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1 KPMG NEWS This newsletter covers matters that are topical and are currently being debated in the medical schemes industry. Volume 1 August 2013 HOW UNIVERSAL HEALTH COVERAGE HAS BENEFITED OTHER COUNTRIES Introduction More than 18 months after the government s Green Paper on National Health Insurance (NHI) was published, NHI remains a contentious issue. There is concern over the accuracy of the government s cost estimates, debate about what health services should be included in the minimum benefit package and questions about the achievability of some of the policy reforms proposed in the Green Paper. Shortly after the release of the Green Paper, we published A Spoonful of Sugar, a study into the likely cost of funding universal healthcare coverage through taxation. The results suggested that tax increases would not need to be huge if the Government s cost estimates were accurate. There are many lessons that can be learnt from looking at the examples set by other developing countries that have introduced universal health coverage, but equally there are many risks in simply trying to take those approaches and applying them in South Africa. The differences in demographics, culture and clinical and social problems faced by the two different countries will inevitably require different health systems. However, there are elements of the universal health systems that have rolled out else where and are highly relevant in South Africa. We have identified two such lessons in this brief article. 1 Background South Africa s health system suffers from the growing pains that come with rapid economic growth. These growing pains a young population and a growing and demanding middle class are exacerbated by poor infrastructure and resource constraints. These conditions make it valuable to learn lessons from countries that have implemented universal health systems whilst in similar situations. South Korea In 1977 South Korea gradually introduced universal health insurance for public sector employees. In 1989 this was extended to the rest of the nation, with the establishment of the National Health Insurance Corporation (NHIC) as a single insurer. This fund is financed through contributions from employers and employees, government subsidies and out-of-pocket payments. The NHIC acts as a single purchaser and contracts almost entirely with private acute care providers. Thailand Thailand started its health system reforms in Government funds are distributed on a per capita basis to health facilities registered with the government s programme. These services are provided by the District Health System for rural areas, and private contractors for urban areas. Budgets are based on capitation per region, which results in hospitals receiving fixed budgets thereby driving them to control costs. 1 The information in this article is based largely on WHO and World Bank information. Impact on health expenditure and outcomes Both countries have seen a tremendous increase in the percentage of the population covered under national health insurance. In South Korea, this increased from 8.6% in 1977 to nearly 94% in Thailand s programme has achieved a 97% coverage rate. Healthcare expenditure, as a percentage of GDP, has stayed relatively stable in both countries, even after the implementation of national health insurance. This should, however, be seen in the light of steady GDP growth in nominal terms in both countries. Life expectancy in South Korea has increased from 64.6 years in 1977, the year when national health insurance started, to 80.8 in In Thailand this number increased from 72.5 in 2000 to 74.1 in The under-five mortality rate decreased in both countries, in South Korea from 24 per live births in 1977 to 4.8 in 2011, in Thailand from 18.5 in 2000 to 12.3 in The same is true for infant mortality rates ; South Korea brought this down from 20.3 in 1977 to 4.1 in In Thailand this was 15.9 in 2001 and 10.6 in The maternal mortality rate respectively decreased in South Korea and Thailand from 18 and 54 in 1990 to 16 and 48 in These dramatic improvements in health outcomes are even more impressive when you compare these countries with others that spend more on healthcare but achieve worse outcomes. Highlights: South Africans are generally alarmed when faced with the prospect of a National Healthcare Insurance (NHI) system. There are, however, valuable lessons we can learn from other countries that have gone through similar experiences. Many entities outsource aspects of their business to a third party service provider. Boards should ensure that they are effectively monitoring the various control environments as they form one of their key responsibilities. This has further implications for the auditor, who needs to consider the various control environments as part of the audit. The accounting treatment and disclosures for the personal medical savings accounts (PMSA) in schemes created challenges at the reporting period ended in Our article on the PMSA provides some guidance on how to deal with common areas of uncertainty going forward. The potential impact of the future insurance standard is highly technical. We have evaluated the possible effect and simplified the understanding thereof, so that schemes can already consider the impact that this could have on future reporting.

