We also own land in the municipality of Ponce, Puerto Rico, in which we have begun to build a multi-segment customer service center. 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.
This financial discussion contains an analysis of our consolidated financial position and financial performance as of December 31, 2014 and 2013, and consolidated results of operations for 2014, 2013 and 2012. 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 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, 2014 we serve approximately 2,139,000 members across all regions of Puerto Rico. For the years ended December 31, 2014 and 2013 respectively, our managed care segment represented approximately 89.0% and 89.5% of our total consolidated premiums earned, net, and approximately 57.3% and 73.4% 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 12% (in terms of premiums written) for 2013. Our property and casualty segment had a market share of approximately 8% (in terms of direct premiums) during the nine-month period ended September 30, 2014.
In October 2014, our Board of Directors authorized a $50.0 million share repurchase program of our Class B common stock. Repurchases are being conducted through open-market purchases of Class B shares only, in accordance with Rule 10b-18 under the Securities Exchange Act of 1934, as amended. During 2014, the Company repurchased and retired 228,525 shares of Class B common stock under this program at an average per share price of $23.55, for an aggregate cost of approximately $5.3 million.
The Commissioner of Insurance of the Commonwealth 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.
General. Our revenue consists primarily of (i) premium revenue we generate from our managed care business, (ii) administrative service fees we receive for services provided to self-insured employers, (iii) premiums we generate from our life insurance and property and casualty insurance businesses and (iv) investment income.
Managed Care Premium Revenue. Our revenue primarily consists of premiums earned from the sale of managed care products to the Commercial market sector, including corporate accounts, federal government employees, local government employees, individual accounts and Medicare Supplement, as well as to the Medicare Advantage (including PDP). 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.
Administrative Service Fees. Administrative service fees include amounts paid to us for administrative services provided to self-insured contracts. We provide a range of customer services pursuant to our administrative services only (“ASO”) contracts, including claims administration, billing, access to our provider networks and membership services. Administrative service fees are recognized in the month in which services are provided. TSS has a contract with the Government of Puerto Rico, to administer the provision of the physical health component of the Medicaid program in designated service regions in Puerto Rico. On July 1, 2013, TSS extended this contract for a 12-month period. This amendment also transferred the administration of the three remaining service regions to TSS upon completion of a transition period, which ended on October 1, 2013. In 2014 the Government of Puerto Rico commenced an RFP process for the Medicaid business and announced its intention to convert the current program to a managed care organization model, under which the selected contractors will be at risk for the provision of the physical and behavioral health components of the program. TSS submitted bids for the Metro north and West regions, which were subsequently awarded on October 14, 2014. Additionally TSS is expected to continue to serve as a third party administrator until December 31, 2015 in order to process all claims incurred on or before March 31, 2015.
Investment Income. Investment income consists of interest and dividend income from investment securities. See note 4 to our audited consolidated financial statements.
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 and 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, 2014, 2013 and 2012. Further details of the results of operations of each reportable segment are included in the analysis of operating results for the respective segments.
Year ended December 31, 2014 compared with the year ended December 31, 2013
Consolidated net realized investment gains of $18.2 million during the year ended December 31, 2014 are the result of net realized gains from the sale of debt and equity securities classified as available for sale, following our asset/liability management and tax planning strategies. The net realized gains were partially offset by a $1.2 million other-than-temporary impairments.
Consolidated claims incurred during the year ended December 31, 2014 decreased by $88.6 million, or 4.8%, to $1.7 billion when compared to the claims incurred during the year ended December 31, 2013. This decrease is mostly in the Commercial business of the Managed Care segment primarily as a result of lower member month enrollment in the 2014 period. Property and Casualty claims also decreased reflecting a favorable loss experience, particularly in the Commercial Multi-peril and Commercial Auto lines of business, partially offset with an unfavorable loss experience in the Medical Malpractice line of business. These decreases were partially offset by an increase in claims of the Life segment of $4.1 million reflecting the addional claims related to the recent ASICO acquisition, which was effective November 2013. The consolidated loss ratio decreased by 120 basis points to 82.1%.
