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

Welcome to the final instalment of the two-part series! This article outlines ways in which capital can be managed to build resilience.

Recap – 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. How the regulator (APRA) uses capital to build insurer resilience

From APRA’s point of view, a private health insurer would ‘lose its shirt’ if it was (close to) being unable to pay a claim. One of the ways APRA tries to prevent this is through its capital adequacy standard (HPS110), a principles-based standard enacted in 2014 which incorporated learnings from the cases of financial distress outlined above. The capital adequacy standard has two key components:

1. A minimum amount of capital that every insurer must hold—we’ll refer to this as the regulatory requirement (RR). This is intended to be enough capital for the insurer to survive the next 12 months at least 49 times out 50, even if its management took no corrective actions. In other words, it should buy enough time for most potential causes of financial distress to be fended off. On average, the RR in PHI is about 5.5% of forecast annual premium revenue.
2. The effective capital requirement, in practice though, is higher than the regulatory requirement. APRA requires private health insurers to have, and comply with, a Board-endorsed capital management policy (CMP), with appropriately set internal capital targets, triggers and management responses, based on the insurer’s own risk assessment. In other words, an insurer breaches the capital adequacy standard if their capital falls below a target or trigger level and they do not carry out the actions specified in their CMP. The focus of this requirement is around insurer practice—as noted above, recent instances of financial distress were averted when the insurer was able to put into practice their capital management plans.

APRA uses the term “Surplus Capital” in its quarterly statistics publications, to refer to the capital amounts over and above the RR. But, in practice, this capital is not “surplus”, as insurers are required, through the capital adequacy standard, to hold the majority of this capital (in the form of their capital target), or to rebuild capital if it depletes over time.  The term “Surplus Capital” may lead to unintended pressure on insurers to reduce their capital targets or to allow capital to fall below their targets, for example through the premium approval process.  This could lead to a higher risk of an insurer ‘losing their shirt’.

APRA’s RR has the following components for an average private health insurer, giving a rough sense of the size of the various risks:

• A significant requirement in relation to capital management (through the CMP);
• A large component that reflects under-pricing risks (part of the RR);
  1. This requirement becomes significantly larger when insurers are growing (or shrinking);
  2. It also increases as expected profitability reduces, as insurers targeting small profit margins are more likely to end up making a loss than insurers targeting higher profits;
  3. The impact of differences in fund size on financial volatility are also considered;
• A moderate component that reflects investment risks (part of the RR); and
• A small component that reflects the risk of inadequate provisions (part of the RR).

The three largest elements of APRA’s capital requirement (relating to under-pricing, growth and capital management) match the three largest contributing factors of recent financial distress.

       2. How private health insurers manage capital to build resilience

Private health insurers hold more capital than the RR for a combination of good reasons, including:

• They are required to—through the CMP requirement, APRA compels insurers to manage their capital to internally set targets, with trigger points for corrective actions. Clearly these levels must exceed the RR.
• They have different risk appetites to APRA—an insurer would probably say that it had ‘lost its shirt’ if it breached APRA’s capital adequacy standard (due to the legal and reputational ramifications). Holding more capital than the RR is a way of protecting against this eventuality.

Target capital levels, trigger points and action plans are not public information.  However, we attempt to illustrate how this might look for a ‘typical’ private health insurer with a risk appetite for no more than a one in 200 chance of breaching the RR within 12 months. The choice of one in 200 is illustrative, but is the stated sufficiency of regulatory minimums in a number of other insurance industries around the world, and would also reflect this insurer having a lower risk appetite than the regulator.

We estimate that this insurer would need to hold capital of around 8% to 10% of forecast annual premium revenue on top of the RR. In reality, the size of this buffer would depend on the size and risk profile of the insurer—typically, larger insurers would require less than this amount and smaller insurers more.

In total, this insurer targets around 14% of forecast annual premium revenue—the 5.5% RR plus a buffer of 8.5%. The only two publicly disclosed capital targets in the Australian PHI market are for the funds with listed parent companies—Medibank Private Limited targets 12% to 14%, and nib health funds limited targets 13.8%.   

Some general insurers quote capital targets as multiples of the APRA RR for general insurers (which is set at a 1 in 200 probability of sufficiency). For example, Suncorp and IAG quote targets of 1.4 to 1.6 times APRA’s prescribed capital amount, and QBE uses 1.6 to 1.8 as its range.

If an average private health insurer used a capital target multiple of 1.5 times a one in 200 RR (estimated above at 8% to 10%), this would be around 12% to 15% of forecast annual premium revenue.

Potentially more important than the amount of capital held, is the management response to a challenging capital situation—including the discipline of the monitoring processes and whether or not the corrective actions included in the plan are followed effectively

        3.Conclusion

Findings:  Recent examples of financial distress in PHI have arisen from a consistent set of risk factors—pricing, growth and capital management.  An FSA study [1] included a finding that “Management problems appear to be the root cause of every failure or near failure.” This indicates a need to focus on underlying internal causes and importance of governance and stewardship such as monitoring trigger points and action plans.

Comparison to General Insurance: Many of the issues that are significant for general insurance (catastrophes, reserves, business changes, impaired affiliates or reinsurance failures) have not been experienced by private health insurers.

On the other hand, Government decisions (through health policy changes, and through its role in the premium increase process) have played a significant role in some instances, which contrasts to their relative lack of influence on general insurers.

While the risks differ, the need to anticipate how risks interact is common for both GI and PHI. For example, correlations between operational risk, underwriting risk and structural change risk could be considered in a ‘group risk map’.

Implications:  A risk-based approach brings benefits and implications. Forward-looking tools (such as scenario analysis) are required in order to set capital targets and triggers, and these are inherently subjective in nature. Despite being good practice (and required by law), capital targets and triggers above the RR can be wrongly perceived as being ‘surplus to’ or ‘in excess of’ requirements.

Limitations: This paper explores themes at the industry level. An individual insurer’s own risk assessment and capital stresses can vary significantly by size and qualitative factors.

Possible next steps:

• Shift the focus of insurer practice from regulatory capital calculations towards scenario and resilience planning in relation to a range of different future landscapes
• Benchmarking Australian PHI not just against GI, but also against global leading insurance practices, including Solvency II
• Review the use of the term ‘Surplus Capital’ to refer to the amount of capital that insurers hold above the RR.

Reflection questions:

• To what extent are pricing errors driven by a lack of technical ability/resource, or by inherent bias (e.g. management incentives)?
• Are capital problems usually driven by a poor CMP, or by a lack of adherence to the CMP?
• Is there any correlation between weaknesses in key relationships (e.g. CEO-Board, CEO-Appointed Actuary, pricing team-sales team) and instances of financial distress?

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

[1] “Managing Risk: Practical lessons from recent “failures” of EU insurers”, 2002, William McDonnell, Financial Services Authority Occasional Papers Series