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Medical aid solvency ratios need to change

The debate about the solvency ratio for medical aids is nothing new. The legislated requirement of 25% needs to be revisited to move away from the one-size-fits-all scenario.
The Medical Schemes Act No 131 of 1998 requires that medical schemes, “shall at all times maintain its business in a financially sound condition”. This means that the medical scheme has sufficient assets for generally conducting it business, providing for its liabilities at all times and for meeting prescribed solvency requirements of 25%.

Dr Anton de Villiers, general manager of research and monitoring at the Council for Medical Schemes (CMS) says, “The objective of a good solvency framework is primarily to maintain financial stability, promote fair competition among market participants and to ensure efficient use of capital and, more importantly, to provide early warning signs of potential failure.

The CMS is currently engaging the industry to refine the statutory solvency levels based on issues such as underlying risk profiles. This will lead to more appropriate reserve levels and therefore enhance capital efficiency. There is over R16bn surplus across the open medical schemes and more appropriate reserve levels would allow excess funds to be put to better use.”

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The irony

One of the perverse results is that under the current framework, if a scheme is experiencing rapid membership growth with a good profile, which is advantageous for the scheme, it will dilute the reserves and can drive the solvency to under 25%. Conversely, a scheme losing members who have a good profile, which is clearly bad for the scheme, will experience a release in reserves thereby increasing the levels. This means, growing schemes may be less competitive because of the need to build and maintain required solvency levels.

New global thinking

However, it has been recognised globally and by the CMS in South Africa that the existing system of determining solvency ratios needs to be revisited. De Villiers says the CMS would like to introduce a solvency framework that will promote growth in the industry while ensuring healthy competition amongst the schemes. He stresses that while financial stability should be maintained there is no one size fits all and individual circumstances of each scheme should be taken into account.

The CMS gives the following reasons for the new thinking:
  • The underlying risk faced by the schemes is not addressed;
  • members have to contribute too much to maintain reserves and it is one of the factors that affected increased premiums;
  • it doesn’t incentivise good risk management by schemes; and
  • it is more difficult for schemes which are growing as they need to accumulate greater reserves and the calculations include members savings accounts.

Dr Humphrey Zokufa, newly appointed registrar of the CMS, also feels that even though the thinking behind the solvency ratio of 25% was to mitigate a risk and to protect the members, it is too blunt an instrument and needs further negotiation and dialogue.

The dynamics in reserve regulation

According to Dr Bobby Ramasia, principal officer of Bonitas Medical Fund, “locally and internationally, the healthcare system is regulated just as any other business. However, significant reserving regulatory advancement is being undertaken in South Africa under the Financial Services Board (FSB), as well as internationally under so-called “Solvency II” regulations. These global initiatives are aimed at ensuring consistency and latest best practice in setting prudent reserves for insurance products.

"The regulations, in summary, aim to determine the amount of reserves required based on the risks underlying the product and market, referred to as “risk-based capital” techniques. Thus, a company (or medical scheme) with more risk would need to hold a higher reserve than a company with less risk."

After submissions from stakeholders in South Africa, the CMS too found that the most popular option is a risk-based solvency.

The greatest risks to solvency

“Reserves are typically set to cover 1 in 200 year events and take into account such risks as uncertainty in claims experience, liquidity constraints, investment market uncertainty and operational risks,” explains Ramasia. “The two greatest risks in the healthcare environment are higher than expected claims followed by investment market risk if the scheme is invested in the equity market.”

Size matters

One clear indicator of risk is the size of the pool of lives being covered. Smaller pools of lives experience more volatile claims, while larger pools experience less volatile claims. All else being equal, a smaller medical scheme would need to hold a larger reserve as a percentage of contributions, than a larger scheme.

What is an equitable solvency ratio?

The CMS is currently exploring risk-based capital techniques as an alternative to the current solvency calculation framework. The Industry Technical Advisory Panel (ITAP) – a body setup by the CMS with collaborative work being done between the CMS, medical schemes, healthcare actuaries, administrators and managed care organisations – conducted some research on risk based techniques in 2012 and presented the findings in March 2013.

The ITAP developed a simplified risk-based capital model that allows for three components:
  • Pricing risk – setting contributions too low results in a risk of operating losses, jeopardising short and long term sustainability.
  • Claims volatility risk – future claim levels are unknown and volatile, thus a scheme must hold sufficient reserves to be able to meet its obligations. Typically smaller schemes have more volatile experience which needs to be taken into account.
  • Liquidity and other risks – a scheme needs to hold reserves to fund claims and expenses in months where the contributions are insufficient, for expenses in a wind-down scenario, for operational risks, etc.

The model assigns a risk category per scheme based on the capital adequacy ratio (CAD) index, with risk category 1 implying a scheme with more than adequate reserves, whereas a category 4 implies the scheme is at significant risk of financial ruin. The CAR index is calculated by expressing the actual scheme reserves as a percentage of the required reserves under this model.

The formula developed by the ITAP is now publicly available and it appears that risk-based solvency measures for the medical scheme industry may be introduced within the foreseeable future.

The risk based framework is not without requirements. It must be:
  • Simple to implement – a complex framework will only increase regulatory costs in an environment already grappling with rising costs.
  • Identify the most significant risks relevant to the schemes and determine appropriate levels of capital to mitigate these.
  • Respond fairly quickly to the changing environment and the risks faced by medical schemes.
  • The methodology must not unfairly advantage some schemes while disadvantaging others.

Analysis of the industry results, based on the 2011 CMS report identified that the medical scheme industry was holding almost twice the required reserves that risk-based techniques suggest are necessary to cover 1 in 200 year extreme events.

To build up and maintain unnecessarily high reserves is inefficient. To build reserves requires additional contributions from members, as this is the only source of income a medical scheme may receive.

A simple formula for determining a scheme’s vital signs as proposed by the ITAP could be as simple as 1,2,3,4. A change in the solvency framework to a risk-based solvency framework will result in medical schemes having to hold lower levels of reserves which, in turn, will mean that the scheme will not have to have high contribution increases in order to meet statutory solvency requirements. This will also mean that the scheme can use excess funds held in reserves to provide richer benefits and services to members.

With rising health costs and unavoidable premium increases the bugbear of the industry, and the low growth in the number of people that are joining medical schemes due to affordability, this can only be seen as a positive step forward.
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