Medibank Private Limited (MPL) Earnings Call Transcript & Summary

Thank you for standing by, and welcome to the Medibank FY '20 Results Briefing. [Operator Instructions] I would now like to hand the conference over to Mr. Craig Drummond. Please go ahead.

Good morning, and welcome to the Medibank Full Year 2020 Financial Results Presentation. I'm joined online by our executive leadership team, including our CFO, Mark Rogers. Health is more important than ever to the community and our customers, and this is demonstrated in today's result by our ability to grow policyholder numbers despite COVID-19. In the face of COVID challenges, we've delivered a sound result by continuing to tightly manage the issues within our control. We remain focused on differentiating and growing our PHI business through leveraging our dual-brand strategy and transforming into a broader health care company. Today, I'll take you through the key highlights from our results, our response to COVID, changes to our milestones and our strategic priorities. I'll then hand over to Mark for the more detailed financials, provide an update on our outlook, and we'll then take your questions. Starting on Slide 4. Despite the challenging external environment, particularly in the fourth quarter, our business has proved resilient. Our people are highly engaged. Our balance sheet remains strong. We've made good progress on growing policyholder numbers on managing our own expenses and setting up Medibank Health for growth. Group operating profit was down 12.8% to $461 million, and group NPAT was down 27.9% to $315.6 million, both on a continuing basis, reflecting the decline in health insurance operating profit and a significant fall in investment income. Management expenses declined 3%, with MER of 8.3%, down from 8.7% in FY '19. PHI operating profit was down 13.3% to $470.6 million. The operating profit of Medibank Health on a continuing basis was $27.8 million, up 25.8% compared to last year. After a volatile year in financial markets, our net investment income was $2.4 million, which compares to $102.8 million in FY '19. While we saw growth of 10,600 net resident policyholders in FY '20, pleasingly, as at 8 August 2020, we have seen policyholders grow by approximately 21,000 in FY '21 so far. Finally, the Board has determined we will pay a fully franked final dividend of $0.063 per share, which takes the total ordinary dividend to shareholders in FY '20 to $0.12 per share, which is 8.4% below FY '19. The Board has maintained a prudent approach to our capital management, with the health fund capital at June 30 above the top end of our mandated range, positioning Medibank well to respond to the uncertain environment and pursue opportunities. Turning to Slide 5. Medibank determined right from the beginning of the pandemic that we would support our customers, our people and the community as they were impacted by the changes that had to happen during COVID. In all, Medibank's financial response to date has totaled more than $185 million. And we'll continue to act swiftly in providing further support to customers as needed. For all customers, we postponed premium increases for 6 months in the first week of the national lockdown. We also extended extras to include telehealth for 7 allied health services, such as psychology and physiotherapy, which -- as of now, we've now extended until further notice. When we get closer to the end of the Medibank claiming year for extras, which is December 31, we will assess if there are any further permanent savings arising from COVID. But as promised, we will commit to give back to customers. While for ahm, we already delivered this benefit through the extras rollover announced back in June. There's been a great deal of community commentary about a windfall profit for health insurers as a result of customers being unable to fully use their cover during the national lockdown. Mark will cover the detail that claims for this 6-week period were around 50% of normal levels. As Australia has emerged from lockdown, except for Victoria, claims have bounced back quickly. Actuarial and clinical expectations over 100% of hospital and almost 50% of extra services that didn't take place from this period were simply deferred and not canceled. Demonstrating the bounce back, in June, we paid for more than 1.2 million dental services compared to 1 million services the same time last year. In June, nationally, extras claims were modestly above the same time last year, as expected, while hospital claims were modestly below. What this shows is that the savings projected by some commentators at the beginning of the crisis have not eventuated. But let me be clear, if there are permanent savings, we will stick by our promise to return them to customers. We know some people are doing it especially tough. For these customers, our financial hardship program is helping them with a range of initiatives, including a 3-month suspension or a 50% premium labor for 6 months. And in a further boost to our COVID financial hardship package, we just announced additional support for our customers who are under financial stress due to the state of disaster declaration currently in Victoria. Our hardship policy has been well received by our customers. While there has been some pressure to extend the blanket premium increase postponement beyond 6 months, which is valued at $70 per policyholder, the $800 average saving for a policyholder through the 6-month premium waiver provides far more breathing space to customers doing it tough. We had around 28,100 customers suspend their cover due to financial hardship between 23 March and 30 June. Total suspensions today only stand at around 11,000. As those suspensions have come off, we have offered these customers an additional suspension, a range of cover change options or the 50% premium waiver. Approximately 3% of suspended customers have lapsed, which demonstrates the value our customers place on their private health insurance. We've also focused on our people and the broader community in our response to COVID, highlighted by a $5 million donation to Beyond Blue. In early March, our team of almost 4,000 people began to work virtually from home. This transition was relatively seamless due to our existing flexible working culture and IT capability. The majority of our people are still working from home, and our Victorian retail stores are temporarily closed. To support our people, we want to provide certainty and security at a time when they need it most, which is why we are working very hard to not stand down any employee as a result of COVID nor have we accessed any taxpayer-funded government relief. Turning to Slide 6. We have made good progress with our FY '20 milestones despite the current environment. You'll find these details in the appendix of the investor presentation. We believe now is the right time to revise a number of our milestones for FY '21 despite the uncertain economic outlook. Firstly, we have broadened our advocacy milestone from customer to customer and employee. The addition of employees reflects the importance of our people's engagement and the impact this has on growing our company. We are targeting ongoing high levels of customer and employee experience. For service NPS, this means pursuing a consistent score of greater than 30 for Medibank and 40 for ahm, while employee engagement and NPS remaining above the Australian