In addition, we lease office space at various locations in 35 states for our Insphere agent field offices comprising in the aggregate approximately 218,000 square feet.
The following selected consolidated financial data as of and for each of the five years in the year ended December 31, 2012 has been derived from the audited consolidated financial statements of the Company. The following data should be read in conjunction with the consolidated financial statements and the notes thereto and Management’s Discussion and Analysis of Financial Condition and Results of Operations included herein.
Expense ratio. The expense ratio is defined as underwriting, acquisition and insurance expenses as a percentage of earned premiums.
Through our insurance subsidiaries, we issue primarily health and life insurance and supplemental products covering individuals, families, the self-employed and small businesses. In 2012, our HealthMarkets Insurance Company subsidiary began marketing stand-alone Medicare prescription drug plans under the Medicare Part D program to the senior market, with coverage effective for January 1, 2013. Insphere serves as an authorized insurance agency in 50 states and the District of Columbia, specializing in the distribution to the small business and middle-income market. Insphere distributes life, health and Medicare insurance through a portfolio of products from nationally recognized insurance carriers. Insphere distributes products underwritten by the Company’s insurance subsidiaries, as well as non-affiliated insurance companies.
The majority of our 2012 revenue was earned on health premiums derived from our inforce block of indemnity and preferred provider organization (“PPO”) policies as well as supplemental products premiums. Premiums on health insurance and supplemental products are recognized as earned over the period of coverage on a pro rata basis. We also earned revenue on premiums from traditional life insurance policies, which are recognized as revenue when due.
The decrease in premium reflects the change in the Company’s strategic focus related to underwriting health insurance products. In connection with the launch of Insphere, the Company currently markets its health insurance products in only a limited number of states.
Effective in 2011, if the medical loss ratios of our fully insured health products (calculated in accordance with the Health Care Reform Legislation and implementing regulations) fall below certain targets, our insurance subsidiaries will be required to rebate ratable portions of their premiums annually. Rebate payments for 2012 are to be paid by August 1, 2013. As a result, the decrease in earned premium also reflects the recording of an accrual for the estimated medical loss ratio rebate. At December 31, 2012 and 2011, the Company accrued $8.6 million and $26.9 million, respectively, for the medical loss ratio rebate.
Investment income includes investment income derived from our investment portfolio and interest received on student loans.
Commission and other income consist primarily of commission and bonus revenue generated from the sale of third-party insurance products, association memberships and ancillary services.
Underwriting, acquisition and insurance expenses consist of marketing and direct expenses incurred across all insurance lines in connection with issuance, maintenance and administration of in-force insurance policies, including amortization of deferred policy acquisition costs, commissions paid to agents, administrative expenses and premium taxes. Benefits and underwriting, acquisition and insurance expenses have continued to decrease in tandem with the decrease in premiums. Prior to 2010, the Company initiated certain general and administrative cost reduction programs. These cost reduction efforts are still ongoing. Beginning in 2010, the Company’s focus has been on selling third-party products rather than the health benefit plans underwritten by its insurance companies. As a result, the majority of our marketing costs have been incurred by Insphere. These marketing costs incurred by Insphere are recorded on the Company’s consolidated statements of operations in “Other Expenses.”
Assets by operating segment at December 31, 2012, 2011, and 2010 are set forth in the table below:
Through our Commercial Health Division, we underwrite and administer a broad range of health and life and supplemental products for individuals, families, the self-employed and small businesses. Our health insurance products are designed to accommodate individual needs and include basic hospital-medical expense plans, plans with preferred provider organization features, catastrophic hospital expense plans, as well as other supplemental types of coverage. Our supplemental products are designed to further protect against risks to which our customer is typically exposed and are sold on a stand-alone basis as well as in connection with the sale of other insurance products. The supplemental products include dental, vision, disability, critical illness, accident, and hospital indemnity/specified disease products.
Set forth below is certain summary financial and operating data for the Commercial Health Division for each of the three most recent fiscal years:
Expense Ratio. The expense ratio is defined as underwriting, acquisition and insurance expenses as a percentage of earned premium revenue.
Other income and other expenses continued to decrease in 2012 compared to the prior year. Other income largely consists of fee and other income received for sales of association memberships prior to the formation of Insphere, for which other expenses are incurred for bonuses and other compensation provided to the agents. The majority of these association memberships were sold along with health policies and as premium continues to decrease we expect the revenue and expense generated from these association memberships to also decrease.
