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A tale of two insurers

“It was the best of times, it was the worst of times, it was the age of wisdom, it was the age of foolishness, […] it was the spring of hope, it was the winter of despair, we had everything before us, we had nothing before us, we were all going direct to Heaven, we were all going direct the other way…”
 
The private health insurance industry finds itself at somewhat of a crossroads. While the Charles Dickens quote above opens ‘A Tale of Two Cities’, the theme of my remarks today is a tale of two insurers. 
 
Navigating through challenges such as declining affordability and participation, together with the policy responses to those challenges, demands a deftness of strategy and maturity of risk management and governance that hasn’t previously been required in this industry. Approaches that were successful for navigating past challenges cannot be assumed to be successful in the future as the environment shifts dramatically.

Today I will speak on three key topics:
  • The first is APRA’s observations of insurer better practices and areas for improvement in managing affordability challenges and policy change risks. Overall our conclusion is that there needs to be a material uplift in insurer strategies for management of these risks. 
  • Second, while a robust strategy is critical to navigating those challenges, we should also recognise that the strategy may not be successful. APRA has spoken previously about the need for insurers to have a sound Plan B so they are prepared if their business model comes under sustainability pressures. Today my key message is that APRA will be moving with some urgency to ramp up the pressure on insurers to be prepared. 
  • Third, I will provide an update on the review of capital requirements. Capital is a key tool for driving the resilience of insurers to emerging challenges.
Before I come to the detail of my comments, let me situate them in the broader context of the debate around private health insurance. Some of the detail may sound a bit esoteric or technical but the reason we take these steps to improve resilience is fundamental to the well-being of Australians. For many years, Australians have benefited from a combined public/private healthcare system, however the ability of the private insurance sector to continue to make its contribution is coming under increasing threat from the challenges of affordability. APRA’s role in the system is to ensure the resilience of private health insurers so they can meet the promises they’ve made to policyholders, and continue to play their role in supporting the broader public health system. 
 
The costs of healthcare continue to rise, across both the private and public systems[1]. It is these increasing costs, together with higher demand for healthcare services, which are the root cause of increasing premiums. Rising premiums are only a symptom; as long as the costs of healthcare grow at 5-6 per cent per annum, there will be pressure on premiums to rise by a similar amount, continuing to damage affordability. The affordability challenge in private health insurance then is part of a broader context – how should society fund healthcare costs? 

I should be clear that APRA doesn’t have or desire a position in that debate; it is rightly a question for the community, governments and the Parliament. But neither are we passive bystanders. APRA has an important role to play:
  • Firstly, by working with insurers and the industry to increase resilience, so that they are able to respond to the challenges. And if those responses are ultimately not effective, to ensure that policyholders are protected.
  • Secondly, APRA aims to aid an informed debate on the role of private health insurance in the broader system. In particular, where we see emerging threats to the sustainability of an insurer or private health insurance generally, to call these to the attention of stakeholders so that decisions can be made with full understanding of the prudential consequences. 
With that said, and in the spirit of my literary opening, let me introduce you to the two insurers that are the main protagonists of my comments today. I’ll start with a disclaimer – these are stylised composites included for illustrative purposes, and no resemblance to any health insurer current or departed is intended. The descriptions incorporate a significant amount of poetic licence. With that said, let me introduce:
  • Resilient Health Fund; and
  • Complacent Health Fund.
In recent years, Resilient Health Fund has invested significantly in its risk management approach. While further improvement can always be made, Resilient is justifiably proud of its progress. Resilient is overseen by a board that has been refreshed to bring in new perspectives. The directors have a range of tenures, skills and experiences, and the board has a robust board renewal policy guided by a board skills matrix. The management team is supported by strong financial and actuarial analysis capabilities. In short, Resilient has invested heavily in its capabilities and is now positioned to reap the benefits.
 
