Australia's private health system is unwell. Insurers are at risk of declining profitability as squeezed margins undermine their ability to pay claims in the long term, and consumers are being turned off by climbing premium costs.

To combat higher claims, Australia's private health insurers have lifted rates yearly over the past decade and premiums are now over 70% higher than in 2010. Average wages, however, have only grown 32% in the same period. This affordability issue, which we expect to continue to worsen over the next five years, has resulted in declines in participation or level of cover sought.

Without structural change, we expect participation rates to continue to fall, likely led by younger members. A decline in younger premium holders will contribute to diminishing cross-subsidy benefits between older and younger members, further hitting the industry's long-term viability. With fewer new and younger policyholders, we expect health insurers to experience further profit and capital pressures, potentially leading to voluntary industry consolidation or funds forced to merge at the brink of failure.

This comes as the Australian health industry is saturated with over 30 players--but with the top five taking in nearly 80% of insurance premiums and about 85% of profits. While the top five insurers dominate the market, many smaller health insurers are member-owned mutual organizations with very limited access to capital.

In recent years, the underwriting profit of mutual health insurers has been declining compared with their corporate counterparts. In the year to June 30, 2020, mutual health insurers recorded an underwriting loss--the first in over seven years (see chart 1). Corporate health insurers, on the other hand, saw a sharper decline in underwriting profit with claims growth 2.6% above premium growth, compared with the prior year. If future premiums and claims growth remain at the average rate of the past two years, we expect underwriting profit to continue to decline over the next three years. The large insurers will threaten to squeeze smaller insurers, particularly the small mutual health insurers, out of the market.

Chart 1

Absent further operational efficiencies and product innovation, the ongoing trends are unsustainable and will weigh significantly on the financial resources of smaller mutual health insurers and weaken their capital positions. We expect that smaller insurers will need to consolidate to survive. Greater economies of scale support negotiating power with hospitals and service providers and provides greater scope to invest in operational efficiencies. This will enable better control over claims experience and operating expenses, with a flow on effect on pricing and affordability.

Premium Rates Are High Relative To Wages And Growing Faster

Heath insurance premiums have been on the rise, leading to potentially unsustainable premium rates and a decline in participation rates. Over the past 10 years, health insurance premiums have increased by 5% a year on average, whereas wages have increased by only 3% (see chart 2). This disparity has exacerbated the affordability of health insurance premiums and accelerated the decline in participation year on year since 2015. The improved participation rate back in early 2000 reflected the introduction of a lifetime health cover penalty tax loading, which penalizes members who did not obtain private health insurance. However, as premium rates continue to increase and the perceived value of the product diminishes for younger members, people are choosing to cut health insurance as a discretionary expense. We expect participation to continue to decline as premium rates remain unaffordable and unattractive to younger members, in particular, and the public health sector provides a viable alternative for many.

Chart 2

Current economic conditions and the ongoing COVID-19 pandemic are also likely to increase policy lapses and deter new members as people manage their discretionary spending, offset to a small degree by the heightened awareness of health-related issues. Although several insurers have deferred the April 2020 premium increases, we do not expect this to be permanent or to improve premium affordability. Some insurers have passed on rate increases in October 2020. We expect wage growth to be minimal over the next three years as companies manage expenses and job seeker numbers remain high. However, we expect health insurance premiums to continue to rise due to rising claims costs. This, in turn, will accelerate the shifting demographics to an older member age, and further pressure product affordability.

Shifting Demographics Undermine Cross-Subsidies

Australia's health insurance industry uses community ratings to determine premiums and has limited underwriting controls as prescribed by the Private Health Insurance Act 2007. This means insurers are unable to apply a risk-based pricing approach or decline new customers based on factors such as age, gender, previous medical history, or family medical history. As a result, health insurance members are charged a standard premium rate regardless of the risk level, limiting an insurer's ability to attract and manage lower-risk customers. Younger policyholders are overpaying relative to their health risk whereas older policyholders are underpaying, reflecting claims history. This is at odds with, say, the New Zealand model with an age-based pricing approach.

The health insurance industry is therefore highly reliant on cross-subsidization between different demographics to reduce the overall cost of premium increases for all its policyholder members. The younger members have a lower propensity to claim hospital benefits and the under 50s group represents about 20% of total hospital benefits, and has been gradually declining (see chart 3).

