A Business Appraisal of Private Medical Insurance in Ireland

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1 A Business Appraisal of Private Medical Insurance in Ireland A Report for The Minister for Health and Children Private Health Insurance Advisory Group March 2007

2 A Business Appraisal of Private Medical Insurance in Ireland Contents Sections Page 1. Introduction and Summary of Recommendations 1.1 Introduction Summary of Recommendations 2 2. The Private Medical Insurance Industry in Ireland 2.1 Market Size General Regulatory Issues 5 3. Financial Characteristics 3.1 Capital Requirements Return on Capital Employed 6 4. Regulation 4.1 Summary Community Rating Risk Equalisation Capital Adequacy in PMI Consumer Issues Vhi Healthcare Summary of Recommendations 34 Attachments 1. Minister s Announcement and Terms of Reference The Competition Authority s Recommendations The Health Insurance Agency s Recommendations Parties Consulted Formally Submissions Received and Documents Reviewed 54

3 A Business Appraisal of Private Medical Insurance in Ireland 1 Introduction and Summary of Recommendations 1.1 Introduction On 17 January 2007 The Minister for Health and Children announced that she had appointed a three person group comprising Colm Barrington (chair), Seamus Creedon and Dorothea Dowling (the Group) to carry out a business appraisal of the private medical insurance (PMI) market in Ireland and to report back to her on the subject by 31 March The Minister s announcement included the following terms of reference for the Group: To examine whether, having regard to all aspects of the current health insurance market in Ireland (structure, size, regulatory framework, etc.) and the need to maintain community rating, it is possible for current and prospective participants in the health insurance market to earn a rate of return on capital employed which would be regarded as adequate for the insurance industry. To make whatever recommendations it considers appropriate in the light of its findings. The Minister s announcement is shown in Attachment 1. This Report sets out the findings and conclusions of the Group on the issues set out in the Minister s terms of reference. In coming to these conclusions the Group has consulted with and received submissions from various parties who have expressed an interest in private medical insurance in Ireland and has reviewed published and unpublished materials deemed relevant to the subject. A non exhaustive list of the materials reviewed is shown in Attachment 2 and a non exhaustive list of the parties consulted is shown in Attachment 3. We appreciate the time taken by all parties to discuss relevant issues with us and we have particularly appreciated the valuable support from officials of the Department of Health and Children. Because of the quantity of written information already available on the subject, our ability to consult with the various parties involved with and interested in PMI in Ireland, the business appraisal nature of the assigned task and the relatively short time frame requested by the Minister, the Group deemed it both unnecessary and impractical to commission any new research on the subject. As a result, the Group s conclusions are drawn from its review of existing material, its discussions with participants in the industry and other interested parties and the general experience of the members of the Group. Private Medical Insurance in Ireland A Business Appraisal Page 1

4 Again, because of the nature of the task which we have been given, the experience of the Group s members and the available time frame, the Group has decided not to support its conclusions with repetitions of exhaustive backup. Much of this detailed backup can be reviewed in the materials identified in Attachment 5 and / or has been publicly stated by the parties identified in Attachment 4 and in the recommendations contained in the very recent reports of The Competition Authority as set out in Attachment 2 and of the Health Insurance Agency (HIA) as set out in Attachment 3. The Group has chosen to make recommendations only on the major issues that we believe can make a significant difference to PMI in Ireland, with resulting benefits for PMI consumers, industry participants and the community at large. We sincerely hope that our analysis and recommendations will be a helpful guide towards resolving some of these complex and important issues. 1.2 Summary of Recommendations We believe that the current PMI market is not one where existing and prospective participants can earn or expect to earn a rate of return on capital employed which would be regarded as adequate for the insurance industry. In order to achieve market conditions that would attract participants based on reasonable expectations of earning an adequate return, our principal recommendations (which are set out in more detail later in this report and are summarised in Section 7) are as follows: 1. Steps should be taken to immediately commercialise and regulate Vhi Healthcare (Vhi) and to mutualise it and arrange third party capital for it by the end of the first quarter of 2008; 2. Government policy should encourage increases in the size, market appeal, innovation and competitiveness of the PMI market as a component of a quality healthcare delivery system; 3. Community Rating should continue to be applied to all insureds but only to those levels of their benefits that are deemed to provide adequate PMI cover by the majority of the insured population and not to the additional coverages for the higher levels of PMI; and 4. A simpler, more limited, transparent and, possibly, prospective form of Risk Equalization should be introduced which would not be regarded as a subsidy to Vhi. 5. The structures for and regulations pertaining to consumer protection in relation to PMI need to be thoroughly overhauled. We hope that our conclusion and recommendations will be acceptable to the Minister and that their execution will not be compromised by vested interest groups. Private Medical Insurance in Ireland A Business Appraisal Page 2

