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The solvency ratio debate: what’s new?

01 November 2016 Dr Bobby Ramasia, Bonitas

The fiscal security of medical schemes is traditionally judged on their solvency ratios. Schemes are ‘hung, drawn and quartered’ for not meeting the prescribed minimum of 25%, which is considered a healthy solvency ratio.

The Medical Schemes Act requires that a medical scheme maintain its business in a financially sound condition. This means that the medical scheme must have sufficient assets for generally conducting its business, providing for its liabilities at all times and for meeting prescribed solvency requirements of 25%.

Preserving funds

The Council for Medical Schemes (CMS) is currently engaging the industry to refine the statutory solvency levels based on issues such as underlying risk profiles.

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 schemes that are growing may be less competitive because of the need to build and maintain the required solvency levels.

Ensuring best practice

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.

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 does not incentivise good risk management by schemes; it is more difficult for schemes which are growing as they need to accumulate greater reserves and the calculations include members savings accounts.

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).

The regulations aim to determine the amount of reserves required based on the risks underlying the product and market, referred to as ‘risk-based capital’ techniques.

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.

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.

Calculation framework

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 set up by the CMS conducted some research and presented the findings of 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 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.

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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