Medibank Private. Forever young A$2.39 AUSTRALIA. Attractive health industry dynamics. Growing health funds under management

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1 AUSTRALIA MPL AU Price (at CLOSE#, 05 Jan 2015) Outperform A$2.39 Valuation - DCF A$ month target A$ month TSR % Volatility Index Low GICS sector Insurance Market cap A$m 6, day avg turnover A$m 59.1 Number shares on issue m 2,754 Investment fundamentals Year end 30 Jun 2015E 2016E 2017E 2018E PBT m Reported profit m Net Op Income m EPS adj PER adj x DPS Dividend yield % Franking % Total Assets m 3, , , ,456.0 Total SH Funds m 1, , , ,712.0 BV/S ROE % ROA % P/BV x Source: FactSet, Macquarie Research, January 2015 (all figures in AUD unless noted) 5 January 2015 Macquarie Securities (Australia) Limited Forever young Attractive health industry dynamics The Australian Private Health Insurance (PHI) sector, where derives ~90% of revenue and held 29.1% policyholder market share at June 2014, is highly attractive. Features include: 8.0% p.a. industry premium growth since 2008, driven by increasing utilisation (impacted by ageing), population growth, and product penetration. 4.5%-6.0% net margin achievable by for-profit status PHI funds, with the best performing funds able to operate above the top of this range. Modest capital requirements, reflecting low risk, delivering high ROE. Supportive government policy reflecting public/private mutual reliance. Growing health funds under management An expanding PHI sector helps promote public savings given the Government pays ~16% of the cost of privately funded services (excluding the PHI rebate) vs. 100% in the public system. Given the current public health funding pressure, this suggests an expansion of PHI is possible. MPL is well placed to participate in long term industry growth driven by demographic factors and government policy. : PHI sector leader with attractive outlook MPL holds the leading market share in a consolidated market: With 29.1% policyholder market share MPL is the largest health fund in the PHI market (the top 5 funds control 82.3% market share). Ongoing opportunities to enhance profitability: MPL has already commenced an efficiency program aimed at improving gross margins and the management expense ratio. Scope for further margin improvement remains. Every 10bps net margin improvement boosts net profit by ~1.6%. Attractive opportunities: MPL s customer base is large, healthy and wealthy providing opportunities beyond PHI. MPL is ungeared, providing capital flexibility. Initiation: Recommendation Outperform, Price Target $2.62 Based on the attractive industry outlook and opportunities for MPL to deliver operational improvement we initiate coverage of with an Outperform recommendation and $2.62 price target. Our FY15 NPAT forecast is 3.5% above proforma prospectus estimates. Our target price implies a 2 yr forward PE ratio of 23.6x and dividend yield of 3.2%. The only relevant listed competitor is NIB (NHF.AU, $3.16, Outperform, PT: $3.50, our target price implies 2 yr fwd PE 17.5x). MPL should trade at a premium to NIB, in our view, given the opportunities to improve operational performance available to MPL. Government policy change is the overarching risk PHI is highly regulated: Government policy and regulatory agencies impact volumes, margins and capital. MPL does not control the enactment or content of new legislation and regulations. Other risks: 1) affordability pressure (switching between funds and policyholders downgrading cover is a current issue); 2) poor product design; 3) inadequate premium rate approvals that impact the net margin; and 4) IT renewal project execution risk. Please refer to page 102 for important disclosures and analyst certification, or on our website

2 Inside Forever young 3 Financial Summary 12 Key investor considerations 13 Valuation and Recommendation 18 Operational analysis 21 Financial Analysis 26 Key Investor Risks 45 Domestic benchmarking 49 Insurance products 59 Current industry issues 66 Health industry structure and funding 73 PHI market structure 75 Health fund and hospital relationship 77 PHI premium rate approval 79 Government incentives and support 85 Government PHI market controls 91 Forever young : PHI sector leader with attractive outlook At June 2014, held 29.1% policyholder market share making it the largest Private Health Insurance fund in Australia. The PHI sector is highly attractive with ~8.0% p.a. industry premium growth since 2008, 4.5%-6.0% net margin achievable by for-profit status PHI funds, modest capital requirements, and supportive government policy. MPL is well placed to participate in long term industry growth driven by demographic factors and government policy. Fig 1 Historic net margin performance forecast to improve above 5% Australian Residents Net Margin 6.0% 5.0% 4.0% 3.0% 2.0% Industry Residents Net Margin (ex ) Residents Net Margin 3.6% 3.6% 4.4% Commission of Audit proposals 96 International system considerations % 0.0% 5.5% 4.6% 4.0% FY12A FY13A FY14A Source: pro-forma financial data, January Fig 2 vs ASX 100 Ind, & rec history Note: Recommendation timeline - if not a continuous line, then there was no Macquarie coverage at the time or there was an embargo period. Source: FactSet, Macquarie Research, January 2015 (all figures in AUD unless noted) 5 January

3 Macquarie Wealth Management Total health expenditure in excess of $147bn with a 10y CAGR of ~8% to 2013 Forever young supported by government policy, consumer participation and demographic trends The health sector is a major part of the Australian economy, with total expenditure in excess of $147bn and a 10y CAGR of ~8% to The performance of the system is high, with Australia s life expectancy of 81.6yrs placing it 5 th amongst 34 OECD peers, as is its efficiency, with healthcare spend as a percentage of GDP remaining below many OECD countries. Fig 3 Health expenditure rising to 9.7% of GDP A$bn Non-government State/territory and local governments Australian Government Health Expenditure / GDP % of GDP Source: AIHW, January Organic and structural factors drive attractive industry growth Within the overall health system, long term organic growth of PHI is supported by: 1) population growth and ageing; 2) greater penetration of PHI coverage among the population (supported by government policy); and 3) increased PHI utilisation per person (especially among older age groups). Fig 4 Older policyholders driving claims growth via utilisation Source: Macquarie Analysis of PHIAC data, Macquarie Research, January January

4 Mar-03 Aug-03 Jan-04 Jun-04 Nov-04 Apr-05 Sep-05 Feb-06 Jul-06 Dec-06 May- Oct-07 Mar-08 Aug-08 Jan-09 Jun-09 Nov-09 Apr-10 Sep-10 Feb-11 Jul-11 Dec-11 May- Oct-12 Mar-13 Aug-13 Jan-14 Macquarie Wealth Management Fig 5 Rising utilisation has been adding ~3.7% p.a. to industry volume growth Utilisation (episodes / insured person) Source: Macquarie Analysis of PHIAC data, Macquarie Research, January Note: Episode refers to medical issue / type of care We expect organic growth may be boosted by structural change Structural factors: In addition, organic growth may be boosted by structural factors. Unlike many health sectors, which are a significant cost to Government, an expanding PHI system helps promote savings given the Government pays only ~16% of the cost of privately funded services excluding the PHI rebate vs. 100% of public patients funding in the public system. Fig 6 PHI funds 77% of the cost of privately funded services excluding the government PHI rebate contribution (2013) Patient out-ofpocket 7% Government 16% PHI fund 77% Source: Based on PHIAC data, January MPL is well placed to participate in restructuring opportunities This dynamic, together with the current health funding pressure on public finances (exacerbated by population ageing), suggests an expansion of the PHI system is possible. PHI can help by both: 1) reducing funding and demand pressure in the public sector; and 2) assisting in service provision efficiency. As the leading PHI in Australia by policyholders, with 29.1% market share at June 2014, MPL is well placed to participate in any industry restructuring opportunities in response to funding and demand pressure in the public sector and as efficiencies are sought. Health funds essential as efficiencies are targeted The structure of the Australian health system and the complexity of healthcare generally means that each individual stakeholder is not in a strong position to control the growth in health expenditure. 5 January

5 This is a result of stakeholders either: 1) not being incentivised to reduce costs; 2) cost control not being a strong priority; or 3) not being in direct control of health expenditure. We consider the position of key individual stakeholders: Patient: complexity and transparency limits the ability of the patient to manage their own health needs, especially with Universal Healthcare and the free public Medicare system. Medical professionals: primary responsibility is to manage the health of the patient. Hospital operator: volumes rather than patient outcomes drive profitability. Government: control of health spending is somewhat macro or involves prescribing standard levels of care. Both may be politically difficult. PHI Fund: health funds are increasingly focused on claims management given the level of claims inflation and a desire to improve patient outcomes but there is limited ability and moderated incentive for health funds to manage claims under the current system structure. PHI funds appear central to change PHI funds appear central to any structural change. Attractive PHI industry dynamics The PHI sector, where derives ~90% of revenue and held 29.1% market share at June 2014, is highly attractive. The key features include: 8.0% p.a. industry premium growth since 2008, driven by increased utilisation (impacted by ageing); population growth; and higher penetration. 4.5%-6.0% net margin achievable by for-profit status PHI funds, with the best performing funds able to operate above the top of this range. This is supported by the premium rate approval process and operational performance (premium rate approvals cover increased utilisation and health cost inflation, with funds competing more on product design). Modest capital requirements, reflecting the low claims risk, delivering high ROE. Supportive government policy reflecting public/private mutual reliance. Fig 7 Medibank FY13 market share of 29.5% of total policies (includes ahm) AHSA members 15.6% HBF 7.5% Other 2.1% Medibank 29.5% NIB 7.7% Source: PHIAC, January 2015 HCF 10.8% BUPA 26.8% PHI in Australia is unique; is the market leader As with many health systems globally, the Australian health system is unique. The PHI policyholder is provided with indemnity for hospital coverage under the policy. The clinicians and hospitals determine the necessary care and the health insurer must pay. The health funds have little control over care and this has contributed to continued increase in utilisation over a long period. New technology, an ageing population and increasing chronic disease all contribute to the increased utilisation of health care services. Ancillary coverage provided under PHI policies is the exception and typically entitles the policyholder to a capped sum/service. Key PHI industry features include: Public/Private system: Health funds compete with the simultaneously available taxpayer funded public offering (Medicare). 5 January

6 Dec-05 Jun-06 Dec-06 Jun-07 Dec-07 Jun-08 Dec-08 Jun-09 Dec-09 Jun-10 Dec-10 Jun-11 Dec-11 Jun-12 Dec-12 Jun-13 Dec-13 Jun-14 Dec-14 Jun-15 Macquarie Wealth Management PHI market share is consolidated with the top 5 funds holdings 82.3% share at June 2013 PHI market share is relatively consolidated with the top 5 funds holdings 82.3% market share at June Note that the market is even more consolidated than the headline market share suggests as a number of smaller PHI funds, through the Australian Health Services Alliance (AHSA), co-operate in hospital contracting and other services. Government incentives (taxes) and support (rebates) boost membership, with 47.2% of the Australian population covered by PHI hospital policies at June Premiums are community rated, with insurers not able to price for individual risk factors, necessitating a risk equalisation scheme across all funds. Premium rate changes require Ministerial approval and largely reflect claims trends. Premium rate approvals have covered increased utilisation and health cost inflation with funds competing more on product design. The 2014 industry claims ratio was 87.4%, management expenses 8.5% and net margin 4.1%. Total Hospital benefits CAGR was 8.6% from June 2004 to June 2014 reflecting increased utilisation, particularly among older age groups. Capital requirements are modest relative to other insurance risks as a result of short tail claims, lack of catastrophe risk, government support and community rating with risk equalisation. Premium change closely reflects increased utilisation and health cost inflation trends The chart below shows that following the increased involvement of PHIAC in the premium approval process, premium change more closely reflects increased utilisation and health cost inflation trends. Fig 8 Premium rate increases offsetting claims inflation and utilisation post increased PHIAC involvement in premium rate approvals 10.0% 9.0% 8.0% 7.0% 6.0% 5.0% 4.0% 3.0% 2.0% 1.0% 0.0% Health Inflation (rolling 12m) Utilisation (rolling 12m) Industry Premium Growth (rolling 12m) PHIAC directly involved in premium rate approval process Forecasts Source: Forecasts based on Macquarie estimates, historicals based on PHIAC data, January business segments Health Insurance segment Through two national brands (Medibank and ahm), the MPL s Health Insurance segment offers PHI policies to resident Australians and overseas visitors health cover (OVHC) and Overseas Students health cover (OSHC). Policyholder premiums are forecast to generate 90% of pro forma FY15 revenue. Key performance drivers: Premium Volumes, Gross Margin, Management Expenses Key performance drivers: Premium volumes, gross margin, management expenses Strategy: active enhancement of Health insurance underwriting margins. Management expenses have been reduced substantially in MER terms, with MPL narrowing the gap to the rest of the industry. MPL s Fit For Purpose cost-out program delivered $49m of cost savings in FY14 (~0.9ppt benefit to the MER). 5 January

7 Fig 9 MPL: Australian Residents Insurance Management Expense Ratio Australian Residents MER 12.0% 10.0% 8.0% 6.0% 4.0% 2.0% 0.0% 10.2% Source: pro forma financial data, January Industry Residents MER (ex ) Residents MER 9.2% 8.7% 8.9% 8.6% 8.4% FY12A FY13A FY14A Opportunities to improve operational outcomes include: Margin outcomes Improved contracting with healthcare providers and increased focus on the quality of patient outcomes. Targeting claims expenses: 1) relationships with providers; 2) product design; 3) benefits utilisation; and 4) reducing improper claims. During FY13, MPL embarked on an a cost reduction program Management cost reduction. During FY13, MPL embarked on an organisation-wide cost reduction program in order to identify sustainable cost savings to be realised over time. Programs to identify further cost savings and efficiencies are ongoing. Markert share, through its dual brand strategy, is also focused on arresting the decline in market share and optimising margins. The market positioning of the ahm brand means that the importance of ancillary cover versus hospital cover will be relatively high. Product design impacts the perceived value of PHI and the profitability of ancillary cover. Fig 10 Medibank and ahm market share trend 35.0% 30.0% ahm market share Medibank Market Share 25.0% 20.0% 15.0% 10.0% 5.0% 0.0% FY01 FY02 FY03 FY04 FY05 FY06 FY07 FY08 FY09 FY10 FY11 FY12 FY13 FY14 Source: Based on PHIAC data, January Complementary Services segment The Complementary Services segment provides a number of related activities that utilise MPL s experience and expertise and support the Health Insurance business. Complementary Services is forecast to contribute 10% of pro forma FY15 revenue. The business generates service fees and commissions from: 1) contracted health management services for government and corporate clients; 2) online and telephone-based health services; and 3) the distribution of travel, life and pet insurance (not underwritten by MPL). 5 January

8 Fig 11 Complementary Services business ex immigration swinging to profitability Complementary Services Operating Profit Immigration Contract Complementary Services ex Immigration Contract Total Complementary Services FY12A FY13A FY14A FY15E Source: Macquarie Analysis of pro forma financial data, January Future opportunities In addition to the current strategy to improve the operational performance of noted above, opportunities beyond the current business could also be attractive. We expect that MPL could expand its current offering within the health sector (e.g. providing more services to government) and potentially across the insurance and financial sector more broadly. MPL is well placed to provide services to government health services beyond PHI MPL is well placed to provide services to government health beyond PHI. Possible examples could include Department of Veterans Affairs ($3.5bn health expenditure in FY13) and the NDIS ($25bn by FY22). In addition, MPL s customer base is large, healthy and wealthy. This platform could be leveraged into other forms of general or life insurance or in a retail financial services offering. Currently MPL only distributes travel, life and pet insurance as authorised agents for other insurers (without taking underwriting risk). Distribution support: MPL holds more than 20% PHI market share in each state and territory and has a national network of 90 retail outlets as well as call centres and online distribution capability. MPL is currently ungeared, providing capital flexibility. Initiation: Recommendation Outperform, Price Target $2.62 Based on the attractive industry outlook and opportunities for MPL to deliver operational improvement we initiate coverage with an Outperform recommendation and $2.62 price target. Our target price implies a 2 yr forward PE ratio of 23.6x and dividend yield of 3.2%. The only relevant listed competitor is NIB (NHF.AU, Outperform, Price Target $3.50, our target price implies 2 yr fwd PE 17.5x). MPL should trade at a premium to NIB, in our view, given the opportunities to improve operational performance available to MPL. Fig 12 FY15 MRE earnings forecasts vs Prospectus MRE estimates Proforma Prospectus Difference Group 1H15E 2H15E FY15E FY15E FY15E Total Revenue 3, , , , % Net Claims -2, , , , % Cost of Sales (Complementary services) % Gross Profit % Health Insurance Management Expenses % Complementary services Management Expenses % Corporate Overheads % Operating Profit % Net Investment income % Other income/expense % Profit before tax % Tax expense % Net Profit After Tax % Source: Prospectus, Macquarie Research, January January

9 Medibank BUPA NIB Aust Unity GUC CUA Health.com.au Doctor's Health Transport Health HCF HBF Teachers GMHBA Defence Health CBHS Health Westfund Latrobe Lysaght HIF QLD Teachers Healthguard Health Partners R&T St Luke's Police Health QLD Country Navy Health Mildura Phoenix Health ACA HCI Reserve Bank Cessnock Macquarie Wealth Management short term and long term management incentive program: Managing Director George Savvides: Short term incentives: 1) Target 70% of base salary (maximum 100% of base salary); 2) Additional STI 70% of base salary around meeting FY15 operating profit forecasts; 3) 50% of STI deferred for 12 months. Long term incentives: MPL intends to grant underlying value of performance rights equivalent to 100% of base salary vesting over three years, determined by: 1) 50% EPS CAGR; 2) 50% TSR (based on percentile ranking vs. mid-cap index ex-resources). Other executive committee: Short term incentives: 1) Target 50% of base salary (maximum 100% of base salary); 2) Additional STI maximum 50% of base salary around meeting FY15 operating profit forecasts; 2) 50% of STI deferred for 12 months Long term incentives: MPL intends to grant underlying value of performance rights equivalent to 60% of base salary vesting over three years, determined by: 1) 50% EPS CAGR; 2) 50% TSR (based on percentile ranking vs. mid-cap index ex-resources). Performance measures: Short term performance measures are linked to operating profit (excluding investment income), profitable PSEU net change, improvement in cost-to-income ratio and rolespecific measure tied directly to MPL s business plan. Long term performance measures: 1) MPL must meet EPS target as determined by the board; and 2) MPL must meet target TSR ranking over the period. : Domestic and International benchmarking Domestic health fund benchmarking: Scale benefits are not yet evident The Australian PHI sector contains a small number of large funds, four of which are for-profit (MPL, BUPA, nib and Australian Unity) and two are not-for profit (HCF and HBF). We present the key PHI metrics across the industry for FY13 (the latest fund level data available for the industry) in the charts below. MPL was lagging for-profit funds in FY13 on gross and net margins while also not growing policyholders as rapidly as peers. While FY14 PHI fund level data is not yet available, the improvement in MPL Australian Residents Insurance net margins (from 3.6% to 4.4%) is in contrast to the rest of the industry, which declined from 4.6% to 4.0%. Fig 13 Margin consistently higher at for-profit funds vs. not-for-profit (FY13) Net Margin 'For-profit ' average: 5.1% 'Not-for-profit ' average: 2.6% Net Margin Note Transport Health converted to For-Profit status on 30 June 2014 Source: Based on PHIAC data, January January

10 Medibank BUPA NIB Aust Unity GUC CUA Health.com.au Doctor's Health Transport Health HCF HBF Teachers GMHBA Defence Health CBHS Health Westfund Latrobe Lysaght HIF QLD Teachers Healthguard Health Partners R&T St Luke's Police Health QLD Country Navy Health Mildura Phoenix Health ACA HCI Reserve Bank Cessnock Medibank BUPA NIB Aust Unity GUC CUA Health.com.au Doctor's Health Transport Health HCF HBF Teachers GMHBA Defence Health CBHS Health Westfund Latrobe Lysaght HIF QLD Teachers Healthguard Health Partners R&T St Luke's Police Health QLD Country Navy Health Mildura Phoenix Health ACA HCI Reserve Bank Cessnock Medibank BUPA NIB Aust Unity GUC CUA Health.com.au Doctor's Health Transport Health HCF HBF Teachers GMHBA Defence Health CBHS Health Westfund Latrobe Lysaght HIF QLD Teachers Healthguard Health Partners R&T St Luke's Police Health QLD Country Navy Health Mildura Phoenix Health ACA HCI Reserve Bank Cessnock Macquarie Wealth Management Fig 14 MPL management expenses above large peers but closing the gap MER 'For-profit ' average: 9.0% 'Not-for-profit ' average: 8.4% MER Source: Based on PHIAC data, January Fig 15 Gross Margin higher at for-profit funds vs. not-for-profit (FY13) Gross Margin Gross Margin 'For-profit ' average: 14.0% 18.0 'Not-for-profit average: 11.0% Source: Based on PHIAC data, January Fig 16 policyholder growth lagging for-profit peers in FY13 Policyholder growth 10.0% 'For-profit' average: 8.0% 2.9% 'Not-for-pofit' average: 3.5% 6.0% 4.0% 2.0% 0.0% Policyholder growth 10.0% 8.0% 6.0% 4.0% 2.0% 0.0% -2.0% -2.0% Source: Based on PHIAC data, January January

11 Domestic cross sector considerations The Australian PHI sector has some similarities to the Australian superannuation system worth highlighting. Parallels can be drawn between the structure of: the direct to individual compulsory defined contribution private superannuation market in Australia, supported by the taxpayer funded Government pension system; and the direct to individual PHI sector in Australia, operating alongside the available to all taxpayer funded public hospital system. In addition, recent policy changes in both systems have seen government policy target its support for the respective systems away from higher income earners. Both the PHI market and the compulsory superannuation system in Australian are supported by structural, regulatory and demographic tailwinds. International benchmarking: There are no listed international health insurance or healthcare companies that can be directly compared to MPL. Based on Macquarie Research analysis, international healthcare models suggest that PHI in Australia could see reduced premium rate controls and an expanded scope. International models that we have reviewed suggest that Australian government policy will continue to support the health system in Australia whereby the private health system operates alongside, and is complementary to, the public health system. Key risks Government policy change is the overarching risk facing MPL and the PHI sector. Government policy and agencies regulation impact volumes, margins and capital. The PHI sector operates in a highly regulated industry, which could change in the future. ML does not control the enactment or content of new legislation and regulations. Other risks include: inadequate premium rate approvals that impact the net margin. product design (in FY14, MPL increased product bonus provisions by $23.9m to provide for all the year s entitlement, taking into account utilisation and current balances); affordability pressure (policyholders switching between funds and policyholders downgrading cover is a current issue for health funds); and IT system renewal: MPL has a strategy to rationalise and simplify its IT infrastructure. MPL s Complementary Services business is subject to contract execution and renewal risk. Management has stated that it is currently evaluating alternatives (including divestment or restructure) in respect of certain activities currently undertaken within Complementary Services that are not providing a stand-alone return and/or are not consistent with MPL s broader financial and strategic aims. 5 January

12 Financial Summary Fig 17 Summary Pro-Forma P&L MPL-AU Share Price 2.39 Private Health Insurance 1H15E 2H15E 1H16E 2H16E FY13A FY14A FY15E FY16E FY17E Premium revenue 2, , , , , , , , ,805.6 Claims -2, , , , , , , , ,863.6 Gross Margin Management Expenses Operating Profit Complementary Services 1H15E 2H15E 1H16E 2H16E FY13A FY14A FY15E FY16E FY17E Revenue Cost of Sales Gross Profit Management Expenses Operating Profit Group 1H15E 2H15E 1H16E 2H16E FY13A FY14A FY15E FY16E FY17E Health Insurance premium revenue 2, , , , , , , , ,805.6 Other revenue (Complementary services) Total Revenue 3, , , , , , , , ,483.1 Net Claims -2, , , , , , , , ,863.6 Cost of Sales (Complementary services) Gross Profit , ,087.0 Health Insurance Management Expenses Complementary services Management Expenses Corporate Overheads Operating Profit Net Investment income Other income/expense Profit before tax Tax expense Net Profit After Tax Remove Immigration contract (post-tax) Investment income volatility on growth assets (post-tax Normalised Net Profit After Tax Reported Net Profit After Tax Balance Sheet 1H15E 2H15E 1H16E 2H16E FY13A FY14A FY15E FY16E FY17E Cash and Equiv Financial Assets Receivables DAC PPE Intangible assets Other Total Assets Payables Claims Liabilities UEP Other Total Liabilities Net Assets Key ratios 1H15E 2H15E 1H16E 2H16E FY13A FY14A FY15E FY16E FY17E Private Health Insurance: Net Policyholder growth 0.8% 0.7% 0.8% 1.0% 1.0% 1.5% 0.7% 0.9% 1.4% PSEU growth 0.8% 0.6% 0.6% 0.8% 1.3% 1.0% 0.6% 0.9% 1.3% Premium growth 5.9% 5.9% 6.6% 6.5% 5.6% 5.7% 5.9% 6.5% 6.8% Gross Margin 13.7% 13.9% 13.9% 13.8% 13.3% 13.5% 13.8% 13.8% 13.8% MER 8.8% 8.6% 8.6% 8.4% 9.6% 9.2% 8.7% 8.5% 8.4% Net Margin 4.9% 5.3% 5.4% 5.3% 3.7% 4.4% 5.1% 5.4% 5.5% Complementary Services: Revenue growth 0.5% 3.0% 76.4% 41.4% -11.0% 1.7% 4.3% Revenue growth - ex Immigration contract 2.0% 3.0% 99.4% 49.3% -2.2% 2.5% 4.3% Gross Profit Margin 21.8% 21.5% 21.4% 21.4% 33.5% 25.7% 21.6% 21.4% 21.4% Operating Profit Margin 3.5% 3.1% 2.6% 2.8% 3.5% 4.7% 3.3% 2.7% 2.8% Operating Profit Margin - ex immigration contract 2.9% 3.1% 2.6% 2.8% -2.0% 1.8% 3.0% 2.7% 2.8% Group: EPS DPS EPS growth 12.3% 6.0% 6.0% 3.4% 9.0% 9.0% PER (x) Dividend Yield 0.0% 4.1% 3.3% 3.3% 2.1% 3.3% 3.6% Franking 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% ROE 18.7% 19.9% 19.2% 19.7% 16.5% 18.5% 19.3% 20.2% Revenue growth 4.0% 4.0% 6.0% 6.1% 9.4% 8.8% 4.0% 6.1% 6.6% Revenue growth ex Immigration 5.0% 5.1% 6.1% 6.1% 9.4% 9.0% 5.1% 6.1% 6.6% Gross Profit Margin 14.5% 14.6% 14.6% 14.5% 15.1% 14.9% 14.5% 14.5% 14.5% Operating Profit Margin 4.3% 4.6% 4.6% 4.6% 3.4% 4.0% 4.5% 4.6% 4.8% Operating Profit Margin - ex immigration contract 4.2% 4.6% 4.6% 4.6% 2.9% 3.7% 4.4% 4.6% 4.8% NPAT growth 4.7% 2.2% 12.3% 6.0% 62.8% 6.0% 3.4% 9.0% 9.0% Underlying NPAT growth 13.2% 11.1% 14.2% 6.0% 16.5% 10.7% 15.6% 9.6% 9.0% Gearing 0% 0% 0% 0% 0% 0% 0% 0% Valuation Valuation as at today 6,875 Capital return 9.7% PER at Current share price (1yr fwd) 23.3 Valuation in 12m time 7,217 Dividend Yield 3.7% PER at Price Target (2yr fwd) 23.6 Number of shares 2,754 Share price target (12m) 2.62 Total Return 13.3% Dividend Yield at Price Target (2yr fwd) 3.2% Source: Macquarie analysis of pro forma financial data, January January

13 Dec-04 Dec-05 Dec-06 Dec-07 Dec-08 Dec-09 Dec-10 Dec-11 Dec-12 Dec-13 Macquarie Wealth Management Key investor considerations Industry growth assured, 4.5%-6.0% net margins achievable Sector supported by government policy and moderate capital requirements #1 Growth: ~8.0% p.a. industry premium growth since 2008, which was driven by high utilisation (impacted by ageing); population growth; and increased penetration, should be ongoing. #2 Net margin: 4.5%-6.0% net margin by for-profit status supported by premium rate approval process. The best performing funds can operate above the top of this range. Premium rate approvals have covered increased utilisation and health cost inflation with funds competing more on product design. #3 Capital: Modest prudential capital requirements reflect low claims volatility. #4 Regulation: Government policy support for the sector reflects mutual reliance. #5 Market position and opportunities: With 29.1% policyholder market share at June 2014 in the consolidated PHI sector, s future opportunities are significant. #1) PHI Industry Premium Growth Rate Industry growth driven by population growth, utilisation and demographics Fig 18 Utilisation is a consistent driver of hospital claims growth Growth in Hospital Benefits (ann. ave) 12% 10% Other Utilisation (episodes per insured person) Inflation (benefits per episode) Volume (penetration) Volume (population growth) Total 8% 6% 4% 2% 0% -2% Source: Macquarie Analysis of PHIAC data, January Industry premium growth of 8.0% p.a. since 2008, driven by high utilisation (impacted by ageing); population growth; and increased penetration. Industry premium growth of 8.0% p.a. since 2008, was driven by: high utilisation (impacted by ageing); population growth; and increased penetration. We expect that under current industry policy settings, this level of growth is sustainable over the long term. We believe that changes to public health policy could add to the PHI sector growth rate. Changes could include: new incentives (discounts) to encourage under 30 year olds to enter the PHI system; added incentives (higher taxes) for take up of PHI for over 30 year olds; and expanding the scope of PHI (e.g. allowing PHI coverage to expand to primary care GPs). Some changes are not without risk for PHI funds, especially should the scope of PHI operations expand under policy changes. 5 January

