We own a seven story building located at 1441 F.D. Roosevelt Avenue, in San Juan, Puerto Rico, and two adjacent buildings, as well as the adjoining parking lot, which is mainly used by the Managed Care segment. In addition, we own five floors of a fifteen-story building located at 1510 F.D. Roosevelt Avenue, in Guaynabo, Puerto Rico, which is mainly used by the Property and Casualty segment. We also own land and a multi-segment customer service center in the municipalities of Mayagüez and Ponce, Puerto Rico. In addition to the properties described above, we or our subsidiaries are parties to operating leases that are entered into in the ordinary course of business. Through a health clinic in which we have a controlling interest, we own land and a two-story medical facility in the municipality of Bayamón, Puerto Rico. These properties are subject to liens under our credit facilities. In connection with our entrance to the Costa Rican market, we acquired a two-story building located in the city of San José, Costa Rica, which is used by the Life segment. See “Item 7 - Management’s Discussion and Analysis of Financial Condition and Results of Operation - Liquidity and Capital Resources”.
We believe that our facilities are in good condition and that the facilities, together with capital improvements and additions currently underway, are adequate to meet our operating needs for the foreseeable future. The need for expansion, upgrading and refurbishment of facilities is continually evaluated in order to keep facilities aligned with planned business growth and corporate strategy.
This financial discussion contains an analysis of our consolidated financial position and financial performance as of December 31, 2018 and 2017, and consolidated results of operations for 2018, 2017 and 2016. 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 are one of the most significant players in the managed care industry in Puerto Rico and have 60 years of experience in this industry. We offer a broad portfolio of managed care and related products in the Commercial, Medicare, and the Government of Puerto Rico health insurance plan (similar to Medicaid) (“Medicaid” or “the Government health plan”) markets. In the Commercial market we offer products to corporate accounts, U.S. federal government employees, local government employees, individual accounts and Medicare Supplement. We market our managed care products through an extensive network of independent agents and brokers located throughout Puerto Rico, as well as an internal salaried sales force. Medicaid is funded by the Government of Puerto Rico and the U.S. Government.
We have the exclusive right to use the BCBS name and mark throughout Puerto Rico, the U.S. Virgin Islands, Costa Rica, the British Virgin Islands and Anguilla. As of December 31, 2018 we serve approximately 876,000 members across all regions of Puerto Rico. For the years ended December 31, 2018 and 2017 respectively, our Managed Care segment represented approximately 92% of our total consolidated premiums earned, net. We also participate in the life and property and casualty insurance markets in Puerto Rico.
Managed Care premiums increased 3.8% when compared to last year, primarily reflecting growth in Medicare premiums following the Company’s achievement of a four-star rated Medicare Advantage HMO contract this year, resulting in a 5% bonus applied to the benchmark used in the premium calculation, as well as an increase in the 2018 Medicare reimbursement rates. This increase was partially offset by lower membership.
General. Our revenue consists primarily of (i) premium revenue generated from our Managed Care segment, (ii) administrative service fees received for services provided to self-insured employers, (iii) premiums we generate from our Life and Property and Casualty segments, and (iv) investment income.
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 are made periodically with respect to our Medicare Advantage plans based on the aggregate health status and risk scores of our plan participants. Premium rates for the Medicaid business are based on a bid contract with ASES and are revised each year, at which time rates are fixed for the plan year.
Operating Expenses. Operating expenses include commissions to external brokers, general and administrative expenses, cost containment expenses such as case and disease management programs, and depreciation and amortization. The operating expense ratio is calculated by dividing operating expenses by premiums earned, net plus administrative service fees. A significant portion of our operating expenses are fixed costs. Accordingly, it is important that we maintain certain level of volume of business in order to compensate for the fixed costs. Significant changes in our volume of business will affect our operating expense ratio and results of operations. We also have variable costs, which vary in proportion to changes in volume of business.
The following table sets forth our consolidated operating results for the years ended December 31, 2018, 2017 and 2016. Further details of the results of operations of each reportable segment are included in the analysis of operating results for the respective segments.
Consolidated operating expenses increased by $77.5 million, or 16.2%, to $554.7 million. The higher operating expenses are mostly the result of the reinstatement of the HIP Fee of $50.1 million and higher professional services and personnel costs related to the ongoing managed care initiatives. The consolidated expense ratio increased 200 basis points to 18.8%.
Consolidated income tax benefit for the year ended December 31, 2018 was $29.8 million, compared to an expense of $24.5 million during the last year, primarily due to a change in the effective tax rate of certain deferred tax liabilities in the Company’s Property and Casualty segment in order to reflect the expected tax rate at which they will reverse, and a change in the enacted tax rate, from 39% to 37.5%, following the Puerto Rico income tax reform enacted in December 2018. These changes increased the deferred tax expense by approximately $9.5 million. The consolidated income tax expense also reflects the tax impact of net unrealized losses on equity investments and the lower operating income of the Managed Care segment.
