We own a seven story building located at 1441 F.D. Roosevelt Avenue, in San Juan, Puerto Rico, and two adjacent buildings, as well as the adjoining parking lot. In addition, we own five floors of a fifteen-story building located at 1510 F.D. Roosevelt Avenue, in Guaynabo, Puerto Rico. We also own a multi-segment customer service center in the municipality of Mayagüez, Puerto Rico. In addition, through a health clinic in which we have a controlling interest, we own land and a two-story medical facility in the municipality of Bayamón. These properties are subject to liens under our credit facilities. In connection with our entrance to the Costa Rican market, we acquired a two-story building located in the city of San José, Costa Rica. See “Item 7 - Management’s Discussion and Analysis of Financial Condition and Results of Operation - Liquidity and Capital Resources”.
(1) Further details of the calculation of basic earnings per share are set forth in notes 2 and 22 of the audited consolidated financial statements for the years ended December 31, 2013, 2012 and 2011.
This financial discussion contains an analysis of our consolidated financial position and financial performance as of December 31, 2013 and 2012, and consolidated results of operations for 2013, 2012 and 2011. 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.
Update to the Interim Condensed Consolidated Financial Statements Included in Earnings Press Release Dated February 11, 2014 for the Fourth Quarter and Year Ended December 31, 2013
We are one of the most significant players in the managed care industry in Puerto Rico and have over 50 years of experience in this industry. We offer a broad portfolio of managed care and related products in the Commercial and the Medicare (including Medicare Advantage and the Part D stand-alone prescription drug plans (“PDP”)) markets. In the Commercial market we offer products to corporate accounts, U.S. federal government employees, local government employees, individual accounts and Medicare Supplement. We also participate in the Government of Puerto Rico Health Reform (a government of Puerto Rico-funded managed care program for the medically indigent that is similar to the Medicaid program in the U.S.) (“Medicaid”), by administering the provision of the physical health component in designated service regions in Puerto Rico.
We participate in the managed care market through our subsidiaries, TSS and AH. TSS and AH are BCBSA licensees, which provides us with exclusive use of the Blue Cross and Blue Shield name and mark throughout Puerto Rico, the U.S. Virgin Islands, Costa Rica, the British Virgin Islands and Anguilla.
On November 7, 2013, our subsidiary TSV completed the acquisition of 100% of the outstanding capital stock of Atlantic Southern Insurance Company (“ASICO”), a life insurance company authorized to do business in Puerto Rico, Costa Rica, Anguilla and the British Virgin Islands. The cost of this acquisition was approximately $9.4 million and was funded with unrestricted cash. Our consolidated results of operations and financial condition included in this Annual Report on Form 10-K reflect ASICO’s acquisition in periods subsequent to the effective date of the transaction and were included within the Life Insurance segment.
In January 2012, we acquired a controlling interest in a health clinic in Puerto Rico, which we expect will provide additional opportunities to our Managed Care segment.
The Commissioner of Insurance of the Commonwealth of Puerto Rico (“Commissioner of Insurance of Puerto Rico”) recognizes only statutory accounting practices for determining and reporting the financial condition and results of operations of an insurance company, for determining its solvency under the Puerto Rico insurance laws and for determining whether its financial condition warrants the payment of a dividend to its stockholders. No consideration is given by the Commissioner of Insurance of Puerto Rico to financial statements prepared in accordance with U.S. generally accepted accounting principles (“GAAP”) in making such determinations. See note 25 to our audited consolidated financial statements.
The consolidated administrative service fees decreased by $1.4 million, or 1.3%, to $108.7 million for the year ended December 31, 2013 when compared with the year ended December 31, 2012. This fluctuation primarily reflects the effect of the amended Medicaid contract, which includes lower per-member per-month fees, offset in part by the increased enrollment after the addition of the three new regions effective October 1, 2013. The new rate per-member per-month fees were effective July 1, 2013.
Consolidated other income increased by $13.1 million during the year ended December 31, 2013 compared with to the year ended December 31, 2012 mostly due to a special distribution received from the Puerto Rico Joint Underwriting Association (“JUA”) in the Property and Casualty segment of $12.8 million, net of a special tax.
Consolidated claims incurred during the year ended December 31, 2013 decreased by $83.6 million, or 4.4%, to $1.8 billion when compared to the claims incurred during the year ended December 31, 2012. This decrease in the claims incurred primarily results from the lower Managed Care member month enrollment and lower utilization and cost trends in the Medicare and Commercial businesses year over year. This decrease was partially offset by an increase in claims of the Life and Property and Casualty segments. The consolidated loss ratio decreased by 190 basis points to 83.3%.
