The regulations also establish significant criminal penalties and civil sanctions for non-compliance. Health Net completed the scope of benefitswork required to be made available to members, (iii) procedures for review of quality assurance, (iv) enrollment requirements, (v) composition of policy making bodies to assure that plan members have access to representation, (vi) procedures for resolving grievances, (vii)compliant with the interrelationship between HMOs and their health care providers, (viii) adequacy and accessibility of the network of health care providers, (ix) provider contracts, and (x) initial and continuing financial viability of the HMO and its risk-bearing providers. Any material modificationsHIPAA Privacy Regulations prior to the organization or operationseffective date of HN California are subjectApril 14, 2003. Further, Health Net was ready to send and receive compliant Transactions and Codesets prior reviewto the effective date of October 16, 2003. The Security regulations have a compliance date of April 2005 and approval byHealth Net has created a security plan to ensure appropriate compliance prior to the DMHC. This approval process can be lengthyeffective date. We spent approximately $6.7 million in 2003 and there is no certainty of approval. Other significant changes require filing with the DMHC, which may then comment and require changes. In addition, under the Knox-Keene Act, HN California and certain of our other subsidiaries must file periodic reports with, and are subjectexpect to periodic review and investigation by, the DMHC. Non-compliance with the Knox-Keene Act may resultspend approximately $1.6 million in an enforcement action, fines and penalties, and, in egregious cases, limitations2004 on or revocation of the Knox-Keene license.HIPAA related expenses.

Gramm-Leach-Bliley Act. The Gramm-Leach-Bliley Financial Modernization Act of 1999 generally requires insurers to provide customers with notice regarding how their personal health and financial information is used and the opportunity to “opt out” of certain disclosures before the insurer shares non-public personal information with a non-affiliated third party. Like HIPAA, this law sets a “floor” standard, allowing states to adopt more stringent requirements governing privacy protection.

Federal HMO Regulations.Act.Under the Federal Health Maintenance Organization Act of 1973 (the "HMO Act"“HMO Act”), services to members must be provided substantially on a fixed, prepaid basis without regard to the actual degree of utilization of services. Premiums established by an HMO may vary from account to account through composite rate factors and special treatment of certain broad classes of members, and through prospective (but not retrospective) rating adjustments. Several of our HMOs are federally qualified in certain parts of their respective service areas under the HMO Act and are therefore subject to the requirements of such act to the extent federally qualified products are offered and sold.

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        Additionally, there are a number of recently enacted federal laws that further regulate managed health care. Recent legislation includes the Balanced Budget Act of 1997 and the Health Insurance Portability and Accountability Act of 1996 ("HIPAA"). The purposes of HIPAA are to (i) limit pre-existing condition exclusions applicable to individuals changing jobs or moving to individual coverage, (ii) guarantee the availability of health insurance for employees in the small group market, (iii) prevent the exclusion of individuals from coverage under group plans based on health status, and (iv) establish national standards for the electronic exchange of health information. In December 2000, the Department of Health and Human Services ("DHHS") promulgated regulations under HIPAA related to the privacy and security of electronically transmitted protected health information ("PHI"). The new regulations require health plans, clearinghouses and providers to (a) comply with various requirements and restrictions related to the use, storage and disclosure of PHI, (b) adopt rigorous internal procedures to protect PHI, (c) create policies related to the privacy of PHI and (d) enter into specific written agreements with business associates to whom PHI is disclosed. The regulations also establish significant criminal penalties and civil sanctions for non-compliance. Health Net has completed the majority of work required to be compliant with the HIPAA Privacy Regulations prior to the effective date of April 2003. Further, Health Net is on target to be in compliance with the Transactions and Codesets requirements prior to the effective date of October 2003. The Security regulations have been recently made final and will not be enforced until approximately April 2005, and Health Net has created a Security plan to ensure appropriate compliance prior to the effective date.

        Our Medicare contracts are subject to regulation by CMS. CMS has the right to audit HMOs operating under Medicare contracts to determine the quality of care being rendered and the degree of compliance with CMS' contracts and regulations. Our Medicaid business is also subject to regulation by CMS, as well as state agencies.

ERISA.Most employee benefit plans are regulated by the federal government under the Employee Retirement Income Security Act of 1974, as amended ("ERISA"(“ERISA”). Employment-based health coverage is such an employee benefit plan. ERISA is administered, in large part, by the U.S. Department of Labor ("DOL"(“DOL”). ERISA contains disclosure requirements for documents that define the benefits and coverage. It also contains a provision that causes federal law to preempt state law in the regulation and governance of certain benefit plans and employer groups, including the availability of legal remedies under state law. Recently,In 2002, the DOL adopted regulations under ERISA which mandatemandated certain claims and appeals processing requirements. These regulations became fully effective starting on July 1, 2002 and fully on January 1, 2003. They will require us to make2003 and, during 2003, we made certain adjustments in our claims systems but we do not anticipate that theto comply with these regulations. The cost of the adjustments will bewas not material from a financial point of viewview.

Miscellaneous.Our Medicare contracts are subject to regulation by CMS. CMS has the right to audit HMOs and PPOs operating under Medicare contracts to determine the quality of care being rendered and the degree of compliance with CMS’ contracts and regulations. Our Medicaid business is also subject to regulation by CMS, as well as state agencies, and is generally examined on a periodic basis by such state agencies.

California Laws and Regulations

Health Insurance Act of 2003. In October 2003, the Governor of California signed the Health Insurance Act of 2003 (the “California Health Insurance Act”) which requires all California employers employing more than 200 employees to pay a fee or show proof of health insurance or other acceptable health coverage for both employees and their dependents. The California Health Insurance Act will become effective January 1, 2006. On January 1, 2007, the requirements of the California Health Insurance Act will extend to employers of 20 to 199 employees, except that the changesthose employers will not be ablerequired to provide coverage for their employees’ dependents and employers of 20 to 49 employees will be exempt from

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the California Health Insurance Act unless certain tax credit legislation is enacted. To date, no such tax credit has been proposed or enacted. If an employer elects to pay a fee rather than provide coverage, the fee will be used by the State to contract with private health carriers to provide health coverage to those who are not covered by their employer.

The California Chamber of Commerce and other business groups have qualified an initiative referendum for the November 2004 ballot to repeal the California Health Insurance Act. Should the referendum fail, some of these groups have indicated that they may sue to overturn substantial portions of the Act based on arguments that these provisions violate Federal law. No assurances can be given as to whether the initiative referendum will successfully overturn the legislation, or whether subsequent litigation will do so. In the event the California Health Insurance Act survives challenge, it may provide us and other health plans with potential additional markets, but it is uncertain at this time whether such additional business, if any, will be forthcoming.

California HMO Regulations.California HMOs, such as HN California and our behavioral health plan, MHN, are subject to California state regulation, principally by the Department of Managed Health Care (“DMHC”) under the Knox-Keene Act. Among the areas regulated by the Knox-Keene Act are:

Any material modifications to the organization or operations of HN California and MHN are subject to prior review and approval by the stated deadline.DMHC. This approval process can be lengthy and there is no certainty of approval. Other significant changes require filing with the DMHC, which may then comment and require changes. In addition, under the Knox-Keene Act, HN California and MHN must file periodic reports with, and are subject to periodic review and investigation by, the DMHC. Non-compliance with the Knox-Keene Act may result in an enforcement action, fines and penalties, and, in egregious cases, limitations on or revocation of the Knox-Keene license.

