UNITED STATES

FORM 10-Q

(Mark One)

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

For the quarterly period ended March 31, 2000

or

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

For the transition period from                 to                

Commission File Number 000-21949

PACIFICARE HEALTH SYSTEMS, INC.

3120 Lake Center Drive, Santa Ana, California 92704

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

     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  [   ]

     The number of shares of common stock outstanding at April 28, 2000 was approximately 35,180,000.

PACIFICARE HEALTH SYSTEMS, INC.

FORM 10-Q

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PART I.  FINANCIAL INFORMATION

Item 1:  Financial Statements

PACIFICARE HEALTH SYSTEMS, INC.

See accompanying notes.

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PACIFICARE HEALTH SYSTEMS, INC.

See accompanying notes.

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PACIFICARE HEALTH SYSTEMS, INC.

See accompanying notes.

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See accompanying notes.

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PACIFICARE HEALTH SYSTEMS, INC.

1.  Basis of Presentation

PacifiCare Health Systems, Inc. is one of the nation’s largest health care services companies, serving approximately 4 million members in the Medicare and commercial lines of business. Following the rules and regulations of the Securities and Exchange Commission (“SEC”), we have omitted footnote disclosures that would substantially duplicate the disclosures contained in the annual audited financial statements. The accompanying unaudited condensed consolidated financial statements should be read together with the consolidated financial statements and the notes included in our December 31, 1999 Annual Report on Form 10-K, filed with the SEC in March 2000.

The accompanying unaudited condensed consolidated financial statements reflect all adjustments, consisting solely of normal recurring adjustments, needed to present fairly the financial results for these interim periods. The consolidated results of operations presented for the interim periods are not necessarily indicative of the results for a full year.

2.  Acquisitions and Dispositions

2000 Acquisitions. On February 1, 2000, we completed our acquisition of Harris Methodist Texas Health Plan, Inc. and Harris Methodist Health Insurance Company, Inc., a health plan and insurance company in Texas, for a purchase price of $122 million. This acquisition added approximately 250,000 commercial members and 50,000 Medicare members to our Texas health maintenance organization (“HMO”). This acquisition was accounted for as a purchase with substantially the entire purchase price being allocated to goodwill and other acquired intangible assets. The goodwill and acquired intangible assets are being amortized over periods ranging from three to 30 years. The operating results of these entities are included in our consolidated financial statements from the acquisition date.

During the first quarter of 2000, we assumed approximately 20,000 members in Colorado and approximately 22,000 members in Washington for a purchase price of approximately $7 million as a result of transition agreements signed with QualMed Plans for Health of Colorado, Inc. in September 1999 and with QualMed Washington Health Plans, Inc. in October 1999, each a subsidiary of Foundation Health Systems, Inc.

1999 Acquisitions. In September 1999, we acquired ANTERO Health Plans in Colorado for a purchase price of $14 million. This acquisition added approximately 32,000 commercial members and 4,000 Medicare members to our Colorado HMO. In February 1999, we assumed approximately 15,000 commercial members in Texas for $4 million. These acquisitions were accounted for as purchases with substantially the entire purchase price being allocated to goodwill and other acquired intangible assets. The goodwill and acquired intangible assets are being amortized over periods ranging from three to 20 years. The operating results of these entities are included in our consolidated financial statements from the acquisition date.

Pro Forma Financial Statements. The pro forma information below presents our consolidated results of operations as if the acquisition of Harris Methodist Texas Health Plan, Inc. and Harris Methodist Health Insurance Company, Inc. occurred at the beginning of each period presented. The pro forma information gives effect to actual results prior to the acquisition plus adjustments for depreciation expense, goodwill amortization, net investment income and income taxes. Because the assumptions of membership in Colorado, Washington and Texas were not material to our consolidated results of operations, these transactions were not included in the pro forma information below.

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3.  Long-Term Debt

Beginning January 1, 1999, and continuing through the January 1, 2002 final maturity date, the amount we may borrow under our credit facility declines incrementally every six months. Borrowings available to us at March 31, 2000 were $1.2 billion. The facility requires mandatory step-down payments if the principal balance exceeds certain thresholds. Based on the $870 million outstanding balance at March 31, 2000, a payment of $70 million will be required by June 30, 2001.

Interest under the credit facility is variable and is presently based on the London Interbank Offered Rate (“LIBOR”) plus a spread. Based on the outstanding balance at March 31, 2000, the average overall rate, excluding the facility fee, was 7.3 percent. The terms of the credit facility contain various covenants, usual for financings of this type, including a minimum net worth requirement, a minimum fixed charge requirement, leverage ratios and limits on the amount of treasury stock we may purchase. At March 31, 2000, we were in compliance with all such covenants. We also have $100 million in senior notes outstanding that we assumed when we acquired FHP International Corporation in 1997. These notes mature on September 15, 2003 and bear an interest rate of seven percent payable semiannually.

4.  Stockholders’ Equity

Stockholder Rights Agreement. In November 1999, our board of directors adopted a stockholder rights agreement to protect stockholder rights in the event of a proposed takeover. The board of directors declared a dividend of one right for each share of our common stock outstanding as of November 19, 1999. The right entitles the registered holder to purchase from PacifiCare 1/100th of a share of Series A junior participating preferred stock at a price of $180 per 1/100th of a preferred share. Similar rights will generally be issued in respect of common stock issued after November 19, 1999.

