Prospects for Conference; HMO Relevance of New Senate Provisions; Re-Importation is Back

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Richard Evans

212.531.6101

richard@sector-sovereign.com

December 21, 2009

Prospects for Conference; HMO Relevance of New Senate Provisions; Re-Importation is Back

Health Reform Heads to Conference. Buckle up ..

  • A January conference will attempt to merge disparate bills against what is likely to be a backdrop of eroding public support
  • Nelson’s abortion compromise is Stupak-like in practical and political effect. Practically, by requiring enrollees to make separate payments for abortion coverage, few if any such plans will exist. Thus politically, the Nelson language is likely to be viewed as a comparable, perhaps even identical, loss of choice
  • Nelson is a credible threat to filibuster a final vote if abortion language is softened; Stupak’s bloc is an equally credible threat in the narrow House. Thus it still appears that progressives would have to accept lost ground on right-to-choose (and the Cadillac Plan tax which falls heavily on unions) in order to pass a final reform bill
  • Consensus appears to be that Senate reform provisions hold sufficient progressive appeal to warrant the loss-of-choice and union-tax tradeoffs. We take a markedly different view, believing that many progressives see the Senate bill as tipping the American health system permanently toward private interests, and away from state power

Manager’s Amendment HMO Provisions …

  • The revised Senate bill restricts insurers’ MLRs to between 80 percent (small group and individual) and 85 percent (large group). The bill calculates MLR differently than insurers report MLR in financial disclosures – taxes, reserves, and other charges are deducted from revenues; operating expenses that improve quality of care are added to medical costs. Both effects raise MLRs. Our calculations suggest large insurers already meet the requirement
  • The tax on insurers now starts later (2011) but gets larger ($10B v. $6.7B), and may be borne wholly by for-profits. We view the tax as a pass-through which, worst-case, represents a 1.4 percent underwriting cost disadvantage for for-profits relative to not-for-profits for a single year – 2017. In preceding and subsequent years the effect is much smaller
  • We review the national plan from the perspective of local (state-level) market share relative to incumbent underwriters. On average, the national plan’s share of enrollees in a given local health market is one-tenth that of the largest local underwriter, meaning the national plan is decidedly sub-critical in terms of negotiating leverage with providers
  • We note that elimination of the tax in 2010 clears the way for insurers’ net profits to reflect MLR expansion as a result of stabilizing employment and a probable easing of flu comparisons

Administration Intends to Pursue Re-Importation Outside of Reform Bill

  • We make our perennial argument that re-importation is nothing more than a political shock-absorber for the large cap pharmaceuticals industry – a means by which Congress can release political energy without having any economic effect
  • Even if we were to bypass FDA and import EMEA approved medications – which we almost certainly won’t – we calculate that branded pharmaceutical revenues would fall by just 2 percent

Reform Prospects – What Likely Happens Next

Odds now clearly favor the Senate passing its amended health bill, moving the health reform process closer to the end game of a House / Senate conference in January. As ever, our thesis is that reform risks have less to do with whether a bill can pass the Senate, and more to do whether the Senate can pass a bill that the House can also pass, and vice versa. These risks come to the forefront in the pending conference process, wherein conferees will attempt to merge two very different bills together against what seems likely to be a backdrop of continued erosion in public support (see Appendix).

The abortion issue remains a primary risk to passage. The Senate’s agreement on compromise language has secured Nelson’s vote, but has not defused the issue – in fact both pro-life and pro-choice groups have rejected the Nelson language over the weekend. The Nelson (Senate) language allows beneficiaries to enroll in plans that cover abortion services; and, these plans can be listed on public exchanges, and can receive federal dollars. The Nelson stipulation is that the beneficiary has to pay the entire cost of the abortion coverage, and has to pay this cost in a payment that is separate and distinct from the premium they pay for non-abortion health coverage. The more stringent Stupak (House) language prevents plans that offer abortion from being listed on exchanges, or from being purchased by anyone that receives a federal subsidy for the purchase of health coverage. The Nelson language is at least cosmetically more permissive than the Stupak language, but as a practical matter both are likely to lead to the same result – no plans with abortion coverage. Forcing beneficiaries to pay separate and distinct premia for abortion coverage makes those plans covering abortion unattractive enough to a large enough percentage of the population that such plans may simply be non-viable. It follows that the abortion issue is anything but defused; we expect that House progressives would tend to view the Nelson language in essentially the same light as the Stupak language. A conference report that softens either / both of these limitations almost certainly loses Nelson’s vote in the Senate, and the 10+ votes of the Stupak bloc in the House. Given narrow margins in each chamber, and the very credible threats from both Nelson and the Stupak bloc to put their pro-life votes ahead of their reform votes, we continue to expect that abortion restrictions in any final bill are on par with the effective nature of the Stupak / Nelson provisions, and are perceived by House progressives as lost ground on right-to-choose.

