Alexander Forbes Hot Topics Workbook - March 2020 by Alexforbes

HOT TOPICS MARCH 2020

ALEXANDER FORBES

Contents Foreword 1 Section one

Ferial Haffajee 4 Muitheri Wahome 7 Isaah Mhlanga 11 Gyongyi King 22

Section two

Mercer | themes and opportunities ... it's a matter of time

Section three

Diagnosis | An analysis of key trends in the medical schemes industry from 2000 to 2018

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HOT TOPICS I MARCH 2020

Foreword Sustainable investing has been gaining momentum in the investment landscape within the last year and it is an agenda that cannot and should not be avoided. The need for the double-benefit bottom line is more apparent than ever and as a leading financial services provider, we acknowledge the role that we play in driving this agenda forward and implementing its principles. The first Hot Topics of seminar of the year focuses on investment issues relating to sustainability through different lenses – from the national level to the local level. It is important for us to take note of what our clients and communities expect of us. We look at South Africa’s current social, political and economic backdrop as these elements either contribute or detract from the sustainability of the country. There is a significant focus on the contribution of these elements to sustainability and what we are getting right as a society. Economic growth is a key measure in how we can analyse whether we are sustainable. Considering the risks of the global and local macroeconomic environment, we look at: ■ ways to improve the growth outlook ■ restoring fiscal credibility ■ the central role of investing in aiding economic growth

Narrowing it down to the internal mechanisms of an asset manager, we address the enabling factors of people, diversity and innovation and how they promote and enhance the sustainability of asset management practices and success. As with everything, asset managers do not exist or operate in isolation and need to consider the demands of society, particularly the growing demand from institutional investors to put their money where it does not compromise the future of generations to come. It is key that we maintain a global outlook to be aware of every cycle and trend in the markets to inform our approach and our views. The 2020 themes and opportunities from our partner Mercer sets the global scene by analysing how risks and opportunities evolve over time, what the resultant trends are and how they affect investors and the investment industry. Some trends have already started to play out in the market – some are focused on the short term, and others will play out over the long term. We believe that sustainable investing makes financial sense. Sustainable investment returns over the long term rely on the creation of sustainable environmental and societal benefits. It is in everyone’s best interests to achieve a sustainable world. Even though the investment landscape is evolving, our goal remains the same – to secure a lifetime of financial well-being for our clients.

SECTION ONE

ALEXANDER FORBES

What about sustainability? Ferial Haffajee The idea of a viral Facebook page called #I’mStaying is great, but it’s not a hashtag I find the need to use. South Africa is home. It is beautiful, challenging, a country with an eight-month summer, an interesting land with many longs walks to a proper freedom. And it’s where Nelson Mandela became Nelson Mandela. I am constantly inspired by the vision and smarts of South Africa’s creatives – Trevor Noah of the Daily Show, John Kani’s stage brilliance, the design beauty of the Mocca Zeitz museum, the fun of the Durban promenade, Laduma MaXhosa’s latest clothing range, DJ Black Coffee’s beats. I draw inspiration from how the Archbishop Desmond Tutu, well into his nineties, is still a voice of grace and leadership – even now, he remains an activist, this time against fossil fuels. With all its challenges, South Africa is always interesting.

But what of our sustainability? Sometimes in the beloved country, I wonder about our resilience and sustainability as a viable state. The networks that undergird the state are on increasingly shaky foundations. Think about our energy systems, our water, our data – in each, there are stresses and strains that threaten their viability. You have experienced load shedding, in December up to the unprecedented Stage 6, which can see power shutdowns for the major part of a day. Sometimes, it seems the grid is being kept going by a combination of bubble-gum and Super-glue – it is that wonky. Now, we are set for regular and scheduled power cuts for 18 months as Eskom implements enhanced maintenance schedules. Eskom’s sustainability is the defining factor in South Africa today. This monopoly utility seems impervious to retrieval from the years of state capture. Electricity prices are rocketing so high that they can now imperil economic growth. But Eskom still thinks tariffs are pegged too low although real increases have shot up by over 100% in the past decade. And what of water? As Cape Town discovered a few years ago, there is a concept of Day Zero, the day when the taps run dry. While it turns out that the Day Zero campaign may have been a marketing ploy to scare Cape Town residents into using less water, the droughts gripping the Eastern Cape and the Northern Cape reveal the truth that South Africa is a water-scarce country.

But who has she put in charge? An adviser called Thami ka Plaatjie who once led the grand Pan Africanist Congress but who has not been a successful political leader in a free South Africa. While government has repeatedly promised that the right people will be put in public jobs to ensure sustainability, the habit of employing political cadres seems too ingrained. And what of data? Data, and access to data, is recognised as essential as energy and water to successful countries. But a data market inquiry found in 2019 that South Africans are paying far more for data than countries of similar sizes and populations. Until these prices start coming down, South Africa will not properly be able to integrate into a global economy that is driven by services and by technology. If you consider that 4 in 10 young people cannot find a job or sustain a small business, then this is our standout sustainability challenge. Cheaper data is key for getting young people into the labour market or enabling them to become self-employed by starting small or micro businesses.

HOT TOPICS I MARCH 2020

So, where’s the bright side? It is 30 years since FW De Klerk, the last apartheid president, saw the writing on the wall. He unbanned the ANC and most other organisations outlawed during apartheid. Democracy in South Africa is 26 years old this year and it has been a sustained democracy. Elections are held regularly and not one has been declared defective – each has been free and fair, according to the Independent Electoral Commission. Given our history, the way in which elections, the symbol of democracy, have become part of our institutional DNA is a credit, as is the Constitution that is sovereign in South Africa. This is not a common story in our region although the electoral trajectory is more positive than negative. Then, the other way to measure democratic sustainability is in how regularly the head of state has changed: President Cyril Ramaphosa is South Africa’s fifth democratic era leader, if you include the term of interim president Kgalema Motlanthe. The idea of the leader for life got short shrift in South Africa when the first democratic president Nelson Mandela stepped down after a single term. This made popular the notion that leaders should not overstay their welcomes. This is also a way to measure democratic sustainability.

But the greatest asset South Africa has to sustain democracy is the quality of the judiciary and civil society. If we are to be honest, the ANC as a government has only been so-so. Its development outcomes have been poor when one considers that South Africa is a middle-income country. The education system is not a sea-change after the criminal system of Bantu education, which was a key disc in the spinal column of apartheid. Obviously, the purpose of today’s system is different, but the execution is tragic. The school dropout rate is extremely high and the matric pass has been compromised by lowering the percentage pass across key subjects like maths, languages and science. In health, it’s the same story. South Africa spends much more than most similarly sized economies on health, but outcomes are poor by comparison. And the government is about to put the entire health industry into disarray through an ill-conceived national health initiative. While the NHI has a laudable goal – to bring in a system of equitable and universal health coverage, the road the ANC has planned is as pot-holed as any street so badly governed.

ALEXANDER FORBES

So, where lies hope? The civil society is a vital vein in South Africa’s body. In the nightmare years of state capture, it was civil society that showed its mettle. While other countries have sunk into kleptocracy when saddled with leaders like the former president Jacob Zuma and netted by the patronage networks like the Gupta family which extracted billions from South Africa, that did not happen here. And the reason it did not was because of civil society, the network of organisations outside the formal political society. This included the whistle-blowers and the media which investigated state capture without fear and who exposed the #GuptaLeaks, the trove of emails which helped them piece together the story of how South Africa was captured.

It was journalists working with whistle-blowers who revealed in x-ray detail what was happening in Eskom, Transnet, SAA and Denel as various patronage networks sucked out rents through colonising the procurement and other strategic sites of the state-owned enterprises. It was civil society who mobilised the unhappiness of South Africans into organisations like Save SA. Civil society took case after case to court to force the reform of institutions like the National Prosecuting Authority It also put pressure on the ANC to change its leadership at the party’s national conference in December 2017, which ushered in a reformist presidency of President Ramaphosa.

Conclusion In future, it is this civil society that will be vital to the idea of what South Africa has set itself to be – a non-racial, non-sexist and equal country of laws. On the globe today, there is no more important topic than sustainability, of earth, our environment and the only planet that humans can call home. At the World Economic Forum in Davos in February the founder Klaus Schwab highlighted the existential questions facing market-based economies. He called for, along with others, a rethink of what capitalism is today and how it is shaped for sustainability in the future. At the centre of new thinking is that the system of sustainability must be one that works for all people, not only for the financial markets – the model of stakeholder capitalism. Of course, in South Africa, the history of our country has meant that we are ahead of the curve. The empowerment charters, the social and labour plans as well as laws like those geared to support employment and other forms of equity are about turning employees, suppliers and small enterprises into stakeholders in the system. But while this is both laudable and gives the country a headstart, the key requirement is implementation and execution.

HOT TOPICS I MARCH 2020

How sustainable is the South African asset management industry? Muitheri Wahome

Lessons from the past and what the future may hold Globally, institutional investors dominate financial markets, controlling more assets than banks and individuals do. Insurers provide us with policies, unit trusts are our savings and pension funds are our retirement savings. The asset management industry is therefore integral to our financial well-being. It plays an important role of allocating risk capital to fund projects and businesses, providing us with investment opportunities that we would not necessarily be able to access on our own.

The rise of institutional investors in South Africa began centuries before asset management firms as we know them were even conceived. The origins can be traced to several moments: ■ the arrival of insurance multi-national companies – an extension of the British industry – from the 1820s ■ the formation of trust companies that administered and settled estates in the Cape of Good Hope ■ the spectacular discovery of minerals that created wealth in the hands of private individuals, to that of banks and stockbrokers

■ the first occupational pension established in the Transvaal Republic in 1882 ■ the Public Investment Corporation Limited (PIC), the largest domestic asset manager in South Africa Initially established as a custodian and asset manager of trust funds, today the PIC manages the assets of the Government Employees Pension Fund, ranked the 17th largest fund in the world. The PIC’s demonstrated track record of 109 years to date, is a feat matched by few asset managers globally.

Assets under management in South Africa in context 1995

2018

Compound annual growth rate

R billion Life insurance

408

2 816

8.8%

PIC

2 083

14.4%

Unit trusts

2 195

19.9%

Private pensions

112

1 224

11.0%

Sources: PIC, ASISA, SARB

ALEXANDER FORBES

Key dates in the evolution of the asset management industry in South Africa 1822

The first savings bank system is established in the Cape Colony

1960

Liberty Life launches first individual retirement annuity

1845

Old Mutual is established by royal charter

1957

UAL, the first local merchant bank, offers segregated investment management services to pension fund clients

1882

First recorded pension fund in the Transvaal

1969

Allan Gray becomes the first South African to qualify as a chartered financial analyst

1887

The discovery of gold in the Witwatersrand leads to the formation of the Johannesburg Stock Exchange

1971

First pension investment performance measurement survey is launched

1890

James McGowan is appointed the first Government Actuary of the Cape Colony

1986

UAL launches first linked-investment services provider

1891

First Life Insurance Act of 1891

1989

UAL launches first standalone equity-linked living annuity

1911

Public Development Corporation (PIC Limited) established as custodian and asset manager of trust funds of the public sector

1990s

Ginsburg Malan Consultants and Actuaries is granted a life licence to operate non-life pooling of annuities, leading to the first multi-managed living annuity in South Africa, Die Nuwe Dinamiese Uittreedings annuiteit (later renamed Superflex)

1918

Sanlam opens its doors

1992

First socially responsible fund Community Growth Fund is launched

1919

Marthinus Louw becomes the first South African- born actuary

1992

SAB issues first corporate bond

1923

Southern Life Association becomes the first local life insurer to open an office in London

1993

Herman Steyn launches the first index fund unit trust

1943

Sanlam opens an investment department

1995

Time Life establishes first multi-manager in South Africa

1946

Sanlam launches the first ‘managed trust’ company in the SA insurance industry

1998

First money market unit trust is launched

1949

National Finance Corporation established to develop the South African money market

2001

First exchange-traded fund launched by a joint venture between Gensec, Corpcapital and the JSE

1956

Pension Funds Act of 1956 – the first dedicated pension fund legislation in the world

2013

South Africa adopts real estate investment trusts (REITs) structure for listed property assets. Tower Property Fund becomes the first new fund to list on the JSE REITs sector

1965

South Africa Growth Equity (SAGE) unit trust is launched

HOT TOPICS I MARCH 2020

Although South Africa accounts for less than 1 of the global GDP, it has seven firms in the list of Top 500 asset managers globally (excluding the PIC) – a standout performance when compared to the BRICs. South African managers have exported their success internationally. For example, Investec Asset Management – a globally competitive firm and a well-established international investment firm based in Cape Town and London – has its roots in South Africa. The late Allan WB Gray built two successful asset management firms – one in Cape Town and another, Orbis which is internationally focused with its home in Bermuda and a presence in Australia. The pioneers of the industry learnt from other parts of the world and found ways to do them in an environment where savings were encouraged. Since the first South African qualified as a chartered financial analyst (CFA) in 1969, increasing numbers have successfully earned the designation, putting South Africa among the top 20 CFA societies in the world. According to Nerina Visser, president of the South African CFA chapter, South Africa is the fourth largest society in the Europe Middle East and Africa (EMEA) region after the UK, Switzerland and Germany, and ahead of larger countries like France and Russia. The financial industry in South Africa maintained international contacts through the presence of foreign insurance and banks, allowing the emergence of human capital development to a level that could compete globally, when South Africa was reintegrated into the rest of the world after 1994.

The modern South African asset management industry took its first steps from the 1950s. The immediate period after World War II was a time of prosperity and optimism globally that heralded significant growth in financial assets and wealth. In 1956, South Africa had an estimated 1 200 pension funds serving approximately 400 000 members. The majority of pension funds were underwritten by insurers and set up by means of a life policy contract. Later in 1965, the pioneers of unit trusts made it possible for small savers to invest in shares by providing them with a professionally managed and diversified portfolio. By pooling small savings, unit trusts also helped increase the supply of risk capital for investment in the economy. As the magnitude of money invested grew, so did the demand for specialist investment expertise to manage it, giving rise to the asset management industry. To manage a portfolio of shares required structure, discipline and significant effort that called for insurers to gradually professionalise their investment activities. A favourable macroeconomic backdrop of low inflation, low interest rates and high economic growth in the 1960s created one of the longest rising markets South Africa had ever seen that lured institutional investors to allocate more capital into listed equities on the JSE Securities Exchange. After years of benign inflation, a surge in inflation in the 1970s spurred investors to invest in equity and property.

