10-Q

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

[ X ]     Quarterly report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the quarterly period ended September 30, 2008

or

[    ]     Transition report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

Commission File Number: 1-12040

SUN HEALTHCARE GROUP, INC.

(Exact name of Registrant as specified in its charter)

Delaware	85-0410612
(State of Incorporation)	(I.R.S. Employer Identification No.)

18831 Von Karman, Suite 400

Irvine, CA  92612

(949) 255-7100

(Address, zip code and telephone number of Registrant)

Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x  No 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definition of “large accelerated filer”, “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer  o	Accelerated filer  x
Non-accelerated filer  o (Do not check if a smaller reporting company)	Smaller reporting company  o

Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o  No x

As of October 27, 2008, there were 43,519,629 shares of the Registrant’s $.01 par value Common Stock outstanding.

1

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

Index

		Page Numbers
PART I.  FINANCIAL INFORMATION
Item 1.	Financial Statements:
	Consolidated Balance Sheets (unaudited)	3-4
	As of September 30, 2008
	As of December 31, 2007
	Consolidated Income Statements (unaudited)	5-6
	For the three months ended September 30, 2008 and 2007
	For the nine months ended September 30, 2008 and 2007
	Consolidated Statements of Cash Flows (unaudited)	7
	For the three months ended September 30, 2008 and 2007
	For the nine months ended September 30, 2008 and 2007
	Notes to Consolidated Financial Statements (unaudited)	8-31
Item 2.	Management's Discussion and Analysis of Financial Condition and Results of Operations	32-46
Item 3.	Quantitative and Qualitative Disclosures About Market Risk	47
Item 4.	Controls and Procedures	47
PART II.  OTHER INFORMATION
Item 6.	Exhibits	48
Signature		48

References throughout this document to the “Company,” “Sun,” “we,” “our,” “ours” and “us” refer to Sun Healthcare Group, Inc. and its subsidiaries.

STATEMENT REGARDING FORWARD-LOOKING STATEMENTS

Information provided in this Quarterly Report on Form 10-Q (this “10-Q”) contains “forward-looking statements” as that term is defined by the Private Securities Litigation Reform Act of 1995 (the “Act”).  All statements regarding our expected future financial position, results of operations, cash flows, indebtedness, lease obligations, financing plans, business strategies, budgets, projected costs and capital expenditures, the occupancy and payor mix at our skilled nursing centers, the anticipated impact of changes in Medicare, Medicaid and other governmental reimbursement programs,  the impact of regulatory initiatives and government investigations and audits that may affect our business, our ability to defend lawsuits, the ability of our self-insurance programs to satisfy claims, plans of management for future operations, interest rate risk exposure, our liquidity and words such as “anticipate,” “believe,” “plan,” “estimate,” “expect,” "intend,” ”should,” “may” and other similar expressions are forward-looking statements.

We caution investors that any forward-looking statements made by us are not guarantees of future performance.  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. Such material differences may result from the factors described in our 2007 Annual Report on Form 10-K (see Item 1A – “Risk Factors”) and other factors that are unknown to us or may be beyond our control.  Such risks should be carefully considered before any investment is made in our securities.  Given these risks and other uncertainties, we can give no assurances that any of the events or circumstances described in our forward-looking statements will in fact transpire, or that the impact of such events or circumstances will be material to our business and financial condition.  Therefore undue reliance should not be placed on such forward-looking statements. We do not intend, and undertake no obligation, to update our forward-looking statements to reflect future events or circumstances.

___________________

2

PART I.     FINANCIAL INFORMATION

ITEM 1.     FINANCIAL STATEMENTS

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS (unaudited)

ASSETS

(in thousands)

	September 30, 2008		December 31, 2007
			(Note 1)
Current assets:
Cash and cash equivalents	$	80,433	$	55,832
Restricted cash		33,464		37,365
Accounts receivable, net of allowance for doubtful accounts
of $43,673 and $42,144 at September 30, 2008 and
December 31, 2007, respectively		197,221		188,882
Prepaid expenses and other assets		22,195		13,290
Assets held for sale		3,651		9,924
Deferred tax assets		31,387		35,354
Total current assets		368,351		340,647
Property and equipment, net		597,373		585,972
Intangible assets, net		52,899		57,044
Goodwill		331,112		324,277
Restricted cash, non-current		3,288		3,829
Deferred tax assets		42,312		51,892
Other assets		6,119		10,165
Total assets	$	1,401,454	$	1,373,826

See accompanying notes.

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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS (unaudited) (CONTINUED)

LIABILITIES AND STOCKHOLDERS’ EQUITY

(in thousands, except share data)

	September 30, 2008			December 31, 2007
				(Note 1)
Current liabilities:
Accounts payable	$	48,457		$	52,836
Accrued compensation and benefits		61,832			61,956
Accrued self-insurance obligations, current portion		42,862			48,646
Income taxes payable		2,782			3,000
Liabilities held for sale		-			3,181
Other accrued liabilities		65,979			58,002
Current portion of long-term debt and capital lease obligations:
Company obligations		11,215			28,480
Clipper partnerships		873			825
Total current liabilities		234,000			256,926
Accrued self-insurance obligations, net of current portion		108,809			106,534
Long-term debt and capital lease obligations, net of current portion:
Company obligations		668,022			651,403
Clipper partnerships		47,901			48,560
Unfavorable lease obligations, net		16,372			18,960
Other long-term liabilities		46,498			44,717
Total liabilities		1,121,602			1,127,100
Commitments and contingencies (Note 6)
Minority interest		1,289			470
Stockholders’ equity:
Preferred stock of $.01 par value, authorized 10,000,000
shares, no shares were issued or outstanding as of
September 30, 2008 and December 31, 2007		-			-
Common stock of $.01 par value, authorized 125,000,000
shares; 43,509,223 and 43,016,042 shares issued and
outstanding as of September 30, 2008 and December 31, 2007,
respectively		435			430
Additional paid-in capital		605,966			600,199
Accumulated deficit		(325,104	)		(351,970	)
Accumulated other comprehensive loss, net		(2,734	)		(2,403	)
		278,563			246,256
Total liabilities and stockholders’ equity	$	1,401,454		$	1,373,826

See accompanying notes.

4

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

CONSOLIDATED INCOME STATEMENTS (unaudited)

(in thousands, except per share data)

	For the
	Three Months Ended
	September 30, 2008			September 30, 2007
Total net revenues	$	456,722		$	432,573
Costs and expenses:
Operating salaries and benefits		259,809			246,632
Self-insurance for workers’ compensation and general and
professional liability insurance		14,580			15,646
Operating administrative expenses		12,792			10,208
Other operating costs		94,893			89,009
Center rent expense		18,551			18,552
General and administrative expenses		13,832			16,877
Depreciation and amortization		10,174			9,961
Provision for losses on accounts receivable		3,306			3,328
Interest, net of interest income of $340 and $604, respectively		13,070			14,841
Loss on sale of assets		-			12
Total costs and expenses		441,007			425,066
Income before income taxes and discontinued operations		15,715			7,507
Income tax expense		6,286			2,627
Income from continuing operations		9,429			4,880
Discontinued operations:
Loss from discontinued operations, net of related taxes		(171	)		(313	)
(Loss) gain on disposal of discontinued operations, net of
related taxes		(654	)		629
(Loss) income from discontinued operations, net		(825	)		316
Net income	$	8,604		$	5,196
Basic earnings per common and common equivalent share:
Income from continuing operations	$	0.22		$	0.11
(Loss) income from discontinued operations, net		(0.02	)		0.01
Net income	$	0.20		$	0.12
Diluted earnings per common and common equivalent share:
Income from continuing operations	$	0.21		$	0.11
(Loss) income from discontinued operations, net		(0.02	)		0.01
Net income	$	0.19		$	0.12
Weighted average number of common and common
equivalent shares outstanding:
Basic		43,468			43,114
Diluted		44,478			44,266

See accompanying notes.

5

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

CONSOLIDATED INCOME STATEMENTS (unaudited)

(in thousands, except per share data)

	For the
	Nine Months Ended
	September 30, 2008			September 30, 2007
Total net revenues	$	1,359,629		$	1,118,006
Costs and expenses:
Operating salaries and benefits		767,583			637,691
Self-insurance for workers’ compensation and general and
professional liability insurance		41,146			33,414
Operating administrative expenses		37,672			28,351
Other operating costs		280,513			228,436
Center rent expense		55,721			52,446
General and administrative expenses		46,528			47,009
Depreciation and amortization		29,576			23,439
Provision for losses on accounts receivable		9,523			8,792
Interest, net of interest income of $1,454 and $2,926, respectively		41,144			28,869
(Gain) loss on sale of assets		(77	)		22
Total costs and expenses		1,309,329			1,088,469
Income before income taxes and discontinued operations		50,300			29,537
Income tax expense		20,119			10,339
Income from continuing operations		30,181			19,198
Discontinued operations:
(Loss) income from discontinued operations, net of related taxes		(792	)		2,334
(Loss) gain on disposal of discontinued operations, net of related
taxes		(2,523	)		626
(Loss) income from discontinued operations, net		(3,315	)		2,960
Net income	$	26,866		$	22,158
Basic earnings per common and common equivalent share:
Income from continuing operations	$	0.70		$	0.46
(Loss) income from discontinued operations, net		(0.08	)		0.07
Net income	$	0.62		$	0.53
Diluted earnings per common and common equivalent share:
Income from continuing operations	$	0.68		$	0.45
(Loss) income from discontinued operations, net		(0.07	)		0.06
Net income	$	0.61		$	0.51
Weighted average number of common and common
equivalent shares outstanding:
Basic		43,240			42,072
Diluted		44,086			43,068

See accompanying notes.

6

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS (unaudited)

(in thousands)

	For the						For the
	Three Months Ended						Nine Months Ended
	September 30, 2008			September 30, 2007			September 30, 2008			September 30, 2007
Cash flows from operating activities:
Net income	$	8,604		$	5,196		$	26,866		$	22,158
Adjustments to reconcile net income to net cash provided by
operating activities, including discontinued operations:
Depreciation and amortization		10,202			10,136			29,802			23,901
Amortization of favorable and unfavorable lease intangibles		(452	)		(193	)		(1,443	)		(602	)
Provision for losses on accounts receivable		3,460			3,520			9,971			9,780
Loss (gain) on sale of assets, including discontinued
operations, net		1,091			(617	)		2,883			(603	)
Impairment charge for discontinued operation		-			-			1,800			-
Stock-based compensation expense		1,405			990			3,738			2,684
Deferred taxes		5,276			-			13,547			-
Minority interest		122			-			819			50
Other		(4	)		(479	)		76			(590	)
Changes in operating assets and liabilities, net of acquisitions:
Accounts receivable		1,751			5,647			(17,701	)		(3,590	)
Restricted cash		1,379			(343	)		4,442			1,274
Prepaid expenses and other assets		(459	)		2,469			(7,649	)		11,760
Assets and liabilities held for sale		(486	)		-			(1,530	)		-
Accounts payable		(3,382	)		(10,378	)		(6,508	)		(17,221	)
Accrued compensation and benefits		2,576			8,701			(330	)		14,910
Accrued self-insurance obligations		(3,330	)		(1,082	)		(3,509	)		(7,910	)
Income taxes payable		(615	)		930			976			8,317
Other accrued liabilities		4,302			1,386			656			17,066
Other long-term liabilities		(1,526	)		(220	)		3,829			(3,387	)
Net cash provided by operating activities		29,914			25,663			60,735			77,997
Cash flows from investing activities:
Capital expenditures		(12,393	)		(11,356	)		(28,532	)		(23,327	)
Purchase of leased real estate		(8,229	)		-			(8,956	)		(33,220	)
Proceeds from sale of assets held for sale		9,840			500			13,797			5,989
Acquisitions, net of cash acquired		(7,060	)		7,432			(7,373	)		(361,083	)
Accrued acquisition costs, net		-			-			-			3,585
Net cash used for investing activities		(17,842	)		(3,424	)		(31,064	)		(408,056	)
Cash flows from financing activities:
Net repayments under revolving credit facility		-			(15,000	)		-			(9,994	)
Principal repayments of long-term debt and capital lease
obligations		(2,221	)		(6,839	)		(27,420	)		(41,637	)
Borrowings under long-term debt and capital lease obligations		-			-			20,290			327,000
Proceeds from issuance of common stock		2,278			116			2,348			781
Distribution of partnership equity		(65	)		-			(288	)		(511	)
Release of third-party collateral		-			-			-			25,640
Distribution of minority interest		-			-			-			(57	)
Deferred financing costs		-			-			-			(18,045	)
Net cash (used for) provided by financing activities		(8	)		(21,723	)		(5,070	)		283,177
Net increase (decrease) in cash and cash equivalents		12,064			516			24,601			(46,882	)
Cash and cash equivalents at beginning of period		68,369			84,537			55,832			131,935
Cash and cash equivalents at end of period	$	80,433		$	85,053		$	80,433		$	85,053

See accompanying notes.

7

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

(1)  Nature of Business

References throughout this document to the Company include Sun Healthcare Group, Inc. and our consolidated subsidiaries. In accordance with the Securities and Exchange Commission’s “Plain English” guidelines, this report has been written in the first person. In this document, the words “we,” “our,” “ours,” and “us” refer to Sun Healthcare Group, Inc. and its direct and indirect consolidated subsidiaries and not any other person.

Business

Our subsidiaries provide long-term, post-acute and related specialty healthcare in the United States.  We operate through three principal business segments: (i) inpatient services, (ii) rehabilitation therapy services, and (iii) medical staffing services.  Inpatient services represent the most significant portion of our business.  We operated 208 long-term care centers in 25 states as of September 30, 2008.

Other Information

The accompanying unaudited consolidated financial statements have been prepared in accordance with our customary accounting practices and accounting principles generally accepted in the United States for interim financial statements.  In our opinion, the accompanying interim consolidated financial statements are a fair statement of our financial position at September 30, 2008, and the consolidated results of our operations and cash flows for the three-month and nine-month periods ended September 30, 2008 and 2007, respectively.  These statements are unaudited, and certain information and footnote disclosures normally included in our annual consolidated financial statements have been condensed or omitted, as permitted under the applicable rules and regulations of the Securities and Exchange Commission. Readers of these statements should refer to our audited consolidated financial statements and notes thereto for the year ended December 31, 2007, which are included in our Annual Report on Form 10-K for the year ended December 31, 2007 (the “2007 Form 10-K”).

The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of significant contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Significant estimates include determination of third-party payor settlements, allowances for doubtful accounts, self-insurance obligations, loss accruals, and income taxes. Actual results could differ from those estimates.

Recent Accounting Pronouncements

In March 2008, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards No. 161, Disclosures About Derivative Instruments and Hedging Activities – an amendment of FASB Statement No. 133 (“SFAS No. 161”), which expands quarterly disclosure requirements in Statement of Financial Accounting Standards No. 133, Accounting for Derivative Instruments and Hedging Activity(“SFAS No. 133”), about an entity’s derivative instruments and hedging activities. SFAS No. 161 is effective for fiscal years beginning after November 15, 2008.  We are currently assessing the impact of SFAS No. 161 on our consolidated financial position and results of operations.

