage of annualized health care costs, or risk based capital, or RBC requirements. The RBC requirements are based on guidelines established by the National Association of Insurance Commissioners, or NAIC. If adopted, the RBC requirements may be modified as each state legislature deems appropriate for that state. The RBC formula, based on asset risk, underwriting risk, credit risk, business risk and other factors, generates the authorized control level, or ACL, which represents the minimum amount of net worth believed to be required to support the regulated entity’s business. For states in which the RBC requirements have been adopted, the regulated entity typically must maintain the greater of the required ACL or the minimum statutory net worth requirement calculated pursuant to pre-RBC guidelines. As of December 31, 2004, the aggregate net worth of our regulated subsidiaries exceeded 300% of the aggregate ACL calculated under NAIC RBC guidelines. The amount of statutory capital in excess of state regulatory requirements was approximately $800 million as of December 31, 2004. In addition to the foregoing requirements, our regulated subsidiaries are subject to restrictions on their ability to make dividend payments, loans and other transfers of cash to the parent company.

The statutory framework for our regulated subsidiaries’ statutory net worth requirements may change over time. These subsidiaries are also subject to their state regulators’ overall oversight powers. Those regulators could require our subsidiaries to maintain minimum levels of statutory net worth in excess of the amount required under the applicable state laws if the regulators determine that maintaining such additional statutory net worth is in the best interest of our members.

Pharmacy Regulations

Our PBM business is subject to state and federal statutes and regulations governing the operation of pharmacies, labeling, packaging and repackaging of drug products, dispensing of controlled substances, disposal, advertising, security, recordkeeping and inventory control.

Many states have laws and regulations that require out-of-state internet and mail-service pharmacies to register with, or be licensed by, the board of pharmacy or a similar regulatory body in the state. Other states generally permit the dispensing pharmacy to follow the laws of the state within which the dispensing pharmacy is located. Various other states, however, have enacted laws requiring, among other things, the hiring of a pharmacist licensed by that state or compliance with all laws of the states into which the out-of-state pharmacy dispenses medications, whether or not those laws conflict with the laws of the state in which the pharmacy is located. If these laws are applicable to us, they could restrict or prevent us from providing prescription internet or mail order in those states.

Other specific laws or regulations that may affect our PBM business include those that address any willing provider, contract limitations, benefit mandates, pharmacy management restrictions, limitations on price negotiations, changes in Medicaid “best price” rules, and the conduct of clinical trials.

Privacy Regulations

The use of individually identifiable data by our businesses is regulated at international, federal, state and local levels. These laws and rules are changed frequently by legislation or administrative interpretation. Various state laws address the use and maintenance of individually identifiable health data. Most are derived from the privacy provisions in the federal Gramm-Leach-Bliley Act and the Health Insurance Portability and Accountability Act of 1996, or HIPAA. HIPAA also imposes guidelines on our business associates (as this term is defined in the HIPAA regulations). Even though we provide for appropriate protections through our contracts with our business associates, we still have limited control over their actions and practices. Compliance with these proposals and new regulations may result in cost increases due to necessary systems changes, the development of new administrative processes, and the effects of potential noncompliance by our business associates. They also may impose further restrictions on our use of patient identifiable data that is housed in one or more of our administrative databases.

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Risk Management

We maintain general liability, property, directors’ and officers’ liability and managed care errors and omissions, which includes medical malpractice, insurance coverage. Policies typically include varying and increasing levels of self-insured retention or deductibles that increase our risk of loss. We operate a wholly owned captive insurance company designed to assist us primarily in managing the risk of loss associated with our retained risk on errors and omissions claims and catastrophic medical claims. We require contracting physicians, physician groups and hospitals to maintain individual malpractice insurance coverage.

Competition

In offering HMOs, PPOs and related products, we compete with Aetna Inc., CIGNA Corporation, Health Net, Inc., WellPoint, Inc., other Blue Cross and Blue Shield plans and UnitedHealth Group Incorporated, as well as other national and regional health insurers for membership. Regional competitors include Kaiser Foundation Health Plan Inc., Health Net, Inc., WellPoint, Inc., Humana Inc., and the member companies of the Blue Cross and Blue Shield Association. We also offer a regional alternative for national employers who are willing to support multiple health plans to maintain plans that best suit the needs of employees within a specific region.

