BBI Contributing Editor

IRVINE, California The U.S. medical device industry, which generated more than $80 billion in sales in 2004 and is expanding at 7% to 9% annually, is driven by a variety of factors, with economic and political/regulatory factors among the most important. Healthcare spending, including spending for medical devices, is highly correlated with economic status throughout the world, and the U.S. has historically had one of the highest rates of healthcare expenditure as a percentage of gross domestic product (GDP). At the 2005 UCI Health Care Forecast Conference, held here annually by the University of California Irvine's Graduate School of Management, leading experts in economics, healthcare policy and the healthcare industry discussed the latest trends impacting healthcare delivery and the healthcare industry in the U.S., and presented forecasts of future trends. The U.S. economy remains strong and, according to analysts, could accelerate in coming years, supporting continued growth in healthcare spending. Growth in healthcare spending, however, is continuing to outpace economic growth, creating a trend that is unsustainable in the long term, and spawning a multitude of proposals and programs for reining in the increasing burden of supporting the healthcare system.

Emerging strategies and tools for remedying the problems with the existing healthcare system in the U.S. include pay for performance for physicians; consumer-driven healthcare, including health savings accounts; and implementation of advanced technologies, particularly in the area of information management, to improve the efficiency of the healthcare system. Provider productivity is an area where significant improvements are envisioned via the expanded use of healthcare information technology, with the added benefit of reducing the rate of medical errors and thus improving patient outcomes and safety. However, some difficult issues must be addressed, particularly within the government sector, due to budget deficits and new programs such as the Medicare prescription drug benefit, which will exacerbate the financial problems of the public sector of the healthcare system. The affordability of healthcare insurance is continuing to decline as increases in premiums outpace economic growth, leading to growing numbers of uninsured individuals in the U.S. and skewing risk pools for insurers, while also adding to the burden of healthcare costs on employers and, increasingly, consumers.

Economic growth to buoy healthcare market

As discussed by James Glassman, PhD, senior economist and managing director, JP Morgan & Co. (New York), the U.S. economy has fully recovered from the 2001 recession, expanding at a 4% annual rate over the past four years. Growth would probably have been even stronger, by 1% to 2% per year, according to Glassman, if oil prices had not doubled over that same period. Given the negative impact of energy costs and other factors, the U.S. economy might well have declined as did the economies of other countries, but instead it expanded at a moderate pace. As a result, the underlying economy is viewed as very strong, due in part to increasing productivity. Glassman is forecasting above-trend economic growth and growth in employment in the future. One key factor underlying that forecast is record profits reported by many major companies recently, and growth in profits in excess of GDP growth. In addition, low inflation, high productivity growth, deregulation, strong international trade and diminished labor market friction are positive factors that should fuel a strong economy.

Certainly, there is no lack of contrary opinions on the future of the U.S. economy. A number of forecasters, including some involved in analyzing federal budget issues, have warned of pending fiscal disaster for federal programs such as Social Security and Medicare/Medicaid because of steadily rising costs coupled with a slowdown in economic growth. However, those forecasts assume a quite conservative economic growth scenario under which growth in the U.S. economy will slow in the long term to half the 3.7% rate that has prevailed over the past 150 years, to rates similar to those prevailing in other developed countries such as Japan and the primary countries in Western Europe. If, instead, a growth rate equal to the historic rate is assumed for the U.S. economy, the federal budget shortfall becomes much more manageable, although funding the Social Security program will remain a problem. One reason cited by Glassman for continued growth at a rate similar to the historic rate is the continued trend toward increased productivity in the U.S. economy, a trend that shows no sign of slowing. The U.S. trade deficit, also cited by many as a factor that could create a financial crisis, is viewed positively by Glassman because it stems largely from dollars flowing to China and East Asia, which in the long run will help create stronger trading partners for the U.S. In the medical device industry, for example, countries such as China represent a growing market opportunity for U.S. suppliers, as their standard of living improves and healthcare becomes a higher priority for the population.

