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Catalyst Health Solutions, Inc. – ‘S-3/A’ on 11/12/04

On:  Friday, 11/12/04, at 6:56am ET   ·   Accession #:  1193125-4-193965   ·   File #:  333-119787

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  As Of                Filer                Filing    For·On·As Docs:Size              Issuer               Agent

11/12/04  Catalyst Health Solutions, Inc.   S-3/A                  4:1.9M                                   RR Donnelley/FA

Document/Exhibit                   Description                      Pages   Size 

 1: S-3/A       S-3/A #1                                            HTML   1.36M 
 2: EX-10.1     Employment Agreement by and Between Catalyst Rx     HTML     30K 
                          and Kevin C Hooks                                      
 3: EX-23.1     Consent of Pricewaterhaousecoopers LLP              HTML      6K 
 4: EX-23.2     Consent of Kaufman Rossin & Co Pa                   HTML      6K 

Table of Contents

As filed with the Securities and Exchange Commission on November 12, 2004

Registration No. 333-119787

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

AMENDMENT NO. 1

TO THE

FORM S-3

REGISTRATION STATEMENT

UNDER

THE SECURITIES ACT OF 1933

HEALTHEXTRAS, INC.

(Exact Name of Registrant as Specified in Its Charter)

800 King Farm Boulevard, Rockville, Maryland 20850

(301) 548-2900

(Address, including zip code, and telephone number, including area code, of registrant’s principal executive offices)

David T. Blair

Chief Executive Officer

800 King Farm Boulevard

Rockville, Maryland 20850

(301) 548-2900

(Name, address, including zip code, and telephone number, including area code, of agent for service)

Copies to:

Approximate date of commencement of proposed sale to the public:    As soon as practicable after the effective date of this Registration Statement.

If the only securities being registered on this Form are being offered pursuant to dividend or interest reinvestment plans, please check the following box.  ¨

If any of the securities being registered on this form are to be offered on a delayed or continuous basis pursuant to Rule 415 under the Securities Act of 1933, other than securities offered only in connection with dividend or interest reinvestment plans, check the following box.  ¨

If this Form is filed to register additional securities for an offering pursuant to Rule 462(b) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering.  ¨

If this Form is a post-effective amendment filed pursuant to Rule 462(c) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering.  ¨

If delivery of the prospectus is expected to be made pursuant to Rule 434, check the following box.  ¨

CALCULATION OF REGISTRATION FEE

The Registrant hereby amends this Registration Statement on such date or dates as may be necessary to delay its effective date until the Registrant shall file a further amendment which specifically states that this Registration Statement shall thereafter become effective in accordance with Section 8(a) of the Securities Act of 1933 or until the Registration Statement shall become effective on such date as the Securities and Exchange Commission, acting pursuant to Section 8(a), may determine.

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The information in this prospectus is not complete and may be changed. We may not sell these securities until the registration statement filed with the Securities and Exchange Commission is effective. This prospectus is not an offer to sell these securities and it is not soliciting offers to buy these securities in any jurisdiction where the offer or sale is not permitted.

Subject to Completion, dated November 12, 2004

PROSPECTUS

5,000,000 Shares

Common Stock

This is an offering of shares of common stock of HealthExtras, Inc. Of the 5,000,000 shares being offered, we are selling 3,500,000 shares and the selling stockholders identified in this prospectus are selling 1,500,000 shares. We will not receive any of the proceeds from the sale of shares by the selling stockholders.

Our common stock is traded on the Nasdaq National Market under the symbol “HLEX.” On November 10, 2004, the last reported sale price of our common stock on the Nasdaq National Market was $14.65 per share.

Investing in our common stock involves risks. “Risk Factors” begin on page 7.

We and the selling stockholders have granted the underwriters a 30-day option to purchase up to an aggregate of 750,000 additional shares of common stock to cover over-allotments.

Neither the Securities and Exchange Commission nor any state securities commission has approved or disapproved of these securities or determined if this prospectus is accurate or complete. Any representation to the contrary is a criminal offense.

Lehman Brothers, on behalf of the underwriters, expects to deliver the shares on or about                     , 2004.

LEHMAN BROTHERS

PIPER JAFFRAY

FIRST ALBANY CAPITAL

                    , 2004.

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You should rely only on the information contained or incorporated by reference in this prospectus. We have not, and the underwriters have not, authorized any other person to provide you with different information. This prospectus is not an offer to sell, nor is it seeking an offer to buy, these securities in any state where the offer or sale is not permitted. The information in this prospectus is complete and accurate as of the date on the front cover, but the information may have changed since that date.

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PROSPECTUS SUMMARY

The items in the following summary are described in more detail later in this prospectus. This summary provides an overview of selected information and does not contain all the information you should consider before making a decision to invest in our common stock. Therefore, you should also read the more detailed information set out in this prospectus and the financial statements and other information incorporated by reference into this prospectus. Unless otherwise indicated in this prospectus, the terms “we,” “us,” “our” and the “Company” refer to HealthExtras, Inc. and its consolidated subsidiaries.

Our Business

We provide pharmacy benefit management, “PBM,” services and supplemental benefit programs. Our PBM segment, which operates under the brand name “Catalyst Rx,” accounted for approximately 86% and 91% of our revenue in 2003 and the first nine months of 2004, respectively, and is expected to be the primary source of our growth and profits in the future. Our PBM clients include more than 1,000 self-insured employers, including state and local governments, third-party administrators, “TPAs,” and managed care organizations, who contract with us to administer the prescription drug component of their overall health benefit programs.

We also offer supplemental benefit programs developed by us under the brand name “HealthExtras,” which include lump sum accidental disability benefits, accidental death and dismemberment benefits, and emergency accident and sickness medical benefits. We contract with insurance companies to underwrite the insurance components of these programs. As a result, the financial responsibility for the payment of claims resulting from a qualifying event covered by the insurance features of our programs is borne by the third-party insurers. Our supplemental benefits segment accounted for approximately 14% and 9% of our revenue in 2003 and the first nine months of 2004, respectively. Individuals are the major purchasers of these programs.

Pharmacy Benefit Management

We provide our clients access to a contracted, non-exclusive national network of more than 53,000 pharmacies. Our services provide our clients’ members with timely and accurate benefit adjudication, while controlling pharmacy spending trends through customized plan designs, physician orientation programs and member education. We maintain an electronic point-of-sale system of eligibility verification and plan design information, and we offer access to rebate arrangements for certain branded pharmaceuticals. Our PBM revenue grew from $4.9 million in 2000 to $331.5 million in 2003. This growth resulted primarily from increased number of clients served, broadened service offerings, increased pharmacy utilization and acquisitions. During 2003 and the first nine months of 2004, we processed more than 9.0 million and 8.7 million pharmacy claims transactions, respectively.

Our acquisitions of International Pharmacy Management, Inc., “IPM,” in 2000, Catalyst Rx, “Catalyst,” in 2001, Pharmacy Network National Corporation, “PNNC,” in 2002, and Managed Healthcare Systems, Inc., “MHS,” in 2004, have contributed significantly to the growth of our PBM business. Approximately 28% of our revenue in 2003 was directly attributable to these acquisitions. This amount of revenue does not include our subsequent expansion of the operations of the acquired businesses. We continue to develop our PBM service offerings and have integrated our strategic acquisitions of IPM, Catalyst and PNNC into a single operating unit. In each of these acquisitions, we achieved our objectives by expanding service offerings, improving profitability and growing the revenue base of the acquired businesses. We are in the process of integrating our most recent acquisition, MHS. MHS was acquired in June 2004 and gives us specialized PBM capabilities for workers’ compensation and hospice care. While internal growth remains central to our strategy, we will continue to selectively pursue acquisition opportunities which complement our existing operations.

The PBM industry has developed and grown in response to the increased utilization of pharmaceuticals, increasing unit costs and broader application of prescription drugs to various health conditions. These factors

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have combined to create a significant and recurring escalation in the cost of drug coverage offered by self-insured employers, including state and local governments and TPAs. According to 2003 survey data from national benefit consultants, employer-sponsored pharmacy benefit costs increased between 14.2% and 16.9% annually in each of the four years ending in 2002. In order to manage and mitigate these trends, many of those organizations have contracted for the services offered by PBMs.

Supplemental Benefit Programs

Our supplemental benefits segment generates revenue from the sale of supplemental benefit programs which include lump sum accidental disability benefits, accidental death and dismemberment benefits, and emergency accident and sickness medical benefits. In recent periods, our supplemental benefit programs have been marketed and sold to individuals primarily by three nationally-recognized companies, which incur the marketing expenses. Accordingly, our supplemental benefit revenue from new members is primarily dependent on the extent and timing of marketing campaigns funded by these three companies and the success they achieve. All of the insurance and service features included in our programs are supplied by third-party insurance companies or other vendors, and the programs are distributed through an independent, licensed and non-affiliated insurance agency.

Our Competitive Strengths

We have demonstrated our ability to add and retain a broad range of clients from large managed care organizations to employer groups with fewer than a thousand members. We believe the following are our principal competitive strengths:

Our Strategy

Key elements of our strategy include:

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Recent Developments

On July 1, 2004, we began providing PBM services to employees, dependents and retirees under a contract with the State of Louisiana, which covers approximately 180,000 lives and has a three-year term. It is the largest contract ever awarded to us in terms of revenue and covered lives. We expect that this contract will generate between 15% and 20% of our revenue in the fourth quarter of 2004. This contract is important not only for its size but because it was awarded in a highly competitive and thorough selection process. The award and successful implementation of the contract should position us favorably for additional growth opportunities in both the public and private sectors.

