Introduction

You should read the following analysis of our consolidated results of operations and financial condition in conjunction with the consolidated financial statements and related consolidated footnotes included in this Annual Report on Form 10-K.

The following discussion and analysis presents a review of the Company as of December 31, 2008 and its results of operations for the fiscal years ended December 31, 2008, 2007 and 2006.

Overview

As a result of the MemberHealth acquisition and Medicare Advantage expansion discussed in the notes to our financial statements set forth above, we have modified the way we manage and report our business compared to that reported during 2006. Our Senior Managed Care-Medicare Advantage segment remains unchanged and we continue to provide separate information on the results of our PFFS and HMO businesses contained in this segment. In addition, we are now including separate information regarding development of our preferred provider organization, or PPO, within this segment. We have split Part D from our Senior Market Health segment and formed a new segment to include both our Prescription PathwaySM historical product and its successor, PrescribaRxSM, and our Community CCRxSM product. We have combined the remaining former Senior Market Health segment, primarily Medicare supplement, with the former Specialty Health and Life & Annuity segments to form a new combined segment, Traditional Insurance. The Senior Administrative Services segment remains unchanged and we continue to report the corporate activities of our holding company in a separate segment. We have made reclassifications to conform prior year amounts to the current year presentation. We began to use this segment reporting structure with our annual report on Form 10-K for the year ended December 31, 2007. See "Note 22-Business Segment Information" in our consolidated financial statements included in this annual report on Form 10-K for a description of our segments.

We report inter-segment revenues and expenses on a gross basis in each of the operating segments but eliminate them in the consolidated results. These inter-segment revenues and expenses affect the amounts reported on the individual financial statement line items, but we eliminate them in consolidation and they do not change income before taxes. The significant items eliminated are

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º inter-segment revenue and expense relating to services performed by the Senior Administrative Services segment for our other segments,

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º inter-segment revenue and expense relating to PBM services performed by the Part D segment for other segments, and

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º interest on notes payable or receivable between the Corporate segment and the other operating segments.

Critical Accounting Policies

Our consolidated financial statements have been prepared in accordance with Generally Accepted Accounting Principles, known as GAAP. The preparation of our financial statements in conformity with GAAP requires us to make estimates and assumptions that affect the amounts of reported by us in our consolidated financial statements and the accompanying notes. Critical accounting policies are ones that require significant subjective or complex judgments, often as a result of the need to make estimates about the effect of matters that are inherently uncertain. These estimates are based on information available at the time the estimates are made, as well as anticipated future events. Actual results could

differ materially from these estimates. We periodically evaluate our estimates, and as additional information becomes available or actual amounts become determinable, we may revise the recorded estimates and reflect them in operating results. We believe that the following accounting policies are critical, as they involve the most significant judgments and estimates used in the preparation of our consolidated financial statements:

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º policy related liabilities and benefit expense recognition,

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º deferred policy acquisition costs,

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º goodwill and other intangible assets,

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º investment valuation,

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º recognition of premium revenues and policy benefits-Medicare products and

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º income taxes.

Policy related liabilities and benefit expense recognition

We calculate and maintain reserves for the estimated future payment of claims to our policyholders using actuarial assumptions that are consistent with actuarial assumptions we use in the pricing of our products. For our accident and health insurance business, we establish an active life reserve for expected future policy benefits, plus a liability for due and unpaid claims and incurred but not reported claims, known as IBNR. Benefit expenses are recognized in the period in which services are provided or claims are incurred and include an estimate of the cost of services and IBNR claims. Our net income depends upon the extent to which our actual claims experience is consistent with the assumptions we used in setting our reserves and pricing our policies. If our assumptions with respect to future claims are incorrect, and our reserves are insufficient to cover our actual losses and expenses, we would be required to increase our liabilities, resulting in reduced net income and shareholders' equity.

The following table presents a summary of our policy-related liabilities by category:

                                                            December 31,
                                                        % of                          % of
                                                        Total                         Total
                                                       Policy                        Policy
Liability Type                           2008        Liabilities       2007        Liabilities
                                                          ($ in thousands)
Policyholder account balances         $   396,700              23 % $   434,859              24 %
Future policy benefit reserves:
      Traditional life insurance          209,986              12 %     202,258              11 %
      Accident and health                 415,026              23 %     414,192              23 %

Total future policy benefit               625,012              35 %     616,450              34 %
reserves

Policy and contract claims-accident       729,070              41 %     735,364              41 %
and health
Policy and contract claims-Life            10,133               1 %      12,213               1 %

Total policy liabilities              $ 1,760,915             100 % $ 1,798,886             100 %

Policyholder account balances represent the balance that accrues to the benefit of the policyholder, otherwise known as the account value, as of the financial statement date. Account values increase to reflect additional deposits received and interest credited based on the account value. Account values decline to reflect surrenders and other withdrawals, including withdrawals relating to the cost of

insurance and expense charges. We review the interest crediting rates periodically and adjust them with minimum levels below which the crediting rate cannot fall as we deem necessary.