Treasury Stock. In October 1999, our board of directors approved a stock repurchase program that allows us to repurchase up to 12 million shares of our outstanding common stock, including any shares purchased from UniHealth Foundation, a non-profit public benefit corporation and our largest stockholder (see “UniHealth Foundation Stock Purchase Agreement” below). We have repurchased approximately 8.4 million shares under this authorization. As of March 31, 2000, we held approximately 11.7 million treasury shares totaling $618 million. To purchase the maximum number of shares authorized, we negotiated an amendment to our existing credit facility that increases the maximum allowable amount of share repurchases to $1 billion from $500 million. We may fund the stock repurchase program through a combination of cash flows from operations, additional borrowings under the credit facility and long- and short-term debt. We have reissued, and will continue to reissue these shares for our employee benefit plans or for other corporate purposes.

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Reclassification of Common Stock. At our June 1999 annual meeting, our Class A and Class B common stockholders, including UniHealth Foundation, approved an amended and restated certificate of incorporation. The amended and restated certificate combined and reclassified our Class A and Class B common stock into a single class of voting common stock. The reclassified common stock has the same rights, powers and limitations as the previously existing Class A common stock. The reclassification of the Class A and Class B common stock had no impact on the total number of our issued and outstanding shares of common stock.

Prior to the combination and reclassification of our Class A and Class B common stock, UniHealth Foundation owned approximately 40 percent of our Class A common stock and approximately one percent of our Class B common stock. As of March 31, 2000, UniHealth Foundation owned approximately 18 percent of our outstanding common stock. In consideration for UniHealth Foundation’s vote in favor of the amended and restated certificate of incorporation, and in consideration of the agreements and covenants contained in the stock purchase agreement discussed below, we paid UniHealth Foundation $60 million in June 1999, when our stockholders approved the amended and restated certificate of incorporation. We also incurred $2 million of expenses related to the reclassification of our common stock and the registration of the shares held by UniHealth Foundation. These amounts were recorded as a reduction of stockholders’ equity in 1999.

UniHealth Foundation Stock Purchase Agreement. In May 1999, we entered into a stock purchase agreement with UniHealth Foundation to repurchase up to 5.9 million shares of our common stock held by UniHealth Foundation. The purchase price for the shares equals the average closing price of the stock for the 30 trading days preceding the scheduled purchase dates. We are not required to buy if the stock price is greater than $120 per share and UniHealth Foundation is not required to sell if the stock price is less than $75 per share. Depending on the average stock price, we may repurchase UniHealth Foundation shares on the following dates and in the following installments:

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During the first quarter, we recognized net pretax charges of $3 million as follows:

Restructuring Charge. We recognized a $9 million ($5 million or $0.14 diluted loss per share, net of tax) restructuring charge during the first quarter. In January 2000, we announced plans to strengthen our operations through productivity enhancements and technology improvements to further our competitive advantages and growth opportunities. The restructuring charge included severance and related employee benefits. Of the approximately 270 employees being terminated by December 31, 2000, the majority of these positions are in the sales & marketing and human resources departments where the corporate and regional functions will be centralized and consolidated. As of March 31, 2000, we paid approximately $1 million to 100 terminated employees. Approximately $7 million of the restructuring charge will be paid by the end of 2000, and the remaining balance will be paid in 2001. Cash flows from operations are expected to fund the restructuring charge. We expect net annual marketing, general and administrative salary savings of approximately $12 million from the centralization and consolidation of corporate and regional functions.

The following table presents the activity during the quarter ended March 31, 2000:

Other Changes in Estimates. We recognized other credits for changes in estimates of $3 million ($2 million or $0.05 diluted earnings per share, net of tax). We have successfully settled certain contingencies related to acquisitions and dispositions in 1997 and 1998 including pending and threatened litigation, as well as indemnifications made to the buyers of sold subsidiaries.

OPM Credits. We recognized OPM credits of $3 million ($2 million or $0.05 diluted earnings per share, net of tax) as a result of 1996 and 1997 Oklahoma HMO premiums received.

6.  Commitments and Contingencies

Provider Instability and Insolvency. Provider reserves include write-offs of certain uncollectable receivables from our providers and the estimated cost of unpaid health care claims normally covered by our capitation payments. Depending on state laws, we may be held liable for unpaid health care claims

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that were contractually the responsibility of the capitated provider. The balance of our provider insolvency reserves included in medical claims and benefit payable was $35 million at March 31, 2000 and $46 million at December 31, 1999. The net decrease in provider insolvency reserves was a result of payments.

Our insolvency reserves relate to specific providers. These reserves include estimates for potentially insolvent providers, where conditions indicate claims are not being paid or have slowed considerably. Based on information currently available, we believe that any liability in excess of amounts accrued would not materially affect our consolidated financial position. However, our evaluation of the likely impact of claims asserted against us could change in the future and an unfavorable outcome, depending on the amount and timing, could have a material effect on our results of operations or cash flows for a future period.

