The Corporation believes that its facilities are in good condition and that the facilities, together with anticipated capital improvements and additions, are adequate to meet its operating needs for the foreseeable future. The need for expansion and upgrading and refurbishment of facilities is continually evaluated in order to remain competitive and to take advantage of market opportunities.
(1) Financial figures for this year are for TSM's predecessor company, SSS.
The analysis in this section is included to provide an overall view of certain information, the consolidated statements of operations, and key financial information. Further details of the results of operations of each reportable segment are included in the respective segment's section.
- The premiums earned, net and fee revenue corresponding to the Health Insurance - Commercial Program reflect an increase of $41.0 million, or 6.4%, during this period. Increases in premium rates as well as a net increase in the average enrollment account for the increase in the segment's earned premiums net, and fee revenue.
- The premiums earned corresponding to the Health Insurance - Healthcare Reform segment increased by $32.1 million, or 7.1%, during this period. This increase is basically the result of increases in premium rates,
- The premiums earned of the property and casualty insurance segment increased by $6.4 million, or 11.7%, during the year 2002. This increase is mostly the result of increases in premium rates due to the deregulation of the commercial property and liability lines of business and to the segment's increased volume of business.
The unrealized loss on trading securities of $8.3 and $3.6 million for the years 2002 and 2001, respectively, are related to investments held by the Health Insurance - Commercial Program, Health Insurance - Healthcare Reform and the Property and Casualty Insurance segments. This unrealized loss is mostly attributed to losses in the portfolios held by such segments in equity holdings that replicate the Standard & Poor's 500 Index (S&P 500 Index). This Index experienced a negative return in 2002 and 2001. These segments plan to continue their long-term strategy of passive management and diversification since historically, performance of these types of investments has outperformed other financial instruments.
The consolidated income tax expense for the year ended December 31, 2002 increased by $1.2 million when compared to the same amount for the prior year. This increase is mostly noted in the income tax expense of the property and casualty insurance segment, which reflect an increase of $685 thousand during the year 2002 that is attributed to the segment's increased volume of business and profitability.
- The premiums earned of the remaining segments increased by $2.7 million, or 4.1%, during this period.
The consolidated net investment income for 2001 increased by $1.1 million or 4.4% when compared to that for the year 2000. This increase is mostly due to a higher average investment balance during the year 2001, partially offset by a reduction on the average interest yield of the fixed income portfolio.
The consolidated realized gain on sale of securities of $4.7 million is the result of the sound and timely management of the investment portfolio in accordance with corporate investment policies and from normal portfolio turnover of the trading and available-for-sale securities. This consolidated realized gain during the year 2001 is mostly due to the sale of common stocks of Popular, Inc., which generated a realized gain of approximately $2.3 million and also to normal portfolio turnover of the trading and available for sale securities.
The unrealized loss on trading securities of $3.6 million are related to investments held by the Health Insurance - Commercial Program, Health Insurance - - Healthcare Reform and the Property and Casualty Insurance segments. This unrealized loss is attributed to losses in certain portfolios held by such segments in equity holdings that replicate the Standard & Poor's 500 Index (S&P 500 Index). This Index experienced a negative return in 2001 and 2000. These segments plan to continue their long-term strategy of passive management and diversification since historically, performance of these types of investments has outperformed other financial instruments.
The Health Insurance - Commercial Program segment's total revenues are primarily generated from premiums earned for risk-based healthcare services provided to its members, revenues generated from self-funded arrangements, and investment income. Claims incurred include healthcare services and other benefit expenses consisting primarily of payments to physicians, hospital and other service providers. A portion of the claims incurred for each period consists of an actuarial estimate of claims incurred but not reported to the segment during the period. Administrative expenses
This segment has a well-diversified investment portfolio with good asset quality and a large portion invested in investment-grade, fixed income securities. The segment's investment portfolio is predominantly held in U.S. Treasury securities, obligations of the U.S. and P.R. government instrumentalities and obligations of state and political subdivisions, which comprise over 60% of the total portfolio value as of December 31, 2002. The remaining investment portfolio consists of an equity securities portfolio that replicates the S&P 500 Index, a corporate bonds portfolio, and investments in strong local stocks of financial institutions. Due to market price appreciation, the segment has a large single issuer equity concentration in Popular, Inc., which is the holding company of Banco Popular de Puerto Rico, the largest local commercial bank in Puerto Rico. As of December 31, 2002 and 2001, the carrying value of the Corporation's investment in Popular, Inc. amounted to $25.8 million and $22.2 million, respectively. This investment represents 11.6% for the year 2002 and 11.4% for the year 2001 of the segments' total investments.