national norm remains the objective. The health and well-being milestone is tracking very well and is one of the critical components to our product and service differentiation. It includes health promotions, prevention through Live Better interactions and support through Medibank Health assisting directions, which includes our programs such as Health Concierge; 24/7 support; CareComplete; Medibank at Home; Better Knee, Better Me; and Heart Health at Home. There has been a 37% improvement in retention rates for customers who have engaged in -- with one of our health service programs over the past 12 months. The health insurance growth milestone reflects our growth ambitions, with a target to increase market share and achieve total resident policyholder growth of greater than 1%, assuming a flat market, including an aspiration to grow the Medibank brand during FY '21. APRA data released this week showed our market share to be up 4 basis points for FY '20, albeit the second half numbers are likely to have been negatively impacted by COVID. Our in-home care milestone is unchanged, and we remain on track to meet our target of more than 300 virtual hospital beds by June 2022. We currently have 259 virtual beds, which is comparable to the capacity of a medium-sized hospital, with 5,850 Medibank customers serviced by 201 beds. For Medibank Health, this milestone remains. Pre-COVID, we made good progress in FY '20, which we are pleased with. The business is well set up to deliver growth. Nevertheless, the ongoing nature of the pandemic gives us reason to be a little more cautious in the short term due to restrictions on international travel and care delivery in community settings. This in no way diminishes this milestone or the expectation of the opportunity that sits in front of the business. And finally, on productivity in FY '20, we delivered savings of $20 million. In continuing recognition of the importance of managing costs, we have updated this milestone to deliver an additional $20 million in productivity savings in FY '21 and a further $30 million between FY '22 and '23. Now to Slide 7. Our strategy remains the same, and that is to leverage our dual brands to create competitive advantage in health insurance and to transform into a broader health care company. The pillars beneath this are also unchanged, but we have updated some of our priorities for FY '21. In the year ahead, the focus will shift more to embedding and scaling our existing health and well-being offers into our customers' experience. In a post-COVID world, an even sharper focus on enhancing these by moderating health system cost growth will remain one of our key priorities. Giving our customers more choice and reducing out-of-pocket costs will remain a priority, with clinically-led alternative ways to delivering care a key component of the solution. This will only be achieved by strengthening and broadening our partnerships, particularly with health care providers and corporates. Finally, there will almost certainly be opportunities for inorganic growth in both Medibank Health and the health insurance business in the stressed operating environment we are now managing through. Moving to Slide 8. Our strategy over the past 2 years in health insurance, as you know, has been to build competitive advantage in PHI. In FY '20, we delivered on this through our continued focus on enhancing customer value by introducing additional benefits during COVID, which I covered earlier; and through our Members' Choice Advantage network for dental, saving customers $10 million in out-of-pocket costs; and the recent introduction of our Members' Choice Advantage optical network. Furthermore, we have rewarded customer loyalty via our Priority program as well as through our Live Better rewards program, which issued over $1 million in rewards to customers for taking healthy actions during COVID. Customers who complete a Live Better challenge, like walking 5,000 steps per day, have a 21% better retention rate. And customers aware of our Live Better rewards program have an NPS that is at least 25 points higher than those who are not. We're also building competitive advantage through our health and well-being offering, delivering around 2 million personalized and proactive health promotions in FY '20 and growing our concierge services by 40%. In FY '21, we'll be focused on scaling the programs we already have on offer, including an uplift in concierge by more than 80%. And finally, our dual-brand strategy gives us a competitive edge. With our Medibank and ahm brands delivering flexibility, broad customer coverage and price competitiveness in the current economic environment, which is unmatched in the market, this strategy is ultimately aimed at increasing acquisition and substantially improving retention, which in FY '20 was at its highest level since 2012. Now on to Slide 9. In 2017, I first spoke about Medibank's strategy to transform into a broader health care company. Since then, we've made good progress, working in partnership with clinicians and providers to deliver outstanding customer outcomes in a more affordable way as the objective. Over the past 12 months, there have been many new opportunities, such as our recent announcement of our minority shareholding in East Sydney Private Hospital. Our investment will fund the capital and operational costs required for the hospital and doctors to scale their short-stay model of care. This is part of a broader strategy to support doctors and hospitals to deliver greater choice to our customers and other patients, providing no-gap short-stay experience and to scale a model of care that is widely available internationally. This investment complements Medibank's ongoing pilot with Nexus Hospitals in Melbourne, which is giving Medibank customers undergoing joint replacements and no-gap short-stay experience. The pilot has recently extended to East Sydney Private Hospital as well as hospitals in Brisbane and Adelaide, with other locations to be added soon. Considerable opportunity exists to grow this model of care, which can only be beneficial to all PHI customers. Additionally, we have a series of new services in place and in the pipeline for other payers, such as the palliative care pilot with Bupa, rehab at home with WorkSafe Victoria and a range of opportunities for public payers. Furthermore, there remains real opportunity for our in-home care offering to grow across the Eastern seaboard. As I mentioned earlier, we are on track to deliver our FY '22 target of more than 300 virtual hospital beds. More than 8,600 patients either used hospital in the home or rehab in the home or other pilot programs in FY '20, of which 5,850 were Medibank customers, up 193% in 2020. We believe COVID will only further embed this trend. We also saw more referrals to our chemotherapy, dialysis and new Heart Health at Home programs. Finally, telehealth has come into its own this year with an increasing demand as we rapidly scaled operations in response to COVID. On top of the existing services we deliver on behalf of clients across the country, we employed an additional 680 temporary frontline clinicians in response to demand from clients. To date, our health services team has handled more than 250,000 COVID-related interactions on behalf of our clients. To support this growth, we have rolled out a new state-of-the-art telephony and analytics platform. I'll now hand over to Mark.

