TSM owns a seven story (including the basement floor) building located at 1441 F.D. Roosevelt Avenue, in San Juan, Puerto Rico where the main offices of TSM, TSI and ISI are located, and the adjacent two buildings, one that houses TCI and certain offices of TSI, and the adjacent parking lot. In addition, TSM is the owner of five floors of a fifteen-story building located at 1510 F.D. Roosevelt Avenue, in Guaynabo, Puerto Rico. These floors house the Internal Auditing Office of the Corporation, SVTS, STS and some divisions of TSI.
This financial discussion contains an analysis of the consolidated financial position and financial performance as of December 31, 2002 and 2001, and consolidated results of operations for 2002, 2001 and 2000. This analysis should be read in its entirety and in conjunction with the consolidated financial statements, notes and tables included elsewhere in this Form 10-K. This financial discussion has been prepared pursuant to the rules and regulations adopted by the U.S. Securities and Exchange Commission.
Consolidated premiums earned, net and fee revenue during 2002 increased by $81.0 million, or 7.0%, when compared to the consolidated premiums earned, net and fee revenue for 2001. This increase is mostly due to a combined increase of $73.1 million in the premiums earned, net and fee revenue of the Health Insurance - Commercial Program and the Health Insurance - Healthcare Reform segments and to the increase in earned premiums of the property and casualty insurance segment.
a net increase in the average enrollment offset by the effect of the exclusion of mental health and substance abuse services.
During the year 2002 the consolidated claims incurred increased by $40.9 million, or 4.0%, due to an increase in the volume of business. However, the loss ratio reflects a decrease of 2.5 percentage points when compared to the prior year. This decrease is mostly attributed to fluctuations in the claims incurred of the Health Insurance - Commercial Program segment and the Health Insurance - Healthcare Reform segment. The decrease in loss ratio is the result of better than expected utilization trends. In addition, management has established several cost containment measures that have allowed cost and utilization trends to maintain levels consistent with pricing and margin objectives thus keeping the loss ratio under control. The consolidated expense ratio has remained similar to that for the year 2001, reflecting an increase of 0.1 percentage points.
The consolidated realized gain on sale of securities of $185 thousand and $4.7 million for the years 2002 and 2001, respectively, is the result of the sound and timely management of the investment portfolio in accordance with corporate investment policies and from normal portfolio turnover of the trading and available-for-sale securities. The consolidated realized gain during the year 2001 is mostly due to the sale of common stocks of Popular, Inc., which generated a realized gain of approximately $2.3 million and also to normal portfolio turnover of the trading and available for sale securities.
Consolidated premiums earned, net and fee revenue during 2001 increased by $66.8 million, or 6.1%, when compared to the consolidated premiums earned, net and fee revenue for 2000. This increase is mostly due to a combined increase of $64.1 million in the premiums earned, net and fee revenue of the Health Insurance - Commercial Program and the Health Insurance - Healthcare Reform segments.
- The premiums earned, net and fee revenue corresponding to the Health Insurance - Commercial Program reflect an increase of $49.0 million, or 8.3%, during this period. Increased premium rates as well as a net increase in the average enrollment account for the increase in the segment's earned premiums net, and fee revenue.
- The premiums earned corresponding to the Health Insurance - Healthcare Reform segment increased by $15.1 million, or 3.4%, during this period. This increase is basically the net result of increases in premium rates, a net decrease in the average enrollment offset by the effect of the exclusion of mental health and substance abuse services.
During the year 2001 the consolidated claims incurred increased by $30.9 million, or 3.1%, due to an increase in the volume of business. However, the loss ratio reflects a decrease of 2.5 percentage points when compared to the prior year. This decrease is mostly attributed to fluctuations in the claims incurred of the Health Insurance - Commercial Program segment and the Health Insurance - Healthcare Reform segment. The decrease in loss ratio is the result of management's ability to adjust its pricing strategy to cope with the increase in claims costs and several measures for cost containment. This process commenced during 1999 and the first half of 2000, and its effect impacted the loss ratio during the second half of 2000 and 2001. The consolidated expense ratio has remained similar to that for the year 2000, reflecting an increase of 0.2 percentage points.
