(FORTUNE Magazine) – A weird but true fact about modern medical insurance: The healthiest way to deal with a managed-care company is to own stock in it. If you're covered by a medical benefits plan and actually go to the doctor, you're making yourself vulnerable to rising deductibles, lost referrals, denied claims--all the extra headaches of modern American medicine. But if you've invested in managed-care giants like UnitedHealth, Wellpoint, or Aetna, you've got to be feeling pretty good: The stocks, as measured by the S&P managed-health-care index, have doubled since the end of 1999. In the same period, the S&P 500 stock index has tumbled by more than a third.

The big reason for the health insurers' robustness is pricing power--an extraordinary five-year run of it, the best in a generation. Year after year the insurers have been able to muscle through accelerating premium increases in dealing with their corporate customers. After rising 11% in 2001--triple the rate of inflation--premiums jumped 12.7% this year, according to the Kaiser Family Foundation, a nonprofit research organization in Menlo Park, Calif. (see chart). Early estimates show that rates for 2003 will climb even more--a staggering 22%, on average, with some customers facing premium increases of nearly 100%.

How do the health insurers get away with it? First, you can thank the merger activity that has swept the industry. Big insurers are swallowing little ones--roughly a third of small firms have been gobbled up in the past few years--giving better pricing leverage to the 600 or so remaining players. Second, despite an environment in which employers are looking to cut any cost they can, health benefits as a rule have remained a sacred cow. Employer payouts for worker health benefits are growing at a substantially higher rate than wages.

Insurers have also benefited on the expenses side. While the total cost of medical care has been growing inexorably, the increases in one big category have actually slowed. Prescription-drug costs--the biggest driver of health-care inflation in recent years--will rise an estimated 16% this year, down from a recent high of 19% in 1999. That easing, which is expected to continue, could save insurers roughly $10 billion over the next few years. Big Pharma is facing the largest wave of patent expirations in its history, with branded drugs representing more than $30 billion a year in U.S. sales going off patent between 2000 and 2005. Generic drugs shave an amazing two-thirds off the cost of a typical branded prescription, or about $700 a year. Some of the savings passes through to consumers, but the bulk of it helps health insurers.

Finally, the events of Sept. 11 forced lawmakers to shelve the Patients' Bill of Rights, which would provide consumers with broad guarantees in dealing with managed-care outfits, including--most alarmingly from the insurers' standpoint--the right to sue. The bill isn't dead, but many predict it will never become law, primarily because insurers have preemptively made many of the changes included in the original bill.

All these forces have combined to create what could be considered the perfect tailwind for the managed-care industry. "The trends are as good as they have ever been," says David Shove, a respected analyst at Prudential Financial. Joshua Raskin of Lehman Brothers agrees: "From a fundamental perspective, this is the best environment we've seen in the last ten years."

Thus it may come as a surprise to learn that the managed-care industry is dying. Oops, did we spill the beans so soon? Well, so be it. Managed care is on the way out.

That's not to say that the alphabet-soup offerings of HMO, PPO, and POS won't be around in a year or two. But look beyond the jargon and you'll discover that today's insurers are offering not managed care, but rather the old-fashioned, high-cost fee-for-service insurance it was intended to replace. "They've evolved into traditional insurance companies," says Kenneth Sperling, a health-care expert at Hewitt Associates, a leading benefits consulting firm. "It's the same kind of insurance we had."

This is no simple matter of semantics. This is an executive-waking-in-the-middle-of-the-night-in-a-sweat nightmare for the $370-billion-a-year health insurance industry. Those perfectly synched trends that have been driving the group's stock prices higher and higher are about to change. Here's how Princeton University's Uwe Reinhardt, a renowned health-care economist, puts it: "There's a two-by-four hanging over the industry that's going to come down with great vehemence."

