On Wednesday morning, the Fairfax Press reported that private health insurance companies should brace for reduced profitability after NIB Holdings Limited (ASX: NHF) revealed slowing claims inflation at its AGM.

Accordingly, investors of listed private health insurers NIB and Medibank Private Ltd (ASX: MPL) should keep an eye on developments, as lower premium increases are an ominous sign of slowing growth for the broader private health insurance industry.

This is my take on what you should do about it.

What happened?

At NIB’s AGM on Wednesday, CEO Mark Fitzgibbon announced that the private health insurance industry is undergoing a period of slowing claims inflation, with slower-than-usual cost increases reducing the amount of insurance payouts by health insurers.

Following years of fast-paced increases in both hospital and treatment costs, private health insurers experienced an unusual slowdown in the level of cost rises for health insurance claims.

Though the cause of the slowdown is unclear, it invariably places pressure on the ability of private health insurance companies to raise premiums.

So what?

Private health insurance companies operate in a heavily regulated environment, where annual premium increases are subject to Ministerial approval.

Health insurance premium increase submissions must be made to the Federal Minister for Health by November each year for a private health insurer to increase premiums in April the following year. Last year, both NIB and Medibank negotiated premium increases of an average 5.55% and 6.59% respectively, justified by claims inflation running at 6% to 7% growth on average.

The slowing trend of higher hospital and treatment costs could have a dramatic effect on insurers like NIB and Medibank, given both are unlikely able to justify strong premium price rises in the future. This will, undoubtedly, place pressure on headline revenue growth.

On the flipside, if private health insurance becomes more affordable as a result of lower premiums, both insurers could benefit by increasing policyholder numbers (in absolute terms).

What should you do?

In my mind, even if NIB and Medibank are able to leverage lower/cheaper premiums to substantially increase customer numbers, the sheer nature of their businesses means profitability cannot be accurately projected.

All it takes is one endemic illness, or sustained intra-year price increases to key medical treatments, to crush margins. This, in my view, makes both NIB and Medibank inherently risky investments.

Admittedly, the one saving grace for both NIB and Medibank was the certainty of pre-determined annual premium increases above the annual rate of inflation. However, with the prospects of sharp premium increases diminishing with lower claims inflation, I believe the current shares prices of both insurers place too much pressure on customer growth.

Foolish takeaway

This lack of pricing power and the uncertain nature of private health insurance businesses means investors of NIB and Medibank should demand higher returns for the level of risk being taken.

In my mind, the risk at the current time is too great given the slowing growth prospects and lack of control over pricing increases. Accordingly, I believe investors should wait for better entry points for both stocks.

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Motley Fool contributor Rachit Dudhwala owns shares of Medibank Private Ltd. The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.