General

We are an integrated managed care organization that delivers managed health care services through health plans and government sponsored managed care plans. We are among the nation's largest publicly traded managed health care companies. Our mission is to help people be healthy, secure and comfortable. We provide health benefits to approximately 6.7 million individuals across the country through group, individual, Medicare (including the Medicare prescription drug benefit commonly referred to as "Part D"), Medicaid, TRICARE and Veterans Affairs programs. Our behavioral health services subsidiary, Managed Health Network (MHN), provides behavioral health, substance abuse and employee assistance programs to approximately 6.9 million individuals, including our own health plan members. Our subsidiaries also offer managed health care products related to prescription drugs, and offer managed health care product coordination for multi-region employers and administrative services for medical groups and self-funded benefits programs.

How We Report Our Results

We currently operate within two reportable segments, Health Plan Services and Government Contracts, each of which is described below.

Our Health Plan Services reportable segment includes the operations of our commercial, Medicare (including the Medicare prescription drug benefit commonly referred to as "Part D") and Medicaid health plans, the operations of our health and life insurance companies, and our behavioral health and pharmaceutical services subsidiaries. We have approximately 3.7 million members, including Medicare Part D members and administrative services only (ASO) members in our Health Plan Services segment.

Our Government Contracts segment includes our government-sponsored managed care federal contract with the U.S. Department of Defense (the Department of Defense) under the TRICARE program in the North Region and other health care related government contracts. Under the TRICARE contract for the North Region, we provide health care services to approximately 3.0 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 1.2 million other MHS-eligible beneficiaries for whom we provide ASO. We also provide behavioral health services to military families under the Department of Defense Military Family Life Counseling contract.

How We Measure Our Profitability

Our profitability depends in large part on our ability to, among other things, effectively price our health care products; manage health care costs, including reserve estimates and pharmacy costs; contract with health care providers; attract and retain members; and manage our general and administrative (G&A) and selling expenses. In addition, factors such as regulation, competition and general economic conditions affect our operations and profitability. The effect of escalating health care costs, as well as any changes in our ability to negotiate competitive rates with our providers, may impose further risks to our ability to profitably underwrite our business, and may have a material impact on our business, financial condition or results of operations.

We measure our Health Plan Services segment profitability based on medical care ratio (MCR) and pretax income. The MCR is calculated as health plan services expense (excluding depreciation and amortization) divided by health plan services premiums. The pretax income is calculated as health plan services premiums and administrative services fees and other income less health plan services expense and G&A and other net expenses. See "-Results of Operations-Table of Summary Financial Information" for a calculation of our MCR and "-Results of Operations-Health Plan Services Segment Results" for a calculation of our pretax income.

Health plan services premiums include health maintenance organization (HMO), point of service (POS) and preferred provider organization (PPO) premiums from employer groups and individuals and from Medicare recipients who have purchased supplemental benefit coverage (which premiums are based on a predetermined prepaid fee), Medicaid revenues based on multi-year contracts to provide care to Medicaid recipients, and revenue under Medicare risk contracts, including Medicare Part D, to provide care to enrolled Medicare recipients. Medicare revenue can also include amounts for risk factor adjustments and additional premiums that we charge in some places to members who purchase our Medicare risk plans (see Note 2 to our consolidated financial statements). The amount of premiums we earn in a given year is driven by the rates we charge and enrollment levels. Administrative services fees and other income primarily include revenue for administrative services such as claims processing, customer service, medical management, provider network access and other administrative services. Health plan services expense includes medical and related costs for health services provided to our members, including physician services, hospital and related professional services, outpatient care, and pharmacy benefit costs. These expenses are impacted by unit costs and utilization rates. Unit costs represent the health care cost per visit, and the utilization rates represent the volume of health care consumption by our members.

G&A expenses include those costs related to employees and benefits, consulting and professional fees, marketing, premium taxes and assessments, occupancy costs and litigation and regulatory-related costs. Such costs are driven by membership levels, introduction of new products, system consolidations, outsourcing activities and compliance requirements for changing regulations. These expenses also include expenses associated with corporate shared services and other costs to reflect the fact that such expenses are incurred primarily to support the Health Plan Services segment. Selling expenses consist of external broker commission expenses and generally vary with premium volume.

