We own a seven story (including the basement floor) 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. The properties are subject to liens under our credit facilities. See “Item 7 - Management’s Discussion and Analysis of Financial Condition and Results of Operation - Liquidity and Capital Resources”.
Shareowners holding qualifying shares were excluded from dividend payment. See note 19 of the audited financial consolidated financial statements for the years ended December 31, 2008, 2007 and 2006.
We are the largest managed care company in Puerto Rico in terms of membership, with 50 years of experience in the managed care industry. We offer a broad portfolio of managed care and related products in the Commercial, Commonwealth of Puerto Rico Health Reform (the Reform) and Medicare (including Medicare Advantage and the Part D stand-alone prescription drug plans (PDP)) markets. The Reform is a government of Puerto Rico-funded managed care program for the medically indigent, similar to the Medicaid program in the U.S. We have the exclusive right to use the Blue Shield name and mark throughout Puerto Rico, serve approximately 1.2 million members across all regions of Puerto Rico and hold a leading market position covering approximately 30% of the population. For the years ended December 31, 2008 and 2007 respectively, our managed care segment represented approximately 89.2% and 87.7% of our total consolidated premiums earned, net, and approximately 62.6% and 68.7% of our operating income. We also have significant positions in the life insurance and property and casualty insurance markets. Our life insurance segment had a market share of approximately 11% (in terms of premiums written) as of December 31, 2007. Our property and casualty segment had a market share of approximately 8% (in terms of direct premiums) as of December 31, 2007.
The Commissioner of Insurance of the Commonwealth 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 the Commonwealth 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.
General. Our revenue consists primarily of (i) premium revenue we generate from our managed care business, (ii) administrative service fees we receive for administrative services provided to self-insured employers (ASO), (iii) premiums we generate from our life insurance and property and casualty insurance businesses and (iv) investment income.
Investment Income and Other Income. Investment income consists of interest income and other income consists of net realized gains (losses) on investment securities. See note 2(e) to our audited consolidated financial statements.
The medical loss ratio (MLR), which is calculated by dividing managed care claims incurred by managed care premiums earned, net is one of our primary management tools for measuring these costs and their
Consolidated premiums earned, net and administrative service fees increased by $217.1 million, or 14.5%, to $1.7 billion during the year ended December 31, 2008 compared to the year ended December 31, 2007. This increase was primarily due to an increase in the premiums earned, net in our managed care segment, principally due to a higher volume in the Medicare Advantage business and general increases in premium rates. The administrative service fees of the managed care segment also increased during the 2008 period mostly as the result of an increased member months enrollment that is mainly attributed to the contract for the Reform’s Metro-North region, which began on November 1, 2008 on an ASO basis.
Net Unrealized Loss on Trading Securities and Other Income (Expense), Net
million, as compared to the combined loss of $0.9 million in 2007. This increase is attributable to the net result of the unrealized loss on the trading portfolio, together with a decrease the fair value of the derivative component of our investment in structured notes linked to the Euro Stoxx 50 and Nikkei 225 stock indexes amounting to $4.7 million due to general market conditions. The unrealized loss experienced on trading securities represents a decrease of 36.67% and 35.78% in TSI and 36.82% in STS in the fair value of the portfolio, which is lower than the decrease experienced by the comparable indexes of 37.0% in the S&P 500 Index and 38.44% in the Russell 1000. The change in the fair value of the derivative component of these structured notes is included within other income (expense), net.
The decrease in consolidated income tax expense during the year ended December 31, 2008 is primarily the result of the lower income before tax during the period. The consolidated effective tax rate for the 2008 period reflects an increase of 2.9 percentage points as compared to the 2007 period, from 19.4% in 2007 to 22.3% in 2008, due to a lower taxable income during 2008 as compared to the 2007 period.
Medical premiums earned during 2008 increased by $211.2 million, or 16.2%, to $1.5 billion when compared to earned premiums during 2007. This increase is principally the result of the following:
Medical premiums generated by the Medicare business increased by $183.1 million, or 71.6%, to $438.7 million, primarily due to an increase in member months enrollment of 300,892, or 54.3%, and a change in the mix of products. The increase in member months is the net result of an increase of 310,762, or 74.6%, in the membership of our Medicare Advantage products, mainly in dual eligible members, and a decrease of 9,870, or 7.2%, in the membership of our PDP product.
The medical claims incurred of the Reform business increased by $16.9 million during the 2008 period and its MLR increased by 1.6 percentage points during the year ended December 31, 2008. The higher MLR is primarily the effect of prior period reserve developments and the retroactive premium rate increase received by this business during June 2007 amounting to $2.8 million corresponding to 2006. Excluding the effect of prior period reserve developments in the 2007 and 2008 periods and considering the effect of this retroactive premium rate increase, the MLR actually decreased by 1.5 percentage points during the 2008 period.