ALEXANDER FORBES

This fertile ground for innovation attracted new contenders to the nascent asset management industry: ■ new competition from merchant banks, owner-managed asset management firms to multi-managers ■ new investment products to hedge against rising inflation ■ new distribution channels that catapulted unit trusts and asset managers who managed the flood of savings that came in the 1990s ■ a focus on portfolio construction and risk

What then are lessons we can learn from the past and what are the implications for the future? Firstly, regulation plays a key role in providing confidence to consumers and in shaping competition and financial market development. The collaboration between industry and policymakers to create a supportive regulatory environment is crucial to the success of an industry. Secondly, innovation that meets the needs of savers and investors is a critical ingredient to the success and sustainability of the asset management industry. As stewards of capital, the industry must consider the interests of those whose assets it represents to remain relevant. The historical reverence with which the life insurance sector was held stemmed from the benefit the community could see and what the institutions did for them providing a safety net against disaster. By offering savings and insurance products that uplifted individual savers from poverty, they earned the trust of their policyholders.

10 |

By pooling capital from savers and allocating it to those who required it, they stimulated the economy. Without addressing the fundamental requirements of a growing economy, the industry is at risk that the government and society at large do not perceive its value – that shared sense of destiny and social utility – and could face both regulatory challenges (risks to fees charged), and worse, lose its social licence to operate. Asset managers cannot shy away from the plight of their clients as they navigate their challenges and strive to meet their financial goals throughout their lifetime. The work of an asset manager is not just about targeting assets under management or beating a benchmark. Behind the assets under management that firms feverishly seek to grow, is what Sunel Veldtman, founder of Family Foundation Wealth calls ‘humans-in-transition’. Thirdly, the asset management industry is heavily dependent on the state of the economy, politics, markets and the global environment. The policies that guide and either build or damage economies have a direct impact on the work of asset managers. They determine the state of the markets into which asset managers make investments and highly influence the availability of funds to be invested. This calls for a responsible partnership between the industry and its regulators that places South Africa first. Astute leadership with an appreciation of the intersection of politics, and a vision for a better society and business are required. The industry must be responsive to the needs of society to avoid criticism. A culture that promotes diversity and inclusion to further the ends of transformation and reflect the increasing broad range of stakeholders is non-negotiable. How to bring the uninsured, unbanked and expand the market to include everyone with the power to save requires market participants to understand the aspirations of the people in product design. Progress demands constant reinvention in this globally competitive industry.

HOT TOPICS I MARCH 2020

Macroeconomic review and outlook Isaah Mhlanga

Reviving economic growth 2019 was dominated by United States (US) and China trade tensions, fears of US recessions, Brexit and Middle East geopolitical uncertainties. However, the year ended on a high note, with global financial markets pulling the best performance since the global financial crisis (GFC). This hit a record high as some of these concerns eased and the global central banks' accommodative stance injected liquidity into financial markets. Asset class returns for December 2019 were strongly boosted by the easing of trade tensions between the US and China when they signed a phase one trade deal, which boosted global risk appetite. An increase in global liquidity by major central banks also supported the global financial markets, with investors buying emerging market equities and bonds, compared to global bonds and US dollar cash.

Global financial markets experienced a strong 2019, returning resilient returns across a broad range of asset classes and geographies. The MSCI ACWI returned 27.3% in 2019, from negative returns of 8.9% in 2018, in US dollars. Regionally, developed markets outperformed the emerging market equities in the year, with the MSCI World (developed markets) returning 28.4% in 2019, from -8.2% in 2018, in US dollars. This was driven by the strong performance in the US, Europe and Japan. In 2019, the MSCI Emerging Markets (MSCI EM) returned 18.6% in US dollars from -14.3% in 2018. Emerging markets were boosted by the strong performance from Russia, India, Brazil, and South Africa. Global bonds underperformed equities for the year as the global fundamentals improved, favouring risky assets. The Citi World Government Bond Index and corporate bonds returned 5.9% and 14.5%, respectively in 2019, in US dollars. In the commodities markets, oil prices and gold saw strong gains of 5.7% and 3.6% in the last month of the year, which brought gains for the year 2019 to 22.7% and 18.3%, respectively. However, iron ore saw the strongest gains in 2019, returning 28.6%, despite the slowing global manufacturing activity during the year. South African markets returned positive returns despite negative domestic fundamentals like power cuts, low business confidence, worsening fiscal constraints, and a weak local economy. Local markets were boosted by rand-hedge stocks and a strong rally in commodities. The economy saw the largest drop in growth over the past decade following the power utilityâ&#x20AC;&#x2122;s implementation of a series of power cuts in the first quarter of 2019, which resulted in a contraction of 3.2%. Economic growth subsequently recovered in the second quarter but contracted again in the third quarter.

The Mid-Term Budget Policy Statement (MTBPS) showed a deterioration in fiscal outlook. Eskomâ&#x20AC;&#x2122;s debt burden and rolling electricity blackouts increased risks for both the fiscus and economic growth and negatively impacted market sentiment and business confidence. Tight domestic credit, weaker currency pass-through effects, and low economic growth have kept inflation contained in 2019. South African CPI slowed to an eight-year low of 3.6% in November 2019. Inflation averaged 4.1% in 2019 to the end of November, well below the South African Reserve Bankâ&#x20AC;&#x2122;s (SARB) point target of 4.5%. The SARB has cut rates by 25 basis points to 6.5% in 2019 due to low inflation and weak economic growth. Ultimately, the favourable global backdrop drove the majority of asset class returns into positive territory. The ALSI returned 12.1% in 2019, from -8.4% in 2018, in rands. While the Capped SWIX returned 6.8% in the year, from -10.9% in 2018, in rands. The ALSI benefitted relative to the Capped SWIX from its higher allocation to commodity shares. The increase in equities was broad-based across, small, medium and large caps. Resources were the best sector in the year, returning 28.6% in 2019 from 15.7% in 2018, in rands, particularly well supported by gold mining shares. It was followed by industrials which returned 9.1% in 2019 from -17.4% in 2018. Despite the dovish global central banks, financials marginally performed in 2019, returning 0.6% from -8.7% in 2018. The financial sector has a strong correlation with the performance of the local economy. Bonds and cash lagged equities in the year, with 10.3% and 6.6%, respectively as global investors preferred risky assets. Property bucked the strong performance trend, returning 1.9% for the year as the rental vacancy rate remained high due to weak economic growth.

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ALEXANDER FORBES

Outlook for 2020 Global outlook â&#x20AC;&#x201C; gradual recovery but growth will remain sluggish Global economic growth has stabilised but the recovery remains sluggish. The slowdown in the US and China is expected to be more than offset by an improvement in some large emerging markets, Europe and the United Kingdom (UK). Inflation expectations remain stable, at or below targets in advanced economies and trending lower in emerging markets. Consequently, monetary policy in many advanced economies is expected to remain loose, which will support global growth. The direction of the US dollar has a disproportionate impact on the global economy as global trade is priced in US dollars to a large extent. The US dollar is expected to weaken against major currencies, which implies that the emerging market exchange rate driving inflationary pressures will remain muted. This will help emerging market economies as well as global economic growth.

Figure 1: G lobal baseline growth forecasts show stabilisation 2.9

3.3

3.4

2.3

2.0

1.7 1.2

2019e

2019e Average: 2.7 2.4

2020f 2021f 2.9 2.5

2020

2021

2019e

2020

3.3

3.5

2021

Euro area

United States

3.1 2.7

1.4

1.3

3.5

5.6

5.8

1.3

2019e

2021

2019e

2020f 2021f

2020

Sub-Saharan Africa

Source: IMF WEO, World Bank and Alexander Forbes Investments

12 |

2021

5.8

2019e

2020

2021

United Kingdom

China

5.9 2.8

3.2

0.8 2019e

6.0

1.5

1.4

2020

6.1

2021 2019e 2020 Emerging and developing Asia

2021 2019e 2020 Middle East and Central Asia

2.3 1.6 0.1 2019e

2020

2021

Latin America and The Caribbean

HOT TOPICS I MARCH 2020

Figure 2: Global inflation Global inflation expected to continue to trend lower %

5.0

Major countries' inflation forecast in 2020 and 2021 % 2.5 2.0 1.5 1.0 0.5 0.0

World

4.0 3.0

2019

Euro Area

2020

2021

China

3.0

2.0

2.5 2.0 1.5

1.0

1.0 0.5

0.0

2019

2020

2021

2022

2023

2024

0.0

2019

2020

2021

Source: IMF and Alexander Forbes Investments

The biggest four global risks that dominated financial markets in 2019 have been reduced:

■ U S–China phase one trade deal ■ B oris Johnson’s decisive victory in the UK election ■ D e-escalation of the US–Iran tensions ■ U S recession risks

In particular, the US dollar has reached the top of the cycle and is overvalued against major currencies. We expect the US dollar to weaken against the pound sterling and against the euro. As far as the pound is concerned, the reduction in Brexit uncertainties and narrowing economic growth differential favours the pound relative to the US dollar, which is why we expect the pound to appreciate against the US dollar. Growth differentials between the US and the euro area also favours the euro going forward.

The reduction in these risks has revived risk appetite. Emerging markets are expected to receive portfolio inflows, which will benefit their currency, equity, and bond markets. The historical weakening of the US dollar has been a major driver of emerging market economic growth. We expect this to be the case if the US dollar cycle turns as the market expects.

Figure 3: The US dollar expected to weaken against the major currencies EURUSD %

EURUSD

GBPUSD Long-term ave

+ Std Dev

-Std Dev

GBPUSD

Long-term ave

+ Std Dev

-Std Dev

1.7

2.1

1.5

1.9

1.3

1.7

1.1

1.5

0.9

1.3

0.7

1.1

0.5 2000 2002 2005 2007 2010 2012 2015 2017

0.9 2000 2002 2005 2007 2010 2012 2015 2017

Source: Bloomberg and Alexander Forbes Investments

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ALEXANDER FORBES

Monetary policy in the advanced economies is expected to remain accommodative given benign inflation outlooks in the US, Europe, the UK, and China and in most of the major economies. With a supportive global monetary policy backdrop visible in looser financial conditions, emerging market currencies are expected to remain stable. This translates into stable or improving inflation outcomes and better economic growth. This should benefit South Africa (SA), but domestic issues outweigh global factors for now.

Figure 4: G lobal financial conditions have improved, while the US dollar is expected to weaken Global financial conditions have loosened Index, 100=January 2017 102 101

The US dollar expected to weaken against major currencies 1.8

Advanced economies excl. United States

1.6

United States

1.4

EMDEs excl.China

1.2

100 99 98

1.0 Q1 2020 Q1 2021 Q1 2022 Q1 2023 Q1 2024 Q1 2025 1.35

GBPUSD

1.30 1.25 1.20 1.15

97 Jan-17 Jun-17 Nov-17 Apr-18 Sep-18 Feb-19 Jul-19 Dec-19

1.10 Q1 2020 Q1 2021 Q1 2022 Q1 2023 Q1 2024 Q1 2025 EURUSD

Source: Bloomberg and Alexander Forbes Investments

14 |

HOT TOPICS I MARCH 2020

SA outlook â&#x20AC;&#x201C; reviving economic growth With a marginally supportive global outlook, we would have expected SAâ&#x20AC;&#x2122;s economic growth to pick up as well. However, domestic constraints remain binding. Electricity shortages, weak consumer demand and a constrained fiscus all contribute to a weak economic growth outlook of about 1.0% this year and 1.5% in 2021. The risks remain tilted to the downside due

to electricity shortages and the slow pace of economic policy reforms. To improve this growth outlook, three things are needed in our view: 1. Re-establish fiscal credibility 2. Implement structural economic reforms 3. Attract fixed investment

Re-establishing fiscal credibility The presence of fiscal credibility means that economic agents believe what the fiscal authorities announced as their target primary budget balance and that they will achieve it in the timeframe they have set. SA's fiscal credibility has deteriorated since the financial crisis, and the risk remains. This could persist if the National Treasury continues to miss its budget targets. Loss of fiscal credibility has two main problems. Firstly, bond yields remain elevated because the sovereign risk premium remains high. This means that the cost of borrowing for the state remains high and therefore crowding out productive spending that can lift economic growth, such as investment,

should be considered. Secondly, loss of fiscal credibility and the resultant higher interest bill as well as the never-changing need for higher social spending necessitates higher taxes in the future to close the revenue gap created by increasing interest costs. While forecasting macroeconomic variables is inherently difficult, it is important that National Treasury sticks to its targets in terms of stated goals or fiscal rules in relation to its primary budget balance, expenditure ceilings, and debt targets if it is to reclaim fiscal credibility. This will reduce the stateâ&#x20AC;&#x2122;s interest cost bill and bring favourable inflation outcomes.

Figure 5: A decomposition of the SA 10-year bond yield %

SA currencyrisk currency riskpremium premium SA

12.0

USrisk riskfree freerate rate US

SAsovereign sovereignrisk riskpremium premium SA

11.0 10.0 9.0 8.0 7.0 6.0 5.0 4.0 3.0 2.0 1.0 0.0 2005

2006

2007

2008

2009

2010

2011

2013

2014

2015

2016

2017

2018

2019

Source: Bloomberg and Alexander Forbes Investments

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ALEXANDER FORBES

Figure 6: Re-establishing fiscal credibility in low growth requires sticking to the budget target Real main budget revenue and non-interest spending % of GDP

Non-interest spending

Revenue

% ch

10 8.4

7.0

6.3 4.9

2.0 2.0

1.6

2009/10

2012/13

2015/16

2018/19

2021/22

-2

3.3 1.4

1.4

1.7 0.8

-0.2 2006/07

2009/10

2012/13

2015/16

2018/19

2021/22

Gross debt-to-GDP ratio

% of the GDP

% of GDP

8 Interest payments

2.4

2.1

Main budget balance

Primary deficit

2019 Budget Revised with financial support for Eskom Revised without financial support for Eskom

1 0

8.3 7.2

22 2006/07

Growth in real main budget non-interest spending

2009/10

2012/13

2015/16

2018/19

2021/22

2015/16

2017/18

2019/20

2021/22

2023/24

2025/26

2027/28

Source: Bloomberg and Alexander Forbes Investments

The budget has an expenditure problem which needs to be corrected by reducing spending. The 2018 MTBPS projected R150 billion in spending will be cut over the next three years, which implies that R50 billion per fiscal year will be trimmed in each of the next three fiscal years. We do not have a high conviction that National Treasury will be able to achieve this target given how difficult it is to reduce headcount in the public sector.

