The private health insurance industry is one of the more unpopular industries of Australia. The government has created a carrot and stick method to encourage people to take up insurance.

The sticks are the Medicare levy surcharge for high earners, the lifetime health cover loading for people over 30 and high medical costs for people that don’t have insurance for certain procedures.

The carrot is the rebate that people receive on their premiums.

The government needs the private health sector to succeed because the cost of the public health system increases every year. As the population ages, it’s expected that public health costs will increase even quicker.

Private health insurance is an interesting system, essentially younger people are subsidising the older person’s premium in the same way that safe drivers subsidise risky drivers.

This system, combined with the government reducing the rebate each year, has led to premiums increasing much faster than inflation. This has seen profits soar in the industry.

Recent results

The ASX-listed insurers had a great year in FY16. NIB Holdings Limited (ASX: NHF) is the smaller of the two listed insurers at $2.1 billion in size. NIB increased its underlying earnings per share and dividend by 25.1% and 28.3% respectively.

Medibank Private Ltd (ASX: MPL) is bigger with a market capitalisation of $7.05 billion. It grew earnings per share by 46.4% in FY16 and increased its September 2016 dividend by 13.2% compared to September 2015.

Reasons to be bullish about the private health sector

As I mentioned above, the government needs the sector to succeed. So somehow it has to make the whole health system more affordable. Part of this will be by cracking down on the costs charged by health providers such as hospitals and doctors.

Private health insurance is a good way to benefit from all the different health problems, it isn’t focused on just one issue like Cochlear Limited (ASX: COH).

Reasons to be bearish

For the first time in a number of years the percentage of people with health insurance actually reduced in 2016 according to the Australian Prudential Regulation Authority. The price increases are starting to make an impact.

The not-for-profit superannuation industry has made a great case of why people are better off with them. There are also not-for-profit health insurers who could become greater competition the more prices increase.

The industry has to walk a tightrope to remain affordable to consumers whilst growing revenue and profits. This is a hard task when it has to consider the wishes of the public, health providers and the government.

Valuation 

NIB is currently trading at 22.6x FY16 earnings with a grossed up dividend yield of 4.41%. Medibank is trading at 16.9x FY16 earnings, with a grossed up dividend yield of 6.14%. Out of the two, Medibank looks better based on these numbers.

Outlook

According to analysts, NIB is expected to grow more than Medibank by FY18. NIB’s earnings are predicted to grow by 20.6% and Medibank’s earnings are forecasted to grow by 8.5% (source: CommSec).

Time to buy?

The private health insurance industry looks like it has a long future ahead of it with the aging population and the need to bring down the cost of the public health system.

Out of the two, I would choose Medibank based on its higher dividend yield and cheaper valuation, though perhaps both could have a place in a Foolish investor’s portfolio. Now could be a good time to buy as the health industry as a whole has suffered a small dip, Medibank is currently trading 21% lower than its June all-time high.

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Motley Fool contributor Tristan Harrison doesn’t own shares in any companies 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.