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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC 20549

FORM 10-K

(Mark One)

For the fiscal year ended December 31, 2004

For the transition period from                  to                 

Commission File Number: 1-12718

HEALTH NET, INC.

(Exact Name of Registrant as Specified in Its Charter)

Registrant’s Telephone Number, Including Area Code: (818) 676-6000

Securities Registered Pursuant to Section 12(b) of the Act:

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. x

Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2). Yes x No ¨

The aggregate market value of the voting stock held by non-affiliates of the registrant at June 27, 2004 was $2,880,397,670 (which represents 112,427,701 shares of Common Stock held by such non-affiliates multiplied by $25.62, the closing sales price of such stock on the New York Stock Exchange on June 25, 2004).

The number of shares outstanding of the registrant’s Common Stock as of March 11, 2005 was 112,334,885 (excluding 23,173,029 shares held as treasury stock).

Documents Incorporated By Reference

Part III of this Form 10-K incorporates by reference certain information from the registrant’s definitive proxy statement for the 2005 Annual Meeting of Stockholders to be filed with the Securities and Exchange Commission within 120 days after the close of the year ended December 31, 2004.

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HEALTH NET, INC.

INDEX TO FORM 10-K

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PART I

Item 1. Business.

General

We are an integrated managed care organization that delivers managed health care services through health plans and government sponsored managed care plans. We operate and conduct our businesses through subsidiaries of Health Net, Inc., which is among the nation’s largest publicly traded managed health care companies. In this Annual Report on Form 10-K, unless the context otherwise requires, the terms “Company,” “we,” “us,” and “our” refer to Health Net, Inc. and its subsidiaries.

Our health plans and government contracts subsidiaries provide health benefits through our health maintenance organizations (“HMOs”), insured preferred provider organizations (“PPOs”) and point-of-service (“POS”) plans to approximately 6.5 million individuals in 27 states and the District of Columbia through group, individual, Medicare, Medicaid and TRICARE programs. We also offer managed health care products related to behavioral health and prescription drugs. In addition, we own health and life insurance companies licensed to sell exclusive provider organization (“EPO”), PPO, POS and indemnity products, as well as auxiliary non-health products such as life and accidental death and dismemberment, dental, vision, behavioral health and disability insurance, in 37 states and the District of Columbia.

Our executive offices are located at 21650 Oxnard Street, Woodland Hills, California 91367, and our Internet web site address is www.healthnet.com.

We make available free of charge on or through our Internet web site, www.healthnet.com, all of our reports on Forms 10-K, 10-Q and 8-K and all amendments to those reports as soon as reasonably practicable after such material is electronically filed with, or furnished to, the Securities and Exchange Commission (“SEC”). Copies of our Corporate Governance Guidelines, Code of Business Conduct and Ethics and charters for the Audit Committee, Compensation Committee, Governance Committee and Finance Committee of our Board of Directors are also available on our Internet web site. We will provide electronic or paper copies free of charge upon request. The SEC also maintains a website at www.sec.gov that contains reports, proxy and information statements and other information regarding issuers that file electronically with the SEC.

Segment Information

We currently operate within two reportable segments, Health Plan Services and Government Contracts, each of which is described below. For additional financial information regarding our reportable segments, see Note 15 in the Notes to Consolidated Financial Statements included as part of this Annual Report on Form 10-K.

Health Plan Services Segment

Our Health Plan Services segment includes the operations of our health plans in Arizona, California, Connecticut, New Jersey, New York and Oregon, the operations of our health and life insurance companies and our behavioral health and pharmaceutical services subsidiaries. We have approximately 3.5 million at-risk and 0.1 million administrative services only (“ASO”) members in our Health Plan Services segment.

Managed Health Care Operations

We offer a full spectrum of managed health care products and services. Our strategy is to offer to employers and individuals a wide range of managed health care products and services that, among other things, provide comprehensive coverage and contain health care costs increases. Over the past five years, we have focused on expanding our POS and PPO product lines, which we believe will enable us to offer greater flexibility to employer groups and individual insureds. As of December 31, 2004, 46% of our commercial members were covered by POS and PPO products, 51% were covered by conventional HMO products and 3% were covered by EPO and fee-for-service products.

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Our health plans offer members a wide range of health care services that are designed to contain costs and provide comprehensive coverage, including ambulatory and outpatient physician care, hospital care, pharmacy services, behavioral health and ancillary diagnostic and therapeutic services. Our health plans include a matrix package which allows members to select their desired coverage from alternatives that have features such as interchangeable outpatient and inpatient co-payment levels; POS programs which offer a multi-tier design that provides both conventional HMO and indemnity-like (in-network and out-of-network) tiers; a PPO traditional product which allows members to self-refer to the network physician of their choice; and a managed indemnity plan which is provided for employees who reside outside of their HMO service areas.

Over the past several years, we have consolidated our health plan operations in six key states, Arizona, California, Connecticut, Oregon, New Jersey and New York and have seen significant growth in our small group business (generally defined as an employer group with 2 to 50 employees). We have also adopted newer forms of medical management techniques that focus on demand management and early development of Consumer Directed Health Plan products. For information regarding the marketing and sales of our health plans and our medical management techniques, see “Additional Information Concerning our Business—Marketing and Sales and—Medical Management.”