The Commercial Health Division reported earned premium revenue of $544.7 million in 2011 compared to $736.8 million in 2010, a decrease of $192.1 million or 26.1%, which is primarily due to a decrease in policies in force. Total policies in force decreased by 22% during 2011 as compared to 2010. The decrease in policies in-force is primarily due to the Company’s decision to discontinue the marketing of its health benefit plans in all but a limited number of states. The Company continues to offer its supplemental products underwritten by Chesapeake and is focused on growing this line of business. However, the premium generated by the supplemental business has not been enough to offset the decline in premium associated with the Company’s health benefit plans. The decrease in premium in 2011 also reflects the accrual of $26.9 million for the medical loss ratio rebate.
For the years ended December 31, 2012 and 2011, the Company earned commission revenue of approximately $88.9 million and $71.6 million, respectively. Approximately 83% and 91% of commission revenue from non-affiliates was generated from four carriers during 2012 and 2011, respectively. Insphere continues to report an increase in commission revenue over the prior year. The increase in commission from non-affiliates is primarily due to the increased sales of Medicare products as well as an increase in commission on renewal premiums from policies sold prior to 2012.
Additionally, these products carry a higher commission rate as a percentage of premium compared to health insurance products.
Other expenses associated with Insphere are related to home office employee compensation, costs associated with our field offices, depreciation and amortization, and other administrative expenses. The Company reduced certain administrative costs compared to the prior year, but overall this category remained flat primarily as a result of the incremental increase in administrative expenses associated with the purchase and ongoing activities of the insurance agency call center discussed below.
For the years ended December 31, 2011 and 2010, the Company earned commission revenue of approximately $71.6 and $44.6 million, respectively. For 2011 and 2010, respectively, approximately 91% and 93% of commission revenue from non-affiliates was generated from four carriers.
Commission expense includes commissions and overrides paid to our independent agents. Commissions are generally based on a percentage of the premiums paid by the insured to the carrier. The increase in commission expense from $22.4 million incurred during the twelve months ended December 31, 2010 to $39.1 million incurred during the twelve months ended December 31, 2011, primarily trends with commission revenue. However, beginning in the third quarter of 2010, Insphere increased its commission rates paid to its agents to incorporate some of the costs previously included in Agent incentives.
Set forth below is a summary of the components of operating income (loss) at Corporate for each of the three most recent fiscal years:
During 2011, the Company sold various fixed maturities to increase liquidity to repay the Company’s term loan due in the first quarter of 2012. As a result of the sales the Company realized significant gains on many of the investments sold in 2011.
Interest expense on corporate debt decreased as a result of the repayment of the Company’s term loan in February 2012. Additionally, the Company had an interest rate swap agreement that expired on April 11, 2011 which caused the Company to pay a fixed rate higher than the current variable rate incurred on the debt during the first quarter of 2011.
General corporate expenses remained comparable in 2012 as compared to 2011.
Net investment impairment losses recognized in earnings decreased by $765,000 as we recognized no impairment losses on other-than-temporary impairments in 2011 as compared to one impairment loss recorded in 2010 on one security. The impairment charges in 2010 resulted from other than temporary reductions in the fair value of these investments compared to our cost basis (see Note 4 of Notes to Consolidated Financial Statements for additional information).
Disposed Operations primarily includes the remaining run out of residual operations from dispositions of businesses prior to 2010. During the years ended December 31, 2012, 2011 and 2010, the operating income from Disposed Operations was $812,000, $1.7 million and $3.0 million, respectively.
Cash flows provided by/used in operating activities are principally net income/loss, net of depreciation and amortization and other non-cash expenses. In 2012, the Company’s operating activities used cash flows primarily as a result of a net loss, the declining block of health insurance business, and establishing a current tax recoverable. Additionally, the increase in “Other operating activities” in 2012 primarily reflects the payment of $26.0 million of the 2011 MLR rebates. In 2011, we generated cash flows from earnings as well as the recognition of some sales production bonuses earned in 2010 and received in 2011. For 2010, the Company’s operating activities used cash flows primarily as a result of the declining block of health insurance business in addition to the costs incurred with the development of Insphere.
redemption of short-term securities for the purposes of paying off the Company’s term loan of $362.5 million. Investing activities for 2010 includes the redemption of invested assets used to pay a dividend in the amount of $118.5 million to shareholders during the year.