On October 10, 2008, the FASB issued FASB Staff Position FAS No. 157-3, Fair Value Measurements (“FSP FAS 157-3”), which clarifies the application of Statement of Financial Accounting Standards No. 157, Fair Value Measurements (“SFAS No. 157”), in an inactive market and provides an example to demonstrate how the fair value of a financial asset is determined when the market for that financial asset is inactive. FSP FAS 157-3 was effective upon issuance, including prior periods for which financial statements had not been issued. The adoption of this standard as of September 30, 2008 did not have a material impact on our results of operations, cash flows or financial positions.

In April 2008, the FASB issued FASB Staff Position FAS No. 142-3, Determination of the Useful Life of Intangible Assets (“FSP FAS 142-3”). This pronouncement amends Statement of Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets (“SFAS No. 142”), regarding the factors that should be considered in developing the useful

8

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

lives for intangible assets with renewal or extension provisions. FSP FAS 142-3 requires an entity to consider its own historical experience in renewing or extending similar arrangements, regardless of whether those arrangements have explicit renewal or extension provisions, when determining the usefullife of an intangible asset. In the absence of such experience, an entity shall consider the assumptions that market participants would use about renewal or extension, adjusted for entity-specific factors. FSP FAS 142-3 also requires an entity to disclose information regarding the extent to which the expected future cash flows associated with an intangible asset are affected by the entity’s intent and/or ability to renew or extend the arrangement. FSP FAS 142-3 will be effective for qualifying intangible assets acquired on or after January 1, 2009. The application of FSP FAS 142-3 is not expected to have a material impact on our results of operations, cash flows or financial positions; however, it could impact future transactions.  

Reclassifications and Adjustments

Certain reclassifications have been made to the prior period financial statements to conform to the 2008 financial statement presentation.  Specifically, we have reclassified the results of operations of five centers divested of or held for sale (see Note 4 – “Discontinued Operations and Assets and Liabilities Held for Sale”) for all periods presented to discontinued operations within the income statement, in accordance with accounting principles generally accepted in the United States.

(2)  Long-Term Debt and Capital Lease Obligations

 In June 2008 we entered into a $25.6 million mortgage note payable.  We used the proceeds to refinance an existing $20.0 mortgage note payable and to finance the purchase of two previously leased centers for $5.6 million.

Long-term debt and capital lease obligations consisted of the following as of the periods indicated (in thousands):

		September 30, 2008			December 31, 2007
Revolving credit facility	$	-		$	-
Mortgage notes payable due at various dates through 2037, interest at rates
from 5.7% to 11.1%, collateralized by various centers (1)(2)		179,249			177,712
Term loan agreement		347,233			349,857
Senior subordinated notes		200,000			200,000
Capital leases		1,529			1,699
Total long-term obligations		728,011			729,268
Less amounts due within one year		(12,088	)		(29,305	)
Long-term obligations, net of current portion	$	715,923		$	699,963

(1)	Includes fair value premium of $0.1 million related to the acquisition of Peak Medical Corporation (“Peak”) in December 2005 and $0.6 million related to our acquisition of Harborside Healthcare Corporation (“Harborside”) in April 2007.
(2)	Includes $48.8 million and $49.4 million related to the consolidation of nine entities (collectively known as “Clipper”), of which we own 34% of the voting interest, as of September 30, 2008 and December 31, 2007, respectively (see Note 5 – “Variable Interest Entities”).

9

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(UNAUDITED)

The scheduled or expected maturities of long-term obligations, excluding premiums, as of September 30, 2008, were as follows (in thousands):

For the twelve months ending September 30:
2009	$	12,088
2010		16,324
2011		43,306
2012		25,699
2013		7,841
Thereafter		622,052
	$	727,310

Included in the expected maturities of long-term debt are the following amounts related to the consolidation of Clipper (in thousands):  $873, $932, $994, $1,054, $1,131, and $43,791 for 2009, 2010, 2011, 2012, 2013 and thereafter, respectively (see Note 5 – “Variable Interest Entities”).

On July 24, 2008, we entered into an interest rate swap agreement for interest rate risk management purposes.  The interest rate swap agreement effectively modifies our exposure to interest by converting a portion of our floating rate debt to a fixed rate.  This agreement involves the receipt of floating rate amounts in exchange for fixed rate interest payments over the life of the agreement without an exchange of the underlying principal amount.  The agreement is based on a notional amount of $50.0 million and has a term of two years.  Settlement occurs on a quarterly basis, which is based upon a floating rate of LIBOR and an annual fixed rate of 3.65%.

(3)  Fair Value of Financial Instruments

SFAS No. 157 establishes a common definition for fair value to be applied to U.S. generally accepted accounting principles requiring use of fair value, establishes a framework for measuring fair value, and expands disclosures about such fair value measurements.  Issued in February 2008, FASB Staff Position No. 157-1, Application of FASB Statement No. 157 to FASB Statement No. 13 and Other Accounting Pronouncements That Address Fair Value Measurements for Purposes of Lease Classification or Measurement under Statement 13, removed leasing transactions accounted for under Statement No. 13 and related guidance from the scope of SFAS No. 157.  FASB Staff Position No. 157-2, Partial Deferral of the Effective Date of Statement 157, deferred the effective date of SFAS No. 157 for all nonfinancial assets and nonfinancial liabilities to fiscal years beginning after November 15, 2008.

We adopted SFAS No. 157 as of January 1, 2008 for financial assets and financial liabilities. There was no material impact on our consolidated financial position and results of operations for the three months and nine months ended September 30, 2008.  We are currently assessing the impact of SFAS No. 157 for nonfinancial assets and nonfinancial liabilities on our consolidated financial position and results of operations.

SFAS No. 157 establishes a hierarchy for ranking the quality and reliability of the information used to determine fair values.  The statement requires that assets and liabilities carried at fair value be classified and disclosed in one of the following three categories:

Level 1:	Unadjusted quoted market prices in active markets for identical assets or liabilities.
Level 2:	Unadjusted quoted prices in active markets for similar assets or liabilities, unadjusted quoted prices for identical or similar assets or liabilities in markets that are not active, or inputs other than quoted prices that are observable for the asset or liability.
Level 3:	Unobservable inputs for the asset or liability.

10

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(UNAUDITED)

We endeavor to utilize the best available information in measuring fair value.  The following table summarizes the valuation of our financial instruments by the above SFAS No. 157 pricing levels as of September 30, 2008 (in thousands):

		Total		Unadjusted Quoted Market Prices (Level 1)		Significant Other Observable Inputs (Level 2)
Cash and cash equivalents – money
market funds/certificate of deposit	$	10,044	$	5,016	$	5,028
Restricted cash – money market funds	$	1,270	$	1,270	$	-
Interest rate swap agreement – liability	$	4,557	$	-	$	4,557

We currently have no other financial instruments subject to fair value measurement on a recurring basis.

Our interest rate swap agreements qualify for hedge accounting treatment under SFAS No. 133 and have been designated as cash flow hedges.  Hedge effectiveness testing indicates that the swaps are fully effective hedges and as such, the derivative mark-to-market adjustment increased our other comprehensive loss by $0.2 million and $1.4 million, net of tax, for the three months ended September 30, 2008 and 2007, respectively, and increased our other comprehensive loss by $0.3 million and $1.4 million, net of tax, for the nine months ended September 30, 2008 and 2007, respectively.  The full balance of accumulated other comprehensive loss is due to accounting for our interest rate swaps.  We do not anticipate any of this balance to be reclassified into earnings within the next year.  Also, since the swaps are fully effective hedging arrangements, there is no amount related to hedging ineffectiveness to expense.

(4) Discontinued Operations and Assets and Liabilities Held for Sale

(a) Discontinued Operations

In accordance with the provisions of Statement of Financial Accounting Standards No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets (“SFAS No. 144”), the results of operations of assets to be disposed of, disposed assets and the gains (losses) related to these divestitures have been classified as discontinued operations for all periods presented in the accompanying consolidated income statements.

We reclassified the results of three skilled nursing centers (two of which were leased) to discontinued operations during the three months ended September 30, 2008.  We exercised options to purchase the two centers and simultaneously sold them in conjunction with the owned location for a net amount to us of $1.1 million (subject to resolution of certain contingencies), which was recorded in other current assets as of September 30, 2008.  We received $0.9 million of cash proceeds on October 1, 2008 and expect to receive the remaining $0.2 million of the sales price by the end of 2008.  A $0.9 million loss on disposal of these centers was recognized in the three months ended September 30, 2008.

During July 2008, we transferred operations of a leased skilled nursing center in Indiana to an outside party.  This center has been classified as a discontinued operation since the third quarter of 2007 and was originally acquired in the second quarter of 2007 with the Harborside acquisition.

We transferred operations of a leased skilled nursing center in Tennessee in June 2008 to an outside party, and the center has been reclassified into discontinued operations.  As a result of June 2008 flooding in the Midwest, our center in Terre Haute, Indiana was severely damaged and the operation permanently discontinued.  The operating results for the Terre Haute center have been reclassified to discontinued operations, and we have recorded a $1.8 million fixed assets impairment charge for the nine months ended September 30, 2008, due to the damage to the building and contents.

During the third quarter of 2007, we reclassified two hospitals to discontinued operations in accordance with SFAS No. 144.  On June 30, 2008, we sold the operations of these two hospitals for $10.1 million (subject to a final working capital reconciliation), which was recorded in other current assets as of June 30, 2008 and received $9.5 million in cash proceeds on July 1, 2008.  The remaining $0.6 million of sales price is expected to be received during the fourth quarter of 2008 in conjunction with the final working capital adjustment.  A $2.7 million loss on disposal of these operations was

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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(UNAUDITED)

recognized in the three months ended June 30, 2008.  The lessor of the two hospitals did not fully release us from our rent obligation subsequent to the sale.  Therefore, in accordance with Statement of Financial Accounting Standards No. 146, Accounting for Costs Associated with Exit or Disposal Activities, the $2.7 million loss includes an accrued liability of $6.3 million for continuing costs incurred without economic benefit as of the date of disposal of the operations (i.e., the “cease-use” date).

We sold our remaining laboratory and radiology services operations in the second quarter of 2007 for $2.5 million plus the value of the working capital.  We received $2.3 million at closing and recognized a gain of $0.6 million. In the third quarter of 2007, following adjustment of the working capital amount, the buyer paid us $0.9 million in full satisfaction of the purchase price and we recognized an additional $1.0 million gain on disposal.

In the first quarter of 2007, we sold a skilled nursing center that was classified as held for sale since 2006 for $4.9 million and recorded a net loss of $0.5 million.

Other discontinued operations are principally comprised of the operations of a regional provider of adolescent rehabilitation and special education services.

A summary of the discontinued operations for the periods presented is as follows (in thousands):

		For the Three Months Ended
		September 30, 2008
		Inpatient			Laboratory/			Home
		Services			Radiology			Health			Other		Total
Net operating revenues	$	2,726		$	-		$	-		$	4,525	$	7,251
(Loss) income from discontinued
operations, net (1)	$	(196	)	$	(7	)	$	(2	)	$	34	$	(171	)
Loss on disposal of
discontinued operations, net (2)		(654	)		-			-			-		(654	)
(Loss) income from discontinued
operations, net	$	(850	)	$	(7	)	$	(2	)	$	34	$	(825	)

(1)  Net of related tax benefit of $114

(2)  Net of related tax benefit of $436

		For the Three Months Ended
		September 30, 2007
		Inpatient			Laboratory/			Home
		Services			Radiology			Health			Other			Total
Net operating revenues	$	17,416		$	-		$	1,298		$	4,478		$	23,192
(Loss) income from discontinued
operations, net (1)	$	(162	)	$	(42	)	$	(412	)	$	303		$	(313	)
(Loss) gain on disposal of
discontinued operations, net (2)		(358	)		992			-			(5	)		629
(Loss) income from discontinued
operations, net	$	(520	)	$	950		$	(412	)	$	298		$	316

(1)  Net of related tax benefit of $141

(2)  Net of related tax expense of $0

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(UNAUDITED)

		For the Nine Months Ended
		September 30, 2008
		Inpatient			Laboratory/			Home
		Services			Radiology			Health			Other			Total
Net operating revenues	$	38,647		$	-		$	-		$	14,115		$	52,762
(Loss) income from discontinued
operations, net (1)	$	(654	)	$	(45	)	$	39		$	(132	)	$	(792	)
(Loss) gain on disposal of
discontinued operations, net (2)		(2,477	)		-			(47	)		1			(2,523	)
Loss from discontinued
operations, net	$	(3,131	)	$	(45	)	$	(8	)	$	(131	)	$	(3,315	)

(1)  Net of related tax benefit of $503

(2)  Net of related tax benefit of $1,631

		For the Nine Months Ended
		September 30, 2007
		Inpatient			Laboratory/		Home
		Services			Radiology		Health			Other			Total
Net operating revenues	$	55,134		$	5,360	$	2,941		$	13,726		$	77,161
Income (loss) from discontinued
operations, net (1)	$	2,491		$	109	$	(827	)	$	561		$	2,334
(Loss) gain on disposal of
discontinued operations, net (2)		(1,001	)		1,597		41			(11	)		626
Income (loss) from discontinued
operations, net	$	1,490		$	1,706	$	(786	)	$	550		$	2,960

(1)  Net of related tax expense of $1,380

(2)  Net of related tax expense of $0

(b) Assets and Liabilities Held for Sale

As of September 30, 2008, assets held for sale consisted of (i) a skilled nursing center with a net carrying amount of $2.7 million, primarily consisting of property and equipment and (ii) an undeveloped parcel of land valued at $0.9 million, which is classified in our Corporate segment in our consolidated financial statements.

(5)  Variable Interest Entities

As of September 30, 2008, we owned 34% of the voting interest (15.5% at September 30, 2007) in the nine Clipper entities, each of which owns one center that we operate in New Hampshire. Clipper’s objective is to achieve rental income from the leasing of its centers. In April 2004, we entered into an agreement with the owners of the remaining interests in those nine entities.  That agreement granted us options, exercisable sequentially over a period of seven years, pursuant to which we can acquire 100% of the ownership of those nine entities for an aggregate amount of up to $10.3 million, of which we have paid an aggregate of $3.0 million through September 30, 2008.  The agreement also provides the owners the right to require us to purchase those ownership interests at the above described option prices.  These put rights can be exercised for any options that have come due but which were not exercised up to that point in time, but no later than December 31, 2010.

FASB’s revised Interpretation No. 46, Consolidation of Variable Interest Entities (“FIN No. 46(R)”) provides guidance on the consolidation of certain entities when control exists through means other than ownership of voting (or similar)

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(UNAUDITED)

 interests and requires consolidation by the majority holder of expected residual gains and losses of the activities of a variable interest entity (“VIE”).

We have concluded that Clipper meets the definition of a VIE because we have agreements with the majority owners granting to us the option to acquire, and to the owners, the right to put to us, 100% ownership of Clipper. We have recognized $5.3 million of the option value in other long-term liabilities in our consolidated balance sheets.  The remaining $2.0 million is recorded as current in other accrued liabilities in our consolidated balance sheets.  We have not recorded any minority interest associated with the 66% interest which we do not own since the partnerships’ net equity was a deficit and as the primary beneficiary, we would be responsible for all of their losses. Pursuant to FIN No. 46(R), we have eliminated center rent expense of $0.7 million for each of the three months ended September 30, 2008 and 2007, and included $48.8 million and $49.4 million of mortgage debt of Clipper in our consolidated balance sheets as of September 30, 2008 and December 31, 2007, respectively, although we own 34% of the voting interest in the Clipper properties and are not directly obligated on the debt. The debt is collateralized by the fixed assets of the respective partnerships and limited liability companies that own the Clipper properties and none of our assets.  Creditors do not have any general recourse against us for the mortgage debt.

