Insurers will consolidate even if mega-mergers fail

Nearly everyone in healthcare speculated for the past year about how the U.S. Justice Department would respond to the mega-deals proposed by Aetna and Anthem. Officials were concise and stern as they delivered their answers from a podium last week.

“Aetna's acquisition of Humana and Anthem's acquisition of Cigna may be a convenient shortcut to increased profits for those companies,” said Bill Baer, one of the department's top antitrust officials. “But the antitrust laws make clear that mergers are not lawful when they risk denying consumers the benefits of competition.”

U.S. Attorney General Loretta Lynch said that if the deals were allowed, “not only the bank accounts of the American people would suffer, but also the American people themselves.”

But even if the federal government buries Anthem's $53 billion acquisition and Aetna's $37 billion purchase, the big five health insurers (which also include UnitedHealth Group) are likely to forge new transactions to scale up and improve their position at the bargaining table with consolidating hospitals and health systems.

“It's still a pretty fragmented industry,” Jeff Loo, an equities analyst at Standard & Poor's Global Market Intelligence, said of health insurers. “If the big five remains and if they make a bid for one of the smaller players, I don't think the Department of Justice would have that strong of an argument to stop it.”

Many people maintain that the insatiable appetite to bulk up is a result of healthcare reform, which encourages hospitals, doctors and insurers to create more cohesive systems of care. “There's a lot in the Affordable Care Act for groups to merge,” said Marianne Udow-Phillips, director of the Center for Healthcare Research and Transformation at the University of Michigan.

Centene Corp., Molina Healthcare and WellCare Health Plans, all publicly traded insurers, are logical targets because of their relatively smaller size. Centene, which recently acquired Health Net, has an annual revenue base of $40 billion, while Molina and WellCare both posted revenue of $14 billion last year. That compares with UnitedHealth, on pace for $182 billion in revenue this year, or 5% of the entire healthcare economy. Aetna, Anthem and Humana all have revenue above $50 billion. Cigna ranks last among the big five, with about $38 billion in 2015 revenue.

Another attractive element of Centene, Molina and WellCare is their primary focus on Medicaid, a program that has seen heavy enrollment growth across the country due in large part to the ACA's Medicaid expansion.

“More Medicaid is going to go managed care, so I think that's a real potential market,” Udow-Phillips said. Centene and WellCare also have significant market share in Medicare Advantage, a prized asset for most large insurers today.

Universal American Corp., which specializes in Medicare Advantage and accountable care organizations, and Magellan Health, a managed-care company with a large pharmacy benefits arm, could become easy targets as well. Even some independent regional insurers may sit in the crosshairs of the large carriers, especially if they sell health plans in important growth markets.

A new round of dealmaking presumes the Anthem-Cigna and Aetna-Humana transactions are on their deathbeds. The Justice Department was adamant in its complaints that both deals would destroy competition in the employer, Medicare Advantage and ACA marketplaces, and experts believe there is some weight in the government's arguments.

“History is with the Department of Justice,” said Leemore Dafny, a health economist at Harvard Business School who wrote about the detrimental effects of the Aetna-Prudential merger of 1999. “If past is prologue, these mergers aren't likely to benefit consumers.”

Jeff Miles, an antitrust attorney with Ober Kaler, said the chances of winning against federal regulators who want to block a merger are “very poor” these days.

In the case of Anthem and Cigna, where there has been contention from the outset, there is a high probability both companies will want to pull the plug. Anthem said it would defend the merger, but Cigna's unenthusiastic statement struck a much different tone. Cigna—led by CEO David Cordani, who failed to acquire Humana and butted heads with Anthem over his future leadership position—said it was “evaluating its options consistent with its obligations under the agreement.” The earliest the merger could be completed was 2017, “if at all,” according to Cigna.

Anthem faces some hurdles if it wants to pursue another deal. The insurer had $1.7 billion in cash and cash equivalents as of March 31, the lowest of the four merging parties, and it would owe Cigna a $1.85 billion breakup fee if the transaction crumbles.

Anthem also is in the middle of a heated lawsuit with pharmacy benefit manager Express Scripts Holding Co.

Cigna, meanwhile, has “strong stand-alone fundamentals” and the ability to “deploy at least $9 billion” for acquisitions if the insurer wanted to raise its debt level, according to a research note from Goldman Sachs analyst Matthew Borsch. That could allow Cigna to buy a Medicaid insurer, a clear area where Cigna lacks heft, or it could try to buy Humana again if both deals are abandoned.

Experts agree Aetna and Humana have better odds than Anthem and Cigna of convincing the court that competition could be preserved by divesting overlapping health plans. But those odds still may be slim. The companies will have to convince a judge that traditional Medicare and Medicare Advantage are competing markets—a theory that many health economists dismiss and the Justice Department rejected.

But Loo said Aetna and Humana executives will make that argument “until they're blue in the face.” And he and other financial analysts think they can win.

“I view them as one market because when you're eligible for Medicare, you're automatically placed in the traditional plan,” Loo said. “You need to actively choose the Medicare Advantage plan.”

Aetna had $3.8 billion in cash at the end of the first quarter, and it issued $13 billion of new debt in anticipation of buying Humana—money that almost certainly would be used on other acquisitions if the Humana deal falls through. However, Aetna would have to pay a $1 billion termination fee to Humana.

Aetna CEO Mark Bertolini told CNBC his company would “vigorously defend” the transaction. He also said during a conference last year that organic growth remains a priority for Aetna because “sooner or later, you run out of assets to buy.”

No matter if the health insurers win their battles with the Justice Department or if there is another round of frenetic speed-dating, many observers hope the companies invest resources in that organic growth.

“I'd like the insurers to sit back down and figure out how they're going to earn their customers and innovate,” said Dafny, who previously worked for the Federal Trade Commission as deputy director for healthcare antitrust. “Some acquisitions may make sense, but I'd like to see some new thinking on their part.”