Healthcare cost increases outpace inflation

Even if the more optimistic scenario of economic growth prevails over the next decade, however, the increasing burden of healthcare costs on employers remains a major concern. As indicated by data presented by Jon Gabel of the Health Research and Educational Trust (Washington) at the UCI conference on trends in health insurance premiums in California over the past five years, shown in Table 1, the rate of premium increases has significantly outpaced overall inflation. Trends in health insurance costs nationwide have resembled those in California, according to experts presenting at the conference, driving overall healthcare expenditures as a percentage of GDP to record levels, with some forecasters predicting that expenditures will reach 19% of GDP by 2014. As shown in Table 2 on page 3, U.S. healthcare expenditures have increased at well in excess of the rate of inflation since at least 1998. The trend has driven the cost of insurance out of reach of many. The annual cost of employer-based insurance for a family in California, for example, now averages $9,950, comparable to the annual earnings of a minimum-wage worker in many states, and, adjusted for plan coverage, California has one of the lowest average premiums of any state.

The rapid increase in healthcare costs in the late 1990s and early 2000s followed a period in the mid-1990s when the aggressive implementation of managed care reduced the rate of cost increases to below the rate of inflation. However, a consumer backlash forced insurers to loosen their restrictions on healthcare utilization, resulting in rising costs. In the U.S., 55% of consumers with health insurance are enrolled in preferred provider organization (PPO) plans, while only 25% are in health maintenance organizations (HMOs). If point-of-service (POS) plans are included, which have a structure similar to that of PPO plans, 70% of all consumers are in PPO/POS plans. The decline of managed care was cited by a number of speakers at the UCI conference as a key factor driving the resurgence in healthcare cost inflation, along with continued introduction of advanced medical technologies, rising costs for drugs and rapidly increasing costs for both inpatient and outpatient hospital services.

As discussed by Walter Zelman, PhD, of the School of Policy, Planning and Development at the University of Southern California (Los Angeles), insurers seeking to reduce the rate of increase in healthcare costs now are focusing on strategies such as disease management, tiered provider networks, cost sharing by members, computer-driven selection of plan benefits and consumer-driven healthcare plans. Such strategies have a limited ability to control costs, according to Zelman, and are not likely to resolve the worsening affordability crisis for healthcare in the U.S. Instead, more emphasis is needed on cost-effectiveness and productivity improvement in healthcare, as well as expanded adoption of evidence-based medicine to reduce the use of ineffective treatments and diagnostic procedures, particularly overuse of diagnostic imaging. Government-funded healthcare programs already are beginning to emphasize evidence-based medicine as an important tool, as exemplified by new policies at the Centers for Medicare & Medicaid Services (CMS; Baltimore) under its top administrator, Mark McClellan. MD.

As such initiatives begin to have an impact on the healthcare system, the value of healthcare services, as opposed to the intensity, may take on greater importance. Another potential strategy, described by Greg Scandlen of the Center for Consumer-Driven Healthcare at the Galen Institute (Alexandria, Virginia) at the UCI conference, is to restructure healthcare insurance to eliminate its dependence on third-party payers in favor of a return to fee-for-service medicine. Scandlen said he believes that a fundamental problem with today's health insurance system stems from third-party payment, which tends to foster over-utilization and over-consumption of healthcare resources, since individuals with employer-provided health insurance do not recognize the true cost of the services they are receiving and have no incentive to limit utilization. One solution is to move to two-party contracts for health insurance, in which the insurer works directly with the patient rather than through an employer. The barrier to widespread adoption of such a system at present lies in the tax regulations, according to Scandlen, which subsidize employer-based healthcare insurance but not insurance purchases by individuals. By moving to a system under which employees purchase their healthcare insurance directly, Scandlen believes more restraint in healthcare utilization would be achieved, reducing demand and thus lowering prices.

