This financial discussion contains an analysis of our consolidated financial position and financial performance as of December 31, 2016 and 2015, and consolidated results of operations for 2016, 2015 and 2014. References to the terms "we", "our" or "us" used throughout this Management's Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”), refer to TSM and unless the context otherwise requires, its direct and indirect subsidiaries. This analysis should be read in its entirety and in conjunction with the consolidated financial statements, notes and tables included elsewhere in this Annual Report on Form 10-K.
Consolidated claims for the year were $2.5 billion, up 6.6% over last year, primarily reflecting the higher fully-insured Managed Care enrollment associated with the new Medicaid contract. The consolidated loss ratio was up 220 basis points, to 85.5%, and the Medical Loss Ratio (“MLR”) increased 240 basis points, to 88.6%. Excluding the impact of prior-period reserve developments, and moving the Medicare risk score revenue adjustments to the corresponding period, the Managed Care MLR for the year was 88.1%, 110 basis points higher than the same metric from the prior year.
Generated net income of $17.4 million in 2016, a decrease from a net income of $52.1 million in the prior year, reflecting the Managed Care segment’s lower Commercial and Medicare enrollment combined with the segment’s higher MLR.
Claims Incurred. Our largest expense is medical claims incurred, or the cost of medical services we arrange for our members. Medical claims incurred include the payment of benefits and losses, mostly to physicians, hospitals and other service providers, and to policyholders. We generally pay our providers on one of three forms: (1) fee-for-service contracts based on negotiated fee schedules; (2) capitation arrangements, generally on a fixed PMPM payment basis, whereby the provider generally assumes some of the medical expense risk; and (3) risk-sharing arrangements, whereby we advance a PMPM payment and share the risk of certain medical costs of our members with the provider based on actual experience as measured against pre-determined sharing ratios. Claims incurred also include claims incurred in our life insurance and property and casualty insurance businesses. Each segment’s results of operations depend to a significant extent on our ability to accurately predict and effectively manage claims and losses. A portion of the claims incurred for each period consists of claims reported but not paid during the period, as well as a management and actuarial estimate of claims incurred but not reported during the period.
Includes Medicare Advantage as well as stand-alone PDP plan membership in 2014.
Membership for 2016 and 2015 is on at-risk basis and for 2014 on a self-insured basis. Effective April 1, 2015, membership decreased since we elected to provide services to only two regions when the delivery model changed to an at-risk basis.
Consolidated operating expenses decreased by $24.8 million, or 4.8%, to $493.9 million. The decrease reflects lower expenses following the change in the Medicaid membership after we elected to reduce the number of regions we serve, from eight regions under an ASO agreement to only two regions when the contract changed to a fully-insured model. The lower operating expenses also reflect a decrease in the provision for doubtful accounts, mostly due to the strengthening of the allowance for doubtful receivables in the 2015 period, lower payroll and related expenses resulting from accruals related to management changes and retirements impacting the 2015 period, as well as a $4.4 million expense related to settlement agreements entered with governmental agencies in 2015. These decreases were partially offset by a new business-to-business tax implemented in Puerto Rico at the end of the third quarter 2015 and an increase in the Health Insurance Providers Fee, reflecting the at-risk Medicaid enrollment after the model changed in 2015. For the year ended December 31, 2016, the consolidated operating expense ratio decreased 130 basis points to 17.0%, as the result of the increase in premiums and lower expenses.
Consolidated income taxes resulted in a benefit of $6.3 million. The tax benefit primarily results from the net effect of the following:
During the 2015 period, the Company executed a Closing Agreement between TSM and its subsidiaries and the Puerto Rico Treasury Department in connection with a local law that provided a temporary preferential tax rate in capital asset transactions. These events allowed the Company to record a $3.1 million benefit in the 2015 period resulting from the enacted lower taxable rate and the reassessment of the realizability of some of its deferred taxes.
The Property and Casualty segment reassessed the tax rate used to measure several temporary differences; as a consequence such rate was increased from 20% to 39%, resulting in an increase to its deferred tax expense of approximately $3.6 million in 2016.