Chart 3

Members under 50 constitute a smaller percentage of insured lives than 10 years ago (see chart 4). We expect younger members are opting out of health insurance due to the unaffordability of premiums and are less likely to benefit from health insurance as it is currently structured. On the other hand, members above 50, who are higher risk and more likely to claim, are increasing as a percentage of insured lives due to the aging population. Members above the age of 80 make up about 5% of the members insured but receive about 45% of the hospital benefits paid (see charts 3 and 4). If younger members continue to opt out, shifting the demographic of the insured lives, and claims from older members grow as a percentage of benefits paid, insurers' ability to meet claims will be compromised. Subsequently, this may lead to further upward pressure on premiums as cross-subsidies diminish, further weighing on affordability.

Chart 4

Claims Costs Are At Risk Of Further Pressuring Affordability And Industry Profitability

Claims costs continue to increase more than premium rates for both mutual health insurers and corporate health insurers; see chart 5 for the difference between premium growth and claims growth. Health insurers are controlling claims costs through partnerships and agreements with hospitals and medical care providers with corporate health insurers experiencing a lower increase in claims costs than their mutual counterparts. The shifting demographics, to older members that have a higher propensity to claim, also adds upward pressure to claims costs and premiums. This will be a greater burden on mutual health insurers that have constrained access to capital and limited bargaining power with providers to manage claims expenditure. Hence, without systemic changes or government intervention, there is little opportunity to reduce premium rates as claim costs are expected to continue to increase.

Chart 5

We expect the reduction in claims due to the COVID-19 pandemic to be short lived, and for claims expenses to revert to normal levels once mobility and travel restrictions are lifted. Strict travel lockdowns, as part of the COVID-19 response, led to the deferral of nonurgent elective surgeries and other ancillary treatments. This deferral resulted in a sharp decline in claims costs during the lockdown period. However, we expect these claims to be incurred in the remainder of 2020 and 2021. Several health insurers deferred premium increases to Oct. 1, 2020, to recognize the inability to claim and to assist members during the pandemic, leading to modest industry premium growth for 2020. Return on equity for the industry has been declining over the past few years and we expect this trend to continue post pandemic (see chart 6). In particular, mutual health insurers are under more severe earnings pressure as evidenced by the decline in return on equity in 2020. We believe that claims that would have been incurred during COVID-19 lock-down have only been deferred and will be paid over the next 12 months.

Chart 6

We also anticipate an increase in mental health claims during and post the pandemic. Government responses to COVID-19, in particular statewide lockdowns and travel restrictions, have hit mental health. According to the Australian Institute of Health and Welfare, the use of mental health services such as Lifeline, Beyond Blue, and Kids Helpline climbed between 15% to 40% over a recent four-week period compared with the prior year. Mental health claims, which are included in some policies as ancillary benefits, typically take longer to be incurred and require repeat treatment. Hence, this could have a lasting impact on insurers, placing further upward pressure on future claims costs.

The catchup in claims when restrictions ease is likely to squeeze health insurance profit margins. We estimate that growth in claims will continue to outpace growth in premiums if there are no changes to existing operating conditions; see chart 5, in which we assume that premium, claims, and expenses grow at the average rate of the past two years. Similarly, chart 6 indicates the resultant impact on forecasted return on equity of claims and expenses trends. In addition to higher claims, mutual health insurers' expenses have been growing rapidly, at an average 10.3% over the past five years. As such, we estimate mutual health insurers will continue to experience profitability pressures over the next three years, in particular.

We expect mutual health insurers will likely consolidate within the next 12 to 24 months. According to Australian Prudential Regulation Authority industry data, 11 insurers reported negative operating profit after tax, as of June 30, 2020. Of the 11 insurers, nine are mutual health insurers, including the industry's largest mutual insurer, the Hospitals Contribution Fund of Australia Ltd. (HCF). Currently, Australia has 25 mutual health insurers that make up about 37% of the country's health insurance market by premium. However, mutual health insurers only achieved a combined profit after tax of A$1.2 million, which is less than 1% of the industry's overall profit for the year. In our view, the ongoing depressed economic conditions and the shifting membership demographics are likely to accelerate failures or trigger industry consolidation.