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. In addition, 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. 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 insurance segment, See “Item 7 - Management’s Discussion and Analysis of Financial Condition and Results of Operation - Liquidity and Capital Resources”.
Further details of the calculation of basic earnings per share are set forth in notes 2 and 21 of the audited consolidated financial statements for the years ended December 31, 2016, 2015 and 2014.
We are 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, Medicaid and Medicare Advantage 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 also participate in the Government of Puerto Rico Health Reform (a managed care program for the medically indigent funded by the Puerto Rico and U.S. federal governments that is similar to the Medicaid program in the U.S.) (Medicaid). The Island is divided in eight regions and we served all of them on an administrative service only basis (ASO) until March 31, 2015. Effective April 1, 2015, the government changed the Medicaid delivery model from an ASO to a risk-based model and we elected to participate as a fully-insured provider in only two regions of Puerto Rico.
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, 2016 we serve approximately 1,017,000 members across all regions of Puerto Rico. For the years ended December 31, 2016 and 2015 respectively, our managed care segment represented approximately 92% of our total consolidated premiums earned, net. We also have significant positions in the life insurance and property and casualty insurance markets in Puerto Rico.
We participate in the managed care market through our subsidiaries, TSS, TSB and TSA. TSS, TSA and TSB are BCBSA licensees, which provide us with exclusive use of the Blue Cross and Blue Shield name and mark throughout Puerto Rico, the U.S. Virgin Islands, Costa Rica, the British Virgin Islands and Anguilla.
The Commissioner of Insurance of the Government of Puerto Rico (“Commissioner of Insurance 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 Puerto Rico to financial statements prepared in accordance with U.S. generally accepted accounting principles (“GAAP”) in making such determinations. See note 24 to our audited consolidated financial statements.
The higher Managed Care premiums reflect the additional Medicaid premiums generated under the new at-risk contract that became effective April 1, 2015 and higher average premium rates in the Commercial business; partially offset by lower Commercial and Medicare membership. Total Medicaid premiums during this period were $783.2 million, $176.0 million higher than last year.
Consolidated operating expenses for the year were $493.9 million and the operating expense ratio was 17.0%.
Managed Care 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.
Investment Income. Investment income consists of interest and dividend income from investment securities. See note 4 of our audited consolidated financial statements.
The following table sets forth our consolidated operating results for the years ended December 31, 2016, 2015 and 2014. Further details of the results of operations of each reportable segment are included in the analysis of operating results for the respective segments.
For the 2016 period the Managed Care segment, which has a higher effective tax rate than our other segments, incurred in a loss before taxes, resulting in the recording of a tax benefit during the period.
Claims incurred during the year ended December 31, 2015 increased by $571.1 million, or 32.7%, to $2.3 billion when compared to the claims incurred during the year ended December 31, 2014, mostly due to higher claims in the Managed Care segment. This increase primarily reflects the claims incurred in the segment’s Medicaid business after the change from an ASO model to a fully insured model as well to an increase in the Medicare business. Increase in claims in the Medicare business is the result of an increase in membership offset by lower MLR. These increases were partially offset by lower claims incurred in the Commercial business, which reflects the business’s lower member month enrollment.
During the years ended December 31, 2014 and 2015, the Company executed in the fourth quarter of 2014 and the second quarter of 2015 Closing Agreements between TSM and its subsidiaries and the Puerto Rico Treasury Department that allowed the Company to take advantage of a temporary preferential tax rate window on capital gains. These events allowed the Company to record a tax benefit of $3.1 million and $17.0 million, in 2015 and 2014, respectively, resulting from the enacted lower taxable rate and the reassessment of the realizability of some of its deferred taxes.
We offer our products in the managed care segment to three distinct market sectors in Puerto Rico: Commercial, Medicare Advantage and Medicaid. For the year ended December 31, 2016, the Commercial, Medicare and Medicaid sectors represented 29.0%, 35.4% and 27.1% of our consolidated premiums earned, net, respectively.
Medical operating expenses decreased by $18.1 million, or 4.6%, to $375.3 million. The decrease mostly reflects lower expenses following the change in the Medicaid membership after we elected to decrease the number of regions we serve, from eight regions under an ASO agreement to only two regions when the contract was changed to a fully-insured model. The lower operating expenses also includes the effect of a decrease in the provision for doubtful accounts, mostly due to the strengthening of the allowance for doubtful receivables in the 2015 period, lower payroll and related expenses resulting from accruals related to management changes and retirements impacting the 2015 period, as well as to a $4.4 million expense related to settlement agreements entered with governmental agencies in 2015. These decreases were partially offset by a new business-to-business tax implemented in Puerto Rico at the end of the third quarter 2015 and an increase in the Health Insurance Providers Fee, reflecting the at-risk Medicaid enrollment after the model changed in 2015. The operating expense ratio increased 110 basis points to 14.0% in 2016 as a result of the increase in premiums and lower expenses.
Medical claims incurred during the year ended December 31, 2015 increased by $567.6 million, or 34.8%, to $2.2 billion, when compared to the prior year. The MLR of the segment was 86.2%, increasing by 30 basis points during the year ended December 31, 2015. These fluctuations are primarily attributed to the net effect of the following:
Policy benefits and claims incurred increased by $4.3 million, or 5.2%, to $86.9 million, mostly reflecting a higher volume of business during the year, particularly in the Cancer line of business, which claims increased by $2.7 million, as well as to an increase of $2.6 million in actuarial reserves. The loss ratio for the period decreased 30 basis points to 55.4% in 2016.
