SIERRA HEALTH SERVICES INC - 10-K Annual Report

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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

(Mark One)

X

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

For the fiscal year ended December 31, 1999

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: 1-8865

SIERRA HEALTH SERVICES, INC.
(Exact name of Registrant as specified in its charter)

NEVADA

(State or other jurisdiction of
incorporation or organization)
88-0200415

(I.R.S. Employer Identification Number)
2724 NORTH TENAYA WAY
LAS VEGAS, NEVADA 89128

(Address of principal executive offices) (Zip Code)

Registrant's telephone number, including area code: (702) 242-7000
Securities registered pursuant to Section 12(b) of the Act:

Title of each class

Name of each exchange on
which registered

Common Stock, par value $.005

New York Stock Exchange

Securities Registered Pursuant to Section 12(g) of the Act: None

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

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

The aggregate market value of the voting stock held by non-affiliates of
the registrant on February 28, 2000 was $145,661,000.

The number of shares of the registrant's common stock outstanding on
February 28, 2000 was 27,041,000.

DOCUMENTS INCORPORATED BY REFERENCE

DOCUMENT WHERE INCORPORATED

Registrant's Current Report on Form 8-K dated Part I
March 15, 2000. Part II, Item 7
Part III
Portions of the registrant's definitive proxy statement for its 2000 annual
meeting to be filed with the SEC not later

than 120 days after the end of the fiscal year.

SIERRA HEALTH SERVICES, INC.

1999 FORM 10-K ANNUAL REPORT

TABLE OF CONTENTS

Page

PART I

Item 1. Business ................................................................................. 1

Item 2. Properties................................................................................ 15

Item 3. Legal Proceedings......................................................................... 16

Item 4. Submission of Matters to a Vote of Security Holders....................................... 16

PART II

Item 5. Market for Registrant's Common Stock and

Related Stockholder Matters............................................................ 17

Item 6. Selected Financial Data................................................................... 18

Item 7. Management's Discussion and Analysis of Financial Condition

and Results of Operations ............................................................. 19

Item 7a. Quantitative and Qualitative Disclosures about Market Risk ............................... 31

Item 8. Financial Statements and Supplementary Data............................................... 32

Item 9. Changes in and Disagreements with Accountants on
Accounting and Financial Disclosure.................................................... 61

PART III

Item 10. Directors and Executive Officers of the Registrant........................................ 61

Item 11. Executive Compensation.................................................................... 61

Item 12. Security Ownership of Certain Beneficial Owners and Management............................ 61

Item 13. Certain Relationships and Related Transactions............................................ 61

PART IV

Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K........................... 62

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PART I

ITEM 1. BUSINESS

GENERAL

The Company filed a Current Report on Form 8-K dated March 15, 2000, which is
incorporated by reference, that set forth cautionary statements pursuant to the
"safe harbor" provisions of the Private Securities Litigation Reform Act of 1995
and identified important risk factors that could cause the Company's actual
results to differ materially from those expressed in any projected, estimated or
forward-looking statements relating to Sierra Health Services, Inc. and its
subsidiaries.

Sierra Health Services, Inc. ("Sierra") and its subsidiaries (collectively
referred to as the "Company"), is a managed health care organization that
provides and administers the delivery of comprehensive health care and workers'
compensation programs with an emphasis on quality care and cost management. The
Company's strategy has been to develop and offer a portfolio of managed health
care and workers' compensation products to employer groups and individuals. The
Company's broad range of managed health care services is provided through its
federally qualified health maintenance organizations ("HMOs"), managed indemnity
plans, a third-party administrative services program for employer-funded health
benefit plans, workers' compensation medical management programs and a
subsidiary that administers a managed care federal contact for the Department of
Defense's TRICARE program in Region 1. This contract is currently structured as
five one-year option periods. If all option periods are exercised by the
Department of Defense ("DoD") and no extensions of the performance period are
made, health care delivery will end on May 31, 2003 for Region 1. Ancillary
products and services that complement the Company's managed health care and
workers' compensation product lines are also offered.

On October 31, 1998, Sierra and one of its subsidiaries, Texas Health Choice,
L.C. ("TXHC"), completed the acquisition of certain assets of Kaiser Foundation
Health Plan of Texas ("Kaiser-Texas"), a health plan operating in Dallas/Ft.
Worth and Permanente Medical Association of Texas ("Permanente"), a medical
group with approximately 150 physicians. The purchase price allocation included
a premium deficiency reserve of $25 million for estimated losses on the
contracts acquired from Kaiser-Texas. The purchase price was $124 million, which
is net $20 million in operating cost support paid to Sierra by Kaiser Foundation
Hospitals in four quarterly installments following the closing of the
transaction. The purchase price included amounts for real estate and eight
medical and office facilities with approximately 500,000 square feet. In
December 1998, certain accreditation goals were met by the health plan resulting
in a purchase price increase of $3.0 million, to $127 million. The purchase
price may increase up to an additional $27 million over three years if certain
growth and member retention goals are met by the health plan; however,
preliminary results indicate these goals were not met for the first year. Sierra
assumed no prior liabilities for malpractice or other litigation, or for any
unanticipated future adjustments to claims expenses for periods prior to
closing. The transaction was financed with a five-year revolving credit facility
and a $35.2 million note payable to Kaiser Foundation Health Plan of Texas. The
note is secured by the acquired real estate. Approximately $110 million of the
$200 million revolving credit facility was used to fund the transaction.

The original liability for the estimated premium deficiency was based upon
assumptions of membership and other operating information, some of which had not
been received as of December 31, 1998. During 1999, the Company continued to
gather such data, including data from the seller, and based upon the receipt and
analysis of this data, the Company revised the initial estimate of the premium
deficiency accrual. In total the Company recorded a $72.0 million premium
deficiency in conjunction with the acquisition. Of this amount, $6.8 million was
utilized in 1998 to offset losses on the acquired contracts and the remainder
was utilized in 1999. Total goodwill recorded in conjunction with the
acquisition was $126.8 million, of which $24.8 million was a result of
adjustments in 1999.

On December 31, 1998, Sierra completed the acquisition of the Nevada health care
business of Exclusive Healthcare, Inc. ("EHI"), United of Omaha Life Insurance
Company and United World Life Insurance Company ("United"), all of which were
subsidiaries of Mutual of Omaha Insurance Company. Sierra initially retained

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approximately 9,000 members (approximately 4,400 HMO members) subsequent to the
acquisition. Effective June 1, 1999, the Company completed the purchase of the
Texas operations of EHI (approximately 1,000 HMO members) and United's related
preferred provider organization ("PPO") that was part of the dual option HMO/PPO
plan. The purchase price of both the Nevada and Texas transactions is contingent
based on how many members are retained through 2000 and 2001. No cash will be
paid until group renewals begin in 2000.

The principal executive offices of the Company are located at 2724 North Tenaya
Way, Las Vegas, Nevada 89128, and its telephone number is (702) 242-7000.

Managed Care Products and Services

The Company's primary types of health care coverage are HMO plans, HMO Point of
Service ("POS") plans, and managed indemnity plans, which include a PPO option.
As of December 31, 1999, the Company provided HMO products to approximately
198,900 members in Nevada, 92,200 in Dallas/Ft. Worth, 33,300 in Houston and
3,100 in Arizona. The POS products allow members to choose one of the various
coverage options when medical services are required instead of one plan for the
entire year. The Company also provides managed indemnity products to
approximately 36,700 members, Medicare supplement products to approximately
28,300 members, and administrative services to approximately 297,500 members.
Medical premiums account for approximately 64% of total revenues. Approximately
72% and 28% of such medical premiums were derived from Nevada HMO and insurance
subsidiaries, and the Texas HMO, respectively in 1999.

Health Maintenance Organizations. The Company operates mixed group network model
HMOs in Las Vegas, Nevada and Dallas/Ft. Worth, Texas and a network model HMO in
Reno, Nevada and Houston, Texas. Contracted primary care physicians and
specialists for the HMOs are compensated on a capitation or modified
fee-for-service basis. Contracts with their primary hospitals are on a
capitation or discounted per diem basis. Members receive a wide range of
coverage after paying a nominal co-payment and are eligible for preventive care
coverage. The HMOs do not require deductibles or claim forms.

Most of the Company's managed health care services in Nevada are provided
through its independently contracted network of approximately 2,000 providers
and 12 hospitals. These Nevada networks include the Company's multi-specialty
medical group, which provides medical services to approximately 73% of the
Company's southern Nevada HMO members and employs over 170 primary care and
other providers in various medical specialties. The Company directly provides
home health care, hospice care and behavioral health care services and operates
a company that provides home infusion, oxygen and durable medical equipment
services. In addition, the Company operates two 24-hour urgent care centers, a
radiology department, a vision department, an occupational medicine department
and two free-standing, state-licensed and Medicare-approved ambulatory surgery
centers. The Company believes that this vertical integration of its health care
delivery system in Nevada provides a competitive advantage as it has helped it
to effectively manage health care costs while delivering quality care.

In Dallas/Ft. Worth, Texas, the Company's affiliated medical group provides
professional services from seven health centers; all of which offer primary care
services while two offer specialty and urgent care services. Approximately 95%
of the Company's 92,200 Dallas/Ft. Worth HMO members are provided care by this
medical group. In addition, TXHC has contracts with 13 hospitals for inpatient
care in Dallas/Ft. Worth. Shortly after the acquisition, the Company changed the
provider model in Dallas/Ft. Worth from a group model to a mixed network model
by overlaying individual practice association ("IPA") delivery systems on top of
the existing group model to provide members with more choice. Currently, the
Dallas/Ft. Worth members are served by approximately 1,500 independently
contracted providers. The 33,300 Houston HMO members are served by approximately
1,600 independently contracted providers and 15 hospitals.

The Company's commercial plans offer traditional HMO benefits and POS benefits.
At December 31, 1999, the Company had approximately 263,100 commercial members
of which 148,400 were located in Nevada, 114,400 in Texas and 300 in Arizona.