The following provides the balance sheet impact of Clipper upon consolidation as of September 30, 2008 and December 31, 2007 (in thousands):

		September 30, 2008			December 31, 2007
Current assets:
Cash and cash equivalents	$	615		$	592
Restricted cash, current		1,622			1,588
Prepaid expenses and other assets		42			130
Total current assets		2,279			2,310
Property and equipment, net:
Land		6,171			6,171
Land improvements		25			29
Buildings		33,477			34,133
Building improvements		2,671			2,835
Equipment		151			153
Construction in progress		36			-
Total property and equipment, net		42,531			43,321
Intangible assets, net		5,445			7,014
Intercompany		5,657			4,836
Total assets	$	55,912		$	57,481
Current liabilities:
Mortgages, current	$	873		$	825
Other accrued liabilities		2,514			2,224
Total current liabilities		3,387			3,049
Mortgages, net of current		47,901			48,560
Other long-term liabilities		14,759			15,163
Total long-term liabilities		62,660			63,723
Total liabilities		66,047			66,772
Stockholders’ deficit:
Accumulated deficit		(10,135	)		(9,291	)
Total liabilities and stockholders’ deficit	$	55,912		$	57,481

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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(UNAUDITED)

       For the three months ended September 30, 2008, the consolidation of Clipper included a net loss of $0.4 million comprised of a $0.9 million charge to interest expense, and a $0.3 million charge to depreciation expense, partially offset by a $0.7 million credit to rent expense and a $0.1 million credit to taxes and other expense. For the three months ended September 30, 2007, the consolidation of Clipper included a net loss of $0.4 million comprised of a $0.8 million charge to interest expense, and a $0.4 million charge to depreciation expense, partially offset by a $0.7 million credit to rent expense and a $0.1 million credit to taxes and other expense.

For the nine months ended September 30, 2008, the consolidation of Clipper included a net loss of $1.0 million comprised of a $2.5 million charge to interest expense, and a $1.0 million charge to depreciation expense, partially offset by a $2.2 million credit to rent expense and a $0.3 million credit to taxes and other expense. For the nine months ended September 30, 2007, the consolidation of Clipper included a net loss of $1.2 million comprised of a $2.3 million charge to interest expense, and a $1.2 million charge to depreciation expense, partially offset by a $1.9 million credit to rent expense and a $0.4 million credit to taxes and other expense.

(6)  Commitments and Contingencies

Insurance

Since January 2000, we have relied upon self-funded insurance programs for general and professional liability claims ($5.0 million per claim since January 1, 2004), which amounts we are responsible for funding, and we have maintained excess insurance policies for claims above those amounts. The Harborside operations, which we acquired in April 2007, and the Peak operations, which we acquired in December 2005, utilized several different general and professional insurance programs.  We have added the Harborside and Peak operations to our general and professional liability programs.  In certain states, we are unable to obtain insurance coverage for punitive damages arising from general and professional liability litigation due to state law, and therefore we would be responsible for the payment of any punitive damages awarded against us in those states.

With the exception of state-controlled workers’ compensation plans, our workers’ compensation risks are insured through high-retention insurance policies with third parties.

We evaluate the adequacy of our self-insurance reserves on a quarterly basis and perform actuarial analyses semi-annually in the second and fourth quarters. The analyses use generally accepted actuarial methods in evaluating the workers’ compensation reserves and general and professional liability reserves.  For both the workers’ compensation reserves and the general and professional liability reserves, those methods include reported and paid loss development methods, expected loss method and the reported and paid Bornhuetter-Ferguson methods.  The foundation for each of these methods is our actual historical reported and/or paid loss data.  In cases where our historical data is not statistically credible, stable, or mature, we supplement our experience with industry benchmark reporting and payment patterns. The use of multiple methods tends to eliminate any biases that one particular method might have. The results of each of the methods is an estimate of ultimate losses which includes the case reserves plus an estimate for future development of these reserves based on past trends and an estimate for losses incurred but not reported. These results are compared by accident year and an estimated unpaid loss and allocated loss adjustment expense is determined for the open accident years based on judgment reflecting the range of estimates produced by the methods.

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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(UNAUDITED)

Activity in our insurance reserves as of and for the nine months ended September 30, 2008 and 2007 is as follows (in thousands):

		Professional			Workers’
		Liability			Compensation			Total
Balance as of January 1, 2008	$	86,291		$	61,439		$	147,730
Current year provision, continuing operations		8,353			6,468			14,821
Current year provision, discontinued operations		433			258			691
Claims paid, continuing operations		(4,167	)		(4,351	)		(8,518	)
Claims paid, discontinued operations		(1,207	)		(1,014	)		(2,221	)
Amounts paid for administrative services and other		(1,052	)		(2,026	)		(3,078	)
Balance as of March 31, 2008	$	88,651		$	60,774		$	149,425
Current year provision, continuing operations		6,609			7,786			14,395
Current year provision, discontinued operations		95			461			556
Prior year reserve adjustments, continuing operations		(5,250	)		2,600			(2,650	)
Prior year reserve adjustments, discontinued operations		(770	)		400			(370	)
Claims paid, continuing operations		(4,379	)		(5,421	)		(9,800	)
Claims paid, discontinued operations		(787	)		(669	)		(1,456	)
Amounts paid for administrative services and other		(1,044	)		(1,157	)		(2,201	)
Balance as of June 30, 2008	$	83,125		$	64,774		$	147,899
Current year provision, continuing operations		6,986			7,594			14,580
Current year provision, discontinued operations		115			52			167
Claims paid, continuing operations		(5,981	)		(5,532	)		(11,513	)
Claims paid, discontinued operations		(1,101	)		(1,041	)		(2,142	)
Amounts paid for administrative services and other		(1,164	)		(2,084	)		(3,248	)
Balance as of September 30, 2008	$	81,980		$	63,763		$	145,743
Balance as of January 1, 2007	$	75,078		$	51,521		$	126,599
Current year provision, continuing operations		6,033			3,923			9,956
Current year provision, discontinued operations		506			372			878
Claims paid, continuing operations		(2,623	)		(2,042	)		(4,665	)
Claims paid, discontinued operations		(2,164	)		(1,406	)		(3,570	)
Amounts paid for administrative services and other		(1,963	)		(1,061	)		(3,024	)
Balance as of March 31, 2007	$	74,867		$	51,307		$	126,174
Current year provision, continuing operations		7,698			6,070			13,768
Current year provision, discontinued operations		441			355			796
Prior year reserve adjustments, continuing operations		(3,962	)		(1,994	)		(5,956	)
Prior year reserve adjustments, discontinued operations		(1,538	)		(1,506	)		(3,044	)
Claims paid, continuing operations		(2,881	)		(4,236	)		(7,117	)
Claims paid, discontinued operations		(1,826	)		(1,094	)		(2,920	)
Amounts paid for administrative services and other		(1,472	)		(1,291	)		(2,763	)
Reserve established through purchase accounting		17,796			14,352			32,148
Balance as of June 30, 2007	$	89,123		$	61,963		$	151,086
Current year provision, continuing operations		8,301			7,345			15,646
Current year provision, discontinued operations		441			305			746
Claims paid, continuing operations		(4,720	)		(4,166	)		(8,886	)
Claims paid, discontinued operations		(2,244	)		(1,250	)		(3,494	)
Amounts paid for administrative services and other		(1,267	)		(2,508	)		(3,775	)
Balance as of September 30, 2007	$	89,634		$	61,689		$	151,323

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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(UNAUDITED)

A summary of the assets and liabilities related to insurance risks at September 30, 2008 and December 31, 2007 is as indicated (in thousands):

		September 30, 2008							December 31, 2007
		Professional		Workers’			|		Professional		Workers’
		Liability		Compensation		Total	|		Liability		Compensation		Total
Assets (1):							|
Restricted cash							|
Current	$	3,236	$	18,704	$	21,940	|	$	3,717	$	20,933	$	24,650
Non-current		-		-		-	|		-		566		566
Total	$	3,236	$	18,704	$	21,940	|	$	3,717	$	21,499	$	25,216
							|
Liabilities (2)(3):							|
Self-insurance							|
Liabilities							|
Current	$	19,342	$	17,592	$	36,934	|	$	20,263	$	20,933	$	41,196
Non-current		62,638		46,171		108,809	|		66,028		40,506		106,534
Total	$	81,980	$	63,763	$	145,743	|	$	86,291	$	61,439	$	147,730

(1)	Total restricted cash above excludes $14,812 and $15,978 at September 30, 2008and December 31, 2007, respectively, held for bank collateral, various mortgages, bond payments and capital expenditures on HUD insured buildings.
(2)	Total self-insurance liabilities in the table exclude $5,928 and $7,450 at September 30, 2008 and December 31, 2007, respectively, related to our employee health insurance liabilities.
(3)	Total self-insurance liabilities are collateralized, in addition to the restricted cash, by letters of credit of $750 and $49,980 for general and professional liability insurance and workers’ compensation, respectively, as of September 30, 2008 and $750 and $50,619 for general and professional liability insurance and workers’ compensation, respectively, as of December 31, 2007.

(7)  Income Taxes

The provision for income taxes of $6.3 million and $20.1 million for the three and nine months ended September 30, 2008, respectively, is based on a combined federal and state income tax rate of approximately 40%.  The provision for income taxes of $2.6 million and $10.3 million for the three and nine months ended September 30, 2007, respectively, was based on a combined income tax rate of approximately 35%.  The lower tax rate in 2007 resulted from a partial reversal of our valuation allowance on net deferred tax assets that were generated after our emergence from bankruptcy in February 2002.

We have established a valuation allowance of $132.9 million for deferred tax assets.  The realization of deferred tax assets is dependent upon generation of taxable income during periods in which deductions and/or credits can be utilized.  As a result, we consider the level of historical taxable income, historical non-recurring credits and charges, the scheduled reversal of deferred tax liabilities, tax-planning strategies and projected future taxable income in determining the amount of the valuation allowance.  Based on these considerations, we believe that a reversal of some or all of the valuation allowance may occur in 2008 if appropriate levels of profitability are attained.

The Internal Revenue Code (“IRC”) Section 382 annual base limitation to be applied to our tax attribute carryforwards is approximately $24.9 million, which includes approximately $14.6 million due to our acquisition of Harborside in 2007. Accordingly, our net operating loss (“NOL”), capital loss, and tax credit carryforwards have been reduced to take into account this limitation and the respective carryforward periods for these tax attributes.  As a result of unused IRC Section 382 limitations from prior years and post-ownership change NOLs, there is approximately $121.6 million of NOLs which can be used to offset U.S. taxable income in 2008.

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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(UNAUDITED)

(8)  Other Events

(a)  Acquisition

During the three months ended September 30, 2008, we acquired all membership interests in a limited liability company that conducts hospice operations in the State of New Jersey.  Its results of operations are included in the accompanying consolidated income statements as of September 1, 2008.  Pro forma information, as required by Statement of Financial Accounting Standards No. 141, Business Combinations, related to this acquisition is not provided because the impact on our consolidated results of operations is not significant.  The $7.7 million purchase price was funded through cash on-hand at the time of acquisition and allocated preliminarily to the following fair values of assets acquired and liabilities assumed at the date of acquisition (in thousands):

Net working capital	$	695
Property and equipment		7
Identifiable intangible assets		228
Goodwill		6,835
Other long-term assets		7
Total assets acquired		7,772
Debt assumed		(92	)
Net assets acquired	$	7,680

(b)  Litigation

We are a party to various legal actions and administrative proceedings and are subject to various claims arising in the ordinary course of our business, including claims that our services have resulted in injury or death to the residents of our centers and claims relating to employment and commercial matters. Although we intend to vigorously defend ourselves in these matters, there can be no assurance that the outcomes of these matters will not have a material adverse effect on our results of operations, financial condition and cash flows.

We operate in industries that are extensively regulated. As such, in the ordinary course of business, we are continuously subject to state and federal regulatory scrutiny, supervision and control. Such regulatory scrutiny often includes inquiries, investigations, examinations, audits, site visits and surveys, some of which are non-routine. In addition to being subject to direct regulatory oversight of state and federal regulatory agencies, these industries are frequently subject to the regulatory supervision of fiscal intermediaries. If a provider is found to have engaged in improper practices, it could be subject to civil, administrative or criminal fines, penalties or restitutionary relief; and reimbursement authorities could also seek the suspension or exclusion of the provider or individual from participation in their program. We believe that there has been, and will continue to be, an increase in governmental investigations of long-term care providers, particularly in the area of Medicare/Medicaid false claims, as well as an increase in enforcement actions resulting from these investigations. Adverse determinations in legal proceedings or governmental investigations, whether currently asserted or arising in the future, could have a material adverse effect on our financial position, results of operations and cash flows.

In December 2006, Harborside was notified by the United States Department of Justice (“DOJ”) that one of its subsidiaries is one of a significant number of unrelated defendants in a qui tam lawsuit filed under the Federal False Claims Act. It is our understanding that Harborside’s involvement relates to its Medicare billings for durable medical equipment. Although the complaint remains under seal pending completion of the DOJ’s investigation, it is our understanding that neither Sun Healthcare Group, Inc. nor any of its other subsidiaries is a defendant in this litigation.  We have met with a representative of the DOJ to discuss the litigation and intend to continue to cooperate with the investigation and respond to the litigation in a timely fashion.  Based on our understanding of the allegations as described by the DOJ, we do not believe that the litigation will have a material impact on our operations, financial condition and cash flows.

The Kentucky Attorney General’s office has commenced an investigation that relates to our centers in Kentucky, which we acquired in April 2007 in the Harborside acquisition.  At present, the investigation appears to be focused on care

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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(UNAUDITED)

provided at one center, but it has not been concluded.  We continue to cooperate with the Attorney General’s office.  At this time we are unable to predict the outcome of the investigation.

(c)  Other Inquiries

From time to time, fiscal intermediaries and Medicaid agencies examine cost reports filed by predecessor operators of our skilled nursing centers. If, as a result of any such examination, it is concluded that overpayments to a predecessor operator were made, we, as the current operator of such centers, may be held financially responsible for such overpayments. At this time we are unable to predict the outcome of any existing or future examinations.

(9)  Segment Information

We operate predominantly in the long-term care segment of the healthcare industry. We are a provider of long-term, sub-acute and related ancillary care services to nursing home patients.

The following summarizes the services provided by our reportable segments:

Inpatient Services:  This segment provides, among other services, inpatient skilled nursing and custodial services as well as rehabilitative, restorative and transitional medical services. We provide 24-hour nursing care in these centers by registered nurses, licensed practical nurses and certified nursing aids.  At September 30, 2008, we operated 208 long-term care centers (consisting of 185 skilled nursing centers, 15 assisted living and independent living centers and eight mental health centers) in 25 states with 23,429 licensed beds as compared with 213 long-term care centers (consisting of 190 skilled nursing centers, 15 assisted living and independent living centers, and eight mental health centers) with 24,002 licensed beds at September 30, 2007.

