The recognition and measurement of stock grants is the same under APB Opinion No. 25 and SFAS No. 123,Accounting for Stock Based Compensation.123R. The related expenses for the fair value of stock grants were charged to salary, general and administrative expenses and are included in net income, as reported in the pro forma net income table above.

Stock option activity during the sixnine months ended JuneSeptember 30, 2006 is summarized below:

The fair value of each option grant is estimated on the date of the grant using the Black-Scholes option-pricing model based on the following weighted-average assumptions:

		Three months ended September 30,					Nine months ended September 30,
		2006		2005			2006			2005
Risk-free interest rate		N/A		4.06	%		4.54	%		4.06	%
Expected volatility		N/A		53.2	%		53.1	%		53.2	%
Expected option life (in years)		N/A		5			6			5
Expected dividend yield		None		None			None			None

The risk-free interest rate is based on the implied yield currently available on U.S. Treasury zero coupon issues. The expected volatility is primarily based on historical volatility levels along with the implied volatility of exchange traded options to purchase our common stock. The expected option life of each award granted was calculated using the “simplified method” in accordance with Staff Accounting Bulletin No. 107. There were no material changes made to the methodology used to determine the assumptions during the secondthird quarter of 2006.

The weighted-average fair value of options granted during the threenine-month period ended September 30, 2006 was $12.87. No options were granted during the third quarter of 2006. The weighted-average fair value of options granted during the three-month and six-monthsnine-month periods ended JuneSeptember 30, 2006 were $16.552005 was $22.27 and $12.87,$22.09, respectively. The total intrinsic value of stock options exercised during the three and six-monthsnine-months periods ended JuneSeptember 30, 2006 was $614$1,295 and $1,869,$3,164, respectively. The total intrinsic value of stock options exercised during the three and six-monthsnine-months periods ended JuneSeptember 30, 2005 was $2,160$295 and $4,959,$5,254, respectively.

Non-vested restricted stock and restricted stock unit activity for the sixnine months ended JuneSeptember 30, 2006 is summarized below:

As of JuneSeptember 30, 2006, there was $10,438$8,900 of total unrecognized compensation cost related to non-vested share-based compensation arrangements granted under the plans. That cost is expected to be recognized over a weighted-average period of two years.

Earnings Per Share

The denominators for the computation of basic and diluted earnings per share are calculated as follows:

New Accounting Pronouncements

In May 2005, the FASB issued Statement No. 154 (SFAS No. 154),Accounting Changes and Error Corrections, which replaced APB Opinion No. 20,Accounting Changes, and FASB Statement No. 3,Reporting Changes in Interim Financial Statements. SFAS No. 154 requires retrospective application to prior periods’ financial statements of voluntary changes in accounting principles and changes required by a new accounting standard when the standard does not include specific transition provisions. Previous guidance required most voluntary changes in accounting principle to be recognized by including in net income of the period in which the change was made the cumulative effect of changing to the new accounting principle. SFAS No. 154 carries forward existing guidance regarding the reporting of the correction of an error and a change in accounting estimate. SFAS No. 154 is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005. Adoption of SFAS No. 154 as of January 1, 2006 did not have a material effect on our consolidated financial position or results of operations.

In July 2006, FASB released Interpretation No. 48, “Accounting for Uncertainty in Income Taxes - an Interpretation of FASB Statement No. 109” (“FIN 48”), which clarifies the accounting and disclosure for uncertainty in income taxes recognized in financial statements. FIN 48 prescribes a comprehensive accounting model for recognizing, measuring, presenting and disclosing in the financial statements uncertain tax positions that the Company has taken or expects to take on a tax return. FIN 48 is effective for fiscal years beginning after December 15, 2006. We have not yet determined the potential impact of this interpretation on our consolidated financial position or results of operations.

Other recent accounting pronouncements issued by the FASB (including its Emerging Issues Task Force), the AICPA, and the SEC did not, or are not believed by management to, have a material impact on our present or future consolidated financial statements.

Reclassifications

Certain amounts for 2005 have been reclassified to conform to the 2006 presentation. Such reclassifications had no impact on net income, cash flow or stockholders’ equity as previously reported.

As of June 30, 2006, we reported an acquired 100% ceded reinsurance arrangement related to the December 2005 purchase of Phoenix National Insurance Company by recording a non-current receivable from the reinsurer with a corresponding non-current liability for ceded life and annuity contracts. Prior period amounts have been reclassified to conform to the 2006 presentation. The reclassification has no effect on our earnings, working capital or stockholders’ equity as previously reported.

3. Loss Contract Charge

In connection with the sale by our New Mexico HMO of certain commercial employer group contracts to another health plan on August 1, 2004, our New Mexico HMO entered into a transition services agreement (the TSA). The TSA required the New Mexico HMO to provide certain administrative services in support of the commercial membership through the date of each member group’s renewal. In exchange for those services, the New Mexico HMO was compensated by the buyer at a specific amount per member per month. The New Mexico HMO entered into the TSA as an inducement to the buyer to purchase the commercial membership, and anticipated that the TSA would be unprofitable. Effective with the implementation of the TSA (August 1, 2004), the New Mexico HMO recorded a liability for the costs of the run out of the commercial business of $2,640, the bulk of which consisted of anticipated losses under the TSA. During the second quarter of 2005, that reserve was exhausted. We anticipated that we would continue to provide services under the TSA through December 31, 2005 at a net cost of $939 and recorded a loss contract charge for that amount at June 30, 2005. As of JuneSeptember 30, 2006, only insignificantthe required run out services remained to be performed under the TSA.TSA were completed. A summary of activity for the net liability for termination of commercial operations for the period July 1, 2004 through JuneSeptember 30, 2006 follows:

4. Receivables

Receivables consist primarily of amounts due from the various states in which we operate. Accounts receivable by operating subsidiary are as follows:

Substantially all receivables due our California HMO at JuneSeptember 30, 2006 and December 31, 2005 were collected in JulyOctober and January of 2006, respectively.

Our agreement with the state of Utah calls for the reimbursement of our Utah HMO for medical costs incurred in serving our members plus an administrative fee of 9% of medical costs and all or a portion of any cost savings realized, as defined in the agreement. Our Utah HMO bills the state of Utah monthly for actual paid health care claims plus administrative fees. Our receivable balance from the state of Utah includes: 1) amounts billed to the state for actual paid health care claims plus administrative fees; 2) amounts estimated to be due under the savings sharing provision of the agreement; and 3) amounts estimated for incurred but not reported claims, which, along with the related administrative fees, are not billable to the state of Utah until such claims are actually paid.

5. Other Assets

Other assets at JuneSeptember 30, 2006 included an equity investment of approximately $1,600 in a vision services provider that provides medical services to the Company’s members. Payments to the vision services provider were $1,999$2,209 and $3,461$5,670 for the three months and sixnine months ended JuneSeptember 30, 2006. Payments to the vision services provider were $579$880 and $1,044$1,924 for the three months and sixnine months ended JuneSeptember 30, 2005. 2005, respectively.