2

The Company offers a Medicare risk product for Medicare-eligible beneficiaries
called Senior Dimensions in Nevada and Golden Choice in Texas. Senior Dimensions
is marketed directly to Medicare-eligible beneficiaries in the Company's Nevada
service area. In the first quarter of 2000, the Company eliminated active sales
and marketing for Golden Choice. The Company will continue to offer the plan to
potential customers who contact the Company, as well as provide service to
existing members. The monthly payment received from the Health Care Financing
Administration ("HCFA") for Medicare members is determined by formula
established by Federal law. The Balanced Budget Act of 1997 included legislative
changes which affected the way health plans are compensated for Medicare members
by eliminating over five years amounts paid for graduate medical education and
by increasing the blend of national cost factors applied in determining local
reimbursement rates over a six-year phase-in period. Both changes will have the
effect of reducing reimbursement in high cost metropolitan areas with a large
number of teaching hospitals; however, the legislation includes a provision for
a minimum increase of 2% annually in health plan Medicare reimbursement through
2003. Under the authority provided by the 1997 Balanced Budget Act (see
"Government Regulation and Recent Legislation"), HCFA has begun to collect
hospital encounter data from Medicare risk contractors. The data will be used to
implement a new risk adjustment mechanism which will be phased in over a
five-year period which began January 1, 2000. Given the relatively high Medicare
risk premium levels in certain of the Company's market areas, the Company is in
jeopardy that the new risk adjustment mechanism to be developed could adversely
affect the Company's Medicare premium rates going forward. The risk adjustment
factors have not been applied to the Social HMO capitation payments for the Year
2000 and the Company does not believe that the risk adjustment mechanism will be
applied to Social HMO capitation payments in the future.

As of December 31, 1999, the Company had 52,900 Medicare members, of which
39,000 were located in Nevada, 11,100 in Texas and 2,900 in Arizona.
Approximately 35,000 of the Nevada Medicare members were enrolled in a Social
HMO (See "Social Health Maintenance Organization" following).

In addition, as of December 31, 1999, the Company had approximately 11,500
members enrolled in its HMO Medicaid risk products. To enroll in these products,
an individual must be eligible for Medicaid benefits in the state of Nevada. The
state's managed care division pays the Company's HMO a monthly fee for each
Medicaid member enrolled.

Social Health Maintenance Organization. Effective November 1, 1996, the Company
entered into a Social HMO II contract with HCFA pursuant to which a large
portion of the Company's Medicare risk enrollees will receive certain expanded
benefits. Sierra was one of six HMOs nationally to be awarded this contract, and
is currently the only company to have implemented the program as of December 31,
1999. The Company receives additional revenues for providing these expanded
benefits. The additional revenues are determined based on health risk
assessments that have been, and will continue to be, performed on the Company's
eligible Medicare risk members. The additional benefits include, among other
things, assisting the eligible Medicare risk members with typical daily living
functions such as bathing, dressing and walking. These members, as identified in
the health risk assessments, are those who currently have difficulty performing
such daily living functions because of a health or physical problem. HCFA is
considering adjusting the reimbursement factors for the Social HMO members in
the future. At this time, however, there can be no assurance as to what the
final per member reimbursement will be or that the Social HMO contract will be
renewed. If the reimbursement for these members decreases significantly and
related benefit changes are not made timely, there could be a material adverse
effect on the Company's business.

Preferred Provider Organizations. The Company also offers health insurance
through its PPO. The Company's managed indemnity plans generally offer insureds
the option of receiving their medical care from either contracted or
non-contracted providers. Insureds pay higher deductibles and co-insurance or
co- payments when they receive care from non-contracted providers. Out-of-pocket
costs are lowered by utilizing contracted providers who are part of the
Company's PPO network. As of December 31, 1999, approximately 36,700 members
were enrolled in Sierra's managed indemnity plans.

The Company currently provides managed indemnity, accidental death and
disability, and Medicare supplement services to individuals in Arizona,
California, Colorado, Iowa, Louisiana, Maryland, Mississippi,

3

Missouri, Nevada, South Carolina and Texas. The Company is also exploring
further expansion in certain other states and currently provides other insurance
services in Missouri. As of December 31, 1999 the managed indemnity subsidiary
was licensed in a total of 43 states and the District of Columbia.

Ancillary Medical Services. Among the ancillary medical services offered by the
Company are outpatient surgical care, diagnostic tests, medical and surgical
procedures, inpatient and outpatient laboratory tests, x- ray, CAT scans,
nuclear medicine services, and mental health and substance abuse services. In
Nevada, the Company also provides home health care services, a hospice program
and vision services. These services are provided to members of the Company's
HMOs, managed indemnity and administrative services plans. The mental health and
substance abuse services are also provided to approximately 145,000 participants
from non-affiliated employer groups and insurance companies. In addition, the
Company offers home infusion, oxygen and durable medical equipment services.

Administrative Services. The Company's administrative services products provide,
among other things, utilization review and PPO services to large employer groups
that are usually self-insured. As of December 31, 1999, approximately 298,000
members were enrolled in the Company's administrative services plans. The
results of operations for these services are included in specialty product
revenues and expenses in the Consolidated Statements of Operations.

Military Contract Services

Sierra Military Health Services, Inc. On September 30, 1997, the DoD awarded the
Company a triple-option health benefits ("TRICARE") contract to provide managed
health care coverage to eligible beneficiaries in Region 1. This region includes
approximately 610,000 eligible individuals in Connecticut, Delaware, Maine,
Maryland, Massachusetts, New Hampshire, New Jersey, New York, Pennsylvania,
Rhode Island, Vermont, Virginia, West Virginia and Washington, D.C. SMHS
completed an eight month implementation phase in May 1998 and began providing
health care benefits on June 1, 1998 under the TRICARE contract.

Under the TRICARE contract, Sierra Military Health Services, Inc. ("SMHS")
provides health care services to dependents of active duty military personnel
and military retirees and their dependents through subcontractor partnerships
and individual providers. Through such partnerships, SMHS also performs specific
administrative services, such as health care appointment scheduling, enrollment,
network management and health care advice line services. SMHS performs such
services using DoD information systems. If all five option periods are exercised
by the DoD and no extensions of the performance period are made, health care
delivery will end on May 31, 2003, followed by an additional eight month
phaseout of the Region 1 managed care support contract.

In June 1996, the DoD awarded a TRICARE contract to TriWest Healthcare Alliance
("TriWest"), a consortium consisting of Sierra and 13 other health care
companies, to provide health services to Regions 7 and 8, which include a total
of 16 states. The Company's interest in this equity investee is approximately
12%. In April 1997, TriWest began providing health care to approximately 700,000
individuals, of which the Company is responsible for providing care to
approximately 93,000 beneficiaries in Nevada and Missouri.

Workers' Compensation Operations

Workers' Compensation Subsidiary. On October 31, 1995, the Company acquired CII
Financial, Inc. ("CII"), for approximately $76.3 million of common stock in a
transaction accounted for as a pooling of interests. CII writes workers'
compensation insurance in the states of California, Colorado, Kansas, Missouri,
Nebraska, Nevada, New Mexico, Texas and Utah. CII has licenses in 32 states and
the District of Columbia. California, Colorado, Texas and Nevada represent
approximately 81%, 8%, 5% and 2%, respectively, of CII's fully insured workers'
compensation insurance premiums in 1999. Workers' compensation insurance
premiums account for approximately 6% of the Company's total revenue. The
workers' compensation subsidiary applies the discipline of managed care concepts
to its operations. These concepts include, but are not limited to, the use of
specialized preferred provider networks, utilization reviews by an employed
board certified occupational

4

medicine physician as well as nurse case managers, medical bill reviewers and
job developers who facilitate early return to work.

Effective September 30, 1997, the Company terminated its workers' compensation
administrative services contract with the state of Nevada. The contract served
approximately 200,000 enrollees and provided approximately $3.2 million in
revenues for the year ended December 31, 1997. The contract was terminated to
allow the Company to participate in the Nevada workers' compensation insurance
market which was opened to competition in July 1999.

Marketing

The Company's marketing efforts for its commercial managed care products usually
involve a two-step process. The Company first makes presentations to employers
and then provides information directly to employees once the employer has
decided to offer the Company's products. Once a relationship with a group is
established and a group agreement is negotiated and signed, the Company's
marketing efforts focus on individual employees. During a designated "open
enrollment" period each year, usually the month preceding the annual renewal of
the agreement with the group, employees choose whether to remain with, join or
terminate their membership with a specific health plan offered by the employer.
New employees decide whether to join one of the employers' health insurance
options at the time of their employment. Although contracts with employers are
generally terminable on 60 days notice, changes in membership occur primarily
during open enrollment periods. Medicare risk products are primarily marketed by
the HMOs' sales employees. Retention of employer groups and membership growth is
accomplished through print advertising directed to employers and through
consumer media campaigns. Media communications convey the Company's emphasis on
preventive care, ready access to health care providers and quality service.
Other communications to customers include employer and member newsletters,
member education brochures, prenatal information packets, employer/broker
seminars and direct mail advertising to clients. Members' satisfaction with
Company benefits and services is monitored by customer surveys. Results from
these surveys and other primary and secondary research guide the sales and
advertising efforts throughout the year.

The Company's workers' compensation insurance policies are sold through
independent insurance agents, who may also represent other insurance companies.
The Company believes that independent insurance agents and brokers choose to
market the Company's insurance policies primarily because of the price the
Company charges. Additional considerations include the quality of service that
the Company provides and the commissions the Company pays. The Company employs
full-time employees as marketing representatives to make personal contacts with
agents, to maintain regular communication with them, to advise them of the
Company's services and products, and to recruit additional agents. In addition,
the Company employs full-time field underwriters who meet with agents and can
provide an immediate quote on a policy. As of December 31, 1999, the Company had
relationships with approximately 881 agents and paid its agents commissions
based on a percentage of the gross written premium produced by such agents and
brokers. The Company also has various agency incentive programs that enable an
agent to earn additional compensation if certain premium production and/or
agency loss ratio goals are met. The Company also utilizes a number of
promotional media, including advertising in publications and at trade fairs, to
support the efforts of its independent agents.

SMHS administers marketing initiatives in accordance with the TRICARE Region 1
managed care support contract. SMHS' dedicated Marketing Division uses a
multi-faceted marketing approach to ensure that all beneficiaries within Region
1 have the opportunity to learn about the health care benefits under TRICARE and
have the opportunity to make health care choices that best fit their specific
needs. Marketing initiatives include direct beneficiary briefings, direct mail,
newspaper advertising, newsletters and web page briefs.