We measure our Government Contracts segment profitability based on government contracts cost ratio and pretax income. The government contracts cost ratio is calculated as government contracts cost divided by government contracts revenue. The pretax income is calculated as government contracts revenue less government contracts cost. See "-Results of Operations-Table of Summary Financial Information" for a calculation of our government contracts cost ratio and "-Results of Operations-Government Contracts Segment Results" for a calculation of our pretax income.

Government Contracts revenue is made up of two major components: health care and administrative services. The health care component includes revenue recorded for health care costs for the provision of services to our members, including paid claims and estimated incurred but not reported claims (IBNR) expenses for which we are at risk, and underwriting fees earned for providing the health care and assuming underwriting risk in the delivery of care. The administrative services component encompasses fees received for all other services provided to both the government customer and to beneficiaries, including services such as medical management, claims processing, enrollment, customer services and other services unique to the managed care support contract with the government. Government Contracts revenue and expenses include the impact from underruns and overruns relative to our target cost under the applicable contracts (see Note 2 to our consolidated financial statements).

Recent Developments

During the fourth quarter of 2008, we announced that the Company's board of directors directed our Chief Operating Officer to assume responsibility for all operational matters of the Company, and our President and Chief Executive Officer to focus his efforts on the Company's strategy, with particular emphasis on how best to deploy the Company's assets in the current competitive and economic environment. This process includes reviewing our health plans in Arizona, Connecticut, New Jersey and New York to determine their long-term strategic position in the Company as well as a possible divestiture among other strategic alternatives. We are continuing with this process and no definitive decisions have been made at this time.

During 2008, we have been actively engaged in the reprocurement process of the TRICARE North contract. In late December 2008, the government requested final proposal revisions from companies bidding on the TRICARE contracts. We submitted our response in early January 2009. We currently expect an award to occur during the first half of 2009.

2008 Financial Performance Summary

Health Net's financial performance in 2008 is summarized as follows:

• Net income for the year ended December 31, 2008 decreased to $95.0 million, or $0.88 per diluted share, from $193.7 million, or $1.70 per diluted share, for the same period in 2007, and was impacted by after tax expenses of $104.1 million, or $0.97 per diluted share, and after-tax charges of $222.4 million, or $1.96 per diluted share, related to our operations strategy, litigation and regulatory matters, and other-than-temporary impairment of investment securities (collectively referred to as Charges) for the year ended December 31, 2008 and 2007, respectively;

• Total health plan enrollment was 3,720,000 as of December 31, 2008, a decrease of 34,000 members, or approximately 1.0%, compared to December 31, 2007;

• Total revenues for the year ended December 31, 2008 increased by approximately 9% to $15.4 billion from the same period in 2007;

• Health plan services segment pretax income was $14.4 million, including $175.1 million of Charges, for the year ended December 31, 2008 and was $164.8 million, including $306.8 million of Charges, for the same period in 2007;

• Government contracts segment pretax income was $132.7 million and $194.1 million for the years ended December 31, 2008 and 2007, respectively; and

• Net cash used in operating activities totaled $159.0 million for the year ended December 31, 2008 compared to net cash provided by operating activities of $605.5 million for the same period in 2007.

Table of Summary Financial Information

The table below and the discussion that follows summarize our results of
operations for the last three fiscal years:



                                                             Year Ended December 31,
                                                   2008                 2007               2006
                                                   (Dollars in thousands, except per share and
                                                                   PMPM data)
Revenues
Health plan services premiums                 $    12,392,006       $  11,435,314      $ 10,364,740
Government contracts                                2,835,261           2,501,677         2,376,014
Net investment income                                  91,042             120,176           111,042
Administrative services fees and other
income                                                 48,280              51,104            56,554

Total revenues                                     15,366,589          14,108,271        12,908,350