Complacent Health Fund has been successful historically and is justifiably proud of the service it has provided to its members over a long period of time. The current directors have been on the board for an extended period and there is very limited acceptance of fresh perspectives. They are a bit bewildered by the ongoing calls to enhance risk management and governance – why would we need to change now when we’ve been successful for so long? As a result, Complacent finds itself confronting a challenging future with a set of practices that are lagging well behind better practice. 
 
Having introduced the two insurers, I’ll now discuss affordability and policy change risks in more detail.  Afterwards, we can return to the story of Resilient and Complacent and see how they fare in responding to the risks. 
 

Managing affordability and policy change risks

 
Policy change risk has long been recognised as one of the major risks to the private health insurance industry. In recent years the risk has increased in prominence, as policymakers respond to widespread dissatisfaction with the value provided to policyholders. Rapidly rising costs and demand for healthcare have driven premium increases significantly above CPI and average weekly earnings, making affordability of private health insurance front page news. Unsurprisingly then, affordability and policy change risk are two of the key risks on APRA’s industry risk register. 
 
Last year, APRA requested a range of information from insurers to help us form a view about how these risks are being managed. Earlier this week, we released a letter to industry setting out our findings including better practices we observed and areas for improvement. The headline story is that while some insurers are more advanced than others, we aren’t convinced that any insurer yet has a robust strategy for managing the risks. 

In some ways, that no one has yet solved this problem is unsurprising – these are challenging issues and the path forward is not clear. Aspects of the problems are outside the control of insurers. But preparation is always better than cure and there is still opportunity for insurers to become more resilient through robust approaches to these issues. Early movers have the opportunity to find a competitive advantage by developing innovative strategies. 
 
One pleasing outcome from APRA’s review is that there is a high degree of awareness of policy change and affordability risks. Yet it remains troubling that few insurers are translating their awareness or understanding into actionable plans – dare I say, an element of being Complacent? 
 
While these risks are often considered as a pair, I will deal them separately today as I draw out some findings from APRA’s information request – and as you will see, this reflects that differing strategies are likely to be needed to address each issue. 
 
You’ll see as we work through the detail that while many insurers are taking at least some steps to respond to the risks, no one can yet lay claim to a genuinely Resilient approach.

Affordability risk

Firstly on affordability risk, APRA has seen that insurers are considering a range of strategies. APRA welcomes this diversity – it is important that the strategies take account of the individual insurers’ business and member characteristics. Yet, often the strategies are vague, fail to address the material risk or rely heavily on actions by others. This is especially the case for insurers that use third parties to support core business functions that are critical to the strategy. 

With 82 per cent of Australian households concerned about the cost of private health insurance[2], awareness is no longer an adequate stance. Insurers need to quantify the impact of an adverse affordability scenario at meaningful extremes and start implementing actions to address the materialising risk. Deferring action or waiting for a third party to ‘serve-up’ a solution is not a defensible strategy. So perhaps most concerning is that many insurers are taking only tentative steps to deliver on their strategies. 

When it comes to thinking about what insurers can do to mitigate affordability risk, APRA considers promising strategies are those where the insurer is actively changing how they provide services to their members – for example where insurers are facilitating substitutes for traditional in-hospital services, revising their health supplier contracts or developing preventative health and well-being offerings for members. These are actions which are well within the control of insurers. Those that move early can benefit from a more open field, with less need to navigate through what others have already implemented. 

Policy change risk

Turning now to policy change. There is no doubt the heavily regulated nature of the industry means insurers are exposed to policy change risk. This is not a new phenomenon – but I expect most of you would agree we are seeing a heightened period of impact from policy reforms as governments grapple with changing demands on the health care system. 

In this context, APRA welcomes steps insurers have taken to understand and model scenarios for the most evident policy change: a period of premium increases being constrained below increases in claims costs. But as we know, shocks to the system rarely follow expectations. Insurers that are not thinking broadly about how policy change may impact their business therefore risk encountering their own “winter of despair”.

I can almost hear some of you sigh, thinking “but what can we do? Policy settings are beyond our control”. While I won’t try to tell you otherwise, APRA’s view is that this does not preclude actions by insurers to mitigate the impact of changes. So it is concerning to APRA that we see passivity among insurers.