The Senate bill continues to rely on the Cadillac Plan tax as a predominant source of pay-fors. Recall that union members’ health benefits are twice as valuable as non-union workers’; and, that the average union worker would fall subject to the Cadillac Plan tax by 2014. The manager’s amendment adds seven states to the original bill’s list of ten states for which the tax is implemented a bit more slowly, but the tax still ultimately comes into complete effect for all states. The amendment adds longshoremen to the list of excluded professions, nevertheless the AFL-CIO and SEIU are increasingly working to defeat the Senate reform bill. Note that ‘yea’ votes on the House reform bill, which has no Cadillac Plan tax, have an almost perfect (98.8 / 100) AFL-CIO score.

Progressives’ favored health reform provisions — the Medicare buy-in and public plan – both are effectively dead in the Senate bill. Thus the pending conference continues to look like a setting in which House liberals / progressives are asked to accept restrictions on choice and a tax on unions in exchange for a health provisions that – at a minimum – they do not support.

More than that, we expect that at least some progressives actively oppose the Senate bill’s reliance on private insurers. The apparent death of the public option emphasizes a deep ideological divide regarding what should be the fundamental structural underpinnings of the health system. Generally speaking, since failure of the public option last week, the progressive argument has been that to continue with reforms risks cementing for-profit insurers’ role as an essential structural element of the health system for decades to come. Thus it may be too restrained to suggest that progressives are likely to be asked to vote for something they don’t like; rather, we sense that many progressives view a vote in support of the Senate bill, or something very much like it, as a vote that closes the door permanently on progressives’ preferred means of structuring and regulating the broader healthcare system.

We acknowledge a series of risks to our thesis that reform efforts fail. On a purely objective level, continuing to argue against passage in the face of House and Senate bills having been passed is a statistical reach, and we plainly recognize this. Nevertheless, we stick to our view that the risks are and have always been concentrated in the differences between the two chambers’ views of healthcare; this has always implied initial passage by both chambers, and failure in conference. We also recognize that a conference report could be brought in the progressives’ direction by moving on two dimensions – protecting union members from Cadillac Plan tax effects such that the tax falls on non-union wealthy; and/or, by tightening regulations on insurers to a point at which progressives are willing to accept the resulting balance between state power and private insurers’ freedoms as sufficient. As regards the former, protecting unions from the Cadillac Plan effects has a 1:1 effect on CBO scores, which are already quite tight, unless additional taxes are added are benefits cut elsewhere. As regards the latter, added MLR restrictions in the manager’s amendment appear to run up against limits of acceptability informally set by CBO, which suggests that any further restrictions on insurers would tend to affect the nature of what is sold, rather than the profitability of the seller.

Effect(s) of the Manager’s Amendment on Insurers

MLR Restrictions

The manager’s amendment provides for medical loss ratio (MLR) minimums on private insurers; these appear to apply to all medical coverage sold in the US, whether sold through the exchanges or otherwise. The minimum ratio for large groups is 85; for individuals and small groups the minimum is 80. These restrictions would go into effect in 2011; unlike provisions in the House bill, the MLR restrictions would not sunset.

Importantly, the manager’s amendment calculates MLR differently than insurers’ calculate and report MLR in financial disclosures. Specifically, the revised Senate bill deducts federal and state taxes, additions to reserves, regulatory fees and other charges from revenues, thus reducing the denominator (and raising the ratio) relative to the traditional reported calculation. And, the revised bill adds to the claims cost numerator (again raising the ratio) that portion of operating expenses incurred for ‘activities that improve healthcare quality’. Such activities are not defined in the bill; the National Association of Insurance Commissioners (NAIC) is tasked with developing this definition by 2011.

We examined the simple-weighted average / as-reported medical loss ratios for the four largest US insurers from 2006 through 2008, and compared reported MLRs to those that we would expect to see under the calculations envisioned by the Senate bill (Exhibit 1). As-reported MLRs varied from 80 to 82 percent between 2006 and 2008. Adjusting revenues for taxes (2.4 percent of revenues) and additions to reserves (1.1 percent of revenues) raises the MLRs by roughly 3 percent. The portion of past operating expense that would fit NAIC’s as-yet non-existent definition of course cannot be known, so we consider a range. Note that we only have to assume that one-quarter of operating expenses can be attributed to activities that improve health quality in order to show MLRs that are already consistent with the most restrictive (large group, 85 percent) of the Senate’s proposed MLR ranges. The ‘blended’ MLR requirement will of course lie somewhere between 80 and 85; and, we make no assumption for expanded volumes as a result of federal subsidies.

The Tax on Insurers is Later but Larger; Impact is Minimal

The original Senate bill provided for a $6.7B tax on insurers beginning in 2010; the revised bill postpones the beginning of such taxes to 2011, and employs a rising scale – the tax is $2B in 2011, $4B in 2012, $7B in 2013, $9B in 2014 – ‘16, and $10B thereafter. Certain non-profits are exempt from paying the tax; it is not yet clear to us whether non-profits’ premiums are included in the denominator used for determining for-profits’ share of total fees. If not, this means that the average for-profit insurers’ share of the tax could be much larger under the manager’s amendment than in the original bill. We continue to view the tax as a pass-through, but recognize that the change toward having a tax that is paid only by for-profits puts non-profits at an incremental underwriting advantage as the tax escalates. Even assuming for-profits pay the entire $10B, at the first year of ‘full’ tax (2017), and assuming a premium growth CAGR of 8 percent, the tax would represent a roughly 1.4% cost of underwriting dis-advantage for for-profit insurers relative to not-for-profit insurers. The effect is smaller in years preceding 2017 because of the ramp-up in the tax, and in subsequent years as the tax remains nominally fixed.

Market Share and Purchasing Power of the National Plan

In place of the public option, the manager’s amendment provides for a national plan along the lines of the Federal Employee Health Benefit Plan (FEHBP).

Whether this version of the public option survives is far from clear; nonetheless we believe it’s worthwhile broadly characterizing the market impact of the national plan as we understand it. The market impact appears to be quite limited, both in terms of the national plan’s effect on existing for-profit insurers, and its effect on providers / suppliers of healthcare products and services.

Building on the premise that healthcare is locally produced and consumed; insurers need a critical mass of local market share in order to have sufficient leverage over local providers. Absent this, sub-critical insurers almost certainly face higher input costs than larger insurers. As far as we can tell, the national public option, as designed, is decidedly sub-critical.

We evaluated the relative market share that a national public option might have, as compared to incumbent insurers in each state. To get to the comparison, we found the number of uninsured persons between 133% and 400% of FPL in each state, and adjusted enrollment rates according to our findings on attitudes / values as outlined in the prior section. We also examined the market shares of the leading health insurers in each state, and compared the estimated market share of the public option to the market shares of the incumbents, again on a state-by-state level. The results are in Exhibit 2. On an enrollment weighted basis, the average public option would have one-tenth the market share of the largest local underwriter, and one-quarter the market share of the second largest local underwriter. Worse, note that these relative shares assume that all public option enrollees in a given state enroll in the same public option – which almost certainly will not be the case. As we understand the design, enrollees will be given a choice of at least two plans within the broader umbrella of a national public option, meaning the already sub-critical relative shares in Exhibit 2 are more of a best-case scenario than an expected value.

Thus the national public option appears to pose very little threat to incumbent underwriters or providers / suppliers of products and services. In fact, the national public option design places incumbent underwriters at an advantage to the extent they are allowed to offer non-profit options in their local markets as a choice on the national ‘menu’. More simply, this latest design appears to complete the migration of the public option from a single payer to a Blue Cross / Blue Shield plan.

Administration Vows to Pursue Re-Importation Outside of Reform Bill

Drug re-importation has made a halting comeback over the last week, first as an amendment to the Senate health bill (which failed), and over the weekend as a promise by Chief of Staff David Axelrod that the Administration would pursue re-importation outside of the context of the immediate legislative effort. As a practical matter we see little risk of re-importation changing the US branded pharmaceuticals market; in fact, we have for many years viewed the re-importation issue as a political shock absorber for the pharmaceuticals industry – an issue on which Congress can spend its pharmaceuticals-directed political energy with no economic effect.