Advances in healthcare technology are another factor cited by many as a driver of the rapid increase in healthcare spending. Patient demands for new diagnostic and therapeutic technologies, coupled with physicians' willingness to provide them, continue to drive the adoption of more effective, but more expensive, medical devices and drugs. As discussed by David Gollaher, PhD, president of the California Healthcare Institute (La Jolla, California), the standard of care for a patient following a heart attack has evolved dramatically over the past 50 years. For example, the therapy prescribed for former President Dwight Eisenhower following a heart attack in 1955 was bed rest, whereas in 2005 treatments may include thrombolysis, drug-eluting stents, left ventricular assist devices, implant-able cardioverter defibrillators and statins. The insatiable demand for new technologies has benefited the medical device industry, which has expanded at a rate at least comparable to the growth in national healthcare expenditures, and is expected to expand at a 7% to 8% compound annual rate over the next five years. And while technology often is blamed as a key culprit in the rise in healthcare costs, it also is an important part of the solution. In particular, the use of advanced information technology to improve efficiency and productivity, as well as to reduce the rate of costly medical errors, is viewed as one of the most promising approaches to reducing healthcare costs. As one indicator of trends in healthcare IT, the proposed 2006 federal budget includes $125 million earmarked to fund development of health information technology, including $75 million to foster collaboration and develop the conceptual framework and infrastructure for a network that would promote patient privacy, connect clinicians, personalize care and improve public health surveillance. The proposed budget also is designed to promote the adoption of electronic medical records in the U.S.

Health politics and policies

Government policies are key factor shaping the future of the healthcare system in the U.S. Faced with an impending crisis in the ability to fund entitlement programs such as Medicare and Medicaid, politicians at the state and federal level are searching for ways to restructure healthcare delivery to improve its efficiency. Projections by the Social Security Administration show that the percentage of the U.S. population represented by Medicare beneficiaries will increase from about 14% at present to around 22% by 2030, and federal analysts predict that the government will pay 49% of all U.S. healthcare costs by as early as 2014. One of the most recent changes in government healthcare policy, the passage of the Medicare prescription drug bill, will add to the government's financial burden for Medicare, increasing the urgency of finding ways to control costs. The Bush administration has proposed consumer-driven health plans to make healthcare more affordable. Key elements of the proposed plan include expanded coverage of low-income children; Health Savings Accounts (HSAs); Association Health Plans (AHPs) and tax credits for low-income families to buy insurance.

The proposed tax credit for low-income families would pay 90% of the premium cost for standard coverage up to $3,000 for a family of four. Another option would allow low-income individuals to use a portion of the credit to pay the premiums for a high-deductible plan, while putting the remaining portion of the credit in an HSA. Middle-income families who purchase a high-deductible health plan in conjunction with an HSA would be allowed to deduct the premium even if they do not itemize deductions. Another administration proposal calls for a national marketplace for health insurance, which would allow individuals to shop for the best buy on health coverage regardless of where they live.

New proposals also include provisions to help small businesses, such as legislation to authorize AHPs that would allow small businesses to join together through industry and professional associations to purchase affordable health benefits for employees. To encourage small employers to contribute to their employees' health savings accounts, the Bush administration has proposed a refundable tax credit for a portion of those contributions.

Consumer-driven healthcare is an important aspect of the proposed new structure for healthcare in the U.S., aimed at improving consumers' cost consciousness when deciding on which healthcare services to use. HSAs and related plans such as Health Reimbursement Arrangements (HRAs) underpin the concept of consumer-driven healthcare, and are attracting increased interest in both the public and private sector as a tool to transform the healthcare system. For example, a 2004 survey conducted by Mercer Human Resources Consulting and presented at the UCI conference by Paul Fronstin of the Employee Benefit Research Institute (Washington), found that the percentage of large employers who are very likely to offer a high-deductible health plan with an HSA will increase from 8% in 2005 to 19% in 2006, while the percentage who are somewhat likely to offer such plans will increase from 35% to 54%. In contrast, the percentage not likely to offer such plans is expected to drop from 56% to 28%.

Although a number of companies will offer HSAs to their employees this year, according to Fronstin, most will not because the new tax regulations pertaining to HSAs did not come out until late in 2004. Consequently, a major increase in HSA adoption is likely in 2006 vs. the existing level of approximately 400,000 enrollees estimated by the insurance industry, although even that number may be underestimated by as much as 10-fold, according to Fronstin. At present, only 2% of employers offer HSAs, but that number is expected to grow to as much as 50%.