Premiums ceded to reinsurers during the year ended December 31, 2015 decreased by approximately $3.4 million, or 6.5%, to $48.7 million. The ratio of premiums ceded to premiums written decreased by 70 basis points, from 36.9% in 2014 to 36.2% in 2015. The lower amount of premiums ceded primarily results from favorable pricing in the reinsurance market.
The change in unearned premiums results from the lower volume of premiums written in the current year.
Underwriting and other operating expenses for the year ended December 31, 2015 increased by $1.0 million, or 2.3%, to $45.4 million mostly due to an increase in net commissions primarily resulting from a higher amortization and lower capitalization of deferred acquisition costs due to lower premium written. The operating expense ratio increased by 360 basis points, to 51.8% in 2015.
Year ended December 31, 2016 compared to year ended December 31, 2015
The increase in other sources of cash for the year ended December 31, 2016 is attributed to changes in the amount of outstanding checks in excess of bank balances.
The Company repurchases shares through open market transactions, in accordance with Rule 10b-18 of the Securities Exchange Act of 1934, as amended, under repurchase programs authorized by the Board of Directors. Shares purchased under share repurchase programs are retired and returned to authorized and unissued status.
A summary of share repurchase programs in place during the three-year-period ended December 31, 2016 is as follows:
In July 2013 the Company’s Board of Directors authorized an $11.5 million repurchase program (2013 $11.5 million stock repurchase program) of its Class B common stock. This program was discontinued on October 28, 2014.
The stock repurchase activity under stock repurchase programs for the years ended December 31, 2016, 2015, and 2014 is summarized as follows:
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, 2016, 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, 2016.
On November 4, 2015, TSS entered into a $50.0 million revolving loan agreement with a commercial bank in Puerto Rico. This unused line of credit has an interest rate of LIBOR plus 250 basis points, matured on November 4, 2016.
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, (iii) Term Loan B in the principal amount of $20.1 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 the outstanding balance of the $41 million secured loan payable with the same commercial bank in Puerto Rico. Proceeds from Term Loans B and C were received on January 11, 2017 and were used to prepay the outstanding principal amount plus accrued interest of the 6.6% Senior Unsecured Notes due January 2021 ($24 million), and fund a portion of a debt service reserve for the Loan (approximately $0.2 million). Pursuant to the credit agreement, interest is payable on the outstanding balance of the Loan at the following annual rate: (1) 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. Interest shall be payable commencing on January 1, 2017, in the case of Term Loan A, and on February 1, 2017, in the case of Term Loan B and Term Loan C. As of December 31, 2016, this loan had an outstanding balance of $11.2 million. This credit agreement is guaranteed by a first mortgage held by the bank on the Company’s land, building, and substantially all leasehold improvements, as collateral for the term of the loan under a continuing general security agreement. The loan includes 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 and dividends. As of December 31, 2016, we are in compliance with these covenants. Failure to meet these covenants may trigger accelerated payment of the secured loans outstanding balance. The Company may, at its option, upon notice, as specified in the credit agreement, redeem and prepay prior to maturity, all or any part of the Loan and from time to time upon the payment of a penalty fee of 3% during the first year, 2% during the second year and 1% during the third year, and thereafter, at par, as specified in the credit agreement, together with accrued and unpaid interest, if any, to the date of redemption specified by the Company.
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, 2016, we had $79.3 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, 2016, our policyholder deposits had a carrying amount of $179.4 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 $4.0 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 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, 2016, our insurance subsidiaries were in compliance with such minimum capital requirements.
The new credit agreement of approximately $35.5 million, limits the amount of dividends or other distributions (including share repurchases) payable by the Corporation to $50 million per year.
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 24, 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.
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 2014, the property and casualty segment has recorded recoveries of assessments for $0.5 million. It is the opinion of management that any possible future guarantee association assessments will not have a material effect on our operating results and/or cash flows, although there is no ceiling on these payment obligations.
The property and casualty segment is also member of the Puerto Rico Fire and Allied Lines Underwriting Association and the Puerto Rico Auto Assign Plan. These entities periodically impose assessments to cover operations and other charges. The assessments recorded from these entities were $1 thousand in 2015 and 2014. There were no assessments during 2016.
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 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.
At December 31, 2016, claim liabilities for the managed care segment amounted to $348.1 million and represented 71.3% of our total consolidated claim liabilities and 25.7% of our total consolidated liabilities.
At December 31, 2016, claim liabilities for the property and casualty insurance segment amounted to $97.0 million and represented 19.9% of the total consolidated claim liabilities and 7.1% of our total consolidated liabilities.
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.
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 4.50% 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.
The property and casualty business acquisition costs consist of commissions net of reinsurance commissions during the production of business and 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.
For our audited consolidated financial statements as of December 31, 2016 and 2015 and for each of the three years ended December 31, 2016 see Index to financial statements in “Item 15. Exhibits and Financial Statements Schedules” to this Annual Report on Form 10-K.