California Assembly Bill 1455. Assembly Bill 1455 (“AB 1455”) was signed into law on September 28, 2000, amending and adding several sections to the Knox-Keene Act. AB 1455 increased the interest rate that health care service plans must pay on uncontested claims not paid promptly within the required time period and granted the DMHC additional authority to impose monetary penalties and other sanctions on health plans engaging in certain “unfair payment practices” (as defined in AB 1455). AB 1455 also required the DMHC to adopt regulations regarding provider dispute resolution by health care service plans. The final regulations, which address both claims reimbursement and provider dispute resolution procedures, took effect on August 25, 2003 and the DMHC advised health care service plans to implement them for all services provided on and after January 1, 2004. On November 12, 2003, the California Healthcare Association (“CHA”) filed a petition for writ of mandate in the Superior Court, County of Sacramento, challenging certain requirements of the AB 1455 regulations regarding timely filing of claims, reasonable and customary charges and timely filing of disputes. We are continuing to comply with all aspects of AB 1455 pending final resolution of CHA’s challenge.

Other HMO Laws and Regulations.

In each state in which our HMOs do business, our HMOs must meet numerous state licensing criteria and secure the approval of state licensing authorities before implementing certain operational changes, including the development of new product offerings and, in some states, the expansion of service areas. To remain licensed, each HMO must continue to comply with state laws and regulations and may from time to time be required to change services, procedures or other aspects of its operations to comply with changes in applicable laws and regulations. In addition, HMOs must file periodic

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reports with, and their operations are subject to periodic examination by, state licensing authorities. HMOs are required by state law to meet certain minimum capital and deposit and/or reserve requirements in each state and may be restricted from paying dividends to their parent corporations under some circumstances. Several states have increased minimum capital requirements, in response to proposals by the National Association of Insurance Commissioners to institute risk-basedrisk- based capital requirements. Regulations in these and other states may be changed in the future to further increase capital requirements. Such increases could require us to contribute additional capital to our HMOs. Any adverse change in governmental regulation or in the regulatory climate in any state could materially impact the HMOs operating in that state. The HMO

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Act and state laws place various restrictions on the ability of HMOs to price their products freely. We must comply with applicable provisions of state insurance and similar laws, including regulations governing our ability to seek ownership interests in new HMOs, PPOs and insurance companies, or otherwise expand our geographic markets or diversify our product lines.

Insurance Regulations.Laws and Regulations

State departments of insurance (the "DOIs"“DOIs”) regulate our insurance and third-party administratorASO businesses under various provisions of state insurance codes and regulations. Our subsidiaries conducting these businesses are subject to various capital reserve and other financial, operating and disclosure requirements established by the DOIs and state laws. These subsidiaries must also file periodic reports regarding their regulated activities and are subject to periodic reviews of those activities by the DOIs. We must also obtain approval from, or file copies with, the DOIs for all of our group and individual insurance policies prior to issuing those policies.

PENDING FEDERAL AND STATE LEGISLATION.Pending Federal and State Legislation

Patients’ Bill of Rights.In 2001, the United States Senate and House of Representatives passed separate bills, sometimes referred to as “patients’ rights” or “patients’ bill of rights” legislation, that sought, among other things, to hold health plans liable for claims regarding health care delivery and improper denial of care. This legislation would have removed or limited federal preemption under ERISA that currently precludes most individuals from suing health plans for causes of action based upon state law and would enable plan members to challenge coverage and benefits decisions in state and federal courts. Although both bills provided for independent review of decisions regarding medical care, the bills differed on the circumstances and procedures under which lawsuits could be brought against managed care organizations and the scope of their liability. Congress did not ultimately enact legislation based on the 2001 bills and adjourned in 2002 without reconciling the two bills. Similar bills were introduced in both houses of Congress in 2003, and it is not known at this time whether this issue will be debated in 2004. If patients’ bill of rights legislation is enacted into law, we could be subject to significant additional litigation risk and regulatory compliance costs, which could be costly to us and could have a significant adverse effect on our results of operations. Although we could attempt to mitigate our ultimate exposure to litigation and regulatory compliance costs through, among other things, increases in premiums, there can be no assurance that we would be able to mitigate or cover the costs stemming from litigation arising under patients’ bill of rights legislation or the other costs that we could incur in connection with complying with patients’ bill of rights legislation.

There are a number of other legislative initiatives and proposed regulations currently pending or previously proposed at the federal and state levels which could increase regulation of and costs incurred by the health care industry. These measures, include a "patients'including the “patients’ bill of rights"rights” and certain other initiatives, which, if enacted, could have significant adverse effects on our operations. See "Cautionary Statements—Federal“Risk Factors – Proposed federal and State Legislation"state legislation affecting the managed health care industry could have an adverse effect on our operations” below. For example, one version of the previously proposed "patients' bill of rights" would allow an expansion of liability for health plans. We cannot predict the outcome of any of the pending legislative or regulatory proposals, nor the extent to which we may be affected by the enactment of any such legislation or regulation.

ACCREDITATION.Service Marks

 We pursue accreditation for certain of our health plans from the National Committee for Quality Assurance ("NCQA") and the Joint Committee on Accreditation of Healthcare Organizations ("JCAHO"). NCQA and JCAHO are independent, non-profit organizations that review and accredit HMOs. HMOs that comply with review requirements and quality standards receive accreditation. Our HMO subsidiaries in California and Arizona have received NCQA accreditation. Certain of our other health plan subsidiaries are in the process of applying for NCQA or JCAHO accreditation. The utilization review activities of our subsidiary, EOS Managed Care Services, are accredited by Utilization Review Accreditation Commission also known as the "American Accreditation Healthcare Commission".

SERVICE MARKS

We have filed for registration of and maintain several service marks, trademarks and tradenames that we use in our business, including marks and names incorporating the "Health Net"“Health Net” phrase. We utilize these and other marks and names in connection with the marketing and identification of products and services. We believe such marks and names are valuable and material to our marketing efforts.

EMPLOYEESEmployees

 We currently employ approximately 9,400 employees, excluding

As of December 31, 2003, Health Net and its subsidiaries employed 8,629 persons on a full-time basis and 424 persons on a part-time or temporary employees.basis. These employees perform a variety of functions, including, among other things,

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provision of administrative services for employers, providers and members; negotiation of agreements with physician groups, hospitals, pharmacies and other health care providers; handling of claims for payment of hospital and other services; and provision of data processing services. Our employees are not unionized and we have not experienced any work stoppages since our inception. We consider our relations with our employees to be very good.

