SIERRA HEALTH SERVICES, INC.
Quarterly Report on Form 10-Q
For the period ended June 30, 2003

PART I. FINANCIAL INFORMATION	Page No.
Item 1. Financial Statements (Unaudited):
Condensed Consolidated Balance Sheets -            June 30, 2003 and December 31, 2002	3
Condensed Consolidated Statement of Operations -            three and six months ended June 30, 2003 and 2002	4
Condensed Consolidated Statement of Cash Flows -            six months ended June 30, 2003 and 2002	5
Notes to Condensed Consolidated Financial Statements	6 - 18
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations	19 - 35
Item 3. Quantitative and Qualitative Disclosures About Market Risk	36
Item 4. Controls and Procedures	36
PART II. OTHER INFORMATION
Item 1. Legal Proceedings	37
Item 2. Changes in Securities and Use of Proceeds	37
Item 3. Default upon Senior Securities	37
Item 4. Submission of Matters to a Vote of Security Holders	37 - 38
Item 5. Other Information	38
Item 6. Exhibits and Reports on Form 8-K	38
Signatures	39

PART I. FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

SIERRA HEALTH SERVICES, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(In thousands, except per share data)
(Unaudited)

                                                                                                    
                                                                      June 30,   December 31,
                                                                        2003        2002
                                                                     ----------  ----------
                              ASSETS                                                                
CURRENT ASSETS:
     Cash and Cash Equivalents..................................... $   78,805  $   45,778
     Investments...................................................    146,616     182,452
     Accounts Receivable (Less Allowance for Doubtful
         Accounts; 2003 - $8,152; 2002 - $10,626)..................     10,529      11,232
     Military Accounts Receivable (Less Allowance for Doubtful
         Accounts; 2003 and 2002 - $100)...........................     75,765      47,126
     Current Portion of Deferred Tax Asset.........................     36,868      50,402
     Prepaid Expenses and Other Current Assets.....................     28,755      18,380
     Assets of Discontinued Operations.............................    562,264     565,058
                                                                     ----------  ----------
         Total Current Assets......................................    939,602     920,428

PROPERTY AND EQUIPMENT, NET........................................     62,275      64,868
RESTRICTED CASH AND INVESTMENTS....................................     17,635      17,557
GOODWILL...........................................................     14,782      14,782
DEFERRED TAX ASSET (Less Current Portion)..........................     20,236      14,947
OTHER ASSETS.......................................................     43,853      33,384
                                                                     ----------  ----------
TOTAL ASSETS....................................................... $1,098,383  $1,065,966
                                                                     ==========  ==========
                                                                                                    
               LIABILITIES AND STOCKHOLDERS' EQUITY                                                 
CURRENT LIABILITIES:
     Accrued Liabilities........................................... $   56,859  $   50,349
     Trade Accounts Payable........................................     24,913      29,249
     Accrued Payroll and Taxes.....................................     23,704      13,660
     Medical Claims Payable........................................    103,943      98,031
     Unearned Premium Revenue......................................     12,882      40,758
     Military Health Care Payable..................................     74,276      65,223
     Current Portion of Long-Term Debt.............................        140         186
     Liabilities of Discontinued Operations........................    468,772     500,720
                                                                     ----------  ----------
         Total Current Liabilities.................................    765,489     798,176

LONG-TERM DEBT (Less Current Portion)..............................    115,296      60,710
OTHER LIABILITIES..................................................     51,266      50,515
                                                                     ----------  ----------
TOTAL LIABILITIES..................................................    932,051     909,401
                                                                     ----------  ----------
COMMITMENTS AND CONTINGENCIES

STOCKHOLDERS' EQUITY:
  Preferred Stock, $.01 Par Value, 1,000
       Shares Authorized; None Issued or Outstanding
  Common Stock, $.005 Par Value, 60,000 Shares Authorized;
       2003 - 31,557; 2002 - 30,953 Shares Issued..................        158         155
  Treasury Stock: 2003 - 3,598; 2002 - 1,163 Common Stock Shares...    (49,120)    (17,148)
  Additional Paid-in Capital.......................................    203,447     196,711
  Deferred Compensation............................................       (180)       (473)
  Accumulated Other Comprehensive Gain.............................        552         381
  Retained Earnings (Accumulated Deficit)..........................     11,475     (23,061)
                                                                     ----------  ----------
TOTAL STOCKHOLDERS' EQUITY.........................................    166,332     156,565
                                                                     ----------  ----------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY......................... $1,098,383  $1,065,966
                                                                     ==========  ==========

See accompanying notes to condensed consolidated financial statements.

                                                Three Months Ended June 30,      Six Months Ended June 30,
                                                ---------------------------     ---------------------------
                                                    2003          2002              2003          2002
OPERATING REVENUES:                             ------------  -------------     ------------  ------------- 
   Medical Premiums.......................... $     239,142  $     211,408     $    474,222  $     418,052
   Military Contract Revenues................       115,431         93,740          219,844        179,194
   Professional Fees.........................         9,715          7,704           18,419         15,226
   Investment and Other Revenues.............         5,917          4,116            9,990          8,244
                                                ------------  -------------     ------------  -------------
         Total...............................       370,205        316,968          722,475        620,716
                                                ------------  -------------     ------------  -------------
OPERATING EXPENSES:
   Medical Expenses..........................       189,775        176,112          380,761        351,444
   Military Contract Expenses................       113,347         89,862          215,143        172,216
   General and Administrative Expenses.......        33,787         33,186           68,000         65,735
                                                ------------  -------------     ------------  -------------
         Total...............................       336,909        299,160          663,904        589,395
                                                ------------  -------------     ------------  -------------