Consolidated claims incurred decreased by $119.1 million, or 4.8%, to $2.4 billion, mostly due to lower claims in the Managed Care segment offset by an increase in claims in the Property and Casualty segment. The decrease in managed care claims primarily reflects lower claims incurred across all businesses in the segment driven by the estimated decrease in utilization as a consequence of the aforementioned hurricanes, lower enrollment in the Commercial and Medicaid enrollment, and favorable fluctuations in the prior period reserve developments in the Commercial and Medicare businesses. The Property and Casualty segment’s estimated net retained losses related to Hurricanes Irma and Maria were approximately $14.8 million after the application of reinsurance. The consolidated loss ratio decreased by 230 basis points to 83.2%. Excluding the impact of prior-period reserve developments, and moving the Medicare risk score revenue and other revenue adjustments to the corresponding period, the managed care MLR for the year was 83.7%, 100 basis points lower than the same metric from the prior year.
Consolidated income taxes increased by $30.8 million, to a net expense of $24.5 million. The year over year change in income taxes primarily results from an increase in the taxable income from the Managed Care segment, which has a higher effective tax rate than our other segments.
primarily reflecting an increase in the 2018 Medicare reimbursement rates fee-for-service benchmark for the first time since 2012, an increase in rates as the result of attaining a four-star rating in the Company’s 2018 HMO product, and higher average membership risk score. These increases were partially offset by lower enrollment of approximately 120,000 member months.
The medical claims incurred of the Commercial business increased by $22.3 million, or 3.6%, during the 2018 period and its MLR, at 82.4%, was 490 basis points higher than the same period last year primarily reflecting the decrease in utilization in the 2017 period caused by Hurricanes Irma and Maria. The hurricane related decrease in utilization was estimated to lower 2017 claims by approximately $27.8 million, or 340 basis points of last year’s MLR. Adjusting for the effect of prior period reserve development in 2018 and 2017 period as well as adjusting for the 2017 hurricane related impact in utilization, the Commercial MLR would have been approximately 83.4%, 330 basis points higher than last year, reflecting claim trends higher than premium trends.
The medical claims incurred of the Medicare business increased by $33.1 million, or 3.6%, during the 2018 period and its MLR decreased by 450 basis points, to 83.2%. The hurricane related decrease in utilization was estimated to lower 2017 claims by approximately $25.1 million, or 240 basis points of last year’s MLR. Adjusting for the effect of prior period reserve development in the 2018 and 2017 periods, moving the risk score revenue to it corresponding period, as well as adjusting for the 2017 hurricane related impact in utilization, the Medicare MLR would have been approximately 83.9%, 640 basis points lower than last year, primarily reflecting the higher premium rates in the 2018 period as well as cost containment initiatives implemented during the year.
The medical claims incurred of the Medicaid business decreased by $1.1 million, or 0.2%, during the 2018 period and its MLR decreased by 300 basis points, to 88.5%. The hurricane related decrease in utilization was estimated to lower 2017 claims by approximately $2.2 million, or 30 basis points of last year’s MLR. Adjusting for the effect of prior period reserve developments and the 2018 profit sharing accrual, the Medicaid MLR would have been approximately 87.8%, 420 basis points lower than the adjusted MLR for last year mostly reflecting the impact of higher premium rates in 2018 and cost containment initiatives.
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 1, 2017, which increased average premium rates by approximately 9%.
The medical claims incurred of the Medicare business decreased by $16.6 million, or 1.8%, during the 2017 period and its MLR decreased by 260 basis points, to 87.7 %. Adjusting for the effect of prior period reserve developments in 2017 and 2016 and moving the additional risk score revenue adjustments to their corresponding period, the Medicare MLR would have been approximately 88.4%, about 80 basis points lower than last year. The estimated decrease in utilization caused by Hurricanes Irma and Maria mitigated the impact of the higher trends in Part B drugs and pharmacy benefits experienced by this business as well as the improvement of benefits in 2017 products taking advantage of the HIP fee moratorium. The estimated decrease in utilization related to the aforementioned hurricanes lowered by approximately 240 basis points the adjusted MLR.
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 1, 2017.
Claims incurred increased by $109.1 million, or 214.8%, to $159.9 million mostly driven by an increase in gross losses related to Hurricane Maria, causing the segment to exceed the applicable catastrophe reinsurance coverage limits and resulting in a $128.7 million unfavorable reserve development. As loss information emerged, reserves have been updated to reflect a worsening in the loss expectations for Hurricane Maria. As a result, the segment’s loss ratio increased to 191.5% during this period. In 2017 we recognized $14.8 million of hurricane related net losses.
