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, 2000

OR

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

For the transition period from ------------ to ------------

Commission file number: 1-8865

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

NEVADA 88-0200415
(State or other jurisdiction of (I.R.S. Employer Identification Number)
incorporation or organization)

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:
Name of each exchange on
Title of each class 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 March 15, 2001 was $111,308,000.

The number of shares of the registrant's common stock outstanding on March 15,
2001 was 27,513,000.

DOCUMENTS INCORPORATED BY REFERENCE
DOCUMENT WHERE INCORPORATED

Registrant's Current Report on Part I
Form 8-K dated March 20, 2001. Part II, Item 7

Portions of the registrant's definitive Part III
proxy statement for its 2001 annual
meeting to be filed with the SEC not later
than 120 days after the end of the fiscal year.

SIERRA HEALTH SERVICES, INC.

2000 FORM 10-K ANNUAL REPORT

TABLE OF CONTENTS

Page
PART I

Item 1. Description of Business .................................................................. 1

Item 2. Description of Properties................................................................. 16

Item 3. Legal Proceedings......................................................................... 17

Item 4. Submission of Matters to a Vote of Security Holders....................................... 17

PART II

Item 5. Market for Registrant's Common Stock and
Related Stockholder Matters............................................................ 18

Item 6. Selected Financial Data................................................................... 19

Item 7. Management's Discussion and Analysis of Financial Condition
and Results of Operations ............................................................. 20

Item 7a. Quantitative and Qualitative Disclosures about Market Risk ............................... 36

Item 8. Financial Statements and Supplementary Data............................................... 38

Item 9. Changes in and Disagreements with Accountants on
Accounting and Financial Disclosure.................................................... 72

PART III

Item 10. Directors and Executive Officers of the Registrant........................................ 72

Item 11. Executive Compensation.................................................................... 72

Item 12. Security Ownership of Certain Beneficial Owners and Management............................ 72

Item 13. Certain Relationships and Related Transactions............................................ 72

PART IV

Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K........................... 73

PART I

ITEM 1. DESCRIPTION OF BUSINESS
GENERAL

Unless otherwise indicated, "Sierra," "we," "us," and "our" refer to Sierra
Health Services, Inc. and its subsidiaries.

We are 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. Our strategy has been to develop
and offer a portfolio of managed health care and workers' compensation products
to employer groups and individuals. Our broad range of managed health care
services is provided through the following:

o federally qualified health maintenance organizations or HMOs

o managed indemnity plans

o a third-party administrative services program for employer-funded health
benefit plans

o workers' compensation medical management and fully insured programs

o ancillary products and services that complement our managed health care and
workers' compensation product lines

o a subsidiary that administers a managed care federal contract for the
Department of Defense's TRICARE program in Region 1

Fiscal year 2000 was a difficult year for us. In the first and second quarters
of 2000 we evaluated and then announced and adopted restructuring plans related
primarily to our Texas operations. This restructuring involved a reduction in
staff and the closing of some of our Texas clinic facilities, which resulted in
our recording of significant goodwill and fixed asset impairment and other
charges of approximately $220 million.

As a result of the asset impairment and other non-recurring charges, we were not
in compliance with the financial covenants in our bank credit facility. We
subsequently entered into an amended $185 million credit facility with the banks
on December 15, 2000. As of December 31, 2000, the facility was reduced to $135
million as a result of our payment of $50 million that we received from the sale
and leaseback of the majority of our administrative and clinical properties in
Las Vegas on December 28, 2000. We are required to make semi-annual principal
payments, ranging from $2 million to $10 million, on the credit facility
starting in June 2001. These payments result in permanent reductions in the size
of the credit facility. The amount outstanding under the credit facility
fluctuates with our working capital needs.

In addition, CII Financial, our wholly-owned workers' compensation subsidiary,
has outstanding approximately $47 million of convertible subordinated debentures
due September 15, 2001. These debentures are subordinated obligations of CII
Financial and are not guaranteed by us. CII Financial, as a holding company, has
limited sources for cash and is dependent on dividends from its subsidiary,
California Indemnity Insurance Company, to meet its debt payment obligations.
CII Financial, as sole obligor under the debentures, currently has no available
source of cash with which to pay the debentures when they mature on September
15, 2001. Due to the foregoing, in December 2000, CII Financial commenced an
exchange offer in which it offered to exchange all of the debentures for cash or
new debentures. There can be no assurance that CII Financial will be successful
in its exchange offer.

We filed a Current Report on Form 8-K dated March 20, 2001, which is
incorporated by reference, that sets forth cautionary statements pursuant to the
"safe harbor" provisions of the Private Securities Litigation Reform Act of 1995
and identifies important risk factors that could cause our actual results to
differ materially from those expressed in any projected, estimated or
forward-looking statements relating to Sierra.

Our principal executive offices are located at 2724 North Tenaya Way, Las Vegas,
Nevada 89128, and our telephone number is (702) 242-7000.

Our fiscal year period is the same as the calendar year and unless otherwise
indicated, any year designated will refer to the year ended December 31.

Managed Care Products and Services

Our primary types of health care coverage are HMO plans, HMO Point of Service,
or POS plans, and managed indemnity plans, which include a preferred provider
organization, or PPO option. 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. As of December 31, 2000, we provided HMO products to
approximately 196,600 members in Nevada and 81,200 in Texas. We also provide
managed indemnity products to approximately 31,000 members, Medicare supplement
products to approximately 28,100 members, and administrative services to
approximately 273,200 members. Medical premiums account for approximately 62% of
total revenues. Approximately 73% and 27% of our medical premiums were derived
from our Nevada HMO and insurance subsidiaries and our Texas HMO, respectively,
in 2000.

Health Maintenance Organizations. We operate a mixed model HMO in Las Vegas,
Nevada, which means that we use our own specialty medical group as well as a
network of independently contracted providers. We also operate network model
HMOs in Reno, Nevada and Dallas, Texas. Independently contracted primary care
physicians and specialists for the HMOs are compensated on a capitation or
modified fee-for-service basis. Contracts with our primary hospitals are on a
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 when the member receives HMO benefits.

Most of our managed health care services in Nevada are provided through our
independently contracted network of approximately 2,000 providers and 13
hospitals. These Nevada networks include our multi-specialty medical group,
which provides medical services to approximately 74% of our southern Nevada HMO
members and employs over 160 primary care and other providers in various medical
specialties. Through our affiliates the following services are offered:

o three urgent care centers
o home health care
o hospice care
o behavioral health care
o home infusion, oxygen and durable medical equipment
o a free-standing, state-licensed and Medicare-approved ambulatory
surgery center
o radiology
o vision
o occupational medicine

We believe that this vertical integration of our health care delivery system in
southern Nevada provides a competitive advantage as it helps us to effectively
manage health care costs while delivering quality care.

Texas Health Choice, L.C., or TXHC, has contracts with 32 hospitals for
inpatient care in Dallas/Ft. Worth. Shortly after we acquired the Dallas/Ft.
Worth membership of Kaiser Foundation Health Plan of Texas, or Kaiser-Texas, we
changed the provider model in Dallas/Ft. Worth from a group model to a network
model by overlaying individual practice association, or IPA, delivery systems on
top of the existing group model to provide members with more choice. During
2000, we terminated the contractual relationship with our affiliated medical
group. Currently, the Dallas/Ft. Worth members are served by approximately 2,250
independently contracted providers.

On October 24, 2000, TXHC entered into an agreement with AmCare Health Plans of
Texas, Inc., or AmCare, for the sale and transfer of TXHC's membership in
Houston. Effective December 1, 2000, AmCare assumed the risk associated with the
commercial HMO and Medicare+Choice, or M+C, member contracts under an assumption
reinsurance agreement with TXHC. The initial term of the agreement was for a
period of three months, which began on December 1, 2000 and ended on February
28, 2001. As of March 1, 2001, the commercial HMO membership has been assumed by
AmCare. The reinsurance agreement is continuing for the M+C members until AmCare
receives approval from the Health Care Financing Administration, or HCFA, and
the Texas Department of Insurance for an assignment or novation of the M+C
members. The sale price is based on the number of members retained at March 1,
2001 and is adjusted based on the medical care ratio of those members. We do not
expect to receive material sales proceeds from this transaction. In addition to
the assumption reinsurance agreements, AmCare entered into an Administrative
Services Agreement with TXHC. In consideration for TXHC's performance of
administrative services related to the aforementioned membership, AmCare has
agreed to pay a monthly fee based on a per member per month rate.