Drugs cannot be prescribed or sold through mainstream channels (drug wholesalers, drug retailers, local pharmacies, PBMs) unless they are FDA approved. To be FDA approved, every step of the manufacturing process, from bulk chemicals to final dosage form in a sealed package, has to be FDA validated and approved. All of the major manufacturers work from global supply chains; however any manufacturer can segregate US and non-US production by segregating a single step or steps out of the global supply chain. For example, a manufacturer can produce its non-US supply on the same production lines as its US supply, but as long as a few key steps — for example pressing of pills or final packaging – are done in a setting that is not offered for or open to FDA inspection, then the (non-US) goods that go through those final steps are not (and cannot be) FDA approved – and correspondingly cannot be sold in the US.

Thus re-importation is a misnomer; goods that would come into the US from non-US countries would never have been made for the US, or FDA approved. There are only two ways around this – require manufacturers to make their global supply chains available for inspection and validation; or, accept other countries’ regulatory approvals as adequate. Both are blind paths. Regarding the first, forcing manufacturers’ to open their ex-US facilities to US inspection, even when no-US commercial activity takes place there, is almost certainly beyond Congress’ legislative reach. And, there is no reason to expect foreign regulators to be complicit in harmonizing their regulatory standards with ours, as to do so is to open their (smaller and lower-priced) markets to US demand – with inevitable home-market supply shortages and/or price inflation as a result. All of which means the US either imports source countries’ regulations, or these countries cannot serve as a source of lower-price goods.

We’re convinced the US will not import source countries’ regulations, and so continue to see re-importation as an aging paper tiger. Nevertheless, to defend the thesis further, even if we assume that we do import source countries’ regulations, we see little or no effect on companies’ earnings. If we were to import source country regulations, we would presumably go for the best, i.e. we would source from EMEA[1] countries. We examined relative pricing and unit volumes in EMEA countries as compared to the US. Most simply, if we assume fixed volumes across the US and EMEA[2], and further assume that borders are transparent and transaction costs are zero, then ‘pan US-EMEA’ prices presumably would move to or toward the volume weighted average of these combined markets. Under these assumptions US prices (ex-manufacturer) would fall by 20%, and EMEA prices would rise by 30% (Exhibit 3). We might further assume that EMEA ex-manufacturer prices would hold because of government fixes on pricing[3], and that only US prices would fall – in which case we would simply have the 20% fall in US prices, without the corresponding benefit to manufacturers of higher selling prices ex-US .

More realistically, we would expect source-country ‘street’ price reactions to be more sudden and severe than in this overly simplified scenario. Again assuming relatively fixed supplies per country, as US demand began to remove units from a given source country, that country’s effective prices would rise as a result of the shortage, to the point that effective prices in the cheapest country were at the same level as in the second cheapest country. At which point prices in the two cheapest countries would rise to the level of the third cheapest, and so on. If we assume that source-country ‘street’ prices rise 1 percent for each 1 percent reduction in supply; and, that re-importers source goods for the US beginning with the cheapest country and moving to more expensive countries as prices react, then (assuming frictionless borders and zero transaction costs) EMEA countries would ‘yield’ enough units to satisfy only half of US demand before source-country prices equaled current US prices. We estimate that these EMEA units would have a weighted average price equal to 80 percent of prevailing US prices, i.e. US retail prices would fall by 10 percent (since EMEA units only satisfy one-half of US demand). Using US wholesale gross margins (roughly 4 percent) as a very conservative estimate of the costs of cross-border movement, we assume that EMEA goods would ‘enter’ the US supply chain at a relative cost equal to at least 84 percent of prevailing US prices. At half supply, this would reduce US prices by 8 percent, and global prices by roughly 2 percent.

  1. European Medicines Agency
  2. There is no reason to believe or assume that manufacturers would ship more volumes to lower priced countries if re-importation legislation passed – since the additional volumes clearly would be shipped to higher priced countries in a price arbitrage. We’re virtually certain manufacturers would limit supplies to limit cross-border price arbitrage, as is current practice, as evidenced by the broad range of prices in the EMEA.
  3. Though end-user prices would certainly rise in source-country markets (as supplies fell), in the face of constant demand.
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