Barriers to entry in the Australian private health insurance market

Transcription

1 Barriers to entry in the Australian private health insurance market 03 Research Paper 3 June 2015

2 1 About PHIAC The Private Health Insurance Administration Council (PHIAC) is an independent statutory authority that regulates the private health insurance industry. Private health insurance policy is set down by the Australian Government via the Department of Health (DoH). PHIAC s statutory objectives are described in the Private Health Insurance Act 2007 (PHI Act). Section of the PHI Act instructs PHIAC in performing its role, to take all reasonable steps to strike an appropriate balance between the three objectives of: a. fostering an efficient and competitive health insurance industry; b. protecting the interests of consumers; and c. ensuring the prudential safety of individual private health insurers. In order to promote these objectives, PHIAC has undertaken research on competition and other issues within the Australian private health insurance industry. The aim of this research is to support an improved understanding of the Australian private health insurance industry. It is important to stress that PHIAC is not a policy body. As noted above, policy responsibility for private health insurance is reposed within the DoH as principal adviser to the Minister for Health and the Government. Accordingly, PHIAC does not seek to propose, nor to advance, any particular policy prescription or solution to the matters it examines. It does, however, aspire to provide the factual and contextual basis for a much improved discussion about the important issues that affect private health insurance in Australia. It should not be implied that any view expressed in this research paper is necessarily that of the Minister for Health or the Government. The Government announced in the Budget that PHIAC will be closed with effect from 1 July PHIAC s operations will be merged into, predominantly, the Australian Prudential Regulation Authority, with the remainder of its functions reverting to other agencies. 1i 02

3 2 Preface Private health insurance is a vital product for many Australians. In December 2014, around 47 per cent of Australians or 11.2 million people held a health insurance policy which covers them for hospital treatment, while around 55.5 per cent of the population or 13.1 million people were covered for general treatment, which provides cover for dental care, optical services, and many other health services. In addition, around 11 per cent of the value of all health services provided in this country is paid for by the private health insurance industry. The level of competition in a market is integrally linked to the ability of suppliers to enter the market. This paper presents for consideration by interested stakeholders a review of the major issues related to the entry of a business into the Australian Private Health Insurance (PHI) market. Perceptions of the severity of the barriers to entry may differ based on the perspective of the viewer. For instance, those already in the market may perceive that the barriers to entry are minimal. On the other hand, those seeking to enter the Australian PHI market or those new to the market and struggling to establish a market presence may view barriers to entry as far more numerous and significant. The paper draws on a variety of sources, many of which are set out in the bibliography in addition to quantitative analysis. The paper also references submissions received by PHIAC in response to its first discussion paper, Competition in the Australian Private Health Insurance Market, released by PHIAC in November 2012 (PHIAC 2012). 1 ii 1 See Not all submissions received by PHIAC were approved for public release. PHIAC has preserved confidentiality where it was sought both in this paper and on its website.

4 Preface 3 Use of this Paper While PHIAC endeavours to ensure the quality of this publication, it does not accept any responsibility for the accuracy, completeness or currency of the material included in this publication and will not be liable for any loss or damage arising out of any use of, or reliance on, this publication. This publication is available for your use under a Creative Commons Attribution 3.0 Australia licence, with the exception of the Commonwealth Coat of Arms, photographs, images, signatures and where otherwise stated. The full licence terms are available from au/legalcode. Use of PHIAC material under a Creative Commons Attribution 3.0 Australia licence requires you to attribute the work (but not in a way that suggests that PHIAC endorses you or your use of the work). PHIAC material used as supplied Provided you have not modified or transformed PHIAC material in any way including, for example, by changing the text; calculating percentage changes; graphing or charting data; or deriving new statistics from published PHIAC statistics then the PHIAC prefers the following attribution: Source: Private Health Insurance Administration Council Derivative work If you have modified or transformed PHIAC material, or derived new material from those of PHIAC in any way, then PHIAC prefers the following attribution: Based on Private Health Insurance Administration Council data Use of the Coat of Arms The terms under which the Coat of Arms can be used are set out on the It s an Honour website (see Disclaimer The purpose of this paper is to stimulate discussion. It is not a position paper and the information canvassed in it does not constitute recommendations or legal advice. While PHIAC endeavours to ensure the quality of this paper, it does not accept any responsibility for the accuracy, completeness or currency of the material included in this paper, and will not be liable for any loss arising out of any use of, or reliance on, this paper. PHIAC encourages private health insurers to seek independent advice and to exercise care in relation to any material contained in this paper.

5 4 Table of Contents About PHIAC 1 Preface 2 1. Conceptual overview of barriers to entry Economics of barriers to entry 5 2. Structure of the Australian private health insurance industry and market entry I ndustry structure and concentration Profitability of the Australian PHI market Entry and exit in the Australian PHI market Entering the Australian PHI market Barriers in the Australian private health insurance market Regulatory burden Sovereign risk barrier the potential of regulation and policy change to impact on profitability Market characteristics and contestability barriers 17 Appendix A Econometric model of sovereign risk in the Australian PHI market 23 Modelling government policy changes on the number of persons covered in the Australian PHI market 23 Abbreviations and acronyms 27 Glossary and definitions 28 References 29