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Other Company Information and Recent and Other Developments

OTHER INFORMATION/RECENT AND OTHER DEVELOPMENTS

DEBT OFFERING.Restatements

On April 12,February 11, 2004, we announced financial results for the fourth quarter and full year 2003. We also announced that we would restate our consolidated financial statements for the first three quarters of 2003 and for the years ended December 31, 2002 and 2001 to reflect certain adjustments primarily affecting general and administrative expenses relating to workers’ compensation expenses, lease expenses and other miscellaneous items. Subsequent to our

February 11, 2004 announcement we:

In addition, certain adjustments that were properly reflected on the statement of operations in our February 11, 2004 announcement required further minor reclassifications on the balance sheets as of December 31, 2003 and 2002. For additional information regarding the various restatement adjustments, see our Amended Annual Report on Form 10-K/A for the year ended December 31, 2002, and our Amended Quarterly Reports on Form 10-Q/A for the quarters ended March 31, 2003, June 30, 2003 and September 30, 2003.

Interest Rate Swap

On February 20, 2004, we entered into an interest rate swap transaction with respect to $400 million aggregate principal amount of 8.375 percent Senior Notesour 8 ³/8% senior notes due 2011 for the purpose of hedging the fair value of our indebtedness. The interest rate swap agreement has an aggregate notional amount of $400 million and matures in April 2011. Under the terms of the swap agreement, we make interest payments based on the six-month London Interbank Offered Rate (“LIBOR”) plus 399.625 basis points and receive interest payments based on the 8 ³/8% fixed coupon rate. For additional information regarding the interest rate swap see “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and “Quantitative and Qualitative Disclosures About Market Risk.”

Sale of Employer Services Group Subsidiaries

On October 31, 2003, we consummated the sale of certain of our subsidiaries organized under HN Employer Services to First Health for $79.5 million in cash. As a result of the sale, we no longer market workers’ compensation managed care cost containment services directly to customers. Pursuant to a workers compensation network access agreement we entered into with First Health, we agreed to maintain our network of health care providers, including physicians, hospitals, pharmacies and other ancillary providers, for purposes or arranging for the delivery of health care to injured workers. Under the agreement, customers of First Health and HN Employer Services have access to our workers’ compensation provider network. We also entered into a non-compete agreement with First Health, as well as an agreement which provides us access to First Health’s preferred provider organization network.

For the ten months ended October 31, 2003, HN Employer Services had $45.6 million of total combined revenues. HN Employer Services had $0.7 million of income before income taxes for the ten months October 31, 2003. As of October 31, 2003, HN Employer Services had a combined total of $42.3 million in net equity, which we recovered

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through the sales proceeds. Prior to the sale, revenue from our employer services group subsidiaries was reported as part of other income in our consolidated statements of operations and therefore had no impact on our reportable segments’ results of operations.

Sale of Dental and Vision Subsidiaries

On October 31, 2003, we consummated the sale of our dental and vision subsidiaries, Health Net Dental and Health Net Vision to SafeGuard and, as a result, we no longer underwrite or administer stand-alone dental and vision products. However, we continue to make available private label Health Net branded dental products via our new strategic relationship with SafeGuard and continue to make available private label Health Net branded vision products via our new strategic relationship with EyeMed. In connection with the sale of Health Net Dental and Health Net Vision, we received approximately $14.8 million in cash. We also and paid $2.1 million in cash and transferred $2.1 million in liabilities to SafeHealth Life under the assumption reinsurance agreement. See “Segment Information – Health Plan Services Segment – Other Specialty Services and Products – Dental and Vision” for further information regarding the sale of Health Net Dental and Health Net Vision.

Withdrawal of 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 intend to maintain our network of providers in Pennsylvania to service our New Jersey members. As of December 31, 2003, we had approximately 3,800 members enrolled in our commercial health plan in Pennsylvania.

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 and we increased the allowance on the note by $3.4 million. The note was fully reserved as of September 30, 2003. We are in the process of trying to restructure the note and are making continued efforts to collect all outstanding principal and interest due on the note. We have recorded the additional $3.4 million allowance in G&A expenses in our accompanying consolidated statements of operations for the year ended December 31, 2003.

Nurse Advice Line and Other Related Services Agreement

On August 6, 2003, we entered into an amendment to modify an existing ten-year agreement for a nurse advice line and other related services, which we entered into in December 1998 with an external third-party service provider. The effective interest ratedate of the amendment April 1, 2003. The amendment changes the pricing schedule of this services agreement to a cost-per-call basis from the per member per month (“PMPM”) basis of the original agreement. The amendment also provides for the modification of the exclusivity provision under the original agreement. Under the terms of the amendment, exclusivity for the provision of nurse advice line and audio health information services is not granted to the external third-party service provider.

Pharmacy Benefit Services Agreement

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 provides 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 (ending 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.

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 Senior Notes when all offering costs are taken into account and amortized over the termsale of the Senior Notes is 8.54 percent per annum.underlying common stock in G&A expenses in May 2003. The net proceeds of $395.1remaining 160,000 shares are scheduled to vest on April 1, 2004.

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In April 2003, we paid $2.9 million from the Senior Notes were used to repay outstanding borrowingsthis external third-party service provider for amounts previously accrued under our then-existing revolving credit facility. On October 4, 2001, we completed an exchange offer for the Senior Notes in which the outstanding Senior Notes were exchanged for an equal aggregate principal amount of new 8.375 percent Senior Notes due 2011 that have been registered under the Securities Act of 1933, as amended.

        The Senior Notes may be redeemed at the optionanother provision of the Company atPharmacy Benefit Services Agreement.

On September 2, 2003, we terminated the Pharmacy Benefit Services Agreement effective April 1, 2004. Concurrent with this termination, we entered into a pricenew 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 or about April 1, 2004, we will pay a termination fee equal to the greater of (A) 100% ofgain realized on the principal amount of the notes to be redeemedexercise and (B) the sum of the present valuessale of the remaining 160,000 shares of common stock of the external third-party service provider scheduled paymentsto vest on April 1, 2004. We have estimated the notestermination fee at $7.0 million as of December 31, 2003, an amount equal to be redeemed (consisting of principal and interest, exclusive of interest accrued through the date of redemption). In calculating the present valuesfair value of the remaining scheduled payments,160,000 shares exercisable under the ratewarrant agreement. We recorded the termination fee as well as the estimated fair value of the remaining shares exercisable under the warrant agreement in effectG&A expenses as of December 31, 2003. We may terminate the new pharmacy claims processing services agreement prior to April 1, 2007, subject to certain termination provisions which include liquidated damages $3.6 million in the aggregate; provided that the liquidated damages are reduced by $100,000 per month through the termination date.

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 Class A 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 Class A 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 December 31, 2003, we had repurchased an aggregate of approximately 16.8 million shares of our Class A Common Stock under our stock repurchase program for aggregate consideration of approximately $453.3 million before taking into account exercise proceeds and tax benefits from the exercise of employee stock options. We repurchased approximately 10.1 million shares of common stock during the year ended December 31, 2003. During 2002, we received approximately $49 million in cash and recognized $18 million in tax benefits as a result of option exercises. During 2003, we received approximately $42 million in cash and recognized $15 million in tax benefits as a result of option exercises.

