False Heroes — How PBMs Add Insult to the Injury of Insurance Cost-Sharing

Peter Kolchinsky
Mar 24, 2018 · 17 min read

Peter Kolchinsky, Ph.D.

This is the fifth in a series of articles that aim to define the biopharmaceutical industry’s social contract with America, to examine practices that deviate from that contract, and to propose refinements to healthcare policy to ensure that our continued investment in scientific progress ultimately yields affordable, effective therapeutics for future generations.

Article 1: America’s Social Contract with the Biopharmaceutical Industry
Article 2: What happens when a drug won’t go generic?
Article 3: Protecting Off-Patent Sole-source Drugs from Price-Jacking
Article 4: Why wait for Generics? In praise of me-too drugs
Article 5: False Heroes — How PBMs Add Insult to the Injury of Insurance Cost-Sharing

Op-Ed: Let’s Throw a Patent-Burning Party

Article 6: The favors they do us: Charging less in other countries makes drugs more affordable in America
Article 7: Hard Negotiating Tactics: Compulsory Licensing and Willingness to Deny
Article 8: Unintended Consequences of “Fairness”: Critically examining the idea of the US referencing EU prices
Article 9: Direct-to-Consumer (DTC) Advertising: misnamed, misunderstood, and underappreciated
Article 10: The strange and special case of epinephrine

Please see Important Disclosures for Readers at the end.

It’s hard to know when actual drug prices for a particular drug really do go up, because there is little transparency in pricing. A lot of the public discourse on pricing is based on “list prices” that no one actually pays since, as with cars and Amazon, everything is always on some kind of sale. In the world of pharmaceuticals, these discounts are called “rebates,” are largely kept as trade secrets, and take the form of payments back from the drug company to the insurer through an intermediary called a Pharmacy Benefit Manager (PBM). PBMs retain a portion of the rebates that pass through them¹, profiting from the same high list prices they appear to heroically negotiate down. A pharmaceutical company offering a lower list price without a rebate would threaten the PBM business model, and so list prices stay high while the PBMs collect their rent.

As with children’s stories, where there is a hero, there is necessarily a villain, and therefore rising list prices give the public the sense that it is the drug companies engaged in extortion despite payers’ best efforts. But in reality, America’s flawed and fragmented health insurance system perversely incentivizes these middlemen to embrace higher drug prices in exchange for their secret discounts and unfairly foists healthcare costs onto patients under the guise of having “skin-in-the-game”. That con goes something like this: unless a patient is responsible for a share of his or her healthcare costs — through copays or ever-higher insurance deductibles — he or she will seek out unnecessary treatments and services. Yet those out-of-pocket costs are exploding and evidence is mounting that patients cannot discriminate between frivolous spending and life-saving treatments.² Faced with overwhelming costs, some patients simply can’t reconcile their financial means with their doctor’s orders, demonstrating that they were never truly insured against the costs of illness. Adding insult to injury, when patients do pay those co-pays, they pay based on list prices while PBMs and other payers keep the rebates they extract from pharmaceutical companies for every filled prescription.

During the year 2017, when the public perception was of drug prices running amok, the actual net prices after rebates only climbed 1.5%³, according to the PBM Express Scripts, with growing rebates representing the difference. Some of those rebates are reflected in PBMs’ rising profits. Some are passed through to the insurer. But these were not actually refunded back to patients subjected to cost-sharing through deductibles and co-pays. For example, patients stuck with a 20% co-pay on a $10,000-per-year drug that may cost the PBM $6,000 are really covering a third ($2,000) of the drug’s cost. Patients that had not used up their deductible would have to buy a drug at full price, but their insurance company would pocket the rebate from the pharmaceutical company. Payers defend the practice by claiming that rebates helped to defray the cost of insurance for everyone, but that meant that sick patients were subsidizing the healthy. The perversity of the current system is galling.