14 Medibank BUPA NIB Aust Unity GUC CUA Health.com.au Doctor's Health Transport Health HCF HBF Teachers GMHBA Defence Health CBHS Health Westfund Latrobe Lysaght HIF QLD Teachers Healthguard Health Partners R&T St Luke's Police Health QLD Country Navy Health Mildura Phoenix Health ACA HCI Reserve Bank Cessnock Macquarie Wealth Management Regulation is extensive and extends to premiums. #2) Margin supported by premium approval process Premium rate approval process supports 3% to 6% net margin For-profit health funds should operate in the top half of this range with the best performing funds able to operate above the top end of the range Our expectation that for-profit status funds can operate with net margins in the % range is based on a combination of: 1) management expense performance at or below industry ratios; 2) premium rate increases at or below industry weighted average increase; and 3) claims cost outcomes at or below industry performance (delivery on clinical outcomes is also an essential part of executing against this strategy). Management Expenses: Despite s increasing focus on the above factors, s FY14 MER was 30bps above industry ex. Every 10bps improvement boosts net profit 1.6%. Premium rates: While impacted by the premium rate approval process, retains 68% of claims efficiencies under the PHI risk equalisation scheme. Regulation of PHI is extensive and this extends to the setting of premium rates. PHI funds submit premium rate changes to the Minister. The Minister must approve the proposed changes unless they are satisfied that a change would be contrary to the public interest. Fig 19 For-Profit funds net margins double the level of not-for-profit funds (FY13) Net Margin 'For-profit ' average: 5.1% 'Not-for-profit ' average: 2.6% Net Margin Source: PHIAC, Macquarie Research, January What margin is sustainable? We believe the current margins being achieved across the sector and by are consistent with regulatory settings. PHIAC supports the principle that the market is the best place to set prices where there is evidence of clear and effective competition for products. In 2011, when industry gross margins were 14.7% and net margins were 5.6%, PHIAC stated that current capital positions and margin outcomes for the industry suggest that price competition is not as sharp as it could be and 2014 industry net margins were ~1.5%pts lower than in 2011 at 4.2% and 4.1%, respectively. In the PHIAC Annual Report, when industry net margins were 4.2%, the following was noted in regard to competition: 1) competition for [ancillary] category of cover is intense ; and 2) the [PHIAC Competition in the Australian Private Health Insurance Market] report supports the conclusion of strongly competitive behaviours in large parts of the market, but with challenges associated with complexity and some elements of the regulatory system, as well as regional differences. 5 January

15 MPL's Health Insurance business had tangible and liquid capital (net of declared dividends) equivalent to 12.4% of premiums #3) PHI sector regulatory capital requirements Modest prudential capital requirements reflect the low claims risk The underlying regulatory capital requirement for PHI operations is low on an absolute basis and relative to other insurance companies. The factors that drive this level of capital include: premium rates are reset annually (albeit premium changes require ministerial approval); predictable and short tail nature of the underlying risk exposure; risk equalisation reduces exposure to high claims expenses volatility; government and regulatory support; and ability to force migrate members where policies prove unprofitable. PHIAC view on industry capital: In its latest Annual Report PHIAC made the following statement: The industry began, and ended, soundly capitalised. MPL holds capital above the minimum level required by PHIAC. Capital requirements include an overarching requirement on funds to have a board approved capital policy. As at 30 June 2014, 's Health Insurance business had tangible and liquid capital (net of declared dividends) equivalent to 12.4% of premiums for the next 12 months, which is above the regulatory capital requirement and within the Board policy to hold between 12.0%-14.0% regulatory capital to premiums over the next 12 months. This compares to the policy set by nib of 13.5% of total projected premiums. satisfies 100% of its capital requirement with common equity. Medibank Private does not currently have any debt. We don t expect debt to be added in the period of transition of prudential capital regulation to APRA (discussed below). s capital policy aims to continue to meet the regulatory requirements in the event of a 1 in 200 year financial stress across the business, and the full impairment of all intangible and illiquid assets, both occurring at the same time Fig 20 Capital intensity: versus nib and other insurers NTA / Premiums 400% 371.6% 300% 200% 100% 0% Genworth Mortgage Australia (1H14) 33.3% 36.9% IAG Group (FY14) SUN GI (FY14) 17.5% 14.0% 18.4% 12.4% nib group (FY14) nib group (FY15 forecast*) Medibank Medibank Private group Private (Health (FY14) Insurance FY15 forecast) Source: Macquarie Research, Company reports,, January Under the PHI Act, Australian health funds are subject to minimum capital adequacy and solvency requirements. The PHIAC is responsible for the determination and application of the industry s solvency and capital adequacy standards, which are binding on PHIs. Transition to APRA: PHIAC s prudential responsibilities will move into APRA from 1 July APRA has not determined its approach to prudential regulation of the PHI industry except that APRA does not intend to make changes to the existing capital and solvency standards for private health insurers before 1 July 2016 and will consult thoroughly. We expect that a transition period will see current capital standards in place for 3 or more years. PHIAC recently updated regulatory capital standards. 5 January

16 Macquarie Wealth Management PHI funds contribute ~8% of national health funding #4) Government support for the sector Mutual reliance assures support The Government and PHI connection is characterised by the following: Funding support: PHI funds contribute ~8% of national health funding. The contribution from the PHI sector has been slowly growing over time, reducing pressure on federal budgets. Growth in private health spending: Over the past 10 years, PHI claims ( hospital benefits ) have risen by 8.6% p.a. across the industry, with increased utilisation the major driver, contributing 3.8ppts or 43% of the growth. Governments fund only ~16% of procedures in private hospitals versus 100% funding of the public system. Increased private sector provision of health services reduces pressure on federal budgets. Private health service provision provides choice: Private hospitals represent ~40% of hospital admittance across the health system each year with private hospitals accounting for 60-70% of elective surgery cases. Private health service provision allows patients: 1) to avoid waiting lists; 2) a choice of a doctor; and 3) a choice of hospital. Fig 21 Health expenditure rising to 9.7% of GDP A$bn Non-government % of GDP State/territory and local governments Australian Government Health Expenditure / GDP Source: AIHW, January While much is made of the highly regulated structure of the community rated PHI market (with risk equalisation) and the need for the government incentives (taxes) and support (rebates) to sustain participation necessary to support affordability, as the points above highlight, the government and PHI are somewhat mutually reliant. The contribution of PHI to the provision of health services is critical in ensuring an effective health system. Fig 22 Utilisation amongst over 65s driving growth in hospital benefits Hospital benefits (10 year CAGR) 14% 12% 10% 8% 6% 4% 2% 0% -2% 7.1% 2.6% 1.5% 1.3% 1.6% Children (<10y.o.) 8.6% 4.5% 2.8% 3.2% 0.5% 0.3% Older Children (10-19 y.o.) Other Inflation (benefits per episode) Utilisation (episodes per insured person) Volume (PHI Penetration) Volume (Population growth) 8.1% 1.1% 1.8% 2.2% 6.4% 2.9% 1.7% 0.7% 1.0% 7.6% 2.4% 2.8% 2.3% 3.0% 3.1% 0.0% 9.7% 0.9% 3.4% 2.2% 11.4% 6.1% 2.8% -0.8% 8.6% 2.1% 3.8% 0.9% 1.7% 20's 30's and 40's y.o Total Source: Macquarie Analysis of PHIAC data, January January

17 Despite the efficiency program, MPL s Australian Residents MER is 30bps above the industry #5) Future Opportunities As the leading PHI in Australia, in addition to the current strategy to improve the operational performance, opportunities beyond the current business could also be attractive. Current business opportunity: Scale benefits are not yet evident s strategy to focus on underwriting, claims, and product design, supported by investment to enable delivery against the strategy, is consistent with improved margins. is focused on active net margin enhancement. has a dedicated team with primary responsibility for delivering on its strategy, known as the Provider Networks and Integrated Care (PNIC) team. Claims expenses are the largest expense and are therefore a major determinant of Medibank Private s profitability. is targeting four key areas to manage claims: provider relationships; product design; benefits utilisation; and reducing improper claims. In relation to management expenses, s Australian resident management expense ratio (MER) in FY14 was 30bps above the industry ex. Every 10bps improvement boosts net profit 1.6%. While impacted by the premium rate approval process, based on PHIAC data Medibank Private retains 68% of claims efficiencies. The scale benefits of holding the leading share in the consolidated PHI market are not yet evident. Fig 23 Gross Margin relatively resilient vs. industry Fig 24 MER gap to industry narrowing Australian Residents Gross Margin 14.0% 12.0% Industry residents gross margin (ex ) residents Gross Margin 13.8% 12.8% 13.1% Australian Residents MER 12.0% 10.0% 10.2% Industry Residents MER (ex ) Residents MER 9.2% 8.7% 10.0% 8.0% 8.0% 6.0% 4.0% 2.0% 0.0% 14.4% 13.3% 12.4% FY12A FY13A FY14A 6.0% 4.0% 2.0% 0.0% 8.9% 8.6% 8.4% FY12A FY13A FY14A Source (for all above): pro forma financial data, Based on PHIAC data, January Future Opportunities: large, wealthy and healthy policyholder base In addition to the current strategy to improve the operational performance, opportunities beyond the current business could also be attractive. MPL could expand its current offering within the health sector and potentially across the insurance and financial sectors more broadly. Health sector opportunities: We expect that could expand its current offering within the health sector (e.g. providing more services to government) and potentially across the insurance and financial sectors more broadly. is well placed to provide services related to government health services beyond PHI. Examples could include Department of Veterans Affairs and the NDIS. Expanded product offering: In addition, the nature of PHI means that MPL s customer base is inherently skewed to higher income households. Currently MPL only distributes travel, life and pet insurance, as authorised agents for other insurers (without taking underwriting risk). Distribution support: MPL holds at least 20% PHI market share in each state and territory and has a national network of 90 retail outlets as well as call centres and online distribution capability. 5 January

18 Valuation and Recommendation $2.62 target price per share Outperform recommendation Our price target implies a 2 yr forward PE ratio of 23.6x and dividend yield of 3.2%. Our $2.50 per share valuation equates to ~$1,800 per member and a 1.15x PHI revenue multiple. The only relevant listed competitor is NIB (NHF.AU, Outperform, Price Target $3.50, our target price implies 2 yr fwd PE 17.5x). MPL should trade at a premium to NIB, in our view, given the opportunities to improve operational performance available to MPL. Initiation: Recommendation Outperform, Target Price $2.62 Based on the attractive industry outlook and opportunities for MPL to deliver operational upside we initiate coverage of MPL with an Outperform recommendation and $2.62 price target. Our target price implies a 2 yr forward PE ratio of 23.6x and dividend yield of 3.2%. The only relevant listed competitor is NIB (NHF.AU, Outperform, Price Target $3.50, our target price implies 2 yr fwd PE 17.5x). MPL should trade at a premium to NIB, in our view, given the opportunities to improve operational performance available to MPL. Summary of key assumptions: Discount rate: 8.5% Cost of Equity Beta: We have assigned a beta of 0.80x, reflecting the defensive predictable growth profile of the business somewhat offset by the tail risk associated with the over-arching regulatory risk associated with government health policy. In addition, MPL is a relatively large business, with a leading market position in a consolidated market where the majority of market share is controlled by health funds with a for-profit status. Risk Free Rate: We have used a long-term risk free rate of 4.5%. Equity Risk Premium: We have used an equity risk premium of 5.0%. Nil debt position: MPL has no debt and we assume that this remains unchanged. Interim growth period: Given the positive long term demographic driven growth in health spending we have incorporated an interim growth period in our valuation from 2026 to 2035, with distributable cash flow growth moderating to 5%. We assume the terminal growth period commences from % Terminal Growth Rate: A 3% nominal terminal growth rate has been factored into the valuation to reflect long term expected profit growth. Key considerations in forming a valuation for When assessing the investment opportunity provided by MPL, we believe the following factors are relevant: Australian PHI growth will likely exceed non health related companies through the cycle PHI sector is not subject to individual or catastrophe risk Growth rates: The underlying growth rate of health expenditure and the potential for an increased role of PHI in the funding of this increase means that growth in Australian PHI and other health related companies will likely exceed non health related companies through the cycle. Margins: We expect that the for-profit health funds should be able to operate with net margins in the range of 4.5% to 6.0% and if policy changes occur that increase the risk adopted by Health funds, margins may expand (albeit with increased capital requirements). Exposure to catastrophe risk: The community rated structure of the PHI market operating alongside the public system means that the PHI sector is not subject to individual or catastrophe risk inherent in other insurance markets and sectors. Investment income contribuition: Investment income comprises ~25% of MPL of net profit after tax and can cause some earnings volatility 5 January

19 Government support: The community rated structure of the PHI Market necessitates government policy to encourage participation. Event risk: The largest single risk for the PHI sector, and MPL specifically, is the Health Minister not approving a premium rate increase as he or she does not consider it in the public interest, resulting in premium rate increases materially below the combination of health inflation and utilisation growth. Ancillary benefits product design risk (22% of industry revenues): Ancillary products are not traditional insurance risk products. Policyholders are able to claim up to limits set in product design for dental, optical, physio and other health related items. The risk from poor product design is therefore heightened. PHI s regulatory capital requirement is low on an absolute basis and relative to other insurance companies Capital requirements: The underlying regulatory capital requirement for PHI operations is low on an absolute basis and relative to other insurance companies. The combination of predictable and short tail claims, community rating with risk equalisation, lack of natural catastrophe exposure and political support for PHI means that the capital requirement is less than for other insurance companies. Market structure factors relevant to the valuation of MPL Profit status: 10 PHIs are for-profit status, accounting for 69% of total policies in Market concentration has increased: The PHI industry is relatively concentrated. At 30 June 2013 the top three private health insurers accounted for 67% of Policyholders nationally and the top 5 PHI funds represent 82% of policyholders nationally. Significant corporate activity has driven this consolidation. Major transactions: HCF/Manchester Unity: HCF announced the proposed acquisition of Manchester Unity in August 2008 for $257m (underlying purchase price of $1,950 per member, 0.69x annual premiums). Medibank/ahm: Medibank acquired ahm for $367m in 2009 (underlying purchase price of $1,913 per member, 0.76x annual premiums). BUPA Australia/MBF merger: In December 2007 the Board of MBF recommended a merger of the two private health insurers following a $2.41bn offer to MBF contributors from BUPA (underlying purchase price of $1,913 per member, 0.78x annual premiums). Avant Mutual Group acquisition of Doctors Health Fund: In 2012, Avant acquired Doctors Health Fund for $30m (including $16.3m capital surplus to regulatory requirements), $3,932 per member or $1,796 adjusted of the surplus capital, 1.03x annual premiums. Primary Healthcare acquired Transport Friendly Society ($18m) in Sept : Our $2.50 per share valuation equates to ~$1,800 per member and a 1.15x PHI revenue multiple. Fig 25 Adjusted acquisition prices consistently ~$1,900 - $1,950 per policyholder Fig 26 Adjusted acquisition multiples consistently ~0.7x 0.8x premiums Price per policyholder 3,500 3,000 2,620 2,500 2,000 1,500 1, ,447 3,200 2,755 1,913 1,913 1,950 1, Note: Adjustments reflect surplus capital and non-phi businesses BUPA Medibank HCF Acquisition NIB NIB MBF AHM Manchester Unity Price per policyholder - headline Price per policyholder - adjusted Source: Institute of Actuaries of Australia, Macquarie Analysis of PHIAC data, Macquarie Research, January Average At listing Current PHI Premium multiple Premium multiple - headline Premium multiple - adjusted BUPA Medibank HCF Acquisition NIB NIB MBF AHM Manchester Unity 0.80 Average At listing Current 5 January

20 31-Dec Jun Dec Jun Dec Jun Dec Jun Dec Jun Dec Jun Dec Jun Dec-14 Macquarie Wealth Management Domestic and International comparatives There are no listed international health insurance or healthcare companies that can be directly compared to MPL. nib is the only relevant listed peer to MPL globally. We consider nib Holdings (NHF-AU) to be the only relevant listed peer to MPL. While we acknowledge a number of fundamental differences exist between MPL and nib (scale, efficiency, policyholder growth and non-phi businesses), a top 5 player in the same industry is naturally going to be the most relevant comparison. The nib valuation has increased over the past 12 months, moving from a small PER discount to the ASX200 in October 2013 to a 27% premium currently. In our view, this was due to: Improved understanding of the industry and nib s earnings stability (as a relatively small, illiquid stock outside of the ASX300, the PHI industry and nib have not been well understood by investors in the past). Clarity on capital outlook provided scope for capital returns: see above for further detail on the capital regime. Strong policyholder growth and relative margin stability: nib has proven it can grow policyholders faster than the industry (albeit now slowing) while maintaining a margin between 5.0% and 5.5%. Fig 27 nib s PER has re-rated vs. the ASX200 to stand at ~18x, a ~27% premium to the ASX200. PER (Consensus 1yr fwd) Premium/Discount nib ASX200 nib PER Premium/Discount (vs ASX200) 50% 40% 30% 20% 10% 0% -10% -20% -30% -40% -50% Source: Factset, January should trade at a premium to nib, in our view, due to: Greater scale: While nib is an efficient, scale insurer (as indicated by its 8.1% Australian residents MER), has greater scope to improve claims efficiency, improving the gross margin through its PNIC strategy. Cost out opportunity: is forecast to continue to improve its MER in the Australian residents PHI business from current 8.7% level in FY14 towards the rest of the industry (8.4%) in FY15 [Source: Based on PHIAC data]. We note nib delivered a 12.3% gross margin, 8.1% MER and 4.2% net margin in FY14 [Source: nib company report]. Costs are expected to remain a focus for over the long term. 5 January

21 Operational analysis Focus on underwriting, claims, product design Investing to enable delivery against strategy Underwriting: Active enhancement of Health Insurance Underwriting claims targeted. Cost reduction: MPL has a continuing cost reduction program focused on reducing the Management Expense Ratio. IT renewal: MPL has a strategy to rationalise and simplify its IT infrastructure. Business overview and structure MPL is the only private health fund in Australia with more than 20% market share in each state and territory MPL PHI policyholder premiums are forecast to generate 90% of pro forma FY15 revenue The PNIC team focuses on more strategic contracting with healthcare providers and increased focus on the quality of patient outcomes Founded in 1976, is Australia s largest private health insurer with a 29.1% market share, over 1.8m Policyholders and over 3.8m people covered as at 30 June Operating throughout Australia, with a limited presence in New Zealand and Singapore, MPL is the only PHI fund in Australia with more than 20% market share in each state/territory. Since 1998, MPL has operated on an arm s length basis from the Government and, in 2009, became a for-profit private health insurer. MPL operates under two divisions: 1) Health Insurance; and 2) Complementary Services. Health Insurance business segment Health Insurance, through two national brands ( and ahm), offers PHI policies and also overseas visitors health cover (OVHC) and overseas students health cover (OSHC). ahm was acquired by Medibank in Key performance drivers: Premium Volumes, Gross Margin, Management Expenses The key drivers of PHI fund performance are: Premium growth: driven by 10 year industry hospital benefits CAGR to FY14 of 8.6%. Gross margin: industry gross margin has ranged from 12.6% to 14.9% since Management costs: industry management expense ratio in the 12 months to June 2014 was 8.5%. MPL pro-forma Australian residents MER was 8.7% over the same period. MPL has a clear strategy on improving hospital claims outcomes. The dedicated PNIC (Provider Networks and Integrated Care) team is focused on more strategic contracting with healthcare providers and increased focus on the quality of patient outcomes. Claims expenses are the largest expense within the Health Insurance business and are therefore a major determinant of profitability. Four key areas targeted to manage claims expenses: Relationships with providers: developing hospital relationships to manage cost and quality of patient outcomes. Product design: balancing product pricing and features such as covered services and claims limits. Benefits utilisation: developing strategies to support and assist the care of high needs Policyholders including those with chronic diseases. Reducing improper claims: improving the detection, recovery and prevention of improper claims. Effectively managing claims expenses may result in higher margins, permitting MPL to maintain margins in the face of increased utilisation or enable MPL to enhance the relative affordability of policies in order to increase market share. 5 January

22 Fig 28 Hospital and Ancillary claims cost (FY13) Physio, Chiro, Alternative therapes 4% Package bonus 1% Other extras 2% Optical 5% Dental 12% Private Hospitals 44% other hospital 1% Overseas workers and students 2% Day facility 2% Public hospital 5% Prostheses 10% Medical services 12% Source: pro forma financial data, January Product design Product design has been a major cause of margin volatility across the industry, largely in relation to ancillary claims Hospital utilisation has accounted for ~62% of growth in claims expenses over 10 years 2.2% of policyholders accounted for 35.2% hospital claims from FY10 FY13 s objective is for its products to deliver customer value, be market competitive and be consistent with delivering its target profitability levels. In designing products s strategy is to balance product pricing with features such as covered services and claim limits. Product design is the primary lever for managing ancillary claims expenses. relies on actuaries as part of achieving this balance. Product design has been a major cause of margin volatility across the industry, largely in relation to ancillary claims. Benefits utilisation Industry wide benefits utilisation per policyholder has accounted for ~62% of growth in hospital cover claims expenses per policyholder in the 10 years to June 2014, largely as a result of increasing claims utilisation from over 65 year olds. The balance of claims growth is attributable to population growth, increased PHI penetration and growth in benefits per episode. MPL, like many other funders in the Australian healthcare industry, is increasing its focus on managing the growth in claims expenses through a number of strategies, including those aimed at supporting primary care givers (such as GPs) to better prevent chronic diseases. MPL s strategies to manage benefits utilisation include a focus on high needs claimants. For instance, 2.2% of the Medibank-branded Policyholders accounted for 35.2% of Medibank-branded hospital and medical claims expenses over the FY10 FY13 period. MPL is starting to work with these Policyholders, to provide them with support to improve their health. By supporting these Policyholders and their primary care givers to achieve better health outcomes, MPL intends to reduce related claims expenses. Reducing improper claims MPL is focused on identifying, preventing and recovering funds from improper or ineligible PHI claims. These improper claims range from unintentional errors (such as submitting the same claim more than once) through to fraud (such as, for example, deliberate submission of a claim for a service that was not provided). 5 January

23 MPL aims to reduce improper claims through improved claims processing rules, data and analytics tools to identify improper payments, and manual audit and investigation functions. The combination of focusing executive resources and increasing technology capability to support improper claims identification is allowing increased focus on this issue. Improved operational performance MPL has disclosed a continuing cost reduction program focused on reducing the Management Expense Ratio (MER), corporate overheads and other costs through: simplifying business processes while improving the customer experience (e.g. claims processing, reducing new product development timeframe); and reviewing the activities undertaken within the Complementary Services segment to ensure they provide value to the Health Insurance business. The majority of Management Expenses for Health Insurance comprise employee expenses and sales and marketing expenses the majority of Management Expenses for Health Insurance comprise employee expenses and sales and marketing expenses. During FY13, MPL embarked on an organisation-wide cost reduction program in order to identify sustainable cost savings to be realised over time. Programs to identify further cost savings and efficiencies are ongoing. Fig 29 Medibank MER seeing benefits of cost rationalisation program Australian Residents MER 12.0% 10.0% 8.0% 6.0% 4.0% 10.2% Industry Residents MER (ex ) Residents MER 9.2% 8.7% 2.0% 0.0% 8.9% 8.6% 8.4% FY12A FY13A FY14A Source: pro-forma financial data, January MPL aims to take advantage of new opportunities within the broader health and insurance industries which leverage or extend its core capabilities Complementary Services are forecast to contribute ~10% of FY15 revenue Leveraging and extending core capabilities has highlighted that they are investing in businesses which provide insights into health management in order to reduce claims expenses. MPL aim to take advantage of new market opportunities within the broader health and insurance industries which leverage or extend MPL s core capabilities. This opportunity could be similar to the ADF contract where MPL undertakes to deliver health services to a specific group that is currently provided by government or other organisations (known as Population Health Management). Complementary Services business segment MPL Complementary Services generates revenue from a number of related activities that utilise MPL s experience and expertise and support the Health Insurance business. Complementary Services is forecast to contribute 10% of pro forma FY15 revenue. The segment generates service fees and commissions from: contracted health management services for government and corporate clients; online and telephone-based health services; and the distribution of travel, life and pet insurance, as authorised agents for other insurers. 5 January

24 Between 2009 and 2011 acquired the following businesses: Health Services Australia, a provider of travel and occupational health services, which the Australian Government transferred to MPL in Health Services Australia held a significant contract to provide pre-immigration visarelated health screening services to the Department of Immigration. The Department of Immigration did not award this contract to MPL on renewal (effective 28 July 2014). This contract was won by BUPA. McKesson Asia Pacific, a provider of telephone and healthcare services in Australia and New Zealand, which was acquired in Carepoint, a provider of occupational health, rehabilitation and travel health services in Western Australia. Complementary Services Activities The activities in the Complementary Services segment include contracting with government and corporate customers to provide health management services, as well as providing a range of telehealth services in Australia and New Zealand. In addition, MPL distributes diversified insurance products on behalf of other insurers (without taking underwriting risk). Products include travel, life and pet insurance, where MPL distributes as the authorised agent of other insurers for a commission. These are sold to both Policyholders and other individuals. Policyholders receive a discount as part of the customer retention strategy. The services provided by as part of its Complementary Services are described below. Population Health Management: is the coordination of healthcare services for groups (or specific populations) whose healthcare needs are met by a single funder, such as the Department of Defence. Examples of potential populations not directly serviced by MPL include people funded by the Department of Veterans Affairs and the National Disability Insurance Authority. Provision of Population Health Management services builds MPL s health assurance capability set by providing insights into healthcare management. These insights not only provide continuous improvement opportunities for customers of Population Health Management services but can also be leveraged by the Health Insurance business to improve product design and preventative care programs. ADF Health Services Contract (Department of Defence): In 2012, MPL entered into a four-year contract to deliver a national integrated healthcare service to the garrisons of the Australian Defence Force (ADF) (ADF Health Services Contract). MPL manages and co-ordinates over 1,100 on base primary health care experts, over 4,300 medical specialists, 254 hospitals and over 8,300 allied health professionals. This network provides access to on-base and off-base healthcare services including pathology services, imaging and radiology services and a health hotline for over 60,000 permanent and over 20,000 reservist uniformed personnel from point of injury or illness to recovery. Telehealth: MPL is one of the largest telehealth providers in Australia and New Zealand with over 700 staff delivering a range of healthcare services via phone, online and video. Services include disease management, health coaching, mental health counselling, after hours GP helplines, Nurse on Call and online health portals. MPL has contracts with Commonwealth, state, territory and local governments in Australia and the New Zealand Government for the provision of HealthLine services in New Zealand on a fee for service basis. Telehealth services are delivered by qualified healthcare professionals. 5 January

25 Corporate Health Services provides services such as pre-employment health checks and health and wellbeing programs. MPL employs health professionals to provide face-to-face services via a national network of clinics through its Workplace Health business. Diversified Consumer Businesses: sell multiple products to both new and existing customers through retail channels. Diversified Insurance: distributes travel, life and pet insurance products as the authorised agent of other insurers for a commission (MPL is not exposed to underwriting risk on these policies). Distribution is to both MPL Policyholders and other individuals. Policyholders receive a discount as part of the customer retention strategy. MPL had a national footprint of over 90 retail locations and 34 clinics Travel Doctor: provides onsite and in-store medical consultations, advice and vaccinations to both corporate customers and, increasingly, to the public. Employees As at 31 July 2014, the MPL employed 3,732 people, 2,947 of whom were full time equivalent (FTE) employees including more than 800 health professionals: 1,640 FTE employees were engaged in the Health Insurance business. 1,275 FTE employees are engaged in the Complementary Services business. Retail footprint As at 30 June 2014, MPL had a national footprint of over 90 retail locations and 34 clinics. MPLgenerally leases the premises required for its operations, however owns properties in Wollongong (the former ahm head office) and Sydney. Under the acqusition terms, MPL made undertakings to maintain a separate ahm headoffice in Wollongong. MPL has recently completed a significant project to consolidate its six office locations in Melbourne into a single headquarters in Melbourne with a reconfigured workplace environment designed to generate efficiencies. MPL began occupying the new premises in August The capital cost of the project is expected to be $74.9m. 5 January

26 FY14A Premium Growth Gross Margin MER Investment Income Comp Serv Other FY15E Premium Growth Gross Margin MER Investment Income Comp Serv Other FY16E Premium Growth Gross Margin MER Investment Income Comp Serv Other FY17E Macquarie Wealth Management Financial Analysis Revenue growth assured, Utilisation is a long term challenge operating below optimal performance levels Double Digit EPS Growth: MPL is forecast to deliver its third consecutive year of double digit underlying NPAT growth in FY15 (+15.6%), underpinned by revenue growth, lower MER and a turnaround in complementary services profitability. Revenue growth assured for MPL and the broader Industry. While MPL has lagged the industry in policyholder growth, the growth it has achieved historically has been relatively profitable at the gross margin level. Utilisation is a long term challenge. MPL is incentivised to invest to reduce hospital claims and drive improved gross margin outcomes over time. MPL is forecast to deliver its third consecutive year of double digit underlying group NPAT growth in FY15 (+15.6%) Expenses have reduced substantially, with MPL narrowing the gap to the rest of the industry. MPL delivered $49m of cost savings in FY14 (~0.9ppt MER benefit). Key drivers of FY15 underlying profit growth is forecast to deliver its third consecutive year of double digit underlying NPAT growth in FY15 (+15.6%), which follows +16.5% underlying profit growth in FY13 and +10.7% underlying profit growth in FY14. In calculating underlying profit we remove the earnings volatility attributed to growth assets investment income and the immigration contract. Fig 30 underlying NPAT drivers Underlying NPAT %4.6% 9.2% 2.3% % 1.1% 2.9% 1.5% % 2.0% 1.6% 0.3% % -0.1% -0.3%-0.8% -1.8% -3.1% Source: Macquarie Analysis of pro-forma data, January Based on Macquarie Research analysis FY15 underlying profit growth is driven by: 1) PHI Revenue growth (+4.6ppts contribution to profit growth), underpinned by 6.5% premium rate increases. 2) Management expense ratio (+9.2ppts contribution to profit growth) as the total PHI MER is forecast to fall from 9.2% in FY14 to 8.7% in FY15. 3) Complementary services (+2.3ppts contribution to profit growth) as this segment swings to profitability excluding the Immigration contract impact. This is offset by lower underlying investment income (-1.8ppts) and higher corporate overheads/other group costs (-3.2ppts). 5 January