OPERATING INCOME FROM CONTINUING OPERATIONS..        33,296         17,808           58,571         31,321
Interest Expense.............................        (1,530)        (1,902)          (3,150)        (4,834)
Other Income (Expense), Net..................          (332)          (126)            (343)          (106)
                                                ------------  -------------     ------------  -------------
INCOME FROM CONTINUING OPERATIONS
   BEFORE INCOME TAXES.......................        31,434         15,780           55,078         26,381
PROVISION FOR INCOME TAXES...................       (10,924)        (5,237)         (19,140)        (8,696)
                                                ------------  -------------     ------------  -------------
INCOME FROM CONTINUING OPERATIONS............        20,510         10,543           35,938         17,685
(LOSS) INCOME FROM DISCONTINUED
   OPERATIONS (net of income tax
   benefit (provision) of $987,
   ($64), $1,322 and ($323)), respectively...          (245)           (20)            (651)           219
                                                ------------  -------------     ------------  -------------
NET INCOME .................................. $      20,265  $      10,523     $     35,287  $      17,904
                                                ============  =============     ============  =============
EARNINGS PER COMMON SHARE:
Income from Continuing Operations............ $        0.75  $        0.37     $       1.27  $        0.63
(Loss) Income from Discontinued Operations...         (0.01)            --            (0.02)          0.01
                                                ------------  -------------     ------------  -------------
   Net Income ............................... $        0.74  $        0.37     $       1.25  $        0.64
                                                ============  =============     ============  =============
EARNINGS PER COMMON SHARE ASSUMING DILUTION:
Income from Continuing Operations............ $        0.68  $        0.34     $       1.18  $        0.58
(Loss) Income from Discontinued Operations...         (0.01)            --            (0.02)          0.01
                                                ------------  -------------     ------------  -------------
   Net Income ............................... $        0.67  $        0.34     $       1.16  $        0.59
                                                ============  =============     ============  =============

See accompanying notes to condensed consolidated financial statements.

                                                                        Six Months Ended June 30,
                                                                      ----------------------------
                                                                          2003           2002
                                                                      -------------  -------------
CASH FLOWS FROM OPERATING ACTIVITIES:
   Net Income ...................................................... $      35,287  $      17,904
   Adjustments to Reconcile Net Income to Net Cash
       Provided by Operating Activities:
          Loss (Income) from Discontinued Operations................           651           (219)
          Depreciation and Amortization.............................         7,715          9,662
          Deferred Compensation Expense.............................           293            292
          Provision for Doubtful Accounts...........................         1,201          1,192
          Loss on Disposal of Assets................................           789            130
   Changes in Assets and Liabilities:
          Other Assets .............................................        (5,335)        (4,086)
          Deferred Tax Asset........................................        12,156         24,499
          Other Liabilities.........................................         7,902         (4,449)
          Other Current Assets......................................       (10,872)         2,841
          Military Accounts Receivable..............................       (28,639)        (3,209)
          Military Health Care Payable..............................         9,053          3,746
          Medical Claims Payable....................................         5,912         13,797
          Accrued Payroll and Taxes.................................        10,044         10,326
          Unearned Premium Revenue..................................       (27,876)       (26,678)
                                                                      -------------  -------------
       Net Cash Provided by Operating Activities
          of Continuing Operations..................................        18,281         45,748
                                                                      -------------  -------------
CASH FLOWS FROM INVESTING ACTIVITIES:
   Capital Expenditures, Net of Dispositions........................        (9,586)        (3,797)
   Change in Investments............................................        34,687        (29,483)
                                                                      -------------  -------------
       Net Cash Provided by (Used for) Investing Activities of
          Continuing Operations.....................................        25,101        (33,280)
                                                                      -------------  -------------

CASH FLOWS FROM FINANCING ACTIVITIES:
   Proceeds from Senior Convertible Debentures......................       115,000             --
   Proceeds from  Sale-Leaseback....................................            --          1,769
   Debt Issue Costs.................................................        (5,137)            --
   Payments on Debt and Capital Leases..............................       (60,460)       (29,988)
   Purchase of Treasury Stock.......................................       (34,267)            --
   Issuance of Stock in Connection with Stock Plans.................         4,294          3,384
                                                                      -------------  -------------
       Net Cash Provided by (Used for) Financing Activities of
          Continuing Operations.....................................        19,430        (24,835)
                                                                      -------------  -------------

NET CASH USED FOR DISCONTINUED OPERATIONS...........................       (29,785)       (26,595)
                                                                      -------------  -------------
NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS................        33,027        (38,962)

CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD....................        45,778        107,114
                                                                      -------------  -------------
CASH AND CASH EQUIVALENTS AT END OF PERIOD.......................... $      78,805  $      68,152
                                                                      =============  =============

Supplemental Condensed Consolidated Continuing Operations
  Statements of Cash Flows Information:
- ---------------------------------------
Cash Paid During the Period for Interest
   (Net of Amount Capitalized)...................................... $      (1,125) $      (3,800)
Net Cash (Paid) Received During the Period for Income Taxes.........       (10,378)        13,104
Non-cash Investing and Financing Activities:
   Retired Sale-Leaseback Assets, Liabilities
       and Financing Obligations ...................................            --         58,053

See accompanying notes to condensed consolidated financial statements.

                                                     Three Months Ended June 30,     Six Months Ended June 30,
                                                     --------------------------     --------------------------
                                                         2003          2002             2003          2002
                                                     ------------  ------------     ------------  ------------
  (In thousands, except per share data)

Net income, as reported............................ $     20,265  $     10,523     $     35,287  $     17,904
Less: total stock-based employee compensation
   expense determined under fair value based
   methods for all  awards, net of tax.............       (2,319)       (1,359)          (3,417)       (2,508)
                                                     ------------  ------------     ------------  ------------
Pro forma net income .............................. $     17,946  $      9,164     $     31,870  $     15,396
                                                     ============  ============     ============  ============

Net income per share, as reported.................. $       0.74  $       0.37     $       1.25  $       0.64
Pro forma net income, per share ...................         0.65          0.32             1.13          0.55