Other assets also includesinclude deferred financing costs associated with our secured credit agreement and certain investments held in connection with our deferred employee compensation program. A liability approximately equal to the assets held in connection with our deferred employee compensation program is included in other long-term liabilities.

6. Long-Term Debt

On March 9, 2005, we entered into an amended and restated five-year secured credit agreement for a $180,000 revolving credit facility with a syndicate of lenders. The credit facility will be used for working capital purposes. This credit facility amends and restates the facility that we entered into on March 19, 2003.

The credit facility has a term of five years and all amounts outstanding under the credit facility will be due and payable on March 8, 2010. Subject to obtaining commitments from existing or new lenders and satisfaction of other specified conditions, we may increase the credit facility to up to $200,000.

Borrowings under the credit facility are based, at our election, on the London interbank deposit rate, or LIBOR, or the so-called base rate plus an applicable margin. The base rate equals the higher of Bank of America’s prime rate or 0.5% above the federal funds rate. We also pay a commitment fee on the total unused commitments of the lenders under the credit facility. The applicable margins and commitment fee are based on our ratio of consolidated funded debt to consolidated EBITDA (earnings before interest, tax, depreciation and amortization). The applicable margins range between 1.00% and 1.75% for LIBOR loans and between 0% and 0.75% for base rate loans. The commitment fee ranges between 0.375% and 0.500%. In addition, we will pay a fee for each letter of credit issued under the credit facility equal to the applicable margin for LIBOR loans and a customary fronting fee.

Our obligations under the credit facility are securedcollateralized by a lien on substantially all of our assets and by a pledge of the capital stock of our Indiana, Michigan, New Mexico, Utah, and Washington HMO subsidiaries and our Molina Healthcare Insurance Company subsidiary.

The credit agreement includes usual and customary covenants for credit facilities of this type, including covenants limiting liens, mergers, asset sales, other fundamental changes, debt, acquisitions, dividends and other distributions, capital expenditures, and investments. The credit agreement also requires us to maintain a ratio of total consolidated debt to total consolidated EBITDA of not more than 2.00 to 1.00 at any time and atime.

At September 30, 2006, we were not in compliance with the covenant in our credit agreement regarding our fixed charge coverage ratio, constituting an event of 1.75default under the credit agreement. Effective as of November 6, 2006, the Company entered into a “Second Amendment and Waiver” with respect to the credit agreement. The Second Amendment and Waiver retroactively waives the Company’s non-compliance at September 30, 2006, modifies the definition of fixed charge coverage ratio to remove from the numerator both capital expenditures and certain defined contributions to subsidiaries, and changes the required ratio to 2.75 to 1.00 for the quarter ended March 31, 2005 and thereafter ranging from 1.20 to 1:00 for the quarter endedfour quarters ending between September 30, 2006 through June 30, 2006 up to2007, 3.00 to 1.00 for allthe four quarters ending after December 31, 2009. Atbetween September 30, 2007 through June 30, 2006,2008, and 3.50 to 1.00 for the quarters ending September 30, 2008 and thereafter. As a result of this amendment, we were in compliance with all financial covenants in the credit agreement.fixed charge coverage ratio covenant for the quarter ended September 30, 2006.

At JuneSeptember 30, 2006, the amount outstanding under the credit facility was $15 million. At December 31, 2005, no amounts were outstanding under the credit facility.

7. Commitments and Contingencies

Legal

The health care industry is subject to numerous laws and regulations of federal, state, and local governments. Compliance with these laws and regulations can be subject to government review and interpretation, as well as regulatory actions unknown and unasserted at this time. Penalties associated with violations of these laws and regulations include significant fines and penalties, exclusion from participating in publicly-funded programs, and the repayment of previously billed and collected revenues.

Securities Litigation.Beginning on July 27, 2005, a series of securities class action complaints were filed in the United States District Court for the Central District of California on behalf of persons who acquired Company stock between November 3, 2004 and July 20, 2005. The class action complaints were consolidated into a single consolidated action, Case No. CV 05-5460 GPS (SHx) (the “Class Action”), and a lead plaintiff was appointed. On March 13, 2006, the lead plaintiff filed its consolidated complaint. The consolidated complaint purports to allege claims against Molina Healthcare, Inc., J. Mario Molina, John C. Molina, and Joseph W. White for alleged violations of the Securities Exchange Act of 1934 arising out of the Company’s announcement of its guidance for the 2005 fiscal year. On May 1, 2006, the defendants filed a motion to dismiss the consolidated complaint for failure to state a claim upon which relief can be granted, and the motion has been fully briefed by the parties. On July 27, 2006, the federal court judge vacated the hearing on the motion and took the motion under submission. To date, no ruling on the motion has been issued. The Class Action is in the early stages, and no prediction can be made as to the outcome.

Derivative Litigation. On August 8, 2005, a shareholder derivative complaint was filed in the Superior Court of the State of California for the County of Los Angeles, Case No. BC 337912 (the “Derivative Action”). The Derivative Action purports to allege claims on behalf of the Company against certain current and former officers and directors for breach of fiduciary duty, breach of the duty of loyalty, gross negligence, and violation of California Corporations Code Section 25402 arising out of the Company’s announcement of its guidance for the 2005 fiscal year. On February 7, 2006, the Superior Court ordered that the Derivative Action be stayed pending the outcome of the Class Action. The Derivative Action is in the early stages, and no prediction can be made as to the outcome.

Arbitration with Tenet Hospital.Hospital. In July 2004, our California HMO received a demand for arbitration from USC/Tenet Hospital, or Tenet, seeking damages of approximately $4,500 involving certain disputed medical claims. In September 2004, Tenet amended its demand to join additional Tenet hospital claimants and to increase its damage claim to approximately $8,000. The parties have agreed to present their argumentsconduct the arbitration in two phases. The first phase of the arbitration, comprising approximately $3,000 of the total demand, concluded in December 2005. At that time, Tenet was awarded approximately $1,700 by the arbitrator. WeOur California HMO paid the award in January 2006. This amount is in addition to approximately $330 weit had paid earlier in the fourth quarter of 2005 to settle a portion of the claims included in the first phase of the arbitration. The parties are currently conducting the second phase of the arbitration. We believe that the California HMO has meritorious defenses to Tenet’s claims and we intend to vigorously defend this matter. Nevertheless, atAt December 31, 2005, weour California HMO had recorded additional expense beyond the amount of $2,030 discussed above in connection with this matter;matter, and the liability associated with that additional expense remainsremained on our consolidated balance sheet at June 30, 2006. We do not believeThe final phase of the arbitration was settled during the third quarter of 2006. In connection with that the ultimate resolution ofsettlement, our California HMO paid Tenet an amount equal to that accrued on our consolidated balance sheet at June 30, 2006. Accordingly, no expense or income has been recognized in relation to this matter will materially affect our consolidated financial position, results of operations, or cash flows beyondduring 2006, and the impact of the liability recorded in connection with this matter.matter is now finally resolved.