Premiums earned, net and fee revenue for the year ended December 31, 2002, reflect an increase of $42.9 million, or 6.7%, when compared to the premiums earned, net and fee revenue for the year 2001. This increase is the result of the following:
- In addition, management service fees increased by $1.7 million, or 19.0%, when compared to the same amount for the year 2001. This increase was due to increases of claims incurred under the self-funded agreements mostly as the result of the increase in membership.
Claims incurred during the year 2002 increased by $14.1 million, or 2.5%, when compared to the claims incurred during the year 2001. This increase is due to the segment's increased volume of business, together with a decrease in the loss ratio of 3.5 percentage points during the year. The improvement in the loss ratio is the result of the following:
- Overall claims trends utilization development for the year 2002 was approximately 12.3% lower than expected.
- Also, the segment experienced a favorable development of $10.9 million of the 2001 claim liabilities estimate mostly because of better than expected utilization trends.
Operating expenses increased by $2.6 million, or 3.0%, when comparing the balances of the years 2002 and 2001. The operating expense ratio decreased by 0.4 percentage points during the year 2002. The lower operating expense ratio for 2002 is mostly due to economies associated with premium revenue growth in relation to fixed company operating expenses. In addition the segment has made technology investments (increase in electronic claims submissions, virtual storage technology, and interactive voice response, among others) that have also resulted in increased efficiency. These economies were mitigated by the increase in the acquisition cost of business, such as marketing and commission expenses and the increase in payroll and payroll related expenses.
Premiums earned, net and fee revenue for the year 2001 reflect an increase of $49.0 million, or 8.3%, when compared to those for the year 2000. This increase is the result of the combined effect of increases in premium rates and net increases in enrollment.
The Health Insurance - Healthcare Reform segment's total revenues are primarily generated from premiums earned according to the provisions of the Government's Healthcare Reform contracts and investment income. Claims incurred include health services and other benefit expenses consisting primarily of payments to physicians, hospitals and other service providers. A portion of the claims incurred for each period consists of an actuarial estimate of claims incurred but not reported to the segment during the period. Administrative expenses consist of general, depreciation, payroll and other related expenses. The segment's results of operations depend largely on its ability to accurately predict and effectively manage healthcare costs.
- Premium rates were increased by approximately 13.2% during the Healthcare Reform contract renegotiation process. New premium rates were negotiated effective October 1, 2001 for a nine-month period and effective July 1, 2002 for a twelve-month period ending on June 30, 2003.
- Effective October 1, 2001, the Government of Puerto Rico excluded mental health and substance abuse benefits from the risks managed by the health insurance carrier. The exclusion of these benefits represented a decrease of approximately $36 million in premiums earned during the year ended December 31, 2002. These services will continue to be directly contracted by the Government with specialized mental health service providers.
Approximately 89.0% of the total premiums increase is attributed to increases in membership, while the remaining 11.0% is attributed to increases in premium rates.
Operating expenses for the year 2002, increased by $3.5 million, or 10.6%, when compared to the year 2001. This increase is due to the segment's increase in membership. The expense ratio for the year 2002 increased by 0.2 percentage points when compared to the expense ratio for the year 2001.
Premiums earned, net for the year 2001 increased by $15.1 million or 3.4% when compared to the same amount for the year 2000. This increase is basically the net result of increases in premium rates offset by a decrease in members and the exclusion of mental health and substance abuse services from the Health Reform insurance policy.
- The average enrollment for this segment reflects a decrease of 20,609 members when compared to the average enrollment for the year 2000. This decrease is attributed to the net effect of the loss of the West Area effective July 1, 2000 and the acquisition of the Southwest Area effective October 1, 2001. The decrease in membership represented about $14.0 million in premiums earned.
Claims incurred increased by $477 thousand or 0.1% when compared to the year 2000. This increase is attributed to the growth in capitation payments to IPA's and in the cost of risks assumed by the segment, net of the exclusion of mental health services and substance abuse benefits and the decrease in membership. During 2001, the loss ratio for the Health Insurance - Healthcare Reform segment decreased by 3.1 percentage points when compared to the loss ratio for 2000. This decrease is mainly due to increases in premium rates, particularly in the Metro-North Area, as well as to a reduction in the coverage of the Healthcare Reform policy. Effective September 30, 2001, the Healthcare Reform policy did not cover mental health and substance abuse benefits. The Government now directly assumes the risk for these benefits.