The pricing of our products is designed to reflect the varying costs of care based on the benefit alternatives in our products. We provide employers and employees the ability to select and enroll in products with greater managed health care and cost containment elements. In general, our HMOs provide comprehensive health care coverage for a fixed fee or premium that does not vary with the extent or frequency of medical services actually received by the member. PPO enrollees choose their medical care from a panel of contracting providers or choose a non-contracting provider and are reimbursed on a traditional indemnity plan basis after reaching an annual deductible. POS enrollees choose, each time they receive care, from conventional HMO or indemnity-like (in-network and out-of-network) coverage, with payments and/or reimbursement depending on the coverage chosen. We assume both underwriting and administrative expense risk in return for the premium revenue we receive from our HMO, POS and PPO products. We have contractual relationships with health care providers for the delivery of health care to our enrollees.

The following table contains information relating to our commercial large group members (generally defined as an employer group with more than 50 employees), commercial small group and individual members, ASO members, Medicare members and Medicaid members as of December 31, 2004 (our Medicare and Medicaid businesses are discussed below under “Medicare Products” and “Medicaid Products”):

The following table sets forth certain information regarding our employer groups in the commercial managed care operations of our Health Plan Services segment as of December 31, 2004:

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A general description of our health plan operations in Arizona, California, Oregon, Connecticut, New Jersey and New York is set forth below.

Arizona. In Arizona, we believe that our commercial managed care operations rank us seventh largest as measured by total membership and fourth largest as measured by size of provider network. Our commercial membership in Arizona was 129,055 as of December 31, 2004, which represented an increase of approximately 8% during 2004. This increase was primarily due to increased sales of our PPO products in the large and small group markets. Our Medicare membership in Arizona was 34,565 as of December 31, 2004, which represented a decrease of approximately 5% during 2004. We did not have any Medicaid members in Arizona as of December 31, 2004 or 2003.

California. We believe that Health Net of California, Inc., our California HMO (“HN California”), is the second largest HMO in California in terms of membership and the largest in terms of size of provider network. Our commercial membership in California as of December 31, 2004 was 1,560,446, which represented a decrease of approximately 7% during 2004. The decrease in commercial membership was primarily due to the implementation of higher premiums during 2004. Our commercial membership in the small group and individual market in California was 459,159 as of December 31, 2004, which represented a decrease of approximately 12% during 2004. Our Medicare membership in California as of December 31, 2004 was 95,449, which represented a decrease of approximately 4% during 2004. Our Medicaid membership in California as of December 31, 2004 was 695,613 members, which represented a decrease of approximately 1% during 2004.

Oregon. We believe that our Oregon operations make us the sixth largest managed care provider in Oregon in terms of membership. Our commercial membership in Oregon was 138,479 as of December 31, 2004, which represented an increase of approximately 15% during 2004. Of these members, approximately 11,459 reside in Washington. Our Medicare membership in Oregon increased by 8,202 members to 8,594 as of December 31, 2004 from 392 as of December 31, 2003. This increase was primarily due to our Oregon health plan’s participation in a Medicare PPO demonstration project. We did not have any Medicaid members in Oregon as of December 31, 2004 or 2003.

Northeast. Our Northeast operations are conducted in Connecticut, New Jersey and New York. For our large employer group business, we directly market commercial HMO, PPO and POS products in Connecticut and New York and commercial HMO and POS products in New Jersey. For our small employer group business in Connecticut, New Jersey and New York, we offer HMO, PPO and POS products through a marketing agreement with The Guardian pursuant to which we do business under the brand name “Healthcare Solutions.” Under the agreement, The Guardian generally has the exclusive right to market and sell our HMO, PPO and POS products to small employer groups. This exclusivity right ceases if certain sales and marketing related requirements are not met. We generally share the profits of Healthcare Solutions equally with The Guardian, subject to certain terms of the marketing agreement related to expenses. The Guardian is a mutual insurer (owned by its policy owners) which offers financial products and services, including individual life and disability income insurance, employee benefits, pensions and 401(k) products. The Guardian is headquartered in New York and has over 3,000 financial representatives in over 100 general agencies.

We believe our Connecticut operations make us the second largest managed care provider in terms of membership and the fourth largest in terms of size of provider network in Connecticut. Our commercial membership in Connecticut was 233,048 as of December 31, 2004 (including 41,232 members under The Guardian arrangement), a decrease of approximately 8% since December 31, 2003. This decrease was primarily due to the implementation of higher premiums during 2004 . Our Medicare membership in Connecticut was 26,596 as of December 31, 2004, which represented a decrease of approximately 3% during 2004, and our Medicaid membership in Connecticut was 93,774 as of December 31, 2004, which represented a decrease of approximately 5% during 2004.

We believe our New Jersey operations make us the fourth largest managed care provider in terms of membership and the fifth largest in terms of size of provider network in New Jersey. Our HMO membership in

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New Jersey was 209,516 as of December 31, 2004 (including 111,237 members under The Guardian arrangement), which represented a decrease of approximately 29% during 2004. This decrease was primarily due to the implementation of higher premiums during 2004. Our Medicaid membership in New Jersey was 42,034 as of December 31, 2004, which represented a decrease of approximately 7% during 2004. We did not have any Medicare members in New Jersey as of December 31, 2004 or 2003.