Our commercial plans offer traditional HMO benefits and POS benefits. At
December 31, 2000, we had approximately 213,400 commercial members of which
approximately 140,100 were located in Nevada, 73,200 in Texas and 100 in
Arizona.

We offer 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 our Nevada service area.
In the first quarter of 2000, we went to a passive sales mode for Golden Choice.
We continued to offer the plan to potential customers who contacted us, as well
as provide service to existing members. We have been actively marketing the
Golden Choice product again since December 2000. The monthly payment received
from HCFA for Medicare members is determined by formula established by Federal
law.

As of December 31, 2000, we had approximately 49,900 Medicare members, of which
approximately 41,900 were located in Nevada and 8,000 in Texas. Approximately
36,000 of the Nevada Medicare members were enrolled in the Social HMO, which is
discussed below.

In addition, as of December 31, 2000, we had approximately 14,600 members
enrolled in our Nevada HMO Medicaid risk products. To enroll in these products,
an individual must be eligible for Medicaid benefits in the state of Nevada. We
are paid a monthly fee for each Medicaid member enrolled by the state's managed
care division.

Social Health Maintenance Organization. Effective November 1, 1996, we entered
into a Social HMO II contract with HCFA pursuant to which a large portion of our
Nevada Medicare risk enrollees will receive certain expanded benefits. We are
one of six HMOs nationally to be awarded this contract and are the only company
to have implemented the program as of December 31, 2000. We receive 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 our 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 daily living functions because of a health or
physical problem. HCFA may consider adjusting the reimbursement factors for the
Social HMO members in the future. At this time, however, the final reimbursement
per member has not been determined and there is no guaranty that the Social HMO
contract will be renewed beyond 2003. If the reimbursement for these members
decreases significantly and related benefit changes are not made timely, there
could be a material adverse effect on our business.

Preferred Provider Organizations. Our managed indemnity plans generally offer
insureds a PPO 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 our PPO
network. As of December 31, 2000, approximately 31,000 members were enrolled in
our managed indemnity plans.

We currently provide managed indemnity, accidental death and disability, and
Medicare supplement services to individuals in Arizona, California, Colorado,
Iowa, Louisiana, Maryland, Mississippi, Missouri, Nevada, New Mexico and Texas.
We have provided enrollees with notice of the intent to withdraw from the
Colorado and Arizona service areas effective April 1, 2001 and May 1, 2001,
respectively. As of December 31, 2000, our managed indemnity subsidiary was
licensed in a total of 43 states and the District of Columbia.

Ancillary Medical Services. Among the ancillary medical services we offer in
Nevada are the following:

o outpatient surgical care
o diagnostic testing
o medical and surgical procedures
o x-ray
o CAT scans
o mental health and substance abuse services
o home health care services
o hospice program
o vision services
o home infusion
o oxygen
o durable medical equipment services

These services are provided to members of our HMO, managed indemnity and
administrative service plans. Mental health and substance abuse services are
also provided to approximately 145,000 participants from non-affiliated employer
groups and insurance companies.

Administrative Services. Our 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, 2000, approximately 273,200 members
were enrolled in our 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 Department of
Defense, or DoD, awarded us a triple-option health benefits contract, known as
TRICARE to provide managed health care coverage to eligible beneficiaries in
Region 1. This region has approximately 621,000 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. Sierra Military Health Services, Inc., or 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, SMHS provides health care services to dependents of
active duty military personnel and military retirees and their dependents
through subcontractor partnerships and individual providers. We also perform
specific administrative services, including health care appointment scheduling,
enrollment, network management and health care management services. We perform
these 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 phase out of the Region 1 managed care support contract.

In June 1996, the DoD awarded a TRICARE contract to TriWest Healthcare Alliance,
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. During
the first quarter of 2000, we sold our interest in TriWest Healthcare Alliance
in exchange for a $3.7 million note, which approximated the carrying value of
our investment.

Workers' Compensation Operations

Workers' Compensation Subsidiary. On October 31, 1995, we acquired CII
Financial, Inc., or CII, for approximately $76.3 million of common stock in a
transaction accounted for as a pooling of interests. Through CII's insurance
subsidiaries, we write workers' compensation insurance in the states of
California, Colorado, Kansas, Missouri, Nebraska, Nevada, New Mexico, Texas and
Utah. CII's insurance subsidiaries have licenses in 35 states and the District
of Columbia and have applications pending for licenses in other states.
California, Colorado and Nevada represent approximately 77%, 8%, and 8%,
respectively, of CII's fully insured workers' compensation insurance premiums in
2000. Workers' compensation insurance premiums account for approximately 9% of
our 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 medicine physician as well
as nurse case managers, medical bill reviewers and job developers who facilitate
early return to work.

Marketing

Our marketing efforts for our commercial managed care products usually involves
a multi-step process. First we make a presentation to employers. Once a
relationship with a group has been established and a group agreement is
negotiated and signed, we focus our marketing efforts 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.

Media communications convey our emphasis on preventive care, ready access to
health care providers and service. Other communications to customers include
employer and member newsletters, member education brochures, prenatal
information packets, employer/broker seminars, certain Internet information and
direct mail advertising to clients. Members' satisfaction with our 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.

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.

Our workers' compensation insurance policies are sold through independent
insurance agents and brokers, who may also represent other insurance companies.
We believe that independent insurance agents and brokers choose to market our
insurance policies primarily because of the price we charge, the quality of
service that we provide and the commissions we pay. We employ full-time field
underwriters in selected geographic areas who meet with agents and advise them
of our services and who can provide an immediate quote on a policy. As of
December 31, 2000, we had relationships with approximately 800 agents and paid
our agents commissions based on a percentage of the gross written premium they
produced. We also have various agency incentive programs that enable an agent to
earn additional compensation if certain premium production and/or agency loss
ratio goals are met. We utilize a number of promotional media, including
advertising in publications and at trade fairs to support the efforts of our
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 Internet web page briefs.

Membership

Period End Membership:

At December 31,
--------------------------------------------------------------------------

2000 1999 1998 1997 1996
-------- -------- -------- ------- --------
HMO:
Commercial (1).......................... 213,000 263,000 272,000 154,000 147,000
Medicare (2)............................ 50,000 53,000 47,000 36,000 30,000
Medicaid................................ 15,000 11,000 5,000 2,000
Managed Indemnity........................... 31,000 37,000 41,000 64,000 46,000
Medicare Supplement......................... 28,000 28,000 26,000 25,000 23,000
Administrative Services (3) ................ 273,000 298,000 318,000 328,000 338,000
TRICARE Eligibles........................... 621,000 610,000 606,000
---------- ---------- --------------------------------------
Total Membership........................ 1,231,000 1,300,000 1,315,000 609,000 584,000
========= ========= ========= ======= =======

(1) The 2000 Commercial membership does not include 12,000 Houston members sold
and transferred to AmCare on December 1, 2000. (2) The 2000 Medicare membership
does not include 5,000 Houston members that AmCare assumed under a reinsurance
agreement on
December 1, 2000.
(3) For comparability purposes, enrollment information has been restated to
reflect the September 30, 1997 termination of our workers' compensation
administrative services contract with the state of Nevada. Enrollment in
the terminated plan was 163,000 at December 31, 1996.

During 2000, 1999 and 1998, we received approximately 24.2%, 23.5% and 23.0%,
respectively, of our total revenues from our contract with HCFA to provide
health care services to Medicare enrollees. Our contract with HCFA is subject to
annual renewal at the election of HCFA and requires us to comply with federal
HMO and Medicare laws and regulations and may be terminated if we fail to
comply. The termination of our contract with HCFA would have a material adverse
effect on our business. In addition, there have been, and we expect 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).

Our ability to obtain and maintain favorable group benefit agreements with
employer groups affects our 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, 2000, our ten largest HMO
employer groups were, in the aggregate, responsible for less than 10% of our
total revenues. Although none of our 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 our business. We have generally been successful in retaining
these employer groups in Nevada. However, there can be no assurance that we will
be able to renew our agreements with our employer groups in the future or that
we will not experience a decline in enrollment within our 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 our health
care delivery system and that of many other managed care providers is the fact
that approximately 73% of our southern Nevada HMO members receive primary health
care through our owned multi-specialty medical group. We make health care
available through independently contracted providers employed by the
multi-specialty medical group and other independently contracted networks of
physicians, hospitals and other providers.

