In last week’s blog (Part 1) we tried to answer the complex question of what is flawed with current insulin pricing system in America. But that left out one vital bit- the why. This week I want to explain why it is so dysfunctional and how the forces at play – given the wonder tyranny of compounding – are so opaque in the short term, yet so aggressively malevolent over the long-term.

Inverted Incentives
Let’s cut to the chase. A reduced rebate rake on a very big market generates much more revenue than an increased rake on a small market. Think about that. This means Pharmacy Benefit Managers (PBMs) are incentivised to increase the size of the market and the best way to do this is by allowing price rises. Yes, you read that correctly – the party designated to negotiate prices down, benefits from prices going up! And this is not a socialist conspiracy theory, this is widely recognised by the sell-side analyst community:

“The rebate basis of the system has a fundamental conflict of interest which has perversely encouraged high list prices for drugs (and concomitant price increases)…. Thus the theoretical fiscal sweet spot for PBMs are high priced drugs, with high rebates and high co-pays….[this is the] “frictional costs” in the drug pricing ecosystem as money (ultimately) paid by the “society” for drugs that do not end up as revenues for Biopharma companies.

-Analyst, Evercore ISI

A Case of Compound (Self) Interest
Why has this been allowed to happen?  We could stop here and just blame lobbyists but that would be too easy. Fundamentally, it happens because the slow-acting and pernicious effects of compounded inflation falls under the radar in the short term. And most things are managed on the short-term. The average human generally struggles to comprehend the non-linear power of compounding, so how can we expect politicians – managing a short-term electoral cycle and influenced by well-funded lobbyists – to fare any better?

I have built a quick model to show how the math works and the chart below is the output. I have used the real price rises per vial of insulin. To show the extent of the inverted incentives, I have assumed the drug price discount actually increases from 50% to 70% and that the PBM rake declines from 20% to 15%. Despite these ‘improving’ terms, the compounding effect of the annual price increases still mean that the revenue growth for drug companies and PBMs is inordinately large.

Insulin prices: Company revenue share & patient costs


Source: Kames Capital
Note: General US inflation between 1997 and 2017 has been +55.6% or a compund annual rate of 2.2%
CAGR = Compound annual growth rate
Vial = 10ml or 1000 units (approx 1.5 vials used per month on average)

The illusion of ‘improved’ terms offered by drug suppliers and PBMs is very important for this political narrative. Mr Machiavelli would be impressed. They can point to these as proof that they are ‘doing their best’. Short-term discounts and reduced rebates rakes are much more intuitive than non-linear compound interest.  Drug makers and PBMs can reasonably claim to be offering bigger percentage discounts and taking lower percentage rebates rakes, all while seeing their revenues, patient prices and the frictional costs paid by society grow massively.

Conclusion: Societal Friction Leads to Disruptive Innovation
This is a remarkable system and a sorry state of affairs, however I believe the historic ‘market forces’ narrative behind the current US healthcare system is running out of road. The statistics have been conflated for too long. The absolute dollar burden on society – not to mention the very real and painful costs to individuals that are so often wilfully overlooked – is becoming too large to ignore. Value based care. Regulation. Populist revolts. I believe these will increasingly pressure the valuations, revenues and cash flows of the companies that have been systematically over-earning from patients and society. The duplicity will become common knowledge. But it won’t stop there.

Disruptive innovation is naturally attracted to such problems and it is here that market forces still have a say. The outrageous frictions caused by a rigged system ultimately create opportunities for mission orientated disruptive entrepreneurs. Indeed, we are already seeing numerous young and innovative companies challenging the norm and leveraging technology to provide better and more cost-effective outcomes for patients. These types of companies have eminently more sustainable business models and are the ones that I think will be the long-term winners in the health care space. They will be supported by those advocating change.

It is undoubtedly true that the change cannot come quickly enough. Sadly, it is too late for many but in the words of Sam Cooke, ‘A Change Is Gonna Come!’ Actually, that would have been a good title for this blog too – and a much more positive one.

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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