We are one of the largest Medicare Advantage organizations measured in terms of membership in the nation, both in absolute terms and as a percentage of overall membership, offering competitive advantages and economies of scale in the Medicare Advantage market. In 2002 and 2003, we reduced our benefits, raised member copays and deductibles, and replaced coverage of brand name prescription drugs with generic drugs in most of the counties where we participate in Medicare Advantage. This was in response to the rising health care costs of treating the senior population and the inadequate rate of increase in levels of Medicare reimbursement from the government. These changes caused members to leave our plans for competing plans or traditional Medicare coverage. Many competing HMO health plans also reduced their participation in the Medicare Advantage program and reduced benefits coverage.

Beginning in 2004, we were able to improve our competitive position in Medicare Advantage for the following reasons:

Because of the increased government funding under the MMA legislation, there is a greater risk that competition among private health plans for Medicare Advantage members could increase in 2005.

The Medicare Supplement product market is highly fragmented with few large competitors. Our primary competition in this market is the Medicare Supplement product marketed by the American Association of Retired Persons, or AARP, and underwritten by UnitedHealth Group Incorporated. We believe that our product offerings and distribution channels differentiate our Medicare Supplement products from competing products.

Prescription Solutions’ PBM services are sold as part of our commercial and Medicare products and on a stand-alone basis to unaffiliated health plans and employer groups. We believe our competitors include Medco Health Solutions Inc., Caremark Rx, Inc. and Express Scripts Inc. We believe because it is aligned with a managed care organization, Prescription Solutions differentiates itself from other independent pharmacy benefit organizations by managing prescription costs and outcomes for managed care organization members. Our mail order prescription drug service competes with national, regional and local pharmacies and other mail order prescription drug companies.

The managed behavioral health care industry is dominated by a few large companies, principally Magellan Health Services, Inc. and ValueOptions, Inc., as well as the behavioral health divisions of health insurers such as UnitedHealth

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Group Incorporated and CIGNA Corporation. Our ability to compete is affected by a limited national supply of providers, particularly psychiatrists and psychiatric hospital units. Our behavioral health subsidiary has a core competency in managing at-risk contracts, which we believe differentiates us competitively in states with mental health parity laws that mandate equal coverage for behavioral health benefits.

We believe that to retain our health plans’ competitive advantages we should continue to focus on developing additional products and services that are demanded by the market. We believe that consumers want products and services that go beyond basic necessity, extending to areas such as lifestyle and wellness enhancing products. The factors that we believe give us competitive advantages are:

Intellectual Property

We own various federally registered trademarks, service marks and other trade names. Some of the more material marks we own include PacifiCare^®, SecureHorizons^®, Prescription Solutions^® and the QUALITY INDEX^® profile. There is also a patent pending for certain methods used in creating our QUALITY INDEX^® profile.

Employees

At January 31, 2005, we had approximately 9,800 full and part-time employees. None of our employees is presently covered by a collective bargaining agreement. We consider relations with our employees to be good and have never experienced any work stoppage.

ITEM 2.  PROPERTIES

As of December 31, 2004, we leased approximately 104,000 aggregate square feet of space for our principal corporate headquarters and executive offices in Cypress, California. In connection with our operations, as of December 31, 2004, we leased approximately 1.8 million aggregate square feet for office space, subsidiary operations, customer service centers and space for computer facilities. Such space corresponds to areas in which our HMOs or specialty managed care products and services operate, or where we have satellite administrative offices. Our leases expire at various dates from 2005 through 2012.

In California, Wisconsin, and Guam, we own three buildings encompassing approximately 625,000 aggregate square feet of space primarily used for the administrative operations of our subsidiary, AMS. All of our facilities are in good working condition, are well maintained and are adequate for our present and currently anticipated needs. We believe that we can rent additional space at competitive rates when current leases expire, or if we need additional space.

ITEM 3.  LEGAL PROCEEDINGS

For information regarding our legal proceedings, see Note 13 of the Notes to Consolidated Financial Statements.

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

No matter was submitted to a vote of security holders during the three months ended December 31, 2004.

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PART II

ITEM 5.  MARKET FOR THE REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER REPURCHASES OF EQUITY SECURITIES

On June 6, 2003, our common stock listing was transferred from the NASDAQ National Market under the symbol PHSY to the New York Stock Exchange (NYSE) under the symbol PHS.