Under our 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. We have a system of
limited incentive risk arrangements and utilization management with respect to
our independently contracted primary care physicians. We compensate our
independently contracted primary care physicians and specialists by using both
capitation and modified fee-for-service payment methods. In Nevada, under the
modified fee-for-service method, 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 our 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, our company and the members because all share in the benefits
of managing health care costs. We have, 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. We monitor
certain health care utilization, including evaluation of elective surgical
procedures, quality of care and financial stability of our capitated providers
to facilitate access to service and to ensure member satisfaction.

We provide or negotiate discounted contracts with hospitals for inpatient and
outpatient hospital care, including room and board, diagnostic tests and medical
and surgical procedures. We believe that we currently have a favorable contract
with our primary southern Nevada contracted hospital, Columbia Sunrise Hospital
or Sunrise Hospital. Subject to certain limitations, the contract provides,
among other things, guaranteed contracted per diem rate increases on an annual
basis. The per diem rate increased 3% in 2000 and is scheduled to increase
approximately 4% in 2001. Since a majority of our southern Nevada hospital days
are at Sunrise Hospital and another Columbia/HCA facility, this contract assists
us in managing a significant portion of our medical costs. We can be and have
been affected by Sunrise Hospital's limited capacity and have had to place our
members in other facilities, with a higher cost to us, due to a shortage of beds
at these two hospitals. In Texas, we have contracts with 18 Columbia/HCA
hospitals and approximately 14 other hospitals for inpatient care in Dallas/Ft.
Worth.

We believe that we have negotiated favorable rates with our contracted
hospitals. For hospitals other than Sunrise Hospital, our contracts with our
hospital providers typically renew automatically with both parties granted the
right to terminate after a notice period ranging from three to twelve 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 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, we solicit
competitive bids.

We utilize two reimbursement methods for health care providers rendering
services under our indemnity plans. For services to members utilizing a PPO
plan, we reimburse 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, we
reimburse non-contracted physicians and hospitals at pre-established rates, less
deductibles and co-insurance amounts.

We manage health care costs through our large case management program, urgent
care centers and by educating our members on how and when to use the services of
our plans and how to manage chronic disease conditions. We audit hospital bills
and review hospital and high volume providers claims to ensure appropriate
billing and utilization patterns. We also monitor the referral process from the
primary care physician to the specialty network for appropriateness. Further, in
Nevada, we utilize our home health care agency and our hospice, which help to
minimize hospital admissions and the length 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 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 with deductibles and cost
shares) 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 32,000 individual providers, 2,000 institutions and
7,000 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
our 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

We maintain general and professional liability and property and fidelity
insurance coverage in amounts that we believe are adequate for our operations.
Our multi-specialty medical groups maintain excess malpractice insurance for the
providers presently employed by the group. In Nevada and Arizona, we have
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 our limits of coverage. In
Texas, we have assumed no self-insured retention per claim. The aggregate
maximum limits for each of these policies is $30 million per year. In addition,
we require all of our 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 we contract
are self-insured. We also maintain stop-loss insurance that reimburses us
between 50% and 90% of hospital charges for each individual member of our 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.

We also maintain excess catastrophic coverage for one of our wholly-owned HMOs,
Health Plan of Nevada, Inc., or HPN, that reimburses us 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 our business, however, we are subject to claims that are not insured,
principally claims for punitive damages.

Effective July 1, 1998, workers' compensation claims with dates of injury
occurring on or after that date, were reinsured under a quota share and excess
of loss agreement, which we refer to as "low level" reinsurance, with Travelers
Indemnity Company of Illinois, which is rated A+ by the A.M. Best Company. The
low level reinsurance provided quota share protection for 30% of the first
$10,000 of each loss, excess of loss protection of 75% of the next $40,000 of
each loss and 100% of the next $450,000 on a per occurrence basis. The maximum
net loss retained on any one claim, up to $500,000, ceded under this treaty was
$17,000. This agreement continued until June 30, 2000, when we executed an
option for a twelve month extension relating to the run-off of policies in force
as of June 30, 2000, which covers claims arising under our policies during the
term of the extension.

In addition to the low level reinsurance, effective January 1, 2000 we entered
into a reinsurance contract that provides statutory (unlimited) coverage for
workers' compensation claims in excess of $500,000 per occurrence. The contract
is in effect for claims occurring on or after January 1, 2000 through December
31, 2002. The reinsurer, National Union Fire Insurance Company, which is rated
A+ by the A.M. Best Company, has a limited ability to cancel this treaty on each
anniversary of inception during that period. Effective July 1, 2000, we entered
into a reinsurance contract, also with National Union Fire Insurance Company,
that provides $250,000 of coverage for workers' compensation claims in excess of
$250,000 per occurrence. The contract is in effect for claims occurring on
policies with effective dates beginning July 1, 2000 and thereafter. The
reinsurer has the ability to cancel the treaty if written notice is provided 90
days prior to each anniversary of inception.

Information Systems

We use data processing systems, which assist us in, among other things, pricing
our services, monitoring utilization and other cost factors, providing bills on
a timely basis, identifying accounts for collection and handling various
accounting and reporting functions. Our imaging and workflow systems are used to
process and track claims and coordinate customer service. Where it is cost
efficient, our systems are connected to large provider groups, doctors' offices,
payors and brokers to enable efficient transfer of information and
communication. In 2000, we began to provide secure access to basic eligibility
and claims information to selected providers via an Internet pilot web site. In
2001, this Internet-based access will be expanded, with security, so members can
access more information and perform self-service transactions. We view our
information systems capability as critical to the performance of ongoing
administrative functions and integral to quality assurance and the coordination
of patient care. We are continually modifying or improving our information
systems capabilities in an effort to improve operating efficiencies and service
levels.

Quality Assurance and Improvement

We promote continuous improvement in the quality of member care and service
through our quality programs. Our quality programs are a combination of quality
assurance activities, including the retrospective monitoring and problem solving
associated with the quality of care delivered, continuous quality improvement
activities, and analysis of ongoing aggregate data for purposes of prospective
planning.

Our quality assurance methodology is based on (i) reviews of adverse health
outcomes as well as appropriateness and quality of care; (ii) focused reviews of
high volume/high risk diagnoses or procedures; (iii) monitoring for trends; (iv)
peer review of the clinical process of care; (v) development and implementation
of corrective action plans, as appropriate; (vi) monitoring compliance/adherence
to corrective action plans; and (vii) assessment of the effectiveness of the
corrective action plans.

Our quality improvement methodology is based on (i) collection and analysis of
data; (ii) analysis of barriers to achieving goals and/or benchmarks; (iii)
development and implementation of interventions to address barriers; (iv)
remeasurement of data to assess effectiveness of interventions; (v) development
and implementation of new or additional interventions, as appropriate; and (vi)
follow-up remeasurement of data to assess effectiveness or sustained impact.

Several independent organizations have been formed for the purpose of responding
to external demands for accountability in the health care industry. We have
voluntarily elected to be evaluated by one of these external organizations, the
National Committee for Quality Assurance, or NCQA. NCQA is an independent,
not-for-profit organization that evaluates managed care organizations.

The NCQA accreditation process includes rigorous evaluations conducted by a team
of physicians and managed care experts. According to NCQA officials, the
standards are purposely set high to encourage health plans to continuously
enhance their quality. No comparable evaluation exists for fee-for-service
health care. NCQA evaluates plans on approximately 50 quality standards that
fall into six categories: Quality Management and Improvement; Physician
Credentials; Members' Rights and Responsibilities; Preventive Health Services;
Utilization Management; and Medical Records. In 2000, HPN earned an "Accredited"
status from the NCQA for its HMO and Medicare products. The NCQA accreditation
for TXHC expired in April of 2000. We have voluntarily postponed our
accreditation renewal process for TXHC and intend to seek NCQA accreditation in
early 2002.

There can be no assurance, however, that we will maintain 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/Fort Worth respectively.

Underwriting

HMO. We structure premium rates for our various health plans primarily through
community rating and community rating by class methods. Under the community
rating method, all costs of basic benefit plans for our 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 including 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. We believe that co-payments encourage
appropriate utilization of health care services while allowing us to offer
competitive premium rates. We also believe that the capitation method of
provider compensation encourages physicians to provide only medically necessary
and appropriate care.