27 Australian Residents PHI business: the engine room of growth The Australian residents PHI business accounts for 86% of FY14 group revenue The Australian residents PHI business accounts for 86% of FY14 MPL group revenue. As the largest private health insurer in Australia, MPL is a scale operator in a growing industry, with earnings growth boosted by significant cost-out opportunity (refer to charts below). The four charts below provide an overview of the Australian residents PHI business vs. the rest of the industry (excluding MPL). Fig 31 Premium growth below industry Fig 32 Gross Margin outperforming the industry Australian Residents premium gr. 10.0% 9.0% 8.0% 7.0% 6.0% 5.0% 4.0% 3.0% 2.0% 1.0% 0.0% Industry residents premium growth (ex ) Residents premium growth 7.0% 5.6% 6.0% 9.0% 8.2% 8.1% FY12A FY13A FY14A Australian Residents Gross Margin 14.0% 12.0% 10.0% 8.0% 6.0% 4.0% 2.0% 0.0% Industry residents gross margin (ex ) residents Gross Margin 13.8% 12.8% 13.1% 14.4% 13.3% 12.4% FY12A FY13A FY14A Fig 33 MER gap to industry narrowing Fig 34 Net Margin above industry in FY14 Australian Residents MER 12.0% 10.0% 10.2% Industry Residents MER (ex ) Residents MER 9.2% 8.7% Australian Residents Net Margin 6.0% 5.0% Industry Residents Net Margin (ex ) Residents Net Margin 4.4% 8.0% 4.0% 3.6% 3.6% 6.0% 3.0% 4.0% 2.0% 2.0% 0.0% 8.9% 8.6% 8.4% FY12A FY13A FY14A 1.0% 0.0% 5.5% 4.6% 4.0% FY12A FY13A FY14A Source (for all above): pro forma financial data, Based on PHIAC data, January The key highlights are: Revenue growth remains high in absolute terms but is below industry levels, driven by market share loss in the core brand. While ahm is growing at ~6x industry levels, this is generating a negative mix impact as ahm policies are on average lower value policies sold to younger policyholders. Gross margin (premiums less hospital and ancillary claims) performance has been much more stable than the industry as MPL leverages its scale with hospital operators and ancillary service providers. Management expenses improving towards industry averages from a relatively high base. PHI industry premium growth is consistently growing between 7% - 9% p.a. MPL has disclosed that it has implemented a cost-out program in FY13 to rationalise spending, which has proven successful to date ($49m of savings in FY14, contributing ~0.9ppts to the MER contraction, partially offset by spending on customer acquisition). Further MER reductions in FY15 appear achievable given operates at 30bps higher MER than the rest of the industry in its resident PHI business. Net margin expanded by 80bps in FY14 as industry margins fell by 60bps, as Medibank Private achieved a stable gross margin and improved efficiency. 5 January

28 Revenue growth stability PHI industry revenue growth is consistently growing between 7% - 9% p.a. underpinned by: For individual private health insurers, premium growth is influenced by lapse rates, market share gains/losses and policyholder age mix Premium rate increases of ~5% to 6% p.a. are required to offset: Health care cost inflation (~2%p.a.). Increasing utilisation (~3% - 4% p.a.). Population growth of ~2% p.a., boosted by an ageing population. While premium growth and population growth are reasonably predictable, key swing factors that drive some year to year variance in PHI industry revenue growth include: Policyholder upgrading/downgrading of cover. Penetration rate changes (% of population that have PHI). Fig 35 Industry revenue growth drivers Industry Premium growth 10% 8% Other Penetration Premium rate Mix, Up/downgrading Population growth Total Premium growth Industry Premium growth 10% 8% 6% 4% 2% 0% -2% FY09A FY10A FY11A FY12A FY13A FY14A FY15E Source: Macquarie Analysis of PHIAC data, Macquarie Research, January % 4% 2% 0% -2% Furthermore, for individual private health insurers, revenue growth is influenced by: Lapse rates, which when deducted from sales growth determine net policyholder growth. Market share gains/losses, largely driven by product design and investment in customer acquisition. Policyholder age mix older policyholders (55+ yr olds) typically purchase higher value policies than younger policyholders (under 40 year olds) due to increased health risks, policy mix (larger number of family policies rather than singles) and higher income levels. Top line revenue growth is not a primary concern What is critical is that premium rate change compensate for increased utilisation While several variables influence revenue growth, in practice, revenues have risen by 7% - 9% p.a. through the cycle, even through material policy/regulatory change. What is critical is that premium rate increases adequately compensate insurers for increased utilisation (which is assessed at the gross margin line). revenue growth below industry levels Revenue growth remains high in absolute terms but is below industry levels, driven by market share loss in the core brand. While ahm is growing at ~6x industry levels according to MPL, this is generating a negative mix impact as ahm policies are on average lower value policies sold to younger policyholders. The key premium rate drivers illustrated above are directly compared for Medibank Australian Resident PHI business and the rest of the industry below. The persistent driver of MPL s below industry revenue growth has been policyholder growth at one third to a half of the rest of the industry. 5 January

29 FY90 FY91 FY92 FY93 FY94 FY95 FY96 FY97 FY98 FY99 FY00 FY01 FY02 FY03 FY04 FY05 FY06 FY07 FY08 FY09 FY10 FY11 FY12 FY13 Macquarie Wealth Management Fig 36 Policyholder growth the major differentiator Australian resident PHI Premium gr. 12.0% 10.0% 8.0% 6.0% 4.0% 2.0% 0.0% -2.0% 9.0% 5.4% 4.7% -1.1% Industry ex Medibank 7.0% 5.2% 1.8% Premium growth 8.2% 5.6% 3.1% 5.6% 5.1% 1.0% 8.1% 6.2% 3.3% 6.0% 6.3% 1.5% 0.0% -0.5% -0.5% -1.4% -1.8% Medibank residents Downgrading & mix Premium rate (Annual weighted average) Policyholder growth Industry ex Medibank Medibank residents Industry ex Medibank Medibank residents FY12 FY13 FY14 Source: Macquarie Analysis of PHIAC and Department of Health data, January The negative FY14 Medibank Brand policyholder growth (-0.7%) has resulted in market share loss as policyholder growth for the rest of the PHI industry (3.3%) was well in excess of Medibank overall (1.5% when ahm is included). This market share trend is expected to continue in FY15 This market share trend is expected to continue in FY15 if MPL s expectations for 1.5% Australian resident Policy Single Equivalent Units (PSEU) growth and 0.6% growth overall (including Overseas Visitors and Students) are delivered, as we forecast the PHI industry to grow policyholders at ~2.3%. Fig 37 Gradual market share loss for Medibank branded policies Market Share 35% 30% 25% 20% 15% 10% 5% 0% Introduction of rebate, MLS and LHC Acquisition of ahm Source: Macquarie Analysis of PHIAC data, January Medibank and ahm policyholder growth diverging s dual brand strategy, if executed to deliver profitable growth, could offer a competitive advantage vs. peers, enabling management to target different policyholder demographics with specific customer acquisition strategies. We compare the two brands below, across the number of policies and PSEUs (Policy Single Equivalent Units a standardised measure which accounts for the number of policyholders and the amount of cover in the policy. PSEUs can range from 1 4 per policy) as well as acquisition strategies, growth rates and lapse rates: The Medibank brand is well established but is not generating policyholder growth: ~1.6m policies and 3.4m people covered. A policyholder base which selects a relatively high level of cover. We estimate Medibank Private branded policies have ~2.8 PSEUs per policy. 5 January

30 Policyholders are older than the industry average (as evidenced by risk equalisation receipts), resulting in higher value policies. Medibank has seen ~9% to 10% sales rates (new policies sold / total policies), ~0.5% below the industry and discontinuance rates broadly in line with the industry (~9% to 10%). The ahm brand is still in the growth stage of its development and is aggressively acquiring customers through both the direct and aggregator channels. 0.2m policies and ~0.4m people covered. Brand positioning results in younger, lower value policies with a value proposition geared towards ancillary cover. We estimate ahm has ~1.9 PSEUs per policy. ahm is growing rapidly off a small policyholder base, with 67,000 new policies sold in FY14 (35% of the opening policyholder base). While ahm s lapse rates are rising (16% in FY14 based on total lapses / opening policyholders), this remains well below sales rates in the short term, resulting in 19.5% net policyholder growth in FY14. We expect this to stabilise over the medium term as recently acquired ahm policyholders are more likely to review their cover more actively than the core Medibank brand based on brand positioning. As a result, we expect a long term 12%-15% lapse rate for ahm policies (vs. 9%-10% for the Medibank brand). As the customer base grows, sales rates will remain elevated but net policyholder growth is likely to decline towards 5%. Fig 38 Net policyholder growth brand divergence Net policyholder growth 20% 19.5% 15% 10% 7.8% 4.7% 5% 3.5% 2.9% 2.6% 1.5% 1.8% 0.3% 1.0% 1.5% 0% -0.7% -5% Medibank brand ahm brand Medibank group PHI Industry FY12A FY13A FY14A Source: PHI Industry data from PHIAC, all other data from, January Every 1% increase in average PSEUs across the group adds 2.2% to NPAT The large number of new policyholders in FY12 impacted FY14 industry gross margins Due to the relatively low net margins associated with new policyholders, holding all else constant (i.e. net margins on new policyholders are in line with existing policyholders), every 1% increase in average PSEUs across the group adds 2.2% to NPAT. MPL is targeting PSEU growth of 0.6% in FY15. NPAT sensitivity to policyholder growth is much less than to changes in margins on the overall book of policyholders. While this policyholder growth has been well below industry levels, it is important to highlight the relatively stable gross margin performance delivered by MPL s Australian Resident PHI business in FY14 (+30bps to 13.1%) relative to peers (-80bps to 12.4%). Policyholder reaction to regulatory changes in 2012 negatively impacted industry profitability in FY14 as a result of: 1) a large cohort of policyholders entering the industry; and 2) prepayment of premiums to lock in rebates ahead of income testing in June 2012 delayed premium rate increases. MLP was less exposed to these industry issues as it saw net policyholder growth of just 1.8% in FY12 vs. 4.7% for the industry ex MPL. The table below illustrates the impact of waiting periods in years one and two as well as the lifetime value of a policyholder using drawing rate analysis from the IAA. 5 January

31 Fig 39 Illustration of drawing rates on lifetime value of a policyholder Yr 1 Yr 2 Yr 3 Yr 4 Yr 5 Yr 6 Yr 7 Yr 8 Yr 9 Yr 10 Assumptions Premium growth 6.5% 6.5% 6.5% 6.5% 6.5% 6.5% 6.5% 6.5% 6.5% 6.5% Hospital Claims per person growth 6.0% 6.0% 6.0% 6.0% 6.0% 6.0% 6.0% 6.0% 6.0% 6.0% Ancillary Claims Per person 8.0% 8.0% 8.0% 8.0% 8.0% 8.0% 8.0% 8.0% 8.0% 8.0% Drawing Rate Analysis Hospital 62% 147% 112% 111% 109% 100% 100% 100% 100% 100% Ancillary 89% 99% 100% 105% 110% 100% 100% 100% 100% 100% Gross Margin contributions Premiums 1,497 1,594 1,697 1,808 1,925 2,050 2,184 2,326 2,477 2,638 Hospital Claims 594 1,492 1,205 1,266 1,318 1,281 1,358 1,440 1,526 1,618 Ancillary Claims Total Claims 889 1,847 1,592 1,705 1,814 1,769 1,885 2,009 2,140 2,281 Gross Margin 608 (253) Gross Margin % 40.6% -15.9% 6.2% 5.7% 5.8% 13.7% 13.7% 13.6% 13.6% 13.5% PV(Gross Margin) 552 (209) SUM (PV Gross Margin) 1,302 Source: Macquarie analysis of Institute of Actuaries of Australia data, January In the first year (FY13), a policyholder claims on average 62% of hospital benefits of a typical policyholder as they are restricted from many procedures for 12 months. In the second year (FY14), a policyholder claims on average 147% of hospital benefits of a typical policyholder as waiting lists are removed and the health needs which drew policyholders into the system are addressed. Over years 3 6 (FY15 FY18), hospital drawing rates gradually return to normal levels. Fig 40 Standardised drawing rates for hospital and ancillary cover Fig 41 Gross margin normalises after year 5 following a ~40% margin in year 1 and -16% in year 2 Standardised drawing rate 150% 140% 130% 120% 110% 100% 90% 80% 70% 60% 50% Hospital Ancillary Yr 1 Yr 2 Yr 3 Yr 4 Yr 5 Yr 6 Gross Margin Source (for all above): Macquarie analysis of Institute of Actuaries of Australia data, January % 40% 30% 20% 10% 0% -10% -20% 40.6% 6.2% 5.7% 5.8% 13.7% 13.7% 13.6% 13.6% 13.5% -15.9% Yr 1 Yr 2 Yr 3 Yr 4 Yr 5 Yr 6 Yr 7 Yr 8 Yr 9 Yr 10 MPL forecasts 1.5% policyholder growth in the Australian resident health insurance business in FY15 The decline in risk equalisation receipts highlights the changing characteristics of the policyholder base FY15 policyholder growth MPL forecasts 1.5% policyholder growth in the Australian resident health insurance business in FY15. The overall policyholder growth forecast of 0.6% is impacted by the repricing and repositioning of the International Students business. This differential between the overall PHI business and the Australian resident PHI business implies a 40% reduction in overseas PHI policies, which includes both students and workers. While management have not quantified the key product and brand contributions to FY15 policyholder growth, management stated policyholder growth is expected to be driven by the ahm brand, and includes some assumed migration of Policyholders from the Medibank brand. This is consistent with management s forecast decline in risk equalisation receipts (from $116.8m in FY14 to $78.7m in FY15) and reflects: 1) the annualisation of the 19.5% policyholder growth in FY14; and 2) the continuation of elevated ahm policyholder growth relative to Medibank brand policyholder growth. The magnitude of this risk equalisation decline highlights the rapidly changing characteristics of the overall policyholder base, as ahm s customer acquisition strategy continues to focus on younger policyholders. 5 January

32 Fig 42 Risk equalisation receipts expected to decline as ahm growth continues Risk eq receipts (A$m) % 83.1 Risk Equalisation receipts Risk Equalisation receipts as % of gross claims 2.3% 2.1% Risk Eq receipts (% of gross claims) 2.5% 1.5% % 1.5% 1.0% 0.5% 0 FY12A FY13A FY14A FY15E 0.0% Source:, January MPL has received approval for above industry average premium rate increases in FY13 and FY14 Premium rates offsetting utilisation and inflation to keep margins constant MPL has received approval for above industry average premium rate increases in FY13 and FY14 as margins have declined and downgrading/mix impacts have weighed on overall revenue growth. The only period over the past five years that saw a materially lower premium rate approval than the industry was in 2012 (4.7% vs. industry at 5.1%). MPL states that this was an intentional decision following a profitable year in 2011 and was intended to drive PSEU growth by offering a better value proposition relative to the market. We note this preceded: PHIAC becoming more directly involved the premium rate setting process which resulted in a more actuarial outcome in 2013 and Utilisation increases drove industry margins down from 5.9% in FY11 to 5.0% in FY13 and 4.1% in FY14. Fig 43 Approved Premium Rate Increases Industry BUPA Australia Hospitals Contribution Fund nib Health Funds HBF Health Australian Unity Health Note: approved premium rate increases exclude ahm prior to 2014 Source: Department of Health, January FY15 forecasts assume a consistent premium rate approval outcome to FY14 (6.5%) FY15 forecasts assume a consistent premium rate approval outcome to FY14 (6.5%). With submissions not due until November 2014, this is not an indication of the likely submission or PHIAC s view on the likely premium rate. While some variance around this 6.5% expectation is likely, the range of potential outcomes is narrow given the current industry claims trends. As a result, we expect a ±0.5% range to be reasonable. The 2015 premium rate will only impact one quarter of the FY15 forecasts (rates are effective from 1 April 2015). This results in a ±$5.4m profit impact (±1.9%). Claims growth elevated, underpinned by utilisation growth PHI benefits (claims) are comprised of hospital benefits net of risk equalisation, ancillary benefits and state ambulance levies. 5 January

33 We illustrate the historical profile and Macquarie PHI industry forecasts for claims and margins below. Note the financial performance for MPL may differ significantly from the broader industry. Variation from the industry claims ratio trends are largely the result of the inclusion of Overseas Students and Visitors as well as product design. Fig ppt FY14 claims ratio deterioration driven by higher hospital (0.8ppts) and ancillary (0.4ppts) Fig 45 Resulting in a material net and gross margin decline in FY14, which Macquarie forecasts to improve Industry Claims Ratio 90% 85% 80% 75% 70% 65% 60% 55% 50% 85.6% 86.1% Levies as % of premiums Ancillary Claims ratio Hospital Claims ratio Total Claims ratio 85.1% 85.7% 86.2% 21.7% 21.4% 20.9% 21.0% 21.8% Industry Claims Actual Macquarie Ratio Forecasts 87.4% 87.1% 90% 22.2% 21.7% 62.8% 63.5% 63.2% 63.7% 63.4% 64.2% 64.5% FY09A FY10A FY11A FY12A FY13A FY14A FY15E Source: PHIAC historical data, Macquarie forecasts, January % 80% 75% 70% 65% 60% 55% 50% Industry Margins 15.0% 12.5% 10.0% 7.5% 5.0% 2.5% 0.0% 14.4% 13.9% 4.7% 4.8% Gross Margin Net Margin 14.9% 5.9% 14.3% 13.8% 4.9% 5.0% Actual 12.6% 12.9% 4.1% 4.6% FY09A FY10A FY11A FY12A FY13A FY14A FY15E Industry Margins Macquarie 15.0% Forecasts 12.5% 10.0% 7.5% 5.0% 2.5% 0.0% PHI is a very short tail business Hospital costs are the largest claims item for private health insurers PHI is a very short tail business, with the majority of claims settled within a few months of first being notified of an upcoming procedure. The outstanding claims reserve on the balance sheet is equivalent to one month worth of claims. This has the effect of reducing reserve based volatility in the claims trends from year to year. Despite this short tail nature, a number of factors impact claims expenses: claims paid; changes in claims liabilities arising from actuarial assessments that take into account historical claims incidences; processing patterns (timing of claims lodgement by Policyholders and service providers); risk margins; and changes in amounts receivable from or payable to the Risk Equalisation Trust Fund. Despite this short tail claims profile, MPL overestimated the central estimate of outstanding claims by $33.5m in FY13 (due to a higher proportion of hospital claims being received from a major hospital group in mid-2013 than was historically the case, which was interpreted as higher utilisation). This over-reserved position was released in the FY14 result, reducing the claims expense. This is an unusual occurrence, as the FY12 and FY13 central estimate was within ±$7m in each year. Importantly this $33.5m reserve release was almost entirely offset by the one off impacts of: Risk margin was increased by MPL from 5.0% to 7.7% of outstanding claims central estimate: This resulted in a $9m increase in the outstanding claims liability. In a listed environment, the calculation of outstanding claims liability will be determined at 30 June each year, increasing the uncertainty associated with the estimate, as actual payments subsequent to year end are unknown. Bonus Provision more conservative: MPL adjusted provision assumptions that resulted in a $23.9m impact in FY % of the year s entitlements are now being provided for, taking into account historical utilisations and current balances. Hospital Claims Hospital costs are the largest claims item for private health insurers. This is also the primary area which is targeting for savings through its PNIC (Provider Networks and Integrated Care) team. The key components of PHI industry hospital claims are: Private hospital (~60% of benefits) 5 January

34 Jun-09 Dec-09 Jun-10 Dec-10 Jun-11 Dec-11 Jun-12 Dec-12 Jun-13 Dec-13 Jun-14 Jun-09 Dec-09 Jun-10 Dec-10 Jun-11 Dec-11 Jun-12 Dec-12 Jun-13 Dec-13 Jun-14 8,206 8,418 8,617 8,750 8,998 9,091 9,348 9,577 9,740 10,053 10,230 10,419 10,654 10,850 11,084 11,201 11,393 11,695 11,956 12,170 12,408 Macquarie Wealth Management Doctors Fees (~16% of benefits) Prostheses (14% of benefits) Public hospital treatment of private patients (~7% of benefits) Other hospital treatment of private patients (~4% of benefits), including day, hospital substitute and nursing home patients Chronic Disease Management Program (CDMP ~0.4% of benefits). Fig 46 Private hospital benefits account for ~60% of hospital claims Hospital Benefits (A$m) 15,000 12,500 10,000 7,500 5,000 2,500 0 CDMP Doctors Fees Prostheses Other hospital Public Hospital Private Hospital Hospital Benefits (A$m) 15,000 12,500 10,000 7,500 5,000 2,500 0 Source: PHIAC, January Over the past 12m, the contribution from private hospital benefits to overall industry hospital claims growth accelerated Given private hospital payments account for 60% of hospital benefits, it is unsurprising that this is the primary driver of industry hospital claims growth through the cycle. Over the past 12 months, the contribution from private hospital benefits to overall industry hospital claims growth has accelerated. At June 2013, hospital claims growth slowed as private hospital benefit growth moderated. At this time however, benefits for private patients in public hospitals accelerated. These trends have reversed over the past 12 months. Fig 47 Private hospitals have driven most of the hospital claims growth, accelerating over the past 12m Hospital Benefits Growth 12.0% 10.5% 11.3% 10.3% 10.6% 9.6% 9.4%8.8% 8.0% 8.0% 8.5%9.5% 9.4% 10.0% 8.2% 7.9% 8.4% 7.5% 7.8%7.9% 8.6% 8.9% 8.0% 6.9% 6.0% 4.0% 2.0% 0.0% -2.0% 6.0% 6.5% 5.9% 5.8% 6.0% 4.7% 4.9% 5.1% 5.2% 5.2% 4.7% 5.2% 5.3% 4.2% 4.6% 4.5% 4.6% 4.0% 4.2% 4.6% 3.4% CDMP Doctors Fees Prostheses Other hospital Public Hospital Private Hospital Hospital Benefits Growth 12.0% 10.0% 8.0% 6.0% 4.0% 2.0% 0.0% -2.0% Source: Macquarie Analysis of PHIAC data, January Utilisation has Underlying drivers of hospital claims growth consistently driven Irrespective of the direct spending on health services (i.e. type of hospital, share of payments industry hospital to doctors vs. prosthesis, etc.), the overarching drivers of claims growth are: claims growth well above health care Policyholder growth (includes population growth and PHI penetration). inflation Health care inflation (broadly in line with CPI). 5 January

35 Jun-01 Jun-02 Jun-03 Jun-04 Jun-05 Jun-06 Jun-07 Jun-08 Jun-09 Jun-10 Jun-11 Jun-12 Jun-13 Jun-14 Jun-15 Macquarie Wealth Management Utilisation (the largest component of claims growth and the key driver of premium rates). Utilisation has consistently driven industry hospital claims growth well above health care inflation, a trend showing no signs of abating due to increased claims utilisation driven by policyholders demanding greater health services, particularly amongst older (65+ years old) policyholders. A simple measure of hospital utilisation is the frequency of hospital visits for each policyholder per year. While this has consistently increased over the past ten years for most policyholder groups, older policyholders have seen the rate of utilisation growth increase materially more than middle aged and young policyholders. Older policyholders have an outsized impact on the industry given the high utilisation in absolute terms, mix impacts from the ageing population and PHI penetration increases faster amongst older policyholders. Fig 48 Utilisation has increased fastest amongst older policyholders Hospital visits per person p.a Total Over 65s Under 40s Actual Hospital visits per person p.a. Forecast Source: Macquarie Analysis of PHIAC data, Macquarie Forecasts, January While increased utilisation rates are likely to continue over the long term, we expect the rate of increase to gradually moderate over the next ten years. This is likely to be driven by: Procurement and Claims management strategies from the major private health insurers, such as MPL s PNIC strategy, will likely have an impact on claims by managing health outcomes more effectively. Minimising unnecessary procedures and development of advanced care planning are two examples of the potential strategies available to the large private health insurers to improve claims performance. Regulatory/budgetary change: With increasing political pressure around the cost of PHI, we expect further structural change in the industry to occur in order to moderate premium rate pressure. This may take the form of the proposals outlined in the Commission of Audit. Utilising market position to improve claims efficiency As Australia s largest PHI, industry hospital claims utilisation trends reflect the challenges MPL faces to moderate claims and protect margins. In FY14, MPL saw hospital claims for Australian residents increase by 5.9% per PSEU. 70% of this growth was attributable to the increased utilisation, with the balance of PSEU growth accounted for through cost inflation. MPL is well placed as the leading private health insurer to improve claims outcomes While rising utilisation amongst older policyholders is an industry wide issue, MPL is well placed as the leading private health insurer to improve claims outcomes. Relative to smaller health insurers, MPL has greater incentives to save hospital claims costs under the current risk equalisation regime, retaining almost half of any industry savings generated for over 65 year olds. This compares to smaller funds, which retain around one third of savings in this demographic (refer to the charts following). 5 January

36 Fig 49 Retention of total claims costs under current retrospective risk equalisation by age category and large claim pool Age % of hospital claims Risk Equalisation % Non-Risk Equalisation component Risk Equalisation component Total % 0% 100% 0% 100% % 15% 85% 4% 89% % 43% 58% 13% 70% % 60% 40% 18% 58% % 70% 30% 21% 51% % 76% 24% 22% 46% % 78% 22% 23% 45% 85+ 7% 82% 18% 24% 42% Weighted average - all policyholders 58% 12% 70% Weighted average - over 65s 28% 21% 49% Source: Macquarie Analysis of PHIAC data, January Rising claims cost for over 65 year olds represents the largest opportunity to reduce claims costs. MPL would retain ~49% of the benefits from any claims cost reduction among this age cohort. This is well in excess of competitors with smaller market share. Fig 50 Retention of total claims costs under current retrospective risk equalisation Fig 51 Retention of over 65 year olds claims costs under current retrospective risk equalisation 70% 60% 12% 11% Claims Costs (risk equalisation component) Claims Costs (non-risk equalisation component) 5% 3% 3% 1% 70% 60% Over 65's Claims Costs (risk equalisation component) Over 65's Claims Costs (non-risk equalisation component) 50% 50% 40% 40% 21% 19% 30% 20% 10% 0% 58% 58% 58% 58% 58% 58% Medibank Private BUPA HCF nib HBF Australian Unity 30% 20% 10% 0% 8% 6% 5% 2% 28% 28% 28% 28% 28% 28% Medibank Private BUPA HCF nib HBF Australian Unity Source: Macquarie Analysis of PHIAC data, January Provider Networks and Integrated Care (PNIC) strategy PNIC: Provider Networks and Integrated Care The PNIC (Provider Networks and Integrated Care) team, led by Dr. Andrew Wilson (EGM PNIC since April 2013) is responsible for managing claims expenses, provider contracting, claims auditing and improved model of care initiatives encompassing relationships with hospitals and medical professionals. This is expected to improve the hospital claims ratio and group gross margins through: Private Hospital: more effective negotiation with hospital operators and other health services providers to realise greater overall value by limiting cost increases and improving performance standards as well as data reporting. Reducing improper claims: developing a variety of techniques to detect fraud and overclaiming, including identifying payments that should have been made by another funder, such as a workers' compensation scheme. Preventative health: seeking alternatives to costly hospitalisation, such as preventative health initiatives, the provision of more integrated care solutions and increased engagement at the primary care stage. Management of high cost claimants: 2.2% of the Medibank-branded Policyholders accounted for 35.2% of Medibank branded hospital and medical claims over the FY10 FY13 period. This equates to ~80,000 policyholders who have been admitted to hospital for an overnight stay on four or more occasions over the past four years. These policyholders have claimed an average of ~$12,000 p.a. prior to risk equalisation. Clearly, this presents a large opportunity for PHI s to manage high cost claimants more effectively. 5 January

37 Ancillary Claims Ancillary services provide value to younger policyholders in particular who have low utilisation of hospital services Utilisation has recently been a key driver of growth in ancillary benefits, but not as consistently through time as what is seen in Product design in hospital ancillary is critical MER efficiencies have been extracted by the PHI sector in each of the past five years Ancillary services are a core offering of private health insurers despite not being traditional insurance. Effectively a group buying program, ancillary services provide value to younger policyholders in particular who have low utilisation of hospital services. The key ancillary services frequently used by policyholders include: Dental: ~49% of MPL ancillary benefits (52% of industry). Optical: ~20% of MPL ancillary benefits (17% of industry). Physio: ~7% of MPL ancillary benefits (8% of industry). Chiro: ~6% of MPL ancillary benefits (~6% of industry) Natural Therapies: ~5% of MPL ancillary benefits (~4% of industry), A long list of other services can be claimed, including podiatry, osteopathy, acupuncture and ambulance only policies. Ancillary is an important customer acquisition tool, particularly for young policyholders. We detail the impact of government policy on PHI participation by age group in the Government incentives and support section of this report. Utilisation has recently been a key driver of growth in ancillary benefits but not as consistently through time as what is seen in hospital. This shift in utilisation, principally over the past months, has coincided with a step change in the rate of policyholder churn as individuals seek value for money from PHI. We review recent ancillary claims trends in the current industry issues section of this report. Product design in ancillary is critical. Insurers must strike a balance between generating policyholder growth while maintaining profitable ancillary products. Products are typically structured so policyholders can claim back around half of the service cost with PHI (this varies between services and providers), subject to annual limits. In order to attract and retain these policyholders with low hospital utilisation, product design has catered towards a value offering. ahm has had a highly effective value offering in the market over the past two years, based on the volume growth achieved. This policy structure is based on ancillary utilisation, where a policyholder does not have individual limits on ancillary services but rather an annual limit which can be fully utilised in the ancillary services demanded. This product structure may encourage utilisation, with margin outcomes dependent on claims frequency versus assumption. Based on the comparison site, at the Lite Cover Plus policy for singles costs $1,014 in annual premiums but has $1,000 of annual ancillary cover that can be flexibly utilised. After acquisition costs, administration expenses, etc., we believe the profitability of this policy will be dependent on claims frequency, which is at the policyholder s discretion. We believe is focussed on the lifetime value of the policyholder, which is enhanced by premium rate increases and the potential for the policyholder to add cover over time. Claims handling costs associated with ancillary cover are low due to the widespread use of HICAPS (Health Industry Claims & Payments Service), which automatically processes and provides rebates to policyholders at the point of sale. Many insurers have also invested in on-line self service claiming engines which further reduce claims handling costs. Management Expenses Private Health Insurers typically view management expenses as a proportion of premium revenue, known as the MER (Management Expense Ratio). For the industry, this stands at 8.5% in FY14, as insurers attempt to moderate the gross margin pressure on net margins. MER efficiencies have been extracted by the PHI sector in each of the past five years as funds have invested in technology and improved operating efficiency. We note the increase in FY12 was driven by advertising by many funds ahead of the means testing of the PHI rebate, which led to many policyholders reviewing their cover and locking in premium rates. 5 January

