The Global Financial Crisis and Australian Private Health Insurers - a healthy future?

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1 The Global Financial Crisis and Australian Private Health Insurers - a healthy future? You will have seen a Finity article on the impact of the Global Financial Crisis ( GFC ) on the general insurance industry The Global Financial Crisis and Australian General Insurers the Calm Within the Storm. In this article we look at the Private Health Insurance market: what are some of the issues that PHI insurers might face? As the majority of health insurers are mutuals they have a narrower range of options if their capital base diminishes and with debt markets being effectively closed, premium sufficiency and retained earnings are critical. While it is unlikely an insurer would consciously be put in financial trouble as a result of the premium approval process, pressure on premium levels would add to any capital stress an insurer may experience. It is not possible to know what the full impact of the GFC will be, and this creates uncertainty for businesses. For this note, we have assumed that the GFC will lead to a period of reduced

2 economic activity in Australia, along with continued volatility in investment markets. That is, we have assumed a strong slowdown/moderate recession the impact of a severe recession may well be more dramatic. For PHI we have looked separately at those impacts that are direct (immediate balance sheet impacts) and indirect (changes to the operating environment that impact future performance). It is likely that the indirect impacts are of greater significance. Direct impacts 1. Assessment of liabilities Health insurance claim liabilities are short tailed in nature, typically with around 90% of claims paid within 3 months of the date of service. Given this short lag, claim amounts are not discounted so movements in yield have little direct impact on liability valuations. There are some adjustments in the capital calculations that reflect yield movements, but these would typically be minor in nature relative to the liabilities on the balance sheet. Similarly we would not expect any impact on any premium liability assessment. As a result, we think there is a low direct impact on the current year profitability due to liability movements....we think there is a low direct impact on the current year profitability due to liability movements. 2. Assessment of assets As at 30 June 2008, around 12% of the industry s assets were held in equities although this ranged from nil (for 16 insurers) to a high of 40%. Since that time, the ASX 200 has fallen by over 30% - potentially a $300m adjustment to the asset position of the industry. A further 52% was held in bonds/fixed interest, and loans. Potential issues in these asset classes include the presence of toxic debt assets (often through an enhanced cash exposure), as well as liquidity and market value movements due to changes in yield and credit spreads. A number of insurers also own direct owner occupied commercial property. The market value of any such property is likely to have experienced significant deterioration placing further stress on the balance sheet. For insurers (both GI and PHI) exposed to significant asset write-downs and subsequent changes in capital position we have found some form of stress testing of both asset values and liquidity useful. This can extend to Asset Liability Modelling ( ALM ) and an assessment of the insurer s tolerance to risk around key financial events. We comment on this in more detail below. Indirect impacts The more substantial impact on PHI Insurers is likely to be as a result of the impact on the general economy, and the environment in which the insurers operate. We have focused below on a few of the key elements. 1. Claim outgo In contrast to some other classes of insurance (eg disability insurance, workers compensation), it is difficult to see a direct increase in utilisation as a result of the GFC that is we believe it is unlikely that the incidence of claims will increase. There are some arguments for lower levels of utilisation

3 ...the major impact on claim outgo will be from demographic shifts. on the more discretionary elements of coverage given the presence of excesses and co-payments that are designed to share the risk (and cost) of a claim with the policyholder. Similarly, it is difficult to see a major impact on the average claim cost, beyond any impact on the demographics of the insurer. This leads us to conclude that the major impact on claim outgo will be from demographic shifts. 2. Membership Health insurers are vulnerable to adverse selection with new policyholders, lapse activity and product migration - in volatile times these risks are exacerbated. In our view the most important issue for health insurers will be the impact on membership. Industry participation and age mix has held up well over the past decade, partly on the back of strong Government support. However as participants in the industry are aware, it is not just the number of members that matter, but the demographic profile. 3. Sales levels Families or individuals who face a purchasing decision for the first time will be making that decision in very different economic conditions to the recent past. The latest forecasts show an In our view the most important issue for health insurers will be the impact on membership. expected increase in unemployment from around 4.5% to 7% or 8% within the space of a year. Not only will those without a job be unlikely to purchase PHI, those still with jobs may think twice. As a result, insurers may need to reassess their marketing strategy, and potentially revise sales forecasts. To the extent that insurers have assumed a proportion of sales to new to PHI this proportion may well drop, leading to an increase in the average claim level as the impact of the non claiming period for new entrants diminishes. 4. Member retention In our view it is likely that the GFC will impact retention levels, although different segments will be impacted differently. Where policyholders have taken out PHI in the expectation of making claims (say the elderly or chronically ill) they are likely to maintain insurance for as long as they are financially able for this segment PHI is viewed as less of a discretionary purchase, and more a necessity. Where people feel they have been forced into a grudge purchase (say due to MLS) we expect they will be more inclined to drop cover under economic hardship. In a similar way to the impact from sales volumes, not only do the numbers matter but so does a changing claim profile due to demographic deterioration. There may be potential for insurers to adopt policyholder interactions that assist customers during economic hardship. This could include offering suitable migration paths or policy downgrades, waiving or paying premiums for policyholders or allowing extended suspensions. While this would support policy numbers and market share, the cost to revenue should be understood.