Net income per share
   assuming dilution, as reported.................. $       0.67  $       0.34     $       1.16  $       0.59
Pro forma net income, per share ...................         0.60          0.30             1.05          0.50

                                              Other
                                           ------------ 
  (In thousands)
Balance, January 1, 2002................. $      4,447
Charges recorded.........................           --
Cash used................................           --
Non-cash activity........................         (500)
Changes in estimate......................           --
                                           ------------
Balance, December 31, 2002...............        3,947
Charges recorded.........................           --
Cash used................................           --
Non-cash activity........................           --
Changes in estimate......................           --
                                           ------------
Balance, June 30, 2003................... $      3,947
                                           ============

This report on Form 10-Q contains "forward-looking statements" within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, both as amended. The forward-looking statements regarding our business and results of operations should be considered by our stockholders or any reader of our business or financial information along with the risk factors discussed in our 2002 annual report on Form 10-K. All statements other than statements of historical fact are forward-looking statements for purposes of federal and state securities laws. The cautionary statements are made pursuant to the "safe harbor" provisions of the Private Securities Litigation Reform Act of 1995, as amended, and identify important factors that could cause our actual results to differ materially from those expressed in any projected, estimated or forward-looking statements relating to us. These forward-looking statements are generally identified by their use of terms and phrases such as "anticipate," "believe," "could," "estimate," "expect," "hope," "intend," "may," "plan," "predict," "project," "seeks," "will," "continue," and other similar terms and phrases, including references to assumptions.

Although we believe that the expectations reflected in any of our forward-looking statements are reasonable, actual results could differ materially from those projected or assumed in any of our forward-looking statements. Readers are cautioned not to place undue reliance on these forward- looking statements that speak only as of the date hereof. We undertake no obligation to republish revised forward-looking statements to reflect events or circumstances after the date hereof or to reflect the occurrence of unanticipated events.

Our consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America. In preparing these financial statements, we are required to make judgments, assumptions and estimates, which we believe are reasonable and prudent based on the available facts and circumstances. These judgments, assumptions and estimates affect certain of our revenues and expenses and their related balance sheet accounts and in disclosing our contingent assets and liabilities. Our most significant accounting estimates are for our premium allowance, the liability for medical claims payable, military contract revenues and expenses, investment impairment, litigation and legal accruals, reserve for losses and loss adjustment expense, or LAE, reinsurance recoverables and deferred tax assets and liabilities. We base our assumptions and estimates primarily on historical experience and trends and factor in known and projected trends. On an on-going basis, we re-evaluate our selection of assumptions and the method of calculating our estimates. Actual results, however, may materially differ from our calculated estimates and this difference would be reported in our current operations.

For a more detailed description of our critical accounting policies and estimates, see Item 7 of our 2002 annual report on Form 10-K and for a more extensive discussion of our accounting policies, see Note 2, Summary of Significant Accounting Policies, in the Notes to the Consolidated Financial Statements in our 2002 annual report on Form 10-K filed on March 24, 2003.

Total Operating Revenues increased approximately 16.8% to $370.2 million from $317.0 million for 2002.

The change in operating revenues was comprised of the following:

• An increase in medical premiums of $27.7 million
• An increase in military contract revenues of $21.7 million
• An increase in professional fees of $2.0 million
• An increase in investment and other revenues of $1.8 million

Medical Premiums from our HMO and managed indemnity insurance subsidiaries increased from $211.4 million to $239.1 million, an increase of $27.7 million or 13.1%. The $27.7 million increase in premium revenue reflects a 7.6% increase in Medicare member months (the number of months individuals are enrolled in a plan), a 28.9% increase in Medicaid member months and a 3.6% increase 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 more than three times higher than the average commercial premium rate.

HMO and POS premium rates for renewing commercial groups increased on average 10% to 12% while the overall recorded per member per month revenue increase, including new and continuing business, was approximately 14%. Managed indemnity rates on renewing groups increased approximately 10%. We did not receive a Medicaid rate increase in 2002 or 2003. The basic Medicare rate increase received in 2003 was approximately 2.0%. Our overall Medicare rate increase was approximately 2.2% due primarily to an increase in the Social HMO membership as a percentage of our total Medicare membership.

The Centers for Medicare and Medicaid Services, or CMS, has adopted a new risk adjustment payment methodology for Medicare beneficiaries who are enrolled in managed care programs, including the Social HMO. Beginning January 2004, 90% of the per member per month prospective payment for the Social HMO members will be based on the member demographics of the current Social HMO payment methodology and 10% will be based on the risk-adjusted payment methodology used for other Medicare+Choice plans. As a result, we are projecting an increase in our CMS rate of approximately 2.2% for 2004. There is ongoing activity in Congress to extend the Social HMO program beyond 2004; however, there is no guarantee at this time that the Social HMO contract will be renewed beyond 2004. If the reimbursement for these members decreases significantly and related benefit changes are not made timely, there could be a materially adverse effect on our business. Continued medical premium revenue growth is principally dependent upon continued enrollment in our products and upon competitive and regulatory factors.

Military Contract Revenues increased from $93.7 million to $115.4 million, an increase of $21.7 million or 23.1%. The increase in revenue is primarily the result of increased eligible beneficiaries resulting from the call up of reservists in Region 1, additional TRICARE change orders and the positive impact of the first year of our contract extension which began June 2003. The base monthly revenue under the contract extension is higher than it was under the previous contract. Family members of reservists are eligible for the TRICARE program after 30 days.

