This financial discussion contains an analysis of our consolidated financial position and financial performance as of December 31, 2010 and 2009, and consolidated results of operations for 2010, 2009 and 2008. 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 are the one of the leading companies 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. We also participated in the government of Puerto Rico Health Care Plan (similar to Medicaid) (“Medicaid”) up to September 30, 2010.
We participate in the managed care market through our subsidiary, TSS. Our managed care subsidiary is a BCBSA licensee, which provides us with exclusive use of the Blue Cross and Blue Shield brand in Puerto Rico and U.S. Virgin Islands. We offer products to the Commercial, including corporate accounts, federal government employees, local government employees, individual accounts, Medicare Supplement, Medicare (including Medicare Advantage and PDP).
We participate in the life insurance market through our subsidiary, TSV, and in the property and casualty insurance market through our subsidiary, TSP. TSV and TSP represented approximately 5.6% and 5.2%, respectively, of our consolidated premiums earned, net for the year ended December 31, 2010 and 19.7% and 4.1%, respectively, of our operating income for that period.
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 26 to our audited consolidated financial statements.
Premiums are set prospectively, meaning that a fixed premium rate is determined at the beginning of each contract year and revised at renewal. We renegotiate the premiums of different groups as their existing annual contracts become due. Our Medicare Advantage contracts entitle us to premium payments from CMS on behalf of each Medicare beneficiary enrolled in our plans, generally on a per member per month (“PMPM”) basis. We submit rate proposals to CMS in June for each Medicare Advantage product that will be offered beginning January 1 of the subsequent year in accordance with the competitive bidding process under the MMA. Retroactive rate adjustments
Premium payments from CMS in respect of our Medicare Part D prescription drug plans are based on written bids submitted by us which include the estimated costs of providing the prescription drug benefits.
Medicaid membership includes rated and self-funded members. We participated in this sector up to September 30, 2010.
The following table sets forth our consolidated operating results for the years ended December 31, 2010, 2009 and 2008.
Consolidated premiums earned, net increased by $32.0 million, or 1.7%, to $1.9 billion during the year ended December 31, 2010 compared to the year ended December 31, 2009. The increase was primarily due to the net effect of an increase in the premiums earned in our managed care segment, primarily from growth in Commercial member months enrollment, as well as higher premium rates across all businesses, offset in part by the termination of the Medicaid contracts effective September 30, 2010.
The decrease in the administrative service fees of the managed care segment of $9.0 million in the 2010 period is attributed to a lower self-funded member months enrollment after the termination of the Medicaid contract for Metro-North region, which we served on an ASO basis until September 30, 2010.
Consolidated net realized investment gains of $2.5 million during the year ended December 31, 2010 are the result of net realized gains from the sale of fixed income and equity securities amounting to $5.5 million. The net realized gains were partially offset by $3.0 million of other-than-temporary impairments related to fixed income and equity securities.
Consolidated claims incurred during the year ended December 31, 2010 decreased by $9.0 million, or 0.6%, to $1.6 billion when compared to the claims incurred during the year ended December 31, 2009. This decrease is principally due to the termination of the Medicaid contracts effective September 30, 2010 offset in part by increased claims in the managed care segment’s Commercial business as a result of higher volume. The consolidated loss ratio decreased by 1.9 percentage points to 84.0%, mostly as the result of lower MLRs in the managed care segment’s Commercial and Medicare businesses.
Consolidated premiums earned, net increased by $176.7 million, or 10.4%, to $1.87 billion during the year ended December 31, 2009 compared to the year ended December 31, 2008. The increase was primarily due to an increase in the premiums earned, net in our managed care segment, primarily from growth in Commercial member months enrollment, reflecting, in large part, the La Cruz Azul de Puerto Rico, Inc. (“LCA”) transaction, as well as higher premium rates across all businesses.
Consolidated net realized investment gains of $0.6 million during the year ended December 31, 2009 are the result of net realized gains from the sale of fixed income and equity securities amounting to $7.7 million. The net realized gains were offset in part by $7.1 million of other-than-temporary impairments related to fixed income and equity securities.