Consolidated operating expenses during the year ended December 31, 2012 increased by $77.6 million, or 22.3%, to $425.2 million as compared to the operating expenses during the year ended December 31, 2011. For the year ended December 31, 2012, the consolidated operating expense ratio increased by 140 basis points to 18.0%, primarily reflecting the higher amount of self-insured contracts after resuming our participation in the Medicaid sector effective November 1, 2011, plus higher expenses in external consultants partly related to the MA business planning and integration.
Consolidated income tax expense during the year ended December 31, 2012 decreased by $8.0 million, or 39.0%, to $12.5 million as compared to the income tax expense during the year ended December 31, 2011. The effective tax rate decreased by 730 basis points, to 18.8%, during the year ended December 31, 2012. The consolidated income tax expense for the year ended December 31, 2011 includes a one-time charge of $6.4 million resulting from the reduction of the net deferred tax assets following the reduction in income tax rates after the enactment of the new Puerto Rico tax reform, which was effective January 2011, that reduced the maximum corporate tax rate from 39% to approximately 30%.
We offer our products in the managed care segment to three distinct market sectors in Puerto Rico: Commercial, Medicare (including Medicare Advantage and PDP) and Medicaid. For the year ended December 31, 2013, the Commercial sector represented 42.4% and -17.6% of our consolidated premiums earned, net and operating income, respectively. Premiums earned, net and operating income generated from our Medicare contracts (including PDP) during the year ended December 31, 2013 represented 47.2% and 58.4%, respectively, of our consolidated earned premiums, net and operating income, respectively. The operating income of the Medicaid sector represented 32.5% of the consolidated operating income for the year ended December 31, 2013.
Medical premiums earned for the year ended December 31, 2012 increased by $187.1 million, or 10.1%, to $2.0 billion when compared to the medical premiums earned during the year ended December 31, 2011. This increase is principally the result of the following:
• Medical premiums generated by the Medicare business increased by $176.9 million, or 19.7%, to $1.1 billion. This fluctuation is the result of an overall increase in the member month enrollment of this business by 217,355, or 17.5%, when compared with the same period in 2011. Increase in member month enrollment was mainly attributed to increased sales across all our Medicare products, as well as to the effect of presenting the members acquired from AH for the full year in 2012 and only for eleven months in 2011. This fluctuation also results from the receipt of higher risk score adjustments from CMS in 2012 as compared to 2011. The 2012 and 2011 periods include the net effect of approximately $12.6 million and $1.9 million, respectively, related to CMS final risk scores adjustments corresponding to prior periods.
Administrative service fees increased by $71.8 million, or 167.0%, to $114.8 million during the year ended December 31, 2012. This fluctuation primarily results from the member months enrollment related to the Medicaid program, which we resumed servicing effective November 1, 2011.
• The medical claims incurred of the Medicare business increased by $151.2 million during the 2012 period primarily due to the increase in member months enrollment in 2012 attributed to increased sales, as well as to the effect of presenting the members acquired from AH for the full period in 2012 and only for eleven months in 2011. The Medicare MLR was 88.8%, which is 60 basis points lower than the MLR for the prior year. Excluding the effect of risk-score premium adjustments and prior period reserve developments in the 2012 and 2011 periods, the MLR increased by 270 basis points, mostly as the result of higher utilization and cost trends in AH, particularly in pharmacy services.
• The medical claims incurred of the Commercial business increased by $39.4 million during the 2012 period and its MLR increased by 300 basis points. Excluding effect of prior period reserve developments in the 2012 and 2011 periods, the MLR of this business presents an increase of 120 basis points in 2012 mostly as the result of moderate premium rate increases and higher utilization trends, particularly in hospital admissions and surgical procedures.
• The medical claims incurred of the Medicaid business increased by $5.3 million during 2012 compared to prior year mostly because of a favorable prior period reserve development recognized in the 2011 period, after the termination of the Medicaid fully-insured contracts that was effective September 30, 2010.
Underwriting and other expenses for the segment increased by $3.4 million, or 5.4%, to $65.8 million during the year ended December 31, 2013, mostly related to a lower amount of expenses capitalized as Deferred Policy Acquisition Costs, primarily resulting from lower commission expenses, premium taxes and approximately $0.9 million of expenses related to the ASICO acquisition. As a result, the operating expense ratio slightly increased 40 basis points, from 50.0% in 2012 to 50.4% in 2013.