2 HOW UNIVERSAL HEALTH COVERAGE HAS BENEFITED OTHER COUNTRIES continued The impact of increasing healthcare expenditure on on life life expectancy - OECD plus selected examples Life expectancy at birth (2009/10 data) China Korea Thailand India Brazil Using life expectancy as an indicator of health outcomes, we can see (above) that South Korea is performing far better than many countries that spend more; and that Thailand, while it still has a relatively low life expectancy, is nonetheless achieving a great deal with an extremely low spend per capita. South Africa s position on the graph is a complicated one. The spend per capita is pushed up by the amount spent on private healthcare by a minority of the population, while the life expectancy is pushed down by the poorer outcomes experienced by patients who rely on the public health system. Although this figure has changed since the 2009/10 data, the life expectancy number is expected to rise to 58.5 in 2013 due to the impact of successful HIV/AIDS treatment programmes. However, even with the improvement in life expectancy, South Africa still lags behind some of its BRICS South Africa 935 US$ PPP per capita spent on healthcare Life expectancy at birth = 54 (OECD & WHO data 2009/10) Total health expenditure per per capita capita US$ US$ PPP PPP (2010 (2010 data) data) Note: Life expectancy data is 2010 data or nearest available (2009) Source: WHO and OECD data;; KPMG analysis USA colleagues, who are achieving better outcomes for less money. Conclusion As we have seen, investing in health care leads to better health outcomes for a country as a whole up to a certain point (although the lesson to be taken from the USA s position is that beyond a certain point increases in spending no longer go on improvements in clinical outcomes). This is a self-reinforcing effect since better health outcomes lead to higher productivity and higher income. Because both of the countries we have looked at in this article were implementing universal coverage at a time of GDP growth, they were able to keep the percentage of GDP spent on healthcare relatively stable while still increasing the investment in healthcare in absolute terms. However, it is not only the investment per se that counts, it is also where the investments were made that made a huge difference. Thailand s investments focussed on primary healthcare and ensuring better accessibility for rural communities. Because hospitals budgets are based on capitation per region it is in the interest of health providers to reach out to these communities with preventative services to reduce the high costs of curative care in the long term. In South Africa, the reforms proposed by the Government and much of the work that Provincial Departments of Health are undertaking at the moment are focussed on achieving that shift, from a reactive, curative health system to a more pro-active, preventative one. Another interesting point is that both countries used both the public and private care providers for healthcare delivery. In South Korea there is very little public-sector provision of healthcare and the government focuses on being an intelligent, efficient purchaser of healthcare rather than a large-scale provider. The government in South Africa has suggested that the private sector will be involved in NHI-funded healthcare but the exact nature of the role of private sector administrators and providers remains unclear. If the government intends to target private-sector expertise at particular problem areas, then making a clear statement about this intention is a necessary first step. Additional information on how NHI could positively impact on South Africa s economy can be found in our thought leadership publication Funding NHI: A spoonful of sugar? available on our website. OUTSOURCING SERVICES WHO NEEDS TO DO WHAT? What has changed? Many entities outsource aspects of their business to a third party service provider. Common examples are retirement funds, medical schemes, asset managers and unit trusts, that outsource their administration, investment and IT functions. International Standard on Auditing ISA402 Audit considerations relating to an entity using a service organisation became effective for periods ended after 15 December 2009 and sets out what needs to be performed by auditors of entities that have outsourced certain of their functions to service organisations. Entities that have outsourced certain functions are commonly referred to as user organisations. There are a number of complexities that the user organisation auditor could be confronted with, including sub-service organisations, group situations and differing year-ends. In addition, since the release of King III in 2009, we have seen an added focus on good corporate governance and changes in legislation to emphasise good governance. Directors and trustees, for example, are required to state in the Responsibility Statement in the Annual Financial Statements that they are satisfied the entity has an adequate internal control system and that it functioned adequately during the period. What does ISA 402 require of the auditor? The auditor of the user organisation must understand how the user organisation uses the service organisation and the impact it could have on the user organisation s internal controls. Often the user organisation has implemented monitoring controls over the outsourced function and it may be adequate for the user auditor to test and rely on these monitoring controls. Examples of such monitoring controls are investment sub-committees who monitor the investment trades and pricing. Another example is where the entity reviews bank and other reconciliations prepared by the outsourced provider on a regular basis. If monitoring controls are adequate, then the user organisation auditor can test and rely on these monitoring controls. If the user organisation auditor is unable to rely on monitoring controls, ISA 402 requires the auditor to either: obtain a Type 1 or 2 service organisation report contact the service organisation to obtain information visit the service organisation and perform procedures relating to controls use another auditor to perform procedures at the service organisation relating to controls.