We believe our acquisition of MHS on June 18, 2004 allows us to offer an improved range of services to our existing clients, facilitates the expansion of our business development initiatives in Florida and increases our revenue and cash flow. While the achievement of these objectives is dependent on the successful integration of MHS into our existing operations, we believe that such integration should be fully and successfully completed by the third quarter of 2005.

HealthExtras is a Delaware corporation. Our principal offices are located at 800 King Farm Boulevard, Rockville, Maryland, 20850, and our telephone number is (301) 548-2900. Our Internet address is www.healthextras.com. The information contained in our Web site is not a part of, nor is it incorporated by reference into, this prospectus.

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The Offering

Risk Factors

For a discussion of certain risks that should be considered in connection with an investment in our common stock, see “Risk Factors.”

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Summary Historical Financial Data

The summary historical consolidated financial data set forth below as of and for each of the five years in the period ended December 31, 2003, have been derived from consolidated financial statements that have been audited by PricewaterhouseCoopers LLP, an independent registered public accounting firm. The consolidated financial statements as of and for the three years ended December 31, 2003 are included elsewhere in this prospectus. The summary historical consolidated financial data as of and for the nine month periods ended September 30, 2003 and 2004 have been derived from our unaudited financial statements included elsewhere in this prospectus. In our opinion, the unaudited financial information includes all adjustments, consisting only of normal recurring adjustments, considered necessary for a fair presentation of that information. Operating results for the nine months ended September 30, 2004 are not necessarily indicative of the results that may be expected for the full year ending December 31, 2004. The following table also sets forth certain unaudited pro forma financial data assuming the acquisition of MHS had been completed as of January 1, 2003, after giving effect to purchase accounting adjustments. The summary unaudited pro forma consolidated statement of operations data for the year ended December 31, 2003 and for the nine months ended September 30, 2004 have been derived from our unaudited pro forma financial statements included elsewhere in this prospectus. The pro forma results of operations are not necessarily indicative of the results that would have occurred had we acquired MHS on January 1, 2003, nor are these results indicative of future operating results.

The information set forth below should be read in conjunction with our consolidated financial statements and the related notes, our Pro Forma Financial Information, and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” appearing elsewhere or incorporated by reference in this prospectus.

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RISK FACTORS

You should carefully consider the following risk factors before you decide to buy our common stock. You should also consider the other information in or incorporated by reference into this prospectus. If any of these risks actually occur, our business, results of operations, financial condition, or cash flows could suffer. This could cause the trading price of our common stock to decline, and you could lose part or all of your investment.

Risks Related To Our Pharmacy Benefits Management Segment

Competition in our industry is intense and could reduce or eliminate our profitability.

The PBM industry is very competitive. If we do not compete effectively, our business, results of operations and financial condition could suffer. The industry is highly consolidated and dominated by a few large companies with significant resources, purchasing power and other competitive advantages, which we do not have. A limited number of firms, including national PBM companies such as Medco Health Solutions, Inc., “Medco,” Express Scripts, Inc., “Express Scripts” and Caremark Rx, Inc., “Caremark,” have an aggregate market share of approximately 70% of prescription volume. Our competitors also include drug retailers, physician practice management companies, and insurance companies/health maintenance organizations. We may also experience competition from other sources in the future. PBM companies compete primarily on the basis of price, service, reporting capabilities and clinical services. In most cases, our competitors are large, profitable and well-established companies with substantially greater financial and marketing resources than our resources.

If we lose key clients as a result of competitive bidding for contracts, consolidation of clients or otherwise, our business, profitability and growth prospects could suffer.

We depend on a limited number of clients for a significant portion of our revenue. Our top ten clients generated approximately 44%, and our top twenty clients generated approximately 56%, of the claims we processed in 2003, although no single client accounted for greater than 11% of all revenue. Our business, results of operations and financial condition could suffer if we were to lose one or more of our significant clients.

Many of our clients put their contracts out for competitive bidding prior to expiration. Competitive bidding requires costly and time-consuming efforts on our behalf and, even after we have won such bidding processes, we can incur significant expense in proceedings or litigation contesting the adequacy or fairness of these bidding processes. We could lose clients if they cancel their agreements with us, if we fail to win a competitive bid at the time of contract renewal, if the financial condition of any of our clients deteriorates or if our clients are acquired by, or acquire, companies with which we do not have contracts. Over the past several years, self-funded employers, TPAs and other managed care companies have experienced significant consolidation. Consolidations by their very nature reduce the number of clients who may need our services. A client involved in a merger or acquisition by a company that is not a client of ours may not renew, and in some instances may terminate, its contract with us. Our clients have been and may continue to be, subject to consolidation pressures.

If we lose pharmacy network affiliations, our business, results of operations and financial condition could suffer.

Our PBM operations are dependent to a significant extent on our ability to obtain discounts on prescription purchases from retail pharmacies that can be utilized by our clients and their members. Our contracts with retail pharmacies, which are non-exclusive, are generally terminable by either party on short notice. If one or more of our top pharmacy chains elects to terminate its relationship with us or if we are only able to continue our relationship on terms less favorable to us, access to retail pharmacies by our clients and their health plan members, and our business, results of operations and financial condition could suffer. In addition, some large retail pharmacy chains either own or have strategic alliances with PBMs or could attempt to acquire or enter into these kinds of relationships in the future. Ownership of, or alliances with, PBMs by retail pharmacy chains, particularly large pharmacy chains which together control 45% of retail pharmacy business, could have material adverse effects on our relationships with those retail pharmacy chains, particularly the discounts they are willing to make available, and on our business, results of operations and financial condition.

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If we lose relationships with one or more key pharmaceutical manufacturers or if rebate payments we receive from pharmaceutical manufacturers decline, our business, results of operations and financial condition could suffer.

We receive rebates from numerous pharmaceutical manufacturers based on the use of selected drugs by members of health plans sponsored by our clients, as well as fees for other programs and services. We believe our business, results of operations and financial condition could suffer if:

Over the next few years, as patents expire covering many brand name drugs that currently have substantial market share, generic products will be introduced that may substantially reduce the market share of these brand name drugs. Historically, manufacturers of generic drugs have not offered formulary rebates on their drugs. Our profitability could be adversely affected if the use of newly approved, brand name drugs added to formularies, does not offset any decline in use of brand name drugs whose patents expire.

If our business continues to grow rapidly and we are unable to manage this growth, our business, results of operations and financial condition could suffer.

Our business has grown rapidly since 2000, in part due to acquisitions, with total annual PBM revenue increasing from $4.9 million in 2000 to $331.5 million in 2003. Our business strategy is to continue to seek to expand our PBM operations, including through possible acquisitions. If we are unable to finance continued growth, manage future expansion or hire and retain the personnel needed to manage our business successfully, then our business, results of operations and financial condition could be adversely affected. Our growth in operations has placed significant demands on our management and other resources, which is likely to continue. Our acquisition of MHS in June 2004 gives us specialized PBM capabilities for workers’ compensation and hospice care, which we did not previously have. Under these conditions, it is important for us to retain our existing management, including those from MHS, Catalyst and PNNC, and to attract, hire and retain additional highly skilled and motivated officers, managers and employees.

If we are unable to manage potential problems and risks related to future acquisitions, our business, results of operations and financial condition could suffer.

Part of our growth strategy includes making acquisitions involving new markets and complementary products, services, technologies and businesses. If we are unable to overcome the potential problems and inherent risks related to such future acquisitions, our business, results of operations and financial condition could suffer. Our ability to continue to expand successfully through acquisitions depends on many factors, including our ability to identify acquisition prospects and negotiate and close transactions. Even if we complete future acquisitions:

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In June 2004, we acquired MHS, which we are in the process of integrating into our business operations. There are risks associated with integrating and operating newly acquired businesses. We can give no assurance that we will successfully operate this new business in the future.

Many companies compete for acquisition opportunities in the PBM industry. Most of our competitors are companies that have significantly greater financial and management resources than we do. This may reduce the likelihood that we will be successful in completing acquisitions necessary to the future success of our business.

If we become subject to liability claims that are not covered by our insurance policies, we may be liable for damages and other expenses that could have a material adverse effect on our business, results of operations and financial condition.

Various aspects of our business may subject us to litigation and liability for damages, for example, the performance of PBM services and the operation of our call centers and Web site. A successful product or professional liability claim in excess of our insurance coverage where we are required to pay damages, incur legal costs or face negative publicity could have a material adverse effect on our business, results of operations and financial condition, our business reputation and our ability to attract and retain clients, network pharmacies, and employees. While we intend to maintain professional and general liability insurance coverage at all times, we cannot provide assurances that we will be able to maintain insurance in the future, that insurance will be available on acceptable terms or that insurance will be adequate to cover any or all potential product or professional liability claims.

Disruption of our point of sale information system and transaction processing system, which relies on third parties, could have a material adverse effect on our business, results of operations and financial condition.