16 |

HOT TOPICS I MARCH 2020

Structural economic reforms to unlock fixed investment The economic reforms are structural in nature and as a result, they will take some time to effect. That said, the reform work that is under way should help improve business confidence and will ultimately attract private sector fixed investment which will lift economic growth.

Figure 7:

Economic reforms under way

An efficient and capable state. Prudent fiscal and monetary policy. A competitive and flexible exchange rate. A trade regime which promotes open and beneficial trade, particularly with the rest of the African continent SEOs. A reimagined industrial strategy. Opening up 'network industries'â&#x20AC;&#x2122; that is transport, logistics and telecommunications. This means reorganising Eskom and other state-owned companies. Lowering barriers to entry. Prioritising job-creating sectors, such as agriculture and tourism. An overarching legal framework with an independent judiciary and strong property rights. A well-functioning financial sector.

Mining (charter 2019)

Land expropriation (2020) draft bill

Reform agenda

Telecoms (2020) Information memorandum

Economic Transportation, Inclusive Growth, and Competitiveness: Towards an Economic Strategy for SA {NT discussion paper}

Must facilitate

Urgency

In energy, water, transport and telecom sectors.

Government \ Growth Governance \ SEOs

REMARKS BY MINISTER OF FINANCE, MR TITO MBOWENI, AT THE TEAM SOUTH AFRICA WEF DAVOS BREAKFAST BRIEFING DATE: 16 JANUARY 2020

Policy certainty

Eskom \ manage cash flow and re-organise (split)

WEF global competitiveness index \ 60th (improvement) Our advantages Perceptions Young labour market

World class infrastructure

2nd SA investment Conference \ pledges

Sophisticated financial market Investment needs

Increase in FDI

Source: National Treasury and Alexander Forbes Investments

| 17

ALEXANDER FORBES

Private sector fixed investment crucial for growth Business confidence has remained weak for most of the past decade which resulted in volatile and low private sector investment growth. Private sector investment will unlikely pick up before business confidence improves meaningfully. The ongoing economic reforms should help to improve business confidence going forward. A trend that is also visible is the contraction in public sector investment which has been contracting for some time as the government embarked on fiscal consolidation to reduce government debt.

Figure 8: Corporate SA (80% of investment) downbeat and “economising” Low business confidence restrains investment

Private sector investment drives overall investment

GFCF growth (% q/q, lhs) BER BCI (Index, rhs)

%q/q 30

% y/y

0 -10

-5

2019

2017

2015

2013

2011

2009

2007

2005

2003

2001

10 0

Private sector GFCF (% y/y) GFCF growth (% y/y)

-20 -30

-10 -15 -20 2005 2007 2009 2011 2013 2015 2017 2019

Source: Bloomberg and Alexander Forbes Investments

Figure 9: Corporate SA (80% of investment) downbeat and “economising” Business confidence drives private sector investment

Public sector investment has been contracting

Real private sector fixed investment (% y/y)

% y/y

General government GFCF (% y/y) Public corporations GFCF (% y/y) GFCF growth (% y/y)

60 50 40 30 20 10 0 -10

Business confidence index

-20 2005

2007

2009

2011

2013

2015

2017

2019

Source: BER, SARB and Alexander Forbes Investments

Inflation remains benign Inflation outcomes have surprised on the downside for most of 2019 and the outlook remains benign. In January 2020, the SARB cut rates by 25 basis points to 6.25% to boost consumer demand. However, the impact of this rate cut on economic growth is negligible.

18 |

HOT TOPICS I MARCH 2020

Figure 10: Inflation forecast remains stable Stable inflation outlook well within the SARB’s

Government CPI and private sector CPI y/y (%)

6.5 6.0

5.6

Government CPI

6.3

6.1 5.8

Headline CPI

9.0

5.5

5.3

5.0

4.6

8.0

4.8

4.6

4.5

7.0

4.8

6.0

4.3

5.0

4.0

3.5 3.0

Headline excl. government CPI

10.0

3.0

2012

2013

2014

2015

2016

2017

2018

2019

2020

2.0

2021

2014

2015

2016

2017

2018

2019

Source: Bloomberg and Alexander Forbes Investments

There is still room for one more cut but the risk of a credit rating downgrade from Moody’s keeps the SARB cautious. We expect Moody’s to downgrade SA’s credit rating from Baa3 to Ba1 over the next 12 months due to lower growth and slow pace of economic reforms.

Moody's likely to downgrade SA to sub-investment grade The credit rating downgrade is largely priced in by financial markets such that the impact on asset prices will likely be limited. However, the macroeconomic adjustment, following the downgrade to sub-investment, is usually painful and lasts for a very long time depending on the speed and extent of policy response.

Figure 11: SA’s credit rating history Factors working against fiscal consolidation

Capital outflows from emerging markets

■ Real economic growth remains low ■ Inflation rate lower than forecast ■ Tax buoyancy rates overestimated ■ SOE bailouts (signs that this will stop are positive) ■ Slow pace of economic reforms, though there

Moody's (RHS)

AA-

S&P

Fitch

A+ A

A-

Baa1

BBB+

Baa2

BBB

Baa3

BBB-

have been some improvements

Ba1

BB+

■ Insufficient economic growth to stabilise debt

Aaa Aa1

Ba2

Ba3

BB1994

1997

2000

2003

2006

2009

2012

2015

2018

We expect Moody’s credit rating downgrade in 2020. Source: S&P, Moody's, Fitch and Alexander Forbes Investments

Figure 12: What happens post the downgrade to sub-investment grade: the case of Brazil and Russia Brazil 10-year bond yields and currency BRL

5.0

Russia 10-year bond yields and currency

10-year yields (RHS)

18 16

4.0 3.0

1.0 0.0 2010

60.0

50.0

2.0

2011

2012

2013

2014

2015

2017

2018

2019

30.0

20.0

10.0 0.0 2010

14 12 10 8

40.0

10-year yields (RHS)

70.0

14 10

RUB

80.0

6 4 2 2011

2012

2013

2014

2015

2017

2018

2019

Source: Bloomberg and Alexander Forbes Investments

| 19

ALEXANDER FORBES

Table 1: Countries that have been downgraded to sub-investment grade Countries

Year lost

Year regained

Years

Reason for downgrade

Policy response

Colombia

1999

2011

Economic deterioration

Significant economic and political reforms

Croatia

2012

2019

A domestic currency, financial or banking crisis

Privatization

Hungary

1990

1996

Economic deterioration

Fiscal consolidation and/or austerity

Iceland

2010

2013

A domestic currency, financial or banking crisis

Active intervention by a newly elected government

Ireland

2011

2014

India (twice)

1991

1994

1998

2004

Fiscal consolidation and/or austerity

Indonesia

1997

2011

Korea Republic

1997

1999

Latvia

2009

2012

Romania

2008

2011

Slovakia

1998

2001

Slovenia

2012

2015

Thailand

1997

2003

Turkey

1994

2013

Uruguay

2002

2011

Average

Unsustainable macroeconomic imbalances

Significant economic and political reforms

A currency, financial or banking crisis resulting directly from neighbouring or regional influences Debt restructuring and economic policy reform Economic deterioration

Fiscal consolidation and/or austerity

Unsustainable macroeconomic imbalances

Active intervention by a newly elected government Fiscal consolidation and/or austerity

A domestic currency, financial or banking crisis

Declining external and fiscal vulnerabilities Significant economic and political reforms

Source: International rating agencies and Alexander Forbes Investments

Financial market performance and outlook Global asset class returns have performed relatively well in 2019 when compared to 2018. Developed market equities, driven by US equities, outperformed emerging markets and local equities. Global bonds underperformed other global asset classes which is a reversal of 2018 market dynamics where bonds performed better than equities. Domestic equity markets performed in line with emerging markets but domestic economic issues capped the performance. Resources, largely the gold and platinum sector, performed well while financials had poor returns.

20 |

HOT TOPICS I MARCH 2020

The longer term trend has seen moderating returns which is the low investment return theme we have highlighted over the past few years. However, for 2020, emerging market equities appear cheap and with stronger fundamentals. In a similar fashion, domestic equities also appear cheap which should benefit investors who have added holdings of local equities in their portfolios. Local bonds also continue to offer attractive real yields, particularly in an environment where global bonds offer negative or close to zero yields.

Table 2: Global asset class returns Global asset class returns in USD

Dec

Q4 2019

2019

2018

5 years

10 years

MSCI DM Index

3.0%

8.7%

28.4%

-8.2%

9.4%

10.1%

MSCI ACWI Index

3.5%

9.0%

27.3%

-8.9%

9.0%

9.4%

MSCI EM Index

7.3%

11.7%

18.6%

-14.3%

6.0%

4.0%

MSCI EFM EX SA Index

4.9%

8.6%

17.2%

-12.6%

-1.2%

2.3%

Citi World GBI

0.3%

-0.4%

5.9%

-0.8%

2.0%

1.9%

JP Morgan EM bonds

4.0%

4.4%

10.1%

-6.9%

2.1%

2.5%

MSCI UK

2.7%

2.3%

16.4%

-8.8%

6.7%

7.1%

Source: Bloomberg and Alexander Forbes Investments

SA asset class returns in ZAR

Dec

Q4 2019

2019

2018

5 years

10 years

All Share Index

3.3%

4.6%

12.1%

-8.4%

6.1%

10.9%

TOP40 Index

3.6%

4.5%

12.5%

-8.2%

6.2%

10.6%

Capped SWIX

3.1%

5.3%

6.8%

-10.9%

JSE Resources

7.0%

13.8%

28.6%

15.7%

8.2%

3.3%

JSE Financials

0.7%

2.8%

0.6%

-8.7%

3.9%

12.3%

JSE Industrials

2.3%

0.0%

9.1%

-17.4%

3.6%

14.0%

ALBI (Bond Index)

1.9%

1.7%

10.3%

7.7%

8.9%

Local property

-2.1%

0.6%

1.9%

-25.2%

1.2%

10.7%

Local cash

0.6%

1.6%

6.6%

6.5%

6.0%

Source: Bloomberg and Alexander Forbes Investments

*Not available

| 21

ALEXANDER FORBES

Change is inevitable Gyongyi King The investments profession is facing challenges that require unconventional ways of thinking. This is sparking conversations around the asset manager of the future and challenging the investment industry as we know it today, with technology being one of the key catalysts to the change. Disruption is inevitable but it does not impact every industry in the same way. The markets have structural weaknesses that expose the sector to significant levels of change but barriers of entry are inhibiting disruption â&#x20AC;&#x201C; for now. The industry will experience higher levels of technological change in the future.

Some structural changes have resulted in an increase of passive investments in the USA, which broadly represents their economy. But in South Africa, the indices do not represent the economy and this adds to structural differences. High fees and sub-par investment returns from active funds globally have led to a flood of assets moving from active to passive managers, and this trend is expected to continue into the future â&#x20AC;&#x201C; highlighting the rise of passive. The number of listed companies in both the New York and Johannesburg Stock Exchange have reduced drastically over the last 10 years. This has been largely driven by increasing venture capital, technology advancements, and diversification risk, among other things.

The asset manager of the future can be defined through three broad categories:

The public markets are becoming less relevant, and asset managers need to position themselves in a way that enables them in the changing environment while keeping to goal-based investment strategies.

The future lens As the asset management industry undergoes rapid change, investment firms are faced with the challenge of integrating technology into their existing business models and developing investment solutions that align with client values. These changes pose significant implications for investment professionals, whose current roles are likely to change in the next 5 to 10 years.

Innovative solutions

Sustainability

People

22 |

HOT TOPICS I MARCH 2020

1. Innovative solutions The winning asset management business models of the future have the challenge of positioning themselves as: ■ distribution powerhouses ■ solution providers ■ beta factories ■ alpha shops Distribution powerhouses

grant access to assorted products, distribution channels and investors

Solution providers

have multi-asset and portfolio construction expertise that allow them to develop innovative solutions

Beta factories

can achieve high operational efficiency through robust product pipelines and operating at scale

Alpha shops

have deep expertise in either traditional or alternative asset classes

The asset management industry is moving to a point where you must be either broad or niche to compete. The players in the middle are going to suffer in these challenging market conditions.

Integrate passive investment strategies Asset managers that want to remain competitive should seek to build solid portfolios that integrate appropriate passive investment strategies. Passive funds continue to gather assets and with the advent of zero-cost exchange-traded funds in the United States, this is likely to accelerate this growth even further. The proportion of passively managed assets in the United States has consistently increased from 19.5% to 22.4% over the last five years and is expected to continue in a similar trajectory. Passive investing will grow at the expense of active management, as investors increase allocations to smart beta.

Investing in artificial intelligence Successful asset managers will use technology to develop innovative solutions – allowing them to optimise their products, gain economies of scale, and improve the overall solution construction. Continuous investment in artificial intelligenceenabled data solutions will help asset managers innovate, improve services and reduce costs. Artificial intelligence is reshaping distribution and enabling asset managers to launch their solutions to new markets and customer segments which have been previously underserved.

| 23

ALEXANDER FORBES

2. Sustainability

3. People

Members in pension funds increasingly demand that all parties in the investment chain take their broader long-term interests, and those of future generations, into account. Society is demanding that environmental, social and governance (ESG) factors, sustainability and climate change become key considerations in the investment process – and their combined voice refuses to be taken lightly.

The world of work is evolving, and the investment industry isn’t exempt from the change. In South Africa, the asset management sector doesn’t reflect the participants in the market and lacks the diversity of views needed to further develop the sector.

Investing for the long term A sustainable investment view is more likely to create and preserve long-term investment capital whereas stewardship through active ownership helps realise long-term shareholder value. Long-term streams of returns and long-term themes, rather than short-term price movements, are more likely to achieve desired investment outcomes.