The liability for future policy benefits represents the present value of estimated future benefits to be paid to or on behalf of policyholders, less the future value of net premiums. We calculate this amount based on actuarially recognized methods using morbidity and mortality tables, which we modify to reflect our actual experience when appropriate.

The liability for future policy benefits represents the present value of estimated future benefits to be paid to or on behalf of policyholders, less the future value of net premiums. We calculate this amount based on actuarially recognized methods using morbidity and mortality tables, which we modify to reflect our actual experience when appropriate.

For our fixed benefit accident and sickness and our long term care products, we establish a reserve for future policy benefits at the time we issue each policy based on the present value of future benefit payments less the present value of future premiums. We have ceased issuing new long term care policies, although our current policies are renewable annually at the discretion of the policyholder, as evidenced by the policyholder continuing to make premium payments. In establishing these reserves, we must evaluate assumptions about mortality, morbidity, lapse rates and the rate at which new claims are submitted to us. We estimate the future policy benefits reserve for these products using the above assumptions and actuarial principles. For long-duration insurance contracts, we use these original assumptions throughout the life of the policy and generally do not subsequently modify them.

A portion of our reserves for long-term care products also reflect our estimates relating to members currently receiving benefits. We estimate these reserves primarily using recovery and mortality rates, as described above.

     Policy and Contract Claims-Accident and Health Policies

    The policy and contract claims liability for our accident and health
policies include a liability for unpaid claims, including claims in the course
of settlement, as well as a liability for IBNR claims. Our IBNR, by major
product grouping is as follows:

                                                              Carrying Value at December 31,
                                                                                               Net of Reserves Ceded
                                                      Direct and Assumed                           to Reinsurers
                                                     % of                        % of
                                                     Total                       Total
                                                    Policy                      Policy
Accident & Health Claims Liability     2008       Liabilities      2007       Liabilities        2008          2007
                                                                     ($ In thousands)
Medicare Part D                      $ 408,802              23 % $ 352,688              20 %  $   396,205    $ 336,218
Medicare Advantage-PFFS                197,942              11 %   246,048              13 %      197,075      240,832
Medicare Advantage-HMO                  59,366               3 %    57,233               3 %       56,367       53,563
Medicare supplement                     43,590               2 %    46,834               3 %       31,715       33,653
Other-specialty                         19,370               2 %    32,561               2 %       16,787       16,346

Total accident and health claim
liabilities                          $ 729,070              41 % $ 735,364              41 %  $   698,149    $ 680,612

The following factors can affect these reserves and liabilities:

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º economic and social conditions,

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º inflation,

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º hospital and pharmaceutical costs,

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º changes in doctrines of legal liability,

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º premium rate increases,

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º extra-contractual damage awards, and

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º other factors affecting health care and insurance generally.

Therefore, we establish the reserves and liabilities based on extensive estimates, assumptions and prior years' statistics. When we acquire other insurance companies or blocks of insurance, our assessment of the adequacy of acquired policy liabilities is subject to similar estimates and assumptions. Establishing reserves involves inherent uncertainties, and it is possible that actual claims could materially exceed our reserves and have a material adverse effect on our results of operations and financial condition.

We develop our estimate for IBNR using actuarial methodologies and assumptions, primarily based upon historical claim payment and claim receipt patterns, as well as historical medical cost trends. Depending on the period for which we are estimating incurred claims, we apply a different method in determining our estimate. For periods prior to the most recent three months, the key assumption we use in estimating our IBNR is that the completion factor pattern, adjusted for known changes in claim inventory levels and claim payment processes, remains consistent over a specified rolling period. This period, ranging from 3 to 12 months, is dependent on the type of business with respect to which we are estimating reserves or liabilities. Completion factors result from the calculation of the percentage of claims incurred during a given period that have historically been adjudicated as of the reporting period. For the most recent three months, we estimate the incurred claims primarily from a trend analysis based upon per member per month, known as PMPM, claims trends developed from our historical experience in the preceding months, adjusted for known changes in estimates of recent hospital and drug utilization data, provider contracting changes, changes in benefit levels, product mix, and seasonality.