Be careful what you wish for. That's the moral of the story in the evolution of the health insurance industry. The original idea of managed care when it was conceived in the early 1980s was to replace traditional fee-for-service indemnity insurance by clamping down both on payments to health-care providers and on patients' access to costly specialists and tests. Prevention was another key element, the theory being that people who are kept healthy require less care. To give doctors a financial incentive to promote wellness, they were paid set amounts per month for each patient, regardless of how much care that patient received. (Old-fashioned indemnity insurers, by contrast, paid doctors on a "fee for service" basis each time a patient was treated.)

The switch to managed care slowed the increase of medical costs in the late 1980s and early 1990s. Employees, however, never took to having their doctor's visits doled out in carefully measured doses. They wanted it both ways--low prices and unrestricted access to care--and let their employers know it. In the booming economy, employers anxious to retain workers passed along these demands to the managed-care suppliers; and the insurers, to accommodate their customers, loosened crucial strictures on access to care.

Soon patients regained some freedom of choice. Between 1990 and 2000, the average number of doctors in each health maintenance organization (HMO)--the most common type of managed-care plan in the beginning--nearly quadrupled, and the number of hospitals per plan more than doubled. At the same time, the percentage of HMOs that paid for treatment by doctors and hospitals outside the HMO's network more than tripled, to 63% of all plans in 2000. Easing the restrictions was tantamount to disconnecting the brakes on medical inflation--causing employers' premiums to go up and up.

Even those liberalized HMO plans were too tightly managed for patients. Over the past decade consumers have increasingly migrated to what's known as preferred-provider organizations, or PPOs. Such plans contract with an extremely broad network of physicians and hospitals, cover all out-of-network care once an annual deductible is met, and reimburse doctors almost entirely on a fee-for-service basis. In other words, PPOs are so loosely managed that they're essentially old-fashioned fee-for-service indemnity plans in drag. This year PPO enrollment jumped to 52% of all covered workers, from 28% in 1996. Meanwhile, enrollment in HMOs fell to 26%, from 31% in 1996 (see chart).

Hospitals also rebelled against managed care. After years of consolidation, big chains now wield much more negotiating power than in the early days of managed care, and can force price increases on the insurers by threatening to walk away. "Hospitals are holding the health plans hostage because they can't afford to lose these hospital systems out of their networks," says Hewitt's Sperling.

Throw in the fact that managed-care firms--which now show up as villains in Hollywood movies and in TV plots--helped destroy their image by pushing too hard on controversial cost-containment measures. They did unbelievably dumb things, like kick women out of hospital beds a day after delivery. As a result, 42 states and the District of Columbia now have independent boards to review coverage decisions. These boards partially or fully overturn more than half of all coverage denials--helping patients but thwarting the insurers' efforts to contain costs.

By forcing doctors and hospitals into contracts with fixed prices, managed care lowered the cost of their services--for a while. Now fees are marching up again, and medical inflation is back with a vengeance. The amount of money the U.S. spent on health care shot up 7%, to $1.3 trillion, in 2000--the largest one-year gain since Bill and Hillary Clinton proposed guaranteeing health insurance to all Americans in 1993. Studies analyzing preliminary 2001 numbers have found that health spending rose last year by an even greater amount.

"These escalations are becoming intolerable," says Henry Simmons, president of the National Coalition on Health Care, an alliance of big companies and unions campaigning for more-affordable health care. Indeed, the good times for the industry are coming to an end. The perfect tailwind has pushed health insurers into the perfect storm.

With employers fuming over skyrocketing medical costs, managed-care companies have been scrambling to come up with a new scheme. What's needed is a system that keeps a lid on costs yet gives patients freedom of choice--in other words, a miracle cure. Remarkably, some insurers think they've found one. A growing number are aggressively trying to sell employers on what are known as "consumer-driven" health plans.

Here's how the new plans work. The employer pays each worker $500 to $1,000 in an annual health savings account to use for family medical expenses. Once that money is spent, additional health bills become the responsibility of the employee, until an annual deductible of $1,500 to $3,000 is reached. At that point, a managed-care arrangement kicks in and the employer covers all or most of the medical claims.