On January 20, 2004, we effected a two-for-one stock split in the form of a stock dividend of one share of our common stock for every share of common stock outstanding to stockholders of record as of the close of business on January 7, 2004. All share price and per share data and numbers of common shares outstanding have been retroactively adjusted to reflect the stock split. See Note 6 of the Notes to Consolidated Financial Statements.

The following table indicates the high and low reported sale prices per share as furnished by the NYSE and NASDAQ.

We have never paid cash dividends on our common stock. We do not expect to declare cash dividends on our common stock in the future, retaining all earnings for business development. Any possible future dividends will depend on our earnings, financial condition, and regulatory requirements. If we decide to declare dividends on our common stock in the future, such dividends may only be made in compliance with our senior credit facility and our 10 ³/4% senior notes.

As of January 31, 2005 there were 281 stockholders of record of our common stock.

We have $135 million in aggregate principal amount of 3% convertible subordinated debentures due in 2032. The debentures are convertible into 6,428,566 shares of common stock under certain conditions, including satisfaction of a market price condition for our common stock, satisfaction of a trading price condition relating to the debentures, upon notice of redemption, or upon specified corporate transactions. Each $1,000 of the debentures is convertible into 47.619 shares of our common stock. The market price condition for conversion of the debentures is satisfied if the closing sale price of our common stock exceeds 110% of the conversion price (which is calculated at $23.10 per share) for the debentures for at least 20 trading days in the 30 consecutive trading days ending on the last trading day of any fiscal quarter. In the event that the market price condition is satisfied during any fiscal quarter, the debentures are convertible, at the option of the holder, during the following fiscal quarter. The market price condition is evaluated each quarter to determine whether the debentures will be convertible at the option of the holder during the following fiscal quarter. Beginning with the quarter ended September 30, 2003 and during each consecutive calendar quarter up through and including the quarter ended December 31, 2004, the market price condition described above was satisfied. As a result, the debentures were convertible beginning October 1, 2003, and remain convertible at the option of the holder at any time during the quarter ended March 31, 2005. While no debentures were converted as of December 31, 2004, they are considered common stock equivalents and are included in the calculation of weighted average shares outstanding on a diluted basis for the years ended December 31, 2004 and 2003.

Beginning in October 2007, we may redeem for cash all or any portion of the debentures, at a purchase price of 100% of the principal amount plus accrued interest, upon not less than 30 nor more than 60 days’ written notice to the holders. Beginning in October 2007, and in successive 5-year increments, our holders may require us to repurchase the debentures for cash at a repurchase price of 100% of the principal amount plus accrued interest. Our payment obligations under the debentures are subordinated to our senior indebtedness, and effectively subordinated to all indebtedness and other liabilities of our subsidiaries.

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In November 2003, we issued 7.6 million shares of our common stock in a public offering. The net proceeds from the offering, approximately $200 million after underwriting fees, were used to redeem $175 million in principal of the company’s outstanding 10 ³/4% senior notes. See Note 6 of the Notes to Consolidated Financial Statements.

With respect to information regarding our securities authorized for issuance under equity incentive plans, the information contained in the section entitled “Equity Compensation Plan Information” of our definitive Proxy Statement for the 2005 Annual Meeting of Stockholders is incorporated herein by reference.

In May 2004, our Board of Directors authorized the repurchase of up to $150 million of our common stock under a 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 using available cash, and may be discontinued at any time. Also, in connection with our employee equity incentive plans, we may repurchase shares of common stock from employees for the satisfaction of their individual payroll tax withholdings upon vesting of restricted stock. For a summary of our repurchase activity for the year ended December 31, 2004, see “Management’s Discussion and Analysis of Financial Condition and Results of Operations-Financing Activities.”

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ITEM 6.  SELECTED FINANCIAL DATA

The following selected financial and operating data are derived from our audited consolidated financial statements. The selected financial and operating data should be read in conjunction with “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations,” and also with “Item 15. Exhibits and Financial Statement Schedules.”

Income Statement Data

See footnotes following “Balance Sheet Data”.