38 FY90 FY91 FY92 FY93 FY94 FY95 FY96 FY97 FY98 FY99 FY00 FY01 FY02 FY03 FY04 FY05 FY06 FY07 FY08 FY09 FY10 FY11 FY12 FY13 Macquarie Wealth Management Fig 52 PHI Industry MER declining to offset gross margin pressure 14% 12% 10% 8% 6% 4% 2% 0% Industry MER Source: Macquarie analysis of PHIAC data, January MPL has materially improved its operating efficiency in recent years. As the largest insurer in an industry which should benefit from scale, has significant scope to become more efficient when compared to the rest of the PHI industry in the chart below. This improving cost discipline has been a key driver of underlying NPAT growth over recent years and for the FY15 forecast: FY13: 100bps Total PHI MER contraction drove a +20.2ppts contribution to +16.5%underlying NPAT growth (gross margin contraction offset much of this MER improvement). FY14: 40bps Total PHI MER contraction drove +8.7ppts of the +10.7% underlying NPAT growth. FY15 forecasts: 50bps Total PHI MER contraction expected to drive +9.2ppts of the +15.6% underlying NPAT growth. If our FY15 forecasts for a further 50bps of total PHI MER improvement to 8.7% are delivered, MPL would have seen its Total MER fall by almost 200bps in three years. Despite this improvement, MPL s Australian residents business remains above the rest of the PHI industry. Given MPL s scale, we would expect it to have a lower MER than the industry over the long term, given ~22% of the revenues in the industry ex MPL are generated by 28 sub-scale private health insurers with less than 2% market share (albeit these insurers gain some scale from memberships with AHSA and HAMBS). Fig 53 forecast MER narrowing gap vs. industry Australian Residents MER 10.0% 10.2% Industry Residents MER (ex ) Residents MER 9.2% 8.7% 5.0% 0.0% 8.9% 8.6% 8.4% FY12A FY13A FY14A Source: pro-forma data, Based on PHIAC data, January Key components of the MER: Employee expenses: salaries and training costs for customer service, claims processing, and other administrative and management personnel. Sales and marketing: direct media and advertising expenditure, commissions paid to aggregators and the amortisation of DAC. Note there is significant seasonality associated with customer acquisition costs, with the second half of each financial year elevated due to the timing of April premium increases and the lead up to financial year end. Increased competition in recent years and increased aggregator volumes (as ahm has rapidly grown) have significantly increased advertising and marketing expenses. 5 January

39 Fixed costs: occupancy costs, IT expenditure, depreciation and amortisation. Cost out initiative: Management is mindful of taking out the right costs as it embarks on an organisation-wide cost rationalisation program (Fit For Purpose); beginning in FY13, this program aims to identify sustainable cost savings. In FY13, the majority of cost savings were related to streamlining sales and customer service costs, IT expenditure and general improvements in procurement. Some of the savings were reinvested into increased sales and marketing support for both the Medibank and ahm brands. In FY14, the cost out program generated $49m of cost savings (improving the MER by ~87bps) PHI claims are short tail, so has a very short investment holding period of ~3 months In July 2014, the Board approved a change in the asset allocation to a target of 75% conservative assets and 25% growth assets In FY14, the program generated $49m of cost savings (improving the MER by ~87bps), which largely offset salary increases and increased sales and marketing spend. Programs to identify further cost savings and efficiencies are ongoing. FY15 forecast total PHI management expense (+0.3% expense growth, MER contraction from 9.2% to 8.7%) driven by: Indirect employee costs are forecast to decrease by 5.1% principally due to a 3% reduction in average FTEs and lower utilisation of contractors. Advertising and marketing expenditure is forecast to decrease by $3.9m (6.1%) from $64.6m in FY14 to $60.7m in FY15. Following a period of aggressive advertising and media spend across the PHI industry in recent years, MPL has seen the spend rates begin to stabilise. FY15 media spend is comparable on a per-revenue and per PSEU basis to historical trends. Reduction in aggregator commissions as MPL seeks to diversify ahm s distribution channels, reducing the reliance on major aggregators such as iselect and Compare The Market. Investment income MPL invests ~$2bn of financial assets backing regulatory capital and shareholder funds, generated through premium payments and retained earnings. Investment income from cash, fixed interest, equity, property and listed infrastructure investments contribute to profitability. Generating investment income from capital held on balance sheet is common practice for general, life and health insurers, however the importance of investment income to overall profitability varies widely. This variance is due to the holding period (investment assets / premiums), which is determined by the capital requirements and the duration of insurance contract risk exposure. PHI claims are short tail, so PHI funds have a very short investment holding period of ~3 months, which compares to general insurers (~18 months) and mortgage insurers (~6 years) according to Macquarie Research analysis. This moderates exposure to reserving volatility and supports return on equity as the business grows (with limited capital required to fund growth). Conversely it does limit the amount of investment earnings due to the smaller investment book relative to premiums and earnings. Net investment income includes both the associated realised and unrealised returns on the asset portfolio, net of administration costs. The investment return in each period is a function of prevailing investment market conditions and the underlying mix of investment assets. Investment approach: MPL takes a relatively simple and conservative approach to financial investments. Key characteristics: In July 2014, the Board approved a change in the asset allocation to a target of 75% conservative assets and 25% growth assets, which is expected to be implemented by December Drivers of overall investment assets: The size of the investment portfolio has been more volatile than would normally be expected over the past three years. This is due to: Pre-payment of premiums in the lead up to the change in income testing of the PHI rebate in June 2012 resulted in MPL (and the rest of the PHI industry) building cash and investment balances as premiums were paid upfront for more than 12 months of PHI cover. This boosted investment assets and investment income in FY13. 5 January

40 Dividend payments: MPL has paid out $1.4bn in dividends to the Federal Government over the past six years, including the $239m of ordinary and special dividends declared post 30 June 2014: $42m ordinary final dividend. $196.8m special dividend, $138m of which is paid from retained earnings and $58.8m from earnings generated prior to the IPO in the five months to November Fig 54 Investment assets impacted by pre-payments in late 2012 and large dividends in FY13 and FY14 Investment Assets (A$bn) ,352 Average Growth investment assets Average Defensive investment assets 2, ,053 1, FY12A FY13A FY14A FY15E Source: pro-forma data, January Fig 55 Average Investment assets moving towards 25% target growth assets by December 2014 Investment Assets Average % growth assets Average % defensive assets 100% 90% 27.6% 17.6% 18.0% 23.0% 80% 70% 60% 50% 40% 72.4% 82.4% 82.0% 77.0% 30% 20% 10% 0% FY12A FY13A FY14A FY15E Asset allocation: MPL has said it expects to shift asset allocation materially over the six months to December The key changes disclosed by MPL are: Increase growth assets target from 17% to 23%: International equities target allocation will double from 4% to 8%. This comprises both direct listed equity investments on overseas stock exchanges and managed funds (both benchmarked to the MSCI developed markets index). Index funds and active external managers are used, with ~50% of the foreign currency exposure hedged. No equity derivative overlays are permitted under the investment mandate. Small increases in the Australian equities and property allocations. Increase Fixed income allocation from 35% to 50%. The fixed income allocation comprises a range of underlying asset classes, each with distinct duration and credit risk profiles. Key sub asset classes include: Floating rate notes and asset backed securities (investment grade and are internally managed with an average credit rating of AA-), Syndicated loans (externally managed and fully hedged), Fixed income absolute return funds (externally managed), Hybrid investments of Australian financial institutions (internally managed). Reduce target cash allocation from 46% to 25%. The shift from cash to fixed income provides greater flexibility and an opportunity to add value through duration, credit and yield curve management. The $239m of dividends declared have been paid out of cash, reducing the reallocation of assets needed to move towards the target allocation Cash investments include: call accounts, bank bills, term deposits, promissory notes, commercial paper and certificates of deposit. Duration is short, with 90% of the allocation within a 185 day term. Fig 56 Asset allocation as at 30 June 2014 Fig 57 Target asset allocation by 31 December 2014 Australian Equities 5% Property 7% International Equities 4% Listed Infrastructure 3% Cash 46% Australian Equities 6% Property 8% International Equities 8% Listed Infrastructure 3% Cash 25% Fixed Income 35% Source: pro-forma data, January Fixed Income 50% 5 January

41 Investment performance: Historical investment performance has featured a degree of volatility as equity investments saw material capital losses in FY12 and gains in FY13 and FY14. The absolute investment returns and contributions are detailed in the charts below. Fig 58 Return on growth assets depressed FY12 then boosted FY13 and FY14 investment income Fig 59 Investment assets moving more into growth assets targeting 25% by December 2014 Investment Income Investment Income from growth Assets (A$m) Investment Income from defensive Assets (A$m) Total Investment Income (A$m) FY12A FY13A FY14A FY15E Investment Yields Return on defensive assets (%) Return on growth assets (%) Total Investment yield 14% 12% 10% 8% 6% 4% 2% 0% -2% -4% -6% FY12A FY13A FY14A FY15E Source: pro-forma data, January Sensitivities: Cash Rate: 25bps increase in the RBA cash rate is expected to have a +$3.1m impact (+1.2%) on FY15 NPAT forecasts. Equities returns: A 100bps increase in average equities return (incl. listed infrastructure) of 8.0% is expected to have a +$2.2m impact (+0.9%) on FY15 NPAT forecasts. Complementary Services The Complementary Services business accounts for ~10% of group FY15 revenue forecasts. This business has been impacted by the non-renewal of the Federal Government immigration contract. While underlying revenue growth is expected to decline into FY15, operating profit is accelerating as costs decline further. Fig 60 Underlying profitability of Complementary Services is improving Complementary Services Operating Profit Immigration Contract Complementary Services ex Immigration Contract Total Complementary Services FY12A FY13A FY14A FY15E Source: Macquarie analysis of pro-forma data, January The Garrison contract accounts for 60% of FY15 revenue and total expenses in ex Immigration contract Complementary Services generates service fees and commissions from: Contracted health management services for government and corporate clients; Online and telephone-based health services; and The distribution of travel, life and pet insurance, as authorised agent for other insurers Complementary Services was built via acquisition, McKesson (tele-health) and Carepoint (occupational health) between 2009 and In addition the Government transferred Health Services Australia (which held the immigration contract) to MPL during this period. The Garrison Health Services ADF contract began in November 2012, and is material for the Complementary Services division, accounting for 60% of both revenue and total expenses in FY15 ex Immigration contract. The ADF is a low margin (Macquarie Research estimates this contract operates at a 2% margin) contract which operates on a cost plus model, so has limited operating risk attached. 5 January

42 Immigration contract not renewed in FY15: The immigration contract was a lucrative but relatively isolated business (from other operating divisions), where MPL conducted premigration visa health screening services to prospective Australian migrants on behalf of the Commonwealth. The Immigration Contract was not renewed with effect from July 2014 (following a two month transition period). The impact is seen in the chart above. Post Immigration contract, MPL reorganised Health Solutions into what is now the Complementary Services business and incurred significant reorganisation ($24.6m) and impairment charges ($96.4m). Management has stated that it is currently evaluating alternatives (including divestment or restructure) in respect of certain activities currently undertaken within Complementary Services that are not providing a stand-alone return and/or are not consistent with MPL s broader financial and strategic aims. FY15 Outlook: Underlying revenue growth is forecast to decline by 2.2% in FY15, driven by: ADF Health Services Contract: A reduction in off-base revenue due to higher than anticipated treatment volumes in late FY14 that are not forecast to recur in FY15 (on base treatment revenues expected to remain stable). Telehealth: revenue is expected to decline based on an assumption that recent trends in call volumes will continue. Diversified Insurance: recent trends in underlying policy numbers will continue, driving forecast revenue declines in FY15. Total underlying expenses are forecast to decline by 3.4% on lower revenue led decline in variable costs, most notably with the ADF contract. The forecast also reflects the assumed impact of the recent restructure of certain businesses within Complementary Services. Earnings Sensitivities MPL has a relatively stable earnings outlook given the scale of the PHI business and relatively moderate pace at which changes in premiums and claims trends occur. Earnings are sensitive to utilisation: A 1% increase in Claims per PSEU would drive a 14.1% decline in NPAT The primary sensitivity is to claims, more specifically to utilisation (claims per PSEU). For every 1% increase in Claims per PSEU, assuming no premium rate offset, NPAT would fall by 14.1%, eliminating all of the forecast underlying FY15 NPAT growth. While profitability is highly sensitive to claims, we note: Under the premium rate setting process, PHIAC focus very closely on utilisation trends, and would be likely to appropriately factor this into the following year s premium rate increase. While conditions can deteriorate between premium rate reviews, this is likely to be a short term earnings impact. Premium rate increases appear to be relatively insignificant in this sensitivity table, however this only represents one quarter of the impact as premium rate changes take effect from 1 April the following year. The annualised impact of a 1% increase in premium rates (~16.8%) is similar to the negative impact from a 1% increase in utilisation. Fig 61 Prospectus earnings sensitivity to key variables Change Current estimate NPAT Sensitivity (A$m) NPAT Sensitivity (%) Premium rate increase 0.50% 6.5% % Average PSEU 1.00% % Claims per PSEU 1.00% 1, % Health insurance gross margin 0.10% 13.6% % Health insurance MER 0.10% 8.7% % Group Operating Margin 0.10% 4.3% % Cash rate 0.25% 2.6% % Equity returns (including listed infra) 1.00% 8.0% % Source: Macquarie Analysis of pro-forma data, January January

43 Divergent reported and pro-forma earnings While normalised earnings provide the best indication of the underlying growth of MPL, a number of adjustments are made to determine pro-forma earnings and reported earnings: Fig 62 Reported vs. pro-forma prospectus and normalised NPAT FY12A FY13A FY14A FY15E Normalised Net Profit After Tax Remove normalisation adjustments Immigration contract (not renewed) Investment income volatility Pro-forma Net Profit after Tax Significant items Reorganisation expenses Impairment expenses Executive retention payments Transaction Costs Melbourne premises establishment costs Adjustments DAC Accounting policy change Public company costs Removal of dental and eyecare loss Rights to future income tax Reported Profit Source: Macquarie Analysis of pro-forma data, January MPL has no debt outstanding and limited risk around reserving due to the short tail nature of claims The largest divergence between reported and pro-forma earnings is in FY14, following the non-renewal of the immigration contract within the Complementary Services business. This triggered $24.6m of reorganisation expenses and a $96.4m impairment charge. Balance sheet conservatively managed MPL has no debt outstanding and limited risk around reserving due to the short tail nature of claims. As a result, changes in central estimate and risk margins are likely to be minor in future years, when compared to other general insurers. Following the impairment charge that was taken as a result of the restructuring post the nonrenewal of the immigration contract we believe that MPL has adopted conservative policies with respect to recognition of assets and liabilities on the balance sheet. In the PHI business segment the deferred acquisition costs related to third party distribution is amortised over 4 years and software/technology cost are capitalised and then amortised over 5 years (recently reduced from 6 years). On the liability side, MPL has also increased risk margin and provisions for bonus and loyalty products. Dividends MPL is expected to pay a sustainably high fully franked dividend which we expect to be attractive to shareholders. MPL expect to pay a fully franked seven month final dividend of $135m in Sept 2015 Payout ratio FY15: 75% underlying payout ratio. The Commonwealth has already been paid a five month dividend (July November) of $58.8m. MPL expect to pay a fully franked seven month final dividend of $135m in Sept 2015, which represents a 75.1% payout ratio on FY15 pro-forma forecasts. Payout ratio FY16: 70 75% of Underlying NPAT. Payout ratio FY17+: 70 80% of annual Underlying NPAT. Underlying NPAT used for the purposes of calculating the dividend: This adjusts statutory NPAT for short term outcomes that are expected to normalise over the medium to longer term (unrealised gains or losses from equity investments and one-off items, especially those which are non-cash, such as asset impairments). Franking: As a tax paying entity, it expects that dividends will be fully franked. Dividend history: MPL has paid out $1.4bn in dividends to the Commonwealth over the past six years, including the $239m of ordinary and special dividends declared post 30 June 2014: $42m ordinary final dividend. $196.8m special dividend, $138m of which is paid from retained earnings and $58.8m from earnings in the five months to November January

44 Capex program MPL has undertaken a number of large capex programs in recent years: Premises consolidation: MPL has consolidated six Melbourne premises into a single new Melbourne head office, capitalising $67.2m of expenditure over FY13 and FY14, with an additional $7.7m to be spent in FY15. IT Renewal Program: MPL expects to incur up to $150m capital expenditure in relation to the IT Renewal Program. IT Platform: A major IT investment program is being implemented to replace the customer, policy, premium and product managed systems with a single integrated, commercial insurance software suite. This program is expected to be completed during FY16 at a total expected cost of $99.7m. Of this, $30.5m was incurred in FY14; $58.7m is forecast in FY15 and a further $10.5m in FY16. BAU Capex: MPL has spent $10m - $20m p.a. of BAU capex over the past three years, with $11.6m forecast for FY15; we consider this to be sustainable long term. Fig 63 Expansionary capex has been elevated in recent years Capex Expansionary (Project related) Maintenance (BAU) FY12A FY13A FY14A FY15E Source: pro-forma data, January Fig 64 Driven by the IT platform and Melbourne Premises, which are expected to roll off after FY16 Capex Other Capex IT investment program Consolidation of Melbourne Premises FY12A FY13A FY14A FY15E 5 January

45 Key Investor Risks Government policy change is the overarching PHI risk Health policy and agency regulation impact volumes, margins and capital The PHI sector in Australia is highly regulated. MPL does not control the enactment or content of new legislation and regulations. Product design and inadequate premium rate approvals may impact the net margin that MPL s PHI products generate. Complementary Services are subject to contract execution and renewal risk. IT renewal: MPL is undertaking a major IT project to replace its core policy and CRM systems. Failure to deliver the project as expected could impact performance. MPL operates in the highly regulated PHI sector (regulated pricing, community rating, risk equalisation, capital requirements, product controls, portability); as such PHI is sensitive to health policy and regulatory change. MPL does not control the enactment or content of new legislation and regulations, or the effect they will have on its business operations or financial results, which could be adverse. Government health policy and agencies impact volumes, margins and capital requirements Government health policy and regulatory agencies impact volumes, margins and capital. We divide our analysis of the key risks facing MPL (and the PHI sector) into: operational risks; and external and regulatory risks. Operational risks Dual brand strategy may impact margins MPL has a two brand strategy (Medibank and ahm). Recent growth has seen increased market share of the ahm brand and falling market share of the Medibank brand. Fig 65 and ahm market share trend 35.0% 30.0% ahm market share Medibank Market Share 25.0% 20.0% 15.0% 10.0% 5.0% 0.0% FY01 FY02 FY03 FY04 FY05 FY06 FY07 FY08 FY09 FY10 FY11 FY12 FY13 FY14 Source: Based on PHIAC data, January If policies sold under the ahm brand are less profitable on average compared to the traditional Medibank brand product offerings, this may result in MPL's margins declining. Cost effective customer acquisition and retention of existing customers under the dual brand strategy is necessary to meet financial forecasts. PHI products premium rates and product design risk Premium rates for MPL s PHI products, which comprise 90% of forecast consolidated revenues in FY15, are priced in advance of each 12 month premium period (1 April - 31 March), based on forecasts for the 12 month premium period. These premium rate increases may not adequately reflect: 1) claims expenses, risk equalisation distributions and Management Expenses; and 2) policyholder retention and attraction. 5 January

46 The risk of PHI products being mispriced may be greater for newly designed PHI products Failure to achieve our forecast reduction in the MER would impact FY15 forecasts Failure to renew a contract at expiry could impact the financial performance of MPL and result in the impairment of MPL s assets The risk of PHI products being mispriced may be greater for newly designed PHI products (e.g. the ahm brand), given they are untested in the market and historical data relevant to these new products may be more limited, increasing the pricing risk. Product design risk resulting from forecasting error is greater for ancillary products due to the greater policyholder discretion over claims. Hospital contracting risk MPL seeks to contract with healthcare providers, and the MPL strategy is intended to drive improved value for money and Policyholder outcomes from this contracting. If MPL is not able to achieve adequate contracting terms with hospital providers and/or is not able to improve policyholder outcomes, this may lead to reputational damage and loss of policyholder goodwill without a corresponding commercial benefit. Management expense ratio efficiencies risk MPL is targeting an improved management expense ratio through a cost reduction program. MPL incurs management expenses associated with the operations of its Health Insurance business including customer acquisition costs (advertising and commissions), occupancy costs, staff costs and other operating expenses. Failure to achieve the forecast reduction in the MER (from 9.2% in FY14 to 8.7% in FY15) would impact FY15 forecasts. Complementary Services Contract risk MPL s Complementary Services business has a range of government and corporate contracts to manage and deliver healthcare services. Failure to renew a contract at expiry could impact the financial performance and result in the impairment of assets. e.g., the non renewal of the Immigration contract between the Commonwealth and MPL for the provision of pre-migration visa health screening services to prospective migrants on behalf of the Commonwealth resulted in a $14m pro-forma NPAT headwind in FY15 (5.4% of FY15 Group NPAT). Some of these contracts, including the ADF Health Services Contract, also contain rights of termination by notice without cause. Complementary Services risk MPL's Complementary Services strategy may not have the expected beneficial impact on Policyholder loyalty and the control of claims. Complementary Services offerings may not be profitable. Management has stated that it is currently evaluating alternatives (incl. divestment or restructure) in respect of certain activities currently undertaken that are not providing a stand-alone return and/or are not consistent with MPL s financial and strategic aims. The sale/discontinuation of Complementary Services business may be costly. Investment return risk MPL holds capital sufficient to comply with regulatory capital requirements. MPL largely holds this capital in cash, cash equivalents and fixed income products and also has some exposure to domestic and international equities and property. A significant portion of MPL s net profit is generated from investments. The FY15 forecast investment income represents 25% of the FY15 NPAT forecast. Lower than expected investment returns may affect financial performance. Equity sensitivity: Each 1% increase/decrease in equity performance from the underlying forecast of 8.0% results in a +/-$2.2m NPAT impact (0.85% of FY15 forecast). Cash rate sensitivity: A 25bps increase/decrease in the average cash rate from the underlying forecast of 2.6% results in a +/-$3.1m NPAT impact (1.20% of FY15 forecast). IT project execution risk MPL is undertaking a major IT project with IBM and SAP, Project DelPHI, to replace its core policy and CRM systems. The project is intended to transform the ongoing operational management of key customer transactions and back office processes and functions. A failure to deliver the project as expected could impact the operational and financial performance. 5 January

47 Adverse clinical outcomes and clinical failures risk If unable to manage claims cost inflation and/or achieve adequate premium rate approval to cover claims cost, net margins could be impacted MPL employs over 800 medical health practitioners in Complementary Services, as well as contracting with a very wide array of providers on behalf of its members and customers. An adverse clinical outcome or failure to meet the clinical standards would be an operational, reputational and financial risk. may fail to comply with regulation MPL and other PHIs are subject to regulation concerning how their business is conducted. PHIs must be registered and must comply with a variety of obligations in relation to the conduct of their business including a requirement to have appointed actuaries, compliance with prudential, solvency and capital adequacy requirements, exclusion of disqualified persons from management and a number of reporting and notification obligations. Failure to comply with these regulatory obligations represents a risk, as it may negatively affect financial performance. Human resources risk The unique nature of the PHI market means that should MPL not be successful in attracting and retaining key executives, the execution of its strategies may be impacted. External risks (including regulatory risks) Premium rate approval and claims inflation The combined impact of increased utilisation, an ageing population and increased cost of medical services has resulted in ~6% p.a. claims growth per person from 2004 to MPL has strategies to manage claims cost inflation and requires premium rate change approval. If MPL is unable to manage claims cost inflation and/or achieve adequate premium rate approval from the Minister to cover claims cost, net margins could be impacted. Government policy and regulation may change MPL predominately operates in the PHI sector, which is subject to extensive laws, policies and regulations that, if changed, may have a material adverse impact on financial and operational performance. MPL does not control the enactment or content of new legislation and regulations, or the effect they will have on its business operations or financial results. While not proposed as part of the Commission of Audit reforms, we expect that the removal of the premium rebate for ancillary cover could be considered in future policy changes as this would reduce budget pressure. Although removal of the PHI premium rebate would be inconsistent with encouraging PHI participation by young people (who are necessary to support the community rating structure of PHI). Key Government policy and regulation that may change includes: 1) changes to the premium rate approval process; 2) changes to Federal Government initiatives which currently promote PHI participation; 3) changes to public hospital policy which may encourage an increase in the admission of private patients into public hospitals; and 4) changes to Medicare. In addition, if the premium approval process is deregulated in the future (which would require legislative change), risks relating to actual or anticipated non-approval by the Minister would reduce or cease to apply, however the competitive tactics of PHI s in relation to both quantum and timing of premium changes may become more variable and less predictable. State and territory governments also have the potential to influence PHI participation through changes to policies and regulations that impact the provision of and access to public services. Members may drop or downgrade their level of PHI cover A number of factors including a worsening economic climate, changes in economic incentives, annual increases to PHI premiums and other factors may cause the number of members in PHI funds to fall or result in members downgrading their PHI coverage. Rising healthcare costs may threaten the affordability of PHI Industry sustainability partly depends on low risk Policyholders (typically younger, healthier Policyholders) perceiving value in PHI even though they are not likely to make large claims. 5 January

48 If PHI as a product category becomes unaffordable or unattractive for low risk Policyholders, the whole industry potentially becomes subject to an adverse cycle. In the absence of increased government incentives to take out and maintain PHI, this cycle could adversely affect the profitability of all private health insurers, including MPL. If premium increases result in low risk Policyholders discontinuing their level of PHI cover, this would have adverse implications for premium revenue and utilisation The level of capital required to be held by MPL may change in the future If premium increases result in low risk Policyholders discontinuing their level of PHI cover, this would have adverse implications for premium revenue and utilisation. These factors would then place additional upward pressure on premiums, which may in turn cause further low risk Policyholders to question the value of their PHI. A sustainable PHI participation rate, to be able to maintain the affordability of premiums to a broad Policyholder base, is important for the overall viability of PHI. s relationships with private hospitals may deteriorate The majority of services are derived from the private hospital sector through negotiated schedules of fees and quality of care requirements. The profitability of MPL s business significantly depends on the ability to reach ongoing commercial agreement with private hospital operators. Failure to reach a satisfactory commercial agreement with key private hospitals has the potential to impact the financial and operational performance of MPL. If the profitability of private hospital operators deteriorates, there is a risk that private hospital operators may put increased pricing pressure on PHI funds such as MPL. s competitive position may deteriorate MPL operates in markets with established competitors and faces competitive pressures. There is a risk that competitors actions will negatively affect MPL s financial performance. Regulatory capital requirements MPL is required to comply with capital requirements set by PHIAC. To maintain capital levels dividend payments may be impacted. MPL may also be required to raise further equity in the future to ensure it holds sufficient capital. This may result in shareholders interests in MPL being diluted and an adverse impact on MPL s share price and financial performance. In addition, the level of capital required to be held by MPL may change in the future. The Government in its Budget announced the transfer of the functions of PHIAC and PHIO to other Departments / agencies by 1 July 2015, subject to the passage of the required legislation. This will see the prudential regulation functions of PHIAC transferred to APRA. Changes that reduce the effectiveness of Government PHI incentives The PHI industry benefits from the combination of Government incentives which are designed to encourage Australians to obtain and maintain appropriate PHI policies, including LHC, the PHI rebate and the MLS. A number of changes have been made to the PHI rebate (income testing, growth in the rebate capped at CPI and removal of the rebate on the LHC loading) to seek to achieve savings in healthcare expenditure by the Australian Government. Changes that reduce the effectiveness of incentives for policyholders to retain PHI could result in those discontinuing or downgrading. The operating margin and net profit of the PHI industry and MPL may be adversely affected. For example, the introduction of income testing of the PHI rebate from 1 July 2012 reduced or removed the PHI rebate for a number of Policyholders and, has resulted in some downgrading of PHI cover. Further adverse changes would likely continue this trend or could result in affected Policyholders discontinuing their policies completely. Changes to Community Rating and risk equalisation measures To support the policy of Community Rating (premiums do not differ based on the health or demographic characteristics of the Policyholder, with some exceptions e.g. LHC loading), risk equalisation arrangements through Risk Equalisation apply to the PHI industry. Under these arrangements, all private health insurers contribute funds to or receive funds from the Risk Equalisation Trust Fund so that the industry as a whole partially shares the hospital and chronic disease management program costs of certain older and high cost Policyholders. Changes to these arrangements may impact MPL negatively. 5 January

49 Domestic benchmarking, BUPA, HCF, nib, HBF and Australian Unity Fund status ( for-profit, not-for-profit ) is the major driver of financial performance. Scale advantage is not clearly observable. Industry holds excess capital: Capital levels, even among some of the top 6 PHI funds, appear excessive. We undertake domestic benchmarking analysis of MPL against the other 33 PHI funds. The table below summarises the 34 PHI funds by status, membership type, and alliances. For-profit funds held 68.7% policyholder share at June 2013 and generated ~80% of the industry net margin For-profit funds held 68.7% policyholder share at June 2013 and generated ~80% of the industry net margin. Open membership funds represented 93.3% policyholder share at June AHSA members represented 15.6% policyholder share at June AHSA represents a group of smaller PHIs and delivers industry competitive scale with respect to supply chain negotiating power. AHSA was formed in January 1994 by a group of registered private health funds as a result of pressures associated with health insurance reforms. HAMBS members represented 11.3% policyholder share at June A number of smaller private health insurers collectively develop systems requirements through HAMBS. Fig 66 PHI fund FY13 policyholder share, status, membership type and alliances Fund Name Code Policyholder share For profit Open Membership AHSA HAMBS Industry MPL 29.5 Yes Yes BUPA Australia BUPA 26.8 Yes Yes Hospitals Contribution Fund HCF 10.8 Yes nib Health Funds NIB 7.7 Yes Yes HBF Health HBF 7.5 Yes Australian Unity Health AUHL 3.2 Yes Yes Yes Teachers Federation Health TFH 1.9 Yes Yes GMHBA GMHBA 1.9 Yes Yes Yes Defence Health Defence 1.7 Yes Yes CBHS Health Fund CBHS 1.3 Yes Westfund Westfund 0.7 Yes Yes Latrobe Health Services Latrobe 0.7 Yes Yes Health Partners H'Partners 0.6 Yes Yes Health Insurance Fund of Australia HIF 0.6 Yes Yes Yes Lysaght Peoplecare Peoplecare 0.5 Yes Yes Yes Grand United Corporate Health GUC 0.4 Yes Yes Healthguard Health Benefits Fund H'guard 0.5 Yes Yes Yes Queensland Teachers' Union Health Fund QTUH 0.4 Yes Yes CUA Health Fund CUA 0.5 Yes Yes Yes Yes Police Health Police 0.3 Yes Yes Railway & Transport Health Fund RT 0.4 Yes Yes St Luke's Medical & Hospital Benefits Association St Luke's 0.4 Yes Yes Queensland Country Health Fund QCH 0.3 Yes Yes Yes Health.com.au HPL 0.3 Yes Yes Yes Yes Navy Health Navy 0.3 Yes Yes Mildura District Hospital Fund Mildura 0.2 Yes Yes Doctor's Health Fund DHF 0.2 Yes Yes Phoenix Health Fund Phoenix 0.1 Yes National Health Benefits Australia NHBA 0.1 Yes Yes Yes Yes ACA Health Benefits Fund ACA 0.1 Yes Yes Transport Health Transport 0.1 Yes Yes Yes Health Care Insurance HCI 0.1 Yes Yes Yes Cessnock District Health Benefits Fund CDH 0.0 Yes Yes Reserve Bank Health Society Ltd RBHS 0.0 Yes Yes Source: PHIAC, January January