Medical premiums generated by the Commercial business increased by $5.5 million, or 0.8%, to $718.7 million during the 2007 period. This increase is primarily the result of an increase in average premium rates of 6.5%, partially offset by a decrease in member months enrollment of 289,007, or 5.5%.
Policy benefits and claims incurred during the year ended December 31, 2008 increased by $1.7 million, or 3.7%, to $47.4 million in 2008. This increase is primarily the result of an increased in claims incurred in the Disability and Cancer lines of business. Despite the higher claim experience, as a result of the increased volume of premiums, the segment experienced a lower loss ratio by 0.3 percentage points, to 51.1%.
The premiums earned generated by the segment increased by $5.5 million, or 6.0%, to $97.4 million during the 2007 period. Premiums earned by GA Life during the month of January 2006 were $6.6 million, which are not reflected in our consolidated financial statements. Eliminating the effect of GA Life’s premiums for the month of January 2006, the premiums earned in the segment decreased by $1.1 million primarily the result of lower sales in the Group Disability and Group Life businesses offset in part by an increase in the premiums of the Individual Life and Cancer businesses.
Policy benefits and claims incurred during the year ended December 31, 2007 increased by $2.1 million, or 4.8%, to $45.7 million in the 2007 period when compared to the 2006 period, principally reflecting the acquisition of GA Life effective January 31, 2006. Policy benefits and claims incurred by GA Life during the month of January 31, 2006, net of the effect of the coinsurance agreement, were $1.0 million. Eliminating the effect of GA Life’s policy benefits and claims incurred for the month of January 2006, this segment presented an increase of $1.1 million. This increase is primarily driven by increases in the benefits of the Cancer and Group Life businesses, as well as to an increase in policy surrenders. These increases were partially offset by decreases in the benefits of the Group Disability and Individual Life businesses. The segment’s loss ratio increased by 1.2 percentage points, from 50.2% in 2006 to 51.4% in the 2007 period, principally as a result of the inclusion of twelve months of GA Life benefits and claims incurred in the 2007 period (as compared to eleven months in 2006) and a higher loss ratio in the cancer business.
Underwriting and other expenses for the segment increased by $1.7 million, or 3.7%, to $47.5 million during the year ended December 31, 2007. Considering the effect of underwriting and other expenses of $1.7 million incurred by GA Life during the month of January 2006, net of the effect of the coinsurance agreement, the underwriting and other expenses of the segment remained flat during the 2007 period. The segment’s operating expense ratio increased by 0.7 percentage points during the year 2007, from 52.7% in 2006 to 53.4% in 2007.
Total premiums written during the year ended December 31, 2008 decreased by $2.9 million, or 1.7%, to $168.0 million. This fluctuation is mostly due to the decrease in the premiums written for the Commercial Auto and inland marine insurance policies amounting to $7.3 million. These decreases were partially offset by increases in the Commercial Multi-Peril and Dwelling insurance policies of $4.4 million. The Commercial products are under soft market conditions reducing premiums and increasing competition for renewals and new business. The Auto insurance products have been affected by lower economic activity in sales and auto loan originations.
Premiums ceded to reinsurers increased by $3.0 million, or 4.3%, to $72.1 million during the year ended December 31, 2008. The ratio of premiums ceded to premiums written increased by 2.5 percentage points, from 40.4% in 2007 to 42.9% in 2008, primarily due to the effect of non-proportional reinsurance treaties in relation to the level of premiums written as well as to the mix of business. The cost of non-proportional treaties is negotiated for the whole year based on expected premium volume; however, since volume for the year was lower than expected, the cost of reinsurance as a percentage of premiums was higher.
The change in unearned premiums presented a decrease of $2.8 million when compared to the prior year as the result of the lower volume of business written during the period.
The increase in the other sources of cash of $18.3 million is attributed to a higher balance in outstanding checks over bank balances in 2008.
Net acquisitions of investment securities increased by $179.6 million during the year ended December 31, 2008, principally as the result of acquisitions of available for sale securities mainly in our managed care segment and the effect of purchases of investments with trade date in December 2007 and a settlement date in January 2008, amounting to $117.5 million.
Capital expenditures increased by $13.0 million as a result of the capitalization of costs related to the new systems initiative in our managed care segment.
Cash provided by operating activities increased by $40.3 million, or 53.3%, to $115.9 million for the year ended December 31, 2007, principally due to the net effect of an increase of $14.2 million in net proceeds received from the sale of trading securities, a reduction in claims paid of $54.4 million, a reduction in cash paid to suppliers and employees of $8.6 million, partially offset by a reduction in premiums collected of $16.2 million. These fluctuations were impacted by the termination of the contract for the Metro-North region of our managed care segment. In addition, in 2007 there was an increase of $23.1 million in the amount of income taxes paid that is the result of the higher taxable income in 2007 of our managed care subsidiary, which has a higher effective tax rate than the other segments.