We believe our New York HMO and PPO operations make us the tenth largest managed care provider in terms of membership and the fifth largest in terms of size of provider network in New York. In New York, we had 251,967 commercial members as of December 31, 2004, which represented a decrease of approximately 7% during 2004. This decrease was primarily due to the implementation of higher premiums during 2004. Such membership included 107,657 members under The Guardian arrangement. Our Medicare membership in New York was 5,739 as of December 31, 2004, which represented an increase of 1% during 2004. We did not have any Medicaid members in New York as of December 31, 2004 or 2003.

Medicare Products

We offer our Medicare products directly to individuals and through employer groups. To enroll in one of our Medicare plans, covered persons must be eligible for Medicare. We provide or arrange health care services normally covered by Medicare, plus a broad range of health care services not covered by traditional Medicare programs. The federal Centers for Medicare & Medicaid Services (“CMS”) pays us a monthly amount for each enrolled member based, in part, upon the “Adjusted Average Per Capita Cost,” as determined by CMS’ analysis of fee-for-service costs related to beneficiary demographics and other factors. Depending on plan design and geographic area, we may charge a monthly premium. We also provide Medicare supplemental coverage to 39,066 members through either individual Medicare supplement policies or employer group sponsored coverage.

On December 8, 2003, the Medicare Prescription Drug, Improvement and Modernization Act of 2003 was signed into law. As a result of this legislation, Medicare private market plans are in the process of changing their names from Medicare+Choice to Medicare Advantage. The name change will become fully effective in 2006. See “Government Regulation—Federal Legislation and Regulation—Medicare Legislation” and “Risk Factors—Our businesses are highly regulated” for additional information regarding the Medicare legislation.

Our Medicare Advantage plans had a combined membership of 170,943 as of December 31, 2004, compared to 169,239 as of December 31, 2003.

Medicaid Products

As of December 31, 2004, we had an aggregate of 831,421 Medicaid members compared to 845,526 members as of December 31, 2003, principally in California. Of our 831,421 Medicaid members as of December 31, 2004, 476,355 reside in Los Angeles County, California. We also had Medicaid members and operations in Connecticut and New Jersey. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Enrollment Information” for detailed information regarding our Medicaid enrollment by state. To enroll in our Medicaid products, an individual must be eligible for Medicaid benefits under the appropriate state regulatory requirements. Our Medicaid HMO products include, in addition to standard Medicaid coverage, certain additional services including dental and vision benefits. The applicable state agency pays our HMOs a monthly fee for the coverage of our Medicaid members.

Our California HMO, HN California, participates in the State Children’s Health Insurance Program (“SCHIP”), which, in California, is known as the Healthy Families program. As of December 31, 2004, there were 93,288 members in our Healthy Families program. SCHIP was designed as a federal/state partnership, similar to Medicaid, with the goal of expanding health insurance to children whose families earn too much money to be eligible for Medicaid, but not enough money to purchase private insurance. Member premiums, which range from $4 to $9 per child, per month, are subsidized by the State of California. California receives two-thirds of the funding for the program from the federal government.

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Administrative Services Only Business

We provide ASO products to large employer groups in California, Connecticut, New Jersey and New York. Under these arrangements, we provide claims processing, customer service, medical management, provider network access and other administrative services without assuming the risk for medical costs. We are generally compensated for these services on a fixed per member per month basis. Our largest concentration of ASO business is in the Northeast and, in particular, Connecticut. As of December 31, 2004, we had 80,612 members through our ASO business. Of those members, approximately 76,000 were located in the Northeast.

Indemnity Insurance Products

We offer insured PPO, POS, EPO and indemnity products as “stand-alone” products and as part of multiple option products in various markets. These products are offered by our health and life insurance subsidiaries which are licensed to sell insurance in 37 states and the District of Columbia. Through these subsidiaries, we also offer group HMO members auxiliary non-health products such as group life and accidental death and dismemberment, dental, vision, behavioral health and disability insurance. Our health and life insurance products are provided throughout most of our service areas.

Other Specialty Services and Products

We offer pharmacy benefits, behavioral health, dental and vision products and services (through strategic relationships with third parties), as well as managed care products related to cost containment for hospitals, health plans and other entities as part of our Health Plan Services segment.

Pharmacy Benefit Management. We provide pharmacy benefit management services to Health Net members through our wholly-owned subsidiary, Health Net Pharmaceutical Services, Inc. (“HNPS”). HNPS provides integrated PBM services to approximately 3.2 million Health Net members who have pharmacy benefits, including approximately 170,000 seniors. HNPS manages these benefits in an effort to achieve the lowest cost for its customers. HNPS focuses its effort on encouraging appropriate use of medications to enhance the overall member outcome while controlling overall cost to the health plan, member and employer. A committee of internal and external physicians and pharmacists select medications by therapeutic class that offer demonstrable clinical value. A cost effective option is then selected from equivalently effective options.

HNPS offers affiliated health plans flexible benefit designs, cost and trend management, and delivery systems at a reasonable cost. HNPS outsources certain capital and labor-intensive functions of pharmacy benefit management, such as claims processing and mail order services in order to provide cost control. HNPS also provides pharmacy benefit administration services to non-affiliated customers who wish to self-fund their pharmacy benefit.

Behavioral Health. We provide behavioral health services through our wholly-owned subsidiary, Managed Health Network, Inc., and its subsidiaries (collectively “MHN”). MHN holds a license in California under the Knox-Keene Health Care Service Plan Act of 1975 (the “Knox-Keene Act”) as a Specialized Health Care Service Plan. MHN offers behavioral health, substance abuse and employee assistance programs (“EAPs”) on an insured and self-funded basis to employers, governmental entities and other payers in various states. These services are offered as a standard part of most of our commercial health plans. They are also sold in conjunction with other commercial and Medicare products and on a stand-alone basis to unaffiliated health plans and employer groups.