50 Industry Health.com.au GUC nib Police CBHS Defence NHBA Peoplecare QCH Transport GMHBA HIF HCI TFH HCF Navy Westfund H'Partners Latrobe H'guard QTUH Mildura Medibank DHF BUPA St Luke's HBF AUHL ACA CUA CDH Phoenix RT RBHS Macquarie Wealth Management Fig 67 PHI fund financial performance (FY13 unless otherwise noted) Fund Name Premium revenue (A$m) Gross margin (%) Expense ratio (%) Net margin (%) Mgmt expenses per policy Mgmt expenses per policy holder Average policy holders per policy Average premium Risk Eq. / Hospital benefits (%) Solvency capital / risk capital multiple Capital per policy PHI NTA to Premium (%) Industry FY13 17, , Industry FY14 19, FY13 5, , FY14 5, BUPA Australia 4, , , Hospitals Contribution Fund of Australia 2, , , NIB Health Funds 1, , HBF Health 1, , , Australian Unity Health , Teachers Federation Health , , GMHBA , , Defence Health , , CBHS Health Fund , , Westfund , , Latrobe Health Services , , Health Partners , , Health Insurance Fund of Australia , , Lysaght Peoplecare , , Grand United Corporate Health , , Healthguard Health Benefits Fund , , Queensland Teachers' Union Health Fund , , CUA Health Fund , , Police Health , , Railway & Transport Health Fund , , St Luke's Medical & Hospital Benefits Association , , Queensland Country Health Fund , , Health.com.au , Navy Health , , Mildura District Hospital Fund , , Doctor's Health Fund , , Phoenix Health Fund , , National Health Benefits Australia , , ACA Health Benefits Fund , , Transport Health , , Health Care Insurance , , Cessnock District Health Benefits Fund , , Reserve Bank Health Society Ltd , , Source: PHIAC, January The relationship of average age of insured member to the proportion of risk equalisation payments to hospital benefits is strong Average age of insurer membership and risk equalisation The impact of age is clearly evident in the industry data. The chart below illustrates the impact of average age of insurer membership and the proportion of risk equalisation payments to hospital benefits. While there is a degree of variability, the relationship of average age of insured member to the proportion of risk equalisation payments to hospital benefits is strong. For example, average claims cost per year of a 5-14 child is $110 p.a. vs. teenagers benefits ($313 p.a., elevated partially due to mental health treatment). Pregnancy boosts the average claims of year olds to $660 p.a. Fig 68 Risk equalisation and average age of insurer membership 60% 50 Proportion of RE payments/receipts to hospital benefits Average Age of insurer membership 40% 45 20% 0% 40-20% 35-40% 30-60% -80% 25 Source: Macquarie analysis of PHIAC data, Macquarie Research, January January

51 Macquarie Wealth Management Fig 69 Variation in hospital benefits does occur below risk equalisation threshold Hospital benefits per person ($) 6,000 5,000 4,000 3,000 2,000 1,000 0 Risk Equalised Retained by insurer Source: Macquarie analysis of PHIAC data, January Average PHI premium Average PHI premium per policy member is broadly similar across the top 6 PHI funds with Australian Unity the clear exception Average PHI premium per policy member shows some variance across the top 6 PHI funds. The difference in the case of Australian Unity appears to reflect: The average age of insurer member, at ~45years for Australian Unity, is higher than for the other top 6 funds (see estimate below). While age does not impact premiums directly, older people tend to have higher value policies with more cover. Australian Unity owns 100% of Grand United Corporate Health (not consolidated in this analysis). GUC is a corporate health insurance specialist. We estimate that GUC has an average insured member age of ~30 years. The number of members per policy at 1.71 for Australian Unity (the lowest across all funds) compares to the industry at 2.08 and other top 6 PHI funds in the range of 1.96 (nib) to 2.31 (HCF). Australian Unity appears to have fewer family policies. Fig 70 Average PHI premium per person (FY13) 1,500 1, Average premium per policy member Average premium per policy 1,697 1,444 1,465 1,467 1,368 1,311 1, Industry Medibank Private BUPA Australia Source: Macquarie analysis of PHIAC data, January Hospitals Contribution Fund nib Health Funds HBF Health Australian Unity Health Among the other top 6 funds we believe the variation in average premium somewhat reflects the age of the insurer membership. We estimate that average age of membership as follows: ~41 years old. BUPA ~40 years old. HCF ~37.5 years old (impacted by a larger number of family policies - note that premiums for family policies are only able to price for up to a maximum of 2 children, effectively making the 3rd or above child free ). nib ~36 years old. 5 January

52 HBF ~40 years old. The lower average premium of HBF, with ~98% Western Australia policyholder distribution from its ~55% WA market share, appears to reflect the lower than average FY13 PHI premium in WA ($1,258) versus the national average ($1,417). Australian Unity ~45 years old. Other than for margins, as a result of the large market share, both MPL and BUPA tend to show closer to industry average results in this domestic benchmarking exercise. The direct comparison of PHI policies is difficult due to the number of limits, exclusions, and excesses, particularly for basic and mid level cover. Policies with top hospital cover and comprehensive ancillary cover are broadly comparable, albeit not representative of the average PHI policy. We do not consider this to be a determination of the value of the PHI policies, rather it is an indication of the drivers of premium rate pricing. Hospital only policies have little variation in price when compared to adding top Adding ancillary cover The comparison in the chart below is for top hospital cover and comprehensive ancillary cover across the top six PHIs. We have decomposed the cost of a PHI policy into Hospital and Ancillary as the ancillary premium represents the marginal increase in the cost of adding comprehensive ancillary to a top hospital only policy. Hospital only policies have less variation in price. Adding ancillary cover to this hospital policy creates a large amount of variation, which in some cases can represent more than the hospital related premium. This reflects: 1) product design; and 2) insurers risk tolerance around ancillary cover. Note that the comparison is for a NSW product and this may impact the marginal cost of ancillary product for HBF which is a WA health fund. Fig 71 High-level policy comparison: Ancillary pricing the key differentiator Annual Premium (pre-rebate) $14,000 $12,000 $10,000 $8,000 $6,000 $4,000 $2,000 $0 $4,999 Marginal cost of comprehensive ancillary above top hospital Hospital Only - Top Cover $3,726 $2,340 $2,711 $7,431 $3,500 $4,576 $4,598 $4,803 $5,354 $4,966 $5,246 Medibank BUPA HCF nib HBF Australian Unity Source: Macquarie analysis of PrivateHealth.gov.au website, January The Australian Government also provides a for information only comparison website service ( Management expense per policy While MPL had the highest MER in FY13 amongst large funds, the MER improved in FY14 and is forecast to continue into FY15 As per our analysis of average premium rate above there is not a large variation in expense performance. Although in had the highest expense ratio among funds with more than 5% market share. An improvement in the MER in FY14 was seen, and forecast this to continue into FY15, as the Fit For Purpose cost rationalisation program continues to contribute to improved performance. 5 January

53 Medibank BUPA NIB Aust Unity GUC CUA Health.com.au Doctor's Health Transport Health HCF HBF Teachers GMHBA Defence Health CBHS Health Westfund Latrobe Lysaght HIF QLD Teachers Healthguard Health Partners R&T St Luke's Police Health QLD Country Navy Health Mildura Phoenix Health ACA HCI Reserve Bank Cessnock Macquarie Wealth Management Fig 72 Management expense per policy member and per policy (FY13) Mgmt expenses per policy member Mgmt expenses per policy Industry Medibank Private BUPA Australia Hospitals Contribution Fund Source: Macquarie analysis of PHIAC data, January nib Health Funds HBF Health Australian Unity Health We also note the following: There does not appear to be strongly evident scale advantages in PHI. Funds which are growing more rapidly will have higher MERs due to marketing expenses and commissions MER is not a pure efficiency measure as customer acquisition costs are an important input into the MER. Funds which are growing more rapidly will have higher MERs due to marketing expenses and commissions (if comparison sites are used). Some of the difference in expense ratio performance appears to be captured in the gross margin result (premiums less claims) and this may reflect different classification of claims benefits versus management expenses among the funds. Fig 73 MER largely similar despite profit motives and scale differences in FY13 MER 'For-profit ' average: 9.0% 'Not-for-profit ' average: 8.4% MER Source: Macquarie analysis of PHIAC data, January Gross Margins are a critical differentiator across PHI funds, as For-Profit PHIs generated ~300bps higher gross margins than Notfor-profit PHIs in FY13 The headline similarity between the for-profit and not-for profit funds in relation to MER mask the difference in composition of management expenses between the funds. Forprofit funds tend to allocate more MER to customer acquisition (marketing, product design) and less to overhead and administration expenses relative to not-for profit funds. Gross and Net Margins Gross margins are a critical differentiator across PHI funds, as for-profit status PHIs generated ~300bps higher gross margins than not-for-profit status PHIs in FY13. This difference in gross margin reflects: Product structuring: For-profit status funds tend to more actively structure product benefits. 5 January

54 Medibank BUPA NIB Aust Unity GUC CUA Health.com.au Doctor's Health Transport Health HCF HBF Teachers GMHBA Defence Health CBHS Health Westfund Latrobe Lysaght HIF QLD Teachers Healthguard Health Partners R&T St Luke's Police Health QLD Country Navy Health Mildura Phoenix Health ACA HCI Reserve Bank Cessnock Macquarie Wealth Management Hospital contratcing: while scale advantages are reduced as AHSA negotiates hospital contracts for smaller PHIs, we believe the best performing for-profit status funds have achieved outcomes with the private hospital operators that are better than industry averages. Premium mix: as illustrated in the chart below For-profit funds typically generate a greater portion of premium revenue from ancillary products which have a higher gross margin. Fig 74 Gross margins materially higher across for-profit insurers in FY13 Gross Margin Gross Margin 'For-profit ' average: 14.0% 18.0 'Not-for-profit average: 11.0% Source: Macquarie analysis of PHIAC data, January While there are classification differences across the funds, and typically hospital and ancillary cover are sold together, not-for-profit status funds do not see as large a contribution from ancillary both in volume and margin terms (with the exception of HBF). HCF is the largest not-for-profit fund. In 2013, HCF reported a negative ancillary product gross margin (-0.7%) vs. the largest for-profit funds reporting gross ancillary margin of 20%-23%. HCF hospital gross margin was in-line with industry. We note that HCF does report a management expense ratio (7.1% in 2013) materially below the industry (9.2%) and for-profit status funds (8.9%). This supports our view that classification differences explain some of the margin difference between funds but does not fully reconcile the overall gap. Fig 75 Premium mix and gross margin: Hospital and Ancillary product ($bn) Industry MPL BUPA HCF NIB HBF AUHL Other Hospital treatment Premium Revenue Fund Benefits Gross Hopsital Margin 11.1% 9.9% 12.4% 11.2% 8.3% 11.8% 10.9% 11.6% Ancillary treatment (incl Ambulance) Premium Revenue Fund Benefits Gross Ancillary Margin 18.2% 20.3% 22.3% -0.7% 23.1% 25.9% 27.8% 11.4% Ancillary premium contribution 28.0% 28.6% 27.1% 23.8% 33.3% 31.3% 26.2% 28.4% Source: Macquarie analysis of PHIAC data, January Geographic differences: Gross margins are lowest in NSW, Victoria and tend to be higher in smaller states/territories as per the table below. The variaion in market share and gross margin by state and fund contributes to the variation in margin nationally between For-proft and Not-for-profit funds and between individual funds. 5 January

55 Medibank BUPA NIB Aust Unity GUC CUA Health.com.au Doctor's Health Transport Health HCF HBF Teachers GMHBA Defence Health CBHS Health Westfund Latrobe Lysaght HIF QLD Teachers Healthguard Health Partners R&T St Luke's Police Health QLD Country Navy Health Mildura Phoenix Health ACA HCI Reserve Bank Cessnock Macquarie Wealth Management For example in South Australia, BUPA s market share (53% by policies and 56% by premium) and their gross margin (19.3%), relative to (24% by policies and 21% by premium with 18.2% gross margin), results in a ~50bps boost to the reported BUPA national gross margin vs MPL in Fig 76 National and state based market share and gross margin by fund (FY13) National Industry MPL BUPA HCF NIB HBF Aust Unity Gross Margin 13.1% 12.8% 15.1% 8.4% 13.2% 16.2% 15.4% Market Share 100.0% 29.5% 26.8% 10.8% 7.7% 7.5% 3.2% NSW/ACT Gross Margin 11.2% 12.2% 12.6% 9.2% 11.7% 20.1% 10.0% NSW Market Share 32.7% 25.2% 24.3% 21.4% 14.6% 0.1% 1.7% ACT Market Share 2.0% 32.6% 21.1% 14.5% 16.5% 0.3% 1.5% VIC Gross Margin 12.1% 11.6% 14.4% 6.1% 13.6% 10.9% 16.1% Market Share 23.3% 36.1% 24.9% 6.8% 5.8% 0.2% 8.8% QLD Gross Margin 12.5% 12.4% 14.3% 5.9% 18.1% 22.7% 15.1% Market Share 18.0% 36.1% 34.1% 7.0% 4.9% 0.2% 2.0% WA Gross Margin 16.9% 16.0% 20.0% 15.5% 25.5% 16.1% 24.8% Market Share 13.3% 20.8% 9.3% 1.9% 1.7% 55.4% 0.6% SA Gross Margin 17.8% 18.2% 19.3% 6.9% 21.5% 23.2% 20.8% Market Share 7.8% 23.6% 53.4% 4.7% 1.7% 0.2% 1.5% TAS Gross Margin 15.6% 13.2% 18.2% 5.5% 18.9% 38.3% 12.9% Market Share 2.1% 34.1% 37.6% 2.1% 1.1% 0.4% 0.8% NT Gross Margin 25.5% 18.6% 30.1% 35.5% 28.5% 47.5% 55.0% Market Share 0.8% 44.5% 38.1% 3.9% 1.9% 1.0% 0.6% Source: Macquarie analysis of PHIAC data, January Net Margins have a similar basis point differential as Gross Margins, as the MER profile is broadly stable Net Margins have a similar basis point differential as Gross Margins, as the MER profile is broadly stable across the industry. For-profit funds are more efficient operationally and spend the difference on marketing to attract more policyholders. Fig 77 Net margins reflect Gross margins differentials in FY13 Net Margin 'For-profit ' average: 5.1% 'Not-for-profit ' average: 2.6% Net Margin Source: Macquarie analysis of PHIAC data, January Long term industry trends We evaluate the historic fund and industry performance of the PHI sector from below. Key highlights from this analysis include: Impact of regulatory change has major, long lasting impacts on the sector Impact of regulatory change has major, long lasting impacts on the sector. This was seen in , where policyholders were brought into the system, impacting premium revenue growth as well as margins (positively in FY01 while policyholders served waiting periods, and negatively in FY02 as these new policyholders began claiming). 5 January

56 FY90 FY91 FY92 FY93 FY94 FY95 FY96 FY97 FY98 FY99 FY00 FY01 FY02 FY03 FY04 FY05 FY06 FY07 FY08 FY09 FY10 FY11 FY12 FY13 FY90 FY91 FY92 FY93 FY94 FY95 FY96 FY97 FY98 FY99 FY00 FY01 FY02 FY03 FY04 FY05 FY06 FY07 FY08 FY09 FY10 FY11 FY12 FY13 FY91 FY92 FY93 FY94 FY95 FY96 FY97 FY98 FY99 FY00 FY01 FY02 FY03 FY04 FY05 FY06 FY07 FY08 FY09 FY10 FY11 FY12 FY13 FY90 FY91 FY92 FY93 FY94 FY95 FY96 FY97 FY98 FY99 FY00 FY01 FY02 FY03 FY04 FY05 FY06 FY07 FY08 FY09 FY10 FY11 FY12 FY13 FY91 FY92 FY93 FY94 FY95 FY96 FY97 FY98 FY99 FY00 FY01 FY02 FY03 FY04 FY05 FY06 FY07 FY08 FY09 FY10 FY11 FY12 FY13 FY90 FY91 FY92 FY93 FY94 FY95 FY96 FY97 FY98 FY99 FY00 FY01 FY02 FY03 FY04 FY05 FY06 FY07 FY08 FY09 FY10 FY11 FY12 FY13 Macquarie Wealth Management Net policyholder growth is critical. Profitability has improved markedly over the past ten years across the industry, largely due to reforms which encouraged policyholders into the PHI system. Consistent negative policyholder growth impacts the rest of the pool as the healthy leave the system, requiring greater premium rate increases for the residual policyholder pool, encouraging further lapses. Fig 78 Policyholder growth Fig 79 Market Share Policyholder Growth 10% FY01: Industry Policyholder 8% growth +25%, with Medibank taking 43% share 6% of new policyholders following introduction of 4% rebate, MLS and LHC 2% 0% -2% -4% -6% Industry ex Medibank Market Share 35% 30% 25% 20% 15% 10% 5% 0% Introduction of rebate, MLS and LHC Acquisition of ahm Fig 80 Premium growth Fig 81 Gross Margin Premium Growth 20% 15% FY01: Industry Premium growth +31%, with Medibank taking 43% share of new policyholders following introduction of rebate, MLS and LHC Industry ex Medibank Gross Margin 25.0% 20.0% Industry ex Medibank 10% 15.0% 10.0% 5% 5.0% 0% 0.0% -5% -5.0% Fig 82 MER Fig 83 Net Margin MER 16% 14% 12% Industry ex Medibank Net Margin 15% 10% Industry ex Medibank 10% 5% 8% 0% 6% 4% 2% -5% -10% 0% -15% Source (for all above): Macquarie analysis of PHIAC data, January PHI fund NTA to Premiums and risk capital multiple Capital levels, even among some of the top 6 PHI funds, appear excessive. Given the mutual status of some of these funds, release of capital is made more difficult. 5 January

57 Fig 84 PHI fund NTA to Premiums and risk capital multiple Industry Medibank Private 11.1 BUPA Australia 2.9 PHI NTA to Premiums (%) Hospitals Contribution Fund nib Health Funds HBF Health Risk capital multiple Australian Unity Health Source: Macquarie analysis of PHIAC data, January Premium rate changes The rate of premium growth has been, and is expected to continue to be, driven by claims growth With claims representing ~87% of FY14 industry premium revenue versus management expenses of ~8.5% and net profit margin of ~4.1%, the rate of premium growth has been, and is expected to continue to be, driven by claims growth. Fig 85 Approved Premium Rate Increases Industry BUPA Australia Hospitals Contribution Fund nib Health Funds HBF Health Australian Unity Health Source: Department of Health and Ageing, January Note that the actual revenue growth per policyholder will differ from the announced premium rate increase as product mix changes (i.e. downgrading by policyholders). Fig 86 Cumulative premium rate increases ( ) Industry BUPA NIB Aust Unity HCF HBF nib HBF HCF Medibank Aust Unity BUPA Source: Macquarie analysis of Department of Health and Ageing data, January The percentage increase in premium rates is typically larger for policies with lower total premiums as the impact of the risk equalisation is greater in percentage terms (e.g. nib). 5 January

58 Approved premium rate changes appear to show little correlation to net margin The charts below illustrate the 2014 premium rate increase relative to the FY13 net margin and FY13 MER. There is no particular pattern where insurers efficiency or different levels of profitability impact premium rate approval. Fig 87 Premium rate increases not correlated to the previous year s net margin 2014 Premium rate 9.0 increase 8.0 NIB HCF Medibank Private Aust Unity BUPA HBF FY13 Net Margin Source: Macquarie analysis of PHIAC data, January Fig 88 Limited relationship between cost efficiency and premium rate increases 2014 Premium rate increase NIB HCF BUPA Medibank Private Aust Unity HBF FY13 Management Expense Ratio Source: Macquarie analysis of PHIAC data, January Individual policy premium rate changes may impact the approved premium rate increase In addition, individual product premium rate changes may impact the group wide weighted average premium rate increase. In FY14, nib ancillary claims were materially impacted by its top extras 85 product, a mispriced offering which experienced very high utilisation. nib highlighted that its Top Extra s 85 product had resulted in a total $8.8m adverse selection impact on FY14 gross operating profit. The repricing of this product by more than 30% from 1 April 2014 contributed more than 60bps to the 7.99% approved premium rate increase for nib. After initially closing the product to new policyholders (Sept/Oct 2013), nib has now force migrated all existing top extra 85 policyholders to alternative products with a less generous premium to benefits ratio. While the impact of the product was negative on the operating performance of nib in FY14, we believe that if health funds innovate in product design, with the aim of gaining market share, the impact should be viewed in the context of longer term market share gain achieved by nib. 5 January

59 Insurance products Residents Insurance, Workers Insurance and Students Insurance Health Insurance for Australian residents is the core product offering Resident Australian Health Insurance: PHI for Resident Australian individuals represents ~97% of FY13 group insurance premiums. Workers and Students Insurance: MPL also offers Overseas Visitors (including Overseas Workers) and Overseas Students Insurance for visitors to Australia. Regulation requires workers and students on entry visas to hold PHI as part of their visa requirement (~2.6% of premiums). Life, Travel and Pet insurance: also offers Life, Travel and Pet insurance on an agency basis (not underwritten by MPL) and earns a commission. Distribution: product is typically distributed direct to individuals via retail stores, call centres, on-line and increasingly customers are utilising comparison websites. Resident PHI, incorporates both Hospital and Ancillary cover A unique feature of the PHI market in Australia is that the system operates alongside the simultaneously available tax payer funded public health system. The operation of the PHI system alongside the public health care system means that rules under which PHI funds offer policyholder coverage are highly regulated. As a result of this regulatory structure PHI funds have developed procedure based health care within a hospital environment, providing access to elective medical treatments, where the policyholder can elect the clinician, hospital and timing of a procedure. PHI also allows policyholders to avoid the needs-based public health system with waiting lists. PHI funds provide coverage for private patients in both private and public hospitals, as well as ancillary services such as dental, optical, physiotherapy, chiropractic care and other supplementary medical services. PHI funds are increasingly covering members for services provided outside of a hospital environment and preventative services aimed at reducing the impact of chronic disease. operates a dual brand model MPL operates a dual brand strategy Medibank brand: Premium, full service PHI to Medibank branded PHI to customers across all distributions channels (with the exception of comparison websites), including over 90 retail locations. ahm brand: affordable, flexible, simple ahm branded PHI to customers via comparison websites and call centres, the ahm call centre and website. Growth in the ahm offering (six times the industry growth rate over the 12 months to March 2014) has moderated group market share loss. Fig 89 Acquisitions by sales channel 100% 80% 60% 40% 20% 0% 39% 38% 33% 34% 28% 26% 13% 13% 16% 12% 22% 28% FY12 FY13 FY14 Other channnels (incl comparison sites) Direct online Direct phone Retail locations Source:, January January

60 Standardised product disclosure, new technology and the emergence of comparison websites have improved comparability of PHI products Standardised product disclosure and technology supporting the emergence of comparison websites have improved PHI product comparability and provided customers with greater access to PHI product prices and terms. While product comparisons can be made, and are assisted by standardised product disclosure, direct comparison of PHI products are difficult due to: 1) product complexity; 2) different levels of cover; and 3) exclusions and product excess. The tables below summarise the result of comparing the largest five Private Health Insurers in Australia (Medibank, BUPA, HCF, nib, HBF and Australian Unity) and the ahm brand operated by MPL. Note that the comparison is for a NSW product and this may impact the marginal cost of ancillary product for HBF which is a WA health fund. The Australian Government provides a for information only comparison website service ( Fig 90 High-cover policy comparison: Ancillary pricing the key differentiator Annual Premium (pre-rebate) $14,000 $12,000 $10,000 $8,000 $6,000 $4,000 $2,000 $0 $4,999 Marginal cost of comprehensive ancillary above top hospital Hospital Only - Top Cover $3,726 $2,340 $2,711 $7,431 $3,500 $4,576 $4,598 $4,803 $5,354 $4,966 $5,246 Medibank BUPA HCF nib HBF Australian Unity Source: Macquarie analysis of website, January Overseas Workers health insurance can be individually risk rated and allows refusal to provide cover Overseas Visitors (incl. Workers) & Overseas Students Insurance Medibank s Working Visa Health Insurance product range Overview: Certain visitors to Australia may be required to take health insurance as part of visa conditions. Workers Visas (Visa Subclass 457 or Visa Subclass 485) require a minimum level of health insurance and to maintain the cover for the duration of the stay in Australia. Unlike Australian Resident PHI, the workers health insurance can individually risk rate premiums and refuse to provide cover. Product range: Working Visa Hospital Insurance has a range of health insurance options, from basic cover to a more comprehensive package. Based on the website, the company offers a range of policies including: Working Visa Hospital Insurance ($26.96 per week, ~$1,400 annual premium with a $300 excess): cover for hospital costs and in-hospital doctor s services. Working Visa Hospital Insurance and Medical ($42.45 per week, ~$2,200 annual premium with a $300 excess): pays benefits towards hospital and medical services (provided in and out of hospital). Top 85 Working Visa ($55.25 p.w., ~$2,870 annual premium with a $300 excess): covers hospital costs, doctors costs in and out of hospital and a comprehensive list of everyday health care services like dental and optical. Financial performance: The financial performance of the overseas visitors insurance has been strong with the top two providers by revenue generate operating margins above 20% and all market participants profitable. 5 January

61 Fig 91 Overseas Visitors revenue and operating margin Revenue ($m) Overseas Visitors Revenue ($m, LHS) Margin (%) Overseas Visitors Margin (%, RHS) Industry Medibank BUPA nib GUC Health Other Source: Macquarie analysis of PHIAC data, January Medibank s Student Visa Health Insurance product range Overview: Students who hold a temporary student visa may be required, as a visa condition, to take out Overseas Student Health Cover (OSHC). To offer students insurance the provider must enter a deed with government covering the following: 1) the offer is community rated; 2) there is no risk equalisation; and 3) insurers can t refuse individuals cover. Product range: MPL offers a range of policies including: Overseas Students Healthcover Essentials ($41.0 per week for singles, ~$2,132 annual premium): provides essential hospital and out of hospital treatment cover. Overseas Students Healthcover Comprehensive (only available through select universities/schools): provides comprehensive hospital and out of hospital treatment cover. Only a small number of registered health insurers offer OSHC: ahm, BUPA, Medibank Private, nib and Allianz Global Assistance (Lysaght Peoplecare). MPL has suffered from adverse selection in its Overseas Students health insurance Financial Performance: MPL has suffered from adverse selection in its Overseas Students health insurance. According to PHIAC data the product generated an $8.7m operating loss in FY13. FY14 data is not available. The product has been repriced (with Family premiums increased) and distribution channels rationalised (Medibank Overseas Students Healthcover Comprehensive is only available through select universities and schools). Repricing occurred from 1 Jan 2014 and will take 3 years to fully impact profitability as the product provides multi-year cover. MPL s FY15 policyholder growth forecasts for the group (+0.6%) and its Australian Residents PHI business (+1.5%) imply a 35% - 40% decline in the number of policyholders in one year. Fig 92 Overseas students revenue and operating margin Revenue ($m) Overseas Students Revenue ($m, LHS) 90 Overseas Students Margin (%, RHS) (30) -1.8 (60) -8.9 (90) Industry Medibank BUPA nib Source: Macquarie analysis of PHIAC data, January Margin (%) (5) (10) (15) 5 January

62 Distribution: PHI is complex despite standardised disclosure Comparison websites have become a prominent feature of the market Standardised product disclosure, new technology and the emergence of comparison websites have improved information around and comparability of PHI products...contributing to the increased rate of switching between funds The industry has experienced greater competition from smaller PHIs which market primarily through aggregation websites Distribution channels: PHI product is typically distributed direct to individuals via retail stores, call centres operations and on-line. Increasingly customers are utilising comparison websites. Corporate cover is limited: PHI is sold direct to individuals typically without any agent involvement (with the exception of comparison sites). Employers are typically not directly involved in PHI in Australia. PHI products are distributed and sold through a variety of channels including: Retail locations: private health insurers may operate retail store networks to enable potential and existing customers to transact in person. Telephone: call centre operations may be used to sell and inform customers of new PHI products and promotions being launched. Online: certain private health insurers sell PHI products through their own websites. Comparison websites: private health insurers may market and advertise their PHI products on a website operated by third parties. Potential customers use these websites to find and compare different PHI products and purchase the one that is best suited to their needs. Comparison websites generally charge private health insurers a commission for sales of PHI policies via, or associated with, their website. Corporate distribution: PHI products can be distributed and promoted via corporate arrangements and contracts, often offering discounts, subsidies and benefits to employees (however, generally the employer does not pay the PHI premium, which remains the responsibility of the individual Policyholder). Partnership and alliances: PHI s may leverage opportunities to form relationships with other businesses to encourage cross-selling and distribution of PHI products. Standardised product disclosure and technology has supported the emergence of comparison websites have improved comparability of PHI products and provided customers with greater access to PHI product prices and terms. This has contributed to the increased rate of switching between funds as policyholders can more readily understand and compare policies with their requirements. Insurers have responded via: Product design: increased focus on product design given the heightened awareness of PHI policies, with greater flexibility and tailoring of products driving net policyholder growth. Distribution channels: As a result of this shifting customer acquisition landscape, some private health insurers have shifted away from relatively expensive, fixed cost distribution channels such as traditional retail stores, towards online and comparison websites. The PHI industry has also experienced greater competition from smaller private health insurers which market primarily through aggregation websites. Additionally, there has been a growing trend of private health insurers targeting certain customer segments through tailored distribution strategies of certain brands (for example, distribution of PHI policies to younger demographics or value-oriented consumers through online channels only). 5 January