Well, thanks, Craig, and good morning. Despite the challenging environment, our business and people have proved resilient; our balance sheet remains strong; and we've made good progress on growing policyholder numbers, managing expenses and setting up Medibank Health for growth. Before I go into more detail on the operating performance and the impact the COVID pandemic had on the business, I'll make a few comments on the group's profit and loss statement. Throughout the presentation, I will focus on the reported financial position, but will call out particular COVID impacts were important. Profit before tax declined 27%, with group operating profit down 12.8% and investment income significantly lower. The fall in other income and expenses includes lower M&A costs. And as was the case last year, high D&O insurance charges were the major driver of the increase in corporate costs. The effective tax rate increased from 29% to 29.9%, reflecting the mix of investment income, and we expect this similar rate going forward. Reported EPS was down 31.3% to $0.114 per share. And underlying EPS, which adjusts for the normalization of investment returns, was down 18.1% to $0.133 per share. Turning to Slide 12. The COVID pandemic has had a number of impacts on our resident health insurance business. However, we expect these will largely be temporary in nature. In line with our commitment that any permanent benefit from lower claims will be returned to customers, we've implemented a number of customer support measures. These reduced FY '20 revenue by approximately $80 million and are expected to have a modestly high impact in FY '21. Since late March, some customers have chosen to suspend their cover, in total impacting 28,100 or 1.6% of all policies. By 30 June, the number of suspended policies had reduced to 18,200 and to approximately 11,000 by the 8th of August. Whilst the environment is still uncertain, with less than 3% of policies lapsing, these suspensions are not expected to have a notable impact on the policyholder trajectory. During the same period, claims were $364 million lower than our pre-COVID expectation. However, we expect that 100% of these lower hospital claims and approximately 50% of lower ancillary claims will still occur. We've accrued a $297 million liability for this deferral, with the remaining $67 million benefit partly funding our customer support measures. By the end of June, ancillary claims activity was modestly above last year. And whilst hospital admissions were modestly below COVID levels -- pre-COVID levels, we anticipate these will progressively increase during the next 6 months. We will continue to monitor activity levels and how this impacts our deferral assumptions, but currently expect that the cost of our customer support measures in FY '21 would largely be offset by further claims benefits. And finally, whilst COVID didn't have a significant impact on either the overseas PHI or Medibank Health businesses in FY '20, short-term performance could be impacted by further restrictions, including to international travel and care delivery into community settings. Turning to Slide 13, which covers the Health Insurance result. Health Insurance gross profit was down $88.6 million or 8% to $1,014 million, with revenue growth of 1.3% offset by a 3.2% increase in net claims expense. This result includes a $22.3 million strengthening of the 30 June claims provision compared to a $9.7 million released 12 months ago as well as the $13 million COVID impact. Adjusting for these provisions and the COVID impact, operating profit and operating margin were down a more modest $8.6 million and 40 basis points, respectively. Turning to Slide 14. COVID has created a level of uncertainty in the PHI market, which has impacted both customer acquisition and retention. In this context, we are pleased to have increased policyholder numbers in the last 12 months by 0.6% or 1.6% if you adjust for suspended policies. Whilst the acquisition rate has fallen by 60 basis points, in large part due to the closure of the Medibank retail network for much of the fourth quarter, retention improved by 140 basis points. This improvement in retention reflects an increasing focus by customers on their health and well-being as well as the strength of their insurer and the benefit of a number of internal initiatives. In the Medibank brand, this included an investment in the Live Better program and Members' Choice Advantage dental network and then ahm continuing to transfer operational learnings from the Medibank brand. As a result, the stabilization of Medibank policyholder numbers continue, which, after adjusting for suspensions, saw a 0.4% decline, materially lower than the 1% decline 12 months ago. This means that in the last 6 months, Medibank policyholder numbers were down by less than 0.1%, in line with our aspiration to grow in FY '21. Despite the strong level of competition in the market, ahm policyholder growth was 7.3% or 9% excluding suspensions with strong growth across both the direct and aggregated channels. And finally, the level of downgrading, which is the difference between the average rate rise and revenue growth per policy unit, reduced to 140 basis points. This reflects the benefit of continued lower premium increases, favorable mix impacts and portfolio management initiatives. And we aim to maintain downgrading at or below the current levels. Slide 15 covers claims. Growth in net claims at 3.2% reflects a 2.5% increase in claims expense, a significant reduction in risk equalization receipts, partially offset by the $67 million COVID ancillary claims benefit. Risk Equalization receipts continue to reduce, in part reflecting the strong growth in ahm policies, which typically attract younger customers on lower levels of cover, and then our claims growth continues to be lower than industry growth. Underlying hospital claims growth of 2.9% is 80 basis points above the prior period, largely due to higher prosthesis and medical claims costs. Modest prosthesis price reductions from 1 February and internal initiatives helped lower underlying hospital claims growth to 2.7% in the last 6 months. Higher dental utilization following the launch of our Members' Choice Advantage dental network resulted in underlying extras claims growth increasing to 3.8%, with claims growth moderating noticeably in the last 6 months as the network matured. With premium increases below health cost inflation, we must continue to explore further opportunities to reduce claims but without impacting the customer value proposition. In payment integrity, this will include using analytics to better target our auditing approach and embedding broader preventative capabilities as well as growing our offering in alternative care settings across both the home and short-stay hospital network. Now turning to Slide 16, I'd like to briefly call out some of the other drivers of claims growth. You can see that despite the price