The California Department of Corporations (“DOC”) entered into a settlement with Alabama-based Caremark Rx, Inc. (formerly MedPartners, Inc. “Caremark”) regarding its California subsidiary, MedPartners Network (“MPN”). MPN was a provider organization licensed by the DOC that arranged health care services for HMO members through arrangements between HMOs and health care providers, such as hospitals and physician groups. MPN was one of our significant provider networks in California. In March 1999, California regulators seized MPN and appointed a conservator to oversee MPN. The conservator placed MPN in bankruptcy. In June 1999, the State of California, the DOC, MPN and Caremark entered into an Operations and Settlement Agreement to ensure continuing patient care and to resolve certain claims by and against MPN and Caremark. Under this agreement, Caremark agreed to fund MPN’s liabilities to its contracted and non-contracted providers in California. As part of the agreement, effective June 1, 1999, we agreed to assume financial responsibility for institutional services that were previously the responsibility of MPN. The agreement required the institutional providers to offer the same terms to us as MPN had through the earlier of the termination of the provider’s contract or December 31, 1999. In addition, we have agreed to participate in the agreement, which requires us to waive or subordinate certain claims against MPN in exchange for waivers of claims against us in connection with services provided by MPN or its affiliates in California. We along with other HMOs will make a loan in the amount of approximately $12 million to KPC Medical Management, Inc., a purchaser of some of the MPN practices, and Chuadhuri Medical Corporation, an affiliate of KPC Medical Management, Inc. Approximately $3 million of the loan will be contributed by us. The principal and interest of the loan to the KPC entities are guaranteed by Caremark. MPN has ceased doing business and all of MPN’s affiliated medical groups in California have been sold.

OPM. Our HMO subsidiaries have commercial contracts with OPM to provide managed health care services to federal employees, annuitants and their dependents under the Federal Employee Health Benefits Plan (“FEHBP”). Rather than negotiating rates with HMOs, OPM requires HMOs 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 state after adjusting for differences in benefits, enrollment demographics, and coordination of costs with Medicare. OPM further requires that every HMO certify each year that its rates meet these requirements. Approximately every three to five years, OPM’s Office of Inspector General (“OIG”) audits each HMO to verify that the premiums charged are calculated and charged in compliance with these rating regulations and guidelines. Each audit encompasses a period of up to six years. Following the government’s initial on-site audit, OPM will provide the HMO with a post-audit briefing indicating its preliminary results. Because these are actuarial calculations, interpretations of the rating regulations and audit findings often raise complex issues. The final resolution and settlement of audits have historically taken more than three years and as many as seven years.

During the audit process, OPM may refer its findings to the United States Department of Justice (“DOJ”) if it believes that the health plan knowingly overcharged the government or otherwise submitted

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

Prior to our acquisition of FHP International Corporation (“FHP”), the former FHP HMO subsidiary, TakeCare of California, was audited by the OIG auditors. The OIG issued a draft audit report in September 1996 alleging that TakeCare overcharged the FEHBP by approximately $24 million including lost investment income. TakeCare responded to this draft audit in January 1997, questioning many of the auditors’ calculations and assumptions. When we purchased FHP in February 1997, we were aware of the government’s claims, and we reserved for potential liabilities in accordance with our accounting policies. In August 1999, we were notified that the auditors had referred certain allegations to the DOJ for review of potential claims under the False Claims Act. We are negotiating with the DOJ to resolve all outstanding issues relating to the TakeCare of California audit amicably. We do not agree with the auditors’ interpretations of the applicable rules and guidelines or their method of calculating rates for the applicable period, and we do not believe there is any evidence that TakeCare of California ever engaged in any action that would violate the False Claims Act.

In July 1999, we received a request from the OIG requesting documentation regarding all of the contracts between OPM and any of the HMOs owned by FHP that related to the contract years 1990 through 1997. The majority of these contract years have already been audited, but are not yet settled. We have complied with this request.

OPM has conducted an audit of our Oregon HMO subsidiary for the years 1991 through 1996. We have been notified that the auditors had referred certain allegations to the DOJ for review of potential claims under the False Claims Act. We intend to negotiate with the DOJ to resolve any potential claims amicably.

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

In late 1997, we established a formal corporate compliance program to specifically address potential issues that may arise from the FEHBP rating process, to work with OPM to understand its interpretation of the rules and guidelines prior to completion of the rating process, to standardize the FEHBP rating process among all of our HMOs, and to help reduce the likelihood that future government audits will result in any significant findings. Based upon the results of a limited number of audits that have been conducted for contract years 1998 and later, we believe that this program has been effective.

Legal Proceedings. On November 2, 1999, Jose Cruz filed a purported class action complaint against PacifiCare, our California subsidiary and FHP in San Francisco Superior Court. On November 9, 1999, Cruz filed a first amended class action complaint that omitted FHP as a defendant. The amended complaint relates to the period from November 2, 1995 to the present and purports to be filed on behalf of all enrollees in our health care plans other than Medicare and Medicaid enrollees. The amended complaint alleges that we have engaged in unfair business acts in violation of California law, engaged in false, deceptive and misleading advertising in violation of California law and violated the California Consumer

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Legal Remedies Act. It also alleges that we have received unjust payments as a result of our conduct. The amended complaint seeks injunctive and declaratory relief, an order requiring the defendants to inform and warn all California consumers regarding our financial compensation programs, unspecified monetary damages for restitution of premiums and disgorgement of improper profits, attorneys’ fees and interest. On December 2, 1999, we removed the action to the United States District Court for the Northern District of California on the grounds that the amended complaint was completely preempted by the Employee Retirement Income Security Act of 1974 or ERISA. We also moved to compel arbitration. The plaintiff sought to have the case returned to state court. The court held a hearing on these motions in February 2000 and has not ruled on the motions. We deny all material allegations in the amended complaint and intend to defend the action vigorously.