Our operations utilize an electronic network connecting approximately 53,000 retail pharmacies to process third-party claims. This system is provided by a third-party adjudication vendor. Because claims are adjudicated in real time, systems availability and reliability are key to meeting customers’ service expectations. Any interruption in real time service, either through systems availability or telecommunications disruptions can significantly damage the quality of service we provide. Our PBM services also depend on third-party proprietary software to perform automated transaction processing. There can be no assurance that our business will not be harmed by service interruptions or software performance problems.

The failure by our health plan clients to pay for prescription claims or a delay in payment of those claims could have a material adverse effect on our business, results of operations and financial condition.

Our contracts with retail pharmacies which participate in our network generally obligate us to make payments for prescription claims even if we are not reimbursed by our clients. If our clients delay their reimbursement payments or fail to make payments for prescription claims, it could have a material adverse effect on our business, results of operations and financial condition.

If we fail to comply with complex and rapidly evolving laws and regulations, we could suffer civil and/or criminal penalties, lose clients, be required to pay substantial damages or make significant changes to our operations.

During the past several years, the U.S. health care industry has been subject to an increase in governmental regulation at both the federal and state levels. We are subject to numerous federal and state regulations. If we fail

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to comply with existing or future applicable laws and regulations, we could suffer civil or criminal penalties. We must devote significant operational and managerial resources to comply with these laws and regulations. Although we believe that we substantially comply with all existing statutes and regulations applicable to our business, different interpretations and enforcement policies of these laws and regulations could subject our current practices to allegations of impropriety or illegality, or could require us to make significant changes to our operations. In addition, we cannot predict the impact of future legislation and regulatory changes on our business or assure you that we will be able to obtain or maintain the regulatory approvals required to operate our business.

Among the legislation and government regulations which could affect us as a provider of PBM services are the following:

Network Access Legislation. A majority of states now have some form of legislation, referred to as any willing provider legislation, which affects our ability to limit access to a pharmacy provider network or remove a network provider. Such legislation may require us or our clients to admit any retail pharmacy willing to meet a health plan’s price and other terms for network participation or may restrict or prevent removal of a provider from a network except in compliance with certain procedures, referred to as “due process” legislation.

Anti-Remuneration Legislation. Anti-kickback statutes at the federal and state level prohibit an entity from paying or receiving any compensation to induce the referral of healthcare plan beneficiaries or the purchase of items or services for which payment may be made under healthcare plans. Additionally, state and federal regulations have been the basis for investigations and multi-state settlements relating to financial incentives provided by pharmaceutical manufacturers to retail pharmacies in connection with pharmaceutical switching or product conversion programs. To our knowledge, these laws have not been applied to prohibit PBM companies from receiving amounts from pharmaceutical manufacturers in connection with pharmaceutical purchasing and formulary management programs, to prohibit therapeutic substitution programs conducted by independent PBM companies, or to prohibit contractual relationships such as we have regarding these types of programs. However, we can make no assurances that such laws will not in the future be applied to restrict PBM companies and the way we conduct our business.

ERISA Regulation. The Employee Retirement Income Security Act of 1974, “ERISA,” regulates certain aspects of employee pension and health benefit plans, including self-funded corporate health plans with which we have agreements to provide PBM services. We believe that the conduct of our business generally is not subject to the fiduciary obligations of ERISA. However, other PBMs, including Medco, Express Scripts, Caremark and AdvancePCS, have disclosed publicly that they are defending private litigant lawsuits alleging that they are ERISA fiduciaries. There can be no assurance that the U.S. Department of Labor, which is the agency that enforces ERISA, or a private litigant would not assert that the fiduciary obligations imposed by ERISA apply to certain aspects of our operations.

In addition to its fiduciary provisions, ERISA imposes civil and criminal liability on service providers to health plans and certain other persons if certain forms of illegal remuneration are made or received. These provisions of ERISA are similar, but not identical, to the health care anti-remuneration laws discussed above. Like the health care anti-remuneration laws, the corresponding provisions of ERISA are written broadly and their application to particular cases is often uncertain. We have implemented policies regarding, among other things, disclosure to health plan sponsors, with respect to any commissions paid by or to us that might fall within the scope of those provisions, and accordingly believe we are in substantial compliance with these provisions of ERISA. However, we can provide no assurance that our policies in this regard would be found by the appropriate enforcement authorities and potential private litigants to meet the requirements of ERISA.

Patient Choice and Benefit Design. Some states have enacted legislation that prohibits a health care plan sponsor from implementing certain restrictive design features, and many states have introduced legislation to regulate various aspects of managed care plans, including provisions relating to PBMs. Legislation has been introduced in some states to prohibit or restrict therapeutic substitution, or to require coverage of all FDA

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approved drugs. Other states mandate coverage of certain benefits or conditions. This type of legislation does not generally apply to us, but it may apply to certain of our clients, such as HMOs and health insurers. If this type of legislation were to become widespread and broad in scope, it could have the effect of limiting the economic benefits achievable through PBMs and consequently make our services less attractive.

Legislation Affecting Drug Prices. Some states have adopted so-called most favored nation legislation providing that a pharmacy participating in the state Medicaid program must give the state the best price that the pharmacy makes available to any third-party plan. This type of legislation may adversely affect our ability to negotiate discounts in the future from network pharmacies. In addition, various Federal and state agencies, legislators and private litigants have raised the issue of how average wholesale price, “AWP,” should be determined. Certain products that represent an insignificant portion of our business will be reimbursed by Medicare under a new reimbursement system known as ASP starting in 2005. Pricing provisions relating to prescriptions in our contracts with clients and pharmacies generally are expressed in relation to AWP. A decrease in AWP could adversely affect our business, results of operations and financial condition.

Consumer Protection Legislation. Most states have consumer protection laws that generally prohibit payments and other broad categories of conduct deemed harmful to consumers. These statutes may be enforced by the states and, in fact, have been the basis for state investigations and at least one multi-state settlement relating to financial incentives provided by drug manufacturers to retail pharmacies in connection with drug switching programs. Further, private litigants have become active in bringing suits against PBMs alleging violations of these laws. We do not believe that we have contractual relationships that include the features that have been viewed adversely by government enforcement authorities. However, no assurance can be given that we will not be subject to scrutiny or challenge under one or more of these laws by the government enforcers or private litigants. Also, several states recently have enacted laws and/or promulgated or proposed regulations regarding the selling, marketing, promoting, advertising or distributing of commercial discount drug cards for cash purchases. These laws and regulations provide generally that any person may bring an action for damages or injunction for violations. While we offer a very limited commercial discount drug card program which we do not consider material to our business, there can be no assurance that the existence of such laws will not materially impact our ability to offer certain new products and/or services in the future.

Licensure. Many states have licensure or registration laws governing certain types of ancillary healthcare organizations, including preferred provider organizations, third party administrators and utilization review organizations. Laws requiring registration and regulating the operations of PBMs meeting certain criteria have also begun to appear. These laws differ significantly from state to state, and the application of these laws to the activities of PBMs is often unclear. We have registered under these laws in those states in which we have concluded that registration is required.

Confidential Information. Most of our activities involve the receipt or use by us of confidential medical information concerning individual members, including the transfer of the confidential information to the member’s health benefit plan. In addition, we use aggregated population data for research and analysis purposes. Health Insurance Portability and Accountability Act, “HIPAA,” requires our PBM clients to enter into business associate agreements with us that require us to assure confidential treatment of health care information and to only use or disclose that information as needed to provide our services and to use certain standard codes and data sets in processing claims. Further, if we become an endorsed discount drug card sponsor under Medicare Prescription Drug, Improvement and Modernization Act of 2003, “ MMA,” we will be a covered entity under HIPAA for purposes of that program. We believe that we have taken all necessary internal measures, and made all external vendor arrangements, to meet these obligations. However, the HIPAA Regulations regarding these privacy matters only became effective on April 14, 2003, and future interpretation could result in expansion of our responsibilities. Moreover, any failure to meet current requirements, because of the heightened profile given to the privacy issue by HIPAA, could result in the loss of business by us. In addition, the laws of many states also restrict the use and disclosure of confidential medical information. State laws that are more protective of medical information are not pre-empted by HIPAA. Therefore, to the extent states enact more protective legislation, we could be required to make significant changes to our business operations.

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Sanctions for failing to comply with these privacy standards under state or federal statutes or regulations include criminal penalties and civil sanctions. If we violate a patient’s privacy or are found to have violated any state or federal statute or regulation with regard to the confidentiality, dissemination or use of patient medical information, we could be liable for significant damages, fines or penalties.

In addition, new laws that may be enacted and new rules and regulations that may be adopted governing privacy and security may reduce the amount of information we may obtain or use without patient consent. Difficulties in obtaining patient consents could limit our ability to use some of our information technology products and services. Even without new legislation, our clients could prohibit us from including their members’ information in our various databases. These clients could also prohibit us from offering services to others that involve the compilation of that information.

Antitrust Legislation. Federal and state antitrust laws regulate trade and commerce and prohibit unfair competition as defined by those laws. Sanctions for failing to comply with these antitrust laws can result in criminal penalties and civil sanctions. Antitrust challenges can be brought either by government agencies or by private plaintiffs, and such actions generally raise very complex issues. Private litigants have become active in bringing suits against PBMs alleging violations of these laws. We do not believe that we have business relationships that include the features that would be viewed adversely by government antitrust enforcement authorities. However, no assurance can be given that we will not be subject to scrutiny or challenge under one or more of these laws by the government enforcers or private litigants.

