Further details of the calculation of basic earnings per share are set forth in notes 2 and 22 of the audited consolidated financial statements for the years ended December 31, 2012, 2011 and 2010.
This financial discussion contains an analysis of our consolidated financial position and financial performance as of December 31, 2012 and 2011, and consolidated results of operations for 2012, 2011 and 2010. 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 the one of the most significant players 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. In the Commercial market we are the largest provider of managed care products. We offer products to corporate accounts, U.S. federal government employees, local government employees, individual accounts and Medicare Supplement. We also participate in the Government of Puerto Rico Health Reform (a government of Puerto Rico-funded managed care program for the medically indigent that is similar to the Medicaid program in the U.S.) (“Medicaid”), by administering the provision of the physical health component in designated service regions in Puerto Rico.
We have the exclusive right to use the Blue Cross and Blue Shield name and mark throughout Puerto Rico and U.S. Virgin Islands. As of December 31, 2012 we serve approximately 1,721,000 members across all regions of Puerto Rico. For the years ended December 31, 2012 and 2011 respectively, our managed care segment represented approximately 90.2% and 89.9% of our total consolidated premiums earned, net, and approximately 67.6% and 68.6% 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 13.1% (in terms of premiums written) for 2011. Our property and casualty segment had a market share of approximately 8.5% (in terms of direct premiums) during the nine-month period ended September 30, 2012.
We participate in the managed care market through our subsidiaries, TSS and AH. TSS is a BCBS licensee, which provides us with exclusive use of the Blue Cross and Blue Shield Association (“BCBSA”) licensee, which provides us with exclusive use of the Blue Cross and Blue Shield name and mark throughout Puerto Rico and U.S. Virgin Islands.
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.
Effective November 1st, 2011, TSS entered into a new contract with the Government to administer the provision of the physical health component of the miSalud program (similar to Medicaid) in designated service regions in the Commonwealth of Puerto Rico.
In February 7, 2011, our subsidiary TSS completed the AH acquisition. As of December 31, 2012 and 2011, the Medicare membership attributable to AH was 50,883 and 47,522, respectively.
Consolidated premiums earned, net increased by $198.9 million, or 9.7%, to $2.3 billion during the year ended December 31, 2012 compared to the year ended December 31, 2011. The increase was mostly the result of the higher member month enrollment in the Medicare and Commercial business, attributed to the new members acquired from AH on February 2011 and organic growth, as well as to the receipt of higher risk score adjustments from CMS in 2012 as compared to 2011.
The increase in the administrative service fees of the Managed Care segment of $71.6 million, or 186.0%, to $110.1 million 2012 is attributed to a higher amount of self-insured contracts after resuming our participation in the Medicaid sector.
Consolidated net investment income decreased by $1.4 million, or 2.9%, to $46.8 million during the year ended December 31, 2012 mostly as the result of lower yields in fixed income investments acquired during the period.
The $1.5 million increase in the consolidated other income primarily results from a lower loss on derivative instruments in 2012. The derivative instruments we held matured during the second quarter of 2012.
Consolidated net realized investment gains of $18.6 million during the year ended December 31, 2011 are the result of net realized gains from the sale of debt and equity securities, including our trading portfolio.
Consolidated claims incurred during the year ended December 31, 2011 increased by $119.5 million, or 7.5%, to $1.7 billion when compared to the claims incurred during the year ended December 31, 2010, mostly due to claims incurred in the Managed Care segment. This increase is principally due to the claims incurred related to the AH acquisition, offset in part by the termination of the Medicaid contracts effective September 30, 2010. The consolidated loss ratio decreased by 50 basis points to 83.5%.
Consolidated income tax expense during the year ended December 31, 2011 increased by $3.1 million, or 17.8%, to $20.5 million as compared to the income tax expense during the year ended December 31, 2010. The effective tax rate increased by 540 basis points to 26.1% during the year ended December 31, 2011. The consolidated income tax expense includes a one-time charge of $6.4 million resulting from the reduction of the net deferred tax assets following the enactment of the new Puerto Rico tax reform, which was effective January 2011 that reduced the maximum corporate tax rate from 39% to approximately 30%. Partially offsetting the effect of this adjustment to net deferred tax assets, is a reduction in the taxable income of the Managed Care segment, which operates at a higher effective tax rate, and the use of tax credits in the 2011 period.
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. For the year ended December 31, 2012, the Commercial sector represented 42.6% and 19.5% 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, 2012 represented 47.6% and 5.0%, respectively, of our consolidated earned premiums, net and operating income, respectively. The operating income of the Medicaid sector represented 46.0% of the consolidated operating income for the year ended December 31, 2012.
