Water Island Capital Special Report: Consolidation in the Health Insurance Space Dated: 6/23/15.

Consolidation in the health care sector has run rampant as of late, whether it be industries such as specialty pharmaceuticals (Salix/Valeant, Pharmacyclics/AbbVie, Allergan/Actavis, and the ongoing Mylan/Perrigo/Teva saga to name just a few recent situations) or pharmacy management services (CVS’s acquisition of Omnicare, UnitedHealth’s acquisition of Catamaran). The latest industry in the health care sector to heat up is the health insurance space. Outlined below is an overview of the prominent players and the prospects for potential consolidation activity.

Overview

Driven by new opportunities and other changes as a result of the Affordable Care Act, companies within the health insurance space are pursuing consolidation. What was once the industry’s core business – covering workers on behalf of big companies (i.e. the “commercial” space which includes traditional employer insurance as well as individual insurance plans) – has been stagnating while the most promising opportunities have emerged in Medicare and other government programs. There are currently five major players – UnitedHealth, Anthem, Aetna, Humana, and Cigna – that have the opportunity to engage in a number of different transactions. Ultimately, analysts believe that when the dust settles only three major players will remain.

Individual Company Profiles

UnitedHealth (2014 Revenue: $130.5 B) – Currently the largest player in the space, it is one of the better diversified companies with a little over half of its revenue coming from commercial plans. It is also the nation’s largest player in private Medicare (also known as Medicare Advantage). It is currently rumored to be pursuing two options for consolidation, either an acquisition of Cigna or an acquisition of Aetna.

Anthem (2014 Revenue: $73.9 B) – The second largest player in terms of revenue, Anthem is primarily involved in the commercial space. Anthem is solely interested in acquiring Cigna, which would make them the largest player in the commercial area and solidify their position as the second largest player in the industry (behind UnitedHealth), even if another acquisition should take place. With this acquisition strategy, Anthem appears to be banking on the belief that an increase in the volume of customers in the commercial space would adequately offset the shrinking profit margins by allowing them better economies of scale and increased negotiating power. Cigna would also provide them with international exposure and their experience in the pharmacy benefit management (PBM) business.

Aetna (2014 Revenue: $58.0 B) – The third largest player in terms of revenue, Aetna is also primarily involved in commercial insurance. One of Aetna’s primary benefits is the series of relationships it has formed with heath systems that rely on its information-technology services. It is currently trying to acquire Humana, which would allow them to diversify their business by adding government plans, in addition to being an acquisition target of UnitedHealth.

Humana (2014 Revenue: $48.5 B) – As the fourth largest player, Humana is a large provider of government plans, which has seen significant growth in recent years. This growth has caused Humana to

be viewed as the proverbial “jewel” of the industry. Their revenue is split evenly between commercial plans, Medicare plans, and Tricare (military) plans. Humana is looking to sell itself and has reportedly drawn interest from both Aetna and Cigna.

Cigna (2014 Revenue: $34.9B) – Cigna is the smallest and least diversified player in the space, with almost the entirety of their revenue coming from commercial plans. Cigna’s strengths come from the close relationships it has formed with employers that self-insure (both large and small) as well as international customers. Cigna is viewed as an acquisition target from both UnitedHealth and Anthem and is itself considering an acquisition of Humana.

Possible Outcomes

Aetna / UnitedHealth – Status: Preliminary takeover approach reported.

• On June 16, the Wall Street Journal reported that UnitedHealth had made a preliminary takeover approach to Aetna but that “It isn’t clear what, if any, Aetna’s response was”.

• A merger between UnitedHealth and Aetna would create a company with massive market share in

many states that might be able to extract deep discounts from medical providers.

• Should this deal materialize it would face intense regulatory scrutiny due to both companies’ commercial exposure.

Humana / Aetna – Status: Takeover proposal reported.

• On June 20, the Wall Street Journal reported that Aetna had made a preliminary takeover approach to Humana.

• Aetna is viewed as the most likely acquirer of Humana by industry analysts.

• Given the possibility that UnitedHealth could come in for Aetna, there is some risk that an

announced deal could unravel due to what we believe would be a required Aetna shareholder vote condition. However, given our views on regulatory risk to an Aetna / UnitedHealth deal, we see this outcome as a low probability.

Cigna / Anthem – Status: Multiple bids have been placed and rejected.

• On June 21, it was reported that Anthem had made four offers for Cigna over the past month, with

the latest bid culminating in a $184/share offer that was rejected (on the 21st).

• A major point of contention regarding the deal has been Anthem’s refusal to guarantee that the current Cigna CEO, David Cordani, would become CEO of the combined entity (a major sticking point for Cordani and the Cigna board).