Managed Indemnity. Premium charges for our 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 including age,
sex and industry factors to develop group-specific adjustments from a given per
member per month base rate by plan. Actual health claim 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, we review, among
other factors, the employer's prior loss experience and other pertinent
underwriting information. Additionally, we determine whether the employer's
employment classifications are among the classifications that we have elected to
insure and if the amounts of the premiums for the classifications are within our
guidelines. We review these classifications periodically to evaluate whether
they are profitable. Of the approximately 550 employment classifications in
California, we are willing to insure approximately two-thirds. The remaining
classifications are either excluded by our reinsurance treaty or are believed by
us to be too hazardous or not profitable. In addition, we increase our
requirements for certain classifications to increase the likelihood of
profitability.

Once an employer has been insured by us, our loss control department may assist
the insured in developing and maintaining safety programs and procedures to
minimize on-the-job injuries and industrial health hazards. The safety programs
and procedures vary from insured to insured. Depending upon the size,
classifications and loss experience of the employer, our loss control department
will periodically inspect the employer's places of business and may recommend
changes that could prevent industrial accidents. In addition, severe or
recurring injuries may also warrant on-site inspections. In certain instances,
members of our loss control department may conduct special educational training
sessions for insured employees to assist in the prevention of on-the-job
injuries. For example, employers engaged in contracting may be offered a
training session on general first aid and prevention of injuries from specific
work exposures.

Competition

HMO and Managed Indemnity. Managed care companies and HMOs operate in a highly
competitive environment. Our major competition is from self-funded employer
plans, PPO networks, other HMOs, such as Nevada Care, Inc., Pacificare Health
Systems, Inc., Aetna and United Healthcare Corp. and traditional indemnity
carriers, such as Blue Cross/Blue Shield. Many of our competitors have
substantially larger total enrollments, greater financial resources and offer a
broader range of products. Additional competitors with greater financial
resources may enter our markets in the future. We believe 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. We depend on a large PPO network and flexible
benefit plans to attract new members. Competitive pressures may result in
reduced membership levels. Any reductions could materially affect our results of
operations.

Workers' Compensation. Our 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. The premium rate
increases on policies renewed in California during 2000 were approximately 26%.
For the second half of the year, rate increases averaged approximately 36%.
Based on public information, other California workers' compensation companies
are issuing year 2000 policies at rates 20% to 40% in excess of the expiring
rates. For the first two months of 2001, the average renewal rate increase for
our California policies was approximately 42%.

Approximately 180 companies wrote workers' compensation insurance in California
in 2000, including the State Compensation Insurance Fund, which is the largest
writer in California. Many of our competitors have been in business longer, have
a larger volume of business, offer a more diversified line of insurance coverage
and have greater financial resources and distribution capability than we do.

Losses and Loss Adjustment Expenses

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, we establish 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 not reported or IBNR.

When a claim is reported, our 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 the 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 National Association of Insurance Commissioners requires that we submit a
formal actuarial opinion concerning loss reserves with each statutory annual
report. The annual report must be filed with each applicable state department of
insurance on or before March 1 of the succeeding year. The actuarial opinion
must be signed by a qualified actuary as determined by the applicable state
insurance regulators. We retain the services of a qualified independent actuary
to periodically review our loss reserves.

We review the adequacy of our reserves on a periodic basis and consider external
forces including 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, or LAE to change.
Reserves are reviewed with our independent actuary at least annually. The
actuarial projections include a range of estimates reflecting the uncertainty of
projections. We evaluate the reserves in the aggregate, based upon the actuarial
indications, and make adjustments where appropriate. Our Consolidated Financial
Statements provide for reserves based on the anticipated ultimate cost of
losses. We also supplement our analyses by comparing our paid losses and
incurred losses to similar data provided by the California Workers' Compensation
Insurance Rating Bureau for all California workers' compensation insurance
companies.

Government Regulation and Recent Legislation

HMOs and Managed Indemnity. Federal and state governments have enacted statutes
that extensively regulate the activities of HMOs. Growing government concerns
over increasing health care costs and quality of care could result in new or
additional state or federal legislation that would impact health care companies,
including HMOs, PPOs and other health insurers. Among the areas regulated by
federal and state law are the scope of benefits available to members, grievances
and appeals, prompt payment of claims, 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 interpreting laws and
promulgating regulations to enforce their interpretations.

While we are unable to predict what regulatory changes may occur or the impact
on us of any particular change, our operations and financial results could be
negatively affected by regulatory revisions. For example, any proposals to
eliminate or reduce the Employee Retirement Income Security Act, or ERISA, which
regulates insured and self-insured health coverage plans offered by employers,
pre-emption of state laws that would increase litigation exposure, affect
underwriting practices, limit rate increases, require new or additional benefits
or affect 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 our business. The
continued consideration and enactment of "anti-managed care" laws and
regulations by federal and state bodies may make it more difficult for us to
control medical costs and may adversely affect financial results.

In addition to changes in applicable laws and regulations, we are subject to
various audits, investigations and enforcement actions. These include possible
government actions relating to ERISA, the Federal Employees Health Benefit Plan,
federal and state fraud and abuse laws and laws relating to utilization
management and the delivery and payment of health care. In addition, our
Medicare business is subject to Medicare regulations promulgated by HCFA.
Violation of government laws and regulations could result in an 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
our reputation in various markets and make it more difficult for us to sell our
products and services.

We have HMO licenses in Nevada, Texas and Arizona. Our HMO operations are
subject to regulation by the Nevada Division of Insurance, the Nevada State
Board of Health, the Texas Department of Insurance and the Arizona Department of
Insurance. Our 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 the other states in which it
operates or holds licenses. Our HMO and insurance premium rate increases are
subject to various state insurance department approvals. Our Nevada HMO and
health insurance subsidiaries currently maintain a home office and a regional
home office, respectively, in Las Vegas and, accordingly, are eligible for
certain premium tax credits in Nevada. This property was not sold as part of our
December 2000 sale-leaseback transaction. We intend 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 our results of operations.

We are subject to the Federal HMO Act and its regulations. Our 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 our health care providers.
Furthermore, an HMO may not refuse to enroll an employee, in most circumstances,
because of a 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 we seek
to structure our operations to comply with corporate practice of medicine laws
in all states in which we operate, there can be no assurance that, given the
varying and uncertain interpretations of those laws, we would be found to be in
compliance with those laws in all states. A determination that we are not in
compliance with applicable corporate practice of medicine laws in any state in
which we operate could have a material adverse effect on us if we were unable to
restructure our operations to comply with the laws of that state.

Certain 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, civil sanctions, fines and possible
exclusion from the Medicare, Medicaid and other federal health care programs.
Similar penalties are provided for violation of state anti-kickback and
anti-referral laws. The Department of Health and Human Services or HHS has
issued regulations establishing and defining "safe harbors" with respect to the
Anti-kickback Statute and the Stark Amendments. We believe that our business
arrangements and operations are in compliance with the Anti-kickback Statute and
the Stark Amendments as defined by the relevant safe harbors. However, there can
be no assurance that (i) government officials charged with responsibility for
enforcing the prohibitions of the Anti-kickback Statute and the Stark Amendments
or Qui Tam relators purporting to act on behalf of the Government will not
assert that we, or certain conduct in which we are involved, are in violation of
those statutes; and (ii) such statutes will ultimately be interpreted by the
courts in a manner consistent with our interpretation.

