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New York City resident M.K. Ramasubramanian has a sneaking suspicion that his medical co-pays are going up a lot faster than health care costs. He used to pay $10 when he visited the doctor -- now insurance requires him to shell out $15. Prescription payments that once were $15 are now $20.

"I don't know what to make of it," says Ramasubramanian, a retiree and member of the Cigna health network. "The cost of health care may have gone up, but I know it's not 50 percent. They're just mopping up revenue here and there where they can get away with it."

Ramasubramanian likens it to subway fare increase: It's little in the grand scheme of things but adds up quickly.

The perception is that managed care companies benefit from higher health care costs because they can raise premiums and potentially add some gravy to their coffers. In practice, it's more complicated than that.

Sure, companies such as United Healthcare, Oxford and Wellpoint could boost rates and expand profit margins, but at some point there will be a backlash from employers, the insured and politicians, which could impose more regulation. It's a fine line to walk.

"Our goal is to deliver consistent performance," Wellpoint CEO Leonard Schaeffer recently told analysts. "We're expanding premiums for cost trends, not to protect margins."

Nevertheless, there could be some profit expansion at work.

"Managed care companies and health insurance companies do benefit from rising health care costs," says Howard Berliner, professor of health management policy at the New School in New York.

According to Berliner, managed care companies are one of the few businesses that can pass on higher premiums. Meanwhile, better efficiencies and management of their subscribers has kept their costs down. For instance, managed care providers such as Aetna, Oxford and Cigna have gained from getting smaller, or dumping customers who are unprofitable -- that is, the ones more likely to get sick, and thus more in need of insurance.

And managed care companies, after a flurry of mergers in the 1990s, have become increasingly efficient. United Healthcare, for example, has used technology to cut costs and smooth out efficiencies. Yet an environment where health care costs are rising gives managed care companies more leeway to raise rates. The resulting spread between premiums and efficiencies could boost the bottom line.

Meanwhile, HMOs have made higher premiums stick because there are less of them these days. "The premium environment has been pretty forgiving," Advest analyst Robert Mains says. "In 1995 and 1996 companies were willing to buy market share, but now there aren't."

In other words, customers have less room to shop around. A survey by Watson Wyatt revealed employers were anticipating a median increase of 15 percent for health care costs in 2003 compared to a median expected increase of 14.7 percent in 2002.

That fact has given managed care companies the ability to pass on increases to customers and preserve margins, analysts say. Those customers, mainly profit-growth-impaired corporations, have passed increases onto workers.

Financials tell the tale. A Merrill Lynch tally of the managed care sector concludes the industry reported $7.19 billion in cash flow from operations, or 1.7 times earnings used to calculate earnings per share. In the fourth quarter, every company except for Cigna exceeded First Call's initial earnings estimates.

Peaking price hikes?

Analysts agree HMOs and the like have been able to pass along increases, but many are wary about how long managed care companies can raise rates. Most analysts expect 2003 to be the peak year for health care cost increases.

"You can't keep building a business on the idea that pricing will go up at double-digit rates every year," Legg Mason analyst Clifford Hewitt says. "Rising costs at double-digit levels with an economy growing at 2 percent to 3 percent is not good."

Managed care companies across the board cite rising health care costs as a future risk in regulatory filings. "Our profitability depends in large part on accurately predicting health care costs and on our ability to appropriately manage future health care costs through underwriting criteria, product design, negotiation of favorable provider contracts and medical management programs," says Aetna in a filing with the Securities and Exchange Commission.

Hewitt argues that managed care companies are boxed in to a degree. HMOs can't reprise their 1990s role of a gatekeeper that restricts care to boost the bottom line. Regulations on the state and federal level have put the kibosh on that idea, and after bad publicity in the 1990s, managed care companies became more lenient and paid for more care. The industry doesn't want to be vilified any more than it has already, Hewitt says.

Simply put, if premiums continue to go up at a rapid clip, employers, consumers and politicos will get involved. "For managed care companies, the bad news is that rising health care costs create a political environment where everyone is looking for someone to blame," says Hewitt. "At some point there's a backlash."

That's why efficiency is the main benchmark to watch in the managed care sector. Analyst favorites include United Healthcare and Wellpoint.

Efficiency is all the more important because rising health care costs makes for an unpredictable market. "The idea that if costs go up 10 percent and premiums also go up 10 percent assumes a clarity of vision," Mains says.

That's why many analysts say the spread between premiums and costs are the key thing to watch among HMOs. For instance, Aetna has been using technology to manage disease and make better predictions. It has also become leaner through layoffs and system consolidation, according to analysts.

A few analysts says the healthcare industry would be better off if costs stabilize. "Counter to some rather silly hypotheses in the market that rising medical costs are positive because companies can raise premiums more during such times, the spread is more likely to be positive during periods of stable or declining medical cost trends," Merrill Lynch analyst Roberta Goodman recently wrote in a report.

Noting that declining costs would smooth political relations and bolster customer goodwill, Goodman says "we would welcome a deceleration in cost trends."

The future

Analysts say that managed care companies are likely to get some breathing room in 2004, when health care cost increases are expected to moderate.

In a Morgan Stanley report, analyst Christine Arnold says HMOs need to move beyond being a middleman. Starting in 2005, the industry needs to become actively involved in keeping the cost of health care down, Arnold believes.

"Products that enable lower rate increases will be better positioned to maintain or even grow membership and attract a more balanced risk pool," she writes.

Hewitt says consumers also need to be educated on the costs of health care and take an active role in keeping them down. For instance, everyone involved in the process needs to understand the trade-offs between a smaller health network and costs.

Easier said than done, given that Americans are accustomed to a high level of care and aren't willing to have restrictions.

"It's tough to see costs coming down since people are living longer and are used to getting a lot of healthcare," Mains says. "If I'm running and blow out my knee I expect a reconstruction that will return me to running. Is anyone going to settle for less?"

Ramasubramanian believes that's a false choice. "I would gladly take a limited network if all the doctors were good," he says. "But the recruitment is pretty spotty."