Tag gross-to-net drug price bubble

Summary

The purpose of paper is to show that the binding arbitration proposal championed by Speaker of the House Nancy Pelosi to lower Medicare Part D drug prices is off-target.

We believe that there three broad categories of drugs where binding arbitration based on some neutral party’s estimate of value is more appropriate than mano-e-mano direct government negotiations with heavy-handed bargaining chips sometimes used to reach agreements.

1. High PMPY  large molecule biologic drugs where patented therapeutic equivalents would be rare.
2. High PMPY cell therapy cancer drugs where outcomes are uncertain.
3. High PMPY orphan drugs due to costs having to be amortized over patient population in the hundreds.

The problem is we estimate that only 19% of total 2017 Medicare Part D list price drug spend is suitable for Pelosi’s binding arbitration scheme.

 

Introduction

Now that the Democrats are in control of the U.S. House of Representatives, they have taken the lead in Congressional efforts to lower prescription drug (Rx) prices with two proposals to modify Medicare Part D.  In addition to uncertainty as to whether either will be effective,  support for the two proposals within the Democratic Party is divided sharply on ideological grounds.

One proposal is a binding arbitration scheme using a neutral third-party arbitrator to evaluate a pharmaceutical manufacturer’s (Pharma)  price offer in comparison with some independent body’s estimates of the drug’s “value”.

The champion of this proposal is Speaker of the House Nancy Pelosi. She is backed by the centrist New Democratic Coalition house caucus.  The details of this scheme are being worked out behind closed doors headed by Pelosi’s aid on healthcare Wendell Primus.

STAT has reported that Primus is being advised by Harvard economist Richard Frank who co-authored a 2008 article proposing binding arbitration to lower Medicare Part D drug prices.

There are also reports that Pelosi’s drug price advisory group has met with Trump administration officials, including John O’Brien, the special adviser to HHS Secretary Alex Azar on Medicare drug pricing.

The other House proposal is championed by Representative Lloyd Doggett of Texas. Doggett has already introduced legislation — H.R.1046 Medicare Negotiation and Competitive Licensing Act  — that has been co-sponsored by 122 members of the Congressional Progressive Caucus.

The Doggett bill would allow the Department of Health and Homeland Security (HHS) to negotiate directly with drug manufacturers. Specifically, the Doggett bill copies the Medicaid formula specifying that Pharma give government its “best price” globally in return for coverage.  

In addition, the Doggett bill includes a new wrinkle to government negotiating schemes — a heavy-handed bargaining chip:

“…if drug companies refuse to negotiate in good faith, it would enable the Secretary to issue a competitive license to another company to produce the medication as a generic”

However, this bargaining chip has been interpreted as falling under  the “March-In Rights”  clause of the 1980 Bayh-Dole legislation specifying when government can or cannot suspend a drug maker’s exclusive patent.  As a result, the use of this bargaining chip is in doubt.

If the goal of modifying Medicare Part D is to lower senior co-pays, we believe that there is a simpler way to achieve this goal than the Doggett “best price” scheme.  We have tweeted about alternative and will provide details in a later paper.

The Origins of the Pelosi Binding Arbitration Proposal

As of April 2019, the Pelosi binding arbitration scheme is still in the talking stage. There are no white papers let alone a legislative bill.  What is known is that the idea for the scheme came from a 2008 article published in Health Affairs by Harvard economists Richard Frank and Joseph Newhouse.

The original Medicare Modernization Act of 2003 launching Medicare Part D specified that Rx drug benefits or seniors would be managed by private sector entities called pharmacy benefits managers (PBMs).  Frank and Newhouse’s 2008 Health Affairs article presented the case that Medicare Part D needed direct government involvement to augment, not replace, price negotiations managed by PBMs.

Unlike Medicaid, the Medicare Part D legislation specifically prohibited direct government negotiations with drug companies. A likely reason for going full “neoliberal” on Medicare Part D was that private sector PBMs had a successful track record of negotiating rebates from Pharma in return for coverage.  

Furthermore, there were plenty of studies showing problems with hard-wired formulas used by government to negotiate prices with Pharma  — the “best price” formula used in Medicaid, and the “buy and bill” formula of average selling price (ASP)  + 6% used in Medicare Part B.

PBMs had developed a wide-range of bargaining chips in addition to the binary “include / exclude” coverage choice that government-run plans settled on.

The problem that Frank and Newhouse saw was that power of PBMs to negotiate rebates for coverage worked only when PBMs could play one drug manufacturer against another.  

PBMs discovered in the late 1990s that they had negotiating power when a number of “me-too” brand drugs came on the market ( e.g. in the statin class – Pravachol, Zocor, Lipitor or in the ACE inhibitor class — Prinivil, Zestril, Accupril, etc).  

For instance, in therapeutic classes like statins or ACE inhibitors, PBMs discovered they could negotiate substantial rebates in neighborhood of 50% off brand list prices in return for coverage.  

 While PBMs were great at negotiating down list prices in what we have labeled “oligopolistic therapeutic classes”, Frank and Newhouse argued that PBMs were powerless to negotiate rebates in cases where there no therapeutic equivalents — what we have labeled “monopolistic therapeutic classes.”  

In a 2018 paper for the Brookings Institute, Frank and Kennedy School economist Richard Zeckhauser present another argument for government intervention based on design flaws in Medicare Part D that reduce PBMs incentives to bargain hard on price.

The first is the coverage gap — the so-called donut hole — where PBMs cost risk is only 5% in the case of brands.  The other is the so-called catastrophic coverage limit of $8,140 for 2019 after which senior co-pays are held to 5. At the same time PBM cost risk to limited to15% while the federal government picks up rest risk cost at 80% of total drug costs.  Below is a nice depiction by the Kaiser Family Foundation of the current distribution of cost risk in Medicare Part D.

 

Defining the Target of the Pelosi Proposal

To repeat, Politico’s sources say that Pelosi’s aid Wendell Primus is looking only at binding arbitration for “select group of high-cost drugs”.  

Frank and Newhouse offered two binding arbitration  variants:

“The first is a final-offer arbitration system in which both parties cases are heard and then offer their best and final prices. The arbitrator then evaluates the case and sets the drug price at one of the two final prices.”