In 1997, Congress passed the Balanced Budget Act, or BBA, which revised the
structure of and reimbursement for private health plan options for Medicare
enrollees. Premiums paid by HCFA to health plans were adjusted to (i) take into
account 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; (ii) provide for gradual removal of the graduate
medical education factor from health plan payments; (iii) provide for the
gradual phase-in of a risk adjustment payment methodology; and (iv) provide a
minimum increase of 2% annually in health plan reimbursement through 2003. As a
result, since 1998, health plan reimbursement from HCFA has generally not
matched the rate of increase for medical costs. The BBA also established a new
Medicare managed care program, entitled Medicare+Choice, or M+C, which was
effective January 1, 1999. Under M+C, we are required to implement new
requirements including, but not limited to, discharge notices, encounter data,
additional provider contract language and extensive new quality improvement
programs. The restructured payments and additional obligations contained in the
BBA increased the burden of administering our Medicare plans. In 1999, Congress
sought to lessen the adverse impact on health plans of the BBA by changing a
number of M+C provisions in the Balanced Budget Refinement Act, or BBRA. In
December 2000, Congress enacted the Beneficiary Improvement and Protection Act,
or BIPA, which, like the BBRA, was an effort to improve the M+C program and
reduce the number of non-renewals by companies that were experiencing
significant difficulties in operating a viable M+C program. In part, this law
revises actions taken in BBA and BBRA that have impacted our operations. With
respect to us, BIPA primarily impacts our Medicare programs. BIPA freezes the
inpatient data risk adjustment payment methodology at the 10% level through 2003
and increases our capitation by a minimum of 3% per member per month starting
March 1, 2001. Subsequent to 2001, the minimum payment reverts to 2%. This law
also extends our Social HMO demonstration program, which has been in place since
1996, an additional year through 2003. Despite BBRA and BIPA, the M+C program
continues to experience difficulties and participation in it may adversely
impact our operations. Because of the potential impact that changes in the
overall Medicare program could have on our various operations, we monitor all
federal activities associated with the Medicare program. The risk adjustment
factors described above have not been applied to the Social HMO capitation
payments for the Year 2000 and we do not believe that the risk adjustment
mechanism will be applied to Social HMO capitation payments in the near future.

The Health Insurance Portability and Accountability Act of 1996, or HIPAA, was
passed by Congress on August 21, 1996 and was effective beginning July 1, 1997.
While HIPAA 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. These provisions and other
factors have resulted in significantly increased enforcement actions involving
the healthcare industry.

HIPAA also contained provisions which mandated the establishment of standards
and requirements for electronic transactions involving certain health
information. Accordingly, on August 17, 2000, the Department of Health and Human
Services, or HHS, issued final regulations establishing standards for electronic
transactions. On December 28, 2000, HHS issued final regulations establishing
standards for the privacy of individually identifiable health information and
the compliance dates under these regulations for health plans, providers and
clearinghouses were originally October 16, 2002 and February 28, 2003,
respectively. However, on February 28, 2001, HHS published a notice reopening
these final privacy regulations. Currently, they are due to become effective on
April 14, 2001, and compliance is required two years thereafter, or April 14,
2003, for health plans, heath care providers and health care clearinghouses. In
view of the reopening of the final privacy regulations, the current compliance
date may be changed. Final regulations establishing a unique identifier for
health plans and standards for security of electronic information systems are
expected to be issued by HHS in 2001 and the compliance date for those
regulations will be established when they are published in final form. Failure
to comply with the standards and implementation specifications of these
regulations could result in investigation by the Office of Civil Rights of HHS
and the imposition of criminal penalties and civil sanctions, including fines.
At this time, we cannot quantify the cost of compliance or the impact it will
have on our business. There can be no assurance that the costs to implement and
to comply will not adversely affect our operating results or financial
condition.

In November 2000, the Department of Labor published the final regulation on
ERISA claims procedures. The first major revision of the existing claims
procedure requirements since 1977, the regulation applies to all employee
benefit plans governed by ERISA, whether the benefits are provided through
insurance products or are self-funded. Some of the provisions require (i)
compressed timeframes for decisions on urgent care and pre-service claims; (ii)
safeguards to ensure that decisions are made consistently and in

accordance with plan provisions; and (iii) two levels of internal appeal and the
use of mandatory arbitration, voluntary arbitration and, under certain
conditions, other forms of alternative dispute resolution. This regulation does
not preempt state laws unless the state laws prevent the application of the
regulation's requirements. This regulation impacts our third party administrator
services and potentially other operations and will apply to all claims filed on
or after January 1, 2002.

Workers' Compensation. We are subject to extensive governmental regulation and
supervision in each state in which we conduct workers' compensation business.
The primary purpose of the 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 it
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 matters such 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.

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. The California
Insurance Guaranty Association has issued an assessment as a result of the
insolvency of the insurers owned by Superior National Insurance Group. The
assessment is 1% of 1999 written premium to be paid in installments. The first
installment was paid on December 31, 2000 and the second is due June 30, 2001.
The payments of approximately $1.2 million will be recouped during 2001 and 2002
through assessments to policyholders. It is likely that guaranty fund
assessments related to this insolvency will continue.

General. Besides state insurance laws, we are 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 our subsidiaries.

In the normal course of business, we may disagree with various government
agencies that regulate our activities 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. We attempt to resolve all issues with the regulatory
agencies, but are willing to litigate issues where we believe we have a strong
position. The ultimate outcome of these disagreements could result in sanctions
and/or penalties and fines assessed against us. Currently, there are no
litigation matters pending with any government agencies.

Deposits. Our HMO and insurance subsidiaries are required by state regulatory
agencies to maintain certain deposits and meet certain net worth and reserve
requirements. We have restricted assets on deposit in various states ranging
from $20,000 to $2.6 million and totaling $24.7 million at December 31, 2000.
Our HMO and insurance subsidiaries are required by statute to meet a minimum
Risk-Based Capital requirement on a statutory accounting basis. 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, on a statutory basis, until it achieves two
consecutive quarters of break-even status.

Dividends. Our 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 the insurer for the 12-month period ending on the preceding
December 31.

In addition, our workers' compensation insurance subsidiaries may not pay a
dividend without the prior approval of the state insurance commissioner to the
extent the cumulative amount of dividends or distributions paid or proposed to
be paid in any year exceeds the amount shown as unassigned funds (reduced by any
unrealized gains included in such amount) on the insurer's statutory statement
as of the previous December 31. California Indemnity Insurance Company, a direct
subsidiary of CII, can pay a dividend of $174,000 without the prior approval of
the California Department of Insurance. We are not in a position to assess the
likelihood of obtaining future approval for the payment of dividends other than
those specifically allowed by law in each of our subsidiaries' state of
domicile. In connection with CII's proposed exchange offer to exchange all of
CII's debentures that mature on September 15, 2001 with cash or new debentures,
California Indemnity filed an application with the California Department of
Insurance to pay an extraordinary dividend of up to $5 million. On February 22,
2001, the California Department of Insurance approved the request for payment by
California Indemnity of an extraordinary dividend of up to $5 million.

No prediction can be made as to whether any legislative proposals relating to
dividend rules in the domiciliary states of our 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 our regulated subsidiaries to declare and pay dividends or as to the
effect of any such proposals or restrictions on our regulated subsidiaries.

Employees

We had approximately 3,800 employees as of March 20, 2001. None of these
employees are covered by a collective bargaining agreement. We believe that our
relations with our employees are good.

ITEM 2. DESCRIPTION OF PROPERTIES

On December 28, 2000, we finalized a sale-leaseback transaction that included
the majority of our administrative and clinical properties in Las Vegas totaling
approximately 478,000 square feet. The lease is for a term of fifteen years and
we have the option of five 5-year renewal periods. We lease additional office
and clinical space in Nevada totaling approximately 134,000 and 124,000 square
feet, respectively. HPN and Sierra Health and Life Insurance Co. Inc., or SHL
have retained ownership of a 134,000 square foot administrative building at
their Las Vegas headquarters, which serves as the home office and a regional
home office for our Nevada HMO and health insurance subsidiaries, respectively.

In conjunction with the Kaiser-Texas acquisition, we 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 with an original balance of $35.2
million and a balance of $34.2 million on December 31, 2000. Approximately
81,000 square feet of the clinical and 67,000 square feet of the administrative
space are subleased by us to outside parties. The Texas assets have been written
down to market value and are classified as held for sale on our balance sheet
while we actively seek a buyer for the properties.

The workers' compensation subsidiary is headquartered in Nevada and subleases
space from us in one of the buildings included in the sale-leaseback transaction
as well as approximately 77,000 square feet of leased office space in
California, Colorado and Texas.

We lease approximately 150,000 square feet of office space in other various
states as needed for the military subsidiary's administrative headquarters,
TRICARE service centers and other regional operations.

We believe that current and planned clinical space will be adequate for our
present needs. However, additional clinical space may be required if membership
expands in southern Nevada.

ITEM 3. LEGAL PROCEEDINGS

We are 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 of medical services rendered to injured workers. In the
opinion of our management, the ultimate resolution of pending legal proceedings
should not have a material adverse effect on our financial condition or results
of operations.

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

None

PART II

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

Market Information

Our 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 our
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 2000 and
1999.

