By Dennis Purcell, Founder and Senior Advisor, Aisling Capital LLC
Herbert Stein, the noted economist, observed that when everyone believes that something won’t change, it most certainly will. Throughout economic history, irrational excess in valuations and costs of assets has been a common occurrence. Recent expressions of this phenomenon include the soaring interest rates in the 1970s, the dot-com bubble of the 1990s, the housing bubble in the early 2000s, and the oil price shocks. During all of these bubbles, the prevailing sentiment was that price rises would go on forever in spite of collective intuition and plain common sense. And, as Dr. Stein observed, all these bubbles not only ended, but reversed — generally in spectacular and, not infrequently, disastrous fashion.
We are now living through a similar trend in the cost of healthcare, which has risen steadily and inexorably for the last 50 years and is now larger than the GDP of every country in the world except China and Japan. We spend more on Medicaid than defense in the U.S. According to the Congressional Budget Office, in less than a decade from now, Medicare, Medicaid, Social Security, and interest on the debt will represent $5.7 trillion out of a $6.3 trillion budget.
INSURANCE COMPANIES’ CHALLENGES
The health insurance industry is faced with having to deal with an aging population that is certain to develop new health problems. At the same time, the pharmaceutical and biotech industries are developing effective but extremely expensive drugs to treat those conditions. Other factors such as nonadherence to drug regimens, spending on unnecessary treatments and procedures, and the advent of new but very expensive drugs that ultimately cure disease (for example, hepatitis C) are causing massive financial uncertainty in the insurance industry.
In other sectors of the economy, including agriculture, energy, and the financial industry (interest rates), there exists a robust futures trading market where industry participants can transfer risk and achieve predictable pricing while at the same time speculators can find opportunity in the trade. Risk transference and mitigation are essential to financial and operating cost management. These critically important financial tools, however, have been nonexistent in the healthcare sector.
healthcare is given to pricing and operational efficiency. Much commendable work is being done on how to attack the issue of pricing. Companies like Real Endpoints are comparing the relative value of drugs in the treatment of a particular disease. As the Affordable Care Act is likely to be amended if not replaced, we will continue to debate the relative value of drugs within the healthcare system.
Operational efficiency is also maturing. At HIMSS (Healthcare Information and Management Systems Society), 40,000 attendees browsed 2,000 exhibits, most of which were touting some way to improve operational efficiency. Improved electronic medical records (EMRs), interconnectedness among operating systems, and ways to enhance customer engagement were all on display. Many were truly impressive.
We believe, however, that in order to “bend the cost curve,” financial management must be the underpinning going forward. Now is the time to develop a novel financial instrument which will provide risk transfer, transparency, and more certainty. A futures market in healthcare is a product whose time has come. Because of the advent of electronic medical records and Big Data, we now can collect detailed information by disease category.
A futures or forward contract is a legal agreement to buy or sell a particular commodity or financial instrument at a predetermined price at a specific time in the future. We will have contracts that are based on the cost of treating a disease (e.g., diabetes) just like energy (oil, gas) or agriculture (wheat, corn). The futures market has been important in other industries because companies can buy or sell futures to ensure future certainty. Jet Blue has the opportunity to lock in its cost of fuel. Ford Motor Company is pricing its new automobiles now and knows its cost of goods sold except the healthcare component, which is estimated at $2,000 per car. A review of large and midsize companies that are typically self-insuring themselves shows very comprehensive hedging strategies to deal with interest rate and currency risk. Yet, their healthcare risk is, by and large, not hedged at all. Even individuals who are facing higher deductibles and premiums don’t have an effective way to manage the financial costs of their healthcare. In fact, 62 percent of all personal bankruptcies are due to medical expenses. The ability to mitigate this problem through new and better financial tools could provide real benefit to both consumers and producers of healthcare services.
Until now, this has not been possible. In order for a futures market to exist, there must be a spot price (the current cost of the commodity). The units of product are self-evident in other markets (e.g., a barrel of oil or a bushel of wheat) but creating a meaningful unit for healthcare has before now been more challenging. Technology has recently provided an answer. Near universal adoption of EMRs enables both the ability to sort vast amounts of data into meaningful subdivisions, and to do it on a timely and reasonably frequent basis. Poliwogg has defined the healthcare “unit” as the cost of treating one patient for one disease for one year. This is the spot price from which futures contracts may be priced, as it is both consistent and scalable — an industry participant can now hedge its risk — whether long or short — in the financial markets, and do it at whatever level suits its particular situation.
Poliwogg is introducing the indexes that will underlie the financial management piece of the puzzle. The Poliwogg Therapeutic Indexes are a series of indexes designed to measure the direct and indirect costs of major chronic diseases in the U.S. They are suitable as the basis for a variety of financial instruments such as futures, swaps, options, or structured notes. The source data for the indexes is paid claims data derived from the largest database of claims currently available. The indexes will enable investors the first real opportunity to express an investment opinion on the course of a particular disease and its state of treatment.
The first index is the Poliwogg Diabetes Index, which includes all the costs (direct and comorbidities) of treating a Type 2 diabetic for one year. Simply put, the seller of the diabetes future (most likely a natural participant) will lock in the price of treating diabetes, and the buyer of the diabetes future (most likely a financial institution) will see that fixed amount back to the buyer. The risk and return of diabetes costs (as measured by a well-constructed index), either being higher or lower than the index, will be borne by the buyer of the index. Going forward, as the futures concept matures, we will be able to provide sub-indexes with more precise measurement and management.
This is an ambitious undertaking. The cost of treating diabetes in the U.S. is already higher than the cost of the oil we use. At over $300 billion annually, every transaction that goes into treating a diabetic is economic in nature. The list of participants in the market is very long, and includes insurance companies, self-insured corporations, pension funds, hospital systems, physicians groups, device manufacturers, medical service providers, drug and biotech companies, and financial institutions. Each one is striving for stability in the market so they can adequately plan for their business going forward.