reductions I just mentioned, prosthesis claims grew at 4%. Given utilization continues to grow at a significantly faster rate than hospital admissions, further prosthesis reform remains a priority. Despite modest utilization growth, private hospital payments, which accounts for 61% of hospital claims, grew at 3%. And the reindexing of the NPS schedule from 1 July and investment in our gap cover schemes drove the increase in medical costs. In ancillary, limited or negative growth in most modalities was due to COVID, with bigger impacts observed in the more discretionary modalities, particularly alternative therapies, which are also impacted by regulatory reform-related product changes. And finally, claims growth in the overseas portfolio was largely driven by investment in additional customer benefits and policy unit growth. Moving to Slide 17, which covers management expenses. Management expenses fell 3% to $543.4 million, with reductions in both cash and noncash expenses. In line with expectations, D&A fell by $4.3 million following the extension of the useful life of key IT assets, and deferred acquisition cost amortization down by $1.9 million as we tightly managed acquisition costs. Pleasingly, operating expenses of $459.6 million were down 2.2%, with expense inflation of approximately 2% more than offset by $20 million of productivity savings. During the period, COVID-related expenses, including a $5 million donation to Beyond Blue, were offset by lower incentive payments. We are targeting a further $50 million in productivity savings across the next 3 years, including $20 million in FY '21, increasingly coming from business simplification and process improvement. Management expense ratio fell 40 basis points to 8.3%, and we expect continued revenue growth and our productivity program will result in this ratio falling further. Slide 18 covers Medibank Health performance. The last 12 months have been a period of transition as we exited the Garrison contract and set the continuing businesses up for growth. This included investing $3 million in home care capability; $5 million in Live Better running costs; and the implementation of a new operating model, which resulted in approximately $7 million of efficiencies. Pleasingly, revenue was up 17.2%, with strong growth across all businesses, including $5.8 million from Live Better program partners and an additional 2-month and $6.2 million contribution from HSS. Management expenses increased by $5 million, reflecting inflation and an additional 2 months and $1.6 million of expenses from HSS. Following a period of investment in the business, we will now leverage this infrastructure to support further revenue growth and realize the benefits of scale. Operating profit was up almost 26% to $27.8 million, and operating margin increased 70 basis points to 10.3%. Whilst gross margin fell 240 basis points, this largely reflects change in business mix and was more than offset by a 310 basis point reduction in the management expense ratio. The business is well set up to deliver growth in FY '21 and beyond and remains on track to deliver on the $30 million operating profit growth milestone. Looking now at our investment portfolio on Slide 19. The second half of the year presented challenging market conditions for both growth and defensive assets, resulting in investment income for the full year of $2.4 million, down from $38.5 million at the half and more than $100 million lower than in FY '19. The significantly lower performance in the growth portfolio reflects weaker returns in all asset classes, particularly in retail property, which has underperformed other growth assets. Income in the defensive portfolio was impacted by widening credit spreads and the lower RBA cash rate, which reduced interest income on domestic holdings by $15 million. Based on the current level to benchmark, we expect interest income will reduce by a further $8 million in FY '21. We've returned to target allocation of the growth and defensive assets of 20% and 80%, respectively. And whilst we did not liquidate any equity positions during the recent market correction, we have started diversifying our property exposure to include office funds. Underlying investment income adjusted for returns on growth assets relative to our long-term return expectation of 8% and for credit spread movements. The lower RBA cash rate was the major driver of lower underlying investment income and also supported the return above our target range of 100 to 200 basis points above the benchmark. Moving on to Slide 20. The most material impact to the cash flow statement was a large reduction in other operating assets and liabilities, and this reflects the deferral of $297 million of claims due to COVID. Following a period of significant investment in technology, capital expenditure is now materially lower than D&A and further reduced this year following completion of regulatory reform implementation in FY '19. And finally, lower income tax paid reflects the timing of tax installments. Moving to capital on Slide 21. Our capital position remains strong, with PHI capital marching above the top end of the 11% to 13% target range and unallocated capital of $188.4 million, both of which are supported by strong capital generation and disciplined capital management. During the period, Health Insurance required capital increase to support revenue growth. And other required capital reduced, largely due to exiting the Garrison contract. Given the uncertain market conditions, we see our strong capital position as being a real differentiator, and we are well placed to fund both organic and inorganic growth as well as consider capital management in the future. As a result of COVID, there has been no further consultation with APRA on the proposed new PHI capital standard that is expected to apply from 1 July 2023. However, we remain well placed to implement this new standard, and we welcome the possibility that APRA may provide transitional relief to capital instruments issued prior to this date. This would be helpful as we consider the issuance of subordinated debt to diversify our capital from 100% shareholders' funds. And finally, moving on to the dividend on Slide 22. The Board has declared a fully franked final ordinary dividend of $0.063 per share, bringing the full year ordinary dividend to $0.12 per share. This is a 90% payout of underlying NPAT. And in line with this, we expect the payout ratio for FY '21 to be towards the top end of our 75% to 85% target range. In conclusion, whilst the last 12 months have been challenging, we continue to focus on leveraging our competitive advantages of scale, differentiation and diversification to ensure we are well placed to respond. We remain focused on our customers and ensuring that our financial strength provides both operating and strategic flexibility. I'll now pass back to Craig, who'll make some comments on future industry reform and the outlook.