Cash flows used in financing activities primarily consist of repayment of long term debt, repurchases of treasury stock, repayment of the student loan credit facility and dividends to shareholders. In 2012, cash flows provided by investing activities consist primarily of proceeds from the sale and maturity of invested assets for use in the repayment of the Company’s term loan of $362.5 million. Cash flows provided by financing activities also consist of proceeds from shares issued to the ISOP. In 2010, cash flows used in financing activities were primarily related to dividend payments to shareholders of $118.5 million.
Set forth below is a summary statement of aggregate cash flows for HealthMarkets, Inc. and HealthMarkets, LLC for each of the three most recent years:
In 2012, 2011 and 2010, the holding company paid $6.5 million, $12.5 million and $18.8 million, respectively in interest on outstanding debt.
During 2012, the holding company made a $5.0 million capital contribution to its HealthMarkets Insurance Company subsidiary.
During 2010, the holding company paid a special cash dividend of $118.5 million.
Our domestic insurance companies paid dividends of $59.5 million, $308.5 million and $96.9 million, respectively, to HealthMarkets, LLC in 2012, 2011 and 2010, respectively. The dividend amount for 2012 includes $30.0 million of extraordinary dividends paid from the Company’s Mid-West insurance subsidiary. The dividend amount for 2011 includes $159.4 million of extraordinary dividends paid from the Company’s MEGA insurance subsidiary.
In April 2006, we borrowed $500.0 million under a term loan credit facility and issued $100.0 million of Floating Rate Junior Subordinated Notes. The Company made principal payments on the term loan and, at December 31, 2011, $362.5 million remained outstanding. On February 29, 2012, the Company paid in full the remaining principal and interest on the term loan in an amount of $363.3 million.
At December 31, 2012, the Company had indebtedness outstanding under a secured student loan credit facility which indebtedness is represented by Student Loan Asset-Backed Notes issued by a bankruptcy-remote special purpose entity. Indebtedness outstanding under the Student Loan Credit Facility is secured by student loans and accrued interest and by a pledge of cash, cash equivalents and other qualified investments.
Testing for impairment of investments requires significant management judgment. The identification of potentially impaired investments, the determination of their fair value and the assessment of whether any decline in value is other than temporary are the key judgment elements. The discovery of new information and the passage of time can significantly change these judgments. Revisions of impairment judgments are made when new information becomes known, and any resulting impairments are made at that time. The economic environment and volatility of securities markets increase the difficulty of determining fair value and assessing investment impairment. The same influences tend to increase the risk of potentially impaired assets.
The Company applied the provisions of ASU 2010-26 beginning January 1, 2012 and determined that certain underwriting and customer lead generation expenses were no longer deferrable under the new guidance. Under the transition guidance provided by ASU 2010-26, the Company has chosen to apply the retrospective method. The retrospective method requires the Company to record the cumulative effect of applying a change in accounting principle to all prior periods presented. As a result of the change in accounting principle, the Company made the following adjustments:
(a) Adjusted the opening balance of the following items as of January 1, 2010: (i) reduced Deferred acquisition costs by $21.0 million, (ii) reduced Retained earnings by $13.6 million, and (iii) reduced Deferred federal income taxes by $7.3 million.
We account for goodwill and other intangibles in accordance with FASB ASC Topic 350, Intangibles - Goodwill and Other (“ASC 350”), which requires that goodwill and other intangible assets be tested for impairment at least annually or more frequently if certain indicators arise. An impairment loss would be recorded in the period such determination was made. Consistent with prior years, we use assumptions and estimates in our valuation, and actual results could differ from those estimates. ASC 350 also requires that intangible assets with estimable useful lives be amortized over their respective estimated useful lives to their estimated residual values. Management makes assumptions regarding the useful lives assigned to intangible assets. We currently amortize intangible assets with estimable useful lives over a period ranging from five to twenty-five years; however, management may revise amortization periods if they believe there has been a change in the length of time that an intangible asset will continue to have value. If these estimates or their related assumptions change in the future, we may be required to record impairment losses or change the useful life, including accelerating amortization for these assets.
We establish liabilities for benefit claims that have been reported but not paid and claims that have been incurred but not reported under health and life insurance contracts. Consistent with overall company philosophy, the claims liabilities estimate is developed and is expected to be adequate under reasonably likely circumstances. This estimate is developed using actuarial principles and assumptions that consider a number of items as appropriate, including but not limited to historical and current claim payment patterns, product variations, the timely implementation of appropriate rate increases and seasonality. We do not develop ranges in the setting of the claims liabilities reported in the financial statements.