Rehabilitation Therapy Services:  This segment provides primarily physical, occupational and speech and respiratory therapy supplies and services to affiliated and nonaffiliated skilled nursing centers.  At September 30, 2008, this segment provided services in 33 states to 441 centers, of which 325 were nonaffiliated and 116 were affiliated, as compared to 412 centers, of which 309 were nonaffiliated and 103 were affiliated at September 30, 2007.

Medical Staffing Services: As of September 30, 2008, this segment provided services in 36 states and derived 63.0% of its revenues from hospitals and other providers,24.4% from skilled nursing centers, 8.0% from schools and4.6% from prisons. We provide (i) licensed therapists skilled in the areas of physical, occupational and speech therapy, (ii) nurses, (iii) pharmacists, pharmacist technicians and medical imaging technicians, (iv) physicians, and (v) related medical personnel. As of September 30, 2008, this segment had 29 branch offices which provided temporary therapy, nursing and physician staffing services in major metropolitan areas, one branch office which specialized in the placement of temporary traveling therapists, and one branch office which specialized in temporary pharmaceutical staffing.

Corporate assets primarily consist of cash and cash equivalents, receivables from subsidiary segments, notes receivable, property and equipment and unallocated intangible assets. Although corporate assets include unallocated intangible assets, the amortization, if applicable, is reflected in the results of operations of the associated segment.

The accounting policies of the segments are the same as those described in Note 3 – “Summary of Significant Accounting Policies” of our 2007 Form 10-K.  We primarily evaluate segment performance based on profit or loss from operations before reorganization and restructuring items, income taxes and extraordinary items (net segment income). Gains or losses on sales of assets and certain items including impairment of assets recorded in connection with SFAS No. 144 and Statement of Financial Accounting Standard No. 142, Goodwill and Other Intangible Assets, and restructuring costs are not considered in the evaluation of segment performance.  Interest expense is recorded in the segment carrying the obligation to which the interest relates.

Our reportable segments are strategic business units that provide different products and services. They are managed separately because each business has different marketing strategies due to differences in types of customers, distribution channels and capital resource needs.

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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(UNAUDITED)

The following tables summarize, for the periods indicated, operating results and other financial information, by business segment (in thousands):

As of and for the
Three Months Ended
September 30, 2008
				Rehabilitation			Medical
		Inpatient		Therapy			Staffing						Intersegment
		Services		Services			Services			Corporate			Eliminations			Consolidated
Revenues from external customers	$	404,701	$	22,756		$	29,256		$	9		$	-		$	456,722
Intersegment revenues		-		15,562			827			-			(16,389	)		-
Total revenues		404,701		38,318			30,083			9			(16,389	)		456,722
Operating salaries and benefits		206,772		31,953			21,084			-			-			259,809
Self-insurance for workers’
compensation and general and
professional liability insurance		13,455		528			389			208			-			14,580
Other operating costs		104,354		2,067			4,864			(3	)		(16,389	)		94,893
General and administrative expenses		10,231		1,747			814			13,832			-			26,624
Provision (adjustment) for losses on
accounts receivable		3,316		(8	)		(2	)		-			-			3,306
Segment operating income (loss)	$	66,573	$	2,031		$	2,934		$	(14,028	)	$	-		$	57,510
Center rent expense		18,207		100			244			-			-			18,551
Depreciation and amortization		8,989		138			216			831			-			10,174
Interest, net		3,548		-			(5	)		9,527			-			13,070
Net segment income (loss)	$	35,829	$	1,793		$	2,479		$	(24,386	)	$	-		$	15,715
Identifiable segment assets	$	1,130,973	$	12,952		$	29,237		$	748,739		$	(528,457	)	$	1,393,444
Goodwill	$	326,579	$	-		$	4,533		$	-		$	-		$	331,112
Segment capital expenditures	$	11,877	$	72		$	51		$	381		$	-		$	12,381

______________________________________

General and administrative expenses include operating administrative expenses.

The term “segment operating income (loss)” is defined as earnings before center rent expense, depreciation and amortization, interest, net gain (loss) on sale of assets, income tax expense and discontinued operations.

The term “net segment income (loss)” is defined as earnings before gain (loss) on sale of assets, net, income tax expense and discontinued operations.

20

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(UNAUDITED)

As of and for the
Three Months Ended
September 30, 2007
				Rehabilitation		Medical
		Inpatient		Therapy		Staffing						Intersegment
		Services		Services		Services			Corporate			Eliminations			Consolidated
Revenues from external customers	$	384,763	$	20,579	$	27,197		$	34		$	-		$	432,573
Intersegment revenues		-		11,300		1,084			-			(12,384	)		-
Total revenues		384,763		31,879		28,281			34			(12,384	)		432,573
Operating salaries and benefits		198,102		26,801		21,729			-			-			246,632
Self-insurance for workers’
compensation and general and
professional liability insurance		14,635		461		417			133			-			15,646
Other operating costs		97,002		1,435		2,955			1			(12,384	)		89,009
General and administrative expenses		8,603		1,172		432			16,878			-			27,085
Provision for losses on accounts receivable		3,181		130		17			-			-			3,328
Segment operating income (loss)	$	63,240	$	1,880	$	2,731		$	(16,978	)	$	-		$	50,873
Center rent expense		18,277		51		224			-			-			18,552
Depreciation and amortization		8,839		132		189			801			-			9,961
Interest, net		3,144		-		(1	)		11,698			-			14,841
Net segment income (loss)	$	32,980	$	1,697	$	2,319		$	(29,477	)	$	-		$	7,519
Identifiable segment assets	$	841,986	$	13,168	$	37,104		$	958,928		$	(570,773	)	$	1,280,413
Goodwill	$	220,753	$	-	$	5,011		$	-		$	-		$	225,764
Segment capital expenditures	$	10,232	$	116	$	143		$	671		$	-		$	11,162

______________________________________

General and administrative expenses include operating administrative expenses.

The term “segment operating income (loss)” is defined as earnings before center rent expense, depreciation and amortization, interest, net gain (loss) on sale of assets, income tax expense and discontinued operations.

The term “net segment income (loss)” is defined as earnings before gain (loss) on sale of assets, net, income tax expense and discontinued operations.

21

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(UNAUDITED)

As of and for the
Nine Months Ended
September 30, 2008
				Rehabilitation			Medical
		Inpatient		Therapy			Staffing						Intersegment
		Services		Services			Services			Corporate			Eliminations			Consolidated
Revenues from external customers	$	1,204,973	$	65,607		$	89,020		$	29		$	-		$	1,359,629
Intersegment revenues		-		44,314			2,155			-			(46,469	)		-
Total revenues		1,204,973		109,921			91,175			29			(46,469	)		1,359,629
Operating salaries and benefits		611,068		90,726			65,789			-			-			767,583
Self-insurance for workers’
compensation and general and
professional liability insurance		37,995		1,582			1,132			437			-			41,146
Other operating costs		308,662		5,326			12,996			(2	)		(46,469	)		280,513
General and administrative expenses		30,120		4,879			2,672			46,529			-			84,200
Provision for losses on
accounts receivable		8,887		245			391			-			-			9,523
Segment operating income (loss)	$	208,241	$	7,163		$	8,195		$	(46,935	)	$	-		$	176,664
Center rent expense		54,704		285			732			-			-			55,721
Depreciation and amortization		26,334		396			611			2,235			-			29,576
Interest, net		10,130		(1	)		(14	)		31,029			-			41,144
Net segment income (loss)	$	117,073	$	6,483		$	6,866		$	(80,199	)	$	-		$	50,223
Identifiable segment assets	$	1,130,973	$	12,952		$	29,237		$	748,739		$	(528,457	)	$	1,393,444
Goodwill	$	326,579	$	-		$	4,533		$	-		$	-		$	331,112
Segment capital expenditures	$	26,355	$	171		$	161		$	1,756		$	-		$	28,443

______________________________________

General and administrative expenses include operating administrative expenses.

The term “segment operating income (loss)” is defined as earnings before center rent expense, depreciation and amortization, interest, net gain (loss) on sale of assets, income tax expense and discontinued operations.

The term “net segment income (loss)” is defined as earnings before gain (loss) on sale of assets, net, income tax expense and discontinued operations.

22

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(UNAUDITED)

As of and for the
Nine Months Ended
September 30, 2007
				Rehabilitation			Medical
		Inpatient		Therapy			Staffing					Intersegment
		Services		Services			Services		Corporate			Eliminations			Consolidated
Revenues from external customers	$	976,928	$	62,048		$	78,962	$	68		$	-		$	1,118,006
Intersegment revenues		-		31,894			2,472		-			(34,366	)		-
Total revenues		976,928		93,942			81,434		68			(34,366	)		1,118,006
Operating salaries and benefits		496,075		78,222			63,394		-			-			637,691
Self-insurance for workers’
compensation and general and
professional liability insurance		30,589		1,303			1,173		349			-			33,414
Other operating costs		250,567		4,837			7,379		19			(34,366	)		228,436
General and administrative expenses		22,423		3,674			2,252		47,011			-			75,360
Provision (adjustment) for losses on
accounts receivable		8,609		(45	)		228		-			-			8,792
Segment operating income (loss)	$	168,665	$	5,951		$	7,008	$	(47,311	)	$	-		$	134,313
Center rent expense		51,639		154			653		-			-			52,446
Depreciation and amortization		20,535		382			553		1,969			-			23,439
Interest, net		8,088		10			13		20,758			-			28,869
Net segment income (loss)	$	88,403	$	5,405		$	5,789	$	(70,038	)	$	-		$	29,559
Identifiable segment assets	$	841,986	$	13,168		$	37,104	$	958,928		$	(570,773	)	$	1,280,413
Goodwill	$	220,753	$	-		$	5,011	$	-		$	-		$	225,764
Segment capital expenditures	$	18,267	$	1,260		$	305	$	2,999		$	-		$	22,831

______________________________________

General and administrative expenses include operating administrative expenses.

The term “segment operating income (loss)” is defined as earnings before center rent expense, depreciation and amortization, interest, net gain (loss) on sale of assets, income tax expense and discontinued operations.

The term “net segment income (loss)” is defined as earnings before gain (loss) on sale of assets, net, income tax expense and discontinued operations.

23

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(UNAUDITED)

Measurement of Segment Income

We evaluate financial performance and allocate resources primarily based on income or loss from operations before income taxes, excluding any unusual items. The following table reconciles net segment income to consolidated income before income taxes and discontinued operations (in thousands):

		For the Three Months Ended
		September 30,
		2008		2007
Net segment income	$	15,715	$	7,519
Loss on sale of assets		-		(12	)
Consolidated income before income taxes and
discontinued operations	$	15,715	$	7,507

		For the Nine Months Ended
		September 30,
		2008		2007
Net segment income	$	50,223	$	29,559
Gain (loss) on sale of assets		77		(22	)
Consolidated income before income taxes and
discontinued operations	$	50,300	$	29,537

(10) Summarized Consolidating Information

In connection with the Company’s offering of 9-1/8% Senior Subordinated Notes due 2015 (the “Notes”) in April 2007, certain of our subsidiaries (the “Guarantors”) have, jointly and severally and fully, unconditionally guaranteed the Notes. The proceeds of the Notes from time to time have been and will be used to benefit the operations of the Guarantors.  These guarantees are subordinated to all existing and future senior debt and guarantees of the Guarantors and are unsecured.

We conduct all of our business through and derive virtually all of our income from our subsidiaries. Therefore, our ability to make required payments with respect to indebtedness (including the Notes) and other obligations depends on the financial results and condition of our subsidiaries and their ability to fund such payments.

Pursuant to Rule 3-10 of Regulation S-X, the following summarized consolidating information is for the Company (the “Parent”), the 100% owned Guarantors, and the Parent’s non-Guarantor subsidiaries with respect to the Notes. This summarized financial information has been prepared from the books and records maintained by the Parent, the Guarantors and the non-Guarantor subsidiaries. The summarized financial information may not necessarily be indicative of the results of operations or financial position had the Guarantors or non-Guarantor subsidiaries operated as independent entities. The separate financial statements of the Guarantors are not presented because management has determined they would not be material to investors. In addition, intercompany activities between subsidiaries and the Parent are presented within operating activities on the condensed consolidating statement of cash flows.

Condensed consolidating financial statements for the Company and its subsidiaries, including the Parent only, the combined Guarantor subsidiaries and the combined non-Guarantor subsidiaries are as follows:

24

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(UNAUDITED)

CONDENSED CONSOLIDATING BALANCE SHEETS

As of September 30, 2008

(in thousands)

					Combined		Combined
		Parent			Guarantor		Non-Guarantor
		Company			Subsidiaries		Subsidiaries		Elimination			Consolidated
Current assets:
Cash and cash equivalents	$	58,529		$	19,574	$	2,330	$	-		$	80,433
Restricted cash		24,601			5,136		3,727		-			33,464
Accounts receivable, net		-			194,308		2,942		(29	)		197,221
Prepaid expenses and other assets		7,740			14,973		658		(1,176	)		22,195
Assets held for sale		943			2,698		10		-			3,651
Deferred tax assets		-			37,474		1,302		(7,389	)		31,387
Total current assets		91,813			274,163		10,969		(8,594	)		368,351
Property and equipment, net		8,474			520,181		68,718		-			597,373
Intangible assets, net		38,327			13,159		1,413		-			52,899
Goodwill		-			324,277		6,835		-			331,112
Restricted cash, non-current		2,953			335		-		-			3,288
Deferred tax assets		9,919			45,928		-		(13,535	)		42,312
Other assets		1,420			4,707		-		(8	)		6,119
Intercompany balances		484,641			-		4,789		(489,430	)		-
Investment in subsidiaries		301,291			-		-		(301,291	)		-
Total assets	$	938,838		$	1,182,750	$	92,724	$	(812,858	)	$	1,401,454
Current liabilities:
Accounts payable	$	9,485		$	38,150	$	851	$	(29	)	$	48,457
Accrued compensation and benefits		7,890			53,028		914		-			61,832
Accrued self-insurance obligations, current portion		3,838			37,884		1,140		-			42,862
Income taxes payable		2,782			-		-		-			2,782
Other accrued liabilities		11,538			51,750		3,867		(1,176	)		65,979
Current portion of long-term debt and capital lease obligations		4,402			6,486		1,200		-			12,088
Deferred tax liabilities		7,389			-		-		(7,389	)		-
Total current liabilities		47,324			187,298		7,972		(8,594	)		234,000
Accrued self-insurance obligations, net of current portion		41,711			66,669		429		-			108,809
Long-term debt and capital lease obligations, net of current portion		550,192			101,017		64,714		-			715,923
Unfavorable lease obligations, net		-			16,372		-		-			16,372
Deferred tax liabilities		-			-		13,535		(13,535	)		-
Intercompany balances		-			489,438		-		(489,438	)		-
Other long-term liabilities		21,048			25,450		-		-			46,498
Total liabilities		660,275			886,244		86,650		(511,567	)		1,121,602
Minority interest		-			1,289		-		-			1,289
Stockholders’ equity:
Common stock		435			-		-		-			435
Additional paid-in capital		605,966			-		-		-			605,966
Accumulated deficit		(325,104	)		295,217		6,074		(301,291	)		(325,104	)
Accumulated other comprehensive loss, net		(2,734	)		-		-		-			(2,734	)
Total stockholders’ equity		278,563			295,217		6,074		(301,291	)		278,563
Total liabilities and stockholders’ equity	$	938,838		$	1,182,750	$	92,724	$	(812,858	)	$	1,401,454

