Further details of the calculation of basic and diluted earnings per share are set forth in Notes 2 and 21 of the audited consolidated financial statements for the years ended December 31, 2017, 2016 and 2015.
This financial discussion contains an analysis of our consolidated financial position and financial performance as of December 31, 2017 and 2016, and consolidated results of operations for 2017, 2016 and 2015. 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.
We participate in the life insurance market through our subsidiary, TSV, and in the property and casualty insurance market through our subsidiary, TSP.
Consolidated claims for the year were $2.4 billion, down 4.8% over last year, primarily reflecting lower Managed Care membership, the ongoing improvement in our managed care operations, and the estimated decrease in the utilization of Managed Care services caused by Hurricanes Irma and Maria in September 2017. These decreases were offset in part by the estimated $14.8 million net retained losses incurred by the Property and Casualty segment caused by the aforementioned Hurricanes. The consolidated loss ratio was down 230 basis points, to 83.2%, and the Medical Loss Ratio (“MLR”) decreased 300 basis points, to 85.6%.
Intersegment revenues and expenses are reported on a gross basis in each of the operating segments but eliminated in the consolidated results. Except as otherwise indicated, the numbers presented in this Annual Report on Form 10-K do not reflect intersegment eliminations. These intersegment revenues and expenses affect the amounts reported on the financial statement line items for each segment, but are eliminated in consolidation and do not change net income. The following table shows premiums earned, net and net fee revenue and operating income for each segment, as well as the intersegment premiums earned, service revenues and other intersegment transactions, which are eliminated in the consolidated results:
Premium Revenue. Our revenue primarily consists of premiums earned from the sale of managed care products to the Commercial, Medicare Advantage and Medicaid sectors. We receive a monthly payment from or on behalf of each member enrolled in our managed care plans (excluding ASO). We recognize all premium revenue in our managed care business during the month in which we are obligated to provide services to an enrolled member. Premiums we receive in advance of that date are recorded as unearned premiums.
Commercial membership includes corporate accounts, self-funded employers, individual accounts, Medicare Supplement, federal government employees and local government employees.
The following table sets forth our consolidated operating results for the years ended December 31, 2017, 2016 and 2015. Further details of the results of operations of each reportable segment are included in the analysis of operating results for the respective segments.
Premiums earned, net decreased by $63.7 million, or 2.2%, to $2.8 billion. This decrease primarily reflects lower premiums in the Managed Care segment by $58.5 million mainly due to lower membership in the segment’s Medicaid and Commercial businesses, the impact of the suspension of the HIP fee pass through, and lower Medicare additional risk score revenue. These decreases were partially offset by higher average premium rates in the Commercial and Medicaid businesses as well as by higher Medicare membership. Property and Casualty premiums decreased by $10.7 million year over year, mostly reflecting the $9.2 million estimated catastrophe reinsurance reinstatement costs following the impact of Hurricanes Irma and Maria in September 2017.
Net investment income increased $2.7 million, or 5.5%, to $51.6 million mostly as a result of higher invested balances.
Administrative service fees decreased $26.8 million, or 60.0%, mostly as a result of the previously mentioned change in the Medicaid contract model. Total administrative fees related to the previous Medicaid ASO agreement during the 2015 period amounted to $24.3 million.
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 Medicaid business decreased by $31.8 million to $751.4 million. This decrease primarily reflects lower fully-insured member months enrollment by approximately 198,400 lives, $10.8 million related to the suspension of the HIP fee pass-through as a result of the 2017 moratorium and, the impact of the 2.5% excess profit accrual that increased 2016 premiums by $10.9 million. Decreases are partially offset by a $12.2 million increase in premium collections related to our compliance with the contract’s quality incentive metrics and the impact of the new premium rates that were effective July 1st 2017, which increased average premium rates by approximately 9%.
The medical claims incurred of the Medicaid business decreased by $18.2 million, or 2.6%, during the 2017 period and its MLR increased by 140 basis points, to 91.5%. Adjusting for the effect of prior period reserve developments in 2017 and 2016, as well as for the impact of the 2.5% excess profit accrual and this year’s quality incentive premiums, the Medicaid MLR would have been approximately 91.8%, about 180 basis points higher than last year. The higher MLR primarily reflects increased pharmacy and outpatient claim trends, partially offset by the estimated decrease in utilization caused by Hurricanes Irma and Maria, which lowered the adjusted MLR by 30 basis points, and the impact of the higher premium rates that were effective July 1st 2017.
Medical operating expenses decreased by $20.4 million, or 5.4%, to $354.9 million. The operating expense ratio decreased by 50 basis points to 13.6% in 2017. The lower operating expenses and expense ratio are mostly the result of the decrease in the HIP Fee of $44.2 million due to the 2017 moratorium offset by increase in personnel costs, professional services and business promotion expenses totaling approximately $28.1 million.