6 5 1. Conceptual overview of barriers to entry Although entry into the PHI market is open, subject to a regulatory vetting process, there have been very few new entrants into the market over the last twenty years. Barriers to entry in any industry allow incumbents to exercise market power and set prices above their costs. The consequences can be that with barriers to entry, prices might be higher than they would otherwise be and so in economic terms there is a loss of welfare to consumers. 1.1 Economics of barriers to entry What is a barrier to entry into a market? Carlton and Perloff (2005, p.76) define barriers to entry as anything that prevents an entrepreneur from instantaneously creating a new firm in a market, while Church and Ware (2000, p.487) define barriers to entry as structural characteristics of a market that protects the market power of incumbents by making entry unprofitable, adding that they typically depend on both structural characteristics of the industry as well as the behaviour of incumbents after entry. Barriers to entry relate both to costs of entry and how long it would take to enter the market (Carlton and Perloff (2005), p.76). According to McAfee et.al. (2004, p.465), where eleven different definitions of barriers to entry in the economic literature are identified; there seems to be no clear consensus on what constitutes a barrier to entry. What can be said from the literature is that a barrier to entry exists if it is not costless to enter or exit the industry and the costliness both in establishing a business and responding to the actions of competitors of overcoming the barrier or group of barriers will determine whether entry can occur. From the perspective of a new entrant to a market, barriers to entry can be classified under two broad categories, legal and natural barriers, and structural and economic barriers. 2 Legal and natural barriers These barriers generally cannot be overcome in the short to medium term and include: Government issued monopoly; 3 Natural monopoly (water distribution, electricity transmission etc.) where only one provider is feasible and market entry leads to wasteful and costly duplication; and Patent barriers, where a firm has a short-term legal monopoly on the production of a good or service. Potential entrants to the Australian PHI market do not appear to face barriers of this kind These barriers to entry are standard concepts of market structures described in most economic and industrial organisation textbooks (See Pass and Lowes 1993 and Church and Ware 2000). 3 For example, in Australia, the market for delivery of small items up to 250 grams is a statutory monopoly held by Australia Post (Australian Postal Corporation Act 1989 (Division 2)).

7 1. Conceptual overview of barriers to entry 6 BOX 1 CONSUMER ADVANTAGE OF MARKET ENTRY IN HIGHLY CONCENTRATED MARKETS Insurers in Australia offer coverage nationally and each geographic market is actively serviced by a number of insurers. In the USA, where insurers offer coverage at the county level, there is perhaps more opportunity to assess the value to consumers of the competitive pressure that a new entrant may provide. The New York Times (2013) has reported that consumers in rural counties which are serviced by a smaller number of insurers are faced with significantly higher premiums than their urban counterparts. In many of these rural counties, there are only one or two insurers. Evidence is cited that in those rural counties where a new competitor has entered the market, premiums are significantly lower compared to neighbouring counties where there was no new entrant. This suggests a strong link between lower levels of industry concentration and reduced premiums. In relation to the barriers faced by insurers and the reasons why these rural markets are concentrated, the New York Times stated that, Insurance companies are reluctant to enter challenging new markets, experts say, because medical costs are higher, dominant insurers are difficult to unseat, and powerful hospital systems resist the efforts to lower rates. (New York Times 2013) Structural and economic barriers These barriers represent features of the structure of an industry and market which deter entry, but which can be overcome at some cost. These include: Regulatory burden and sovereign risk Prudential capital and solvency requirements; Price regulation; Regulation of products; Sovereign risk. Market characteristics and contestability Cost advantage of incumbency including product differentiation, brand loyalty and name recognition coupled with consumer apathy, high switching costs between suppliers to the market; Economies of scale and scope; Incumbents strategic response to potential new entrants adversely affecting the new entrants profitability. These barriers to entry may impact on costs and/or pricing and market access which can combine and reinforce each other to delay or prevent market entry. The existence of any of the above barriers to entry could restrict the supply of goods and services to the market and result in incumbent firms earning above normal profits in the longer term. As pointed out in a 2013 submission to the first PHIAC paper on competition in the Australian PHI market, the market displays some competitive signs, as there are 12.5 million persons with insurance provided by 34 insurers competing to meet the specific needs of customers by providing thousands of differentiated health insurance products which can all be compared (Peter Carroll 2013, p.4). Furthermore, policy holders can change insurer at little or no cost. While these factors suggest that the market has a number of competitive features, they do not necessarily mean that the market is easily contestable for new entrants even if the insurer seeking entry can provide a better offering both in terms of price and coverage (See Box 1 for example of geographic barriers to entry in PHI). A new entrant into the Australian PHI market represents a competitive threat to incumbents with the potential to recruit members and in so doing to moderate increase in industry premiums. However, a new market participant may face competition in market conditions at some disadvantage compared to incumbents, who as a consequence of long tenure in the market, possess significant industry and corporate knowledge as well as brand recognition. It could be argued that unless a new entrant has a superior product or service offering, that is sufficiently price competitive, they may not be able to achieve the minimum threshold of policy holders needed to compensate for the sunk and fixed set-up costs of entry. 4 4 KPMG (2013), p.7 concurred with this point.