Climate change Climate change is a growing and significant priority to investors globally. The social, environmental and economic risks posed by climate change have long-term ramifications, including risks posed on investments. The causes of climate change need to be addressed timeously to avoid spiralling into dangerous temperature levels and the investment industry has a role to play in doing this. The future will take its cue from the turbulence of the past. The private markets have seen negative share price reactions to investor activism and this has led to occurrences like the tabling of climate change resolutions by the Johannesburg Stock Exchange in 2019. Increasingly, investors and companies are including climate change in their investment decisions. Industry interventions such as Bloomberg’s Task Force on Climaterelated Financial Disclosures (TCFD) and the Carbon Disclosure Project have ensured that disclosing climate change and environmental risk is increasingly becoming part of companies’ financial reporting.

Looking at transformation trends in the South African asset management industry, black-owned market share of traditional equities has fallen. This has been due to merger and acquisition activities that have increased across the sector, driven by B-BBEE and consolidation. The financial services sector should be radically transformed to become a vibrant and globally competitive industry that reflects the demographics of South Africa and contributes to the establishment of an equitable society by providing accessible services to black people and directing investment into targeted economic sectors.

We need two types of diversity To effectively function in the future, asset managers need to be cognisant of both cognitive diversity and identity diversity:

Cognitive diversity It’s important to have a team of varied thinking and problem-solving skills. This means that we move away from hiring professionals with just accounting and investment backgrounds and seek to hire individuals whose educational background and working experience lie anywhere in the spectrum. Data analysts, geologists and information technology specialists, amongst others, all have a place in the investment team. I dentity diversity We live and work in a world in which individuality should be embraced because individuality is all around us. ‘Different’ should never be seen as an anomaly, and investment teams need to reflect the society we live in. Both cognitive and identity diversity are connected, because people of different identities often have different backgrounds and experiences, making diversity a critical aspect in investment teams to help foster a better understanding of the marketplace and society to spark innovative solutions for clients.

24 |

HOT TOPICS I MARCH 2020

T-shaped leaders are in demand Researchers have coined the term ‘T-shaped skills’ as valuable skills to have in the future. A T-shaped person is an all-rounder who:

Adapts successfully to changing environments Works across disciplines

■ adapts successfully to changing environments ■ works across disciplines

Is at ease with technology

An example is an engineer who is a subject matter expert, easily transitions into investment management and knows how to code. Both traditional and practical learning will drive the new era of T-shaped leaders who combine leadership, soft and technical skills. No single investment team can afford to have a lack of diversity. Without diversity, people aren’t able to sufficiently connect across disciplines to develop innovative investment products. The future presents a world in which artificial and human intelligence complement each other, allowing people to leverage the benefits of technology while enhancing transparency, ethical consideration, communication and knowledge sharing.

Depth of related skills and expertise

■ is at ease with technology

Path to the future The roadmap to success in the investment profession isn’t simple – a combination of skills and abilities will continue to shape the industry. What hasn’t changed, however, is that the asset management industry will always attract investment professionals with a passion for learning and this will result in better outcomes for clients. It is the desire of investment professionals to learn, adapt and gain new abilities that will shape the asset manager of the future and make it one that can adequately serve its clients. Our role as leaders in the financial services industry is to build the foundation that welcomes continuous development, technological change and enhanced diversity and inclusivity to help propel asset managers into the future and investors closer to their financial goals.

| 25

SECTION TWO welcome to brighter 2020 vision themes and opportunities ... it's a matter of time

| 27

2020 vision: themes and opportunities

A number of forces have the potential to radically reshape the investment landscape over the next decade. After the first decade of this century brought 9/11, the â&#x20AC;&#x153;tech wreckâ&#x20AC;? and the global financial crisis, the taper tantrums, polarized politics and trade wars of the 2010s seem quite benign. However, the puzzles facing investors in the coming decade are far from harmless: negative yields on more than a fifth of global bonds, stubbornly low inflation in the developed world, central banks running out of ammunition to stimulate growth, growing wealth inequality, and high public debt levels. The effects of climate change are also becoming clear: CO2 emissions are higher than ever and climate-related activism is accelerating. Change is on the horizon and you need to be ready.

28 |

2020 vision: themes and opportunities

It’s a matter of time … Be clear on your timeframe, be prepared for business as unusual and position your portfolio for climate change — all of this requires a clear understanding of how related risks and opportunities could develop over time. For most investors, this means extending focus beyond current events, such as geopolitical risk and slowing economic growth, to bigger-picture issues, such as potential shifts in economic regime, the impact of evolving structural trends and increasing market recognition of environmental, social and governance (ESG) issues, particularly climate change. To succeed in the coming years, you must reconcile all these issues and their different timeframes.

How long have you got?

Policy risk

Structural trends It’s a matter of time

Business as unusual

Social license to operate

Position for climate change

| 29

2020 vision: themes and opportunities

How long have you got? First off, you need to be clear on your timeframe. If your time horizons are shorter, perhaps exhibit more caution and focus on market and liquidity risks. If your time horizons are longer, you need vision to understand the evolution of structural trends and their impact on markets. The primary risk to any investor is not meeting their objectives. Assess your risk in specific environments through scenario testing linked to your time horizon. This helps identify ways to potentially mitigate your risk and is a cornerstone of the strategic investment process. In hindsight, the 2010s were an “easy” investment environment, with rallying equity and bond markets driving strong returns. And with QE suppressing volatility, market risk over this period was much lower than the previous decade. However, stability can breed instability, and with a long market rally behind us, riding the late cycle feels increasingly risky. This isn’t the time to give up on diversification. Few investors expect a repeat of the past decade’s equity and bond returns. Bond yields in developed markets are extremely low or negative, appear to offer little downside protection and could perform poorly if inflation ticks up. Equity market valuations are not cheap and could be vulnerable to late-cycle dynamics.

30 |

We continue to advise allocations to less-constrained strategies, well-placed to capitalize on market dislocations. You may also find opportunities in strategies that have struggled to keep pace with broad market indices, such as value stocks, hedge funds, real assets and emerging markets. Policy risk increases as we extend time horizons, and we discuss many of these risks below: • The reduced power of central banks to stimulate growth • The likelihood that fiscal stimulus will make up some of the next wave • The need for climate policy development in response to increasing scientific evidence and mounting activism • The rising need for companies to earn a “social license” to operate Other areas, such as inequality and continuing global tensions, also raise policy questions, and the long list of issues suggests significant policy and regulatory change in the coming years.

2020 vision: themes and opportunities

Longer-term investors should give much thought to the impact of structural trends — powerful, transformative forces changing the global economy and the way we invest. Demographics have influenced the multi-decade fall in rates and will continue to impact economic growth for decades. Technology and artificial intelligence are already revolutionizing investment processes, alpha generation, and product design and distribution. Climate change is literally a force of nature, and its effects extend far beyond policy risk to serious physical impact risks and resource shortages. Apart from perhaps demographics, structural trends don’t develop in predictable straight lines. Sentiment spikes and crashes over time, creating opportunities for dynamic investors. In this way, the “long term” is a series of short terms, and investing in structural trends means balancing commitment to a long-term orientation with the need to be opportunistic. Longer time horizons allow deeper liquidity budgets, and the impact and thematic opportunities expected to capitalize on long-term structural trends are found in both public and private markets.

| 31

2020 vision: themes and opportunities

Business as unusual Investors must constantly adapt to the changing environment. We’ve seen the emergence of new nonbank lenders, passive and factor investing (as well as exchangetraded funds), the personalization of savings, and major fractures in global trading relations. We see two trends as particularly vulnerable to change, and these are areas where you should prepare for a period of business as unusual: 1. Central bank asset purchases to increase liquidity, stimulate the economy and counteract disinflationary forces will likely be backed up by fiscal stimulus. 2. Regulation to counter climate-related environmental damage concerns will ramp up. The challenge is that the monetary policy measures used over the past decade are reaching their effective limits in many developed market countries. Central banks have relied on lower rates and balance-sheet expansion to steer the economy. Since 2008, however, those balance sheets have grown to unprecedented levels due to quantitative easing. With low or even negative interest rates across the developed world, monetary policy options are limited and there are concerns over what comes next. In recent years, fiscal deficits appear to have become more acceptable across the political spectrum — the US is currently running a trillion-dollar deficit during an economic expansion under a Republican administration. Monetary and fiscal policy could morph into “modern monetary policy,” essentially removing the separation between fiscal and monetary policy because central

32 |

banks would increase the money supply to directly fund government deficits, allowing fiscal stimulus without raising taxes. Critics suggest this could lead to high inflation, weakening of the benefits of central bank independence (which has done much to prevent partisan economic policy, or “knee jerk” politics) and capital misallocation; supporters suggest offsets could be employed to minimize such risks. In an environment of fiscal stimulus, it’s increasingly important to evaluate how much portfolios protect against surprise scenarios, such as unexpectedly high inflation, which could make commodities, real assets and inflation break-evens more attractive. Depending on fiscal stimulus in other countries, such an environment could weaken the US dollar, and, in this case, the value of monetary hedges, such as gold, could increase. Beyond inflation protection, you should diversify your defensive portfolio positioning to protect against multiple shocks. With traditional defensive assets like government bonds being richly valued in developed markets, investors with fewer constraints may consider more attractively priced defensive asset classes, such as creditworthy floating rate assets and structured credit, or simply keep some powder dry by holding cash. Regulation has proved insufficient for dealing with climate and societal change. Consumers are increasingly aware of companies’ environmental and social impact and are challenging Milton Friedman’s maxim that “corporations have no higher purpose than maximizing profits for their shareholders.” With the help of social media, consumers are also increasingly aware of the negative impacts of “business as usual” and are reflecting their values in their consumption. To earn their social license to operate from consumers, investors and wider stakeholders, companies will need to demonstrate that their contribution is leaving the world in a better place.

2020 vision: themes and opportunities

In August 2019, US-based organization Business Roundtable issued a dramatically revised set of corporate governance principles that recognized a much wider set of company stakeholders, and it was signed by 181 CEOs. The principles stated, â&#x20AC;&#x153;If companies fail to recognize that the success of our system is dependent on inclusive long-term growth, many will raise legitimate questions about the role of large employers in our society.â&#x20AC;? Companies that donâ&#x20AC;&#x2122;t evolve may lose out, which is a risk that should be assessed in portfolio construction and further supports a case for investing in strategies with higher ESG ratings.

| 33

2020 vision: themes and opportunities

Position for climate change Climate change can feel like a long-term issue, with long-term consequences, for long-term investors. We believe, however, that the risks for investors are clear and present. Even if the physical effects of the climate crisis fall outside of your time horizons, climate policy has the potential to impact portfolios much sooner, independently of any realized physical impacts. Currently, there is a gap between the stated ambitions of the world’s governing bodies to limit global warming to well below 2°C and the pathway for global temperatures that will actually occur if governments adhere to current environmental policy. Most world leaders agree on the need for action, and visible evidence of the effects of climate change are only increasing, so we expect this gap to be closed by a more targeted policy. The convergence of environmental policy and stated ambitions is unlikely to be smooth, but some sort of policy response is inevitable. This represents a significant risk to carbon-intensive companies and industries over even relatively short time horizons, and we don’t believe that this is fully priced into current valuations.

34 |

The most likely policies to address these issues include: Increased renewable infrastructure spending

Carbon pricing that could increase the risk of stranding a portion of energy producers’ fossil-fuel assets Increased air flight taxes

Restrictions on internal combustion engine vehicles

More broadly, as consumers and other stakeholders demonstrate behavioral change to moderate their environmental impact and become more politically active, we expect that firms in any industry that fail to follow suit will find their social license to operate (and ultimately their revenues) increasingly under threat. Investors will find themselves under increasing pressure to understand and address the environmental impact of their investments. While more investors are acknowledging climate change and seeking to address it in their policy documents, efforts to address climate change within portfolios have progressed more slowly. We recommend all investors undertake some form of carbon-footprint analysis of their investment portfolios as part of a broader assessment of their exposure to climate policy risk, and then chart a course for alignment with global climate targets.

2020 vision: themes and opportunities

Looking beyond the policy horizon of the next few years, the physical and human risks to investors’ portfolios resulting from climate change are broader, more complex and potentially much more severe — especially if the policy response is muted. Mercer’s latest climate change study emphasized how much greater the physical damages and investment risks are if global warming reaches 3°C or 4°C. Expected annual return impacts are most visible at an industry or sector level, rather than at an asset-class level and are most evident in the 2°C scenario over the next decade, in which climate-change mitigation efforts are significant. This means that the most appropriate way to defend returns in the most damaging climate scenarios, and to improve returns in a transition scenario, is to invest in sustainable or low-carbon strategies that are positioned to capture a low-carbon transition premium.

The Intergovernmental Panel on Climate Change estimates that for each degree of global warming, approximately 7% of the global population will experience a decrease in renewable water resources of at least 20%. That resource strain will, in some cases, require new infrastructure assets, such as desalination plants, but more broadly will increase demand for water-efficient technologies and could lead to the relocation of certain water-intensive activities. Such assets could offer investors opportunities to achieve strong, inflation-sensitive and climate-resilient returns. Investors can influence the likelihood of a transition to a lower-carbon economy by investing positively — and those that do have the opportunity to be “future makers.”

Any type of climate transition will require significant investment in infrastructure, which brings opportunities for real asset investors, among others. Transforming the world’s energy supply from primarily fossil fuel to renewables demands new structures, such as wind turbines, hydro-stations and solar farms. Technological investment is also needed to improve storage and combat weather dependency. All of this requires equity and debt financing, potentially supporting an expansion of the emerging green bond universe. There are opportunities for real asset investors, but also vulnerabilities. The stubborn locations of existing assets may become less attractive with a more substantially changed environment, and aging infrastructure built for a milder climate may require retrofits or see its yield curtailed.

| 35

2020 vision: themes and opportunities

Taking action: Key recommendations for 2020 Change is on the horizon, and you need to be ready. Be clear on your timeframe, be prepared for business as unusual and position for climate change. We’ve highlighted many actions for investors to consider, and here are our key recommendations. • We continue to advise allocations to lessconstrained strategies well placed to capitalize on either market dislocations or long-term structural trends. These can be found in both public and private markets. • You may find opportunities in strategies that have struggled to keep pace with broad market indices, such as value stocks, hedge funds, real assets and emerging markets. Now isn’t the time to give up on diversification.