In a speech delivered to insurance company executives in early March, FDA Commissioner Scott Gottlieb hammered home the point. “Patients shouldn’t face exorbitant out-of-pocket costs, and pay money where the primary purpose is to help subsidize rebates paid to a long list of supply chain intermediaries, or is used to buy down the premium costs for everyone else,” he said at the national health policy conference of AHIP, the insurance company lobby. “After all, what’s the point of a big co-pay on a costly cancer drug? Is a patient really in a position to make an economically-based decision? Is the co-pay going to discourage over-utilization? Is someone in this situation voluntary seeking chemo?”

In early March the insurer United Health caused a stir in the world of health insurance by suggesting the most banal and what might seem obvious measure: beginning in 2019, United would begin to pass rebates through to some patients. The details remain opaque — and whether consumers would see any real savings remains to be seen — but this is an overdue if narrowly applied gesture designed to assuage Americans angry about their growing out-of-pocket expenses. United’s program will cover plans affecting only seven million Americans, and hopefully more plans will follow.

Counteracting co-pay assistance

But if insurance companies appear to be giving with one hand, they’re likely taking away with the other. In 2018, a new “benefit” appearing in health plans across the country is designed to thwart the ability of drug companies to help patients pay the out-of-pocket costs of drugs, particularly the costs of specialty medicines that can reach tens of thousands of dollars per year. Drug companies often provide patients with coupons to use at the pharmacy that cover the costs of their medicines until a patient has reached an out-of-pocket maximum spend, after which the patient’s insurance company covers the costs. These co-pay assistance coupons represent yet another way, besides rebates, that pharmaceutical companies charge less than their publicly disclosed list price; they are the most direct way to counteract the toxicity of cost-sharing imposed on sick patients by payers. Yet so-called “co-pay accumulator” programs would block manufacturer assistance from being applied to a patient’s deductible or co-pay, so that the patient herself must pay the cost once the drug company discount runs out.

In essence, the payers have found a way to tell pharmaceutical companies, “we won’t pay anything until the patient has felt the sting of your drug’s cost; only then will we believe that the prescribed treatment is actually medically necessary.” The wealthy can afford this arrangement, but it’s punitive to the large portion of the population on private plans, Medicare, and many on Medicaid and likely to result in decreased adherence to a physician-prescribed treatment. Poor adherence to medication often results in lower drug spend — but overall health costs may in fact rise when health problems go untreated.

Paraphrasing from “America’s Social Contract with the Biopharmaceutical Industry,” it is not the actual price of drugs that make them unaffordable to individuals. It’s America’s intentionally poorly designed health insurance, specifically the practice of cost-sharing, which through co-pays and deductibles offloads cost disproportionately onto sick patients. Drug companies compensated with co-pay assistance, and now insurance companies are responding with co-pay accumulator programs. Patients will suffer — financially or with poorer health.

Most patients are not qualified to second guess their doctors, but payers might be expected to spot overutilization and make sure that physicians adhere to standards of care, prescribing less expensive drugs whenever appropriate. It wouldn’t be necessary to even use co-pays to nudge patients to take a generic version of a branded drug if formularies simply refused to carry a brand unless it cost the same as its generics (which is essentially how it’s done in some European countries). And as nice as it was that United Health decided to use rebates to at least partially offset co-pays, if drugs were properly covered by insurance without cost-sharing, as they are in many countries, the discounts payers appropriately negotiate by playing similar drugs off one another actually could go towards lowering insurance premiums and healthcare-related taxes for everyone.

A Counter-factual

Just about everyone, except the PBMs themselves, appear to be outraged by what’s coming to light as the public learns more about PBM tactics. PBM contracts with their clients are filled with hidden pockets of profit even beyond the comparatively straightforward idea of retaining drug rebates, according to a recently leaked contract. Their bargaining power stems from how concentrated the PBM market has become; the top three, Express Scripts, CVS/Caremark, and United’s OptumRx, represent 80% of the PBM market and serve insurance plans covering half of the US population.