63 Product regulation: Resident, Workers and Students Insurance Heavily regulated: The operation of the PHI system alongside the public health system means that rules under which PHI funds offer policyholder coverage are highly regulated, especially for PHI sold to resident Australian individuals. Exclusions: regulation of resident Australian individuals PHI prohibits coverage for GP visits, Pharmaceutical Benefits Scheme listed pharmaceuticals, and Aged Care. Hospital policies fall into four general categories: Top, Medium, Basic and Public hospital cover Medicare will cover 75% of the MBS fee for medical costs for private patients in hospital The Australian Government PHI Ombudsman website ( provides details of how the PHI market operates including what is covered; and how it works. We summarise the key information from the website below. Resident PHI, incorporating both Hospital and Ancillary cover The structure of the Australian health system means that rules under which PHI funds offer policyholder coverage are highly regulated. What is covered and how PHI works? There are two types of private health insurance. Hospital policies cover policyholders in hospital, Ancillary policies cover policyholders for treatment outside of hospital (e.g. dental). Most funds offer combined policies that provide a packaged for hospital and ancillary treatment services. Depending on the level of cover, the policyholder may not be fully covered against all costs associated with treatment and have to pay some out-of-pocket expenses. Hospital cover Hospital policies help cover the cost of in-hospital treatment by a doctor and hospital costs such as accommodation and theatre fees. Generally, any medical services listed under the Medicare Benefits Schedule (MBS) can be covered by private hospital insurance. Some services which are not listed on the MBS, such as elective cosmetic surgery or laser eye surgery, are only covered by private hospital insurance to a limited extent or not at all. Hospital policies fall into four categories. The classifications are based on the services that are shown as covered, excluded or restricted on standard information statements. Top Private Hospital Cover: must cover all services where Medicare pays a benefit. Medium Private Hospital Cover: excludes or restricts one or more of the following but includes any services in the basic classification: Pregnancy and birth related services, Assisted reproductive services, Cataract and eye lens procedures, Joint replacements i.e. shoulder, knee, hip and elbow including revisions, Hip and knee replacements, Hip replacements, Dialysis for chronic renal failure and Sterilisation. Basic Private Hospital Cover: excludes or restricts one or more of the following: Cardiac and cardiac related services, Non-cosmetic plastic surgery, Rehabilitation, Psychiatric services, Palliative care. Public Hospital Cover: covers default benefits for treatment in public hospital only. Funds generally offer several different policies across these categories, combined with different levels of excess or co-payments. What is covered under hospital cover? Choice of public or private: policyholders can choose to be treated as a private patient in either a public or a private hospital. Choice of doctor: policyholders can choose their own doctor, and decide whether they will go to a public or a private hospital that the doctor attends. Choice of timing: policyholders may have more choice as to when admitted to hospital. If a policyholder chooses to be treated as a private patient in a hospital (public or private), MPL covers 75% of the Medicare Benefits Schedule (MBS) fee for associated medical costs. 5 January

64 The remaining hospital and medical costs will be charged to the policyholder. Some or all of these costs may be covered on the policyholder s PHI, depending on the policy. The remaining costs include 25% of the MBS fee for doctors' services and any amount the doctors charge above the MBS fee, plus some or all the costs of: 1) hospital accommodation, theatre fees, intensive care; 2) drugs, dressings and other consumables; 3) prostheses (surgically implanted); 4) diagnostic tests; 5) pharmaceuticals; and 6) any additional doctor's fees. Medicare will not pay a private patient s hospital accommodation costs and items such as theatre fees & medicines. A PHI policyholder can elect under Medicare to be treated as a public patient in a public hospital by a doctor appointed by the hospital. If a policyholder elects to be treated as a public patient they cannot choose their own doctor and may not have a choice about when they are admitted to hospital. As a public patient they will be treated at no charge. What is covered under Medical Services cover? If a patient visits a doctor outside a hospital, Medicare will reimburse 100% of the MBS fee for a general practitioner and 85% of the MBS fee for a specialist - this applies whether or not the patient holds PHI. If the doctor bills Medicare directly (bulk billing), the patient will not have to pay anything. What may not be covered? Health insurance policies have limitations on hospital treatment, which might include: Exclusions: specific services that are not covered at all. Restriction benefits: services that are covered up to a limit. Benefit limitation periods: which pay reduced benefits for a set period of time after the waiting period, and then pay full benefits after this period. Surgery or hospital treatment that Medicare does not pay a benefit for: Health funds may not cover optional treatments such as elective cosmetic surgery. Long stay patients: If patients are in hospital for more than 35 days in succession, they will be regarded as a long stay or nursing home type patient, unless their doctor specifies otherwise. The Health Insurance Act 1973 does not allow health funds to insure for this cost. Ancillary treatment policies may be offered separately or combined with hospital cover. There are three ancillary categories of policies Comprehensive, Medium and Basic cover Nearly all services covered under ancillary treatment are only covered to a limited extent Single vs. shared rooms: some hospital policies cover the full cost of a shared room, but not a single room. This limitation can apply in a private hospital, a public hospital, or both. Ancillary Treatment cover Ancillary treatment policies provide benefits for non-hospital based medical services, for example, physiotherapy, dental and optical treatment. Ancillary treatment policies may be offered separately or combined with hospital cover. There are three general categories of policies. The classifications are based on the services that are shown as covered on standard information statements. Comprehensive Cover: must include cover for general dental, major dental (benefit limit must be average or above average for the industry), endodontic, orthodontic (benefit limit must be average or above average for the industry), optical, non-pbs pharmaceuticals, physiotherapy, podiatry, psychology; Medium Cover: must include cover for general dental, major dental, endodontic and any five of the following: orthodontic, optical, non-pbs pharmaceuticals, physiotherapy, chiropractic, podiatry, psychology, hearing aids; Basic Cover: all other policies. What is covered under Ancillary Treatment cover? PHI may cover many of the following services that are not covered by Medicare: 1) most dental examinations and treatment; 2) most physiotherapy, occupational therapy, speech therapy, eye therapy, chiropractic services, podiatry or psychology services; 3) acupuncture (unless part of a doctor's consultation); 4) glasses and contact lenses; 5) hearing aids and other appliances; and 6) home nursing. 5 January

65 Nearly all services covered under ancillary treatment are only covered to a limited extent. There are various limits that may apply, for example a limit per service, per year, or lifetime limits. Some services may not be covered at all. PHI funds are currently restricted from funding GP services, PBS pharmaceuticals, and aged care Policyholders purchasing cover for the first time or upgrading cover need to serve a waiting period of 2mths - 12mths A 'gap' is the amount a policyholder pays either for medical or hospital charges, over and above what they get back from Medicare or the PHI Many health funds offer their members access to a range of chronic disease management programs to manage and prevent chronic diseases and self management programs for healthier lifestyles PHI funds are currently restricted from funding: General Practitioner services: although PHI funds are increasingly working alongside GP s to help manage policyholder health outcomes and the funding of GP management of patient care by PHI funds is currently central to the public policy debate surrounding the management of health care expenditure growth. Pharmaceutical Benefits Scheme listed pharmaceuticals. Aged Care: although some Health insurance groups that provide PHI also operate age care facilities within overall corporate structure but outside the health fund. Other PHI product structure issues Waiting periods Policyholders purchasing cover for the first time or upgrading cover need to serve a waiting period. The government sets the maximum waiting periods that funds can impose for hospital treatment: 1) 12 months for pre-existing conditions; 2) 12 months for obstetrics (pregnancy); 3) two months for psychiatric care, rehabilitation or palliative care, even for a pre-existing condition; and 4) two months in all other circumstances. The waiting periods for ancillary treatment cover are set by individual health funds. Pre-existing condition: Under the PHI ACT 2007, a fund may impose a 12 mth waiting period on hospital treatment benefits for a pre-existing condition. Even if you have a preexisting condition, funds must allow you to purchase any cover, at the same price as every other person. Once you have served any waiting periods, you will be entitled to claim. Obstetrics (Pregnancy): The maximum waiting period for benefits is 12 months. Many less expensive hospital covers do not include obstetrics, or pay restricted benefits that only cover you for obstetrics as a private patient in a public hospital, not in a private hospital. Out of pocket expenses (gap cover) A 'gap' is the amount a policyholder pays either for medical or hospital charges, over and above what they get back from Medicare or the private health insurer. Some health funds have gap cover arrangements to insure against some or all of these additional payments. The Government does not set doctors' fees and the doctor is free to decide on a case-bycase basis whether he or she wishes to use an insurer's gap cover arrangement. Medicare sets the price it will fund services through the Medical Benefits Schedule (MBS). Chronic Disease Management Programs Many funds offer their members access to a range of chronic disease management programs to manage and prevent chronic diseases and self management programs for healthier lifestyles. These may include: 1) heart/cardiovascular health; 2) risk factors for chronic disease; 3) diabetes management/education; 4) mental health; 4) weight loss/management; 5) quit smoking; 6) asthma management; 7) back pain; and 8) healthy lifestyle. Pharmaceutical Cover Under the Pharmaceutical Benefits Scheme (PBS), patients pay only part of the cost of most prescription medicines purchased at pharmacies - this applies whether or not the patient holds PHI. The rest of the cost is covered by the PBS. Patients can arrange PHI to cover many prescription medicines which aren't listed on the PBS, usually with a co-payment and limit. Ambulance Cover In Queensland and Tasmania, emergency ambulance services are provided free by the State Government. In other states policyholders can arrange ambulance cover from the ambulance authority or with a health fund. MPL does not cover the cost of emergency or other ambulance services. 5 January

66 Current industry issues Sector continues to tackle utilisation, switching and downgrading Ageing of the policyholder pool will be an ongoing feature Utilisation driven hospital claims growth: Utilisation growth across hospital and ancillary products remains an issue for the sector. Switching continues to increase: Increased switching and downgrading activity is yet to stabilise as policyholders respond to increased premium rates, changes to government policy, more flexible product design, broader distribution channels and increased marketing. Population ageing will be a long term issue: Ageing of the policyholder pool will be an ongoing feature of the sector without new government initiatives to boost the participation of young people. PHI funds are focused on cost performance improvement. Affordability is considered a major issue given the magnitude of premium rate increases but there is still some time until premiums becomes a meaningful part of household spending. #1) Utilisation driven hospital claims trends unlikely to change Increased utilisation by policyholders continues to be the major driver of claims growth. Utilisation has driven 3.8ppts of the 8.6% claims growth Over the past 10 years, industry claims ( hospital benefits ) have risen by 8.6% p.a., with increased utilisation the major driver, contributing 3.8ppts or 43% of the growth. Only two demographic groups have seen hospital benefits growth above the total industry retirees (65-79 year olds) and the elderly (80+ yrs old), with this growth (9.7% and 11.4% respectively) driven by increased penetration of PHI and increased utilisation. Teenage children are also seeing elevated claims growth, in part due to rising mental health admission related claims. Fig 93 Volume and utilisation amongst over 65s driving growth in hospital benefits Hospital benefits (10 year CAGR) 14% 12% 10% 8% 6% 4% 2% 0% -2% 7.1% 2.6% 1.5% 1.3% 1.6% Children (<10y.o.) 8.6% 4.5% 2.8% 3.2% 0.5% 0.3% Older Children (10-19 y.o.) Other Inflation (benefits per episode) Utilisation (episodes per insured person) Volume (PHI Penetration) Volume (Population growth) 8.1% 1.1% 1.8% 2.2% 6.4% 2.9% 1.7% 0.7% 1.0% 7.6% 2.4% 2.8% 2.3% 3.0% 3.1% 0.0% 9.7% 0.9% 3.4% 2.2% 11.4% 6.1% 2.8% -0.8% 8.6% 2.1% 3.8% 0.9% 1.7% 20's 30's and 40's y.o Total Source: Macquarie Analysis of PHIAC data, January The trend in increased utilisation has been consistent over time, with utilisation a large contributor to hospital benefits growth in every period over the past 10 years. With utilisation and penetration contributing the majority of hospital benefits growth, it is unsurprising that 65+ year old policyholders are currently driving 4.7ppts of the 7.8% benefit growth, an outsized impact given this demographic represents 16% of hospital policyholders. 5 January

67 Dec-02 Dec-03 Dec-04 Dec-05 Dec-06 Dec-07 Dec-08 Dec-09 Dec-10 Dec-11 Dec-12 Dec-13 Dec-04 Dec-05 Dec-06 Dec-07 Dec-08 Dec-09 Dec-10 Dec-11 Dec-12 Dec-13 Macquarie Wealth Management Fig 94 Utilisation a consistently large contributor to hospital benefits growth Growth in Hospital Benefits (ann. ave) 12% 10% Other Utilisation (episodes per insured person) Inflation (benefits per episode) Volume (penetration) Volume (population growth) Total 8% 6% 4% 2% 0% -2% Source: Macquarie Analysis of PHIAC data, January Fig 95 with over 65 s contributing over half of the growth in claims... Growth in Hospital Benefits (ann. ave) 12.0% 10.0% 8.0% 6.0% 4.0% 2.0% 0.0% y.o. 30's and 40's Under 30's Total Source: Macquarie Analysis of PHIAC data, January Older policyholders in aggregate claim at a much higher rate than younger policyholders, necessitating risk equalisation. The relative claim profiles and recent trends are stark. The claims intensity curve below illustrates the average claim per policyholder for each five year age bracket. Three issues are clear from the charts below: The front half of the hospital claims curve is very flat. The hospital claims curve steepens from the age of (average annual claims per policyholder increases from ~$1,200 for a 55-59yr old to ~$5,300 for an 85-90yr old). The hospital claims curve is steepening, as the average claim for an yr old has increased from $3,900 five years ago, to $5,300 currently. The shape of hospital benefits claims curve differs markedly from the relatively flat ancillary curve. Fig 96 Hospital claims intensity curve steepens Fig 97 Ancillary claims curve relatively flat Claims Intensity Curve (Ancillary Claims per policyholder) Sep-14 Dec-13 Dec-12 Dec-11 Dec-10 Dec-09 Dec-08 Source (for all above): Macquarie analysis of PHIAC data, January January

68 Jun-03 Dec-03 Jun-04 Dec-04 Jun-05 Dec-05 Jun-06 Dec-06 Jun-07 Dec-07 Jun-08 Dec-08 Jun-09 Dec-09 Jun-10 Dec-10 Jun-11 Dec-11 Jun-12 Dec-12 Jun-13 Dec-13 Jun-14 Jun-03 Dec-03 Jun-04 Dec-04 Jun-05 Dec-05 Jun-06 Dec-06 Jun-07 Dec-07 Jun-08 Dec-08 Jun-09 Dec-09 Jun-10 Dec-10 Jun-11 Dec-11 Jun-12 Dec-12 Jun-13 Dec-13 Jun-14 Macquarie Wealth Management The June quarter lapse rate of 4.8% was the highest individual quarter in over ten years. #2) Switching rates and downgrading of cover Policyholders are increasingly seeking value from their PHI Switching rates have increased over the past 4-5 years as policyholders have responded to increased premium rates, changes to government policy, more flexible product design, broader distribution channels (comparison sites) and increased marketing. The 2014 Sept qtr switching rate of 3.9% moderated qoq, in line with seasonal expectations vs. June quarter lapse rate of 4.8% (the highest individual quarter in over ten years). Sept qtr 2014 lapse levels were well above the 3.3% seen in Sept 2013 and was the highest Sept quarter switching rate for the data that we have. Current levels of policyholders downgrading and dropping out of the system (5.3% of policyholders driven by hit and run policyholders, retirement, permanent resident and long term departures and mortality) and elevated switching rates (3.7% of policyholders) now combine to exceed policyholders entering the system. Fig 98 Hospital switching rate has increased by 10bps QoQ to 3.7% Hospital switching rate 5.0% 4.5% 4.0% 3.5% 3.0% 2.5% 2.0% 1.5% 1.0% 0.5% 0.0% Switching between funds (quarter) Switching between funds (12m rolling) Hospital switching rate 5.0% 4.5% 4.0% 3.5% 3.0% 2.5% 2.0% 1.5% 1.0% 0.5% 0.0% Source: Macquarie Analysis of PHIAC data, January The industry is seeing a stable level of new to PHI policyholders (~7.3% over the past 12m) The industry is seeing a relatively stable new to PHI policyholders (~7.3% 12m growth). Fig 99 while policyholders leaving the industry have remained broadly stable % of hospital policyholders 13.0% 12.0% 11.0% 10.0% 9.0% 8.0% 7.0% 6.0% 5.0% 4.0% 3.0% 2.0% 1.0% 0.0% Switching between funds (12m rolling) Leaving the Industry New to PHI (12m rolling) % of hospital policyholders 13.0% 12.0% 11.0% 10.0% 9.0% 8.0% 7.0% 6.0% 5.0% 4.0% 3.0% 2.0% 1.0% 0.0% Source: Macquarie Analysis of PHIAC data, January With claims growth being driven by utilisation and aging, the switching is likely to remain a key issue following: 1) premium rate increases of over ~6% across the industry; and 2) reduced rebates for middle to high income earners amplifying the premium rate increase. Downgrading is an ongoing headwind for the industry as this has four primary impacts: 1) reduces revenue growth even if the policyholder is retained as they are switching to a lower value policy on average; 2) increases switching rates as policyholders look to aggregator sites and other PHI s for suitable insurance; 3) increases utilisation as claims increase for a given level of premium; and 4) introduces higher excesses and copayments. 5 January

69 Jun-2003 Jun-2004 Jun-2005 Jun-2006 Jun-2007 Jun-2008 Jun-2009 Jun-2010 Jun-2011 Jun-2012 Jun-2013 Jun-2014 Jun-2003 Jun-2004 Jun-2005 Jun-2006 Jun-2007 Jun-2008 Jun-2009 Jun-2010 Jun-2011 Jun-2012 Jun-2013 Jun-2014 Macquarie Wealth Management Affordability has been raised as an issue, but we see little evidence of any impact thus far Downgrading cover via customisation of cover, higher excesses and copayments does partially undermine the community rated pricing structure of the Australian PHI sector. Affordability of health insurance: PHI industry premium rates have increased at 5.9% p.a. from June 2003 to June 2014, well ahead of post tax income growth (4.5% p.a.). While this premium rate growth has supported industry revenues, policyholders have responded by downgrading cover. Fig 100 Premium rates above after tax income growth YoY Growth 9.0% 8.0% 7.0% 6.0% 5.0% 4.0% 3.0% 2.0% 1.0% 0.0% Average post tax income growth (YoY) PHI Premium rate increase (YoY) Source: Macquarie Analysis of Department of Health, ABS and ATO data, January The removal of the 30% Government PHI rebate for some policyholders in July 2012 has accentuated affordability concerns PHI costs (after the rebate) just 2.1% of after tax income Accentuating affordability concerns was the removal of the 30% PHI rebate in July 2012 (for the ~20% of holders whose income is above the new limits imposed) and indexation of the rebate going forwards for those who still receive it, among other PHI policy changes. Indexation will accentuate any price increases above CPI for policy holders, i.e. if a policy increases by 6% in total, but the rebate proportion only increases by 2.5%, the proportion paid by the policy holder increases by 7.5%. This has had limited impact on the absolute level of affordability for most policyholders to date (outside of policyholders on higher incomes which were means tested out of part or all of the rebate) but is expected to drive ongoing downgrading. but we see little evidence of an affordability issue: Whilst rebate means-testing (which increased the effective policy price by up to 43%) has driven downgrading, the quantum of impact has been relatively small. Policies with exclusions have remained relatively unchanged and low at only ~25% of policies. As the price of top-tier policies varies by 30%+ between insurers, consumers appear somewhat price-insensitive. Furthermore, PHI costs (after the rebate) as a proportion of after tax income in Australia has increased to just 2.1% for the average premium per policyholder ($1,237 p.a. post 29% rebate) and the average after tax income ($59,492), which is below means testing for the MLS. While premiums have clearly increased as a proportion of incomes, the absolute magnitude of PHI premiums is still low on average. Fig 101 PHI premiums on average just ~2% of after tax income PHI % of est. post tax income 2.2% 2.0% 1.8% 1.6% 1.4% 1.2% 1.0% 0.8% 0.6% 0.4% 0.2% 0.0% 2.1% 2.0% 0.9% 1.0% 1.0% 1.1% 1.1% 1.2% 1.3% 1.3% 1.3% 1.3% 1.4% 1.4% 1.4% 1.5% 1.5% 1.6% 1.6% 1.7% 1.8% 1.8% 1.9% Source: Macquarie Analysis of Department of Health, ABS and ATO data, January January

70 Dec-08 Mar-09 Jun-09 Sep-09 Dec-09 Mar-10 Jun-10 Sep-10 Dec-10 Mar-11 Jun-11 Sep-11 Dec-11 Mar-12 Jun-12 Sep-12 Dec-12 Mar-13 Jun-13 Sep-13 Dec-13 Mar-14 Jun-14 Sep-14 Macquarie Wealth Management Given the incentives to stay in the PHI system, affordability is unlikely to result in many policyholders dropping their PHI cover completely. Rather, some policyholders will reduce their premiums by downgrading cover, which has been seen over FY13 and FY14 for and the industry. Ancillary claims growth moderated in June and Sept 2014 We compare policyholder growth and downgrading to industry levels in detail in the financial analysis section of this report. Cross sector switching comparison While switching has increased across the industry, it remains relatively low when considered against other sectors. Mortality and Australian residents leaving Australia (travel and work related) is a significant contributor to lapses as well as people entering retirement and policyholders who join PHI (serve a waiting period) and subsequently drop coverage after a procedure. #3) Elevated ancillary claims growth moderated in June & Sept Qtrs Product design and seasonality impact Ancillary claims growth moderated in the June and Sept 2014 quarters, declining significantly from the prior three quarters, which was utilisation driven. A moderation in the rate of ancillary claims growth (+8.2% over the 12 months to Sept 2014, +9.6% over the 12 months to June 2014, +12.4% over the 12 months to March 2014) reflected a sharp moderation in June quarter 2014 ancillary claims, which continued into the September qtr. The moderation was impacted by product design changes from 1 April 2014 and the children's dental scheme introduced by the previous Government. Seasonality also contributed to this moderation. The timing of Easter holidays added one public holiday to the June Quarter in 2014 vs and the proximity of Easter holidays to ANZAC day also likely caused some moderation in hospital claims growth in the quarter. Growth off a higher base (June 2013 was the start of this claims cycle) and product changes from 1 April 2014 have also contributed to sub-10% ancillary claims growth over the past twelve months. Fig 102 Ancillary claims moderation: 12.4% in March, 9.6% in June, 8.2% in Sept PHI Benefits growth (rolling 12m) 14% 12% 10% 8% 6% 4% 2% 0% Hospital Ancillary Source: Macquarie Analysis of PHIAC data, January Ancillary cover is a key retention tool for Private Health Insurers. Dental, optical, physio, chiro and natural therapy are key services driving the value proposition of PHI. These services are widely marketed to younger policyholders with very low hospital utilisation. Utilisation has recently been a key driver of growth in ancillary benefits, but not as consistently through time as what is seen in hospital. This shift in utilisation, principally over the past months has coincided with a step change in the rate of policyholder churn as individuals seek value for money from PHI. Higher utilisation pushed ancillary benefits growth from its long term range of 7.5% % up to 12.4% in March This was 9.6% in June 2014 and moderated further to +8.2% over the 12 months to Sept 2014, as the increase in utilisation declined. 5 January

71 Jun-01 Jun-02 Jun-03 Jun-04 Jun-05 Jun-06 Jun-07 Jun-08 Jun-09 Jun-10 Jun-11 Jun-12 Jun-13 Jun-14 Jun-15 Dec-00 Dec-01 Dec-02 Dec-03 Dec-04 Dec-05 Dec-06 Dec-07 Dec-08 Dec-09 Dec-10 Dec-11 Dec-12 Dec-13 Jun-04 Jun-05 Jun-06 Jun-07 Jun-08 Jun-09 Jun-10 Jun-11 Jun-12 Jun-13 Jun-14 Macquarie Wealth Management Fig 103 Utilisation drove the moderation in ancillary claims in June/Sept 2014 Ancillary benefits 15.0% growth 12.5% 10.0% 7.5% 5.0% 2.5% 0.0% -2.5% Other Change in PHI contribution to ancillary fee Service Fee inflation Utilisation Penetration of Ancillary cover Population growth Ancillary benefits growth 15.0% 12.5% 10.0% 7.5% 5.0% 2.5% 0.0% -2.5% -5.0% -5.0% Source: Macquarie Analysis of PHIAC data, January The overall ancillary trends are driven by a number of underlying themes within each product. For example: The volume of dental claims spiked post the closure of the Government funded chronic disease dental scheme (1 December 2012) with a moderating impact from the children's dental scheme introduced by the previous Government becoming evident. Optical service fee deflation has been driven by competition from scale operators entering the market. Natural therapies (naturopathy, massage, kinesiology, etc) are growing rapidly, with volume growth of 15%-20% and increased contributions from PHI driving consistent YoY growth of ~20%. #4) Ageing of the policyholder pool Hospital penetration rates have been broadly stable for most young groups, with only two key age groups seeing penetration increase: yrs old and 80+ yrs old. This has pushed the average age of hospital policyholders to 40.6yrs, two years older than the overall population. Fig 104 Ageing population and rising PHI penetration amongst over 65s driving ageing of PHI pool Fig 105 Resulting in an older average age for hospital policyholders (40.6yrs) vs. ancillary (38.8yrs) % Over 65 20% 19% 18% 17% 16% 15% 14% 13% 12% 11% 10% PHI Policyholders Overall Population April 2005: Increased rebates for older policyholders % Over 65 Actual Fcast 20% 19% 18% 17% 16% 15% 14% 13% 12% 11% 10% Average Age Average age of general population (RHS) Average Age 41 Average age of insured - ancillary policyholder weighted (RHS, ex Ambulance Only) 40.6 Average age of insured - policyholder weighted (RHS) Source (for all above): Macquarie Analysis of PHIAC and ABS data, January Policyholder growth for under 65 s is falling back towards population growth, while over 65 s are seeing continued increases in penetration Policyholder growth for under 65 s is falling back towards population growth, while over 65 s are seeing continued increases in penetration, on top of already high population growth due to ageing. This trend is placing greater pressure on claims and premium rates, as the policyholder pool ages, with over 65 hospital policyholder growth of 5.4% vs. under 65 policyholder growth of 1.8%. With utilisation and penetration contributing the majority of hospital benefits growth, it is unsurprising that 65+ old policyholders are currently driving 4.7ppts of the 7.8% benefits growth, an outsized impact given this demographic represents just 16% of hospital policyholders. 5 January

72 Sep-02 Sep-03 Sep-04 Sep-05 Sep-06 Sep-07 Sep-08 Sep-09 Sep-10 Sep-11 Sep-12 Sep-13 Sep-02 Sep-03 Sep-04 Sep-05 Sep-06 Sep-07 Sep-08 Sep-09 Sep-10 Sep-11 Sep-12 Sep-13 Macquarie Wealth Management The impact of the ageing of the pool of policyholders is illustrated in the chart below. Fig 106 Hospital penetration amongst under 65 s continues to increase, but is moderating Fig 107 as policyholders over 65 are growing, driven by increased penetration and ageing Policyholder growth (Hospital - Under 65) 7% 6% 5% 4% 3% 2% 1% Under 65 Impact of Hospital PHI penetration Under 65 Population growth Under 65 Hospital Policyholder growth Policyholder growth (Hospital 7% - Over 65) 6% 5% 4% 3% 2% 1% Over 65 Impact of Hospital PHI penetration Over 65 Population growth Over 65 Hospital Policyholder growth 0% 0% -1% -1% -2% -2% -3% -3% Source (for all above): Macquarie Analysis of PHIAC data, January With their claiming and growing penetration profile it is clear that year olds are the largest and fastest growing component of the claims pool. #5) Moderating management expenses growth Funds remain focused on improving cost performance Management expense ratio improved but the rate of improvement has stabilised in the Sept quarter. The industry MER was down 10bps qoq to 8.41% over the 12 months to Sept 2014 vs. 8.51% over the 12 months to June Fig 108 Management expense ratio continues to fall, now at 8.4% with expense growth (+4.6%) below premium growth (+7.9%) Source: Macquarie Analysis of PHIAC data, January January

73 Health industry structure and funding The public and private health system is simultaneously available PHI funds account ~8% of national health care expenditure Total Australian healthcare expenditure for 2013 was estimated to be $147.4bn. Federal and state governments contributed ~68% of the funding. The PHI sector funding contribution, of ~8% of Australian healthcare expenditure, has been slowly increasing over time. Australian healthcare expenditure has been increasing at a faster rate than nominal GDP, growing at a CAGR of ~8% Funding mix of Australian Healthcare: ~68% Government ~8% PHI ~24% other (incl. patients out of pocket) PHI critical in ensuring an effective health system The healthcare industry is an integral part of the Australian economy, representing ~9.7% of GDP in Australian healthcare expenditure has been increasing at a faster rate than nominal GDP, growing at a CAGR of ~8% from $68.8bn in 2003 to more than $147.4bn in This compares to a nominal GDP CAGR of 6.6% over the same period. Annual healthcare expenditure per person has also increased at a CAGR of 6.2% from $3,510 in 2003 to $6,430 in The Australian healthcare industry consists of public and private organisations which provide healthcare services to patients. These include hospital services, medical treatments, medications and other related services. The funding of Australian healthcare, estimated to be $147.4bn in 2013, comprises contributions from: Federal and State Governments: ~68% of Australian healthcare expenditure via Medicare and the Pharmaceutical Benefits Scheme (PBS). Private Health Insurance: ~8% of Australian healthcare expenditure via PHI benefits (excludes the premium benefits). Patients out-of-pocket and other organisations: ~24% of Australian healthcare expenditure from: 1) patients out-of-pocket (where PHI coverage is not sufficient to cover the cost of the procedure). 2) via other organisations such as general insurers who may fund healthcare services that are excluded under the PHI Act 2007, including medical treatment covered by compulsory third party insurance. The mix of Australian healthcare expenditure comprises: Hospital expenditure accounted for approximately 38%. Medical services, including general practitioner (GP) services and diagnostics (pathology and medical imaging) accounted for 17%. Medications accounted for 14%. Other expenditure: The remaining 31% comprised patient transport (ambulance services), capital expenditure, dental services, public and community health, other health practitioners services, aids and appliances, administration and research. PHI funds ~8% of all health services The contribution of PHI to the provision of health services is critical in ensuring an effective health system. PHI can provide for all or part of the costs associated with hospital and ancillary treatments, but often involves the sharing of some costs with the Commonwealth Government (through Medicare) and some with patients/policyholders in out-of-pocket costs. PHI provides funding for: 1) private hospital care; 2) private health care at public hospitals; 3) a range of ancillary medical services (such as dental, optical, physiotherapy, chiropractic etc) and preventative health. The PHI industry complements the public healthcare system by providing additional choice and affordability for Policyholders through: 5 January

