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Merck Data Discredits PBM-Sponsored Study of Brand Drug Price Inflation

Lawrence W. Abrams No Comments

Summary

We present data supplied by the drug company Merck that discredits a study sponsored by the pharmacy benefit manager (PBM) trade association showing no correlation between PBM rebate rates and brand drug price inflation.

Introduction

The management of the prescription (Rx) drug benefit portion of health care plans has become the domain of contracted specialists called pharmacy benefit managers (PBMs).

The three largest, independent PBMs — Express Scripts, CVS Health,  and Optum Rx, (known as “The Big 3”) control 73% of the total Rx claims processed the United States in 2015.

Since the early 2000s, PBMs have continually come under attack for not acting in the best interest of their clients.  We have written a number of papers since 2004 pinpointing an opaque reseller business model as the source of this misalignment.

In a 2017 paper, we have presented the case that there have been 3 distinct phases of the PBM business model over the past 15 years demarcated by radical shifts in the primary source of gross profits:

  1. up to 2005 — reliance on retained rebates from small molecule brand drugs;  
  2. 2005 – 2010 — reliance on mail order generics Rx margins;
  3. 2010 – today — reliance on retained rebates from specialty drugs.

To compensate for declining mail order generics Rx margins after 2010, PBMs saw the rising trend of specialty and biotech drugs as a promising basis for a renewed reliance on retained rebates.

But there are several constraints today on this phase of the PBM business model.

The first constraint in that the specialty drug Rx volume “basis” for collecting rebates today is a lot less than it was ten years ago when small molecule drugs were the basis for rebates.

The second constraint is a newfound awareness by clients of PBMs that retained rebate dollars can be substantial yet an opaque source of PBM gross profits.   As a defensive move, CVS Health finally declared publicly on their website that,

“CVS Caremark was able to reduce trend for clients through… negotiations of rebates, of which more than 90 percent are passed back to clients.”

The problem facing PBMs today is how to derive a majority of gross profits from specialty Rx while maintaining a transparent rebate retention rate at 10% on average.

In order to show how PBMs can overcome these constraints,  we have deconstructed data supplied by the drug company Merck (see below) that depicts a growing a divergence between their list prices for brand drugs (gross) and the prices they receive after deductions of rebates paid to PBMs (net).

This growing divergence has come to be known as   “gross-to-net rebate bubble”   Other drug companies are publishing similar data as a way of defending themselves against charges of double-digit price-gouging tactics.

This is a graphic depiction of Merck’s gross-to-net price bubble:

Our deconstruction of the Merck data lays out a step-by-step sequence of how PBMs and drug companies might negotiate the parameters of a rebate deal today under the constraint that PBMs have to grow gross profit DOLLARS over time while fixing the rebate retention rate at 10%.

We can use the same Merck-supplied data to plot annual % increases in list prices (line 1 above) against the annual negotiated rebates and discounts as a % of the list prices (line 3 above).  The result shows a significant positive correlation coefficient ratio of .653

PBMs Under Attack for Causing Drug Price Inflation

In January, 2017 newly elected President Donald Trump attacked drug companies in press conference for “getting away with murder” by raising drug prices at double-digit rates in recent years.

Since the Trump rant,  there have been articles in the New York Time, the Los Angeles Times and other publication where both retail pharmacists and drug companies are quoted as saying it is PBMs that drive drug price inflation.  Here is a quote from the New York Time article,

“Want to reduce prescription drug costs?” the pharmacists argued during their visits. “Pay attention to the middlemen.”

The PBM-Sponsored Study

The PBM trade group association Pharmaceutical Care Management Association (PCMA) commissioned a study by the health care consulting company Visante to provide data relevant to the issue of the causes of recent drug price inflation.  

In April 2017, the PCMA announced in a press release that results of the Visante study were available on-line.  The key result:

“There is no correlation between the prices drug companies set and the rebates they negotiate with PBMs”

The press release also provided a quote by PCMA President and CEO Mark Merritt:

“This study debunks the notion that the prices drugmakers set are contingent on the rebates they negotiate with PBMs…”

Below is a screenshot of the graph depicting the finding of “no correlation”

Reconciling Differences in Results: A Question of Sample Chosen

The Merck data shows a significant positive correlation between annual brand drug list price inflation and annual rebates rates that Merck has negotiated with PBMs.  The PBM-sponsored study shows no correlation.

Obviously, a key reconciling difference revolves around the sample chosen.  

The Merck results are heavily weighted by three brand drugs.  Merck has reported In its 2017 annual 10-K report that about one-third of its drug sales comes from three brand drugs: (1) the diabetes drug Januvia; (2) the cholesterol drug combinations Zetia/Vytorin; and (3) the cervical cancer prevention vaccine Gardasil.  

In terms of rank among the top 200 selling brand drugs, Januvia ranked #19, Zetia #38, and Gardasil #56 according to a 2015 listing.

Each of these drugs are what we call highly “rebatable” — in therapeutic classes where there are a number of other brand that are therapeutically equivalent.  

Merck competes vigorously with other drug companies for preferred status on formularies which list drugs approved by PBMs for coverage.  Competition insures that winning bids are high for placement in these therapeutic classes.  Merck has to “pay to play” and covers higher and higher rebate percentages paid to PBMs with list price inflation.