On November 22, 1999, Debbie Hitsman filed a purported class action complaint against PacifiCare in the United States District Court for the Southern District of Mississippi, Hattiesburg Division. The complaint relates to the period from November 22, 1995 to the present and purports to be on behalf of all enrollees in our health care plans other than Medicare and Medicaid enrollees. The complaint alleges causes of action for violations of the Racketeer-Influenced and Corrupt Organizations Act and ERISA. The complaint seeks an unspecified amount of compensatory and treble damages, injunctive and restitutionary relief, attorneys’ fees, the imposition of a constructive trust and interest. On January 13, 2000, we filed a motion to compel arbitration and a motion to dismiss or, in the alternative, to transfer the case for lack of personal jurisdiction and improper venue. The court has not ruled on these motions. We deny all material allegations and intend to defend the action vigorously.

In 1997, Tim Brady and other individuals filed a class action suit against PacifiCare, several PacifiCare officers and several former officers of FHP in the United States District Court for the Central District of California. In addition, in 1997, Brady and other individuals filed a class action suit against PacifiCare and several PacifiCare officers and several former officers of FHP in the Orange County Superior Court. Finally, in 1997, William Madruga and another individual filed a class action suit against PacifiCare and several of its directors and officers in the United States District Court for the Central District of California. Each of the complaints related to the period from the date of proxy statement for the FHP acquisition through our November 1997 announcement that earnings for the fourth quarter of 1997 would be lower than expected. These complaints primarily alleged that we previously omitted and/ or misrepresented material facts with respect to our costs, earnings and profits. The trial courts dismissed the Brady cases, brought on behalf of former FHP shareholders, but the cases are now on appeal. On May 2, 2000, the Madruga case was dismissed in part without permission to amend and in part with permission to amend the complaint. The claims dismissed without permission to amend relate to specific statements we made in press releases, analyst conference calls and our annual report that the plaintiffs alleged were misleading. We do not know whether the plaintiffs will appeal this order. We deny all material allegations and intend to defend the actions vigorously.

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

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7.  Earnings Per Share

We calculated the denominators for the computation of basic and diluted earnings per share as follows:

8.  Comprehensive Income

Comprehensive income represents our net income plus changes in equity, other than those changes resulting from investments by, and distributions to our stockholders. Such changes include unrealized gains or losses on our available-for-sale securities. Our comprehensive income totaled $78 million for the three months ended March 31, 2000 and $68 million for the three months ended March 31, 1999.

9.  Future Application of Accounting Standards

Stock-Based Compensation. In March 2000, the Financial Accounting Standards Board issued Interpretation No. 44, “Accounting for Certain Transactions Involving Stock Compensation.” The Interpretation provides guidance on certain implementation issues related to Accounting Principles Board Opinion 25, “Accounting for Stock Issued to Employees.” The Interpretation is effective July 1, 2000 and is not expected to have a material impact to our consolidated financial position or results of operations.

Derivatives. In June 1998, the Financial Accounting Standards Board issued SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities.” This standard requires companies to record all derivatives on the balance sheet as either assets or liabilities and measure those instruments at their fair value. The manner in which companies record gains or losses resulting from changes in the values of those derivatives depends on the use of the derivative and whether it qualifies for hedge accounting. This standard is effective for our consolidated financial statements beginning January 1, 2001, although early adoption is permitted. We believe that the adoption of this statement will not have a material impact to our consolidated financial position or results of operations.

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

Results of Operations

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

Events significant to our business in 2000 include the following:

•	On February 1, 2000, we completed our acquisition of Harris Methodist Texas Health Plan, Inc. and Harris Methodist Health Insurance Company Inc. (collectively “Harris”), a health plan and insurance company in Texas with approximately 250,000 commercial and 50,000 Medicare members. See Note 2 of the Notes to Condensed Consolidated Financial Statements.
•	During the first quarter, we assumed approximately 20,000 members in Colorado and 22,000 members in Washington as a result of transition agreements signed with QualMed Washington Health Plans, Inc. and with QualMed Plans for Health of Colorado (collectively “QualMed”), each a subsidiary of Foundation Health Systems, Inc. See Note 2 of the Notes to Condensed Consolidated Financial Statements.
•	During the first quarter, we recognized net pretax charges for impairment, disposition, restructuring and other charges primarily related to the January 2000 work force reduction. See Note 5 of the Notes to Condensed Consolidated Financial Statements.

2000 Compared With 1999

Membership. Total membership increased 12 percent to approximately 4 million members at March 31, 2000 from approximately 3.6 million members at March 31, 1999.

Medicare membership increased approximately three percent at March 31, 2000 compared to the same period in the prior year due to:

•	Membership increases in Texas due to the addition of 43,000 Harris members; and
•	Competitor exits in markets where Secure Horizons will remain, primarily in Arizona, Colorado and Nevada; partially offset by

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•	Membership decreases primarily in California due to disenrollment resulting from reduced benefits, increased copayments and instituted or increased member-paid supplemental premiums in certain markets; and
•	Slight membership decreases as a result of our planned county exits in Ohio, Washington, California and Oregon.

Commercial membership increased approximately 15 percent at March 31, 2000 compared to the same period in the prior year due to:

•	Membership increases in Texas due to the addition of 202,000 Harris members;
•	Growth in California primarily due to marketing efforts to retain membership and the renewal of major employer accounts; and
•	Membership increases of approximately 20,000 in Colorado and 22,000 in Washington as a result of membership transitions from QualMed.