Sierra Military Health Services, Inc., or SMHS, completed the last year of a five-year contract in May 2003, and has begun the first year of the contract extension which can be up to four additional years at the government's sole option on a year-to-year basis. The Department of Defense, or DoD, is also currently procuring bids for managed care services under the TRICARE Next Generation contract, or the T-Nex contract, in a combined and larger North Region (covering Michigan, Ohio, Kentucky, Indiana, Illinois, Wisconsin, West Virginia and North Carolina in addition to the areas that make up Region 1 which we currently serve). SMHS submitted its bid to the DoD for the T-Nex contract for the North Region on January 29, 2003, with Sierra as a proposed guarantor. The award decision for this contract is expected to be made in the third quarter of 2003. Once awarded, the new contractor is scheduled to be fully operational in Region 1 by the third quarter of 2004 based on the current timetable set by the DoD, and the new contract would supersede the remainder of the contract extension we have negotiated with the DoD under our current TRICARE Region 1 contract. In March 2003, we contributed $35.0 million of the proceeds from the sale of the Sierra senior convertible debentures to SMHS in furtherance of its bid for the T-Nex contract.

Professional Fees increased from $7.7 million to $9.7 million, an increase of $2.0 million, or 26.1% as a result of increased visits due to membership growth, a higher percentage of members selecting our owned medical group and an increase in related services performed by our other provider subsidiaries.

Investment and Other Revenues increased from $4.1 million to $5.9 million, an increase of $1.8 million or 43.8%. Investment revenues increased due to higher average invested balances, an increase in net gains on the sale of investments, higher than usual gains on our deferred compensation plan assets and an increase in revenues associated with administrative services. Investment and other revenues now include the revenue associated with administrative services, which were previously reported as part of specialty product revenues.

Medical Expenses increased from $176.1 million to $189.8 million, an increase of $13.7 million or 7.8%. The increase is due primarily to our increased membership which is in part offset by a lower medical care ratio. Medical expenses as a percentage of medical premiums and professional fees decreased to 76.3% from 80.4%. The favorable decrease is primarily due to premium yields in excess of cost and utilization increases and was partially offset by malpractice cost increases at our medical provider subsidiary. Our medical claims payable liability requires us to make significant estimates.

We contract with hospitals, physicians and other independently contracted providers of health care under capitated or discounted fee-for-service arrangements including hospital per diems to provide medical care services to members. Capitated providers are at risk for a portion of the cost of medical care services provided to our members in the relevant geographic areas; however, we are ultimately responsible for the provision of services to our members should the capitated provider be unable to provide the contracted services. We incurred capitation expenses of $26.6 million and $23.0 million or 14.0% and 13.0% of our total medical expenses for the three months ended June 30, 2003 and 2002, respectively.

During the third quarter of 2002, we entered into a new hospital contract. With this new contract, which began October 1, 2002, we hold some form of contracted provider relationship with every hospital in the Las Vegas area.

Military Contract Expenses increased from $89.9 million to $113.3 million, an increase of $23.4 million or 26.1%. The increase is consistent with the increase in revenues discussed previously and includes $1.8 million in bid proposal costs. 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 672,000 eligible individuals of active duty military personnel, military retirees under the age of 65 and dependents of military retirees through a network of approximately 55,000 health care providers and certain other subcontractor partnerships. Also included in military contract expenses are costs incurred to perform specific administrative services, such as health care appointment scheduling, enrollment, medical and network management services as well as health care advice line services, and other administrative functions of the military health care subsidiary. These administrative services are performed for active duty personnel and family members as well as retired military families.

General and Administrative Expenses, or G&A, increased from $33.2 million to $33.8 million, an increase of approximately $600,000 or 1.8%. G&A expenses increased due to increases in payroll and benefits, and facility lease expense offset by a decrease in legal expenses. The increase in facility lease expense is due to the rent payments associated with the sale-leaseback transaction for our administrative buildings now being recorded as an operating expense. Previously, the rent payments were recorded as interest and a reduction of principal and the assets were being depreciated. As a percentage of revenues, G&A expenses were 9.1% for 2003, compared to 10.5% in 2002. As a percentage of medical premium revenue, G&A expenses were 14.1% for 2003, compared to 15.7% for 2002. G&A expenses now include the expenses associated with certain administrative services which were previously reported as part of specialty product expenses.

Interest Expense decreased from $1.9 million to $1.5 million, a decrease of approximately $400,000 or 19.6%. Interest expense related to the sale-leaseback transaction decreased by approximately $500,000 as the remaining buildings qualified as a sale during 2002. The decrease in the interest expense related to our revolving credit facility was primarily offset by an increase in interest related to the new senior convertible debentures. We incur a fee of 0.5% on the unused portion of our new revolving credit facility.

Other Income (Expense), Net resulted in expense of approximately $300,000 for 2003 compared to approximately $100,000 for 2002.

Provision for Income Taxes was recorded at $10.9 million for 2003 compared to $5.2 million for 2002. The effective tax rate for 2003 was 34.8% compared to 33.2% for 2002. Our ongoing effective tax rate is less than the statutory rate due primarily to tax preferred investments. Due to the increase in income from continuing operations in 2003, tax preferred investments have less of an impact on our effective tax rate when compared to 2002.

Discontinued Operations consist of our Texas HMO health care operations and the CII workers' compensation operations. The net loss from discontinued operations for 2003 was approximately $300,000 compared to $20,000 for 2002. The Texas HMO health care operations had net income of approximately $800,000 for 2003, which was offset by a net loss on the CII workers' compensation operations of $1.1 million.

Discontinued Texas HMO health care operations. The income from the Texas HMO health care operations for 2003 included a pre-tax gain on the early payoff of the remaining Kaiser-Texas mortgage loan of $2.1 million offset by an increase in litigation accruals of approximately $500,000 and a write down of the remaining real estate of approximately $300,000. The combined adjustments resulted in income from the discontinued Texas HMO health care operations of $1.3 million pre-tax or net income of approximately $800,000.

Discontinued CII workers' compensation operations. The discontinued workers' compensation operations for 2003 had a net loss of $1.1 million. We are continuing to operate the business until a disposal occurs.

