Are Health Insurance Margins Sustainable?

This story features NIB HOLDINGS LIMITED, and other companies. For more info SHARE ANALYSIS: NHF

-Claims inflation likely heading higher
-NHF management upbeat about reviews
-MS downgrades Medibank Private
 

By Eva Brocklehurst

Health insurer margins are in the spotlight. Brokers interpret commentary from nib Holdings ((NHF)) as either a glass half full or empty, in terms of the outlook. The company's update clarified underlying operating profit in FY16 should be in the previously expected range of $125-135m, but comments regarding claims inflation were somewhat open to interpretation.

The trend of falling claims utilisation, which has been of benefit to private health insurers, seems to be stabililsing and potentially reversing. How slow or fast this occurs is the main issue for the outlook for FY17.

Macquarie notes the company observes claims inflation is heading back towards more normal levels post the March quarter and not declining as it was earlier in the year. That is, management is not witnessing the declines that were evident over the past 12 months. The broker finds these comments consistent with private hospital admission volumes, which are up 3.2% in a rolling 12-months to April but are tracking well below long-term averages.

Meanwhile, nib is intent on improving customer experience in terms of lapse and retention, claims management and working with the government on sector reform. The broker also observes the company expects to renegotiate debt facilities in 2016, with capital management centre stage in its considerations.

Ord Minnett remains bullish on the near term trends for nib, particularly Australian margins into FY17. The broker retains a Buy rating on the stock, the only top rating in FNArena's database with six others sustaining Hold ratings. The broker notes the CEO's remark that margins could overshoot in the near term if claims inflation remains low but that longer term nib would aim to get margins in a 5-6% range.

Yet, Ord Minnett finds no evidence from the company's comments that the favourable claims trends have started to reverse significantly, also flagging the comment that some of the claims savings from prosthetics reforms have not yet been announced, although the extent of these may be lower than expected.

The prevailing low claims inflation provides comfort to the broker that margins are likely to be strong in FY17, perhaps stronger than FY16 and some of this upside could subsequently be returned to policy holders in the form of lower premium rate increases.

Morgans notes management is upbeat about the potential outcomes of the current private health insurance review, believing disparities in prosthesis pricing will be removed. This ultimately costs the industry $800m per year.

The broker observes, in terms of the Australian Resident Health Insurance (ARHI) business, the under 40s segment is shrinking and most growth is now in the over 55s market on which nib is increasingly focused. Morgans points out that the nib lapses in membership remain higher than the market, potentially driven by a higher exposure to a younger segment, but product downgrading is a smaller issue for nib than for the broader industry.

Any benefits from elevated net margins into FY17 will be short-lived and recycled into lower prices and growth, Deutsche Bank suggests. The broker envisages some normalisation of the claims inflation trends, with future earnings growth increasingly reliant on indirect volume growth from ARHI and targeted returns in adjacent businesses.

Management expects to put through price increases to offset the 5-6% per annum industry cost growth going forward. In New Zealand, digitisation is expected to drive cost efficiencies and lift net margins to 7-8% with the company expecting a 15% return on equity in that segment by 2018. For the World Nomads business, the broker observes volume growth has slowed along with consumer sentiment and hitting targets may take longer.

Credit Suisse is a little sceptical, noting that, while management appears confident of ongoing premium rate increases around 5%, claims inflation is below historical levels and the decline appears to have levelled off. The broker also asserts management does not envisage a risk from increased pricing scrutiny and believes returns and the level of excess capital in the industry is irrelevant in respect of how much it charges the consumer.

Credit Suisse also maintains the concept of managed care in the home, cited as an opportunity by management, is uncertain in terms of expanding the earnings base, as it requires major structural change in the GP environment.

Morgans likes the overall story on nib, believing it offers a differentiated growth outlook to peer, Medibank Private ((MPL)) but considers the stock fair value. Some caution is also warranted, the broker asserts, given the ongoing government reviews.

Meanwhile, another concern for the industry has arisen in that the Australian Competition and Consumer Commission has started proceedings against Medibank Private in the Federal Court for misleading and unconscionable conduct, asserting the insurer failed to give notice to members about its decision to limit benefits paid for in-hospital pathology and radiology. Medibank Private is rejecting the claims.

Coincidentally, on the subject of Medibank Private, Morgan Stanley has downgraded the stock to Underweight from Equal-weight, believing the near-term upside is priced in and reflecting the expectations of another upgrade following a benign March quarter in claims experience.

The market seems comfortable that the company's current net margins over 8% can be sustained, but the broker suspects these will peak in FY16/17, reverting to more sustainable levels with top line headwinds and normalising claims inflation.

The broker expects a major shift to lower premium policies and lower premium rate risks will reduce top line growth at Medibank Private. Morgan Stanley agrees the limited political appetite in the current federal election year means the chance of reform is all but gone this year, although industry feedback suggests a 5-10% cut in prostheses may eventuate this year. The broker's bear case probability on this risk is unwound to 20% from 30%.

Credit Suisse considers the industry to be structurally unsustainable, but a lack of regulatory change is allowing a period of inflated earnings for nib. The broker concludes that a regulated industry cannot be faulted for an increase in costs resulting in higher profits and lower costs meaning even higher profits, but struggles to accept this environment will continue forever.

Hence, valuation remains a hurdle. In the near term the stock remains a safe investment heading into the August results and Credit Suisse retains a Neutral rating. The consensus target for NHF on FNArena's database is $4.13, suggesting 3.5% in downside to the last share price. Targets range from $3.30 (Morgan Stanley) to $4.60 (Ord Minnett).
 

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