• Additionally, Cigna’s leadership has pushed for more significant roles in the combined company;

something Anthem is contesting given the premium they have offered.

• Completion of this acquisition would put Anthem much closer to the size of UnitedHealth and would create the largest commercial plan provider with strong positions among individual, small-business and big-employer clients.

• Should a deal materialize, we believe regulators will take a hard look but will ultimately approve the

transaction. Anthem will also need to address potential conflicts between Cigna’s business and Anthem’s Blue Cross Blue Shield plans.

Cigna / UnitedHealth – Status: Rumored

• Completion of this deal would cement UnitedHealth’s standing as the largest health insurance provider in terms of revenue, lead to it gaining a massive market share in the commercial plan space, and provide access to international customers.

• Additional cost savings may be attained by combining Cigna’s PBM (pharmacy benefit management)

business with UnitedHealth’s Optum PBM.

Humana / Cigna – Status: Rumored

• Cigna, along with Aetna, has held preliminary discussions with Humana regarding a sale, but there isn’t any other news regarding a Humana / Cigna deal.

• It’s entirely possible that this approach represents a defensive move on Cigna’s part to elicit an

alternative transaction, which the company would prefer to a merger with Anthem.

Additional Rumors:

• A UnitedHealth deal for Humana has been seen as less likely because of the potential size of the two companies’ combined Medicare businesses, which could draw antitrust pushback.

Our Thoughts

Regarding Humana:

• Cigna seems to be a very logical choice as a Humana acquirer but both Aetna and Anthem could afford to pay more.

• The ultimate outcome, however, is still unclear

Aetna could still be taken out by UnitedHealth Cigna’s interest seemed to be designed to ward off Anthem’s bid

• We did not get involved with Humana in early May (when reports were coming out detailing its talks

with Aetna and Cigna) because the stock had already priced in most of the upside.

• Given where it is trading at today, a deal involving Humana as a target would only be attractive to us if a bidding war were likely to materialize. This is unlikely to happen if a Cigna / Anthem deal were announced as it would take two buyers off the market, leaving Aetna as the sole remaining potential buyer.

• In addition, should Aetna be the ultimate buyer, we believe Humana will trade with a wide spread due to the acquirer vote risk. On this basis we believe there is limited upside to owning Humana today.

Regarding Cigna / Anthem: • While it is possible that UnitedHealth could still come over-the-top for Cigna, we do not put a high

probability on this scenario and see an Anthem / Cigna deal as our base case.

• Should Cigna and Anthem come to terms, we believe the deal will take over a year to complete and will trade with a wide spread due to the potential regulatory noise that could transpire.

• Similar to Humana, we believe the risk/reward is unfavorably skewed, with limited upside should a

definitive deal be announced.

In General:

• The two we remain focused on are Cigna and Aetna, which would be our most likely candidates should we get involved in the space. An Aetna acquisition of Humana could be significantly accretive while significantly

transforming Aetna’s business for growth. Alternatively, the low but not impossible scenario that UnitedHealth bids for Aetna remains. Both extremes would be a positive for Aetna’s stock.

We believe it is unlikely that Cigna will remain an independent company and that the most likely outcomes are the company being sold to either UnitedHealth or Anthem.

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We are making this research available to you for your information and education. Any references in this research to specific holdings are not to be considered recommendations by the Arbitrage Fund (the “Fund”) or Water Island Capital (the “Advisor”), the Fund’s advisor. Any discussion of specific securities is intended to help readers understand the Advisor’s investment management style vis-à-vis the current deal environment, and should not be regarded as a recommendation of any security or of the Fund.

RISKS: The Fund uses investment techniques that are different from the risks ordinarily associated with equity investments. Such techniques and strategies include merger arbitrage risks, high portfolio turnover risks, options risks, borrowing risks, short sale risks, and foreign investment risks, which may increase volatility and may increase costs and lower performance. Past performance is not a guarantee of future results.

Top ten holdings for the Arbitrage Fund as of 9/30/15: PartnerRe Ltd, Precision Castparts Corp, Sigma-Aldrich Corp, Chubb Corp, Cytec Industries Inc, Thoratec Corporation, Ansaldo STS SpA, Symetra Financial Corp, HCC Insurance Holdings, World Duty Free SpA. Top 10 holdings represent 37.7% of the portfolio. Holdings are subject to change. Current and future holdings are subject to risk. The Arbitrage Funds are distributed by ALPS Distributors, Inc., which is not affiliated with Water Island Capital, LLC. [ARB000799 2016-12-31]