Period High Low
------ ---- ---

2000

First Quarter........................................ $8.25 $4.31
Second Quarter....................................... 5.13 2.75
Third Quarter........................................ 4.75 2.44
Fourth Quarter....................................... 6.00 2.75

1999
First Quarter........................................ $22.13 $11.56
Second Quarter....................................... 16.25 10.44
Third Quarter........................................ 14.56 10.06
Fourth Quarter....................................... 10.00 4.63

On March 15, 2001, the closing sale price of Common Stock was $4.52 per share.

Holders

The number of record holders of Common Stock at March 15, 2001 was 224. Based
upon information available to us, we believe there are approximately 5,300
beneficial holders of the Common Stock.

Dividends

No cash dividends have been paid on the Common Stock since our inception. We
currently intend to retain our earnings for use in our business and do not
anticipate paying any cash dividends in the foreseeable future. As a holding
company, our ability to declare and to pay dividends is dependent upon cash
distributions from our operating subsidiaries. The ability of our HMOs and our
insurance subsidiaries to declare and 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 our Board of Directors and will
depend on, among other things, future earnings, debt covenants, operations,
capital requirements, our financial condition and general business conditions.

ITEM 6. SELECTED FINANCIAL DATA

The table below presents our selected consolidated financial information for the
years indicated. The table 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 our audited Consolidated
Financial Statements.

Years Ended December 31,
----------------------------------------------------------------
2000 1999 1998 1997 1996
---------- ---------- ---------- ---------- -----------
(In thousands, except per share data)
Statements of Operation Data:
OPERATING REVENUES:

Medical Premiums.................................... $ 869,875 $ 827,779 $ 609,404 $ 513,857 $ 386,968
Military Contract Revenues ......................... 330,352 287,398 204,838 4,346
Specialty Product Revenues ......................... 135,844 94,221 148,368 146,211 133,324
Professional Fees................................... 35,607 51,842 45,363 31,238 28,836
Investment and Other Revenues....................... 21,300 22,571 29,230 26,072 26,283
------------ ------------ ------------- ---------- ----------
Total............................................. 1,392,978 1,283,811 1,037,203 721,724 575,411
---------- ---------- ----------- --------- ---------

OPERATING EXPENSES:
Medical Expenses.................................... 810,390 749,797 513,209 419,272 315,915
Military Contract Expenses ........................ 323,265 276,493 196,625 4,193
Specialty Product Expenses.......................... 152,733 96,487 142,258 143,082 130,758
General, Administrative and Marketing Expenses...... 136,660 137,812 110,687 93,919 72,237
Asset Impairment, Restructuring,
Reorganization and Other Costs (1) .............. 220,440 18,808 13,851 29,350 12,064
----------- ------------ ---------- ----------- ----------
Total............................................. 1,643,488 1,279,397 976,630 689,816 530,974
---------- ---------- --------- ---------- ---------

OPERATING (LOSS) INCOME ............................... (250,510) 4,414 60,573 31,908 44,437

INTEREST EXPENSE AND OTHER, NET........................ (23,630) (14,980) (7,181) (4,433) (2,823)
----------- ------------- ---------- ----------- ----------

(LOSS) INCOME FROM OPERATIONS
BEFORE INCOME TAXES .............................. (274,140) (10,566) 53,392 27,475 41,614
BENEFIT (PROVISION) FOR INCOME TAXES................... 74,225 5,935 (13,796) (3,234) (10,471)
----------- ------------ ----------- ----------- ----------

NET (LOSS) INCOME ..................................... $(199,915) $ (4,631) $ 39,596 $ 24,241 $ 31,143
========= =========== ========== ========= =========

EARNINGS PER COMMON SHARE (2):
Net (Loss) Income Per Share ........................... $(7.37) $(.17) $1.45 $.90 $1.17
====== ===== ===== ==== =====

Weighted Average Number of Common
Shares Outstanding ............................... 27,142 26,927 27,391 27,013 26,589
====== ====== ====== ====== ======

EARNINGS PER COMMON SHARE ASSUMING
DILUTION (2):
Net (Loss) Income Per Share ........................... $(7.37) $(.17) $1.43 $.88 $1.15
====== ===== ===== ==== =====

Weighted Average Number of Common
Shares Outstanding Assuming Dilution ............. 27,142 26,927 27,747 27,426 27,191
====== ====== ====== ====== ======

December 31,
- ------------------------------------------------------------------------------------------------------------------------------------
2000 1999 1998 1997 1996
---------- ---------- ---------- ---------- ---------
(In thousands)

Balance Sheet Data:

Working Capital ............................................. $ 76,414 $ 112,105 $ 198,092 $211,911 $189,943
Total Assets................................................. 1,165,100 1,130,112 1,045,120 723,936 629,462
Long-term Debt (Net of Current Maturities)................... 225,355 258,854 242,398 90,841 66,189
Cash Dividends Per Common Share.............................. none none none none none
Stockholders' Equity......................................... 90,473 278,412 303,714 265,682 234,482

(1) We recorded certain identifiable asset impairment, restructuring,
reorganization and other costs. See Note 16 of Notes to the Consolidated
Financial Statements.

(2) Adjusted to account for three-for-two stock split of our 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 our 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 2000 Annual Report on Form 10-K should be considered in
connection with certain cautionary statements contained in our Current Report on
Form 8-K filed March 20, 2001, which is incorporated 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 our actual results to differ materially from those
expressed in any projected, estimated or forward-looking statements relating to
us.

Overview

We derive revenues from our health maintenance organizations, managed indemnity,
military health care services and workers' compensation insurance subsidiaries.
To a lesser extent, we also derive 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.

Our 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 members, as well as the aggregate expenses to operate and
manage our multi-specialty medical groups and other provider subsidiaries. As a
provider of health care management services, we seek to positively affect
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, monitoring and managing utilization of
physicians and hospital services and 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 our 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.

Calendar year 2000 was one of significant challenges and successes for Sierra.
In the first quarter, we engaged a consulting firm to assist us in evaluating
our Texas operations. One of the results of this evaluation was the development
of action plans to improve our Texas operations. This started with a major
restructuring of the Dallas/Ft. Worth HMO operations of TXHC, which included
replacement of the senior management, reduction in staffing along with
consolidation of certain services to Las Vegas and a revision of product
strategy. In the second quarter, we implemented another part of the plan by
closing certain of our Texas clinic facilities and reducing the physician and
support staff. We initiated plans to terminate our contracting relationship with
our affiliated medical provider operations in Dallas/Ft. Worth. We stopped
actively marketing our Medicare HMO product in Texas while we assessed its cost
structure. We then re-evaluated our goodwill asset related to our Texas
operations and determined that future cash flows would be insufficient to
recover this asset and we completely wrote-off the asset. We also decided to
sell our Texas real estate. The market valuations we received resulted in fixed
asset impairment charges of approximately $37 million. Concurrently, our real
estate holdings in Arizona and one of our underperforming Las Vegas, Nevada
clinics were also determined to be impaired based on market valuations, which
resulted in fixed asset impairment charges and a re-evaluation of goodwill
related to our Prime Holdings, Inc. acquisition of 1997 and a subsequent
goodwill impairment charge.

As a result of the asset impairment and other changes in estimate charges we
took in the second quarter, we were not in compliance with our bank line of
credit facility financial covenants. We were able to obtain temporary waivers
from the banks by paying additional fees, pledging certain assets and having
some of our subsidiaries guarantee the credit facility debt, which at June 30,
2000, was $185 million. While continuing to negotiate with the banks on a new
credit agreement, we undertook steps to conserve our cash by delaying
non-essential capital expenditures and reducing our corporate general and
administrative expenses. We also commenced initiatives to sell our non-core
assets including the majority of our Las Vegas real estate in a sale-leaseback
transaction, our corporate airplane, our corporate residence in Utah used to
entertain clients and our Houston HMO membership.

In the third quarter, we completed the sale of our affiliated medical provider
group in Dallas/Ft. Worth and our corporate residence in Utah. In the fourth
quarter, we completed the sale of our corporate airplane, the Houston HMO
membership and the sale-leaseback of the majority of our Las Vegas real estate.
In addition, we were able to renegotiate the credit facility agreement with the
banks in December and we are now in compliance with all financial covenants. We
used $50 million of the sale-leaseback proceeds to permanently pay down the
credit facility debt and at December 31, 2000, our credit facility debt balance
was $135 million.