Some presenters at the UCI conference, most notably Robert Margolis, MD, CEO of HealthCare Partners (Torrance, California), said they believe HSAs represent a move in entirely the wrong direction, in part because such plans do not influence the purchase decisions of patients with chronic disease, who are responsible for an estimated 80% of healthcare costs. Nevertheless, current trends favor a move to consumer-driven healthcare. One factor is the high deductible required for the insurance policy coupled with HSA plans, which results in significant savings for employers, particularly if they do not fund the HSA account. Fronstin believes employers may be more likely to fund HRAs, because HRA accounts are not funded until the employee incurs expenses, and HSAs are owned by the employee and can be transferred with the employee when he or she leaves the job. However, even if HSAs and HRAs are widely implemented, they are unlikely to have a major impact on healthcare spending, since the total amount that can be accumulated is limited (to $44,000 at present) and the accounts will represent only a minor proportion of total healthcare expenditures.

Health literacy also is an issue, since a recent report by the Institute of Medicine (Washington) found 50% of the adult population to be health illiterate, and thus unable to make educated decisions about their healthcare options. Finally, healthcare plans that employ a "donut hole" design, with a built-in coverage gap designed to foster more selective consumption of routine healthcare services while still providing catastrophic coverage, are not highly effective in driving reform of the delivery system for chronic care, since patients with chronic disease will typically spend well in excess of the gap limit annually regardless of how discriminating they are in their purchasing decisions.

In the public sector, attention is focused on ways to improve the efficiency of healthcare delivery, and also on moving more Medicare beneficiaries into managed care plans with the hope of achieving better cost control. At present, 95% of Medicare beneficiaries are in fee-for-service programs, and only 5% are in managed care, which is almost the reverse of the plan participation in the private sector. Prior attempts at implementing managed care in the Medicare program have failed, however, because insurers found the plans to be unprofitable. In addition, the implementation of the Medicare prescription drug benefit will make the financial situation of the program even more difficult to resolve.

Other strategies include pay for performance for physicians, designed to improve the efficiency of physician services and link pay to the quality of services; assessment of the utilization of imaging services to ensure proper utilization; expansion of the benefit options available to enrollees; and assessment of the cost-effectiveness of certain types of providers such as specialty hospitals.

The current status of the federal budget, as well as forecast trends for the budget deficit, has a major impact on proposals to revamp the Medicare and Medicaid programs. As shown in Table 3, projections of the federal budget deficit under current assumptions show a decline in the deficit from the record $412 billion level in 2004 over the next few years, with the deficit turning to a surplus in 2012. However, a key assumption underlying the current projections is that a rollback in tax cuts scheduled in 2010 will in fact be implemented, driving a significant increase in federal revenues. In addition, restrictions on spending that were to have been implemented in past budgets, such as physician fee limits, have been eliminated via congressional intervention, while new spending programs (e.g., the prescription drug benefit, which will account for 24% of the Medicare budget by 2014) have been enacted. Consequently, there is considerable uncertainty in the budget projections shown in Table 3, and changes in the assumptions underlying the budget could result in the projected surplus swinging to a deficit that is at least as large as the current one.

While the deficit when expressed as a percentage of GDP is about average in historic terms going back to the mid 1960s, it is likely that there will be continued pressure to address it with new cost-cutting programs, and the Medicare and Medicaid programs will be key targets. Projections by the Congressional Budget Office, presented by James Baumgardner, deputy assistant director for health policy, at the UCI conference, call for Medicare and Medicaid to account for 21% and 11% of total federal spending respectively by 2015, vs. 13% and 8% in 2005, whereas spending on Social Security will only increase from 21% to 24% of the total. If matching funds spend by the states on Medicaid are included, the total burden of healthcare spending on government budgets becomes even more severe, creating a strong incentive for politicians to take remedial action.

Overhauling the healthcare system

There is a strong public mandate to transform the healthcare system in the U.S. A survey conducted by the Galen Institute, described by Greg Scandlen at the UCI conference, found that over 80% of the individuals polled in the U.S. regarding the need to change the current healthcare system believed that either complete or fundamental change is needed, and less than 20% believed that only minor change is required. The U.S. is not alone in that regard, as the poll found a similar proportion of individuals want complete or fundamental change in Canada, the UK, Australia and New Zealand. The U.S. system is based on a post-World War II benefit model that assumed lifelong employment at a single company, with the employer acting as an agent for the employee and serving as the risk pool for indemnity coverage. The system has been kept in place, according to Scandlen, because of the substantial tax subsidy enjoyed by employers for healthcare expenses, which totals about $189 billion for U.S. industry and is highly regressive, with the subsidy increasing with household income.