“Another potential model would be tri-offer arbitration in which a third-party expert or “fact finder” offers a third price for arbitrator consideration. The tri-offer model may be desirable because neither the Center for Medicare and Medicaid Services nor drug manufacturers alone hold the final say in a drug’s price. The system encourages informed negotiations, and an arbitrator only steps in if the two parties cannot reach an agreement.”

By all accounts, the choice of independent  assessor of price based on value would go to ICER, the leading think tank on such matters.

Frank and Newhouse’s case for augmenting PBMs negotiating efforts is solid in cases where there are not Pharma with therapeutic equivalents to play against each other.  

The question is where exactly do those opportunities exist today and how much is the associated drug spend?

Frank and Newhouse were explicit in saying that in 2008 there were few therapeutic classes where there was both lack of negotiating leverage and, this is key, where the total spend was material, say in the $130 Million Medicare Part D drug spend. Their assessment was similar to a 2007 assessment by the Congressional Budget Office.

However,  they could see back in 2008 a pipeline of unique drugs with large drug spend that would justify augmenting PBMs with government-run binding arbitration. Quoting from their paper

“We believe that it is premature to conclude that there are enough unique drugs to create a meaningful budget problem. Nonetheless, the likelihood of drug products better tailored to specific genetic defects raises the possibility of many more unique drugs in the future”

We see three broad categories of drugs where binding arbitration is more appropriate than mano-e-mano direct government negotiations with heavy-handed bargaining chips sometimes used to reach agreements.

1. High PMPY large molecule biologic drugs where patented therapeutic equivalents would be rare.

 In the case of large molecule biologics, it is impossible to produce molecule-for-molecule generics so that PBMs have no bargaining leverage.  The only possibility for negotiating leverage would come after the approval of therapeutically equivalent “biosimilars”.   Plus, we believe value become a factor in all cases where where PMPY costs exceeding $50,000.

Here is a table of the top high PMPY drug treatments covered by Medicare Part D in 2017 that we believe would be best suited for binding arbitration  based on an independent assessment of “value”:

Data comes from Medicare Part D Drug Spending Dashboard & Data.  It is based on list price, not net price after rebates.

2. High PMPY cell therapy cancer drugs where outcomes are uncertain.

Much of call for value-based pricing comes for cases in which the degree of success is more in question that the value of the of the outcome itself .  Neutral assessment of probabilities of success are appropriate in these cases.  Prime examples of such drugs are new drugs to treat melanoma  Keytruda and Opdivo whose costs exceed $150,000 a year and with remission rates only somewhat better than just chemotherapy. 

The problem here is that most of these new cell therapy treatments are covered under Medicare Part B, not Part D, as they are infused treatments occurring in physicians’ offices, out-patient clinics, and hospitals.

3. High PMPY orphan drugs due to having to be amortized over patient population in the hundreds.

The justification for binding arbitration as an augment to PBM negotiations is solid for so-called “orphan drugs.” 

The market for orphan drugs is less than several hundred patients so that amortized R&D and manufacturing costs alone exceed $100,000 per person. The cumulative total number of orphan drugs approved by the FDA has accelerated since 2012.

 

 

Here, it seems appropriate to treat orphan drugs as a “natural monopoly” with government rather than private PBMs setting the price on a cost-plus or value basis.  Here is a list of the top orphan drugs by PMPY drug spend:

While the number of orphan drugs is on the rise, the total drug spend is relatively low due to the small number of patients treated.  Subjecting orphan drugs to binding arbitration would have a minor impact on overall Medicare Part D drug spend.

 

An Estimate of the Impact of Pelosi’s Proposal

In terms of % of total Medicare Part D drug spend,  the question is how large is opportunity to lower drug spend using a binding arbitration scheme? 

To answer that question, we use data from the Medicare Part D Drug Spending Dashboard & Data.  It is based on list price, not net price after rebates:

“Drug spending metrics for Part D drugs are based on the gross drug cost, which represents total spending for the prescription claim, including Medicare, plan, and beneficiary payments. The Part D spending metrics do not reflect any manufacturers’ rebates or other price concessions as CMS is prohibited from publicly disclosing such information.”

For purposes of targeting opportunities, this list price data is better than net price data.

We first filter out drugs with multiple sources.  This are mostly generics where dispensing pharmacies have great success in negotiating purchase volume discount off wholesale acquisition costs.

Next, we filtered out drugs with PMPY drug spend > $50,000. We think this filter captures most of the drugs in the three categories better handled by binding arbitration  — unique biologics,  drugs with uncertain outcomes, and orphan drugs.

But, the filter is not perfect. In particular, there are two therapeutic classes  — Insulin and Hepatitis C Virus (HCV) — representing 11% of total drug spend that are arguably more amenable to direct negotiation than binding arbitration.  We chose to place the two therapeutic classes in the direct negotiation subset.

In the case the insulin, while biologics, they have been proved to be therapeutically similar.  Furthermore, the drugs have been around for decades, the outcomes are relatively certain and costs are less than $50,000 PMPY.

In the HCV drugs, while costs are greater than $50,000 PMPY, cure rates exceed 90%, and they have proved to be therapeutically similar by genotype.

In fact, because there are therapeutic equivalents in these two classes, PBMs have had recent success in negotiating rebates in these two classes.

The following is a listing of drugs in these two therapeutic classes we chose to place in the direct negotiation subset and rather than Pelosi binding arbitration subset.

 

 

After that, we filtered out drugs with total drug spend > $130 Million to represent the core opportunity for Doggett’s direct government negotiation bill.  Here are the top 36 candidates for direct negotiations in addition to the insulin and HCV therapeutic classes

The remaining drugs was single source drugs representing 61% of drug numbers — 1,786 –but only a paltry 9% of total drug spend.

The following table summarizes the division of drug spend by size of the opportunity targeted by the Pelosi proposal vs the Doggett bill.

We estimate that only 19% of total 2017 Medicare Part D list price drug spending is suitable for Pelosi’s binding arbitration scheme.

 

 

Another way to depict the relative targets of opportunity for the two proposals is to graph total revenue by rank.  A comparison of the graphs indicates a much more severe revenue rank power function for drugs best suited for binding arbitration than drugs best suited for direct government negotiations.

 

 

 

 

Summary:

Using CVS’s 2017 10-K reports to the SEC and its 2017 drug trend report, we convert its PBM segment (a.k.a. Caremark) reseller gross profits business model to a single transparent fee-for-service expressed in terms of dollars per member per year (PMPY).  