Medical premiums generated by the Medicare business decreased by $73.8 million, or 6.7%, to $1,000 million. This fluctuation primarily results from lower risk score revenue as compared with 2015, lower member months enrollment, and a reduction in 2016 Medicare reimbursement rates.
The medical claims incurred of the Medicaid business increased by $150.7 million during the 2016 period reflecting the previously mentioned change in the Medicaid contract effective April 1, 2015.
The medical claims incurred of the Medicare business decreased by $4.1 million, or 0.4%, during the 2016 period reflecting the previously mentioned decrease in membership and changes in benefit design included in 2016 products as the result of the decrease in reimbursement rates. This decrease is offset by unfavorable prior period reserve developments. The Medicare MLR was 90.3%, which is 570 basis points higher than the MLR for the perior year. Adjusting for the effect of prior period reserve developments, and moving the 2015 final risk score revenue adjustments to its corresponding period, our Medicare MLR would have been 90.0%, about 530 basis points higher than last year. The higher MLR primarily reflects higher Part B drug costs mainly related to cancer and rheumatoid arthritis, additional deterioration in the experience of End Stage Renal Disease (ESRD) and the effect of the decrease in 2016 Medicare reimbursement rates.
Medical premiums generated by the Medicaid business amounted to $607.2 million during the year ended December 31, 2015 after the change in the Medicaid service model, from an ASO agreement to a fully insured model effective April 1, 2015.
Medical premiums generated by the Medicare business increased by $84.0 million, or 8.3%, to $1.1 billion during the year ended December 31, 2015 as compared to the year ended December 31, 2014. This fluctuation primarily results from higher member month enrollment in Medicare Advantage products, which carry a higher average premium rate, offset by our exit of stand-alone PDP product. In 2015 we also had a higher risk score revenue as compared with 2014. The increase in premiums resulting from the change in mix of our products was offset in part by a decrease in PMPM of our Medicare Advantage products by 3.0% during 2015.
Medical premiums generated by the Commercial business decreased by $37.8 million, or 4.3%, to $844.6 million during the year ended December 31, 2015 as compared to the year ended December 31, 2014. This fluctuation is primarily the result of a decrease in fully-insured member month enrollment by 532,889, or 10.6%, mainly in our rated groups and individual accounts products and reflecting cancellation of several commercial accounts and attrition in existing accounts as a result of Puerto Rico’s challenging economic situation. The effect of the decreased membership is partially offset by a 7.1% year over year increase in average premium rates.
Effective April 1, 2015, the Medicaid delivery model changed from an ASO contract to a fully insured model. The medical claims incurred related to this contract for year ended December 31, 2015 amounted $555.3 million. The medical loss ratio of this segment was 91.5%, in line with our bid.
The medical claims incurred of the Commercial business decreased by $41.5 million, or 5.5%, during the 2015 period mostly reflecting a lower fully-insured member month enrollment. The 2015 Commercial MLR was 84.2%, which is 110 basis points lower than the prior year. Excluding the effect of prior period reserve developments in 2015 and 2014, the MLR would have decreased by 120 basis points, mostly reflecting premium trends that were higher than claims trends.
The premiums ceded to reinsurers decreased by $2.7 million, or 5.5%, mostly reflecting favorable pricing in the market for nonproportional reinsurance treaties.
As a result of the above fluctuations net premiums earned for the year ended December 31, 2015 decreased by $4.5 million, or 4.9%, to $87.6 million.
Payments of long-term borrowings decreased by $35.9 million during the year ended December 31, 2016, primarily due to the payment of a repurchase agreement of $25.0 million that matured and a $11.0 million repayment of principal of certain senior unsecured notes during the 2015 period.
Net purchases of sales of investment securities were $41.6 million during the year ended December 31, 2015, primarily resulting from the net cash flows received from the purchases and sales of investment securities during the 2015 period following our asset/liability management strategy. During the year ended December 31, 2014 we had net proceeds of investments of $34.0 million.