Proceeds from long-term borrowings amounted to $35.0 million during 2006 as a result of the issuance and sale of our 6.7% senior unsecured notes during the first quarter of 2006, which were used for the acquisition of GA Life.
On January 31, 2006, we acquired GA Life at a cost of $27.8 million, net of $10.4 million of cash acquired.
As of December 31, 2008, we had the following senior unsecured notes payable:
The 6.3% notes, the 6.6% notes and the 6.7% notes contain certain covenants. At December 31, 2008, we and our managed care subsidiary, as applicable, are in compliance with these covenants.
In addition, as of December 31, 2008 we are a party to a secured term loan with a commercial bank, FirstBank Puerto Rico. This secured loan bears interest at a rate equal to the London Interbank Offered Rate (LIBOR) plus 100 basis points and requires monthly principal repayment of $0.1 million. As of December 31, 2008, this secured loan had an outstanding balance of $24.3 million and an average annual interest rate of 2.4%.
This secured loan is guaranteed by a first lien on our land, buildings and substantially all leasehold improvements, as collateral for the term of the agreements under a continuing general security agreement. This secured loan contains certain covenants which are customary for this type of facility, including, but not limited to, restrictions on the granting of certain liens, limitations on acquisitions and limitations on changes in control. As of December 31, 2008, we are in compliance with these covenants. Failure to meet these covenants may trigger the accelerated payment of the secured loan’s outstanding balances. Principal repayments on this loan are expected to be paid out from our operating and investing cash flows.
During 2005, our managed care business began a project to change a significant part of its operations computer system. This project is expected to be carried out in phases until 2012 at a cost of approximately $64.0 million. Our managed care business expects to incur costs of approximately $26 million during 2008. We estimate that $17 million of the costs expected to be incurred in 2009 will be capitalized over the system’s useful life and the remaining amount will be expensed. This amount is expected to be paid out of the operating cash flows of our managed care business.
As of December 31, 2008, our long-term borrowings consist of our managed care subsidiary’s 6.3% senior unsecured notes payable (which are unconditionally guaranteed as to payment of principal, premium, if any, and interest by us), our 6.6% senior unsecured notes payable, our 6.7% senior unsecured notes payable, and a loan payable to a commercial bank. Total contractual obligations for long-term borrowings include the current maturities of long term debt. For the 6.3%, 6.6% and 6.7% senior unsecured notes, scheduled interest payments were included in the total contractual obligations for long-term borrowings until the maturity dates of the notes in 2019, 2020, and 2021, respectively. We may redeem the notes starting five years after issuance; however no redemption is considered in this schedule. The interest payments related to our loan payable were estimated using the interest rate applicable as of December 31, 2008. The actual amount of interest payments of the loans payable will differ from the amount included in this schedule due to the loans’ variable interest rate structure. 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, 2008. 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 $30.4 million of reserves had been ceded at December 31, 2008.
To monitor the solvency of the operations, the BCBSA requires us and our managed care subsidiary 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, 2008, both we and our managed care subsidiary’s estimated RBC ratio were above the 200% of our RBC required by the BCBSA and the 375% of our RBC level required by the BCBSA to avoid monitoring.
To operate in Puerto Rico, insurance companies, such as our insurance subsidiaries, are required to participate in guarantee associations, which are organized to pay policyholders contractual benefits on behalf of insurers declared to be insolvent. These associations levy assessments, up to prescribed limits, on a proportional basis, to all member insurers in the line of business in which the insolvent insurer was engaged. During the years ended December 31, 2008 and 2007, no assessment or payment was made in connection with insurance companies declared insolvent. During 2006, we paid assessments in connection with insurance companies declared insolvent in the amount of $1.0 million. It is the opinion of management that any possible future guarantee association assessments will not have a material effect on our operating results and/or cash flows, although there is no ceiling on these payment obligations.
Pursuant to the Puerto Rico Insurance Code, our property and casualty insurance subsidiary is a member of Sindicato de Aseguradores para la Suscripción Conjunta de Seguros de Responsabilidad Profesional Médico-Hospitalaria (SIMED) and of the Sindicato de Aseguradores de Responsabilidad Profesional para Médicos. Both syndicates were organized for the purpose of underwriting medical-hospital professional liability insurance. As a member, the property and casualty insurance segment shares risks with other member companies and, accordingly, is contingently liable in the event the previously mentioned syndicates cannot meet their obligations. During 2008, 2007 and 2006, no assessment or payment was made for this contingency. It is the opinion of management that any possible future syndicate assessments will not have a material effect on our operating results and/or cash flows, although there is no ceiling on these payment obligations.