25

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(UNAUDITED)

CONDENSED CONSOLIDATING BALANCE SHEETS

As of  December 31, 2007

(in thousands)

					Combined		Combined
		Parent			Guarantor		Non-Guarantor
		Company			Subsidiaries		Subsidiaries			Elimination			Consolidated
Current assets:
Cash and cash equivalents	$	30,221		$	23,547	$	2,064		$	-		$	55,832
Restricted cash		27,441			6,370		3,554			-			37,365
Accounts receivable, net		-			187,144		1,747			(9	)		188,882
Prepaid expenses and other assets		2,060			11,130		100			-			13,290
Assets held for sale		912			9,015		(3	)		-			9,924
Deferred tax assets		35,344			-		10			-			35,354
Total current assets		95,978			237,206		7,472			(9	)		340,647
Property and equipment, net		8,924			507,022		70,026			-			585,972
Intangible assets, net		41,612			14,142		1,290			-			57,044
Goodwill		-			324,277		-			-			324,277
Restricted cash, non-current		566			3,263		-			-			3,829
Deferred tax assets		51,993			-		(101	)		-			51,892
Other assets		5,190			4,939		36			-			10,165
Investment in subsidiaries		249,903			-		-			(249,903	)		-
Total assets	$	454,166		$	1,090,849	$	78,723		$	(249,912	)	$	1,373,826
Current liabilities:
Accounts payable	$	14,203		$	38,095	$	547		$	(9	)	$	52,836
Accrued compensation and benefits		8,100			53,270		586			-			61,956
Accrued self-insurance obligations, current portion		5,509			39,822		3,315			-			48,646
Income taxes payable		3,000			-		-			-			3,000
Liabilities held for sale		-			3,181		-			-			3,181
Other accrued liabilities		15,063			36,667		6,272			-			58,002
Current portion of long-term debt and capital lease obligations		3,760			24,397		1,148			-			29,305
Total current liabilities		49,635			195,432		11,868			(9	)		256,926
Accrued self-insurance obligations, net of current portion		36,415			69,690		429			-			106,534
Long-term debt and capital lease obligations, net of current portion		546,739			87,606		65,618			-			699,963
Unfavorable lease obligations, net		-			24,949		(5,989	)		-			18,960
Intercompany balances		(444,757	)		448,544		(3,787	)		-			-
Other long-term liabilities		18,986			18,064		7,667			-			44,717
Total liabilities		207,018			844,285		75,806			(9	)		1,127,100
Minority interest		892			100		(522	)		-			470
Stockholders’ equity:
Common stock		430			-		-			-			430
Additional paid-in capital		600,199			-		-			-			600,199
Accumulated deficit		(351,970	)		246,464		3,439			(249,903	)		(351,970	)
Accumulated other comprehensive loss, net		(2,403	)		-		-			-			(2,403	)
Total stockholders’ equity		246,256			246,464		3,439			(249,903	)		246,256
Total liabilities and stockholders’ equity	$	454,166		$	1,090,849	$	78,723		$	(249,912	)	$	1,373,826

26

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(UNAUDITED)

CONDENSED CONSOLIDATING INCOME STATEMENTS

For the Three Months Ended September 30, 2008

(in thousands)

					Combined			Combined
		Parent			Guarantor			Non-Guarantor
		Company			Subsidiaries			Subsidiaries		Elimination			Consolidated
Total net revenues	$	9		$	465,622		$	7,480	$	(16,389	)	$	456,722
Costs and expenses:
Operating salaries and benefits		-			256,463			3,346		-			259,809
Self-insurance for workers’ compensation and
general and professional liability insurance		208			14,199			173		-			14,580
General and administrative expenses (1)		13,832			12,792			-		-			26,624
Other operating costs		2			109,731			1,549		(16,389	)		94,893
Center rent expense		-			18,376			175		-			18,551
Depreciation and amortization		831			8,778			565		-			10,174
Provision for losses on accounts receivable		-			3,146			160		-			3,306
Interest, net		9,527			2,315			1,228		-			13,070
Gain on sale of assets		-			-			-		-			-
Income from investment in subsidiaries		(23,238	)		-			-		23,238			-
Total costs and expenses		1,162			425,800			7,196		6,849			441,007
(Loss) income before income taxes and
discontinued operations		(1,153	)		39,822			284		(23,238	)		15,715
Income tax (benefit) expense		(9,757	)		15,929			114		-			6,286
Income from continuing operations		8,604			23,893			170		(23,238	)		9,429
Discontinued operations:
(Loss) income from discontinued operations, net		-			(273	)		102		-			(171	)
(Loss) gain on disposal of discontinued
operations, net		-			(1,085	)		431		-			(654	)
(Loss) income on discontinued operations, net		-			(1,358	)		533		-			(825	)
Net income	$	8,604		$	22,535		$	703	$	(23,238	)	$	8,604

 (1) Includes operating administrative expenses

27

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(UNAUDITED)

CONDENSED CONSOLIDATING INCOME STATEMENTS

For the Three Months Ended September 30, 2007

(in thousands)

					Combined			Combined
		Parent			Guarantor			Non-Guarantor
		Company			Subsidiaries			Subsidiaries			Elimination			Consolidated
Total net revenues	$	35		$	437,974		$	6,948		$	(12,384	)	$	432,573
Costs and expenses:
Operating salaries and benefits		-			243,857			2,775			-			246,632
Self-insurance for workers’ compensation and
general and professional liability insurance		134			15,347			165			-			15,646
General and administrative expenses (1)		15,172			11,908			5			-			27,085
Other operating costs		-			100,182			1,211			(12,384	)		89,009
Center rent expense		-			18,390			162			-			18,552
Depreciation and amortization		801			8,798			362			-			9,961
Provision for losses on accounts receivable		-			3,152			176			-			3,328
Interest, net		11,698			1,890			1,253			-			14,841
Loss on sale of assets		-			12			-			-			12
Income from investment in subsidiaries		(35,591	)		-			-			35,591			-
Total costs and expenses		(7,786	)		403,536			6,109			23,207			425,066
Income before income taxes and
discontinued operations		7,821			34,438			839			(35,591	)		7,507
Income tax expense		2,627			-			-			-			2,627
Income from continuing operations		5,194			34,438			839			(35,591	)		4,880
Discontinued operations:
(Loss) income from discontinued operations, net		-			(4	)		(309	)		-			(313	)
Gain (loss) on disposal of discontinued
operations, net		2			(4	)		631			-			629
Income (loss) on discontinued operations, net		2			(8	)		322			-			316
Net income	$	5,196		$	34,430		$	1,161		$	(35,591	)	$	5,196

(1)   Includes operating administrative expenses

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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(UNAUDITED)

CONDENSED CONSOLIDATING INCOME STATEMENTS

For the Nine Months Ended September 30, 2008

(in thousands)

					Combined			Combined
		Parent			Guarantor			Non-Guarantor
		Company			Subsidiaries			Subsidiaries		Elimination			Consolidated
Total net revenues	$	29		$	1,384,590		$	21,479	$	(46,469	)	$	1,359,629
Costs and expenses:
Operating salaries and benefits		-			758,266			9,317		-			767,583
Self-insurance for workers’ compensation and
general and professional liability insurance		437			40,215			494		-			41,146
General and administrative expenses (1)		46,006			38,194			-		-			84,200
Other operating costs		2			322,448			4,532		(46,469	)		280,513
Center rent expense		-			55,217			504		-			55,721
Depreciation and amortization		2,235			25,653			1,688		-			29,576
Provision for losses on accounts receivable		-			9,199			324		-			9,523
Interest, net		31,029			6,576			3,539		-			41,144
Gain on sale of assets		(77	)					-		-			(77	)
Income from investment in subsidiaries		(74,628	)		-			-		74,628			-
Total costs and expenses		5,004			1,255,768			20,398		28,159			1,309,329
(Loss) income before income taxes and
discontinued operations		(4,975	)		128,822			1,081		(74,628	)		50,300
Income tax (benefit) expense		(31,842	)		51,529			432		-			20,119
Income from continuing operations		26,867			77,293			649		(74,628	)		30,181
Discontinued operations:
(Loss) income from discontinued operations, net		(1	)		(1,905	)		1,114		-			(792	)
(Loss) gain on disposal of discontinued
operations, net		-			(4,100	)		1,577		-			(2,523	)
(Loss) income on discontinued operations, net		(1	)		(6,005	)		2,691		-			(3,315	)
Net income	$	26,866		$	71,288		$	3,340	$	(74,628	)	$	26,866

 (1) Includes operating administrative expenses

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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(UNAUDITED)

CONDENSED CONSOLIDATING INCOME STATEMENTS

For the Nine Months Ended September 30, 2007

(in thousands)

					Combined			Combined
		Parent			Guarantor			Non-Guarantor
		Company			Subsidiaries			Subsidiaries			Elimination			Consolidated
Total net revenues	$	68		$	1,135,518		$	16,786		$	(34,366	)	$	1,118,006
Costs and expenses:
Operating salaries and benefits		-			631,094			6,597			-			637,691
Self-insurance for workers’ compensation and
general and professional liability insurance		348			32,647			419			-			33,414
General and administrative expenses (1)		44,126			31,220			14			-			75,360
Other operating costs		16			259,723			3,063			(34,366	)		228,436
Center rent expense		-			52,087			359			-			52,446
Depreciation and amortization		1,969			20,633			837			-			23,439
Provision for losses on accounts receivable		-			8,555			237			-			8,792
Interest, net		20,766			4,853			3,250			-			28,869
Loss on sale of assets		-			22			-			-			22
Income from investment in subsidiaries		(99,651	)		-			-			99,651			-
Total costs and expenses		(32,426	)		1,040,834			14,776			65,285			1,088,469
Income before income taxes and
discontinued operations		32,494			94,684			2,010			(99,651	)		29,537
Income tax expense		10,339			-			-			-			10,339
Income from continuing operations		22,155			94,684			2,010			(99,651	)		19,198
Discontinued operations:
Income (loss) from discontinued operations, net		1			3,436			(1,103	)		-			2,334
(Loss) gain on disposal of discontinued
operations, net		2			(629	)		1,253			-			626
Income (loss) on discontinued operations, net		3			2,808			150			-			2,960
Net income	$	22,158		$	97,491		$	2,160		$	(99,651	)	$	22,158

(1)   Includes operating administrative expenses

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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(UNAUDITED)

CONDENSED CONSOLIDATING STATEMENTS OF CASH FLOWS

For the Nine Months Ended September 30, 2008

(in thousands)

					Combined			Combined
		Parent			Guarantor			Non-Guarantor
		Company			Subsidiaries			Subsidiaries			Elimination		Consolidated
Net cash provided by operating activities	$	17,009		$	42,166		$	1,560		$	-	$	60,735
Cash flows from investing activities:
Capital expenditures		(1,755	)		(26,624	)		(153	)		-		(28,532	)
Purchase of leased real estate		-			(8,956	)		-			-		(8,956	)
Proceeds from sale of assets held for sale		13,617			180			-			-		13,797
Acquisitions		-			(7,373	)		-			-		(7,373	)
Net cash provided by (used for) investing activities		11,862			(42,773	)		(153	)		-		(31,064	)
Cash flows from financing activities:
Long-term debt borrowings		-			20,290			-			-		20,290
Long-term debt repayments		(2,911	)		(23,656	)		(853	)		-		(27,420	)
Proceeds from issuance of common stock		2,348			-			-			-		2,348
Distribution of partnership equity		-			-			(288	)		-		(288	)
Net cash used for financing activities		(563	)		(3,366	)		(1,141	)		-		(5,070	)
Net increase (decrease) in cash and cash equivalents		28,308			(3,973	)		266			-		24,601
Cash and cash equivalents at beginning of period		30,221			23,547			2,064			-		55,832
Cash and cash equivalents at end of period	$	58,529		$	19,574		$	2,330		$	-	$	80,433

For the Nine Months Ended September 30, 2007

(in thousands)

		Parent Company			Combined Guarantor Subsidiaries			Combined Non-Guarantor Subsidiaries			Elimination		Consolidated
Net cash provided by (used for) operating activities	$	2,233		$	80,695		$	(4,931	)	$	-	$	77,997
Cash flows from investing activities:
Capital expenditures		(2,862	)		(20,061	)		(404	)		-		(23,327	)
Purchase of leased real estate		-			(33,220	)		-			-		(33,220	)
Proceeds from sale of assets held for sale		2,251			3,238			500			-		5,989
Acquisitions, net		(361,083	)		-			-			-		(361,083	)
Accrued acquisition costs, net		3,585			-			-			-		3,585
Net cash (used for) provided by investing activities		(358,109	)		(50,043	)		96			-		(408,056	)
Cash flows from financing activities:
Net borrowings under Revolving Credit Facility		(9,994	)		-			-			-		(9,994	)
Long-term debt borrowings		304,142			10,404			12,454			-		327,000
Long-term debt repayments		(6,719	)		(28,587	)		(6,331	)		-		(41,637	)
Proceeds from issuance of common stock		781			-						-		781
Distribution of partnership equity		-			-			(511	)		-		(511	)
Distribution of minority interest		-			-			(57	)		-		(57	)
Release of third party collateral		25,640			-			-			-		25,640
Deferred financing costs		(18,045	)		-			-			-		(18,045	)
Net cash provided by (used for) financing activities		295,805			(18,183	)		5,555			-		283,177
Net (decrease) increase in cash and cash equivalents		(60,071	)		12,469			720			-		(46,882	)
Cash and cash equivalents at beginning of period		119,810			11,337			788			-		131,935
Cash and cash equivalents at end of period	$	59,739		$	23,806		$	1,508		$	-	$	85,053

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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Overview

Sun Healthcare Group, Inc.’s subsidiaries are providers of long-term, subacute and related specialty healthcare services primarily to the senior population in the United States. Our core business is providing inpatient services, primarily through 185 skilled nursing centers, 15 assisted and independent living centers and eight mental health centers with 23,429 licensed beds located in 25 states as of September 30, 2008. Our subsidiaries also provide hospice services, rehabilitation therapy services and temporary medical staffing services to skilled nursing centers.

Revenues from Medicare, Medicaid and Other Sources

We receive revenues from Medicare, Medicaid, commercial insurance, self-pay residents, other third party payors and long-term care centers that utilize our specialty medical services. The sources and amounts of our inpatient services revenues are determined by a number of factors, including the number of licensed beds and occupancy rates of our centers, the acuity level of patients and the rates of reimbursement among payors. Federal and state governments continue to focus on methods to curb spending on health care programs such as Medicare and Medicaid, and pressures on state budgets resulting from the worsening economic conditions in the United States may intensify these efforts. This focus has not been limited to skilled nursing centers, but includes other services provided by us, such as skilled therapy services. We cannot at this time predict the extent to which proposals limiting federal or state expenditures will be adopted or, if adopted and implemented, what effect, if any, such proposals will have on us. Efforts to impose reduced coverage, greater discounts and more stringent cost controls by government and other payors are expected to continue.