APRA expects to see insurers drawing on their expertise to develop specific policy proposals, undertaking evidence-based analysis and using these insights to engage with policy makers and others in the health care system on reform proposals. Looking within their business, APRA would expect that better prepared insurers are taking actions to improve the value of services for members. This might be via service quality offerings, non-PHI benefits or strategies that can control costs. Together these types of actions may help insurers address affordability risk and so position them to tolerate policy changes. 
 
Let’s pick up the story of Complacent Health Fund in the light of the findings of APRA’s letter.
 
Complacent’s under-developed risk management and governance approaches meant they were slow to react to the emerging challenges. They took comfort from their past successes and the fact that in the past when participation rates fell, policymakers had responded by adjusting policy settings. They didn’t develop a proactive strategy and instead saw themselves as passengers rather than in the driving seat. 
 
Resilient moves far more quickly, gaining a competitive advantage that sets them up for future success.
 
APRA’s work on affordability and policy change risks shows there is still a path forward for Complacent Health. By taking steps to translate awareness of the risks into proactive strategic plans, there is time to increase their resilience and avoid going “the other way”. 
 

Recovery planning and plan B

 
We all hope that all insurers are able to respond to the challenges and continue to serve their policyholders for a long time to come. But there is no guarantee that will be the case, and so developing a robust plan to recover from stress should be on the agenda for any responsible insurer. 
 
This is not unique to your industry; APRA has been working with the major banks and other insurers on recovery planning since 2011. But the need amongst private health insurers is particularly heightened at present given the challenging conditions in the industry. We are already in a period of premium growth being constrained at a level below the growth in underlying costs. APRA is on the record as stating that such an environment will challenge the sustainability of insurers and that it is likely to lead to consolidation if it continues for an extended period.

APRA has already commenced bilateral discussions with a number of insurers who we have identified as the most likely to face sustainability challenges. As flagged in our letter to industry this week, our work with relevant insurers on recovery plans will continue to intensify. Our key message is that insurers should proactively develop recovery options, including a Plan B. For many insurers, the likely Plan B will be a merger with a like-minded partner. APRA will not hesitate to act to protect the interests of policyholders should it become necessary due to viability concerns with an insurer. That can take the form of an orderly merger or other exit from the market. Importantly, an insurer that has a plan and executes it when it becomes necessary can control its own destiny; an insurer that fails to plan will find that it loses that opportunity.
 
We pick up the story of Complacent and Resilient as their strategy for addressing affordability and policy change risks falter and their business models come under sustainability pressures. 

Complacent doesn’t grasp the severity of the challenge until the situation has deteriorated significantly. Rather than receiving and acting on the early warning signals, the board doesn’t act until APRA imposes strong pressure. By that time, the options available to the insurer have narrowed, and the insurer is pushed into a hastily arranged merger. Policyholders are protected, but the process is somewhat disorderly and reflects poorly on both Complacent and the industry more broadly. 
 
Resilient commences its preparations far earlier. Although the board has confidence that their strategy for managing the risks will be successful, they also recognise the need to prepare just in case. The board and management develop a recovery plan that has escalating metrics or triggers to determine when action should be taken. As they come under sustainability pressure, consideration is given to the range of possible actions outlined in the recovery plan, and the board determines that a merger would be the best outcome for its members. 

In developing the recovery plan, the board had exploratory discussions with potential preferred merger partners, and these discussions firm up as the situation continues to deteriorate. At the point determined in the plan, the board agrees to implement its plan B. As a result, policyholders are transitioned in an orderly way with plenty of time for communication. The merged entity emerges stronger than the sum of its parts and the reputation of the insurers involved and the industry as a whole is protected. 
 
APRA’s letter to industry from earlier in the week outlines some practical steps that insurers can take to prepare. We will follow that up with further detailed guidance on an insurer-by-insurer basis, together with clear timeframes for each insurer to respond. I urge insurers to consider that guidance seriously, engage openly with APRA and to put in place a plan well ahead of any urgent need for action. 
 