3 OUTSOURCING SERVICES WHO NEEDS TO DO WHAT? CONTINUED What is a Type 1 or Type 2 service organisation report? A service organisation report will cover certain specified control objectives, which are agreed up front with users of the report. A Type 1 report will look at the design and implementation of controls relating to each control objective at a specific date. A Type 2 report will in addition test the operating effectiveness of the controls covering a specific period. Complexities arising from ISA 402 Sub-service organisations Sub-service organisations are often used in retirement funds and medical schemes, where the outsourced asset manager places funds with other organisations, including other asset managers, life companies and unit trusts. If a Type 1 or 2 report is obtained from the service organisation in this example, the asset manager and the report excludes relevant controls relating to the sub-service organisation, the user auditor must apply the requirements of ISA 402 to the sub-service organisation. This could become extremely difficult for the user organisation auditor if, for example, some of these are foreign sub-service organisations and do not have Type 1 or 2 reports. Differing year ends In most instances a service organisation will provide services to a number of users, who will have a variety of financial yearends. If the service organisation produces a Type 2 service auditor report, it is usually produced annually or every six months, which may often not cover the same period as the user organisation. In such instances, the user entity auditor will need to perform additional work, which may include additional work on monitoring controls or having to do work at the service organisation. Increased costs Unless there is a Type 1 or 2 report, or adequate monitoring controls, the user organisation auditor will need to spend additional time performing the alternative procedures set out in ISA 402, with resultant increased costs and fees that need to be passed on to the user organisation. Even if there is a service organisation report, additional time may be incurred in reviewing and following up the report or performing additional procedures, if the Type 2 report is at an interim date. What should trustees and directors be doing? Good corporate governance requires the trustees and directors to ensure that there is an adequate system of internal control in place and that these controls were functioning throughout the year. Trustees and directors would normally obtain this assurance from internal audit reports and, risk and compliance reports. However, where functions have been outsourced, trustees and directors need to ensure that there are adequate controls, either in the form of monitoring controls at the entity, or by obtaining confirmation that controls at the service organisation are adequate and were functioning throughout the period. What needs to be done? Service level agreements The starting point must be to have an adequate and up-to-date service level agreement between the user organisation and the service provider. This service level agreement should require the service organisation to provide the user organisation with a written report on a regular basis regarding the adequacy and functioning of controls. It is best that the service level agreement specifically requires a Type 2 service auditor report and specifies the frequency and timing of the report. It should also deal with controls at sub-service organisations. While many service level agreements contain penalty clauses, should there be a control breakdown at the service organisation that results in a loss to the user, the reputational risk remains with the user organisation. The benefit to service organisations is confirmation that they have sound governance in place which also enhances trust between the user organisation and themselves. Early communication If a service organisation report is to be produced, it is important that there is early communication between the service organisation, the user organisation s directors or trustees, and the user organisation s auditor to ensure that the control objectives to be covered are adequate and that the date of issue of the service organisation report aligns with the reporting requirements of the user organisation as much as possible. An emphasis on monitoring controls User organisations should implement monitoring controls over the functions performed by service organisations. This would give trustees and directors added assurance over the controls at the service organisation. If there are adequate monitoring controls over functions performed by service organisations this could reduce the extent of time spent by the user organisation auditor, with resultant cost savings to the user organisation. The above recommendations should result in improved controls at outsourced service organisations and more diligent monitoring by the user organisation, to the benefit of all. PERSONAL MEDICAL SAVINGS ACCOUNTS Circular 38 of 2011 Circular 38 of 2011 Personal Medical Savings Accounts (Circular 38) was issued by the Council for Medical Schemes (Council) in Based on the Omnihealth court judgement, Circular 38 indicates that all personal medical savings accounts (PMSA) constitute trust monies. Consequently Circular 38 states that PMSA contributions should be retained in a separate trust bank account. Furthermore Circular 38 states that the PMSA liability and the responding cash (or investments) should be removed from the statement of financial position. This matter was discussed at the Accounting Practices Committee (APC) of South African Institute of Chartered Accountants (SAICA). The majority view of the APC was that the MSA liability and corresponding asset should remain on the statement of financial position of a medical scheme. The Medical Schemes Accounting Guide (Guide) issued by the SAICA followed this majority view. Circular 41 of 2012 The Council subsequently released Circular 41 of 2012 Prescribed format for the Statement of Comprehensive income and disclosure required in respect of Personal Medical Savings Accounts (Circular 41). Circular 41 indicates that the statement of comprehensive income should refer to risk contribution income and not net contribution income as was previously done. It also requires that interest paid on savings accounts is listed as an expense. Furthermore Circular 41 requires a detailed reconciliation of the PMSA. Disclosure of a note on the investment of personal medical savings account trust monies managed by the scheme on behalf of its members is also required.

