Changing Ownership in Australian Private Health Insurance Markets:

1. Changing Ownership in Australian Private Health Insurance Markets: What are the economic implications of demutualisation? Luke Connelly ACERH UQ

2. Some broad-brush on structure • 38 Registered* Private Health Insurers * Insurers must be registered under thePrivate Health Insurance Act 2007 by 1 July 2008; existing, registered insurers are required to re-register (PHIAC 2008 “Health Funds”). • Only 6 for-profit (FP) PHIs; remainder NFP. • The largest of NFP organisation, Medibank Private Ltd (MPL), is government owned • legal and/or beneficial owner? • Otherwise, the NFPs may be characterised as “mutuals”.

3. What is a “mutual”? • NSW Supreme Court: The Corporations Law does not anywhere refer to a mutual company. It makes no provision for the creation of such a company. Nor does it contain a definition of what a ‘mutual’ is, or articulate any principles for the management of the affairs of a mutual company...” (cited in Buckmaster and Davidson 2006, p.21)

4. The “mutuality principle” • Individuals form an association for a common purpose and contribute funds to further that purpose. • Any surplus funds are regarded as ‘overpayments’ by members (as opposed to ‘profits’), to be used for their benefit, e.g. • via provision of more or better goods and services • to lower fees • etc.

5. Characteristics • Mutual membership availability traditionally based on some common characteristic or bond (e.g., Teachers’ Credit Union). • Restricted membership PHI funds (Navy Health, Reserve Bank HSL, etc.) are modern PHI examples. • Objective to maximise member benefits • often the objective function is stated quite imprecisely.

6. Nature of ownership in a mutual • Members each hold one (non-transferable) share in the mutual and one vote • Individuals relinquish mutual entitlements when they relinquish their membership • Members have no individual claim on the mutual’s capital • However, if the mutual is wound up or demutualized existing members may have entitlements to some or all inherent capital • Implicit intergenerational entitlements (Davis 2007)?

7. Industry Structure 2005-2006

8. What is demutualisation? • A change in the governance and ownership e.g., conversion to a joint stock company. • This breaks the member=owner=customer nexus that exists and • involves a transformation from not-for-profit to for-profit.

9. Drivers of Demutualisation? • (Self-interest, but more specifically...) • Value expropriation • unlock communal capital and convert it to private wealth • extant stock companies, managers of mutuals, owner-members of mutuals, investment bankers and financial service organisations may all be motivated by this objective. • Scale economies and growth opportunities • Desire to capitalise some slice of the PHI Rebate (subsidy) • aided and abetted by the Medicare Levy Surcharge

10. Sources of Welfare Gain • Proponents make the following arguments: • the mutual structure limits access to capital • capital growth comes from generating and retaining surpluses from mutual members; and • this can make it difficult to achieve economies of scale and scope; • mutual structure may be associated with greater agency problems than joint-stock co: • one member, one vote • entrenched management?

11. Sources of Welfare Loss • Increase in monopoly power, market concentration: • demutualisation results in NFP FP transformation; • large mutuals theoretically use their market power exclusively for the benefit of members; • large FP stock firms use market power to maximise profit; • this will consist of some transfer of value (from customers to shareholders) and some deadweight loss ceteris paribus.

12. Transfers • Distinguish between (i) static and (ii) dynamic transfers/capture of value. • Static transfers (wealth expropriation): transfer of the stock existing value, inherent in the mutual organisation (e.g., the fund and its assets) to others. • Dynamic transfers/capture of value by demutualised (FP) firm (stock-holders and management) of value previously captured by mutual members (and management).

13. Transfers • In my view, static transfers are more likely to be pure transfers • wealth is transferred from one party to another with no efficiency implications • not really “loss of value” (Davis 2007) as sometimes characterised. • Dynamic capture of value is of more concern from an economic point of view • deadweight losses that arise from increased monopoly power entail efficiency losses • there are also distributional implications (e.g., how does this change the incidence of government subsidies for PHI?)

14. Static transfers and the demutualisation process • Pure demutualisation • shares in the demutualised entity are allocated to members (usually a formula based on membership contributions); float occurs; value of shares determined by trades on stock market. • Subscription • shares are sold to applicants, • existing members often given a zero-price allocation, discount, or preferential allocation. • Merger • firm offers target mutual members cash payments or scrip.

15. Pure demutualisation results in zero value transfer from mutual members to others members receive full asset value and any “franchise value” share appreciates on float if traders consider the new organisational form more efficient Subscriptions and mergers each are susceptible to value expropriation. Members are, of course, free to choose not to agree to a particular “scheme of arrangement”, but... Value expropriation

16. Some reasons members may agree to value expropriation: • First, usually not a distribution of offers. • Second, a low offer may be acceptable because of the non-liquid nature of ownership • ownership of mutual is non-redeemable unless demutualisation occurs; members may discount the value of their ownership heavily for this reason • opportunity cost of rejection of any scheme of arrangement is a direct, personal, financial gain. • Third, it may be difficult to assess the value of the assets of the mutual per se. • Davis (2007) suggests several principles to incorporate in legislative change.