Net earned premiums decreased by $8.5 million or 19.4% due primarily to a decrease in direct earned premiums of $7.8 million and an increase in ceded reinsurance premiums of $1.5 million offset by an increase in assumed premiums of approximately $800,000. Direct written premiums decreased by $8.8 million due primarily to reduced California premium writings. We have been increasing our premium rates, especially in California, where we have experienced significant adverse loss development. In addition, we are becoming more selective in the types of accounts we insure. In the second quarter of 2003, our average premium rate increase on renewing California policies was approximately 58%, which is in addition to a 35% average premium rate increase in the second quarter of 2002. In other states, our average premium rate increase on renewing policies was approximately 6% in 2003 compared to approximately 8% in 2002.

We continue to implement stricter underwriting guidelines and we believe that our announcement that the workers' compensation insurance business was reclassified to discontinued operations has negatively impacted our premium production. These factors have limited our ability to retain current business and obtain new business. Direct written premiums for the three months ended June 30, 2003 in California are down $8.2 million or 29% over the comparable 2002 period. Direct written premiums in our other states are down by approximately $600,000 or 5%, primarily in Texas and Colorado. Premium production results for the quarter may not be indicative of the full year's premium production.

Premiums in force are an indicator of future written premium trends and represent the total estimated annual premiums of all policies in force at a point in time. Total inforce premiums decreased by 21% from $160.3 million at June 30, 2002 to $126.9 million at June 30, 2003.

Investment and other revenue decreased by $400,000 or 13.6% due to a decrease in the average investment yields during the period.

Expenses decreased in the CII workers' compensation operations by approximately $6.4 million or 13.6%. The decrease is primarily due to the following:

• In 2002 and 2003, we recorded $3.2 million of net adverse loss development for prior accident years. The net adverse loss development recorded in 2003, was largely attributable to higher costs per claim, or claim severity, in California, primarily on accident years 1997, 1998 and 2001. Higher claim severity has had a negative impact on the entire California workers' compensation industry in the past few periods and this trend may continue.
• The loss and LAE ratio for the 2003 accident year compared to the 2002 accident year was lower by 3.0%, which resulted in a decrease of approximately $1.1 million.
• A $6.2 million reduction in loss and LAE is related to the decrease in net earned premiums in 2003 compared to 2002.

• In order to write down the workers' compensation operations to its current estimated realizable value, CII recorded valuation adjustments, which included the write down of accounts receivable, fixed assets and certain other adjustments totaling $4.0 million.

• The net decrease in underwriting expenses, policyholders' dividends and other operating expenses was approximately $1.7 million.
• A gain on the redemption of the 9½% senior debentures of $1.4 million.

The net adverse loss development on prior accident years included those years that were covered by our low level reinsurance agreement. This resulted in an increase in the reinsurance recoverable balance which was then reduced by amounts collected from reinsurers. During the three months ended June 30, 2003, we increased our ceded reserves by $8.1 million and received payments from our reinsurers totaling $9.5 million.

The loss and LAE reserves recorded as of June 30, 2003 reflect our best estimate of the ultimate loss costs for reported and unreported claims occurring in accident year 2003 as well as those occurring in accident years prior to 2003. 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.

The combined ratio is a measurement of the workers' compensation 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 119.0% compared to 107.4% for 2002. The increase was primarily due to the $4.0 million write down, an increase in the policyholders' dividend ratio and the decrease in net earned premiums. Excluding the $4.0 million write down, as well as prior accident years' adverse loss development, the combined ratio would have been 98.6% for 2003 and 100.0% for 2002.

In February 2002, California enacted Assembly Bill 749. This new legislation increased benefits paid to injured workers starting January 1, 2003. Increased loss costs, such as benefit increases, are normally built into the rate making process so that premiums are increased to cover the increase in costs. On October 18, 2002, the California Insurance Commissioner approved an increase of 10.5% in pure premium rates for new and renewal policies effective in 2003. In addition, the Commissioner approved a 4.9% increase in pure premium rates for the unexpired terms of policies in force at January 1, 2003. The Commissioner also approved an additional mid year rate increase of 7.2% effective July 1, 2003. Although we have increased our premiums, there is no assurance that our increase will be sufficient enough to cover the ultimate cost increases or that the estimate of cost increases provided by the Workers' Compensation Insurance Rating Bureau (the organization that accumulates premium and loss data for the State of California for rate making purposes) is accurate. Assembly Bill 749 is effective for claims occurring on and after January 1, 2003. However, due to other statutes, certain temporary total disability claims with dates of injury prior to 2003 automatically increased to the new benefit levels effective January 1, 2003.

In the wake of the events of September 11, 2001 and the ensuing hardening of the reinsurance market, our new reinsurance agreements, which cover new and renewal policies effective on and after January 1, 2003, cost more and have reduced coverage limits, including exclusions for terrorist acts. We continue to retain the first $500,000 per occurrence but the maximum coverage has been reduced from statutory (i.e., unlimited) limits to $20.0 million per occurrence. We also must meet certain annual aggregate deductibles before we can begin to recover from some of our reinsurers. This new coverage will result in our retaining more of the losses and LAE. We have factored these higher costs into our premium rates but there is no assurance that our rates will be adequate to cover the ultimate costs.

Reinsurance contracts do not relieve us from our obligations to injured workers or policyholders. At June 30, 2003, we had $181.5 million in reinsurance recoverable. We evaluate the financial condition of our reinsurers to minimize our exposure to significant losses from reinsurer insolvencies. We also periodically review the financial strength ratings of our reinsurers to determine if an allowance for uncollectible reinsurance is warranted. As of June 30, 2003, no allowance was established. At June 30, 2003, all of our reinsurers were rated A- or better by Fitch Inc. (7^th of 23) and the A.M. Best Company (4^th of 16). Should these companies be unable to perform their obligations to reimburse us for ceded losses, we would experience significant losses.

Total Operating Revenues increased approximately 16.4% to $722.5 million from $620.7 million for 2002.