We use the completion factor method for the months of incurred claims prior to the most recent three months because the historical percentage of claims processed for those months is at a level sufficient to produce a consistently reliable result. Conversely, for the most recent three months of incurred claims, the volume of claims processed historically is not at a level sufficient to produce a reliable result, which therefore requires that we examine historical trend patterns as the primary method of evaluation. Because cumulative claims payment development often fluctuates widely close to the incurral date of claims, estimates for the most recent three months of incurred claims are based largely on our pricing assumptions for the product. The amounts above reflect the estimated potential medical and other expenses payable based upon assumptions used in determining the loss ratio for the pricing of our PFFS products.

Medical cost trends potentially are more volatile than other segments of the economy. The principal intrinsic drivers of medical cost trends are:

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º changes in the utilization of hospital facilities, physician services, prescription drugs, and new medical technologies, and

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º the inflationary effect on the cost per unit of each of these expense components.

Other external factors may impact medical cost trends, such as:

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º government-mandated benefits,

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º other regulatory changes,

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º increases in medical services,

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º an aging population,

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º natural disasters and other catastrophes, and

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º epidemics.

Factors internal to our company may also affect our ability to accurately predict estimates of historical completion factors or medical cost trends, such as:

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º claims processing cycle times,

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º changes in medical management practices, and

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º changes in provider contracts.

We consider all of these factors in estimating IBNR and in estimating the PMPM claims trend for purposes of determining the reserve for the most recent three months. Additionally, we continually prepare and review follow-up studies to assess the reasonableness of the estimates generated by our process and methods over time. We also consider the results of these studies in determining the reserve for the most recent three months. Each of these factors requires significant judgment by management.

The following table presents the components of the change in our accident and health policy and contract claim liabilities for the years ended December 31, 2008, 2007 and 2006:

                                               2008          2007         2006
                                                       (In thousands)
       Balance at beginning of year         $   735,364   $   193,391   $ 107,156
          Less reinsurance recoverables         (56,580 )     (54,615 )   (29,258 )

       Net balance at beginning of year         678,784       138,776      77,898

       Balances acquired                              -       280,982           -
       Incurred related to:
          Current year                        3,846,808     1,881,554     857,898
          Prior years                           (44,803 )      (1,485 )      (628 )

       Total incurred                         3,802,005     1,880,069     857,270
       Paid related to:
          Current year                        3,210,310     1,463,482     720,901
          Prior years                           574,495       157,561      75,491

       Total paid                             3,784,805     1,621,043     796,392

       Net balance at end of year               695,984       678,784     138,776
       Plus reinsurance recoverables             33,086        56,580      54,615

       Balance at end of year               $   729,070   $   735,364   $ 193,391

The negative medical cost amount, noted as "prior year development" in the table above, represents favorable adjustments as a result of prior year claim estimates being settled for amounts less than originally anticipated. These favorable developments occur due to differences between the actual medical utilization and other components of medical cost trends, and actual claim processing and

payment patterns compared to the assumptions for claims trend and completion factors used to estimate our claim liabilities.

The claim reserve balances at December 31, 2007 ultimately settled during 2008 for $44.8 million less than originally estimated, representing 2.4% of the incurred claims recorded in 2007. The majority of the favorable development of 2007 claim reserves resulted from our Senior Managed Care-Medicare Advantage segment, including $35.2 million relating to our PFFS business and $6.9 million relating to our HMO business. The actual claims trends were lower than the original estimate of trend factors as a result of:

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º lower than estimated utilization of hospital and physician services, and

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º limited historical information from which to base trend rate estimates at December 31, 2007, due to the rapid growth in our PFFS product in new geographic areas.

Additionally, our original estimate of the completion factors used to establish reserves at December 31, 2007, which were based upon historical patterns, were lower than the actual pattern that emerged during 2008. The actual patterns reflect a shortening of the cycle time associated with provider claim submissions and changes in claim payment and recovery patterns associated with continued enhancements made in our claims processing functions for our PFFS product.

We have adjusted for the favorable historical trend and completion factor experience together with our knowledge of recent events that may impact current trends and completion factors when establishing our reserves at December 31, 2008. However, based on our historical experience, it is reasonably likely that our actual trend and completion factors may vary from the factors used in our December 31, 2008 estimates. Any future variances are expected to be within the ranges presented in our sensitivity analysis table.