The following table summarized our results:

Our estimated FFS equivalent of $64 PMPY is a relatively small 6% of CVS’s  $1,067 PMPY drug spend delivered. But, it must be remembered that Rx drugs are a relatively homogenous healthcare benefit compared to hospital procedures or even office visits.

The relatively ease of managing a drug benefit versus a medical benefit is reflected in CVS’s SG&A expense ratio of 1.0% of sales.  In contrast, the SG&A expense ratio in 2017 for healthcare insurance companies Aetna and Cigna was 24.5% and 19.5%, respectively.  

If PBM business models shift to FFS, we expect plans to shift their attention to PMPY trend delivered via significant increases in formulary exclusions.  It would be ironic if  “a world without rebates” becomes a greater threat to Pharma profitability than a world with rebates.   

 

Introduction

PBMs have come under attack since the early 2000s 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.

Over the course of the last 15 years, we have observed dramatic shifts in the distribution of PBM gross profits. These radical shifts in source of gross profits in such a short period of time is unprecedented among Fortune 50 companies.  It 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 pharmaceutical drug companies.   These upstream suppliers and the Big 3 PBMs make up two sides of intermediate market bilateral oligopolies.

Our paper Three Phases of the Pharmacy Benefit Manager Business Model  is an attempt to deduce motives for these shifts.  

We believe that motive is key to determining whether it is Pharma or PBMs who should be blamed for the gross-to-net drug price bubble since 2010. Based on our analysis of the shifting sources of gross profits presented in our paper cited above, we place the blame on PBMs.

In February, 2019,  Health and Human Services Secretary Alex Azar called on Congress to eliminate anti-kickback safe harbors for rebates as a mechanism for making formulary (insurance coverage) choices by private sector PBMs who manage Medicare Part D drug plans. This has been followed up by a bill introduced by Senator Mike Braun (R-Ind) to extend the elimination of rebates to commercial plans in the private sector.

In order to have any meaningful reduction in drug list price,  we strongly believe that two interrelated changes need to be embedded in government or private sector initiatives:

1. PBMs need to convert to a transparent fee-for-service business model
2. PBMs need to find an alternative the high list – high rebate market design for formulary placement

Despite our fifteen year critique of PBMs and their misaligned business model, we are not supportive of rebate-ending initiatives if they fail to include alternative PBM business models and alternative formulary market designs.  

Studies by consultants of the impact of eliminating PBM rebates on Medicare Part D varies greatly depending on assumptions about Pharma list price reductions.  To us, this variability in outcomes suggest that it would be dangerous to implement such changes without more specifics about what alternative business model and market design PBMs are likely to adopt.  

The purpose of this paper to take the first steps forward in “a world without rebates” by presenting an estimate a single transparent FFS to replace reseller gross profits using data from the largest PBM — CVS’s pharmacy segment ( a.k.a. Caremark).

The financial data comes from their 2017 annual 10-K report to the SEC: Source: CVS 10-K 2018, Page 14. The PMPY drug trend expenditures comes their 2017 annual drug trend reports: Source: CVS Trend Report – 2017. The number of covered lives comes from another annual reports: Source: CVS Facts and Figures – 2017

 

The Current PBM Reseller Business Model

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 current PBM business model is a reseller business model where the PBM earns margins on prescription drug fills at retail and mail order and retains a percentage of rebates paid by brand drug manufacturers in return for preferred formulary placement.

Specifically, the current PBM business model features five major streams of revenue and gross profits flowing through their financials:

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.

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.

 

Converting CVS’s Business Model to a Single Fee-for-Service

Currently, PBMs such as CVS actually buy prescriptions, mark them up (i.e. “spread margin”), and then resell them to plan sponsors that contract with them for drug benefit management.  This spread margin is on top of a dispensing pharmacy fill margin. Separately, PBMs negotiate with brand name drug manufacturers for the payment of rebates, of which they retain a percent, in return for preferred formulary placement.  

As principals in these transactions, these flows are accounted for on  PBMs’ income statement. An interesting accounting question would be raised If PBMs converted customers to a single FFS business model with 100% pass-through of pharmacy claims and Pharma rebates.  Here PBMs become agents, and generally accepted accounting practices (GAAP) might dictate that these flows by-pass the PBM income statements to be posted first on their balance sheets as client receivables and payables.  The account balances would be relieved as they are paid to / by clients.

Today, we estimate that a majority of Big 3 PBMs profits comes from retained rebates.  We still have retail spread margins at 7% of gross profits, which is surprisingly low given the attention to this source of PBM profit at the state level driven by independent pharmacists.

 

Details of our disaggregation of PBM gross profits by source over the past 15 years can be found at Three Phases of the Pharmacy Benefit Manager Business Model .  Here is  summary graph from that paper:

 

We propose an alternative business model featuring a single fee-for-service equivalent to PBM gross profits.  It would entail 100% pass through of all Rx claims without any spread margin and 100% pass through of all rebates and drug inflation guarantees. It would also entail elimination of all miscellaneous claims processing and data fees.

Instead of gross profits, the transparent FFS would be used to cover corporate indirect sales, general, and administrative (SG&A) costs. What is left over, “falls to the bottom line” as operating profits and taxes.  As we said before, all other flows would be 100% pass-throughs and no longer have any impact on gross profits.

Whether 100% pass-through would flow through the income statement or by-pass it and flow directly to the balance sheet depends on whether PBM auditors decide to keep PBMs current classification as principals with legal liability in these transactions or re-classify them as agents.

Below is our calculation of a single FFS equivalent for CVS pharmacy segment (Caremark) for 2017.

Discussion of Results:

Our estimated FFS equivalent of $64 PMPY is a small 6% of the average $1,067 PMPY trend management. But, it must be remembered that Rx drugs are a relatively homogenous healthcare benefit compared to a hospital and outpatient procedures,  or even physicians’ office visits.

Plus, most of claims managed come from only 3 drug store chains including CVS’s own whereas healthcare benefit managers need to manage thousands of hospital, outpatient, and physicians accounts.

The relatively ease of managing a drug benefit versus a medical benefit is reflected in CVS’s SG&A expense ratio of 1.0% of sales.  In contrast, the SG&A expense ratio in 2017 for healthcare insurance companies Aetna and Cigna was 24.5% and 19.5%, respectively.  