5 2 The Private Medical Insurance Industry 2.1 Market Size Since the formation of the Voluntary Health Insurance Board in 1957, Ireland has had a relatively well supported PMI industry. This may stem from our history, when at the time that the Voluntary Health Insurance Board was formed, 15% of our population did not qualify for public health facilities. It may also stem from our current situation where our public health facilities are regarded by many as being inadequate. Whatever the reasons, the fact that more than 50% of the Irish population subscribe to PMI suggests that it is a product that is valued by the population here. This market penetration compares to approximately 10% of the population in the United Kingdom and is up from about 30% in Ireland in the 1980s. A basic tenet of insurance is that the losses of the few are funded by the contributions of the many - ultimately policyholders pay for everything. Normally, the larger the pool of insurance contributions then the cost to each member will be less burdensome. Despite the relatively high PMI market penetration here, Ireland s relatively low population size means that our PMI market is still relatively small in total terms, with total premium income of approximately 1.25 Billion. In addition to PMI, the general economic environment here also appears to have facilitated the purchase not just of medical insurance but of similar products, such as income continuance, hospital cash plans, and personal accident benefits. It is surprising how many people have two or more such products as shown in the September 2005 Insight survey for the HIA. Our conclusion from this information is that, while relatively small, the Irish market could be an attractive one for PMI providers. There appears to be some uncertainty among policy makers, both here and abroad, as to whether a strong and vibrant PMI market that is embraced by a sizeable percentage of the population is a good or a bad thing. This uncertainty became quite apparent during our discussions with officials from the Department of Health and Children (DOHC). This uncertainty probably stems from a perception among both politicians and civil servants that the provision of public health services is their duty and that encouragement of PMI is potentially both an admission of defeat in their job of providing these services and a potential source of social disharmony between those who are insured and those who are not. The Group found this uncertainty particularly surprising in the context of the government s strong support, including through fiscal measures, for the development of private hospitals. The Group is aware that some countries have achieved universal medical insurance through a combination of public and private arrangements. The arguments for this are strong in that through ensuring insurance for all of the community rather than providing healthcare, the state has empowered the consumer with the buy decision and so has encouraged the supply side to respond to consumer needs. While the Group can see merit in this approach, we believe that a recommendation on it is beyond our remit and a full analysis of the issues involved is also beyond the expertise of and time available to the Group. Private Medical Insurance in Ireland A Business Appraisal Page 3

6 The trend for unit costs in the field of medicine to increase more rapidly than general inflation is observable worldwide. Additionally, in Ireland there is some need for rebalancing of costs from public to private care. Furthermore, the population profile in Ireland is likely to be aging for the foreseeable future. These factors will tend to lead to significant real increases in the cost of insurance, although we believe that competition can mitigate these to a limited extent. It is likely that the voluntary Community Rating model will come under pressure in the longer term and that alternatives such as Statesupported universal PMI may have to be evaluated in due course. Voluntary participation in PMI has grown steadily for most of the fifty years since inception of the Voluntary Health Insurance Board. This is in contrast with the United Kingdom where participation in PMI has varied downwards as well as upwards. Steady sustained growth is conducive to stability of the Community Rating model and in our view should be encouraged by government policy. While the take-up of PMI in Ireland is relatively high as compared to other countries, because of our relatively small population the total size of our market is still relatively small as compared to some other countries. As a result, the Group believes that the Irish PMI market would benefit from a clear government policy decision to encourage it and with this policy decision potentially supported by fiscal measures. The Group, while not being experts in the provision of public health services, concluded that PMI should be strongly encouraged as it puts management of their healthcare into people s own hands and encourages them to take a proactive approach to their health management. From a business perspective, a larger and more vibrant PMI industry is likely to attract more insurance providers and lead to increased demand for quality health facilities, potentially a more healthy population and more competitive pricing of health products. From the State s point of view, and provided that public health facilities that are made available to private customers are properly priced, then the fact that individuals are prepared to pay for their own healthcare should be regarded positively, at least from economic and fiscal perspectives. As regards pricing of healthcare products, the Group was not convinced by the arguments made by some parties that greater availability of private healthcare facilities leads to higher pricing. While greater availability of health facilities may lead to a higher total national spend on health, if this is mainly because needed facilities are more readily available and without inordinate waiting periods, then it must be regarded as a good thing. Obviously, providers of PMI need to ensure that expenditures are reasonable and that claims are not being abused. An active PMI market generating price competition among providers is more likely to achieve this objective than is a moribund one. Private Medical Insurance in Ireland A Business Appraisal Page 4