Whether or not insurers should continue to rely on PBMs to manage drug price negotiations is a point of some debate; one could argue that the bloated administrative costs of PBMs’ complex scheming and the profits they generate represent a layer of rent on society that can be eliminated. Indeed, not all insurers sub-contract with a PBM, choosing instead to create their own formularies and negotiate directly with drug companies.

Yet, by my crude estimate¹⁰ (extrapolating from Express Script’s financials¹¹ and 28% market share¹² to the whole PBM market), what PBMs skim off the top by these controversial means would add up to maybe as much as 7% of the estimated $338B drug spend in the US in 2017¹³, not a source of dramatic savings for society. Even so, doing away with PBMs would go some way towards closing the gap between the list prices that the public sees (and scorns) and the net price that more accurately reflects the cost of drugs to society.

Someone has to do the work of managing formularies and negotiating drug prices, just as someone has to do the work of organizing health insurance overall, so there is probably a role for PBMs, just as there is a role for health insurance companies (i.e., the payers). However, PBMs should compete based on their overall level of effectiveness and efficiency, without the perverse incentive to encourage higher drug prices off which they can negotiate steeper rebates. If, as a recently proposed federal bill directs¹⁴, PBMs were required to pass through the entire rebate to their insurance-company customers, many of these perverse incentives would go away. As would a portion of PBM profits. So be it. Though it would still leave the insurance companies conflicted.

Misalignment and Myopia

The larger truth is that payers have an incentive to let the overall cost of healthcare rise. For example, the Affordable Care Act plans that the US Government contracts will explicitly spend 80–85% of their revenues on patient care, the so-called Medical Loss Ratio (MLR)¹⁵, which includes hospital services and drugs, leaving 15–20% for the insurance companies to spend on their own operations, with anything left over as profit for their shareholders. If their profits are linked to the size of the pie, then they will want the pie to grow, though for appearances they will want to be seen trying to contain costs. In theory, multiple payers bidding to manage a government plan or administer one for a private company will try to demonstrate that they can provide great care at a low cost to the client. However, with all the consolidation in the insurance business, most purchasers only have two or three plans in their region to choose from, and some have just one. When there are so few choices, sellers can tacitly collude to keep costs high: without saying so (which would make it actual, illegal collusion), one can convey through inaction that “I won’t offer your customers a discount to switch to my plan if you don’t offer my customers a discount to switch to your plan.”

Payers set their budgets annually, having to guess as to their costs over the next year so as to set their premiums at just the right level so that they are competitive with what other plans charge but have at least the 15–20% margin they want to make to cover their own operating costs (and, in the case of for-profit plans, have some profit left over). Sometimes they are caught off guard by the launch of a drug for which they failed to anticipate the price and degree of demand, as happened when Gilead launched its breakthrough hepatitis C drugs Solvaldi and Harvoni in 2014. It was in fact predicted well in advance (and some did¹⁶), while the drugs were still in development, that a pill that increased cure rates as substantially as these treatments did would drive much higher utilization (i.e. lots of patients would want treatment) and wouldn’t be cheap.

But payers seemed to need to actually see the FDA approve these drugs, although their safety and efficacy profiles in developmental stages were highly compelling and lauded by physicians. Payers needed to see these drugs actually priced at levels that were predictable to investors and analysts who long followed the development of these drugs and knew that Gilead’s share price was predicated on high pricing. And some payers even maybe needed to see physicians prescribe them with enthusiasm to droves of patients who had been holding back on taking other, less effective, injectable therapies, in anticipation of Gilead’s all-oral cure coming to market. Once all that played out, payers reacted with shock and outrage over the “unexpected” cost to their budgets, joined in their outrage by politicians and the public. In 2015, the outcry over drug costs contributed to a steep decline in the value of stocks in the biotech sector and the pace of investing due to fears that the industry would face price controls. But within two years of Harvoni’s launch, the uproar over pricing died down. Payers assimilated the cost of these drugs into their budgets and arguably overcompensated as they discovered that competition within the class (thanks to the launch in 2015 of AbbVie’s competing drug Viekira Pak) quickly cut prices by as much as half, of course generating windfall rebates for the payers.¹⁷

What payers really want is predictability of expenses so they can adjust their future revenues to future expenses. Were they to do a better job of anticipating what’s coming through the R&D pipelines of pharmaceutical companies, they might budget more effectively and spare patients the kinds of rationing tactics payers employed in the case of hepatitis C drugs. For example, even though the FDA had approved the drugs for the treatment of patients with hepatitis C regardless of stage of their disease, some plans restricted the drugs to patients with more advanced disease¹⁸, triggering injunctions by federal judges concerned that rationing might be illegal (cases are still winding through courts).¹⁹ Many restrictions were later lifted as prices fell, demonstrating that the most powerful negotiating position is the willingness to just to say “no” to a new drug, which European countries are more willing to do than payers in the United States.²⁰

Many hailed hepatitis C drugs as cost effective compared to the alternative: letting patients continue to suffer from the disease, develop liver cirrhosis, and either die or undergo an extremely expensive liver transplant.²¹ But cirrhosis and transplant occur only later in life, in most cases after a person is over 65 and on Medicare. Therefore, private insurers covering younger, typically-employed individuals and Medicaid plans covering younger, poor individuals only considered the cost of curing patients, not the downstream savings, which would accrue primarily to Medicare. Furthermore, private payers often cite the mobility of their customers (patients typically switch plans every few years) as reason why it’s not worth paying for a treatment today that will result in savings down the road. This is clearly parochial thinking; if all payers agreed to pay for prevention, they would all benefit as they get each other’s patients over the course of many rounds of musical chairs.

Flawed and Fragmented

A single-payer system would capture both the total costs and the total savings of a new treatments, running cost-effectiveness models that latitudinally spanned the entire population as well as longitudinally extended out to patients’ whole lives. Further integrating how much more individuals could produce if they stayed healthy and attributing some value to just being alive, happy, and contributing to one’s family and community, one could construct a grand unified model of the value that a drug brings to society. Extend that model over the course of a hundred or more years during which any one drug is on-brand for only 10–15 years but then is a cheap generic the rest of the time, and it would be evident that most new drugs are cost-effective and valuable in the long-run.

And yet, we are far from such an idealized insurance model (one that would eagerly incentivize more genericizable innovation by paying for it) not only because our healthcare system is fragmented and the incentives of the various plans misaligned with society’s true goal of investing for its long-term benefit, but also because neither the American government nor any government for any large country has demonstrated the bureaucratic competence to be entrusted with the complexity and accountability needed to pull off the kind of central planning required of a single-payer system (even China is encouraging a competitive healthcare insurance market²²).

As our flawed healthcare insurance system struggles with its own contradictions, it will continue to present itself as society’s hero — trying ever so valiantly to contain costs — while vilifying everyone from physicians to drug companies and even patients. But an informed observer will note that these same plans prosper in the long run from rising healthcare expenditure. A complex shell game of rebates, co-pays, accumulators, and other absurdities offers mechanisms for payers to pad their profits but also, in a kind of byzantine arms race, creates bloated armies of administrators throughout the US healthcare system that can’t help but bludgeon patients with bureaucracy (the US spends 8% of GDP on healthcare administrative costs, compared to 1–3% in some European countries²³).

The Economist recently analyzed what they called the excess profits (those in excess of a 10% return on capital, which the authors deemed reasonable) of the two hundred largest healthcare companies, ranging from pharmas to pharmacies to payers.²⁴ Although they concluded that excess profits only represented about 2% of total healthcare spending (or 4% of what they estimated the US over-spent relative to other countries) and therefore, even if eliminated, were not a source of tremendous savings, the allocation of those profits was far from intuitive. Most people would think that drug companies are the worst offenders, but The Economist pointed out that while average drug prices (net of rebates) have risen by about 5% annually, their development costs have also climbed steeply, cutting their return on capital in half since the late 90s and nearly eliminating excess returns. Meanwhile, the profits of the rent-seeking middlemen, including PBMs, insurers, wholesalers, and pharmacies, have climbed from 20% roughly 15 years ago to 41% today, and they claim two-thirds of the healthcare industry’s excess profits.

Still, I’m not suggesting that the public should redirect its ire to whichever stakeholder in the healthcare industry commands the highest profits; what matters is the value that each is offering for what they are charging. The stronger argument is therefore that, while drug companies are ultimately building a generic drug mountain that will serve mankind for the rest of time at a low cost, there are countless middlemen who will continue to extract high rents from society, including from desperate patients, while trying to direct the public’s rising outrage to the high prices of not-yet-generic (i.e. branded) drugs.

Imagine that you are paying off a mortgage on your home; the mortgage payments are high and you still have to pay for electricity, water, and property taxes. While indeed the mortgage might consume that largest fraction of your budget for now, those payments to the bank are an investment, whereas the bills you pay are expenses. Eventually, even when the house is paid off, it will be those bills that determine the true cost of home ownership. Similarly, society’s payments for branded drugs are an investment towards ownership of generics. But even if all drugs were inexpensive generics, the middlemen would still be there, extracting their rent while casting blame elsewhere.

Ultimately, the fact that drugs are inaccessible and unaffordable to some patients is due to payers choosing to engage in aggressive cost-sharing, making sick patients pay more for drugs their physicians prescribe in the hopes that patients will fail to follow their physicians’ recommended course of treatment.

“Skin-in-the-game” works when informed customers can comparison shop, but most sick patients have neither the medical training nor often the composure to truly understand their options. Patients deputized via cost-sharing by payers, including by our government plans, and coerced into second guessing their doctor’s orders are understandably frustrated and looking for someone to blame; having paid for what they thought was insurance, they expect and deserve better than to be so conned. These patients’ suffering and angst rightfully attracts media attention. What media should illuminate is the true nature and value of America’s biotech social contract and the heartlessness of its flawed insurance system.

Acknowledgements: I’m grateful to Aaron Hiltner and Chris Morrison for their invaluable and substantive thought-partnership and drafting/ editing, to everyone who engaged with me in the constructive debates that led up to these articles, and to Erin Clutter and the RA Capital graphics team for creating artwork that so astutely captures the essence of each core concept.


¹ http://nationalprescriptioncoveragecoalition.com/hep-c-drugs-is-your-plan-really-benefiting-from-your-pbms-deal/

² https://www.kff.org/medicaid/issue-brief/the-effects-of-premiums-and-cost-sharing-on-low-income-populations-updated-review-of-research-findings/

³ http://lab.express-scripts.com/lab/drug-trend-report/2017-dtr







¹⁰ Extrapolating to the whole PBM market from the financial statements of Express Scripts, a PBM with 28% market share in 2017, and assuming that even as much as 75% of PBM gross profits are derived from rebates which are then spent on unnecessarily complex administration and profits (which would mean that 25% of gross profits covers the cost of necessary administration), then PBM profits and excess operating costs that one conceivably could try to eliminate add up to ~$23B, less than 7% of the estimated $338B of total US retail drug spend in 2017.

¹¹ Express Scripts 2017 10-k SEC filing: https://expressscriptsholdingco.gcs-web.com/static-files/60778216-3b36-4b25-94ea-0a9b3e39059b

¹² http://www.healthstrategies.com/blog/select-emerging-pbms-gain-market-share

¹³ http://www.pewtrusts.org/en/research-and-analysis/fact-sheets/2018/02/a-look-at-drug-spending-in-the-us

¹⁴ https://www.finance.senate.gov/ranking-members-news/wyden-calls-for-increased-drug-pricing-transparency-to-lower-costs

¹⁵ https://www.cms.gov/CCIIO/Programs-and-Initiatives/Health-Insurance-Market-Reforms/Medical-Loss-Ratio.html

¹⁶ https://www.xconomy.com/boston/2013/07/22/how-to-save-200-billion-and-cure-hepatitis-c/