Starko.Starko. Our New Mexico HMO is named as a defendant in a class action lawsuit brought by New Mexico pharmacies and pharmacists, Starko, Inc., et al. v. NMHSD, et al., No. CV-97-06599, Second Judicial District Court, State of New Mexico. The lawsuit was originally filed in August 1997 against the New Mexico Human Services Department (“NMHSD”). In February 2001, the plaintiffs named HMOs participating in the New Mexico Medicaid program as defendants, including the predecessor of the New Mexico HMO. Plaintiff asserts that NMHSD and the HMOs failed to pay pharmacy dispensing fees under an alleged New Mexico statutory mandate. Discovery has recently commenced.is currently underway. It is not currently possible to assess the amount or range of potential loss or probability of a favorable or unfavorable outcome. Under the terms of the stock purchase agreement pursuant to which we acquired

Health Care Horizons, Inc., the parent company to the New Mexico HMO, an indemnification escrow account was established and funded with $6,000 in order indemnify our New Mexico HMO against the costs of such litigation and any eventual liability or settlement costs. Currently, $4,456$4,466 remains in the indemnification escrow fund.

Antelope Valley. On May 1, 2006, Antelope Valley Healthcare District (“Antelope Valley”) filed a complaint in Los Angeles County Superior Court against our California HMO, Case No. BC351590. To date, our California HMO has not been served with the complaint, and upon information and belief the complaint was filed by Antelope Valley at this stage in order to toll the applicable statute of limitations. The complaint alleges claims for breach of contract, breach of implied contract, quantum meruit, unfair business practice, and declaratory relief related to the payment of emergency room claims for Molina members who sought treatment at Antelope Valley facilities from January 2002 to the present. Antelope Valley alleges that the emergency room claims, which our California HMO paid in accordance with its Medicaid contract with the California Department of Health Services and Title 22 of the California Code of Regulations, Section 53855, were underpaid. The complaint seeks damages in the amount of $2,001, plus interest and attorney fees. An administrative hearing currently pending before a California Department of Health Services (DHS) hearing officer involves the same parties and the same general subject matter as the complaint, but the amount at issue in that hearing is considerably less than the damage amount alleged in the complaint. The parties are currently awaiting the ruling of the DHS hearing officer in the administrative matter. The Antelope Valley matter is in the early stages, and no prediction can be made either as to its outcome or the circumstances under which Antelope Valley would serve the complaint on our California HMO.

We are involved in other legal actions in the normal course of business, some of which seek monetary damages, including claims for punitive damages, which are not covered by insurance. These actions, when finally concluded and determined, will not, in our opinion, have a material adverse effect on our consolidated financial position, results of operations, or cash flows.

Provider Claims

Many of our medical contracts are complex in nature and may be subject to differing interpretations regarding amounts due for the provision of various services. Such differing interpretations may lead medical providers to pursue us for additional compensation. The claims made by providers in such circumstances often involve issues of contract compliance, interpretation, payment methodology, and intent. These claims often extend to services provided by the providers over a number of years.

Providers have contacted us seeking additional compensation for claims that we believe to have been settled. These matters, when finally concluded and determined, will not, in our opinion, have a material adverse effect on our consolidated financial position, results of operations, or cash flows.

Subscriber Group Claims

The United States Office of Personnel Management (OPM) has contacted our New Mexico HMO seeking repayment of approximately $3,800 in premiums paid by OPM on behalf of Federal employees for the years 1999, 2000 and

2002. OPM is also seeking recovery of approximately $500 in interest in connection with this matter. OPM is asserting that, during the years in question, it did not receive rate discounts equivalent to the largest discount given by the New Mexico HMO for Similar Sized Subscriber Groups as required by the New Mexico HMO’s agreement with OPM. In consultation with its external actuaries, our New Mexico HMO responded to OPM duringasserting that, based upon its analysis, no funds are owed to OPM. Our New Mexico HMO is currently awaiting the years in question. We are continuing to analyze the OPM claim and are unable at this time to determine either the validityresponse of the claim or the degree, if any, of our liability in regards to this matter.OPM.

Regulatory Capital and Dividend Restrictions

Our principal operations are conducted through our seveneight HMO subsidiaries operating in California, Indiana, Michigan, New Mexico, Ohio, Texas, Utah, and Washington. Our HMOs are subject to state regulations that, among other things, require the maintenance of minimum levels of statutory capital, as defined by each state, and restrict the timing, payment and amount of dividends and other distributions that may be paid to us as the sole stockholder. To the extent the subsidiaries must comply with these regulations, they may not have the financial flexibility to transfer funds to us. The net assets in these subsidiaries (after intercompany eliminations), which may not be transferred to us in the form of loans, advances, or cash dividends, was $174,200$200,100 at JuneSeptember 30, 2006 and $155,900 at December 31, 2005. The National Association of Insurance Commissioners, or NAIC, adopted rules effective December 31, 1998, which, if implemented by the states, set minimum capitalization requirements for insurance companies, HMOs and other entities bearing risk for health care coverage. The requirements take the form of risk-based capital (RBC) rules. Washington, Indiana, Michigan, Ohio, Texas and Utah have adopted these rules (which vary from state to state). While New Mexico

has not formally adopted the RBC rules, that state holds our New Mexico HMO to those rules. California has not yet adopted NAIC risk-based capital requirements for HMOs and has not given notice of any intention to do so. Such requirements, if adopted by California, may increase the minimum capital required by that state.

At JuneSeptember 30, 2006, our HMOs had aggregate statutory capital and surplus of approximately $178,400$206,600 compared with the required minimum aggregate statutory capital and surplus of approximately $118,600.$118,900. All of our HMOs were in compliance with the minimum capital requirements. We have the ability and commitment to provide additional working capital to each of our HMOs when necessary to ensure that statutory capital and surplus continue to meet regulatory requirements.

8. Acquisitions

Michigan HMO

On May 18, 2006, the Companyour Michigan HMO completed its acquisition of HCLB, Inc. (“HCLB”). HCLB is the parent company of CapeCAPE Health Plan, Inc. (“Cape”CAPE”), a Michigan corporation based in Southfield, Michigan. CapeCAPE serves approximately 90,000 Medicaid members primarily in Southeast Michigan. The CapeCAPE acquisition has expanded our geographic presence within Michigan. The purchase price was $44.0 million in cash and the acquisition was deemed effective May 15, 2006 for accounting purposes. Accordingly, the results of operations for CapeCAPE are included in theour consolidated financial statements for the periods following May 15, 2006.