5

Membership

Period End Membership:

At December 31,

1999 1998 1997 1996 1995
-------- -------- -------- ------- ------
HMO:

Commercial.............................. 263,000 272,000 154,000 147,000 116,000
Medicare................................ 53,000 47,000 36,000 30,000 25,000
Medicaid................................ 11,000 5,000 2,000
Managed Indemnity........................... 37,000 41,000 64,000 46,000 31,000
Medicare Supplement......................... 28,000 26,000 25,000 23,000 15,000
Administrative Services (1) ................ 298,000 318,000 328,000 338,000 117,000
TRICARE Eligibles........................... 610,000 606,000 ______ ______ ______
---------- ----------
Total Membership........................ 1,300,000 1,315,000 609,000 584,000 304,000
========= ========= ======= ======= =======

(1) For comparability purposes, enrollment information has been restated to
reflect the September 30, 1997 termination of the Company's workers'
compensation administrative services contract with the state of Nevada.
Enrollment in the terminated plan was 163,000 and 94,000 members at
December 31, 1996 and 1995, respectively.

For the years ended December 31, 1999, 1998 and 1997, the Company received
approximately 23.5%, 23.0% and 23.7%, respectively, of its total revenues from
its contract with HCFA to provide health care services to Medicare enrollees.
The Company's contract with HCFA is subject to annual renewal at the election of
HCFA, and requires the Company to comply with federal HMO and Medicare laws and
regulations and may be terminated if the Company fails to so comply. The
termination of the Company's contract with HCFA would have a material adverse
effect on the Company's business. In addition, there have been, and the Company
expects that there will continue to be, a number of legislative proposals to
limit Medicare reimbursements and to require additional benefits. Future levels
of funding of the Medicare program by the federal government cannot be predicted
with certainty. (See "Government Regulation and Recent Regulation").

The Company's ability to obtain and maintain favorable group benefit agreements
with employer groups affects the Company's profitability. The agreements are
generally renewable on an annual basis but are subject to termination on 60 days
prior notice. For the fiscal year ended December 31, 1999, the Company's ten
largest HMO employer groups were, in the aggregate, responsible for less than
10% of the Company's total revenues. Although none of such employer groups
accounted for more than 2% of total revenues during that period, the loss of one
or more of the larger employer groups would, if not replaced with similar
membership, have a material adverse effect upon the Company's business. The
Company has generally been successful in retaining these employer groups.
However, there can be no assurance that the Company will be able to renew its
agreements with such employer groups in the future or that it will not
experience a decline in enrollment within its employer groups. Additionally,
revenues received under certain government contracts are subject to audit and
retroactive adjustment.

Provider Arrangements and Cost Management

HMO and Managed Indemnity Products. A significant distinction between the
Company's health care delivery system and that of many other managed care
providers is the fact that approximately 73% of the Company's southern Nevada
HMO members and 95% of its Dallas/Ft. Worth, Texas HMO members receive primary
health care through the Company's affiliated multi-specialty medical groups. The
Company makes health care available through independently contracted providers
employed by the multi-specialty medical groups and other independently
contracted networks of physicians, hospitals and other providers.

Under the Company's HMOs, the member selects a primary care physician who
provides or authorizes any non-emergency medical care given to that member.
These primary care physicians and some specialists are compensated to a limited
extent on the basis of how well they coordinate appropriate medical care. The
Company has a system of limited incentive risk arrangements and utilization
management with respect to its

6

independently contracted primary care physicians. The Company compensates its
independently contracted primary care physicians and specialists by using both
capitation and modified fee-for-service payment methods. In Nevada, under both
the capitation and modified fee-for-service methods, an incentive risk
arrangement is established for institutional services. Additional amounts may be
made available to certain capitated physicians if hospital costs are less than
anticipated for the Company's HMO members. For those primary care physicians
receiving payments on a modified fee-for-service basis, portions of the payments
otherwise due the physicians are withheld. The amounts withheld are available
for payment to the physicians if, at year-end, the expenditures for both
institutional and non-institutional medical services are within predetermined,
contractually agreed upon ranges. It is believed that this method of limited
incentive risk payment is advantageous to the physician, the Company and the
members because all share in the benefits of managing health care costs. The
Company has, however, negotiated capitation and reduced fee-for- service
agreements with certain specialists and primary care providers who do not
participate in the incentive risk arrangements. The Company monitors health care
utilization, including evaluation of elective surgical procedures, quality of
care and financial stability of its capitated providers to facilitate access to
service and to ensure member satisfaction.

The Company provides or negotiates discounted contracts with hospitals for the
provision of inpatient and outpatient hospital care, including room and board,
diagnostic tests and medical and surgical procedures. The Company believes that
it currently has a favorable contract with its primary southern Nevada
contracted hospital, Columbia Sunrise Hospital. Subject to certain limitations,
the contract provides, among other things, guaranteed contracted per diem rate
increases on an annual basis after December 31, 1997. The per diem rate
increased 2% in 1999 and is scheduled to increase 3% in 2000. Since a majority
of the Company's southern Nevada hospital days are at Columbia Sunrise Hospital,
this contract assists the Company in managing a significant portion of its
medical costs. The contract expires in the year 2012. Columbia Sunrise Hospital
has requested to renegotiate the contract. While the Company intends to enforce
the existing terms of the contract, legal and other expenses will be incurred.
In Texas, the Company has negotiated a per diem arrangement with Columbia
Hospital, Inc., for hospital services provided through 15 hospitals in Houston
and has contracts with 13 Columbia hospitals and several tertiary hospitals for
inpatient care in Dallas/Ft. Worth.

The Company believes that it has negotiated favorable rates with its contracted
hospitals. For hospitals other than Columbia Sunrise Hospital, the Company's
contracts with its hospital providers typically renew automatically with both
parties granted the right to terminate after a notice period ranging from
between three and eighteen months. Reimbursement arrangements with other health
care providers, including pharmacies, generally renew automatically or are
negotiated annually and are based on several different payment methods,
including per diems (where the reimbursement rate varies and is based on a per
day of service charge for specified types of care), capitation or modified
fee-for-service arrangements. To the extent possible, when negotiating
non-physician provider arrangements, the Company solicits competitive bids.

The Company utilizes two reimbursement methods for health care providers
rendering services under the Company's indemnity plans. For services to members
utilizing a PPO plan, the Company reimburses participating physicians on a
modified fee-for-service basis which incorporates a limited fee schedule and
reimburses hospitals on a per diem or discounted fee-for-service basis. For
services rendered under a standard indemnity plan, pursuant to which a member
may select a non-plan provider, the Company reimburses non-contracted physicians
and hospitals at pre-established rates, less deductibles and co- insurance
amounts.

The Company manages health care costs through its large case management program,
urgent care centers and by educating its members on how and when to use the
services of its plans and how to manage chronic disease conditions. The Company
also audits hospital bills to identify inappropriate charges. Further, in
Nevada, the Company utilizes its home health care agency and its hospice which
helps to minimize hospital admissions and lengths of stay.

Military Health Services. Under the TRICARE contract, dependents of active
duty military personnel and military retirees and their dependents choose one of
three option plans available to them for health care

7

services: (1) TRICARE Prime (an HMO style option with a self-selected primary
care manager and no deductibles), (2) TRICARE Extra (a PPO style option), or (3)
TRICARE Standard (an indemnity style option with deductibles and cost shares).
Approximately 35% of eligible beneficiaries receive their primary care through
existing Military Treatment Facilities. SMHS negotiated discounted contracts
with approximately 25,000 individual providers, 1,500 institutions and 5,000
pharmacies to provide supplemental network access for TRICARE Prime and Extra
beneficiaries. SMHS' contracts with providers are primarily on a discounted
fee-for-service basis with renewal and termination terms similar to Sierra's
commercial practice. SMHS is at- risk for and manages the health care service
cost of all TRICARE Extra and Standard beneficiaries as well as a small
percentage of TRICARE Prime beneficiaries.

Risk Management

The Company maintains general and professional liability, property and fidelity
insurance coverage in amounts that it believes are adequate for its operations.
The Company's multi-specialty medical groups maintain excess malpractice
insurance for the providers presently employed by the group. In Nevada and
Arizona, the Company has assumed the risk for the first $250,000 per malpractice
claim, not to exceed $1.5 million in the aggregate per contract year up to its
limits of coverage. In Texas, the Company has assumed no self-insured retention
per claim. The aggregate maximum limits for each of these policies is $30
million per year. In addition, the Company requires all of its independently
contracted provider physician groups, individual practice physicians,
specialists, dentists, podiatrists and other health care providers (with the
exception of certain hospitals) to maintain professional liability coverage.
Certain of the hospitals with which the Company contracts are self-insured. The
Company also maintains stop-loss insurance that reimburses the Company between
50% and 90% of hospital charges for each individual member of its HMO or managed
indemnity plans whose hospital expenses exceed, depending on the contract,
$75,000 to $200,000, during the contract year and up to $2.0 million per member
per lifetime.

Effective July 1, 1997, the Company also maintains excess catastrophic coverage
for one of the Company's wholly-owned HMOs, Health Plan of Nevada, Inc. ("HPN"),
that reimburses the Company for amounts by which the ultimate net loss exceeds
$400,000, but does not exceed the annual maximum of $19.6 million per occurrence
and $39.2 million per contract. In the ordinary course of its business, however,
the Company is subject to claims that are not insured, principally claims for
punitive damages.

Effective January 1, 1998, workers' compensation claims are reinsured between
$500,000 and $100 million per occurrence. For claims occurring on and after July
1, 1998, that are below $500,000, the Company obtained quota share and excess of
loss reinsurance. Under this agreement, the Company reinsures 30% of the first
$10,000 of each claim, 75% of the next $40,000 and 100% of the next $450,000.
The Company receives a ceding commission from the reinsurer as a partial
reimbursement of operating expenses. This agreement expires June 30, 2000 and
there is a provision for optional twelve-month run-off coverage on policies in
force at June 30, 2000.

Effective January 1, 2000, the reinsurance on workers' compensation claims
between $500,000 and $100 million was replaced with a three-year agreement which
provides coverage for claims exceeding $500,000 per occurrence with no upper
limit.

The Company is unaware of any pending disputes with any of its reinsurers that
could result in termination, recision, arbitration or litigation of its
reinsurance agreements.

Information System

The Company has in place certain data systems which assist the Company in, among
other things, pricing its services, monitoring utilization and other cost
factors, providing bills on a timely basis, identifying accounts for collection
and handling various accounting and reporting functions. Its imaging and
workflow systems are used to process and track claims and coordinate customer
service. Where it is cost efficient, the Company's system is connected to large
provider groups, doctors' offices, payors and brokers to enable efficient
transfer of information and communication. In 2000, the Company plans to
implement an internet-based health access

8

system to serve its members, providers and employees. The Company views its
information systems capability as critical to the performance of ongoing
administrative functions and integral to quality assurance and to the
coordination of patient care across care sites. The Company is continually
modifying or improving its information systems capabilities in an effort to
improve operating efficiencies.

