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2005 Trend: HMOs Face Pricing Headwinds

Next year could finally test the health of managed-care providers.

For years, double-digit premium increases have kept profits -- and stock prices -- soaring in the health insurance sector. Thus, companies like UnitedHealth (UNH - Get Report) and WellPoint (WLP) have consistently ranked among the healthiest performers in the market. But recent trends indicate that industry doubters, who have long warned of an inevitable downturn, may soon be proven right.

Goldman Sachs analyst Matthew Borsch, known for his caution on the group, recently offered up fresh evidence of a looming down cycle. He pointed to this year's health benefits report from Mercer Consulting, which showed health insurance costs increasing at just half the clip of a year ago, when making his case against the sector.

Borsch offered a reasonable explanation for the slowdown. He said that not-for-profit health insurers, which dominate the industry, have been generating excess profits in recent years. As a result, he said, they have scaled back their premium increases and -- in the process -- have pressured their for-profit competitors to do the same. He predicted that 2005 will be a tough year for the sector as a result.

"We are convinced that, within the next six to nine months, we will see a meaningful deterioration in earnings within the group," wrote Borsch, who has a neutral rating on the sector. And "we caution that the recent very strong rally in managed care may lead to a correction in the stocks when evidence of the downturn becomes widespread."

Still, Borsch believes that strong players -- such as Aetna (AET - Get Report) and WellPoint -- can weather the coming storm. He likes UnitedHealth, long an outperformer, as well. All three stocks have handily outpaced the broader market over the past year.

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