¹⁷ https://www.realclearhealth.com/articles/2016/11/04/the_drug_pricing_conundrum_explained_110224.html?se=body&so=cu

¹⁸ https://www.everydayhealth.com/news/hepatitis-c-drug-price-wars-unlikely-boost-access-medications/ ; http://www.thefiscaltimes.com/2016/02/11/Budget-Strapped-States-Are-Rationing-Hepatitis-C-Drug-Treatment

¹⁹ http://drugwonks.com/blog/icer-involved-in-unlawful-hep-c-drug-rationing-scheme ; https://www.tennessean.com/story/news/2017/11/26/federal-order-foreshadows-possibility-tennessee-must-treat-all-inmates-infected-hepatitis-c/882171001/

²⁰ https://www.theguardian.com/society/2016/jul/28/nhs-abandoning-thousands-by-rationing-hepatitis-c-drugs

²¹ https://www.reuters.com/article/us-health-hepc-drug-costs/expensive-new-hep-c-drugs-may-be-cost-effective-even-for-early-disease-idUSKBN0TC2ES20151123

²² http://www.ey.com/Publication/vwLUAssets/EY-the-rise-of-private-health-insurance-in-china/$FILE/EY-the-rise-of-private-health-insurance-in-china.pdf

²³ https://www.washingtonpost.com/news/wonk/wp/2018/03/13/the-real-reason-the-u-s-spends-twice-as-much-on-health-care-as-other-wealthy-countries/?utm_term=.0bb0bf775941

²⁴ https://www.economist.com/news/business/21738934-it-not-pharmaceutical-companies-which-firms-profit-most-americas-health-care-system

Peter Kolchinsky, Ph.D.

Peter Kolchinsky is a founder, Portfolio Manager, and Managing Director at RA Capital Management, LLC, a multi-stage investment manager dedicated to evidence-based investing in healthcare and life sciences. Peter is active in both public and private investments in companies developing drugs, medical devices, diagnostics, and research tools, and serves as a Board Member for various public and privately held companies, including Dicerna Pharmaceuticals, Inc. and Wave Life Sciences Ltd. Peter also leads the firm’s outreach and publishing efforts, which aim to make a positive social impact and spark collaboration among healthcare stakeholders, including patients, physicians, researchers, policy makers, and industry. He authored “The Entrepreneur’s Guide to a Biotech Startup”, written on the biotech social contract, and served on the Board of Global Science and Technology for the National Academy of Sciences. Peter holds a BS from Cornell University and a Ph.D. in Virology from Harvard University.

Important Disclosures for Readers

The contents of this publication are intended for informational and educational purposes. The views and opinions expressed are those of the author and are subject to change. They do not necessarily reflect the views or opinions of RA Capital Management® or any other person the author is affiliated with.

Nothing of the content should be construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any security or product. The author and/or RA Capital Management® may hold or trade securities of the companies named in this publication or that manufacture the drugs discussed.

Designations used by companies to distinguish their products are often claimed as trademarks. All brand names and product names used in this article are trade names, service marks, trademarks or registered trademarks of their respective owners.

The author’s opinions are based upon information he considers reliable, and there is no obligation to update or correct any information provided.

© 2018 Peter Kolchinsky, Ph.D.

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The Biotech Social Contract

These articles clearly frame the biotech social contract…

The Biotech Social Contract

These articles clearly frame the biotech social contract, explore how it’s really being broken and how it’s not, and propose realistic improvements to encourage affordable healthcare innovation for ourselves and future generations. Guest/co-authors with ideas welcome.

Peter Kolchinsky

Written by

Scientist turned biotech investor, always learning, guided by fatherhood, share The Economist’s world view, inspired to write by Hamilton’s Federalist Papers.

The Biotech Social Contract

These articles clearly frame the biotech social contract, explore how it’s really being broken and how it’s not, and propose realistic improvements to encourage affordable healthcare innovation for ourselves and future generations. Guest/co-authors with ideas welcome.