Notes on Engineering Health, January 2024: Notes on Pharmacy Benefit Managers

Jonathan Friedlander, PhD
Geoffrey W. Smith

Jonathan Friedlander, PhD & Geoffrey W. Smith

January 30, 2024

As we enter the New Year, healthcare cost increases continue to make headlines. The reasons for these increases are manifold, but understanding the different players is key to understanding where they come from and where and how the system can be improved. Back in March 2023, we wrote about employer-sponsored health insurance, and in October 2023, we covered the role of payers in setting the price of health care in the US and their recent evolution and consolidation. For this third installment of our series about the American healthcare system, we cover the pharmacy benefit managers (or PBMs), an idiosyncratic and opaque player unique to the American system. The lack of clarity around PBMs arises from complex relationships between stakeholders and the fact that patients never directly interact with PBMs. In these notes, we’ll attempt to clarify their role, describe their history and evolution, and understand how they influence the healthcare system.

An Evolving Definition
In short, pharmacy benefit managers are middlemen handling the cost and access to prescription drugs for people with health insurance. PBMs sit at the confluence of insurance companies (e.g., Aetna), drug manufacturers (e.g., Pfizer), wholesalers (e.g., McKesson Corporation), and pharmacies (e.g., CVS). Patients have access to medications according to their health plans, and a PBM’s goal is to ensure that these medicines are affordable, available at the right places, and used safely. Their activities touch nearly all aspects of getting the right drug at the right price to insured patients and are supposed to streamline the prescription drug supply chain. To perform their tasks successfully, PBMs have become masters in data management and information technologies. With the rapid evolution of computational sciences and expansion of the healthcare industry, PBMs have evolved from their core function to sprawling organizations.

From early on PBMs’ core functions have included:
Negotiating Drug Prices. PBMs negotiate with drug manufacturers and wholesalers to get better prices. They use their bargaining power to ensure these medications cost less for insurance companies and employers.
Creating Formularies. PBMs compile lists of medicines that a given insurance plan will cover. These lists are called "formularies." Some medicines are on the list, and some are not. A primary goal of these lists is to encourage the use of less expensive drugs and generic versions whenever possible.
Choosing Where You Can Get Your Medications. PBMs create networks of pharmacies that work with insurance plans. If you have insurance, you can get your medicines at these pharmacies, and the cost is usually lower than at other places.
Handling Medication Claims. When patients go to a pharmacy and use their insurance to buy medicine, the PBM handles the paperwork and payments. They ensure the pharmacy gets paid and their insurance is correctly charged.

As time went on and PBMs evolved, they took on additional functions such as monitoring consumer behavior, ensuring physician connectivity to their patients and insurance, as well as some of the mail services delivering prescription drugs directly to the home. While the influence of PBMs affects patients covered by insurance most directly, their role in setting the price of drugs impacts everyone.

Early Days: Managing Complexity and Volume
PBMs first appeared in the 1960s as the number of drugs available increased sharply. Their initial purpose was to take on the tedious tasks of managing prescription benefits, particularly processing claims. As prescription drug coverage increased, insurance companies had to manage efficiently and economically a growing volume of relatively small dollar items. While the PBM did not decide whether a drug was covered, it did handle the paperwork and payments to ensure the pharmacy got paid and the insurance was correctly charged. The ongoing effort in data standardization and the early push in information technology development allowed the PBMs to become the cornerstone of electronic claims processing. PBMs changed how drugs were bought and paid for: a patient pays only a small copayment (if they’re using a network pharmacy and are eligible), and the pharmacist receives the balance from the PBM. Consequently, the patient was no longer required to file paper claims, and the pharmacist was paid quickly.

The other early role of PBMs was to combine buying power facing drug manufacturers to reduce costs. In economic terms, we can say that PBMs were supposed to aggregate demand, giving them leverage in the market. This system would benefit insurers and pharmacies, giving consumers lower costs.

The proof of their efficacy early on in both controlling costs for insurers and pharmacies and managing processes effectively is that nearly all payers chose to use their services rather than manage drug procurement internally.

Modern Days: Horizontal + Vertical Growth
As with the insurance field we discussed last October, the PBM industry has evolved considerably since its inception in the 1960s through both horizontal and vertical integration. The first wave of consolidation was wholesalers buying PBMs in order to both have more control over pricing and to add data analytics and forecasts to their business. After that, a series of horizontal integrations happened, the most telling example being Baxter International, the largest manufacturer of hospital supplies in the US, buying one of the biggest PBMs.