Consolidated income tax expense during the year ended December 31, 2009 increased by $7.8 million to $14.9 million as compared to the income tax expense during the year ended December 31, 2008. The effective tax rate decreased by 4.5 percentage points to 17.8% primarily due to the use of tax credits during the 2009 period, the increase in the weight of exempt income as compared to the taxable income and a higher taxable income in the Life segment, which is taxed at a lower rate.
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 up to September 30, 2010. For the year ended December 31, 2010, the Commercial sector represented 49.8% and 5.6% 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, 2010 represented 24.6% and 45.2%, respectively, of our consolidated earned premiums, net and operating income, respectively. During the same period the Medicaid sector represented 15.0% and 21.6%, of our consolidated premiums earned, net and our operating income, respectively.
Medical premiums earned for the year ended December 31, 2010 increased by $23.1 million, or 1.4%, to $1.7 billion when compared to the medical premiums earned during the year ended December 31, 2009. This increase is principally the result of the following:
The medical claims incurred of the Medicare business decreased by $52.6 million during the 2010 period primarily due to the lower member months enrollment. The MLR for the year was 83.9%, 4.1 percentage points lower than 2009. Adjusting the MLR for changes in prior period reserve developments and risk score premium adjustments, the 2010 MLR would have decreased by 2.7 percentage points as compared to the adjusted MLR for 2009. The lower adjusted MLR is primarily the result of the new risk sharing agreement with our providers in the dual-eligible product, changes in benefits and higher average premium rates.
The medical claims incurred of the Reform business decreased by $64.7 million and its MLR decreased by 2.3 percentage points during the year ended December 31, 2010. Excluding the effect of prior period reserve developments and premium adjustments, the MLR would have increased 1.3 percentage points, mostly resulting from a lower premium yield due to the extension of prior year’s Medicaid contracts without premium rate increases until September 2010.
Medical operating expenses for the year ended December 31, 2010 increased by $17.1 million, or 9.3%, to $201.7 million when compared to the year ended December 31, 2009. The increase in the operating expenses is mainly due to the segment’s higher volume in the Commercial business, as well as to the costs related to the implementation of a new information system and a higher amortization of intangibles. The operating expense ratio increased by 0.9 percentage points, from 10.7% in 2009 to 11.6% in 2010. The higher operating expense ratio is primarily the result of expenses related to the implementation of the segment’s new IT system, including information systems consultants and depreciation and amortization expense, which increased by approximately $6.2 million. The higher operating expense ratio was also attributed to the effect of the termination of the Medicaid contracts. In addition, the operating expenses were affected by an increase of $1.4 million related to a new product launched during January 2010 and higher charges and amortization expense related to the intangible assets recorded after the LCA acquisition by approximately $2.3 million. In the 2009 period a contingent property tax accrual of approximately $7.5 million was recorded, offset in part by the effect of $3.6 million related to the settlement of an insurance recovery receivable of legal expenses. This contingent property tax accrual was approximately $2.1 million higher than the actual payment made during the 2010 period.
Medical premiums earned for the year ended December 31, 2009 increased by $167.2 million, or 11.1%, to $1.68 billion when compared to the medical premiums earned during the year ended December 31, 2008. This increase is principally the result of the following:
Medical premiums generated by the Commercial business increased by $87.9 million, or 12.0%, to $822.1 million during the year ended December 31, 2009. This fluctuation is primarily the result of an increase in member months enrollment of 473,732, or 9.6%, and higher average premium rates per member of approximately 2.9%. Increase in member months was mainly attributed to new members acquired from LCA effective July 1, 2009, which represented 49.1% of the increase in member months enrollment during this period, and to new groups acquired during the period.
Medical premiums earned in the Medicaid business increased by $8.0 million, or 2.4%, to $348.1 million during the year ended December 31, 2009. This fluctuation is due to an increase in premium rates, effective July 1, 2008, of approximately 10%, offset in part by a lower member months enrollment in the Reform’s fully-insured membership by 85,573, or 2.1% and premium adjustments of approximately $8.3 million to provide for unresolved reconciling items with the government of Puerto Rico.