Medical premiums earned increased by $99.0 million, or 3.9%, to $2.6 billion. This increase is principally the result of the following:
Medical claims incurred increased by $150.8 million, or 6.9%, to $2.3 billion. The MLR of the segment increased 240 basis points during the 2016 period, to 88.6%. These fluctuations are primarily attributed to the net effect of the following:
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 prior 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.
Premiums earned, net increased by $8.8 million, or 5.9% to $156.9 million, reflecting improved policy retention and higher sales in the segment’s Individual Life and Cancer lines of business of $4.0 million and $2.7 million, respectively, as well as growth in the Costa Rica operations.
Underwriting and other expenses increased by $3.4 million, or 4.9%, primarily reflecting an increase in commissions expense following the segment’s premium growth mentioned above. In addition, the segment has incurred in higher development and marketing expenses related to the development of the Costa Rica operations. The segment’s operating expense ratio decreased 50 basis points to 46.8% in 2016, reflecting the increase in premiums during the period.
Total premiums written increased by $10.7 million, or 8.0%, to $143.8 million, driven by higher sales of Commercial property and Commercial liability products, mainly as a result of the acquisition of a large account, as well as to higher sales of Personal package products.
The change in unearned premiums mostly reflects the segments higher premiums written in 2017.
Claims incurred increased by $10.0 million, or 24.5%, to $50.8 million mostly driven by $14.8 million of net losses related to Hurricanes Irma and Maria. As a result, the segment’s loss ratio increased by 1,940 basis points, to 65.8% during this period. Estimated gross losses related to Hurricanes Irma and Maria were $6.4 million and $687.0 million, respectively. While the segment’s ultimate losses cannot be determined with certainty at this time, management believes the catastrophe coverage for losses and allocated loss expenses is sufficient to cover anticipated gross losses.
Underwriting and other operating expenses decreased by $2.0 million, or 4.6%, to $41.9 million mostly due to lower personnel costs and net commissions. The operating expense ratio increased by 440 basis points, to 54.3% in 2017.
Total premiums written decreased by $1.3 million, or 1.0%, to $133.1 million, mostly resulting from lower sales of Commercial Package, offset by higher sales in the Compulsory Vehicle Liability insurance products.
Increase in net purchases of investments in securities are part of our asset/liability management strategy using cash on hand.
During the year 2017, we received the remaining $24.3 million from a loan with a commercial bank related with a credit agreement entered into in December 2016. These proceeds were used to prepay the outstanding principal amount of $24.0 million of the 6.6% senior unsecured notes.
In August 2017 the Company’s Board of Directors authorized a $30.0 million repurchase program of its Class B common stock. Repurchases were conducted through open-market purchases of Class B shares only, in accordance with Rule 10b-18 under the Securities Exchange Act of 1934, as amended. During the year 2017, the Company repurchased and retired 861,415 shares of our Class B Common Stock shares at an average per share price of $23.38, for an aggregate cost of $20.2 million.
We have several short-term facilities available to address timing differences between cash collections and disbursements. These short-term facilities are mostly in the form of arrangements to sell securities under repurchase agreements. As of December 31, 2017, we had $60.0 million of available credit under these facilities. There are no outstanding short-term borrowings under these facilities as of December 31, 2017.
On December 28, 2016, TSM entered into a $35.5 million credit agreement with a commercial bank in Puerto Rico. The agreement consists of three term loans: (i) Term Loan A in the principal amount of $11.2 million, (ii) Term Loan B in the principal amount of $20.2 million and (iii) Term Loan C in the principal amount of $4.1 million. Term Loan A matures in October 2023 while the Term Loans B and C mature in January 2024. Term Loan A was used to refinance a previous $41.0 million secured loan payable with the same commercial bank. Pursuant to the credit agreement, interest is payable on the outstanding balance of the Loan at the following annual rate: (i) 1% over LIBOR for Term Loan A, (ii) 2.75% over LIBOR for Term Loan B, and (iii) 3.25% over LIBOR for Term Loan C. The loan includes certain financial and non-financial 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 and dividends. Failure to meet these covenants may trigger the accelerated payment of the outstanding balance. As of December 31, 2017 we are in compliance with these covenants.
On March 11, 2016 TSS entered into a $30.0 million revolving loan agreement with a commercial bank in Puerto Rico. This unused line of credit had an interest rate of LIBOR plus 220 basis points and contained certain financial and non-financial covenants that are customary for this type of facility. This revolving loan agreement matured on March 11, 2017, and was not renewed.