The relative size of a plan’s drug benefit management cost — $64 PMPY — versus its cost of the drug benefit itself — $1,067 PMPY — suggests plans pay more attention to trend delivered.  So what, if a smaller PBM charges 20% higher FFS — increasing management costs by $13 PMPY –if it can deliver a 10% reduction in trend — saving $107 PMPY.

The movement toward demanding more PBM transparency culminating in significant switches to a FFS business model just might be the beginning of a movement toward more attention being paid by plan sponsors to trend delivered.

Concluding Remarks

FFS is just the beginning in defining an alternative PBM business model.

1. Our estimated $64 PMPY FFS is too high to serve as a starting point as it represents profits earned by an oligopolist using an opaque business model;
2. It lacks incentives to bargain hard with Pharma.

The key to discovering what FFS number would emerge in a competitive market is to get small PBMs to start with our estimated $64 PMPY and go from there.

For example, the University of Michigan has been at the forefront at playing an active role in the design of their drug benefit plan at the highest level (formulary and copay design) while contracting out to a small PBM — MedImpact — for claims and rebate management.  Based on data presented in their 2017 annual report, we calculated that their management costs at $17 PMPY — 27% of CVS’s average $64 PMPY.

On the other hand, their trend delivered — $1,246 PMPY — was $179 PMPY or 17% higher.   The question is this higher trend the result of relatively weak rebates bargaining power of MedImpact or a more expansive formulary?

 

To be sure, smaller PBMs currently do compete with the Big 3 PBMs on the basis of business model, primarily touting 100% pass-through of rebates.  But, their business models are still a mish-mash of fees and even opaque spread margins on retail Rx.

We have only come across the startup PBM SmithRx who clearly states on its landing page that is offers a single FFS business model:

We applaud SmithRx with this bold move and urge others small PBMs to consider adopting this alternative and touting it on their landing pages.

The second problem is that the incentives to bargain down the now inflated drug list prices is lessened when a simple FFS replaces retained rebates.  Incentives for meeting or exceeding drug spend as measured on a PMPY basis needs to be added to a FFS. Also, incentives for meeting patient adherence and other outcome measures need to be included.

Express Scripts and CVS Caremark do disclose average drug spend (“trend”) in their annual Trend Reports.  They are proud of their delivered trend reductions and the importance of formularies in managing trend. But, they do not compete outwardly on that basis.  

Source: CVS Trend Report, 2017

 

 

Source: Express Scripts Trend Report, 2017

We believe smaller PBMs can compete with the Big 3 PBMs on trend level and year-over-year trend reduction.  What small PBMs give up in rebate bargaining power, we believe that they can make up with greater outright formulary exclusion of high cost drugs that are not cost-effective.

Here is a rare example of a PBM  — the startup RxAdvance — declaring on its landing page a specific trend reduction if clients switch to them.

Source: RxAdvance

 

Here is another startup call ActiveRADAR that specializes modifying the misaligned national PBM formulary received by self-insured plans.  Basically, it is a carve-out of the core “smarts” of PBM  — formulary management — and makes the design more cost-effective by suggesting lost-cost therapeutic equivalents to individual members of a plan.  The claim they can reduce trend 15% to 28%

 

The focus is similar to our startup pitch for an IFC: An Independent Formulary Company

 

Finally, here is a screenshot from some work-in-progress indicating how the small PBM MedImpact delivered in 2017 a PMPY trend  23% lower than Express Scripts despite being one-fourth its size:

 

Source: Express Scripts Trend Report – 2017     

Source: Express Scripts Formulary – 2017

Source: MedImpact Formulary – 2017

Source: MedImpact Trend Report – 2017

 

 

 

 

Summary

We contend that recent insulin drug price inflation is a case of perverse competition rather than a case of illegal racketeering in violation of the RICO Act.  

We will present the case that a now consolidated racketeering RICO lawsuit initiated by the law firm Hagens Berman has inverted the hierarchy of the Pharma – PBM enterprise.  The lawsuit claims that the bidders — Pharma — “spearheaded” rebate negotiations and that pharmacy benefit managers (PBMs) as rebate-collecting gatekeepers are the followers.  This makes no sense and is grounds for a dismissal of the lawsuit.

We concede that there was coordinated list pricing, but these were opening moves in a two-step bidding process driven by a perverse PBM business model rather than initiated by Pharma. We will present charts of formulary choices made by PBMs that are so varied that they could not be the result of collusion.  

Rather the varied formulary choices in this case had to be the result of vigorous competition among insulin drug companies vying to be the highest gross rebate bidder that culminated in rational economic decisions by PBMs to award formulary exclusivity to the lowest net price bidder.  In other words, there are no antitrust issues in this case.

 

Racketeers as Gatekeepers to Markets With Reduced Competition

Racketeering is organized crime.  It involves hierarchical groups of individuals working cooperatively under the direction of leaders. The organization can run the gamut from a traditional  business like a trade show logistics company to a tight knit “association-in-fact” enterprise like a mafia crew.

The Racketeer Influenced and Corrupt Organizations Act  (RICO) was passed by Congress in the 1970 to deal with organized crime.  For example, the Sopranos of HBO fame operated an ongoing “association-in-fact” enterprise involving rigged bids for suburban New Jersey garbage collection contracts.  The RICO Act is ideally suited to deal with the Sopranos bid-rigging enterprise.

The Soprano scheme can be viewed as being in a class of rackets involving collecting “tariffs” in return either for opening up markets blocked by government or for providing entrance to legitimate markets with the understanding that further competition would be limited.

Prohibition era bootlegging is the classic racket involving opening up markets blocked by government regulations.  Garbage collection bid rigging is the classic racket of illegally limiting entrance to normally competitive markets.

Money laundering, loan sharking, convention center service contracts, building permits issued without inspections, drug smuggling, sports betting, arms dealing, and human trafficking are other examples of rackets involving payment for access to markets with reduced competition.

Potential entrants are willing to make substantial payments in these cases because they are cuts from super-competitive profits that normally would flow to consumers in the form of lower prices.

Potential bidders in racketeering schemes face a “prisoner’s dilemma”. On the one hand,  it is in the best interest of all potential entrants to wait their turn and cooperate.  On the other hand,  the best strategy for any individual bidder is go it alone, defect and enter the market secretly without paying any tariff.  

The ‘prisoner’s dilemma” is the reason why successful rackets often require threat of harm  — horizontal restraints in antitrust parlance —  to insure cooperation. For example, Tony Soprano regularly would dispatch his nephew Christopher Moltisanti to coach sanitation companies on upcoming municipal garbage collection contracts up for bid, and remind them of what would happen to their kneecaps if they failed to cooperate.

RICO enterprises that do not use physical force to insure cooperation look to other mechanisms to foster cooperation among bidders.  In cases of price-fixing, short-term retaliation via sharp undercutting of a defector’s price is used to remind the defector of the costs of competition.  

Also, bidders are more likely to cooperate long term if the racketeering gatekeeper exhibits a sense of “fairness” by distributing the rigged bid opportunities evenly across bidders.

 

Racketeering Lawsuits

On November 3, 2016, Senators Bernie Sanders (I-Vt)  and Elijah Cummins (D-Md), asked the Department of Justice and the Federal Trade Commission to investigate insulin drug manufacturers for possible anti-competitive practices in setting list prices, noting that “the potential coordination by these drug makers may not simply be a case of ‘shadow pricing,’ but may indicate possible collusion.”

Over the course of 2017, there have been a number of class action lawsuits and state Attorney General Civil Investigative Demand (CID) letters filed against three makers of insulin — Sanofi, Eli Lilly, and Novo Nordisk — on behalf of patients incurring high out-of-pocket costs for needed insulin drugs. The lawsuits alleged a pattern of racketeering — repeated, organized criminal acts involving secret agreements to inflate drug prices to the benefit of drug companies.

These lawsuits all alleged that the three drug companies “spearheaded” the insulin list price inflation and that insulin list price inflation was the “proximate cause” of damages suffered by patients who could not afford to continue treating their diabetes with insulin made by these companies.

The original racketeering lawsuit was filed by the law firms of Hagens, Berman, Sobol, & Shapiro (hereafter Hagens Berman)  and Carella, Byrne, Cecchi, Olstein, Brody & Agnello, P.C. on January 30, 2017, amended on March 17, 2017 and again on December 27, 2017.  Hagens Berman has been consistent in naming the three insulin drug companies — Sanofi, Eli Lilly, and Novo Nordisk — as “spearheading” the racket and as co-defendants.

Hagens Berman characterized pharmacy benefit manager (PBMs)  as “knowing and willing participants” in the racketeering enterprise who helped “perpetuate” the fraud (¶ 300) and “reaped profits” ( ¶ 300) from the racket,  But Hagens Berman has stopped short of naming PBMs as co-defendants. In a June 2017 interview with Bloomberg, Partner Steve W. Berman offered this lame explanation of why his law firms decided to name only drug companies as defendants:

In September, 2017,  U.S. District Judge Brian R. Martinotti of the U.S. District Court for the District of New Jersey consolidated all RICO lawsuits and named Steve W. Berman of Hagens Berman and James E. Cecchi of Carella Byrne as interim lead counsel.

There are two other RICO lawsuits by Weitz & Lutzenberg and by Keller Rohrback LLP  consolidated into the Hagen Berman lawsuit by the U.S. District Judge Martinotti.  These other lawsuits have named the three largest PBMs — Express Scripts, CVS Health, and OptumRx — as co-defendants. But, even these lawsuits characterize the drug companies as the masterminds of the collusion.

In consolidating these lawsuits, the New Jersey District Court has said that

“ the issue of joinder and/or severance of the three pharmacy benefit managers, will be addressed at a later date.”

 

Formulary Rebate Negotiations Between Pharma and PBMs

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 State in 2015.

We have estimated that a majority of PBM gross profits today come from retained rebates from specialty and injectable biologic drugs — infused autoimmune drugs like Humira and Enbrel and self-injectable insulin drugs like Lantus discussed below.  

These rebates are paid by drug companies in return for placement in a formulary — a table of preferred drugs covered by insurance.   The formulary is a lookup table that PBMs inserted into their retail drug store point of sale claims processing systems that checks a Rx request against a list of therapeutic equivalents preferred by the plan.  The formulary is designed to limit Rx to the most cost-effective drug(s) in each of 50-80 different therapeutic classes.  

In 2005, we were the first to conceptualize PBMs as “gatekeepers” to markets with reduced competition, rebates as “tariffs” willingly paid by Pharma in return for formulary access, and formularies a set of markets with a varying degree of competitiveness (competitive, monopolistic, oligopolistic) among drugs that are “therapeutic equivalents”.

On the sell-side are brand drug companies with therapeutic equivalent drugs vying for placement in therapeutic class “markets”.  On the buy-side are the Big 3 PBMs deciding which drugs among therapeutic equivalents should be listed in the formulary and covered by insurance.

Economists call such markets bilateral oligopolies.  We have written a number of papers about the Pharma – PBM bilateral oligopoly available for download free on our website.

In sum, rebates are tariffs paid by drug companies to PBMs for limiting access to oligopolistic therapeutic classes in formularies.  That broad description — tariffs paid for access to markets with reduced competition — is the same as the Soprano bid-rigging scheme and the same as a whole class of illegal rackets.  RICO lawsuits in this case have to prove an ongoing pattern of overt collusion and conspiracy involving secret plans with the intent to do something unlawful or harmful.

 

The Cause of The Recent  Drug List Price Inflation

We have written a number of papers presenting the case that it has been PBMs, not Pharma, that has driven the recent drug list price inflation.

• Blame PBMs (Not Pharma) For Driving Drug Price Inflation (09/17)
• Three Phases of the Pharmacy Benefit Manager Business Model (09/17)
• Merck Data Discredits PBM-Sponsored Study of Brand Drug Price Inflation (09/17)

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.

To compensate for declining mail order generic margins after 2010, 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 and biologic drug rebates.  The first is that basis for gross rebate percentages — specialty and biologic drug — represents only 20% of the Rx volume of the “rebatable” small molecule drugs available to PBMs a decade earlier.  

The second constraint that there is an awareness by plans and the public today that opaque retained rebate are a dominant source of gross profits.    Today,  articles critical of PBMs in general, and retained rebates specifically,  seem to be at least ten times 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 and biologic Rx while maintaining a transparent “reasonable” rebate retention rate at 10% on average?  

How have the Big 3 PBMs accomplished this?  Pharma knows that PBMs are desperate to make formulary choices in oligopolistic therapeutic classes on the basis of gross rebates received first and net prices second.

 Pharma knows that it will disqualify itself from a chance to be winning bidder for placement in a formulary if their first move in rebate negotiations is a low list price without any room for further rebate offers.

In sum,  it is the perverse PBM business model that drives tacit cooperation among Pharma to increase list prices in lock-step. Since 2010, PBMs required ever increasing retained rebates to offset continuing losses in mail order generic margins.  The timing of the need to offset one source of gross profits with another fits the acceleration in drug list price inflation between 2010 and 2014 with a tailing off since then (see chart below).

Source: Motley Fool , April 2017

 

Lock-Step Insulin Drug List Pricing

There is little question that there has been some sort of coordination among the insulin drug companies in setting list prices — formally known as wholesale acquisition costs (WAC) over the last decade.

We think the coordination is not overt, but a “follow-the-leader” understanding developed independently over the years. Pharma understands that a move to list price significantly below a competitor only reduces their ability to compete on gross rebates in the second round of this two-step bargaining process.   Here is a quote from Novo Nordisk’s CEO admitting that they follow closely any list price change of their competitors.

Below are charts of lock-step increases in insulin drug prices presented by the law firm Hagens Berman in their RICO lawsuit.   These charts are clearly the most damaging evidence of in support of the allegations of collusion.

 

Source: Business Insider, September 2016

But, we believe that the insulin list price inflation is NOT an offensive move to increase gross profits, but defensive opening moves in a competitive two-step rebate negotiating game “spearheaded” by PBMs.

Negotiable prices are a hallmark of bargaining situations involving a few sellers and a few buyers.  Baseball player salary arbitration starts with each party offering prices far apart from what both parties ultimately agree to.

The real estate website Zillow presents extensive historical data showing that the norm in residential home sales is a high opening list price followed by periodic price reductions until a sale is made.

In healthcare, it is a standard practice for providers vying for preferred provider status to start negotiations with high list prices and then offer varying degrees of discounts in return for the higher volume that comes with being named a preferred provider.   

What is going on between insulin drug manufacturers and PBMs is no different.  High list prices are just the standard opening round in a negotiation process among companies vying for preferred status on formularies for their “therapeutic equivalent” drugs.  

The practice of lock-step drug list price inflation is not unique to insulin drug makers.  Below is a chart of lock-step list prices between two manufacturers of top selling autoimmune drugs — AbbVie’s Humira and Amgen’s Enbrel.  Both drugs require regular infusions at clinics and hospitals.  These drugs are covered by a medical benefit managed by insurance companies  rather than a drug benefit plan managed by PBMs.  

It is interesting to note that the lock-step drug price inflation pattern  exists even though the “gatekeepers” in this case are insurance companies.   Unlike PBMs, insurance companies have rational business models — 100% pass through or capitated insurance premiums — where the only consideration is net price regardless of gross rebates received.

The lock-step list pricing for autoimmune drug managed by insurance companies is another piece of evidence that cast doubt on the claim that insulin drug price inflation is a case of organized crime rather than a standard open move in all negotiations for preferred provider status between healthcare providers and healthcare benefit managers.

Source: Washington Post, November 2016

 

The Motivation for Insulin List Price Drug Inflation

The Hagens Berman RICO lawsuit argued that insulin drug inflation was driven by drug companies motivated to increase profits.  But, there is plenty of evidence that insulin drug companies received relatively small cumulative increases in net prices after a decade of substantial list price inflation.  

Here are two charts provided by Novo Nordisk to show that their net price after rebates for their Novolog insulin vial has increased only a cumulative 36% over the last decade even though their list price have risen a cumulative 363%.

Here are two other charts of gross to net price increases from a June 2016 Bloomberg article based on data assembled by SSR Health, an investment research company.  The first is Eli Lilly’s Humalog indicating cumulative list price inflation of 138% over a six year period from 4Q09 to 4Q15, but only a cumulative net price inflation of 6%

Here is another chart of Sanofi’s Lantus showing a cumulative list price inflation of 189%, but a net price inflation of only 42% over a 5 year period.

Finally, here are a couple of quotes from an October 2016 Biopharma Dive article on fierce price competition among insulin manufacturers:

“Long-acting insulins have become a commodity,” said David Kliff, who publishes the industry newsletter Diabetic Investor, in an interview with BioPharma Dive. “In today’s environment, payers have the upper hand when it comes to making deals.”

That advantage is translating into pressure on insulin pricing, which all three drugmakers have begun to feel.

Novo has said average net prices for its diabetes drugs, particularly in the basal segment, are expected to be low- to mid-single digit percentages lower next year compared to 2016”.

Eli Lilly, which recently committed to averaging 5% revenue growth through 2020, has also baked in intensified pricing pressures in the U.S. to its forecasts. Lilly CFO Derica Rice, speaking on recent earnings call, pointed to increased rebating and discounting for diabetes products as a byproduct of stepped-up competition.

And Sanofi gave guidance last October forecasting its global diabetes sales will decline by an average annualized rate of between 4% and 8% through 2018.”

These quotes run counter to the RICO lawsuit claim that insulin list price inflation has been driven by Pharma and has resulted in substantial increases in profits.  Rather, we have argued earlier that the high list price / high gross rebate scheme has been driven by PBMs with a business model under stress needing more and more retained rebates to offset continuing losses in mail order generic margins since 2010.

 

Charges of Violation of Antitrust Laws

Besides allegation of  violations of the RICO Act, two RICO lawsuits by Weitz & Lutzenberg (Count ONE and TWO, pages 54-57) and by Keller Rohrback LLP ( Count 7, page 175), but not the final consolidated lawsuit of Hagen Berman,  include counts of violation Sections 1 and 3 of Sherman Antitrust Act.

We believe these antitrust allegations are frivolous and should be summarily dismissed.

Following the generally accepted theories of the late legal scholar and Supreme Court nominee Robert Bork, vertical restraints such as exclusive dealing in formulary contracts are presumptively welfare-enhancing and procompetitive because it would not be rational for a buyer to exclude the lowest cost supplier.  