The idea is to shift the financial incentive from the insurance companies to the patients, encouraging them to shop around for cheaper drugs and services, or at least think twice about seeing the doctor for a sniffle. The plans are specifically designed to attack what many say is an unwanted legacy of managed care: that patients, "spoiled" by paying piddling $10 to $20 co-payments for office visits or drugs, are almost completely insulated from the full cost of medical treatment.

"The present system doesn't educate consumers," asserts Ken Linde, chairman of the Consumer-Driven Health Care Association and president of Destiny Health, a startup insurer in Bethesda, Md., that offers the new plans. "Our movement is about educating consumers, involving them in the decision-making, and eventually helping to lessen the cost of health care." Education, that is, and instant savings for employers that are right now stuck in a spiral of rising premiums.

"If done right, consumer-directed health plans will be an answer to a prayer that we won't have double-digit inflation," adds Blaine Bos, principal at Mercer Human Resource Consulting, an employee-benefits firm. Just as managed care temporarily succeeded in reining in medical costs in the late '80s and early '90s, says Bos, insurers are betting that consumer-driven health plans will put a lid on soaring rates. "The hope is that this is the next managed care."

Major corporations such as Medtronic, Xerox, and Textron are signing on, and insurance heavyweights, including Aetna, Cigna, UnitedHealth Group, and Wellpoint Health Networks, are all rolling out their own products.

This summer consumer-driven health plans were catapulted into the spotlight when the Internal Revenue Service issued long-awaited tax guidelines. It ruled that money provided by employers for employees' out-of-pocket medical expenses will not be subject to tax. Further, the IRS said, unspent funds in employer-funded health savings accounts can be rolled over from year to year and retained when an employee switches jobs or retires. In announcing the ruling, Treasury Secretary Paul O'Neill was predictably upbeat. "With this new guidance, we clear the way for employers to adopt health plans with patient-directed features so that employees have more choice and greater control over their health-care coverage," he said. Others could hardly contain themselves. In an editorial entitled "Three Cheers for the IRS," the Wall Street Journal declared: "The IRS, of all things, may have started a revolution."

Health insurers are banking on that revolution. But what the industry's executives aren't saying is that the plans are off to a very slow start. Consultants estimate that enrollment, even after an aggressive marketing drive, is below 10% at the employers offering the plans. Consider Aetna, the first national insurer to introduce a consumer-driven plan. Its year-old HealthFund has attracted 17 employers, including Levi Strauss and Toys "R" Us. That's 17 out of the more than 4,000 current customers that are eligible for the new plan. In all but one case, HealthFund, which competes with Aetna's HMO and PPO models, has reached enrollment of less than 5%.

The reason for the low appeal is simple. "This is not a consumer-friendly product," says Princeton's Reinhardt, who refers to the schemes as "smacking-the-consumer-in-the-head health plans." The main problem, he says, is that they heap way too much out-of-pocket cost on the employee--a typical managed-care plan carries an annual family deductible of a few hundred dollars. Says Reinhardt: "Just wait until a huge number of employees are asked to fork over $2,500 out of their own pocket."

Aetna strongly denies its new plan has been a bust. "Employers are really wild about this," says CEO John Rowe. He and other proponents of the new model point out that managed care was also slow to catch on, adding that it will be another year or two before anyone knows if the new plans are successful. As to whether or not they are patient-friendly, Rowe says, "I think we should just let the consumer decide."

As evidence of the plans' appeal, proponents point to Medtronic, a FORTUNE 500 medical-device maker with 26,000 employees. Since it began offering the plan two years ago, 14% of its eligible employees have signed on. The plan, provided by small insurer Definity Health, lets members access web pages to manage their health-care accounts and conduct research through the Johns Hopkins medical library. Members also get access to Definity's national database of 450,000 doctors and information about the going rates for everything from checkups to knee surgeries. David Ness, Medtronic's vice president of compensation and benefits, says the plan is so popular that all but five of the company's 1,300 first-year members reenrolled this year.