- This segment has been successful in monitoring premium rates, particularly in the rated Corporate Accounts business, assuring adequate premium rates that reflect actual claims experience.
- The segment's enrollment increased by 3,245 members, or 0.5%, when comparing the average enrollment as December 31, 2002 with the average enrollment as of December 31, 2001. This increment is mostly reflected in the Individual Accounts, Self-funded Employers and Local Government Employees membership, where average enrollment increased by 5,231, or 6.8%, 4,814, or 4.1%, and 1,832, or 4.4%, during the year, respectively. The average enrollment of the Corporate Accounts groups decreased by 8,812 members, or 2.7%, during the year 2002.
- In addition, the segment continues with cost containment measures that have allowed cost and utilization trends to maintain levels consistent with pricing and margin objectives. These cost containment initiatives have caused some utilization indicators to exhibit a downward trend.
- Total enrollment increased by 8,675 members or 1.4% during the year 2001. This increase is mostly attributed to the increase in membership observed in the Individual Accounts of 7,303 members or 10.0%.
Approximately 81.5% of the total premiums increase is attributed to increases in premium rates, while the remaining 18.5% is attributed to increases in membership.
Claims incurred increased by $29.6 million or 5.6% when compared to 2000. This increase is due to the net effect of the increase in membership net of a decrease in loss ratio of 2.3 percentage points during the year 2001. The improvement in the loss ratio is the result of better premium pricing and cost containment measures for claims. As a result of the segment's cost containment initiatives, cost and utilization trends have been maintained at levels consistent with pricing and margin objectives. Due to the various initiatives, average length of hospital stays and emergency room visits continue to exhibit a downward trend. In addition, the implementation of certain pharmacy programs maintained the pharmacy cost trends at single digit numbers during 2001. For additional details of claims costs containment measures see Item 1 in the section "Health Insurance Commercial Program Segment".
The expense ratio for 2001 remained at the same level as the year 2000 levels. The amount of operating expenses increased by $5.8 million, or 7.4%, during the year 2001. This increase is mostly attributed to increases in normal costs incurred in the acquisition of new business, such as marketing and commission expenses, expenses related to compliance with the federal HIPAA, and in payroll and payroll related expenses. The expense ratio for the year 2001 decreased by 0.2 percentage points when compared to the expense ratio of the year 2000.
Premiums earned, net of the Healthcare Reform segment for the year 2002 increased by $32.1 million, or 7.1%, when compared to the year 2001. This increase is the result of the following:
- The average enrollment for this segment reflects an increase of 40,668 members when comparing to the average enrollment for the year 2001. This increase is due to the net effect of the following: the acquisition of the Southwest Area effective October 1, 2001, the merger of six (6) new municipalities into existing areas effective July 1, 2002 and the loss of the Northwest Area, which municipalities were merged into the West Area (served by another carrier) effective July 1, 2002.
Claims incurred during the year 2002 increased by $24.1 million, or 5.7%, when compared to the claims incurred during the year 2001. The increase is attributed to the increase in volume of business, net of the exclusion of mental health services and substance abuse benefits from the coverage of the policy. During the year ended 2002, the loss ratio decreased when compared with the year 2001, as a result of the increase in premiums rates, as well as to a reduction in the coverage of the Healthcare Reform policy.
- New premium rates were negotiated effective October 1, 2001 for a nine-month period ending on June 30, 2002.
- Effective October 1, 2001, the Government of Puerto Rico excluded mental health and substance abuse benefits from the coverage offered in the policy. The exclusion of the mental health and substance abuse benefits from the coverage of the Healthcare Reform insurance policy represented a decrease of approximately $9.0 million in premiums earned during 2001. These services will continue to be directly contracted by the Government with specialized mental health service providers.