Government efforts to reduce health care costs and alter health care financing practices could lead to a decreased demand for our services or to reduced rebates from manufacturers.

Efforts to control health care costs, including prescription drug costs, are underway at the federal and state government levels. Congress is also currently considering proposals to reform the U.S. health care system. These proposals may increase governmental involvement in health care and PBM services and may otherwise change the way our clients do business. Our clients and prospective clients may react to these proposals and the uncertainty surrounding them by cutting back or delaying the purchase of our PBM services, and manufacturers may react by reducing rebates or reducing supplies of certain products. These proposals could lead to a decreased demand for our services or to reduced rebates from manufacturers.

In addition, both Congress and state legislatures are expected to consider legislation to increase governmental regulation of managed care plans. Some of these initiatives would, among other things, require that health plan members have greater access to drugs not included on a plan’s formulary and give health plan members the right to sue their health plans for malpractice when they have been denied care. The scope of the managed care reform proposals under consideration by Congress and state legislatures and enacted by states to date vary greatly, and we cannot predict the extent of future legislation. However, these initiatives could greatly limit our business practices and impair our ability to serve our clients.

MMA creates an endorsed discount drug card and a new drug benefit, which will provide both new risks and opportunities for PBMs to participate in the Medicare program, and possible increased competition.

There are many uncertainties presented by the new law, which is one of the reasons we opted not to participate under the interim endorsed drug discount card program even though we were selected as a national sponsor. We do not know whether we will participate or be able to participate in the new drug benefit under Medicare which takes effect in 2006. Possible effects of the MMA include:

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Risks Related To Our Supplemental Benefits Segment

The National Do Not Call Registry under FTC rules may have a material adverse effect on the marketing of our supplemental benefit programs.

Over 50 million consumers have registered on the “Do-Not-Call Registry” established by the Federal Trade Commission “FTC”, which became effective on October 1, 2003. This Registry limits the ability to telemarket our supplemental benefit programs. Although we do not believe the Registry has had a material adverse effect on sales of our supplemental benefit programs to date, it could have such an effect in the future.

We have experienced a greater reliance on monthly rather than annual sales and a reduction in program renewals as a result of reliance on telemarketing.

A significant percentage of our sales of supplemental benefit programs is attributable to telemarketing sales. These sales involve a much higher percentage of monthly rather than annual sales than was our previous experience. This has resulted in higher initial cancellation rates and a reduction in program renewals.

The loss of our ability to use endorsements by Christopher Reeve, a key promoter of our supplemental benefit programs, could significantly impair our brand recognition and, thus, our ability to sell our programs.

The management and staff at HealthExtras are deeply saddened by the loss of Christopher Reeve. Our relationship with him has allowed us to share in his optimism, energy and convictions over the past eight years. Mr. Reeve was an integral part of the development and marketing of the programs offered in our supplemental benefits segment. We believe that the benefits of these programs can still be communicated effectively in the market with a less direct personal association. We may explore, when appropriate, opportunities to preserve elements of our relationship through Mr. Reeve’s family and an affiliated charity. Foremost, our conduct will be driven by respect and discretion. Should we be unable to continue our relationship as outlined above, or should our alternative marketing efforts produce disappointing results, our revenues and earnings could be adversely affected.

If we lose one or more of our marketing relationships, our access to potential customers would decline, and our business, results of operations and financial condition could suffer.

A significant majority of all of our supplemental benefit program sales is attributable to our marketing relationships with Stonebridge Life Insurance Company, the successor to JC Penney Life Insurance Company, a member of the AEGON Group of Companies, “Stonebridge,” American Express Travel Related Services Company, Inc., “Amex” and Citibank N.A. If we lose one or more of these relationships and are unable to replace them with other marketing outlets, our access to potential customers would decline and our business, results of operations and financial condition could suffer.

If we lose our relationships with the providers of the benefits under our programs, we could have difficulty meeting demand for our programs.

We are dependent on third party providers for the benefits included in our supplemental benefit programs. Those benefits are provided pursuant to arrangements with The Chubb Group of Insurance Companies, National Union Fire Insurance Company of Pittsburgh, a subsidiary of American International Group Inc., Unum Life Insurance Company of America, and others, which may be terminated on relatively short notice. If we were to lose these relationships and were unable to replace them quickly and cost effectively, we would not be able to satisfy consumer demand for our programs.

If the providers of the benefits included in our programs fail to pay or otherwise provide accrued benefits, or the extent of those benefits is deemed to be greater than the providers are obligated to pay, we could become subject to liability claims by program members.

The benefits included in the member programs are provided by other firms. If the firms with which we have contracted to provide those benefits fail to pay or otherwise provide them as required, or are negligent or

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otherwise culpable in providing them, or if it is determined that the level of benefits to which members are entitled exceeds the obligations of the providers, we could become involved in any resulting claim or litigation.

If we fail to comply with all of the various and complex laws and regulations governing our products and marketing, we could be subject to fines or additional licensing requirements or lose the ability to market in particular jurisdictions.

Complex laws, rules and regulations of each of the 50 states and the District of Columbia pertaining to insurance impose strict and substantial requirements on insurance coverage sold to consumers and businesses. Compliance with these laws, rules and regulations can be arduous and imposes significant costs. The underwriters of the insurance benefits included in our programs are responsible for obtaining and maintaining regulatory approvals for those benefits. If the appropriate regulatory approvals for those insurance benefits are not maintained, we would have to stop including them. An independent licensed insurance agency is responsible for solicitations regarding the insurance benefits involved in our programs.

State insurance laws and regulations are complex and broad in scope and are subject to periodic modification as well as differing interpretations. There can be no assurance that insurance regulatory authorities in one or more states will not determine that the nature of our business requires us to be licensed under applicable insurance laws. A determination to that effect or that we or our business partners are not in compliance with applicable regulations could result in fines, additional licensing requirements or the inability to market our programs in particular jurisdictions. Such penalties could significantly increase our general operating expenses and harm our business, results of operations and financial condition. In addition, even if the allegations in any regulatory or legal action against us turn out to be false, negative publicity relating to any such allegation could result in a loss of consumer confidence and significant damage to our brand.

Telemarketing is one of the primary means by which our programs are marketed. Telemarketing has become subject to an increasing amount of Federal and state regulation in the past several years. For example, such regulation limits the hours during which telemarketers may call consumers and prohibits the use of automated telephone dialing equipment to call certain telephone numbers. The Federal Telemarketing and Consumer Fraud and Abuse Prevention Act of 1994 and FTC regulations prohibit deceptive, unfair or abusive practices in telemarketing sales. Both the FTC and state attorneys general have authority to prevent certain telemarketing activities deemed by them to violate consumer protection. The FTC has adopted regulations which, beginning October 1, 2003, prohibit most telemarketers from calling a number listed on a National Do Not Call Registry. Violators are subject to a fine of up to $11,000 per violation. Under those FTC regulations, telemarketers can continue to call consumers with whom a company has an existing business relationship and consumers who request information about a company’s products can be called for three months. In addition, some states have enacted laws and others are considering enacting laws targeted directly at regulating telemarketing practices, and there can be no assurance that any such laws, if enacted, will not adversely affect or limit our current or future operations. While compliance with these regulations is generally the responsibility of the marketers and subcontractors, there can be no assurance that we would have no exposure to liability.

Risk Related to this Offering

Future sales of our common stock may depress our stock price, even if our business is doing well.

Up to 1,364,330 shares of our common stock may be sold pursuant to a currently effective registration statement registering the resale of common stock previously issued in a private transaction or to be acquired upon the exercise of warrants issued in that transaction. In addition, approximately 5,229,018 shares of our common stock may be sold pursuant to currently effective registration statements registering the sale of common stock reserved for issuance upon the exercise of options granted or to be granted under our stock option plans. Sales of a substantial number of shares of our common stock in the public market after the offering could depress the market price of our common stock and impair our ability to raise capital through the sale of additional equity securities.

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Purchasers in this offering may experience additional dilution upon the exercise of outstanding options and warrants to purchase our common stock.

As of September 30, 2004, options and warrants to purchase a total of 6,293,348 shares of our common stock were outstanding, at a weighted-average per share exercise price of $6.26. This does not include 300,000 shares issuable upon the exercise of outstanding warrants at a weighted average exercise price of $15.45 per share, subject to performance-based criteria. The exercise of all of these outstanding options and warrants would dilute the ownership percentage of our stockholders, including the purchasers in this offering, by approximately 15%, and could cause the market price of our common stock to decline.

Our management will have broad discretion in using the proceeds from this offering and, therefore, you will be relying on the judgment of our management to use those funds effectively.

We intend to use the net proceeds of this offering for working capital and other general corporate purposes, including acquisitions of other complementary businesses and the repayment of existing debt. The amounts and timing of these expenditures will vary significantly depending upon a number of factors, including the amount of cash generated or consumed by our operations, and our ability to identify and effect acquisition opportunities. Our management will retain broad discretion with respect to the use of the proceeds of this offering and, therefore, you will be relying on the judgment of our management to use those funds effectively.

Other Risks

Our stock price may be volatile and you may not be able to resell your shares at or above the price you paid for them.

