It seemed inevitable only two years ago that Health Net Inc. would meet the same fate as California’s other publicly held health insurers: being swallowed by an out-of-state competitor.

Rumors swirled that Aetna Inc. might be a suitor, but the Woodland Hills managed care provider ultimately chose independence over consolidation.

It must be breathing a sigh of relief.

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.”