Expenses
Health plan services (excluding
depreciation and amortization)                     10,762,657           9,762,896         8,600,443
Government contracts                                2,702,573           2,307,610         2,234,535
General and administrative                          1,291,059           1,275,555         1,165,313
Selling                                               360,381             327,827           245,304
Depreciation and amortization                          59,878              42,982            25,591
Interest                                               42,909              32,497            51,179
Debt refinancing charge                                    -                   -             70,095
Litigation, severance and related benefit
costs                                                      -                   -             37,093

Total expenses                                     15,219,457          13,749,367        12,429,553

Income from operations before income taxes            147,132             358,904           478,797
Income tax provision                                   52,129             165,207           149,484

Net income                                    $        95,003       $     193,697      $    329,313

Net income per share:
Basic                                         $          0.89       $        1.74      $       2.86
Diluted                                       $          0.88       $        1.70      $       2.78
Pretax margin                                             1.0 %               2.5 %             3.7 %
Health plan services medical care ratio
(MCR) (a)                                                86.9 %              85.4 %            83.0 %
Government contracts cost ratio (b)                      95.3 %              92.2 %            94.0 %
G&A expense ratio (c)                                    10.4 %              11.1 %            11.2 %
Selling costs ratio (d)                                   2.9 %               2.9 %             2.4 %
Health plan services premiums per member
per month (PMPM) (e)                          $        277.79       $      263.54      $     243.70
Health plan services costs PMPM (e)           $        241.27       $      225.00      $     202.22

(a) MCR is calculated as health plan services cost divided by health plan services premiums revenue.

(b) Government contracts cost ratio is calculated as government contracts cost divided by government contracts revenue.

(c) The G&A expense ratio is computed as G&A expenses divided by the sum of health plan services premium revenues and administrative services fees and other income.

(d) The selling costs ratio is computed as selling expenses divided by health plan services premium revenues.

(e) PMPM is calculated based on total at-risk member months and excludes ASO member months.

Summary of Operating Results

Year Ended December 31, 2008 compared to Year Ended December 31, 2007

Net income for 2008 decreased to $95.0 million from $193.7 million in 2007. Earnings per share fell to $0.89 per basic share and $0.88 per diluted share for 2008 compared with $1.74 per basic share and $1.70 per diluted share for 2007. Pretax margin was 1.0% for 2008 compared to 2.5% for 2007. Included in the 2008 operating results are $175.1 million in Charges including the following:

• $119.6 million recorded as part of G&A expenses primarily for severance and other costs associated with Health Net's operations strategy which is aimed at achieving substantial reductions in G&A by 2010. This amount also includes attorney's fees and regulatory fines associated with our rescission practices and in connection with the settlement agreement for the McCoy, Wachtel and Scharfman lawsuits. See "Item 3. Legal Proceedings" for additional information regarding these matters;

• $37.5 million recorded as part of health plan services expenses for estimated litigation and regulatory actions related to the Company's rescission practices in Arizona and California and claim-related matters in connection with the settlement agreement for the McCoy, Wachtel and Scharfman lawsuits;

• $14.6 million loss recorded as part of net investment income from other-than-temporary impairments in our available-for-sale investments and money market funds; and

• $3.4 million recorded as part of administrative services fees and other income for an impairment of assets of a small, non-core subsidiary.

Total health plan enrollment, including Medicare Part D, decreased to 3,720,000 members at December 31, 2008 from 3,754,000 members at December 31, 2007, primarily due to a decline of 225,000 commercial and ASO members and 34,000 Medicaid members, partially offset by an increase of 166,000 Medicare Part D members and 59,000 Medicare Advantage members. Our TRICARE membership increased to approximately 3.0 million beneficiaries at December 31, 2008 from 2.9 million beneficiaries at December 31, 2007.

Health Net's total revenues increased 9% in 2008 to $15.4 billion from $14.1 billion in 2007. Health plan services premium revenues increased 8% to $12.4 billion in 2008 compared to $11.4 billion in 2007. Our total premium revenue yield on a PMPM basis was 5% in 2008 compared to 8% in 2007. The health plan services medical care ratio (MCR) was 86.9% in 2008 compared to 85.4% in 2007. The MCR for 2008 and 2007 included 40 and 180 basis points, respectively, impact from the Charges.