The following table sets forth the total nonaffiliated revenues and percentage of revenues by payor source for our continuing operations, on a consolidated and on an inpatient operations only basis, for the periods indicated (data is in thousands and includes revenues for acquired centers following the date of acquisition only):

		For the								For the
		Three Months Ended								Nine Months Ended
Sources of Revenues		September 30, 2008				September 30, 2007				September 30, 2008				September 30, 2007
Consolidated:
Medicaid	$	184,771	40.5	%	$	184,545	42.7	%	$	543,464	40.0	%	$	461,385	41.3	%
Medicare		128,154	28.1			113,013	26.1			386,893	28.5			296,363	26.5
Managed care and commercial insurance		22,173	4.9			16,898	3.9			68,037	5.0			41,318	3.7
Private pay and other		121,624	26.5			118,117	27.3			361,235	26.5			318,940	28.5
Total	$	456,722	100.0	%	$	432,573	100.0	%	$	1,359,629	100.0	%	$	1,118,006	100.0	%
Inpatient Only:
Medicaid	$	184,715	45.6	%	$	184,523	48.0	%	$	543,347	45.1	%	$	461,289	47.2	%
Medicare		124,976	30.9			110,757	28.8			378,191	31.4			290,336	29.7
Managed care and commercial insurance		22,044	5.4			16,743	4.4			67,611	5.6			40,983	4.2
Private pay and other		72,966	18.1			72,740	18.8			215,824	17.9			184,320	18.9
Total	$	404,701	100.0	%	$	384,763	100.0	%	$	1,204,973	100.0	%	$	976,928	100.0	%

Medicare

Medicare is available to nearly every United States citizen 65 years of age and older. It is a broad program of health insurance designed to help the nation’s elderly meet hospital, hospice, home health and other health care costs. Health insurance coverage extends to certain persons under age 65 who qualify as disabled or who have end-stage renal disease. Medicare is comprised of four related health insurance programs.  Medicare Part A provides for inpatient services including

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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

hospital, skilled long-term care, and home healthcare.  Medicare Part B provides for outpatient services including physicians’ services, diagnostic service, durable medical equipment, skilled therapy services and medical supplies.  Medicare Part C is a managed care option (“Medicare Advantage”) for beneficiaries who are entitled to Part A and enrolled in Part B.  Medicare Part D is a benefit that provides prescription drug benefits for both Medicare and Medicare/Medicaid dually eligible patients.

Medicare reimburses our skilled nursing centers for Medicare Part A services under the Prospective Payment System (“PPS”) as defined by the Balanced Budget Act of 1997 and subsequently refined in 1999, 2000 and 2005.  PPS regulations predetermine a payment amount per patient, per day, based on the 1995 costs of treating patients indexed forward. The amount to be paid is determined by classifying each patient into one of 53 resource utilization group (“RUG”) categories that are based upon each patient’s acuity level.

The following table sets forth the average amounts of inpatient Medicare Part A revenues per patient, per day, recorded by our long-term care (“LTC”) centers for the periods indicated (data includes revenues for acquired centers following the date of acquisition only):

	For the				For the
	Three Months Ended				Nine Months Ended
	September 30, 2008		September 30, 2007		September 30, 2008		September 30, 2007
$	423.30	$	392.47	$	417.14	$	383.31

In 2007, the Centers for Medicare and Medicaid Services of the Department of Health and Human Services (“CMS”) issued a final rule which included a 3.3% market basket increase effective for the 2008 federal fiscal year which commenced on October 1, 2007.  We estimate that the implementation of this market basket increase has increased our revenues by approximately $3.5 million per quarter.

On July 31, 2008, CMS issued a final rule to implement a 3.4% market basket increase for the 2009 federal fiscal year which will commence on October 1, 2008. The rule also contained an update of the wage indices.   We estimate that the net impact of these changes will be a 3.3% increase in our reimbursement rates, which should result in increased revenues of approximately $3.8 million per quarter. 

The Balanced Budget Act of 1997 established limits on reimbursement provided under Medicare Part B for therapy services.  An automatic exception is currently in place for LTC patients until at least December 31, 2009.

Medicaid

Medicaid is a state-administered program financed by state funds and federal matching funds. The program provides for medical assistance to the indigent and certain other eligible persons. Although administered under broad federal regulations, states are given flexibility to construct programs and payment methods. Each state in which we operate nursing centers has its own unique Medicaid reimbursement program.  State Medicaid programs include systems that will reimburse a nursing center for reasonable costs it incurs in providing care to its patients, based upon cost from a prior base year, adjusted for inflation and per diems based upon patient acuity.

The following table sets forth the average amounts of inpatient Medicaid revenues per patient, per day (excluding any impact of state-imposed provider taxes), recorded by our LTC centers for the periods indicated (data includes revenues for acquired centers following the date of acquisition only):

	For the				For the
	Three Months Ended				Nine Months Ended
	September 30, 2008		September 30, 2007		September 30, 2008		September 30, 2007
$	168.64	$	164.28	$	167.51	$	159.29

Medicaid outlays are a significant component of state budgets, and there have been increased cost containment pressures on Medicaid outlays for nursing homes. It is not certain whether reductions in Medicaid rates would be imposed in the future for any states in which we operate.

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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

Eighteen of the states in which we operate impose a provider tax on nursing homes as a method of increasing federal matching funds paid to those states for Medicaid.  Those states that have imposed the provider tax have used some or all of the matching funds to fund Medicaid reimbursement to nursing homes.

Managed Care, Commercial Insurance and Private Payors

During the three months ended September 30, 2008, we received 31.4% of our revenues from commercial insurance, long-term care centers that utilize our specialty medical services, self-pay center residents, and other third party payors. These private third party payors are continuing their efforts to control healthcare costs through direct contracts with healthcare providers, increased utilization review and greater enrollment in managed care programs and preferred provider organizations. These private payors increasingly are demanding discounted fee structures and the assumption by healthcare providers of all or a portion of the financial risk.

Other Reimbursement Matters

Net revenues realizable under third-party payor agreements are subject to change due to examination and retroactive adjustment by payors during the settlement process. Under cost-based reimbursement plans, payors may disallow, in whole or in part, requests for reimbursement based on determinations that certain costs are not reimbursable or reasonable or because additional supporting documentation is necessary. We recognize revenues from third-party payors and accrue estimated settlement amounts in the period in which the related services are provided. We estimate these settlement balances by making determinations based on our prior settlement experience and our understanding of the applicable reimbursement rules and regulations.

Critical Accounting Policies Update

In October 2006, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards No. 157, Fair Value Measurements (“SFAS No. 157”), which effectively defines fair value for purposes of accounting principles generally accepted in the United States and expands disclosures of fair value measurements.  SFAS No. 157 changes the underlying methodology of establishing fair value for our financial instruments, including our interest rate swap agreement (see Note 3 – “Fair Value of Financial Instruments”).  We adopted SFAS No. 157 as of January 1, 2008.  There was no material impact on our financial condition upon adoption of SFAS No. 157 for our financial assets and financial liabilities.

We believe there have been no significant changes, other than the adoption of SFAS No. 157, during the three and nine months ended September 30, 2008 to the items that we disclosed as our critical accounting policies and estimates in our discussion and analysis of financial condition and results of operations in our Annual Report on Form 10-K for the year ended December 31, 2007.

In March 2008, the FASB issued Statement of Financial Accounting Standards No. 161, Disclosures About Derivative Instruments and Hedging Activities – an amendment of FASB Statement No. 133 (“SFAS No. 161”), which expands quarterly disclosure requirements in Statement of Financial Accounting Standards No. 133,Accounting for Derivative Instruments and Hedging Activity, about an entity’s derivative instruments and hedging activities. SFAS No. 161 is effective for fiscal years beginning after November 15, 2008.  We are currently assessing the impact of SFAS No. 161 on our consolidated financial position and results of operations.

On October 10, 2008, the FASB issued FASB Staff Position FAS No. 157-3, Fair Value Measurements (“FSP FAS 157-3”), which clarifies the application of Statement of Financial Accounting Standards No. 157, Fair Value Measurements (“SFAS No. 157”), in an inactive market and provides an example to demonstrate how the fair value of a financial asset is determined when the market for that financial asset is inactive. FSP FAS 157-3 was effective upon issuance, including prior periods for which financial statements had not been issued. The adoption of this standard as of September 30, 2008 did not have a material impact on our results of operations, cash flows or financial positions.

In April 2008, the FASB issued FASB Staff Position FAS No. 142-3, Determination of the Useful Life of Intangible Assets (“FSP FAS 142-3”). This pronouncement amends Statement of Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets (“SFAS No. 142”), regarding the factors that should be considered in developing the useful lives for intangible assets with renewal or extension provisions. FSP FAS 142-3 requires an entity to consider its own

34

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

historical experience in renewing or extending similar arrangements, regardless of whether those arrangements have explicit renewal or extension provisions, when determining the useful life of an intangible asset. In the absence of such experience, an entity shall consider the assumptions that market participants would use about renewal or extension, adjusted for entity-specific factors. FSP FAS 142-3 also requires an entity to disclose information regarding the extent to which the expected future cash flows associated with an intangible asset are affected by the entity’s intent and/or ability to renew or extend the arrangement. FSP FAS 142-3 will be effective for qualifying intangible assets acquired on or after January 1, 2009. The application of FSP FAS 142-3 is not expected to have a material impact on our results of operations, cash flows or financial positions; however, it could impact future transactions.  

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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

Results of Operations

The following table sets forth our unaudited historical consolidated income statements and certain percentage relationships for the periods presented (dollars in thousands):

		For the Three			For the Three	As a Percentage of Net Revenues
		Months Ended			Months Ended
		September 30, 2008			September 30, 2007	September 30, 2008		September 30, 2007
Total net revenues	$	456,722		$	432,573	100.0	%	100.0	%
Costs and expenses:
Operating salaries and benefits		259,809			246,632	56.9		57.0
Self-insurance for workers’ compensation and general
and professional liabilities		14,580			15,646	3.2		3.6
Other operating costs		107,685			99,217	23.6		23.0
Center rent expense		18,551			18,552	4.1		4.3
General and administrative expenses		13,832			16,877	3.0		3.9
Depreciation and amortization		10,174			9,961	2.2		2.3
Provision for losses on accounts receivable		3,306			3,328	0.7		0.8
Interest, net		13,070			14,841	2.9		3.4
Other (income) expenses		-			12	-		-
Income before income taxes and discontinued
operations		15,715			7,507	3.4		1.7
Income tax expense		6,286			2,627	1.4		0.6
Income from continuing operations		9,429			4,880	2.0		1.1
(Loss) income from discontinued operations, net		(825	)		316	(0.1	)	0.1
Net income	$	8,604		$	5,196	1.9	%	1.2	%

		For the Nine			For the Nine	As a Percentage of Net Revenues
		Months Ended			Months Ended
		September 30, 2008			September 30, 2007	September 30, 2008		September 30, 2007
Total net revenues	$	1,359,629		$	1,118,006	100.0	%	100.0	%
Costs and expenses:
Operating salaries and benefits		767,583			637,691	56.5		57.1
Self-insurance for workers’ compensation and general
and professional liabilities		41,146			33,414	3.0		3.0
Other operating costs		318,185			256,787	23.4		22.9
Center rent expense		55,721			52,446	4.1		4.7
General and administrative expenses		46,528			47,009	3.4		4.2
Depreciation and amortization		29,576			23,439	2.2		2.1
Provision for losses on accounts receivable		9,523			8,792	0.7		0.8
Interest, net		41,144			28,869	3.0		2.6
Other (income) expenses		(77	)		22	-		-
Income before income taxes and discontinued
operations		50,300			29,537	3.7		2.6
Income tax expense		20,119			10,339	1.5		0.9
Income from continuing operations		30,181			19,198	2.2		1.7
(Loss) income from discontinued operations, net		(3,315	)		2,960	(0.2	)	0.3
Net income	$	26,866		$	22,158	2.0	%	2.0	%

The following discussion of the “Three Months Ended September 30, 2008 Compared to Three Months Ended September 30, 2007” and the “Nine Months Ended September 30, 2008 Compared to Nine Months Ended September 30, 2007” is based, in part, on the financial information presented in Note 9 – “Segment Information” in our consolidated financial statements.

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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

Three Months Ended September 30, 2008 Compared to Three Months Ended September 30, 2007

The following summarizes our results of operations on a consolidated basis.  A more detailed discussion and analysis of the results of operations of each of our segments (Inpatient Services, Rehabilitation Therapy Services, Medical Staffing Services and Corporate) is provided below under “Segment Information.”

Net revenue increased $24.1 million, or 5.6%, to $456.7 million for the three months ended September 30, 2008 from $432.6 million for the three months ended September 30, 2007. We reported net income for the three months ended September 30, 2008 of $8.6 million compared to net income of $5.2 million for the three months ended September 30, 2007.

The increase in net revenue for the 2008 period included $19.9 million of additional revenue in our Inpatient Services segment due to increases in Medicare Part A rates, Medicaid rates, private payor rates, and commercial insurance revenues, offset by decreases due to a lower Medicaid and private pay customer base.  The remainder of the increase primarily resulted from a $1.8 million increase in revenue from our Medical Staffing segment mainly due to an increase in billable hours, increases in temporary placement of physicians and increases in average bill rates and a $6.4 million increase in revenue from our Rehabilitation Therapy segment due to increases in billable minutes and billing rates.

Operating salaries and benefits, excluding workers’ compensation insurance costs, increased $13.2 million, or 5.4%, to $259.8 million (56.9% of net revenues) for the three months ended September 30, 2008 from $246.6 million (57.0% of net revenues) for the three months ended September 30, 2007.  The increase resulted primarily from $8.7 million of wage increases in our Inpatient Services segment and a $5.2 million increase from our Rehabilitation Therapy segment attributable to wage rate increases and business growth.

Self-insurance for workers’ compensation and general and professional liability insurance decreased $1.0 million, or 6.4%, to $14.6 million (3.2% of net revenues) for the three months ended September 30, 2008 from $15.6 million (3.6% of net revenues) for the three months ended September 30, 2007 primarily due to decreased medical, legal and administrative costs associated with claims.

Other operating costs increased $8.5 million, or 8.6%, to $107.7 million (23.6% of net revenues) for the three months ended September 30, 2008 from $99.2 million (23.0% of net revenues) for the three months ended September 30, 2007.  The increase was primarily due to a $7.4 million increase in our Inpatient Services segment driven by increased therapy costs due to an increase in higher acuity patients requiring more rehabilitation therapy, utilities expense and expenses for education and training, as well as a $1.9 million increase in our Medical Staffing segment, primarily for travel and lodging expenses.

Center rent expense remained constant for the three months ended September 30, 2008 and September 30, 2007 at $18.6 million.

General and administrative expenses decreased $3.1 million, or 18.3%, to $13.8 million (3.0% of net revenues) for the three months ended September 30, 2008 from $16.9 million (3.9% of net revenues) for the three months ended September 30, 2007.  The decrease was primarily due to cost reductions in our Corporate segment from reduced professional and consultant fees, contract labor and office lease expense.

Depreciation and amortization increased $0.2 million, or 2.0%, to $10.2 million (2.2% of net revenues) for the three months ended September 30, 2008 from $10.0 million (2.3% of net revenues) for the three months ended September 30, 2007.  The increase was attributable to the purchase of previously leased centers and property and equipment acquired during the period.

The provision for losses on accounts receivable remained constant for the three months ended September 30, 2008 and September 30, 2007 at $3.3 million.