7 2.2 General Regulatory Issues In broad terms, we recommend that PMI be regulated by the Financial Regulator, to whom the Health Insurance Authority should in future report in relation to the Risk Equalisation Scheme. Taking just the simple practical concerns of market players, insurers prefer having to deal with a single regulator. This arises not just in terms of cost and time but also for the consistency of principles that may apply to such issues as consumer protection. Even the very definition of terms such as settled claim reflects a technical difference between the HIA and the Financial Regulator. Since the High Court decision in BUPA v The Health Insurance Authority and others in November 2005 there is a greater clarity about the operation of Risk Equalisation in Ireland, although we are still in the first stage in introducing some greater predictability into what that means in financial terms. It will obviously be a matter for the Financial Regulator to ensure that liabilities arising under the Risk Equalisation Scheme (as modified by our recommendations) are reasonably reserved. A more predictable system of Risk Equalisation would also assist the Financial Regulator in ensuring that the accounting treatment is adequate for solvency purposes but not excessive as, of course, returnable profits for tax purposes will be reduced accordingly. Substantial data is collected by the HIA for the purpose of Risk Equalisation. The publication of costs by age and gender on a market aggregate basis might well attract new entrants who would then have some comfort about the dynamics of the market that they are considering entering. A similar proposal by the Competition Authority on general insurance is now being implemented by the Financial Regulator in relation to motor insurers raw data. In these days of sophisticated Information Technology, electronic filing of returns is preferable for all parties. The Financial Regulator is currently upgrading the system for the Blue Book so it would be timely to incorporate into that specification the health insurers returns. This is particularly so given that returns are likely to be required on a quarterly basis in future and with more extensive data by individual ages rather than ten year bands. While we have only undertaken preliminary research, it seems possible to purchase an off the shelf package for calculations under the revised Risk Equalisation Scheme which we propose. Private Medical Insurance in Ireland A Business Appraisal Page 5

8 3 Financial Characteristics 3.1 Capital Requirements The major requirement for capital in the PMI industry is to fund assets required to comply with the capital adequacy requirements of the Financial Regulator. While capital is also required by new entrants for start up costs and working capital, the Financial Regulator s requirement that all participants in the Irish PMI market (other than Vhi) provide capital equal to at least 40% of their annual premiums as a solvency margin is the major use of capital in the PMI industry here. In simple terms, if an insurer needs to provide capital equal to 40% of its income to meet capital adequacy requirements and needs to earn a pre-tax return of 12.5% on that capital, then it will need to be able to provide that at least 5% of its annual income is retained, after all other expenses, to meet its return on capital requirements. The Group has concluded (see later discussion) that the solvency requirement of 40% of annual premiums required by the Financial Regulator is high in relation to the risks to consumers presented by a mature firm doing business in the PMI market. As a result, the cost of servicing this capital is higher than the Group believes that it needs to be. This in turn results in higher costs to the consumer than would otherwise be required. In Section 4 the Group makes a recommendation in respect of what it believes are more appropriate capital adequacy policies for the PMI market. 3.2 Return on Capital Employed In general terms the Group established that insurer participants in stable, well regulated and predictable markets regard PMI as being relatively low risk as compared to other forms of non-life insurance. As a result, existing participants in such markets generally appear to be prepared to participate if they can expect pre-tax returns on equity capital employed in the range of 10% to 15% per annum., As previously explained, this requires regulated participants in the PMI market to retain approximately 5% of their annual premium income if they are to achieve their required targeted return on capital employed. As it is not regulated and is not required to earn a return on capital employed, the Vhi does not have this requirement. The Group concluded that this level of return on capital employed is reasonable for incumbents in a PMI industry that is relatively stable and predictable. However, new entrants will likely seek an initial target rate that is higher in order to compensate for venture risk. New entrants in a market which is unpredictable in scale and profitability will likely seek additional returns to compensate for this also. Current and potential new participants (that is those parties other than Vhi) have concluded that it is not possible to earn a rate of return on capital employed in the Irish PMI market that they regard as adequate. This is despite the fact that the size of the Irish market in relation to population is relatively large as compared to other countries that have a mixture of public and private healthcare (although our population is substantially smaller than some of the other more active markets such as Australia and The Netherlands). Private Medical Insurance in Ireland A Business Appraisal Page 6

9 The legislation establishing Vhi does not require it to achieve any particular rate of return on capital nor to pay any dividends. The legislation merely requires it to operate at a break-even level. We note that expected changes in the framework for prudential solvency supervision in the EU/EEA will increase the attractiveness of the Irish PMI market for European firms. This is because, in contrast to the historic supervision regime, the advantages to insurers of diversification by geographic exposure and by line of business will be explicitly recognised. All other things being equal, this should enhance the interest of EU/EEA based insurers in the Irish PMI market. Private Medical Insurance in Ireland A Business Appraisal Page 7