Our stock price may be volatile, and the causes for volatility could include, among other factors:

We believe that quarter-to-quarter comparisons of our operating results are not necessarily meaningful indicators of our future performance. Due to the above-mentioned and other factors, it is possible that in one or more future quarters our operating results will fall below the expectations of securities analysts and investors. If this happens, the trading price of our common stock would likely decrease.

We do not intend to pay dividends in the foreseeable future.

We do not currently pay any cash dividends on our common stock and do not anticipate paying any cash dividends in the foreseeable future. We intend to retain future earnings to fund our growth. Accordingly, you will not receive a return on your investment in our common stock through the payment of cash dividends in the foreseeable future, and you may not realize a return on your investment even if you sell your shares. As a result, you may not be able to resell your shares at or above the price you paid for them.

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Our charter documents and Delaware law contain provisions that may discourage takeover attempts which could preclude our stockholders from receiving a change of control premium.

Our charter documents and Delaware law contain anti-takeover provisions that could have the effect of delaying or preventing changes in control that a stockholder may consider favorable. The provisions in our charter documents include the following:

The foregoing could have the effect of delaying, deferring or preventing a change in control, discourage bids for our common stock at a premium over the market price, or harm the market price of, and the voting and other rights of the holders of, our common stock. We also are subject to certain Delaware laws that could have similar effects. One of these laws prohibits us from engaging in a business combination with any significant stockholder for a period of three years from the date the person became a significant stockholder unless certain conditions are met.

A large number of shares may be sold into the market following this offering, which may cause the price of our common stock to decline.

After this offering, 36,949,970 shares of our common stock will be outstanding based upon shares outstanding as of September 30, 2004. The 5,000,000 shares we and certain stockholders are selling in this offering, and up to 750,000 shares being offered by us and the selling stockholders if the underwriters exercise their over-allotment option in full, will be freely tradable, without restriction or further registration, under the federal securities laws unless purchased by our affiliates.

Certain of our stockholders beneficially owning an aggregate of approximately 16,797,400 shares after this offering have agreed not to sell their shares of stock for 90 days after the completion of this offering. Lehman Brothers Inc. may waive any of these lock-up restrictions prior to the expiration of the lock-up period without prior notice. Lehman Brothers Inc. has no current intention to waive any of these lock-up restrictions. If, however, Lehman Brothers Inc. elects to waive such restrictions, all of these shares would be available for sale. Of the shares of common stock that will be available for sale after the expiration of the lock-up period, or upon any election of Lehman Brothers Inc. to waive the lock-up restrictions, approximately 16,797,400 will be subject to the volume restrictions of Rule 144 under the federal securities laws because they are held by our affiliates.

In May 2004, certain of our executive officers entered into Rule 10b5-1 trading plans with respect to their anticipated sales of our common stock. Sales have begun under these plans and may continue during 2004 and thereafter, and are not subject to the lock-up restrictions described in the previous paragraph.

Our executive officers and directors own a significant percentage of our stock, and as a result, the trading price for our shares may be depressed and these stockholders can take actions that may be adverse to your interests.

Following this offering, our executive officers and directors, and persons and entities affiliated with directors, will beneficially own approximately 43% of our common stock. These stockholders, acting together, will have the ability to significantly influence all matters requiring approval by our stockholders, including the election and removal of directors and any proposed merger, consolidation or sale of all or substantially all of our assets. In addition, they could dictate the management of our business and affairs. A significant concentration of share ownership can adversely affect the trading price for our common stock because investors often discount the value of stock in companies that have controlling stockholders. Furthermore, the concentration of ownership in our company could delay, defer or prevent a merger or consolidation, takeover or other business combination that could be favorable to you.

We could be adversely affected if we fail to retain key personnel.

We depend to a significant extent on certain key personnel. If we were to lose any of our key personnel, particularly our executive officer, we could be potentially and adversely affected. For additional information regarding dependence on key personnel, see “Management.”

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SPECIAL NOTE REGARDING FORWARD LOOKING INFORMATION

This prospectus contains “forward-looking statements” as defined in Section 27A of the Securities Act and Section 21E of the Securities Exchange Act, principally in the sections entitled “Summary,” “Risk Factors,” “Use of Proceeds,” “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and “Business.” Generally, you can identify these statements because they include words and phrases such as “expect,” “estimate,” “anticipate,” “predict,” “believe,” “plan,” “will,” “should,” “intend,” “new market,” “potential market applications” and similar expressions and variations. These statements are only predictions. Although we do not make forward-looking statements unless we believe we have a reasonable basis for doing so, we cannot guarantee their accuracy, and actual results may differ materially from those we anticipated due to a number of uncertainties, many of which cannot be foreseen. You should not place undue reliance on these forward-looking statements, which apply only as of the date of this prospectus. Our actual results could differ materially from those anticipated in these forward-looking statements for many reasons, including, among others, the risks we face that are described in the section entitled “Risk Factors” and elsewhere in or incorporated by reference in this prospectus.

We believe it is important to communicate our expectations to our investors. There may be events in the future, however, that we are unable to predict accurately or over which we have no control. The risk factors discussed on the previous pages, as well as any other cautionary language in this prospectus, provide examples of risks, uncertainties and events that may cause our actual results to differ materially from the expectations we describe in our forward-looking statements. Before you invest in our common stock, you should be aware that the occurrence of the events described in the previous risk factors and elsewhere in this prospectus could negatively impact our business, results of operations, financial condition and stock price.

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USE OF PROCEEDS

We estimate that the net proceeds to us from the sale of the 3,500,000 shares of our common stock we are offering under this prospectus at an assumed public offering price of $14.65 per share (the closing price of our common stock on November 10, 2004) will be approximately $47.9 million, after deducting the underwriting discount and estimated offering expenses. We will not receive any of the proceeds from the sale of our shares by the selling stockholders.

We intend to use the net proceeds received by us in this offering to repay the outstanding balance of our revolving credit facility and for working capital and other general corporate purposes, including possible acquisitions. At September 30, 2004, $24.3 million was outstanding under the revolving credit facility. Accordingly, our management will have broad discretion in applying the net proceeds from this offering. As of the date of this prospectus, we have no binding agreements or commitments with respect to any acquisition.

The revolving credit facility of $30 million, together with a term loan for $20 million, were entered into in June 2004. The revolving credit facility replaced a previous credit facility with an outstanding balance of $10.0 million at the beginning of the year and the proceeds were also used to finance the acquisition of MHS. The revolving credit facility bears interest at LIBOR plus 2.0%. The effective interest rate at September 30, 2004 was 3.24% and the credit facility is due in June 2006. The proceeds of the term loan were used to fund our acquisition of MHS. This term loan has an interest rate of LIBOR plus 2.00% and is payable in equal monthly installments over a four year period. We have entered into a swap agreement which has the effect of converting the interest rate on the term loan to a fixed rate of 5.23%.

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MARKET PRICE OF COMMON STOCK

Our common stock trades on the Nasdaq National Market under the symbol “HLEX.” The following table presents the high and low closing sales prices for our common stock for each quarter for the periods indicated, as reported on the Nasdaq National Market System.

The closing price for our common stock on November 10, 2004 was $14.65 per share. We had approximately 463 stockholders of record as of September 30, 2004, including holders of record representing an indeterminate number of beneficial owners of our common stock.

DIVIDEND POLICY

We currently intend to retain future earnings for use in the expansion and operation of our business. We have never paid a dividend on our common stock. Although we have no present intention of paying cash dividends, it is possible that the Board could determine in the future, based on our financial and other relevant circumstances at that time, to pay dividends.

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CAPITALIZATION

The following table sets forth our cash and cash equivalents and capitalization as of September 30, 2004, on an actual basis and as adjusted to give effect to our receipt of the estimated net proceeds of $47.9 million from the sale of 3,500,000 shares of common stock we are offering for sale under this prospectus at an assumed public offering price of $14.65 per share (the closing price of our common stock on November 10, 2004) and the application of these proceeds as set forth under the caption “Use of Proceeds.”

You should read this table in conjunction with our consolidated financial statements and the related notes and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and “Use of Proceeds.”

The outstanding share information in the table above is based on the number of shares outstanding as of September 30, 2004. The table excludes shares issuable upon exercise of the underwriters’ over-allotment option and an aggregate of 6,593,348 shares, comprised of the following:

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SELECTED CONSOLIDATED FINANCIAL DATA

The selected consolidated financial data as of and for each of the five years in the period ended December 31, 2003, have been derived from consolidated financial statements that have been audited by PricewaterhouseCoopers LLP, an independent registered public accounting firm. The consolidated financial statements as of and for the three years ended December 31, 2003 are included elsewhere in this prospectus. The selected consolidated financial data as of and for the nine-month periods ended September 30, 2003 and 2004 have been derived from our unaudited financial statements included elsewhere in this prospectus. In our opinion, the unaudited financial information includes all adjustments, consisting only of normal recurring adjustments, considered necessary for a fair presentation of that information. Operating results for the nine months ended September 30, 2004 are not necessarily indicative of the results that may be expected for the full year ended December 31, 2004. The information set forth below should be read in conjunction with our consolidated financial statements and the related notes and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” appearing elsewhere or incorporated by reference in this prospectus.