The Company has allocated the purchase price to the fair value of HCLB assets acquired and liabilities assumed, including identifiable intangible assets, and the excess of purchase price over the fair value of net assets acquired was recorded as goodwill. Based upon our preliminary valuation, we have assigned $13.4 million of the purchase price to finite-lived intangible assets with a life of between five and ten years and approximately $16.2$15.8 million to goodwill. These amounts are subject to change upon completion of the final valuation.

9. Related Party Transactions

Effective March 1, 2006, we assumed an office lease from Millworks Capital Ventures with a remaining term of 52 months. Millworks Capital Ventures is owned by John C. Molina, our Chief Financial Officer, and his wife. The monthly base lease payment is approximately $18 and is subject to an annual increase. Based on a market report prepared by an independent realtor, we believe the terms and conditions of the assumed lease are at fair market value. We are currently using the office space under the lease for an office expansion.

On June 14, 2006, Mr. Wayne Lowell was elected to serve as a director by our Board of Directors. Prior to his election, Mr. Lowell had provided consulting services to the company.Company. For the three months and sixnine months ended JuneSeptember 30, 2006, total payments for his consulting services were $19.1$45.6 and $34.1,$79.7, respectively. For the three months and sixnine months ended JuneSeptember 30, 2005, total payments for his services were $95.9$47.6 and $136.6,$184.2, respectively. It is our expectation that Mr. Lowell will continue to provide us with his consulting services in the future.

Effective June 1, 2006, we entered into an additional contractThe Company is a party to a fee for service agreement with Pacific Hospital of Long Beach (“Pacific Hospital”) as part of a capitation arrangement.. Pacific Hospital is owned by Abrazos Healthcare, Inc., the shares of which are held as community property by the husband of Dr. Martha Bernadett, our Executive Vice President, Research and Development. Amounts paid under the terms of that agreement were $73.1 and $316.0 for the three and nine months ended September 30, 2006, respectively, and $128.9 and $288.0 for the three and nine months ended September 30, 2005, respectively. The claims submitted to us by Pacific Hospital were reimbursed at prevailing market rates.

Effective June 1, 2006, the Company entered into an additional agreement with Pacific Hospital as part of a capitation arrangement. Under this arrangement, Pacific Hospital will receive a fixed fee from us based on member type. For the one monththree months ended JuneSeptember 30, 2006, approximately $146$759 was accrued as medical care costs and no payment was madepaid to Pacific Hospital for capitation services. The Company had previously entered into a fee for service contractbelieves this agreement with Pacific Hospital. Amounts paid under the terms of that agreement were $106.9 and $242.9 for the three and six months ended June 30, 2006, respectively, and $70.5 and $159.1 for the three and six months ended June 30, 2005, respectively. The claims submitted to us by Pacific Hospital were reimbursed atis based on prevailing market rates.rates for similar services.

Mr. Harvey Fein, our Vice President of Internal Audit, serves on the board of directors of CADRE Funds, the professional portfolio manager of our invested cash and cash equivalents. Mr. Fein has no direct management control over the Company’s funds invested by CADRE Funds, and donates his board fees to charity.

Item 2.

Management’s Discussion and Analysis of Financial Condition and Results of Operations.

Forward Looking Statements

The information made available below and elsewhere in this quarterly report on Form 10-Q contains forward-looking statements that involve risks and uncertainties. These forward-looking statements are often accompanied by words such as “believe,” “anticipate,” “plan,” “expect,” “estimate,” “intend,” “seek,” “goal,” “may,” “will” and similar expressions. These statements include, without limitation, statements about our anticipated financial performance, our market opportunity, our growth strategy, competition, expected activities, future acquisitions and investments, and the adequacy of our available cash resources. Forward-looking statements involve known and unknown risks and uncertainties that may cause our actual results in future periods to differ materially from those projected or contemplated in the forward-looking statements as a result of, but not limited to, the following factors:

Investors should refer both to our Annual Report on Form 10-K for the year ended December 31, 2005, and to “Part II, Item 1A – Risk Factors” below, for a discussion of certain risk factors which could materially affect our business, financial condition, or future results. Given these risks and uncertainties, we can give no assurances that any results or events projected or contemplated by our forward-looking statements will in fact occur and we caution investors not to place undue reliance on these statements.

This document and the following discussion of our financial condition and results of operations should be read in conjunction with the accompanying consolidated financial statements and the notes to those statements appearing elsewhere in this report and the audited financial statements and Management’s Discussion and Analysis appearing in our Report on Form 10-K for the year ended December 31, 2005.

Overview

We are a multi-state managed care organization that arranges for the delivery of health care services to persons eligible for Medicaid and other government-sponsored programs for low-income families and individuals. Our objective is to become the leading managed care organization in the United States focused primarily on serving people who receive health care benefits through government-sponsored programs for low-income populations.

We generate revenues primarily from premiums we receive from the states in which we operate. Premium revenue is fixed in advance of the periods covered and is not subject to significant accounting estimates. For the sixnine months ended JuneSeptember 30, 2006, we received approximately 86.7%87.3% of our premium revenue as a fixed amount per member per month pursuant to our contracts with state Medicaid agencies and other managed care organizations with which we operate as a subcontractor. These premium revenues are recognized in the month members are entitled to receive health care services. Approximately 7.7%7.1% of our premium revenue in the sixnine months ended JuneSeptember 30, 2006 was realized under a cost plus reimbursement agreement that our Utah HMO has with that state. We also received approximately 5.6% of our premium revenue for the sixnine months ended JuneSeptember 30, 2006 in the form of birth payments (one-time payments for the delivery of children) from the Medicaid programs in Indiana, Michigan, New Mexico, Ohio, and Washington. Such payments are recognized as revenue in the month the birth occurs. The state Medicaid programs periodically adjust premium rates.

Membership growth has been the primary reason for our increasing revenues. We have increased our membership through both internal growth and acquisitions. The following table sets forth the approximate number of members by state as of the dates indicated.

(2)	The Company’s Texas plan commenced operations in September 2006.

The following table details member months (defined as the aggregation of each month’s ending membership for the period) by state for the periods indicated:

		Three months ended September 30,					% of Increase (Decrease)			Nine months ended September 30,					% of Increase (Decrease)
		2006		2005						2006		2005
California		911,000		1,006,000			(9.4	)%		2,785,000		2,598,000			7.2	%
Indiana		150,000		59,000			154.2	%		328,000		79,000			315.2	%
Michigan		681,000		441,000			54.4	%		1,677,000		1,375,000			22.0	%
New Mexico		181,000		183,000			(1.1	)%		535,000		553,000			(3.3	)%
Ohio		95,000		N/A	(1)		—			229,000		N/A	(1)		—
Texas		3,000		N/A	(2)		—			3,000		N/A	(2)		—
Utah		167,000		164,000			1.8	%		527,000		492,000			7.1	%
Washington		846,000		856,000			(1.2	)%		2,572,000		2,521,000			2.0	%
Total		3,034,000		2,709,000			12.0	%		8,656,000		7,618,000			13.6	%

Our operating expenses include expenses related to the provision of medical care services and salary, general and administrative, or SG&A, costs. Our results of operations depend onare impacted by our ability to effectively manage expenses related to health care services and accurately predict costs incurred.

