Saturday, 20 January 2018

Why US drug prices have been rising, not falling

The US pharmaceutical industry is fundamentally broken. As has now been widely publicised, drug prices have been rapidly rising for several decades now, and the pace of increase has accelerated in recent years, with the price of a number of low-volume highly-specialised drugs in many cases increasing by several hundred percent. Valeant Pharmaceuticals and Martin Shkreli have been obvious offenders, but the practices have been systemic right across the industry (Shkreli's main mistake was putting up prices a lot in one go instead of steadily over a decade, and doing so with such repulsive smugness).

This continued escalation in drug prices is curious, because what we should be seeing - were markets properly functioning - is continuing and incessant drug price decreases. The productivity of pharmaceutical R&D (defined as the number of new breakthrough drug discoveries as a percentage of R&D) has now been falling for many decades - partly because of diminishing returns to research (the easiest and most effective cures have already been discovered; new therapeutic discoveries are incrementally more difficult to achieve; more costly; and more likely to fail). Newly-discovered drugs only have patent protection for 20yrs, and in most cases, approximately half of that period is consumed by obtaining FDA approvals to commercialise the drugs, so in practice this period of commercial exclusivity is generally a decade or less.

After loss of exclusivity, in theory the field is open for generic manufactures to copy the drug and produce it in high volume at low cost. Because the rate of addition of new essential patented medicines has been falling short of the patent roll-off cycle, drug prices should, in the aggregate, be rapidly deflating as the industry falls off the veritable 'patent cliff'. New competing patented therapies for existing ailments are also regularly being approved, which ought to be pressuring the price of existing patented drugs. And finally, generic companies are free to apply for FDA approval to produce generic drugs for off-patent drugs that already have generic alternatives on the market but which are overpriced, which ought to also be resulting in vigorous price competition and price deflation. And yet we see prices continuing to rise (although the pace of increase has slowed of late - mostly due to increased political pressure and media scrutiny). What on earth is going on?

This is a complicated issue, and I am only part way through my research process on it. It is therefore likely that I am still seeing only part of the picture and have missed many important components of the problem, and that my understanding lacks nuance. Healthcare is not one of my areas of sector expertise. The below is an analysis of just one dimension of the problem - the high cost of hospital pharmaceuticals. I welcome any feedback or criticism, which will help the maturation of my thinking on this important issue. But I feel I have learnt enough to offer some initial insights.

How the drug industry, hospitals, and insurers work symbiotically to inflate prices

Part of what is now a systemic and serious drug pricing problem is this. Hospitals are a big purchaser of pharmaceuticals, and a drug supplier might unilaterally decide to hike prices by, say, 30%. The first issue is that hospitals are not very price sensitive when it comes to drugs and so do not care all that much about price increases, and may not even have the systems to notice the price increase at first. Why is that? Aren't drugs and important cost for hospitals?

Yes and no. What hospitals actually do is on-sell those drugs to patients at a mark-up. If you are getting surgery, and are subsequently billed for the drugs used in that surgery, there is a mark-up on the drugs supplied to you by the hospital. Let's say the initial drug price charged by the drug company to the hospital was $100 a dose. The hospital might mark that up by 20% and sell it to you for $120, making a $20 profit. If the drug company increases the price of the said dose charged to the hospital by 30% to $130, the hospital is likely to continue to mark the drug up by 20%, and so turn around and sell it to patients for $156, but it now makes a $26 per-dose profit, rather than $20.

As long as all competing hospital companies in the region are being billed the same increased price for the same drugs, and that alternative, cheaper therapies are not available and being used by competing hospitals (this could happened due to there being a relatively small number of suppliers, and/or all suppliers hiking prices simultaneously to play the game), the hospital has little incentive to push back against increasing pharmaceutical prices, as those price increases further pad their profits.

But what about the paying customer? What about the patient that is now being billed $156 instead of $120 for the same drug? The fundamental problem is this: third-party payers. In very few instances is the paying customer actually the patient (and even in the rare instances they are, differences in prices at different hospitals are not transparent, and for serious health matters, patents are also relatively price insensitive, which also limits price competition). Instead of the patient, the paying customer is usually either the government (Medicare or Medicaid in the US), or a private insurer.

In the case of Medicare or Medicaid, the hospital sends the government a bill for the 'cost' of hospital services rendered, which includes the cost of the said overpriced, marked-up drugs discussed. The only way the government has to determine whether the 'cost' of the services being billed is reasonable is to compare the price to those charged by other competing hospitals in the area. But all providers are playing the same game. After surveying prices across the board in the area, the government concludes that the billed amount is roughly the 'market price' of the hospital services rendered, and provides reimbursements to providers. When the price of these reimbursements increases, the cost is borne by society as a whole through higher taxes (or in the short run, an increase in the fiscal deficit).

