Oligopoly Watch

Oligopoly Watch

Industry brief: Pharmacy Benefit Managers

Saturday, September 13, 2003

If you have health insurance in the United States, you have probably run into the following problem: your doctor prescribes a drug, but your insurance company tells you it won't pay for it. You can, however, receive another drug that is judged to have similar properties. Sometimes the drug is a generic; sometimes it is just a different medicine from another major drug company. What drugs are accepted by your insurer is determined by what is called a formulary; the original drug was not included in the formulary.

In general, these formularies are determined by a set of companies called Pharmacy Benefit Managers (PBMs). These companies act as middlemen between drug companies on one side and insurance companies, pharmacies, hospitals, government health plans, and managed care plans on the other. They also evaluate the effectiveness of drugs and create formularies of the most cost-effective ones for treating each condition or disease. And they act as bargainers to get the lowest price from the drug companies.

Currently, there are over 60 PBMs. But, in fact, there are four major companies that have a large majority of the market. These companies are:

Medco Health Solutions, the largest. 2002 sales $33 billion. 65 million "members"
AdvancePCS, $14 billion in sales, 75 million "members"
Express Scripts , $13 billion in sales, 50 million "members"
Caremark Rx $6.8 billion in sales, 20 million "members"

With a total of 210 million participants (some in Canada), these companies control over two-thirds of the market. That means they control vast amounts of prescriptions. Medco, for example, handles 550 million prescriptions a year.

This industry has a long history of mergers. In fact, AdvancePCS is the result of a recent merger between Advanced Paradigm and PCS Health Systems. In the early '90s there were many small and mid-size PBMs. But then the big drug companies started acquiring and rolling them up. For example, in 1994. Merck & Co. acquired Medco Containment Services; SmithKline Beecham P.L.C. bought Diversified Pharmaceutical Services; and Eli Lilly acquired PCS Health Systems.

From the start, there were demands for antitrust action, but the FTC is much slower dealing with such vertical mergers, as opposed to the horizontal mergers that more typically get scrutiny. The point, of course, is that when a pharmaceutical company owns the formulary, it can boost its own products, set price levels, and freeze out the competition. So the other pharmaceutical giants weren't happy, and neither were the generic drug manufacturers. Lawsuits soon followed.

In 1998, Eli Lilly sold PCS to Rite-Aid pharmacy chain, which, in turn, offloaded it to Advanced Paradigm in 2002. In 1999, SmithKline Beecham sold off the Diversified Pharmaceutical Services division to Express Scripts.

Last month, Merck spun off its Medco unit, to rid itself of liabilities from false claims lawsuits, which alleged that Medco favored drugs from Merck over products from other pharmaceutical firms.

But Merck, while shedding the liability, keeps its advantageous position contractually. According to an article in the Drug Industry Daily, "Going forward, however, Medco will continue to be obligated under a managed care agreement with Merck to maintain certain market-share levels for Merck-patented products in Medco-managed prescription benefit plans. If the PBM fails to meet those market share commitments, it will owe Merck liquidated damages equal to half of Merck's resulting revenue shortfall."

In this way, Merck maintains its influence over the formulary, while distancing itself from conflict-of-interest lawsuits.

Now on the table is further concentration in the industry, Caremark Rx has made a proposal to buy AdvancePCS. That would reduce to three the number of major buying groups.

According to a Reuters story,

In order to gain FTC approval, the companies must persuade the agency to rethink some past views and address harsh criticism leveled against PBMs in recent court cases, antitrust attorneys said.

The merger proposal comes at a time when FTC Chairman Timothy Muris has made health care a priority, undertaking a series of antitrust probes of the industry, including inquiries into doctor groups, hospital mergers and drug manufacturers.

Of course, this looms the larger as Congress is considering a Medicare drug prescription plan, and is considering allowing PBMs to control it. The danger, of course, is kickbacks. There's so much money to be earned here that it is a situation that naturally breeds corruption. With even fewer players, the temptation, and the rewards will be all the greater.