Review of capital standards

 
Before I leave you today, I want to touch briefly on APRA’s thinking on the review of capital requirements. Without doubt, a robust and well-managed capital position is one source of resilience for an insurer. 
 
As most of you would know, in November last year APRA outlined its planned approach to reviewing the capital framework for private health insurers. The current capital framework has been in place since 2014, and this review provides an opportunity to ensure that capital standards in the industry provide for an appropriate level of resilience to protect policyholders. 
 
As outlined in its earlier letter to industry, APRA intends to consult on proposals which adapt the capital framework already in place for the life and general insurance sectors – or LAGIC – for the private health insurance industry. This does not mean APRA will apply LAGIC as is, in an unconsidered way. Rather, APRA is identifying areas where sector-specific adjustments are warranted to recognise the differing risk profile and business models in the private health insurance industry. 
 
In particular, APRA is considering adjustments that reflect the characteristics of insurance risk in the industry to take account of factors like the short-tail nature of claims, risk equalisation, health-related business and the constraints on premium setting and product design in a Gold/Silver/Bronze/Basic world. We are also considering how to think about potential insurance concentration risks and how the capital framework should recognise the legislative requirements for community rating that underpin the industry. I expect you would not be surprised that APRA is also considering how to address policy change risk in the capital framework, given that such changes have been a source of insurer stress in the past. 
 
We are pleased that the Actuaries Institute is assisting us by providing some early advice on these matters. The Institute has established a technical working group to identify issues and suggest approaches that APRA could take to address them in the capital framework. This group has provided early feedback to APRA on a range of issues and this is a valuable input to our thinking. 

Beyond the work with the Actuaries Institute, APRA is engaging broadly through industry roundtables and bilateral discussions with a range of interested parties. APRA’s door remains open to anyone who would like to discuss the review with us. The discussions are extremely useful as we continue to firm up our proposals for consultation.
 
We expect to release an initial discussion paper in the coming months outlining in principle APRA’s proposed new capital framework for private health insurers. The release of that paper will kick off an extended formal consultation period and we’re looking forward to continuing to work with the industry to develop a capital framework that supports insurer resilience for the protection of policyholders. To reiterate our earlier messaging, APRA does not expect that a revised capital framework would be implemented before the end of 2021. 
 

Conclusion

 
The industry is under significant and increasing pressure. The challenges of affordability, and existing and potential policy changes, are difficult to resolve, and we anticipate they will continue to intensify. While some of these pressures reflect challenges being felt across the healthcare system, the industry needs to step forward to address the impacts on their business. These challenges demand a proactive response – waiting for someone else to solve them is not an option. Doing nothing is a sure-fire way to forgo the opportunity to steer your own destiny. 
 
Actions to mitigate these risks and establish robust recovery plans are part of preparing for the challenging conditions facing the industry. More forward-looking insurers that invest in developing new strategies and approaches will find themselves not only more resilient to stress but can also benefit from competitive advantages as new opportunities emerge. Complacent insurers are likely to find themselves without a sustainable business model and under pressure to exit the industry. 
 
While APRA doesn’t have any predetermined view on the future structure of the industry, we will not hesitate to act to protect policyholders should an insurer’s viability come into question. 
 
Times of challenge like these are the opportunity to shape a new future. To borrow again from Dickens, this time from Great Expectations, suffering is stronger than all other teaching. We encourage you to seize the opportunity to develop bold strategies to address the challenges and emerge stronger. More Resilient and less Complacent. 
 
 

Footnotes

[1] Australian Institute of Health and Welfare 2018. Health expenditure Australia 2016-17. Health and welfare expenditure series no. 64. Cat. No. HWE 74. Canberra: AIHW.
[2] CHOICE March 2019 Consumer pulse. https://www.choice.com.au/money/insurance/health/articles/health-insuran... accessed 26 March 2019.