Employers participating in MHN’s programs range in size from Fortune 100 companies to mid-sized companies with under 100 employees. MHN’s strategy is to extend its market share in the Fortune 500 and health plan markets, through a combination of direct, consultant/broker and affiliate sales. MHN intends to achieve additional market share by broadening its employer products, including using the Internet as a distribution channel and by continuing to pursue sales of mental health plans that are not integrated in comprehensive benefit plans.

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MHN’s products and services were being provided to over 7.3 million individuals as of December 31, 2004, with approximately 2.3 million individuals under risk-based programs, approximately 2.3 million individuals under self-funded programs and approximately 2.8 million individuals under EAP.

In 2004, MHN’s total revenues were $231 million. Of that amount, $153 million represented revenues from business with MHN affiliates and $78 million represented revenues from non-affiliate business.

Dental and Vision. As a result of the sale of our dental and vision subsidiaries in 2003, we no longer underwrite or administer stand-alone dental and vision products. We continue to make available to our current and prospective members in Arizona, California and Oregon, private label dental products through a strategic relationship with SafeGuard Health Enterprises, Inc. (“SafeGuard”) and private label vision products through a strategic relationship with EyeMed Vision Care LLC (“EyeMed”). The stand alone dental products are underwritten and administered by SafeGuard companies and the stand alone vision products are underwritten by Fidelity Security Life Insurance Company and administered by EyeMed.

Government Contracts Segment

Our Government Contracts segment includes government-sponsored managed care plans through the TRICARE program and other health care-related government contracts. Our Government Contracts segment administers one large, multi-year managed health care government contract and other health care related government contracts. Certain components of these contracts are subcontracted to unrelated third parties.

TRICARE

Our wholly-owned subsidiary, Health Net Federal Services, Inc. (“HNFS”), administers a large managed care federal contract with the U.S. Department of Defense (the “Department of Defense”) under the TRICARE program in the North Region. Through the TRICARE program, HNFS provides eligible beneficiaries with improved access to care, lower costs and improved quality. We have been serving the Department of Defense since 1988 under the TRICARE program and its predecessor programs. We believe we have established a solid history of operating performance under our contracts with the Department of Defense. We believe there will be further opportunities to serve the Department of Defense and other governmental organizations in the future.

During 2004, we began the transition from our old TRICARE contracts to our new TRICARE contract for the North Region. Our old TRICARE contracts were comprised of three contracts covering five regions:

Our TRICARE contract for the North Region is one of three regional contracts awarded by the Department of Defense in August 2003 under the TRICARE Program. The North Region contract is a five-year contract and covers Connecticut, Delaware, Illinois, Indiana, Kentucky, Maine, Maryland, Massachusetts, Michigan, New Hampshire, New Jersey, New York, North Carolina, Ohio, Pennsylvania, Rhode Island, Vermont, Virginia, West Virginia, Wisconsin and the District of Columbia. In addition, the contract covers a small portion of Tennessee, Missouri and Iowa. Under the TRICARE contract for the North Region, we provide health care services to approximately 2.9 million Military Health System (“MHS”) eligible beneficiaries (active duty personnel and TRICARE/Medicare dual eligible beneficiaries), including 1.8 million TRICARE eligibles for whom we provide health care and administrative services and 1.1 million other MHS-eligible beneficiaries for whom we provide administrative services only.

HNFS began health care delivery on the TRICARE contract for the North Region on July 1, 2004 for the area that was previously TRICARE Regions 2 and 5 (now referred to as the Mid-Atlantic and Heartland sub-

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regions) and September 1, 2004 for the area that was previously TRICARE Region 1 (now referred to as the National Capital and Northeast sub-regions).

Health care delivery ended under our former Region 11 contract on May 31, 2004, our former Regions 9, 10 and 12 contract on June 30, 2004, and our former Region 6 contract on October 31, 2004.

Eligible beneficiaries in the TRICARE program are able to choose from a variety of program options. They can choose to enroll in TRICARE Prime, which is similar to a conventional HMO plan, or they can select, on a case-by-case basis, to utilize TRICARE Extra, which is similar to a conventional PPO plan, or TRICARE Standard, which is similar to a conventional indemnity plan.

Under TRICARE Prime, enrollees pay an enrollment fee (which is zero for active duty participants and their dependents) and select a primary care physician from a designated provider panel. The primary care physicians are responsible for making referrals to specialists and hospitals. Except for active duty family members who have no co-payment charges, TRICARE Prime enrollees pay co-payments each time they receive medical services from a civilian provider. TRICARE Prime enrollees may opt, on a case-by-case basis, for a point-of-service option in which they are allowed to self-refer but incur a deductible and a co-payment.

Under TRICARE Extra, eligible beneficiaries may utilize a TRICARE network provider but incur a deductible and co-payment which is greater than the TRICARE Prime co-payment. Under TRICARE Standard, eligible beneficiaries may utilize a TRICARE authorized provider who is not a network provider but pay a higher co-payment than under TRICARE Prime or TRICARE Extra.

As of December 31, 2004, there were 1,350,153 TRICARE eligibles enrolled in TRICARE Prime under our North Region contract. The total estimated number of eligible beneficiaries for the North Region contract as of December 31, 2004, based on data provided by the Department of Defense, was 2,928,627.