The table below describes the payments due under our contractual obligations, aggregated by type of contractual obligation, including the maturity profile of our debt, operating leases and other long-term liabilities, but excludes an estimate of the future cash outflows related to the following:
Alternative investments - The Company has $117.6 million of unfunded capital commitments related to alternative investments. These commitments were excluded from this disclosure due to the undeterminate nature of their cash flows.
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, 2017, we had $86.3 million in unearned premiums.
Other long-term liabilities - Due to the indeterminate nature of their cash outflows, $107.9 million of other long-term liabilities are not reflected in the following table, including $33.7 million of liability for pension benefits, $21.9 million in deferred tax liabilities, and $52.3 million in liabilities to the Federal Employees’ Health Benefits Plan Program.
As of December 31, 2017, our long-term borrowings consist of a credit agreement entered with a commercial bank in Puerto Rico. 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, 2017. 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 $642.5 million of reserves had been ceded at December 31, 2017.
We have no off-balance sheet arrangements that have or are reasonably likely to have a current or future material effect on our financial condition, revenues and expenses, results of operations, liquidity, capital expenditures or capital resources.
Our insurance subsidiaries are subject to the regulations of the Commissioner of Insurance of Puerto Rico. These regulations, among other things, require insurance companies to maintain certain levels of capital, thereby restricting the amount of earnings that can be distributed by the insurance subsidiaries to TSM. As of December 31, 2017, our insurance subsidiaries were in compliance with such minimum capital requirements.
Various litigation claims and assessments against us have arisen in the course of our business, including but not limited to, our activities as an insurer and employer. Furthermore, the Commissioner of Insurance, as well as other Federal, Puerto Rico, and Costa Rica government authorities, regularly make inquiries and conduct audits concerning our compliance with applicable insurance and other laws and regulations.
Given the inherent unpredictability of these matters, it is possible that an adverse outcome in certain matters could, from time to time, have an adverse effect on our operating results and/or cash flows. For a description of our legal proceedings, see Note 23, Contingencies, of the Notes to Consolidated Financial Statements, included in Item 8, Financial Statements and Supplementary Data, of this Annual Report on Form 10-K.
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). The syndicate was 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 syndicate cannot meet their obligations. During 2017, 2016 and 2015, 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.
The policies discussed below are considered by management to be critical to an understanding of our consolidated financial statements because their application places the most significant demands on management’s judgment, with financial reporting results relying on estimation about the effect of matters that are inherently uncertain. For all these policies, management cautions that future events may not necessarily develop as forecasted, and that the best estimates routinely require adjustment. Management believes that the amounts provided for these critical accounting estimates are adequate.
Claim liabilities by segment as of December 31, 2017 were as follows:
Managed care claim liabilities also include a provision for adverse deviation, which is an estimate for known environmental factors that are reasonably likely to affect the required level of reserves. This provision for adverse deviation is intended to capture the potential adverse development from known environmental factors such as our entry into new geographical markets, changes in our geographic or product mix, the introduction of new customer populations, variation in benefit utilization, disease outbreaks, changes in provider reimbursement, fluctuations in medical cost trend, variation in claim submission patterns and variation in claims processing speed and payment patterns, changes in technology that provide faster access to claims data or change the speed of adjudication and settlement of claims, variability in claim inventory levels, non-standard claim development, and/or exceptional situations that require judgmental adjustments in setting the reserves for claims.
Circumstances to be considered in developing our best estimate of reserves include changes in enrollment, utilization levels, unit costs, mix of business, benefit plan designs, provider reimbursement levels, processing system conversions and changes, claim inventory levels, regulatory and legislative requirements, claim processing patterns, and claim submission patterns. A comparison or prior period liabilities to re-estimated claim liabilities based on subsequent claims development is also considered in making the liability determination. In the actuarial process, the methods and assumptions are not changed as reserves are recalculated, but rather the availability of additional paid claims information drives our changes in the re-estimate of the unpaid claim liability. Changes in such development are recorded as a change to current period benefit expense. The re-estimates or recasts are done monthly for the previous four calendar quarters. On average, about 92% of the claims are paid within three months after the last day of the month in which they were incurred and about 5% are within the next three months, for a total of 97% paid within six months after the last day of the month in which they were incurred.
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 consolidated statement of earnings 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 incorporates those trends as part of the development of premium rates in an effort to keep premium rating trends in line with claims trends.
Amounts incurred related to prior years vary from previously estimated liabilities as the claims are ultimately settled. Liabilities at any year-end are continually reviewed and re-estimated as information regarding actual claims payments, or run-out becomes known. This information is compared to the originally established year-end liability. Negative amounts reported for incurred claims related to prior years result from claims being settled for amounts less than originally estimated. The reverse is true of reserve shortfalls. Medical claim liabilities are usually described as having a “short tail”, which means that they are generally paid within several months of the member receiving service from the provider. Accordingly, the majority, or approximately 93%, of any redundancy or shortfall relates to claims incurred in the previous calendar year-end, with the remaining 7% related to claims incurred prior to the previous calendar year-end. Management has not noted any significant emerging trends in claim frequency and severity and the normal fluctuations in enrollment and utilization trends from year to year.