Year ended December 31, 2002 compared with the year ended December 31, 2001
Total premiums written for the year ended December 31, 2002 increased by $15.5 million, or 16.0%, when compared to the year 2001. This increase is reflected in the premiums written for the following lines of business:
- The commercial multiple peril line accounted for the principal increase in premiums volume, increasing by $7.6 million, or 18.6%, during the year 2002. This increase is due to increases in premium rates as a result of the commercial lines deregulation. Also, during the year 2002 the segment subscribed new business with higher average premium rates that substituted other accounts with average premium rates below desired levels. As in the previous years, the increase in average premium rates of the commercial business is the primary contributor to the fluctuation experienced in total premiums written.
- STS has increased its retention of the commercial property portfolio. The increased retention, which decreases the amounts or premiums ceded to reinsurers, allows the segment to keep more premiums on profitable business.
- An increase of over 30% in catastrophe reinsurance costs due to recent worldwide catastrophes.
- Acquisition of additional catastrophe protection as a result of a shortfall on the property first surplus treaty.
During the year ended December 31, 2002 the property and casualty segment loss ratio decreased by 2.9 percentage points as compared to the loss ratio for the year 2001. This decrease is mostly the result of favorable underwriting results in the commercial multiperil line of business (resulting from increases in premium rates as a consequence of deregulation) and an increased retention of the segment's profitable lines of business, which has increased the premiums earned base. Also, the professional liability line experienced an improvement in its loss ratio as a result of premium rate increases of approximately 60% (which were effective April 2001) and strict adherence to underwriting practices and reinsurance constraints. In addition, the loss ratio of the auto physical damage line of business shows a decrease of 7.8 percentage points, mostly due to the net effect of increased premium rates and reserve releases.
- Premiums written in the commercial multiple peril line increased by $9.9 million, or 32.0%, during the year 2001. This increase in volume is due to STS' efforts to establish itself as the island's leader in the commercial package business.
- Premiums written in the professional liability line increased by $1.4 million, or 34.2%, during the year 2001. This is the result of rate increases of 59.9% for physicians and surgeons and 85.6% for hospitals. These increases were effective April 1, 2001.
Premiums ceded to reinsurers during 2001 increased by $8.4 million or 26.9% when compared to 2000. This increase is due to the effect of the following:
- Most of the increase in premiums ceded is concentrated in catastrophe reinsurance premiums and attributed to recent worldwide catastrophes, which influence the global condition on the cost and availability of catastrophe coverage. In STS this situation resulted in an increase in catastrophe coverage costs of 44% in the 2002 treaty renewal, which is expected to be recovered through an average increase in property risks rates of approximately 35% and a reduction in acquisition costs.
SVTS segment has a well-diversified investment portfolio with good asset quality and a large portion invested in investment-grade, fixed income securities. The segment's investment portfolio is predominantly held in U.S. Treasury securities, obligations of U.S. government instrumentalities and obligations of state and political subdivisions, which comprise over 91% of the total portfolio value as of December 31, 2002. The remaining investment portfolio consists of investments in strong local stocks from financially sound financial institutions. The segment has a large single issuer equity concentration in Popular, Inc. As of December 31, 2002 and 2001, the carrying value of the Corporation's investment in Popular, Inc. amounted to $1.7 million and $2.2 million, respectively. This investment represents 4.6% for the year 2002 and 5.3% for the year 2001 of the segment's total investments.
Premiums ceded to reinsurers during the year 2002 increased by $1.3 million or 24.8%. This increase is directly related to the increase in volume of business of the segment. The ratio of premiums ceded to earned premiums during 2002 increased from 28.7% in 2001 to 30.8% in 2002. This is mainly due to the product mix of subscribed business in the year. In 2002, more new business was subscribed in disability lines where the company retains 25% of the risk as compare to group life where the company retains 70% of the risk.
Claims incurred increased by $819 thousand or 11.8% when compared to 2001 mainly due to the increase in volume. The segment's loss ratio and administrative expense ratio remains constant when compared to 2001, due to favorable experience in all lines of business and cost control measures in place.
Premiums ceded to reinsurers during the year 2001 increased by $607 thousand, or 13.3%. This increase is directly related to the increase in volume of business of the segment. The ratio of premiums ceded to earned premiums during 2001 was consistent with the ratio for 2000. The premiums ceded to earned premiums' ratio were 28.7% for 2001 and 29.2% for 2000.