10 4 Regulation 4.1 Summary Based on discussions with the participants and with other interested parties, the Group concluded that the Irish PMI market is not stable, well regulated nor predictable. We concluded that the main reasons for this, and why there are not more participants in the PMI market here, are because: The State owned Vhi has a dominant, favoured and protected position in the Irish PMI market. Vhi has not shown itself to be clearly supportive of an enlargement of the market by new competitors, which would appear to be at odds with government policy. There is also plausible anecdotal evidence that Vhi can do much more to contain the cost of claims, which is by far the major driver of its prices to customers. While Vhi claims that its operating costs as a percentage of revenues are lower than its competitors, the Group believes that this can largely be explained by Vhi s greater scale and by the fact that the newer competitors are attempting to establish and grow their business. Specifically, Vhi benefits from the following: A dominant market position resulting from its long history and a reputation (earned mostly in the forty years before competition) for providing an essential service to the Irish PMI consumer; Consumer perception of its inherent stability resulting from State sponsorship; Consumer lethargy in moving from their existing provider despite considerable potential cost savings; The operation of the current Risk Equalization Scheme, which is regarded by its competitors as subsidization of an inefficient competitor; The fact that Vhi does not come under the regulatory requirements of the Financial Regulator (which, in addition to other advantages, saves it at least 30 Million per annum as a result of not having to meet the Financial Regulator s solvency requirements); and The fact that its sponsor does not require it to earn a return on capital or to pay a dividend. The concept of Community Rating, although understood to be and generally accepted as a key part of public policy and a given part of the Minister s brief to the Group, is inherently at odds with an open and free market. While from a social point of view it is to be welcomed that a concept whereby everyone pays the same regardless of their level of risk (unusual in any other area of insurance) is so well accepted by the community, it does potentially create instabilities and obstacles to the growth of the market that, in the long run, may actually work against the purposes for which it is intended. Private Medical Insurance in Ireland A Business Appraisal Page 8

11 Community Rating has resulted in a perceived requirement for some form of Risk Equalization in order to compensate insurers who have an older customer profile and so a higher claims experience from the same level of premium per insured as received by the insurers with a younger customer profile. Risk Equalisation as it applies in Ireland is calculated on a retrospective basis and based on claims benefits paid in the previous six months. As a result it can be difficult for new competitors to evaluate their likely future liabilities. Risk Equalisation as applied here also is regarded as requiring the contributing insurers to subsidise the potential inefficiencies of the receiving insurers through the zero sum adjustment. Because of its long history, Vhi naturally has an older customer profile than the industry newcomers and so, since the application of Risk Equalisation, Vhi has been the only active potential recipient. This has caused particular angst among the new participants, who are attempting to break into the market, as it has required them to contribute to an organisation that is the dominant incumbent and which they regard as being moribund and predatory. Also, the perception that Risk Equalisation was imposed by the government after Vhi s financial results turned from several years of healthy profits to a sudden and significant, loss is regarded with great suspicion by Vhi s competitors. The Financial Regulator requires participants in the PMI market (other than Vhi) to retain Capital Adequacy amounts which the Group considers high in relation to the risks inherent in PMI and which are also high in relation to international comparisons. As solvency margins reflect the majority of the capital employed in the PMI industry, this represents an additional burden and hurdle for new entrants. Ireland has inadequate consumer information and protection regulations which the Group believes defend the position of the dominant player. Partly because of the variances in regulatory framework, PMI consumers are inadequately protected and informed as compared to other classes of insurance business, particularly in areas such as ease of switching providers. With the application of better consumer information and consumer choice regulations, the Group believes that the opportunity for new participants to expand the business and to increase their market shares would be considerably enhanced. In any event, the facts speak for themselves. There is not a vibrant, competitive and stable PMI market here. Despite the fact that it has been technically possible for new participants to enter the Irish PMI market since 1994, the following situation currently exists: Vhi, a State entity that operates outside the financial regulatory framework that applies to other participants, remains the single dominant player, with more than a 75% market share; BUPA Ireland (BUPA), part of a major provider of PMI worldwide, has left the Irish market after ten years and after establishing an approximate 20% market Private Medical Insurance in Ireland A Business Appraisal Page 9

12 share, stating that since Risk Equalization has been applied it cannot operate within the regulatory structure here; VIVAS Health (VIVAS), after three years in the market, will be subject to Risk Equalisation from October 2007 as a result of which it is expected to become unprofitable. One could understand if VIVAS shareholders were to question the rationale of contributing the extra capital required to meet its solvency requirements in these circumstances and in the current market environment; and The Quinn Group (Quinn) has reportedly entered into an agreement to acquire BUPA s portfolio. Quinn has stated quite categorically that, while it is not against Community Rating and some form of Risk Equalisation per se, it will not make any Risk Equalisation payments that benefit Vhi while Vhi is in such a dominant position and while Vhi enjoys a protected status and exemption from solvency requirements. The Group, which was appointed by the Minister primarily because of the uncertainties that currently exist in the Irish PMI market, has concluded that the main reason for such uncertainties is the hugely dominant position of Vhi and the manner in which Vhi has used this State-supported and dominant position. It is unlikely that new participants in the Irish PMI market will ever achieve an adequate rate of return while Vhi s position remains so dominant. The remainder of this Section 4 deals with these issues in more detail and in this Section and in Section 7 we set out our recommendations as to how they should be tackled. Private Medical Insurance in Ireland A Business Appraisal Page 10