Year 2000

The Year 2000 issue existed because many computer systems and applications used
two-digit date fields to designate a year. As the century date change occurred,
date-sensitive non-compliant systems may have recognized the year 2000 as 1900,
or not at all. This inability to recognize or properly treat the Year 2000 may
have caused systems to process critical financial and operational information
incorrectly.

The Company replaced or remediated its mission critical financial systems as
well as its mission critical operational computer systems, remediated databases
and validated the readiness of all computing and non- computing systems. The
Company also engaged in a thorough evaluation to validate that all systems,
computing and non-computing, were functioning. The Company is unaware of any
Year 2000 related outages over the century date change.

The Company implemented two major systems in 1999 and is in the process of
implementing a third, at an estimated cost of over $50 million, which includes
the implementation costs related to the acquired Kaiser- Texas operations. To
date the Company has spent approximately $48.9 million on the new computer
systems and other Year 2000 items. The Company expensed the costs to make
modifications to existing computer systems and non-computer equipment.
Management currently estimates the remaining new computer system costs to be
$4.0 million to $6.0 million. While this has been a substantial effort, the
results should give the Company the benefits of new technology and functionality
for many of its financial and operational computer systems and applications.

Quality Assurance and Improvement

The Company has developed programs to help ensure that the health care services
provided by its HMO and managed indemnity plans meet the professional standards
of care established by the medical community. The Company believes that its
emphasis on quality allows it to increase and retain its members. The Company
monitors and evaluates the availability and quality of the medical care rendered
by the providers in its HMO and insurance plans and periodically audits selected
diagnoses, problems and referrals to determine adherence to appropriate
standards of medical care. In addition, the Company has medical directors who,
supported by a professional medical staff, monitor the quality and
appropriateness of health care by analyzing a physician's utilization of
diagnostic tests, laboratory and radiology procedures, specialty referrals,
prescriptions and hospitals. Physicians and hospitals selected to provide
services to the Company's members are subject to the Company's quality assurance
programs including a formal credentialing process of all physicians.

The Company also has internal quality assurance and improvement review
committees that meet on a regular basis to review specialist referrals, monitor
the performance of physicians and review practice patterns, complaints and other
patient issues. Staff members regularly visit hospitals to review medical
records, meet with patients and review treatment programs and discharge plans
with attending physicians. In addition, the Company solicits information from
both existing and former members as to their satisfaction with the care
delivered.

Several independent organizations have been formed for the purpose of responding
to external demands for accountability in the health care industry. The Company
has voluntarily elected to be evaluated by these external organizations,
including the National Committee for Quality Assurance ("NCQA") and the Joint
Commission on Accreditation of Healthcare Organizations ("JCAHO").

The NCQA is an independent, not-for-profit organization dedicated to measuring
the quality of America's health care. The NCQA survey includes rigorous on-site
and off-site evaluations of over 60 standards. A team of physicians and managed
care experts conducts accreditation surveys. A national oversight committee of
physicians analyzes the team's findings and assigns an accreditation level based
on the performance level of each plan being evaluated to NCQA's standards.
Health Plan of Nevada, Inc., has received a Commendable Accreditation from NCQA,
for the Commercial HMO and Medicare HMO product

9

lines in the Las Vegas metropolitan area and Pahrump. TXHC has earned an
Accredited status from NCQA for its commercial HMO product in the Dallas/Ft.
Worth service area.

The TXHC accreditation will expire in April of 2000. At this time, the Company
has voluntarily postponed its accreditation renewal process for TXHC and a
scheduled site examination visit of TXHC by the NCQA in the second quarter of
2000 was cancelled. The Company expects to reschedule the site examination for
the first quarter of 2001 depending on the NCQA's availability. There can be no
assurance, however, that the Company will maintain or re-obtain NCQA or other
accreditations in the future and there is no basis to predict what effect, if
any, the lack of NCQA or other accreditations could have on HPN's or TXHC's
competitive positions in southern Nevada and Dallas/Ft. Worth, Texas
respectively.

The JCAHO reviews rights, responsibilities and ethics, continuum of care,
education and communication, leadership, management of information, and human
resources and network performance. The Company's home health care and hospice
subsidiaries are JCAHO accredited.

Underwriting

HMO. The Company structures premium rates for its various health plans primarily
through community rating and community rating by class method. Under the
community rating method, all costs of basic benefit plans for the Company's
entire membership population are aggregated. These aggregated costs are
calculated on a "per member per month" basis and converted to premium rates for
various coverage types, such as single or family coverage. The community rating
by class method is based on the same principles as community rating, except that
actuarial adjustments to premium rates are made for demographic variations
specific to each employer group such as the average age and sex of their
employees, group size and industry. All employees of an employer group are
charged the same premium rate if the same coverage is selected.

In addition to premiums paid by employers, members also pay co-payments at the
time certain services are provided. The Company believes that such co-payments
encourage appropriate utilization of health care services while allowing the
Company to offer competitive premium rates. The Company also believes that the
capitation method of provider compensation encourages physicians to provide only
medically necessary and appropriate care.

Managed Indemnity. Premium charges for the Company's managed indemnity products
are set in a manner similar to the community rating by class method described
above. This rate calculation utilizes similar demographic adjustment factors
such as age, sex and industry factors to develop group-specific adjustments from
a given per member per month base rate by plan. Actual health claims experience
is used in whole or in part to develop premium rates for larger insurance member
groups. This process includes the use of utilization experience, adjustments for
incurred but not reported claims, inflationary factors, credibility and specific
reinsurance pooling levels for large claims.

Workers' Compensation. Prior to insuring a particular risk, the Company reviews,
among other factors, a standard industry application, a supplemental
questionnaire and the employer's prior loss experience. Additionally, the
Company determines whether the employer's employment classifications are among
the classifications that the Company has elected to insure and if the amounts of
the premiums for the classifications are within the Company's guidelines. The
Company reviews these classifications periodically to evaluate whether they are
profitable. A member of the Company's loss control department may conduct an
on-site safety inspection before the Company insures the employer. The Company
generally initiates this inspection for enterprises classified as higher hazard
or ones identified as needing loss control attention or service such as
manufacturing and construction. The Company may also initiate inspections if the
enterprise previously has had a high loss ratio, a high experience modification
factor or frequency of losses. If the on-site inspection reveals hazards that
can be corrected, and an agreement can be reached with the employer that these
hazards will be corrected in a time frame established by the Company's
underwriting department, the Company may issue a policy subject to correction of
those hazards. In the event the Company has issued a policy where no previous
inspection has been conducted, and subsequently learns through an inspection the
employer has hazards that must be corrected, the Company will request that the
employer correct the hazards within a specified period of time. If these hazards
are not corrected, the Company may cancel the policy for non-compliance of the
hazard correction, within legal requirements. With regard to new business, the
agent or broker will usually submit the claims history on the prospective
account. In those situations where the claims history is not supplied by the
agent or broker, other sources (such as the Industry Experience Modification
Worksheets) are used to obtain the appropriate claims history if possible.

10

Competition

HMO and Managed Indemnity. Managed care companies and HMOs operate in a highly
competitive environment. The Company's major competition is from self-funded
employer plans, PPO networks, other HMOs, such as Humana Care Plus, Pacificare
Health Systems, Inc., Aetna and United Healthcare Corp. and traditional
indemnity carriers, such as Blue Cross/Blue Shield. Many of the Company's
competitors have substantially larger total enrollments, have greater financial
resources and offer a broader range of products than the Company. Additional
competitors with greater financial resources than the Company may enter the
Company's markets in the future. The Company believes that the most important
competitive factors are the delivery of reasonably priced, quality medical
benefits to members and the adequacy and availability of health care delivery
services and facilities. The Company depends on a large PPO network and flexible
benefit plans to attract new members. Competitive pressures may result in
reduced membership levels. Any such reductions could materially affect the
Company's results of operations.

Workers' Compensation. The Company's workers' compensation business is
concentrated in California, a state where the workers' compensation insurance
industry is extremely competitive. Since open rating became effective for
policyholders in 1995, there have been substantial reductions in premiums.
However, for renewal policies issued year to date in 2000, Sierra's workers'
compensation business has obtained premium rate increases in excess of 15%. The
increase seen so far in 2000 is a material positive change from the previous
rate trend. Based on public information, other California workers' compensation
companies are issuing year 2000 policies at rates 15% to 20% in excess of the
expiring premiums.

The Company believes that there are more than 200 insurance companies writing
workers' compensation insurance in California. Many of the Company's competitors
have been in business longer, have a larger volume of business, offer a more
diversified line of insurance coverage, have greater financial resources and
have greater distribution capability than the Company. The largest writer of
workers' compensation insurance in California is the State Compensation
Insurance Fund.

Losses and Loss Adjustment Expenses

Often, in workers' compensation insurance, several years may elapse between the
occurrence of a loss and the final settlement of the loss. To recognize
liabilities for unpaid losses, the Company establishes reserves, which are
balance sheet liabilities representing estimates of future amounts needed to pay
claims and related expenses for insured events, including reserves for events
that have been incurred but have not yet been reported to the Company ("incurred
but not reported" or "IBNR").

When a claim is reported, the Company's claims personnel initially establish
reserves on a case-by-case basis for the estimated amount of the ultimate
payment. These estimates reflect the judgment of the claims personnel based on
their experience and knowledge of the nature and value of the specific type of
claim and the available facts at the time of reporting as to severity of injury
and initial medical prognosis. Included in these reserves are estimates of the
expenses of settling claims, including legal and other fees. Claims personnel
adjust the amount of the case reserves as the claim develops and as the facts
warrant.

IBNR reserves are established for unreported claims and loss development
relating to current and prior accident years. In the event that a claim that
occurred during a prior accident year was not reported until the current
accident year, the case reserve for such claim typically will be established out
of previously established IBNR reserves for that prior accident year.
Unallocated loss adjustment expense reserves are established for the estimated
costs related to the general administration of the claims adjustment process.

