It has been a nerve-racking year for health insurers. Whether it was the possibility of another insurance industry investigation, the flap over Canadian drug imports, or the fears of a Kerry presidency, health insurance stocks took a bit of a smacking through the first half of 2004.

As some of the fear has abated, the stocks have rebounded, and Humana (NYSE:HUM) in particular has been strong. Its stock has been up more than 50% over the past three months and up more than 100% from the 52-week lows.

While management warned on Monday's conference call that pricing competition was not abating, financial performance for the fourth quarter and full-year 2004 was pretty good. While year-over-year comparisons for fourth-quarter revenue and earnings were hurt by a change in the company's TRICARE contracts, full-year revenue was still up over 7%, and the company improved its operating margin by 40 basis points to 3.4%.

Strong cash flow generation has left the firm with around $3 billion in cash and investments. Fools analyzing Humana must remember, though, that various insurance regulatory agencies require certain reserves to be kept. So the company's cash balance is quite strong, but not all of that cash is distributable to shareholders.

Shareholders can take heart in the fact that Humana is also trying to aggressively manage its profitability. By holding the line on pricing and letting unprofitable accounts lapse, Humana is demonstrating that it's not going to sacrifice profits simply to increase the size of the business. What's more, the company continues to try to move clients to more-profitable ASO-style (administrative services only) accounts. As raising premiums becomes more difficult and medical costs stay firm, this sort of profit-oriented mentality will become increasingly important.

At least one other factor in Humana's favor is the relatively high percentage of government accounts (Medicare and TRICARE) in its business. While government business generally isn't quite as profitable as commercial, it tends to be a bit more stable. What's more, the Medicare Modernization Act of 2003 opened the door to many new opportunities for Humana, and the company looks to continue to add to its Medicare business.

Given the strong rally in the shares, Humana no longer presents a compelling valuation story. Though the stock still trades at a discount to its comparable group, Humana's lower margins and returns on capital suggest that at least some of that discount may be warranted. While Humana is undeniably a well-run insurance company, Fools might want to wait for one of the seemingly annual declines to snap up these shares at a better valuation.

Fool contributor Stephen Simpson, a chartered financial analyst, has no ownership interest in any stocks mentioned.