Results of Operations

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

Years Ended December 31,
------------------------
2000 1999 1998
---------- ---------- ----------

OPERATING REVENUES:

Medical Premiums........................................ 62.4% 64.5% 58.8%
Military Contract Revenues.............................. 23.7 22.4 19.7
Specialty Product Revenues ............................. 9.8 7.3 14.3
Professional Fees....................................... 2.6 4.0 4.4
Investment and Other Revenues .......................... 1.5 1.8 2.8
-------- ------- -------
Total................................................ 100.0 100.0 100.0
----- ----- -----

OPERATING EXPENSES:
Medical Expenses........................................ 58.2 58.4 49.5
Military Contract Expenses ............................. 23.2 21.6 19.0
Specialty Product Expenses.............................. 11.0 7.5 13.7
General, Administrative and Marketing Expenses.......... 9.8 10.7 10.7
Asset Impairment, Restructuring,
Reorganization and Other Costs....................... 15.8 1.5 1.3
------ ----- ------

Total................................................ 118.0 99.7 94.2
----- ---- -----

OPERATING (LOSS) INCOME ..................................... (18.0) .3 5.8

INTEREST EXPENSE AND OTHER, NET.............................. (1.7) (1.1) (.7)
------ ----- ------

(LOSS) INCOME FROM OPERATIONS
BEFORE INCOME TAXES .................................... (19.7) (.8) 5.1

BENEFIT (PROVISION) FOR INCOME TAXES......................... 5.3 .4 ( 1.3)
------ ----- -----

NET (LOSS) INCOME ........................................... (14.4)% (.4)% 3.8%
===== ===== =====

Year Ended December 31, 2000 Compared to 1999

Total Operating Revenues for 2000 increased approximately 8.5% to $1.39 billion
from $1.28 billion for 1999. Medical premium revenues accounted for
approximately 62.4% and 64.5% of our total revenues for the years ended December
31, 2000 and 1999, respectively. The decrease in medical premiums as a
percentage of total revenues in 2000 is primarily due to the increase in
specialty product and military contract revenues and a decrease in HMO
membership in Texas. Continued medical premium revenue growth is principally
dependent upon continued enrollment in our products and upon competitive and
regulatory factors.

The change in operating revenues was comprised of the following:

o An increase in medical premiums of $42.1 million
o An increase in military contract revenues of $43.0 million
o An increase in specialty product revenues of $41.6 million
o A decrease in professional fees of $16.2 million
o A decrease in investment and other revenues of $1.3 million

Medical premiums from our HMO and managed indemnity insurance subsidiaries
increased $42.1 million or 5.1%. The $42.1 million increase in premium revenue
reflects a 5.3% increase in Medicare member months (the number of months of each
year that an individual is enrolled in a plan) offset by a 6.2% decrease in
commercial member months. The 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. HMO premium rates for commercial groups increased approximately 4% in
Nevada, 17% in Dallas/Ft. Worth and 4% in Houston. Our managed indemnity rates
increased approximately 12% and Medicare rates increased approximately 2%. Over
95% of our Las Vegas, Nevada Medicare members are enrolled in the Social HMO
Medicare program. The Health Care Financing Administration, or HCFA, may
consider adjusting the reimbursement factor or changing the program 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 our business.

Military contract revenues increased $43.0 million or 14.9%. The increase was
primarily attributable to additional accrued bid price adjustment revenues
related to a true-up of prior periods' information received from the government
in the third quarter of 2000. Partially offsetting this was a decrease recorded
in the first quarter for a reduction in the at-risk health care population of
beneficiaries as additional beneficiaries enrolled with military treatment
facility primary care managers. We are not at-risk for those TRICARE eligibles
and receive less revenue related to them from the government. Military contract
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, we record revenue based on estimates of the earned portion of any
contract change orders not originally specified in the contract.

Specialty product revenues increased $41.6 million or 44.2%. Revenue increased
in the workers' compensation insurance segment by $42.7 million, which was
offset by a slight decrease in administrative services revenue of $1.1 million.
The increase in the workers' compensation insurance segment was primarily due to
a larger amount of direct written premiums with an 18% composite increase in
premium rates for all states and a 24% increase in production growth.

Net earned premiums are the end result of direct written premiums, plus the
change in unearned premiums, less premiums ceded to reinsurers. Direct written
premiums increased by 37% due primarily to growth in California and Nevada.
Partially offsetting the growth in direct written premiums was an increase in
premiums ceded to reinsurers, which increased by 22%. The growth in ceded
reinsurance premiums was lower than the growth in direct written premiums
primarily due to the expiration of our low level reinsurance agreement on June
30, 2000 and new lower cost reinsurance agreements, all of which reduced the
percentage of premiums being ceded.

As compared to the low level reinsurance agreement that expired on June 30,
2000, the new lower cost reinsurance agreements result in higher net earned
premium revenues, as we retain more of the premium dollars, but also leads to
our keeping more of the incurred losses. This may result in a higher loss and
loss adjustment expense, or LAE, ratio if the percentage increase in the
additional incurred losses should be greater than the percentage increase in the
additional premiums we retained. The effect on the balance sheet will result in
a lower amount of reinsurance recoverables. However, due to the length of time
that it typically takes to fully pay a claim, we should see an increase in
operating cash flow and amounts available to be invested.

Professional fees decreased $16.2 million or 31.3%. The revenue for 1999
included the pharmacy operations in Texas until they were sold during the fourth
quarter of 1999 and the inpatient operations at the Mohave Valley Hospital until
they were closed during the first quarter of 1999. The fees in 2000 also reflect
staffing reductions and subsequent closure or sale of our affiliated medical
groups in Texas and Arizona.

Investment and other revenues decreased $1.3 million or 5.6%, due primarily to a
decrease in the average invested balance during the year.

Medical Expenses increased $60.6 million or 8.1%. Excluding the effects of
changes in estimate charges, medical expenses increased approximately $16.9
million or 2.2%. Medical expenses as a percentage of medical premiums and
professional fees decreased from 86.1% to 85.5%, excluding changes in estimate
charges and premium deficiency as described below. The improvement is primarily
due to the closing and sale of operations with higher medical care ratios,
primarily in Texas and rural Nevada, offset by an increase in Medicare members
as a percentage of fully-insured members. The cost of providing medical care to
Medicare members generally requires a greater percentage of the premiums
received.

Medical expenses reported in the first quarter of 2000 included $1.0 million of
prior period reserve strengthening. In the second quarter of 2000, we recorded
changes in estimate charges of $29.5 million for reserve strengthening primarily
due to adverse development on prior years' medical claims, $15.5 million in
premium deficiency medical expenses for the Texas operations and $10.2 million
for other changes in estimate charges.

In the first quarter of 1999, we recorded a premium deficiency medical charge
accrual of $8.1 million related to losses in underperforming markets, primarily
in Arizona and rural Nevada, all of which was used during 1999. In the fourth
quarter of 1999, we recorded a premium deficiency charge accrual of $21.0
million for estimated deficient premiums associated with 2000 contracts in the
Texas market of which, $10.0 million was included in premium deficiency medical
expenses and $11.0 million was recorded in asset impairment, restructuring,
reorganization and other costs. During the fourth quarter of 1999, we recorded
changes in estimate charges of $11.2 million primarily related to an adjustment
to the estimate for medical expenses recorded in previous years and $6.8 million
primarily related to contractual settlements with providers of medical services

The medical expenses for 2000 include the utilization of $20.3 million of
premium deficiency reserve to offset losses on contracts in Texas compared to
the utilization of $43.9 million in 1999. (See Note 15 of Notes to the
Consolidated Financial Statements).

We believe that the remaining premium deficiency medical reserve of $5.2
million, as of December 31, 2000, is adequate and that no revision to the
estimate is necessary at this time.

Military Contract Expenses increased $46.8 million or 16.9%. The increase is
consistent with the increase in revenues discussed previously. Health care
delivery expense consists primarily of costs to provide managed health care
services to eligible beneficiaries in accordance with Sierra's TRICARE contract.
Under the contract, SMHS provides health care services to approximately 621,000
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 us. 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 increased $56.2 million or 58.3%. Of the increase,
approximately $32.1 million is a direct result of the costs associated with the
increase in workers' compensation premiums and associated loss and loss
adjustment expenses.