Medicare Premiums. Medicare premiums increased nine percent or $135 million for the three months ended March 31, 2000 compared to the same period in the prior year as follows:

Commercial Premiums. Commercial premiums increased 22 percent or $210 million for the three months ended March 31, 2000 compared to the same period in the prior year as follows:

Other Income. Other income increased approximately 18 percent or $5 million for the three months ended March 31, 2000 compared to the same period in the prior year. The increase was primarily due to increased mail-service revenues, including mail-service revenues from Harris. Mail-service revenues are generated by our pharmacy benefit management company, where we, rather than network retail pharmacies, collect the member copayments.

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Consolidated Medical Care Ratio. The consolidated medical care ratio (health care services as a percentage of premium revenue) increased slightly for the three months ended March 31, 2000 as compared to the same period in the prior year.

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

Medicare Medical Care Ratio. The Medicare medical care ratio increased for the three months ended March 31, 2000 compared to the same period in the prior year due to:

•	Higher hospital utilization; partially offset by
•	Premium rate increases; and
•	Favorable changes in prior-period estimates related to a provider contract.

Commercial Medical Care Ratio. The commercial medical care ratio includes the specialty HMOs and indemnity insurance results. The commercial medical care ratio for the three months ended March 31, 2000 increased as compared to the same period in the prior year due to:

•	Higher contracted physician costs; and
•	Higher prescription drug costs; partially offset by
•	Premium rate increases; and
•	Favorable changes in prior-period estimates related to a provider contract.

Marketing, General and Administrative Expenses. For the three months ended March 31, 2000, marketing, general and administrative expenses as a percentage of operating revenue was comparable to the same period in the prior year.

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Impairment, Disposition, Restructuring, Office of Personnel Management (“OPM”) and Other Charges (Credits). During the first quarter, we recognized net pretax charges of $3 million. We recognized a $9 million ($5 million or $0.14 diluted loss per share, net of tax) restructuring charge during the first quarter. In January 2000, we announced plans to strengthen our operations through productivity enhancements and technology improvements to further our competitive advantages and growth opportunities. The restructuring charge included severance and related employee benefits. Of the approximately 270 employees being terminated by December 31, 2000, the majority of these positions are in the sales & marketing and human resources departments where the corporate and regional functions will be centralized and consolidated. As of March 31, 2000, we paid approximately $1 million to 100 terminated employees. Approximately $7 million of the restructuring charge will be paid by the end of 2000, and the remaining balance will be paid in 2001. Cash flows from operations are expected to fund the restructuring charge. We expect net annual marketing, general and administrative salary savings of approximately $12 million from the centralization and consolidation of corporate and regional functions.

We recognized other credits for changes in estimates of $3 million ($2 million or $0.05 diluted earnings per share, net of tax). We have successfully settled certain contingencies related to acquisitions and dispositions in 1997 and 1998 including pending and threatened litigation, as well as indemnifications made to the buyers of sold subsidiaries. We recognized OPM credits of $3 million ($2 million or $0.05 diluted earnings per share, net of tax) as a result of 1996 and 1997 Oklahoma HMO premiums received. See Note 5 of the Notes to Condensed Consolidated Financial Statements.

Operating Income. Operating income as a percentage of operating revenue was 4.4 percent for the three months ended March 31, 2000 and was 4.7 percent for the three months ended March 31, 1999. Factors contributing to the changes are discussed above and are detailed in earnings per share below.

Net Investment Income. Net investment income increased approximately 24 percent for the three months ended March 31, 2000 compared to the same period in the prior year due to the following:

•	Higher average invested balances; and
•	Increases in short- and long-term interest rates.

Interest Expense. Interest expense increased significantly for the three months ended March 31, 2000 compared to the same period in the prior year due to:

•	Increased borrowings on our credit facility to fund our share repurchase program;
•	Higher short-term interest rates; and
•	Higher interest margin rate as a result of the reduction in our credit rating by the credit rating agencies combined with a higher interest fee structure in the credit facility amendment.

Provision for Income Taxes. The effective income tax rate was 41.8 percent for the three months ended March 31, 2000 compared with 41.4 percent for the three months ended March 31, 1999. The rate increased primarily due to decreases in tax-exempt earnings.

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Diluted Earnings Per Share. For the three months ended March 31, 2000, net income was $75 million or $2.04 diluted earnings per share compared to net income of $74 million or $1.61 diluted earnings per share for the same period in the prior year. Components of the increase in diluted earnings per share from the prior period were as follows:

Liquidity and Capital Resources

Operating Cash Flows. Our consolidated cash, equivalents and marketable securities increased to $1.9 billion at March 31, 2000 from $1.8 billion at December 31, 1999. The combined increase in cash, equivalents and marketable securities was primarily related to current year earnings that were invested and additional cash, including the prepaid April 2000 Health Care Financing Administration (“HCFA”) payment, resulting from the Harris acquisition.

Cash flows from operations, excluding the impact of deferred revenue, were $113 million at March 31, 2000 and $90 million at March 31, 1999. The increase was primarily attributable to lower income tax payments.

Investing Activities. For the three months ended March 31, 2000, our investing activities provided $18 million in cash. This compared to $48 million used during the three months ended March 31, 1999. We sold more securities in the first quarter of 2000 to provide cash to fund the Harris acquisition and share repurchases resulting in the majority of the change from the prior year.

Financing Activities. For the three months ended March 31, 2000, we used $97 million of cash for financing activities compared to $72 million used for the same period in the prior year. The changes were as follows:

•	We repurchased 2.1 million shares of our common stock in 2000 for $94 million under our stock repurchase program. No shares were repurchased during the same period in 1999; and
•	We paid a net $3 million on our long-term debt, including net credit facility payments of $5 million, during the first three months of 2000 compared to $75 million for the same period in 1999.