Consolidated operating expenses during the year ended December 31, 2014 increased by $19.0 million, or 4.0%, to $497.2 million as compared to the operating expenses during the year ended December 31, 2013. For the year ended December 31, 2014, the consolidated operating expense ratio increased by 140 basis points to 22.1%. The higher operating expenses and operating expenses ratio are mainly related to $27.7 million of Health Insurance Providers Fee that became effective January 1, 2014, an increase of $4.4 million in premium taxes and incremental expenses related to the administration of the three new service regions of the Medicaid program effective October 1, 2013. The effect of new taxes and fees and the increased Medicaid enrollment was partly offset by the impact of cost containment initiatives in place during 2014.
Consolidated premiums earned, net decreased by $50.4 million, or 2.2%, to $2.2 billion during the year ended December 31, 2013 compared to the year ended December 31, 2012. The decrease was mostly the result of lower member month enrollment in the Medicare and Commercial businesses and the receipt of lower risk score adjustments from CMS in 2013 as compared to 2012.
Consolidated other income increased by $13.1 million during the year ended December 31, 2013 compared with to the year ended December 31, 2012 mostly due to the JUA special distribution received from the Property and Casualty segment of $12.8 million, net of a special tax.
Consolidated operating expenses during the year ended December 31, 2013 increased by $53.0 million, or 12.5%, to $478.2 million as compared to the operating expenses during the year ended December 31, 2012. For the year ended December 31, 2013, the consolidated operating expense ratio increased by 270 basis points to 20.7%, The higher operating expenses and operating expenses ratio are mainly related to special technology initiatives, expenses related to the reorganization of the Medicare business, higher payroll and related expenses mostly as a result of recruitment of additional Medicare sales force, and additional expenses incurred to serve the additional three Medicaid regions effective October 1, 2013. Professional services also reflect an increase related to our CMS star ratings efforts. Operating expenses for the year ended December 31, 2013 also include approximately $5.0 million in premium taxes. These premium taxes became effective on July 1, 2013.
Medical premiums earned for the year ended December 31, 2014 decreased by $78.6 million, or 4.0%, to $1.9 billion when compared to the medical premiums earned during the year ended December 31, 2013. This decrease is principally the result of the following:
• Medical premiums generated by the Commercial business decreased by $53.4 million, or 5.7%, to $882.4 million during the year ended December 31, 2014 as compared to the year ended December 31, 2013. This fluctuation is primarily the result of a decrease in fully-insured member month enrollment by 477,997, or 8.7%, mainly in our rated groups and individual accounts products and reflecting pricing sensitivity, cancellation of several commercial accounts and attrition in existing accounts as a result of Puerto Rico’s challenging economic situation. The effect of the decreased membership is partially offset by a 3.3% year over year increase in average premium rates.
• Medical premiums generated by the Medicare business decreased by $25.2 million, or 2.4%, to $1.0 billion during the year ended December 31, 2014 as compared to the year ended December 31, 2013. This fluctuation primarily results from lower risk score adjustments when compared to the 2013 period, a decrease in risk score revenue when compared to last year, and the decline in 2014 premiums mandated by CMS and a change in membership mix in 2014.
Premiums earned, net for the year ended December 31, 2014 increased by $11.9 million, or 9.1%, to $142.5 million as compared to the year ended December 31, 2013, mostly as result of $7.0 million of additional life premiums provied by the ASICO acquisition which was effective as of November 2013. Premiums from the Cancer and Individual Life lines of business increased by $2.4 million as the result of new sales of home service products, while the premiums from the Group Life line of business increased $2.5 million year over year.
Premiums earned, net for the segment increased by $5.9 million, or 4.7%, to $130.6 million during the year ended December 31, 2013 as compared to the year ended December 31, 2012, primarily as the result of new sales in the Cancer and Individual Life businesses during the period. Of the increase experienced year over year, $1.4 million is related to premiums earned by TSB, the insurance company acquired by TSV in November 2013.
