It’s become clear recently that the traditional "bigger is
better" axiom that health care insurers have long labored under might
have its limits.Cypress-based rival Pacificare, acquired by
UnitedHealth Group Inc., was hit last month by the state with fines
that might top $1 billion over improper claims handling. And both
UnitedHealth and WellPoint Inc., which acquired Thousand Oaks-based
WellPoint Health Networks, have been struggling with their earnings.

"Traditional thinking had been that you wanted to become
humungo, because that gave you negotiating leverage with providers and
economies of scale," said Dave Shove, an industry analyst for BMO
Capital Markets Corp. "But the pressure to consolidate isn’t as black
and white as it once was, because the players that are truly giganto
don’t
seem to be generating significantly better growth than a normal size
giant."

Last month, WellPoint missed analysts’ expectations for the
fourth quarter, and UnitedHealth posted its worst fourth quarter since
1995. By contrast, Health Net earlier this month reported its
fourth-quarter earnings rose nearly 50 percent as it reported solid
growth in its Medicare and commercial enrollment.

That’s not to say that Health Net is small.

It insures more than 6.6 million commercial and government plan
members in 27 states, including roughly a half-million of them in Los
Angeles County. And it’s one of only three in the country that handles
health care for members of the U.S. armed forces, veterans and
dependents under a program known as TriCare.

Still, it’s a tyke compared to WellPoint, which is the nation’s
largest health insurer by enrollment with nearly 35 million members.
And Health Net’s $14.1 billion in 2007 revenue is dwarfed by the $75.4
billion reported by UnitedHealth, the largest insurer by revenue. Storm
of controversy But all that heft, which was supposed to generate
efficiencies in scale, has only seemed to generate ill will and
inefficiencies.

Upon announcing fines that could total $1.33 billion against
PacifiCare because of 133,000 alleged violations of claims law, state
Insurance Commissioner Steve Poizner was quoted saying "If PacifiCare
can’t understand the ABCs of basic claims payments, maybe it will
understand the dollars and cents of regulatory actions."

And just last week, Blue Cross of California, WellPoint’s
California subsidiary, faced a storm of controversy over
letters it sent to doctors asking them to report new enrollees who had
lied about pre-existing medical conditions. Blue Cross quickly halted
the practice amid a tide of criticism.

"As HR directors get pissed off at Pacificare, they may turn to
Health Net, particularly as Blue Cross has gotten so much bad press,"
said Jerry Flanagan, health care advocate for the Santa Monica-based
Foundation for Taxpayer and Consumer Rights. "They also benefit from
the perception — which Health Net is encouraging — that they’re the
smaller, hometown HMO, even though they have the same pressure as the
other public insurers to put profits over patients."

Health Net, one of five insurers that control 80 percent of the
HMO business in California, became the last remaining public
California-headquartered insurer of that group after Blue Cross of
California parent WellPoint Health Networks and Pacificare Health
Systems were acquired over the last five years.Among its other
competitors is nonprofit Blue Shield Inc. and the nonprofit Kaiser
Permanente health maintenance organization. What remains to be seen, is
how well Health Net will be able to capitalize on the travails of its
larger rivals.

The entire sector has seen its stock swoon amid concerns by
investors that a slowing economy could reduce membership growth in both
the private and public sectors. Shares of Health Net closed Feb. 14 at
$45.49, down nearly 2 percent for the day and nearly 25 percent off its
52-week high of $59.25 in May.

However, the company reported earlier this month that in the
fourth quarter it had 55,000 more members than a year ago, about 8,000
added since the previous quarter — and apparently some of them former
Pacificare members. It also had a quarter in line with analyst
expectations as net income rose 45 percent to $123 million and sales
were up 12 percent to $3.58 billion. But it did narrow its outlook for
2008 due to costs related to a wide-ranging restructuring.

The company is seeking to improve efficiencies and margins by
reorganizing its business units to bring all its West and Northeast
commercial, Medicare and Medicaid programs under one division. It’s
also putting less emphasis on adding larger employers and instead
focusing on small group and individual members business.

"We want to get the value out of being a big company," said
Stephen Lynch, president of the new Health Plan Division. "That means
taking a best practice from one region and applying it throughout,
while still being a local company in each region. We don’t want to
standardize the wrong thing."

Indeed, Health Net has had some recent missteps itself. It was
fined $1 million in November by the state Department of Managed Health
Care, and is facing a lawsuit from a former member, over a program that
gave financial
incentives to workers to ferret out apparent omissions in enrollee
medical histories — such as a history of high blood sugar readings,
which would indicate diabetes, a costly chronic disease. The company
then used the information to
rescind policies from members who had individual memberships, not those
through their employers.

"There’s no doubt that (Health Net’s) incentive program was
dirty — not even Blue Cross had tried that," Flanagan said. "But they
do seem to get some benefit of the doubt from still being a local
company."

Stressing that the company had cancelled the incentive program
prior to the state’s investigation, Lynch said there needs to be more
clarity from regulators and lawmakers on how far a company can go in
rooting out individual plan
policyholders who misrepresent their health status on applications.

"We’ve heard loud and clear that the public and regulators feel
it’s a distasteful practice, but it puts us in a real dilemma as to how
do you act," he said. "We think it’s clear we’re not breaking the law
now, but it’s unclear where people want to see the regulations."

Meanwhile, Health Net is seizing the opportunity to grow where
it can, even if that means cooperating with its rivals. Recently, in a
bid to strengthen its military business, it joined with UnitedHealth to
take advantage of the insurance giant’s larger network. The two
companies plan to jointly bid on renewal of the TriCare contact, which
expires next year. Health Net not only removes the larger insurer as a
direct competitor, but also particularly benefits from UnitedHealth’s
larger mental health network around the country.

With the Department of Defense under criticism for providing
insufficient mental health care to soldiers returning from Iraq, it’s a
benefit likely to be emphasized in the forthcoming request for
proposal.

"It’s a smart move for both companies," said analyst Thomas
Carroll at Stifel Nicolaus Co. "TriCare is a sound stable business for
Health Net that they would fear losing. UnitedHealth gets to dip their
toe into TriCare without a lot of risk,
since they’d benefit from Health Net’s established infrastructure."