8 7 2. Structure of the Australian private health insurance industry and market entry The number of health insurers has declined over the last forty years, but only recently has this been as a result of merger and acquisition activity. Insurers in general have seen increases in profitability with strong and stable net margins. 2.1 Industry structure and concentration The proportion of the population covered by private health insurance in Australia has declined significantly since the 1970s. In 1971 more than 77 per cent (or 10.2 million people) were covered and this had declined to 47 per cent (or 11.2 million people) by Over the same period there has been considerable consolidation in the industry as Figure 1 shows. In June 1971, there were 110 private health insurers. At the end of , the number of health insurers had fallen by almost two-thirds to 34. There has also been significant structural change over the period, from a total absence of for-profit insurers in 1971 to 9 in 2014, accounting for 68 per cent of the market. Industry concentration as measured by the Herfindahl Hirschman Index (HHI) 5 is an indicator of competition in the market. 6 Figure 2 shows the quarterly HHI market concentration for the Australian PHI industry from December 1995 to December Based on the U.S. Department of Justice and the Federal Trade Commission definition of market concentration 7, the data shows that prior to June 2010, the Australian PHI industry was below the 1500 level (defined as unconcentrated). In recent years, a number of acquisitions and mergers has seen the HHI index increase to the moderately concentrated market range The HHI index is based on adding the sum of the squares of market shares. 6 Concentration measures such as the HHI are set and used by various competition authorities as a form of evidence of the competition impacts of mergers (see U.S. Department of Justice and the Federal Trade Commission (2010); Australian Competition and Consumer Commission (2008)) 7 The ACCC (2008) uses a 2000 HHI threshold and will generally be less likely to find adverse impacts of horizontal mergers or if over 2000 but with a change in the index of less than 100 units.

9 2. Structure of the Australian private health insurance industry and market entry 8 1. Number of insurers in the Australian PHI market 1971 to Number of insurers Restricted for profit Open for profit Restricted not-for-profit Open Non-Profit Source: PHIAC data Note: This chart shows the number of insurers in the Australian PHI market. Prior to national registration began in 1995, insurers could have separate funds in different state jurisdictions. 2. Herfindahl Hirschman Index of market concentration for the Australian PHI market (total policies) December 1995 to December Highly concentrated market: HHI above Herfindahl-Hirschman Index Moderatly concentrated market: HHI between 1500 and 2500 MBF merger by Bupa All industry market concentration AHM merger by Medibank Private 1400 Largest four insurers (in 2014) market concentration Source: PHIAC data Unconcentrated market: HHI below 1500 Dec 95 Jun 96 Dec 96 Jun 97 Dec 97 Jun 98 Dec 98 Jun 99 Dec 99 Jun 00 Dec 00 Jun 01 Dec 01 Jun 02 Dec 02 Jun 03 Dec 03 Jun 04 Dec 04 Jun 05 Dec 05 Jun 06 Dec 06 Jun 07 Dec 07 Jun 08 Dec 08 Jun 09 Dec 09 Jun 10 Dec 10 Jun 11 Dec 11 Jun 12 Dec 12 Jun 13 Dec 13 Jun 14 Dec 14

10 2. Structure of the Australian private health insurance industry and market entry 9 3. Gross and net margins in the Australian PHI industry June 1995 to Dec % 25% Gross Margin (GM) Net Margin (NM) 20% Percentage of premium income 15% 10% 5% 0% 5% 10% 15% Jun 95 Jun 96 Jun 97 Jun 98 Jun 99 Jun 00 Jun 01 Jun-02 Jun 03 Jun 04 Jun 05 Jun 06 Jun 07 Jun 08 Jun 09 Jun 10 Jun 11 Jun 12 Jun 13 Jun 14 Source: PHIAC data Note: Gross margin is defined as premium income less benefits paid. Net margin is gross margin less managerial expenses. The large jump and subsequent fall in the gross and net margins around 2000 reflect the implementation of Lifetime Health Cover (LHC). 2.2 Profitability of the Australian PHI market Is the level of net margin/profitability in the industry sufficient to attract new entrants? If so, why have there been so few entrants in recent years? By some measures, the Australian PHI industry has in recent years been a relatively profitable and therefore apparently attractive industry to enter. Figure 3 shows it achieved a positive and consistent net margin for most of the period, averaging 4.5 per cent over the last ten years, indicating apparent strong levels of profitability and low volatility across the industry over an extended period. Further, the industry has historically experienced a very low risk of operational loss which reinforces the attractiveness of entry into the PHI market. The private health insurance industry has not always been as profitable (as indicated by strong net margins) as it has in the last ten years. Figure 3 shows that prior to 2000, net margins were zero or negative and experienced significant volatility reflecting both the steady decline in the number of persons insured (since the introduction of Medicare in 1984) and demographic changes in the market. As the proportion of the population covered by PHI decreased, the average age of policy holders increased as the younger and healthier policy holders were less likely to take-up or retain private health cover than their older and less healthy counterparts (the result of adverse selection). The average health status of persons with PHI declined leading to higher average claims per person covered which had an adverse effect on gross and net industry margins and the overall level of industry profitability.