13 4.2 Community Rating Introduction Community Rating means that the level of risk that a particular consumer poses to an insurer does not affect the premium paid, and is an established cornerstone of government policy in order to assure availability of cover for all. Consideration of an appropriate mechanism for Risk Equalisation is a logical corollary to a commitment to Community Rating. Community Rating may however reasonably mean different things to different people, and the appropriate mechanism for Risk Equalisation will correspondingly differ. Risk Equalisation itself can have a variety of meanings, including that of avoiding a degree of difference between insurer portfolios such as to prevent market disruption. Insurers suggest that the viability of their business depends on their freedom to make use of customer-specific information in order to offer terms. This is particularly the case where insurance is on a voluntary rather than a compulsory basis. The principle can be controversial as rating based on gender has been challenged and rating based on genetic information remains extremely controversial. In contrast, life assurance rating based on state of health and lifestyle factors, such as smoking, is widespread and uncontroversial. A particular feature of PMI is that conventional risk rating leads to high prices for those people suffering from chronic illness and many of these would almost certainly be unable to afford coverage. This is the principal argument for an approach to rating which is blind to underlying risk factors. The Voluntary Health Insurance Board (as it then was) operated from inception a system of Community Rating under which all insureds paid the same premium for a given level of benefits. This is a distortion of the market, but we concur with others who have concluded that abandonment of the principle of Community Rating at the present time would cause difficulties. In any event it is part of the brief given by the Minister to the Group. Community Rating is effectively a transfer from PMI policyholders with lower risk profiles to those at higher risk. In most cases this involves transfers from younger policyholders to the older generations. It is likely to become increasingly unstable as the demographic profile of the potentially insured population ages and as insured provision is increasingly separated from public provision. The Australian example of growing tax subsidies in an unavailing effort to grow participation is relevant. Private Medical Insurance in Ireland A Business Appraisal Page 11

14 4.2.2 Scope of Community Rating As we see it there are at least four generic levels of health care available to PMI subscribers: Level 1: Level 2: Level 3: Level 4: Basic coverages providing treatment in public hospitals; Midrange coverages providing semi-private care in either public or private hospitals; Upper level coverages providing private care in private hospitals; and Top level coverages providing what many would regard as luxury facilities in top of the range private hospitals. While all PMI insureds are covered to Level 1 or Level 2, approximately 15% of those insured also subscribe for Level 3 and Level 4. Coverages tend to be defined principally in terms of hospital care provided, with ancillary benefits also ranging from basic to luxury levels. The Group believes that as a matter of principle, Community Rating should apply only up to a level of coverage which is deemed adequate for and by the major proportion of the insured population (which would correspond to Level 1 and Level 2 above). Additional coverage in excess of Level 2 is appropriately risk-rated and should be capable of being freely priced by insurers. This would ensure that a standard level of cover would always be available to the population generally at a rate likely to be affordable, while avoiding cross-subsidies and potential instability in relation to higher cover levels. The initial definition and ongoing review of a standard level of coverage up to which Community Rating should apply should be progressed on a consultative basis. We believe the views of the PMI providers, clinical professionals, the DOHC and the full range of stakeholders are relevant, and consultation should proceed both at a reasonable pace and with the fullest transparency. The consultation should also embrace the scope of benefits to be included in Risk Equalisation arrangements (see Section 4.3 below). We do understand that a minority (estimated at approximately 5%) of insureds will as a result of this change likely either have to pay more for cover or to make use of lowercost hospital facilities. On the other hand the change should make it possible for larger numbers of young and middle-aged insureds to take advantage of newer and higher-cost facilities than is at present the case. Private Medical Insurance in Ireland A Business Appraisal Page 12