The Company reviews the adequacy of its reserves on a periodic basis and
considers external forces such as changes in the rate of inflation, the
regulatory environment, the judicial administration of claims, medical costs and
other factors that could cause actual losses and loss adjustment expenses
("LAE") to change. Reserves are reviewed with the Company's independent actuary
at least annually. The actuarial projections include a range of estimates
reflecting the uncertainty of projections. Management evaluates the reserves

11

in the aggregate, based upon the actuarial indications, and makes adjustments
where appropriate. The consolidated financial statements of the Company provide
for reserves based on the anticipated ultimate cost of losses.

Government Regulation and Recent Legislation

HMOs and Managed Indemnity. Federal and state governments have enacted statutes
extensively regulating the activities of HMOs. In addition, growing government
concerns over increasing health care costs and quality of care could result in
new or additional state or federal legislation that could affect health care
providers, including HMOs, PPOs and other health insurers. Among the areas
regulated by federal and state law are the scope of benefits available to
members, premium structure, procedures for review of quality assurance,
enrollment requirements, the relationship between an HMO and its health care
providers and members, licensing and financial condition.

Government regulation of health care coverage products and services is a
changing area of law that varies from jurisdiction to jurisdiction. Changes in
applicable laws and regulations are continually being considered and
interpretation of existing laws and rules also may change from time to time.
Regulatory agencies generally have broad discretion in promulgating regulations
and in interpreting and enforcing laws and regulations.

While the Company is unable to predict what regulatory changes may occur or the
impact on the Company of any particular change, the Company's operations and
financial results could be negatively affected by regulatory revisions. For
example, any proposals to eliminate or reduce ERISA pre-emption of state laws
that would increase litigation exposure, affecting underwriting practices,
limiting rate increases, requiring new or additional benefits or affecting
contracting arrangements (including proposals to require HMOs and PPOs to accept
any health care provider willing to abide by an HMO's or PPO's contract terms)
may have a material adverse effect on the Company's business. The continued
consideration and enactment of "anti-managed care" laws and regulations by
federal and state bodies may make it more difficult for the Company to control
medical costs and may adversely affect financial results.

In addition to changes in applicable laws and regulations, the Company is
subject to various audits, investigations and enforcement actions. These include
possible government actions relating to the federal Employee Retirement Income
Security Act, which regulates insured and self-insured health coverage plans
offered by employers, the Federal Employees Health Benefit Plan, federal and
state fraud and abuse laws, and laws relating to utilization management and the
delivery of health care and payment or reimbursement therefor. In addition, the
Company is subject to Medicare regulations promulgated by HCFA. Any violation of
such government laws and regulations could result in assessment of damages,
civil or criminal fines or penalties, or other sanctions, including exclusion
from participation in government programs. In addition, disclosure of any
adverse investigation or audit results or sanctions could negatively affect the
Company's reputation in various markets and make it more difficult for the
Company to sell its products and services.

The Company has HMO licenses in Nevada, Texas and Arizona. The Company's HMO
operations are subject to regulation by the Nevada Division of Insurance, the
Board of Health, the Texas Department of Insurance and the Arizona Department of
Insurance. The Company's health insurance subsidiary is domiciled and
incorporated in California and is licensed in 43 states and the District of
Columbia. It is subject to licensing and other regulations of the California
Department of Insurance as well as the insurance departments of other states in
which it operates or holds licenses. The Company's HMO and insurance premium
rate increases are subject to various state insurance department approvals. The
Company's Nevada HMO and health insurance subsidiaries currently maintain home
offices and a regional home office, respectively, in Las Vegas and, accordingly,
are eligible for certain premium tax credits in Nevada. The Company intends to
take all necessary steps to continue to comply with eligibility requirements for
these credits. The elimination or reduction of the premium tax credit would have
a material adverse effect on the Company's results of operations.

12

The Company is subject to the Federal HMO Act and its regulations. The Company's
HMOs are federally- qualified under this Act. In order to obtain federal
qualification, an HMO must, among other things, provide its members certain
services on a fixed, prepaid fee basis and set its premium rates in accordance
with certain rating principles established by federal law and regulation. The
HMO must also have quality assurance programs in place with respect to its
health care providers. Furthermore, an HMO may not refuse to enroll an employee,
in most circumstances, because of such person's health, and may not expel or
refuse to re-enroll individual members because of their health or their need for
health services.

Under the "corporate practice of medicine" doctrine, in most states, business
organizations, other than those authorized to do so, are prohibited from
providing, or holding themselves out as providers of, medical care. Some states,
including Nevada, exempt HMOs from this doctrine. The laws relating to this
doctrine are subject to numerous conflicting interpretations. Although the
Company seeks to structure its operations to comply with corporate practice of
medicine laws in all states in which it operates, there can be no assurance
that, given the varying and uncertain interpretations of those laws, the Company
would be found to be in compliance with those laws in all states. A
determination that the Company is not in compliance with applicable corporate
practice of medicine laws in any state in which it operates could have a
material adverse effect on the Company if it were unable to restructure its
operations to comply with the laws of that state.

Medicare and Medicaid antifraud and abuse provisions are codified at 42 U.S.C.
Sections 1320a-7(b) (the "Anti-kickback Statute") and 1395nn (the "Stark
Amendments"). Many states have similar anti-kickback and anti-referral laws.
These statutes prohibit certain business practices and relationships involving
the referral of patients for the provision of health care items or services
under certain circumstances. Violations of the Anti-kickback Statute and the
Stark Amendments include criminal penalties and civil sanctions, including fines
and possible exclusion from the Medicare and Medicaid programs. Similar
penalties are provided for violation of state anti-kickback and anti-referral
laws. The Department of Health and Human Services ("HHS") has issued regulations
establishing "safe harbors" with respect to the Anti-kickback Statute. The
Company believes that its business arrangements and operations are in compliance
with the Anti-kickback Statute and the Stark Amendments and the exceptions set
forth therein, regardless of the availability of regulatory safe harbor
protection with respect to those statutes. There can, however, be no assurance
that (i) government officials charged with responsibility for enforcing the
prohibitions of the Anti-kickback Statute and the Stark Amendments will not
assert that the Company or certain transactions in which it is involved are in
violation of those statutes; and (ii) such statutes will ultimately be
interpreted by the courts in a manner consistent with the Company's
interpretation.

In 1997, Congress passed the Balanced Budget Act ("Act") which revised the
structure of and reimbursement for private health plan options for Medicare
enrollees. The Act seeks to expand the options available to Medicare enrollees
by permitting HCFA to contract with a variety of types of managed care plans,
creating a new Medicare fee-for-service option and establishing a Medicare
Medical Savings Account Demonstration Program. The legislation also encourages
provider sponsored organizations to contract directly with HCFA to provide
coverage for Medicare enrollees. Federal reimbursement was modified so that the
premiums paid by HCFA will be adjusted to take into account, on an increasing
basis, a blend of national and local health care cost factors, rather than only
local costs--starting with a 10% national factor in 1998 and moving to a 50%
national factor by 2003. Congress also provided for gradual removal of a
graduate medical education factor in determining reimbursement and, for the
phase in of a risk adjustment payment methodology. As a result, it is likely
that premiums paid by HCFA will not match the rate of increase for medical
costs.

The legislation includes a provision for a minimum increase of 2% annually in
health plan Medicare reimbursement through 2003. The legislation also provides
for expedited licensure of provider-sponsored Medicare plans and a repeal of the
rule requiring health plans to have one commercial enrollee for each Medicare or
Medicaid enrollee. These changes could have the effect of increasing competition
in the Medicare market. Further, effective January 1, 1999, the Company was
required to implement new Medicare regulations including, but not limited to,
discharge notices, additional provider contract language and extensive new
quality improvement programs. In 1999, Congress changed a number of the Act
provisions in the Balanced Budget Refinement Act ("BBRA"). The BBRA made
numerous changes in Medicare payment,

13

contracting, enrollment rules, and altered the risk adjustment phase-in
schedule. These new regulations are likely to increase the burden of
administering the Company's Medicare plans and may adversely impact the
Company's operations.

The Health Insurance Portability and Accountability Act of 1996 (the
"Accountability Act") was passed by Congress and signed into law by President
Clinton on August 21, 1996 and effective beginning July 1, 1997. While the
Accountability Act contains provisions regarding health insurance or health
plans, such as portability and limitations on pre-existing condition exclusions,
guaranteed availability and renewability, it also contains several anti-fraud
measures that significantly change health care fraud and abuse provisions. Some
of the provisions include (i) creation of an anti-fraud and abuse trust fund and
coordination of fraud and abuse efforts by federal, state and local authorities;
(ii) extension of the criminal anti-kickback statues to all federal health
programs; (iii) expansion of and increase in the amount of civil monetary
penalties and establishment of a knowledge standard for individuals or entities
potentially subject to civil monetary penalties; and (iv) revisions to current
sanctions for fraud and abuse, including mandatory and permissive exclusion from
participation in the Medicare or Medicaid programs.

Workers' Compensation. The Company is subject to extensive governmental
regulation and supervision in each state in which it conducts workers'
compensation business. The primary purpose of such regulation and supervision is
to provide safeguards for policyholders and injured workers rather than protect
the interests of shareholders. The extent and form of the regulation may vary,
but generally has its source in statutes that establish regulatory agencies and
delegate to the regulatory agencies broad regulatory, supervisory and
administrative authority. Typically, state regulations extend to such matters as
licensing companies; restricting the types or quality of investments; requiring
triennial financial examinations and market conduct surveys of insurance
companies; licensing agents; regulating aspects of a company's relationship with
its agents; restricting use of some underwriting criteria; regulating premium
rates, forms and advertising; limiting the grounds for cancellation or
nonrenewal of policies; solicitation and replacement practices; and specifying
what might constitute unfair practices. Moreover, the payment of dividends and
the making of other distributions to the Company by its workers' compensation
insurance company subsidiaries are contingent upon the earnings of those
subsidiaries and are subject to various business considerations, applicable
state corporate laws and regulations, the terms of agreements to which they may
become a party and government regulations, which restrict in certain
circumstances the payment of dividends and distributions, and the transfer of
assets to the Company.

In the normal course of business, the Company and the various state agencies
that regulate the activities of the Company may disagree on interpretations of
laws and regulations, policy wording and disclosures or other related issues.
These disagreements, if left unresolved, could result in administrative hearings
and/or litigation. The Company attempts to resolve all issues with the
regulatory agencies, but is willing to litigate issues where it believes it has
a strong position. The ultimate outcome of these disagreements could result in
sanctions and/or penalties and fines assessed against the Company. Currently,
there are no litigation matters pending with any department of insurance.