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Other Balance Sheet Change Explanations

Receivables, Net. Receivables, net increased $104 million from December 31, 1999 as follows:

•	$38 million increase in premium receivables;
•	$33 million increase in provider receivables;
•	$18 million increase attributable to the Harris acquisition; and
•	$15 million increase in other trade receivables.

Premium receivables increased in the first quarter due to open enrollment, membership increases including acquired membership and premium rate increases for existing and new members. Open enrollment increases are typical in the first quarter as membership information is gathered and reconciled. Our consolidated membership increased nine percent over December 31, 1999 primarily as a result of the Harris acquisition, growth in California and the membership transitions from QualMed. Finally, we successfully implemented premium rate increases for both the commercial and Medicare markets.

Provider receivables increased as a result of our higher proportion of shared-risk hospital contracts. In shared-risk contracts, we share the risk of certain health care costs not covered by capitation arrangements and recognize receivables for our portion of health care costs above the budgeted percentage as specified in the contract. We also had provider receivable increases due to capitation advances paid to certain providers. These capitation advances will be recovered through subsequent capitation withhold adjustments.

Other trade receivables increased in the first quarter primarily due to higher rebate receivables as a result of additional Harris membership and higher prescription drug utilization.

Goodwill and Intangible Assets, Net. Goodwill and intangible assets increased $69 million from 1999 as follows:

•	$81 million increase attributable to the Harris acquisition; and
•	$8 million increase attributable to membership assumptions in Colorado and Washington; partially offset by
•	$20 million decrease attributable to goodwill and intangible amortization expense.

Medical Claims and Benefits Payable. Medical claims and benefits payable increased $168 million from December 31, 1999 as follows:

•	$97 million increase attributable to the Harris acquisition, including $22 million in loss contract reserves to be amortized through the fourth quarter of 2001;
•	$54 million increase in claims incurred but not yet reported for increased membership and utilization under shared-risk hospital arrangements. Under shared-risk arrangements, claims are payable once incurred. This results in a payable for claims incurred but not yet paid, as well as an estimate of claims incurred but not yet reported to PacifiCare; and
•	$13 million increase in capitation liabilities primarily due to premium increases from open enrollment and membership retroactivity; partially offset by
•	$4 million net increase in other provider liabilities.

Accounts Payable and Accrued Liabilities. Accounts payable and accrued liabilities increased $35 million from December 31, 1999 primarily due to the timing of payment of the current year income tax provision.

Material Commitments. See Note 4 of the Notes to Condensed Consolidated Financial Statements for a discussion of our agreement to purchase shares of our common stock held by UniHealth Foundation.

New Accounting Pronouncements. See Note 9 of the Notes to Condensed Consolidated Financial Statements for a discussion of future application of accounting standards.

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Three Months Ended March 31, 2000 Compared With Three Months Ended December 31, 1999

The following presents our results of operations for the three months ended March 31, 2000 in comparison to the results of operations for the three months ended December 31, 1999. We are presenting this information to assist in the understanding of our discussions about our operating trends. This includes our outlook on future performance and the risks affecting our future performance discussed below in Forward Looking Information under the Private Securities Litigation Act of 1995.

Membership. Total membership increased approximately nine percent at March 31, 2000 from December 31, 1999.

Medicare membership increased slightly at March 31, 2000 from December 31, 1999 due to the addition of 43,000 Harris members, partially offset by membership decreases in California.

Commercial membership increased approximately 13 percent at March 31, 2000 from December 31, 1999 primarily due to the addition of 202,000 Harris members, growth in California and the membership transitions from QualMed in Colorado and Washington.

Medicare Premiums. Medicare premiums increased approximately five percent or $75 million for the three months ended March 31, 2000 compared to premiums for the three months ended December 31, 1999 as follows:

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Commercial Premiums. Commercial premiums increased approximately 16 percent or $161 million for the three months ended March 31, 2000 compared to premiums for the three months ended December 31, 1999 as follows:

Other Income. Other income increased approximately six percent for the three months ended March 31, 2000 compared to the three months ended December 31, 1999. The increase was primarily due to increased mail-service revenues, including mail-service revenues from Harris. Mail-service revenues are generated by our pharmacy benefit management company, where we, rather than network retail pharmacies, collect the member copayments.

Consolidated Medical Care Ratio. The consolidated medical care ratio increased for the three months ended March 31, 2000 compared to the consolidated medical care ratio for the three months ended December 31, 1999.

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

Medicare Medical Care Ratio. The Medicare medical care ratio increased for the three months ended March 31, 2000 compared to the three months ended December 31, 1999 due to:

•	Increased utilization related to seasonal influenza; and
•	Higher contracted physician costs; partially offset by
•	Premium rate increases; and
•	Favorable changes in prior-period estimates related to a provider contract.

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Commercial Medical Care Ratio. The commercial medical care ratio includes the specialty HMOs and indemnity insurance results. The commercial medical care ratio for the three months ended March 31, 2000 decreased compared to the three months ended December 31, 1999 due to:

•	Premium rate increases; and
•	Favorable changes in prior-period estimates related to a provider contract; partially offset by
•	Higher contracted physician costs; and
•	Higher prescription drug costs.

Marketing, General and Administrative Expenses. Marketing, general and administrative expenses as a percentage of operating revenue was 10.7 percent for the three months ended March 31, 2000 compared to 11.6 percent for the three months ended December 31, 1999. This decrease was due to lower open enrollment, marketing and consulting costs in the first quarter of 2000 compared to the fourth quarter of 1999.

