Medibank & NIB: Result 2016

In Medibank faces big hurdles, we explained how a 6% a year increase in the price of private health insurance policies over the past decade – far higher than wage growth – has made affordability an issue for many Australians. Medibank Private's customers have responded by downgrading to cheaper products or letting their policies lapse.

Unfortunately, Medibank's latest full-year result suggests that the issue isn't just here to stay – it's getting worse. The number of policyholders fell 2.6% overall to 3.8 million people, and fell 3.8% for the core Medibank brand. This compares to a 2% fall in the total number of members for the first half of the financial year, and flat member numbers in 2015.

‘Member switching between health insurers increased further in the period and the Medibank brand's underperformance in this segment was the largest contributor to the market share reduction in 2016,' said management.

What wasn't mentioned is that member switching is basically happening in one direction. Around 59,400 customers abandoned Medibank this year – a whole stadium full, as one broker put it – and 19,500 of them found their way to smaller competitor NIB, despite it being just a quarter of Medibank's size.

The number of NIB policyholders increased 3.8% over the year, compared to total industry growth of 1.3%. NIB's strategy of targeting young people by offering cheaper products with lots of exclusions has grown its market share for 16 consecutive years.

Don't get attached

Declining policyholder numbers is an anchor on Medibank's total revenue, which increased 2.5% to $6.7bn thanks to higher prices. Thankfully, the 4% increase in premium revenue was a decent clip above the 1% increase in claims – meaning gross profit jumped 22% to $1.0bn, and the gross margin rose from 14.2% to 16.6%.

The only trouble is that when it comes to private health insurers, wide margins attract the wrong kind of attention. Private health insurance premiums are highly regulated, with insurers needing approval from the Minister of Health before raising prices.

Gross margins for the industry have been extremely stable at around 15% over the past decade, which suggests that this is the level of profitability targeted by the Department of Health. Medibank's above average margin, low claims growth, and increasing affordability issues all point to one thing – we shouldn't get too attached to that 16.6% margin. It's a safe bet that the Government will choose to slow premium growth in future years and squeeze Medibank's margins before it lets a lack of affordability push people back to the overburdened public health system.

Underwriting strong

The growth in NIB policyholder numbers and rising prices led to a 14% increase in revenue to $1.9bn. As with Medibank, growth in claims was below premium revenue growth, so NIB's gross margin increased from 13.3% to 14.9%, while operating profit rose 50% to $132m. Medibank had an even stronger underwriting result, with operating profit of $511m, an increase of 54%.

We were also encouraged by Medibank's decrease in the proportion of revenue that goes to management expenses, which fell from 8.6% to 8.4%. Management said the improvement was due to cost cutting initiatives.

Improving the management expense ratio was one of the big promises Medibank made when it was privatised in 2014. Having come down from 9.1% in 2014, we're pleased to see management making good on that promise.

Investments sting

Both insurers hit a rough patch with their large investment portfolios. NIB's net investment income fell 46% to $17m, while Medibank's fell a slightly less horrific 37% to $59m. Both companies put it down to lower interest rates on their fixed income investments and lower returns from stocks.

What concerns us, however, is that both companies increased their portfolio allocation to risky assets, such as equities. NIB had 14.5% of its $672m portfolio in risky assets, up from 10.9% last year, while Medibank's $2.4bn portfolio had a more worrisome 24.5% allocation to risky assets, compared to 23.8% last year.

A high allocation to stocks does wonders if share prices move higher, but it also makes the portfolios – and overall net profit – much more exposed to volatile swings in the share market.  

With the Reserve Bank's recent decision to reduce interest rates to their lowest level since the 1960s, we expect returns from both insurers' investment portfolios will be dismal for some time yet, which makes growing revenue and profitable underwriting even more important.

NIB's management expects underlying operating profit of $130–140m for 2017. ‘[2016] will be a hard act to follow and the pressures of competition and premium affordability means pressure on margins. We'll be looking more towards growing our top line across the Group and additional new business opportunities to create shareholder value,' said chief executive Mark Fitzgibbon. We're increasing NIB's price guide and, with a price-earnings ratio of 23, we continue to recommend you HOLD.

Medibank's management didn't provide specific guidance for 2017, but did flag slower premium growth and that the company would continue to lose market share. While we were pleased to see Medibank achieve a meaningful improvement in margins over the past year, we expect them to shrink over the medium term and we're concerned by the ongoing loss of customers. With this in mind, the lower price-earnings ratio of 19 isn't enough to temp us and we're sticking with HOLD.