Thanks, Mark. Now to Slide 24. Affordability will remain the greatest challenge for the industry post-COVID. The affordability and hence, participation challenges for the sector will likely become more acute if economic conditions are slow to improve. That said, the burgeoning public wait times for elective surgery, along with the increasing importance of health and well-being to our customers, has driven improved retention rates from existing policyholders in recent months. While we saw a reduction in claims from the government suspension of elective surgeries, there remains a lot of uninformed commentary around PHI affordability, participation and profitability. Let me be crystal clear on the facts. In the year to June 30, the industry pretax margin was 2.8%, down 43% from 12 months ago. For 7 of the last 8 quarters, industry premiums have been insufficient to cover the growth in claims costs. Governments through the COAG process have granted public hospitals a 6.5% funding increase every year until 2025. In contrast, the average premium increase permitted for private health care is 2.9%. Health care and hospital costs in Australia have increased at around twice the rate of inflation each year in the past 25 years, driven by more frequent and more expensive hospital admissions and a population that is getting older. Our regulator, APRA, collects industry data, as you know, and has been clear that they are concerned about the viability of a majority of private health insurers simply because there is a growing and unsustainable shortfall between premiums charged and claims received. Forgoing a premium increase by funding claims out of surplus equity reserves is unsustainable and will likely be a concern for APRA and consumers who want assurances that their health fund will be able to continue to adequately cover their health care claims in the long term or in a stressed operating environment. So what needs to happen to ensure private health care sustainability? The current industry average premium increase of 2.9% deferred until 1 October will need to proceed, combined with ongoing targeted hardship policies to support those Australians doing the toughest. PHIs, including Medibank, will need to commit to ongoing and substantial cost reductions of their own. Private health care will need to be provided at a more affordable cost. And the government will need to implement a series of ongoing reforms. We understand the Commonwealth Government is considering some welcome reform measures for inclusion in the forthcoming October Commonwealth budget in areas such as out-of-hospital care and particularly, measures to boost participation, such as a potential increase in the Medicare levy surcharge. An estimated 200,000 high-income Australians have chosen not to take out private health insurance, and a 100 basis point increase in the MLS would go a long way to boosting participation without penalizing middle and low-income earners. Furthermore, increasing the age threshold for family PHI eligibility from 25 to 30 years of age would encourage younger people to keep private health insurance. These are sensible reforms. Additionally, there are further reforms through an active discussion. While PHI rebate restoration, incentives for employer-sponsored health care and other measures to encourage the under 40s that come at a cost to the budget are not palatable in the immediate term, the areas that don't come at cost to taxpayers are being pursued even more rigorously in order to ensure premium moderation. These include a review of lifetime health cover, a tightening of Type C certification and further prosthesis reforms, which we understand will not be implemented before January 2022 but are inevitable. There remains meaningful savings in prosthesis reform, which the industry will commit to pass directly through to consumers. Turning to Slide 25. The COVID pandemic demonstrated that Australia's mixed public-private system works well, especially in the face of a national health crisis, with the private system providing surge demand capacity. Private health insurers demonstrated agility through COVID, with Medibank quickly and successfully supporting more virtual services, delivering targeted support for customers affected by COVID and making wider use of alternative ways of delivering care. Looking ahead, post the immediate crisis, public sector funding of health care is likely to be constrained certainly compared to the prosperous past decade. The implications are significant given the competitive pressure that the public health offer had been placing on the private health care proposition in recent years. This funding pressure will come as public wait times for common elective surgical procedures have been blowing out noticeably, as demonstrated on Slide 25. So for Medibank, in the next 3 years, we are planning for ongoing low premium increases, a noticeable widening in the gap between public and private health care elective surgical wait times, a significant improvement in the perceived quality and value of private care relative to public and hence, the likely continuation of the recent trend towards improved customer retention rates and an inevitable consolidation for the PHI industry. The consequence of this means Medibank will remain very vocal in pursuing industry reform to lower industry cost growth. We will continue to invest in clinically-led alternative ways to provide care. Furthermore, we envisage stronger partnership opportunities with like-minded health care clinicians, providers and payers to deliver more short-stay and out-of-hospital solutions across a range of modalities. Finally, moving to Slide 26 and the outlook. We aim to increase market share and achieve total policyholder growth of greater than 1%, assuming a flat market, including an aspiration to grow the Medibank brand during FY '21. Our underlying drawing rate growth or increase in annualized average net claims expense per policy unit for FY '21 is forecast to be broadly in line with FY '20. We are targeting $20 million in productivity savings in FY '21 and an additional $30 million between '22 and '23. The dividend payout ratio is expected to be towards the top end of our target range of 75% to 85%. And targeted inorganic growth for Medibank Health and Health Insurance remain areas of focus. Finally, a couple of thank yous. I'd like to take the opportunity to thank the executive online today and everyone at Medibank for delivering another sound result. I'd also like to take this opportunity to acknowledge the announcement that was made by the Medibank Board today, and that is the retirement of Elizabeth Alexander as our Chairman and the appointment of Mike Wilkins as our new Chairman. I'd like to personally thank Elizabeth for her support and leadership and recognize her significant contribution, guiding Medibank from government ownership to an ASX-listed company that is a stronger and more sustainable business today. I look forward to working with our new Chairman as we continue our transformation to a broader health care company. 2020 has been a challenging year for everyone. I'm incredibly proud of how our people have managed through COVID by putting our customers first. To repeat a comment I made earlier, if there are any further permanent savings from COVID, we will stick by our promise to return them to customers. Medibank will remain well positioned for the period ahead. I'll now hand over the call for any questions. Thank you.