Impairment, Disposition, Restructuring, Office of Personnel Management and Other Charges (Credits). During the first quarter, we recognized net pretax charges of $3 million. We recognized a $9 million ($5 million or $0.14 diluted loss per share, net of tax) restructuring charge during the first quarter. In January 2000, we announced plans to strengthen our operations through productivity enhancements and technology improvements to further our competitive advantages and growth opportunities. The restructuring charge included severance and related employee benefits. Of the approximately 270 employees being terminated by December 31, 2000, the majority of these positions are in the sales & marketing and human resources departments where the corporate and regional functions will be centralized and consolidated. As of March 31, 2000, we paid approximately $1 million to 100 terminated employees. Approximately $7 million of the restructuring charge will be paid by the end of 2000, and the remaining balance will be paid in 2001. Cash flows from operations are expected to fund the restructuring charge. We expect net annual marketing, general and administrative salary savings of approximately $12 million from the centralization and consolidation of corporate and regional functions.

We recognized other credits for changes in estimates of $3 million ($2 million or $0.05 diluted earnings per share, net of tax). We have successfully settled certain contingencies related to acquisitions and dispositions in 1997 and 1998 including pending and threatened litigation, as well as indemnifications made to the buyers of sold subsidiaries. We recognized OPM credits of $3 million ($2 million or $0.05 diluted earnings per share, net of tax) as a result of 1996 and 1997 Oklahoma HMO premiums received. See Note 5 of the Notes to Condensed Consolidated Financial Statements.

Operating Income. Operating income as a percentage of operating revenue was 4.4 percent for the three months ended March 31, 2000 and was 4.1 percent for the three months ended December 31, 1999. The sequential changes are discussed above and are detailed in earnings per share below.

Net Investment Income. Net investment income increased approximately eight percent for the three months ended March 31, 2000 compared to the three months ended December 31, 1999. The increase was primarily due to higher overall invested balances and a slight increase in short- and long-term interest rates over the previous quarter.

Interest Expense. Interest expense increased approximately 50 percent for the three months ended March 31, 2000 compared to the three months ended December 31, 1999 due to higher average balances outstanding on our credit facility. In addition, the reduction in our credit rating by the credit rating agencies combined with a higher interest fee structure in the credit facility amendment resulted in higher overall rates.

Provision for Income Taxes. The effective income tax rate was 41.8 percent for the three months ended March 31, 2000 compared with 42.1 percent for the three months ended December 31, 1999. The sequential decrease was primarily due to lower nondeductible goodwill.

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Diluted Earnings Per Share. For the three months ended March 31, 2000, net income was $75 million or $2.04 diluted earnings per share compared to net income of $66 million or $1.59 diluted earnings per share for the three months ended December 31, 1999. Components of the change were as follows:

Forward Looking Information Under the Private Securities Litigation Act Of 1995

This document contains forward-looking statements that involve risks and uncertainties. These statements relate to future events or our future financial performance. In some cases, you can identify forward-looking statements by terminology including, “may,” “will,” “could,” “should,” “intend,” “expect,” “plan,” “anticipate,” “believe,” “estimate,” “predict,” “potentially,” “continue,” or “opportunity” or the negative of these terms or other comparable terminology. The statements about our plans, strategies, intentions, expectations and prospects contained throughout the document are forward-looking and are based on current expectations. Actual results may differ materially from those predicted as of the date of this report in the forward-looking statements. In addition, past financial performance is not necessarily a reliable indicator of future performance and investors should not use historical performance to anticipate results or future period trends. In evaluating these statements, you should specifically consider factors, including the risks described below and in other parts of this annual report.

The expectations discussed below include QualMed membership assumed during the first quarter of 2000 and the February 1, 2000 acquisition of Harris. See Note 2 of the Notes to Condensed Consolidated Financial Statements.

Membership. We expect Medicare membership for the second quarter of 2000 to remain comparable to the first quarter. For the year ended December 31, 2000, we expect Medicare membership to increase up to three percent in comparison to December 31, 1999. The increase is primarily due to the Harris acquisition. We will also continue to focus our marketing efforts on group retiree members and growing membership as our competitors exit markets where Secure Horizons will remain. These increases will be partially offset by membership decreases as a result of reducing benefits, increasing copayments and instituting or increasing member-paid supplemental premiums in certain markets.

We expect commercial membership for the second quarter of 2000 to remain comparable to the first quarter. For the year ended December 31, 2000, we expect commercial membership growth to range from 13 percent to 15 percent in comparison to December 31, 1999. The majority of the growth will be a result of the Harris acquisition. We also assumed approximately 20,000 members in Colorado and approximately 22,000 members in Washington during the first quarter of 2000 as a result of the agreements signed with QualMed. In addition, expect growth in California, where we plan to focus our marketing efforts on membership retention and renewal of national and major employer accounts.

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Premiums. We expect Medicare premium revenue for the second quarter of 2000 to be comparable to the first quarter premium revenue of $1.6 billion. HCFA premium rate increases combined with supplemental member premiums are expected to be approximately three percent to five percent in 2000. We are expecting Medicare premium revenue to increase approximately seven percent in 2000.