Expenses related to medical care services include two components: direct medical expenses and medically related administrative costs. Direct medical expenses include payments to physicians, hospitals, and providers of ancillary medical services, such as pharmacy, laboratory, and radiology services. Medically-related administrative costs include expenses relating to health education, quality assurance, case management, disease management, 24-hour on-call nurses, member services, and compliance. Some of our primary care physicians are paid on a capitation basis (a fixed amount per member per month regardless of actual utilization of medical services), while others are paid on a fee-for-service basis. Specialists and hospitals are paid for the most part on a fee-for-service basis. For the sixnine months ended JuneSeptember 30, 2006, approximately 84.2%84.0% of our direct medical expenses were related to fees paid to providers on a fee-for-service basis, with the balance paid on a capitation basis. Physician providers paid on a fee-for-service basis are paid according to a fee schedule set by the state or by our contracts with these providers. We pay hospitals in a variety of ways, including fee-for-service, per diems, diagnostic-related groups, capitation, and case rates.

Capitation payments are fixed in advance of periods covered and are not subject to significant accounting estimates. These payments are expensed in the period the providers are obligated to provide services. All capitation expenses are recorded as “Medical services” in our Condensed Consolidated Statements of Income.

Fee-for-service payments are expensed in the period services are provided to our members. Medical care costs include actual historical claims experience and estimates of medical expenses incurred but not reported, or IBNR. We estimate our IBNR monthly based on a number of factors, including prior claims experience, inpatient hospital utilization data, and prior authorization of medical services. As part of this review, we also consider estimates of amounts to cover uncertainties related to fluctuations in provider billing patterns, claims payment patterns, and membership, and medical cost trends. These estimatesEstimates are adjusted monthly as more information becomes available. We employ our own actuary and engage the service of independent actuaries as needed. We believe that our process for estimating IBNR is adequate, but all estimates are subject to uncertainties and our actual medical care costs have in the past exceeded such estimates. Our estimates of IBNR may be inadequate in the future, which would negatively affect our results of operations. Additionally, our inability to accurately estimate IBNR may also affect our ability to take timely corrective actions, further exacerbating the extent of the negative impact on our results of operations.

Medically-related administrative costs include expenses relating to health education, quality assurance, case management, disease management, 24-hour on-call nurses, member services, and compliance. Salary and benefit costs are a substantial portion of these expenses. During the nine months ended September 30, 2005 and 2006, medically-related administrative costs, classified as “Medical services” in our Condensed Consolidated Statements of Income, constituted between 2.5% and 3% of premium revenue.

SG&A costs are largely comprised of wage and benefit costs related to our employee base and other administrative expenses. Some SG&A services are provided locally, while others are delivered to our health plans from a centralized location. The major centralized functions are claims processing, information systems, finance and accounting services, and legal and regulatory services. Locally-provided functions include marketing (to the extent permitted by law and regulation), plan administration, and provider relations. Included in SG&A expenses are premium taxes for our California HMO (beginning July 1, 2005), Michigan HMO, New Mexico HMO, Ohio HMO, Texas HMO (beginning September 2006), and Washington HMO.

Results of Operations

The following table sets forth selected operating ratios. All ratios with the exception of the medical care ratio are shown as a percentage of total revenue. The medical care ratio is shown as a percentage of premium revenue because there is a direct relationship between the premium revenue earned and the cost of health care.

		Three Months Ended September 30,						Nine Months Ended September 30,
		2006			2005			2006			2005
Premium revenue		99.0	%		99.4	%		99.0	%		99.4	%
Investment income		1.0	%		0.6	%		1.0	%		0.6	%
Total revenue		100.0	%		100.0	%		100.0	%		100.0	%
Medical care ratio		84.1	%		86.1	%		84.4	%		87.6	%
Salary, general and administrative expenses		11.7	%		11.0	%		11.5	%		9.6	%
Operating income		4.0	%		2.5	%		3.9	%		2.3	%
Net income		2.4	%		1.6	%		2.3	%		1.4	%

Three Months Ended JuneSeptember 30, 2006 Compared With Three Months Ended JuneSeptember 30, 2005

Net Income or Loss

Net income for the quarter ended JuneSeptember 30, 2006 was $13.2$12.3 million, or $0.47$0.44 per diluted share, compared with net lossincome of $4.7$6.8 million, or $0.17$0.24 per diluted share, for the quarter ended JuneSeptember 30, 2005. Comparability betweenThe increase in net income was primarily the second quarterresult of 2006improved medical care costs as a percentage of premium revenue (the medical care ratio) for our Washington, Michigan, and New Mexico HMOs, offset in part by the second quarterhigher medical care ratio of 2005 was affected by:

our ongoing medical care cost control initiatives.

Premium Revenue

Premium revenue for the quarter ended JuneSeptember 30, 2006 was $479.8$512.1 million, representing an increase of $77.9$86.2 million, or 19.4%20.2%, over 2005 premium revenue of $401.9 million.$425.9 million for the quarter ended September 30, 2005. Increased membership provided $62.2$54.8 million of the increase in premium revenue, while the remainder of the increase was due to higher per member per month (PMPM) premium revenue. Acquisitions in California in June 2005 andThe acquisition of CAPE Health Plan in Michigan inon May 15, 2006 and start-up operations in Indiana and Ohio and enrollment growth in Utah were the primary drivers of the increase in premium revenue. Membership growth was partially offset by declines in membership in California and Michigan (exclusive of acquisitions) and(excluding the CAPE acquisition). The Utah HMO also contributed to the increase in New Mexico.premium revenue as higher medical costs resulted in higher premiums earned under our cost reimbursement formula with that state.

Investment Income

Investment income increased by $2.5to $5.4 million or 103.9%, in the secondthird quarter of 2006 compared withfrom $2.7 million reported in the secondthird quarter of 2005 as a result of higher invested balances and higher rates of return.

Medical Care Costs

Medical care costs as a percentage of premium revenue (theThe medical care ratio)ratio decreased to 83.7%84.1% in the secondthird quarter of 2006 from 91.9%86.1% in the secondthird quarter of 2005. The medical care costs for the second quarter of 2006 included approximately $5 millionyear-over-year improvement in favorable prior period claims development related to our claims liability at December 31, 2005. The medical care costs for the second quarter of 2005 included approximately $13.4 million in adverse prior period claims development related to claims incurred for the first quarter of 2005. Excluding the respective adjustment for both quarters, the medical care ratio would have been 84.8%was the result of improved medical care ratios in our Washington, Michigan, and 88.6% forNew Mexico HMOs. The improved medical care ratios in those states was partially offset by increased medical care ratios in our California and Indiana HMOs, and by the secondstart-up of our Ohio HMO, which had a medical care ratio that is substantially higher than that experienced by the Company as a whole.