[Operator Instructions] The first question today comes from Matt Dunger from Bank of America.

If I could first ask on the policyholder growth target of over 1%. You've delivered 1.6%, excluding COVID policyholder growth, which has improved. You've talked to over 1.5% of policies being suspended, and very few are actually lapsing. Why aren't you more positive on the outlook for policyholder growth?

Well, I think, Matt, what I'd say is we have good momentum in our brands, and I think you've highlighted that. But what we don't know is clearly what happens to the economy and what happens as we exit COVID and indeed, how long COVID goes on for. So I don't think we or any other organization will be -- being extraordinarily brave in looking at making forecasts out over the next 12-or-so months. But to be very clear, we have good momentum in our brands, and we are pleased with the start to the year, as I said, with 21,000 policies, of which I think about 7,000 or 8,000 of those policy growth are suspensions coming off. But there's good underlying growth. And I just think the environment is so uncertain that you need to be a bit careful about the expectations you put into the marketplace.

Okay. If I could just ask a question to Mark as well. On the costs, looking at some $20 million of productivity initiatives in FY '21, what's the right cost base that we should be looking at, Mark, given you had some nonrecurring impacts from COVID in FY '20, including the Beyond Blue donation?

Yes. So Matt, the reported position, I'd say that's the underlying position we had. The lower incentive payments during the period effectively offset the COVID one-off costs. So I'd take that reported position this year as a starting point to forecast for next year.

The next question comes from Andrew Buncombe from Macquarie.

Just the first one is in relation to the 49% stake that you bought in the private hospital recently. How significant do you think that will be for the group earnings over time? And is that the first of a couple that you could potentially be doing?

Thanks, Andrew. Look, we're considering this -- the acquisition of stakes in day hospitals on 3 horizons. I'd say the first horizon is the operating investment. We'd expect in the short term, the contribution to be relatively modest. But we're also contemplating the impact that these acquisitions can have in our benefit outlay line, noting that some of the benefit will be shared with customers. But I think the longer-term benefit is the ability to operate -- offer these services to customers of other PHIs and to help implement broader system change. So it's not going to be a material impact to earnings in the short term. This is an investment in medium- to longer-term system change.

I think -- and the other thing I'd add to that is, clearly, what it will do. It's very, very helpful to have a no-gap experience for our customers. So it will help with -- we think, ultimately, it'll help with participation. It'll certainly help with brand NPS and customer support for the Medibank brand.

And just my second question, it sounds like the contract with the Department of Veterans' Affairs has ended. If that is correct, can you just give us some background on why that was?

Yes. Look, I might ask Andrew Wilson to take this one. Andrew, do you want to cover that?

Yes. Sure, Craig. Actually, I think the first important point to say is that both the Department of Veterans' and Affairs and Medibank are both committed to the sort of ongoing development of payment integrity approaches for both of our claims portfolio. The decision was made by both parties not to continue with this project at this time.