17. Dynamic transfers/capture of value • Government policies must have heightened interest in PHI investments in Australia. • Three reasons PHI demand is now less price sensitive • Medicare Levy Surcharge • 30%-40% Rebate (subsidy) • Lifetime Health Cover • These must have increased the capital value of accumulated assets in mutual takeover targets (and other insurers).

18. Monopoly power • Demutualisation and its attendant affects (FP to NFP, mergers, takeovers) will increase concentration. • It is central that the monopoly power previously held by mutual insurers was, theoretically, “consumer surplus” (at least theoretically, producer surplus=0). • The conversion to FP status involves not only a transfer of surplus • but also potential deadweight losses due to the exercise of market power.

19. Data Sources • Private Health Insurance Ombudsman’s The State of the Health Funds Report 2006http://www.phio.org.au/pub_sta.html

20. Four-Firm Concentration Ratios (CR4s), PHI “Markets”, 2006-2007

21. Herfindahl-Hirschman Indexes (HHIs), PHI “Markets”, 2006-2007 moderately concentrated concentrated ACCC DMGs

22. ACCC “safe harbour” thresholds • Mergers fall outside safe harbour(/first ports of call) thresholds either: • if merger will result in combined market share of four largest firms (CR4) of ≥75% and the merged firm will have ≥ 15% market share; or • if the merged firm will have ≥ 40% of the market (Mallesons Stephen Jacques 2008). • 8 Feb 2008 new Draft Merger Guidelines issued by ACCC for public consultation.

23. Draft Merger Guidelines 2008 • Assessment of mergers to be based on whether • market is concentrated with HHI (sum of squared market shares of suppliers) > 2000 • merged firm’s products are close substitutes • target has engaged in conduct (e.g., aggressive share growth, pricing, or particularly innovative service/production) that has enhanced the competitiveness of market • ACCC has previously notified firm(s) concerned or industry in question that notification of proposed merger is “advisable”. • (Proper definition of “the market” is central.)

24. United States HMGs • “Markets in which the HHI is between 1000 and 1800 points are considered to be moderately concentrated...” • “[Markets in which the] HHI is in excess of 1800 points are considered to be concentrated...” • Transactions that increase the HHI by more than 100 points in concentrated markets presumptively raise antitrust concerns under the Horizontal Merger Guidelines issued by the U.S. Department of Justice and the Federal Trade Commission.” (DoJ, http://www.usdoj.gov/atr/public/testimony/hhi.htm, accessed February 2008.)

25. MBF Demutualisation/merger • 31 August 2007: BUPA issues statement of interest in merging its Australian business with MBF. • MBF Board of the view that demutalisation and listing on the ASX “the preferred option”. • MBF Board receives $2.41b offer from Board. • MBF Board recommends “...BUPA proposal as being in the best interests of contributorsand MBF.” • 8 February 2008 MBF Council votes in favour of merger proposal to go to MBF contributors.

26. Implication of proposed MBF demutualisation and takeover by BUPA on HHIs

27. Conclusions • Sound economic arguments can be found in favour of demutualisation... • some of these are private interest arguments and do not involve perfect agency. • Demutualisation promises potentially substantial efficiency gains... • but there are also important caveats. • Changes to the carrot-and-stick arrangements for PHI in Australia (which consist mostly of stick) are liable to become less amenable to change after the demutualisation tide.

28. Extras

29. NIB – Demutualised Nov 07

30. Medibank Private • Previous government planned to privatise MPL; ALP announced its opposition to the sale of MPL prior to election. • A recent newspaper article (Feb 11) citing MPL CEO Savvides suggests corporatisation is being considered. • The proposed sale of MPL raised some interesting proprietary issues. • Who owns Medibank?

31. Who owns Medibank Private? • That depends... • The legislation makes clear distinction between health funds and the organisations that are authorised to operate health funds • There is a basis, in law, for viewing the organisation Medibank Private Limited and the Medibank fund as distinct. • The Commonwealth government is unambiguously the legal owner of Medibank Private Limited.

32. Who Owns Medibank? Whilst organisations such as Medibank Private Limited and, before it, the Health Insurance Commission hold, or have held the legal interest in Medibank Private Fund assets, whether they hold the beneficial interest in those assets, or whether their interests are subject to the rights of others, are separate questions.

33. Who owns Medibank? In our view...the provisions of the relevant legislation have the effect that neither the Commonwealth, nor Medibank Private Limited, or its predecessor, the HIC, hold the beneficial interest in the fund or associated assets. It seems difficult to attribute beneficial ownership of an asset to an entity that cannot sell the asset, cannot distribute profits generated by the asset and must give priority to the interest of others (i.e. members) when dealing with the surplus earnings of the asset (Buckmaster and Davidson2006 p.19, emphasis added).

34. Who owns Medibank? [The proposed sale of Medibank Private Ltd is] not in any sense of the word a demutualisation...[t]his is not a mutual fund in any sense of the word. It is a government-owned business (Minchin 2006).

35. Who owns Medibank? [W]hile the government clearly ‘owns’ Medibank Private Limited (the managing organisation of the Medibank Private fund) the fund itself is best characterised as a government controlled not-for-profit entity (not strictly owned by either the Commonwealth or the fund members)” (Buckmaster and Davidson 2006, p.1).