Our Washington, Michigan, and New Mexico HMOs all reported lower medical care ratios in both the quarter and the nine months ended JuneSeptember 30, 2006 when compared with the comparable periods in 2005. We believe that the improvement at these health plans is principally the result of re-contracting efforts and 2005, respectively.improved monitoring and management of medical utilization.

We believe that the decline in our California HMO’s profitability is the result of limited premium increases compounded by higher hospital costs. Utilization of medical services does not appear to be a significant contributor to difficulties in the California market. Our California HMO has taken a number of actions designed to improve its performance, including adding new senior staff and renegotiating certain provider contracts. It is also exploring ways to increase premium rates from the state.

The medical care ratios in Ohio and Indiana were substantially higher than that experienced historically by the Company as a whole. We believe that the higher medical care ratios in Ohio and Indiana are primarily due to the following factors:

Membership at our Ohio health plan has grown dramatically since September 30, 2006, increasing to approximately 77,000 at November 1, 2006. We anticipate substantial additional growth in Ohio during 2007 related to the state’s expansion of its Medicaid Managed Care Program for its Aged, Blind and Disabled (ABD) population.

As previously disclosed, the Medicaid contract of our Indiana HMO will expire on December 31, 2006. Our Indiana HMO has appealed the State’s decision not to renew the contract, but there can be no assurance that this appeal will be successful. We do not believe that the discontinuation of Medicaid services by our Indiana HMO will have a material impact on the Company’s cash flows or results of operations.

Medical care costs increased in absolute terms to $401.7$430.9 million in the secondthird quarter of 2006 from $369.5$366.6 million in the secondthird quarter of 2005. Medical services costs increased as a percentage of premium revenue in the second quarter of 2006 when compared with the same period in 2005 due primarily to higher capitation costs. Hospitalcosts, hospital and specialty services, and pharmacy costs decreased as a percentage of premium revenue in the second quarter of 2006 when compared with the second quarter of 2005.

We believe that the medical cost control initiatives undertaken since the second quarter of 2005 have begun to have a positive impact upon our medical care ratio. In particular, we believe that the following actions have contributed to lower medical care cost trends since the second quarter of 2005:

Nevertheless, we can give no assurances that the improved performance is not at least partially the result of factors beyond our control, nor can we give any assurances that the improved medical care cost trends will continue.

Furthermore, progress has not been uniform among our health plan subsidiaries. For example, our results during the first half of 2006 were adversely affected by the financial performance of our California HMO, principally due to profitability issues in San Diego County.costs.

Salary, General and Administrative Expenses

Salary, general and administrative expenses were $56.3$60.5 million for the secondthird quarter of 2006, representing 11.6%11.7% of total revenue, compared with $37.1$47.0 million, or 9.2%11.0% of total revenue, for the secondthird quarter of 2005.

Core G&A (defined as SG&A expenses less premium taxes) increased to 8.6% of total revenue in the secondthird quarter of 2006 compared with 6.7%7.4% in the secondthird quarter of 2005. The increase in core G&A was primarily due to investments in infrastructure to support our medical care cost control initiatives, our information technology initiatives, our expansion into Ohio and Texas, and the launch of our Medicare Advantage Special Needs Plans. Expensing of stock option, effective January 1, 2006, reduced earnings per diluted share by approximately $0.02 in the secondthird quarter of 2006.

Interest Expense

Interest expense increased to $0.6 million in the second quarter of 2006 from $0.4 million for the same period in 2005 due to increased credit facility fees, increased borrowings and higher interest rates.

Depreciation and Amortization

Depreciation and amortization expense increased to $4.9$5.6 million for the three month period ended JuneSeptember 30, 2006 from $3.6$4.1 million for the same period in 2005. Increased amortization expense due to our acquisitionsthe CAPE acquisition in California (which closed on June 1, 2005) and Michigan, (whichwhich closed on May 15, 2006)2006, contributed $0.6 million and $0.1$0.7 million in additional amortization, respectively.amortization. Depreciation expense increased by $0.8 million as a result of investmentinvestments in infrastructure, principally at our corporate offices.

Interest Expense

Interest expense totaled $0.6 million for the third quarter of 2006, essentially flat when compared with the same period of 2005. Interest expense includes interest on borrowings and the facility fee on unused amounts available under our credit facility.

Income Taxes

Income taxes were recognized in the secondthird quarter of 2006 based upon an effective tax rate of 37.9%37.7% compared with an effective tax rate of 38.0%33.9% in the secondthird quarter of 2005. We believe that the most significant factor affecting ourThe effective tax rate isfor the proportionthird quarter of consolidated2005 was less than the 38.0% effective rate anticipated by the Company due to an increase in that portion of the Company’s net income earned by subsidiaries operatingthat are not subject to state income tax, coupled with larger than anticipated economic development credits in states that impose premium taxes rather than income taxes.California.

SixNine Months Ended JuneSeptember 30, 2006 Compared With SixNine Months Ended JuneSeptember 30, 2005

Net Income

Net income for the sixnine months ended JuneSeptember 30, 2006, was $21.7$34.1 million, or $0.77$1.21 per diluted share, compared with $10.1$16.9 million, or $0.36$0.60 per diluted share, for the sixnine months ended JuneSeptember 30, 2005. The increase in net income was primarily the result of a lowerdecrease in the medical care ratio of 320 basis points for the nine months ended September 30, 2006 when compared with the same period in the first half of 2006.2005. The $5.0 million of positive prior period claims development that we experienced in the first halfsecond quarter of 2006 partly contributed to our lower medical care ratio.

Premium Revenue

Premium revenue for the sixnine months ended JuneSeptember 30, 2006 was $929.1$1,441.2 million, representing an increase of $135.0$221.2 million, or 17.0%18.1%, over premium revenue of $794.1$1,220.0 million for the same period of 2005. Increased membership added $117.9

$172.8 million to our premium revenue, while increases in the amount of revenue received per member per month provided the remainder of the increase. The acquisitions inmembership growth associated with the acquisition of CAPE Health Plan by our Michigan HMO on May 15, 2006, with the acquisition of Sharp Health Plan by our California HMO on June 1, 2005, and Michigan,with the start-ups instart-up of our Indiana and Ohio and enrollment growth in Utah wereHMOs, was the primary driversdriver of the increase in premium revenue. MembershipPartially offsetting this membership growth was partially offset by declinesthe decline in membership inexperienced by our California and Michigan (exclusive ofHMOs (excluding acquisitions) and New Mexico.. The Utah HMO also contributed to the increase in premium revenue as higher medical costs resulted in higher premiums earned under our cost reimbursement formula with that state.

