(MONEY Magazine) – Rising health-care costs are putting the squeeze on everybody--well, almost everybody. According to the Kaiser Family Foundation, health-plan premiums are up nearly 14% this year, and deductibles and prescription co-pays are rising too. But there's at least one group that isn't feeling your pain: health insurers. Take a look at the earnings statement from Anthem (ATH), the Blue Cross/Blue Shield insurer that's acquiring WellPoint Health Networks (WLP) for roughly $14 billion, creating the nation's largest private health plan. Over the 12 months ended this September, Anthem says its medical costs jumped 10%, but its premiums increased a bit more--about 11%.

That spread has been a boon for Anthem. The company boosted its profits by 15% in the third quarter (vs. the same period last year), comfortably ahead of analysts' expectations. And Anthem's competitors have been recording similarly solid numbers. But after a sharp run-up earlier this year--the S&P Managed Health Care index is up 25% so far in 2003--Wall Street's enthusiasm for the sector seems to be waning. Pessimistic analysts worry that insurers' pricing power is finally beginning to slip and that a long overdue industry slowdown is just around the corner.

Are they right? Or should you use any further dips in insurers' share prices as an opportunity to buy into a profitable, still growing business? To answer this question, there's one thing that any investor in managed-care stocks has to understand: the underwriting cycle.

GOOD NEWS! WE WERE WRONG

For decades, health insurance profits have run in cycles of roughly four years up, four years down. Underwriting profits depend largely on premiums, and those premiums are driven by a tricky mix of guesswork and competition. Let's take the guesswork first. When managed-care providers set their prices for the coming year, they first have to project how much the health-care costs they cover will rise. A number of big insurers guessed wrong about this last year. According to Anthem chief financial officer Michael L. Smith, the company expected its medical costs to rise by 11% to 13%, well above the actual 10% increase. An Aetna (AET) spokesman says that firm overestimated its costs by a similar margin. What happened? Smith cites the dramatic drop-off in hormone replacement therapy, increased use of generic drugs and the fact that pills like Claritin have gone over the counter. Insurers can't always expect such pleasant surprises.

As for competition, witness what took place in the mid-to late 1990s. In an effort to steal market share from one another, companies set their prices too low and many managed-care stocks tanked. In the years since, plans have been setting prices steadily higher in hopes of making up for the damage. The industry's top players have in recent years brought their medical loss ratios--basically, the percentage of premiums paid out in benefits--from around 85% down to around 80%. That figure, industry watchers say, is probably as low as it can get. "That's when employers start pushing back," says Thomas Carroll, health-care analyst at Legg Mason Wood Walker. Politicians eye high insurer profits skeptically, so government action is also a risk. And now that insurers are more financially fit, it seems plausible that they'll begin cutting premiums to win market share again, starting a new cycle.

Smith disagrees, arguing that there is "little incentive for a company in our business to gain market share by pricing below underlying costs." What's changed? The players are bigger. Any company that tried to undercut Anthem on price would still have to match Anthem's network of doctors and hospitals.

It would have to control costs as well as Anthem does too. Larger insurers have more bargaining power and should be able to pay less for hospital beds, physician visits and pills than their smaller competitors do. They can also invest more in cost-saving technologies. And insurers with more data on more people ought to be able to forecast their future costs more accurately. Given all this, the latest managed-care mergers--in addition to the Anthem/WellPoint deal, UnitedHealth Group (UNH) is picking up Mid Atlantic Medical Services (MME)--seem sensible.

Kris Jenner of T. Rowe Price Health Sciences fund thinks Anthem and UnitedHealth look like buys. At $50, UnitedHealth is trading at 14 times its estimated 2004 earnings. Anthem is at $68 with a P/E of 11. "Both stocks are being priced with the cycle in mind," says Jenner. "If that doesn't occur, then these are going to be fantastic."

But there's the rub. We've heard talk about cycles being over before--remember the "end" of the tech cycle in the '90s? The insurance cycle is probably becoming less volatile, but it remains to be seen whether it will really disappear. --ERICA GARCIA