Prior to 2011, the majority of health insurance products offered through the Commercial Health Division established the claims liabilities using the modified incurred date technique. Under the modified incurred date methodology, claims liabilities for the cost of all medical services related to the accident or sickness are recorded at the earliest date of diagnosis or treatment, even though the medical services associated with such accident or sickness might not be rendered to the insured until a later financial reporting period. A break in service of more than six months will result in the establishment of a new incurred date for subsequent services. A new incurred date will be established if claims payments continue for more than thirty-six months without a six month break in service. See Change in Accounting Principle on Claim Liabilities below for discussion on the change in methodology from the modified incurred date to service date.
Beginning in 2008, the Commercial Health Division began using the date of service techniques opposed to the modified incurred date technique to establish the claims liabilities for new contracts introduced or updated in or after 2008.
In estimating the ultimate level of claims for the most recent incurral months, we use what we believe are prudent estimates that reflect the uncertainty involved in these incurral months. An extensive degree of judgment is used in this estimation process. For healthcare costs payable, the claim liability balances and the related benefit expenses are highly sensitive to changes in the assumptions used in the claims liability calculations. With respect to health claims, the items that have the greatest impact on our financial results are the medical cost trend, which is the rate of increase in healthcare costs, and the unpredictable variability in actual experience. Any adjustments to prior period claim liabilities are included in the benefit expense of the period in which adjustments are identified. Due to the considerable variability of healthcare costs and actual experience, adjustments to health claim liabilities usually occur each quarter and are sometimes significant.
The completion factors and loss ratio estimates in the most recent incurred months are the most significant factors affecting the estimate of the claim liability. The Company believes that the greatest potential for variability from estimated results is likely to occur at the Commercial Health Division.
The Company continues to update its completion factors to reflect more recent patterns of claim payments. Throughout 2010, we saw an ongoing decrease in the time period from incurral to payment of a claim, resulting
in higher completion factors and lower reserves. In response to these trends, we used more recent experience to develop the completion factors, resulting in a decrease in claim liabilities of $30.6 million recognized during the three months ended September 30, 2010. During 2011, the Company again updated its completion factors to reflect the more recent patterns of claim payments, resulting in a decrease in the claim liabilities of $7.8 million in the three months ended September 30, 2011. We will continue to evaluate and update completion factors on an ongoing basis, as appropriate, and will evaluate the impact, if any, that Health Care Reform Legislation may have on the completion factors.
For the majority of health insurance products in the Commercial Health Division, the Company’s claims liabilities are estimated using the developmental method. The Company establishes the claims liabilities based upon claim incurral dates, supplemented with certain refinements as appropriate. Prior to January 1, 2011, for products introduced prior to 2008, the Company used a technique for calculating claims liabilities referred to as the Modified Incurred Date (“MID”) technique. Under the MID technique, claims liabilities for the cost of all medical services related to a distinct accident or sickness are based on the earliest date of diagnosis or treatment, even though the medical services associated with such accident or sickness might not be rendered to the insured until a later financial reporting period. Claims liabilities based on the earliest date of diagnosis generally result in larger initial claims liabilities which complete over a longer period of time than claims estimation techniques using dates of service. Under the MID technique, the Company modifies the original incurred date coding by establishing a new incurral date if: (i) there is a break of more than six months in the occurrence of a covered benefit service or (ii) if claims payments continue for more than thirty-six months without a six month break in service.
For products introduced in 2008 and later, claims payments were considered incurred on the date the service is rendered, regardless of whether the sickness or accident is distinct or the same. This is referred to as the Service Date (“SD”) technique. This is consistent with the assumptions used in the pricing of these products and the policy language. At December 31, 2010, the Company had claims liabilities for products using the SD technique in the amount of $10.6 million, representing approximately 8% of the total claims liabilities of the Commercial Health Division. The use of the SD technique in establishing claims liabilities requires the establishment of a future policy benefit reserve while the MID technique does not. For the reasons discussed below, we believe that it is preferable to estimate the Company’s claims liabilities using the SD technique, and to apply such technique for claims liabilities previously calculated based on the MID technique.