Net interest expense decreased $1.7 million, or 11.5%, to $13.1 million (2.9% of net revenues) for the three months ended September 30, 2008 from $14.8 million (3.4% of net revenues) for the three months ended September 30, 2007 due to lower interest rates on variable rate indebtedness in the current quarter, notwithstanding an increase in aggregate indebtedness in 2008.

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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

Segment Information

The following table sets forth the amount and percentage of certain elements of total net revenues for the three months ended September 30 (dollars in thousands):

		2008					2007
Inpatient Services	$	404,701		88.6	%	$	384,763		89.0	%
Rehabilitation Therapy Services		38,318		8.4			31,879		7.4
Medical Staffing Services		30,083		6.6			28,281		6.5
Corporate		9		-			34		-
Intersegment Eliminations		(16,389	)	(3.6	)		(12,384	)	(2.9	)
Total net revenues	$	456,722		100.0	%	$	432,573		100.0	%

Inpatient services revenues for long-term care, subacute care and assisted living services include revenues billed to patients for therapy and medical staffing provided by our affiliated operations.  The following table sets forth a summary of the intersegment revenues for the three months ended September 30 (in thousands):

		2008		2007
Rehabilitation Therapy Services	$	15,562	$	11,300
Medical Staffing Services		827		1,084
Total intersegment revenue	$	16,389	$	12,384

The following table sets forth the amount of net segment income (loss) for the three months ended September 30 (in thousands):

		2008			2007
Inpatient Services	$	35,829		$	32,980
Rehabilitation Therapy Services		1,793			1,697
Medical Staffing Services		2,479			2,319
Net segment income before Corporate		40,101			36,996
Corporate		(24,386	)		(29,477	)
Net segment income	$	15,715		$	7,519

Inpatient Services

Net revenues increased $19.9 million, or 5.2%, to $404.7 million for the three months ended September 30, 2008 from $384.8 million for the three months ended September 30, 2007.  The increase was primarily the result of:

- an increase of $14.2 million in Medicare revenues comprised of an $8.1 million increase from an increase in Medicare Part A rates, a $3.1 million increase from a higher customer base, a $1.8 million increase in hospice revenues related to an increase in customer base and the acquisition of a hospice business, and a $1.4 million increase in Medicare Part B revenues partially offset by a $0.2 million decrease in enteral nutrition revenues;

- a $5.3 million increase in managed care and commercial insurance revenues driven by a higher customer base, which contributed $3.3 million of the increase, and higher rates, which drove the remaining $2.0 million of the increase;

- an increase of $4.8 million in Medicaid revenues due to improved rates; and

- a $2.3 million increase in private pay revenues due to higher rates;

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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

	Offset in part by:
-	a $4.6 million decrease in Medicaid revenues due to lower customer base; and
-	a $2.1 million decrease in private pay revenues due to lower customer base and lower other revenues.

 Operating salaries and benefits expenses increased $8.7 million, or 4.4%, to $206.8 million for the three months ended September 30, 2008 from $198.1 million for the three months ended September 30, 2007.  The increase was attributable to the following:

-	wage increases and related benefits and taxes of $8.3 million; and
-	an increase of $1.8 million in health insurance expense;
	Offset in part by:
-	a decrease of $0.8 million in overtime pay; and
-	a decrease of $0.6 million in bonus expense.

Self-insurance for workers’ compensation and general and professional liability insurance decreased $1.1 million, or 7.5%, to $13.5 million for the three months ended September 30, 2008 as compared to $14.6 million for the three months ended September 30, 2007, primarily due to decreased medical, legal and administrative costs associated with claims.

Other operating costs increased $7.4 million, or 7.6%, to $104.4 million for the three months ended September 30, 2008 from $97.0 million for the three months ended September 30, 2007.  The increase was attributable to the following:

-	a $4.1 million increase in therapy and equipment rental costs due to an increase in higher acuity patients requiring more rehabilitation therapy;
-	a $1.4 million increase in purchased services including repairs and maintenance and service contracts;
-	a $1.0 million increase in utilities expense, principally due to increases in natural gas and electricity rates;
-	a $0.8 million increase in supplies, due to higher costs for medical, incontinency and food supplies;
-	a $0.5 million increase in legal fees and civil monetary penalties;
-	a $0.4 million increase in dues and subscriptions and miscellaneous expenses;
-	a $0.3 million increase in education and training, primarily related to increased clinical training; and
-	a $0.2 million increase in professional and consultant fees;
	Offset in part by:
-	a $1.0 million decrease in nursing contract labor; and
-	a $0.3 million increase in rebates and discounts.

General and administrative expenses increased $1.6 million, or 18.6%, to $10.2 million for the three months ended September 30, 2008 from $8.6 million for the three months ended September 30, 2007. The increase is primarily due to the salaries and benefits associated with the filling of open positions, travel and utility costs.

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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

The provision for losses on accounts receivable increased $0.1 million, or 3.1%, to approximately $3.3 million for the three months ended September 30, 2008 from $3.2 million for the three months ended September 30, 2007.

Center rent expense of $18.2 million for the three months ended September 30, 2008 decreased $0.1 million, or 0.5%, compared to $18.3 million for the three months ended September 30, 2007.

Depreciation and amortization increased $0.2 million, or 2.3%, to $9.0 million for the three months ended September 30, 2008 from $8.8 million for the three months ended September 30, 2007. The increase was attributable to additional depreciation expense for property and equipment acquired during the period.

Net interest expense for the three months ended September 30, 2008 was $3.5 million as compared to $3.1 million for the three months ended September 30, 2007.  The increase of $0.4 million, or 12.9%, was primarily due to interest on new debt obligations related to the conversion of leased centers to owned.

Rehabilitation Therapy Services

Total revenues from the Rehabilitation Therapy Services segment increased $6.4 million, or 20.1%, to $38.3 million for the three months ended September 30, 2008 from $31.9 million for the three months ended September 30, 2007. The revenue increase was the result of:

- an increase of $5.2 million attributable to a 15.8% increase in billable minutes; the volume increase being due to an increase in contract count and an overall increase in service volume, mainly in the affiliated LTC center segment and non-affiliated rehabilitation agencies; and

- an increase of $1.2 million attributable to a 3.7% increase in our revenue per minute rate due to our renegotiation of certain customer contract rates, an increase in assisted and community living business and operating efficiencies.

Operating salaries and benefits expenses increased $5.2 million, or 19.4%, to $32.0 million for the three months ended September 30, 2008 from $26.8 million for the three months ended September 30, 2007. The increase was primarily driven by wage rate increases coupled with the aforementioned increase in service volume.

Medical Staffing Services

Total revenues from the Medical Staffing Services segment increased $1.8 million, or 6.4%, to $30.1 million for the three months ended September 30, 2008 from $28.3 million for the three months ended September 30, 2007.  The increase was primarily the result of:

-	an increase of $0.7 million attributable to a 2.6% increase in billable hours;
-	an increase of $1.5 million due to an increase in temporary placement of physicians; and
-	an increase of $0.4 million due principally to an average bill rate per hour increase;
	Offset in part by:
-	a decrease of $0.3 million related to a shift from affiliated revenue to non-affiliated in Harborside’s medical staffing business, and
-	a decrease of $0.5 million related to disposed offices.

Operating salaries and benefits expenses were $21.1 million for the three months ended September 30, 2008 as compared to $21.7 million for the three months ended September 30, 2007, a decrease of $0.6 million, or 2.8%. The decrease in operating salaries and benefits resulted from a decrease in the nurse staffing business.

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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

Other operating costs increased $1.9 million, or 63.3%, to $4.9 million for the three months ended September 30, 2008 from $3.0 million for the three months ended September 30, 2007. The increase was primarily attributable to costs paid for travel and lodging for nurses and therapists.

Corporate

General and administrative expenses not directly attributed to segments decreased $3.1 million, or 18.3%, to $13.8 million for the three months ended September 30, 2008 from $16.9 million for the three months ended September 30, 2007. The decrease was primarily due to cost reductions in professional and consultant fees, contract labor and office lease expense.  As a percent of consolidated revenues, general and administrative expenses were 3.0% for the three months ended September 30, 2008 compared to 3.9% for the three months ended September 30, 2007.

Interest expense

Interest expense not directly attributed to operating segments decreased $2.2 million, or 18.8%, to $9.5 million for the three months ended September 30, 2008 from $11.7 million for the three months ended September 30, 2007 due to lower interest rates on variable rate indebtedness in the current quarter, notwithstanding an increase in aggregate indebtedness in 2008.

Nine Months Ended September 30, 2008 Compared to Nine Months Ended September 30, 2007

The following summarizes our results of operations on a consolidated basis.  A more detailed discussion and analysis of the results of operations of each of our segments (Inpatient Services, Rehabilitation Therapy Services, Medical Staffing Services and Corporate) is provided below under “Segment Information.”

Net revenue increased $241.6 million, or 21.6%, to $1,359.6 million for the nine months ended September 30, 2008 from $1,118.0 million for the nine months ended September 30, 2007. We reported net income for the nine months ended September 30, 2008 of $26.9 million compared to net income of $22.2 million for the nine months ended September 30, 2007.

The increase in net revenue for the 2008 period included $228.1 million of additional revenue in our Inpatient Services segment, of which $167.0 million is attributable to our acquisition of Harborside in April 2007, with the remainder primarily due to increases in Medicare Part A rates, Medicaid rates, private pay rates, and commercial insurance revenues, partially offset by decreases due to a lower Medicaid and private pay customer base.  The remainder of the increase primarily resulted from a $9.8 million increase in revenue from our Medical Staffing segment mainly due to an increase in billable hours, increases in average bill rates, increases in temporary placement of physicians and the addition of a medical staffing business in the Harborside acquisition, and a $15.9 million increase in revenue from our Rehabilitation Therapy segment due to an increase in service volume and the renegotiation of customer contracts.

Operating salaries and benefits, excluding workers’ compensation insurance costs, increased $129.9 million, or 20.4%, to $767.6 million (56.5% of net revenues) for the nine months ended September 30, 2008 from $637.7 million (57.1% of net revenues) for the nine months ended September 30, 2007.  Our Inpatient Services segment contributed $115.0 million of the increase, of which $90.7 million related to the Harborside acquisition and the remainder resulted from wage and benefit increases.  We also experienced increases of $2.4 million in our Medical Staffing segment and $12.5 million in our Rehabilitation Therapy segment, in each case attributable to higher wage rates and business growth.

Self-insurance for workers’ compensation and general and professional liability insurance increased $7.7 million, or 23.1%, to $41.1 million (3.0% of net revenues) for the nine months ended September 30, 2008 from $33.4 million (3.0% of net revenues) for the nine months ended September 30, 2007.  The addition of Harborside contributed $4.7 million to the increase.  The remaining increase is primarily due to higher medical, legal and administrative costs associated with claims.

Other operating costs increased $61.4 million, or 23.9%, to $318.2 million (23.4% of net revenues) for the nine months ended September 30, 2008 from $256.8 million (22.9% of net revenues) for the nine months ended September 30, 2007.  The increase was primarily due to $39.3 million in additional costs due to the addition of Harborside’s operations and a $18.8 million increase in our Inpatient Services segment driven by increased therapy costs due to an increase in higher acuity patients requiring more rehabilitation therapy, increased supplies costs, increased education and training, and

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increased utilities expense, as well as a $5.6 million increase in our Medical Staffing segment primarily for travel and lodging expenses.

Center rent expense increased $3.3 million, or 6.3%, to $55.7 million (4.1% of net revenues) for the nine months ended September 30, 2008 from $52.4 million (4.7% of net revenues) for the nine months ended September 30, 2007, of which $4.7 million of the increase was due to the additional rent expense resulting from the Harborside acquisition partially offset by rent decreases related to conversions of leased centers to owned.

General and administrative expenses decreased $0.5 million, or 1.1%, to $46.5 million (3.4% of net revenues) for the nine months ended September 30, 2008 from $47.0 million (4.2% of net revenues) for the nine months ended September 30, 2007.  The decrease was primarily due to cost reductions in our Corporate segment from reduced professional and consultant fees, contract labor and office lease expense, partially offset by the incremental costs associated with supporting Harborside’s operations for a full nine months in 2008 versus only six months during the corresponding 2007 period.

Depreciation and amortization increased $6.2 million, or 26.5%, to $29.6 million (2.2% of net revenues) for the nine months ended September 30, 2008 from $23.4 million (2.1% of net revenues) for the nine months ended September 30, 2007.  The increase was primarily attributable to the addition of the Harborside centers and additional depreciation expense for property and equipment acquired during the period.

The provision for losses on accounts receivable increased $0.7 million, or 8.0%, to $9.5 million (0.7% of net revenues) for the nine months ended September 30, 2008 from $8.8 million (0.8% of net revenues) for the nine months ended September 30, 2007.  The increase was primarily due to the addition of Harborside’s operations offset by improved collections at existing centers.

Net interest expense increased $12.2 million, or 42.2%, to $41.1 million (3.0% of net revenues) for the nine months ended September 30, 2008 from $28.9 million (2.6% of net revenues) for the nine months ended September 30, 2007. The increase was attributable to the debt incurred and assumed in the Harborside acquisition, offset by rate decreases on variable rate debt.

Segment Information

The following table sets forth the amount and percentage of certain elements of total net revenues for the nine months ended September 30 (dollars in thousands):

		2008					2007
Inpatient Services	$	1,204,973		88.6	%	$	976,928		87.4	%
Rehabilitation Therapy Services		109,921		8.1			93,942		8.4
Medical Staffing Services		91,175		6.7			81,434		7.3
Corporate		29		-			68		-
Intersegment Eliminations		(46,469	)	(3.4	)		(34,366	)	(3.1	)
Total net revenues	$	1,359,629		100.0	%	$	1,118,006		100.0	%

Inpatient services revenues for long-term care, subacute care and assisted living services include revenues billed to patients for therapy and medical staffing provided by our affiliated operations.  The following table sets forth a summary of the intersegment revenues for the nine months ended September 30 (in thousands):

		2008		2007
Rehabilitation Therapy Services	$	44,314	$	31,894
Medical Staffing Services		2,155		2,472
Total intersegment revenue	$	46,469	$	34,366

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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

The following table sets forth the amount of net segment income (loss) for the nine months ended September 30 (in thousands):

		2008			2007
Inpatient Services	$	117,073		$	88,403
Rehabilitation Therapy Services		6,483			5,405
Medical Staffing Services		6,866			5,789
Net segment income before Corporate		130,422			99,597
Corporate		(80,199	)		(70,038	)
Net segment income	$	50,223		$	29,559

Inpatient Services

Net revenues increased $228.1 million, or 23.3%, to $1,205.0 million for the nine months ended September 30, 2008 from $976.9 million for the nine months ended September 30, 2007. The addition of Harborside contributed $167.0 million of the increase.  The remaining increase of $61.1 million was primarily the result of:

-	an increase of $35.2 million in Medicare revenues comprised of a $22.8 million increase in Medicare Part A rates, a $6.2 million increase from a higher customer base, a $4.0 million increase in hospice revenues related to an increase in customer base and an acquisition of a hospice business in the third quarter of 2008, a $2.0 million increase in Medicare Part B revenues and $0.2 million in enteral nutrition revenues;
-	a $17.3 million increase in Medicaid revenues due to higher rates;
-	an $17.5 million increase in managed care and commercial insurance revenues driven by a higher customer base, which contributed $12.9 million of the increase, and higher rates, which drove the remaining $4.6 million of the increase; and
-	a $6.1 million increase in private pay revenues driven by a improved rates;
	Offset in part by:
-	a $13.5 million decrease in Medicaid revenues due to a lower customer base; and
-	a $1.5 million decrease in private pay revenues due to lower customer base.