There are certain differences in the economic structure of the new TRICARE contract for the North Region as compared to our old TRICARE contracts. The old TRICARE contracts included a fixed price for health care costs for the term of the contracts, subject to adjustment based primarily on the number of TRICARE eligibles and utilization of services within military hospitals and clinics, with underruns and overruns of our fixed price provision borne 70% by the government and 30% by us. The new TRICARE contract includes a target price for the cost reimbursed health care costs which is negotiated annually during the term of the contract, with underruns and overruns of our target price provision borne 80% by the government and 20% by us. Under our old contracts, the administrative price was fixed, whereas under the new contract certain components of the administrative price are subject to volume-based adjustments.

With respect to cash flow, under the old contracts we were paid monthly based on incurred claims with an annual reconciliation of the risk sharing provision. Under the new contract, we are paid within five days for each claims run based on paid claims with an annual reconciliation of the risk sharing provision. Under the old contracts, we were responsible for providing pharmaceutical benefits, claims processing for TRICARE and Medicare dual eligibles and certain marketing and education services that we will not provide under the new contract. Under the old contracts and the new contract, the administrative price is paid on a monthly basis, one month in arrears.

We believe that the changes in the economic structure of the new TRICARE contract, when compared to our old TRICARE contracts, should reduce our risk related to the ability to accurately project our profitability over the term of the new contract. For additional information regarding our TRICARE contract for the North Region, see “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

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Other Department of Defense Contracts

During 2004, HNFS managed two behavioral health services subcontracts which support prime contracts issued by the Department of Defense’s Quality of Life Office. Under these subcontracts, HNFS and MHN have teamed together to provide family counseling and domestic abuse victim advocacy to members of the U.S. military and their families at certain Department of Defense locations in the United States, Germany and Italy. The services provided under these subcontracts are not TRICARE benefits and are provided independently from the services provided under our TRICARE contract for the North Region. Total revenue for these subcontracts as of December 31, 2004 was $5,595,939.

Veterans Affairs

During 2004, HNFS administered 17 contracts with the U.S. Department of Veterans Affairs to manage community based outpatient clinics in 12 states. HNFS also managed 21 other contracts with the U.S. Department of Veterans Affairs in 135 locations and one contract with the U.S. Marshals Service for claims re-pricing services. Total revenues for our Veterans Affairs business were approximately $20.1 million as of December 31, 2004, representing a 17.5% increase over 2003. These revenues are derived from service fees received and have no insurance risk associated with them.

Provider Relationships and Responsibilities

We maintain a network of qualified physicians, hospitals and other health care providers in each of the states we offer managed care products and services.

Physician Relationships

The following table sets forth the number of primary care and specialist physicians contracted either directly with our HMOs or through our contracted participating physician groups (“PPGs”) as of December 31, 2004:

Under many of our HMO plans and POS plans, and primarily in California, members are required to select a PPG and a primary care physician from within that group. In our other plans, including most of our plans outside of California, members may be required to select a primary care physician from the broader HMO network panel of primary care physicians. Some HMO “open access” plans and PPO plans do not require the member to select a primary care physician. The primary care physicians and PPGs assume overall responsibility for the care of members. Medical care provided directly by such physicians includes the treatment of illnesses not requiring referral, and may include physical examinations, routine immunizations, maternity and child care, and other preventive health services. The primary care physicians and PPGs are responsible for making referrals (approved by the HMO’s or PPG’s medical director as required under the terms of our various plans) to specialists and hospitals. Certain of our HMOs offer enrollees “open panels” under which members may access any physician in the network, or network physicians in certain specialties, without first consulting their primary care physician.

PPG and physician contracts are generally for a period of at least one year and are automatically renewable unless terminated, with certain requirements for maintenance of good professional standing and compliance with our quality, utilization and administrative procedures. In California and Connecticut, PPGs generally receive a monthly “capitation” fee for every member assigned to it. Under a capitation fee arrangement, we pay a provider group a fixed amount per member on a regular basis and the provider group accepts the risk of the frequency and cost of member utilization of professional services. The capitation fee represents payment in full for all medical and ancillary services specified in the provider agreements. In these capitation fee arrangements, in cases where the capitated PPG cannot provide the health care services needed, such PPGs generally contract with specialists and other ancillary service providers to furnish the requisite services under capitation agreements or negotiated

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fee schedules with specialists. Outside of California and Connecticut, most of our HMOs reimburse physicians according to a discounted fee-for-service schedule, although several have capitation arrangements with certain providers and provider groups in their market areas.

Our Connecticut HMO has a capitation contract with the Connecticut State Medical Society IPA (“CSMS”). However, all administration, referral authorization and claims administration is performed by our Connecticut health plan. Physicians are paid on a fee-for-service basis and reinsurance is provided by Health Net Services (Bermuda), Ltd., a wholly-owned subsidiary of the Company, to the IPA if claims exceed a specified aggregate limit, which means we effectively assume all risk for costs exceeding the capitation payment. We are in the process of renegotiating our contract with CSMS to eliminate the capitation arrangement and, as such, the need for reinsurance. We currently expect to finalize the new contract with CSMS on or prior to the end of the first quarter of 2005.

The inability of provider groups to properly manage costs under capitation arrangements can result in their financial instability and the termination of their relationship with us. A provider group’s financial instability or failure to pay secondary providers for services rendered could lead secondary providers to demand payment from us, even though we have made our regular capitated payments to the provider group. Depending on state law, we could be liable for such claims.

