Too much cash in medical schemes
I attended the Actuarial Society of South Africa Health Seminar in Cape Town last week. While much of the agenda focused on developments surrounding benefits being offered (low cost benefits attracting a great deal of attention), one topic stood out to me and that was how medical schemes invest their assets. This led me to do some digging and I have come to the conclusion that medical schemes in SA hold too much cash. By the end of 2014, I estimate that these schemes were sitting on cash piles of c.R36bn. Including other fixed investments (government and company bonds), I estimate that more than 80% of medical scheme assets were invested in low-risk assets.
Why is this a problem? The two main reasons are that 1) it disadvantages scheme members, who are the ultimate owners of these assets and 2) that this money is lying fallow and is not available for investment in the SA economy, which suffers from a low savings rate to start off with.
Medical schemes in SA are required to have solvency equal to at least 25% of their annual medical scheme contributions. As a result, these schemes have had to build up substantial capital bases. The latest disclosed numbers were R46bn at the end of 2013 (R52.5bn including medical savings accounts). This could have grown to R60bn by the end of 2014. This capital ultimately belongs to the medical scheme members, although they will never be able to extract it. However, if the capital is invested wisely, it can earn a healthy return for members who can then benefit from lower medical scheme contribution increases in the future.
The problem with investing such a large proportion of assets in cash and bonds is that it becomes really difficult for assets to earn an inflation-beating return. This means that the return on assets, instead of contributing to the health of the scheme (by generating returns in excess of inflation) is instead a drain on the health of the average scheme. The medical scheme contributions grow every year in line with medical inflation and for solvency as a percentage of contributions to be maintained, the assets also have to grow in line with medical inflation. If they do not, then solvency has to be boosted every year from contributions, via a higher annual increase. If medical schemes had a more aggressive investment philosophy, higher returns would be earned over the long-term, which could well exceed medical inflation and help to reduce the necessary annual increases. This would certainly have been the case over the past decade.
South Africa suffers from a low savings rate and could benefit from increased investment. The medical schemes in SA could contribute to this if they were to adopt a more balanced approach to their asset investment. If these schemes had a balanced fund backing their assets, they could increase their investment in equities and properties by c.R20bn.
What stands in the way of more aggressive investment by medical schemes? There are a number of factors, including:
- The conservatism of trustees;
- The short-term focus of what is in essence a very long-term business; and
- The rigidity of the Council for Medical Schemes on solvency.
Medical scheme trustees in SA take their fiduciary responsibility very seriously. Their primary focus is to make sure that the schemes are conservatively run, that solvency is maintained, that appropriate benefits are offered to members and that contribution increases are kept low. There is also a meaningful focus on keeping non-health expenses low, with the most important being administration and managed care fees. This desire to limit non-health expenses is also sometimes put forward as a reason for not employing asset consultants to invest their assets. Trustees appear averse to have to pay excessive asset fees to consultants.
It is my opinion that trustees may be doing their members a disservice by being overly conservative in asset allocations. I think it is time for increasing discussion on this issue, especially for schemes that have solvency levels in excess of 30% (as most have). Trustees should also not under-estimate the potential return benefit of a balanced portfolio and should not shy away from paying asset fees to achieve this. It is important though to negotiate and make sure that asset fees are not excessive.
The business of medical schemes is managed with a very short-term focus. There is annual negotiation with service providers, benefits are redesigned if needed on an annual basis, administration fees are negotiated annually and contribution rates are set on an annual basis. Although it makes sense to run the operations of the scheme in this fashion, it does not necessarily make sense to manage the assets on the balance sheet with a similar short-term focus. The revenues within the typical scheme from contributions are generally sufficient to deal with the expenses as and when they become due. There is a limited need for some cash in the bank to facilitate these transactions, but the vast majority of the assets of a medical scheme will not be called upon in a year of operation. As such, cash flow requirements do not demand large cash balances and operationally, it would be totally acceptable for the bulk of assets to be tied up in longer-term investments.
A concern that is sometimes put forward surrounding increased investment in riskier assets such as equities and property is that asset values can fluctuate. Although this is true in the short-term, such assets tend to consistently outperform cash over the long term. As long as there is not an operational call to liquidate such assets in the short-term, fluctuations in asset values can be negotiated by an investor. They could ride out any asset value fluctuations to achieve a superior return over the long term.
An area where asset fluctuations can become a concern is if it pushes solvency levels below the 25% mark at the end of the year. This would cause the Council for Medical Schemes (CMS) to become involved. If the CMS adopted a longer-term approach and started to introduce risk based capital (RBC) measurements for medical schemes, it may free schemes up to invest more aggressively without having to worry about falling shy of the 25% level in a given year.
In conclusion, it is time for medical scheme trustees and the CMS to start thinking and talking about a different approach to investing medical scheme assets. The CMS should come up with new solvency guidelines that are more long-term focused and encourage schemes to invest their assets to match their long-term need to beat inflation. Trustees should recognise that managing the assets of medical schemes is also a very important part of their role and one that should attract more attention. The right changes to asset mix can help medical scheme assets beat inflation and can help to limit medical contribution increases going forward.
What do you think of my assessment? Were you aware of the large assets that medical schemes hold in SA? Did you know that they were so heavily weighted towards cash? Do you believe that it is necessary to invest more long-term to beat inflation? Do you think trustees and the CMS will change the way they think about medical scheme assets? I would love to read your feedback.
In the mean time, keep your talking straight!