We recorded net adverse loss development for prior accident years of $23.3
million in 2000 compared to $9.9 million in 1999. The net adverse development
recorded in 1999 and 2000 for prior accident years was largely attributable to
higher costs per claim, or claim severity, in California. Higher claim severity
has had a negative impact on the entire California workers' compensation
industry. The majority of the adverse loss development occurred on accident
years that were not covered by our low level reinsurance agreement. While the
low level reinsurance agreement is in run-off effective July 1, 2000, California
premium rates have been increasing, which we believe will largely mitigate the
loss of this very favorable reinsurance protection. The premium rate increases
on policies renewed in California during the year ended December 31, 2000 were
approximately 26% and for the second half of the year alone, averaged
approximately 36%. In the first two months of 2001, the average renewal rate
increase for our California policies was approximately 42%.

We recorded a higher loss and LAE ratio for the 2000 accident year, which
resulted in an increase of approximately $8.6 million in specialty product
expense. The majority of the increase is due to the termination of the low level
reinsurance agreement on June 30, 2000, which results in a higher risk exposure
on policies effective after that date and a higher amount of net incurred loss
and LAE. In addition, in light of the lower premium rates on policies written in
1999, inflationary trends in health care costs, the fact that we have seen our
reserves develop adversely for the past two years and that projecting ultimate
reserves cannot be done with 100% accuracy, we believed it prudent to establish
reserves at a higher loss ratio to mitigate any future adverse loss development
that may occur.

The loss and LAE reserves booked as of December 31, 2000 reflect our best
estimate of the ultimate loss costs for reported and unreported claims occurring
in accident year 2000 as well as those occurring in accident years prior to 2000
and is slightly in excess of our independent actuary's estimate. Loss and LAE
reserves have a significant degree of uncertainty when related to their
subsequent payments. Although reserves are established on the basis of a
reasonable estimate, it is not only possible but probable that current reserves
will differ from their related subsequent developments. Any subsequent change in
loss and LAE reserves established in a prior year would be reflected in the year
when the change is identified. 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 to generate investment income.

Under our low level reinsurance agreement, we reinsure 30% of the first $10,000
of each claim, 75% of the next $40,000 and 100% of the next $450,000. The
maximum net loss retained on any one claim ceded under this agreement is
$17,000. This agreement covered all policies in force at July 1, 1998 and
continued until June 30, 2000 when we executed an option to extend coverage to
all policies in force as of June 30, 2000. For policies effective from July 1,
2000, we obtained excess of loss reinsurance for 100% of the losses above
$250,000 and less than $500,000. We already had an existing excess of loss
reinsurance agreement that covered 100% of the losses above $500,000. (See Note
6 of Notes to the Consolidated Financial Statements).

The combined ratio is a measurement of underwriting profit or loss and is the
sum of the loss and LAE ratio, underwriting expense ratio and policyholders'
dividend ratio. A combined ratio of less than 100% indicates an underwriting
profit. Our combined ratio was 115.8% compared to 105.5% for 1999. The increase
was primarily due to a higher loss and LAE ratio of 13.4 percentage points and
policyholders' dividend ratio of 1.6 percentage points, offset slightly by a
decrease in the underwriting expense ratio of 4.7 percentage points. The
increase in the loss and LAE ratio was due to an increase in net adverse loss
development which represents 6.6 percentage points of the change in the loss and
LAE ratio; and a higher loss and LAE ratio on the 2000 accident year of $8.6
million, which represents 6.8 percentage points of the change in the loss and
LAE ratio.

General, Administrative and Marketing Expenses, or G&A, decreased $1.2 million
or .8%. As a percentage of revenues, G&A costs for 2000 were 9.8% compared to
10.7% in 1999 due primarily to higher revenues in 2000. As a percentage of
medical premium revenue, G&A costs improved from 16.6% for 1999 down to 15.7%
for 2000. Excluding the utilization of premium deficiency reserves for
maintenance costs of $12.1 million for 2000 and $20.9 million for 1999, G&A
costs decreased $10.1 million or 8.7% for the year. The $10.1 million decrease
was primarily attributable to the consolidation of much of the Texas G&A
services with our existing operations in Las Vegas as well as overall reductions
in the Texas operations. This was offset by an increase in depreciation and
amortization expense of $1.8 million.

Asset Impairment, Restructuring, Reorganization and Other Costs consist of the
following:

Asset Impairments. During the first quarter of 1999, we closed all inpatient
operations at Mohave Valley Hospital, a 12-bed acute care facility in Bullhead
City, Arizona, and terminated over 40 employees. We recorded a charge of $3.5
million for the write-off of goodwill associated with these operations.

In the first quarter of 2000, we engaged a consultant to help us assess our
Texas operations. In late February, the consultant issued its report and we
implemented strategic action plans to turn around the Texas operations. These
actions included the replacement of the Texas senior management, a reduction in
staffing along with a consolidation of certain services to Las Vegas and a
revision of product strategy. The new management was charged with further
assessing the Dallas/Ft. Worth health care delivery system. In May, we decided
that the delivery system, which emphasized our affiliated medical group as the
primary provider network, would be replaced by an expanded network of contracted
physician groups and individuals. In addition, the contracted hospital network
would be significantly expanded. As a result, during the second quarter of 2000,
we adopted and announced a further restructuring of the Dallas/Ft. Worth
operations, which entailed a significant reduction of physicians and staff and
the closing of several clinic sites. In addition, management decided that the
real estate assets would be sold.

Management also adopted a plan in the second quarter of 2000 to discontinue
medical delivery operations in Mohave County, Arizona and to sell the real
estate assets located there, as well as an underperforming medical clinic in Las
Vegas.

In connection with the restructuring plans we adopted and announced in the
second quarter of 2000, we re-evaluated the recoverability of certain long-lived
assets, primarily associated with the Texas operations, in accordance with
Statement of Financial Accounting Standards No. 121, "Accounting for the
Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of", or
SFAS No. 121, and Accounting Principles Board Opinion No. 17, "Intangible
Assets", or APB No. 17, and determined that the carrying values of certain
goodwill and other long-lived assets were impaired.

In assessing the asset impairment of the long-lived assets, we first allocated a
portion of related goodwill to the fixed assets to be disposed of, in accordance
with SFAS No. 121. The fixed assets were then written down to their estimated
fair value less costs to sell, which was determined from independent valuations.
The remainder of the related goodwill was then assessed for recoverability in
accordance with APB No. 17 based on projected discounted cash flows.

The charges recorded for the write-off of goodwill totaled $126.4 million for
the Texas operations and $15.1 million related primarily to the Prime Holdings,
Inc. acquisition.

The charges recorded for fixed asset impairment totaled $36.5 million for the
Texas operations and $9.5 million for the Arizona and Nevada operations.

During the second quarter of 2000, we wrote-off capitalized costs of $3.0
million related to the application development of an information system software
project for the workers' compensation operations, that was canceled because the
vendor was unable to fulfill its contractual obligations. The amounts written
off included software and consulting costs of $1.6 million and capitalized
internal personnel costs of $1.4 million.

Restructuring and Reorganization. In the first quarter of 1999, we incurred
$450,000 for certain legal and contractual settlements and $400,000 to provide
for our portion of the write-off of start-up costs at our equity investee,
TriWest Healthcare Alliance.

In the first quarter of 2000, we announced a restructuring of our managed health
care operations in Texas. As a result of this restructuring, we incurred
approximately $1.4 million of severance pay for employees who were terminated.
The restructuring involved changes in senior management at our Texas facilities
and the centralization of key services to Las Vegas. Also in the first quarter
of 2000, we incurred $1.5 million of costs, consisting primarily of consulting
fees, in conjunction with a review and reorganization of our managed care
operations in Texas.

In the second quarter of 2000, we adopted a plan and announced additional
restructuring of our managed health care operations, primarily in Texas and
Arizona. As a result of this restructuring, we recorded charges in accordance
with Emerging Issues Task Force Issue No. 94-3, "Liability Recognition for
Certain Employee Termination Benefits and Other Costs to Exit an Activity
(Including Certain Costs Incurred in a Restructuring)" of approximately $10.6
million. Of the costs recorded, $5.9 million was for severance, $2.9 million was
related to clinic closures and lease terminations and $1.8 million was for other
costs. The severance charge resulted from the termination of 315 employees at
our subsidiaries and affiliated medical groups.

As compared to the quarter ended June 30, 2000, the restructuring and
reorganization activities resulted in cash flow savings of approximately $2.0 to
$3.0 million per quarter be