Our Government contracts revenues increased 13% in 2008 to $2.8 billion from $2.5 billion in 2007. The Government contracts cost ratio increased to 95.3% in 2008 compared to 92.2% in 2007.

Our G&A expense ratio improved by 70 basis points to 10.4% in 2008 compared to 11.1% in 2007. The G&A expense ratio for 2008 and 2007 included the impact of 100 basis points and 90 basis points, respectively, of G&A expenses related to the operations strategy and litigation and regulatory-related charges. Our selling costs ratio remained stable at 2.9% in 2008 and in 2007.

Net cash used in operating activities totaled $159.0 million for the year ended December 31, 2008 compared to net cash provided by operating activities of $605.5 million for the same period in 2007. This decrease in cash was driven by payments made in 2008 related to operations strategy and regulatory related matters and an increase in our CMS receivables relating to catastrophic and low-income subsidies.

Year Ended December 31, 2007 compared to Year Ended December 31, 2006

Net income for 2007 decreased to $193.7 million from $329.3 million in 2006. Earnings per share fell to $1.74 per basic share and $1.70 per diluted share for 2007 compared with $2.86 per basic share and $2.78 per diluted share for 2006. Pretax margin was 2.5% for 2007 compared to 3.7% for 2006. The primary drivers of these declines were charges incurred related to litigation and regulatory matters and debt refinancing activities.

In 2007, we recorded a $306.8 million pre-tax, or $222.4 million after-tax, charge incurred as a result of us reaching an agreement in principle to settle the McCoy, Wachtel and Scharfman class action lawsuits; the proposed resolution of regulatory issues with the New Jersey Department of Banking and Insurance; arbitration settlement; and other immaterial litigation matters. See "Item 3. Legal Proceedings" for additional information regarding these matters. The charge amount was comprised of the following:

• $201.5 million recorded as part of health plan services expenses during the year ended December 31, 2007 for claim-related matters, class disbursements and remediations; and

• $105.3 million recorded as part of G&A expenses during the year ended December 31, 2007 for attorney's fees, regulatory fines, arbitration settlement and estimated liability for litigation unrelated to the class action lawsuits.

Results in 2006 reflect the impact of a $37.1 million litigation charge related to estimated legal defense costs for the McCoy, Wachtel and Scharfman litigation and $70.1 million of expenses related to the refinancing of our senior notes. See "Item 3. Legal Proceedings" for additional information on these litigation matters. See "Liquidity and Capital Resources-Capital Structure" for additional information on the refinancing of our senior notes.

Total health plan enrollment, including Medicare Part D, increased to 3,754,000 members at December 31, 2007 from 3,699,000 members at December 31, 2006, primarily due to a 73,000-member increase in our commercial small group/individual membership and a 116,000-member increase in our Medicare membership, partially offset by 140,000-member decrease in our commercial large group and ASO membership. Our strategy of targeting the small group and individual market resulted in changing the mix of our membership: approximately 35% of our commercial risk enrollment was in the small group and individual market at the end of 2007, up from 31% at the end of 2006. We continued to expand our Medicare membership, which increased by 116,000 members in 2007. On January 1, 2007, we began offering Medicare Advantage Private-Fee-For Service plans, and we began marketing our Medicare Part D plans in all 50 states and the District of Columbia. We also increased the number of Part D plan choices that we offer seniors from two in 2006 to three in 2007, one of which provides beneficiaries with coverage of generic drug expenses through the coverage gap, or "donut hole." Our TRICARE membership was stable at 2.9 million beneficiaries, and we expanded our relationship with the Department of Defense by providing behavioral health counseling services starting in 2006. In addition, our behavioral health care business unit was awarded a five-year contract in 2007 to develop, administer and monitor the non-medical counseling program for military service members known as Military Family and Life Consultant Program (MFLC). The total contract is valued at approximately $250 million.

Health Net's total revenues increased 9% in 2007 to $14.1 billion from $12.9 billion in 2006. Health plan services premium revenues increased 10% to $11.4 billion in 2007 compared to $10.4 billion in 2006. Our commercial revenue yield was 9.2% in 2007 compared to 7.6% in 2006. The health plan services MCR was 85.4% in 2007 compared to 83.0% in 2006. The MCR for 2007 included the impact of the $201.5 million, or 180 basis points, of health plan services expenses related to the litigation and regulatory-related charge noted above.