However, in the case of PBMs you have to take out Bork’s “presumptive” qualifier because the PBM business model is not rational in the traditional economics sense.  

While PBMs are resellers of brand drugs, their gross profits on brand Rx are derived only from a retained rebate percentages. The PBM business model setups up a possible misalignment of interests between plan sponsor preferences for the lowest net cost drug in a therapeutic class and PBM preferences for the drug with the highest rebate retention DOLLARS.  

But, because insulin drug list prices are in lock-step, the insulin drugs with the greatest gross rebate offer are also the drugs with the lowest net price.  This means that PBM formulary choices with regard the insulin drugs are aligned with client’s interests. There is not an antitrust issue associated with recent insulin drug price inflation.

Below is a spreadsheet of the 2016 list prices (WAC)  of long-lasting insulin drugs at the time of the introduction of the Lilly’s Basaglar, a follow-on biologic to Sanofi’s best selling drug Lantus.  Lilly chose to “play to game”, not challenge the PBM business model, and takes its chances competing on the basis of gross rebates.

 

The result was that Lilly and Basaglar was excluded by Express Scripts and OptumRx, but included by CVS Health.   Per Chicago School theory, all of these choices are pro-competitive as  it would be irrational for any PBM to exclude the lowest cost supplier.

Had Lilly started out with a list price for Basaglar at least 70%-80% lower than the list price of the incumbent Lantus, they might have been in a position to show that they were the lowest cost supplier in the long-acting insulin therapeutic class and merit inclusion in all 3 PBM formularies. Furthermore, they would have been in a position to expose any of the PBMs’ misaligned business models should one of them exclude Basaglar.

We have written a paper recently which compares AbbVie’s aggressive list pricing of its new-to-market Hepatitis C Virus (HCV) drug Mavyret versus the incumbent biologic drug Harvoni.

Mavyret’s exclusion by CVS Health created a real possibility of an anti-competitive and antitrust case of exclusive dealing  despite Mavyret being the lowest cost drug available in the HCV therapeutic class.  We discussed this case in more detail in another recent paper titled Was CVS’s Formulary Exclusion of Mavyret a Violation of Antitrust Laws?

 

Inversion of the Pharma – PBM Enterprise

The  consolidated RICO lawsuit filed by Hagens Berman has inverted the hierarchy of the Pharma – PBM rebate negotiations relationship.  This lawsuit claimed that the bidders — Pharma — “spearheaded” the rebate negotiations and that the rebate-collecting gatekeepers — PBMs — are the followers.

Here are quotes from he consolidated RICO lawsuit on how it views the hierarchy in the Pharma – PBM Enterprise:

 

The Levemir / Novolog Pricing Enterprise

 

 

 

 

The Humalog Pricing Enterprise

 

The Lantus / Apidra Pricing Enterprise

This makes no sense.  Hagens Berman’s steadfast insistence that Novo Nordisk, Eli Lilly, and Sanofi “spearheaded” the racket is inexplicable. Generally, in cases of bidders vying for access to markets with reduced competition, it is the tariff-collecting gatekeepers that “spearhead” the scheme and the bidders are the followers.

Below is our diagrams of the Hagen Berman inverted view versus the correct view of the Pharma – PBM enterprise.  To highlight the nonsense of the Hagens Berman view, we compare it with two views of the Sopranos bid-rigging racket enabled by use of force to insure cooperation among bidders.

 

 

Formulary Choices as Evidence of Competition

In all likelihood,  there was a preliminary competitive round in the Soprano bid-rigging racket where Tony Soprano solicited bids from the suburban municipal garbage collection companies for the rights to be the rigged “winning” bid on any given garbage collection contract.

In order to make the actual bidding process seem legitimate, Tony probably told other companies to participate in the actual bidding, but make their bids higher than the favored company.  Obviously, the Soprano bid-rigging racket took lots of cooperation to pull it off even with threats of physical violence for defection.

Bid-rigging without threats of violence for defectors is problematic.  The RICO lawsuits essentially claim that insulin drug pricing was a bid-rigging racket. Not only did the bids have to be coordinated,  but according to the lawsuit, the bid-rigging was coordinated by the bidders and not the PBM gatekeepers.  A racket with this inverted hierarchy of command would be extremely hard to pull off.

We acknowledge that the lock-step list-price inflation was the result of a common understanding among insulin manufacturer that the perverted PBM business model favored  bidders with the highest gross rebates over bidders with the lowest net price after rebates.

But, what kind of mechanism did Pharma and PBMs use to rig the rebate offers? Unless RICO lawyers can present evidence of some sort of mechanism to enforce cooperation among insulin drug companies, the resulting pattern of formulary choices is more than likely the result of a competitive bidding process.

Below is a series of spreadsheets which show no favoritism among insulin drug companies.  This evidence tends to refute the claim that there is collusion between any given PBM and the three insulin drug companies vying for preferred formulary placement.

The following formulary choices below shows Novo Nordisk winning the the rights from Express Scripts for exclusivity for one of its drugs Levemir but losing the rights from Express Scripts for exclusivity for its other drugs Novolog.  

Was this achieved via just horizontal collusion among drug companies without any knowledge of the horizontal collusion by Express Scripts?   Or, more likely was this a case of an all-around horizontal and vertical collusion among both bidders and PBMs?  

If so, the highly varied outcome depicted above would have required a ton of coordination with potential for a lot of bickering among bidders as to its fairness.    And the outcome depicted above is just one of three bidding outcomes between drug company bidders and PBM gatekeepers.  

 The charts presented above and below depict formulary choices made by PBMs that are so varied that they could not have been the results of collusion.  

Rather the varied formulary choices in this case had to be the result of vigorous competition among insulin drug companies vying to be the highest gross rebate bidder and ending in a rational decisions by PBMs to award formulary exclusivity to the lowest net price bidder.

 

 

Below is an alternative spreadsheet of PBM formulary choice that in our opinion indicates no overriding  cooperation between drug companies and PBMs.  It is indicative of a pro-competitive rebate negotiation process in which the low net cost supplier wins exclusivity on the PBM formulary of drugs covered by insurance.

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.

 

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 from 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 awareness by their clients that retained rebate dollars can be a 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 $1+ 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. 