We expect our commercial premium revenue for the second quarter of 2000 to be comparable to the first quarter premium revenue of $1.2 billion. Commercial HMO premium rate increases are expected to range from seven percent to nine percent in 2000. We expect our commercial premium revenue to increase 22 percent to 26 percent as a result of these rate increases combined with our expected commercial membership growth. In addition, in the second half of the year we plan to implement higher premium rate increases in California to cover the cost of new mental health coverage mandated under state and federal laws.

Membership and Premium Risk Factors. An unforeseen loss of profitable membership or a change in premium expectations could negatively affect our financial position, results of operations and cash flows. Factors that could contribute to the loss of membership or lower premiums include:

•	The inability of our marketing and sales plans to attract new customers or retain existing customers;
•	The effect of premium increases, benefit changes and member-paid supplemental premiums and copayments;
•	Our exit from certain markets;
•	Reductions in work force by existing customers;
•	Negative publicity and news coverage or threats of litigation;
•	Our failure to successfully complete and/or integrate contemplated acquisitions; and
•	The loss of our key employees in sales and marketing.

Other Income. For the year ended December 31, 2000, we expect other income to increase approximately 25 percent to 30 percent over the $119 million reported for the year 1999. The growth is primarily related to increased pharmacy mail-service revenues.

Health Care Costs. Our profitability depends, in part, on our ability to control health care costs while providing quality care. Our primary focus is securing cost-effective physician, hospital and other health care provider contracts to maintain our qualified network of providers in each geographic area we serve. Through December 31, 1999, consolidated medical and hospital costs were trending between one and five percent higher. Other costs, the majority of which is prescription drugs, were trending between 12 percent and 16 percent higher. These health care cost trends are expected to be slightly higher in 2000.

Since the end of 1998, our hospital providers have increasingly not wanted to renew capitated hospital contracts and have requested fee-for-service and shared-risk arrangements. As a result of this trend, the percentage of consolidated members under capitated arrangements for hospital contracts decreased from 85 percent at the end of 1998 to nearly 80 percent at the end of 1999. We expect the percentage of capitated hospital contracts to continue to decrease in 2000 to between 70 percent and 75 percent, particularly in markets where providers face less competition. We expect to increase the capitation rates we pay some of our medical and hospital providers to improve the network stability of our capitated providers. To offset these increases, we have reduced benefits, increased copayments and instituted or increased member-paid supplemental premiums in certain markets for our Secure Horizons members. In addition, we will continue to make investments in medical management throughout 2000 to improve the performance of our provider contracts. Members in contracts that are capitated for professional risk were approximately 90 percent to 95 percent at December 31, 1999 and are not expected to change in 2000.

We work closely with our provider partners to ensure the strength and quality of our network. Under fee-for-service contracts, we have no insolvency risk; however, we do have increased utilization risk. Under our capitated arrangements, we face the risk of a provider becoming insolvent. To minimize our insolvency

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Pharmacy. Our prescription drug costs have been rising for the past few years. The increases are due to the introduction of new drugs costing significantly more than existing drugs, direct consumer advertising by the pharmaceutical industry creating consumer demand for particular brand drugs, patients seeking medications to address lifestyle changes and higher prescribed doses of medications and enhanced pharmacy benefits for members such as reduced copayments and higher benefit maximums. Our efforts to mitigate these trends and ensure appropriate utilization include formulary management, provider education, successful pharmaceutical contracting and increased utilization of our in-house mail service pharmacy operated by Prescription Solutions.

Formularies are lists of physician-recommended drugs in different therapeutic classes that have been reviewed for safety, efficacy and value. These lists help ensure that members get the right prescription at the right time in the right dose, avoiding potential adverse effects. Formularies also ensure that the costs are effectively managed; if two medications have the same effect, the less expensive option is recommended. Medically necessary drugs not included in the formulary can be obtained through our authorization process. We continue to conduct member and physician education programs to provide information on the appropriate use of generic drugs, over the counter drugs and antibiotics. Many of our medical groups share the financial risk for prescription drugs to find the most effective and cost-efficient treatments for our members. Prescription drug benefit changes for Secure Horizons members have been implemented in almost all our geographic areas for 2000 as a way of controlling this health care cost component.

Consolidated Medical Care Ratio. Our strategy is to manage premium increases sufficient to offset health care cost increases, to maintain long-term stability in our medical care ratio. We expect our consolidated medical care ratio for the second quarter of 2000 and for the year to remain comparable to the 85.4 percent reported for the first quarter, excluding the provider credit.

Medicare Medical Care Ratio. We expect the Medicare medical care ratio for the second quarter of 2000 to remain comparable or slightly increase compared to the first quarter, excluding the provider credit. We expect higher claims under shared-risk arrangements to cause this slight increase. As we increase our hospital utilization management, we are expecting the Medicare medical care ratio for the year ended December 31, 2000 to remain comparable to the 87.6 percent reported for the first quarter, excluding the provider credit.

Commercial Medical Care Ratio. The commercial medical care ratio for the second quarter of 2000 and for the year is expected to remain comparable to the 82.5 percent reported for the first quarter, excluding the provider credit.

Medical Care Ratio Risk Factors. An increase in our consolidated medical care ratio could have an adverse effect on our profitability. Uncertainties that could have a negative impact on our medical care ratio include:

•	The mix of our capitated, shared-risk and fee-for-service provider contracts;
•	Medical and prescription drug costs that rise faster than premium increases;
•	Increases in utilization and costs of medical and hospital services;
•	Our inability to successfully implement our new medical management initiatives including hospital utilization management initiatives;
•	The effect of federal and/or state legislation on our ability to secure cost-effective contracts with providers;
•	The effect of actions by competitors;

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