Health insurer Medibank Private Ltd (ASX: MPL) will be a familiar name to most readers, and as a result, the first port of call for many individuals who are just getting started in investing. Before buying any company, it’s important to take a look at how it makes its money.

source: Medibank presentation

source: Medibank presentation

Here’s some things to know about Medibank Private:

90% of the company’s revenues are earned from health insurance premiums, while the remaining 10% comes from ‘Complimentary Services’ which is corporate and government business (eg., health checks before commencing work). Regular premium increases every year will provide steady increases to revenue and thus profits, if Medibank can contain its costs.

Despite this, 75% of profits before tax come from health insurance, 3% from complimentary services, and 21% from investment income from Medibank’s portfolio. Although Medibank has a smallish ‘float’ (investment portfolio) this is growing and will be an important driver of earnings over the long term. It is sensitive to higher interest rates.

It’s pretty clear that the biggest driver of profits is the health insurance business. Accounting for over 90% of revenues and 75% of profits, changes in claim expenses can make a big impact on the bottom line – Medibank’s recent profit upgrade was due to lower claim expenses.

Thus, it would also make sense to look at a breakdown of the claim expenses. This is the first half of 2016, compared to the first half of 2015:

source: Medibank presentation

source: Medibank presentation

Notably, we can see that costs are pretty well contained, with prostheses and day facility the fastest growing areas. The pricing of prosthetics has come into question recently, and we might see some moderation of growth in this area if a recently established Industry Working Group on Prosthesis Reform has any success.

There are many moving parts in the health insurance business. Going forwards, Medibank has identified a number of areas to work on, including:

  • Introducing new products and addressing underperforming products
  • Strengthening its ahm/Medibank strategy by further segmenting the two brands
  • Focussing on primary care (eg at nurse/GP level) in order to reduce chronic disease burden and costs
  • Increased marketing and investment
  • Targeted approach to customer retention
  • Upgrading core systems to improve efficiency and reduce cost

As I’ve noted in a previous article, chronic disease is one of the biggest claim costs for Medibank, which claims that 20% of Australians lives with two or more chronic conditions. Chronic disease claims are a small portion of total fund members but result in an outsized percentage of claims.

Medibank Private is a great business, but one that looks a little pricy today. Before buying Medibank, investors would be better off considering one of The Motley Fool's Top 3 blue chips for 2016 - because these 3 'new breed' shares pay fully franked dividends AND offer the very real prospect of significant capital appreciation.

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Motley Fool contributor Sean O'Neill has no position in any stocks mentioned. The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.