This analysis has relevance to RICO cases in at least three areas:

• the  “proximate cause” of damages : Pharma, PBMs, and/or plan sponsors?
• the “association-in-fact” enterprises — horizontal, vertical, or both?
• the  very question of conspiracy — a cooperative vs non-cooperative game?

For example, assuming this is a racket, we would argue that PBMs are the “capos” and drug companies are the flunkies.  And what about plan sponsors, including the Federal, state and local governments?

Aren’t plan sponsors, not PBMs, directly responsible for setting copayment or coinsurance?     We addressed this question 12 years ago in our 2005 letter published by the Journal of Managed Care Pharmacy called The Role of Pharmacy Benefits Managers in Formulary Design: Service Providers or Fiduciaries? 

So, why don’t RICO lawyers go after the Feds with their donut hole concoction?  Well, RICO lawyers are calculating types and their cost-benefit calculations point to flunkies, not “capos”, and surely not the Feds, are the most likely to “cop a plea” here.

(Note: see a detailed follow-up article written in January, 2018 called Insulin Drug Price Inflation: Racketeering or Perverse Competition? )

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.

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”.

Today, there are several disruptive forces, including PBM vs PBM,  challenging the PBM business model.  In our opinion, these rent-seeking initiatives  will increase consumer welfare more and faster than any government regulation or ill-conceived RICO lawsuit.

1. Express Scripts is going after CVS’s bricks and mortar pharmacies by announcing it will soon open up its networks to outside mail order pharmacies.  Express Scripts is positioning itself to cover Rx drugs by Amazon’s soon-to-be rolled out online pharmacy.
2. Amazon will be rolling out an online pharmacy.  Likely, it will be subscription business model designed NOT to make money on Rx but make it up on whim purchases of private label, beauty, household, and OTC healthcare products.
3. Pharma is showing signs of challenging the current (see below) PBM rebate game of high list – high rebate by list pricing drugs below net prices of therapeutic class leaders.  The first crack in the PBM rebate game came a year ago with AbbVie’s pricing of its HCV drug Mayrret.
4. Startups are recognizing that you don’t have to be come a full-fledge PBM to disrupt the Big 3.  The core money maker of PBMs today is “smarts” — formulary management — not “plumbing” — mail order pharmacies and retail Rx adjudication software.   Our open-source idea for an independent formulary company fits this trend.

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.

While we are naming names responsible for one the most consumer unfriendly antitrust  decisions in recent history, we want to called out Howard Shelanski et al  at the FTC and George Rozanski, partner at Bates White  Economic Consulting as the economists whose analysis of this merger focused mistakenly on PBMs as sellers of benefits management services rather than as buyers of drugs for resale to plans.

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 considerably over the past 15 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.

At the same time Medco’s rebate retention rate — rebates retained divided by gross rebates received — dropped from 55% in 1Q03 to 28% in 2Q05

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 to be 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 to 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 of 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  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 reducing costs by promising increased volume to preferred providers in return for lower unit prices.  In 2006,  we found PBMs’ 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 read our 2005 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 ten times 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?  This is achieved by a perverse business model that forces Pharma to play a two-step negotiating game starting with lock-step list price inflation 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 increase 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 model. There are other drug companies besides Merck that 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 Hepatitis 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 drug now on the market.

 

PBMs as Business Model Imperialists

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.

An example of this is Express Scripts’  October 2017 acquisition of the medical benefit management company eviCore Healthcare for $3.6 Billion dollars.

On the one hand, self-injectable biologic drugs are covered under a drug benefit plan administered by a PBM like Express Scripts. On the other hand,  biologic drugs requiring infusion or injection supervised by a physician at a doctor’s office, clinic, or hospital are covered by a medical benefit plan managed by insurance companies and contracted specialists like eviCore.

The business models are different with PBMs using a reseller model while companies like eviCore use a fee-for-service model.

We think that Express Scripts will try to convince insurance companies that contract with eviCore to switch from a fee-for-service model to a reseller model.  Express Scripts will promise eviCore customers a reduction in overall drug benefit costs if they allow a business model switch.

Express Scripts will achieve cost-saving by promising specialty drug companies exclusivity in insurance coverage for any given therapeutic class in return for greater rebates.  The opaque rebate retention Express Scripts earns should exceed what eviCorp had been getting from fees-for-services.

This is not the first time that a PBM has pursued  a new area of managed care with the intent of changing the business model.

In a 2008 article, we called Medco’s move into fee-for-service disease management a case of “business model imperialism.”

Another example of PBM business model imperialism was a 2009 deal between Express Scripts and Anthem (formerly Wellpoint) to manage its PBM business.  It was structured as a “book of business” deal  where Express paid $4.68 Billion upfront in return a 10 year right to the opaque P&L.  An alternative would have been to structure the deal as a normal fee-for-service PBM contract with 100% pass through.

We called the deal a “double-trouble front” and sure enough, it proved very lucrative for Express Scripts.  It was a headache for Anthem because they had no idea how much Express Scripts was profiting from managing their PBM business.

Express Scripts was painted as the bad guy in this deal, but the fault lies mostly with Wellpoint’s then CEO Angela Braley for selling out Wellpoint’s customers with little controls over how much Express Scripts could make.

The top priority of both Express Scripts and CVS Caremark today is looking to get into the medical drug benefit business — managing drugs requiring infusion or injection  at physician offices, clinics, or by mobile nurses in the home — and converting the business model from fee-for service or capitated insurance premium to a reseller model with opaque retained rebates.

In January 2018, the new Secretary of Health and Human Services Alex Azar made the recommendation at a Senate Finance Committee that infused drugs coverage Medicare Part B be taken over by private sector PBMs who manage Medicare Part D.

This change might result in a lower costs incurred by the government. But, under the current opaque PBM reseller business model, it would be impossible to tell how much profits PBMs would be making.

All papers downloadable .pdf

 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

Biosimilars & Exclusive Dealing Antitrust Law: The Case of Pfizer Inc v Johnson & Johnson et al. (10/17)

Was CVS’s Formulary Exclusion of Mavyret a Violation of Antitrust Laws? (10/17)

Hepatitis C Virus Formulary Choices for 2018: Will CVS Caremark Risk Looking Bad? (09/17)

Blame Pharmacy Benefit Managers (Not Pharma) For Driving Drug Price Inflation (09/17)

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