Typically, states mandate participation in insurance guaranty associations,
which assess solvent insurance companies in order to fund claims of
policyholders of insolvent insurance companies. Under this arrangement, insurers
can be assessed up to 1% (or 2% in certain states) of premiums written for
workers' compensation insurance in that state each year to pay losses and LAE on
covered claims of insolvent insurers. In California and certain other states,
insurance companies are allowed to recoup such assessments from policyholders
while several states allow an offset against premium taxes. Potential assessment
expenses, net of recoupment, if any, for insolvencies are not accrued until
after an insolvency has occurred since the likelihood and the amount of the
assessment expense cannot be reasonably determined or estimated. In California,
there have been no new assessments for insolvent workers' compensation insurance
companies since 1990.

General. Besides state insurance laws, the Company is subject to general
business and corporation laws, federal and state securities laws, consumer
protection laws, fair credit reporting acts and other laws regulating the
conduct and operation of its subsidiaries.

14

Deposits. The Company's HMO and insurance subsidiaries are required by state
regulatory agencies to maintain certain deposits and must also meet certain net
worth and reserve requirements. The Company has restricted assets on deposit in
various states ranging from $20,000 to $2.0 million and totaling $21.7 million
at December 31, 1999. The Company's HMO and insurance subsidiaries meet
requirements to maintain minimum stockholder's equity ranging from $1.1 million
to $5.2 million. In addition, in conjunction with the Kaiser-Texas acquisition,
TXHC entered into a letter agreement with the Texas Department of Insurance
whereby TXHC agreed to maintain a net worth of $20.0 million.

Dividends. The Company's HMO and insurance subsidiaries are also restricted by
state law as to the amount of dividends that can be declared and paid. Moreover,
insurance companies and HMOs domiciled in Texas, Nevada and California generally
may not pay extraordinary dividends without providing the state insurance
commissioner with 30 days prior notice, during which period the commissioner may
disapprove the payment. An "extraordinary dividend" is generally defined as a
dividend whose fair market value together with that of other dividends or
distributions made within the preceding 12 months exceeds the greater of (i) ten
percent of the insurer's surplus as of the preceding December 31 or (ii) the net
gain from operations of such insurer for the 12-month period ending on the
preceding December 31. The Company is not in a position to assess the likelihood
of obtaining future approval for the payment of "extraordinary dividends" or
dividends other than those specifically allowed by law in each of its
subsidiaries' states of domicile. No prediction can be made as to whether any
legislative proposals relating to dividend rules in the domiciliary states of
the Company's subsidiaries will be made or adopted in the future, whether the
insurance departments of such states will impose either additional restrictions
in the future or a prohibition on the ability of the Company's regulated
subsidiaries to declare and pay dividends or as to the effect of any such
proposals or restrictions on the Company's regulated subsidiaries.

Employees

The Company had approximately 4,700 employees as of December 31, 1999. None of
these employees are covered by a collective bargaining agreement. The Company
believes that its relations with its employees are good.

ITEM 2. PROPERTIES

The Company owns several administrative facilities in southern Nevada totaling
approximately 400,000 square feet. Such facilities include an approximate
110,000 square foot six-story home office building and an approximate 43,000
square foot two-story corporate administrative headquarters. These buildings are
subject to liens securing a $400,000 loan balance. Also included in this total
is a 198,000 square foot six-story administrative headquarters building which
became fully occupied in 1998. This building is subject to a $11.6 million loan
balance. The Company also owns clinical facilities in the southern Nevada area
totaling approximately 425,000 square feet and consisting primarily of ten
medical clinics including one medical clinic that opened for business in January
2000 and two surgery centers. The Company leases additional office and clinical
space in Nevada totaling approximately 129,000 and 90,000 square feet,
respectively.

In conjunction with the Kaiser-Texas acquisition, the Company purchased eight
medical and office facilities with approximately 323,000 square feet of clinical
facilities and approximately 175,000 square feet of administrative facilities.
These buildings are subject to a deed of trust note securing a $34.7 million
note balance. In addition, the Company leases additional office and clinical
space in Texas totaling approximately 24,000 square feet and 56,000 square feet,
respectively. The above properties are utilized primarily for the managed care
operations. The workers' compensation subsidiary is headquartered in Nevada and
occupies approximately 25% of the 198,000 square foot administrative building as
well as leases approximately 64,000 square feet of office space in California.
The Company leases approximately 150,000 square feet of office space in other
various states as needed for the military subsidiary's administrative
headquarters, for TRICARE service centers and for other regional operations.

15

The Company believes that current and planned clinical space will be adequate
for its present needs. Additional clinical space may be required, however, if
membership continues to expand in southern Nevada.

The Company owns real estate and a building in Park City, Utah purchased in 1996
to provide entertainment and a meeting environment for significant current and
prospective clients, brokers and others who assist in the Company's marketing
efforts.

ITEM 3. LEGAL PROCEEDINGS

The Company is subject to various claims and other litigation in the ordinary
course of business. Such litigation includes claims of medical malpractice,
claims for coverage or payment for medical services rendered to HMO members and
claims by providers for payment for medical services rendered to HMO members.
Also included in such litigation are claims for workers' compensation and claims
by providers for payment for medical services rendered to injured workers. In
the opinion of the Company's management, the ultimate resolution of pending
legal proceedings should not have a material adverse effect on the Company's
financial condition.

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

None

16

PART II

ITEM 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER
MATTERS

Market Information

The Company's common stock, par value $.005 per share (the "Common Stock"), has
been listed on the New York Stock Exchange under the symbol SIE since April 26,
1994 and, prior to that, had been listed on the American Stock Exchange since
the Company's initial public offering on April 11, 1985. The following table
sets forth the high and low sales prices for the Common Stock for each quarter
of 1999 and 1998.

Period High Low

1999

First Quarter........................................ $22 1/8 $11 9/16
Second Quarter....................................... 16 1/4 10 7/16
Third Quarter........................................ 14 9/16 10 1/16
Fourth Quarter....................................... 10 4 5/8

1998

First Quarter........................................ $26 7/8 $20 9/16
Second Quarter....................................... 27 37/64 23 1/4
Third Quarter........................................ 26 15 7/8
Fourth Quarter....................................... 24 15/16 17 15/16

On February 28, 2000 the closing sale price of the Common Stock was $6.00 per
share.

Note: The above stock prices have been adjusted to account for the
three-for-two stock split of the Company's Common Stock to stockholders
of record as of May 18, 1998.

Holders

The number of record holders of Common Stock at February 28, 2000 was 241. Based
upon information available to it, the Company believes there are several
thousand beneficial holders of the Common Stock.

Dividends

No cash dividends have been paid on the Common Stock since the Company's
inception. The Company currently intends to retain its earnings for use in its
business and does not anticipate paying any cash dividends in the foreseeable
future. As a holding company, the Company's ability to declare and to pay
dividends is dependent upon cash distributions from its operating subsidiaries.
The ability of the Company's health maintenance organizations ("HMOs") and
insurance subsidiaries to declare and to pay dividends is limited by state
regulations applicable to the maintenance of minimum deposits, reserves and net
worth. (See Management's Discussion and Analysis of Financial Condition and
Results of Operations -- Liquidity and Capital Resources). The declaration of
any future dividends will be at the discretion of the Company's Board of
Directors and will depend on, among other things, future earnings, debt
covenants, operations, capital requirements and the financial condition of the
Company and upon general business conditions.

17

ITEM 6. SELECTED FINANCIAL DATA

The following selected consolidated financial data of Sierra Health Services,
Inc., and subsidiaries (the "Company"), for each of the fiscal years in the
five-year period ended December 31, 1999 should be read in conjunction with the
Consolidated Financial Statements and the related Notes thereto, "Management's
Discussion and Analysis of Financial Condition and Results of Operations" and
other information which appears elsewhere in this Annual Report on Form 10-K.
The selected consolidated financial data below has been derived from the audited
Consolidated Financial Statements of the Company.

Years Ended December 31,
-----------------------------------------------
1999 1998 1997 1996 1995
---------- ---------- ---------- ---------- --------
(Amounts in thousands, except per share data)
Statement of Operations Data:
OPERATING REVENUES:

Medical Premiums............................................. $ 827,779 $ 609,404 $513,857 $386,968 $319,475
Military Contract Revenues .................................. 287,398 204,838 4,346
Specialty Product Revenues .................................. 94,221 148,368 146,211 133,324 102,807
Professional Fees............................................ 51,842 45,363 31,238 28,836 19,417
Investment and Other Revenues................................ 22,571 29,230 26,072 26,283 25,310
------------- ------------ ---------- ---------- ----------
Total...................................................... 1,283,811 1,037,203 721,724 575,411 467,009
----------- ---------- --------- --------- ---------

OPERATING EXPENSES:
Medical Expenses............................................. 749,797 513,209 419,272 315,915 245,135
Military Contract Expenses ................................. 276,493 196,625 4,193
Specialty Product Expenses................................... 96,487 142,258 143,082 130,758 102,859
General, Administrative and Marketing Expenses............... 137,812 110,687 93,919 72,237 63,562
Impairment, Settlement and Other Costs (1) .................. 18,808 13,851 29,350 12,064 11,614
------------- ------------ ---------- ---------- ----------
Total...................................................... 1,279,397 976,630 689,816 530,974 423,170
----------- ----------- --------- --------- ---------

OPERATING INCOME ............................................... 4,414 60,573 31,908 44,437 43,839

INTEREST EXPENSE AND OTHER, NET................................. (14,980) (7,181) (4,433) (2,823) (3,737)
------------ ------------ ----------- ---------- ----------

(LOSS) INCOME FROM CONTINUING OPERATIONS
BEFORE INCOME TAXES ....................................... (10,566) 53,392 27,475 41,614 40,102
BENEFIT (PROVISION) FOR INCOME TAXES............................ 5,935 (13,796) ( 3,234) (10,471) (12,198)
-------------- ----------- ----------- --------- ---------
(LOSS) INCOME FROM CONTINUING OPERATIONS........................ (4,631) 39,596 24,241 31,143 27,904
LOSS FROM DISCONTINUED OPERATIONS .............................. (6,600)
----------------- ----------------- --------------- -------------

NET (LOSS) INCOME .............................................. $ (4,631) $ 39,596 $ 24,241 $ 31,143 $ 21,304
============ =========== ========= ========= =========