The change in operating revenues was comprised of the following:

• An increase in medical premiums of $56.1 million
• An increase in military contract revenues of $40.6 million
• An increase in professional fees of $3.2 million
• An increase in investment and other revenues of $1.8 million

Medical Premiums increased from $418.1 million to $474.2 million from our HMO and managed indemnity insurance subsidiaries, an increase of $56.1 million or 13.4%. The $56.1 million increase in premium revenue reflects a 7.4% increase in Medicare member months (the number of months individuals are enrolled in a plan), a 31.8% increase in Medicaid member months and a 2.6% increase 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 more than three times higher than the average commercial premium rate.

HMO and POS premium rates for renewing commercial groups increased on average 10% to 12% while the overall recorded per member per month revenue increase, including new and continuing business, was approximately 13%. Managed indemnity rates on renewing groups increased over 10%. We did not receive a Medicaid rate increase in 2002 or 2003. The basic Medicare rate increase received in 2003 was approximately 2.0%. Our overall Medicare rate increase was approximately 3.6% due primarily to the following:

• An increase in the Social HMO membership as a percentage of our total Medicare membership. The Social HMO members have a higher average rate than our other Medicare members. Approximately 96% of our Nevada Medicare members are enrolled in the Social HMO Medicare program which includes our Reno membership which was not part of the Social HMO program prior to 2003.
• Our Social HMO Medicare membership experienced an increase in risk factors which contributes to higher rates and corresponding increases in medical expenses.

Military Contract Revenues increased from $179.2 million to $219.8 million, an increase of $40.6 million or 22.7%. The increase in revenue is primarily the result of increased eligible beneficiaries resulting from the call up of reservists in Region 1, additional TRICARE change orders and the positive impact of the first year of our contract extension which began in June 2003. The base monthly revenue under the contract extension is higher than it was under the previous contract. Family members of reservists are eligible for the TRICARE program after 30 days.

Professional Fees increased from $15.2 million to $18.4 million, an increase of $3.2 million or 21.0% as a result of increased visits due to membership growth, a higher percentage of members selecting our owned medical group and an increase in other related services performed by our other provider subsidiaries.

Investment and Other Revenues increased from $8.2 million to $10.0 million, an increase of approximately $1.8 million or 21.2%. Investment revenues increased due to higher average invested balances, an increase in net gains on the sale of investments, higher than usual gains on our deferred compensation plan assets and an increase in revenues associated with administrative services. Investment and other revenues now include the revenue associated with administrative services, which were previously reported as part of specialty product revenues.

Medical Expenses increased from $351.4 million to $380.8 million, an increase of $29.4 million or 8.3%. The increase is due primarily to our increased revenues and associated membership which is in part offset by a lower medical care ratio. Medical expenses as a percentage of medical premiums and professional fees decreased to 77.3% from 81.1%. The favorable decrease is primarily due to premium yields in excess of cost and utilization increases and was partially offset by malpractice cost increases at our medical provider subsidiary. Our medical claims payable liability requires us to make significant estimates.

We contract with hospitals, physicians and other independently contracted providers of health care under capitated or discounted fee-for-service arrangements including hospital per diems to provide medical care services to members. Capitated providers are at risk for a portion of the cost of medical care services provided to our members in the relevant geographic areas; however, we are ultimately responsible for the provision of services to our members should the capitated provider be unable to provide the contracted services. We incurred capitation expenses of $52.0 million and $45.3 million or 13.7% and 12.9% of our total medical expenses for the six months ended June 30, 2003 and 2002, respectively.

Military Contract Expenses increased from $172.2 million to $215.1 million, an increase of $42.9 million or 24.9%. The increase is consistent with the increase in revenues discussed previously and includes $4.1 million in bid proposal costs. 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 672,000 eligible individuals of active duty military personnel, military retirees under the age of 65 and dependents of military retirees through a network of approximately 55,000 health care providers and certain other subcontractor partnerships. Also included in military contract expenses are costs incurred to perform specific administrative services, such as health care appointment scheduling, enrollment, medical and network management services as well as health care advice line services, and other administrative functions of the military health care subsidiary. These administrative services are performed for active duty personnel and family members as well as retired military families.

General and Administrative Expenses, or G&A, increased from $65.7 million to $68.0 million, an increase of $2.3 million or 3.4%. G&A expenses increased due to increases in payroll and benefits, and facility lease expense offset by a decrease in legal expenses. The increase in facility lease expense is due to the rent payments associated with the sale-leaseback transaction for our administrative buildings now being recorded as an operating expense. Previously, the rent payments were recorded as interest and a reduction of principal and the assets were being depreciated. As a percentage of revenues, G&A expenses were 9.4% for 2003, compared to 10.6% in 2002. As a percentage of medical premium revenue, G&A expenses were 14.3% for 2003, compared to 15.7% for 2002. G&A expenses now include the expenses associated with certain administrative services which were previously reported as part of specialty product expenses.

Interest Expense decreased from $4.8 million to $3.2 million, a decrease of $1.6 million or 34.8%. Interest expense related to the sale-leaseback transaction decreased by $2.2 million as the remaining buildings qualified as a sale during 2002. The decrease in the interest expense related to our revolving credit facility was primarily offset by an increase in interest related to the new senior convertible debentures. We incur a fee of 0.5% on the unused portion of our new revolving credit facility.

Other Income (Expense), Net resulted in expense of approximately $300,000 compared to approximately $100,000 for 2002.

Provision for Income Taxes was recorded at $19.1 million for 2003 compared to $8.7 million for 2002. The effective tax rate for 2003 was 34.8% compared to 33.0% for 2002. Our ongoing effective tax rate is less than the statutory rate due primarily to tax preferred investments. Due to the increase in income from continuing operations in 2003, tax preferred investments have less of an impact on our effective tax rate when compared to 2002.

Discontinued Operations consist of our Texas HMO health care operations and the CII workers' compensation operations. The net loss from discontinued operations for 2003 was approximately $700,000 compared to income of approximately $200,000 for 2002. The Texas HMO health care operations had net income of $2.9 million for 2003, which was offset by a net loss on the CII workers' compensation operations of $3.6 million.