Operating salaries and benefits expenses increased $115.0 million, or 23.2%, to $611.1 million for the nine months ended September 30, 2008 from $496.1 million for the nine months ended September 30, 2007.  The accretive impact of the Harborside operations contributed $90.7 million of the increase, with the remaining increase of $24.3 million attributable to the following:

-	wage increases and related benefits and taxes of $22.6 million; and
-	an increase of $3.3 million in health insurance expense;
	Offset in part by:
-	a decrease of $1.0 million in bonus expense; and
-	a decrease of $0.6 million in paid time-off, including sick, vacation and holiday.

Self-insurance for workers’ compensation and general and professional liability insurance increased $7.4 million, or 24.2%, to $38.0 million for the nine months ended September 30, 2008 as compared to $30.6 million for the nine months ended September 30, 2007.  The addition of Harborside accounted for $4.7 million of the net increase for the nine months ended September 30, 2008.  The remainder of the increase is primarily due to a net increase in costs associated with workers

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compensation and general and professional liability insurance related to increased medical, legal and administrative costs associated with claims.

Other operating costs increased $58.1 million, or 23.2%, to $308.7 million for the nine months ended September 30, 2008 from $250.6 million for the nine months ended September 30, 2007.  Approximately $39.3 million of this amount was due to the addition of Harborside.  The remaining increase of $18.8 million was primarily due to:

-	a $11.3 million increase in therapy and equipment rental costs due to an increase in higher acuity patients requiring more rehabilitation therapy;
-	a $3.0 million increase in utilities expense, principally due to increases in natural gas and electricity rates;
-	a $2.9 million increase in supplies, due to higher costs for medical, incontinency and food supplies;
-	a $2.3 million increase in education and training related to increased clinical training;
-	a $2.0 million increase in purchased services including repairs and maintenance and service contracts;
-	a $1.1 million increase in legal fees and civil monetary penalties;
-	a $0.6 million increase in travel and other miscellaneous expenses; and
-	a $0.3 million increase in license fees and bank service charges;
	Offset in part by:
-	a $2.6 million decrease in nursing contract labor;
-	a $1.2 million increase in discounts and rebates; and
-	a $0.9 million decrease in taxes primarily related to gross receipts, provider and real estate taxes.

General and administrative expenses increased $7.7 million, or 34.4%, to $30.1 million for the nine months ended September 30, 2008 from $22.4 million for the nine months ended September 30, 2007. The addition of the Harborside operations accounted for $3.2 million of the increase with the remaining $4.5 million resulting primarily from the filling of open positions, travel and utilities.

The provision for losses on accounts receivable increased $0.3 million, or 3.5%, to approximately $8.9 million for the nine months ended September 30, 2008 from $8.6 million for the nine months ended September 30, 2007. The increase was primarily attributable to the addition of the Harborside operations offset by improved collections at existing centers.

Center rent expense of $54.7 million for the nine months ended September 30, 2008 increased $3.1 million, or 6.0%, compared to $51.6 million for the nine months ended September 30, 2007, due to $4.7 million of rent expense associated with the acquired Harborside operations offset by $1.6 million of rent decreases related to conversions of leased centers to owned.

Depreciation and amortization increased $5.8 million, or 28.3%, to $26.3 million for the nine months ended September 30, 2008 from $20.5 million for the nine months ended September 30, 2007. The increase was primarily attributable to the addition of the Harborside centers and additional depreciation expense for property and equipment acquired during the period.

Net interest expense for the nine months ended September 30, 2008 was $10.1 million as compared to $8.1 million for the nine months ended September 30, 2007.  The increase of $2.0 million, or 24.7%, was primarily due to debt incurred and assumed in the Harborside acquisition as well as interest expense associated with debt incurred on the purchase of leased centers.

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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

Rehabilitation Therapy Services

Total revenues from the Rehabilitation Therapy Services segment increased $16.0 million, or 17.0%, to $109.9 million for the nine months ended September 30, 2008 from $93.9 million for the nine months ended September 30, 2007. The revenue increase was the result of:

- an increase of $11.6 million attributable to a 11.8% increase in billable minutes; the volume increase being due to an increase in contract count and an overall increase in service volume, mainly in the affiliated LTC center segment and non-affiliated rehabilitation agencies; and

- an increase of $4.4 million attributable to a 4.7% increase in our billing rate due to our renegotiation of certain customer contract rates, an increase in assisted and community living business and operating efficiencies.

Operating salaries and benefits expenses increased $12.5 million, or 16.0%, to $90.7 million for the nine months ended September 30, 2008 from $78.2 million for the nine months ended September 30, 2007. The increase was primarily driven by higher wage rates coupled with the aforementioned increase in service volume.

Medical Staffing Services

Total revenues from the Medical Staffing Services segment increased $9.8 million, or 12.0%, to $91.2 million for the nine months ended September 30, 2008 from $81.4 million for the nine months ended September 30, 2007.  The increase was primarily the result of:

-	an increase of $5.9 million attributable to an 8.3% increase in billable hours;
-	an increase of $3.1 million due to an increase in temporary placement of physicians;
-	an increase of $1.4 million due to the addition of Harborside’s medical staffing business, and
-	an increase of $0.3 million due to an average bill rate per hour increase;
	Offset in part by:
-	a decrease of $1.3 million related to disposed offices.

Operating salaries and benefits expenses were $65.8 million for the nine months ended September 30, 2008 as compared to $63.4 million for the nine months ended September 30, 2007, an increase of $2.4 million, or 3.8%. The increase in operating salaries and benefits resulted from the increase in business.

Other operating costs increased $5.6 million, or 75.7%, to $13.0 million for the nine months ended September 30, 2008 from $7.4 million for the nine months ended September 30, 2007. The increase was primarily attributable to costs paid for physicians and travel and lodging for nurses and therapists.

Corporate

General and administrative expenses not directly attributed to segments decreased $0.5 million, or 1.1%, to $46.5 million for the nine months ended September 30, 2008 from $47.0 million for the nine months ended September 30, 2007. As a percent of consolidated revenues, general and administrative expenses were 3.4% for the nine months ended September 30, 2008 compared to 4.2% for the nine months ended September 30, 2007.  The decrease was primarily due to cost reductions from reduced professional and consultant fees, contract labor and office lease expense, partially offset by the incremental costs associated with supporting Harborside’s operations for a full nine months in 2008 versus only six months during the corresponding 2007 period.

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Interest expense

Interest expense not directly attributed to operating segments increased $10.2 million, or 49.0%, to $31.0 million for the nine months ended September 30, 2008 from $20.8 million for the nine months ended September 30, 2007. The increase in expense was due to the debt incurred and assumed in the Harborside acquisition, offset by rate decreases on variable rate debt.

Liquidity and Capital Resources

For the three and nine months ended September 30, 2008, our net income was $8.6 million and $26.9 million, respectively.  As of September 30, 2008, our working capital was $134.4 million. As of September 30, 2008, we had cash and cash equivalents of $80.4 million, $728.0 million in borrowings and $50.0 million available under our revolving credit facility.

We believe that our operating cash flows, existing cash reserves and availability for borrowing under our revolving credit facility will provide sufficient funds for our operations, capital expenditures and regularly scheduled debt service payments at least through the next twelve months.  Recent issues involving the stability of financial institutions generally have called into question credit availability, and under our Credit Agreement, if one lender defaults on a borrowing request, then the other lenders are not required to fund that lender’s share.  While we do not anticipate that any of our lenders will be unable to lend under our revolving credit facility if we determine to borrow funds, no assurance can be given that one or more of our lenders will be able to fulfill their commitments.  We do not depend on cash flows from discontinued operations to provide for future liquidity.

Cash Flows

During the three months ended September 30, 2008, net cash provided by operating activities increased by $4.3 million as compared to the same period last year. This increase was the result of (i) our quarter-over-quarter increase in net income of $3.4 million, (ii) our quarter-over-quarter decrease in working capital changes of $6.9 million, driven by changes in accounts receivable and accrued compensation and benefits and other accrued liabilities and (iii) a $7.7 million increase in non-cash adjustments to net income, principally related to deferred tax assets, stock based compensation expense and losses in discontinued operations.

Debt

On July 24, 2008, we entered into an interest rate swap agreement for interest rate risk management purposes.  The interest rate swap agreement effectively modifies our exposure to interest by converting a portion of our floating rate debt to a fixed rate.  This agreement involves the receipt of floating rate amounts in exchange for fixed rate interest payments over the life of the agreement without an exchange of the underlying principal amount.  The agreement is based on a notional amount of $50.0 million and has a term of two years.  Settlement occurs on a quarterly basis, which is based upon a floating rate of LIBOR and an annual fixed rate of 3.65%.

In June 2008 we entered into a $25.6 million mortgage note payable for purposes of refinancing an existing mortgage note payable of approximately $20.0 million.  The additional $5.6 million was used in connection with our purchase of two previously leased centers.  See Note 2 – “Long-Term Debt and Capital Lease Obligations.”

Capital Expenditures

We incurred capital expenditures, related primarily to improvements in continuing operations, as reflected in our consolidated statements of cash flows, of $12.4 million and $11.4 million for the three months ended September 30, 2008 and 2007, respectively, and of $28.5 million and $23.3 million for the nine months ended September 30, 2008 and 2007, respectively.

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ITEM 3.  QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

We are exposed to market risk because we have issued debt that is sensitive to changes in interest rates. We manage our interest rate risk exposure by maintaining a mix of fixed and variable rates of interest on our debt. The following table provides information regarding our market sensitive financial instruments and constitutes a forward-looking statement.

																							Fair Value			Fair Value
		Expected Maturity Dates																					September 30,			December 31,
		2009			2010				2011			2012			2013			Thereafter			Total		2008 (1)			2007 (1)
							(Dollars in thousands)
Long-term debt:
Fixed rate debt (2)	$	6,761		$	13,898			$	16,632		$	23,700		$	5,842		$	434,811		$	501,644	$	464,302		$	428,428
Rate		7.4	%		8.4	%			8.1	%		6.5	%		8.3	%		8.1	%
Variable rate debt	$	6,028		$	2,426			$	26,674		$	1,999		$	1,999		$	187,241		$	226,367	$	215,104		$	248,128
Rate		5.6	%		5.3	%			5.8	%		5.2	%		5.2	%		5.2	%
Interest rate swaps:
Variable to fixed	$	150,000		$	150,000				-			-			-			-				$	(4,557	)	$	(4,005	)
Average pay rate		4.8	%		4.8	%			-			-			-			-
Average receive rate		2.8	%		2.8	%			-			-			-			-

(1)	The fair value of fixed and variable rate debt was determined based on the current rates offered for debt with similar risks and maturities.
(2)	Fixed rate long-term debt includes $48.8 million related to the consolidation of Clipper as of September 30, 2008 and $49.4 million as of December 31, 2007 (see Note 5 – “Variable Interest Entities”).

ITEM 4.  CONTROLS AND PROCEDURES

As of the end of the period covered by this report, our management, including our principal executive officer (Richard Matros) and our principal financial officer (L. Bryan Shaul), conducted an evaluation of the effectiveness of our disclosure controls and procedures.  Disclosure controls  and procedures are defined as controls and procedures designed to ensure that information required to be disclosed by an issuer in the reports that it files or submits under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms, and include, without limitation, controls and procedures designed to ensure that information is accumulated  and communicated to the issuer's management, including its principal executive and principal financial officers, or persons performing similar functions, as appropriate to allow timely decisions regarding  required disclosure.  Based on that evaluation, our principal executive officer and principal financial officer concluded that our disclosure controls and procedures were effective as of September 30, 2008.  No change in our internal control over financial reporting occurred during the period covered by this report that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

47

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

PART II. OTHER INFORMATION

ITEM 6. EXHIBITS

31.1	Section 302 Sarbanes-Oxley Certification by Chief Executive Officer
31.2	Section 302 Sarbanes-Oxley Certification by Chief Financial Officer
32.1	Section 906 Sarbanes-Oxley Certification by Chief Executive Officer
32.2	Section 906 Sarbanes-Oxley Certification by Chief Financial Officer

SIGNATURE

Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

SUN HEALTHCARE GROUP, INC.

By:  /s/ L. Bryan Shaul                                        

L. Bryan Shaul

Executive Vice President and Chief Financial Officer

(Principal Financial and Accounting Officer)

October 30, 2008

48

EX-31.1

EXHIBIT 31.1

CERTIFICATION PURSUANT TO

SECTION 302 OF

THE SARBANES-OXLEY ACT OF 2002

I, Richard K. Matros, certify that:

1. I have reviewed this quarterly report on Form 10-Q of Sun Healthcare Group, Inc.;

2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;

3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;

4. The registrant's other certifying officer(s) and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and have:

a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;

b) Evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and

c) Disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter (the registrant's fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and

5. The registrant's other certifying officer(s) and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent functions):

a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and

b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting.

Date: October 30, 2008	/s/ Richard K. Matros
	Richard K. Matros Chief Executive Officer (Principal Executive Officer)

EX-31.2

EXHIBIT 31.2

CERTIFICATION PURSUANT TO

SECTION 302 OF

THE SARBANES-OXLEY ACT OF 2002

I, L. Bryan Shaul, certify that:

1. I have reviewed this quarterly report on Form 10-Q of Sun Healthcare Group, Inc.;

2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;

3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;

4. The registrant's other certifying officer(s) and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and have:

a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;

b) Evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and

c) Disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter (the registrant's fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and

5. The registrant's other certifying officer(s) and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent functions):

a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and

b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting.

Date: October 30, 2008	/s/ L. Bryan Shaul
	L. Bryan Shaul Executive Vice President and Chief Financial Officer (Principal Financial and Accounting Officer)

EX-32.1

EXHIBIT 32.1

WRITTEN STATEMENT

 PURSUANT TO

18 U.S.C. SECTION 1350

   The undersigned, Richard K. Matros, the Chief Executive Officer (Principal Executive Officer), of Sun Healthcare Group, Inc. (the "Company"), pursuant to 18 U.S.C. Section 1350, hereby certifies that:

(i)   the Quarterly Report on Form 10-Q for the quarter ended September 30, 2008 of the Company (the "Report") fully complies with the requirements of section 13(a) and 15(d) of the Securities Exchange Act of 1934; and

(ii)   the information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company.

Date: October 30, 2008	/s/ Richard K. Matros
	Richard K. Matros

EX-32.2

EXHIBIT 32.2

WRITTEN STATEMENT

 PURSUANT TO

18 U.S.C. SECTION 1350

   The undersigned, L. Bryan Shaul, the Chief Financial Officer (Principal Financial Officer), of Sun Healthcare Group, Inc. (the "Company"), pursuant to 18 U.S.C. Section 1350, hereby certifies that:

(i)   the Quarterly Report on Form 10-Q for the quarter ended September 30, 2008 of the Company (the "Report") fully complies with the requirements of section 13(a) and 15(d) of the Securities Exchange Act of 1934; and

(ii)   the information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company.

Date: October 30, 2008	/s/ L. Bryan Shaul
	L. Bryan Shaul