Deregulated health care not the answer

Medical capitalism works for investors, not patients

THE UNITED STATES has by far the most expensive health care system in the world. We spent $3.35 trillion, almost 18 percent of GDP and more than $10,000 per person, on health costs last year. The next highest country, Switzerland, spends approximately $7,000 per capita. France, Canada, Australia, and the UK spend about half of the US average on each person and produce outcomes that are no worse and in some cases better. This is not news. The US has maintained its outsized health-cost growth for years and, given our aging population, continuing on this path will choke off other important spending and constitute an economic drag for decades. We are dramatically less efficient at delivering this service than any other industrialized country. Things have to change.

The policy makers now in charge in Washington believe they have the answer and the House-passed American Health Care Act is an attempt to advance it. Republicans advocate market-driven health care with fewer government mandates on employers, insurers, providers, and consumers. House Speaker Paul Ryan and others argue that the government’s oversized role in health care has impeded the development of real market competition. Conservatives point to significant deregulation in the airline and trucking industries that led to greater competition, lower costs, and more price transparency. They think that deregulated, market-driven health care can achieve a similar outcome if government would get out of the way.

But evidence indicates that unbridled market forces will not make health care less expensive and more efficient. Hundreds of health-related companies are listed on stock exchanges and face the cold-hearted judgment of investors every day. Analysis of information disclosed by those companies suggests that market forces will only accelerate cost pressures and divert more money away from patient care.

There are 60 large health care companies included in the S&P 500. The total revenue of those companies last year was $1.68 trillion with net profit of more than $150 billion. There are 10 other categories of companies in the S&P 500 ranging from energy to financials to telecommunications. The health care sector has more revenue than any other category except “consumer discretionary” companies, an enormous group that includes durable goods, apparel, automobiles, entertainment, and leisure. At the same time, the S&P 500 health care companies collectively generate more profit than any other sector except information technology and financial services.

The revenue and profitability captured by those 60 health care companies can be further divided into 10 subsectors to show where the money goes within the health economy.

The two largest slices of revenue go to distributors and managed care companies. Distributors are intermediaries who help manage the supply chain of specialized products for hospitals, clinics, doctor offices, and nursing homes. Managed health care refers to insurance companies and HMOs that collect billions in premiums from employers, individuals, and governments and reimburse providers who deliver care to their insured populations. But in this health care market, there is less symmetry than one might think between revenue and profit.

When measured by profit, distributors and managed care companies shrink substantially compared to biotechnology, pharmaceutical, and equipment companies. The biotech and pharma businesses are particularly eye-catching because they captured a combined 58.1 percent of the S&P 500 health care profit with only 21.3 percent of the corresponding revenue. Both biotech and pharma companies are in the business of producing medicines. The difference is that pharma companies do it based on chemistry while biotech firms produce medicine from organisms such as bacteria or enzymes. Their extremely high relative profitability echoes almost daily newspaper stories about skyrocketing drug prices.

When one drills down into the information filed by individual companies, the trends seen in the overall industry are reinforced. For example, the 10 most profitable health care companies in the S&P 500, as measured by profit margin, are listed in the chart below.

All of these companies except Intuitive Surgical (a manufacturer of robotic surgery technology) make prescription medicines. The very high profitability of biotech and pharma companies offers insight into the marketplace in which they operate. They produce important, sometimes life-saving, medications. For example, Gilead Sciences, the most profitable of these companies, makes anti-viral products that treat HIV and Hepatitis B. Biogen, based in Cambridge, produces therapies for neurological and neurodegenerative diseases. Almost two-thirds of the revenue of AbbVie comes from sales of a single anti-inflammatory drug called Humira that treats rheumatoid arthritis, ulcerative colitis, and similar conditions. Well over half of Celgene’s revenue derives from the sale of Revlimid, a treatment for anemia and multiple myeloma. Highly concentrated revenue sources and the limited life of patents places enormous pressure on these companies to create new products to sustain their business.

The need for heavy spending on research and development is the traditional rationale used by biotech and pharma companies to justify high drug prices. Indeed, these companies do invest a lot of money in R&D. According to their filings, Gilead spent $5 billion in 2016; Biogen $1.97 billion; Amgen $3.84 billion; Celgene $4.4 billion; AbbVie $4.3 billion; and Johnson & Johnson $9 billion. The other firms made similar expenditures. But, as the chart shows, these companies have very impressive profit margins even after accounting for R&D expenses, a fact that undermines the argument for high pricing.

Another element of the high profitability of biotech and pharma companies derives from the unusual market conditions in which they operate. Their biggest customer, Medicare, is prohibited from negotiating for lower prices even though the program accounted for 29 percent of all retail drug spending in 2015. When Congress expanded the Medicare drug benefit in 2003, the price of getting the law passed was a concession to the powerful pharmaceutical lobby. In a classic example of what economists call rent-seeking, the federal government was prohibited from negotiating or setting drug prices reimbursed by Medicare. This has produced a bizarre situation in which other federal programs such as Medicaid and the Veterans Administration pay substantially less than Medicare for the same drugs.

The broader array of health care companies have lower margins than the biotech and pharma businesses. That is not to say they are unprofitable. The chart on the top of page 71 displays the 2016 financial performance of a sample of the largest companies in each of the health care subsectors.  Note that the subsector boundaries are not perfect and some companies are in more than one. For example, Johnson & Johnson, which one might associate with Band-Aids and baby products, receives 46 percent of its revenue from pharmaceuticals, 35 percent from medical devices, and 19 percent from consumer products.While all of these companies sell things aimed at patient service, it is striking how few of them have direct interaction with health care consumers. Only businesses in three of the categories routinely encounter a patient: retail pharmacies, facilities, and to some extent managed care companies. In all the other cases, someone else is buying the product or service before it gets to the patient needing care.

The large retail pharmacy companies CVS and Wal-greens are the places most familiar to customers and, because of their multiple locations and easy access, might be sites where patients could make market decisions based on price. But as anyone who has purchased a prescription knows, the price is normally determined by the patient’s insurance provider, not by the drug store. Customers might see price competition for toothpaste in the front of the store but not for prescriptions.

HCA Holdings, formerly known as Hospital Corp-oration of America, is the largest facility operator with 120 hospitals and 118 surgery centers concentrated in the southern and western parts of the United States. (The company has two hospitals in New Hampshire.) HCA is known for very strong cash flow and its 2016 profit was just under $2.7 billion. The company also spent $3.2 billion in special shareholder dividends plus $8.9 billion in share buybacks to elevate its stock price. It is notable to taxpayers that 41.7 percent of HCA’s revenue came from Medicare and Medicaid.

The other consumer-facing health care companies on the list are insurers and managed care organizations. United Healthcare Group is the biggest—so big that it joined two other health care companies (McKesson and CVS) in the top 10 of last year’s Fortune 500. All three of them were bigger in terms of revenue than General Motors, Ford, and AT&T. Managed care organizations have relatively low profit margins. Their revenue balloons because of the premiums paid by their customers, but they serve largely as transfer agents to providers who treat the patients. Their inventory is money.

United exploits its size and aggressively navigates the regulatory environment in which insurers work. One of the main issues facing insurers since the passage of Obamacare is what’s called the medical loss ratio, which requires insurers to spend a certain minimum percentage of premium dollars on actual medical costs for their covered population. The minimum is 80 percent for small group plans and 85 percent for large group plans. If insurers fall below these levels, they must rebate the difference to their customers. This means that United and similar companies can use 15 to 20 percent of the premiums they collect for marketing, overhead, executive salaries, and profit. United’s medical loss ratio for 2016 was 81.2 percent, which is about as low as it can get and the envy of its competitors. The US Department of Justice alleges that United is too aggressive and has sued the company to recover hundreds of millions of dollars billed to the Medicare Advantage program.

Company filings make it clear that some health care firms have enormous profits and almost all of them do very well in spite of the significant competition they face from other market participants. The disclosures are useful to the companies’ investors but less so for patients trying to make better informed purchasing decisions. The market is effectively opaque from the point of view of an individual trying to decide where to seek treatment or what type of prescription to take.

The large and aggressive market in which health care companies operate has produced more than ample profit but has not effectively restrained the cost of our health care system. The reason is simple. The goal of those companies is to benefit their shareholders and they are free to do so when their customers cannot function as an effective counterweight.

The Republican majority in Congress and many right-wing think tanks want to double down on this approach, further reduce government involvement, and hope for the kind of efficiency produced by deregulated airlines. Few Americans would object to companies earning reasonable profit in the service of an efficient and effective health care system. Governments are capable of purchasing health care efficiently if they can avoid self-imposed restraints. Washington conservatives want to repeal the medical loss ratio provision of Obamacare because it limits the profitability of insurance companies and is viewed as excessive government interference in the marketplace. For the same reason, the conservatives want to retain the law precluding Medicare from negotiating drug prices, which has the effect of increasing the profits of pharma and biotech companies.

Knee-jerk opposition to government involvement in the health care marketplace is misplaced for two reasons. First, government can’t get out of the market. Even in the supposedly ideal deregulated health care world, the government would remain a dominating presence. In 2015, the federal government was the source of 28.7 percent of all the health care dollars spent in the country. State and local governments provided another 17.1 percent. That’s almost 46 percent of health care dollars which governments, as customers, have an obligation to spend well. Second, no one else can effectively negotiate with S&P 500 corporations, especially considering that another 27.7 percent of health care spending comes out of the pockets of individual households. Only about a quarter of the spending comes from businesses or other private sources. The inefficiency of our system compared to the rest of the developed world may arise not from government interference but from our government’s self-imposed inability to act like a sensible buyer.

The argument that health care should become a true market rests on the classical economic theory that competition is the primary regulatory mechanism in a market system. That mechanism can indeed work if certain preconditions are met: numerous competitive firms doing the selling; identical products offered by multiple sellers; and accurate knowledge of prices by the consumer. Those conditions exist in air travel but not in health care, nor will they in the event of massive deregulation. Laissez-faire capitalism is by its nature Darwinian, a concept that works in many industries but is ill-suited for health care. How likely is it that a patient needing the medicine produced by Gilead Sciences will choose to die rather than support their 47 percent profit margin?

In 1963, Nobel prize winner Kenneth Arrow published an article in the American Economic Review called “Uncertainty and The Welfare Economics of Medical Care,” in which he argued that, because of its peculiar nature, health care could not function as a normal market. He predicted that “when the market fails to achieve an optimal state, society will, to some extent at least, recognize the gap, and nonmarket social institutions will arise attempting to bridge it.” His identification of the need for a bridge is not an argument that all physicians should report to bureaucrats or that the federal government should control everything. It is a recognition that some social institution must mediate between patients and the other market participants who have multiple goals of which the patient’s well-being is only one.

Arrow’s advice has value today if we want to provide adequate health care without destroying our economy. But to accomplish that goal we need to contain the uncontrolled market forces that have allowed for disproportionate profitability on the part of some health care companies. Rather than trying to restrain markets even less, conservatives should work to design the social institutions that can moderate greed while encouraging creativity and reasonable returns. The American health care system needs a hybrid design to manage conflicting goals. It should use market forces to encourage efficiency and innovation while using government purchasing power to limit exploitation.

If policy makers choose to make rules that benefit investors at the expense of patients, the system won’t last long before it transforms into something conservatives like even less, complete government control. Writing recently in the New York Times, another Nobel economist, Angus Deaton of Princeton, called for a single-payer health system “not because I am in favor of socialized medicine but because the artificially inflated costs of healthcare are powering up inequality…commanding an ever-larger share of GDP, and funneling resources to the top of the income distribution.”

Meet the Author

Edward M Murphy

Guest Contributor

About Edward M Murphy

Edward M. Murphy worked in state government from 1979-1995, serving as the commissioner of the Department of Youth Services, commissioner of the Department of Mental Health, and executive director of the Health and Educational Facilities Authority. He recently retired as CEO and chairman of one of the country’s largest providers of services to people with disabilities.

About Edward M Murphy

Edward M. Murphy worked in state government from 1979-1995, serving as the commissioner of the Department of Youth Services, commissioner of the Department of Mental Health, and executive director of the Health and Educational Facilities Authority. He recently retired as CEO and chairman of one of the country’s largest providers of services to people with disabilities.

The current system is not sustainable and a fully deregulated market-driven approach is less so. The right policy goal is to create a hybrid public-private system capable of evolving quickly in pursuit of its singular mission to serve patients effectively and efficiently. The market shows that much of our current health care system is structured to serve investors rather than patients. The correct way to reform the system is to realign those priorities so that investors are only a means to an end.

Edward M. Murphy was head of three state agencies between 1979 and 1995: the Department of Youth Services, the Department of Mental Health, and the Health and Educational Facilities Authority. He subsequently ran several health care companies in the private sector and recently retired.  John Frechette and Hunter Fogarty, recent graduates of the business school at Bridgewater State University, gathered financial information for this article. Murphy is a trustee at BSU.