Medibank & NIB: Result 2017

Australia's two listed private health insurers follow very different strategies. The largest, Medibank Private, is your typical premium provider, complete with all the insurance bells and whistles one could desire. Competitor NIB, on the other hand, is focused on the basics and targets the young. Their results show who plays the better hand.

Medibank increased premium revenue 1.2% in the year to June, while claims rose just 0.6%. That revenue outpaced claims at all is a big deal for a health insurer – it hasn't been a common experience in recent years. Not to be shown up, however, NIB grew premium revenue 6.4%, which easily outpaced a 5.0% increase in claims.

When revenue is in the billions, a basis point here and a percentage point there adds up to real money. Medibank's gross profit increased 3.8% to $1.1bn, but NIB's rose 14.3% to $267m.

NIB attributed the result to better management of claims and net policyholder growth that was almost four times the industry average. In fact, nearly a third of new policyholders industry-wide opted for an NIB policy, despite the company being just a quarter the size of Medibank.

Medibank's management said that despite the subdued growth, it did see improvements in lapse rates and managed a 13% increase in policyholders for the company's cheaper AHM brand, which offset a 4% loss of policyholders in the core Medibank brand. That's good and well, but the cost of acquiring a new AHM customer is higher as the brand relies heavily on brokers, which take a 30% cut of the first-year's premium. All things being equal, as AHM products become a larger slice of Medibank's business, margins will decline.

Lapse rates

Still, the growing AHM brand and declining lapse rate shows that Medibank is doing something right. Curiously, Medibank's lapse rate fell from 12.4% to 12.0%, while NIB's rose from 12.6% to 13.5%. NIB may be better at getting customers through the door and signing them up to policies, but Medibank's customers seem to be a little happier.

Keeping customers happy is more important than ever. Private health insurance premiums are tightly regulated, with insurers required to get approval from the Minister of Health before raising prices. However, premiums have increased by 6% a year on average over the past decade for the industry as a whole – Medibank increased premium prices 4.5% this year, while NIB pushed them up 4.6%.

That's well above wage growth, so affordability is a mounting issue. As the American economist Herbert Stein crisply put it, ‘If something cannot go on forever, it will stop'. Premium growth cannot outstrip wage growth forever, and customers are already responding by downgrading to cheaper products (arguably a tailwind for AHM and NIB).

If claims expenses aren't kept under control, and premium growth held down, we expect it to become more difficult for private health insurers to grow policyholder numbers. No doubt they'll try, but that will probably mean higher spending on marketing and shrinking margins.

Indeed, this was another point where NIB's seemingly stellar result hides a few blunders. The company's management expenses, which include marketing, rose 14% to $268m. Medibank's management expenses grew an unsightly 10% to $568m, but that at least showed some hint of control. As a percentage of premiums, NIB's management expense ratio is now 9.7%, compared to Medibank's 9.1%.

Investments

The two insurers experienced even more diverse outcomes for their large investment portfolios.

NIB's net investment income rose 69% to $29m, for a yield on its portfolio of 4.1%, mainly due to strong returns from equity markets. Medibank's net investment income, however, rose an impressive 135% to $139m, for a yield of 5.8%. This was aided by strong equity returns and also benefited from a lower Aussie dollar.

It was interesting to see Medibank take a step back from its more aggressive approach to investment management, relative to NIB. The company previously had a target allocation to ‘growth' assets of 25%, but that has been lowered to 20%. Management said this was justified due to ‘elevated equity valuations and continued global uncertainties'. Nonetheless, it is still higher than the 15% allocation to equities and property that NIB maintains, which means Medibank is likely to have relatively more volatile earnings (a good thing in years like this).

Bottom line

Summing it all up, Medibank's operating profit fell 3% to $498m, while underlying net profit fell 1% to $419m. NIB churned out a 16% increase in underlying operating profit to $154m, with net profit up 31% to $120m. On the whole, NIB posted a better bottom line, but Medibank showed many points of improved performance.   

Medibank's management didn't provide specific financial guidance for 2018 – which usually comes at the annual meeting – but did forecast flat policyholder growth and said that it expects to lose less market share than this year.

While we were pleased to see Medibank achieve a meaningful improvement in lapse rates and management expenses, the rising tide of policy downgrades and ongoing loss of market share – which management only expects to end in 2019 – will make earnings growth difficult in the medium term. With a price-earnings ratio of 19, HOLD.

NIB's management expects an underlying operating profit of at least $150m in 2018. We're increasing the price guide slightly and, with a strong brand, growing market share and price-earnings ratio of 21, we recommend you HOLD.