Any refund of premiums in excess of the required MLR will be based on the completion of claims three months after the calendar year end. Based on the MLR calculation requiring only three additional months of claims and the SD technique being the most prevalent method of estimating claims liabilities in the health insurance industry, the Company believes that the SD technique is the preferable method for calculating the MLR. The Company also believes that using the SD method for the settlement of the MLR calculation will reduce uncertainty regarding the ultimate amount of incurred claims, as the MID technique estimates claims over a longer settlement period. The calculation of the MLR using the Company’s current data results in claims for a given incurred year that are approximately 95% complete three months after the valuation date using the SD technique, whereas claims are approximately 82% complete 3 months after the valuation date using the MID technique. Additionally, the use of the MID technique for financial reporting purposes, with the settlement of the MLR calculated on a SD basis, may result in an over accrual of the claims liabilities on the financial statements as a result of the Company’s accrual for rebates in the MLR calculation.
In light of the changes resulting from the Health Care Reform Legislation, and given that the Company’s insurance contracts would support the use of either reserving technique, the Company, after discussions with its domiciliary insurance regulators on the preferred methodology for calculating rebates under the MLR requirements of the Health Care Reform Legislation, determined that the SD method is preferable in determining the estimation of its claims liabilities. For the in-force policies utilizing the MID technique for estimation of claims liabilities, effective January 1, 2011, the Company changed the method used to calculate its claims liabilities from the MID technique to the SD technique. Consistent with the Company’s products introduced in 2008 and later, the Company established a reserve for future policy benefits for products introduced prior to 2008.
compensation expense over the vesting period in an amount equal to the fair market value of vested shares at the date of their vesting and distribution to the agent-participant. The Company accounts for the Company-match feature of the ISOP for employees by recognizing compensation expense over the vesting period in an amount equal to the fair market value of each award at the date of grant, or, in the case of outstanding awards transferred from the Predecessor Plans, the fair market value at the date of employment.
We are subject to proceedings and lawsuits related to insurance claims, regulatory issues, and other matters (see Note 16 of Notes to Consolidated Financial Statements). We are required to assess the likelihood of any adverse judgments or outcomes to these matters, as well as potential ranges of probable losses. A determination of the amount of accruals required, if any, for these contingencies is made after careful analysis of each individual issue. The required accruals may change in the future due to new developments in each matter or changes in approach, such as a change in settlement strategy in dealing with these matters.
At December 31, 2012, the Company had $118.6 million of debt exposed to the fluctuation of the three-month London Inter-bank Offer Rate (LIBOR) and is comprised of the UICI Capital Trust I note and the HealthMarkets Capital Trust I and II notes. The sensitivity analysis shows that if the three-month LIBOR rate changed by 100 basis points (1%), our interest expense would change by approximately $1.2 million.
Included in the fixed maturity portfolio are mortgage-backed securities, including collateralized mortgage obligations, mortgage-backed pass-through certificates and commercial mortgage-backed securities. To limit our credit risk, we invest in mortgage-backed securities that are rated investment grade by the public rating agencies. Our mortgage-backed securities portfolio is a conservatively structured portfolio that is concentrated in the less volatile tranches, such as planned amortization classes and sequential classes. We seek to minimize prepayment risk during periods of declining interest rates and minimize duration extension risk during periods of rising interest rates. We have less than 0.2% of our investment portfolio invested in the more volatile tranches.
A quality distribution for fixed maturity securities at December 31, 2012 is set forth below:
(2) Represents $78.4 million face value security received from the purchaser as consideration upon sale of our former Star HRG Division in July 2006. This security is held in a bankruptcy remote entity with the Company’s exposure limited to its residual investment of approximately $7.2 million at December 31, 2012.
(3) Funds are diversified institutional money markets that invest solely in United States dollar denominated securities.
Inflation historically has had a significant impact on the health insurance business. In recent years, inflation in the costs of medical care covered by such insurance has exceeded the general rate of inflation. Under basic hospital medical insurance coverage, established ceilings for covered expenses limit the impact of inflation on the amount of claims paid. Under catastrophic hospital expense plans and preferred provider contracts, covered expenses are generally limited only by a maximum lifetime benefit and a maximum lifetime benefit per accident or sickness. Therefore, inflation may have a significantly greater impact on the amount of claims paid under catastrophic hospital expense and preferred provider plans as compared to claims under basic hospital medical coverage. As a result, trends in healthcare costs must be monitored and rates adjusted accordingly. Under the health insurance policies issued in the self-employed market, the primary insurer generally has the right to increase rates upon 30-60 days written notice, and subject to regulatory approval in some cases.
individuals’ nonpublic personal data by financial institutions, including insurance companies, may have a significant impact on the financial condition and results of operations. See Item 1. Business - Regulatory and Legislative Matters.