The expense ratio for the year 2001 reflects an increase of 1.2 percentage points when compared to the year 2000. This increase is the result of increased commission expense attributed to the increase in volume of business observed during the year and to the overall increase in payroll and payroll related expenses.
The Corporation maintains good liquidity measures due to the quality of its assets, the predictability of its liabilities, and the duration of its contracts. The liquidity of the Corporation is primarily derived from the operating cash flows of its insurance subsidiaries.
As of December 31, 2002 and 2001, the Corporation's cash and cash equivalents amounted to $82.8 million and $81.0 million, respectively. Sources of funds considered in meeting the objectives of the Corporation's operations include cash provided from operations, maturities and sales of securities classified within the trading and available-for-sale portfolios, securities sold under repurchase agreements, and issuance of long and short-term debt.
Most of the cash flows from operating activities are generated from the insurance subsidiaries. The basic components of the cash flows from operations are premium collections, claims payments less reinsurance premiums, and payment of operating expenses.
Net cash flows provided by operating activities amounted to $56.8 million, $69.4 million and $7.4 million as of December 31, 2002, 2001 and 2000, respectively, a decrease of $12.6 million in 2002 and an increase $62.0 in 2001. The fluctuation in cash flows provided by operating activities is mainly attributed to the net effect of the following:
- Increase in collections of premiums of $74.0 million in 2002 and $65.9 million in 2001. The increase in premium collections is the result of the increased volume of business and increased premium rates of the operating segments.
- Increase of $6.3 million in 2002 and $15.9 million in 2001 in the amount of cash paid to suppliers and employees. The amount of cash paid to suppliers and employees increased mainly as a result of additional expenses generated from the acquisition of new business.
Net cash flows used in investing activities amounted to $43.5 million, $24.8 million and $7.4 million as of December 31, 2002, 2001 and 2000, respectively. The cash flows used in investing activities during 2002 and 2001 is mainly due to the investment of the excess cash generated from the operations and reinvestment of securities called or matured during the years 2002 and 2001. Total acquisition of investments exceeded the proceeds from investments sold or matured by $38.3 million and $18.8 million during the years 2002 and 2001, respectively.
- The payments of long-term debt increased by $3.2 million and $113 thousand during the years 2002 and 2001, respectively. This increase during the year 2002 is due to additional payments made during the year over the scheduled principal payments of the credit agreements. Scheduled principal repayments for 2003 amount to $1.6 million. Principal repayments are expected to be paid out of the Corporation's cash flows from operations.
- During the year 2002, the amount of net surrenders of individual retirement accounts experienced an increase of $829 thousand. This fluctuation in the net surrenders of individual retirement accounts is attributed to the aggressive competition in the market for this product in Puerto Rico.
The Corporation has significant short-term liquidity supporting its businesses. It also has available short-term borrowings from time to time to address timing differences between cash receipts and disbursements. These short-term borrowings are mostly in the form of securities sold under repurchase agreements. As of December 31, 2002, the Corporation had $81 million in available credit on these agreements, although there is no balance due as of that date.
In addition, during 1999 the Corporation entered into two credit agreements with a commercial bank, FirstBank Puerto Rico. These credit agreements bear interest rates determined by the London Interbank Offered Rate (LIBOR) plus a margin specified by the commercial bank at the time of the agreement. As of December 31, 2002, the two credit agreements have an outstanding balance of $34.0 million and $16.0 million and an average annual interest rate of 4.47% and 3.26%, respectively. During 2001, the Corporation amended the $19.0 million credit agreement to extend its maturity date and to restructure its repayment schedule, which was originally due in August 31, 2001. The amended agreement stipulates repayments of principal amounts of not less than $250 thousand and in integral multiples of $50 thousand. The aggregate principal amounts of this credit agreement, as amended, shall be reduced annually to the amounts on or before the dates described below:
These credit agreements contain several restrictive covenants, including, but not limited to, restrictions to incur in additional indebtedness and the granting of certain liens, limitations on acquisitions and limitations on changes in control. As of December 31, 2002, management believes the Corporation is in compliance with these covenants. Failure to meet these covenants may trigger the accelerated payment of the credit agreements' outstanding balance. Principal repayments on these loans are expected to be paid out of the operating and investment cash flows of the Corporation.