For services provided under our PPO and POS products, we ordinarily reimburse physicians pursuant to discounted fee-for-service arrangements.

Hospital Relationships

Our health plan subsidiaries arrange for hospital care primarily through contracts with selected hospitals in their service areas. These hospital contracts generally have multi-year terms or annual terms with automatic renewals and provide for payments on a variety of bases, including capitation, per diem rates, case rates and discounted fee-for-service schedules.

Covered inpatient hospital care for our HMO members is comprehensive. It includes the services of hospital-based physicians, nurses and other hospital personnel, room and board, intensive care, laboratory and x-ray services, diagnostic imaging and generally all other services normally provided by acute-care hospitals. HMO or PPG nurses and medical directors are actively involved in discharge planning and case management, which often involves the coordination of community support services, including visiting nurses, physical therapy, durable medical equipment and home intravenous therapy.

In late 2001, we began to see a pronounced increase in the number of high dollar, stop-loss inpatient claims we were receiving from hospitals. This increase was caused by some hospitals, primarily in California, aggressively raising chargemasters and billing for items separately when we believed they should have been included in the base charge. We responded to this trend by instituting a number of practices designed to reduce the cost of these claims, including, but not limited to, line item review of itemized billing statements and review of, and adjustment to, the level of prices charged on stop-loss claims.

By early 2004 we began to see evidence that our claims review practices were causing significant friction with hospitals. In the fourth quarter of 2004, management decided to enter into negotiations to settle a large number of provider disputes in our California and Northeast health plans, a majority of which related to alleged underpayment of stop-loss claims. As a result of management’s decision to settle these provider disputes, we recorded a $169 million pre-tax charge in the fourth quarter of 2004 for expenses associated with provider settlements that have been, or are currently in the process of being, resolved. We are now in the process of renegotiating our contracts with our California hospitals to provide for, among other things, a fixed reimbursement structure for reimbursement of inpatient costs, including methodologies such as diagnostic-related groupings, higher stop-loss thresholds and not-to-exceed provisions. For additional information regarding provider disputes and the fourth quarter 2004 earnings charge, see “Item 3. Legal Proceedings—Provider Disputes” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

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Ancillary and Other Provider Relationships

Our health plan subsidiaries arrange for ancillary and other provider services, such as ambulance, laboratory, radiology and home health primarily through contracts with selected providers in their service areas. These contracts generally have multi-year terms or annual terms with automatic renewals and provide for payments on a variety of bases, including capitation, per diem rates, case rates and discounted fee-for-service schedules. In certain cases, these provider services are included in contracts our health plan subsidiaries have with PPGs and hospitals.

Additional Information Concerning Our Business

Competition

We operate in a highly competitive environment in an industry currently subject to significant changes from business consolidations, new strategic alliances, legislative reform and market pressures brought about by a better informed and better organized customer base. Our HMOs face substantial competition from for-profit and nonprofit HMOs, PPOs, self-funded plans (including self-insured employers and union trust funds), Blue Cross/Blue Shield plans, and traditional indemnity insurance carriers, some of which have substantially larger enrollments and greater financial resources than we do. The development and growth of companies offering Internet-based connections between health care professionals, employers and members, along with a variety of services, could also create additional competitors. We believe that the principal competitive features affecting our ability to retain and increase membership include the range and prices of benefit plans offered, size and quality of provider network, quality of service, responsiveness to user demands, financial stability, comprehensiveness of coverage, diversity of product offerings, and market presence and reputation. The relative importance of each of these factors and the identity of our key competitors varies by market. Over the past several years, a health plan’s ability to interact with employers, members and other third parties (including health care professionals) via the Internet has become a more important competitive factor. To that end, we have made technology investments to enhance our electronic interactions with third parties. We believe that we compete effectively against other health care industry participants.

Our key competitors in California are Kaiser Permanente, Blue Cross of California, PacifiCare of California and Blue Shield of California. Kaiser is the largest HMO in California based on number of enrollees and Blue Cross of California is the largest PPO provider in California based on number of enrollees . All together, these four plans and Health Net account for a majority of the insured market in California. There are also a number of small, regional-based health plans that compete with Health Net primarily in the small business group market segment. The combined commercial HMO membership for Aetna, Inc., CIGNA Corp. and the regional plans constitutes approximately 7% of the insured market in the state.

Our largest competitor in Arizona is Blue Cross/Blue Shield. Our Arizona HMO also competes with UnitedHealth Group Inc., CIGNA, PacifiCare Health Systems, Inc., Aetna and Humana Inc. Our Oregon health plan competes primarily against Kaiser, PacifiCare of Oregon, Providence, Regence Blue Cross Blue Shield and Lifewise.

Our Connecticut health plan competes for business with WellPoint, Inc., ConnectiCare, Inc. and CIGNA. Our main competitors in New York are UnitedHealthcare/Oxford Health Plans, WellChoice, Inc. and Aetna. Our main competitors in New Jersey are UnitedHealthcare/Oxford Health Plans, Horizon Blue Cross and Health Insurance Plan of New York.

Marketing and Sales

We market our products and services to individual members through independent brokers, agents and consultants and through the Internet. We market our products and services for our group health business utilizing a three-step process. We first market to potential employer groups and group insurance brokers and consultants.