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, Claim Liabilities and Claim Adjustment Expenses, of the Notes to Consolidated Financial Statements, included in Item 8, Financial Statements and Supplementary Data, of this Annual Report on Form 10-K). This table shows that the segments’ estimates of this liability have approximated the actual development.
At December 31, 2017, claim liabilities for the life insurance segment amounted to $45.5 million and represented 4.1% of total consolidated claim liabilities and 2.1% of our total consolidated liabilities.
At December 31, 2017, claim liabilities for the property and casualty insurance segment amounted to $694.4 million and represented 62.7% of the total consolidated claim liabilities and 31.5% of our total consolidated liabilities. Claims liabilities related to losses caused by Hurricanes Irma and Maria amount to approximately $605 million.
Estimates of the ultimate cost of claims and loss-adjustment expenses of this segment are based largely on the assumption that past developments, with appropriate adjustments due to known or unexpected changes, are a reasonable basis on which to predict future events and trends, and involve a variety of actuarial techniques that analyze current experience, trends and other relevant factors. Property and casualty insurance claim liabilities are categorized and tracked by line of business. Medical malpractice policies are written on a claims-made basis. Policies written on a claims-made basis require that claims be reported during the policy period. Other lines of business are written on an occurrence basis. Hurricane losses include the use of models from industry recognized firms having data, historical and current information about the events, to estimate ultimate losses. These estimates are supplemented by internal estimates of other costs deemed necessary to develop the ultimate losses.
At December 31, 2017, the actuarial reserve range determined by the actuaries was from $638 million to $760 million. Excluding Hurricanes losses, the range is $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 $5.4 million.
Liabilities for future policy benefits for whole life and term insurance products and active life reserves for accident and health products are computed by the net level premium method, using interest assumptions ranging from 3.90% to 5.75% and withdrawal, mortality, morbidity and maintenance expense assumptions appropriate at the time the policies were issued (or when a block of business was purchased, as applicable). Accident and health unpaid claim reserves are stated at amounts determined by estimates on individual claims and estimates of unreported claims based on past experience. Deferred annuity reserves are carried at the account value.
Impairment of an investment exists if a decline in the estimated fair value is below the amortized cost of the security. Management regularly monitors and evaluates the difference between the cost and estimated fair value of investments. For investments with a fair value below cost, the process includes evaluating: (1) the length of time and the extent to which the estimated fair value has been less than amortized cost for fixed maturity securities, or cost for equity securities, (2) the financial condition, near-term and long-term prospects for the issuer, including relevant industry conditions and trends, and implications of rating agency actions, (3) the Company’s intent to sell or the likelihood of a required sale prior to recovery, (4) the recoverability of principal and interest for fixed maturity securities, or cost for equity securities, and (5) other factors, as applicable. This process is not exact and further requires consideration of risks such as credit and interest rate risks. Consequently, if an investment’s cost exceeds its estimated fair value solely due to changes in interest rates, other-than temporary impairment may not be appropriate. Due to the subjective nature of our analysis, along with the judgment that must be applied in the analysis, it is possible that we could reach a different conclusion whether or not to impair a security if we had access to additional information about the investee. Additionally, it is possible that the investee’s ability to meet future contractual obligations may be different than what we determined during its analysis, which may lead to a different impairment conclusion in future periods. If after monitoring and analyzing impaired securities, management determines that a decline in the estimated fair value of any available-for-sale or held-to-maturity security below cost is other than temporary, the carrying amount of the security is reduced to its fair value according to current accounting guidance. The new cost basis of an impaired security is not adjusted for subsequent increases in estimated fair value. In periods subsequent to the recognition of an other-than-temporary impairment, the impaired security is accounted for as if it had been purchased on the measurement date of the impairment. For debt securities, the discount (or reduced premium) based on the new cost basis may be accreted into net investment income in future periods based on prospective changes in cash flow estimates, to reflect adjustments to the effective yield.
During the year ended December 31, 2017, we recognized an other-than-temporary impairment amounting to $49 thousands on equity securities classified as available for sale. The impairment analysis indicated that, 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.
For our audited consolidated financial statements as of December 31, 2017 and 2016 and for each of the three years ended December 31, 2017, 2016 and 2015 see Index to consolidated financial statements in “Item 15. Exhibits and Financial Statements Schedules” to this Annual Report on Form 10-K.