In addition, pursuant to Article 12 of Rule LXIX of the Insurance Code, 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 2008, 2007 and 2006, the Association distributed a dividend based on the good experience of the business amounting to $1.1 million, $1.0 million and $0.8 million, respectively.
accompanying notes. Such estimates and assumptions could change in the future as more information is known. Actual results could differ materially from those estimates.
Claim liabilities as of December 31, 2008 by segment were as follows:
The liability for estimated unreported losses is the amount needed to provide for the estimated ultimate cost of settling those claims related to insured events that have occurred but have not been reported to us.
Management regularly reviews its assumptions regarding claim liabilities and makes adjustments to claims incurred when necessary. If management’s assumptions regarding cost trends and utilization are significantly different than actual results, our statement of earning and financial position could be impacted in future periods. Changes to prior year estimates may result in an increase in claims incurred or a reduction of claims incurred in the period the change is made. Further, due to the considerable variability of health care costs, adjustments to claims liabilities are made in each period and are sometimes significant as compared to the net income recorded in that period. Prior year development of claim liabilities is recognized immediately upon the actuary’s judgment that a portion of the prior year liability is no longer needed or that an additional liability should have been accrued. Health care trends are monitored in conjunction with the claim reserve analysis. Based on these analyses, rating trends are adjusted to anticipate future changes in health care cost or utilization. Thus, the managed care segment incorporated those trends as part of the development of premium rates in an effort to keep premium rating trends in line with claims trends.
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, 2008 claim liabilities, assuming the indicated hypothetical changes in completion and trend factors:
Management expects that substantially all of the development of the 2008 estimate of medical claims payable will be known during 2009 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.
At December 31, 2008, claim liabilities for the property and casualty insurance segment amounted to $81.9 million and represented 25.3% of the total consolidated claim liabilities and 7.7% of our total consolidated liabilities.
At December 31, 2008, the actuarial reserve range determined by the actuaries was from $79.2 million to $89.7 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 $5.3 million.
The schedules of amortization of life insurance deferred policy acquisition costs (DPAC) and VOBA are based upon actuarial assumptions regarding future events that are uncertain. For all products, other than universal life and deferred annuities, the most significant of these assumptions is the level of contract persistency and investment yield rates. For these products according to FASB No. 60 the basis for the amortization of DPAC and VOBA is established at the issue of each contract and would only change if our segment’s experience deteriorates to the point that the level of the liability is not adequate. We do not currently expect that level of deterioration to occur. For the universal life and deferred annuity products, amortization schedules are based upon the level of historic and anticipated gross profit margins, from the date of each contract’s issued (or purchase, in the case of VOBA). These schedules are based upon several actuarial assumptions that are uncertain, are reviewed annually and are modified if necessary. The most significant of these assumptions are anticipated universal life claims, investment yield rates and contract persistency. Based upon the most recent actuarial reviews of all of the assumptions, we do not currently anticipate material changes to the level of these amortization schedules.
The managed care and property and casualty business acquisition costs consist of commissions incurred during the production of business and are deferred and amortized ratably over the terms of the policies.
Impairment of an investment exists if a decline in the estimated fair value is below the amortized cost of the security. When this happens, an evaluation of whether that impairment is other than temporary is necessary. This evaluation is subjective and requires a high degree of judgment. Management regularly reviews each investment security for impairment based on criteria that include the extent to which cost exceeds estimated fair value, general market conditions (like changes in interest rates), our ability and intent to hold the security until recovery in estimated fair value, the duration of the estimated fair value decline and the financial condition and specific prospects for the issuer. Management regularly performs market research and monitors market conditions to evaluate impairment risk. A decline in the estimated fair value of any available-for-sale or held-to-maturity security below cost, which is deemed to be other than temporary, results in a reduction of the carrying amount to its fair value. The impairment is charged to operations when that determination is made and a new cost basis for the security is established.
During the years ended December 31, 2008, 2007 and 2006 we recognized other-than-temporary impairments amounting to $16.5 million, $1.1 million and $2.1 million, respectively, on equity securities and perpetual preferred stocks classified as available for sale. As of December 31, 2008, of the total amount of investments in securities of $1,010.3 million, $32.2 million, or 3.2%, are classified as trading securities, and thus are recorded at fair value with changes in estimated fair value recognized in the statement of operations. The remaining $978.1 million is classified as either available-for-sale or held-to-maturity and consists of high-quality investments. Of this amount, $805.0 million, or 82.3%, 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
For our audited consolidated financial statements as of December 31, 2008 and 2007 and for the three years ended December 31, 2008 see Index to financial statements in “Item 15 - Exhibits and Financial Statement Schedules” to this Annual Report on Form 10-K.
For the selected unaudited quarterly financial data corresponding to the years 2008 and 2007, see note 28 of the audited consolidated financial statements as of December 31, 2008 and 2007 and for the three years ended December 31, 2008.