Operating expenses for the year 2001 increased by $2.3 million, or 7.6%, when compared to the operating expenses for the year 2000. This increase is attributed to the increased volume of business of the segment. The expense ratio increased by 0.3 percentage points when compared to the expense ratio for the year 2000.
The property and casualty insurance segment's total revenues are primarily generated from net premiums earned and investment income. Claims incurred are composed of losses and loss-adjustment expenses. A portion of the claims
incurred for each period consists of an estimate of unreported losses to the segment during the period. Administrative expenses consist of general, commissions, depreciation, payroll and other related expenses.
STS has a well-diversified investment portfolio with good asset quality and a large portion invested in investment-grade, fixed income securities. The segment's investment portfolio is predominantly held in U.S. Treasury securities, obligations of U.S. government instrumentalities and obligations of state and political subdivisions, which comprise over 80% of the total portfolio value as of December 31, 2002. The remaining balance of the investment portfolio consists of an equity securities portfolio that replicates the S&P 500 Index, a corporate bonds portfolio, and investments in strong local stocks of financially sound financial institutions. Due to market value increase, the segment has a large single issuer equity concentration in Popular, Inc. As of December 31, 2002 and 2001, the carrying value of the Corporation's investment in Popular, Inc. amounted to $2.3 million and $4.2 million, respectively. This investment represents 2.2% for the year 2002, and 4.2% for the year 2001 of the segments total investments.
- The auto business also contributed to this year's increase, where the auto physical damage lines and the commercial auto liability line increased by $3.0 million, or 21.2%, and $2.5 million, or 30.8%, respectively. These increases are also attributed to the deregulation of premium rates, mostly as a result of the elimination of credits or discounts in the commercial accounts.
- The amount of premiums written in the general liability business (included within the "All Other" caption in the above summary) reflect an increase of $2.0 million during the year 2002. This increase is due to the acquisition of one significant account within this line of business, with premiums written of approximately $1.6 million.
- On the contrary, dwelling premiums reflect a decrease of $886 thousands, or 4.9%, during the year 2002. This decrease is basically the result of a decrease in new business from financial institutions. This segment's management has been devoting additional efforts to increase its client base in this financial sector to mitigate the effect of such fluctuation.
Approximately 60.0% of the increase in total premiums written is due to increases in premium rates. The remaining 40.0% is attributed to an increase in the volume of business.
Premiums ceded to reinsurers for the year ended December 31, 2002 remained similar to the same amount for the year 2001, reflecting an increase of $198 thousand, or 0.5%. The ratio of premiums ceded to total premiums written, however, reflects a decrease of 5.4 percentage points. This fluctuation is the net result of several factors:
- During the reinsurance contract renewal process, the segment cancelled a commercial quota share reinsurance treaty. This cancellation propitiated a reinsurance portfolio transfer that resulted in the reacquisition of business previously ceded, and, accordingly, a reduction in premiums ceded.
Year ended December 31, 2001 compared with the year ended December 31, 2000
Gross premiums written in the property and casualty insurance segment for the year 2001 increased by $9.6 million, or 11.0%, when compared to the year 2000. This increase is reflected in the premiums written for the following lines of business:
- In addition, STS' growth in the commercial property sector caused a proportional increase in aggregate levels needed to be covered by catastrophic and proportional treaties.
During 2001, property and casualty loss ratio decreased by 1.6 percentage points, primarily as a result of favorable underwriting results in the auto business and premium rate increases of approximately 60% that were effective April 2001. Operating expenses increased by $2.0 million, or 9.6%, during the year 2001. The increase in the expense ratio of 3.0 percentage points is the result of a reduction in the reinsurance commission income, which is presented netting the commission expense of the segment. The decrease in the reinsurance commission income is due to the restructuring of the reinsurance program during the contract renewal process.
The life and disability insurance segment's total revenues are primarily generated from net premiums earned and investment income. Claims incurred are composed of benefits and claims. A portion of the claims incurred for each period consists of an estimate of unreported claims to the segment during the period. Administrative expenses consist of general, commissions, depreciation, payroll and other related expenses.