• You should reassess your portfolio’s resilience to “inflation surprise” scenarios, which could make commodities, real assets and inflation break-evens more attractive. • Companies and asset owners face increasing social pressure to consider a broader range of stakeholders, further supporting a case for investing in strategies with higher ESG ratings. • With traditional bonds richly valued in many markets, investors with fewer constraints should consider creditworthy floating rate assets and structured credit, or cash. • We recommend undertaking a carbon-footprint analysis and charting a course for alignment with global climate targets. It isn’t a question of whether current economic, political, social and environmental trends will impact portfolios, but rather how and when. It’s a matter of time.

It isn’t a question of whether current economic, political, social and environmental trends will impact portfolios, but rather how and when. It’s a matter of time.

36 |

Important notices References to Mercer shall be construed to include Mercer LLC and/or its associated companies. © 2020 Mercer LLC. All rights reserved. This contains confidential and proprietary information of Mercer and is intended for the exclusive use of the parties to whom it was provided by Mercer. Its content may not be modified, sold or otherwise provided, in whole or in part, to any other person or entity without Mercer’s prior written permission. Mercer does not provide tax or legal advice. You should contact your tax advisor, accountant and/or attorney before making any decisions with tax or legal implications. This does not constitute an offer to purchase or sell any securities. The findings, ratings and/or opinions expressed herein are the intellectual property of Mercer and are subject to change without notice. They are not intended to convey any guarantees as to the future performance of the investment products, asset classes or capital markets discussed. For Mercer’s conflict of interest disclosures, contact your Mercer representative or see http://www.mercer.com/conflictsofinterest. This does not contain investment advice relating to your particular circumstances. No investment decision should be made based on this information without first obtaining appropriate professional advice and considering your circumstances. Mercer provides recommendations based on the particular client’s circumstances, investment objectives and needs. As such, investment results will vary and actual results may differ materially.

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6010327a-GB

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SECTION THREE DIAGNOSIS | 2019/2020

| 39

ALEXANDER FORBES HEALTH

Introduction The Technical and Actuarial Consulting Solutions team of Alexander Forbes Health is proud to present this yearâ&#x20AC;&#x2122;s Diagnosis. We are confident that this publication will give you a comprehensive view of the performance of the South African medical schemes industry as well as some of the changes and challenges that the industry is facing. This analysis covers key statistics and trends over the 19-year period from 2000 to 2018, based on the consolidated financial results for all registered medical schemes, with specific focus on the 10 largest open and the 10 largest restricted medical schemes by principal membership. The publication of the revised National Health Insurance Bill and the final report on the Competition Commissionâ&#x20AC;&#x2122;s Health Market Inquiry have resulted in much debate in the medical schemes industry during 2019. The Council for Medical Schemes' move to abolish primary healthcare products from March 2021 and address this need through a primary healthcare package is expected to create further debate in 2020. If you would like to discuss any of the issues addressed in more detail, please speak to your Alexander Forbes Health consultant or contact one of the specialists listed at the end of this publication.

40 |

DIAGNOSIS 2019/2020

Contents 1. Key industry developments

2. Performance indicators

2.1 Size and scale

2.2 Market share

2.3 Membership profile

2.4 Contributions

2.5 Inflationary trends

2.6 Healthcare expenditure

2.7 Non-healthcare expenditure

2.8 Financial performance

2.9 Investments

2.10 Solvency levels

3. Alexander Forbes Health Medical Schemes Sustainability Index

4. Conclusion

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ALEXANDER FORBES HEALTH

Key industry developments 1998 ■ The Medical Schemes Act is signed into law. It introduces prescribed minimum benefits (PMBs), community-rated contributions and open enrolment.

2000 ■ The Medical Schemes Act comes into effect and the Council for Medical Schemes (CMS) is established.

2003 ■ The National Health Act gives a framework for a structured and uniform health system for the entire country. ■ Personal medical savings accounts are limited to 25% of gross contributions.

2004 ■ A Competition Commission ruling bans the system of collective tariff setting between schemes and healthcare providers. ■ Single exit price (SEP) is implemented for pharmaceutical manufacturers. ■ The National Health Reference Price List (NHRPL) is first published by the Department of Health. ■ Medical schemes must maintain a minimum solvency level of 25%.

2005 ■ The Government Employees Medical Scheme (GEMS) is registered. ■ The Children’s Act stipulates the age of consent of minors to medical and surgical treatment.

2006 ■ The CMS takes over publication of the National Health Reference Price List, a guideline for healthcare service tariffs.

2008 ■ The Medical Schemes Amendment Bill is proposed but not signed into law. It provides for the Risk Equalisation Fund (REF), low-income benefit options, improved governance, and an amendment of the definition of the business of a medical scheme. ■ The Health Professions Council of South Africa (HPCSA) scraps ethical tariffs, used by providers as a ceiling for patient accounts.

42 |

2009 ■ The Competition Amendment Act is signed into law. It provides a legal framework and gives formal powers to the Competition Commission to conduct market enquiries. ■ The Protection of Personal Information (POPI) Bill is published to protect personal information processed by public and private bodies, including medical schemes and industry stakeholders.

2010 ■ Dispensing fee regulation is introduced for pharmacists and licensed health professionals. ■ The High Court rules the National Health Reference Price List invalid and sets it aside. ■ The High Court dismisses the Board of Healthcare Funders’ (BHF) court application to seek clarity on the meaning of Regulation 8(1). ■ The CMS publishes the prescribed minimum benefits code of conduct to comply with Regulation 8(1) – ‘pay in full’.

2011 ■ The Consumer Protection Act takes effect to support a culture of consumer rights and responsibilities. ■ The Green Paper on the National Health Insurance Policy is published for public comment.

2012 ■ The Taxation Laws Amendment Act provides for a new medical tax credit system to replace medical tax deductions. The definition of a dependant is widened in the Income Tax Act to be the same as the definition of a dependant in the Medical Schemes Act. ■ Draft demarcation regulations propose the removal of most gap cover products and hospital cash plans.

2013 ■ The Financial Services Laws General Amendment Act amends the Medical Schemes Act by widening the definition of the ‘business of a medical scheme’. ■ Schemes must hold members’ medical savings account (MSA) contributions separate from scheme reserves and allow interest to accrue to positive MSA balances. ■ The National Health Amendment Act provides for the establishment of the Office of Health Standards Compliance (OHSC), a key building block of the National Health Insurance (NHI). ■ The Competition Commission Inquiry into Private Healthcare is announced. ■ The Protection of Personal Information (POPI) Act) is signed into law.

DIAGNOSIS 2019/2020

2017

2014 ■ The 12-member board of the newly established Office of Health Standards Compliance is named. ■ The Competition Commission Inquiry into Private Healthcare begins. ■ The Draft Road Accident Fund Benefit Bill provides for a no-fault benefit scheme and a new administrator to replace the Road Accident Fund. ■ The Financial Services Board (FSB) introduces Treating Customers Fairly (TCF), a market conduct framework of regulatory reform. ■ The National Department of Health publishes a national health insurance booklet.

■ The revised National Health Insurance White Paper is gazetted on 30 June 2017. This version does not provide updated estimates of the NHI costs, but identifies additional potential sources of funding, including the removal of medical aid tax credits as well as the public sector medical aid subsidies. ■ The findings and recommendations of the Competition Commission’s Health Market Inquiry are delayed to 30 November 2017. ■ The Constitutional Court overturns the Supreme Court’s ruling that requires schemes to hold medical savings account assets separately from the rest of the scheme’s assets. This means that: ● medical savings account assets will now form part of the scheme’s assets ● assets can be invested in investment classes other than cash ● interest on medical savings account assets can accrue to the scheme ■ A National Health Insurance Implementation Committee on Consolidation is established to oversee the restructuring of the industry before the full implementation of NHI. This process includes: ● consolidating those schemes with fewer than 6 000 members into larger schemes ● merging public sector schemes ● reducing the number of benefit options offered by the remaining schemes

2018 2015 ■ The Competition Commission Inquiry into Private Healthcare continues, with medical schemes and administrators being requested to provide claims and tariff information for the last 17 years. ■ The Minister of Health publishes a draft amendment to Regulation 8. Medical schemes are no longer required to pay for PMBs at cost, but rather at either a contracted rate or the 2006 guideline tariff plus inﬂation. ■ The Council for Medical Schemes approves the framework for exemption and allows low-cost benefit options to be introduced from 1 January 2016. The framework is then withdrawn soon afterwards. ■ The National Health Insurance White Paper is published on 10 December 2015. It proposes a single payer system with no option to opt out and medical schemes being limited to offer complementary cover.

2016 ■ The Competition Commission Inquiry into Private Healthcare is delayed, with the draft report not being published by August 2016 as proposed in the revised timelines. ■ The CMS releases a proposed risk-based solvency framework to replace the controversial 25% statutory minimum that has been in place since the introduction of the Medical Schemes Act. ■ Draft demarcation guidelines are published in a joint statement by the Department of Health and National Treasury, allowing hospital cash plans and gap cover to continue, but prohibiting primary healthcare insurance products.

■ The National Health Insurance Bill is published on 21 June 2018. It sets out the framework for establishing the National Health Insurance Fund, which will be a single, mandatory public purchaser and financier of health services in South Africa. ■ The Medical Schemes Amendment Bill is published on 21 June 2018 and proposes wide-ranging reforms to the Medical Schemes Act. The changes include: ● redefining the benefits package all schemes are mandated to cover ● revising the governance structures of medical schemes ● changing the way schemes are allowed to differentiate contributions across beneficiaries ■ The Competition Commission’s Health Market Inquiry publishes its provisional findings on 5 July 2018 after a series of delays. The findings identify the concentration of market share with select funders and facilities as one of the market failures in providing private healthcare and propose remedies to improve transparency and market competitiveness. ■ The Council for Medical Schemes publishes a draft framework on the consolidation of medical schemes, setting forth a fourpillar approach to consolidation. The framework also proposes the consolidation of public sector schemes into the Government Employees Medical Scheme.

2019 ■ Cabinet approves the National Health Insurance Bill on 11 July 2019. A revised version is published on 8 August 2019, which will be tabled before Parliament. ■ The Competition Commission’s Health Market Inquiry publishes its final report on 30 September 2019. The report recommends that supply-side regulation be introduced as a remedy to the rising cost of private healthcare. ■ The Council for Medical Schemes allows the original demarcation exemption granted for primary healthcare products to be extended until 31 March 2021. No low-cost benefit option framework is put forward and these products will be prohibited from 1 April 2021.

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ALEXANDER FORBES HEALTH

Performance indicators 44 |

DIAGNOSIS 2019/2020

This section analyses the key statistics inﬂuencing the performance of medical schemes. When evaluating the performance of medical schemes, the key factors to consider are:

Size and scale

Larger schemes tend to have more stable and more predictable claims experience. They should also have greater negotiating power when setting prices.

Membership growth

Increasing membership reduces the volatility of a scheme’s claims and improves the profile, as new members tend to claim less than the average member in their first year of membership.

Membership profile

Claims experience will be more favourable for younger populations with lower chronic prevalence.

Financial results

The trend in a scheme’s financial results illustrates the adequacy of their pricing.

Solvency levels

Each scheme should have sufficient reserves after considering each of the previous factors. The current statutory requirement is for schemes to hold 25% of gross contribution income.

ALEXANDER FORBES HEALTH

2.1 Size and scale Medical schemes in numbers 100

6 000 000

90 5 000 000 80

Number of beneficiaries

3 000 000

40 2 000 000

Number of medical schemes

70 4 000 000

20 1 000 000 10

2000

2001 2002 2003

2004 2005

2006 2007

2008 2009 2010 2011 2012 2013 2014

Beneficiaries in open medical schemes

Beneficiaries in restricted medical schemes

Number of open medical schemes

Number of restricted medical schemes

At the end of 2018 there were 79 registered medical schemes in South Africa, down from 80 at the end of 2017. From the end of 2000 to the end of 2018, the number of medical schemes reduced from 144 to 79, which represents a 44% decrease in the number of registered medical schemes over 18 years, mainly as a result of amalgamations among the smaller, less sustainable schemes. The number of open medical schemes has decreased by 26 (55%) compared to a decrease of 39 (40%) restricted medical schemes over the 18-year period. The consolidation appears to be driven by the: â&#x2013; difficulty in maintaining the financial sustainability of small schemes in the current environment and particularly for restricted medical schemes â&#x2013; significant amount of management time needed to manage an employer-based restricted scheme This trend in consolidation continued into 2019 as Spectramed amalgamated with Resolution Health Medical Scheme to form Health Squared Medical Scheme on 1 January 2019.

46 |

2015

2016

2017 2018

Topmed Medical Scheme amalgamated with Fedhealth Medical Scheme starting from 1 August 2019. An amalgamation was also proposed between BP Medical Aid Society and Momentum Health during 2019 which was declined by the regulator. Despite the observed decrease in the number of medical schemes, the industry has grown by 1.50 million principal members (58.9%) and 2.33 million beneficiaries (35.3%) since 2000. The 79 medical schemes operating in South Africa at the end of 2018 served a total of 4.04 million principal members and 8.92 million beneficiaries. The number of principal members covered on medical schemes increased by 0.7% during 2018, while the total number of beneficiaries under cover increased by 0.5%, driven mainly by a growth in beneficiaries covered on restricted medical schemes. A total of 59.0% of principal members participated in open medical schemes at the end of 2018 with the balance of 41.0% participating in restricted medical schemes. This is in line with the membership split seen at the end of 2017.

DIAGNOSIS 2019/2020

The graph below shows the percentage change in medical scheme membership over the last 18 years.

Annual percentage growth in membership 30%

25%

Percentage annual growth rate

20%

15%

10%

-5% 2001

2002

2003

2004

2005

2006

2007

2008

All schemes

There is a significant difference between the trends in the annual growth rate of open and restricted medical schemes, with the divergence in the trend beginning in 2006 when the first members registered on GEMS. Following the significant increase in restricted scheme membership attributable to GEMS in 2006 and 2007, the annual growth in restricted schemes reduced each year, with little growth being observed in the restricted schemes from 2013 to 2015. In 2018 principal membership of open medical schemes grew by 0.7% while membership of restricted schemes grew by 0.6%, with net growth of 26 983 members across the industry during the year. The minimum membership requirement set by the Council for Medical Schemes (CMS) for registering a new medical scheme is 6 000 principal members. At the end of 2018 there were three open medical schemes and 27 restricted schemes with fewer than 6 000 principal members.