11 2. Structure of the Australian private health insurance industry and market entry Age demographics of insured persons before and after LHC 40% Lifetime Health Cover 1 July % 0 29 Percentage of insured persons 30% 25% 20% Age groups of insured persons % 10% Sep 97 Mar 98 Sep 98 Mar 99 Sep 99 Mar 00 Sep 00 Mar 01 Sep 01 Mar 02 Sep 02 Mar 03 Sep 03 Mar 04 Sep 04 Mar 05 Sep 05 Mar 06 Sep 06 Mar 07 Sep 07 Mar 08 Sep 08 Mar 09 Sep 09 Mar 10 Sep 10 Mar 11 Sep 11 Mar 12 Sep 12 Mar 13 Sep 13 Mar 14 Sep 14 Source: PHIAC data Figure 4 shows that when LHC was introduced, younger people responded to that incentive to takeup private health cover (particularly the age group), the average age of policy holders declined and industry net margins improved (as indicated in Figure 3). The increase in the size of the market and changing demographics underpinned stronger industry profitability in subsequent years. To put recent average net margins into perspective, Table 5 shows profitability rates (defined as profit (after tax) divided by the end of financial year health benefits fund capital) 8. The data shows that for the industry, net margins and profit rates of return as measured against health fund capital appear healthy and may be expected to provide a strong incentive for market entry. However, we should be mindful that accounting profits differ from economic profits and insurers may in fact be earning zero economic profits, as economic profits must take into account the opportunity cost of capital (the return on the capital from an alternative investment) and market related risk. 8 The health benefits fund capital is one option to value the investment required to establish a health insurer business. The next best option is to compare the profits/surplus generated with the value of the business.

12 2. Structure of the Australian private health insurance industry and market entry Returns on health benefit fund capital (HBFC) of market participants in the Australian PHI market Return on health fund capital Industry average 18.3% BUPA Australia Pty Ltd 52.3% National Health Benefits Australia Pty Ltd 33.2% NIB Health Funds Ltd 27.2% Australian Unity Health Ltd 25.1% Police Health Ltd 22.6% Grand United Corporate Health Ltd 20.9% HBF Health Ltd 18.9% Railway & Transport Health Fund Ltd 16.8% Medibank Private Ltd 16.3% Doctors Health Fund Ltd, The 14.4% Health Partners Ltd 14.4% Lysaght Peoplecare Ltd 14.2% Transport Health Pty Ltd 13.9% Health Insurance Fund of Australia Ltd 12.9% GMHBA Ltd 12.8% CUA Health Ltd 12.7% Healthguard Health Benefits Fund Ltd 12.4% Defence Health Ltd 11.6% Reserve Bank Health Society Ltd 11.5% Hospitals Contribution Fund of Australia Ltd, The 11.3% CBHS Health Fund Ltd 10.9% Navy Health Ltd 10.2% St Luke s Medical & Hospital Benefits Assocn Ltd 10.2% ACA Health Benefits Fund Ltd 10.0% Westfund Ltd 9.5% Queensland Country Health Fund Ltd 9.4% Queensland Teachers Union Health Fund Ltd 9.3% Health.com.au Pty Ltd 9.1% Mildura District Hospital Fund Ltd 6.3% Health Care Insurance Ltd 6.2% Cessnock District Health Benefits Fund Ltd 5.9% Latrobe Health Services Ltd 5.5% Teachers Federation Health Ltd 5.5% Phoenix Health Fund Ltd 3.7% Return on health fund capital Industry average 17.1% BUPA Australia Pty Ltd 60.5% NIB Health Funds Ltd 31.0% National Health Benefits Australia Pty Ltd 30.9% Australian Unity Health Ltd 22.9% Doctors Health Fund Ltd, The 20.7% Medibank Private Ltd 20.2% Police Health Ltd 16.9% CUA Health Ltd 13.0% Lysaght Peoplecare Ltd 12.6% GMHBA Ltd 12.5% CBHS Health Fund Ltd 11.5% Transport Health Pty Ltd 11.5% HBF Health Ltd 11.3% Health.com.au Pty Ltd 10.1% Queensland Country Health Fund Ltd 10.0% Navy Health Ltd 9.7% Healthguard Health Benefits Fund Ltd 9.6% Defence Health Ltd 8.5% Latrobe Health Services Ltd 8.2% Teachers Federation Health Ltd 8.0% Grand United Corporate Health Ltd 8.0% Health Partners Ltd 7.7% Health Insurance Fund of Australia Ltd 7.7% Hospitals Contribution Fund of Australia Ltd, The 7.5% Reserve Bank Health Society Ltd 7.1% ACA Health Benefits Fund Ltd 6.7% Queensland Teachers Union Health Fund Ltd 5.9% Phoenix Health Fund Ltd 5.3% Westfund Ltd 5.0% Railway & Transport Health Fund Ltd 3.7% Mildura District Hospital Fund Ltd 3.3% St Luke s Medical & Hospital Benefits Assocn Ltd 3.2% Health Care Insurance Ltd 2.3% Cessnock District Health Benefits Fund Ltd 0.8% Source: Based on return on fund capital calculation from the operations of private health insurers annual reports and (PHIAC (2013a) and PHIAC (2014)) Note: For-profit insurers highlighted.