Medical claims incurred during the year ended December 31, 2009 increased by $165.9 million, or 12.4%, to $1.51 billion, when compared to the year ended December 31, 2008. The MLR of the segment increased by 1.0
percentage points during the 2009 period, to 89.9%. These fluctuations are primarily attributed to the effect of the following:
Premiums earned, net for the segment increased by $5.7 million, or 5.7%, to $105.8 million during the year ended December 31, 2010 as compared to the year ended December 31, 2009, primarily as the result of higher sales in the Cancer and Individual Life lines of business during the period.
segments increased volume in the Cancer and Home Service lines of business and a higher amount of claims incurred in the Ordinary Life business, partially offset by a lower volume and claims experience in the Group Life line of business. The segment also experienced an increase in the change of the liability for future policy benefits. The segment’s loss ratio decreased by 0.9 percentage points, to 50.2% during the year ended December 31, 2009.
Underwriting and other expenses for the segment increased by $2.6 million, or 5.3%, to $52.0 million during the year ended December 31, 2009 primarily the result of the higher volume of business of this segment. The segment’s operating expense ratio decreased by 1.3 percentage points, to 51.9% during the 2009 period.
Premiums ceded to reinsurers during the year ended December 31, 2010 decreased by approximately $3.8 million, or 5.6%, to $63.7 million. The ratio of premiums ceded to premiums written decreased by 1.3 percentage points, to 40.0% in 2010. This fluctuation was the result of the a reduction of reinsurance cessions in quota share contracts for commercial and personal property insurance risks of 3.0% and 2.2%, respectively.
Premiums ceded to reinsurers during the year ended December 31, 2009 decreased by approximately $4.6 million, or 6.4%, to $67.5 million. The ratio of premiums ceded to premiums written decreased by 1.6 percentage points, to 41.3% in 2009. This fluctuation was the result of the a reduction of reinsurance cessions in quota share contracts for commercial and personal property insurance risks of 5.0% and 7.2%, respectively. This decrease is offset in part by the increase in the cost of non-proportional insurance treaties.
Year ended December 31, 2010 compared to year ended December 31, 2009
Cash flows from operating activities decreased by $34.9 million during the year ended December 31, 2010 as compared to the year ended December 31, 2009, principally due to the increases claims paid and cash paid to suppliers and employees amounting to $23.7 million and $4.2 million, respectively, offset in part by the effect of increase in premiums collections by $12.3 million and lower income tax payments by $11.1 million. The increase in premiums collected is the result of a higher member months enrollment, mainly in the managed care segment’s Commercial business offset in part by a higher amount in accounts receivable. The fluctuation in claims paid is primarily the result of the effect of the run-off of the Medicaid business and a higher volume in the Commercial business. The decrease in income tax payments results from the use of tax credits acquired during the year ended December 31, 2009.
The net proceeds from policyholder deposits increased by $4.4 million during the year ended December 31, 2010 primarily due to deposits received during the period.
The increase in the other sources (uses) of cash of $5.8 million is attributed to changes in the amount of outstanding checks over bank balances in the 2010 period.
Year ended December 31, 2009 compared to year ended December 31, 2008
The decrease in the other sources (uses) of cash of $23.9 million is attributed to changes in the amount of outstanding checks over bank balances in the 2009 period.
The net proceeds from policyholder deposits decreased by $3.7 million during the year ended December 31, 2009 primarily due to the lower deposits received during the period.
On December 8, 2008 we announced the immediate commencement of a $40.0 million share repurchase program. We paid approximately $32.3 million under the stock repurchase program during the year ended December 31, 2009.
We have several short-term facilities available to address timing differences between cash receipts and disbursements. These short-term facilities are mostly in the form of arrangements to sell securities under repurchase agreements. As of December 31, 2010, we had $215.0 million of available credit under these facilities. There were $15.6 millions outstanding short-term borrowing at December 31, 2010.