2009

2010

Open schemes

2011

2012

2013

2014

2015

2016

2017

2018

Restricted schemes

The open schemes with membership below this threshold are Cape Medical Plan (4 864 principal members), Makoti Medical Scheme (4 715 principal members) and Suremed Health (1 180 principal members). A large membership base allows for lower claims volatility and helps schemes, or their administrators, negotiate more competitive reimbursement rates and fees with healthcare service providers. This ensures that medical scheme members have lower shortfalls or copayments when using these designated service providers. A small membership base results in a more variable claims experience, which increases the risk of contributions not being set at an appropriate level to cover all claims and expenses. This variability is compounded by the negative impact of high-cost claims, especially in the current environment where schemes are required to pay in full for the cost of prescribed minimum benefits, regardless of the rates charged.

| 47

ALEXANDER FORBES HEALTH

Despite these risks as well as amalgamations of many small schemes, a fair number of restricted schemes are still performing well. Of the 30 schemes referred to earlier that have fewer than 6 000 members, only 8 achieved a surplus before investment income in 2018, down from 10 in 2017, which indicates the risk profile and claims volatility to which smaller schemes are exposed.

As a result, Sasolmed has moved up to eighth place while Umvuzo Health Medical Scheme is now in the top 10 as the ninth largest restricted medical scheme. Transmed and the Chartered Accountants (SA) Medical Aid Fund (CAMAF) are the 11th and 12th largest restricted schemes at 31 December 2018 with 25 115 and 24 692 principal members respectively.

The graph below ranks the top 10 open schemes and top 10 restricted schemes according to the number of principal members at 31 December 2018. This represents 88.2% of all principal members participating on a registered medical scheme, or 95.7% and 77.3% of open and restricted medical scheme membership respectively.

Five of the open schemes and eight of the restricted schemes considered here experienced growth in 2018, with the remaining seven experiencing a reduction in membership numbers. The number of beneficiaries with medical scheme cover increased by 0.5% during 2018, after the net decrease in lives observed in 2017.

The top 10 open medical schemes by principal membership have remained unchanged in 2018. Topmed Medical Scheme and Resolution Health Medical Scheme are the 11th and 12th largest open schemes at 31 December 2018 with 18 506 and 13 592 principal members respectively.

The number of principal lives covered increased by 0.7%, which resulted in the average family size in the industry remaining stable at 2.21 from 2017 to 2018. This follows the consistent decline observed each year since 2000, which is indicative of financial pressures resulting in fewer dependants being added to cover. Members also tend to add beneficiaries to cover only when they need medical attention. This anti-selective risk is greatest for those schemes with the fewest underwriting controls, as they are most vulnerable to these high claimers.

The top 10 restricted medical schemes by principal membership have largely remained unchanged in 2018. However, Transmed is no longer in the top 10 as a result of continued decline in principal membership over the year. The scheme lost 12.8% of its principal membership in 2018, having already lost 13.7% of members in the preceding year.

Membership by medical scheme 30%

1 600 000

1 400 000

Number of lives covered

1 200 000 10% 1 000 000

800 000

600 000 -10%

400 000 -20% 200 000

2018 principals

48 |

2018 dependants

Growth in principal members

Growth in dependants

p ou gr

N ed

m U

ed m of

lth SA

U M

lth Pl

in u

ed m

H ea LA

S M

nk Ba

ed m

lth

os H

yH ea

zw e

lth

ea dh

ie l

el p

ed tm

ed M

tu m en om

Be s

s ni ta M

Di sc

ov er y

-30%

Percentage growth from 2017 to 2018

20%

DIAGNOSIS 2019/2020

2.2 Market share

In 2018 GEMS’ total market share was 17%, compared to 2% in 2006 when the first members joined. The rapid growth in membership includes:

The industry’s net growth of 26 983 principal members over the 2018 financial year was driven by the growth in: ■ Discovery Health Medical Scheme (Discovery), which experienced net growth of 27 427 principal members ■ the Government Employees Medical Scheme (GEMS), which grew by 13 090 principal members

■ qualifying government employees transferring from other open schemes ■ the amalgamation with Medcor in 2010 ■ the transfer of a group of 16 000 pensioners from Medihelp to GEMS early in 2012

Discovery’s total market share based on the number of principal members has increased from 16% in 2001 to 33% at the end of 2018, compared to a decrease in market share for the rest of the open schemes from 54% in 2001 to 26% in 2018.

Continued new member growth, stimulated by an attractive employer subsidy, has increased the market share of GEMS in the past. However, that employer subsidy was not increased for several years from 2011, which may have contributed to the slowdown in membership growth.

This decline in open medical scheme membership (excluding Discovery) is due to:

It is likely that the increases in the public sector subsidy announced since 1 January 2016 have contributed towards the growth in lives covered on GEMS during the year. The total market share of the balance of the restricted schemes has decreased from 30% to 24%, driven by some amalgamations of restricted schemes into the open medical scheme environment.

■ many members choosing to move from their current medical scheme to join Discovery Health ■ qualifying public sector employees moving from open schemes to GEMS since its inception

Market share by principal membership GEMS

Discovery

2010: Medcor 2012: Pre-92 Medihelp pensioners

2004: AngloGold 2010: Afrisam, Umed 2012: Edcon 2013: Nampak, IBM 2014: Altron, Afrox, PG Bison 2018: WitsMed

2018 33%

2011 2%

17% 16%

29%

2006

27%

2001 16% 28% 25% 24%

30% 54% 43% 30% 26%

All restricted medical schemes (excluding GEMS)

All open medical schemes (excluding Discovery)

2001 to 2018

Net reduction of 38 schemes

Net reduction of 28 schemes | 49

ALEXANDER FORBES HEALTH

2.3 Membership profile One of the most important contributing factors to a scheme’s performance is the risk profile of its members, with some of the key statistics being: ■ average age of beneficiaries ■ pensioner ratio (defined as the percentage of beneficiaries over the age of 65 years) ■ average family size Let us consider the trends in each of the above factors.

Average age of beneficiaries 35

Average age of beneficiaries

28 2005

2006

2007

2008

2009

2010

All schemes

2011 Open schemes

2012

2013

2014

Restricted schemes

Note: Average age of beneficiaries was recorded in the CMS Annual Reports from 2005 only.

50 |

2015

2016

2017

2018

DIAGNOSIS 2019/2020

From 2011 the growth driven by GEMS slowed down, and this has resulted in the average age of restricted scheme beneficiaries increasing from that point.

The average age of beneficiaries on open schemes decreased by 0.1 years to 34.8 years in 2018, while the average age on restricted schemes remained stable at 31.0 years from 2017 to 2018.

As a scheme ages, we expect the average claims per member to increase, with a benchmark of a 2% increase in average claims per year increase in average age. A typical claims curve is shown on the next page.

From 2006 to 2010, the average age of beneficiaries in restricted schemes reduced consistently each year. This was due to the rapid growth of GEMS, with significant numbers of younger members joining the scheme in the early years.

Average age of beneficiaries 2017 All schemes

33.2

Open schemes

34.9

Restricted schemes

31.0

2018 All schemes

33.1

Open schemes

34.8

Restricted schemes

31.0

Note: Average age of beneficiaries was recorded in the CMS Annual Reports from 2005 only.

| 51

ALEXANDER FORBES HEALTH

A typical claims curve over a member’s lifetime

Young and single

Family with children

Middle-aged

Retired or retiring

■ Hospital cover ■ Limited or no day-to-day cover

■ ■ ■ ■

■ Hospital cover ■ Higher day-to-day cover ■ Chronic benefits

■ Hospital cover ■ Comprehensive day-to-day cover ■ Higher chronic benefits ■ Cover for joint replacements and other age-related conditions

Average claim per member

Hospital cover Day-to-day cover Maternity benefits Limited chronic benefits

Age Individual claims

52 |

Family claims

70+

DIAGNOSIS 2019/2020

The following graph considers the average age of beneficiaries for each scheme included in this year’s analysis. It also includes the change in the average age of each of the schemes from 31 December 2015 to 31 December 2018.

-1

-2

-3

-4

-5

gr ed

vu N

m U

lm so Sa

M U W

lth ea

ea H in at Pl

ed m

nk Ba

lm Po

m os H

ie ed

ih M

ed M

ed m st

tu en

s ta ni

om M

er ov sc Di

Change in age

lth

Average age

Average age of beneficiaries 55

Average age in 2018

While the absolute age of a scheme’s membership is important and indicative of the likely claims profile, the change in this figure signals a change in the profile that would result in the medical scheme needing to take corrective action in its pricing of benefits, especially if the age were to increase.

Three-year change

LA Health’s average age has reduced significantly over the last three years as a result of the high rate of growth from younger members. Medshield and Umvuzo also experienced decreases in the average age of beneficiaries over the threeyear period. As in previous years, Polmed has the lowest average age of beneficiaries for all the schemes considered.

Of the 20 schemes included in this year’s Diagnosis, KeyHealth and Profmed have the highest average age of beneficiaries in open and restricted medical schemes respectively.

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ALEXANDER FORBES HEALTH

Pensioner ratio 11%

10%

Pensioner ratio

4% 2005

2006

2007

2008

2009

2010

All schemes

2011

2012

Open schemes

2013

2014

2015

2016

2017

2018

Restricted schemes

The average pensioner ratio across the industry increased from 8.4% to 8.5% in 2018. Open schemes experienced a greater increase in the pensioner ratio while restricted schemes experienced no change.

Pensioner ratio 2017 All schemes

8.4%

Open schemes

10.0%

Restricted schemes

6.5%

2018 All schemes

8.5%

54 |

Open schemes

10.1%

Restricted schemes

6.5%

DIAGNOSIS 2019/2020

Average family size 2.8 2.7

Average family size

2.6 2.5 2.4 2.3 2.2 2.1 2.0

2000

2001

2002

2003

2004

2005

2006

2007

All schemes

2008

2009

Open schemes

2010

2011

2012

2013

2014

2015

2016

2017

2018

Restricted schemes

The average family size for open and restricted medical schemes largely remained unchanged from 2017 to 2018.

Family size 2017 All schemes

2.21

Open schemes

2.10

Restricted schemes

2.38

2018 All schemes

2.21

Open schemes

2.09

Restricted schemes

2.38

| 55

ALEXANDER FORBES HEALTH

However, the average family size for the entire medical schemes industry has declined over the last 18 years but it did not decrease further in 2018. This indicates that fewer dependants per principal member are being registered with medical schemes over time. This may be because some members can no longer afford to provide medical cover for their entire family, which may become more of an issue once children become ineligible for subsidies of medical scheme contributions. Those beneficiaries who have been removed from cover may be added back as a dependant when they need medical cover, for example during a pregnancy, and medical schemes may use waiting periods to try to control this anti-selective behaviour. In addition to this, as members’ dependent children become self-supporting, they no longer qualify for membership as dependants on their parents’ medical scheme and in turn become principal members themselves.

This has a direct impact on the average family size in two ways: ■ Dependants being removed from a medical scheme reduce the average family size. ■ Individuals joining a medical scheme as single members will also reduce the average family size.

2.4 Contributions Medical schemes work on the concept of risk pooling, where the risk contribution charged to members depends on a combination of these factors: ■ Claims: the expected medical expenses of the entire membership group ■ Non-healthcare expenses: the expected costs associated with any administration of claims and day-to-day operations ■ Investment income: the interest or returns expected from the scheme’s assets

In simple terms, the financial operations of a medical scheme can be described by four main factors, shown in the equation:

contributions + investment income ≥ claims + expenses

56 |

DIAGNOSIS 2019/2020

Allocation of contribution income in 2018 120% 110% 100%

Percentage of gross contribution income

90% 80% 70% 60% 50% 40% 30% 20% 10% 0% -10%

du In

ric

ed N

m U

so Sa

of Pr

U W

M SA

in Pl

lth ea

lth

H LA

S M

lth

ed M

om M

-20%

Medical savings account

Healthcare expenditure

Where the schemeâ&#x20AC;&#x2122;s claims and expenses exceed the contributions, investment income is required to subsidise this shortfall. Any remaining investment income is then added to the reserves of the scheme and serves to maintain its solvency levels. However, where investment income is not sufficient to cover this shortfall, the scheme is forced to use its existing reserves, which results in decreasing solvency levels. A scheme may decide to use investment income to cover claims or expenses for a number of reasons, including increasing claims costs, adverse claims experience and cross-subsidisation between benefit options. Some schemes may intentionally set contributions to use part of the investment income to subsidise claims and expenses, particularly schemes which have significant reserves in excess of the statutory requirements. However, this would not be sustainable in the long term, as over time the scheme would become underpriced and would need to adjust its pricing with larger contribution increases in future years.

Non-healthcare expenditure

Contribution to reserves

The graph above considers the top 10 open schemes and top 10 restricted schemes, together with the totals for open and restricted schemes and the industry as a whole. Where the contribution to reserves sits below the 0% line, schemes have used part or all of their investment income to fund for claims and expenses. In some cases, where investment income has not been sufficient, schemes have had to use their existing reserves, placing pressure on solvency levels. In 2018, 11 of the 20 schemes considered did not have sufficient contribution income to cover both their claims and non-healthcare expenses in full and so used investment income and in some cases their existing reserves to subsidise the cost incurred. Three open schemes, Momentum, Medshield and Sizwe, and two restricted schemes, Polmed and Profmed, did not have sufficient contribution income to add to their reserves during the year. Each component of the medical scheme pricing equation is considered in more detail in the sections that follow. However, first some of the inflationary trends that have been seen in the industry over the past 19 years are examined.

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ALEXANDER FORBES HEALTH

2.5 Inflationary trends The illustration below compares medical scheme contribution inflation, along with medical care and healthcare expense inflation trends, to consumer price index (CPI) inflation in the past decade, where: ■ CPI inflation is the weighted average price inflation in different sectors and indicates the general level of price increases. Viewed in isolation, it does not necessarily give a true reflection of cost pressures in a particular sector. Individual sectors may experience cost increases that differ from CPI inflation, as is the case in the healthcare sector. ■ Medical care and health expense inflation is measured by Statistics South Africa and is based on that component of CPI which relates to doctors’ fees, nurses’ fees, hospital fees, nursing home fees, medical and pharmaceutical products and therapeutic appliances.