Total premiums written during the year ended December 31, 2014 decreased by $11.2 million, or 7.4%, to $141.1 million, mostly resulting from lower sales of commercial products, primarily package, liability, and auto insurance products.
Premiums ceded to reinsurers during the year ended December 31, 2014 decreased by approximately $5.5 million, or 9.5%, to $52.1 million. The ratio of premiums ceded to premiums written decreased by 90 basis points, from 37.8% in 2013 to 36.9% in 2014. The lower amount of premiums ceded primarily results from a change in the commercial quota share agreement where the cession was changed from 37% to 30% in 2014.
Underwriting and other operating expenses for the year ended December 31, 2014 decreased by $6.9 million, or 13.5%, to $44.4 million primarily due to a lower net commission expense resulting from the decrease in net premiums earned, favorable variance in salaries and benefits after the implementation of changes in employee benefits and headcount reduction, and recoveries resulting from premium surcharges to recover assessments paid to the Puerto Rico Guarantee Fund. The operating expense ratio decreased by 290 basis points during the same period, to 48.2% in 2014.
The change in unearned premiums presented an increase of $7.1 million, to $5.6 million during the year ended December 31, 2013, primarily as the result of the lower volume of premiums written during this period.
Claims incurred during the year ended December 31, 2013 increased by $5.8 million, or 11.8%, to $55.1 million. The loss ratio increased by 440 basis points, to 54.9% in 2013, as a result of unfavorable loss experience in the Commercial Package, General Liability and Auto Insurance lines of business. The increase also responds to a lower proportion of Dwelling business in our portfolio.
Underwriting and other operating expenses for the year ended December 31, 2013 increased by $0.8 million, or 1.6%, to $51.3 million. The increase is mainly related to an assessment received from the Puerto Rico Guarantee Fund and recorded as a charge to operations of $0.6 million to cover the insolvencies of insurers under liquidation. The operating expense ratio decreased by 60 basis points during the same period, to 51.1% in 2013.
During the year ended December 31, 2014 we received $9.6 million in policyholder deposits. This represents an increase of $0.4 million when compared to the prior year and is the result of higher sales of annuity products.
Net proceeds of investment securities were $34.0 million during the year ended December 31, 2014, primarily resulting from the net cash flows received from the sales, net of purchases, of investment securities during 2014. During the year ended December 31, 2013 we had net purchases of investments of $66.2 million, primarily resulting from higher excess cash flows from operations.
Repurchase and retirement of common stock decreased by $6.9 million mainly due to the repurchase and retirement of 1,000,000 shares of common stock as part of the secondary public offering conducted during the year ended December 31, 2013. During 2014, the corporation repurchased and retired 596,225 with a total cost of $11.3 million.
Cash flows from operating activities increased by $3.2 million for the year ended December 31, 2013 as compared to the year ended December 31, 2012, principally due to the effect of lower claims paid by $70.6 million, offset in part by lower premiums collections by $53.6 million and higher cash paid to suppliers and employees by $9.0 million. The decrease in premiums collected is principally the result of the lower Managed Care membership enrollment. The decrease in claim payments mostly results from the lower enrollment in the Managed Care membership. This decrease also reflects improved drug costs after the new PBM contract in TSA and the impact of changes in 2013 product design.
Payments of long-term borrowings of $12.0 million during the year ended December 31, 2013 are primarily the result of a $10.0 million prepayment of one of our senior unsecured notes. The $14.9 million decrease in payments of long-term debt is due to the prepayment of another senior unsecured note of $25.0 million during the year ended December 31, 2012.
Repurchase and retirement of common stock increased by $15.9 million mainly due to the repurchase and retirement of 1,000,000 shares of common stock as part of the completed secondary public offering conducted during the year ended December 31, 2013.
On September 29, 2010, we announced the immediate commencement of the 2010 stock repurchase program. The program was 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. On March 23, 2013, we discontinued our 2010 stock repurchase program.