On December 21, 2005, we issued and sold $60.0 million of our 6.6% senior unsecured notes due December 2020 (the 6.6% notes). The 6.6% notes were privately placed to various institutional accredited investors. The notes pay interest each month until the principal becomes due and payable. These notes can be redeemed after five years at par, in whole or in part, as determined by us. The proceeds obtained from this issuance were used to pay the ceding commission to GA Life on the effective date of the coinsurance funds withheld reinsurance agreement. On October 1, 2010 we repaid $25.0 million of the principal of these senior unsecured notes.
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, 2010 investment securities available for sale with fair value of $27.2 million (face value of $19.7 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.
In addition, as of December 31, 2010 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, 2010, this secured loan had an outstanding balance of $21.0 million and an average annual interest rate of 1.66%.
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 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. As of December 31, 2010, we understand are in compliance with these covenants. Failure to meet these non-financial 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 the third quarter in 2011. Total external costs for the entire project are expected to amount approximately $55.0 million. Our managed care business expects to incur costs of approximately $15.9 million during 2011. We estimate that $2.2 million of the costs expected to be incurred in 2011 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.
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, 2010, we had $98.3 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, 2010, our policyholder deposits had a carrying amount of $49.9 million.
Purchase obligations represent payments required by us under material agreements to purchase goods or services that are enforceable and legally binding and where all significant terms are specified, including: quantities to be purchased, price provisions and the timing of the transaction. Other purchase orders made in the ordinary course of business for which we are not liable are excluded from the table above. Estimated pension plan contributions amounting to $10.0 million were included within the total purchase obligations. However, this amount is an estimate which may be subject to change in view of the fact that contribution decisions are affected by various factors such as market performance, regulatory and legal requirements and plan funding policy.
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, 2010 and are gross of any
reinsurance recoverable. The $954.8 million total estimated cash flows for all years in the table is different from the liability of future policy benefits of $236.5 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.
Based on the information currently known by our management, in its opinion, the outcomes of such pending investigations and legal proceedings are not likely to have a material adverse effect on our financial position, results of operations and cash flows. However, 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. See “Item 3. Legal Proceedings”.
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, 2010, 2009 and 2008, no assessment or payment was made in connection with insurance companies declared insolvent. 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.
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 2010, 2009 and 2008, the Association distributed the Company a dividend based on the good experience of the business amounting to $1.3 million, $1.2 million and $1.1 million, respectively.
Claim liabilities by segment as of December 31, 2010 were as follows:
At December 31, 2010, claim liabilities for the managed care segment amounted to $236.2 million and represented 65.6% of our total consolidated claim liabilities and 20.7% of our total consolidated liabilities.
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 77% of the claims are paid within three months after the last day of the month in which they were incurred and about 13% are within the next three months, for a total of 90% paid within six months after the last day of the month in which they were incurred.
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, 2010 claim liabilities, assuming the indicated hypothetical changes in completion and trend factors:
At December 31, 2010, claim liabilities for the life insurance segment amounted to $41.2 million and represented 11.4% of total consolidated claim liabilities and 3.6% of our total consolidated liabilities.
At December 31, 2010, claim liabilities for the property and casualty insurance segment amounted to $82.8 million and represented 23.0% of the total consolidated claim liabilities and 7.2% of our total consolidated liabilities.
unreported claims based on past experience. Liabilities for universal life policies are stated at policyholder account values before surrender charges. Deferred annuity reserves are carried at the account value.
Certain costs for acquiring life and property and casualty insurance business are deferred. Acquisition costs related to the managed care business are expensed as incurred.
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 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 it 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.
Identification and evaluation of securities that have possible indications of other-than-temporary impairment, which includes an analysis of all investments with gross unrealized investments losses that represent 20% or more of cost.
For the selected unaudited quarterly financial data corresponding to the years 2010 and 2009, see note 30 of the audited consolidated financial statements as of December 31, 2010 and 2009 and for the three years ended December 31, 2010.