Our Government contracts revenues increased 5% in 2007 to $2.5 billion from $2.4 billion in 2006. The Government contracts cost ratio improved to 92.2% in 2007 compared to 94.0% in 2006.

Our G&A expense ratio improved by 10 basis points to 11.1% in 2007 compared to 11.2% in 2006. The G&A expense ratio for 2007 included the impact of $105.3 million, or 90 basis points, of G&A expenses related to the litigation and regulatory-related charge. Our selling costs ratio increased by 50 basis points to 2.9% in 2007 compared to 2.4% in 2006.

Net cash provided by operating activities increased to $605.5 million in 2007 compared to $277.9 million for 2006, reflecting TRICARE payment for Option 3 Period underwriting fee and the growth in our Medicare Part D business.

Consolidated Segment Results

The following table summarizes the operating results of our reportable segments
for the last three fiscal years:



                                                            Year Ended December 31,
                                                           2008        2007      2006
                                                             (Dollars in millions)
Pretax income:
Health plan services segment                             $    14.4    $ 164.8   $ 444.5
Government contracts segment                                 132.7      194.1     141.5

Total segment pretax income                              $   147.1    $ 358.9   $ 586.0
Debt refinancing charge                                         -          -      (70.1 )
Litigation, severance and related benefit costs                 -          -      (37.1 )

Income from operations before income taxes as reported   $   147.1    $ 358.9   $ 478.8

Health Plan Services Segment Membership

The following table below summarizes our health plan membership information by
program and by state:



                                 Commercial                ASO                Medicare             Medicaid          Health Plan Total
                            2008    2007    2006    2008   2007   2006   2008   2007   2006   2008   2007   2006   2008    2007    2006
                                                                     (Membership in thousands)
Arizona                       123     137     125     -      -      -      67     51     35     -      -      -      190     188     160
California                  1,352   1,468   1,483      5      6      6    133    112    104    765    712    710   2,255   2,298   2,303
Connecticut                   139     161     183     25     32     67     57     45     34     -      90     84     221     328     368
New Jersey                     73      90     103      3     17     19     -      -      -      47     44     46     123     151     168
New York                      204     234     224     11     13     17      6      3      6     -      -      -      221     250     247
Oregon                        133     135     133     -      -      -      22     21     20     -      -      -      155     156     153
Other States                   -       -       -      -      -      -      10      4     -      -      -      -       10       4      -

                            2,024   2,225   2,251     44     68    109    295    236    199    812    846    840   3,175   3,375   3,399
Medicare Part D                -       -       -      -      -      -     545    379    300     -      -      -      545     379     300

Total                       2,024   2,225   2,251     44     68    109    840    615    499    812    846    840   3,720   3,754   3,699

December 31, 2008 Compared to December 31, 2007

Our total health plan membership decreased by 34,000 members, or 1%, to 3.7 million members at December 31, 2008 when compared to December 31, 2007. The decrease was driven by a decline of 225,000 commercial and ASO members and 34,000 Medicaid members, partially offset by an increase of 166,000 Medicare Part D members, and 59,000 Medicare Advantage members.

Membership in our commercial health plans decreased by 201,000 members, or 9%, at December 31, 2008 compared to December 31, 2007. This decrease was primarily attributable to our California plan, which experienced declines of 63,000 small group/individual members and 53,000 large group members, and our Northeast plans, which experienced declines of 48,000 large group members and 21,000 small group/individual members. Our Arizona and Oregon plans experienced declines of 14,000 and 2,000 members, respectively. Our ASO enrollment declined by 24,000 members, or 35%, at December 31, 2008 compared to December 31, 2007, due to membership losses in our Northeast plans.

Membership in our Medicare Advantage program increased by 59,000 members at December 31, 2008 compared to December 31, 2007, due to membership growth primarily in California, Arizona and Connecticut. Medicare Part D membership increased by 166,000 members at December 31, 2008 compared to December 31, 2007.

In January 2008, we were directed by CMS to temporarily cease the sale of our . . .