13 2. Structure of the Australian private health insurance industry and market entry 12 It may be the case that the rates of return presented in Table 5, in fact represent the required return on capital adjusted for market risks (Brealey et al 2005). These risks can take the form of regulatory risks, sovereign risks (government policy changes) and risks associated with the characteristics of the market such as the behaviour of competitors and the type of product being offered and more fundamentally, market uncertainty in the longer term which drives up the risk premium on an investment. 9 It may be that a material decline in current profitability would see insurers vacate the industry and seek to deploy their capital in activities with higher risk adjusted returns. Consistent with this view, it is reasonable to assume that a diminution of these risks would encourage entry into the market. 2.3 Entry and exit in the Australian PHI market The fact that there have been only two new entrants who have entered the market by establishing a new insurer since , suggests there may be barriers that are restricting market entry. If entry barriers were low as suggested by some industry participants 11, the lack of new entrants into the market despite apparent persistent strong profitability across all sizes of insurers in the market (see Table 5) requires explanation. 12 It is noteworthy that over this period there has been a significant level of merger and acquisition activity reducing the number of insurers in the market (See Figure 1) It may also be that health fund capital is not an accurate representation of the capital that must be invested in order to achieve the returns experienced. 10 National Health Benefits Australia Pty Ltd on 8 June 2007 and health. com.au Pty Ltd on 16 April Deloitte Access Economics 2012, p.18; AHSA and hirmaa 2013, p.8 9; KPMG 2013, p.14; HBF 2013, p Submissions to the first PHIAC paper (Deloitte Access Economics 2012, p.35; AHSA and hirmaa 2013, p.18) suggest that the level of profitability is not sufficient to attract new entrants and that if profits were excessive then there would be more entry into the market (AHSA and hirmaa 2013, p.8). 13 Gale and Watson (2007) provided a detailed chronology of the changing nature of the Australian PHI market and health funds from 1840 to A Poisson regression model (a type of count model used to identify the probability of certain events occurring such as market entry) were constructed using the number of insurers who entered the market over the period 1971 to 2014 as the dependant variable and the number of persons covered by the industry and significant policy changes (binary variables) as the independent variables to test market size and policy drivers of entry into the Australian PHI market. Because of the large number of binary variables representing key policy change were still effective in the industry and the lack of variation in the dependent variable (number of firms entering the market), the model 2.4 Entering the Australian PHI market A greenfield entrant establishing a new health insurer The process for registration of a private health insurer in Australia is contained in Division 126 of the PHI Act PHIAC is the body which determines if an applicant is to be registered as a health insurer. 15 The PHIAC practice note Registration of a private health insurer (PHIAC 2013b) provides an overview of the registration process and the supporting documentation required to be submitted with an application. Applicants seeking to establish a new health insurer must adhere to a number of regulations including satisfying the capital and solvency standards. 16 Sunk costs may however represent a more significant barrier to this form of market entry, with the potential for significant costs being required to establish a brand able to successfully compete with incumbent insurers. Figure 6 shows the number of health insurers in the Australian market from June 1971 to June 2014 and the number of new entrants over that period. The data shows that although there have been a number of new entrants into the market, the total number of insurers has been in consistent decline and there were no entrants in the 11 years prior to the entry of National Health Benefits Australia Pty Ltd in This decline has occasionally been through actual exit from the industry, but more commonly, through insurer acquisitions and mergers. 17 The most recent entrant has been health. com.au in April cannot be estimated because of severe multicolinearity (the inability to estimate a unique parameter for the variables). Estimation of a Poisson regression using maximum likelihood estimation with limited binary variables (introduction of Medicare and the requirements of registration and LHC) resulted in a model with a poor fit coupled with incorrect signs expected for the coefficients suggests misspecification. 15 Private Health Insurance (Prudential Supervision) Bill 2015 was introduced into Parliament on 27 May This Bill transfers the responsibility for supervision of the PHI industry (including the registration function) to the Australian Prudential Regulation Authority. 16 See Private Health Insurance (Health Benefits Fund Administration) Rules Including amendments around the capital adequacy standard, capital management plans and solvency standards. 17 A large number of insurers also exited the market due to re-registration requirements associated with policy changes in , and 2007 with the PHI Act 2007.

14 2. Structure of the Australian private health insurance industry and market entry Number of PHI health insurers in the Australian PHI market June 1971 to June 2014 Number of private health insurers New entrants/departures in that year Departing insurers from previous year (RHS) New entrants (RHS) Number of private health insurers (LHS) Source: PHIAC annual reports (various issues) Note: A number of new entrants, particularly in the 1980 s were health organisations which had previously left the market. Entry through acquisition An alternative to a greenfield entry is one achieved through acquisition of an existing insurer. In the case of an entrant from outside the Australian PHI market, many of the significant potential barriers to entry such as establishing a brand and brand name recognition, achieving the minimum required market share, negotiating supplier contracts and developing operational and systems capability may be overcome by the purchase of an existing PHI business. This method of entry allows for a rapid acquisition of market share (See Figure 8A for the BUPA acquisition of MBF and MBF Alliance) and reduces the need for significant expenditure of sunk costs in establishing brand awareness and insurer infrastructure. 18 The purchase of an insurer is relatively straight forward, where an offer is made, it can be accepted or rejected by the insurer. An acquisition (from a participant outside the market) does not change the number of insurers in the market, but it may change the competitive dynamics. One such change is the movement of the industry from a not-for-profit majority to a for-profit majority, as the acquisition process has usually been preceded by a demutualisation and conversion to for-profit by the insurer being acquired. Acquisition of an existing health insurer can overcome market based barriers faced by insurers seeking to expand operations in other states. 18 Merger and acquisition of health benefits funds processes are identified in Private Health Insurance (Health Benefits Fund Administration) Rules 2007 Part 4 and Schedule 1, and Division 146 of the PHI Act 2007.