74 Hospital funding for treatment in private hospitals or private patient in public hospitals; Choice: greater choice of clinician, medical service provider and location, as well as in general shorter waiting periods; and PHI industry premium revenue was ~$19.3bn in 2014 and has grown at a CAGR of 8.4% since 2004 Ancillary cover: additional funding for healthcare services (e.g. dental and physiotherapy services) that are not covered or are only partially covered by Medicare. Fig 109 Summary of private services funding PHI fund Government Patient outof-pocket Total Funding of Private hospital services Funding of Private medical services Funding of general (ancillary) services Total Funding Funding of Private hospital services 42.7% 0.0% 1.9% 44.6% Funding of Private medical services 8.2% 10.6% 2.9% 21.7% Funding of general (ancillary) services 17.5% 0.0% 16.3% 33.7% % of Funding 68.4% 10.6% 21.1% 100.0% Source: Based on PHIAC data, January The classification of funding of private hospital services by use is as follows: Hospital Services: Treatment that is intended to manage a disease, injury or condition provided at a hospital or provided/arranged with the direct involvement of a hospital. Refers to accommodation, meals, theatre fees, nursing care, medicines and disposables. Medical Services: Insurers pay medical benefits for in-hospital services provided by medical specialists. The amount that insurers pay toward these costs will depend on the Government contribution for the service (75% of the Medical Benefits Schedule fee) and the agreement the insurer has with the specialist provider. If the agreement between the insurer and specialist provider does not cover all costs, an out-of-pocket contribution (gap payment) toward the cost of the service will need to be made by the patient medical services provided by authorised medical specialists. Medicare pays 75% of the MBS, insurers pay the remaining 25% of the MBS fee (not covered by Medicare), and insurers may pay for charges in excess of the MBS fee where gap cover arrangements are in place. Ancillary Services: Treatment that is intended to manage or prevent a disease, injury or condition and is not hospital treatment includes a broad range of goods and services which work to manage a person s health and/or prevent health issues developing outside a hospital setting. Ancillary treatment can include: 1) general services, such as dental, physiotherapy and optical services; and 2) preventative health services, such as medical checks, health programs and online support tools. Fig 110 Funding of PHI services classified by source ( ) Fig 111 Funding of PHI services by use ( ) Patient out-of-pocket 21% Funding of general (ancillary) services 34% Funding of Private hospital services 44% Government 11% Source (for all above): Based on PHIAC data, January PHI fund 68% Funding of Private medical services 22% 5 January

75 BUPA HCF NIB HBF Aust Unity Teachers Federation Health GMHBA Defence Health CBHS Health Fund Westfund Latrobe Health Services Health Partners Health Insurance Fund of Lysaght Peoplecare Grand United Corporate Healthguard Health Benefits Queensland Teachers' CUA Health Fund Police Health Railway & Transport Health St Luke's Medical & Hospital Queensland Country Health Health.com.au Navy Health Mildura District Hospital Fund Doctor's Health Fund Phoenix Health Fund National Health Benefits ACA Health Benefits Fund Transport Health Health Care Insurance Cessnock District Health Reserve Bank Health Society Macquarie Wealth Management PHI market structure The PHI market has become increasingly consolidated For-profit status PHI funds account for ~68% of PHI industry premium revenue Concentrated market share: The PHI industry is relatively concentrated, with the top 5 funds accounting for 82% of policyholders. For-profit status funds lead the sector: 10 private health insurers are for-profit status, including MPL, BUPA and nib. For-profit health funds account for ~70% of total PHI industry premium revenue in Ongoing consolidation is likely: Consolidation has occurred despite the capital light nature and community rating of the PHI (reducing the potential for competition and moderating scale advantage). Regulation has been a driver of consolidation. PHI is heavily regulated: PHIAC is the regulatory body responsible for the PHI sector. PHIAC will move into APRA and Department of Health by 1 July 2015, separating prudential regulation and competition monitoring. PHI is dominated by 5 major providers Industry structure increasingly for-profit and consolidated Despite a large number of smaller market share participants, the industry has moved from a highly fragmented structure, which had been dominated by, not-for-profit mutuals and a plethora of restricted membership funds, to a concentrated sector where the top 5 sector participants account for 82% of policyholders. Market consolidation and a shift to for-profit status was impacted by national registration requirements and changes on how not-for-profit funds could allocate assets. Consolidation occurred despite the capital light nature of the product and community rating coupled with the risk equalisation scheme (reducing the potential areas of competition and scale advantage). PHIAC expects that further consolidation of the industry will occur in the future. Fig 112 Australia PHI industry market share (FY13) Number of Policies 2,000,000 1,800,000 1,600,000 1,400,000 1,200,000 1,000, , , , , Market Share NT ACT TAS SA WA QLD VIC NSW Source: Macquarie Analysis of PHIAC data, January January

76 Significant corporate activity which has driven this consolidation includes: HCF/Manchester Unity: HCF announced the proposed acquisition of Manchester Unity in August 2008 for $257m ($3,200 per member, 1.14x annual premiums). Medibank/ahm: Medibank acquired ahm for $367m in 2009 ($2,447 per member, 0.97x annual premiums). BUPA Australia/MBF merger: In December 2007 the Board of MBF recommended a merger of the two private health insurers following a $2.41bn offer to MBF contributors from BUPA ($2,620 per member, 1.07x annual premiums). While not driving market share consolidation through acquisition, the decision by nib to demutualise and list has had an impact on the sector dynamics given the above system growth that nib that has achieved. In July 2007, nib Company Members and Eligible Policyholders voted in favour of a proposal to demutualise. nib listed on the ASX in Nov In addition, corporate activity in the sector has been ongoing. Transactions include: The Doctors Health fund demutualised and was acquired by Avant ($30m) in mid 2012; and The Australian Health Service Alliance delivers industry competitive scale Primary Healthcare acquired Transport Friendly Society ($18m) in Sept In 2013, the PHI industry comprised 34 funds, which are categorised by: Membership criteria: 22 private health insurers, representing 93% of total policies in 2013, are open private health insurers offering PHI policies to the general public. 12 private health insurers are restricted private health insurers offering PHI policies to Policyholders from specific employment groups, professional associations or unions. Profit status: 10 private health insurers are for-profit private health insurers, accounting for ~70% of total policies in Major for-profit funds include MPL, BUPA and nib. 24 private health insurers are not-for-profit private health insurers, including HCF and HBF. Market concentration is higher than appears While the move of prudential regulation from PHIAC to APRA is expected to increase the level of compliance and disproportionally increase costs for smaller funds, the market is already more consolidated than the number of funds indicates. The pressure for consolidation at an operating level is somewhat mitigated by: Participation in the Australian Health Service Alliance (AHSA). AHSA delivers industry competitive scale with respect to supply chain (hospitals) negotiating power, contracting and claims management services. AHSA was formed in January 1994 by a group of registered private health funds as a result of pressures associated with health insurance reforms. AHSA members are typically smaller private health insurers and mainly comprise restricted and not-for-profit private health insurers. AHSA, representing an aggregate market share of ~18% by number of policyholders, collectively contract with private hospitals and other healthcare providers. AHSA simplified agreements for hospitals by giving the hospitals access to a large number of private health funds and their members. The combined membership of AHSA funds purchase in excess of $2.3bn worth of hospital and health care services on behalf of ~2 million Australians, making AHSA member funds the third largest purchaser of private hospital and health care services in Australia. AHSA also provides contract and claims management services for its members. A number of these smaller private health insurers also collectively develop systems requirements through HAMBS. 5 January

77 Ramsay Healthscope St John of God Healthe Care Calvary St Vincents Epworth Unitingcare Mater Adventist Macquarie Wealth Management Health fund and hospital relationship Mutually dependent relationship Selective contracting could become increasingly common For-profit private hospitals dominate the industry capacity available in the relatively concentrated private hospital sector. ~66% of PHI hospital benefits are paid to hospitals (private 59% and public 7%). ~68% of hospital revenues come from PHI funds. Most insurers contract with all private hospitals:, as part of its drive to improve the quality of members services, has stated that it will increasingly be willing to fall out of contract with providers delivering poor quality services. Health fund relationship with the private hospital sector PHIs operate closely with private hospitals with ~59% of hospital benefits for the average insurer being directed to private hospitals Funding: PHI s operate closely with private hospitals. ~59% of hospital benefits for the average insurer are paid to private hospitals (payments to public hospitals represent 7% of PHI hospital benefits), and ~68% of private hospital revenues are from PHI funds. The balance is funded from a combination of state and territory governments (~20%) and direct payment by individuals (~12%). Fig 113 Insurers and private hospitals share a close relationship PHI Industry Claims Hospital revenue source 26% Hospital 74% Ancillary Private health insurance funds¹ 68% Individuals 12% Department of Veteran Affairs 8% TAC/WorkCover and other 6% State/Territory and local government Federal Government 2% 4% Source: Based on PHIAC data, AIHW, Australian Health Expenditure ( ). 1. Includes PHI rebates paid by the Federal Government to health funds to reduce premiums. Private hospitals represent ~40% of hospital admittance across the health system each year Capacity: Private hospitals represent ~40% of hospital admittance across the health system each year, with for-profit status private hospitals dominating the capacity available in the private sector (see chart below). Private hospitals account for 60-70% of elective surgery cases. Fig 114 Australia s Private hospital industry is relatively concentrated 68 # of Private Overnight Hospitals 44 Not for profit For profit Source: Company websites, Macquarie Research, January January

78 Most insurers contract with all private hospitals Most PHIs and private hospitals have negotiated agreements known in the industry as Hospital Purchaser Provider Agreements (HPPA). MPL is increasingly focused on hospital service quality and is willing to fall out of contract with some hospitals Most PHIs and private hospitals have negotiated agreements known as Hospital Purchaser Provider Agreements (HPPA). These agreements detail the fees that the private health insurer pays towards the cost of hospital services incurred by its Policyholders. These fees represent the benefits payable to Policyholders but are paid directly to the private hospital on the Policyholder s behalf, less any Excess or Co-Payments to be funded by the Policyholder. Although there are some exceptions, the majority of health insurers contract with all private hospital providers in Australia. An HPPA may include terms that share risk between the private health insurer and the hospital (e.g. hospital services may be billed on an episodic basis so that the hospital is paid an agreed price by the private health insurer based on the type of case rather than length of stay, thereby transferring the financial risk of the patient requiring an extended length of stay from the private health insurer to the hospital). Universal arrangements with hospitals are not essential however Although a relatively rare event, some insurers will at times not have an active HPPA with particular hospitals. In this instance the PHI Act provides a minimum level of benefit for Policyholders who receive services at uncontracted hospitals, through either: Minimum default benefit rates, which represent the lowest daily amount of benefits payable by a private health insurer for admission to private hospitals that are not eligible for second-tier benefits. The minimum default benefits rates are determined annually by the Australian Government under the PHI Act and are generally well below the market rates for private hospital services; or Second-tier benefit rates, which represent benefits payable only for treatment in facilities that have obtained second-tier status 1 (available on application for facilities that are accredited and have appropriate billing and informed financial consent processes) and are calculated by the private health insurer at 85% of the private health insurer s average contracted rate for an equivalent episode of hospital treatment at comparable private hospitals within a particular state / territory. In practice this means that Policyholders who are treated at non-contracted private hospitals have some PHI coverage for their hospital fees, but are likely to need to make a gap payment to the private hospital, and the gap payment will be a lower amount if the relevant private hospital has second-tier status. Selective contracting could become increasingly common Historically insurers have been coy to go out of contract with hospitals, primarily due to a concern that their members could leave the fund if they cannot access the hospital services they wish to use without paying additional fees. The PHI industry portability legislation, which allows members to immediately switch health funds without having to re-serve waiting periods, means that members can relatively easily, painlessly and rapidly switch funds if they are unhappy with their service., as part of its drive to improve the quality of services delivered to it members, has stated that it will increasingly be willing to fall out of contract with providers it believes are delivering poor quality services to members. Although Medibank concedes that reduced access may be perceived negatively by some members, it believes members will overall be happy to forgo some access if it means they avoid being exposed to low quality services. If successful, this strategy could provide financial benefit for Medibank through a combination of reduced claims (i.e. reduction in unnecessary procedures, over-billing), and better health outcomes for its members. 1 Second-tier benefit rates are not applicable for public hospitals 5 January

79 PHI premium rate approval Premium rate approval process supports 3% to 6% net margin the best performing funds are able to operate above the top end of the range Premium changes require Minister approval: PHI funds must submit premium rate changes to the Health Minister (effectively submissions are made direct to PHIAC) and the premium rate change must be approved, unless approval would be contrary to the public interest. Approval process has become more commercial: The premium rate approval process has become more commercial as funds submit premium rate applications direct to PHIAC, resulting in a greater actuarial focus. Claims growth drives premium increases: The increase in premium rates relative to claims growth impacts the sustainable net margin achievable for the industry and individual PHI funds. Premium rate approvals have covered increased utilisation and health cost inflation. Product design a key differentiator: Funds largely compete on product design not premium rate. Net margins in the 3% to 6% range are supported by regulatory settings. Individual PHI funds margins will typically vary around this range, both above and below. PHIAC is focused on the overall PHI fund margin outcome. For-profit status funds can operate with net margins in the % range Our expectation that for-profit status funds can operate with net margins in the % range is based on a combination of these funds delivering: management expense performance at or below the industry management expense ratio; premium rate increases at or below the industry weighted average increase; and claims cost outcomes at or below the industry performance. The best performing funds are able to operate above the top end of the net margin range as long as they are able to deliver on the above criteria and demonstrate that their premium pricing is not contrary to the public interest. Fig 115 Sector net margins split by for-profit and not-for-profit funds Source: Macquarie Analysis of PHIAC data, January Boost to net margin from ancillary product contribution The gross margin contribution from ancillary products provides a boost to for-profit status funds net margin performance. The table below compares gross margin between hospital and ancillary products and also shows the premium contribution from ancillary is based on PHIAC annual data for January

80 While there are classification differences across the funds, and typically hospital and ancillary cover are sold together, the not-for-profit status funds do not see as large a contribution from ancillary products both in volume and margin terms (with the exception of HBF). The largest not-for-profit fund is HCF. For 2013, HCF reported a negative gross margin on ancillary product (-0.7%) versus the largest for-profit funds (MPL, BUPA and nib) reporting gross ancillary margin of 20%-23%. HCF hospital gross margin was in-line with industry. We note that HCF does report a management expense ratio (7.1% in 2013) materially below the industry (9.2%) and for-profit status funds (8.9%). This supports our view that classification differences explain some of the margin difference between funds but does not fully reconcile the overall gap. Fig 116 Hospital versus Ancillary gross margin ($bn) Industry MPL BUPA HCF NIB HBF AUHL Other Hospital treatment Premium Revenue Fund Benefits Gross Hopsital Margin 11.1% 9.9% 12.4% 11.2% 8.3% 11.8% 10.9% 11.6% Ancillary treatment (incl Ambulance) Premium Revenue Fund Benefits Gross Ancillary Margin 18.2% 20.3% 22.3% -0.7% 23.1% 25.9% 27.8% 11.4% Ancillary premium contribution 28.0% 28.6% 27.1% 23.8% 33.3% 31.3% 26.2% 28.4% Source: Based on PHIAC data, Macquarie Research, January Regulation of PHI is extensive and this includes the setting of premum rates The current premium rate change approval process operates as follows: PHI funds submit premium rate change application direct to PHIAC. PHIAC then provide advice to the Minister for approval of premium rate changes. The Minister must approve the proposed change, unless the Minister is satisfied that a change would be contrary to the public interest. The Minister announces the average premium rate increase across the industry and by individual fund. Individual product premium rate changes are then communicated directly to policyholders. Although the PHI Act allows insurers to apply to the Minister for PHI product premium increases at any time, the current practice is for insurers to apply once annually (in November), with the approved premiums then applying for a full 12 month period (generally from each 1 April). PHIAC reviews all pricing applications and provides advice to the Minister on: the impact of the proposed premium change on the financial viability of PHI; the fund s competitiveness relative to others; and the expected impact on consumers. 5 January

81 Dec-05 Jun-06 Dec-06 Jun-07 Dec-07 Jun-08 Dec-08 Jun-09 Dec-09 Jun-10 Dec-10 Jun-11 Dec-11 Jun-12 Dec-12 Jun-13 Dec-13 Jun-14 Dec-14 Jun-15 Macquarie Wealth Management Fig 117 Premium rate changes offsetting hospital claims growth in recent years 10.0% 9.0% 8.0% 7.0% 6.0% 5.0% 4.0% 3.0% 2.0% 1.0% 0.0% Health Inflation (rolling 12m) Utilisation (rolling 12m) Industry Premium Growth (rolling 12m) PHIAC directly involved in premium rate approval process Forecasts Source: Macquarie Analysis of PHIAC data, Macquarie Forecasts, January Product mix changes impact overall premium growth Note that the actual rate of premium growth per policyholder will differ from the announced premium rate increase, driven by product mix changes (i.e. downgrading of cover by policyholders). The percentage increase in premium rates is typically larger for policies with lower total premiums as the impact of the risk equalisation is greater in percentage terms. Fig 118 Industry premium revenue growth underpinned by rate increases, however population growth, PHI penetration and mix/downgrading impact overall growth Industry Premium growth 10% 8% 6% 4% 2% 0% -2% Other Penetration Premium rate Mix, Up/downgrading Population growth Total Premium growth FY09A FY10A FY11A FY12A FY13A FY14A FY15E Source: Macquarie Analysis of PHIAC data, Macquarie forecasts, January Industry Premium growth 10% 8% 6% 4% 2% 0% -2% PHIAC supports the principle that the market is the best place to set prices PHIAC supports the principle that the market is the best place to set prices where there is evidence of clear and effective competition for products. Where the market is failing, or inefficient, further inquiry may be required. PHIAC key observations during the 1 April 2014 premium rate change approval process considered the market a mixed bag : Good news: 1) strong commercial visibility; 2) vigorous retail presence (unlike many other countries); 3) strong awareness of product price; 4) small funds competing effectively with big funds; and 5) emerging areas of strong competition. Bad news: 1) market not perfect or optimally efficient; 2) market not dynamically competitive (i.e. lack of new entrants despite high profitability); 3) market experiencing growth but relatively low movement between insurers (switching has increased in the past 12 months); and 4) market dealing with an information poor consumer sector. PHIAC has stated that it will give fair weight to the pricing judgements presented and generally not second guess but we will examine [funds] forecasts and capital projections as we have always done. PHIAC will, above all, be looking out for consumers PHIAC considers evidence of an efficient market to be: 1) evidence of accurate and complete information about products and prices; 2) portability working efficiently; 3) new entrants at times of high profitability; 4) competition for new and current members; 5) substitutable products readily available; and 6) suppliers don t have disproportionate bargaining power. 5 January

82 PHIAC observes the following factors impact the efficient operation of competition: 1) consumers are turned off by complexity; 2) consumers exhibit a strong degree of stickiness; and 3) there is not much evidence that consumers are actually responding to price and product signals other than some fairly narrow and highly contested areas (especially entry point, young adults caught by LHC). How has the premium rate change approval process changed in recent years? Over the past several years PHIAC has played a greater role in the premium rate change approval process and the robustness of the process has increased Over the past several years PHIAC has played a greater role in the premium rate change approval process and the commercial robustness of the process has increased. PHIAC has communicated with funds that in assessing the submissions it wants to be light touch, transparent, remove scope for confusion and surprise and encourage regular communication. Fig 119 Approved Premium Rate Increases Source: Department of Health, January Industry BUPA Australia Hospitals Contribution Fund nib Health Funds HBF Health Australian Unity Health What margin is considered sustainable for the industry in setting premium rate changes? We believe the current margins being achieved across the sector and by Medibank Private are consistent with regulatory settings. PHIAC has previously stated that Historical figures show that the core business performance of the industry that is, the provision of PHI measured by the net margin has consistently been in the range of 3 6%. This range has proven to be more than sufficient to meet the ongoing growth in costs and minimum capital requirements of the industry. In 2011, when industry gross margins were 14.7% and net margins were 5.6%, PHIAC stated that current capital positions and margin outcomes for the industry suggest that price competition is not as sharp as it could be. In the PHIAC Annual Report, when industry net margins were 4.2%, the following was noted in regard to competition: 1) competition for [ancillary] category of cover is intense ; and 2) the [PHIAC Competition in the Australian Private Health Insurance Market] report supports the conclusion of strongly competitive behaviours in large parts of the market, but with challenges associated with complexity and some elements of the regulatory system, as well as regional differences. Fig 120 forecast MER narrowing gap vs. industry Australian Residents MER 10.0% 10.2% Industry Residents MER (ex ) Residents MER 9.2% 8.7% 5.0% 0.0% 8.9% 8.6% 8.4% FY12A FY13A FY14A Source:, January January

83 What changes in the premium rate approval process may occur in the future? Membership levels rapidly increased in response to the introduction of 1) LHC loadings, 2) the MLS and 3) the rebate of PHI premiums between 1997 and 2000 While we expect current regulation of the PHI sector to remain substantially in-place, a major regulatory change would be to allow PHI funds to set premium rates within a price monitoring framework, rather than the current annual approval process that requires written Ministerial approval. PHI premium competition has been examined extensively in the past, including the 1997 Industry Commission report, and more than ten ACCC reports since The current price approval regulations were introduced in At this time government incentives to take up PHI were limited. Policies were focused on extending the principles of fairness and equity that underpin the public health system into the private sector, through levers such as community rating, risk equalisation and portability. With PHI participation at just 34%, membership was very low, and given low take-up as well as issues of adverse selection, premiums were high. We believe the following points should be considered when assessing the potential move to a price monitoring framework: based on PHIAC data the introduction of the current premium rate approval process in 1996 did little to increase membership levels, with participation falling from 34% in 1996 to 31% in Membership levels rapidly increased in response to the introduction of: 1) Lifetime Health Cover (LHC) loadings; 2) the Medicare Levy Surcharge (MLS); and 3) the rebate of PHI premiums between 1997 and PHI hospital cover membership rose from ~34% to over 45% of the Australian population in less than one year in response to the policy change. the move of PHIAC into APRA and Department of Health by 1 July 2015, separating prudential regulation and competition monitoring. the recent government PHI policy change (means testing the PHI rebate, capping the growth in the rebate at CPI and removing the PHI rebate from the LHC loading) limiting the rate of growth in government PHI fiscal support reduces the need for the Minister to approve premium rate changes. a number of papers have concluded that the current PHI premium rate approval process is sub-optimal and a move to a price monitoring framework. The Industry Commission Report into PHI (1997) stated, There appears to be a reasonable degree of competition among health funds, more so in some areas than in others, but behaviour and performance are constrained by regulations that affect incumbents and potential entrants alike. A 2005 Access Economics report stated that, Private Health Insurance is a heavily regulated industry. Competition appears relatively weak; although it is not clear whether this is a cause or an effect of the existing regulatory structure. In the PHIAC Annual Report, when industry net margins were 4.2%, the following was noted in regard to competition; 1) competition for [ancillary] category of cover is intense ; and 2) the [PHIAC Competition in the Australian Private Health Insurance Market] report supports the conclusion of strongly competitive behaviours in large parts of the market, but with challenges associated with complexity and some elements of the regulatory system, as well as regional differences. The table below is extracted from a Deloitte Access Economics report, Medibank: The Future of Private Health Insurance Premium-setting: Seeking Integrative Solutions, November This report also reached the conclusion that the current system is sub-optimal. 5 January

84 Fig 121 Summary of prior PHI premium rate report review findings and evidence Review authors Year Findings regarding current process Recommended approach Analysis of industry competition? Benchmarking of other approaches? Insight Economics Access Economics Port Jackson Partners Booz Allen Co. Access Economics 2011 Current process sub-optimal 2010 Current process sub-optimal 2009 Current process sub-optimal 2008 Current process sub-optimal 2005 Current process sub-optimal NERA 2005 Current process sub-optimal Industry Commission 1998 Suggests process is suboptimal Price monitoring Price monitoring Price Monitoring Modification of current process and consultation on long-term options Price monitoring Removal of price regulation Changes to premia should not subjected to monitoring or screening Some consideration uses PHIAC analysis, ACCC rulings and number of funds as evidence None, but suggests that competition is not effective; funds look to regulator rather than competitors Relatively limited assumes competitive, points to industry fragmentation as evidence Relatively limited suggests competitive due to similar concentration to general insurance and financial services industries, as well as low barriers to entry Relatively limited assumed lack of competition due to extensive regulation and low profitability Relatively limited suggests number of existing providers and low barriers to entry mean the industry is competitive Extensive analysis. Concludes reasonable degree of competition on price and product. Source: Deloitte Access Economics report: Medibank: The Future of Private Health Insurance Premium-setting: Seeking Integrative Solutions, November None Airports Essential services regulations Extensive review of essential services, including telecommunications, gas, water, electricity Essential services regulation in Victorian ports and telephony Considers long distance telephony, energy, airports and seaports, but suggests none of these are ideal None A move to a price monitoring framework is possible over the medium term The table predates the Commission of Audit, which proposed a price monitoring, and the PHIAC Competition in the Australian PHI Market discussion paper and research paper. In addition, the government s recent Competition Policy Review, which was asked to undertake a comprehensive review of Australian competition law and policy included PHI. The conclusion was to agree with the previous government review, the National Commission of Audit, which noted that: 1) there may be scope for lighter touch regulation of the private health insurance sector, which could encourage innovation and wider product availability for consumers; 2) price regulation could be replaced with a price monitoring scheme; and 3) health funds could be allowed to expand their coverage to primary care settings. The report notes that insurers preferred provider arrangements have been examined by the ACCC, which concluded they raise no competition concerns. However the report does note inefficiencies in the regulation of prosthesis pricing. Despite the points above, the current system has been in place since We expect that PHIAC will remain central to the premium rate approval process for the short to medium term. A move to a price monitoring framework is possible over the medium to long term. If the premium approval process is deregulated (which would require legislative change), risks relating to actual or anticipated non-approval by the Minister for Health would reduce or cease to apply, however the competitive tactics of private health insurers in relation to both quantum and timing of premium changes may become more variable and less predictable. 5 January

85 Government incentives and support Sticks and carrots support PHI participation Government targeting smaller carrots Australian Government policy boosts participation via incentives (taxes) and support (rebates) in PHI. No individual risk rating: PHI product is community rated with risk equalisation. Government policy is designed to encourage participation to ensure that sufficient young and healthy persons remain in the private health system to balance older and high cost policyholders. This ensures premiums remain affordable. PHI reduces pressure on the public health system: Government PHI initiatives and support also maintain a balance between public and private healthcare funding. Key features of the PHI industry which differentiates health insurance from other forms of insurance and other health insurance systems globally: 1) Government incentives 2) regulation of premiums 3) Community Rating There are a number of PHI industry features which differentiate health insurance from other forms of insurance and other health insurance systems globally, including: government incentives and support boost participation in PHI (reviewed below); regulation of premiums (reviewed in the PHI premium rate approval process section of this report); and community rating, risk equalisation and portability (reviewed in the Government PHI market controls section of this report). History of PHI participation Based on PHIAC data at Sept 2014 the penetration of PHI among the total population was: 47.2% for Hospital treatment membership; and 55.3% for Ancillary treatment membership (includes ambulance cover). Penetration has been steadily increasing since June 2005 at an average rate of ~0.5% p.a. This period of steady growth followed the introduction of government incentives and support that caused the level of PHI penetration to jump from ~30% in 1998 to 47.2% currently. Fig 122 Hospital treatment coverage (insured persons as a % of the population) Hospital Treatment Coverage (insured persons as % of population) 90.00% 80.00% 70.00% 60.00% Commonwealth medical benefits at 30% flat rate restricted to those with at least basic medical cover from September 1981 Introduction of Medicare from 1 February 1984 Introduction of Life Time Health Cover from 1 July 2000 Higher rebates for older persons from 1 April 2005 Introduction of 30% Rebate means testing from 1 July % 40.00% 30.00% 20.00% 10.00% Medibank began on 1 July A program of universal, non contributory, health insurance it replaced a system of government subsidised voluntary health insurance. 1 July A Medicare Levy Surcharge (MLS) of 1% of taxable income is introduced for higher income earners who do not take out private health insurance. 31 October Increase in MLS income thresholds, subject to annual adjustment. Introduction of 30% Rebate from 1 January % Source: PHIAC, January As the chart above illustrates, after Medibank s introduction in 1975, and the introduction of the Medicare Levy (set at 1.5% of taxable income) in February 1984, a material and steady decline in PHI coverage resulted as Medicare in effect became a free competitor against PHI. 5 January

86 % 20.3% 41.5% 44.6% 46.5% 52.5% 46.2% 53.8% 44.8% 52.2% 34.7% 40.1% 31.7% 38.2% 45.8% 50.3% 49.4% 54.1% 49.8% 55.1% 50.9% 56.0% 53.4% 57.8% 55.9% 58.8% 58.2% 58.9% 56.8% 54.2% 53.3% 47.9% 49.9% 42.0% 47.7% 36.7% 43.3% 31.3% 33.2% 31.9% Macquarie Wealth Management The government introduced the first round of carrot and stick legislative amendments in the late 1990s, designed to encourage the young and healthy to take up (and remain in) PHI PHI participation is lowest amongst the age group as: cover under family PHI policies may cease; LHC loadings do not yet take effect; the MLS may have limited application (due to lower income levels); and affordability may be an issue With the decline in PHI membership that resulted, coverage deteriorated to ~30% of the population, a level which threatened the very stability of the health system as privately insured demographics deteriorated and the funding and service burden in the public health system increased. It was at this point that the government introduced the first round of carrot and stick legislative amendments designed to encourage the young and healthy to take up (and remain in) PHI including: Portability: introduction of portability requirements obligating funds to recognise lapsed waiting periods for policyholders transferring from other insurers. Medicare Surcharge Levy: a surcharge levy for high income earners without private insurance first introducted in 1997 (modified 1 July 2012). PHI premium rebate: introduction of the 30% rebate on PHI premiums in 1999 and increased for those aged over 65 in 2005 (income tested from 1 July 2012). Lifetime Health Cover (LHC): a financial loading applied on top of PHI hospital premiums at a rate of 2% for every year a policyholder is aged over 30 when they take out hospital cover for the first time, up to a maximum of 70%. PHI participation rates are influenced by age and affordability, while individuals decisions to obtain or maintain PHI often relate to milestones such as establishing households, having children and retirement. Under the age of 70, PHI participation is lowest amongst the age group when cover under family PHI policies generally ceases, LHC loadings do not yet take effect, the MLS may have limited application (due to lower income levels) and affordability may be an issue. This group is also typically healthy, decreasing the probability of hospital admission (especially for elective surgery). Participation tends to increase strongly in the and age groups once the LHC loadings and tax incentives take effect, and due to family and lifestyle changes. Participation rates then slowly increase up to the age group. PHI participantion rates decline thereafter, possibly due to the retirement of the older population, which decreases income and may impact affordability. Fig 123 Hospital and ancillary penetration profile by age Penetration of PHI 60% Hospital Penetration Ancillary Penetration (ex Ambulance only) 50% 40% 30% 20% 10% 0% Source: Macquarie Analysis of PHIAC data, January Long term Australian Government initiatives The community rating of premiums necessitate government policy designed to encourage PHI participation to ensure that sufficient young and healthy persons remain in the system to balance older and high cost policyholders. This ensures premiums remain affordable. Government incentives and support for Australians to obtain and retain PHI also maintain a balance between public and private healthcare funding. The incentives and support are as follows: 5 January