EARNINGS PER COMMON SHARE (2):
(Loss) Income from Continuing Operations Per Share .......... $(.17) $1.45 $.90 $1.17 $1.07
Loss Per Share from Discontinued Operations ................. (.25)
-------- -------- ------ -------- -------
Net (Loss) Income Per Share ................................. $(.17) $1.45 $.90 $1.17 $ .82
===== ===== ==== ===== ======

Weighted Average Number of Common

Shares Outstanding ........................................ 26,927 27,391 27,013 26,589 26,121
====== ====== ====== ====== ======

EARNINGS PER COMMON SHARE ASSUMING
DILUTION (2):
(Loss) Income from Continuing Operations Per Share ...... $(.17) $1.43 $.88 $1.15 $1.05
Loss Per Share from Discontinued Operations ............. (.25)
-------- --------- ----- --------- ------
Net (Loss) Income Per Share ............................. $(.17) $1.43 $.88 $1.15 $ .80
===== ===== ==== ===== ======

Weighted Average Number of Common

Shares Outstanding Assuming Dilution ...................... 26,927 27,747 27,426 27,191 26,601
====== ====== ====== ====== ======

18

Years Ended December 31,

1999 1998 1997 1996 1995
---------- ---------- ---------- ---------- --------

(Amounts in thousands)

Balance Sheet Data:

Working Capital ............................................. $ 114,740 $ 198,092 $ 211,911 $189,943 $192,873
Total Assets................................................. 1,130,112 1,045,120 723,936 629,462 575,146
Long-term Debt (Net of Current Maturities)................... 258,854 242,398 90,841 66,189 71,257
Cash Dividends Per Common Share.............................. none none none none none
Stockholders' Equity......................................... 278,412 303,714 265,682 234,482 207,715

(1) The Company recorded certain identifiable impairment, settlement and
other costs. See Note 15 of Notes to the Consolidated Financial Statements.

(2)
Adjusted to account for three-for-two stock split of the Company's common stock
to stockholders of record as of May 18, 1998.

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

The following discussion and analysis provides information which management
believes is relevant for an assessment and understanding of the Company's
consolidated financial condition and results of operations. The discussion
should be read in conjunction with the Consolidated Financial Statements and
Related Notes thereto. Any forward-looking information contained in this
Management's Discussion and Analysis of Financial Condition and Results of
Operations and any other sections of this 1999 Annual Report on Form 10-K should
be considered in connection with certain cautionary statements contained in the
Company's Current Report on Form 8-K filing dated March 15, 2000, incorporated
herein by reference. Such cautionary statements are made pursuant to the "safe
harbor" provisions of the Private Securities Litigation Reform Act of 1995 and
identify important risk factors that could cause the Company's actual results to
differ materially from those expressed in any projected, estimated or
forward-looking statements relating to the Company.

Acquisitions

On October 31, 1998, Sierra Health Services, Inc. ("Sierra") and one of its
subsidiaries, Texas Health Choice, L.C. (formerly HMO Texas L.C.) completed the
acquisition of certain assets of Kaiser Foundation Health Plan of Texas
("Kaiser-Texas"), a health plan operating in Dallas/Ft. Worth, and Permanente
Medical Association of Texas ("Permanente"), a medical group with approximately
150 physicians. The purchase price was $124 million, which was net $20 million
in operating cost support paid to Sierra by Kaiser Foundation Hospitals in four
quarterly installments following the closing of the transaction. The purchase
price allocation included a premium deficiency reserve of $25 million for
estimated losses on the contracts acquired from Kaiser-Texas. The purchase price
also included amounts for real estate and eight medical and office facilities
with approximately 500,000 square feet. In December 1998, certain accreditation
goals were met by the health plan resulting in a purchase price increase of $3.0
million to $127 million. The purchase price may increase up to an additional $27
million over three years if certain growth and member retention goals are met by
the health plan; however, preliminary results indicate these goals were not met
for the first year. Sierra assumed no prior liabilities for malpractice or other
litigation, or for any unanticipated future adjustments to claims expenses for
periods prior to closing. The transaction was financed with a five-year
revolving credit facility and a $35.2 million note payable to Kaiser Foundation
Health Plan of Texas. The note is secured by the acquired real estate.
Approximately $110 million of the $200 million revolving credit facility was
used to fund the transaction.

The original liability for the estimated premium deficiency was based upon
assumptions of membership and other operating information, some of which had not
been received as of December 31, 1998. During 1999, the Company continued to
gather such data, including data from the seller, and based upon the receipt and

19

analysis of this data, the Company revised the initial estimate of the premium
deficiency accrual. In total the Company recorded a $72.0 million premium
deficiency in conjunction with the acquisition. Of this amount, $6.8 million was
utilized in 1998 to offset losses on the acquired contracts, and the remainder
was utilized in 1999. Total goodwill recorded in conjunction with the
acquisition was $126.8 million of which $24.8 million was a result of
adjustments in 1999.

On December 31, 1998, Sierra completed the acquisition of the Nevada health care
business of Exclusive Healthcare, Inc. ("EHI"), United of Omaha Life Insurance
Company and United World Life Insurance Company ("United"), all of which were
subsidiaries of Mutual of Omaha Insurance Company. Sierra initially retained
approximately 9,000 members (approximately 4,400 HMO members) subsequent to the
acquisition. Effective June 1, 1999, the Company completed the purchase of the
Texas operations of EHI (approximately 1,000 HMO members) and United's related
preferred provider organization ("PPO") that is part of the dual option HMO/PPO
plan. The purchase price of both the Nevada and Texas transaction is contingent
based on how many members are retained through 2000 and 2001. No cash will be
paid until group renewals begin in 2000.

In August 1997, the Company acquired the assets and operations of Total Home
Care, Inc. ("THC") for approximately $3.1 million, net of cash acquired. THC
provides home infusion, oxygen, and durable medical equipment services in Nevada
and Arizona. The Company sold the Arizona operations in the first quarter of
1998 for approximately $1.5 million. Also, in the first quarter of 1998, the
Company purchased three medical clinics in southern Nevada for approximately
$7.3 million.

Overview

The Company derives revenues from its health maintenance organizations, managed
indemnity, military health care services and workers' compensation insurance
subsidiaries. To a lesser extent, the Company also derives additional specialty
product revenues from non-HMO and insurance products (consisting of fees for
workers' compensation administration, utilization management services and
ancillary products), professional fees (consisting primarily of fees for
providing health care services to non-members and co- payment fees received from
members), and investment and other revenue. Medical premium revenues accounted
for approximately 64.5%, 58.8% and 71.2% of the Company's total revenues for
1999, 1998 and 1997, respectively. The decrease in medical premiums as a
percentage of total revenues in 1998 is primarily due to the addition of
military contract revenues. The increase in the percentage of medical premiums
as a percentage of total revenues in 1999 is due to the acquisitions discussed
previously. Continued medical premium revenue growth is principally dependent
upon continued enrollment in the Company's products and upon competitive and
regulatory factors.

The Company's principal expenses consist of medical expenses, military contract
expenses, specialty product expenses, and general, administrative and marketing
expenses. Medical expenses represent capitation fees and other fee-for-service
payments paid to independently contracted physicians, hospitals and other health
care providers to cover enrollees, as well as the aggregate expenses to operate
and manage the Company's multi-specialty medical groups and other provider
subsidiaries. As a provider of health care management services, the Company
seeks to positively effect quality of care and expenses by employing or
contracting with physicians, hospitals and other health care providers at
negotiated price levels, by adopting quality assurance programs, by monitoring
and managing utilization of physicians and hospital services and by providing
incentives to use cost-effective providers. Military contract expenses represent
the expenses of delivering health care, as agreed to in the TRICARE contract
with the federal government, as well as administrative costs to operate the
military health care subsidiary. Specialty product expenses primarily consist of
losses and loss adjustment expenses, policy acquisition expenses and other
general and administrative expenses associated with the Company's workers'
compensation insurance subsidiaries. General, administrative and marketing
expenses generally represent operational costs other than those associated with
the delivery of health care services, military contract services and specialty
product services.

On September 30, 1997, Sierra Military Health Services, Inc. ("SMHS"), a
wholly owned subsidiary of the Company, was awarded a TRICARE contract to
provide managed health care coverage to eligible

20

beneficiaries in Region 1. Under the contact, SMHS provides health care services
to approximately 610,000 dependents of active duty military personnel and
military retirees and their dependents through subcontractor partnerships and
individual providers. In June 1998, the Company began providing health care
benefits to individuals in Connecticut, Delaware, Maine, Maryland,
Massachusetts, New Hampshire, New Jersey, New York, Pennsylvania, Rhode Island,
Vermont, Virginia, West Virginia and Washington, D.C. SMHS was notified on
February 13, 1998 that the United States General Accounting Office sustained a
competitor's protest of the contract award for TRICARE Managed Care Support
Region 1 and recommended that the contract be re-bid. In December 1998, the
Company reached an agreement to settle the protest. As part of the settlement,
the competitor has foregone any and all rights it may have to challenge the
contract award and seek a re-bid. (See Note 15 of Notes to the Consolidated
Financial Statements).

Impairment, settlement and other costs represent identifiable incremental costs
the Company has incurred primarily in connection with various mergers,
acquisitions and planned dispositions as well as expenses associated with the
Company's proposal to serve TRICARE beneficiaries in Region 1 and the ultimate
cost to settle the bid protest. Start-up expenses associated with the proposal
to serve TRICARE beneficiaries were charged to operations upon notification of
award. (See Note 15 of Notes to the Consolidated Financial Statements).

Results of Operations

The following table sets forth selected operating data as a percentage of
revenues for the periods indicated:

Years Ended December 31,
--------------------------------
1999 1998 1997
---------- ---------- -------

OPERATING REVENUES:

Medical Premiums........................................ 64.5% 58.8% 71.2%
Military Contract Revenues.............................. 22.4 19.7 .6
Specialty Product Revenues ............................. 7.3 14.3 20.3
Professional Fees....................................... 4.0 4.4 4.3
Investment and Other Revenues .......................... 1.8 2.8 3.6
------- ------ ------
Total................................................ 100.0 100.0 100.0
----- ----- -----

OPERATING EXPENSES:
Medical Expenses........................................ 58.4 49.5 58.1
Military Contract Expenses ............................. 21.6 19.0 .6
Specialty Product Expenses.............................. 7.5 13.7 19.8
General, Administrative and Marketing Expenses.......... 10.7 10.7 13.0
Impairment, Settlement and Other Costs.................. 1.5 1.3 4.1
----- ----- ------

Total................................................ 99.7 94.2 95.6
---- ---- ----

OPERATING INCOME ............................................ .3 5.8 4.4

INTEREST EXPENSE AND OTHER, NET.............................. (1.1) (.7) (.6)
----- ---- ----

(LOSS) INCOME FROM CONTINUING OPERATIONS
BEFORE INCOME TAXES .................................... (.8) 5.1 3.8

BENEFIT (PROVISION) FOR INCOME TAXES......................... .4 (1.3) ( .4)
------ ----- -----

NET (LOSS) INCOME ........................................... (.4)% 3.8% 3.4%
====== ==== ====

21

1999 Compared to 1998

Revenues. The Company's total operating revenues for 1999 increased
approximately 23.8% to $1.28 billion from $1.04 billion for 1998. The increase
was primarily due to an increase in premium revenue of $218.4 million and
increases in military contract revenue of $82.6 million, offset by a decrease in
specialty product revenue of $54.1 million.