15 14 3. Barriers in the Australian private health insurance market It could be argued that potential entrants to the Australian PHI market face, to some degree, all of the economic barriers to entry outlined in Chapter 1. Does regulation of the PHI industry impact on market entry? If so, are there ways in which these regulations can be modified to make entry of a new insurer less difficult? When firms consider entry into a market, an analysis is undertaken of the costs and benefits of entry. In the PHI market, the economic barriers to entry described in Chapter 1 may all be present to some degree. In this chapter, we will describe how these barriers may impact on a new entrant. Economic barriers which will be discussed in detail come under three broad headings: Regulatory burden Sovereign risk Market characteristics and contestability. 3.1 Regulatory burden Private health insurance has attracted more attention from policy makers than most other industries. This may be attributable to the vital nature of the services it funds, the interplay between these private services and the public services that governments fund, the prudential safety requirements that are common to many financial and insurance products, and in recent years the financial stake the government has in private health insurance (through the PHI rebate). This policy intervention has resulted in regulatory barriers to entry such as the need to satisfy prudential capital requirements and the impact of continued regulation of operations. Premium changes are governed by legislation as are the requirements of what must or must not be included in a private health insurance policy, who can take out such policies and the minimum cover that must be provided. 19 The regulatory framework for complying health insurance products is underpinned by the consumer and industry protection issues that these regulations were designed to address. Not only must these issues be faced, but a potential entrant must take into account that they may change. Prudential capital and solvency requirements Entry into the Australian PHI market requires a significant level of capital investment. For a new entrant, raising this capital may represent a significant barrier to entry. Capital in the form of liquid assets is required to begin operations and to be available to pay out potential claims. The Capital and Solvency standard are set out in the Private Health Insurance (Health Benefits Fund Administration) Rules 2007 in Schedule 2 and 3 of the rules and Division 140 and 143 of the PHI Act This capital requirement may be a significant barrier to entry as the new entrant would require a minimum rate of return on the capital they raise in order to make entry attractive. The requirement to meet capital and solvency standards applies equally to all insurers. However, new entrants may find this requirement more difficult to meet as they will not have had the opportunity to build up their capital reserves through the operation of the health insurer and accumulation of net margins These issues are detailed in Chapter 3 of the PHI Act 2007, Complying health insurance products.

16 3. Barriers in the Australian private health insurance market 15 Price regulation A condition of entry into the Australian PHI market is that premium changes are subject to Ministerial oversight. Premium change proposals must be submitted for Ministerial approval each year as part of a premium round and may be refused if the minister considers that it would be contrary to the public interest to allow the increase (PHI Act 2007 section 66-10(3)). Unsurprisingly, this level of oversight which means that unlike general insurers, private health insurers are not in control of their own pricing is often regarded as a features of the regulatory environment which gives pause for thought to prospective entrants and as such could be seen as a barrier to entry. In practice, there are a number of aspects to premium regulation which affect insurers including: the of limit of one price change per year at a specific time 20 ; and limited ability to undertake strategic premium pricing through discounts. These regulatory elements may be perceived by potential new entrants as a condition affecting the competitive operation of a private health insurer and as imposing constraints on the market. However, as Figure 3 and Table 5 shows, the operation of these restrictions did not result in negative industry net margins or profitability. Both prior to the introduction of the premium approval process and subsequently, premiums have increased mostly in line with hospital and medical inflation, perhaps suggesting no significant financial disadvantage to insurers or consumers. Seen in this light, perhaps the greater risk is the belief that, notwithstanding this experience, there is a potential for pricing process to go awry in a PHI business in ways which could not occur in other comparable businesses. 21 It should be noted that price regulation is not unique to PHI, it applies to a number of industries with important social and economic objectives, particularly those characterised as critical infrastructure (health care and hospitals, utilities, communications etc.). Product and other regulation A new entrant is obliged to satisfy the requirements set out by the PHI Act including the issuing and pricing of health insurance policies based on community rating, the associated risk equalisation arrangements, product content requirements (the minimum coverage that must be offered by a private health insurer) and portability. 22 Community rating is one of the most important regulatory conditions in the Australian PHI market. Community rating regulations require a health insurance policy to be offered to any person on the same terms, regardless of their health risk (and potential cost to the insurer) or based on a number of other factors. This differs from general insurance and may represent a significant financial risk for a new entrant, as initially they would be without the support of a significant customer base to smooth out benefit expenditure volatility or accumulated capital through operation. This risk is somewhat mitigated by the risk equalisation transfer arrangements established to support community rating. Portability rules mandate that waiting periods for hospital treatment cover already served by a transferring consumer from another insurer be recognised by the insurer to which they are transferring. With portability requirements, a new entrant may face significant hospital and medical benefit claims despite having received minimal premium income from the transferring member. Of course, a new insurer may well find it difficult to attract customers from other insurers if previously served waiting periods were not recognised. The new insurer appears to face a dilemma the need to attract consumers from other insurers but not being able to impose a waiting period prior to being confronted with significant benefit claims. This issue was canvassed in the PHIAC paper, Portability, switching and competition in the Australian private health insurance market. 20 Although this is the de facto process, there is nothing in the PHI Act which stops an insurer seeking premium changes at different times of the year or more than once per year. 21 Deloitte Access Economics 2012, p.18; HBF 2013, p.7; KPMG 2013, p.14; AHSA and hirmaa 2013, p Under the PHI Act 2007, community rating regulation is covered under Part 3-2, risk equalisation under part 6-7, product content under Part 3-3 (which also covers portability and waiting periods) and obligations relating to complying health insurance products under Part 3-4.