As a result of the $67 million (in 2002) and $57 million (in 2003) in realized and estimated benefits, our total authority under our stock repurchase program is estimated at $574 million based on the dateauthorization we received from our Board of calculationDirectors to repurchase up to an aggregate of up to $450 million (net of exercise proceeds and tax benefits from the redemption price is to be used, discounted to the dateexercise of redemption on a semiannual basis (assuming a 360-day year consistingemployee stock options) of twelve 30-day months) at the applicable treasury yield plus 40 basis points and with interest accrued through the date of redemption.our Class A Common Stock.

FLORIDA OPERATIONS.Florida Operations

Effective August 1, 2001, we sold our Florida health plan, known as Foundation Health, a Florida Health Plan, Inc. (the "Florida Plan"“Plan”), to Florida Health Plan Holdings II, L.L.C. In connection with the sale, we received approximately $49 million which consisted of $23 million in cash and approximately $26 million in a secured six-year note bearing eight percent8% interest per annum.annum for which we recorded a full reserve. We also sold the corporate facility building used by theour Florida Planhealth plan to DGE Properties, LLC for $15 million, payable by a secured five-year note bearing eight percent8% interest per annum. We estimated and recorded a $76.1 million pretax loss on the sales of our Florida Plan and the related corporate facility building during the second quarter ended June 30, 2001.

Under the Stock Purchase Agreement that evidenced the sale (as amended, the "SPA"“SPA”), we, through our subsidiary FH Assurance Company ("FHAC"(“FHAC”), entered into a reinsurance agreement (the "Reinsurance Agreement"“Reinsurance Agreement”) with the Florida Plan. Under the terms of the Reinsurance Agreement, FHAC will reimburse the Florida Plan for certain medical and hospital expenses arising after the Florida health plan sale. The Reinsurance Agreement will covercovers 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 Florida Plan will be reimbursed for medical and hospital expenses relative to covered claims in excess of certain baseline medical loss ratios, as follows:

•

88% for the six-month period commencing on August 1, 2001;



•

89% for the six-month period commencing on February 1, 2002;



•

90% for the six-month period commencing on August 1, 2002.

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        The Reinsurance Agreement is limited to $28 million in aggregate payments and is subject to the following levels of coinsurance:

•

5% for the six-month period commencing on August 1, 2001;



•

10% for the six-month period commencing on February 1, 2002;



•

15% for the six-month period commencing on August 1, 2002.

        If the baseline medical loss ratio is less than 90% at the end of the six-month period commencing on August 1, 2002, Health Net is entitled to recover medical and hospital expenses below the 90% threshold up to an amount to not exceed 1% of the total premiums for those members still covered during the six-month period under the Reinsurance Agreement.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. As of December 31, 2002,2003, we have paid out $20.3$24.8 million under this Reinsurance Agreement.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. During the year endedAs of December 31, 2002,2003, we had 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 toon the financial condition, results of operations or liquidity of the Company.

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

•

A retrospective post-closing settlement of statutory equity based on subsequent adjustments to the closing balance sheet for the Florida Plan.



•

A settlement of unpaid provider claims as of the closing date based on claim payments occurring during a one-year period after the closing date.



•

A settlement of the reinsured claims in excess of certain baseline medical loss ratios. Final settlement is not scheduled to occur untilIn February 2004, we provided a final calculation of the latter part of 2003. The development ofloss on the claims and claims related metrics and information provided by Florida Health Plan Holdings II, L.L.C. have not resulted in any revisions to the maximumPlan and, in connection therewith, paid additional amounts to the Plan with the effect that we have now paid our $28 million maximum liability we originally estimated.

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 probability or estimate any adjustment to the recorded loss on the sale of the Florida Plan as of December 31, 2002.

INVESTMENT IN AMCARECO, INC.

        In 1999, we sold our HMO operations in the states of Louisiana, Oklahoma and Texas to AmCareco, Inc. ("AmCareco"). As part of the transaction, we received shares of AmCareco convertible preferred stock with an aggregate par value of $10.7 million and established an allowance of $4.2 million based on the estimated net realizable value. During 2000, we made additional investments in AmCareco and received subordinated notes totaling $2.6 million. As of June 30, 2002, the net carrying value of our investment in AmCareco was $9.1 million and was included in other noncurrent assets on our condensed consolidated balance sheets. In July 2002, we exercised our rights to draw upon a $2 million letter of credit that was established by AmCareco to secure the redemption of a portion of our preferred stock of AmCareco, resulting in a net investment of $7.1 million in AmCareco after such redemption.

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        In August 2002, the Oklahoma State Health Commissioner determined not to continue AmCareco's license in Oklahoma to operate an HMO due to AmCareco's alleged violations of Oklahoma's prompt-pay law and AmCareco's failure to maintain the minimum net worth requirement to operate an HMO in that state. This license denial became effective October 1, 2002. In September 2002, the Louisiana Department of Insurance upgraded its regulatory control of AmCareco's Louisiana operations from supervision to rehabilitation, and an Order of Liquidation was entered against AmCareco's Louisiana subsidiary on October 21, 2002. Due in part to the actions taken by Oklahoma and Louisiana, the Texas Department of Insurance also commenced a conservatorship process in September 2002 related to AmCareco's operations in Texas, and a competitor was designated to absorb all of the Texas operation's member groups as of November 1, 2002.2003.

 Given the foregoing adverse regulatory actions, AmCareco's operations have been or are in the process of being terminated in all three of these states. These actions have caused us to determine that the carrying value of these assets is no longer recoverable. Accordingly, we wrote off the total carrying value of our investment of $7.1 million during the third quarter ended September 30, 2002.

EOS CLAIMS SERVICES, INC.Shareholder Rights Plan

 Effective July 1, 2002, we sold our claims processing subsidiary, EOS Claims Services, Inc. ("EOS Claims"), to Tristar Insurance Group, Inc. ("Tristar"). In connection with the sale, we received $500,000 in cash, and also entered into a Payor Services Agreement. Under the Payor Services Agreement, Tristar has agreed to exclusively use EOS Managed Care Services, Inc. (one of our remaining subsidiaries) for various managed care services to it customers and clients.

        We estimated and recorded a $2.6 million pretax loss on the sale of EOS Claims during the second quarter ended June 30, 2002. As of the date of sale, EOS Claims had no net equity after dividends to its parent company and the goodwill impairment charge taken in the first quarter ended March 31, 2002.

INVESTMENT IN MEDUNITE.

        Throughout 2000 and 2001, we provided funding in the aggregate amount of approximately $10 million to MedUnite in exchange for preferred stock of MedUnite. During 2002, we provided approximately $3.4 million in additional funding to MedUnite. In December 2002, MedUnite was sold to ProxyMed, Inc. and we received cash and contingent notes of the buyer in connection with the sale transaction. As a result of the sale, we recorded a $12.4 million charge attributed to the write-off of our investment in MedUnite during the fourth quarter ended December 31, 2002 which included an allowance against the full value of the notes.

INVESTMENT IN NAVIMEDIX.

        During 2000, we secured an exclusive e-business connectivity services agreement from the Connecticut State Medical Society IPA, Inc. ("CSMS-IPA") for $15.0 million. CSMS-IPA is an association of medical doctors providing health care primarily in Connecticut. The amounts paid to CSMS-IPA for this agreement are included in other noncurrent assets, and we periodically assess the recoverability of such assets.