Medical premiums generated by the Medicare business increased by $176.9 million, or 19.7%, to $1.1 billion. This fluctuation is the result of an overall increase in the member months enrollment of this business by 217,355, or 17.5%, when compared with the same period in 2011. Increase in member months enrollment was mainly attributed to increased sales across all our Medicare products, as well as to the effect of presenting the members acquired from AH for the full year in 2012 and only for eleven months in 2011. This fluctuation also results from the receipt of higher risk score adjustments from CMS in 2012 as compared to 2011. The 2012 and 2011 periods include the net effect of approximately $12.6 million and $1.9 million, respectively, related to CMS final risk scores adjustments corresponding to prior periods.
Administrative service fees increased by $71.8 million, or 167.0%, to $114.8 million during the year ended December 31, 2012. This fluctuation primarily results from the member months enrollment related to the miSalud program, which we resumed servicing effective November 1, 2011.
Medical claims incurred during the year ended December 31, 2012 increased by $195.9 million, or 12.2%, to $1.8 billion, when compared to the year ended December 31, 2011. The MLR of the segment experienced an increase of 160 basis points during the 2012 period, to 88.8%. These fluctuations are primarily attributed to the effect of the following:
Medical premiums earned for the year ended December 31, 2011 increased by $146.1 million, or 8.6%, to $1.8 billion when compared to the medical premiums earned during the year ended December 31, 2010. This increase is principally the result of the following:
Medical premiums generated by the Commercial business remained in line with prior year at $947.1 million. This is the result of a decrease in member months enrollment of 176,041, or 2.9%, and higher average premium rates per member of approximately 3.0%. Premium rate increases were consistent with claim trends.
Medical claims incurred during the year ended December 31, 2011 increased by $112.7 million, or 7.5%, to $1.6 billion, when compared to the year ended December 31, 2010. The MLR of the segment presented a decrease of 90 basis points during the 2011 period, to 87.2%. These fluctuations are primarily attributed to the effect of the following:
Premiums earned, net for the segment increased by $7.2 million, or 6.8%, to $113.0 million during the year ended December 31, 2011 as compared to the year ended December 31, 2010, primarily as the result of higher sales in the Cancer and Individual Life lines of business.
The change in unearned premiums presented a decrease of $9.2 million, to $1.5 million during the year ended December 31, 2012, primarily as the result of the higher volume of premiums written during this period.
Claims incurred during the year ended December 31, 2012 increased by $1.1 million, or 2.3%, to $49.3 million. The loss ratio increased by 110 basis points, to 50.5% in 2012, as a result of unfavorable loss experience in the Commercial Auto and General Liability line of business, primarily resulting from the receipt of several large auto liability claims that together had the effect of increasing 2012 claims incurred by approximately $2.3 million, offset in part by a decrease in the claims related to the Dwelling line of business.
Total premiums written during the year ended December 31, 2011 decreased by $6.3 million, or 4.0%, to $152.9 million, mostly in the Dwelling and Commercial Property Mono-line and Commercial Auto insurance products; offset in part by higher sales of Commercial Multi-peril products. Soft market conditions also prevailed in 2011, thus reducing premium rates and increasing competition for renewals and new business.
Premiums ceded to reinsurers during the year ended December 31, 2011 decreased by approximately $0.7 million, or 1.1%, to $63.0 million. The ratio of premiums ceded to premiums written increased by 120 basis points, to 41.2% in 2011. This fluctuation was primarily the result of higher Commercial Property cessions, which were increased from 32% to 37%.
Claims incurred during the year ended December 31, 2011 decreased by $1.0 million, or 2.0%, to $48.2 million. The loss ratio decreased by 20 basis points, to 49.4% during the year ended December 31, 2011, as a result of a favorable loss experience in the Commercial Auto line of business resulting from lower claim amounts in the claims reported in 2011; offset in part by an increase in Commercial Multi-Peril line of business. Although the current period reflects $1.6 million of net losses related to Tropical Storm Irene, the 2010 period was impacted by several large losses caused by fires and liability claims in excess of $1.9 million.
Underwriting and other operating expenses for the year ended December 31, 2011 decreased by $2.1 million, or 3.7%, to $54.4 million. This decrease is primarily due to a lower commission expense as a result of the lower premiums written; offset in part by an increase in the provision for uncollectible amounts. The operating expense ratio decreased by 130 percentage points during the same period, to 55.7% in 2011.
Net purchases of investment securities were $91.1 million during the year ended December 31, 2012, $77.5 million higher than last year, primarily resulting from the investment of excess cash flows from operations.
Capital expenditures are $4.2 million lower during the year ended December 31, 2012 primarily as a result of the completion of the Managed Care new core system implementation during the third quarter of this year.
The increase in other uses of cash is attributed to changes in the amount of outstanding checks over bank balances in the 2012 period.