To achieve such high rankings,  it means that Merck must be winning placement for its top selling drugs with each of the Big 3 PBMs who control collectively 73% of the market.

While Merck’s sample size is small compared to the PBM-sponsored study, Merck’s data represents the essence of what has been going on between Pharma and Big 3 PBMs since 2010.

The sample size of the PBM-sponsored study is much larger. It contained a

“sample of the top 200 self-administered, patent protected, brand-name drugs, 24 drugs were excluded because of incomplete data for the study time period, leaving a remaining sample of 176 drugs for analysis”.

First, the initial sample size of 176 was aggregated in 23 therapeutic classes with the averages used in plots.  No mention is made as to whether the 23 data points represent simple or averages weighted by revenue.  In any case, samples of averages smooth out differences in the raw data.

Second, the larger sample size could contain significant number of drugs that just are not “rebatable” — in “aging” therapeutic classes with a 4+ brand drugs that are therapeutically equivalent (“me-too drugs”) plus a number of off-patent, low cost generic drugs.

In short, we believe that the sample used in the PBM-sponsored study is a smoothed-out representation of the outcomes of negotiations between drug companies with “rebatable” brand drugs and the Big 3 PBMs.

 

Blame Pharmacy Benefit Managers For Driving Drug Price Inflation

Lawrence W. Abrams No Comments

Summary:

We start with a review of the history of the opaque pharmacy benefit manager (PBM) reseller business model. We present our prior estimates of the distribution of PBM gross profits over the past decade showing that they have become dependent today on retained rebates from specialty drugs.

Next, we present numbers showing how PBMs today have painted themselves into a corner with a relatively small basis for drug rebates coupled with promises to hold their overall average rebate retention rate, a term we coined in 2003, to a “reasonable” 10%.

We conclude the paper with a deconstruction of the growing divergence between brand drug list prices (gross) and the prices Pharma actually receive after PBM rebates (net) — the so-called “gross-to-net price bubble”.  We use data supplied by the drug company Merck to go through a step-by-step sequence of how PBMs and drug companies might negotiate the parameters of a rebate deal today under the constraint that PBMs have to grow gross profit DOLLARS over time while fixing the rebate retention rate at 10%.  

We show that the outcome of such constrained negotiations produces a gross-to-net price bubble.

The “Gross-To-Net Price Bubble”

Before 2017, there had been two well-publicized exposes of massive increases in the list price of off-patented brand drugs that were rubber-stamped by pharmacy benefit managers (PBMs).  This included Mylan’s EpiPen and Martin Shkreli and his Turning Pharmaceutical’s HIV drug Daraprim.

There are now numerous reports providing quantitative evidence of outrageous increases in specialty brand drugs list prices over the past 5 year.  For example, consider this table of list price inflation between 2012-7 of Multiple Sclerosis drugs taken from Congressman Michael Vounatsos’ request to manufacturers for more information:

In April 2017, Adam Fein first reported on his blog Drug Channels that the health information company QuintilesIMS had just published  aggregate trend data for brand name drug prices before (gross) and AFTER rebates (net) had been paid to pharmacy benefit managers (PBMs).

The data showed  two trends beginning in 2011: (1) gross prices were growing faster than net prices; (2) the divergence itself was growing.

Dr. Fein coined the term “gross-to-net rebate bubble” to describe (2) above, which has become the standard lexicon for the phenomena. Below is graph summarizing QuintilesIMS latest findings taken from an April 2017 blog post by Dr. Fein:

The PBM Business Model:  2005 – 2010

In an earlier 2017 paper, we presented the case that there has been three distinct phases of the pharmacy benefit manager (PBM) business model over the past 15 years. Each has been demarcated by radical shifts in their primary source of gross profits:

  1. up to 2005 — reliance on retained rebates from small molecule brand drugs;  
  2. 2005 – 2010 — reliance on mail order generic Rx margins;
  3. 2010 – today — reliance on retained rebates from specialty drugs.

Below is graph of our estimates of the distribution of PBM gross profits over the past 15 years.

The majority of PBMs gross profits between 2005 – 2010 came a mail order generic Rx.   The Big 3 PBMs devised a strategy of tacitly colluding with their counterpart Big 3 retail pharmacies — Walgreen, CVS, and Rite-Aid — to hold up margins on generic Rx fills.  

Essentially the Big 3 PBMs have the power to set their competitors’ prices, an anti-competitive weapon if there ever was one.   PBMs gave retailers fat margins for 30-day generics in return for promises not to compete on 90-day Rx.  Then, PBMs set the prices of generic Rx filled by captive mail order operations slightly less than retail to give the appearance of alignment with client interests.  But, the supply chain hold up still allowed for fat mail order generic Rx margins.

The first blow to this scheme came in late 2006 when Walmart saw the fat retail margins and began a disruptive  $4 / generic Rx campaign. They could do this as an “outsider” retailer because their business model wasn’t dependent on fat pharmacy margins subsidizing the rest of the store.

The final blow to this “hold-up” scheme came around 2008 several years after the vertical merger of the pharmacy retailer CVS and the PBM Caremark.   Consistent with the business model of the merged company, CVS-Caremark began offering preferred provider pharmacy networks featuring lower  unit prices at retail in return for Rx volume.  

While this managed care technique is used successfully in reducing hospital and physician costs, it has never really been instituted by PBMs prior to the CVS-Caremark merger.  This absence had been an obvious sign to us at the time of tacit collusion between the Big 3 retail pharmacies and the Big 3 PBMs.

The PBM Business Model: 2010 – today

To compensate for declining mail order generic margins after 2010, PBMs saw the rising trend of specialty and biotech drugs as a promising basis for a renewed reliance on retained rebates.

But there were several problems with the goal of deriving a majority of gross profits from specialty drug rebates.    Reconstructing how PBMs solved these problems is the key to understand why PBMs, not Pharma, drive the gross-to-net drug price bubble today.

First, assume that since 2010, the Big 3 PBMs needed additional gross profits each year from specialty drug retained rebates to replace incremental losses in margins from mail order generics Rx.

This creates a problem in that the specialty drug Rx volume “basis” for collecting rebates today is a lot less than it was ten years ago when small molecule drugs were the basis for rebates.  How much less?  The Pew Charitable Trust Foundation sponsored a study which found that in 2015 special Rx comprised only 1% of total Rx.  

A decade ago, we estimated that about 20% of total Rx filled were “rebatable” brand drugs, i.e. in therapeutic classes with a few other brand drugs that were therapeutic equivalents.  So instead of 1:100 specialty Rx to total Rx basis differential, we arrive at a 1:20 “rebatable” specialty drug Rx to “rebatable” small molecule brand drug Rx basis differential.

In other words,  ten years ago PBMs has 20 times the volume of Rx available to them to use as a basis for generating retained rebates as they do today.

The second constraint that PBMs have today is an the awareness by their clients that retained rebate dollars can be substantial yet opaque source of PBM gross profits.    

Today,  there seems to be an order of magnitude more articles critical of PBMs in general, and retained rebates specifically,  As a defensive move, CVS Health finally declared publicly on its website that,

“CVS Caremark was able to reduce trend for clients through… negotiation of rebates, of which more than 90 percent are passed back to clients.”

The problem facing PBMs today is how to derive a majority of gross profits from specialty Rx while maintaining a transparent rebate retention rate at 10% on average.

The business model of the drug companies is simple and stable by comparison.  Sure, drug companies want to maximize profits just like the PBMs.  But drug companies are not constrained as much as the Big 3 PBMs and don’t need a convoluted gross-to-net price scheme to achieve their targets.

It is important to remember that it takes two parties to negotiate drug rebate deals. Drug companies have some power in determining how these deals are structured, especially if there are only one or two other brands drugs that are therapeutic equivalents.

The Big 3 PBMs today have a lot of power in rebate negotiations.  Drug companies have a lot to lose if negotiations fall through.  Exclusion of a single drug from one of Big 3 PBMs’ national lists of drugs covered by an insurance plan  — called formularies — can cost a widely-used or expensive drug $3+ Billion dollars in lost revenue.

It is the Big 3 PBMs who drive schemes involving high-list-price / high-rebate specialty drug deals.  For now, drug companies are accomplices along for the ride. They are culpable, but much less so than PBMs.  

A Deconstruction of Merck’s Gross-to-Net Drug Price Bubble

We conclude the paper with a deconstruction of the growing divergence between brand drug list prices (gross) and the prices Pharma actually receive after PBM rebates (net) — the so-called “gross-to-net price bubble”.  We use data supplied by the drug company Merck to go through a step-by-step sequence of how PBMs and drug companies might negotiate the parameters of a rebate deal today under the constraint that PBMs have to grow gross profit DOLLARS over time while fixing the rebate retention rate at 10%.

We show that the outcome of such constrained negotiations reproduces produces a gross-to-net price bubble.

Below is a screenshot from a Merck memo laying out for all to see their “gross-to-net drug price bubble”.  Other drug companies are publishing similar data as a way of defending themselves against charges of “double-digit” price-gouging tactics.

This is a graphic depiction of Merck’s gross-to-net price bubble:

Below we build a spreadsheet which “deconstructs” Merck’s bubble for a hypothetical specialty drug.  It  shows how PBMs can grow retained rebates dollars via a combination of growing rebate percentages while maintaining a retention rate fixed at 10%.

A larger view of the spreadsheet above:

 

Note that despite being constrained to a 10% rebate retention rate, this deal scheme give PBMs yearly retained rebate DOLLARS that are 176% greater that what they received 6 years earlier.

Some have predicted that the divergence between gross and net prices will level off after 2017.

We tend to agree with that prediction as the current bubble was fueled by PBMs’ need to REPLACE a declining trend in gross profits from mail order generic Rx.  With that loss fully offset, PBMs could grow gross profits in the future by maintain a steady divergence between list prices and net prices.

Three Phases of the Pharmacy Benefit Manager Business Model

Lawrence W. Abrams No Comments

We present the case that there has been three distinct phases of the pharmacy benefit manager (PBM) business model over the past 15 years. Each phase has been demarcated by a major shift in the dominant source of gross profits.

These radical shifts in the primary source of gross profits in such a short period of time is unprecedented among Fortune 50 companies.  This is indicative of the opaqueness of the PBM business model to their downstream customers — health care plan sponsors.  

It is also indicative of PBMs’ relative power to negotiate rapid changes in payment streams from upstream suppliers — the Big 3 retail pharmacies and drug companies.   These upstream suppliers and the Big 3 PBMs make up two sides of intermediate market bilateral oligopolies.

It is instructive to understand why PBMs had to recalibrate their business model twice now in the last 15 years.  In today’s terminology,  what “disrupted” this powerful cartel? Our examination of recent history suggests that  government regulations and lawsuits have had little impact on PBM decisions to change their business model.  

Rather, our view is that the disruptors have been “rent-seekers” whose business models were not in alignment with the rest of the cartel.  This included the emergence of a vertically integrated PBM in the form of CVS-Caremark and the powerful outsider Walmart with a business model that allowed for the retail pharmacy to be a “loss-leader”.

Below is a spreadsheet which summarizes the data sources for our estimation of distribution of PBM gross profits over the past 15 years.

Below is a graph of our estimates of PBM gross profits share by source over the past 15 years indicating that there have been 3 distinct periods where a different source dominated.

In support of our contention of the replacement of lost margins on mail order generics with retained rebates after 2010, we present data assembled by Adam Fein  estimating total rebates to PBMs and discounts to drug distributors between 2007 – 2016.   Note that the total increases was 126% between 2010 and 2016.

 

The Pharmacy Benefit Management Business

PBMs provide a bundle of managed care services designed to provide a cost-effective prescription (Rx) drug benefit to plan sponsors and their members.  The PBM bundle includes the following list of services:  

  1. create a retail preferred provider pharmacy network and negotiate brand and generic Rx reimbursements;
  2. provide 90-day Rx exclusively from captive mail order pharmacies;  
  3. provide specialty (high priced and biotech) drugs Rx from captive specialty pharmacies;
  4. create a formulary — a look up table that restricts fills to preferred drugs — and negotiate rebates with Pharma in return for placement;
  5. provide other Rx cost-saving measures such as prior authorization, step-therapy, quantity limits, and co-pays.   

Concentration in the PBM Business

The three largest PBMs today — Express Scripts, CVS Health,  and Optum Rx, (known as “The Big 3”) control 73% of the total Rx claims processed the United State in 2015.  

Prior to 2013, the Big 3 PBMs were Express Scripts, Medco, and Caremark with a combined concentration similar to today.  The concentration in the PBM industry today has been the result of a series of horizontal mergers mistakenly approved by the Federal Trade Commission (FTC).

In 2004, there was a horizontal merger between #3 PBM Caremark and #4 PBM AdvancePCS.

In 2007, there was, in our opinion, a disruptive pro-competitive, vertical merger between #2 retail pharmacy CVS and #2 PBM Caremark. At the time, #1 PBM Express Scripts make a hostile bid for Caremark, but withdrew over concerns over the length of antitrust investigations by the FTC.

In 2012, there was a horizontal merger between the #1 PBM Express Scripts and #3 PBM Medco.  In our opinion, this anti-competitive merger was mistakenly approved by the FTC with a one vote majority.  The deciding vote was made by a President Obama appointee, and Harvard Law School classmate, Edith Ramirez.  In our opinion, Edith Ramirez has cost the American public $75+ Billion in excessive Rx costs over the past 5 years —   5 times an estimated inflated 5% of $300 Billion in yearly Rx drug expenses.

In 2013, the largest health insurer in the USA, UnitedHealth Group,  ended its long running PBM contract with Medco, now owned by Express Scripts.  To handle its own PBM needs, UnitedHealth created an internal unit OptumRx. It grew the unit via taking business away from CVS and Express Scripts and via a 2015 purchase of the tech-savvy PBM Catamaran.

The Pharmacy Benefit Manager Business Model

Since the early 2000s, PBMs have continually come under attack for not acting in the best interest of their clients.  We have written a number of papers since 2004 pinpointing an opaque reseller business model as the source of this misalignment.

The PBM reseller business model is in stark contrast to the two other transparent business models used by managed care companies:  

  1. a self-insurance agency model with 100% pass through of claims expenses to plans accompanied by per-member-per-month (PMPM) management fees;
  2. a risk-based insurance model with capitated premiums paid by plans.

The way companies monetize their businesses — a key component of their overall business model — is a choice.  Often companies sell bundles of products and services and make strategic decisions to monetize one component at a higher margin rate than another component.  Disguising gross profit margins by line of business or bundle components is considered a good business practice.

Take, for example, General Motors. It aspires to build great cars, yet a good share of its gross profits comes from car finance. McDonald’s aspires to offer customers a great tasting hamburger, yet the company has a higher markup on beverages that it does on food. Best Buy recoups slim margins on consumer electronics products with fat margins on extended warranties.

So why should the opaque PBM reseller business model be judged differently than, say, Best Buy’s?  Aren’t PBMs subject to ERISA laws mandating fiduciary responsibility — i.e. acting in best interest of clients?  

Actually no, according to court cases.  It is up to clients of PBMs to hold them accountable for claims that they act in clients’ best interests.  It is up to clients of PBMs to pressure them to offer alternative, more transparent business models.

The Evolution of the PBM Business Model

The PBM business model has evolved considerable over the past 20 years both in terms of the array of managed care services offered and the corresponding distribution of gross profits.

In 2001, PriceWaterhouseCoopers  published an excellent business history of PBMs to that date.   PBMs started out in the 1980s as computer networking specialists who automated Rx claims processing by connecting retail pharmacy point of sales terminals to back-office health insurance mainframes.  

Between 1980-1990, PBMs’ prime source of revenue was claims processing fees.  PBMs only focus was minimizing claims processing costs, a goal totally in line with the goals of their clients.

The excellent PriceWaterhouseCoopers PBM history did mention that PBMs tried a totally transparent insurance premium business model in the early 1990s. But, they abandoned it after a few years due to losses caused by unexpected mid-year increases in unit drug costs and uncontrollable, Pharma-initiated direct-to-consumer advertising campaigns that greatly increased utilization.

The current PBM business model features five major streams of revenue and gross profits:

  1. “spread margins” on top of retailers’ own margins and lately, direct and indirect reimbursement (DIR) fees, that are collected from retail pharmacies in return for being included in their networks;
  2. claims processing and data fees;
  3. rebates given by Pharma on small molecule brand drugs in return for preferred status on formularies;
  4. rebates give by Pharma on speciality (biotech) drugs in return for preferred status on formularies;
  5. profit margins on 90-day generic Rx filled by captive mail order operations.

Since we began following PBMs in 2002, the distribution of gross profits has changed dramatically. These radical shifts in such a short period of time is unprecedented among Fortune 50 companies.

These radical changes are indicative of the opaqueness of the PBM business model to their downstream customers — health insurance plan sponsors.  It is also indicative of the power of the Big 3  PBMs to negotiate rapid changes in payment streams with upstream suppliers — retail pharmacies and brand drug companies –who tacitly collude with them in two intermediate market bilateral oligopolies.

We see 3 distinct phases of the PBM business model over the past 15 years demarcated by radical shifts in the primary source of gross profits:

  1. up to 2005 — reliance on retained rebates from small molecule brand drugs;  
  2. 2005 – 2010 — reliance on mail order generic Rx margins;
  3. 2010 – today — reliance on retained rebates from specialty drugs.

Phase 1:  Retained Rebates from Small Molecule Brand Drugs

Phase 1 ended in 2005 after blog posts started appearing which disaggregated the 10-Qs and 10-Ks of Medco’s business model revealing outrageous rebate retention rates.  There was also a 2004 lawsuit initiated by U.S. Philadelphia District Attorney Patrick Meehan (now Congressman) accusing Medco of switching mail order generic Rx to higher priced rebatable brands.  As part of the settlement, Medco agreed to inform plans of gross rebates received and their rebate retention rates.

For 3Q04, we derived with certainty from Medco’s 10-Q that 71% of its gross profits came from retained rebates from small molecule brand drugs.  By 2Q05, we estimated with certainty that Medco’s retained rebate share of gross profits had dropped to 48% with the difference going to their newly found focus on mail order generics.

We have written extensively about the Pharma – PBM bilateral oligopoly that enabled this phase of the PBM business model.  Rather than rehash this, we refer to the following papers downloadable for free from our website:

  1. Pharmacy Benefit Managers as Conflicted Countervailing Powers , January 2007
  2. Who is Best at Negotiating Pharmaceutical Rebates?  December 2005
  3. PBMs as Bargaining Agents Paper presented at the 80th Annual Western Economic Association Meeting, July 6, 2005, San Francisco
  4. PBMs as Bargaining Agents PowerPoint presented at the 80th Annual Western Economic Association, Meeting, July 6, 2005, San Francisco
  5. The Effect of Corporate Structure on Formulary Design: The Case of Large Insurance Companies Poster Presentation, ISPOR 10th Annual Meeting, Washington DC, May 2005
  6. The Role of Pharmacy Benefit Managers in Formulary Design: Service Providers or Fiduciaries? Journal of Managed Care Pharmacy Vol. 10 No. 4 July/August 2004 pp 359-60

Phase 2: Mail Order Generic Rx Margins

The “interregnum” Phase 2 featured a successful replacement of retained rebates with mail order generic margins.   The Big 3 PBMs devised a strategy of tacitly colluding with the Big 3 sell-side retail pharmacies  — Walgreen, CVS, and Rite-Aid — to hold up retail generic prices in order to allow for PBMs’ mail order generics prices lower but still with fat margins.  

Essentially, it was a scheme to limit price competition between retailers and mail order by “buying off” retail pharmacies with reimbursements for 30-day generic Rx at fat margins in return for ceding  90-day generics Rx to captive mail order operations at lower prices but equally fat margins.

According PBMs,  mail order was good for plans because mail order generic Rx were cheaper than at retail.  Nevermind, if this was only because of PBMs’ rare ability to set the price their competitors.  This hold-up scheme was just a sure-fire version the anti-competitive tactic of raising rivals costs.

Below is a diagram which compares the margins at the height of Phase 2 “hold-up” scheme versus the lower prices and margins existing today.

The “hold-up” scheme worked for a couple of years. Our 2003 paper which disaggregated Walgreen’s gross profits likely was read by an “outsider” retailer with a different business model that wasn’t dependent on fat Rx margins subsidizing the rest of the store.  That outsider was Walmart.  