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We then provide information directly to employees once the employer has selected our health coverage. Finally, we engage members and employers in marketing for member and group retention. Although we market our products and services primarily through independent brokers, agents and consultants, we use our limited internal sales staff to serve certain large employer groups. Once selected by a large employer group, we solicit enrollees from the employee base directly. During “open enrollment” periods when employees are permitted to change health care programs, we use a variety of techniques to attract new enrollees, including, without limitation, direct mail, work day and health fair presentations and telemarketing. Our sales efforts are supported by our marketing division, which engages in product research and development, multicultural marketing, advertising and communications, and member education and retention programs.

Premiums for each employer group are generally contracted on a yearly basis and are payable monthly. We consider numerous factors in setting our monthly premiums, including employer group needs and anticipated health care utilization rates as forecasted by us based on the demographic composition of, and our prior experience in, our service areas. Premiums are also affected by applicable regulations that prohibit experience rating of group accounts (i.e., setting the premium for the group based on its past use of health care services) and by state regulations governing the manner in which premiums are structured.

We believe that the importance of the ultimate health care consumer (or member) in the health care product purchasing process is likely to increase in the future, particularly in light of advances in technology and online resources. Accordingly, we intend to focus our marketing strategies on the development of distinct brand identities and innovative product service offerings that will appeal to potential health plan members. For example, in 2004, we introduced Decision Power^SM, which is a series of programs designed to more directly involve patients in their health care decisions. These programs allow our members to access information and consult with health coaches as they are making decisions regarding health care issues. We first introduced Decision Power^SM to a select group of health plan participants in January 2004 and, in 2005, are expanding access to Decision Power^SM to a broader range of our health plan members. Based on feedback received from health plan members who have participated in the Decision Power^SM programs, we believe Decision Power^SM is being met favorably throughout our service areas. We believe that Decision Power^SM could be a meaningful competitive differentiator for our health plans in the future.

Health Net One Systems Consolidation Project

We are in the process of converting a number of information systems in our health plan business to a single system environment. At the completion of the project, we will consolidate various systems into one general ledger system, one core claims system, one data warehouse system and one core web system. In addition, we will reduce our number of surround information systems to 16 and consolidate our data centers to a single site with a tested backup facility. Key actions completed on the Health Net One systems consolidation project to date include consolidation to a single general ledger, consolidation of health plan portals, consolidation of data centers to a single site with backup facilities, consolidation of surround information systems and conversion of Arizona’s core claims system. In late 2003, we converted to a common eligibility database and in 2004 we converted to a common provider database. In order to increase our focus on market demands, revenue generation and cost-containment initiatives and to ensure the continued stabilization of claim payment patterns, we have decided to change the sequence of the Health Net One initiatives, placing the medical management initiatives and developing market capabilities ahead of the claim components of Health Net One. As a result, the conversion of the California and Oregon claims systems have been rescheduled for 2006. We believe that completion of the Health Net One systems consolidation project will improve customer/client service and communication, national product capabilities realize operational and cost efficiencies and improve our decision making capability. In addition, we believe that completion of the project will enable us to improve our claims turnaround time, auto adjudication rates, electronic data interchange and Internet capabilities. However, there are risks associated with the Health Net One systems consolidation project. See “Risk Factors—The failure to effectively maintain our management information systems could adversely affect our business.”

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Medical Management

We believe that managing health care costs is an essential function for a managed care company. Among the medical management techniques we utilize to contain the growth of health care costs are pre-authorization or certification for outpatient and inpatient hospitalizations and a concurrent review of active inpatient hospital stays and discharge planning. We also contract with third parties to manage certain conditions such as neonatal intensive care unit admissions and stays, as well as chronic conditions such as asthma, diabetes and congestive heart failure. These techniques are widely used in the managed care industry and are accepted practice in the medical profession. In 2004, we adopted several new initiatives, primarily in the Northeast, intended to strengthen medical management practices and to help lower commercial health care cost trends. We recontracted for radiology services, engaged a new out-of-network contractor and implemented more stringent inpatient concurrent review. We began to see some positive results from these initiatives throughout 2004. For example, our more focused inpatient review processes caused commercial hospital days per thousand commercial enrollees in New Jersey to drop from 263 in the first quarter of 2004 to 246 in the fourth quarter of 2004. We expect to continue to see positive results, including lower commercial health care cost trends throughout 2005. We are also engaged in similar efforts in California, where the focus has been management of inpatient hospital stays and recontracting with hospitals to reduce our exposure to charge-based reimbursement.

Accreditation

We pursue accreditation for certain of our health plans from the National Committee for Quality Assurance (“NCQA”), the Joint Committee on Accreditation of Healthcare Organizations (“JCAHO”) and the Utilization Review Accreditation Commission (“URAC”). NCQA, JCAHO and URAC are independent, non-profit organizations that review and accredit HMOs. HMOs that comply with review requirements and quality standards receive accreditation. Our California HMO subsidiary has received NCQA accreditation, our Connecticut, New Jersey and New York subsidiaries have received JCAHO accreditation and MHN and our Arizona subsidiary have each received URAC accreditation. Certain of our health plan subsidiaries are in the process of applying for NCQA or JCAHO accreditation.

Cost Containment

In most HMO plan designs, either the primary care physician or the treating specialist is responsible for obtaining authorization from either the health plan or the PPG for most medical services (except for emergency services). We believe that this authorization process reduces inappropriate use of medical resources and achieves efficiencies in cases where reimbursement is based on risk-sharing arrangements.