On July 29, 2013 the Company’s Board of Directors authorized an $11.5 million repurchase program of its Class B common stock. On October 28, 2014, we discontinued our 2013 stock repurchase program. During the year ended December 31, 2014, under this program the Company repurchased and retired 367,700 of our Class B Common Stock shares at an average per share price of $16.32, for an aggregate cost of $6.0 million.
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, 2014, we had $135.0 million of available credit under these facilities. There are no outstanding short-term borrowings under these facilities as of December 31, 2014.
On December 21, 2005, we issued and sold $60.0 million of our 6.6% senior unsecured notes due December 2020 (the “6.6% notes”). The 6.6% notes were privately placed to various institutional accredited investors. The notes pay interest each month until the principal becomes due and payable. These notes can be redeemed after five years at par, in whole or in part, as determined by us. On October 1, 2010 we repaid $25.0 million of the principal of these senior unsecured notes. The 6.6% notes contain certain non-financial covenants. At December 31, 2014, we are in compliance with these covenants.
On November 1, 2010, we entered into a $25.0 million arrangement to sell securities under repurchase agreements that matures on November 2015. The repurchase agreement pays interest quarterly at 1.96%. The investment securities underlying such agreements were delivered to the financial institution with whom the agreement was transacted. The dealers may have loaned, or used as collateral such securities in the normal course of business operations. We maintain effective control over the investment securities pledged as collateral and accordingly, such securities continue to be carried on our consolidated balance sheet. At December 31, 2014 investment securities available for sale with fair value of $27.1 million (face value of $27.1 million) were pledged as collateral under this agreement. The proceeds obtained from this agreement were used to repay $25.0 million of the 6.6% notes.
As part of the acquisition of the controlling stake in a health clinic during 2012, we assumed a secured term loan with original principal balance of $14.1 million that was paid in full on December 23, 2014. This loan was guaranteed by a first position held by the bank on the health clinic’s premises (land and building) and all of the health clinic's assets as collateral for the term of the loan under a continuing general security agreement. The secured loan contained 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.
• Other long-term liabilities - Due to the indeterminate nature of their cash outflows, $133.1 million of other long-term liabilities are not reflected in the following table, including $86.7 million of liability for pension benefits, $30.7 million in deferred tax liabilities, and $15.7 million in liabilities to the Federal Employees’ Health Benefits Plan Program.
(1) As of December 31, 2014, our long-term borrowings consist of our 6.6% senior unsecured notes payable, and a $25.0 million arrangement to sell securities under repurchase agreements which requires quarterly interest payments at 1.96%. Total contractual obligations for long-term borrowings include the current maturities of long term debt. For the 6.6% senior unsecured notes and the arrangement to sell securities under repurchase agreements, scheduled interest payments were included in the total contractual obligations for long-term borrowings until the maturity dates of the notes in 2020, and 2015 respectively. We may redeem the senior unsecured note starting five years after issuance; however no redemption is considered in this schedule. See the “Financing and Financing Capacity” section for additional information regarding our long-term borrowings.
Since 2009, local insurers and health organizations are required by the Insurance Code to submit to the Commissioner of Insurance Puerto Rico RBC reports following the NAIC’s RBC Model Act and accordingly are subject to the relevant measures and actions as required based on their capital levels in relation to the determined risk based capital. In February 2010 Insurance Regulation No. 92 (“Rule 92”) entered into effect establishing guidelines to implement the RBC requirements. Rule 92 provides for a gradual compliance and a five-year transition period, including dividend payment restriction and exemption to comply with requirements.
As of December 31, 2014, our insurance subsidiaries were in compliance with such minimum capital requirements.
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 2013, the property and casualty segment paid $0.6 million for an assessment imposed by the Puerto Rico Guaranty Association for Property and Casualty Insurers. In accordance with insurance laws and regulations assessments are recoverable through policy surcharges. In 2014 and 2013, the property and casualty segment has recorded recoveries of assessments for $0.5 million and $15 thousand. During the year ended December 31, 2012, no assessment or payment was made in connection with insurance companies declared insolvent. It is the opinion of management that any possible future guarantee association assessments will not have a material effect on our operating results and/or cash flows, although there is no ceiling on these payment obligations.