Furthermore, the people making these assessments are government employees, and they are not paying these inflated care costs out of their own pocket, so they have no real incentive to object to rising prices. Indeed, how many people go to work for Medicare or Medicaid because they want to provide less medical services to the needy, or at lower cost? Not many. Most of the employees in these departments want healthcare spending to rise, as they perceive it to be synonymous with increased levels of care to the needy, so unsurprisingly, the level of push-back to price increases from these institutions is limited.

The other third-party payer is private insurance companies. Surely they have an incentive to reduce claims costs, since they are profit-seeking private enterprises that are paying claims out of their own pockets? The answer here is counter-intuitive. If insurers' aggregate claims costs rise, what they do is increase premiums to maintain their profit margins (I'm sure many readers are familiar with the loss of one's 'no-claims bonus' on their auto insurance policy after filing a claim).

Indeed, insurers have no incentive to see claims costs fall, as a general trend, in much the same way that hospitals have no incentive to see pharmaceutical prices fall. Health insurers generally make a pre-tax profit margin of roughly 5-10% on total premiums. Let's say an insurer's total premium income is $1,000, and their profit margin is say 7.5%, or $75, after paying claims costs of say $750, and operating expenses of $175 (the claims ratio is high in the US both because it is inflated by overpriced care, and because insurers' claims expense ratios are required by regulations to be high - something which has the unintended consequences of providing further incentives to inflate claims). 

If claims costs rise by 10% to $825, the insurer is likely to turn around and raise premiums by approximately 10% as well, to $1,100, so as to maintain a 75% claims ratio. If operating expenses were to remain unchanged, the insurer's profits would rise to $100, and it's profit margin on its higher premium volume to 9.1%. Consequently, somewhat counterintuitively, insurers also have no incentive to push back against rising prices, because much like the hospital, they also benefit from rising prices.

This works for insurers so long as the cost of claims is rising for competing insurers as well. And they are/will be, because if hospitals are putting up prices for care across the board (because pharmaceutical companies are pushing up drug prices across the board), all insurers will simultaneously see rising claims costs, and hence will all look to put their prices up.

This peculiarity is not unique to healthcare insurance. Some observers have expressed concern that climate change and an increased incidence of extreme weather might be negative for the global insurance industry (through an increased incidence of costly claims). That perspective is understandable but misguided. In the long run, P&C insurers would actually benefit from increased damage from extreme weather, as it will cause premiums to rise. Conversely, autonomous self-driving cars that reduce the incidence of road accidents to negligible levels will be a disaster for the auto insurance industry, as premiums will plummet alongside a collapse in claims.

But what about the people paying the rapidly-rising cost of health insurance premiums? Firstly, in the US, those people are usually employers rather than employees (health insurance is generally provided by employers in the US as part of an employee's compensation). Economically, the burden is borne by employees, as employers deduct the cost of providing health care coverage from the gross compensation they are prepared to pay their employees (and it is arguable that one cause of the stagnation in US real middle-class wages since the 1970s has been the rapidly-rising cost of employer-paid healthcare insurance). However, the actual payer is the employer, and there is little transparency to the ultimate payer - the employee - about how much they are actually paying for health insurance. All employees see is a reduced pace of growth in their cash compensation.

Furthermore, even if employers would like to keep down health insurance costs, because that would allow them to pay their employees more (or earn higher profits), if all health insurers have been raising their premiums at the same time (because all hospitals have been raising the prices at the same time, because all drug companies have been raising their prices at the same time), employers have little in the way of superior choices. They could attempt to self-insurer - some have - and pay employee healthcare costs to providers directly out of their own pocket. But they will then face the same problem the government or insurance industry faces in trying to source providers offering lower rates (indeed to an even greater extent, given their reduced bargaining power) - all providers will be offering high prices, due to their high 'costs'.

In short, the entire system has embedded within it, incentives for all commercial players to raise prices, because the consumers of healthcare services (patients) are generally not the direct payers for those services. Ultimately, patients do pay - through higher taxes and higher health insurance premiums, effectively deducted from their compensation - but they do not pay directly or transparently.

The system is broken, but what can be done?

It is a tremendously broken system, that is imposing high and rising social as well as economic costs on society. Firstly, large amounts of societal resources are being directed to the purchase of overpriced healthcare services. This results in much profiteering by the few (primarily healthcare service providers), to the detriment of the rest of society, who must pay higher taxes and accept reduced gross pay, in order to finance all this largess. Furthermore, those that lack insurance and/or Medicare or Medicaid coverage can find themselves financially ruined in the event they suffer an unanticipated and uncovered health emergency, as they are forced to consume overpriced medical care (the trend of growing medical tourism is one mitigant, but is unavailable for emergency, non-elective care).