To limit possible abuse in utilization of hospital services in non-emergency situations, all of our health plans require that a member obtain certification for specified medical conditions prior to admission as an inpatient, and the inpatient admission is then subject to continuing review during the member’s hospital stay. In addition to reviewing the appropriateness of hospital admissions and continued hospital stays, we play an active role in evaluating alternative means of providing care to members, such as outpatient services and home-based care.

Quality Assessment

Quality assessment is a continuing priority for us. All of our health plans have a quality assessment plan administered by a committee composed of medical directors and primary care and specialist physicians. The committees’ responsibilities include periodic review of medical records, development and implementation of standards of care based on current medical literature and community standards, and the collection of data relating to results of treatment. All of our health plans also have a subscriber grievance procedure and/or a member satisfaction program designed to respond promptly to member grievances. Elements of these subscriber grievance procedures and member satisfaction programs are incorporated both within the PPGs and within our health plans.

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Government Regulation

Our business is subject to comprehensive federal regulation and state regulation in the jurisdictions in which we do business. These laws and regulations govern how we conduct our businesses and result in additional requirements, restrictions and costs to us. We believe we are in compliance in all material respects with all current state and federal laws and regulations applicable to our business. Certain of these laws and regulations are discussed below.

Federal Legislation and Regulation

Medicare Legislation. On December 8, 2003, the Medicare Prescription Drug, Improvement and Modernization Act of 2003 (the “MMA”) was signed into law. This complex legislation made many significant structural changes to the federal Medicare program. Of special interest to us and other companies with Medicare contracts is that funding has been increased to the Medicare Advantage program in 2004 and 2005. In addition, Health Savings Accounts were allowed as part of the MMA for non-Medicare eligible individuals and groups. The MMA also added a voluntary prescription drug benefit, called a “Part D” benefit, that will be available to Medicare beneficiaries starting January 1, 2006. Medicare Advantage plans will be required to offer the voluntary prescription drug benefit in at least one of their product options. The MMA also authorized a Medicare-endorsed prescription drug card program that is offered on a voluntary basis and provides Medicare beneficiaries access to prescription drug discounts. We participate in the prescription drug discount card program and began offering the card to our members in June 2004. These drug cards will cease being available when the voluntary prescription drug benefit program is implemented in January 2006.

The MMA changes the methodology for payment to private plans beginning in 2006, when a form of competitive bidding begins. The first bids are due in June 2005. For the Medicare Advantage plans, the bidding process compares each plan’s bid, which is based on historical health care costs, to a benchmark cost figure developed by CMS. The projected savings from the benchmark rate will be used 75% to fund additional benefits. The remaining 25% will be retained by CMS. The MMA also authorized regional PPOs to serve 26 regions, and other features with the intent to provide a private market option on a broader scale across the United States.

Many significant parts of the MMA were addressed through the regulatory process. The CMS issued final regulations to implement the MMA in January 2005. We are engaged in intensive evaluation of this legislation and the related regulations and intend to pursue opportunities either enhanced or created by the law. We have also restructured our Medicare program management team in an effort to build infrastructure to capitalize on opportunities presented by the MMA. The restructured Medicare program management team has been designed to increase our capability for effective execution on growth and cost management initiatives in response to opportunities presented by the MMA and the Medicare program generally.

Privacy Regulations. The use of individually identifiable data by our businesses is regulated at the federal, state and local level. These laws and regulations are changed frequently by legislation or administrative interpretation. Various state laws address the use and maintenance of individually identifiable health data. Most are derived from Health Insurance Portability and Accountability Act of 1996 (“HIPAA”) and the privacy provisions in the federal Gramm-Leach-Bliley Financial Modernization Act of 1999 (the “Gramm-Leach-Bliley Act”).

HIPAA and the implementing regulations that have been adopted in connection therewith impose obligations for issuers of health insurance coverage and health benefit plan sponsors relating to the privacy and security of electronically transmitted protected health information (“PHI”). The regulations, consisting of privacy regulations, transactions and codeset requirements and security regulations require health plans, clearinghouses and providers to:

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The regulations also establish significant criminal penalties and civil sanctions for non-compliance. We are in compliance with the HIPAA privacy regulations and the requirements relating to transactions and codesets. The security regulations have a compliance date of April 2005 and we have implemented many of the security regulations well in advance of the compliance date. In addition, we have created a security plan to ensure appropriate compliance prior to the effective date for the remaining security regulations.

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

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

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

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

California Laws and Regulations

Health Insurance Act of 2003. In October 2003, the Governor of California signed the Health Insurance Act of 2003 (the “California Health Insurance Act”), commonly referred to as “pay or play,” which would have required all California employers employing more than 200 employees to pay a fee or show proof of health insurance or other acceptable health coverage for both employees and their dependents beginning January 1, 2006. The California Health Insurance Act was repealed by referendum in November 2004. The vote to repeal the Act was close and supporters have threatened to circulate an initiative measure to reenact it. No assurances can be given as to whether or not such a measure will be considered in 2005 or thereafter.

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

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On September 28, 2000, Assembly Bill 1455 (“AB 1455”) was signed into law. AB 1455 amended and added several sections to the Knox-Keene Act. For example, AB 1455 increased the interest rate that health care service plans must pay on uncontested claims not paid promptly within the required time period and granted the DMHC addi