15 4.2.3 Price Differentials There is also a plausible argument for flexing the universal Community Rating basis in order to offer some incentive to healthy lifestyle behaviours, such as not smoking. In practice, it is unlikely in current circumstances that any loading on smokers would be actively applied, resulting in a risk of destabilisation of the Community Rating system. Thus Community Rating as presently interpreted can inhibit encouragement of socially desirable health-maintaining behaviours. The current legislation giving effect to Community Rating allows for a discount of up to 10% of the standard rate. In practice, the scope of this discount has been extended to embrace payroll deduction schemes, arrangements entered into on the internet and more. It appears, according to our discussions with firms, that the original discount has evolved into an effective surcharge paid only by a small minority of customers who lack the sophistication to avoid this. This surcharge appears indefensible, and we recommend early consultation with the industry with a view either to eliminating the price differential or replacing it with a fairer approach Transparency to Customers As already noted, Community Rating is an artificial construct reflecting an implicit assumption that the young and healthy are willing to subsidise other members of the community. It was put to us that it could be advantageous to make this element more explicit, in that this could reduce the controversy associated with Risk Equalisation as a means of giving effect to Community Rating. One way of doing this would be to give prominence to a calculated community rate based on the market average age and gender profile and a market average claims cost. Individual insurers could adjust this rate by addition or subtraction of amounts reflecting their own costs of administration, any variation from the average in unit claims costs, costs of any additional benefits and so on. A similar alternative would be to make explicit the difference between the standard rate calculated at each age and the market average rate. Thus the premium for each insured younger than the average includes a solidarity contribution while for each older insured the premium is reduced by a solidarity benefit. These could be shown explicitly on statements to customers. These and other similar suggestions are beyond the scope of our remit. While we favour transparency in principle, we note that a probable corollary of such an explicit approach would be a tight mechanism to transfer corresponding amounts between insurers. This would probably reinforce the anti-competitive aspects of Community Rating overall. Neither have we considered what might be the effect of a more transparent approach on participation in the PMI market generally. Private Medical Insurance in Ireland A Business Appraisal Page 13

16 4.2.5 Lifetime Rating / Late Entry Loading We understand that legislation is imminent to implement the recommendations of several bodies to the effect that insurers be allowed to discriminate between first-time insureds based on the age at which insurance is effected. There is a consensus that it is fairer to charge those who effect insurance later in life an annual additional amount to reflect their likely greater level of risk. To the extent that this change can be represented as what it is, a loyalty bonus for long-term participation in PMI, it seems more likely to be acceptable to the public. We support this change, and believe that the scale to be implemented should be constant up to about age 30, graduated smoothly from about age 30 to age 65 and constant from age 65 on. For example an effective formula could be one such as: Rate (age x) = Rate (30) x (1+k (x-30)) Where: k is of the order of 3% (so that a 45-year old entrant would pay 145% of the rate paid by his 30-year old counterpart) It unlikely that the amount of loadings to be generated by this change will of itself be significant to the finances of the Community Rating scheme. We do believe however that consultation with the industry on the manner of its implementation can facilitate co-ordinated promotional communication so as to boost overall participation (by attracting older insureds prior to the date of change and younger insureds afterwards). This consultation should also embrace an appropriate scheme for pooling of the loadings paid by customers across the industry and whether or to what degree agedependent waiting periods for new entrants may be reduced and made consistent. Private Medical Insurance in Ireland A Business Appraisal Page 14

17 4.3 Risk Equalisation Introduction Risk Equalisation has been the principal focus of controversy throughout the twelve years since the Irish PMI market was first opened to competition, and this continues to be the case. The recent High Court judgement left open the challenge of devising a better scheme. Respondents have put strong views to us, and we characterise the extremes of the range of these below. One view holds that Risk Equalisation is a transfer of resources from advantaged insureds to disadvantaged insureds in the interests of community solidarity. This view, which sees Risk Equalisation as essential to sustaining Community Rating, tends to favour a comprehensive scheme having regard to all of age, gender, health status and other factors which might all be used as a basis for selection. This view would include up to the full community-rated Level 2 coverage (see Section above) within the scope of equalised benefits. The alternative view suggests that Risk Equalisation is not a requirement at all. Given that all insurers are legally obliged to offer community rates, lifetime cover, and open enrolment, there is no need to operate a transfer mechanism between insurers. If one insurer experiences difficulties due to insuring a disproportionate number of poor risks, its customers may transfer elsewhere. Competition is a safeguard for and in the best interests of consumers. Proponents of this view may concede that a transfer mechanism should be available as a last resort in the face of extreme instability but that this should be of a minimalist character. Both views have some superficial coherence, and in practice most players acknowledge the need for some balance: Taken to its extreme, the solidarity view reinforces the anti-competitive aspects of Community Rating generally and is clearly a deterrent to market entry and innovation. It seems likely that it operates to favour larger, longer established competitors. At the other extreme, the high-stakes competition view would expose insurers to spiral failure and their customers would likely have to be prepared to switch regularly. This would be unfair to less well-informed customers and would likely damage consumer confidence. The existing arrangements recognise both views, and allow limited discretion to both the HIA and the Minister for Health and Children to form their own view on the appropriate balance between solidarity and competition. Our view, however, is that markets operate best when the competitive context is clear rather than being dependent on the exercise of discretion. The slow pace of change in the movement of market shares, together with the limited interest in the market on the part of new entrants, leads us to believe that the present Risk Equalisation arrangements operate more to enforce solidarity than to stimulate competition in the present state of development of the market. Private Medical Insurance in Ireland A Business Appraisal Page 15

