Medibank faces big hurdles

Something curious happened back in January: Medibank Private (ASX:MPL) asked the Government if it could earn less money. But before I get to how and why, it helps to have a little context.  

Private health insurance premiums are tightly regulated, with insurers required to get approval from the Minister of Health before raising prices. Historically, premiums have been allowed to rise in line with claims to maintain relatively stable underwriting margins.

But this is now causing problems. Premiums have increased 6% on average over the past decade for the industry as a whole, which is far higher than wage growth. That's making affordability an issue.

Generous premium increases have historically supported revenue growth for Medibank, but its customers have responded by downgrading to cheaper products or letting their policies lapse.

The proportion of members who let their Medibank policies lapse in 2015 rose from 10% to 11%, causing the number of policyholders under the core brand to fall 2%. Medibank's cheaper AHM brand has been growing strongly, but it has its own set of shortcomings. AHM's lapse rate of 16% is well above Medibank's as a whole, which suggests even less customer loyalty.

Overearning

So where does that leave shareholders? Medibank had a gross margin of 17.2% in the 6 months to December 2015, but we doubt it will last. Gross margins for the industry have been extremely stable at around 15% over the past 10 years, which suggests that this is the level of profitability targeted by the Department of Health.

Our bet is that the Government will squeeze private health insurer margins back to this level, if not lower, before it lets a lack of affordability push people back to the overburdened public health system.

After some prodding by health minister Sussan Ley in January, all the major health insurers – including Medibank, Bupa and NIB (ASX:NHF) – resubmitted their 2016 premium round applications to request lower premium growth. As a whole, the industry received approval for a 5.59% increase in premiums this year, which is the lowest it's been in four years.

Two things are likely to happen from here. We expect the gross margin to revert to around 15% in the medium term and premium growth to slow further. That should help with the lack of affordability, but high lapse rates seem to be here to stay.