4 5. Product migration Along with sales and retention, health insurers should be actively monitoring product migration, especially downgrades. Depending on the advice given to policyholders by branches or call centres, product downgrades can be either a valuable retention tool, or a hidden anti-selection pathway. 6. Expenses In the short term, it is probably difficult for an insurer to reduce expense levels. This would result in increased expense ratios if current expense levels are spread across fewer policies. The expenses most likely to be variable in nature are probably sales related marketing and commissions. Reducing these costs may improve ratios, but to the long term detriment of the insurer. 7. Capital position Each of the above elements will translate into an impact (in most cases some deterioration) in the insurers capital position. Analysis of these elements would also be useful in ensuring that forecasts used in capital calculations reflect the insurer s view of likely outcomes over the next 12 months. In a number of cases this will no longer be the same as the budget or premium submission forecasts. Allowance should also be made for increases in target surplus above the regulatory minimum. We have found companies benefit from assessing the capital position under a range of various pessimistic scenarios. Understanding your position So what can you do to better understand your position? We have seen insurers take a number of approaches to understand the potential impacts. Most often this is done using a range of scenarios (to test tolerance to continued extreme events) often combined with a re-assessment of risk profile. Specific actions could include: Investments Ensuring there is no exposure to toxic assets in your defensive portfolio Reconsidering investment allocations given the current position Risk profile Testing the current attitude towards risk through scenarios or stochastic modelling, e.g: Assuming 0% investment earnings over the next 12 months, or continued negative earnings from growth assets Assessing the impact of a low or nil premium increase (potentially over 2 years) Confirming the acceptability of poor financial outcomes (both P&L and forecast capital position) under the above scenarios Claims profile Analysing the selection impact of a changed demographic profile Using the analysis carried out for MLS changes will be a useful starting point Capital management Stress test the business plan and capital forecasts against a range of GFC scenarios Prepare contingency plans for the more significant outcomes Expenses Ensuring that expenditure levels balance the current financial position and long term strategy We would expect that most insurers are well advanced with most or all of the above actions. Finally, there are a range of strategic responses to extreme events such as the GFC. These could range from (due to either culture or necessity) battening down the hatches (an internal/defensive approach) to pursuing growth opportunities if you have the courage and capital (an external/ expansionist approach).

5 Finity is the largest independent general insurance actuarial and consulting firm in Australia, with around 80 staff in Sydney and Melbourne. Finity has a dedicated practice to provide actuarial and management consulting to private health insurance companies. Our core areas of expertise include: Strategy: Finity assists insurers with a range of strategic issues. Recent assignments have included assisting health insurance companies to review their capital management plans in response to recent financial events. Appointed actuary role: Our consultants have experience in preparing liability valuations and Financial Condition Reports, and can provide the necessary opinions on pricing and product design. Our reputation is built on providing advice that is clearly communicated and of outstanding technical quality. Demutualisation, merger and acquisition: Finity has been actively involved in recent industry consolidation, engaged by insurers on both the buy and sell sides in recent transactions. Contacts Geoff Atkins Geoff.Atkins@finity.com.au Ian Burningham Ian.Burningham@finity.com.au Loan-Anh Nguyen Loan-anh.Nguyen@finity.com.au Jamie Reid Jamie.Reid@finity.com.au Sonia Tripolitano Sonia.Tripolitano@finity.com.au Copyright 2009 Finity Consulting Pty Limited Sydney ph: fax: Level 7, 155 George Street THE ROCKS NSW 2000 Melbourne ph: fax: Level 6, 30 Collins Street MELBOURNE VIC 3000 Finity Consulting Pty Limited ABN: