Wednesday 13 March 2019

The great bribe-the-distributor US drug pricing scam

The US Senate Finance Committee recently conducted a hearing investigating galloping list prices for US drugs, quizzing the chiefs of a number of pharmaceutical giants. One of the key messages from these drug companies was that their 'net' received prices, after paying significant rebates to PBMs (Pharmacy Benefit Managers) and insurance companies, are considerably less than 'list' drug prices, and that furthermore, their net prices had been rising at very modest rates, in comparison to spiralling list prices, or even falling. They blamed middlemen for escalating drug prices.

While these apparent deflections of blame are self-serving, and the drug companies are certainly far from blameless (they use, for instance, a lot of unethical 'lifestyle management' tactics to prolong effective patent protection for drugs reaching initial patent expiry), they are, in my submission, largely correct that pricing rebates are a core driver of drug price inflation. Indeed, the functioning of the US's drug rebate system is nothing short of scandalous.

One of the most interesting comments was from Merek CEO Ken Frazier, who said that Merek had attempted to lower the list prices for some of its drugs in the past, but that doing so had put the company at a competitive disadvantage, and so it had been forced to reverse course. Now let's stop and think about this for a second - in how many other industries does cutting your prices lead to a decrease in competitiveness? If cutting prices reduces your competitiveness, it stands to reason that raising them increases your competitiveness, and if that is the case, should we be surprised that drug price inflation has been rampant? Something appears truly broken. 

So what is going on here? The answer is that the third-party-payer model in healthcare has resulted in the industry evolving a 'bribe the distributor' model. The vast majority of end pharmaceutical consumers do not pay out-of-pocket for drugs (although there is often a small co-pay). Instead, insurance companies foot the bill, and due to the (vicious circle) astronomical price inflation that has happened over time, few uninsured customers can afford to purchase the drugs themselves. 

What this means is that only drugs covered by insurance will be prescribed and consumed, and the middlemen - primarily PBMs, working in conjunction with insurance companies - are the ones that get to determine which drugs are reimbursable by being included within insurance coverage plans. In short, they hold the power to determine which drugs have access to the market. They can therefore demand drug companies pay them large price 'rebates' on list prices for reimbursing the drug (which are really nothing less than distributor kickbacks), and threaten to remove drugs from formularies if drug companies do not comply. Where a drug company has the only drug on the market capable of treating a given ailment, this distributor power is lessened (although PBMs still have it in their power to deny customers access to these treatments). However, in the much more common case where multiple treatment options exist, the PBMs and insurance companies hold considerable power. 

One of the important consequences of this is that it effectively creates an incentive for drug companies to raise list prices, because it creates room to provide larger 'rebates' to PBMs and insurance companies to secure market access. Furthermore, there is an incentive for PBMs and insurance companies to favour drugs with higher list prices, as (1) it creates more money to go around, which means more distributor kickbacks; and (2) by raising list prices beyond the realm of affordability to ordinary people, insurance companies guaranty continuing high consumer demand for health insurance (galloping insured costs also justify galloping premiums, so the combination of higher insurance penetration and higher monthly premiums significantly boost insurance company profits).

Here is an example. Let's say treatment A exists and has a list price of $1,000. Let's say the company selling treatment A pays a $400 'rebate' (kickback) to PBMs and insurance companies for carrying the drug. If I come along with a new drug with equal efficacy, but want to charge $500, I'm at a big disadvantage. If I give the middlemen a similar percentage rebate of 40%, I will only be paying the middlemen $200. But why would the middlemen trade a drug on which they make $400 for one on which they make $200? (A meaningful portion of this is 'passed on' to end insured customers - in quotation marks because the practice driver drug price inflation in the first place, so there are no actual savings - but the middlemen still keep plenty of loot for themselves; this also further increases health insurance penetration, as it means access to healthcare is effectively cheaper via insurance).

The practical reality is that if I don't pay the PBMs and insurance companies at least a $400 kickback, they have no incentive to include my drug on their formularies and insurance coverage, despite the drug being just as good (or better) than the existing treatment, and half the price. If my list price is $500, I will therefore have to settle for a net price of $100 or less - only 1/6th of the net price received by the competing pharmaceutical company selling the same treatment at twice the cost, so I will therefore be at a huge competitive disadvantage. I won't be able to afford to spend as much on R&D, and over time I will likely go out of business. This is what Merek's CEO is talking about when he says lower list prices make a drug company uncompetitive.

If, by contrast, I decide to list my drug at $1,500 instead of $500, now a 40% rebate will be $600. Indeed, I could even offer a 60% discount, or $900, and still achieve the same net price as my competitor. Now you have the PBMs' attention. They will likely strongly consider including your drug in their formularies, and dropping the old drug, because they stand to earn significantly higher distribution kickbacks (loot which they share with the insurance companies). But if I attempt to do this, there is a good chance company A will respond by upping the ante and raising their list price from $1,000 to $1,750, to defend their turf. The middlemen, having considerable power to decide who has access to reimbursement, are able to profit handsomely while driving rabid drug price inflation. 

The incentives are truly perverse, and are having many very negative effects on society. The impacts extend beyond denying customers access to cheaper but equally effective drugs, and actively driving absurd degrees of cost inflation (which in turn, leads to escalating health insurance premiums, which lowers consumers' standards of living). It also occasions significant collateral damage amongst the uninsured, for instance. By pushing list prices up without restraint, the result is that those without insurance, who generally have to pay list prices, face potentially financially ruinous costs to access lifesaving drugs, if they can afford them at all. Furthermore, this places pressure on the government to expand the expensive and grossly inefficient Medicare and Medicaid regimes, where 'costs' and 'reimbursements' often mirror private sector practices (indeed, by demanding they pay prices equivalent to the lowest prices paid by private players, they create an additional incentive for industry players to push prices up further still and to refrain from all price discounting), putting significant pressure on fiscal resources, raising taxes and crowding out other spending priorities.

Furthermore, the distributor-kickback model actively contributes to the success of drug companies' 'lifecycle management' programmes, where superficial changes to drugs nearing patent expiry are filed as a new patent, extending effective patent protection for many more years, while also delaying generic competition with these drugs post initial patent expiry. This is because the middlemen have no incentive to see prices for drugs fall, so they have little reason to push back on the lack of added efficacy benefits of extended patents vs. existing generic alternatives, or stimulate more rapid generic penetration by dropping expensive branded drugs coming off patent from their formularies, and substituting generics with comparable efficacy that cost a small faction of the price.

Middleman control over 'who gets reimbursed' also thwarts the ability of increased upstream competition (i.e. amongst drug companies) from translating into lower prices for end consumers. In a well functioning market, what should happen as competing treatment options become available for ailments, and as the industry experiences a 'patent cliff' that allows for rapid growth in generic penetration, is that competition between drug companies should drive a rapid deflation in end-consumer drug prices. However, what has actually happened is that as upstream competition has increased, the gains have been captured by the middlemen. They have been able to play off competing treatments against one another, demanding higher rebates for keeping the drug on their formularies, and are not under any compulsion to pass those gains on to end customers. This has the effect of thwarting declines in end-customer prices; swelling middleman economic rents; and also denying upstream drug companies funds they could use for R&D. 

Continuing my initial example, if the only drug on the market for a condition is drug A at $1,000, the PBMs have little alternative but to carry it, and they have reduced power to negotiate rebates. However, if drug B comes along that has comparable efficacy, instead of the added competition between A and B pushing down the price for end customers, the PBMs play drug company A and B off against each other, demanding higher rebates, and then pocket the gains. The net result has been that list prices for drugs (and insurance premiums) have continued to rise rapidly over the past decade, despite an industry patent cliff and slowing R&D productivity, which should have ushered in a period of rapidly deflating drug prices. 

The system is totally broken. It is corrupt and unethical beyond belief. Something needs to be done about it. The good news is that probes into the esoteric and non-transparent nature of drug pricing are now starting to happen, and there is an incipient push in the US to outlaw the use of rebates (I prefer the term kickbacks - let's call it what it is). That is a good thing and is absolutely needed. Indeed, if implemented, it could be the crowning achievement of Trump's presidency - particularly given that there aren't too many other tangible achievments competing for that spot.

From an investment perspective, the removal of rebates could have very major ramifications, although in and of itself, it will not comprehensively remove the incentive for higher prices. What will also be needed is a far greater level of pricing transparency, as well as regulatory dictates that middlemen act in the best interests of customers, and carry the cheapest drugs where no substantive efficacy differences can be demonstrated. Regular audits/spot checks ought to also occur to ensure compliance, with hefty fines meted out where it is shown PBMs failed to act in customers' best interests. There also needs to be much greater competition in healthcare insurance, and greater transparency on the costs of different health care coverage.

If fundamental reform happens, the impact on PBMs could be quite severe. Insurance companies would also likely be affected to some degree (they are - disingenuously - trying to claim insurance premiums will rise if rebates are removed, but in reality, list prices will fall to current net prices at a minimum, so this is hogwash), as might drug distributors (as they take 4% of inflated list prices, which might be 8% of reduced list prices (net prices), the latter of which are also still grossly inflated in many instances, and because no one has had an incentive to reduce prices in the past, distribution spreads are likely higher than they could/should be). 

In addition, certain drug companies could be decimated. It would be those selling overpriced drugs which are only sustaining market access at current prices because they are paying inflated rebates to middlemen. Many 'specialty pharmaceutical' companies in the US fall into this bucket (e.g. Mylan, Endo Pharmaceuticals, Mallinckrodt, etc), many of which are also very highly leveraged. They will probably all go bankrupt if reform happens and rebates are outlawed.  

However, historical precedent suggests that those hoping for comprehensive reform probably should not hold their breath.