Medibank & NIB: Results 2015

Something very odd happened in the private health insurance industry this year – growth in premium revenue outpaced growth in claims, bucking the trend of the past few years.

Medibank Private, Australia's largest private health insurer, increased premium revenue 5.1% in the year to June, while claims rose just 4.3%. Smaller competitor NIB had a similar experience, with premium growth of 8.8% outpacing an increase in claims of 7.5%. Consequently, Medibank's gross margin increased from 13.5% to 14.2%, while NIB's rose from 12.3% to 13.3%.

Medibank attributed the good result to better management of claims and improved detection of fraud. 'We are managing claims growth and integrity around claimants. We found a lot of fraud throughout the year through our Payment Integrity Program … The key focus of payment integrity was in ancillary claims and remedial massage. That will now move more broadly as we look at unwarranted variations in hospital procedures,' said chief executive George Savvides. 

Managing claims 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. Historically, premiums have been allowed to rise in line with claims to maintain relatively stable net underwriting margins of around 5%.

However, premiums have increased at 6% on average over the past decade for the industry as a whole, which is far higher than wage growth, making affordability a significant issue. More recently, the Minister has let claims grow more quickly than revenue, forcing insurance margins to contract.

While generous premium increases have supported Medibank's and NIB's revenue, their customers have responded by downgrading their cover to cheaper products. The proportion of members who let their Medibank policies lapse during the year rose from 10% to 11%, causing the number of policyholders under the core brand to fall 2%.

With overall industry growth of 2.5%, Medibank is losing market share. Declining policyholder numbers is also an anchor on revenue, which increased 5% to $5.9bn for the year.

Policy downgrades

Thankfully, growth in Medibank's cheaper AHM brand offset the loss of policyholders in the core Medibank brand, so total policyholders increased 1% to 1.8 million. But growth in AHM also has its share of shortcomings.

AHM's lapse rate of 15.6% – up from 14.5% last year – is well above Medibank's as a whole, which suggests a lack of customer loyalty. That's likely to mean it will be more difficult for Medibank to upgrade members to high-margin products in future years.

A second drawback is that the cost of acquiring a new AHM customer is typically higher as the brand relies heavily on brokers, which take up to 30% of the first-year's premium as a commission. All things being equal, as Medibank's product mix shifts towards cheaper AHM policies, we expect margins to decline.

NIB fared better and managed a 5% increase in policyholders, surpassing 1 million customers for the first time and increasing its market share for the 15^th year in a row. The company now accounts for 14.6% of the industry.

Investments

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

Medibank's net investment income fell 18% to $94m due to 'lower interest rates and lower returns from growth assets'. What concerns us, however, is the company's decision to increase its target allocation to risky assets, such as equities, from 17% to 25%. That's all well and good if stocks move higher, but it also makes the portfolio – and Medibank's overall earnings – much more exposed to volatile swings in the stockmarket.   

NIB's net investment income grew 6% to $31m – all the more impressive considering its allocation to 'growth' assets was 17%, compared to 24% for Medibank. Even after stripping out the $5.5m earned from selling its stake in Pacific Smiles Group, the underlying result was down 11% – still meaningfully ahead of Medibank.

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 lacklustre for some time yet, increasing their reliance on good operating results and claims management.

Bottom line

Medibank's management expects premium growth above 5.5% for 2016, with an operating profit above $370m, an increase of 12%. While we were pleased to see Medibank achieve a meaningful improvement in its handling of claims, the rising tide of policy downgrades and the loss of market share make it hard to imagine long-term earnings growth for Medibank above mid-single digits.

The stock is up 9% since Ramsay vs Medibank: The only trend that matters from 24 Jul 15 (Hold – $2.05), putting it on a price-earnings ratio of 22. The board declared its first dividend of 5.3 cents and intends to maintain a payout ratio of 70-75%, for a forecast yield of around 3.2%. We'll wait for a larger margin of safety before considering an upgrade but we're happy to HOLD.

NIB's management expects net profit of $85–90m for 2016. With the stock down 10% since Medibank & NIB: Interim result 2015 from 23 Feb 15 (Hold – $3.66), it trades on a price-earnings ratio of 20 and we continue to recommend you HOLD.