How to lose your shirt in private health insurance: Part one

What we’re asking:

• What are the circumstances that could cause you to ‘lose your shirt’ in PHI in Australia?
• How might you build financial readiness and resilience?

In order to identify the types of circumstances, we study the drivers of previous occurrences of financial distress for private health insurers. We also consider whether the reasons that general insurers fail are also relevant to private health insurers.

We then look at how capital can be used and managed to avoid an insurer ‘losing its shirt’—both from the regulator’s perspective and from an insurer’s perspective.

As such, the roadmap for the articles are:

Part one

1. Recent history of stresses and failures in PHI
2. Potential causes of failure in general insurance, and the implications for PHI

Part two

1. How the regulator (APRA) uses capital to build insurer resilience
2. How private health insurers manage capital to build resilience
3. Conclusions

Our intention is that this article will help inform discussions around:

• the nature of these circumstances and how they differ to general insurance;
• minimum regulatory requirements; and
• capital management policy considerations for resilience in the face of stresses.

1. Recent history of stresses and failures in PHI

Here we list the primary contributing factors to and broad themes behind 14 instances of financial distress for Australian private health insurers between 2000 and 2012, derived from an internal study conducted by the Private Health Insurance Administration Council (PHIAC).  This is not an exhaustive list of factors—if one studies the instances through other ‘lenses’, other factors such as quality of governance, strategy and relationships could also be identified.

Under-pricing – 100% of instances

More specifically:

• under-estimation of benefit costs for new products, new markets or new policy holders occurred in more than 80% of instances;
• forecasting did not reflect all the key drivers of experience (in particular drawing rates by duration of membership) in more than 80% of instances; and
• intentionally setting low prices to drive growth occurred in around 30% of instances.

Capital management – more than 80% of instances

More specifically:

• there were thin capital targets in around 40% of instances; and
• there was a lack of robust capital management practices (including setting targets and triggers, regular monitoring, and implementing remedial management responses) in more than 80% of instances.

Rapid membership growth (exceeding 10% p.a.) – around 70% of instances

This included:

• intentional strategic growth in around 40% of instances; and
• unplanned growth as a result of a Government policy change (for example, the introduction of lifetime health cover loadings in 2000 caused PHI participation to increase by around 50% in the space of a few months) in around 50% of instances.

Membership shrinking in around 10% of instances. This led to anti-selective lapses and joins and spiralling prices.

In summary, all of the 14 instances of financial distress in PHI were caused by deficiencies in at least one of:

• pricing practices; 
• capital management practices; and
• growth management practices.

All 14 instances involved weaknesses in pricing practices, and 10 also involved rapid membership growth.

Importantly, financial failure was averted in two instances because the insurers were able to carry out their capital management plans and triggers, and as a result they implemented premium increases of greater than 14%. However, the other 12 instances also involved capital management problems, which led to more serious distress.

Government decisions were a contributing factor in 10 out of 14 instances—either through a policy change leading to a surge in membership, and/or through Ministerial intervention in the annual premium increase process.

Investment losses played a secondary role in only one case, and inadequate provisions played a minor role in one other case.

2. Potential causes of failure in general insurance, and the implications for PHI

We now list the reasons for failure in general insurance and comment on whether these could also be principal causes for failure in PHI.

Catastrophic events – this is not a principal risk of failure for Australian private health insurers. Primary and public healthcare would absorb most of the cost of a catastrophic health event (such as a pandemic).

Inadequate provisions – this is not a principal risk of failure for Australian private health insurers. Provisions represent a small proportion of annual claim costs.

Inadequate premiums – this is also a principal risk of failure for Australian private health insurers. It includes risks relating to product design changes—i.e. the premium is insufficient for the product. However, the short-tailed nature of PHI means that under-pricing should become apparent quickly. Corrections can be made quickly because private health insurers are allowed to make adverse changes to benefits with only a small amount of notice to customers.

Rapid growth – this is also a principal risk of failure for Australian private health insurers. Combining rapid growth with inadequate premiums means private health insurers may become insolvent before corrective action can be taken.

Significant change in business – this is not a principal risk of failure for Australian private health insurers. Private health insurers are monoline (although a private health insurer’s membership base could change rapidly due to inadequate premiums or a new product suite – see above).

Mis-stated accounts / fraud – this is also a principal risk of failure for Australian private health insurers. However, the short-tailed nature of PHI means that there is less scope for mis-statement of outstanding claims or unearned premiums.

Impaired affiliate – this is not a principal risk of failure for Australian private health insurers. Most Australian private health insurers are largely focussed on PHI only. APRA’s prudential standards should ensure the insurer remains solvent if a related entity fails (although, the same should be true for Australian general insurers).

Reinsurance failure – this is not a principal risk of failure for Australian private health insurers. Private health insurers do not reinsure, except in limited small-scale circumstances.

The key risk that is more significant for private health insurers than for general insurers is the potential for Government decisions (policy and premium approval) and structural reform to drive sudden growth or reduced profitability.

See the full report here: How to lose your shirt in Australian private health insurance.

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