Our paper confirmed what they saw — the fat generic Rx margins of Walgreen, etc. dispensed from a “1,000 square foot hole in the back” (our words) making up for slim margins coming the poorly merchandised, 10,000 square foot “front store”.   

In 2006,  Walmart rolled out a  transparent $4 / generic Rx campaign that proved to be the first blow to this hold-up scheme.

The 2007 vertical  merger of the pharmacy retailer CVS and the PBM Caremark marked the beginning of the end of the era of fat generic Rx margins.

A fundamental tool of managed care companies are preferred provider networks.  They succeed in reduce costs by promising increased volume to preferred providers in return for lower unit prices.  In 2006,  we found PBM’s lack of use of preferred provider networks , along with lack of 90-day Rx at retail, to be obvious signs of the tacit collusion between the Big 3 pharmacy retailers and the Big 3 PBMs.

CVS likely read our 2015 paper confirming their success at beating out competitors in a Medicare Part D precursor program which was agnostic as to whether the Rx was filled at retail or mail order.

At the time of the CVS Caremark merger in 2006, we predicted  a “coming preferred provider war” among PBMs. Ten years later  “narrow networks” are common.  Generic Rx prices and margins are on a downtrend. And, PBMs no longer tout their mail order generics as the key to their profitability.

Phase 3: Retained Rebates From Specialty Drugs

To compensate for declining mail order generic margins, PBMs saw the rising trend of specialty and biotech drugs as a basis for a renewed reliance on retained rebates.

But there are several problems with the goal of deriving a majority of gross profits from specialty drug rebates.   Reconstructing how PBMs solved these problems provides insights in two observable phenomena of the era of specialty drug rebates:

  1. the so-called deep rebate practice and related gross to net drug price bubble;
  2. the trend of growing number of drugs excluded outright from PBM formulary lists.

First, assume that Big 3 PBMs need to derive about the same 50% of gross profits from specialty drug retained rebates as was derived a decade ago from retained rebates from small molecule “rebatable” brands.

This creates a problem in that the Rx volume “basis” for collecting rebates today is a lot less than it was ten years ago.  How much less?  The Pew Charitable Trust Foundation sponsored a study which found that in 2015 special Rx comprised only 1% of total Rx.  

A decade ago, we estimated that about 20% of total Rx filled were “rebatable” brand drugs, i.e. in therapeutic classes with a few other brand drugs that were therapeutic equivalents.  So instead of 1:100 specialty Rx to total Rx basis differential, we arrive a 1:20  “rebatable” specialty drug Rx to “rebatable” small molecule brand drug Rx basis differential.

In other words,  ten years ago PBMs has 20 times the volume of Rx available to them to use as a basis for generating retained rebates as they do today.

The second constraint that PBMs have today that they did not have a decade ago was the awareness by plans and the public that opaque retained rebate could be a dominant source of gross profits.    

Our 2003-8 era papers listed below were rare examples of quantitative articles exposing PBM reliance on retained rebates:

  1. Quantifying Medco’s Business Model: An Update November 2008
  2. Medco As a Business Model Imperialist  July 2008
  3. A Tale of Two PBMs: Express Scripts vs. Medco November 2005
  4. Quantifying Medco’s Business Model April 2005
  5. Estimating the Rebate-Retention Rate of Pharmacy Benefit Managers April 2003

Today,  articles critical of PBMs in general, and retained rebates specifically,  seem to be at least 10 more numerous than a decade ago.  In 2016, CVS Health has even stated publicly on its website that,

“CVS Caremark was able to reduce trend for clients through… negotiation of rebates, of which more than 90 percent are passed back to clients.”

The problem facing PBMs today is how to derive around 50% of gross profits from specialty Rx while maintaining a transparent “reasonable” rebate retention rate at 10% on average?

How have the Big 3 PBMs accomplished this?  They are doing by tacitly colluding with Pharma to increase brand list price at double digit rates which enables PBMs to opaquely offset the list price inflation with growing “deep discount” rebates.  

Below is a screenshot from a Merck memo laying out for all to see its “gross-to-net drug price bubble”: 

In another paper, we “deconstructed” the Merck data by laying out a step-by-step sequence of how PBMs and drug companies might negotiate the parameters of a rebate deal today under the constraint that PBMs have to gross profit DOLLARS over time while fixing the rebate retention rate at 10%.   Below is a spreadsheet of that step-by-step process:

It is clear that Pharma is getting fed up as an enabler of a convoluted PBM business. Other drug companies are publishing similar data as way of defending themselves against charges of “double-digit” price-gouging tactics.  A testy exchange between executives at Gilead Science and Express Scripts over who is to blame for the high list prices of Gilead’s top selling Hepatitus C virus drugs went public.

We have written about AbbVie’s “disruptive” low list pricing of its new HCV drug Mavyret that dares PBMs to exclude a no-rebate drug that also happens to be the most cost-effective HCV now the market.

It is the PBM business model, not the Pharma business model, that is currently stressed.   If PBMs can no longer rely on specialty drug retained rebates,   they will have to seek a new service to build up opaque margins or convert finally to a 100%  pass through fee-for-service business model.

 

Trumpcare Needs Milton Friedman

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Trumpcare has focused exclusively on eliminating mandates, reducing tax credits, and rolling back Medicaid expansion to the working poor. But, the consequences of this are an estimated 24 Million people dropping coverage and huge increases in premiums for those who wish to remain covered.

Trumpcare is up for a vote in the House of Representatives and its passage very much in doubt despite a 24 vote majority held by Republicans. Even it passes the House, its chances of passage in the Senate are deemed slim seemingly by design.

To appeal to moderates, Trumpcare needs to preserve Obamacare’s affordability, keep the Medicaid expansion, while at the same find a way to reduce overall budget costs in the order of 20%. To appeal to conservatives, Trumpcare must reduce overall costs in the order of 20% plus eliminate mandates which was a source of affordability by providing cross subsidies between health-risk cohorts.

The only way we see out of this conundrum is a move to consumer-directed healthcare espoused by the late economist Milton Friedman.

While Friedman is probably better known for his voucher plan for schools, he had similar ideas espoused in a paper written in 2001 called “How to Cure Healthcare.” A condensed version has been made available online by the conservative think tank The Hoover Institute.

Friedman’s big idea in 2001 was this:

“Two simple observations are key to explaining both the high level of spending on medical care and the dissatisfaction with that spending. The first is that most payments to physicians or hospitals or other caregivers for medical care are made not by the patient but by a third party — an insurance company or employer or governmental body. The second is that nobody spends somebody else’s money as wisely or as frugally as he spends his own.”

Friedman was no knee-jerk conservative. He made it clear that Federal subsidies to the uninsured was a fairness issue and not some handout. This is because of the unfairness of the current system of giving tax exemptions only to employer-provided medical insurance.

When Friedman wrote his healthcare piece in 2001, the estimate of this tax shelter was $100 Billion. Today, The Brookings Institute estimates this selective subsidy at $261 Billion.

When Friedman wrote this piece in 2001, consumer-directed healthcare with payments made from a Health Savings Account (HSA) was a new idea. He envisioned HSAs eventually as centerpiece of both Medicare and Medicaid through a combination of Federal contributions deposited in HSAs to cover normal expenses supplemented by Federal government single payer, high-deductible catastrophic insurance.

There have been three trends since Friedman’s 2001 article that have made consumer-directed health care so much more a viable option today. Trumpcare should take advantage of these trends.

The first trend — a negative one — is the dearth of Federal Trade Commission challenges to anti-competitive mergers among healthcare insurers and pharmacy benefit managers (PBMs). It is ludicrous today to think that insurance companies and PBMs compete for customers today by working hard to hold down healthcare costs and associated premiums. We have written extensively about the bilateral oligopolies in the drug supply chain and the misaligned PBM business model.

The second trend — a positive one — is the extent to which the Internet, payments technology, and mobile phones have lowered transactions costs — price discovery, evaluation of treatment options, patient advocacy, and payments — associated with the purchase of healthcare. This includes the substitution of the costly paperwork that used to plague HSAs with HSA-linked debit and credit cards programmed to pay only for SKUs certified as reimbursable healthcare costs.

Interestingly, it was Friedman’s colleague at the University of Chicago, the late Ronald Coase, that had the big idea that transactions costs could have profound effects on markets and institutions.

Notice, we said nothing about the need for government mandates for healthcare price transparency similar to the recent bipartisan legislationintroduced in Congress.

We have no doubt, as would have Friedman, that consumer-directed healthcare would create such an explosion in provider price transparency as to make regulation unnecessary.

Recently, the U.S. House Oversight Committee Chairman Jason Chaffetz admonished people who complained about increased premiums under Trumpcare. He said they should get their priorities straight and cut back on luxuries like iPhones.

If Trumpcare were consumer-directed, this admonishment would be ironic because smartphones would pay for themselves by helping consumers hold down costs. For example, it is a sure thing that there would be app-based patient advocate services you could summon on a moment’s notice upon being admitted to a hospital. All bills would be run through the service. Consultants would be available 24/7 to review proposed treatments.

Indeed, we would argue that under consumer-directed healthcare, a portion of a smartphone’s expense should be a deductible.

The third trend — a positive one — is the exponential growth in venture-capital funded startups focused on healthcare price discovery, cash-only drop-in clinics, labs test for early detection of cancer, low cost step-therapies, etc. All of these services are in a symbiotic relation with consumer-directed healthcare.

We would like to mention just two of the many healthcare startups out there with services focused on enhancing consumer-directed healthcare. Both would thrive if Trumpcare were based on Milton Friedman’s ideas.

One is a basic healthcare clinic just starting up in San Francisco called Forward. The innovation here is an out-of-pocket only subscription business model of $1,800 a year billed annually. They do not accept insurance. This type of clinic is made-to-order for consumer-directed healthcare.

The other startup we want to mention is the crowd-sourced price discovery website Clear Health Costs. Here is just one screenshot to give you some idea of its value to consumer-directed healthcare.

Screenshot from Clear Health Costs Website

Again these are just two of the hundreds of healthcare startups that would make consumer-directed healthcare a viable alternative to Trumpcare as initially designed.

We conclude below with a table outlining how Obamacare, Trumpcare, and Trumpcare + Milton Friedman would address major issues:

Trumpcare + Milton Friedman

Pharmacy Benefit Managers – Research Papers

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All papers downloadable as .pdf  for free

CURRENT PAPERS ON PBMs

It is Pharmacy Benefit Managers that Drive the Gross-to-Net Drug Price Bubble (09/17)

AbbVie’s Mavyret Hep C Drug Pricing Is Disruptive to the PBM Business Model (09/17)

The FTC and Pharmacy Benefit Managers: A History of Failed Economic Analysis, forthcoming

Merck Data Discredits PBM-Sponsored Study of Brand Drug Price Inflation (09/17) 

Pharmacy Benefit Managers: The Sopranos of The Specialty Drug Market (09/17)

THE PHARMACY BENEFIT MANAGER BUSINESS MODEL

Pharmacy Benefit Manager Valuation and Profitability: Business Models Matter (07/09)

Medco As a Business Model Imperialist (07/08)

Quantifying Medco’s Business Model: An Update (11/08)

A Tale of Two PBMs: Express Scripts vs. Medco (11/05)

Searching for Windfall Profits from a Change in the AWP Markup Ratio (09/09)

Exclusionary Practices in the Mail Order Pharmacy Market (09/05)

Quantifying Medco’s Business Model (04/05)

Estimating the Rebate-Retention Rate of Pharmacy Benefit Managers (04/03)

Walgreen’s Transparency Issue (11/03)

 UNDERSTANDING DRUG REBATES THROUGH BARGAINING THEORY

Pharmacy Benefit Managers as Conflicted Countervailing Powers (01/07)

Who is Best at Negotiating Pharmaceutical Rebates? (12/05)

The Role of Pharmacy Benefit Managers in Formulary Design: Service Providers or Fiduciaries?
Journal of Managed Care Pharmacy Vol. 10 No. 4 July/August 2004 pp 359-60

PBMs as Bargaining Agents
Paper presented at the 80th Annual Western Economic Association Meeting, July 6, 2005, San Francisco

PBMs as Bargaining Agents
PowerPoint presented at the 80th Annual Western Economic Association, Meeting, July 6, 2005, San Francisco

The Effect of Corporate Structure on Formulary Design: The Case of Large Insurance Companies
Poster Presentation, ISPOR 10th Annual Meeting, Washington DC, May 2005

PREFERRED PROVIDER PHARMACY NETWORKS

The CVS-Caremark Merger and the Coming Preferred Provider War (12/06)

Medicare Part D and Preferred Provider Pharmacy (04/05)

The CVS-Caremark Merger: The Creation of an Elasticity of Demand for Retail Rx (11/06)

Contrary to What Wall Street and the FTC Say, The PBM Business Model is Misaligned (11/05)

Sins of Omission’: A Review of the FTC Study of PBM Conflict of Interest (10/05)

THE EXPRESS SCRIPTS – ANTHEM 2009 DEAL

Express Scripts – Anthem 2009 Deal as Double Trouble Front (08/09)

Express Scripts Misses on Guidance of Anthem’s NextRx PBM Business Article Written for Seeking Alpha, November 4, 2010

THE FUTURE OF CONSUMER-DIRECTED PHARMACY BENEFITS

The Future of Consumer-Directed Pharmacy Benefits (08/07)

Show Me the Display: A Review of an ESI Study of Consumer-Directed Pharmacy Benefits (07/07)

LEGAL ISSUES

Exclusionary Practices in the Mail Order Pharmacy Market (09/05)

Practical Issues With PBM Full Disclosure Laws
Originally Published in Update Magazine, Issue 4, 2004. Available with permission from FDLI

The Formulary Game (07/03)

About the author:

I have a B.A. in Economics from Amherst College. I have a Ph.D. in Economics from Washington University in St. Louis.

My writings are at the intersection of economics, accounting,  financial analysis, and high tech.

I have received no remuneration for these articles. I have no financial relation with any company written about in these articles.

Lawrence W. Abrams

 

©Lawrence W. Abrams, 2017
To Contact:
labrams9@gmail.com
831-254-7325

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The Pharmacy Benefit Manager Business Model

Lawrence W. Abrams No Comments

CURRENT PAPERS:

Three Phases of the Pharmacy Benefit Manager Business Model (09/17)

It is Pharmacy Benefit Managers that Drive the Gross-to-Net Drug Price Bubble (09/17)

Merck Data Discredits PBM-Sponsored Study of Brand Drug Price Inflation (09/17) 

Pharmacy Benefit Managers: The Sopranos of The Specialty Drug Market (09/17)

AbbVie’s Mavyret Hep C Drug Pricing is Disruptive to the PBM Business Model (09/17)

PAST PAPERS:

Pharmacy Benefit Manager Valuation and Profitability: Business Models Matter (07/09)

Medco As a Business Model Imperialist (07/08)

Quantifying Medco’s Business Model: An Update (11/08)

A Tale of Two PBMs: Express Scripts vs. Medco (11/05)

Searching for Windfall Profits from a Change in the AWP Markup Ratio (09/09)

Exclusionary Practices in the Mail Order Pharmacy Market (09/05)

Quantifying Medco’s Business Model (04/05)

Estimating the Rebate-Retention Rate of Pharmacy Benefit Managers (04/03)

Walgreen’s Transparency Issue (11/03)