■ Medical scheme contribution inﬂation is calculated for all medical schemes who submit annual financial returns to the Registrar of Medical Schemes. Percentage increases are based on the average contribution per principal member per month and allow for normal medical scheme contribution increases, as well as buy-ups and buy-downs to other benefit options. Changes in contributions as a result of family size or family composition are also taken into account.

Average inflation over 19 years Medical scheme contribution inﬂation Medical care and health expenses inﬂation

7.4% per year

Rebased CPI inﬂation

5.7% per year

58 |

7.6% per year

DIAGNOSIS 2019/2020

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ALEXANDER FORBES HEALTH

Average annualised contribution increases from 2007 to 2020

The general observation in the industry is that medical inflation (medical care and health expenses inflation) will be 2% to 3% higher than CPI inflation over the long term. However, increases in a particular year may be significantly higher because of adverse claims experience. The deviation from CPI is due to: ■ high increases in healthcare service provider fees ■ a rising burden of disease ■ increasing hospital admission rates ■ higher use of benefits ■ new medical technologies ■ the requirement to maintain reserves of at least 25% of gross contribution income ■ certain benefit enhancements ■ fraud, waste and abuse CPI inflation has averaged 5.7% over the last 19 years, while medical care and health expenses inflation has been on average 7.4% per year, resulting in a gap of 1.7% per year. Over the same period, average medical scheme contribution inflation for the industry overall was 7.6% per year, resulting in actual increases in medical scheme contributions per principal member exceeding CPI inflation by at least 1.9% per year.

12% Medshield Medihelp Discovery KeyHealth | Sizwe CPI

9.9% 9.5% 9.2%

10.7% Bestmed 10.0% Fedhealth 9.3% Momentum | Bonitas 8.7% Hosmed

8.4% 5.9%

The gap between medical scheme contribution inflation and CPI inflation has reduced in recent years, most likely as a result of efforts by medical schemes in managing the costs charged by providers. While this would have a direct impact on medical scheme contribution increases, the further reduction in the gap between average medical scheme contribution inflation and CPI inflation indicates the extent of member buy-downs to lower cost benefit options, new entrants joining low-income options, and changes to family size, possibly when dependants are removed because of affordability constraints. The illustration on the left summarises the average headline contribution increases announced by medical schemes since 2007 and compares them to average CPI. Note that an arithmetic average has been used for illustrative purposes and only medical schemes where this information is available have been included. Also note that these increases are based on the headline increases announced by individual schemes and the method of calculation may vary. It does, however, provide some useful information on real contribution increases faced by members. The average contribution increases for the top 10 open medical schemes since 2007 have far exceeded average CPI. The margin between the level of CPI and the industry’s contribution rate was highest from 2008 to 2011.

60 |

DIAGNOSIS 2019/2020

Since 2012 the contribution increases have tended to be closer to CPI as schemes have limited increases in contributions to: â&#x2013; increase competitiveness â&#x2013; reduce membership losses from affordability constraints Increases announced for 2019 were higher than in prior years in part because of the higher claims ratio in 2018. The 2020 contribution increases are again higher despite a lower level of CPI inflation in 2019, as many schemes reported higher claims.

2.6 Healthcare expenditure One of the main components influencing the performance of a medical scheme is its healthcare expenditure or claims experience. In this section the claims ratio as well as the actual level of claims that are paid by medical schemes are considered. Healthcare expenditure includes all payments made for claims incurred by members. The risk claims ratio is defined as the ratio of risk claims to risk contributions (the proportion of contributions that are used to fund claims, excluding any allowance for medical savings accounts).

The risk claims ratio for all medical schemes increased from 88.7% in 2017 to 90.2% in 2018. For the 2018 benefit year, open medical schemes had an overall risk claims ratio of 89.8% compared to the 90.7% experienced by restricted medical schemes. The noticeable increase in the claims ratio from 2014 to 2015 was in part due to the inclusion of managed care fees in healthcare expenditure from 2015. Many restricted schemes do not incur certain non-healthcare expenditure items such as distribution costs, marketing expenses and broker fees. As a result, they can often afford to use a higher percentage of risk contributions towards risk claims than open medical schemes. This trend is illustrated in the graph below. This graph also shows a cyclical trend. This is most likely caused by the lag effect of annual pricing exercises by medical schemes. Where a scheme has experienced adverse claims during the year, it would usually only correct that experience through higher contributions or benefit reductions (and therefore lower relative claims) in the next financial year and this corrective action often needs to take place over at least two years.

Trend in claims ratios 120%

Risk claims as a percentage of risk contributions

110%

Managed care fees were included with healthcare expenditure from 2015. 100%

90%

80%

70%

60% 2000

2001

2002

2003

2004

2005

2006

All medical schemes

2007

2008

2009

2010

Open medical schemes

2011

2012

2013

2014

2015

2016

2017

2018

Restricted medical schemes

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ALEXANDER FORBES HEALTH

R1 200

75%

R1 000

70%

R800

65%

R600

60%

R400

55%

R200

50%

45%

m of

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Risk claims ratio

80%

R1 400

85%

R1 600

lth

90%

R1 800

95%

R2 000

lth

100%

lth

R2 200

105%

R2 400

Average contribution or claim per beneficiary per month (PBPM)

Claims and contributions by scheme

Average contributions PBPM

Average claims PBPM

Medical schemes usually finalise their benefits and contributions reviews in September each year, without the full membership and claims experience of that year. Where experience has been worse than expected in the first part of the year and is therefore included in the data used for the purposes of pricing, allowances can be made for this experience in the next financial year. However, where the adverse experience occurs in the second half of the year, it cannot be allowed for in the pricing of benefits into the next year, and so this adverse experience must be made up in the following year. In addition, the adverse experience in the second half of the year has a direct impact on the reserves and solvency levels of the scheme going into the next year. In general, medical schemes with a risk claims ratio of above 85% face the challenge of achieving an operating surplus (contributions less claims and expenses) while: ■ containing non-healthcare expenses below the Council for Medical Schemes’ guideline of a maximum of 10% of contributions ■ building and maintaining reserves at a sustainable level

62 |

2018 claims ratio

Although 85% is the benchmark for the claims ratio, the ideal ratio for a particular scheme will depend on its current circumstances such as: ■ the current adequacy of contributions ■ the level of non-healthcare expenses ■ the need for reserve-building ■ the scheme’s long-term strategy The graph above specifies the average claims paid per beneficiary per month (PBPM), as well as the risk claims ratio in 2018, for the 20 schemes included in the Diagnosis this year. These claims ratios all include any managed care fees incurred by the schemes. While the claims ratios show the adequacy of contribution levels, the actual average claims paid per beneficiary indicate the level of benefits provided by a scheme. The graph above shows that KeyHealth paid the highest amount in claims per beneficiary in 2018 and had the highest contribution income per beneficiary during the year.

DIAGNOSIS 2019/2020

Polmed experienced the highest claims ratio of these schemes, with a claims ratio of 102.1% for 2018. LA Health had a claims ratio of 82.7% for 2018, the lowest claims ratio of the 20 schemes considered. The actual healthcare costs funded by medical schemes are driven largely by the use of services as well as the actual cost of claims. The use of services is influenced by: ■ demographic factors (age profile and pensioner ratio) ■ the incidence and distribution of disease (often called disease burden) ■ advances in diagnostic technology and biological drugs The increase in actual cost of claims can be managed by the negotiating power of a medical scheme or its administrator. The level of the average claims and contributions per beneficiary for a particular scheme depends on the: ■ richness of benefits offered ■ split of members between high-cover and low-cover options ■ demographic profile of the scheme in terms of average age and chronic prevalence

A scheme with a significant level of reserves might intentionally price for an operating deficit to use some of those reserves, while a scheme which does not meet the statutory solvency requirements may have higher contributions than their demographic and claims profile would require to build reserves.

2.7 Non-healthcare expenditure Non-healthcare expenditure (NHE) includes administration fees, broker commission, distribution costs, bad debts, and reinsurance costs. Up to 2014, managed care fees were reported as part of non-healthcare expenditure. However, since 2015 managed care fees have been recognised as part of healthcare expenditure, which means that the proportion of gross contribution income spent on NHE has reduced significantly from 2014 to 2015. Total non-healthcare expenditure, as a proportion of gross contribution income (GCI), decreased marginally in 2018 for the medical schemes industry. Restricted medical schemes decreased the proportion of gross contribution income spent on non-healthcare expenditure from 6.0% to 5.7%.

The relationship between contributions and claims for a medical scheme depends on the pricing philosophy followed by that scheme.

Trend in non-healthcare expenditure 20%

Managed care fees were excluded from non-healthcare expenditure from 2015.

18%

16%

NHE as a percentage of GCI

14%

12%

10%

0% 2000

2001

2002

2003

2004

2005

2006

All medical schemes

2007

2008

2009

Open medical schemes

2010

2011

2012

2013

Restricted medical schemes

2014

2015

2016

2017

2018

10% line

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ALEXANDER FORBES HEALTH

we would expect the proportion paid to NHE to decrease over time, irrespective of whether additional cost controls are introduced. In addition, broker fees paid each year may not increase at the same rate as contributions. This is due to the commission cap in place, which does not increase at CPI and contributes to the decreased NHE percentage. As a result, a more suitable measure of NHE is the absolute cost per member.

For open schemes, the NHE proportional spend remained unchanged at 10.0% from 2017 to 2018. The lower level of non-healthcare expenditure within restricted schemes is driven to a large extent by GEMS and Polmed whose nonhealthcare expenditure was 4.9% and 3.7% respectively of gross contribution income in 2018. Restricted schemes are expected to have lower non-healthcare costs primarily because they have lower or no distribution expenses or broker fees and certain operating expenses may be subsidised by their participating employers. However, some restricted schemes, for example Profmed and LA Health, do compete with the open market to a certain extent, and as a result will budget for marketing expenses and broker fees.

The graph below illustrates the components of NHE for the top 10 open and top 10 restricted schemes for 2018 as well as for open and restricted schemes and the medical schemes industry as a whole. The marked difference between non-healthcare expenses of open and restricted medical schemes is evident from the graph below.

As we assume that NHE increases with CPI while contributions increase with medical inflation, which is usually 2% to 3% more than CPI on average each year,

R100

R50

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du In

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U W

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km Ba n

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Administration expenses

64 |

Broker and marketing fees

Bad debts or other operating expenses

NHE as a percentage of GCI

NHE as a percentage of gross contribution income (GCI)

R150

st ry

R200

10%

R250

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R300

14%

R350

16%

R400

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18%

R450

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20%

R500

22%

R550

24%

R600

NHE per member per month

Non-healthcare expenditure by scheme

DIAGNOSIS 2019/2020

Breakdown of non-healthcare expenditure

R Administration fees

Broker fees (and marketing)

83.1%

14.9% Bad debts

2.0% Even after excluding broker fees, the pure administration costs of open and restricted medical schemes are significantly different. This may be due to the sponsoring employers of the restricted schemes taking on some expenses incurred in running the medical scheme through the corporate entity, and so reducing the costs borne by the medical scheme itself. There is no fixed definition for what expenses can be included as administration fees, which contributes to varied levels of administration fees charged across the market. Some administrators may include services other than pure administration, for example actuarial services, which will affect the overall profile of administration expenses. The illustration above shows the breakdown of NHE expenditure into its different components across the industry in 2018.

2.8 Financial performance One of the key factors used to measure the performance of a medical scheme is the scheme’s operating result. A scheme’s operating result is an indication of its financial soundness after claims and non-healthcare expenditure are deducted from contribution income. It shows the surplus or deficit before investment income. Drivers of strong financial performance by medical schemes include: ■ appropriate benefit pricing ■ adequate risk management and claims control ■ favourable age and risk profile of the membership base ■ low non-healthcare expenditure The industry ended 2014 with an operating deficit of R0.465 billion, which grew to R1.219 billion at the end of 2015 and further deteriorated in 2016 as the industry ended the year with an operating deficit of R2.391 billion.

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ALEXANDER FORBES HEALTH

Trend in operating results R4 000

R3 000

Operating result (R million)

R2 000

R1 000

-R1 000

-R2 000

-R3 000 2000

2001

2002

2003

2004

2005

2006

2007

Open medical schemes

The trend of deteriorating financial results that has been observed in the industry since 2014 improved in 2017 and continued to improve into 2018, with the industry generating an operating surplus of R1.218 billion. Restricted schemes achieved an operating surplus of R2.550 billion, driven by the large operating surplus generated by GEMS, while open schemes incurred an operating deficit of R1.331 billion. This was the largest operating deficit generated by open schemes since 2009, driven by experience on each of the top 10 open schemes. Exceptions are Bestmed, KeyHealth and Hosmed. The longer-term trend in operating results since 2000 has been driven in large part by the current regulations. Medical schemes were priced to target significant surpluses in the years prior to 2004 in order to meet the regulatory solvency requirements by 2004.

66 |

2008

2009

2010

2011

Restricted medical schemes

2012

2013

2014

2015

2016

2017

2018

All medical schemes

During the years following 2004 many schemes had met the solvency requirements and no longer had to price for larger surpluses. They were, however, then faced with significant increases in claims in the following years as a result of a change in service provider charging habits with the requirement to pay PMBs at costs. In 2018, 6 of 21 open schemes and 20 of 59 restricted schemes achieved an operating surplus. In comparison, 11 of 21 open schemes and 24 of 59 restricted schemes achieved an operating surplus at the end of 2017.

DIAGNOSIS 2019/2020

The operating deficits seen in 2018 were partly driven by an increase in Value Added Tax (VAT) which was increased from 14% to 15% effective 1 April 2018. Although medical schemes are VAT exempt, they are affected by this tax through the tariffs charged by service providers. Schemes would not have budgeted for this increase in their pricing and had to absorb the additional cost.

Schemes incurring operating deficits rely on investment income to break even in their net results. In 2018, with the addition of investment and other income, the industry achieved a net surplus of R5.021 billion, compared to the overall net surplus of R8.931 billion achieved in 2017. Open schemes achieved an overall net surplus of R0.822 billion (2017: R4.052 billion) and restricted schemes achieved an overall net surplus of R4.199 billion (2017: R4.879 billion). In 2018, 10 of 21 open schemes and 35 of 59 restricted schemes achieved a net surplus, compared to 16 of 21 open schemes and 51 of 60 restricted schemes in 2017.