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.
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.
A summary of our major sources and uses of cash for the periods indicated is presented in the following table:
Cash flow from operating activities decreased by $281.4 million for the year ended December 31, 2018 as compared to the year ended December 31, 2017, mostly reflecting Property and Casualty hurricane related claim payments, last year’s collection of advances from reinsurers, and the 2018 HIP Fee payment; offset in part by higher premium collections.
Cash flow from operating activities increased by $279.7 million for the year ended December 31, 2017 as compared to the year ended December 31, 2016, principally due to, lower claims paid, a decrease in cash paid to suppliers and employees; partially offset by lower premium collections.
Net capital expenditures increased by $16.6 million for the year ended December 31, 2017 mostly related to information technology initiatives in the Managed Care segment.
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, 2018, 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, 2018.
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, 2018 we are in compliance with these covenants.
Alternative investments - The Company has $80.5 million of unfunded capital commitments related to alternative investments. These commitments were excluded from this disclosure due to the undetermined timing 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, 2018, we had $83.0 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, 2018, our policyholder deposits had a carrying amount of $174.1 million.
Our Life 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, 2018 and are gross of any reinsurance recoverable. The $670.6 million total estimated cash flows for all years in the table is different from the liability of future policy benefits of $361.5 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.
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 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. In accordance with insurance laws and regulations, assessments are recoverable through policy surcharges. In January 2019, a local property and casualty insurance company entered a liquidation process, accordingly, the property and casualty guarantee fund has initiated the process to settle unpaid claims and return unearned premiums of the insolvent insurer. The guarantee fund currently has not determined and imposed assessments to cover claims and return premiums. Annual assessments are limited to 2% of direct premiums written, as defined. During 2018, 2017 and 2016, no assessment or payment was made for this contingency. 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, 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 2018 and 2016, the Association distributed to the Company an amount based on the good experience of the business amounting to $0.2 million and $0.5 million, respectively. In June 2017, the Association declared a special dividend of $70 million as authorized by a recent amendment to the Act creating the Association. The distribution was subject to a unique and special tax rate of 50%. The dividend was paid net of its related tax in December 2018. The share of the Property and Casualty segment in this distribution was $2.4 million.
Our consolidated financial statements and accompanying notes included in this Annual Report on Form 10-K have been prepared in accordance with GAAP applied on a consistent basis. The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. We continually evaluate the accounting policies and estimates we use to prepare our consolidated financial statements. In general, management’s estimates are based on historical experience and various other assumptions it believes to be reasonable under the circumstances. The following is an explanation of our accounting policies considered most significant by management. These accounting policies require us to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and 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 by segment as of December 31, 2018 were as follows:
At December 31, 2018, claim liabilities for the Managed Care segment amounted to $393.7 million and represented 42.0% of our total consolidated claim liabilities and 20.3% of our total consolidated liabilities.
As described above, completion factors and claims trend factors can have a significant impact on the determination of our claim liabilities. The following example provides the estimated impact on our December 31, 2018 claim liabilities, assuming the indicated hypothetical changes in completion and trend factors:
In the event this segment experiences an unexpected increase in health care cost or utilization trends, we have the following options to cover claim payments:
In the Commercial business we have the ability to increase the premium rates throughout the year in the monthly renewal process, when renegotiating the premiums for the following contract year of each group as they become due. We consider the actual claims trend of each group when determining the premium rates for the following contract year.
Claim reserve reviews are generally conducted on a monthly basis, in light of continually updated information. We review reserves using current inventory of policies and claims data. These reviews incorporate a variety of actuarial methods, judgments and analysis.
At December 31, 2018, claim liabilities for the Property and Casualty segment amounted to $496.9 million and represented 53.0% of the total consolidated claim liabilities and 25.6% of our total consolidated liabilities. Claims liabilities related to losses caused by Hurricanes Irma and Maria amount to approximately $415.9 million.
Individual case estimates for reported claims are established by a claims adjuster and are changed as new information becomes available during the course of handling the claim. Our property and casualty business, other than medical malpractice, is primarily short-tailed business, where losses (e.g. paid losses and case reserves) are generally reported quickly.
Our Life 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. We compute the amounts for actuarial liabilities in conformity with GAAP.
Certain costs for acquiring life and property and casualty insurance business are deferred. Acquisition costs related to the Managed Care segment are expensed as incurred.
The property and casualty business acquisition costs consist of commissions net of reinsurance commissions, during the production of business are deferred and amortized ratably over the terms of the policies. The method used in calculating deferred acquisition costs limits the amount of such deferred costs to actual costs or their estimated realizable value, whichever is lower.