Under the emerging new healthcare paradigm, which is structured in part around HSAs and HRAs, the goal is to balance insurance and direct pay, and to restore the physician/patient relationship that existed in the 1960s when more than 55% of all healthcare was funded by out-of-pocket payments. Individuals will begin to have more control over their healthcare funds, with portability of plans when an employee changes jobs, and with increased access to web-enabled information on provider quality and cost.

The initial steps in the transformation already have been taken via the enactment of HSAs and HRAs by the federal government, rollbacks of state regulations, new programs to modernize Medicare and Medicaid, and incentives to expand the use of information systems. Pending government actions include employer rebates for HSA deposits, tax credits/deductions for individuals who purchase their own health insurance, a continued rollback of state regulations, implementation of AHPs, and malpractice reform. In the private sector, major insurers already have begun to offer HSA and HRA plans, and programs are underway to provide more transparency of hospital pricing and information on hospital quality, as well as to foster more competition among hospitals. Over the next five years, Scandlen predicts strong enrollment growth for HRAs and HSAs, and a new era in which many more patients will pay cash rather than submitting the bill to their insurance company.

Healthcare insurance reform will, however, need to address the costs of care for chronic disease patients, whose needs may not be adequately addressed by consumer-driven health plans. As shown in Table 4, medical costs are highly concentrated in a relatively small number of disease states, with 15 medical conditions accounting for 56% of total healthcare costs. Ten of those conditions are classifiable as chronic diseases. Funding of healthcare for such high-cost patients requires reliance on sufficiently large risk pools that effectively redistribute income from the healthy to the sick. A similar issue arises when considering how to deal with the growing number of Medicaid patients and the uninsured, whose healthcare costs are covered either directly or indirectly by taxpayers, including those with health insurance and out-of-pocket payers. On average, each resident in the U.S. paid $918 in 2003 for Medicaid, according to data from the California Healthcare Foundation, and 14% of the non-elderly population in the U.S. is covered by the Medicaid program. Given the rapid rise in the number of Medicaid and uninsured patients, steps also must be taken to restructure the way in which those patients are managed. Part of the solution will be to discontinue coverage for patients who are no longer eligible, and to reduce fraud in the existing system. In addition, the Bush administration has proposed cuts in Medicaid that would include a crackdown on inappropriate utilization, and curb the use of asset transfer to gain eligibility for long-term care.

Trends in the provider segment of the healthcare system also were a key topic at the UCI conference. As discussed by Sheryl Skolnick, PhD, managing director, Fulcrum Global Partners (New York), a worrisome trend in 2004 was the drop in patient volume, including a drop in the volume of elective procedures, as well as explosive growth in the number of non-paying patients. In spite of those negative trends, cash flows have remained positive for hospitals and an increase in merger and acquisition activity shows that investors are willing to put money into healthcare. One segment of the provider market that is expected to fare less well is specialty hospitals, which number about 48 in the U.S. and are typically majority-owned by physicians and focus on the most profitable patients with orthopedic or cardiovascular conditions, as well as surgery. Congress imposed an 18-month moratorium in the Medicare Prescription Drug, Improvement, and Modernization Act of 2003 that effectively halted the development of new physician-owned specialty hospitals, while conducting a survey to determine their cost-effectiveness and their potential negative impact on community hospitals.

There is some evidence that specialty hospitals have taken advantage of certain inaccuracies in the Medicare reimbursement system that have allowed them to generate higher profits than existing community hospitals, and that they have focused on the less severe, more profitable cases while limiting admissions of Medicare patients. As a result, the Medicare Payment Advisory Commission has recommended an extension of the moratorium until more data can be collected, effectively halting any further development of the specialty hospital segment of the provider industry.

That will be a positive factor for community hospitals, since they were potentially threatened by the specialty providers. However, the key factor that must be addressed by providers in order to achieve long-term success, according to Skolnick, is to develop more affordable healthcare, in order to allow more individuals to enter the healthcare system. The trend by managed care to offer lower priced, high-deductible plans is a move in the right direction in order to preserve market share. But providers must deal with the issue of rising costs in order to avoid pricing an increasingly larger proportion of the population out of the system, or falling patient volume will eventually have a significant negative impact on the market.