No Containment in Health Costs

While inflation in the United States remains subdued overall, there are some goods and services which have experienced exponential price growth over the past several years, not the least of which is health care.

Data from the World Health Organization shows that our annual per capita health care spending runs at just more than $8,600. That amounts to more than 17 percent of our gross domestic product (GDP) with direct spending of $3.8 trillion last year. If you also factor in indirect costs as well as salaries and benefits for health care workers, the US health care sector generates about $5 trillion worth of economic activity.

Given the sheer size of the health care industry and that spending is likely only to grow as our population ages, health care inflation is a closely watched metric by economists and policymakers. In the three decades before the Great Recession, health care inflation outpaced overall price increases largely because consumers had little incentive to comparison shop. Low co-pays across a relatively large pool of insured patients meant that most health care consumers simply opted for the most convenient options rather than looking for the cheapest ones.

As the rolls of the unemployed – and uninsured – spiked during the recession, that dynamic shifted. More people reported that they were looking for the lowest-cost providers since they were now paying out of pocket. Those who did have insurance also saw a growing percentage of the cost burden shifted onto them, with rising co-pays and lower reimbursements. As a result, price growth in the health care sector actually hit its lowest point since the 1960s around the middle of 2013. The annual grown rate was just 1 percent. That led many to speculate that the growth trend was reversing and the term "Great Moderation" was coined.

But the reversal was short-lived. Heath care expenses rose by 5.6 percent annual rate in the four! th quarter of 2013 and an eye-popping 9.1 percent annual rate in the first quarter of this year, even as the overall economy actually contracted by 1 percent. One potential cause for the spike in health care spending was the influx of insured patients due to the rollout of health care exchanges under the Affordable Care Act (ACA). Of those who enrolled through the exchanges, 6.7 million were eligible for Medicaid coverage. Many of them would be receiving care through managed Medicaid programs, which are typically operated by private insurers under contract through the states. That could create a significant spike in spending since most of the insurers operating those plans are paid per patient, per month, regardless of whether or not the patient is actually seen by a health care provider. Those payments are counted as health care expenditures when they are made.

Another potential driver of the spending spike is the growth of expensive medical treatments. For instance, there are currently five drugs on the market which cost more than $300,000 per year per patient.

Thanks to advances in genetic technologies that have allowed for the development of "designer drugs" tailored to specific patients, costs are only going to be going up from here. Given the fact that the technologies behind the drugs are so new, and many of those technologies are themselves patent-protected, it will be at least a decade before meaningful generic competition emerges for these new drugs.

At the same time, while the ACA has done an admirable job of expanding coverage, health care reform measures have done relatively little to actually contain costs. A prime example of where the program has stumbled is the fact that 40 percent of Americans live in counties where three or fewer insurers offer coverage under the ACA. In those counties the cost of coverage through an exchange runs at more than $250 per month while those live in countries with 10 or more options pay an average of $175. By way of comparison, only 18! percent ! of the population lives in those higher coverage areas.

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Thanks to muted cost controls under the ACA, higher prescription costs due to fewer patent expirations and increased utilization, the Centers for Medicare & Medicaid Services expects that health care spending will increase 6.1 percent this year largely as prices rise. That compares to just a 4 percent increase last year thanks to muted gains in the first half of 2013. So, while inflation generally may be tame, look for health care costs to continue their upward march.

That's good news for most health care stocks. While the biotechnology space has had a weaker 2014 as compared to last year, both biotechnology and health care generally continue to outperform the broader indexes so far this year.