Discontinued Texas HMO health care operations. The income from the Texas HMO health care operations for 2003 included a pre-tax gain on the early payoff of the remaining Kaiser-Texas mortgage loan of $2.1 million, a net decrease in litigation accruals of $1.4 million, favorable development in medical claim liabilities of $1.4 million partially offset by a write down of the remaining real estate of approximately $300,000. The combined adjustments resulted in income from the discontinued Texas HMO health care operations of $4.6 million pre-tax or net income of $2.9 million.

Discontinued CII workers' compensation operations. The discontinued workers' compensation operations for 2003 had a net loss of $3.6 million. We are continuing to operate the business until a disposal occurs.

Net earned premiums decreased by $13.3 million or 15.6% due primarily to a decrease in direct earned premiums of $11.5 million and an increase in ceded reinsurance premiums of $2.9 million offset by an increase in assumed premiums of $1.1 million. Direct written premiums decreased by $17.3 million due primarily to reduced California premium writings. We have been increasing our premium rates, especially in California, where we have experienced significant adverse loss development. In addition, we are becoming more selective in the types of accounts we insure. For the first six months of 2003, our average premium rate increase on renewing California policies was approximately 62%, which is in addition to a 33% average rate increase in the first six months of 2002. In other states, our average premium rate increase on renewing policies was approximately 8% in 2003 compared to approximately 7% in 2002.

We continue to implement stricter underwriting guidelines and we believe that our announcement that the workers' compensation insurance business was reclassified to discontinued operations has negatively impacted our premium production. These factors have limited our ability to retain current business and obtain new business. Direct written premiums for the first six months of 2003 in California are down $15.3 million or 26% over the comparable 2002 period. Direct written premiums in our other states are also down by $2.0 million or 7%, primarily in Texas and Colorado. Premium production results for the first six months of 2003 may not be indicative of the full year's premium production.

Investment and other revenue increased by $800,000 or 12.1% due to an increase in realized gains of $2.6 million offset by a decrease in the average investment yields during the period.

Expenses decreased in the CII workers' compensation operations by approximately $5.4 million or 5.9%. The decrease is primarily due to the following:

• In 2003, we recorded $9.4 million of net adverse loss development for prior accident years compared to net adverse loss development of $5.3 million recorded in 2002. The net adverse loss development recorded in 2003, was largely attributable to higher costs per claim, or claim severity, in California, primarily on accident years 1997, 1998, 2001 and 2002. Higher claim severity has had a negative impact on the entire California workers' compensation industry in the past few periods and this trend may continue.
• The loss and LAE ratio for the 2003 accident year compared to the 2002 accident year was lower by .2% which resulted in a decrease of approximately $100,000.
• A $9.9 million reduction in loss and LAE is related to the decrease in net earned premiums in 2003 compared to 2002.

• In order to write down the workers' compensation operations to its current estimated realizable value, CII recorded valuation adjustments, which included the write down of accounts receivable, fixed assets and certain other adjustments totaling $4.0 million.

• The net decrease in underwriting expenses, policyholders' dividends and other operating expenses was approximately $2.1 million.
• A gain on the redemption of the 9½% senior debentures of $1.4 million.

The net adverse loss development on prior accident years included those years that were covered by our low level reinsurance agreement. This resulted in an increase in the reinsurance recoverable balance which was then reduced by amounts collected from reinsurers. During the six months ended June 30, 2003, we increased our ceded reserves by $19.4 million and received payments from our reinsurers totaling $27.3 million.

The combined ratio is a measurement of the workers' compensation 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 121.1% compared to 107.0% for 2002. The increase was primarily due to the $4.0 million write down, increased net adverse loss development for prior accident years and the decrease in net earned premiums. Excluding the $4.0 million write down, as well as prior accident years' adverse loss development, the combined ratio would have been 102.5% for 2003 and 100.8% for 2002.

LIQUIDITY AND CAPITAL RESOURCES

For continuing operations, we had cash provided by operating activities of $18.3 million in 2003, compared to $45.8 million in 2002. We received only five monthly CMS payments during the first six months of 2003 and 2002. We received the January payments of $29.9 million and $26.8 million in December 2002 and 2001, respectively. When the periods are adjusted to reflect the January monthly payments from CMS, the cash flow from continuing operations is $48.2 million in 2003 compared to $72.6 million in 2002. We believe presenting this adjustment for the timing of the CMS payments is useful for making a period to period comparison of our cash flow from continuing operations. The decrease in cash provided by operating activities in 2003 when compared to 2002 is primarily related to the increase in the military accounts receivable balance of $28.6 million from December 31, 2002 to June 30, 2003 and tax payments of $10.4 million in 2003 compared to tax receipts of $13.1 million in 2002.

Our business and cash flows could be adversely affected if the timing or amount of the payments we receive from the DoD vary significantly from our expectations.

On November 16, 2001, SMHS entered into a securitization arrangement with General Electric Capital Corporation. The arrangement provides for the assignment of SMHS' Federal Government accounts receivable to SMHS Funding. SMHS Funding is a special purpose limited liability company owned by SMHS and was formed for the purpose of purchasing all receivables of SMHS. This entity is fully consolidated into SMHS. SMHS Funding may assign an undivided interest in certain of the receivables to a subsidiary of General Electric Capital Corporation in the event that additional financing by SMHS is warranted. This securitization arrangement has not been utilized and we do not anticipate utilizing it in 2003.

In the event SMHS wins the competitive bid procurement for the North Region T-Nex contract, SMHS has received a commitment from General Electric Capital Corporation to provide a $200.0 million senior secured revolving credit facility to support SMHS' additional working capital needs and to refinance its existing securitization agreement.

For continuing operations, cash provided by investing activities during 2003 was $25.1 million, compared to a use of cash of $33.3 million in 2002. The 2003 amount included $9.6 million in net capital expenditures compared to $3.8 million in 2002. The net change in investments for the period was a decrease in investments of $34.7 million for 2003, as investments matured or were sold and were converted to cash. For 2002, we used cash from operations to purchase investments for a net increase in investments of $29.5 million.