        During 2002, we entered into various agreements with external third parties in connection with this service capability. We entered into a marketing and stock issuance agreement with NaviMedix, Inc. ("NaviMedix"), a provider of online solutions connecting health plans, physicians and hospitals. In exchange for providing general assistance and advise to NaviMedix, we received 800,000 shares of NaviMedix common stock and the right to receive an additional 100,000 earnout shares for each $1 million in certain NaviMedix gross revenues generated during an annualized six month measurement period.

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        In March 2002, we entered into an assignment, assumption and bonus option agreement with CSMS-IPA pursuant to which CSMS-IPA rececived 32,000 shares or 4% of the NaviMedix shares that we received and the right to receive 4% of any of the earnout shares we may realize. Under the agreement, CSMS-IPA is also entitled to receive up to an additional 8.2% of the earnout shares from us depending on the proportion of NaviMedix gross revenue that is generated in the state of Connecticut. In March 2002, we also entered into a cooperation agreement with CSMS-IPA pursuant to which we jointly designate and agree to evaluate connectivity vendors for CSMS-IPA members.

CREDIT AGREEMENTS.

        We have two credit facilities with Bank of America, N.A., as administrative agent, each governed by a separate credit agreement dated as of June 28, 2001. The credit facilities, provide for an aggregate of $700 million in borrowings, consisting of:

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a $175 million 364-day revolving credit facility; and



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a $525 million five-year revolving credit and competitive advance facility.

        We established the credit facilities to refinance our then-existing bank debt and for general corporate purposes, including acquisitions and working capital. The credit facilities allow us to borrow funds:

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by obtaining committed loans from the group of lenders as a whole on a pro rata basis;



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by obtaining under the five-year facility loans from individual lenders within the group by way of a bidding process; and



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by obtaining under the five-year facility letters of credit in an aggregate amount of up to $200 million.

        The credit agreement for the 364-day revolving credit facility was amended on June 27, 2002 to extend the term of this facility for an additional 364 days.

        Repayment.    The 364-day credit facility expires on June 26, 2003. We must repay all borrowings under the 364-day credit facility by June 26, 2003, unless the Company avails itself of a two-year term-out option in the 364-day credit facility. The five-year credit facility expires on June 28, 2006, and we must repay all borrowings under the five-year credit facility by June 28, 2006, unless the five-year credit facility is extended. The five-year credit facility may, at our request and subject to approval by lenders holding two-thirds of the aggregate amount of the commitments under the five-year credit facility, be extended for up to two twelve-month periods to the extent of the commitments made under the five-year credit facility by such approving lenders.

        Covenants.    The credit agreements contain negative covenants, including financial covenants, that impose performance requirements on our operations. The financial covenants in the credit agreements provide that:

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for any period of four consecutive fiscal quarters, the consolidated leverage ratio, which is the ratio of (i) our consolidated funded debt to (ii) our consolidated net income before interest, taxes, depreciation, amortization and other specified items (consolidated EBITDA), must not exceed 3 to 1;



•

for any period of four consecutive fiscal quarters, the consolidated fixed charge coverage ratio, which is the ratio of (i) our consolidated EBITDA plus consolidated rental expense minus consolidated capital expenditures to (ii) our consolidated scheduled debt payments (defined as the sum of scheduled principal payments, interest expense and rent expense) must be at least 1.5 to 1; and

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•

we must maintain our consolidated net worth at a level equal to at least $945 million (less the sum of a pretax charge associated with our sale of our Florida health plan and specified pretax charges relating to the write-off of goodwill) plus 50% of our consolidated net income and 100% of our net cash proceeds from equity issuances.

        The other covenants in the credit agreements include, among other things, limitations on incurrence of indebtedness by our subsidiaries and on our ability to:

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incur liens;



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extend credit and make investments in non-affiliates;



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merge, consolidate, dispose of stock in subsidiaries, lease or otherwise dispose of assets and liquidate or dissolve;



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substantially alter the character or conduct of the business of Health Net, Inc. or any of its "significant subsidiaries" within the meaning of Rule 1-02 under Regulation S-X promulgated by the SEC;



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make restricted payments, including dividends and other distributions on capital stock and redemptions of capital stock if the Company's debt is rated below investment grade by either Standard and Poor's Rating Service or Moody's Investor Services; and



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become subject to other agreements or arrangements that restrict (i) the payment of dividends by any Health Net, Inc. subsidiary, (ii) the ability of Health Net, Inc. subsidiaries to make or repay loans or advances to lenders, (iii) the ability of any subsidiary of Health Net, Inc. to guarantee our indebtedness or (iv) the creation of any lien on property, provided that the foregoing shall not apply to (a) restrictions and conditions imposed by regulatory authorities or (b) restrictions imposed under either the 364-day Revolving Credit Facility or the five-year revolving credit facility.

        Interest and fees.    Committed loans under the credit facilities bear interest at a rate equal to either (1) the greater of the federal funds rate plus 0.5% and the applicable prime rate or (2) LIBOR plus a margin that depends on our senior unsecured credit rating. Loans obtained through the bidding process bear interest at a rate determined in the bidding process. We pay fees on outstanding letters of credit and a facility fee, computed as a percentage of the lenders' commitments under the credit facilities, which varies from 0.130% to 0.320% per annum for the 364-day credit facility and from 0.155% to 0.375% per annum for the five-year credit facility, depending on our senior unsecured credit rating.

        Events of Default.    The credit agreements provide for acceleration of repayment of indebtedness under the credit facilities upon the occurrence of customary events of default.

SHAREHOLDER RIGHTS PLAN.

On May 20, 1996, our Board of Directors declared a dividend distribution of one right (a "Right"“Right”) for each outstanding share of our Class A Common Stock and Class B Common Stock (collectively, the "Common Stock"“Common Stock”), to stockholders of record at the close of business on July 31, 1996 (the "Record Date"“Record Date”). Our Board of Directors also authorized the issuance of one Right for each share of Common Stock issued after the Record Date and prior to the earliest of the "Distribution Date"“Distribution Date” the Rights separate from the Common Stock under the circumstances described below and in accordance with the provisions of the Rights Agreement, as defined below, the redemption of the Rights and the expiration of the Rights, and in certain other circumstances. Rights will attach to all Common Stock certificates representing shares then outstanding and no separate Rights certificates will be distributed. Subject to certain exceptions contained in the Rights Agreement dated as of June 1, 1996 by and between us and Harris Trust and Savings Bank, as Rights Agent (as amended on October 1, 1996 and May 3, 2001, the "Rights Agreement"“Rights Agreement”), the Rights will separate from the Common Stock following any person, together

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with its affiliates and associates (an "Acquiring Person"“Acquiring Person”), becoming the beneficial owner of 15% or more of the outstanding Class A Common Stock, the commencement of a tender or exchange offer that would result in any person, together with its affiliates and associates, becoming the beneficial owner of 15% or more of the outstanding Class A Common Stock or the determination by the Board of Directors that a person, together with its affiliates and associates, has become the beneficial owner of 10% or more of the Class A Common Stock and that such person is an "Adverse“Adverse Person,"” as defined in the Rights Agreement. The Rights Agreement provides that certain passive institutional investors that beneficially own less than 17.5% of the outstanding shares of our Class A Common Stock shall not be deemed to be Acquiring Persons.