In October 2014 the Company’s Board of Directors authorized a $50.0 million repurchase program (2014 $50.0 million share repurchase program) of its Class B common stock. This program was completed on October 7, 2015.
In November 2015 the Company’s Board of Directors authorized a $25.0 million repurchase program (2015 $25.0 million share repurchase program) of its Class B common stock. This program was completed on September 14, 2016.
On December 21, 2005, we issued and sold $60.0 million of our 6.6% senior unsecured notes due December 2020 (the “6.6% notes”). The 6.6% notes were privately placed to various institutional accredited investors. The notes pay interest each month until the principal becomes due and payable. These notes can be redeemed after five years at par, in whole or in part, as determined by us. On October 1, 2010 and May 14, 2015 we repaid $25.0 million and $11.0 million, respectively, of the principal of these senior unsecured notes. Amount currently outstanding is $24.0 million. The 6.6% notes contain certain non-financial covenants. At December 31, 2016, we are in compliance with these covenants.
Other long-term liabilities - Due to the indeterminate nature of their cash outflows, $84.2 million of other long-term liabilities are not reflected in the following table, including $31.0 million of liability for pension benefits, $18.8 million in deferred tax liabilities, and $34.4 million in liabilities to the Federal Employees’ Health Benefits Plan Program.
As of December 31, 2016, our long-term borrowings consist of our 6.6% senior unsecured notes payable. Also, total contractual obligations for long-term borrowings include the current maturities of long term debt. For the 6.6% senior unsecured notes, scheduled interest payments were included in the total contractual obligations for long-term borrowings until the maturity date of the note in 2020. We may redeem the senior unsecured note starting five years after issuance; however no redemption is considered in this schedule. See the “Financing and Financing Capacity” section for additional information regarding our long-term borrowings.
Claim liabilities represent the amount of our claims processed and incomplete as well as an estimate of the amount of incurred but not reported claims and loss-adjustment expenses. This amount does not include an estimate of claims to be incurred subsequent to December 31, 2016. The expected claims payments are an estimate and may differ materially from the actual claims payments made by us in the future. Also, claim liabilities are presented gross, and thus do not reflect the effects of reinsurance under which $39.0 million of reserves had been ceded at December 31, 2016.
Our life insurance segment establishes, and carries as liabilities, actuarially determined amounts that are calculated to meet its policy obligations when a policy matures or surrenders, an insured dies or becomes disabled or upon the occurrence of other covered events. A significant portion of the estimated obligation for future policy benefits to be paid included in this table considers contracts under which we are currently not making payments and will not make payments until the occurrence of an insurable event not under our control, such as death, illness, or the surrender of a policy. We have estimated the timing of the cash flows related to these contracts based on historical experience as well as expectations of future payment patterns. The amounts presented in the table above represent the estimated cash payments for benefits under such contracts based on assumptions related to the receipt of future premiums and assumptions related to mortality, morbidity, policy lapses, renewals, retirements, disability incidence and other contingent events as appropriate for the respective product type. All estimated cash payments included in this table are not discounted to present value nor do they take into account estimated future premiums on policies in-force as of December 31, 2016 and are gross of any reinsurance recoverable. The $556.7 million total estimated cash flows for all years in the table is different from the liability of future policy benefits of $321.2 million included in our audited consolidated financial statements principally due to the time value of money. Actual cash payments to policyholders could differ significantly from the estimated cash payments as presented in this table due to differences between actual experience and the assumptions used in the estimation of these payments.
In addition, our property and casualty insurance subsidiary is a member of the Compulsory Vehicle Liability Insurance Joint Underwriting Association (the “Association”). The Association was organized in 1997 to underwrite insurance coverage of motor vehicle property damage liability risks effective January 1, 1998. As a participant, the segment shares the risk proportionally with other members based on a formula established by the Insurance Code. During the years 2016, 2015 and 2014, the Association distributed to the Company an amount based on the good experience of the business amounting to $0.5 million, $0.7 million and $0.9 million, respectively. In December 2015 the Association declared a special dividend of $21 million subject to a special tax of 15% that was retained upon distribution. This special dividend was paid in three installments during 2016. The share of the property and casualty segment in this special dividend was approximately $1.7 million, net of tax.