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MANAGEMENT’S DISCUSSION AND ANALYSIS OF

FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion and analysis of our financial condition and results of operations should be read together with the “Selected Consolidated Financial Data” and our consolidated financial statements and the related notes appearing elsewhere or incorporated by reference in this prospectus. This discussion and analysis contains forward-looking statements that involve risks, uncertainties and assumptions. Our actual results may differ materially from those anticipated in these forward-looking statements as a result of many factors, including but not limited to those described above in the section “Risk Factors.” See “Special Note Regarding Forward-Looking Statements.”

Overview

We provide PBM services and supplemental benefit programs. Our PBM segment accounted for approximately 86% of our revenue in 2003 and 91% of our revenue in the first nine months of 2004, and is expected to be the primary source of our growth and profits in the future. Our PBM clients include more than 1,000 self-insured employers, including state and local governments, TPAs and managed care organizations, who contract with us to administer the prescription drug component of their overall health benefit plans.

We also offer supplemental benefit programs, which include lump sum accidental disability benefits, accidental death and dismemberment benefits, and emergency accident and sickness medical benefits. This segment accounted for approximately 14% of our revenue in 2003 and 9% of our revenue in the first nine months of 2004. Individuals are the major purchasers of our supplemental benefit programs.

Pharmacy Benefit Management

We have established a non-exclusive nationwide network of more than 53,000 retail pharmacies. In general, clients contract with us to access negotiated retail pharmacy network rates, participate in certain rebate arrangements with manufacturers based on formulary design, and benefit from the other care enhancement protocols in our system. Our primary PBM services consist of the automated online processing of prescription claims on behalf of our clients. When a member of one of our clients presents a prescription or health plan identification card to a retail pharmacist in our network, our system provides the pharmacist with access to online information regarding eligibility, patient history, health plan formulary listings, and contractual reimbursement rates. The member generally pays a co-payment to the retail pharmacy and the pharmacist fills the prescription. We electronically aggregate pharmacy benefit claims, which include prescription costs plus our claims processing fees for consolidated billing and payment. We receive payments from clients, make payments of amounts owed to the retail pharmacies pursuant to our negotiated rates, and retain the difference, including claims processing fees.

Pharmacy benefit claim payments from our clients are recorded as revenue, and prescription costs to be paid to pharmacies are recorded as direct expenses. Under our network contracts, we generally have an independent obligation to pay pharmacies for the drugs dispensed and, accordingly, have assumed that risk independent of our clients. When we administer pharmacy reimbursement contracts and do not assume a credit risk, we record only our administrative or processing fees as revenue. Rebates earned under arrangements with manufacturers are recorded as a reduction of direct expenses. The portion of manufacturer rebates due to clients is recorded as a reduction of revenue.

Member co-payments are not recorded as revenue or operating expenses. Under our pharmacy agreements, the pharmacy is solely responsible for collecting co-payments from members. Under our client contracts, we do not assume liability for member co-payments in pharmacy transactions.

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Supplemental Benefit Programs

Our supplemental benefits segment generates revenue from the sale of supplemental benefit programs which include lump sum accidental disability benefits, accidental death and dismemberment benefits, and emergency accident and sickness medical benefits. In recent periods, our supplemental benefit programs have been marketed and sold to individual customers primarily by three nationally recognized companies, which incur the marketing expenses. Accordingly, our supplemental benefit program revenue from new members is primarily dependent on the extent and timing of marketing campaigns funded by these three companies and the success they achieve. Correspondingly, these companies are compensated with an increasing percentage of total program revenue, which is accounted for as direct expense by us.

The primary determinant of revenue recognition for this segment is monthly program enrollment. In general, program revenue is recognized based on the number of members enrolled in each reporting period multiplied by the applicable monthly fee for their specific membership program. The program revenue we recognize includes the cost of membership features supplied by others, including the insurance components.

Direct program expenses consist of the costs that are a direct function of a period of membership and a specific set of program features. The coverage obligations of our benefit suppliers and the related expense are determined monthly, as are the remaining direct expenses. Prior to October 2002, payments from program marketers related to new member enrollments were recorded as revenue to the extent of related direct expenses, which cumulatively exceeded payments from those marketers.

Revenue from program payments received, and related direct expenses, are deferred to the extent that they are applicable to future periods or to any refund guarantee we offer. We have committed to minimum premium volumes with respect to the insurance features of our programs supplied by others. In the event that there were insufficient members to utilize the minimum premium commitment, the differential would be expensed by us without any related revenue. We believe that current enrollment trends will allow the minimum future commitments at September 30, 2004 to be fully utilized by current enrollment levels.

Acquisitions

We have supported the growth of our PBM segment through four acquisitions.

On June 18, 2004, we acquired 100% of the common stock of MHS for a cash payment of $37.3 million and 100,739 shares of our common stock valued at $1.5 million. In addition, we agreed to issue $4.0 million principal amount of non-negotiable promissory notes, warrants to purchase up to 300,000 shares of our common stock at an exercise price of $15.45 per share, and to pay $2.0 million in cash, all subject to performance-based standards and certain revenue and gross profit criteria attributable to MHS. The acquisition of MHS was accounted for using the purchase method of accounting, and we have recorded preliminarily goodwill of approximately $30.8 million and intangible assets of $8.0 million.

On December 1, 2002, we acquired 100% of the common stock of PNNC for $20.2 million in cash. The acquisition of PNNC was accounted for using the purchase method of accounting. The acquisition resulted in goodwill of approximately $10.6 million and intangible assets of approximately $8.0 million.

On November 14, 2001, we acquired an 80% interest in Catalyst for an aggregate purchase price of approximately $14.3 million, consisting of $10.4 million in cash, the assumption of $1.6 million in liabilities and the issuance of 366,730 shares of common stock valued at $2.3 million. The acquisition of Catalyst was accounted for using the purchase method of accounting, and resulted in $9.1 million of goodwill, and $4.0 million of intangible assets.

During the first quarter of 2002, we purchased the remaining 20% minority interest in Catalyst for $5.3 million, consisting of 319,033 shares of our common stock valued at $1.1 million and notes in the principal

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amount of $4.2 million. This minority interest purchase resulted in additional goodwill of $3.2 million and intangible assets of $1.7 million. The stock was transferred to the seller on April 1, 2002, $3.1 million in cash was paid in 2002, and the final cash installment of $1.1 million was paid on March 1, 2003.

Effective November 1, 2000, we acquired IPM for an aggregate purchase price of approximately $9.2 million, consisting of approximately 95% cash and the remainder in common stock. The acquisition of IPM was accounted for using the purchase method of accounting and resulted in $9.2 million of goodwill.

We have successfully integrated IPM, Catalyst, and PNNC into our financial, organizational, management and technology structure. As a result, we achieved cost savings from the consolidation of certain corporate activities and the elimination of certain duplicated components of our corporate operations. We are in the process of integrating MHS.

Critical Accounting Policies and Estimates

Management’s Discussion and Analysis of the Financial Condition and Results of Operations discusses our consolidated financial statements. The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. The most significant accounting estimates made by us in preparing our financial statements include the following:

Revenue and direct expense recognition

We recognize revenue from PBM services, which include sales of prescription drugs by pharmacies in our nationwide network and related claims processing fees, provided to our clients. Revenue is recognized when the claims are adjudicated. Pharmacy claims are adjudicated at the point-of-sale using an on-line claims processing system. When we have a contractual obligation to pay our network pharmacy providers for benefits provided to our clients’ members, total payments from these clients are recorded as revenue and payments to the network pharmacy provider are recorded as direct expenses. The contracts require us to assume the credit risk of our clients’ abilities to pay. In addition, under most of our client contracts, we are at risk for the difference between the payments we receive from our clients and the negotiated reimbursements we pay to pharmacies. When we administer pharmacy reimbursement contracts and do not assume credit risk, we record only our administrative or processing fees as revenue. Rebates earned under arrangements with manufacturers are recorded as a reduction of direct expenses. The portion of such rebates due to clients is recorded as a reduction of revenue. Manufacturers rebates are based on estimates, which are subject to final settlement with the contracted party.

Member co-payments are not recorded as revenue. Under our client contracts, the pharmacy is obligated to collect the co-payments from the members. Under client contracts, we do not assume liability for member co-payments in pharmacy transactions. As such, we do not include member co-payments to pharmacies in revenue or operating expenses.

The primary determinant of revenue recognition for our supplemental benefits segment is monthly program enrollment and, prior to October 2002, payments related to new member enrollments from certain marketers of our programs. In general, program revenue is recognized based on the number of members enrolled in each reporting period multiplied by the applicable monthly fee for their specific membership program. The program revenue recognized by us includes the cost of membership features supplied by others, including the insurance components. Direct program expenses consist of the costs that are a direct function of a period of membership and a specific set of program features. The coverage obligations of our benefit suppliers and the related expense are determined monthly, as are the remaining direct expenses.

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Pharmacy Benefit Management Rebates

Rebates earned under arrangements with manufacturers are recorded as a reduction of direct expenses. The portion of such rebates due to clients is recorded as a reduction of revenue. Manufacturer rebates are based on estimates, which are subject to final settlement with the contracted party on an annual basis. Resulting adjustments historically have not been significant.

Allowance for Bad Debts

We estimate reserves for doubtful PBM accounts receivable as of each balance sheet date. Historically, we have very limited exposure to bad debts due to the nature of the employee benefits involved, the necessity of maintaining benefit continuity for employees, and the general financial strength of our client base. Substantially all supplemental benefits revenues are collected in advance via credit card and as such generate no accounts receivable exposure.