87 Macquarie Wealth Management Medicare Levy Surcharge (MLS) The MLS, introduced 1 July 1997, provides an incentive for higher income earners to have private hospital cover by imposing an additional levy if PHI is not held. The rate of the MLS (1.0% to 1.5%) depends on an individual s income and is paid in addition to the Medicare Levy (1.5%) which is applied to all Australian taxpayers irrespective of income or PHI membership. The introduction of the MLS in 1997 appeared to have had no apparent impact on coverage, for those consumers earning an income above the threshold. The MLS presumably raised the effective level at which PHI was viewed as affordable (by virtue of the tax penalty if not insured) and therefore has more than likely contributed to the extent of uplift associated with the initial introduction of the 30% PHI rebate in Potential future changes to MLS: We estimate that there are currently ~200,000 persons paying the MLS (equivalent to ~1.6% of policyholders, or ~1yr new to policyholder growth). Other than in relation to the ~200,000 persons not currently paying the MLS, future adjustments to the MLS are not likely to have a major positive impact on policyholder numbers, particularly given a current PHI participation rate of ~47%. A higher MLS is more likely to act as a retention tool as it will encourage people to hold onto their PHI cover despite the income testing of the PHI tax rebate. Note that the removal of the PHI rebate from the LHC loading, increasing the effective price of PHI for persons that attract a PHI rebate, may partially offset the impact of a higher MLS. Lifetime Health Cover Loading (LHC) LHC, introduced 1 July 2000, encourages Australians to take out private hospital insurance earlier in life and to maintain cover. The system of LHC applies a financial loading to a hospital policy premium, increasing 2% for each year following a person s 31st birthday that hospital cover has not been purchased and maintained. For example, if you take out hospital cover at age 40 you will pay 20% more than someone who first took out hospital cover at age 30. The maximum loading is 70%. Once a policyholder has paid a LHC loading for 10 continuous years, the loading is removed as long as hospital cover is retained m policyholders (~10.6% of all hospital policyholders) were subject to a LHC loading in Sept Impact of LHC: As per the hospital and ancillary penetration chart above there is a significant increase in penetration between yr olds and yr olds. Combined with the introduction of the PHI rebate (discussed below) and the MLS, the LHC legislation had a meaningful impact on coverage (which rose from 30% to ~45%) as well as impacting member demographics. Fig 124 Percent of insured persons aged over 65 decrease reflects the combination of LHC, MLS and the PHI rebate introduced between % 14% 12% 10% 8% 6% LHC, MLS and PHI tax rebate introduced 4% 2% 0% Source: Macquarie Analysis of PHIAC data, January January

88 The revenue generated by LHC loadings is captured by the private health insurer LHC revenue impact: The revenue generated by the LHC loadings is captured by the private health insurer. While this would appear at face value to make such customers more profitable as they pay a higher premium there is an offsetting impact from new policyholders anticipating the need for certain treatment and taking out PHI in response. PHIAC also consider the impact of LHC loading on the PHI fund revenue. After the initially positive impact of the LHC introduction it is a moot point as to whether the threat of a higher cost in the future (as a result of LHC) will have any further meaningful impact on participation it arguably will have an impact on the wealthy (but then they are already largely insured as a result of the MLS) but not on lower income households where affordability today (not tomorrow) is the critical issue. The removal of the PHI rebate on the LHC may impact new member volumes. Fig 125 Income testing the PHI tax rebate and MLS changes Base Tier 1 Tier 2 Tier 3 Singles <$90,000 $90,001-$105,000 $105, ,000 >$140,000 Families <$180,000 $180, ,000 $210, ,000 >280,001 Rebate < age % 19.36% 9.68% 0 Age % 24.20% 14.52% 0 Age % 29.04% 19.36% 0 Medicare Levy Surcharge All ages 0.00% 1.00% 1.25% Note: The PHI rebate shown above is effective from 1 April 2014 to 31 March 2015 only. Capping of the rate of growth in the PHI rebate at the lower of CPI or the PHI premium increase will see the PHI rebate % shown above fall each year on 1 April. Source: 2014/15 Federal government budget, Australian Tax Office. PHI premium rebate The PHI rebate, introduced in 1999 at 30% for all policyholders irrespective of income, is a rebate provided by the Australian Government to subsidise Policyholders in covering the cost of PHI premiums. When initially introduced the PHI tax rebate scheme directly reduced the cost of all premiums by 30% with a higher rebate subsequently introduced on 1 April 2005 for older people (35% for those aged and 40% for those aged 70 and above). Following changes in Government policy the PHI rebate is now subject to income testing and varies by age. Combined with the MLS and LHC the introduction of the 30% rebate stemmed the decline in coverage as it improved the affordability of PHI materially. Recent changes to long term Australian Government initiatives The Australian Government has recently made a number of policy changes that seek to achieve healthcare expenditure savings by reducing the cost of Australian Government support for the PHI rebate. The key changes are: Income testing of the PHI rebate Income testing of the PHI rebate has been in effect since 1 July 2012 and is subject to age, and number of children covered under the policy. The full PHI rebate is available to individuals earning $90,000 or less annually and families earning $180,000 or less annually. Policyholders begin to see the contribution from the Australian Government step down as their income increases above $90,000 for singles and $180,000 for couples/families (see detail in the table above). For eligible Policyholders, the rebate differs based on age and income thresholds and ranges between 9.68% and 38.72% of the premium (above the top income threshold no rebate applies). Rebates are a material consideration for policyholders. Family cover: an average Medibank Hospital Cover premium for a family cost ~ $4,000 in Assuming a 29% rebate, the premium decreased to ~$2,800. Singles cover: an average Medibank Hospital Cover premium for an individual cost ~$1,900 in Assuming a 29% rebate, the premium decreased to ~$1, January

89 Few policyholders would benefit financially from outright dropping (lapse) their PHI coverage in response to the loss of the PHI rebate (as a result of the MLS) but there has been an increase in the level of switching and downgrading of coverage in response to policy changes. Capping of the rate of growth in the PHI rebate The growth in the rebate will be capped to no more than the consumer price index From 1 April 2014, rather than the PHI rebate continuing to increase in line with premium rate increases, growth in the rebate will be capped to no more than the CPI. The rebate contribution from the Australian Government will increase based on a weighted average ratio. The weighted average ratio is determined using a formula which takes into account growth in the CPI and the industry weighted average premium increase. We illustrate the combined impact of the income testing of the PHI rebate and the capping of the rate of growth in the PHI rebate in the chart below. Fig 126 Illustration of acceleration in effective dollar value of premium as a result of PHI rebate income testing and PHI rebate growth caps 4,500 4,000 3,500 3,000 Net Premium (>140,001 income, no PHI rebate) Net Premium (105, ,000 income, rebate indexed to CPI) Net Premium (90, ,000 income, rebate indexed to CPI) Net Premium (<90,000 income, rebate indexed to CPI) Net Premium (Pre-rebate indexation and income testing) Impact of income testing the PHI rebate 2,500 2,000 1, Assumptions: The acceleration in effective premium rate from policy changes in the illustration is based on Medium level Hospital and Ancillary cover with a $300 excess for a single person in NSW with no dependents. The $1,680 net premium (net of the 30% PHI rebate impact) in 2013 assumes the policyholder prepaid their 2013 premium to qualify for the PHI rebate in the 2012 tax year. In subsequent years we assume annual PHI premium rate growth of 6% p.a. and inflation constant at 2.5%. Source: Macquarie Research, January For policyholders that continue to receive the PHI rebate, this policy change will have the effect of increasing the rate of growth in PHI premium rates above the headline premium rate increase as the rebated percentage of the PHI premium will fall. The impact is that from 1 April 2014 only 96.8% of the premium paid (excluding the LHC loadings) attracts a rebate and in subsequent years the percentage of the premium paid that attracts the PHI rebate will continue to fall should PHI premium rates increase faster than CPI, as expected. Removal of the government rebate on LHC loadings For policyholders with high LHC loading rates this policy change has the potential to push PHI premiums above the level of the MLS reducing the incentive for PHI, increasing the risk of downgrading or lapse As of 1 July 2013 policyholders that are currently paying a LHC loading, the PHI rebate no longer applies to the LHC component of the PHI hospital cover premiums. Policyholders continue to receive the rebate on the standard component of the PHI hospital cover premium, subject to income testing. For policyholders with high LHC loading rates this policy change has the potential to push PHI premiums above the level of the MLS reducing the incentive for PHI, increasing the risk of downgrading or lapse. Assuming these policyholders are average claimants this would exacerbate the negative impact on PHI funds profitability as these policyholders pay a higher premium due to the loading, for the same level of cover. We note however that the PHI fund annual PHIAC pricing and product submissions detail the impact of LHC loadings on premiums and the impact is therefore incorporated into the current PHI premium approval process, and overall industry profitability. 5 January

90 The policy change may also discourage new policyholders entering the system who would be subject to the LHC loading as the price for these potential policyholders has effectively increased. Freezing the indexation of the income tiers for the MLS and PHI premium rebates for three years likely to result in downgrading Freezing the indexation of the income tiers for the MLS and PHI premium rebates Government policy changes freezing the indexation of the income tiers for the MLS and PHI premium rebates for three years from 1 July 2015 will result in more people being pushed into the high income tiers, and receiving lower PHI premium rebates. Previously, the income tier thresholds are indexed every year by average weekly ordinary time earnings. As has been seen, at least somewhat in response to the income testing of the PHI rebate, policyholders have been downgrading their level of cover and we expect a similar response as policyholders drop down a PHI rebate tier. Conclusion: Government PHI incentives and support will continue, albeit with further changes possible to target assistance to lower income earners and the young. Despite a series of measures that target Government support for the PHI sectors away from higher income earners and that limit the growth in PHI fiscal support, government policy providing incentives and support for participation in the PHI sector are central to the stability of PHI. We expect this support to continue given the supplementary role that PHI provides in the financing of healthcare in Australia. Health spending has outstripped that of education and welfare As discussed above Federal Government policy changes, consistent with previous PHI policy adjustments, seek to reduce and limit growth in government PHI fiscal support, while maintaining PHI participation. The initiatives reflect the growth in health spending relative to other major components of government expenditure (i.e. education and welfare) illustrated below. Fig 127 Aust. Governments expenditure change to (% above CPI & relative to GDPg) Notes: Categories shown are the 10 largest expenditure categories for Other comprises all expenditure not elsewhere included, including (from largest to smallest) community services, government operations, superannuation, disability services, emergency services, foreign affairs, climate change and environment, employment, legal, immigration and customs, arts and sport, housing, emergency services, communications, and water Source: Grattan Institute analysis of Commonwealth and State budget papers for and A moderation in the growth of government health funding should strengthen the position of PHI as individuals utilise PHI to meet their healthcare needs. Reduced federal support for state government heath budgets and patient contributions to the cost of healthcare should positively influence consumers PHI decisions. The perception that public hospital funding does not meet consumer demand (a perception largely created through public hospital waiting lists) is likely to increase following recent changes. 5 January

91 Government PHI market controls Premiums are community rated supported by risk equalisation Health funds cannot refuse cover or individually risk rate premiums Community rating: no Australian can be refused a PHI policy, or particular product features, or asked to pay a higher premium/be offered a discount beyond prescribed limits (subject to some limited exceptions e.g. Lifetime Health Cover loading, rebates by age) because of past claims history, age, medical history (including preexisting conditions) or lifestyle choices. Waiting periods are also regulated. Risk equalisation arrangements support community rating. Through risk equalisation, private health insurers share some of the claims expenses of Policyholders aged over 55 and high claiming Policyholders so that no fund is adversly disadvantaged based on the risk profile of their policyholder base. Government intervention supports the community rating system: MLS, PHI rebate, LHC loading ensure that the young/relatively healthy remain in the system. PHI operates alongside the simultaneously available taxpayer funded ( free ) public health system No The risk objective rating in of PHI the Community due to Community Rating principle Rating is to ensure that PHI is accessible and affordable A unique feature of the PHI market is that the system operates alongside the simultaneously available taxpayer funded public health system. PHI provides a supplementary role in the financing of Healthcare in Australia. Key financing priorities for PHI include achieving universal access, equity in service provision, as well as containing the cost of health services. The operation of the PHI system alongside the public healthcare system and the Government priorities for PHI means that rules under which PHI funds offer policyholder coverage are highly regulated. Central to this regulation is: community rating; risk equalisation; portability and waiting periods government intervention including MLS, PHI rebate, LHC loading (discussed in the previous section of this report); and medical gap legislation. In combination the above regulation is central to the PHI sector. Anti-discrimination requirements are designed to ensure that PHI products are available to all residents irrespective of risk factors which might ordinarily impact upon their insurability. Community rating is a key feature of PHI regulation in Australia The principle of community rating requires that the PHI premium, and the cover that is provided under the PHI product, are standardised (subject to LHC loading, PHI rebate and / or state / territory premium differences). The objective of the community rating principle is to ensure that PHI is accessible and affordable. PHI premiums cannot risk rate or price premiums at actuarially determined levels for an individual. This means that a private health insurer cannot discriminate by varying PHI premium rates or refusing to insure or sell any policy on the basis of an individual s: health (including pre-existing conditions, although waiting periods may apply just as for other policyholders new to PHI); age; gender; lifestyle choice; or propensity to make a claim (medical history). Product design may target a particular age group, for example by excluding cover for procedures that younger policyholders are unlikely to need. These products are nonetheless open to policyholders of all ages and PHI premiums for these products do not vary with age. 5 January

92 The cross subsidisation inherent within a community rating system (with risk equalisation discussed below) requires significant government intervention (MLS, PHI rebate, LHC loading) to ensure that the young and relatively healthy join and remain in the system. Risk Equalisation supports Community Rating, pooling claims from over 55 s and high cost claimants This enables the inherent mispricing of older and/or more chronically ill members to be shared across a large number of young and healthy so that the product remains affordable. Risk Equalisation Trust Fund The Risk Equalisation Trust Fund arrangements support the community rating principle. Through the risk equalisation, private health insurers share some of the claims expenses of Policyholders aged over 55 and high claiming Policyholders. Risk equalisation does not equalise all risk factors associated with higher claims expenses and does not completely remove the benefit of having a lower claiming Policyholder base or the commercial incentive to achieve operating efficiencies. The current risk equalisation arrangements, effective since 1 April 2007, are based on: an aged-based pool, as per the table below, with risk redistribution rates varying by age bands. Applicable claims include costs paid for hospital and hospital-substitute, and medical costs associated with those hospital services, as well as eligible claims paid for chronic disease management programs. A residual high cost claimants group (i.e. calculated after the aged based pool) pools 82% of net claims in excess of a $50,000 claims threshold. The high cost claimants pool limits the net claims expense to a PHI from a single Policyholder to a maximum of $50,000 plus 18% of that Policyholder s claims in a rolling 12 month period. Fig 128 Age based and High cost claimant pool Age cohorts Age based claimant pool % of eligible benefits included in pool from $0 - $50,000 High cost claimant pool % of eligible benefits included in pool above $50, % 82.0% % 82.0% % 82.0% % 82.0% % 82.0% % 82.0% % 82.0% % 82.0% (rolling 12mths per person post age based pool) Source: PHIAC, January MPL retains the greatest percentage of its claims versus other PHI funds via direct claims The scheme works by pooling and redistributing each funds proportion of eligible claims expenses, so that each individual PHI s exposure to those expenses is adjusted to match its market share. Separate risk equalisation pools operate within each state and territory. The redistribution is calculated based on the average benefit paid by private health insurers (per state) to policyholders in their age-based pool (policyholders over the age of 55) and the high costs claimants pool (claims exceeding $50,000 each). Fig 129 risk equalisation Risk eq receipts Risk Equalisation receipts (A$m) Risk Equalisation receipts as % of gross claims % 2.3% % Risk Eq receipts (% of gross claims) 2.5% 2.0% 1.5% 1.5% % 0.5% 0 0.0% FY12A FY13A FY14A FY15E Source:, January January

93 The chart above highlights s net receipts from risk equalisation and the expected reduction in risk equalisation in FY15 following strong ahm policyholder growth. PHIs pay or receive a levy into or out from the RETF on a quarterly basis so that a PHI that paid a higher proportion of risk equalised benefits than its overall market share average will have an amount receivable from the RETF, whereas a PHI that paid a lower proportion than its overall market share will have an amount payable to the RETF. The chart below illustrates the impact of risk equalisation on the percentage of a funds claims that are retained by different PHI funds (assuming the same age based distribution for each health fund in practice the average age of policyholders will vary between health funds). Due to having the largest market share, retains the greatest percentage of its claims versus other PHI funds via direct claims and the allocation of the Risk equalisation redistribution based on market share as illustrated in our review of the operations in the operational analysis of this report. Risk equalisation results in private health insurers with lower-claiming policyholders typically those who are younger and healthier usually being net contributors to the scheme while private health insurers with higher claiming policyholders typically those with older, less healthy policyholders tend to be net receivers from the scheme. The risk equalisation scheme largely reflects the age profile of each PHI fund as illustrated previously in the domestic benchmarking section of this report. The current risk equalisation structure is an iteration of the previous arrangements originally known as reinsurance (the 1976 Hospital Benefits Reinsurance Trust Fund). Fig 130 Summary of previous risk equalisation arrangements Who is subsidised? Subsidy Amount Who pays subsidy? 1959 Insureds with chronic illness or preexisting conditions, or requiring hospitalisation beyond a limited period Claimants eligible for subsidy are grouped into a special account Subsidy covers the differences between premiums and the insurer s costs for these claimants However, the special account only covered standard benefits, which were often less than the actual cost of care. Commonwealth Government 1976 Insureds requiring hospitalisation beyond a limited period 1989 Insured aged over 65, and under 65s requiring hospitalisation beyond a limited period 1995 Insured aged over 65, and under 65s requiring hospitalisation beyond a limited period Insureds aged over 55, and insureds with very high claim costs Subsidy covers full cost of eligible claims Subsidy covers full cost of eligible claims Subsidy reduced to 79% of eligible claims as an incentive to control costs Subsidy varies depending on age of claimant, varying from 15% for year olds to 82% for over 85 year olds Insurers based on membership However, insurer costs are reduced by Commonwealth Government subsidies of $50 million to $100 million per year until 1983, with much lower subsidies in later years. Insurers based on membership (government subsidies now minimal) Insurers based on membership Insurers based on membership Source: Finity Consulting: Risk Equalisation 2020 is the current system sustainable? Risk equalisation payments have increased as a percentage of total claims as per the charts below. 5 January

94 Claims ($bn) % of Claims Equalised % of Claims Equalised Macquarie Wealth Management Fig 131 Proportion of hospital costs shared through risk equalisation 55% 50% Historical maximum: 46% (1994) High 45% 40% 35% Low 30% 2020F 2018F 2016F 2014F Year Ending 30 June Source: Finity Consulting: Risk Equalisation 2020 is the current system sustainable? Fig 132 Historical hospital benefits paid and risk equalisation New RE arrangements Lifetime health cover introduced New RE arrangements 60% 50% 8 40% 6 30% 4 20% 2 10% 0 0% Year Ending June Hospital Claims Paid Claims subject to risk equalisation Risk equalisation % Source: Finity Consulting: Risk Equalisation 2020 is the current system sustainable? Portability: Policyholders can switch policies between funds Portability and waiting periods The PHI Act guarantees Policyholders portability. This means Policyholders can switch PHI policies between private health insurers that offer similar or equivalent levels of cover without having to re-serve waiting periods. However, PHI s may impose a waiting period for any extra benefits or services on a new PHI product when the cover is upgraded. For any services where the entire waiting period has not been served on the previous PHI product, the balance will generally need to be served with the new private health insurer. The PHI Act provides maximum periods for which Policyholders can be required to wait before they can claim Hospital Cover benefits in the event they transfer from one policy to another or obtain new PHI policies. Waiting periods that are part of Extras Cover are not regulated. 5 January

95 Gap legislation enables PHIs to cover doctor s charges above the prescribed MBS fee for in-hospital services provided If the agreement between the insurer and specialist provider does not cover all costs, an out-of-pocket contribution (gap payment) will need to be made by the patient Medical gap legislation Medical gap legislation, introduced in 1995, enables PHIs, doctors and hospitals to negotiate the benefits to be paid to privately insured patients. The gap legislation enables PHIs to cover doctor s charges above the prescribed Medicare Benefits Schedule Fee for in-hospital services provided the PHI has a contractual arrangement with the doctor or the hospital the legislation was designed to increase the value of PHI to the consumer and encourage greater supply-chain efficiency for industry participants. The Australian Government makes contributions to the cost of medical services provided to privately insured patients in the form of Medicare benefits for medical services related to a hospital or hospital-substitute episode of care. For privately funded services, the Government provides a rebate of 75% of the Medical Benefits Schedule fee. Insurers pay medical benefits for in-hospital services provided by medical specialists. The amount that insurers pay toward these costs will depend on the Government contribution for the service (75% of the Medical Benefits Schedule fee) and the agreement the insurer has with the specialist provider. If the agreement between the insurer and specialist provider does not cover all costs, an out-of-pocket contribution (gap payment) toward the cost of the service will need to be made by the patient. The gap legislation was amended further with the August 2000 introduction of the Gap Cover Scheme which does not require a contract to exist between an PHI and a doctor (making it more attractive for many medical practitioners). Out of pocket expenses or gaps for medical services highlights the importance of the medical gap legislation. According to PHIAC, in FY13, 89% of all medical services did not require a gap payment to be made by the patient. Out-of-pocket costs, or gaps, is a common cause of complaints and disputes between the insurers and policyholders. Confidence in the private health care market is critical to keep policyholder numbers up and controlling out-of-pocket costs is an important part of this. On average, the out-ofpocket payment for the 11% of medical services where a gap payment was required to be made was $182. At June 2013, 80% of privately insured people were covered by a policy that required either an excess or co-payment for hospital treatment, an increase of 1.1ppts over the year. The proportion of policies that have exclusions has declined in recent years, from 24.4% in FY11 to 22.0% in FY13. Fig 133 Increasing proportion of policies with excess and co-pay arrangements % of policies with exclusions 30.0% 25.0% 20.0% 15.0% 10.0% 5.0% 0.0% % of policies with excess and % of policies with exclusions (LHS) co-payments 85.0% % of policies with Excess and Co-payments (RHS) FY08 FY09 FY10 FY11 FY12 FY % 75.0% 70.0% 65.0% Fig 134 While services with known gap payments remain limited Average Gap payment $200 Average gap payment (LHS) % of services with gap (RHS) % of policies with a known gap payment6.0% $180 $ % $ % $120 $ % $80 $60 2.0% $40 1.0% $20 $0 0.0% FY08 FY09 FY10 FY11 FY12 FY13 Source (for all above): Macquarie Analysis of PHIAC data, January January

96 Commission of Audit proposals Health funding was a central Commission of Audit consideration Commission proposals would be positive for PHI if adopted as health policy The size, growth and government contribution to the funding of health services means that the health system will always be central to any review of the national fiscal position and outlook. The Commission stated there is a strong and vibrant health insurance market, and governments should not act as the insurer of first resort. The National Commission of Audit proposed a number of reforms to the PHI sector. While the Commissions proposed reforms would most likely be positive for the PHI sector, many of the proposals are of a long term nature, requiring significant government, industry and community consultation. There is likely to be substantial debate, which may see some of the reforms not adopted as government policy. Even among PHI funds a consensus view on proposed reforms may not emerge. We review the key reform proposals below. National Commission of Audit terms of reference The National Commission of Audit was established to review the performance, functions and roles of the Commonwealth government. The terms of reference were that the Federal budget should achieve a 1% surplus of GDP prior to Given the growth in healthcare expenditure, the combination of the following make it unsurprising that the health system was a major consideration of the Commission report: governments account for ~68% of total Australian healthcare expenditure; healthcare expenditure accounts for ~20% of combined governments expenditure; and Healthcare expenditure has been growing, and is forecast to continue to grow at a rate in excess of GDP growth Increasing the MLS from 1.0%-1.5% to 3.0%-3.5%, would effectively make PHI mandatory for high income earners healthcare expenditure has been growing at a rate in excess of GDP growth and is forecast to continue to do so (Australian Institute of Health and Welfare predict government and private health spending will rise by another 3% of GDP over the next 20 years). Of the three major components of government expenditure (Health, Education and Welfare), only healthcare expenditure has been growing at a rate in excess of GDP growth and is forecast to continue to do so on current policy settings. Commission proposed reform proposals Overall the Commission stated, there is a strong and vibrant health insurance market in Australia, and therefore governments should not act as the insurer of first resort. Mandatory PHI: would be positive for industry volumes The Commission proposed Mandatory PHI for high income earners by increasing the MLS from 1.0%-1.5% to 3.0%-3.5%, effectively making PHI mandatory. Volume impact: There are currently ~200,000 persons paying MLS (~1.6% of PHI policyholders, the equivalent of ~1yr new to PHI policyholder growth). A higher MLS would also ensure the growth in PHI premiums does not result in a larger percentage of the population becoming in different between acquiring PHI or paying the MLS. Profitability potential: As these persons would attract the LHC loading should PHI become mandatory following an increase in the MLS they would most likely be relatively profitable customers, assuming they are average claimants. Note that the removal of the PHI rebate from the LHC loading, increasing the effective price of PHI for persons that attract a PHI rebate, may partially offset the impact of a higher MLS in terms of attracting policyholders. The charts below illustrate that an increase in the MLS would create added financial incentive for those persons where the MLS amount and PHI cost is currently only marginally different. 5 January

97 $0 $10,000 $20,000 $30,000 $40,000 $50,000 $60,000 $70,000 $80,000 $90,000 $100,000 $110,000 $120,000 $130,000 $140,000 $150,000 $160,000 $170,000 $180,000 $190,000 $200,000 $0 $20,000 $40,000 $60,000 $80,000 $100,000 $120,000 $140,000 $160,000 $180,000 $200,000 $220,000 $240,000 $260,000 $280,000 $300,000 $320,000 $340,000 $360,000 $380,000 $400,000 Macquarie Wealth Management Adopting the reform would require legislation. This proposal would impact on the government budget (i.e. loss of MLS revenue and increase PHI rebate costs). A mandatory PHI for high income earners would increase debate about a two-tiered health system. Fig 135 A 3% MLS would effectively make PHI compulsory for individuals earning over $90,000 $7,000 Basic PHI singles policy ($90 per month) $6,000 Current MLS (Singles) $5,000 Proposed MLS (Singles) $4,000 $3,000 $2,000 $1,000 $0 Fig 136 A 3% MLS would effectively make PHI compulsory for families earning over $180,000 $16,000 Basic PHI Family policy ($190 per month) $14,000 Current MLS (Family) $12,000 Proposed MLS (Family) $10,000 $8,000 $6,000 $4,000 $2,000 $0 Note: this analysis assumes no rebate on premiums given the uncertainty around the future of the rebate for high income earners. Source: PrivateHealth.gov.au, Macquarie Research, January Replacement of the current premium approval process with a monitoring framework would increase incentives for PHI funds to reduce claims costs Allowing health funds to cover primary care settings would make it possible for health funds to be more aware of members health risks Deregulation of premium rate approval and efficiency incentives The Commission proposed replacement of the current Ministerial approval of PHI premiums with a monitoring framework and increasing incentives for PHI funds to reduce claims costs and management expenses. We consider the potential for the deregulation of the premium rate change process for PHI in the PHI premium rate approval process section of this report. Prospective risk equalisation The Commission proposed a prospective risk equalisation (from the current retrospective arrangement) to incentivise PHIs to invest in preventative care and disease management. Under the current retrospective risk equalisation structure the largest market participants have the greatest incentive to invest to reduce claims cost as they capture the greatest proportion of the savings. A change to the risk equalisation structure has been petitioned by some PHI funds as a key plank of increasing efficiency. A prospective risk equalisation program would continue to equalise for age, through an upfront payment based on the likely policyholder claims, but would enable the insurer to keep/share benefits from improved outcomes. Introduction of limited risk rating The Commission proposed introduction of risk rating of certain lifestyle choices, such as smoking, when calculating premiums. In addition, the Commission proposed PHIs could offer incentives for positive health choices through premium discounts. This would be a relatively straight forward change as discounts are already offered on PHI premiums. PHI funding of primary care (GP services) The Commission proposed PHI funding of GP services and this proposal has broad support across the industry. The current rules prevent PHI s from covering primary care settings, including medical items and services provided through the Medicare Benefits Schedule. This limits the health funds ability to assist in improving the health outcomes of the elderly and chronically ill at the point of diagnosis, which is usually when they initially visit their local doctor. Allowing health funds to cover primary care settings would make it possible for health funds to be more aware of members health risks. Funds could assist members to manage chronic conditions in out-of-hospital settings. 5 January

98 Any change to the coverage of primary care by PHI funds would result in operational risks as health funds have not had to manage relationships with GP s under the current product structure. There would also be significant public debate in respect of any such changes. Longer term targets of a whole of life model The Commission proposed longer term targets of a whole of life rather than an episode to episode approach to health care, principally achieved through the broadening of PHI s role in the health sector to coordinate GP s (also considered above), hospitals and specialists to deliver a more efficient outcome. The use of preventative care and the ability to plan for major episodes is a critical step in minimising system costs and improving the level of care for individuals. This initiative would require significant changes to the system, and is naturally a longer term prospect. PHI is cast as central to Healthcare funding and efficiencies While there is likely to be substantial debate about the reforms, and a consensus view may not emerge, we consider the proposed reforms support: 1) increased PHI growth, via proposed Mandatory PHI for higher income earners; 2) reduced risk of PHI margin decline, based on the proposal that the Minister no longer approves premium rate increases, as the sector shifts to a price monitoring framework (although fund pricing behaviour may become increasingly uncertain); and 3) increased PHI net margins, based on the proposal of providing incentives to invest in programs which increase efficiency. The Commission proposals would significantly expand the scope PHI funds operations but are not without risk (e.g. PHI funds have not had to manage relationships with GP in the past). Commission: Funding of healthcare expenditure The Commission report highlighted the pressure from increased healthcare expenditure on the funding of healthcare provision. Productivity Commission projections suggest Commonwealth Government spending on health will rise from around 4% of GDP in to 7% in Fig 137 Projected growth in Commonwealth health spending Source: National Commission of Audit, January Health expenditure by State governments is projected to rise from around 2.5% of GDP to almost 4% of GDP over the same period. Other research projects similar trends. Health care spending represents the Commonwealth s single largest long-run fiscal challenge, with expenditure on all major health programmes expected to grow strongly to and beyond. 5 January