Policy benefits and claims incurred increased by $8.9 million, or 15.5%, to $66.4 million during the year ended December 31, 2012. This fluctuation is primarily the result of higher claims received for the Cancer line of business, and also to an increase in the liability for future policy benefits that was driven by new business subscribed in the period and improved persistency on the Individual Life business. The loss ratio for the period increased from 50.9% in 2011 to 53.2% in 2012, or 230 basis points.
Total premiums written during the year ended December 31, 2013 decreased by $10.4 million, or 6.4%, to $152.3 million, mostly resulting from lower sales of Dwelling and Commercial insurance products. The commercial business remains under soft market conditions with strong competition.
On November 7, 2013, we completed the acquisition of 100% of the outstanding shares of capital stock of ASICO for an aggregate purchase price of approximately $4.8 million, net of $4.6 million of cash acquired. On January 18, 2012, we acquired a controlling stake in a health clinic in Puerto Rico at a cost of $2.7 million, net of $0.8 million of cash acquired. On February 7, 2011, we acquired AH at a cost of $54.0 million, net of $30.1 million of cash acquired.
Cash flows from operating activities decreased by $52.8 million for the year ended December 31, 2012 as compared to the year ended December 31, 2011, principally due to the effect of higher claims paid and cash paid to suppliers and employees by $163.1 million and $39.5 million, respectively, offset in part by higher premiums collections by $195.3 million. The increase in premiums collected is principally the result of the higher Managed Care membership enrollment. The increase in claim payments mostly results from the higher enrollment and increased utilization trends in the Managed Care segment. The 2011 operating cash flows include $50.3 million of net proceeds from the trading portfolio, which was sold during that year.
During the year ended December 31, 2012 we received $39.7 million in policyholder deposits. This represents an increase of $7.9 million when compared to the prior year and is the result of new annuity products that are more attractive to prospective policyholders.
On September 29, 2010 we announced the commencement of a $30.0 million share repurchase program (the “2010 stock repurchase program”). During the year ended December 31, 2012 we paid approximately $2.3 million under the 2010 share repurchase program.
On November 1, 2010, we entered into a $25.0 million arrangement to sell securities under repurchase agreements that matures on November 2015. The repurchase agreement pays interest quarterly at 1.96%. The investment securities underlying such agreements were delivered to the financial institution with whom the agreement was transacted. The dealers may have loaned, or used as collateral such securities in the normal course of business operations. We maintain effective control over the investment securities pledged as collateral and accordingly, such securities continue to be carried on our consolidated balance sheet. At December 31, 2013 investment securities available for sale with fair value of $27.9 million (face value of $27.8 million) were pledged as collateral under this agreement. The proceeds obtained from this agreement were used to repay $25.0 million of the 6.6% notes.
• Unearned premiums - This amount accounts for the premiums collected prior to the end of coverage period and does not represent a future cash outflow. As of December 31, 2013, we had $87.4 million in unearned premiums.
• Policyholder deposits - The cash outflows related to these instruments are not included because they do not have defined maturities, such that the timing of payments and withdrawals is uncertain. There are currently no significant policyholder deposits in paying status. As of December 31, 2013, our policyholder deposits had a carrying amount of $115.9 million.
• Other long-term liabilities - Due to the indeterminate nature of their cash outflows, $83.6 million of other long-term liabilities are not reflected in the following table, including $54.7 million of liability for pension benefits, $20.8 million in deferred tax liabilities, and $8.1 million in liabilities to the Federal Employees’ Health Benefits Plan Program.
(1) As of December 31, 2013, our long-term borrowings consist of our 6.6% senior unsecured notes payable, a $25.0 million arrangement to sell securities under repurchase agreements which requires quarterly interest payments at 1.96%, and loans payable to commercial banks. Total contractual obligations for long-term borrowings include the current maturities of long term debt. For the 6.6% senior unsecured notes and the arrangement to sell securities under repurchase agreements, scheduled interest payments were included in the total contractual obligations for long-term borrowings until the maturity dates of the notes in 2020, and 2015 respectively. We may redeem the senior unsecured note starting five years after issuance; however no redemption is considered in this schedule. The interest payments related to our loans payable were estimated using the interest rate applicable as of December 31, 2013. The actual amount of interest payments of the loan payable will differ from the amount included in this schedule due to the loan’s variable interest rate structure. See the “Financing and Financing Capacity” section for additional information regarding our long-term borrowings.