Earned premiums for the year 2002 increased by $2.9 million or 16.3% when compared to 2001. This increase in earned premiums is mostly due to an increase in the number of certificates in force in the group life and group disability business totaling 38,386 certificates or 12.9% during the year 2002. Approximately 99% of the increase experienced in the earned premiums is attributed to increased volume of business. The remaining 1% of the increase in earned premiums is attributed to increased premium rates.
Total earned premiums in the year 2001 increased by $2.4 million, or 15.4%, when compared to the year 2000. This increase in earned premiums is mostly due to an increase in the number of certificates in force in the group life and group disability business totaling 12,702 certificates, or 13.1%, during the year 2001. Approximately 99% of the increase experienced in the earned premiums is attributed to the increased volume of business. The remaining 1% of the increase in earned premiums is attributed to increased premium rates.
Claims incurred increased by $1.1 million or 19.7% when compared to the year 2000. The segment's loss ratio reflects an increase of 1.6 percentage points during the year 2001. This increase is mostly attributed to the net effect of a decrease in claims costs during 2001 and to non-recurring release of incurred but not reported claims reserve of approximately $1 million during the year 2000. This adjustment is the result of a better than expected actual development of the incurred but not reported claims reserve determined in 1999 for a significant new group that commenced coverage during the last quarter of 1999. Management assumed a conservative approach in determining the incurred but not reported claims reserve for this group in 1999, assuming a worst-case scenario in the absence of historical claim trends. Also, during the year 2001 the segment subscribed more disability business than during the year 2000, fact that also contributes to greater control in the loss ratio for the segment.
- Increase of $72.0 million in 2002 and a decrease of $12.3 in 2001 in the amount of claims losses and benefits paid. In the year 2002 the increase in the amount of claims losses and benefits paid is mostly the result of the segment's increased volume of business. The decrease in the amount of claims losses and benefits paid during the year 2001 is the result of the establishment of several costs containment measures by operating segments.
- In addition during the year 2002, the amount of net acquisitions of investments in the trading portfolio increased by $9.5 million.
This excess liquidity is available, among other things, to invest in high quality and diversified fixed income securities and, to a lesser degree, to invest in marketable equity securities.
Net cash flows (used in) provided by financing activities amounted to $(11.5) million, $2.8 million and $5.2 million for the years ended December 31, 2002, 2001 and 2000, respectively. The decrease of $14.3 million during the year 2002 and $2.4 million during the year 2001 in the cash flows from financing activities is due to the effect of the following fluctuations:
- The change in outstanding checks in excess of bank balances decreased by $10.2 and $2.8 million during the years 2002 and 2001, respectively. This represents a timing difference between the issuance of checks and the cash balance in the bank account at one point in time.
The Corporation continually monitors existing and alternative financing sources to support its capital and liquidity needs.
The Corporation's contractual obligations include loans payable to a bank (refer to the previous section) and operating leases. The Corporation has operating non-cancelable leases for several offices and certain equipment. The maturity schedule of the Corporation's contractual obligations at December 31, 2002 is as follows:
The Corporation has an interest-rate related derivative instrument to manage the variability caused by interest rate changes in the cash flows of its loan agreements. The Corporation does not enter into derivative instruments for any purpose other than cash flow hedging purposes. That is, the Corporation does not speculate using derivative instruments. To meet this objective, on December 6, 2002 management entered into an interest rate swap agreement to manage fluctuations in cash flows resulting from interest rate risk. This five-year interest swap changes the variable-rate cash flow (LIBOR plus 100 basis points) exposure on the debt obligation to fixed-rate cash flow (4.72%). The interest rate swap agreement is effective April 1, 2003.
Other than as noted above, the Corporation does not have any material off-balance sheet arrangements, trading activities involving non-exchange related contracts accounted for at fair value or relationships with persons or entities that derive benefits from a non-independent relationship with the Corporation or the Corporation's related parties.
The Corporation is a for-profit organization that operates as a not-for-profit organization by virtue of the affirmative vote of its stockholders. As a result, the Corporation does not distribute dividends. This resolution could be altered anytime by the affirmative vote of stockholders and thus, dividends could be available for distribution subject to the applicable obligations and responsibilities.
TSI is not allowed to distribute dividends on its common stock. This is due to an income tax administrative ruling issued by the Department of the Treasury of the Commonwealth of Puerto Rico, which grants the subsidiary a total tax exemption from Puerto Rico taxes if it complies with several conditions, one of which prohibits the payment of dividends.
TSM's insurance subsidiaries are subject to the regulations of the Commissioner of Insurance of the Commonwealth of Puerto Rico. These regulations, among other things, require insurance companies to maintain certain levels of capital; therefore, restricting the amount of earnings that can be distributed. As of December 31, 2002, the insurance subsidiaries were in compliance with such minimum capital requirements. These regulations are not directly applicable to TSM, as a holding company, since it is not an insurance company. Except for TSI, which has the dividend restriction imposed by the Department of the Treasury's income tax administrative ruling, the regulations applicable to insurance subsidiaries are not expected to affect their ability to distribute dividends to TSM.
TSI's compliance with the requirements of its income tax ruling is currently being audited by representatives of the Puerto Rico Department of the Treasury. Management is of the opinion that TSI is in compliance with such ruling at December 31, 2002 and 2001.
Based on the information currently known by the Corporation's management, in its opinion, the outcomes of such pending investigations and legal proceedings are not likely to have a material adverse effect on the Corporation's 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 the Corporation's operating results and/or cash flows (see "Item 3. Legal Proceedings").
Pursuant to the Puerto Rico Insurance Code, the property and casualty insurance segment is a member of Sindicato de Aseguradores para la Suscripcion Conjunta de Seguros de Responsabilidad Profesional Medico-Hospitalaria (SIMED) and of the Sindicato de Aseguradores de Responsabilidad Profesional para Medicos. Both syndicates were organized for the purpose of underwriting medical-hospital professional liability insurance. As a member, the segment shares risks with other member companies and, accordingly, is contingently liable in the event the previously mentioned syndicates cannot meet their obligations. In recent years, SIMED has encountered financial difficulties, mainly attributed to premium deficiencies. As of December 31, 2001 (date of latest financial statements available), SIMED presented a deficit of approximately $22.3 million. During 2002, 2001 and 2000, no assessment or payment has been made for this contingency.
(3) Examination from Regulator - The Puerto Rico House of Representatives Banking and Insurance Committee (the Committee) is conducting an investigation of TSI's tax treatment under rulings issued by the Puerto Rico Department of the Treasury that grant TSI's tax exempt status. A similar resolution was approved by the Puerto Rico Senate. TSI has provided to the Committee and Puerto Rico Senate information and documents as requested.
The Corporation continually evaluates the accounting policies and estimates it uses to prepare the consolidated financial statements. In general, management's estimates are based on historical experience and on various other assumptions that are believed to be reasonable under the facts and circumstances. Actual results could differ from those estimates made by management.
- Claims processed and incomplete for the health insurance segments represent the estimated amounts to be paid to providers based on experience and accumulated statistical data. Loss-adjustment expenses related to such claims are accrued based on estimated future expenses necessary to process such claims.
- Claims processed and incomplete and loss-adjustment expenses of the property and casualty insurance segment represents the individual case estimate for reported claims and estimates for unreported losses, net of any salvage and subrogation as well as an estimate of expenses for investigating and settling claims. These estimates are based on analysis of prior loss experience modified for current trends.
- Claims processed and incomplete of the life and disability insurance segment are based on the amount of benefits contractually determined for reported claims and on estimates for unreported claims. These estimates are based on analysis of prior loss experience modified for current trends.
Management continually evaluates the potential for changes in its claim liabilities estimates, both positive and negative, and uses the results of these evaluations both to adjust recorded claim liabilities and to adjust underwriting criteria. The Corporation's profitability depends in large part on accurately predicting and effectively managing the amount of claims incurred, particularly those of the health insurance segments and the losses arising from the property and casualty insurance segment. Management regularly reviews its premiums and benefits structure to reflect the Corporation's underlying claims experience and revised actuarial data; however, several factors could adversely affect the Corporation's underwriting. Some of these factors are beyond management control and could adversely affect its ability to accurately predict and effectively control claims incurred. Examples of such factors include changes in health practices, economic conditions, the advent of natural disasters, and malpractice litigation. Costs in excess of those anticipated could have a material adverse effect on the Corporation's results of operations.