From the 1990s on, successive waves of vertical integration took place. First, drug manufacturers went on an acquisition spree, with Merck & Co merging with Medco (a PBM) and Eli Lilly acquiring PCS (a PBM) from McKesson (a wholesaler). Later in the same decade, national pharmacies such as Rite Aid and CVS started buying PBMs. Finally, insurers saw alignment with their businesses, and the biggest healthcare groups all have integrated pharmacy solutions into their businesses. These successive acquisitions and consolidation events gave rise to healthcare giants as the three biggest PBMs — CVS Caremark, Express Scripts, and OptumRx — that manage ~80% of prescriptions and are tightly integrated with the health insurers Aetna, Cigna, and United Healthcare, respectively. A strong criticism of the consolidated model is that it changes the incentive structure, making higher prices more attractive for all stakeholders except patients who eventually pay the price. The concentration in bargaining power, the opacity on where savings go, and the ever-increasing drug prices for patients have prompted heightened scrutiny from regulators. For the past two years, PBMs have been on Congress’s radar for legislation that would demand greater transparency from PBMs, implicitly reproaching them for keeping most, if not all, of the rebates they negotiated with drug manufacturers without passing the savings on to consumers. The PBMs, historically wrapped in secrecy, are fighting back by trying to clarify their role and protect their turf.

In addition to potential legislatively driven reforms, attempts have arisen to consider PBMs as public goods and run them as non-profit organizations. Organizations like AffirmedRx in the US and Maisha Meds in Africa attempt to be a more transparent solution focused on clinical outcomes. Whether they will be able to reach the scale and technological sophistication necessary to process millions of claims and payments remains to be seen. Any efforts to make the system more efficient and transparent should , however, be encouraged and celebrated.

– Jonathan Friedlander, PhD & Geoffrey W. Smith

Engineering Biology
Jacob Oppenheim, PhD, and Entrepreneur-In-Residence at Digitalis Ventures, writes Engineering Biology at Digitalis Press:

This month, Jacob wrote about how limited the adoption of digital technology and systems has been in most industries.  A reliance on archaic technology and poorly fitting solutions, such as MS Excel, unites failures as disparate as the Southwest Airlines meltdown in late 2022, FedEx packages arriving months late during the pandemic, and organizations caught in endless spin, unable to make decisions.  Finance and Fintech show a better path and the enormous value that can be unlocked.  Until industries digitize, they will not be able to benefit from recent innovations in AI.

First Five
First Five is our curated list of articles, studies, and publications for the month.

1/ A sobering number

Although it has been broadly relayed in the general press, it is impossible not to mention this recent JAMA Internal Medicine study. Using data from the Centers for Disease Control and Prevention, the Bureau of Justice Statistics, and the FBI, researchers estimated that more than 64,500 pregnancies have resulted from rape in 14 states that banned abortion following the overturning of Roe v. Wade. A way to remind all of us that legislative and political victories for some have meaningful and dreadful consequences for others.

2/ Treat sugary drinks like cigarettes
The trick that seemed to have worked for cigarettes has been adapted to sugary drinks. The effect of taxing cigarettes on smoking prevalence is a well-studied and understood phenomenon. A study published in JAMA Health Forum has recently shown that a 33% price increase in sugar-sweetened beverages (through taxation) reduced consumption by at least 33%, corresponding to a precise -1.00 price elasticity of demand. Limited to 5 cities in the US for the time being, this playbook could certainly be adapted as a nationwide policy and could have substantial public health benefits.

3/ CAR-T against aging
Two trends came together recently in a compelling Nature Aging article as a new way to prophylactically help healthy aging. Researchers brought together a known biological phenomenon—that senescent cells are detrimental to health—and a promising technology— CAR-T cells able to target specific antigens over long periods. By training T cells to eliminate senescent cells, scientists significantly prevented age-related metabolic dysfunction in mice.

4/ Mystery solved!
Another daily mystery was recently solved. A team of scientists revealed in Nature Microbiology what gives urine its distinctive yellow color—and no, it is not just a lack of hydration. The culprit is an enzyme produced by our microbiome called the bilirubin reductase. The enzyme reduces bilirubin to urobilinogen and plays a key role in eliminating bilirubin from the blood, which accumulation can cause jaundice and neurological damage.

5/ On the nose
The mammalian nose is extraordinarily fine-tuned. It contains millions of nerve cells, each tailored with just one of thousands of specific odor-chemical receptors encoded in the genome. These nerve cells can collectively distinguish a trillion distinct scents. A team from Columbia University recently published in Nature what could explain how each sensory cell becomes tailored to detect a specific chemical. Essentially, a “choice” is made among 2,000 olfactory receptor alleles by an RNA-mediated break in symmetry that then gets stabilized through complex feedback loops. The process is repeated millions of times, giving rise to stunning collective capabilities and integrated into the nervous system.

Did You Know?
This month, we are introducing a new section in our newsletter in which we hope to demystify common terms and structures used in the work we do as investors.

Venture Capital vs. Private Equity
Venture capital and private equity represent two different investment approaches. Venture capital focuses on nurturing early-stage startups by providing funding, guidance, and resources for their growth to eventually achieve a successful exit, typically through IPOs or acquisitions. Private equity, on the other hand, is more about investing in mature companies to improve their performance and create value, often through operational enhancements, before selling them for a profit.

– Haiming Chen & Dylan Henderson

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