Claim liabilities by segment as of December 31, 2016 were as follows:
Management continually evaluates the potential impact of changes in the factors considered for its claim liabilities estimates, both positive and negative, and uses the results of these evaluations to adjust recorded claim liabilities and underwriting criteria. Our profitability depends in large part on our ability to accurately predict and effectively manage the amount of claims incurred, particularly those of the Managed Care segment and the losses arising from the Property and Casualty and Life Insurance segment. Management regularly reviews its premiums and benefits structure to reflect our underlying claims experience and revised actuarial data; however, several factors could adversely affect our underwriting results. Some of these factors are beyond management’s control and could adversely affect its ability to accurately predict and effectively control claims incurred. Examples of such factors include changes in health practices, economic conditions, change in utilization trends including those caused by epidemic conditions, healthcare costs, the advent of natural disasters, and malpractice litigation. Costs in excess of those anticipated could have a material adverse effect on our results of operations.
As described above, completion factors and claims trend factors can have a significant impact on determination of our claim liabilities. The following example provides the estimated impact on our December 31, 2016 claim liabilities, assuming the indicated hypothetical changes in completion and trend factors:
The following table shows the variance between the segment’s incurred claims for current period insured events and the incurred claims for such years had they been determined retrospectively (the “Incurred claims related to current period insured events” for the year shown plus or minus the “Incurred claims related to prior period insured events” for the following year as included in note 10 of the audited consolidated financial statements). This table shows that the segments’ estimates of this liability have approximated the actual development.
Management expects that substantially all of the development of the 2016 estimate of medical claims payable will be known during 2017.
Key assumptions are based on the consideration that past emergence of paid losses and case reserves is credible and likely indicative of future emergence and ultimate losses. A key assumption is the expected loss ratio for the current accident year. This expected loss ratio is generally determined through a review of the loss ratios of prior accident years and expected changes to earned pricing, loss costs, mix of business, and other factors that are expected to impact the loss ratio for the current accident year. Another key assumption is the development patterns for paid and reported losses (also referred to as the loss emergence and settlement patterns). The reserves for unreported claims for each year are determined after reviewing the indications produced by each actuarial projection method, which, in turn, rely on the expected paid and reported development patterns and the expected loss ratio for that year.
For deferred annuities, the liability for future policy benefits is equal to total policy account values. The liabilities for all other products are based upon a variety of actuarial assumptions that are uncertain. The most significant of these assumptions is the level of anticipated death and health claims. Other assumptions that are less significant to the appropriate level of the liability for future policy benefits are anticipated policy persistency rates, investment yields, and operating expense levels. These are reviewed frequently by our subsidiary’s external actuaries, to assure that the current level of liabilities for future policy benefits is sufficient, in combination with anticipated future cash flows, to provide for all contractual obligations. For all products, except for deferred annuities, the basis for the liability for future policy benefits is established at the time of issuance of each contract and would only change if our experience deteriorates to the point that the level of the liability is not adequate to provide for future policy benefits. We do not currently expect that level of deterioration to occur.
During the year ended December 31, 2016, we recognized other-than-temporary impairments amounting to $1.4 million on equity securities classified as available for sale. The impairment analysis as of December 31, 2016 indicated that, other than those securities for which an other-than-temporary impairment was recognized, none of the securities whose carrying amount exceeded its estimated fair value was considered other-than-temporarily impaired as of that date; however, several factors are beyond management’s control, such as the following: financial condition of the issuers, movement of interest rates, specific situations within corporations, among others. Over time, the economic and market environment may provide additional insight regarding the estimated fair value of certain securities, which could change management’s judgment regarding impairment. This could result in realized losses related to other-than-temporary declines being charged against future income.