Assets Acquired and Liabilities Assumed in Business Combinations

In our acquisitions, we are required to make judgments regarding the fair values of the assets acquired and the liabilities assumed. For significant acquisitions, management engages independent consultants to assist it in estimating the fair values of acquired intangible assets.

Intangible Assets

The estimated fair value and the weighted average useful-life of the intangible assets are based on income-method valuation calculations, performed by an independent consulting firm. The remaining useful life of intangible assets is evaluated periodically and adjusted as necessary to match the period that the assets are expected to provide economic benefits.

Goodwill

Goodwill is subject to a periodic impairment assessment, by applying a fair value based test, requiring judgments concerning the value of our PBM segment. We concluded that no impairment of goodwill existed at December 31, 2003.

Income Taxes

In 2001, we recorded a full valuation allowance against our deferred tax assets due to the uncertainty as to their ultimate realization. In the fourth quarter of 2002, as a result of our profitability, we recognized approximately $10.2 million in tax benefits principally resulting from releasing the full valuation allowance for our deferred tax asset. In 2003, we recorded a provision of income taxes of approximately $6.3 million. As we now have achieved sustained profitability, no additional valuation allowances are expected in the foreseeable future.

Common Stock Warrants

From time to time we have issued warrants to purchase shares of our common stock under arrangements with our business partners or as consideration in acquisitions. We are required to estimate the fair value of such warrants for purposes of recording these transactions in our financial statements. Such estimates require judgments regarding, among other things, interest rates, common stock price volatility and annualized revenues.

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Results of Operations

Nine Months Ended September 30, 2004 Compared to Nine Months Ended September 30, 2003

Revenue. Revenue from operations for the nine months ended September 30, 2004 was $367.9 million, consisting of $333.0 million generated from the PBM segment and $34.9 million from the supplemental benefits segment. PBM revenue increased by $92.3 million, including $64.8 million of revenue from increased prescription volume, $4.7 million from MHS, and $38.0 million in increased unit prices, offset by a reduction of revenue by $15.2 million due to increased member co-payments. The supplemental benefits revenue decreased by $5.3 million, largely as a result of lower levels of coverage purchased and decreased membership. Revenue for the nine months ended September 30, 2003 was $280.9 million, consisting of approximately $240.7 million and $40.2 million attributable to the PBM and supplemental benefits segments, respectively.

The increase in revenue for 2004 was related to the ongoing growth of our PBM revenue. Revenue growth in the PBM segment in the first nine months of 2004 was primarily attributable to an overall increase in the number of pharmacy transactions processed. Total claims processed increased to approximately 8.7 million in the first nine months of 2004 from approximately 6.8 million in the first nine months of 2003.

Direct Expenses. Direct expenses for the nine months ended September 30, 2004 were $325.8 million, consisting of $300.3 million from the PBM segment and $25.5 million from the supplemental benefits segment. PBM segment direct expenses increased by $80.0 million, while the supplemental benefits segment direct expenses decreased by $4.4 million. The PBM segment’s $80.0 million increase in direct expenses was related to the $92.3 million in increased PBM revenue. The $80.0 million increase was consistent with our anticipated gross margin contributions from increased prescription volume, the acquisition of MHS and increased unit prices. The decrease in direct expenses in the supplemental benefits segment was largely a result of the modest decrease in membership and the negotiation of lower costs for certain of the benefits in our programs.

Direct expenses for the nine months ended 2003 were $250.2 million, consisting of approximately $220.3 million and $29.9 million attributable to the PBM and supplemental benefit segments, respectively. The direct expenses of $325.8 million and $250.2 million for the nine months ended September 30, 2004 and 2003 represented 93.0% of operating expenses for both of the respective periods.

Gross margins for the PBM segment for the nine month period ended September 30, 2004 were 9.8%, or $32.7 million, compared to 8.5%, or $20.4 million, for the nine month period ended September 30, 2003. Gross margins for the supplemental benefits segment for the nine month period ended September 30, 2004 were 26.9%, or $9.4 million, compared to 25.6%, or $10.3 million, for the nine month period ended September 30, 2003.

Gross margins in the PBM segment are generally predictable based on client contract terms and vendor/supplier contracts. Factors that can result in changes in gross margins include generic substitution rates, changes in the utilization of preferred drugs with higher discounts and changes in the volume of prescription dispensing at lower cost network pharmacies. None have materially changed in a manner that would meaningfully affect current or anticipated results. In the nine months ended September 30, 2004, gross margins were improved by an increased volume of higher margin workers compensation business resulting from the acquisition of MHS. This increase was largely offset in percentage terms by the addition of the State of Louisiana contract that has lower percentage margin contributions than our historical averages. Excluding these changes, there were no other significant factors that influenced reported gross margins or indicated likely changes in the near future.

Gross margins in the supplemental benefits segment are generally consistent on a per transaction basis. Gross dollar margins have been declining as new enrollments, with lower gross margins, have replaced attrition in membership under more profitable prior marketing arrangements. This gradual shift in business mix is likely to continue in the future but is not anticipated to accelerate.

Selling, General and Administrative. Selling, general and administrative expenses for the nine months ended September 30, 2004 totaled approximately $24.6 million, or 7.0% of operating expenses, $17.3 million of which

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was related to the PBM segment, $3.2 million of which was related to the supplemental benefits segment, while the remaining $4.1 million was related to corporate overhead. These expenses included $11.7 million in compensation and benefits, $3.6 million in commissions, other professional services, insurance and taxes, $3.0 million in other expenses, $2.0 million in depreciation and amortization, $1.5 million for creative development, product endorsement and market research, $1.6 million in facility costs, $1.1 million in travel expenses, and $38,000 in loss on the disposal of fixed assets.

Selling, general and administrative expenses for the first nine months of 2003 totaled approximately $19.0 million, or 7.1% of total operating expenses, $10.7 million of which was related to the PBM segment, $4.2 million of which was related to the supplemental benefits segment, while the remaining $4.1 million was related to corporate overhead. These expenses included approximately $7.9 million in compensation and benefits, $3.7 million in commissions, other professional services, insurance and taxes, $2.2 million in other expenses, $1.8 million in depreciation and amortization, $1.3 million for creative development, product endorsement and market research, $1.3 million in facility costs, and $830,000 in travel expenses.

Interest Expense, Net. Interest expense, net for the nine months ended September 30, 2004, was approximately $524,000 compared to interest expense, net of $362,000 for the nine-month period ended September 30, 2003. This was principally due to the higher dollar amounts outstanding on our line of credit and the initiation of the $20.0 million term loan. Interest expense on borrowings for the nine months ended September 30, 2004 was $693,000.

Other Income. In the second quarter of 2004, we reached a legal settlement related to litigation initiated by us on December 3, 2002. The terms of the settlement are confidential; however, the net proceeds from the settlement constitute the significant portion of the other income reported in our 2004 statement of operations.

Income Tax Provision. In the nine-month periods ended September 30, 2004 and 2003, we recorded a provision for income taxes of approximately $7.2 million and $4.4 million, respectively. Determining the consolidated provision for income taxes expense involves judgment. We are required to calculate and provide for income taxes in each of the tax jurisdictions where we operate. This involves estimating our current tax exposures in each jurisdiction. Change in the geographic mix or estimated level of pre-tax income can affect the overall effective tax rate. The effective rate of the tax provision was 37.7% in the first nine months of 2004; the effective rate was 38.6% in the first nine months of 2003.

Net Income. Net income for 2004 increased by approximately $4.9 million over the same period in 2003. The increase in net income was primarily a function of an increase in other income as well as increased gross margins in the PBM segment. PBM segment gross margins increased to $32.7 million in 2004 from $20.4 million in 2003, an increase largely attributable to the $92.3 million increase in PBM revenue from the first nine months of 2003 to the first nine months of 2004.

Segment operating information for the nine months ended September 30, 2004 and 2003, respectively, is as follows (in thousands):

We do not allocate to our separate segments certain general expenses not directly related to our business segments, such as insurance and public company costs. We believe this segment disclosure, which excludes overhead expenses, allows management to more accurately assess each segment’s operating performance without an arbitrary allocation of non-operating expenses.

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Year Ended December 31, 2003 Compared to Year Ended December 31, 2002

Revenue. The increase in revenue for 2003 was primarily related to the ongoing growth of our PBM revenue. Revenue growth in the PBM segment in 2003 was primarily attributable to new accounts added during the year, a full year consolidation of the results of our acquired subsidiary, PNNC, and a significant overall increase in the number of pharmacy claim transactions processed. Total claims processed increased from approximately 4.8 million in 2002 to approximately 9.0 million in 2003. Revenue also increased due to modest increases in unit prices.

Revenue decreases in the supplemental benefits segment were a function of contractual changes in the economic terms of our marketing arrangements. While net membership levels were largely unchanged from 2002 to 2003, our marketers began to incur the direct marketing costs for new members added during the year and we recognized lower revenue levels accordingly. The reduction in revenue of approximately $13.5 million in the supplemental benefits segment in 2003 was more than offset by the $15.4 million decrease in the segment’s combined marketing and creative development expenses recorded in selling, general and administrative expenses. The decrease in combined marketing and creative development expenses was primarily attributable to the restructured distribution arrangements under which the distributor became responsible for marketing expenses.