The Rights will first become exercisable on the Distribution Date and will expire on July 31, 2006, unless earlier redeemed by us as described below. Except as set forth below and subject to adjustment as provided in the Rights Agreement, each Right entitles its registered holder to purchase from us one one-thousandth of a share of Series A Junior Participating Preferred Stock at a price of $170.00 per one-thousandth share.

Subject to certain exceptions contained in the Rights Agreement, in the event that any person shall become an Acquiring Person or be declared to be an Adverse Person, then the Rights will "flip-in"“flip-in” and entitle each holder of a Right, other than any Acquiring Person or Adverse Person, to purchase, upon exercise at the then-current exercise price of such Right, that number of shares of Class A Common Stock having a market value of two time such exercise price.

In addition, and subject to certain exceptions contained in the Rights Agreement, in the event that we are acquired in a merger or other business combination in which the Class A Common Stock does not remain outstanding or is changed or 50% of the assets or earning power of the Company is sold or otherwise transferred to any other person, the Rights will "flip-over"“flip-over” and entitle each holder of a Right, other than an Acquiring Person or an Adverse Person, to purchase, upon exercise at the then current exercise price of such Right, such number of shares of common stock of the acquiring company which at the time of such transaction would have a market value of two times such exercise price.

We may redeem the Rights until the earlier of 10 days following the date that any person becomes the beneficial owner of 15% or more of the outstanding Class A Common Stock and the date the Rights expire at a price of $.01 per Right.

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In May 2001, we appointed Computershare Investor Services, L.L.C. to serve as the Rights Agent under the Rights Agreement.

The foregoing summary description of the Rights does not purport to be complete and is qualified in its entirety by reference to the Rights Agreement, which is incorporated by reference in Exhibits 4.2, 4.3 and 4.4 to this Annual Report.Report on Form 10-K.

STOCK REPURCHASE PROGRAM.Potential Divestitures

 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 Class A Common Stock. Pursuant to this repurchase program, we repurchased an aggregate of 10.0 million shares of our Class A Common Stock for aggregate consideration of approximately $249 million as of March 20, 2003. Share repurchases are made under this repurchase program from time to time through open market purchases or through privately negotiated transactions.

        During 2002, we received approximately $48 million in cash and $18 million of tax benefits as a result of option exercises. In 2003, we expect to receive approximately $58 million in cash and $17 million in tax benefits from estimated option exercises during the year. As a result of the $66 million (in 2002) and $75 million (in 2003) aggregate amounts of realized and estimated benefits, our total authority under the stock repurchase program is estimated at $390 million based on the

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authorization we received from our Board of Directors to repurchase $250 million net of exercise proceeds and tax benefits from the exercise of employee stock options.

TRICARE CONTRACTS.

        Our wholly-owned subsidiary, Health Net Federal Services, Inc. ("Federal Services") (formerly known as Foundation Health Federal Services, Inc.), administers large, multi-year managed care federal contracts with the United States Department of Defense ("DoD").

        Federal Services currently administers health care contracts for DoD's TRICARE program covering approximately 1.5 million eligible individuals under TRICARE. Through TRICARE, Federal Services provides eligible beneficiaries with improved access to care, lower out-of-pocket expenses and fewer claims forms. Federal Services currently administers three TRICARE contracts for five regions:

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Region 11, covering Washington, Oregon and part of Idaho



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Region 6, covering Arkansas, Oklahoma, most of Texas, and most of Louisiana



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Regions 9, 10 and 12, covering California, Hawaii, Alaska and part of Arizona

        On August 1, 2002, the DoD issued a Request For Proposals ("RFP") for the rebid of the TRICARE contracts. The RFP divides the United States into three regions (North, South and West) and provides for the award of one contract for each region. The RFP also provides that each of the three new contracts will be awarded to a different prime contractor. Proposals in response to the RFP for each of the three regions were submitted by Federal Services in January 2003 and it is anticipated that DoD will award the three new TRICARE contracts on or before June 1, 2003. Health care delivery under the new TRICARE contracts will not commence until the expiration of health care delivery under the current TRICARE contracts.

        If all option periods are exercised by DoD under the current TRICARE contracts with Federal Services and no further extensions are made, health care delivery ends on February 29, 2004 for the Region 11 contract, on March 31, 2004 for the Regions 9, 10 and 12 contract and on October 31, 2004 for the Region 6 contract. As set forth above, Federal Services is competing for the new TRICARE contracts in response to the RFP.

CHANGE IN EXECUTIVE OFFICERS.

        Effective January 28, 2002, Steven P. Erwin resigned as Executive Vice President and Chief Financial Officer of the Company and Marvin P. Rich was appointed in his place as Executive Vice President, Finance and Operations. Effective August 6, 2002, Jeffrey Bairstow resigned as President of the Company's Government and Specialty Services Division; effective April 30, 2002, Cora Tellez, resigned as President of the Company's Health Plans Division; and effective April 15, 2002, Gary S. Velasquez resigned as President of the Company's Business Transformation and Innovation Services Division. Effective May 24, 2002, Jeffrey Folick became Executive Vice President, Regional Health Plans and Specialty Companies of the Company and effective April 1, 2002, Christopher P. Wing became Executive Vice President, Regional Health Plans and Specialty Companies of the Company and President of the Company's California operations. Finally, effective May 23, 2002, James P. Woys, President of Health Net Federal Services, was designated as an executive officer of the Company.

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LEGISLATION.

        In 2001, the United States Senate and House of Representatives passed separate bills, sometimes referred to as "patients' rights" or "patients' bill of rights" legislation, that sought, among other things, to hold health plans liable for claims regarding health care delivery and improper denial of care. This legislation would have removed or limited federal preemption under the Employee Retirement Income Security Act of 1974 ("ERISA") that currently precludes most individuals from suing health plans for causes of action based upon state law and would enable plan members to challenge coverage and benefits decisions in state and federal courts. Although both bills provided for independent review of decisions regarding medical care, the bills differed on the circumstances and procedures under which lawsuits could be brought against managed care organizations and the scope of their liability. Although Congress did not ultimately enact legislation based on the 2001 bills, and adjourned in 2002 without reconciling the two bills, we expect the issue to be considered again in 2003 and that similar bills will be introduced. If patients' bill of rights legislation is enacted into law, we could be subject to significant additional litigation risk and regulatory compliance costs, which could be costly to us and could have a significant adverse effect on our results of operations. Although we could attempt to mitigate our ultimate exposure to litigation and regulatory compliance costs through, among other things, increases in premiums, there can be no assurance that we would be able to mitigate or cover the costs stemming from litigation arising under patients' bill of rights legislation or the other costs that we could incur in connection with complying with patients' bill of rights legislation.

FIRST OPTION HEALTH PLAN.