The maturity schedule of the Corporation's other commercial commitments as of December 31, 2002 is as follows:
As of December 31, 2002, $682 thousand of deferred loss on the derivative instrument was included within the accounts payable and accrued liabilities in the consolidated balance through a charge to accumulated other comprehensive income. No derivative instrument was held by the Corporation as of December 31, 2001.
In the event that the stockholders decide to operate as a for-profit organization and the Board of Directors decides to pay dividends, the amount that could be available for distribution would exclude TSI's operating reserve and the capital contributions made by TSI to its former subsidiaries before the corporate reorganization, due to TSI's tax exemption. This fact was reaffirmed by a letter issued by the Department of Treasury on July 3, 2001.
The credit agreements with a commercial bank restrict the amount of dividends that TSM and its subsidiaries can declare or pay to stockholders. According to the credit agreements, the dividend payment cannot exceed the accumulated retained earnings of the paying entity.
None of the previously described dividend restrictions are expected to have a significant effect on TSM's ability to meet its cash obligations.
To monitor the solvency of the operations, the Blue Cross and Blue Shield Association (BCBSA) requires TSM and TSI to comply with certain specified levels of Risk Based Capital (RBC). RBC is designed to identify weakly capitalized companies by comparing each company's adjusted surplus to its required surplus (RBC ratio). The RBC ratio reflects the risk profile of insurance companies. At December 31, 2002, both entities had a RBC ratio above the level required by BCBSA.
(1) Legal Proceedings - Various litigation claims and assessments against the Corporation have arisen in the course of the Corporation's business, including but not limited to, its activities as an insurer and employer. Further, the Commissioner of Insurance of the Commonwealth of Puerto Rico, as well as other Federal and Puerto Rico government authorities regularly make inquiries and conduct audits concerning the Corporation's compliance with applicable insurance and other laws and regulations.
The Corporation recognizes claim liabilities for all its insurance subsidiaries as follows:
Claim liabilities amounted to $244.6 million as of December 31, 2002; of that total, $103.1 million are related to unreported losses and $13.6 million are related to unpaid loss-adjustment expenses. The remaining balance corresponds to claims processed and incomplete.
The Corporation has other significant accounting policies that do not involve the same degree of measurement uncertainty as those discussed above, that are nevertheless important to an understanding of the financial statements. These significant accounting policies are disclosed in note 2 of the notes to the audited consolidated financial statements.
In June 2001, FASB issued SFAS No. 143, Accounting for Asset Retirement Obligations. SFAS No. 143 requires the Company to record the fair value of an asset retirement obligation as a liability in the period in which it incurs a legal obligation associated with the retirement of tangible long-lived assets that result from the acquisition, construction, development, and/or normal use of the assets. The Company also records a corresponding asset which is depreciated over the life of the asset. Subsequent to the initial measurement of the asset retirement obligation, the obligation will be adjusted at the end of each period to reflect the passage of time and changes in the estimated future cash flows underlying the obligation. The Company is required to adopt SFAS No. 143 on January 1, 2003. The adoption of SFAS No. 143 is not expected to have a material effect on the Company's financial statements.
In January 2003, the FASB issued Interpretation No. 46, Consolidation of Variable Interest Entities, an interpretation of ARB No. 51. This interpretation addresses the consolidation by business enterprises of variable interest entities as defined in the interpretation. The interpretation applies immediately to variable interests in variable interest entities created after January 31, 2003, and to variable interests in variable interest entities obtained after January 31, 2003. For public enterprises with a variable interest in a variable interest entity created before February 1, 2003, the interpretation applies to that enterprise no later than the beginning of the first interim or annual reporting period beginning after June 15, 2003. The application of this interpretation is not expected to have a material effect on the Company's financial statements. The interpretation requires certain disclosures in financial statements issued after January 31, 2003 if it is reasonably possible that the Company will consolidate or disclose information about variable interest entities when the interpretation becomes effective.
For the consolidated financial statements as of December 31, 2002, 2001 and 2000, see Index to financial statements in "Item 15. Exhibits, Financial Statement Schedules, and Reports on Form 8-K" to this Form 10-K.
(1) Further details on the calculation of basic earnings per share are set forth in notes 2 and 22 to the audited consolidated financial statements for the years ended December 31, 2002, 2001 and 2000.