The next question comes from Andrew Paine from MST Marquee.

Just trying to get an understanding of your claims profile in the coming period. So you said average claims policy per unit will be in line with FY '20 growth. But as patients return to ancillary and hospital services, our expectation is this could be higher than pre-COVID due to conditions worsening on delayed treatment. So I just want to get an understanding of your expectations here and whether you're accounting for this as part of your deferred claims provision.

Yes. So the guidance is in terms of underlying claims growth being broadly in line with FY '20 so that excludes any of the catch-up from delayed services as a result of COVID. And I will note that our underlying claims growth in the second half was lower than the first half outcome as well.

Okay. So that doesn't include any not just catch-up, but higher costs for patients deferred -- deferring treatment over the last 3 to 6 months?

So we'd expect that any deferred treatments will be managed through the $297 million COVID provision that we've put in place for that particular purpose.

Okay. So is that like the previously deferred levels of treatment? Or does that account for some increase in costs for treatment there?

So effectively, we will look at our claims expectation we had pre-COVID for FY '21, and we'll compare that to what the actual claims experience is. And then based on why -- looking at where there is a variance, we'll make a judgment on whether that is a deferred treatment or whether it's underlying utilization growth or inflation that would have occurred excluding COVID.

Okay. That helps. And just one other. Do you have any views about competition to capacity in private hospitals, especially in Melbourne, given the recent lockdown?

Sorry, I just missed that question.

Sorry. Just any views about competition for capacity in private hospitals for treatment given the lockdown and the catch-up required.

I might make a very brief comment, and then pass to Andrew Wilson. I think it will vary from hospital to hospital, age of hospital, et cetera. But from what -- anecdotally, and it's only anecdotal, that hospitals, and it depends on the doctors as well, have got an ability to run at slightly higher levels if they need to, but I suspect not for an extended period of time. And the higher levels of -- I would think, if you're looking at sort of 110%, 120%, they could do that for a period of time, but not for an extended period of time. But Andrew, I'll pass to you.

Yes. Look, I think that's right, Craig. I think -- and we've seen some hospitals or groups able to already flex -- not obviously in Victoria, but in other jurisdictions, flex above 100% for periods of time. So I think we can certainly see that. I think if you're referring to competition in relation to public patients versus private patients, I think one of the key fundamentals there is who is going to fund the public patients. I think the concept of catch-up obviously requires funding. And in the context of a COVID-impacted economy, I think it would be question marks around whether -- to what extent catch-up can occur in the public sector. So I think that's an open question at this point.

The next question comes from Nigel Pittaway from Citi.

Just first of all, I mean, your forecast -- you're saying claims inflation will be around 3%. You're saying premium rate increases will be low. You're saying you'll give back all permanent COVID savings to policyholders. So is there anything else we should be taking into account when thinking about your gross margin moving forward?

Yes. I guess, Nigel, probably 2 -- a key point will be in the level of downgrading. So we reported a significant improvement in the level of downgrading this year, 140 basis points, with a stronger outcome in the second half, and that will be a key area of focus for us in FY '21. And that, plus the productivity program, are the 2 areas that we can actually have significant focus to try and reduce any strain we have at the gross margin line.

Nigel, yes, sorry. You should also look at the -- where there are some benefits coming through on the claims line. We're obviously using those to help fund the hardship policies so it's not all one way.

Okay. Fair enough. And then actually, my second question was on downgrading. I mean, as you say, you must have got about 110 basis points in the second half so quite a material drop. So when you're saying your aim is to keep those flat, are you allowing for sort of some deterioration with the likely situation that the economy is in? And how are you thinking about that?

Yes. So the 110 basis points, you're correct, was in the second half. But to put that in context, there was no rate rise in the period, and that normally is a precursor for a downgrading conversation. To be clear, at 140 basis points, we are still above the industry average so there's more work for us to do. And we have a number of activities. Our mix as well as our portfolio management and product simplification actions, I think, will help the trend going forward. So to be clear, we're not -- 140 was a good improvement, but I don't think the work's finished in that regard.

[Operator Instructions] The next question comes from Ashley Dalziell from Goldman Sachs.

Just first question on the claims outlook at sort of 3%. Just surprised that you're not guiding to a little lower on that front given there were a number of one-offs through the year. I mean if I wind back to the first half when your underlying claims growth was closer to 3.4%, you were sort of suggesting if you looked through a lot of those one-offs, you are closer to 2%, which is probably the fair benchmark for the business. What sort of worked against you through the second half to now be sort of steering us towards 3% for next year?

Yes. So Ashley, the second half margin was 2.7%. But we did see risk equalization -- the risk equalization outcome being significantly lower in the second half compared to the first half, and that's the only caution I'd say in terms of a headwind going into 2021.

Okay. But even on -- I mean, the drop-out of some of those one-offs that you called out over the course of the year, I mean, I would have thought there's a bit of a tailwind for you into '21. Is risk equalization the only piece that's sort of changed the outlook?