Medical premium revenue from the Company's HMO and managed indemnity insurance
subsidiaries increased $218.4 million, or 35.8%. Excluding the effect of the
Kaiser-Texas acquisition, premium revenue increased $84.9 million, or 14.6%. The
$84.9 million increase in premium revenue reflects a 7.9% increase in member
months (the number of months of each year that an individual is enrolled in a
plan). Additionally, Medicare member months increased 16.2%. Such growth in
Medicare member months contributes significantly to the increase in premium
revenues as the Medicare per member premium rates are over three times higher
than the average commercial premium rate. The Company's premium rates increased
approximately 4% for its Nevada HMO commercial groups and 11% for its Houston,
Texas commercial groups. Compared to the fourth quarter of 1998, the commercial
rates for the Company's acquired Dallas/ Ft. Worth operations have increased
approximately 8%. The Company's managed indemnity rates increased approximately
8% and Medicare rates increased approximately 2%. Over 90% of the Company's
Nevada Medicare members are enrolled in the Social HMO Medicare program. The
Health Care Financing Administration ("HCFA") is considering adjusting the
reimbursement factor for the Social HMO members in the future. If the
reimbursement for these members decreases significantly and related benefit
changes are not made timely, there could be a material adverse effect on the
Company's business.

Military contract revenues increased $82.6 million, or 40.3%. Military contact
revenue is recorded based on the contract price as agreed to by the federal
government, adjusted for certain provisions based on actual experience. In
addition, the Company records revenue based on estimates of the earned portion
of any contract change orders not originally specified in the contract. The
revenue recorded in 1999 is a result of the provision of health care services
for twelve months. Revenue recorded in 1998 was comprised of revenue earned for
five months of contract implementation and seven months of health care delivery.

Specialty product revenue decreased $54.1 million, or 36.5%, for the year ended
December 31, 1999 compared to the prior year. Of the decrease, $51.1 million was
due to a decrease in revenue in the workers' compensation operations segment and
$3.0 million was due to a decrease in administrative services revenue. The
decrease in specialty product revenues related to the workers' compensation
insurance segment was primarily due to a full year of additional ceded
reinsurance premiums on the low level reinsurance agreement effective July 1,
1998, totaling $60.7 million. This agreement was entered into in the fourth
quarter of 1998. In addition, ongoing price competition, especially in
California, is contributing to the reduction in revenue. The decrease in
administrative services revenue was primarily attributable to a decrease in
membership.

Professional fee revenue increased $6.5 million primarily due to the Company's
medical group operations in Dallas/Ft. Worth related to the Kaiser-Texas
acquisition. Investment and other revenue decreased approximately $6.7 million
over the comparable prior year period. Of this decrease, $2.7 million was due
primarily to capital gains realized on the sale of investments in the prior year
period. The remaining decrease was primarily due to a decrease in invested
balances.

Medical Expenses. Total medical expenses for the year ended December 31, 1999
increased $236.6 million compared to the prior year. The following costs were
included in 1999 medical expenses:

Premium Deficiency. In the first quarter of 1999, the Company recorded a premium
deficiency charge of $8.1 million related to losses in underperforming markets
primarily in Arizona and rural Nevada. This deficiency reserve was utilized
during 1999 to offset losses as they occurred. In the fourth quarter of 1999,
the Company recorded $21.0 million for estimated deficient premiums associated
with contracts in the Texas market. Of this amount $10.0 million was included in
medical expenses and $11.0 million was recorded in impairment, settlement and
other costs.

22

Adverse Development and Contractual Adjustments. In the fourth quarter of 1999,
the Company recorded approximately $18.0 million in non-recurring medical
expenses, of which $11.2 million primarily related to an adjustment to the
estimate for medical expenses recorded in previous periods. The remaining
non-recurring amount primarily relates to contractual settlements with providers
of medical services. (See Note 15 of Notes to the Consolidated Financial
Statements).

Excluding the effect of the Dallas/Ft. Worth operations, as well as the
non-recurring charges, medical expenses increased approximately $83.4 million or
17.0% compared to the prior year. Medical expenses as a percentage of medical
premiums and professional fees ("Medical Care Ratio") increased from 78.4% to
85.2%, or 81.1% excluding the non-recurring charges, for the year ended December
31, 1999 compared to the prior year. The increase in the medical care ratio
reflects the Kaiser-Texas membership which has a higher medical care ratio, and
the charges discussed previously, as well as an increase in Medicare members as
a percentage of fully-insured members, and higher pharmacy costs. The cost of
providing medical care to Medicare members generally requires a greater
percentage of the premiums received. Pharmacy costs increased as the management
of the pharmacy benefit was transitioned from a capitated pharmacy benefits
contract to in-house management in the third quarter of 1998. The costs under
such capitation contract were substantially below actual claims experience.
Included in medical expenses is the utilization of $43.9 million of premium
deficiency reserve to offset losses on contracts from the Kaiser-Texas
acquisition. Although not reflected in earnings, $20 million of these losses
were funded by Kaiser as agreed to in the purchase agreement.

Military Contract Expenses. Military contract expenses for the twelve months
ended December 31, 1999, increased approximately $79.9 million or 40.6%,
compared to the prior year. The military contract expenses in 1999 are a result
of twelve months of health care delivery. Expense in 1998 was for five months of
contract implementation and seven months of health care delivery. Health care
delivery expense consists primarily of costs to provide managed health care
services to eligible beneficiaries in accordance with the Company's TRICARE
contract. Under the contract, SMHS provides health care services to
approximately 610,000 dependents of active duty military personnel and military
retirees and their dependents through subcontractor partnerships and individual
providers. Health care costs are recorded in the period when services are
provided to eligible beneficiaries, including estimates for provider costs which
have been incurred but not reported to the Company. Also, included in military
contract expenses are costs incurred to perform specific administrative
services, such as health care appointment scheduling, enrollment, network
management and health care advice line services, and other administrative
functions of the military health care subsidiary.

Specialty Product Expenses. Specialty product expenses decreased approximately
$45.8 million, or 32.2%, due primarily to the implementation of the low level
reinsurance agreement as discussed previously, offset by adverse development of
$9.9 million on prior accident years for the Company's workers' compensation
business. Effective January 1, 1998, workers' compensation claims are 100%
reinsured between $500,000 and $100 million per occurrence. For claims occurring
on and after July 1, 1998, that are below $500,000, the Company obtained low
level quota share and excess of loss reinsurance. Under this agreement, which
was not reflected in the financial statements until the fourth quarter of 1998,
the Company reinsures 30% of the first $10,000 of each claim, 75% of the next
$40,000 and 100% of the next $450,000. Claims occurring in the third quarter of
1998 are accounted for as retroactive reinsurance. (See Note 6 of Notes to the
Consolidated Financial Statements).

The combined ratio for the workers' compensation insurance business was 105.5%
in 1999 compared to 98.7% for the prior year. The increase was due to a 380
basis point increase in the net loss and loss adjustment expense ("LAE") ratio,
a 290 basis point increase in the underwriting expense ratio and 10 basis points
of policyholders' dividend expense incurred in 1999. The increase in the loss
and LAE ratio was primarily due to 1999 net adverse loss development of $9.9
million on prior accident years compared to 1998 net favorable loss development
of $9.6 million. The increase in the underwriting expense ratio was primarily
due to the lower net earned premium base that resulted from higher ceded
reinsurance premiums in 1999.

The adverse development recorded in 1999 for the prior accident years is
primarily attributable to increased California claim severity. Higher claim
severity has had a negative impact on the entire California workers'
compensation industry. The historical claim frequency development patterns have
not significantly changed

23

in 1999. In addition, continuing price competition in California has negatively
affected operating ratios. However, for renewal policies issued year to date in
2000, Sierra's workers' compensation business has obtained premium rate
increases in excess of 15%. The increase seen so far in 2000 is a material
positive change of the previous rate trend. Based on public information, other
California workers' compensation companies are issuing year 2000 policies at
rates 15% to 20% in excess of the expiring premiums.

The loss and loss adjustment expense reserves booked as of December 31, 1999
reflect the Company's best estimate of the ultimate loss costs for reported and
unreported claims occurring in accident year 1999 as well as those occurring in
accident years prior to 1999. The loss estimates are subject to change in
subsequent accounting periods and any change to the current reserve estimates
would be accounted for in future results of operations. The Company may incur
future adverse or favorable loss development. Workers' compensation claim
payments are made over several years from the date of the claim. Until the final
payments for reported claims are made, reserves are invested and the interest
proceeds are included in investment income.

General, Administrative and Marketing Expenses. General, administrative and
marketing ("G&A") cost increased $27.1 million, or 24.5%, compared to 1998. As a
percentage of revenues, G&A costs for 1999 was 10.7% which is consistent with
1998. Of the $27.1 million increase in G&A, $14.3 million was due to additional
G&A related to the acquired HMO business in the Dallas/Ft. Worth area, net of
premium deficiency utilization of $20.9 million. The remaining increase of $12.8
million included a $6.9 million increase in compensation expense, resulting
primarily from additional employees supporting expanded services. Broker and
premium tax expense increased approximately $2.2 million due to increased
membership. In addition, depreciation expense increased $2.4 million.

Impairment, Settlement and Other Costs. In March 1999, the Company closed all
inpatient operations at Mohave Valley Hospital, a 12-bed acute care facility in
Bullhead City, Arizona, and terminated approximately 45 employees. The Company
recorded a charge of $4.3 million related primarily to the write-off of goodwill
associated with the Mohave