        Effective July 30, 1999, a wholly-owned subsidiary of ours merged with and into FOHP, Inc., a then-majority owned subsidiary of ours, which, as a result of the merger, became a wholly-owned subsidiary of the Company. In connection with the merger, the former minority shareholders of FOHP were entitled to receive either $.25 per share or payment rights which entitled the holders to receive as much as $15.00 per payment right on or about July 1, 2001, provided certain hospital and other provider participation and other conditions are met. Also in connection with the merger, certain holders of payment rights were also entitled to receive additional consideration of $2.25 per payment right ("Bonus Consideration") if our New Jersey health plan achieved certain annual returns on common equity and the participation conditions are met. Based on the satisfaction of certain participation and other conditions by the former minority shareholders of FOHP, FOHP has made aggregate payments of approximately $30.4 million to certain holders of payment rights. FOHP is in the process of making the remaining $3.3 million in payments to additional holders of payment rights, subject to such holders submitting appropriate documentation.

ASSET IMPAIRMENT AND RESTRUCTURING CHARGES.

2002 Charges

        During the fourth quarter ended December 31, 2002, we recognized $35.8 million of impairment charges stemming from purchased and internally developed software that was rendered obsolete as a result of our operations and systems consolidation process. In addition, beginning in the first quarter of 2003, internally developed software of approximately $13 million in carrying value will be subject to accelerated depreciation to reflect their revised useful lives as a result of our operations and systems consolidation.

        Effective December 31, 2002, MedUnite, Inc., a health care information technology company, in which we had invested $13.4 million, was sold. As a result of the sale, our original investments were exchanged for $1 million in cash and $2.6 million in notes. Accordingly, we wrote off the original investments of $13.4 million less the $1 million cash received and recognized an impairment charge of $12.4 million on December 31, 2002 which included an allowance against the full value of the notes.

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        During the third quarter ended September 30, 2002, we evaluated the carrying value of our investments available for sale in CareScience, Inc. ("Care Science"). The common stock of CareScience has been consistently trading below $1.00 per share since early September 2002, and is at risk of being delisted. As a result, we have determined that the decline in the fair value of CareScience's common stock was other than temporary. The fair value of these investments was determined based on quotations available on a securities exchange registered with the SEC as of September 30, 2002. Accordingly, we recognized a pretax $3.6 million write-down in the carrying value of these investments which is classified as asset impairment and restructuring charges for the third quarter ended September 30, 2002. Subsequent to the write-down, our new cost basis in our investment in CareScience was $2.6 million as of September 30, 2002. Our remaining holdings in CareScience are included in investments available for sale on the accompanying condensed consolidated balance sheets.

        During the third quarter of 2002, we evaluated the carrying value of our investments in convertible preferred stock and subordinated notes of AmCareco, Inc. arising from a previous divestiture of health plans in Louisiana, Oklahoma and Texas in 1999. Since August 2002, authorities in these states have taken various actions, including license denials and liquidation-related processes, that have caused us to determine that the carrying value of these assets is no longer recoverable. Accordingly, we wrote off the total carrying value of our investment of $7.1 million which was included as a charge in asset impairment and restructuring charges for the third quarter ended September 30, 2002. Our investment in AmCareco had been included in other noncurrent assets on the accompanying condensed consolidated balance sheets.

2001 Charges

        As part of our ongoing general and administrative expense reduction efforts, during the third quarter of 2001, we finalized a formal plan to reduce operating and administrative expenses for all business units within the Company (the "2001 Plan"). In connection with the 2001 Plan, we decided on enterprise-wide staff reductions and consolidations of certain administrative, financial and technology functions. We recorded pretax restructuring charges of $79.7 million during the third quarter ended September 30, 2001 (the "2001 Charge"). As of September 30, 2002, we had completed the 2001 Plan. As of December 31, 2002, we had $3.4 million in lease termination payments remaining to be paid under the 2001 Plan. These payments will be made during the remainder of the respective lease terms.

        Severance and Benefit Related Costs.    During the third quarter ended September 30, 2001, we recorded severance and benefit related costs of $43.3 million related to enterprise-wide staff reductions, which costs were included in the 2001 Charge. These reductions include the elimination of approximately 1,517 positions throughout all functional groups, divisions and corporate offices within the Company. As of September 30, 2002, the termination of positions in connection with the 2001 Plan had been completed and we recorded a modification of $1.5 million to reflect an increase in the severance and related benefits in connection with the 2001 Plan from the initial amount of $43.3 million included in the 2001 Charge to a total of $44.8 million. No additional payments remain to be paid related to severance and benefit-related costs included in the 2001 Charge.

        Asset Impairment Costs.    We also evaluated the carrying value of certain long-lived assets that were affected by the 2001 Plan. The affected assets were primarily comprised of information technology systems and equipment, software development projects and leasehold improvements. We determined that the carrying value of these assets exceeded their estimated fair values. The fair values of these assets were determined based on market information available for similar assets. For certain of the assets, we determined that they had no continuing value to us due to our abandoning certain plans and projects in connection with our workforce reductions.

        Accordingly, we recorded asset impairment charges of $27.9 million consisting entirely of non-cash write-downs of equipment, building improvements and software application and development costs,

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which charges were included in the 2001 Charge. The carrying value of these assets was $6.9 million as of December 31, 2002.

        The asset impairment charges of $27.9 million consist of $10.8 million for write-downs of assets related to the consolidation of four data centers, including all computer platforms, networks and applications into a single processing facility at our Hazel Data Center; $16.3 million related to abandoned software applications and development projects resulting from the workforce reductions, migration of certain systems and investments to more robust technologies; and $0.8 million for write-downs of leasehold improvements.

        Real Estate Lease Termination Costs.    The 2001 Charge included charges of $5.1 million related to termination of lease obligations and non-cancelable lease costs for excess office space resulting from streamlined operations and consolidation efforts. Through December 31, 2002, we had paid $1.7 million of the termination obligations. The remainder of the termination obligations of $3.4 million will be paid during the remainder of the respective lease terms.

        Other Costs.    The 2001 Charge included charges of $3.4 million related to costs associated with closing certain data center operations and systems and other activities which were completed and paid for in the first quarter ended March 31, 2002.

POTENTIAL DIVESTITURES.

We continue to evaluate the profitability realized or likely to be realized by our existing businesses and operations. We are reviewing from a strategic standpoint which of such businesses or operations, if any, should be divested.

APPROVAL OF NON-AUDIT SERVICESRisk Factors

 The Audit Committee

This discussion and analysis and other portions of our Board of Directors has approved the following non-audit services to be performed by Deloitte & Touche LLP, our independent auditor: (1) certain tax services and consultations; (2) actuarial certification services; (3) benefit plan audit services; and (4) certain other miscellaneous non-audit services permitted under Section 10A of the Exchange Act.

CAUTIONARY STATEMENTS

        In connection with the "safe harbor" provisions of the Private Securities Litigation Reform Act of 1995, we are hereby filing cautionary statements identifying important risk factors that could cause our actual results to differ materially from those projected in "forward-looking statements" of the Company made by orthis Annual Report on behalf of the Company,Form 10-K 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.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"“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 the forward-looking statements include, but are not limited to, the factors set forth below 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 the Company. The followingus. 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 these forward-

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lookingany forward-looking statements, which reflect management'smanagement’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.