Revenue from operations for the year ended December 31, 2003 was $384.1 million, consisting of $331.5 million generated from the PBM segment and $52.6 million from the supplemental benefits segment. PBM revenue increased by $149.3 million, including a $99.2 million increase from PNNC. Of the $99.2 million increase from PNNC, $17.8 million was attributable to revenue from new clients signed by PNNC in 2003. The remaining increase of $50.1 million was attributable to $55.5 million of revenue from prescription volume increases and $2.2 million to increased unit prices, offset by a $7.6 million reduction in revenue due to increased member co-payments. Supplemental benefits revenue decreased by $13.5 million. Revenue for the year ended December 31, 2002 was $248.4 million, consisting of approximately $182.3 million and $66.1 million attributable to the PBM and supplemental benefits segments, respectively.

Direct Expenses. Operating margins in the PBM segment were improved in 2003 through an increase in more profitable generic drug dispensing rates, consolidation of our claims processing systems to a single more cost-effective platform, the introduction of standardized pharmacy reimbursement contract rates across all our business units and more effective formulary compliance programs which result in increased margins from the use of preferred drugs.

The decrease in direct expenses in the supplemental benefits segment was largely a result of lower levels of coverage being purchased by new members. A modest decrease in membership and the negotiation of lower costs paid by us for certain of the benefits included in our programs (available for the first time in 2003) also contributed to the decrease.

Direct expenses for the year ended December 31, 2003 were $341.2 million, consisting of $302.2 million in direct costs from the PBM segment and $39.0 million in direct expenses from the supplemental benefits segment. PBM segment direct expenses increased by $134.2 million, including a $89.1 million increase from PNNC. The remaining $45.1 million increase was directly related to the $50.1 million increase in revenue in 2003. This $45.1 million increase in related direct expenses was consistent with our anticipated PBM segment gross margin contribution of approximately 10% from increased prescription volume during 2003. Direct expenses for the year ended 2002 were $209.5 million, consisting of approximately $168.0 million and $41.5 million attributable to the PBM and supplemental benefit segments, respectively. The direct expenses of $341.2 million and $209.5 million for the years ended December 31, 2003 and 2002 represented 93.0% and 85.5% of operating expenses for the respective periods.

Selling, General and Administrative. From 2002 to 2003, selling, general and administrative expenses decreased by approximately $9.6 million. This decrease, as discussed above, was primarily a result of a change in our marketing arrangements. In 2003, Company funded direct marketing expenses for supplemental benefits

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were eliminated and resulted in an expense reduction of approximately $12.6 million. The offsetting increase in selling, general and administrative expenses was primarily associated with PNNC’s operations, personnel costs and other expenses being consolidated for the full calendar year.

Selling, general and administrative expenses for the year ended December 31, 2003 totaled $25.9 million, or 7.0% of operating expenses, of which $15.6 million related to the PBM services segment, $4.9 million related to the supplemental benefits segment, and $5.4 million related to corporate overhead. These expenses included $10.7 million in compensation and benefits, $4.8 million in commissions, other professional services, insurance and taxes, $3.2 million in other expenses, $2.4 million in depreciation and amortization, $1.8 million for creative development, product endorsement and market research, $1.8 million in facility costs, and $1.2 million in travel expenses. We had no supplemental benefits direct marketing expense in 2003, as direct marketing expenses were paid by the marketers.

Selling, general and administrative expenses for the year ended 2002, were approximately $35.5 million, or 14.5% of total operating expenses, of which $5.9 million related to the PBM services segment, $23.1 million related to the supplemental benefits segment, and $6.5 million related to corporate overhead. These expenses included $4.1 million for creative development, product endorsements and market research, $12.6 million in direct marketing, $8.2 million in compensation and benefits, $1.6 million in commissions, professional fees, other insurance and taxes, $2.4 million in other expenses, $1.4 million in facility costs, $826,000 in travel expenses, $1.7 million in depreciation and amortization, and $2.7 million related to the impairment of and write-off of fixed assets.

Interest Expense, Net. Interest expense, net for the year ended December 31, 2003, was approximately $443,000 compared to interest expense, net of $82,000 for the year ended December 31, 2002. This increase was principally due to increased borrowings under our line of credit commencing in the fourth quarter of 2002. Interest expense on borrowings for 2003 was approximately $595,000.

Income Tax (Benefit) Provision. Through the third quarter of 2002, we maintained a full valuation allowance against our deferred tax assets due to the uncertainly as to their ultimate realization. Due to the recording of the full valuation allowance, no provision for income taxes was recorded in the first nine months of 2002. In the fourth quarter of 2002, as a result of our 2002 profitability and projected future profitability, we recognized a $10.2 million tax credit principally resulting from our releasing the valuation allowance for our deferred tax asset. In 2003, our effective tax rate was 37.7% and the provision for income taxes was $6.3 million.

Minority Interest. There was no minority interest charge in 2003. The $45,000 charge in 2002 represents the net income attributable to the 20% minority interest in Catalyst for January and February 2002. We purchased the remaining minority interest on March 1, 2002. As a result, we do not recognize any minority interest charge for Catalyst after that date.

Net Income. Net income in 2003 was down by $3.1 million from 2002 despite a $13.6 million improvement in operating income. The decrease was attributable in large part to the recognition of the $10.2 million tax benefit in 2002. In contrast, we reported a $6.3 million tax expense in 2003. The increase in operating income was primarily a function of increased gross margins in the PBM segment. PBM segment gross margins increased from $14.2 million in 2002 to $29.3 million in 2003, an increase largely attributable to a comparable percentage increase in revenue.

In the supplemental benefits segment, the increase in net income was attributable to reduced marketing expenses and increases in fees charged to vendors. Net income also increased from 2002 to 2003 because results for 2002 reflected a $2.6 million charge for software impairment.

Net income for the year ended December 31, 2003, was $10.3 million compared to $13.5 million in 2002. The $13.5 million net income in 2002 included the tax benefit of $10.2 million while the $10.3 million net income for 2003 included a $6.3 million provision for income taxes, as discussed above. As a percentage of revenue, pre-tax income increased from 1.3% to 4.3%.

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Segment operating information for 2003 and 2002 is as follows (in thousands):

Operating expenses of the segments exclude $5.4 million and $6.5 million in corporate overhead that was not allocated by management in assessing segment performance for the years ended December 31, 2003 and 2002, respectively. We do not allocate to our separate segments certain general expenses not directly related to our business segments, such as insurance and public company costs. We believe this segment disclosure, which excludes overhead expenses, allows management to more accurately assess each segment’s operating performance without an arbitrary allocation of non-operating expenses.

Year Ended December 31, 2002 Compared to Year Ended December 31, 2001

Revenue. The increase in revenue for 2002 was primarily related to the ongoing growth of our PBM revenue. Revenue growth in the PBM segment in 2002 was primarily attributable to increased prescription volume, a full year consolidation of Catalyst’s results, the acquisition of PNNC in December of 2002 and a significant overall increase in the number of pharmacy claim transactions processed. Total claims processed increased from approximately 1.2 million in 2001 to approximately 4.8 million in 2002.

Revenue decreases in the supplemental benefits segment were a function of the initial phase of contractual changes in the economic terms of our marketing arrangements. While net membership levels were largely unchanged from 2001 to 2002, the marketers of our programs began to incur the direct marketing costs for new members added commencing in the fourth quarter of 2002 and we recognized lower revenue levels accordingly. The reduction in revenue of approximately $5.2 million in 2002 was largely offset by lower marketing expenses in our own selling, general and administrative expenses.

Revenue from operations for the year ended December 31, 2002, was $248.4 million, compared to $118.2 million for the year ended December 31, 2001. The PBM segment contributed $135.4 million of this revenue increase, a 289% increase, while the supplemental benefits segment decreased by $5.2 million, a 7.3% decrease. The PBM increase was principally due to our acquisition of Catalyst on November 14, 2001, which increased revenue by $115.2 million from 2001 to 2002. Of that $115.2 million, $49.8 million was attributed to new business for Catalyst in 2002.

Direct Expenses. Operating margins in the PBM segment were improved in 2002 through an initial consolidation of our claims processing systems, the increasing use of standardized pharmacy reimbursement contract rates and more effective formulary compliance programs which result in increased margins from the use of preferred drugs. Also, the closure of our Birmingham facility resulted in management efficiencies.

Direct expenses in the supplemental benefits segment were largely unchanged from 2001 to 2002. Because of the changes to our marketing arrangements, the portion of program revenue retained by our partners increased, but this did not affect the cost of the benefits provided.

Direct expense for the year ended December 31, 2002 of $209.5 million consisted of $168.0 million in direct costs associated with the pharmacy benefit management services segment and $41.5 million attributable to

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benefit costs and compensation to our marketers for supplemental benefits products. Direct expenses for the year ended 2001 were $87.5 million, consisting of approximately $43.6 million and $43.9 million attributable to the PBM and supplemental benefits segments, respectively. The increase of $124.4 million in PBM direct expenses included $106.6 million attributable to Catalyst Rx and $17.8 million related to $20.2 million of revenue from increased prescription volume. This $17.8 million increase in related direct expenses was consistent with our anticipated PBM segment gross margin contribution of approximately 10% from increased prescription volume. The direct expenses of $209.5 million and $87.5 million for the years ended 2002 and 2001, represent 85.5% and 69.5% of operating expenses for the respective periods.