Cash flows from operating activities increased by $124.8 million during the year ended December 31, 2011 as compared to the year ended December 31, 2010, principally due to the effect of higher premiums collections by $289.9 million and increase in net proceeds from our trading portfolio by $51.9 million, offset in part by an increase in claims paid, cash paid to suppliers and employees and income tax paid by $125.6 million, $76.7 million and $15.2 million, respectively. The increase in premiums and service fee collected is principally the effect of the AH acquisition as well as to the collection of past due Medicaid balances. The higher net proceeds from our trading portfolio results from the sale of this portfolio. The fluctuations in claims paid and cash paid to suppliers and employees is primarily as the result of the effect of the AH acquisition. The increase in income tax payments results from the use of tax credits during the year ended December 31, 2010.
Net acquisition of investment securities decreased by $10.1 million during the year ended December 31, 2011 when compared to the prior year. This fluctuation is primarily due to a reduction in the acquisition of investment securities as part of our decision to increase liquidity to pay for the AH acquisition and to repay some of our long-term borrowings.
Payments of long-term borrowings increased by $25.2 million during the year ended December 31, 2011 as the result of the repayment of our senior unsecured notes.
On September 29, 2010, we announced the immediate commencement of the 2010 stock repurchase program. The program is conducted using available cash through open-market purchases and privately-negotiated transactions of Class B shares only, in accordance with Rules 10b-18 and 10b5-1 under the Securities Exchange Act of 1934, as amended. During the year ended December 31, 2012 we repurchased and retired 136,222 shares at an average per share price of $16.86, for an aggregate cost of $2.3 million.
In addition, we are a party to a secured term loan with a commercial bank in 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 repayments of $0.1 million. As of December 31, 2012, this secured loan had an outstanding balance of $17.7 million and average annual interest rate of 1.44%.
As part of the acquisition transaction of the controlling stake in a health clinic, we assumed a term loan with balance of $13.5 million as of December 31, 2012. The loan requires monthly payments of $0.1 million, including principal and interest, is due on December 23, 2014, with a final payment of $12.9 million and bears interest at an annual rate of 4.75%.
Federal regulations require that we begin using a new set of standardized diagnostic codes, known as ICD-10, by October 2014, which will require a significant information technology investment. In order to become ICD-10 compliant, we need to upgrade the version of TSS’s core business application that we previously implemented in the third quarter of 2012. We expect to begin this upgrade during the second quarter of 2013 and have completed the migration of our membership on time to comply with the current ICD-10 deadline. The estimated cost of the core business application upgrade and ICD-10 compliance efforts is approximately $6.0 million.
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, 2012, our policyholder deposits had a carrying amount of $111.7 million.
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, 2012. 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 $39.1 million of reserves had been ceded at December 31, 2012.
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 2012, 2011 and 2010, 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 2012, 2011 and 2010, the Association distributed the Company a dividend based on the good experience of the business amounting to $1.2 million in 2012 and $1.3 million in 2011 and 2010.
At December 31, 2012, claim liabilities for the managed care segment amounted to $284.4 million and represented 68.2% of our total consolidated claim liabilities and 21.9% of our total consolidated liabilities.
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 91% of the claims are paid within three months after the last day of the month in which they were incurred and about 4% are within the next three months, for a total of 95% 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 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.
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, 2012 claim liabilities, assuming the indicated hypothetical changes in completion and trend factors:
At December 31, 2012, claim liabilities for the life insurance segment amounted to $44.6 million and represented 10.7% of total consolidated claim liabilities and 3.4% of our total consolidated liabilities.
At December 31, 2012, the actuarial reserve range determined by the actuaries was from $87 million to $97 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 $5.8 million.
The costs of acquiring new life business, principally commissions, and certain variable underwriting, agency and policy issue expenses of our life insurance segment, have been deferred. These costs, including value of business acquired (“VOBA”) recorded upon our acquisition of GA Life (now TSV), are amortized to income over the premium-paying period of the related whole life and term insurance policies in proportion to the ratio of the expected annual premium revenue to the expected total premium revenue, and over the anticipated lives of universal life policies in proportion to the ratio of the expected annual gross profits to the expected total gross profits. The expected premiums revenue and gross profits are based upon the same mortality and withdrawal assumptions used in determining the liability for future policy benefits. For universal life and deferred annuity policies, changes in the amount or timing of expected gross profits result in adjustments to the cumulative amortization of these costs. The effect on the amortization of deferred policy acquisition costs of revisions to estimated gross profits is reported in earnings in the period such estimated gross profits are revised.
The consolidated and Managed Care claims incurred would have increased by $2.4 million during the three months ended March 31, 2011 and decreased by $0.7 and $1.8 million during the three months ended June 30, 2011 and September 30, 2011, respectively.
We assessed the impact of the adjustments needed to account for these errors in their appropriate periods and concluded that recording these adjustment in the consolidated results of operations in the three months ended December 31, 2011, rather than restating the quarters affected, was quantitatively and qualitatively not material to the results of operations, financial position, or cash flows corresponding to each of the quarters that comprise the year ended December 31, 2011. These out-of-period adjustments involve only reported quarterly results and, because they were corrected during the last quarter of the year, have no effect on the results of operations, financial position and cash flows for the year ended December 31, 2011.