 In making these statements, we are not undertaking

Our profitability will depend, in part, on our ability to address or update each factor in future filings or communications regarding our business or results, nor are we undertaking to address how any of these factors may have caused changes to matters discussed or information contained in previous filings or communications. In addition, certain of these factors may have affected our past results and may affect future results.accurately predict health care costs.

 HEALTH CARE COSTS.    

A large portionsubstantial majority of the revenue we receive is expended to pay the costs of health care services or supplies delivered to our members. The total health care costs incurred by uswe incur are affected by the number and type of individual services renderedprovided and the cost of each service. MuchOur future profitability will depend in part on our ability to accurately predict health care costs and to control future health care costs through underwriting criteria, utilization management, product design and negotiation of favorable professional and hospital contracts. Changes in utilization rates, demographic characteristics, the regulatory environment, health care practices, inflation, new technologies, clusters of high-cost cases, continued consolidation of physician, hospital and other provider groups and numerous other factors affecting health care costs may adversely affect our ability to predict and control health care costs as well as our financial condition, results of operations or cash flows. Periodic renegotiations of hospital and other provider contracts, coupled with continued consolidation of physician, hospital and other provider groups, may result in increased health care costs or limit our ability to negotiate favorable rates.

The managed health care industry is labor intensive and its profit margin is low. As such, it is especially sensitive to inflation. Health care industry costs have been rising annually at rates higher than the rate of increase of the Consumer Price Index. Increases in medical expenses or contracted medical rates without corresponding increases in premiums could have a material adverse effect on us.

We face competitive pressure to contain premium prices.

In addition to the challenge of controlling health care costs, we face competitive pressure to contain premium prices. While health plans compete on the basis of many factors, including service and the quality and depth of provider

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networks, we expect that price will continue to be a significant basis of competition. Our premium revenue is set in advance of the actual delivery of services, and in certain circumstances before contracting with providers, and the related incurringpricing of the cost, usually on a prospective annual basis.services rendered by these providers. While we attempt to base the premiums we charge at least in part ontake into account our estimate of expected health care costs over the fixed premium period in setting the premiums we charge, factors such as competition, regulations and other circumstances may limit our ability to fully base premiums on estimated costs. In addition, many factors may and often do cause actual health care costs to exceed those costs estimated and reflected in premiums. These factors may include increased utilization of services, increased cost of individual services, catastrophes, epidemics, seasonality, new mandated benefits or other regulatory changes, and insured population characteristics. Our financial condition or results of operations could be adversely affected by significant premium decreases by our major competitors or by limitations on our ability to increase or maintain our premium levels.

Our inability to estimate and maintain adequate reserves for claims may adversely affect our business, financial condition and results of operations.

 The managed health care industry is labor intensive and its profit margin is low; hence, it is especially sensitive to inflation. Health care industry costs have been rising annually at rates higher than the rate of increase of the Consumer Price Index. Increases in medical expenses or contracted medical rates without corresponding increases in premiums could have a material adverse effect on us.

        RESERVES FOR CLAIMS.Our reserves for claims are estimates of future costs based on various assumptions. The accuracy of these estimates may be affected by external forces such as changes in the rate of inflation, the regulatory environment, the judicious administration of claims, medical costs and other factors. Included in the reserves for claims are estimates for the costs of services which have been incurred but not reported. EstimatesThese estimates are continually monitored and reviewed and, as settlements are made or estimates adjusted, differences are reflected in current operations. Given the uncertainties inherent in such estimates, the actual liability could differ significantly from the amounts reserved. Moreover, if the assumptions on which the estimates are based prove to be incorrect and reserves are inadequate to cover our actual claim costs, our business, financial condition and results of operations could be adversely affected.

        PHARMACEUTICAL COSTS.We may experience losses as a result of the regional concentration of our business.

Our business operations are concentrated in the Northeast (in the states of Connecticut, New York and New Jersey) and in the states of California, Arizona and Oregon. Due to this concentration in a small number of states, we are exposed to a potential deterioration in our financial results resulting from the risk of a significant economic downturn in these states. If economic conditions in these states significantly deteriorate, we may experience a reduction in existing and new business, which may have a material adverse effect on our business, financial condition and results of operations. In addition, if any one of our health plans experiences significant losses, our consolidated results of operations may be materially and adversely affected. For example, our New Jersey health plan is currently experiencing hospital cost trends significantly higher than the trends we estimated when we established premiums and potentially higher than those of its competitors. These higher hospital cost trends have caused a deterioration in margins and we may not be able to offset this issue with adequate future premium increases. The deterioration in margins in New Jersey has, and may continue to have, an adverse effect on our business, financial condition and results of operations. A similar deterioration in margins in any one of the other small number of states we operate in could also have an adverse effect on our financial condition and results of operations. For additional information regarding the challenges we face in the Northeast and, in particular, New Jersey, see “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Executive Summary — Operating Highlights and Outlook for 2004.”

If we are unable to forecast and manage hospital and pharmaceutical costs, our revenues could decline and our results of pharmaceutical products and services are oneoperations could be adversely affected.

One of the fastest increasing categories of our health care costs.costs are the costs of hospital based products and services. Thus, in addition to the circumstances and factors that may limit our ability to fully base premiums on estimated costs, as mentioned in the health care costs cautionary statements, our HMOs face an even higher risk with pharmaceuticalhospital expenses that could have a material adverse effect. The inabilityFactors underlying the increase in hospital costs include, but are not limited to, managethe underfunding of public programs, such as Medicaid and Medicare, growing rates of uninsured individuals, new technology, state initiated mandates, alleged abuse of hospital chargemasters, an aging population and, under certain circumstances, relatively low levels of hospital competition. Significant consolidation of hospital providers in certain markets in which we operate may continue to limit our ability to negotiate favorable rates for hospital services.

Another significant category of our health care costs are costs of pharmaceutical products and services. Although pharmaceutical costs could have an adverse effect on our financial condition. In addition,not been increasing at the level of hospital costs, evolving regulation may impact the ability of our HMOs to continue to receive existing price discounts on pharmaceutical products for our membership.members. Other factors affecting our pharmaceutical costs include, but are not limited to, the price of drugs, utilization of new and existing drugs and changes in discounts. The inability to forecast and manage these costs could have an adverse effect on our financial condition and results of operations.

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Proposed federal and state legislation affecting the managed health care industry could have an adverse effect on our operations.

        FEDERAL AND STATE LEGISLATION.

There are frequently legislative proposals before the United States Congress and state legislatures which, if enacted, could materially affect the managed health care industry and the regulatory environment. Recent financial difficulties of certain health care service providers and plans and/or continued publicity of the health care industry could alter or increase legislative consideration of these or additional proposals. These proposals include federal and state "patients'“patients’ bill of rights"rights” legislation and other initiatives which, if enacted, could have significant adverse effects on our operations.operations, including subjecting us to additional litigation risk and regulatory compliance costs. Such measures propose, among other things, to:

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