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 2014, 2013 and 2012, 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, 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 2014, 2013 and 2012, the Association distributed the Company a distribution based on the good experience of the business amounting to $0.9 million, $1.2 million and $1.2 million, respectively. In September 2013, the Association declared a special distribution to its members for $200 million. This distribution was subject to a special and unique tax rate of 50%. The property and casualty then received $12.8 million, net of tax, from this distribution.
Claim liabilities by segment as of December 31, 2014 were as follows:
Management continually evaluates the potential impact of changes in the factors considered for its claim liabilities estimates, both positive and negative, and uses the results of these evaluations to adjust recorded claim liabilities and underwriting criteria. Our profitability depends in large part on our ability to accurately predict and effectively manage the amount of claims incurred, particularly those of the managed care segment and the losses arising from the property and casualty and life insurance segment. Management regularly reviews its premiums and benefits structure to reflect our underlying claims experience and revised actuarial data; however, several factors could adversely affect our underwriting results. Some of these factors are beyond management’s 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, change in utilization trends including those caused by epidemic conditions, healthcare costs, the advent of natural disasters, and malpractice litigation. Costs in excess of those anticipated could have a material adverse effect on our results of operations.
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, 2014 claim liabilities, assuming the indicated hypothetical changes in completion and trend factors:
At December 31, 2014, claim liabilities for the property and casualty insurance segment amounted to $97.5 million and represented 25.0% of the total consolidated claim liabilities and 7.6% of our total consolidated liabilities.
At December 31, 2014, the actuarial reserve range determined by the actuaries was from $93 million to $108 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 liabilities for all products, except for universal life and deferred annuities, are based upon a variety of actuarial assumptions that are uncertain. The most significant of these assumptions is the level of anticipated death and health claims. Other assumptions that are less significant to the appropriate level of the liability for future policy benefits are anticipated policy persistency rates, investment yields, and operating expense levels. These are reviewed frequently by our subsidiary’s external actuaries, to assure that the current level of liabilities for future policy benefits is sufficient, in combination with anticipated future cash flows, to provide for all contractual obligations. For all products, except for universal life and deferred annuities, the basis for the liability for future policy benefits is established at the time of issuance of each contract and would only change if our experience deteriorates to the point that the level of the liability is not adequate to provide for future policy benefits. We do not currently expect that level of deterioration to occur.
• Identification and evaluation of securities that have possible indications of other-than-temporary impairment, which includes an analysis of all investments with gross unrealized investments losses that represent 20% or more of cost and all investments with an unrealized loss greater than $100 thousand.
• Review and evaluation of any other security based on the investee’s current financial condition, liquidity, near-term recovery prospects, implications of rating agency actions, the outlook for the business sectors in which the investee operates and other factors. This evaluation is in addition to the evaluation of those securities with a gross unrealized investment loss representing 20% or more of their cost.
• Consideration of evidential matter, including an evaluation of factors or triggers that may or may not cause individual investments to qualify as having other-than-temporary impairments; and
For our audited consolidated financial statements as of December 31, 2014 and 2013 and for each of the three years ended December 31, 2014 see Index to financial statements in “Item 15. Exhibits and Financial Statements Schedules” to this Annual Report on Form 10-K.
As a result of this out-of-period adjustment the consolidated income before tax was overstated by $1.9 million during the three months ended March 31, 2013 and understated by the same amount during the three months ended June 30, 2013.
We assessed the impact of the adjustment needed to account for this error in their appropriate period and concluded that recording this adjustment in the consolidated results of operations in the three months ended June 30, 2013, 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, 2013. This out-of-period adjustment involves only reported quarterly results and, because they were corrected during the year, have no effect on the results of operations, financial position and cash flows for the year ended December 31, 2013.