Health Insurer Consolidation Aims For Market Control

by: Dana Blankenhorn

Health insurers seek consolidation as they approach political uncertainty in 2016.

Market control will give them flexibility no matter which party wins.

Vertical integration, ownership of the means of health production, is the goal.

Health insurers have had an incredible run ever since the Affordable Care Act was signed in 2010.

They have been benefitting from the increased number of customers flowing in from the law, and from the wellness efforts that are starting to minimize payouts. Even if you accept the law's language that insurers must spend 85% of premiums on care. This still leaves a fat profit margin, and it's real easy to pad the care bills with paperwork and bureaucracy.

Since March of 2010 UnitedHealth (NYSE:UNH) shares are up by over 250%, Aetna (NYSE:AET) over 280%, Humana (NYSE:HUM) over 330% and Cigna (NYSE:CI) over 340%. The laggard has been Anthem (NYSE:ANTM), which runs most of the Blue Cross franchise, up "just" 160%.

A lot of the gains have come from buying defined-benefit groups, essentially Medicare and Medicaid practices, and using the full range of network control, wellness and cost containment offered within the law to keep costs on these high risk groups down and increase profits. But to make that work for the larger population, the insurers need to control their downstream costs. They need the scale to control whole markets, to make hospitals, clinics, and other suppliers dance to their tune.

That's what is driving all the current talk of consolidation. Humana, smallest by revenue but largest in stock gains, is naturally anxious to sell itself, since it lacks the heft to control markets but has valuable lessons to offer any acquirer.

There are immense profits to be made in surviving this consolidation, which is why Anthem may have rebuffed Cigna and Aetna may be playing hard to get with United Health. Gaining dominance within markets and geographic diversity would give the winners the heft needed to move on companies as big as Hospital Corp. of America (NYSE:HCA), Community Health (NYSE:CYH) and Tenet (NYSE:THC), at minimum with "affiliation agreements" tying them to the insurers and perhaps even with acquisitions, since the insurers are now worth many times more than the largest hospitals.

All this is being done in the name of cost containment, higher profits, and political power. Vertical integration keeps costs down, market control means higher profits, and the combination means the winners can resist any drive to cut profits by a future Democratic Administration. It could also line up insurer management to take political control of the U.S. health care system in the event of a Republican victory, because while companies like United Health have been the biggest beneficiaries of "Obamacare," they still contribute more to Republican candidates than Democratic ones.

My favorite in the group has always been UnitedHealth, because their OptumHealth unit supports just the kind of cost containment we are talking about, and because health IT was singled out for $19.2 billion in 2009 stimulus funding. This has given it, at $113 billion, by far the largest market cap of the group, so when deals are being talked about, it's the most likely acquirer.

While Humana seems most anxious to find a buyer, either Cigna, worth $39 billion or Aetna, worth $42 billion, could easily be played as a take-out target. Much of the pay-off would likely be in stock -- UNH only has $8.6 billion in ash on its books -- so in either case technology is a key force in the coming consolidation.

The result is very bullish for the sector.

Some bits of the last half-decade's gains are at risk. In the near term, a Supreme Court decision against Obamacare could cause stock prices to drop. But that will be a temporary phenomenon, a buying opportunity. Because the gains being made through automation, vertical integration of services and a focus on wellness are permanent. Insurers won't just toss away these savings. And if a Republican administration gives them more pricing flexibility -- perhaps at the cost of a few million contracts -- the remaining players will adjust.

Right now you're paying about 20 times earnings for this group. That's a premium over the market. It's another motivation for more consolidation, more mergers, and more gains, as the more highly-automated firms like UnitedHealth absorb and transform the less highly-automated ones.

The only real risk to health insurance wealth lies in something like a single-payer system replacing the present one, and that's just not in the political cards. Right now you can invest here with confidence.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.