Trend in net surplus R9 500 R9 000 R8 500 R8 000 R7 500 R7 000 R6 500

Net surplus (R million)

R6 000 R5 500 R5 000 R4 500 R4 000 R3 500 R3 000

R2 500 R2 000 R1 500 R1 000 R500 R0 -R500

2000

2001

2002

2003

2004

2005

2006

2007

Open medical schemes

2008

2009

2010

2011

Restricted medical schemes

2012

2013

2014

2015

2016

2017

2018

All medical schemes

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ALEXANDER FORBES HEALTH

Schemes' financial performance for 2018 R4 200

Operating or net result (R million)

R3 600 R3 000 R2 400 R1 800 R1 200 R600 R0

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-R600

Operating result

Net result

The graph above shows the financial performance of the top 10 open schemes and top 10 restricted schemes in 2018. Of the 20 schemes considered in this yearâ&#x20AC;&#x2122;s Diagnosis, 11 did not attain an operating surplus in 2018 and therefore had to rely on investment income to subsidise claims and non-healthcare expenditure. Three of the 10 open schemes and two of the 10 restricted schemes also did not attain a net surplus, and so were net disinvestors for the 2018 benefit year.

68 |

DIAGNOSIS 2019/2020

50%

30%

40%

20%

30%

10%

20%

10%

p ou gr ed

vu N

m of

so Sa

M U W M

H um in

lth ea

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lth

m os H

ea yH

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dh Fe

p el

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m tu

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ov sc Di

Solvency

40%

60%

50%

70%

lth

60%

80%

70%

90%

80%

lth

100%

90%

110%

100%

Asset allocation

Asset allocation at 31 December 2018

Cash and money market

Bonds

Property

2.9 Investments Where medical schemes do not achieve operating surpluses, they rely on the investment returns earned over the year to fund part of their claims and non-healthcare expenditure. In 2018, 53 of 79 medical schemes failed to achieve an operating surplus and therefore had to draw on their investment returns, placing additional pressure on solvency levels. This strategy is not sustainable unless investment returns keep pace with, and preferably exceed, claims inflation. At present, however, most medical schemes follow highly conservative investment strategies as shown in the graph above. The graph shows the asset allocation for the 20 schemes under consideration in this publication. In 2018 open schemes held 17.0% of assets in equites, with 30.8% being held in bonds and 44.8% of assets being held in cash. In contrast, restricted schemes held 9.1% of assets in equities, 22.7% in bonds and 63.1% in cash or cash equivalents. The balance is held in property mainly, with some exposure to debentures and insurance policies.

Equities

Debentures

Other

Solvency

Asset class limits are placed on medical schemes in Annexure B of the Regulations to the Medical Schemes Act, but most schemes are operating well inside the limits for riskier asset classes. The limit on equities is 40%, while the limit on property is 10%. This implies that schemes could have up to 50% of their investments in these higher-risk asset classes, whose returns are expected to exceed CPI inflation. There are no limits on exposure to conservative asset classes, such as cash, money market instruments and bonds. The only restrictions on these asset classes are on the exposure to specific issuers, to ensure diversification. Medical schemesâ&#x20AC;&#x2122; preference for cash appears to be driven by a preference for liquid assets, given that medical scheme liabilities are short term, as well as concerns about risks related directly to the investments (the possibility of making negative returns or losing scheme assets). However, for the long-term sustainability of the scheme, average returns below medical inflation may pose a greater risk, especially for schemes that rely on investment returns when they fail to achieve an operating surplus.

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ALEXANDER FORBES HEALTH

2.10 Solvency levels

In particular, claims expenditure tends to grow faster than CPI. To maintain solvency year on year, the accumulated funds need to increase in line with the increase in contributions. If investment returns cannot keep pace with the increase in claims inflation and accumulated funds increase at a rate less than contributions, then solvency levels will decrease, resulting in a need to either increase contributions further (which would exacerbate this issue) or reduce benefits.

The solvency ratio is the level of reserves (accumulated funds) that a medical scheme needs to hold as a percentage of gross annualised contributions. Regulation 29 promulgated in terms of the Medical Schemes Act prescribes that medical schemes maintain a minimum solvency ratio of 25%. The graph below shows the solvency levels of open and restricted schemes against the statutory level over the past 19 years. The increase in industry solvency levels from 2000 to 2004 is primarily attributable to the calculated efforts of medical schemes to build reserves to the prescribed minimum solvency level that was required by 31 December 2004.

As a result, for schemes failing to meet the solvency requirement, low investment returns as a result of conservative asset allocations may in fact be increasing risk for the scheme. For schemes meeting the solvency threshold, this can be eroded over time if returns are below claims inflation, and they may be missing an opportunity to maintain affordable contribution increases in the future.

On average, restricted schemes have maintained higher solvency compared to open schemes. From 2006 the solvency level for all restricted schemes has declined because of rapid membership growth in GEMS. The average solvency of open schemes has remained relatively stable since 2006.

Where a scheme already has sufficient reserves, there is a strong argument to invest at least some of the reserves in riskier asset classes allowed by Regulation B. Conversely, schemes that are not adequately funded can increase their expected return by investing in riskier assets, which will then increase the reserves held and thereby the solvency ratio. This also depends on the absolute value of the asset base.

In 2018 the average solvency for all schemes increased to 34.5% (2017: 33.2%). The solvency ratio of open schemes decreased from 29.7% in 2017 to 29.3% in 2018. The overall solvency level for restricted schemes increased from 38.1% in 2017 to 41.9% in 2018.

Trend in solvency levels 70%

60%

50%

Solvency

40%

30%

20%

10%

0% 2000

70 |

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

Prescribed minimum solvency

All medical schemes

All restricted medical schemes

Restricted medical schemes (excluding GEMS)

2011

All open medical schemes

2012

2013

2014

2015

2016

2017

2018

DIAGNOSIS 2019/2020

■ Nature of the solvency calculation formula On the one hand, schemes showing membership growth are penalised from a solvency perspective. On the other hand, schemes losing members are rewarded because of the nature of the solvency calculation formula. Therefore, schemes that are growing are less competitive because of the need to build and maintain solvency levels.

Medical schemes who do not meet the regulatory required minimum level of 25% need to submit a business plan to the CMS, outlining their plans to achieve this level. This may include benefit reductions or additional contribution increases. In 2018 Momentum and GEMS were unable to achieve the statutory minimum solvency level of 25%. The graph below illustrates the solvency levels for the 20 schemes considered at the end of 2018.

In 2015 the Council for Medical Schemes released Circular 68 on 25 November 2015, which discusses a review of the current solvency framework and outlines a proposed alternative risk-based solvency framework. In 2016 the industry was invited to comment on:

The suitability of the current solvency framework requiring schemes to allocate a minimum of 25% of gross contributions to reserves has long been debated. Reasons that support the need to revisit the current framework:

■ the proposed move to a risk-based solvency framework ■ their proposed calculation ■ how the transition from the existing solvency calculation should be managed

■ Appropriateness of a ‘one size ﬁts all’ approach Medical scheme claims experience is likely to be more stable for larger schemes, so the solvency requirements should be less onerous, while solvency requirements for smaller schemes should be higher.

Workshops were held with various stakeholders. In 2019 the CMS published an update on the review of the solvency framework. The review included comments from industry stakeholders on the merits and drawbacks of the proposed framework.

Solvency levels by scheme 105%

95%

85%

65%

55%

45%

35%

25%

15%

p gr ou ed

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Solvency in 2018

75%

2018 solvency

25% line

| 71

ALEXANDER FORBES HEALTH

72 |

Alexander Forbes Health Medical Schemes Sustainability Index With the continued consolidation of medical schemes in the industry as well as rising claims costs, the sustainability of medical schemes and the assessment thereof have become increasingly important for all industry stakeholders. Throughout this publication we have analysed key statistics of medical schemes, but it is difficult to assess how these work together to affect the sustainability of a medical scheme. The Alexander Forbes Health Medical Schemes Sustainability Index attempts to do this by combining certain key factors and considering their impact to a medical scheme in future years.

ALEXANDER FORBES HEALTH

The index has been calculated from a base year of 2006 and considers the following factors: ■ The size of the scheme relative to the average scheme size in the industry. A larger membership base would reduce volatility in the claims experience and benefit from economies of scale. ■ Membership growth over time indicates that benefits are attractive. In addition, an increase in size serves to reduce volatility of the scheme’s claims experience. ■ The change in the average age of beneficiaries over time. An increasing average age indicates a worsening profile and higher expected claims. This would require a medical scheme to adjust its base pricing for benefits through either contribution increases or benefit reductions. ■ The operating result of the scheme relative to the industry each year, as this would indicate the medical scheme’s performance relative to its peers. ■ The change in the operating result per beneﬁciary each year. The operating result should give an indication of the suitability of current contribution levels and whether higher or lower contribution increases can be expected in the next year. ■ The change in the accumulated funds per beneficiary held at the end of each year. Accumulated funds act as a buffer against adverse claims experience, and an increase in the accumulated funds per beneficiary would improve this buffer.

74 |

■ The scheme’s actual solvency relative to the statutory requirement. Although there is debate about the suitability of the current statutory requirement, schemes whose solvency is below 25% are required to have business plans in place with the CMS and their contribution increases would include an element of additional reserve-building in future. Higher than average contribution increases would serve to reduce the scheme’s marketability. If the 25% solvency requirement is replaced with a risk-based capital requirement, this component of the index would be replaced with actual solvency relative to the risk-based requirement. ■ The trend in the scheme’s solvency. Increasing solvency levels over time would also support the sustainability of a medical scheme. Using a base year of 2006, these factors are considered for each of the years from 2007 to 2018 with the final index score reflecting the cumulative impact over this period. The medical schemes are ranked from highest to lowest to show their relative sustainability. The index aims to provide a comparative assessment between schemes. For this reason, the relative positioning is more important than the absolute score. Note that small differences in the scores (between 10 to 20 points) are not significant. The graph on the next page shows the 2017 and 2018 index scores for each of the top 10 open and top 10 restricted medical schemes, using a base year of 2006.

DIAGNOSIS 2019/2020

Medical Schemes Sustainability Index: 2017 and 2018 (base year: 2006) 500

150%

450

130%

400 110%

90%

300

250

70%

200

50%

Change from 2016 to 2017

Index score (base year: 2006)

350

150 30% 100 10%

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2017

2018

The biggest increases in the index for 2018 were observed for GEMS and Hosmed, who improved their 2017 scores by 27.4% and 15.3% respectively. GEMS experienced a substantial increase in its index value in 2017 and 2018. The scheme generated a significant surplus at both operational and net levels during both years, which resulted in a significant increase in the solvency level from 7.0% at the end of 2016 to 24.7% at the end of 2018.

2018 change

LA Health and SAMWUMED are the top performers over the 12-year period. Polmed was the top performer in the index for 2017, although it was not the top performer for 2018. The scheme has been achieving operating deficits since 2014 and saw a decline in its level of reserves in 2017 and 2018. This resulted in a solvency level of 43.2%, which is lower than the 2014 solvency level of 53.6%.

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ALEXANDER FORBES HEALTH

Index trends for open schemes 450

400

350

Index score

300

250

200

150

100

2006

2007

Discovery

2008 Bonitas

2009

2010

Momentum

Bestmed

2011 Medihelp

2012

2013

Medshield

2014

Fedhealth

2015 Hosmed

2017

2016 Sizwe

2018

KeyHealth

Index trends for restricted schemes 530

480

430

Index score

380

330

280

230

180

130

80 2006 GEMS

76 |

2007 Polmed

2008 Bankmed

2009

2010

Platinum Health

2011 LA Health

2012

2013

SAMWUMED

2014 Umvuzo

2015 Profmed

2016 Nedgroup

2017

2018

Sasolmed

DIAGNOSIS 2019/2020

4. Conclusion We can make the following key observations from the analysis: ■ The number of medical schemes reduced to 79 at the end of 2018. ■ The number of principal members increased marginally by 0.7% from 2017 to 2018, compared to growth of 0.5% from 2016 to 2017. Principal members at the end of 2018 totalled 4 039 705 (2017: 4 012 722). ■ The average age of beneficiaries decreased to 33.1 years at the end of 2018 (2017: 33.2 years), with the pensioner ratio increasing to 8.5% (2017: 8.4%). ■ Family size has remained unchanged at 2.21 from 2017 to 2018. ■ The risk claims ratio for all schemes increased from 88.7% in 2017 to 90.2% in 2018.

■ Total non-healthcare expenditure as a percentage of gross contribution income decreased marginally from 8.36% in 2017 to 8.21% in 2018. ■ A total of 26 of 79 schemes (32.9%) achieved an operating surplus in 2018. By comparison, 43.8% (35 of 80) of schemes achieved an operating surplus in 2017. ■ In 2018 most scheme assets were held as cash, either in bank accounts or through money market instruments. ■ The average solvency for all schemes increased from 33.2% at the end of 2017 to 34.5% at 31 December 2018.

Overall, the profile of the industry remained fairly stable and the financial position is sound despite another year of operating losses for many schemes. The year 2020 may hold some challenges as the industry is faced with consolidation measures and legislative reform in the build-up to the full implementation of NHI. We look forward to the debate over the findings of the Competition Commission’s Health Market Inquiry to assist with controlling costs and contributions in the industry.

Alexander Forbes Health Technical and Actuarial Consulting Solutions (TACS) is a professional independent actuarial and consulting team within Alexander Forbes Health (Pty) Ltd. The Alexander Forbes Health team has been delivering innovative and customised healthcare solutions to corporate clients, medical schemes and individuals since 1991.

For more information, please contact:

Roshan Bhana

Linda Webb

Zaid Saeed

Branch Head: TACS bhanar@aforbes.com 011 269 1798

Senior Health Actuary webbl@aforbes.com 011 269 2510

Senior Actuarial Specialist saeedz@aforbes.com 011 269 1050

We would like to thank the following members of the TACS team for their contribution to this year’s publication:

Khulekani Sindana

Nasiphi Hlalele

Ruanne de Wit

Seshin Reddy

Sources Council for Medical Schemes Annual Reports (2000 to 2018) Audited annual financial statements of medical schemes

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Credits: Alexander Forbes Communications (production) | Getty Images (imagery) 19067-2020-02