Investment Income

Investment income for the sixnine months ended JuneSeptember 30, 2006 increased to $8.9$14.3 million from $4.1$6.8 million for the same period of 2005, an increase of 115.6%110.3%, principally as a result of larger invested balances as well asand higher rates of return.

Medical Care Costs

The medical care ratio decreased to 84.5%84.4% in the first half ofnine months ended September 30, 2006 from 88.5%87.6% in the same six-month period of 2005. Medical care costs increased in absolute terms to $785.0$1,215.8 million in the sixnine months ended JuneSeptember 30, 2006 from $702.6$1,069.2 million in the same period of 2005.

The decrease in our medical care ratio for the sixnine months ended JuneSeptember 30, 2006 compared with the sixnine months ended JuneSeptember 30, 2005 was due to the same factors as identified above regardingdiscussed earlier in the improvement in ourresults of operations for the three months ended September 30, 2006 compared with the three months ended September 30, 2005. Additionally, the medical care ratio for the nine months ended September 30, 2006 benefited from the $5.0 million of positive prior period claims development that we experienced in the second quarter of 2006.

Salary, General and Administrative Expenses

SG&A expenses were $107.5$168.0 million for the first half ofnine months ended September 30, 2006, representing 11.5% of total revenue, compared with $70.6$117.6 million, or 8.8%9.6% of total revenue, for the first half ofnine months ended September 30, 2005.

Core G&A (defined as SG&A expenses less premium taxes) increased to 8.6%8.5% of total revenue in the second quarter ofnine months ended September 30, 2006 compared with 6.2%6.7% in the first half ofnine months ended September 30, 2005. The increase in core G&A during the sixnine months ended JuneSeptember 30, 2006 compared with the same period in 2005 was primarily due to the same factors identified above regardinginfrastructure improvements and product and market expansions as discussed earlier in the increase in core G&Aresults of operations for the second quarter of 2006.three months ended September 30, 2006 compared with the three months ended September 30, 2005. Expensing of stock options, effective January 1, 2006, reduced earnings per diluted share by approximately $0.04$0.06 for the nine months ended September 30, 2006.

Depreciation and Amortization

Depreciation and amortization expense for the nine months ended September 30, 2006 increased to $15.3 million from $10.9 million for the same period of the prior year. Amortization expense increased by $1.5 million, principally due to our California and Michigan acquisitions. Depreciation expense increased by $2.9 million as a result of investments in the first half of 2006.infrastructure, principally at our corporate offices.

Interest Expense

Interest expense increased to $1.0$1.6 million for the sixnine months ended JuneSeptember 30, 2006 from $0.7$1.3 million for the first halfsame period of 2005 due to increased credit facility fees, increased borrowings, and higher interest rates.

Depreciation and Amortization

Depreciation and amortization expense for the six months ended June 30, 2006 increased to $9.6 million from $6.8 million for the same period of the prior year. Increased amortization expense was principally due to our California and Michigan (CAPE) acquisitions. Depreciation expense increased as a result of investments in infrastructure, principally at our corporate offices.

Income Taxes

Income tax expense increased to $13.2$20.6 million in the sixnine months ended JuneSeptember 30, 2006 from $6.2$9.7 million in the same period of the prior year period due to higher operating profit in 2006. Our effective tax rate was 37.7% for the sixnine months ended JuneSeptember 30, 2006, compared with 38.0%36.4% for the six months ended June 30,same period of 2005.

Liquidity and Capital Resources

We generate cash from premium revenue and investment income. Our primary uses of cash include the payment of expenses related to medical care services and SG&A expenses. We generally receive premium revenue in advance of payment of claims for related health care services.

Our investment policies are designed to provide liquidity, preserve capital, and maximize total return on invested assets. At JuneSeptember 30, 2006, we invested a substantial portion of our cash in a portfolio of highly liquid money market securities.

At JuneSeptember 30, 2006, our investments (all of which are classified as current assets) consisted solely of investment grade debt securities. Our investment policies require that all of our investments have final maturities of ten years or less (excluding auction rate securities and variable rate securities, for which interest rates are periodically reset) and that the average maturity be four years or less. Two professional portfolio managers operating under documented investment guidelines manage our investments. The average annualized portfolio yield for the sixnine months ended JuneSeptember 30, 2006 and 2005 was approximately 4.7%4.8% and 2.5%2.8%, respectively.

The states in which we operate prescribe the types of instruments in which our subsidiaries may invest their funds. Our restricted investments are invested principally in certificates of deposit and treasury securities.

Net cash provided by operating activities was $38.6$67.2 million for the sixnine months ended JuneSeptember 30, 2006 and $8.4$61.0 million for the sixnine months ended JuneSeptember 30, 2005. Net income and the timing of payments for medical claims and benefits payable were the primary sources of cash provided by operating activities for the sixnine months ended JuneSeptember 30, 2006. Partially reducing cash provided by operating activities during the nine months ended September 30, 2006 was an increase in receivables of $13.1 million due to the timing of cash receipts from the state of Utah.

Cash provided by operating activities for the first half of 2005nine months ended September 2006 was less$6.2 million higher than the same period in 20062005 due to lowerhigher operating profit, and an increase in tax receivable of $17.8 million, partially offset by the timing of payments for medical claims and benefits payable.payable, taxes and receivables.

At JuneSeptember 30, 2006, we had working capital of $206.9$220.3 million compared with $189.2 million at December 31, 2005. At JuneSeptember 30, 2006 and December 31, 2005, cash and cash equivalents were $312.1$337.1 million and $249.2 million, respectively. At JuneSeptember 30, 2006 and December 31, 2005, investments (all classified as current assets) were $94.6$91.7 million and $103.4 million, respectively. At September 30, 2006, the parent company (Molina Healthcare, Inc.) had cash and investments of approximately $28.3 million.

At JuneSeptember 30, 2006, we owed $15.0were not in compliance with the covenant in our credit agreement regarding our fixed charge coverage ratio, constituting an event of default under the credit agreement. Effective as of November 6, 2006, we entered into a “Second Amendment and Waiver” with respect to the credit agreement. The Second Amendment and Waiver retroactively waives the Company’s non-compliance at September 30, 2006, modifies the definition of fixed charge coverage ratio to remove from the numerator both capital expenditures and certain defined contributions to subsidiaries, and changes the required ratio to 2.75 to 1.00 for the four quarters ending between September 30, 2006 through June 30, 2007, 3.00 to 1.00 for the four quarters ending between September 30, 2007 through June 30, 2008, and 3.50 to 1.00 for the quarters ending September 30, 2008 and thereafter. As a result of this amendment, we were in compliance with the fixed charge coverage ratio covenant for the quarter ended September 30, 2006.

