Yesterday, the Senate Judiciary Committee’s Subcommittee on Antitrust, Competition Policy and Consumer Rights held a hearing on “Examining Consolidation in the Health Insurance Industry and Its Impact on Consumers,” at which the CEOs of Anthem and Aetna testified. Both of these health insurers have announced friendly take-overs of two other insurers, Cigna and Humana.
One indicator regulators use to determine whether a business combination will reduce competition is whether there are significant barriers to entry in the industry. If there are, new competitors will not exploit openings created by incumbents’ consolidation. During the hearing, the CEOs of Anthem and Aetna each (independently) pointed to Oscar, a new health insurer with highly pedigreed investors, as evidence that health insurance is an easy business to enter.
Oscar is indeed an interesting enterprise, which has attracted fawning coverage in the business press both for its innovation and the quality of its investors. Nevertheless, Oscar is a curious start up, because it focuses exclusively on a market – Obamacare exchanges – in which insurers are taking on a lot of pain.
As I noted in a previous column, health insurance combinations are fraught with political risk. Although viewed by investors as being in a winning position due to the Affordable Care Act, health insurers have provoked Republican lawmakers into a largely hostile stance. This became apparent during Congressional hearings about Obamacare’s “three Rs” – risk adjustment, reinsurance, and risk corridors – in which health insurers were challenged to explain why taxpayers who now bear the legal obligation to buy health insurance must also be on the hook for losses health insurers suffer in Obamacare’s exchanges.
In this environment, it is not surprising investors are skeptical these combinations will close as announced. Chart I shows the expected rates of return for investors shorting the spread of these two deals, as they have changed from the shares’ closing prices on June 24 (the date Anthem’s bid for Cigna turned from hostile to friendly) to last Friday. Each rate of return assumes it will take until the third quarter of 2016 for each deal to close.
Anthem’s takeover of Cigna indicates a return of 27 percent to the merger arbitrage and Aetna’s takeover of Humana indicates a return of 19 percent. These extremely high risk premiums largely reflect political risk: No politician wants to be blamed for loss of choice among health plans.
With respect to Oscar, Obamacare exchanges are poorly designed, so they motivate insurers to compete by offering plans attractive to healthy people, not sick people. Unfortunately (for the insurers), they largely fail to achieve this goal, disproportionately enrolling sick people instead. Because Congress finally managed to limit taxpayers’ liability for health plans’ losses in Obamacare’s exchanges, participating insurers have been losing lots of money. This is why double-digit premium hikes have been announced for 2016. In 2017, the taxpayer-funded training wheels come off the exchanges, and participating insurers will have to cover their losses solely by moving money among themselves.
Into this minefield springs Oscar, which came into existence specifically to compete in Obamacare exchanges and has raised capital at increasingly rich valuations. In 2014, Oscar’s revenue (earned entirely through New York’s Obamacare exchange) was $56.9 million, of which it lost $27.6 million. Oscar appears to want to make it up on volume. Currently offering plans only in New York and New Jersey, it will soon expand to other states, especially Texas and California. To fund this expansion, it has raised money from highly pedigreed institutional investors. Last week, Google Capital invested $32.5 million, valuing Oscar at $1.75 billion. This is an increase from a $1.5 billion valuation at its previous raise of $145 million last April.
Some of the press around Oscar reads like we’re talking about Zappos, the online shoe store. Apparently, its online greeting of “High, we’re Oscar” and “minimalist” website count as remarkable innovation for health insurance. That is true, but does describe a path to profitability. It is important that Oscar offers free Misfit activity trackers and Amazon gift cards as rewards to beneficiaries who stay fit, because that increases the likelihood that Oscar attracts healthy, not sick, applicants. Nevertheless, its first-year experience in New York shows this is not enough.
Maybe Oscar simply hopes to show incumbent insurers how to attract individual subscribers, and sell itself to the highest bidder once Obamacare exchanges become a profitable business. However, that is an unlikely prospect. The exchanges are in a nasty political tangle the current Congress has no interest in unravelling.
I hope that I am wrong about Oscar, because health insurance needs customer friendly innovation and a thriving individual market. However, that outcome requires a very different health reform than Obamacare.
Investors' Note: Anthem (NYSE: ANTM), Cigna (NYSE: CI), Aetna (NYSE: AET), and Humana (NYSE: HUM) are subjects of the health insurance consolidation discussed here.