4 PERSONAL MEDICAL SAVINGS ACCOUNTS CONTINUED Challenges in the industry In the industry, a few challenges were experienced during financial years that ended on 31 December 2012 when complying with Circular 38 and 41. We have listed a few below. Cash and cash equivalents IAS 7 Statement of Cash Flows defines cash and cash equivalents as short-term, highly liquid investments that are readily convertible to known amounts of cash and which are subject to an insignificant risk of changes in value. It also states that cash equivalents are held for the purpose of meeting short-term cash commitments rather than for investment or other purposes. Therefore, an investment normally qualifies as cash equivalent only when it has a short maturity of, three months or less from the date of acquisition. In many cases the financial assets purchased with savings account contributions or even risk contributions meet the definition of cash and cash equivalents. Medical schemes should closely evaluate the financial assets purchased to determine if they should be classified as investments or cash and cash equivalents. In this regard we understand that the Council requires cash and cash equivalents in the statement of financial position and in the statement of cash flows to be separated as effectively those belonging to the members and to the medical scheme. Presentation of investment income on the statement of comprehensive income and investments in the statement of financial position The investment income presented in the statement of comprehensive income should be the total investment income derived from investments in which the risk and savings account contributions were invested. It is recommended that medical schemes present on the face of the statement of comprehensive income the investment income from savings contributions invested and from risk contributions invested. Investments are to be presented separately on the face of the statement of financial position, ie investments made with savings account contributions and investments made with risk contributions. Recognition of savings account contributions The systems of medical schemes recognise savings account contributions when due and not when the cash has been received. The contributions are recognised in profit or loss, and at the same time a debtor is raised. A savings account liability is then recognised with a corresponding entry in profit or loss. The net effect of these entries is that there is no impact on the medical schemes statement of financial position and statement of comprehensive income. Therefore in our view, the savings account contributions should be recognised when received in cash and claims recovered from the savings account when paid. However where the medical scheme has utilised future savings account contributions (not yet received in cash) to recover claims, a debtor should be recognised, as effectively the member owes the medical scheme the money. WILL THE FUTURE INSURANCE STANDARD CHANGE THE ACCOUNTING OF MEDICAL SCHEMES? For medical schemes to plan ahead and understand the impact on future systems and business, it is important that they should understand how the future insurance standard will impact them. However, the impact will not be soon as it is expected that the new standard will have an effective date for annual reporting periods beginning on or after 1 January The International Accounting Standards Board (IASB) currently estimates that the issue date of the new standard will be late 2014, early 2015 and will require the retrospective restatement of results for 3 years. The new standard will replace IFRS 4 Insurance Contracts (IFRS 4), effective for annual periods beginning on or after 1 January We have listed below a few areas which could change the accounting of medical schemes in the future based on the exposure draft (ED) released in June Level of measurement In general, the proposed measurement principles should be applied to a group of insurance contracts. This group is referred to as a portfolio. A portfolio of insurance contracts is defined as contracts that: provide coverage for similar risks and that are priced similarly relative to the risk taken on are managed together as a single pool. It is envisaged that each benefit option will meet the definition of a portfolio. Medical schemes manage and report on benefit options separately. The number and value of benefits provided by the benefit option will impact the contribution per member. Recognition Insurance contracts should initially be recognised from the earliest of the following: the date of the coverage period the date on which the first payment from the policyholder becomes due if applicable the date on which the portfolio of insurance contracts to which the contract will belong becomes onerous. An entity needs to assess whether a contract is onerous when facts and circumstances indicate that the portfolio of contracts that will contain the contract is onerous. Medical insurance contracts should be recognised on 1 January of each year even though members will be required to elect their benefit options in the previous year. However medical schemes may be required to recognise benefit options that will be making losses already in the previous financial year. Contract boundary A contract boundary represents the period from when coverage starts, ie when the contract is recognised until the contract is derecognised (when the insurer is no longer required to provide coverage). Cash flows are within the boundary of an insurance contract when the entity can compel the policyholder to pay the premiums or has a substantive obligation to provide the policyholder with coverage or other services.