(3) 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, 2013. 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 $37.6 million of reserves had been ceded at December 31, 2013.
(4) 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, 2013 and are gross of any reinsurance recoverable. The $330.7 million total estimated cash flows for all years in the table is different from the liability of future policy benefits of $304.4 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 2013, 2012 and 2011, the Association distributed the Company a distribution based on the good experience of the business amounting to $1.2 million, $1.2 million and $1.3 million, respectively. In September 2013, the Association declared a special distribution to its members for $200 million. This distribution was subject to a special and unique tax rate of 50%. The property and casualty then received $12.8 million, net of tax, from this distribution.
The property and casualty segment is also member of the Puerto Rico Fire and Allied Lines Underwriting Association and the Puerto Rico Auto Assign Plan. These entities periodically impose assessments to cover operations and other charges. The assessments recorded from these entities were $3 thousand in 2013. No assessments were received in 2012 and 2011.
Claim liabilities by segment as of December 31, 2013 were as follows:
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, 2013 claim liabilities, assuming the indicated hypothetical changes in completion and trend factors:
Management expects that substantially all of the development of the 2013 estimate of medical claims payable will be known during 2014 and that the variance of the total incurred claims on a retrospective basis when compared to reported incurred claims will be similar to the prior years.
• Through the management of our cash flows and investment portfolio.
• In the Commercial business we have the ability to increase the premium rates throughout the year in the monthly renewal process, when renegotiating the premiums for the following contract year of each group as they become due. We consider the actual claims trend of each group when determining the premium rates for the following contract year.
At December 31, 2013, claim liabilities for the life insurance segment amounted to $43.7 million and represented 10.4% of total consolidated claim liabilities and 3.5% of our total consolidated liabilities.
At December 31, 2013, claim liabilities for the property and casualty insurance segment amounted to $93.6 million and represented 22.3% of the total consolidated claim liabilities and 7.4% of our total consolidated liabilities.
At December 31, 2013, the actuarial reserve range determined by the actuaries was from $84 million to $99 million. Management reviews the results of the reserve estimates in order to determine any appropriate adjustments in the recording of reserves. Adjustments to reserve estimates are made after management’s consideration of numerous factors, including but not limited to the magnitude of the difference between the actuarial indication and the recorded reserves, improvement or deterioration of actuarial indications in the period, the maturity of the accident year, trends observed over the recent past and the level of volatility within a particular line of business. In general, changes are made more quickly to more mature accident years and less volatile lines of business. Varying the net expected loss ratio by +/-1% in all lines of business for the six most recent accident years would increase/decrease the claims incurred by approximately $5.8 million.
During the year ended December 31, 2013, we recognized other-than-temporary impairments amounting to $1.0 million on equity securities classified as available for sale that had been in an unrealized loss position for a period longer than six months. During the year ended December 31, 2012, there were no realized losses associated with other-than-temporary impairments, as compared to the $0.3 million recognized in 2011 on fixed income, equity securities and perpetual preferred stocks classified as available for sale. As of December 31, 2013, the investment in securities of $1.3 billion is classified as either available-for-sale or held-to-maturity and consists of high-quality investments. Of this amount, $906.2 million, or 69.6%, are securities in obligations of U.S. government-sponsored enterprises, U.S. Treasury securities, obligations of the Commonwealth of Puerto Rico, municipal securities, obligations of U.S. states and its political subdivisions, mortgage backed and collateralized mortgage obligations that are U.S. agency-backed. The remaining $395.9 million, or 30.4%, are corporate fixed income securities, equity securities and mutual funds. The gross unrealized gains and losses as of December 31, 2013 of the available-for-sale and held-to-maturity portfolios amounted to $90.0 million and $11.8 million, respectively.
The impairment analysis as of December 31, 2013 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 issuer, 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.
For our audited consolidated financial statements as of December 31, 2013 and 2012 and for each of the three years ended December 31, 2013 see Index to financial statements in “Item 15. Exhibits and Financial Statements Schedules” to this Annual Report on Form 10-K.
During the three months ended June 30, 2013, we recorded an out-of-period adjustment that affected our consolidated results of operations of the previous quarter as well as those of our Managed Care segment, related to the recording of incentives to providers. The effect of this out-of-period adjustment in previous periods was that the claims incurred would have increased by $1.9 million during the three months ended March 31, 2013.