I often struggle to come up with a title for my blogs, but other times – like this week – it’s difficult to pick between all the options. I had thought about ironically calling it “No collusion!” but you’ve probably had enough of that phrase. I considered “Because we can!”, but that had already been used by a journalist writing on this very topic. In the end an implied expletive was really the only way to go.

Consumer good prices from 1996-2017
Sources: www.bls.gov, www.ibm.com/watson-health/learn/truven-health-analytics, insulin.substack.com/p/insulin-list-price-data-sources

A dysfunctional market
In my opinion, the US drug market is broken. To me, it looks more like a system designed to gouge a cornered customer base than a typical ‘market’. In the case of insulin this ‘market’ equates to 30 million diabetics (2.5 million of whom are type 1 diabetic). It could more appropriately be defined as a racket. Thinking about it, “What a racket!” would have been a good title for this article too.

As an outsider looking in, the US healthcare system can be difficult to get to grips with, particularly for someone who can access socialised universal healthcare. The logic of a private healthcare system is predicated on market forces and justified on the basis of high quality, but if this is true then in the US it comes at a very high cost. Indeed, the stark difference between private healthcare costs in the UK and the US was noted recently by our UK equities team when reviewing the Spirax-Sarco management benefits.  Guess what country Mr Whalen is based in?


Source: Spirax-Sarco company reports

Market forces can be distorted when a product is non-discretionary (like a lifesaving drug), and supply is tightly controlled (or poorly regulated). If those who supply the product are allowed to raise prices significantly above the rate of inflation for 20 years, questions need to be asked. In the case of Insulin, they should have been asked long before prices went up 1171%.

I have written a series about abusive pricing and why fairness can be a source of competitive advantage (see part I, part II and part III). I have also written on the intersection between healthcare and market forces (see Human life: A cost-benefit analysis and Can technology disrupt and democratise drug development?). Our research has translated into a long-term investment theme in our portfolio which I call “Healthy Healthcare”.

We believe companies that deliver improved health outcomes and take cost out of the healthcare system will deliver long-term value for shareholders. Our bottom up stock picks, which we believe fall directly into this category, include Insulet, Peptidream, Cochlear, Illumina, Penumbra, Medidata, Diasorin, Amplifon and Veracyte. Conversely, we believe companies that do the opposite will be put under increasing pressure. In many cases, the drug companies are the focus because they seem to be pushing unreasonable price increases through with little to no added value.

Back to insulin. How and why have prices been rising so fast? A few reasons.

The dark art of ‘patented generics’
I believe insulin is effectively a generic that is patented. What do I mean by this? I would argue that insulin formulas have not improved that much in 20 years. Purity has improved and formulas have been tweaked, but I suspect this has been achieved at relatively low cost. Most importantly it has been just enough to maintain patent protection and prevent generic competition. These improvements are used as justification to push through large prices increases year on year. According to the Lancet, 90% of US patients are put on the most expensive insulins. I strongly suspect this dynamic means that diabetics are used to heavily subsidise R&D in other drug categories – small mercies if this is the case. NB – This all seems somewhat perverse when you consider that Frederick Banting (who discovered insulin in 1923) felt it was unethical to patent or profiteer from his innovation. His co-inventors sold the patent for $1.

The system is opaque
Most American diabetics “co-pay” for their insulin. This means that insurance companies pick up part of the bill. So if insurance companies are paying, why don’t they fight to push prices down or want patients on cheaper formulations?  Well this is where the Pharmacy Benefit Managers (PBMs) come in and it all gets very complex and opaque… so please bear with. A full definition of what PBMs do can be found here but in simple terms, they are buying groups designed to negotiate drug prices down on behalf of insurance companies and patients.  But as part of their role as the patients advocate middle man they are allowed to take some of the discount that they negotiate as their cut or “rebate”. Sounds reasonable right? Except they don’t need to disclose what the discount is or what percentage their rebate rake is. The net price is a closely guarded secret. So patients can’t see how much of the benefit is passed to them.

Poacher turned game keeper… ehh… turned poacher!?

All of the PBMs have been acquired by insurance companies. This means the insurance companies get to keep the PBM rebate rake, whilst also passing on price rises to patients via increased insurance premiums and the patient’s deductibles upfront claim penalty. Thus, assuming competition is rational co-ordinated, insurance companies will pass insulin price rises on to patients whilst also capturing the PBM rebate rake.

Ok, so the system is never going to be perfect. Pharmaceutical companies will obviously push for price rises but the market mechanism should still keep prices down to some extent, right? Wrong.

Next week I will explain why this is …….

About the author

Craig Bonthron is an investment manager in the Equities team, responsible for actively co-managing high conviction global equities portfolios. He focuses on analysing disruptive and sustainable investment trends within the technology, healthcare, industrial and consumer sectors in order to identify high conviction stock specific investment ideas.

He joined us in 2014 from SWIP, where he was an investment director in global equities. Prior to SWIP, he was a portfolio manager at Kleinwort Benson Investors. Craig has a 1st Class honours degree in Building Surveying and an MSc with Distinction in Business Information Technology Systems from Strathclyde Business School. He has 18 years’ industry experience (as at 30 April 2019).

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