Furthermore, that is not even the worst of it. The system also has deeply embedded within it not just the incentive to raise prices, but also to increase the amount of patient volume. This results in financial incentives for overdiagnosis; excessive testing; unnecessary surgeries; and an over-prescription of pharmaceuticals (how many people have been to the doctor and not been subscribed pharmaceuticals, and rather told just to get some rest? It almost never happens. Think about it).

Something needs to fundamentally change to fix this mess. One way would be to move to a first-party-payer system, along with a mandated increase in price transparency. If this were to occur, the whole horror movie described above would play out in reverse. Prospective patients would balk at high prices, and/or be unable to afford them, so they would seek out the cheapest hospital alternatives. This, in turn, would provide incentives for hospitals to offer lower prices, in order to secure increased volumes. In order to do so, they would seek to lower costs, and one way they would do that would be to try to find more competitively-priced pharmaceuticals.

Pharmaceutical companies would then be incentivised to provide lower prices in order to secure increased volumes (and the FDA speeding up its approval process for new generics would significantly assist in this regard, by increasing supply; under Trump, the FDA has recently been moving in this direction). Pharmaceutical prices would then begin to fall. This is how normal market forces work, and it is why in competitive markets, we see a pattern over time of falling prices; rising quality; and a high level of customer responsiveness and customer service. The US healthcare system is broken because market forces have been thwarted, and incentives distorted by government policies.

Unfortunately, politically, this would be almost impossible to implement. Howls and wails about the masses being deprived of healthcare would be sure to occur, and most of the electorate would be terrified they would face financial ruin were government coverage and/or their private insurance to be withdrawn. Accustomed to seeing healthcare prices rise inexorably for 40yrs, it would be almost impossible for most people to believe that healthcare prices would soon plunge to affordable levels.

In addition, the social concern of the less well off being unable to access healthcare is a legitimate one. Even with healthcare costs heavily deflated, there is still a significant concern to be had about the social consequences of leaving healthcare purely to the free market. If someone is poor and cannot afford a new plasma TV screen or iPhone X, and have to make do without, that is merely unfortunate. However, if someone cannot afford urgent medical care and dies, that is an absolute tragedy. I am absolutely sympathetic to that reality, and so agree that healthcare cannot be left purely to the free market. However, the current system in the US is completely broken, and needs to change.

Treading wearily from an investment perspective

From an investment standpoint, I am still largely standing clear of the healthcare industry, for several reasons (I have a small position in Gilead Pharmaceuticals, and that is all). Firstly, I still don't understand it very well; secondly, it is relatively expensive (although with some clear exceptions now), given its long track record of strong growth and high profitability, as well as the obvious demographic tailwinds working in support of the industry long term; and thirdly, there is so much unethical and, probably, unsustainable profiteering happening in the industry, which is fast approaching a breaking point now that US healthcare expenditures have reached an astonishing 18% of GDP. Financial necessity is going to force change at some point, and there could be absolute carnage in the industry if and when that eventually happens. Given the formidable obstacles to reform, however, it is unlikely to happen any time soon, and it may ultimately require a financial crisis to force the issue.

Comments and questions welcome. I would particularly appreciate being pointed towards any helpful resources that could help me deepen my industry understanding.


*For those interested in further reading, I highly recommend H. Gilbert Welch's book Overdiagnosed: Making People Sick In The Pursuit of Health, and David Goldhill's book Catastrophic Care: How American Health Care Killed My Father - And How We Can Fix It.


  1. I, too, am not very educated on this topic, but ] a quick search seems to suggest the margins of a company like GSK has actually deteriorated over time. (

    From the perspective of a consumer, I would say a lack of transparency and readily available benchmarks (price comparison websites) makes it difficult to challenge the price you are quoted.

    1. Thanks Ethan. We have indeed seen some emergent weakness in drug prices here and there over the past few years, as drug price increases have become increasingly politicised and exposed to media scrutiny.

      However, the general trend is still one of rising prices, and there is likely a much bigger fallout coming at some point.

      A lack of transparency is indeed a big part of the problem. Also the incentives baked into the system - often the providers who prescribe medicines after your doctors visit also benefit from high drug prices (and quantities prescribed), as they are more profitable. They know that the if the patient is covered by govt or private insurance they are not paying out of pocket, so they will often prescribe expensive drugs even when they know a cheaper generic version is available.

      It's a complex problem with lots of complex drivers, but at the end of the day it all boils down to bad incentives.