For continuing operations, cash provided by financing activities during 2003 was $19.4 million, compared to cash used of $24.8 million in 2002. The 2003 amount included net payments of $60.0 million on the revolving credit facility compared to $29.0 million in 2002. In addition, in 2003 we received $115.0 million in proceeds from the sale of our senior convertible debentures. These proceeds were offset by debt issue costs of $5.1 million. Proceeds from the issuance of stock in connection with stock plans were $4.3 million in 2003, compared to $3.4 million in 2002. We used cash of $34.3 million to purchase treasury stock during the first six months of 2003.

Discontinued operations used cash of $29.8 million in 2003, compared to $26.6 million in 2002. Cash used in 2003 was primarily for the payoff of the remaining Kaiser-Texas mortgage loan for $11.3 million and the redemption of the outstanding 9½% senior debentures for $15.3 million. Cash used in 2002 was primarily for the run out of claims and other legal and restitution related items. Based on the current estimated Texas HMO health care run-out costs and recorded reserves, we believe we have adequate funds available and the ability to invest, should we be required to do so, adequate funds in Texas to meet the anticipated obligations for our members' health care claims.

In March 2003, the Company issued $115.0 million aggregate principal amount of its 2¼% senior convertible debentures due March 15, 2023. The debentures pay interest, which is due semi-annually on March 15 and September 15 of each year, commencing September 15, 2003. Each $1,000 principal amount of debentures is convertible, at the option of the holders, into 54.6747 shares of Sierra Health Services, Inc., common stock prior to March 15, 2023 if (1) the sale price of our common stock for at least 20 trading days in a period of 30 consecutive trading days ending on the last trading day of the preceding fiscal quarter exceeds 120% of the conversion price per share of our common stock on such last trading day; (2) the debentures are called for redemption; (3) there is an event of default with respect to the debentures; or (4) specified corporate transactions have occurred. The conversion rate is subject to certain adjustments. This conversion rate initially represents a conversion price of $18.29 per share. Holders of the debentures may require the Company to repurchase all or a portion of their debentures on March 15 in 2008, 2013 and 2018 or upon certain corporate events including a change in control. In either case, the Company may choose to pay the purchase price of such debentures in cash or common stock or a combination of cash and common stock. The debentures can be redeemed by the Company for cash beginning on or after March 20, 2008.

The debentures were sold to Banc of America Securities LLC, Credit Lyonnais Securities (USA), Inc., and U.S. Bancorp Piper Jaffray, as "accredited investors" within the meaning of Rule 501 under the Securities Act of 1933, in reliance upon the private placement exemption afforded by Section 4(2) of the Securities Act, and were offered and resold to "qualified institutional buyers" under Rule 144A of the Securities Act. The Company has filed a registration statement under the Securities Act to permit registered resales of the debentures and the common stock into which the debentures are convertible. This registration statement has not yet been declared effective by the Securities and Exchange Commission.

The aggregate offering price of the debentures was $115.0 million, 100% of the principal amount thereof. The purchase price paid to the Company by the initial purchasers was the initial offering price less a discount of $3.5 million, 3.0% of the principal amount of the debentures. The Company used the net proceeds of the offering to repay the $39.0 million outstanding under the existing credit facility and to contribute $35.0 million to SMHS in furtherance of its bid for the TRICARE Next Generation contract. The Company also used $19.9 million of the proceeds to purchase 1.6 million shares of the Company's common stock under its repurchase program. The remainder of the net proceeds were used for working capital and general corporate purposes including additional share repurchases.

On March 3, 2003, we entered into a new $65.0 million revolving credit facility which replaced the amended and restated credit facility. The new facility may be increased up to an aggregate amount of $125.0 million upon receipt of new commitments from existing or additional lenders. Interest on the facility is initially LIBOR plus 2.25%. The facility will expire on April 30, 2006 but can be extended, at the sole discretion of each of the lenders, until March 3, 2008. The new facility is available for general corporate purposes. We have not yet utilized this facility.

The new credit facility is secured by guarantees by certain of our subsidiaries and a first priority perfected security interest in (i) all the capital stock of each of our unregulated, material domestic subsidiaries (direct or indirect) as well as all of the capital stock of certain regulated, material domestic subsidiaries and (ii) all other present and future assets and properties of ours and those of our subsidiaries that guarantee our credit agreement obligations (including, without limitation, accounts receivable, inventory, real property, equipment, contracts, trademarks, copyrights, patents, license rights and general intangibles) subject, in each case, to the exclusion of the capital stock of CII Financial, Inc., or any of its subsidiaries and certain other exclusions.

The new revolving credit facility has covenants that limit or restrict our ability and the ability of our subsidiaries to dispose of assets, incur indebtedness, incur other liens, make investments, loans or advances, make acquisitions, engage in mergers or consolidations, or make capital expenditures and otherwise restricts certain corporate activities. In addition, we are required to comply with specified financial ratios as set forth in the new credit agreement. The Company believes it is in compliance with all covenants of the new credit agreement.

The Company's Board of Directors has authorized a program for the repurchase of up to 4.6 million shares of the Company's common stock. During 2003, the Company repurchased a total of 2.6 million shares for $34.3 million.

Statutory Capital and Deposit Requirements

Our HMO and insurance subsidiaries are required by state regulatory agencies to maintain certain deposits and must also meet certain net worth and reserve requirements. The HMO and insurance subsidiaries, including the discontinued operations, had restricted assets on deposit in various states totaling $32.8 million at June 30, 2003. The HMO and insurance subsidiaries must also meet requirements to maintain minimum stockholders' equity, on a statutory basis, as well as minimum risk-based capital requirements, which are determined annually. In conjunction with the exit from the Texas HMO health care market, the Texas D