17 3. Barriers in the Australian private health insurance market Hospital treatment coverage by insured persons June 1971 to December 2014 Millions covered by PHI Commonwealth medical benefits at 30% flat rate restricted to those with at least basic medical cover from September Medibank began on 1 July A program of universal, non contributory, health insurance it replaced a system of government subsidised voluntary health insurance. 31 October Increase in MLS income thresholds, subject to annual adjustment. Introduction of Medicare from 1 February Introduction of Life Time Health Cover from 1 July July A Medicare Levy Surcharge (MLS) of 1% of taxable income is introduced for higher income earners who do not take out private health insurance. Change in the rebate indexation 1 July Introduction of 30% Rebate means testing from 1 July Higher rebates for older persons from 1 April Introduction of 30% Rebate from 1 January % 80% 70% 60% 50% 40% 30% 20% 10% Proportion with PHI 0 Jun 71 Jun 73 Jun 75 Jun 77 Jun 79 Jun 81 Jun 83 Jun 85 Jun 87 Jun 89 Jun 91 Jun 93 Jun 95 Jun 97 Jun 99 Jun 01 Jun 03 Jun 05 Jun 07 Jun 09 Jun 11 Jun 13 Jun 72 Jun 74 Jun 76 Jun 78 Jun 80 Jun 82 Jun 84 Jun 86 Jun 88 Jun 90 Jun 92 Jun 94 Jun 96 Jun 98 Jun 00 Jun 02 Jun 04 Jun 06 Jun 08 Jun 10 Jun 12 Jun 14 0% Persons covered by PHI (LHS) Proportion of persons covered by PHI (RHS) Source: PHIAC 3.2 Sovereign risk barrier the potential of regulation and policy change to impact on profitability Is the possibility of changes in industry regulation a significant barrier to entry? Can this risk be assessed? Sovereign risk in the context of the Australian PHI industry refers to the possibility that the government will change policies and regulations such that the business operations and profitability of private health insurers are affected. Sovereign risk has been put forward by many stakeholders as the main reason why there have been so few new entrants in the market. 23 The primary sovereign risks for the industry are changes to policy settings that would impact on the incentive for Australians to purchase PHI cover. 23 HBF 2013, p.7; KPMG 2013, p.14; AHSA and hirmaa 2013, p.17; Deloitte Access Economics 2012, p.18. All of these submissions identify very few other barriers apart from sovereign risk and regulatory burden. Figure 7 shows PHIAC trends data of the number of persons covered and the proportion of persons covered by hospital polices from June 1971 to December 2014 and significant changes in government policy with respect to PHI over that time. Although it would appear from the figure that particular government policy changes resulted in fluctuations in the number of insured persons (both positive and negative changes to the size of the market), it is difficult to say merely from a visual inspection the extent to which the changes in policy were a contributing factor. A quantitative analysis was conducted in the hope that it may shed some light on the impact of these changes. The analysis is detailed in Appendix A, where the policy effects were estimated for both the number of people and the proportion of the population covered by PHI. The analysis showed that for the population covered by hospital PHI, only two major policy changes, the commencement of Medicare and the introduction of LHC initiative had a statistically significant impact on the size of the market. The estimated effect of the introduction of Medicare, as a standalone effect (excluding all other factors) was to reduce the number of policy holders by 16.3 per cent

18 3. Barriers in the Australian private health insurance market 17 from the mean. The estimated effect of the introduction of LHC, as a standalone effect was to increase the number of policy holders by 24.2 per cent from the mean. In aggregate, the estimated impact of government policy changes which had a significant effect on the size of the market over the past four decades appear to have had a net positive effect on the size of the PHI market (as illustrated in Figure 7 by the steep upward slope of the coverage curve from 2000). Undertaking the same analysis for the proportion of persons covered, the results show that only the introduction of Medicare had a statistically significant and negative effect (also by a 16.3 per cent decline) on the proportion covered by PHI and explains why the proportion of policy holders has not increased to the same extent as persons covered over the period (see Figure 7). Of course potential new entrants will need to assess both the possibility of future changes to regulation and legislation and their effects on the PHI market. Uncertainty regarding future policy changes would most likely be a consideration in any decision to enter the Australian PHI market. 3.3 Market characteristics and contestability barriers Do incumbents through their actions or strategic decisions impose barriers to entry? The Australian PHI market is characterised by a small number of large insurers and a large number of small insurers. In this section, we will describe some of the barriers a new entrant might face that derive from the actions of incumbents and the dynamics of the PHI market. Strategic response of incumbents In the Australian PHI market, characterised as a mature market (Stephen 2012, p11), incumbents may make it difficult and costly for a new entrant to attract new customers. Some of the direct methods said to be employed include: Use of retention teams, where insurers employ persons to enquire as to why the policy holder chose to change insurers, challenging their decision and encouraging them to remain with their current insurer. 24 Product differentiation: the creation of different types and pricing of health insurance policies (including excesses and exclusionary products) to capture or target specific (sometimes price sensitive) sectors of the market and reducing the need or incentive for those policy holders to switch insurers. A new entrant may find it difficult to match these products due to their lack of scale and consequent inability to absorb the sunk costs need to develop and advertise these products (Kessides 1986). Incumbents may also have the advantage of established preferred provider contracts (particularly for dental and optical, in addition to certain specialists) increasing the attractiveness to consumers of their policies over those of new entrants (through potentially lower or no gap payments). As a consequence of these and potentially other responses from incumbents, the task facing a new entrant to compete on price and non-price factors may be more difficult. In addition, new entrants would need to establish brands in order to compete in a market with existing and well-known brands. Economies of scale and scope Entering the Australian PHI market is not costless. Even if entry is via an internet based business with no physical shopfronts, significant information technology, management and administrative sunk costs will still be incurred. This suggests that for a start-up insurer to be viable, they need to quickly acquire a minimum policy subscriber base in order to remain viable. However, insurers new to the market can often access efficient processing and contract management capability networks. In terms of the management of claims processing and policy management, most small insurers have agreements in place with organisations which specialise in these tasks (examples include but not limited to providers such as HAMBS, Paragon21 and CIVICA). In terms of hospital contracting, smaller insurers belong to one of two organisations (Australian Health Services Alliance and Australian Regional Health Group) which negotiate on their behalf. In addition, a new insurer can purchase these operational requirements and management expertise directly from other insurers (examples of insurers who do this include the Reserve Bank Health Society Ltd and National Health Benefits Australia Pty Ltd). 24 Queensland Teacher s Union Health 2013, p 5 6 and confidential submission to PHIAC DP1.