Still, there's good reason to believe the new plans may never take off as managed care once did. Why? It's called adverse selection. Many health-care economists predict that consumer-driven plans will appeal more to healthy young workers who have fewer medical bills than do older, sicker people. Healthy families on tight budgets will like the notion of piling up unused funds and rolling them over from year to year. But families faced with serious illness will be scared away by the high deductibles and will choose to stay with traditional managed-care plans. Employers still have to provide insurance for employees with more expensive medical needs. As the young and healthy drop out of the traditional plans, and the plans' percentage of sick people rises, the premiums employers pay for traditional insurance will go up and up. Insurance experts have a scary term for this dynamic: death spiral. It means employers will have to say goodbye to much of the cost savings they expect to derive from consumer-driven plans.

Adverse selection is no pie-in-the-sky theory. It is essentially why Joseph Stiglitz, former World Bank chief economist and head of Bill Clinton's Council of Economic Advisors, and others won the Nobel Prize in economics last year. Among many other real-world applications, the theory explains the need for universal health insurance, in the form of Medicare, for the elderly.

"Philosophically, the consumer-driven concept is a very good idea," says Bruce Bradley, director of health plan strategy and public policy at General Motors, one of the nation's largest employers, with 500,000 workers. "But when it comes down to the practicalities of the marketplace, there are serious problems with it." Bradley adds that adverse-selection fears are the biggest reason GM hasn't offered the new plans to employees--a big knock, considering GM is the largest private purchaser of health care in the U.S.

Supporters of the new plans argue that companies now using them haven't had a significant problem with adverse selection--and that businesses that have shifted all of their workers to the new plans won't, since the workers will have no choice. But almost all large corporations prefer to give employees a selection of health benefit plans. GM is by no means the only business to shun consumer-driven schemes. Overall, 77% of employers say they are unlikely to switch to one in the next five years, according to the Kaiser Family Foundation. "They're not a magic answer," says Kaiser president Drew Altman.

What's looking increasingly likely is that consumer-driven plans will fail--and insurers have no Big Ideas left about how to rein in skyrocketing medical costs. That leaves the industry vulnerable on a number of levels.

For one, there's a growing backlash brewing among employers. Small businesses, which are routinely hit with the biggest rate hikes, are agitating to change a law that prevents them from banding together to form purchasing cooperatives. The idea is that, by working across state lines in trade or professional groups, small employers would gain leverage to fight premium increases. President Bush has voiced strong support for these cooperatives, or "association health plans," and a bipartisan group of more than 100 Congressmen, led by Representative Ernie Fletcher (R-Kentucky), plans to present him with a bill allowing for their creation before year-end.

That's not the only threat. Senator John Breaux of Louisiana, an influential moderate Democrat, is drumming up support for universal health insurance, a proposal that has received little attention, except from labor unions and liberals, since the collapse of the Clintons' health plan nearly a decade ago. Unlike the Clinton plan, which proposed to deliver coverage through employers, Breaux wants to require every citizen to purchase at least a basic health plan and wants the federal government to subsidize those who can't afford one. He could have surprising allies. The California Public Employees' Retirement System, or Calpers, is well known for its success at negotiating affordable health care for its 1.2 million members. But late last year the nation's largest pension fund threw in the towel and joined the National Coalition on Health Care, which favors universal coverage. AT&T, DaimlerChrysler, and 80 other big employers, pension plans, and unions have also signed on. Breaux plans to introduce a bill next year.

Even without additional pressure from Washington or business groups, health insurance companies (and their stocks) may be running out of steam. According to Lehman Brothers analyst Raskin, up cycles--those in which the increase in health insurance premiums accelerates each year--typically last five years. Next year will mark the sixth of this strong pricing cycle. As many investors have learned recently, stock market anomalies don't last forever. Indeed, apparently convinced that the cycle is peaking, top portfolio managers at Vanguard, Longleaf Partners, and T. Rowe Price have been unloading health-insurance shares in droves.

Did someone say perfect storm?

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