Well, that's the major -- this is the major impact. But we also -- on ancillary, we had the natural therapies reform that was implemented that won't recur. We implemented the New South Wales private room rate in November, so that won't have as big a tailwind next year. There's a whole series of factors that are debits and credits. I'd say the major risk to the second half claims rate of 2.7% is where risk equalization lands next year.

Yes. Okay. Great. Look, maybe just a second question on the investment in the hospital. Could you maybe just talk us through, I guess, the governance and the strategy around that? If I think back to the outset of your pivoting to the delivery of health care services, you always said owning a hospital is something that we'd never expect to see from Medibank, just too much clinical risk involved, don't understand the operational side of the business. Could you just sort of talk us through, I guess, why you have comfort there now?

Ashley, I think we -- what we said is we'd never own a large acute overnight hospital. I don't think we ever said we would never own a hospital, period, but maybe that's nuanced. But they're quite different. And I don't think we've ever said we were not comfortable with the clinical risk because we clearly have clinical risks and we manage clinical risk, and we have a very strong clinical governance platform inside the company already. We managed a lot of clinical risk, for example, when we had the Garrison contract. In all of our existing telehealth services with the 1,500 clinicians that we have in the company, clinical risk is a day-to-day. It's in our DNA day-to-day, but I might pass to Andrew Wilson just to give an additional issue. But I can talk about, strategically, what we want to do is we want to offer our customers more choice. We want to offer our customers a short-stay experience. We want to facilitate doctors that actually want to do this work in the country. We want to make health care more affordable, which is what this will do. And we want to ensure, clearly, the quality of the outcomes -- clinical outcomes remain very high. And I think if you look around Europe, the U.S., Asia, these short-stay procedures are being done routinely, whereas they're not as routine -- or they have not been routine in Australia. But Andrew?

Yes. Look, I won't comment further on the strategy, Craig, because I think you've outlined that pretty fulsomely. Look, just on the clinical risk issue, I mean, clearly, East Sydney itself has a very well-functioning clinical governance and is totally committed to clinical safety and quality. And that's obviously one of the reasons why we're comfortable with the investment. And secondarily, to Craig's point, we actually run hospital in the home services right now. We run a lot of programs that have significant clinical risk. Clinical risk is just a fact of delivering clinical services. Every clinical service has a risk just like any other service and it's how you manage that. And we're very comfortable that both the existing East Sydney clinical governance model, with the additional layering of our own one, will deliver very high-quality clinical services to the hospitals' customers and our members.

The next question comes from Siddharth Parameswaran from JPMorgan.

Just a couple of questions, please. The first one is just on the claims -- on your claims cost that you've actually booked this year. How did you actually come up with that $297 million of claims liability for COVID? I mean is it basically just effectively applied to get to your budget? And just another comment. I mean it seems like the actual -- the 50% ancillary bounce back that you're assuming is quite different to the guidance that ASIC and APRA provided. I was just wondering if you could just comment on why you've taken a different assumption. It seems to be worth about $85 million on my estimates.

So I'll take that, Sid. So to be really clear, we have auditors that audit our accounts, and I think they take a very dim view of us actually creating a plug in our financial accounts so I can confirm that wasn't the case. So the basis of that provision, we start with what our most recent expectation of the claims was pre-COVID. We then looked at actual claims, and that difference was $364 million. And then we then make a deferral -- an assessment on how many of those claims are actually deferrals rather than permanent savings, and that's how we've come up with the $297 million. So there's no contemplation of a plug.

So how did you come up with that estimate of the deferral?

So probably more easily on hospital. The expectation is the absolute vast majority of those deferred procedures need to happen. You either need a hospital procedure or you don't. And then on ancillary, there's a large number of factors depending on the modality, and that's capacity of providers to catch-up type of treatment. Is it monthly routine treatment? Is it as a result of sports injuries that haven't happened? If it's dental, our people will still catch up and have their annual scraping claim. So as you'd expect, with all of these estimates is a range, and we -- and I would expect the majority of the industry have taken a fairly conservative view initially. To your question on ASIC and APRA, in fact, it's APRA not ASIC that have provided the guidance. But to put that in context, our financial accounts are generated based on a central estimate or a 50th percentile. The APRA accounts are on a 75th percentile stress basis. So they're 2 completely different bases. In terms of our APRA claims, they're actually $39 million higher than what our statutory claims are, not $85 million. And at an 82% deferral, I'm very comfortable with that level of deferral. And in fact, since the balance side, I've seen nothing that gives me any cause for concern that we've been anything other than conservative in terms of our levels of deferral.

Okay. Just the second question, just in terms of the actual experience you're seeing to date. I mean you did give some figures that, I think, in June, you'd seen a bounce back above 100%. But could you just give us an idea right now in states outside of Victoria, what do you think claims activity is running at?

Yes. So it's slightly harder to get a view on hospital given that it takes 2 to 3 months to come through in totality, all of your claims from prior service month. But in terms of ancillary, we're probably running around 5% higher than we were this time last year. So around a modest 5% utilization increase versus the prior period. And if you put that in context, that's not a -- that what we'd expect based on the catch-up of claims coming through from the deferrals in April and May.

Thank you. At this time, we're showing no further questions. That does conclude our conference for today. Thank you for your participation. You may now disconnect.