19 3. Barriers in the Australian private health insurance market 18 8A. Market share in the PHI market (2% to 30% of the market) June 1995 to December % 30% Insurer market share (as a percentrage of the market) 25% 20% 15% 10% 5% Medibank MBF until 2010 and BUPA after BUPAAH HCF NIB HBF AUHL 0% MBF Alliance AHM TFH Jun 95 Dec 95 Jun 96 Dec 96 Jun 97 Dec 97 Jun 98 Dec 98 Jun 99 Dec 99 Jun 00 Dec 00 Jun 01 Dec 01 Jun 02 Dec 02 Jun 03 Dec 03 Jun 04 Dec 04 Jun 05 Dec 05 Jun 06 Dec 06 Jun 07 Dec 07 Jun 08 Dec 08 Jun 09 Dec 09 Jun 10 Dec 10 Jun 11 Dec 11 Jun 12 Dec 12 Jun 13 Dec 13 Jun 14 Dec 14 Source: PHIAC data Note: Points where market share stop indicate that the insurer is no longer in operation. Market share for an insurer which suddenly jumps up is indicative of an intra-industry (within industry) merger of an existing insurer. Acquisitions usually occur prior to mergers. This figure excludes the insurers HBA and AXA which were acquired by BUPAAH and PA Health Benefits merged with AUHL in early With the availability of these networks and the ability to offer health insurance products over the internet, scale economies may no longer act as a significant barrier to entry as it was in the past. This means that scale economies may be less likely to hinder the viability of entry of a new competitor into the industry or overly benefit those incumbents with existing and expensive internal networks. Scale economies can give larger incumbent insurers an advantage in attracting new members through marketing spends, which may be unaffordable to a new entrant. However, this may be mitigated by smaller funds and new entrants utilising the services of intermediaries who directly enrol consumers. Cost advantage of incumbency Attracting new policy holders or wresting existing policy holders from competitors in order to maintain a minimum scale of operation is unlikely to be easy in the current PHI market where there is significant rivalry among firms (Deloitte Access Economics, 2012, p.18). Further, it may be that the general apathy of many customers in making a set and forget decision on PHI represents a significant barrier to entry that new entrants will need to overcome. 25 Looking at the market share of policy holders over time (Figure 8A, 8B and 8C shows the relative size of industry participants with most of the industry made up of insurers with less than one per cent of the market), the data show that the market has been relatively static with changes in market share occurring very slowly. The only significant change in the industry has been when a private health insurer was purchased by their peers as an intra-industry acquisition (as in the case of the BUPA, MBF and MBF Alliances merger in mid-2010, which saw BUPA s market share jump significantly). 25 IPSOS (2013) indicates that only 1.6 per cent of policy holder change insurers in any given year.

20 3. Barriers in the Australian private health insurance market 19 8B. Market share in the PHI market (0.5% to 2% of the market) June 1995 to December % GMHBA Defence Insurer market share (as a percentrage of the market) 1.5% 1.0% 0.5% Health Partners GMF IOR Latrobe HIF MU 0% Jun 95 Dec 95 Jun 96 Dec 96 Jun 97 Dec 97 Jun 98 Dec 98 Jun 99 Dec 99 Jun 00 Dec 00 Jun 01 Dec 01 Jun 02 Dec 02 Jun 03 Dec 03 Jun 04 Dec 04 Jun 05 Dec 05 Jun 06 Dec 06 Jun 07 Dec 07 Jun 08 Dec 08 Jun 09 Dec 09 Jun 10 Dec 10 Jun 11 Dec 11 Jun 12 Dec 12 Jun 13 Dec 13 Jun 14 Dec 14 CBHS Westfund Healthguard Source: PHIAC data Note: see notes for Figure 8A. Increasing market share to achieve a minimum number of policy holders for long term viability may require significant expenditure on advertising or intermediaries, representing a large upfront cost and a financial barrier to entry into the Australian PHI market. By increasing an insurer s policy membership, the insurer also increases their financial burden where additional levels of capital reserves would be required to meet prudential and capital standards of increased membership. Given the stable level of market share over the medium term as illustrated in Figure 8A, 8B and 8C, achieving a growth strategy in the PHI market is likely to be a costly undertaking and would imply a compounding of the barriers to entry in the PHI market for a new insurer deciding to enter and achieve a significant presence in the market. The difficultly new entrants face in increasing their market share is reflected in the health insurance retention index presented in Figure 9. This data shows that over the last seven years, average retention rates for health insurance policies held for two years or longer have been around 88 per cent, with restricted and not-for-profit funds having higher retention rates.