18 Specifically we consider that the present approach of a set of triggers for partly discretionary action variously by the HIA and by the Minister makes for an unpredictable competitive context. We favour a single bi-directional trigger, i.e. one that is an MEP threshold above which Risk Equalisation operates and below which it ceases to operate. In current circumstances, we believe that the setting of this MEP threshold at not less than 3% for the foreseeable future would offer a reasonable incentive to competitors of Vhi to seek to attract sufficient older members to achieve tolerable portfolio convergence across the market. This is compared to a present portfolio mix which corresponds to an MEP of 4.8% (average for 2006). We further believe that the benefit costs included in the Risk Equalisation Scheme should be limited to a proportion of the benefits subject to Community Rating, in order to provide some competitive incentive. Such an adjustment is not unusual in similar schemes elsewhere and is particularly appropriate in a context in which one player (Vhi) enjoys a considerable scale advantage. We have recommended above that the scope of community-rated benefits be the subject of consultation and we recommend that the proportion of benefits subject to equalisation be addressed in that context also. Pending the outcome of consultation, we believe that not more than 80% of benefits subject to equalisation under present arrangements be included in the Scheme. We have considered the merits of replacing the present Risk Equalisation Scheme with a prospective calculation. Such an approach would have considerable advantages in terms of ease of understanding and use (especially for smaller firms) and would assist the general public in understanding that Risk Equalisation transfers between firms broadly are on behalf of customers. We have been impressed with the design and management of the scheme introduced in South Africa. On the other hand, there are practical difficulties in sustaining balance in a prospective scheme and most participants acknowledge that the difference should not be material financially. We have therefore chosen to frame our recommendations in the form of changes to present arrangements, while supporting further exploration and consultation on a prospective approach. The market stability justification for Risk Equalisation should by definition embrace only firms which are active in open enrolment in the public marketplace and subject to public supervision. We do not believe that provident funds offering benefits only to a closed group should either contribute to or benefit from the Risk Equalisation Scheme. We appreciate that implementation of this recommendation (affecting only the ESB Provident Fund) may cause some or all insureds to transfer from the closed to the open system, possibly by inviting bids from the open enrolment insurers. This may well be a desirable development in any event. We believe that the non-application of Risk Equalisation transfer requirements to new entrants for a period of over three years following entry was a crude form of incentive which tended to further distort the market and, in our view, has appropriately been eliminated. We believe that it is sustained competition over the medium- to long-term which should be encouraged in the manner set out above. We believe it right to emphasise that our recommendations in relation to Risk Equalisation are intended to be consistent with all other elements of our recommendations, and particularly those in relation to the future of Vhi. If for some Private Medical Insurance in Ireland A Business Appraisal Page 16

19 reason the latter cannot be progressed according to the timetable we envisage in Section 6, then it is our view that the objections by firms and by many commentators to risk equalisation will have much justification and a completely new scheme with higher thresholds and lower levels of benefit equalisation would be needed to sustain a competitive marketplace. Private Medical Insurance in Ireland A Business Appraisal Page 17

20 4.4 Capital Adequacy in PMI Objectives of Prudential Supervision Like other insurers, and indeed other types of financial institution, PMI insurers operate in a quasi-fiduciary capacity, collecting premiums from the public in exchange for a contractual promise to meet financial liabilities in various specified circumstances. It is generally accepted that such firms cannot be allowed to operate entirely without constraint, but are appropriately subject to supervision in order to contain the risk of failure to a level consistent with maintaining public confidence. Supervision is a restraint of competition in that, for example, it creates a barrier to market entry in the form of various authorisation requirements. Similarly, supervisory requirements to maintain assets in excess of liabilities (solvency margins) affect the price of insurance to customers all other things being equal a higher solvency margin translates into a higher price. This potential tension between level of risk and level of competition in financial services is very well recognised, and also is increasingly recognised as a global rather than purely local issue. Across all the financial sectors, there are moves to harmonise standards which achieve a reasonable balance between effective competition and a tolerable risk of failure for an individual firm Regulatory Authority The relevant regulatory authority for health insurers with their head office in Ireland (or operating in Ireland with a head office outside the EU) is the Financial Regulator (formerly the Irish Financial Services Regulatory Authority). Until now, Vhi has been allowed a derogation from the requirements of the Financial Regulator both in relation to prudential supervision and in relation to conduct of business. As already noted by this Group and most observers, this anomalous position implies a dependence on the State s sponsorship and provides an unfair competitive advantage. VIVAS and, prospectively, Quinn Health (denoting the Quinn company which will act as underwriter for health insurance) are subject to all relevant requirements of the Financial Regulator. For completeness, health insurance policies offered by BUPA Ireland were underwritten by an Irish branch of a BUPA underwriting company headquartered in the UK, and were therefore subject to the parallel requirements of the Financial Services Authority in the UK. We note that the latest available Insurance Statistical Review published by the Financial Regulator indicated that over 50 insurers with an Irish head office were authorised to underwrite Class 2 non-life insurance (which includes health insurance), although only those noted above are active within Ireland. Private Medical Insurance in Ireland A Business Appraisal Page 18