Continued on next page

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Other Financial and Operating Data

The 2002 results include a cumulative effect of a change in accounting principle in connection with the goodwill impairment recognized upon the adoption of Statement of Financial Accounting Standards, or SFAS, No. 142, Goodwill and Other Intangible Assets, totaling $929 million ($897 million or $12.73 diluted loss per share, net of tax). See Note 7 of the Notes to Consolidated Financial Statements.

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

Overview

In this Annual Report on Form 10-K, we refer to PacifiCare Health Systems, Inc. as “PacifiCare,” “the Company,” “we,” “us,” or “our.” Statements that are not historical facts are forward-looking statements within the meaning of the Federal securities laws, and may involve a number of risks and uncertainties which could cause actual results to differ materially from those anticipated as of the date of this report. In addition, past financial and/or operating performance is not necessarily a reliable indicator of future performance and you should not use our historical performance to anticipate results or future period trends. In evaluating these forward-looking statements, you should specifically consider the risks described below under “Cautionary Statements” which follows our discussion on Critical Accounting Estimates and in other parts of this report.

We offer managed care and other health insurance products to employer groups, individuals and Medicare beneficiaries throughout most of the United States and Guam. Our commercial and senior plans are designed to deliver quality health care and customer service to members cost-effectively. These products include health insurance, health benefits administration and indemnity insurance products such as Medicare Supplement products offered through health maintenance organizations, or HMOs, and preferred provider organizations, or PPOs. We also offer a variety of specialty managed care products and services that employees and individuals can purchase as a supplement to our basic commercial and senior medical plans or as stand-alone products. These products include pharmacy benefit management, or PBM, services, behavioral health services, group life and health insurance, dental and vision benefit plans.

Acquisitions.  During 2004, we entered into agreements to acquire two businesses. On December 13, 2004, we completed our acquisition of American Medical Security Group, Inc., or AMS. AMS provides an expansion of our commercial membership, strengthens our position in the individual and small group markets and adds new proprietary products including a health savings account and group life products. We paid $32.75 in cash for each share of AMS common stock outstanding and cashed out all outstanding options on a net basis for a total equity purchase price of approximately $505 million. We financed the acquisition through proceeds from a new $825 million credit facility and the use of internally generated cash. The new credit facility includes a total of $625 million of term debt, approximately $148 million of which was used to refinance our existing senior credit facility and approximately $30 million was used to refinance AMS’s senior credit facility, and a new $200 million unutilized revolving credit facility. We recorded $295 million of goodwill and $26 million of intangible assets as a result of this acquisition. As of December 31, 2004, AMS provided a variety of individual and small group insurance products to approximately 271,200 PPO members, 206,100 dental members and 40,900 employer self-funded members. See Note 3 of the Notes to Consolidated Financial Statements.

On November 29, 2004, we entered into a definitive agreement to purchase Pacific Life Insurance Company’s, or Pacific Life, group health insurance business. The transaction will be financed through internally generated cash. The group health insurance business we are acquiring from Pacific Life includes medical, dental and life coverage for small and large group employers. Through the transaction, which is structured as a coinsurance arrangement, we expect to acquire up to 140,000 PPO members and obtain assets necessary to support and preserve the continuity of the acquired business and the rights to offer employment to the approximately 700 Pacific Life employees who currently provide service and support to the group insurance business. The transaction is subject to approvals from the California Insurance Commissioner and certain other state regulatory approvals. We anticipate the acquisition will be consummated during the spring of 2005.

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2004 Changes in Debt.

Senior Credit Facility.  In December 2004, concurrent with the acquisition of AMS, we replaced our senior credit facility with a new syndicated senior credit agreement. The new facility consists of a $200 million term A loan, which matures on December 13, 2009, a $425 million term B loan, which matures on December 13, 2010, and a $200 million revolving line of credit, which matures on December 13, 2009. We used the proceeds of the term A and term B loans to refinance approximately $149 million (including accrued interest and fees of approximately $1 million) outstanding under our previous senior credit facility entered into in June 2003, refinance approximately $30 million outstanding under the senior credit facility of AMS and to fund a portion of the merger consideration paid to acquire AMS. See Note 3 of the Notes to Consolidated Financial Statements. In connection with the credit agreement, we incurred approximately $9 million in fees and expenses that are being amortized over the term of the facility. As of December 31, 2004, we had $625 million outstanding on the term A and term B loans and no balance outstanding on the revolving line of credit. There were no borrowings under the revolving line of credit (or the line of credit we refinanced) during the year ended December 31, 2004.

