Health insurance cage match: NIB v Medibank

Of all the money you’ll spend on healthcare during your lifetime, 30% will likely go towards keeping you alive the final six months.

For government budgets, this is a growing problem. As technology advances, new treatments are being developed to extend life: more tests, more drugs and more specialist services. That’s great for those needing treatment, but it all comes at a cost to the system.

Government health spending has risen 74% over the past decade, now accounting for 19% of the Australian budget, and it’s getting too much to bear. As a result, the Government is increasingly relying on private health insurers (PHIs), funnelling a growing pool of customers towards the industry with financial incentives such as the private health insurance rebate.

Despite this growth, regulatory barriers to entry have kept the industry remarkably concentrated – the top five insurers account for nearly 85% of the market. Fifth on the list, NIB Holdings, is Australia’s only listed PHI but this may not be the case for much longer.

Medibank takes the stage

The new federal government is keen to float the industry heavyweight, Medibank Private, to raise at least $4bn in what would be the biggest privatisation since Telstra. Medibank’s market share of 30% – four times that of NIB – is sure to get investors salivating.

You’d think this kind of market dominance would give Medibank a big advantage over the other players, but that’s not the case here as it’s almost impossible for PHIs to compete on price. Regulation forbids the discounting of premiums by more than 12% and any increases require approval from the Minister of Health, whose priority is, at least in principle, to protect the public from unfair pricing.

PHIs instead compete on product differentiation, offering a mix of inclusions and exclusions that’s as finely graded as they can administratively handle. The result has been an explosion of advertising and product variety. Marketing expenditure has increased 160% over the last six years and there are now more than 28,000 different health insurance policies for you to choose from.

Most people now find the comparison process extremely difficult. This makes insurance policies some of the stickiest purchases consumers will make (so it’s a good idea to first visit the comparison website www.privatehealth.gov.au). Only around 5% of policyholders switch in any given year – a figure that’s significantly lower than the 8-10% switching rate for other financial products such as life insurance and bank accounts.

Lean and mean

NIB takes full advantage of this by targeting members when they are young and healthy (via low-cost policies with lots of exclusions) and then upgrading them to more profitable products as they age and need more services to be covered.

This strategy has been extremely effective and the company now has a disproportionate share of the under-35s market. What’s more, NIB has grown its overall market share every year for the past 14, and now accounts for 7.5% of total policies nationally and 15% in its home state, NSW.

While they have similar capital ratios, NIB runs a much leaner and meaner operation than Medibank with one of the highest returns on capital in the industry – 18% compared to Medibank’s 13%. NIB also has the second-highest operating margin of the big five insurers – around 5.5% compared to 3.5% for Medibank.

Medibank’s low profit margin means it’s more reliant on returns from its $1.5bn investment portfolio. Investment returns made up 44% of the company’s profit this year, compared to 30% for NIB. Medibank’s portfolio also has twice the exposure to equities, so earnings have been more volatile. As a Government-owned institution that’s not a problem, but private investors may not have the stomach for wild profit swings.

Negotiating power

Where Medibank does have a formidable advantage is in negotiating better prices for services with hospitals. The private hospital industry has consolidated significantly over the past decade, and large operators such as Healthscope and Ramsay Health Care now have much more bargaining power.

Historically, the hospitals never posed much of a threat as insurers could maintain profitability through the granting of higher premiums in the ministerial approval process. However, the average allowed premium increase in 2013 was 5.6% – significantly less than the 9.3% rise in benefits paid by the PHIs to their members in 2012. Premium increases have far outpaced the consumer price index over the past decade and the Minister may be less inclined to let that trend go on as the voters begin to grumble of high prices.

If hospitals continue to add cost pressure, and the Minister refuses premium increases, the PHI’s will see their margins squeezed and returns on capital decline. Still, while these risks are real, we feel the huge cost of providing medical care to an ageing nation will leave the Government with no choice but to side with the insurers.

If Medibank were to list for the rumoured $4bn it would be 17 times this years earnings. This doesn't scream buy to us at the moment but we’ll review the company again should a float be formally announced. In the meantime, NIB has a respectable strategy and is one of the most efficient operators in an industry predestined to grow in importance. We’d love to own it at the right price, but at 17 times 2013 earnings per share and three times book value, NIB only offers fair value. HOLD.