21 4.4.3 Current Regulatory Standards In essence, all insurers are in principle obliged to manage their financial resources so as to provide adequately for liabilities to customers and others and, in addition to such provisions, to maintain a Solvency Margin in order to reduce the risk of insolvency to a negligible level. Provisions are established by management, are subject to audit review, and are also usually (Vhi being a temporary exception) subject to specific regulatory reporting requirements which should allow any systematic under-provisioning to be detected. In this respect, medical insurance is little different to other forms of non-life insurance, such as household or motor insurance. Provisions are subject to all relevant accounting standards. The principal focus of this section of our report is the appropriate or required Solvency Margin dictating that assets be held in addition to those required in respect of provisions. As already noted, this has a bearing on insurance pricing, in that insurers will aim to charge prices which achieve an overall target rate of return on capital inclusive of capital required to maintain the required Solvency Margin. The current absolute minimum requirement in this respect for insurers subject to conventional prudential requirements (again Vhi is a temporary exception) is the required minimum Solvency Margin stipulated in European Union (formerly EEC) directives, and is: 16% of premium income (18% of the first 50 Million); or, if higher 23% of claims outgo (26% of the first 50 Million) Typical loss ratios on medical insurance are such that these requirements can normally be expected to translate into approximately 20% of premium income. We note at this point that while the foregoing requirement applies to all forms of nonlife insurance, the consensus of actuarial professional opinion is that it underestimates the true solvency margin requirement for most lines which tend to exhibit volatile results because of cyclical influences on pricing and the effect of low-frequency high severity events. Typically a benchmark solvency of 40% of premium income would be regarded as the minimum required for non-life insurance generally, and regulators on both sides of the Irish Sea have operated an informal minimum requirement of 200% of the directive requirements noted above. The FSA in the United Kingdom has recently introduced a series of benchmarks of capital requirements for premium and provision insufficiency, with those for accident/sickness insurance (embracing medical insurance) being much the lowest. This Enhanced Capital Requirement is a multi-factor calculation, but would be of the order of 15% to 20% of premium for PMI. As noted earlier, VIVAS is the only domestically-oriented medical insurer supervised by the Financial Regulator, and currently operates subject to a minimum solvency margin requirement of 50% of premium income (expected to reduce to 40% as the company builds up its exposure base and gains experience). Private Medical Insurance in Ireland A Business Appraisal Page 19

22 4.4.4 Solvency 2 The European Union is engaged in a major project to modernise its framework of insurance prudential supervision in line with the corresponding Based 2 (Capital Requirements Directive) framework for the banking sector. This project, expected to be implemented in member state legislation by 2012, is known as Solvency 2. The main features of the Solvency 2 project are: The directive to implement Solvency 2 will be published in 2007, and while important elements of the new regime have yet to be agreed most of the framework and its implications are already clear: There will be a Solvency Capital Requirement (SCR) calculated according to a model or formula intended to ensure that the risk of insolvency over a oneyear horizon is not greater than 0.5%; The calculation of the SCR will be able to take account of diversification of statistically independent risks, and this will in turn incentivise insurers to diversify portfolios; and The framework will strengthen disclosure requirements and enlarge the scope and impact of supervisory review, but will reduce supervisors discretion to impose additional capital requirements. Solvency 2 is expected to prove a significant stimulus to the competitiveness of the European insurance industry and we note that a number of regulators (most obviously in the United Kingdom and The Netherlands), with the support of major local firms, are moving to anticipate as far as practicable the change of regime (an example being the FSA s enhanced capital requirements as mentioned above). We understand that the Department of Finance, the Financial Regulator, the industry and stakeholders are considering these issues for Ireland. We encourage this, having regard to an apparent clear risk of regulatory arbitrage in relation to PMI business. It seems likely that the implementation of Solvency 2 will cause greater interest in the Irish PMI market on the part of overseas firms motivated by portfolio diversification considerations Implications for the PMI Market In effect, Vhi enjoys an implicit subsidy through its sponsorship by the State, as compared to competitors who have to set aside financial resources from the equity provided by investors. The value of this subsidy might reasonably be quantified at 25 Million to 45 Million per annum. This reliance on State sponsorship is undesirable both on grounds of fair financial competition and because of the perceived conflict of interest created for the State as sponsor. We believe that bringing Vhi within the conventional regime of insurer prudential supervision should be of the highest priority. We also believe that the Financial Regulator should, as far as is practicable, consider the authorisation of Vhi within the emerging Solvency 2 framework, with the requirements of Solvency 1 as a secondary constraint. This will require consideration of a number of issues: Private Medical Insurance in Ireland A Business Appraisal Page 20

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