A decline in the estimated fair value of any available for sale or held to maturity security below cost, which is deemed to be other than temporary, results in a reduction of the carrying amount to its fair value. The impairment is charged to operations and a new cost basis for the security is established. Management regularly reviews each investment security for impairment based on criteria that include the extent to which cost exceeds estimated fair value, the duration of the estimated fair value decline and the financial health and specific prospects for the issuer. Management regularly performs market research and monitors market conditions in order to minimize impairment risk. Investment in securities amounted to $469.6 million as of December 31, 2002. Gross unrealized gains and losses included in that carrying amount related to fixed maturity securities amounted to $8.8 million and $177 thousand, respectively. Gross unrealized gains and losses on equity securities, classified as securities held for trading and securities held as available for sale, amounted to $25.0 million and $10.1 million, respectively. Management believes that none of the securities whose carrying amount exceeds its estimated fair value at December 31, 2002 is at risk of being charged to operations during the year 2003. During the year 2002, the Corporation recognized an other than temporary impairment on one of its available for sale securities amounting to $311 thousand. No other than temporary impairment was recognized in the years 2001 and 2000.
The Corporation estimates the amount of uncollectible receivables in each period and establishes an allowance for doubtful receivables. The amount provided is based on management's continuous evaluation of the aging of accounts receivable and such other factors that deserve current recognition. A change in the level of uncollectible accounts could have a significant effect on the Corporation's results of operations. The allowance for doubtful receivables amounted to $13.8 million and $11.7 million as of December 31, 2002 and 2001, respectively.
In April 2002, the FASB issued SFAS No. 145, Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections. SFAS No. 145 amends existing guidance on reporting gains and losses on the extinguishment of debt to prohibit the classification of the gain or loss as extraordinary, as the use of such extinguishments have become part of the risk management strategy of many companies. SFAS No. 145 also amends SFAS No. 13 to require sale-leaseback accounting for certain lease modifications that have economic effects similar to sale-leaseback transactions. The provisions of the statement related to the rescission of SFAS No. 4 are applied in fiscal years beginning after May 15, 2002. Earlier application of these provisions is encouraged. The provisions of the statement related to SFAS No. 13 were effective for transactions occurring after May 15, 2002, with early application encouraged. The adoption of SFAS No. 145 is not expected to have a material effect on the Company's financial statements.
In June 2002, the FASB issued SFAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities, SFAS No. 146 addresses financial accounting and reporting for costs associated with exit or disposal activities and nullifies Emerging Issues Task Force (EITF) Issue 94-3, Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity. The provisions of this statement are effective for exit or disposal activities that are initiated after December 31, 2002, with early application encouraged. The adoption of SFAS No. 146 is not expected to have a material effect on the Company's financial statements.
In November 2002, the FASB issued Interpretation No. 45, Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness to Others, an interpretation of FASB Statements No. 5, 57, and 107 and a rescission of FASB Interpretation No. 34. This interpretation elaborates on the disclosures to be made by a guarantor in its interim and annual financial statements about its obligations under guarantees issued. The interpretation also clarifies that a guarantor is required to recognize, at inception of a guarantee, a liability for the fair value of the obligation undertaken. The initial recognition and measurement provisions of the interpretation are applicable to guarantees issued or modified after December 31, 2002 and are not expected to have a material effect on the Company's financial statements. The disclosure requirements are effective for financial statements of interim and annual periods ending after December 31, 2002.
In December 2002, the FASB issued SFAS No. 148, Accounting for Stock-Based Compensation - Transition and Disclosure, an amendment of FASB Statement No. 123. This statement amends FASB Statement No. 123, Accounting for Stock-Based Compensation, to provide alternative methods of transition for a voluntary change to the fair value method of accounting for stock-based employee compensation. In addition, this statement amends the disclosure requirements of SFAS No. 123 to require prominent disclosures in both annual and interim financial statements. Certain of the disclosure modifications are required for fiscal years ending after December 15, 2002. The adoption of SFAS No. 148 is not expected to apply on the Company's financial statements.