In November 2005, we filed a shelf registration statement on Form S-3 with the Securities and Exchange Commission covering the issuance of up to $300 million of securities, including common stock and debt securities. No securities have been issued under the shelf registration statement. We may publicly offer securities from time to time at prices and terms to be determined at the time of the offering.

Anticipated membership growth in our Ohio HMO may require us to contribute up to $50.0 million in regulatory capital to that health plan by the end of 2007. This funding requirement is the result of the minimum net worth commitment required under our $180.0 millioncurrent and anticipated contracts with the Ohio Department of Jobs and Family Services. This requirement is based upon the actual membership of the health plan and is calculated on a per member per month basis. This requirement is likely to exceed any risk-based capital or other regulatory requirements. The anticipated infusion of regulatory capital into Ohio will need to be funded under our credit facility.facility or by alternative funding means.

In addition, the continuing difficulties of our California HMO, and the expansion of our start-up Texas HMO, may require the infusion of additional capital. Other than the required infusions of regulatory capital into Ohio, we believe that our cash resources and internally generated funds will be sufficient to support our operations, regulatory requirements, and capital expenditures for at least the next 12 months.

Regulatory Capital and Dividend Restrictions

Our principal operations are conducted through our seveneight HMO subsidiaries operating in California, Indiana, Michigan, New Mexico, Ohio, Texas, Utah, and Washington. The HMOs are subject to state laws that, among other things, may require the maintenance of minimum levels of statutory capital, as defined by each state, and may restrict the timing, payment, and amount of dividends and other distributions that may be paid to their stockholders.

The National Association of Insurance Commissioners, or NAIC, has established rules which, if adopted by a particular state, set minimum capitalization requirements for HMOs and other insurance entities bearing risk for health care coverage. The requirements take the form of risk-based capital, or RBC, rules. These rules, which in their final adopted form vary slightly from state to state, have been adopted in Indiana, Michigan, Ohio, Texas, Utah, and Washington. While New Mexico has not formally adopted the RBC rules, that state holds our New Mexico HMO to those rules. California has not adopted RBC rules and has not given notice of any intention to do so. The RBC rules, if adopted by California, may increase the minimum capital required by that state.

At JuneSeptember 30, 2006, our HMOs had aggregate statutory capital and surplus of approximately $178.4$206.6 million, compared with the required minimum aggregate statutory capital and surplus of approximately $118.6$118.9 million. All of our HMOs were in compliance with the minimum capital requirements at JuneSeptember 30, 2006. We have the ability and commitment to provide additional working capital to each of our HMOs when necessary to ensure that capital and surplus continue to meet regulatory requirements. Barring any change in regulatory requirements, we believe that we will continue to be in compliance with these requirements at least through 2006. We also believe that our cash resources and internally generated funds will be sufficient to support our operations, regulatory requirements, and capital expenditures for at least the next 12 months.

Contractual Obligations

In our Annual Report on Form 10-K for the year ended December 31, 2005, we reported on our contractual obligations as of that date. There have been no material changes to our contractual obligations since that report other than the draw down of $15 million on the credit facility which(which is due in year 2010.2010) and the contractual funding requirement in Ohio discussed above.

Critical Accounting Policies

When we prepare our consolidated financial statements, we use estimates and assumptions that may affect reported amounts and disclosures. The determination of our liability for claims and medical benefits payable is particularly important to the determination of our financial position and results of operations and requires the application of significant judgment by our management and, as a result, is subject to an inherent degree of uncertainty.

Our medical care costs include actual historical claims experience and estimates for medical care costs incurred but not reported to us, or IBNR. We together with our in-house actuaries, estimate medical claims liabilities using actuarial methods based upon historical data adjusted for payment patterns, cost trends, product mix, seasonality, utilization of health care

services, information provided by our providers, and other relevant factors. The estimation methods and the resulting reserves are frequently reviewed and updated, and adjustments, if necessary, are reflected in the relevant period.

While we believe our current estimates areestimated IBNR is adequate, we have in the past been required to make a significant adjustment to these estimates and it is possible that we will be required to make significant adjustments or revisions to these estimates in the future. The most significant estimates involved in determining our claims liability concern the determination of claims payment completion factors and trended per member per month cost estimates.

For the five monthsfifth month of service prior to the reporting date and earlier, we estimate our outstanding claims liability based upon actual claims paid, adjusted for estimated completion factors. Completion factors seek to measure the cumulative percentage of claims expense that will have been paid for a given month of service as of the reporting date based on historical payment patterns.

The following table reflects the change in our estimate of claims liability as of JuneSeptember 30, 2006 that would have resulted had we changed our completion factors for the fifth through the twelfth months preceding JuneSeptember 30, 2006 by the percentages indicated. A reduction in the completion factor results in an increase in medical claims liabilities. Our Utah HMO is excluded from these calculations because the majority of its business is conducted under a cost reimbursement contract. Our recent acquisition, CapeCAPE Health Plan, is excluded from these calculations because our statement of operations only includes CapeCAPE Health Plan for the period subsequent to May 15, 2006. Dollar amounts are in thousands.

For the four months of service immediately prior to the reporting date, actual claims paid are not a reliable measure of our ultimate liability because of the inherent delay between the patient/physician encounter and the actual submission of a claim. For these months of service, we estimate our claims liability based upon trended per member per month (PMPM) cost estimates. These estimates reflect recent trends in payments and expense, utilization patterns, authorized services, and other relevant factors.

The following table reflects the change in our estimate of claims liability as of JuneSeptember 30, 2006 that would have resulted had we altered our trend factors by the percentages indicated. An increase in the PMPM costs results in an increase in medical claims liabilities. Our Utah HMO is excluded from these calculations because the majority of its business is conducted under a cost reimbursement contract. Our recent acquisition, CapeCAPE Health Plan, is excluded from these calculations because our statement of operations only includes Cape Health Plan for the period subsequent towhich was acquired on May 15, 2006.2006, is included in these calculations. Dollar amounts are in thousands.

Assuming a hypothetical 1% change in completion factors from those used in our calculation of IBNR at JuneSeptember 30, 2006, net income for the sixnine months ended JuneSeptember 30, 2006 would increase or decrease by approximately $3.8$3.9 million, or $0.13$0.14 per diluted share, net of tax. Assuming a hypothetical 1% change in PMPM cost estimates from those used in our calculation of IBNR at JuneSeptember 30, 2006, net income for the sixnine months ended JuneSeptember 30, 2006 would increase or decrease by approximately $2.0$2.2 million, or $0.07$0.08 per diluted share, net of tax.

The following table shows the components of the change in medical claims and benefits payable for the sixnine months ended JuneSeptember 30, 2006 and 2005. Dollar amounts are in thousands.