The big surprise from the recent reporting season was Medibank Private (ASX:MPL). Guidance suggests health insurance operating profit will increase by more than 12% in FY16 to over $370 million on revenue growth of 5.5%.
Following the full year results for Medibank Private (ASX:MPL), we believe the upside potential for the company has materially improved relative to our previous base case. This is partly because management has offered guidance for the company’s MER (Management Expense Ratio) to fall from 8.6% in FY15 to 8.3% in FY16 and below 8% in FY17.
Importantly, over the last few years, the amortization of customer acquisition costs has been rising and it will continue to do so. What that means is that the real reductions in the management expense ratio are meaningfully higher.
We had previously and conservatively believed that that most of the available net cost reductions available from management expenses had already been realized. Clearly this is not the case and as a result the Montgomery Intrinsic Value base case rises to $2.51 and that is with our volume and revenue growth assumptions remaining below management’s guidance and below recent historical performance.
That’s the base case. Our upside case has always been expected to come from an improved claims ratio and management’s progress in FY15 provided some reasons for confidence in the upside potential. A lower claims expense ratio (see glossary below) of 85.8% for the year (we were forecasting 86.2%) delivered $20 million higher underwriting profit and a margin of 5.5% compared to our forecast of 5.2%.
And while our upside valuation has increased only marginally to $2.95, fewer positive variables are required to deliver that outcome. Those variables are an improvement in the claim ratio between FY17 and FY21 and a marginally better volume outcome.
The majority of the gains, however, are still expected to be realised from FY17 onwards, due to the timing of the contract renegotiations with the major hospital operators.
Investors should also reign in their enthusiasm for immediate gains because of the weakening outlook for investment returns, due to lower interest rates and lower equity markets (15% of the investment portfolio), which will negatively impact near term earnings forecasts, not to mention constrain the share price performance directly.
And while the underlying insurance result was better than expected, due to claims management, the market will remain concerned about the weak revenue growth outcome and a significant step up in the lapse rate for the Medibank Private brand in 2H15.
Growth in total policyholder numbers was just 0.9% in FY15 and 0.6% in the six months to 30 June despite a big lift in marketing spend.
Policyholder numbers in the core Medibank brand fell 2% over the year, offset by a 21.5% increase in (lower revenue per policy) ‘ahm’ policyholders.
Lapse rates for Medibank continued to rise, reaching 10.9% in FY15. Lapse rates increased from 9% in 1H14 to 12% in 2H15 and reflect a problem with customer retention rather than the acquisition rate, which has remained reasonably consistent for the Medibank brand over the last two years. A revamped marketing and deal campaign to get new customers is a high cost way to fix this problem, so it should be accompanied by efforts to retain existing customers with better products and options.
It’s worth noting that the price/benefit equation could also be part of management’s focus with average revenue per policy increasing 5.1% in 2H15 and average price increases of around 6.25%.
Overall we believe we have invested in a quality company, with bright prospects and it remains, at the time of writing, at a discount to our estimate of its intrinsic value.
Glossary
If you’ve never thought about investing in an insurance company, the terminology can be a little daunting. Here’s a list of terms that you will inevitably come across:
Claims ratio
Net claims incurred as a percentage of net earned premium.
Combined operating ratio
The sum of the claims ratio, commission ratio and expense ratio. A combined operating ratio below 100% indicates profitable underwriting results. A combined operating ratio over 100% indicates unprofitable underwriting results.
Gross earned premium (GEP)
The total premium on insurance earned by an insurer or reinsurer during a specified period on premiums underwritten in the current and previous underwriting years.
Gross written premium (GWP)
The total premium on insurance underwritten by an insurer or reinsurer during a specified period, before deduction of reinsurance premium.
Insurance profit
The sum of the underwriting profit (loss), and the investment income.
Insurance profit margin
The ratio of insurance profit to net earned premium.
Net earned premium (NEP)
Net written premium adjusted by the change in net unearned premium for a year.
Net written premium (NWP)
The total premium on insurance underwritten by an insurer during a specified period after the deduction of premium applicable to reinsurance.
Outstanding claims provision
The amount of provision established for claims and related claims expenses that have occurred but have not been paid.
Underwriting result
The amount of profit or loss from insurance activities exclusive of net investment income and capital gains or losses.
Unearned premium
The portion of a premium representing the unexpired portion of the contract term as of a certain date.
Written premium
Premiums written, whether or not earned, during a given period.