For additional details related to our debt and financings, see Note 5 of the Notes to Consolidated Financial Statements.

Other

Segment Reporting.  We regularly review for changes in our segment reporting. We expect our specialty product revenues may increase in 2005 and rise to the level of a reportable segment. As a result of entering into contracts that bear margin or pricing risk, we expect there will be an increase in revenues and expenses. Accordingly, we have included in Note 15 of the Notes to Consolidated Financial Statements, disclosures related to our Health Plans and Specialty segments.

Intercompany Transactions.  All intercompany transactions and accounts are eliminated in consolidation.

Results of Operations

Revenue

Health Plans Segment.  Our commercial and senior revenues include all premium revenue we receive from our health plans, indemnity insurance subsidiaries and Medicare Supplement and Senior Supplement products, as well as fee revenue we receive from administrative services we offer through our commercial and senior health plans and related subsidiaries. We receive a monthly payment on behalf of each subscriber enrolled in our commercial HMOs and our indemnity insurance service plans. Generally, our Medicare Advantage, formerly Medicare+Choice, contracts entitle us to per member per month payments from the Centers for Medicare and Medicaid Services, or CMS, on behalf of each enrolled Medicare beneficiary. We report prepaid health care premiums received from our commercial plans’ enrolled groups, CMS, and our Medicare plans’ members as revenue in the month that members are entitled to receive health care. We record premiums received in advance as unearned premium revenue.

Premiums for our commercial products and Medicare Advantage products are generally fixed in advance of the periods covered. Of our commercial business, more than 50% of our membership renews on January 1 of each year, with premiums that are generally fixed for a period of one year. In addition, each of our subsidiaries that offers Medicare Advantage products must submit adjusted community rate proposals, generally by county or service area, to CMS, in early September for each Medicare Advantage product that will be offered in the subsequent year. As a result, increases in the costs of health care services in excess of the estimated future health care services expense reflected in the premiums or the adjusted community rate proposals generally cannot be recovered in the applicable contract year through higher premiums or changes in benefit designs.

Specialty Segment.  Our specialty and other revenues include all premium revenues we receive from our behavioral health, dental and vision service plans and fee revenue we receive from administrative services we offer though our specialty companies, primarily from our PBM subsidiary. Our PBM subsidiary generates mail order revenue where we, rather than network retail pharmacies, collect the member copayments for both affiliated and unaffiliated members. Additionally, we record revenues for prescription drug costs and administrative fees charged on prescriptions dispensed by our mail order pharmacy when the prescription is filled. Beginning in January 2004, our PBM subsidiary began

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entering into retail service contracts where we assume margin or pricing risk. Under these retail service contracts, we are separately obligated to pay our network pharmacy providers for benefits provided to our plan sponsors’ members, and as a result, we have included the total revenues we are contracted to receive from the plan sponsors as specialty and other revenue. Payments we are obligated to make under these retail service contracts to the network pharmacy providers are recorded as health care services and other expenses. For all contracts where we earn a fixed fee per transaction and we do not assume margin or pricing risk, specialty and other revenue and specialty and other health care services and other expenses do not include the network pharmacies’ drug costs and dispensing fees. Instead, we record administrative services fees that we are entitled to receive, in specialty and other revenue. In all retail pharmacy transactions, revenues recognized and expenses recorded are always exclusive of the member’s applicable copayment. Collection of copayments from members is the responsibility of the retail pharmacies.

Net Investment Income.  Net investment income consists of interest income and gross realized gains and losses incurred on cash investments during each period.

Expenses

Health Plans Segment.  Health care services and other expenses for our commercial plans and our senior plans primarily comprise payments to physicians, hospitals and other health care providers for services provided to our commercial and senior health plan members and indemnity insurance plan members. We pay our providers under capitated contracts, fee-for-service contracts, or a combination of both. In the situation where we pay a provider under a combination of capitation and fee-for-service, a member, during the same episode of care, may incur services that are rendered and paid for under the capitated portion of a contract with a physician or hospital and also incur services that are rendered and paid for under the fee-for-service component of the same contract.