5 WILL THE FUTURE INSURANCE STANDARD CHANGE THE ACCOUNTING OF MEDICAL SCHEMES? CONTINUED A substantive obligation to provide coverage or other services ends when: The entity has the right or the practical ability to reassess the risk of the portfolio of insurance contracts that contains the contract and as a result can set a price or level of benefits that fully reflect the risk of that portfolio The pricing of the premiums for coverage up to the date when the risks are reassessed does not take into account the risks that relate to future periods. Views in the industry are that the contract boundary of medical insurance contracts is a year. Medical schemes have the practical ability to reassess the risk of the various benefit options annually and can set contribution levels accordingly. Measurement The building-block approach is the new measurement model to be applied by insurers. This method requires a portfolio of the insurance contracts to be measured based on following: Explicit, unbiased and probability-weighted estimates of future cash outflows less future cash inflows have to be determined. Net cash flows have to be adjusted for the time value of money using discount rates that reflect the characteristics of the cash flows. The present value of the net cash flows has to be adjusted for the effects of uncertainty about the amount and timing of cash flows that arise as the entity fulfils the insurance contract. This margin has to be recognised to remove any profit at inception. This will be the case when the present value of net cash inflows less the risk adjustment is greater than zero. Another simplified measurement approach permitted is the premium-allocation approach. This approached is permitted if: reasonable approximation of those that would be produced by the building-block approach at initial recognition is one year or less. When applying the premium-allocation approach, an insurer should recognise a liability for the remaining coverage and a liability for incurred claims. The liability for the remaining coverage should initially be measured as follows: any) less acquisition costs. recognised (as part of the liability for the remaining coverage), using the building block approach, if facts and circumstances indicate that a portfolio of insurance contracts (containing the contract) has become onerous. The liability for incurred claims should be measured as the present value of the fulfilment cash flows (ie using the building-block approach). As indicated above, it is envisaged that medical insurance contracts will be regarded as annual contracts. Consequently medical schemes will apply the premium-allocation approach. Unbundling An investment component in an insurance contract is an amount that the insurer is obliged to pay the policyholder regardless of whether an insured event occurs. If an investment component is distinct, an insurer should unbundle the investment component from the host insurance contract and apply IFRS 9 Financial Instruments in accounting for the investment component. An investment component is distinct if the investment component and the insurance component are not highly interrelated and a contract with equivalent terms (than the investment component) is sold, or could be sold separately in the same market or jurisdiction (either by the entities that issue insurance contracts or by other parties). Indicators that an investment component is highly interrelated with an insurance component are: according to the value of the investment component or the value of the investment component varies according to the value of the insurance component to lapse or mature without the other component also lapsing or maturing. An insurer should account for investment components that are not distinct from the insurance contract together with the insurance component under the future insurance contracts standard. Insurers should exclude from insurance contract revenue and incurred claims presented in the statement of comprehensive income any investment components that have not been unbundled. Based on the above, the savings account may not be required to be unbundled. It will be accounted for as part of the measurement of the medical insurance contracts. However, premium income presented in the statement of comprehensive income should exclude the savings account contributions. Scope A scope exemption that is not currently in IFRS 4 has been included for fixed- fee contracts. If fixed-fee contracts meet all of the following criteria, then they would be excluded from the future insurance standard: assessment of the risk associated with the individual customer providing a service rather than cash payment from the use of services by the customer. Contracts that did not meet all three criteria would be considered to be insurance contracts. This exemption could impact capitation agreements that medical schemes have entered into. Currently these agreements might meet the definition of risk transfer arrangements and therefore be within the scope of IFRS 4 as they would be classified as reinsurance contracts. These agreements are generally based on the number of members in a scheme without considering the risk associated with each member. Services will be provided to these members. The service provider is at risk that the capitation fee is not adequate if the members require more services than what were initially envisaged when the fee was determined. These contracts will be outside the scope of the future standard. This will remove the requirement for medical schemes to determine whether a capitation agreement meets the definition of a risk transfer arrangement. There are views in the industry that medical insurance contracts may meet the definition of a fixed-fee contract as well and therefore will be scoped out of the future insurance standard. Medical schemes of the future... Medical schemes should update their systems to cope with the future insurance standard. It might be wise to prepare for the impact over a few years to spread the costs and effort.

6 Contact us Sven Byl Partner T: E: Marcelle Fouché Partner T: E: Ashlene Van Der Colff Partner T: E: KPMG Services Proprietary Limited, a South African company and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative ( KPMG International ), a Swiss entity. All rights reserved. Printed in South Africa. The KPMG name, logo and cutting through complexity are registered trademarks or trademarks of KPMG International. MC10254

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