During the fourth quarter of 2008, we determined that a number of PFFS claims had been submitted to us by fictitious providers, as well as by some actual providers, seeking reimbursement for services that were not rendered. We believe that these activities are part of a pattern that has targeted traditional Medicare, as well as several Medicare Advantage PFFS plans including ours. We estimate that we paid approximately $18.9 million in benefits as a result of these false claims, mostly incurred in the fourth quarter of 2008, which reduced our fourth quarter profits by approximately $0.14 per share. These false claims, which we reflected in claims and other benefits in the consolidated statements of operations, did not have any impact on our prior year claim reserve development, as discussed above.

During 2007, the claim reserve balances at December 31, 2006 ultimately settled for $1.5 million less than originally estimated, representing 0.2% of the incurred claims recorded in 2006. During 2006, the claim reserve balances at December 31, 2005 ultimately settled for $0.6 million more than originally estimated, representing 0.1% of the incurred claims recorded in 2005.

In 2007, we acquired MemberHealth. The "balances acquired" line item in the table above represents the accident and health claim liabilities acquired in this transaction.

The following table illustrates the sensitivity of our accident and health IBNR payable at December 31, 2008 to identified reasonably possible changes to the estimated weighted average completion factors and health care cost trend rates. However, it is possible that the actual completion

factors and health care cost trend rates will develop differently from our historical patterns and therefore could be outside of the ranges illustrated below.

               Completion Factor(1):              Claims Trend Factor(2):
                               Increase                           (Decrease)
                            (Decrease) in                        Increase in
           (Decrease)        Net Accident     (Decrease)         Net Accident
            Increase           & Health        Increase            & Health
           in Factor             IBNR         in Factor              IBNR
                                    ($ in thousands)
                    (3 )%    $       2,115             (3 )%    $       (11,269 )
                    (2 )%    $       1,409             (2 )%    $        (7,512 )
                    (1 )%    $         704             (1 )%    $        (3,756 )
                     1 %     $        (704 )            1 %     $         3,769
                     2 %     $      (1,407 )            2 %     $         7,537
                     3 %     $      (2,111 )            3 %     $        11,306


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   º (1)

º (2)
º Reflects estimated potential changes in medical and other expenses payable, caused by changes in annualized claims trend used for the estimation of per member per month incurred claims for the most recent three months.

The liability for unpaid claims, which also reflects IBNR, reflects estimates of amounts to fully settle known reported claims as well as claims related to insured events that we estimate have been incurred, but have not yet been reported to us.

We defer the following costs of acquiring new business:

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º non-level commissions,

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º agency production costs,

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º policy underwriting costs,

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º policy issue costs,

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º associated issuance costs, and

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º other costs that vary with, and are primarily related to, the production of new and renewal business.

We refer to these costs as deferred acquisition costs or DAC. For interest-sensitive life and annuity products, we amortize these costs in relation to the present value of expected gross profits on the policies arising principally from investment, mortality and expense margins in accordance with FAS No. 97, "Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses from the Sale of Investments." The determination of expected gross profits for interest-sensitive products is an inherently uncertain process that relies on assumptions regarding:

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º projected interest rates,

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º the persistency of the policies issued,

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º anticipated benefits,

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º anticipated commissions,

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º anticipated expenses, and

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º other factors regarding these products.

It is possible that the actual profits from the business may vary materially from the assumptions used in the determination and amortization of DAC.

For other life and health products, we amortize DAC in proportion to premium revenue using the same assumptions used in estimating the liabilities for future policy benefits in accordance with FAS No. 60, "Accounting and Reporting by Insurance Enterprises." Under FAS No. 60, any unamortized DAC relating to lapsed policies must be amortized as of the date of the lapse. During 2007, we experienced an increase in the amount of lapses on our Medicare supplement business, resulting in an increased level of DAC amortization. During 2008, we have seen improved persistency on this business, requiring less amortization of DAC.

We have approximately $238 million of unamortized DAC as of December 31, 2008. Approximately $84 million relates to our Life and Annuity business which we have entered into an agreement to reinsure. We anticipate that the closing will take place during the second quarter of 2009. Upon the closing of the reinsurance agreement, the Life & Annuity DAC will be written off as part of the net gain or loss on the transaction.

We test for the recoverability of DAC at least annually. To the extent that we determine that the present value of future policy premiums and investment income or the net present value of expected gross profits would not be adequate to recover the unamortized costs, we would write off the excess deferred policy acquisition costs. Based on our review of DAC recoverability as October 1, 2008, we determined the DAC was recoverable.

Goodwill and other intangible assets

Valuation of acquired intangible assets

Business combinations accounted for as a purchase result in the allocation of the purchase consideration to the fair values of the assets and liabilities acquired, including the present value of future profits, establishing these fair values as the new accounting basis of the acquired assets. The present value of future profits is based on an estimate of the cash flows of the in force . . .