Our fee-for-service based health care services expenses consist mostly of four cost of care components: outpatient care, inpatient care, professional services (primarily physician care) and pharmacy benefit costs. All four components are affected by both unit costs and utilization rates. Unit costs, for example, are the cost of outpatient medical procedures, inpatient hospital stays, physician fees for office visits and prescription drug prices. Utilization rates represent the volume of consumption of health services and vary with the age and health of our members and broader social and lifestyle patterns of the population as a whole.

The cost of health care provided is accrued in the month services are provided to members, based in part on estimates of claims for hospital services and other health care costs that have been incurred but not yet reported (including those claims received but not yet paid), or IBNR, under our fee-for-service based provider contracts as well as some services under our capitation contracts for which we retain financial liability, or carve-outs, primarily using standard actuarial methodologies based on historical data. These standard actuarial methodologies include, among other factors, contractual requirements, historical utilization trends, the interval between the date services are rendered and the date claims are paid, denied claims activity, disputed claims activity, benefit changes, expected health care cost inflation, seasonality patterns and changes in membership. These estimates are adjusted in future periods as we receive actual paid claims data, and can either increase or reduce our accrued health care costs. Included in health care services and other expenses for the year ended December 31st of last year were net favorable adjustments of 2002 and prior period medical cost estimates of approximately $54 million. During 2003, both commercial and senior net favorable adjustments were mainly from our Texas and California markets and were the result of lower than anticipated health care costs that materialized primarily in senior markets that we exited and recoveries of claims overpayments made in prior periods at rates higher than historic recovery patterns.

The cost of prescription drugs covered under our commercial and senior plans is expensed when the prescription drugs are dispensed. Our commercial and senior plans also provide incentives, through a variety of programs, for health care providers that participate in those plans to control health care costs while providing quality health care. Expenses related to these programs, which are based in part on estimates, are recorded in the period in which the related services are provided. Historically, we have primarily arranged health care services for our members by contracting with health care providers on a capitated basis, regardless of the services provided to each member. Under some of our capitation contracts, we partially share the risk of excess health care expenses with health care providers, meaning that if member utilization of health care services exceeds agreed-upon amounts or falls into certain defined categories, we partially

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share the excess expenses with the applicable health care provider. Under fee-for- service arrangements, we generally bear the full risk of member utilization of health care services.

Specialty Segment.  Health care services and other expenses for our specialty companies primarily comprise payments to physicians, hospitals and other health care providers under capitated or fee-for-service based contracts for services provided to our behavioral health and dental and vision members and the cost of acquiring drugs for our mail order PBM subsidiary where we assume margin or pricing risk. Health care services and other expenses also include expenses for administrative services performed by our specialty companies.

2004 Compared With 2003

Membership

Health Plans Segment Membership.  Total managed care membership increased 14% to approximately 3.3 million members at December 31, 2004 from approximately 2.9 million members at December 31, 2003.

Commercial membership increased approximately 18% at December 31, 2004 compared to the prior year primarily due to an increase in membership in our PPO and employer self-funded products, which includes the addition of 271,200 PPO and 40,900 employer self-funded members as a result of the AMS acquisition. Membership increases were offset by a net decrease in commercial HMO membership primarily due to the planned termination of large employer groups in Texas and Oklahoma.

Medicare Advantage membership increased approximately 3% at December 31, 2004 compared to the prior year primarily due to increased membership in the HMO product in Arizona, California and Texas from service area expansions and sales through new broker channels.

Medicare Supplement membership increased approximately 35% at December 31, 2004 compared to the prior year primarily due to membership growth in Texas and expansion into 19 new states through new broker channels.

We anticipate that our health plans segment membership will increase in 2005.

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Below is a summary of our commercial and senior membership.

Specialty Segment Membership.  PBM unaffiliated membership at December 31, 2004 increased approximately 24% compared to the prior year primarily due to a net addition of 22 new clients, or approximately 175,000 new members, and approximately 317,000 new members from existing clients. PBM PacifiCare membership at December 31, 2004 increased 4% compared to the prior year primarily due to managed care membership growth.

Total behavioral health membership at December 31, 2004, increased approximately 4% compared to the prior year primarily due to growth in PacifiCare commercial membership in the PPO products, partially offset by group terminations in the Employee Assistance Program.

Total dental and vision membership at December 31, 2004, increased approximately 45% compared to the prior year primarily due to the addition of 206,100 members as a result of the AMS acquisition and new PacifiCare vision product offerings which resulted in increased membership in Arizona, California and Nevada.

We anticipate that our specialty segment membership will increase in 2005.

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Below is a summary of our specialty membership.

Revenues

Health Plans Segment Revenue

Commercial Revenue.  Commercial revenue increased 13%, or $643 million, to $5.69 billion for the year ended December 31, 2004, from $5.04 billion for the year ended December 31, 2003 as follows:

We anticipate revenue increases in 2005 primarily due to rate increases and membership growth, which includes expansion through our completed and announced and pending acquisitions.

Senior Revenue.  Senior revenue increased 8%, or $415 million, to $5.81 billion for the year ended December 31, 2004 from $5.40 billion for the year ended December 31, 2003 as follows:

Premium rate increases include additional retroactive premiums received from CMS during the year ended December 31, 2004, based upon the health status of our members as of December 31, 2003. Retroactive premiums recorded during the quarter ended September 30, 2004 and year ended December 31, 2004 were approximately $28 million and represented reimbursement for fee-for-service health care costs incurred during the period January 1 through June 30, 2004. In addition, upon receipt of the additional premium revenue, we recorded retroactive capitation expense to providers of approximately $15 million. Ongoing premium payments reflecting the health status of our members were adjusted effective July 1, 2004.

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In 2005, during the third quarter, we anticipate receiving additional premiums related to health status similar to what we experienced in the third quarter of 2004. However in 2005, since we now have historical information related to this payment from 2004, we will estimate and record premium revenue and associated expenses on a quarterly basis during the quarter in which health care services are rendered.

We anticipate revenue increases in 2005 primarily due to membership and rate increases as well as from changes due to the MMA legislation.

Specialty Segment Revenue.  Specialty and other revenue increased 39%, or $193 million, to $692 million for the year ended December 31, 2004, from $499 million for the year ended December 31, 2003. The increase was primarily due to the growth of unaffiliated PBM membership which resulted in increased service fee revenue charged to external customers, overall growth in the volume of mail service business which generated increased revenue from mail service customers of our PBM subsidiary, volume of PBM service contracts where we assume margin or pricing risk, and premium rate increases in our behavioral health business. Our PBM subsidiary began entering into retail service contracts where we assume margin or pricing risk as of January 2004. For these contracts, revenues we are contractually entitled to receive are included in Specialty and Other Revenue with corresponding costs recorded as Health Care Services and Other Expenses. Please refer to the section entitled “Specialty Segment Margin” for a discussion of the net growth of the Specialty Segment.

We anticipate revenue increases in 2005 primarily due to membership increases.

Net Investment Income.  Net investment income increased 25%, or $17 million, to $88 million for the year ended December 31, 2004 from $71 million for the year ended December 31, 2003. The increase was primarily due to increased net realized gains and higher invested balances compared to the same period in the prior year.

Segment Margins

Health Plans Segment Margin

Commercial Margin.  Our commercial margin increased 16%, or $127 million, to $900 million for the year ended December 31, 2004, from $773 million for the year ended December 31, 2003 as follows:

We anticipate our commercial margin in 2005 will be slightly higher than 2004.

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Senior Margin.  Our senior margin decreased 6%, or $53 million, to $802 million for the year ended December 31, 2004, from $855 million for the year ended December 31, 2003 as follows:

We anticipate our senior margin in 2005 will be lower than in 2004 primarily due to health care services and other expenses which are expected to outpace the increases in our premium revenue.

Specialty Segment Margin.  Our specialty and other margin increased 28%, or $69 million, to $313 million for the year ended December 31, 2004 from $244 million for the year ended December 31, 2003, which was primarily driven by growth of unaffiliated PBM membership, additional funds received for our Medicare drug discount card program under MMA, and premium rate increases in our behavioral health business.

We anticipate our specialty segment margin in 2005 will be higher than in 2004 primarily due to membership increases.

Medical Loss Ratios.  Our medical loss ratios, or MLRs, are calculated using premium revenue and related health care services and other expenses and cannot be directly calculated from the line items in the Consolidated Statement of Operations. Our MLRs are calculated using the following categories of revenue and expenses:

All non-premium revenues and related health care services and other expenses are excluded from the calculation of our MLR.

The consolidated MLR and its components, unadjusted for any prior period changes in health care cost estimates, for the year ended December 31, 2004 and 2003 are as follows:

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Private—Commercial MLR.  Our private—commercial MLR decreased to 83.5% for the year ended December 31, 2004 compared to 84.0% for the same period in 2003. The decrease was primarily due to a 13% increase in premium revenue, offset by a 12% increase in health care services and other expenses.

Private—Senior MLR.  Our private—senior MLR increased to 70.6% for the year ended December 31, 2004 compared to 63.4% for the same period in 2003 primarily due a 39% increase in health care services and other expenses, offset by a 24% increase in premium revenue.

Government—Senior MLR.  Our government—senior MLR increased to 86.1% for the year ended December 31, 2004 compared to 84.2% for the same period in 2003 primarily due to a 10% increase in health care services and other expenses, offset by a 8% increase in premium revenue.

Selling, General and Administrative Expenses.  Total selling, general and administrative expenses increased 7%, or $109 million, to $1.56 billion for the year ended December 31, 2004 from $1.45 billion for the year ended December 31, 2003. Total selling, general and administrative expenses increased primarily due to increased labor expense to support product development and membership growth, increased broker and internal sales commissions and premium taxes as a result of a shift in product mix, and higher expenses related to employee compensation programs, such as our employee stock purchase plan. This increase was partially offset by a lower write-off of property and equipment in 2004 as compared to 2003.

For the year ended December 31, 2004, total selling, general and administrative expenses as a percentage of operating revenue (excluding net investment income) decreased compared to the same period in the prior year primarily due to an increase in operating revenue (excluding net investment income) that outpaced the increase in selling, general and administrative expenses described above. Operating revenue (excluding net investment income) increased $1.25 billion for the year ended December 31, 2004.

We anticipate selling, general and administrative expenses will increase in 2005 from 2004 primarily due to labor expense to support membership growth and new initiatives under MMA legislation and increases in broker and internal sales commissions.

Interest Expense.  Interest expense decreased 52%, or $53 million, to $48 million for the year ended December 31, 2004, from $101 million for the year ended December 31, 2003. The decrease was due to the following:

Provision for Income Taxes.  The effective income tax rate was 38.6% for the year ended December 31, 2004, compared with 37.7% for the year ended December 31, 2003. The increase in our effective income tax rate is primarily due to increases in non-deductible stock-based compensation in 2004.

Our effective tax rate is based on expected income, statutory tax rates and tax planning opportunities available to us in the various jurisdictions in which we operate. Significant management estimates and judgments are required in determining our effective tax rate. We are routinely under audit by federal, state or local authorities regarding the timing and amount of deductions, nexus of income among various tax jurisdictions and compliance with federal, state and local tax laws. Tax assessments related to these audits may not arise until several years after tax returns have been

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filed. Although predicting the outcome of such tax assessments involves uncertainty, we believe that the recorded tax liabilities appropriately account for our analysis of probable outcomes, including interest and other potential obligations. Our tax liabilities are adjusted in light of changing facts and circumstances, such as the progress of audits, case law and emerging legislation and such adjustments are included in the effective tax rate.

2003 Compared with 2002

Membership

Health Plans Segment Membership.  Total managed care membership decreased 8% to approximately 2.9 million members at December 31, 2003 from approximately 3.1 million members at December 31, 2002.

Commercial membership decreased approximately 7% at December 31, 2003 compared to the prior year primarily due to elimination of unprofitable commercial HMO business and the termination of contracts with network providers. As previously announced, our contract with the California Public Employee Retirement System, or CalPERS, was not renewed for 2003, resulting in the loss of approximately 180,100 commercial HMO members in California effective January 1, 2003. The decreases were offset by increased PPO and indemnity membership primarily due to enhanced marketing and the addition of approximately 14,900 members from new product initiatives primarily in California and Colorado.

Medicare Advantage membership decreased approximately 10% at December 31, 2003 compared to the prior year primarily due to county exits and member disenrollments attributable to reduced benefits and increased premiums effective January 1, 2003. As previously announced, we exited five counties in California and Texas resulting in the loss of approximately 63,000 senior HMO members effective January 1, 2003.

Medicare Supplement membership increased approximately 72% at December 31, 2003 compared to the prior year primarily due to membership increases in the individual and group Medicare Supplement product across core states.

Below is a summary of our commercial and senior membership.