BBI Contributing Editor

IRVINE, California – The health care industry is one of the major segments of the U.S. economy, comprising 13.5% of gross national product in 1998. Although economic growth roughly matched growth in health care spending from 1993 to 1998, more recently growth in health care spending has outpaced growth in the economy. A recent conference of leading experts in health care economics from both industry and government, sponsored here by the University of California, Irvine (UCI), addressed major trends that are driving growth in the industry as well as factors that are expected to impact health care industry participants in the future.

As indicated by speakers at the UCI conference, the economic status of the health care industry has improved substantially over the past two years as more funds have flowed to insurers and providers. The robust economy played a role in stimulating industry growth, at least until recently, but other factors such as increased government spending, markedly higher hospital occupancy rates, and growth in the prescription drug market also have played major roles. Rising health insurance premiums in the private sector constitute another factor responsible for renewed growth. On Wall Street, stock prices of health care companies have benefited from rotation away from the technology sector into sectors that are considered more stable, such as health care. While the financial status of providers has not improved as much as might be expected, given recent increases in health care insurance premiums that are moving into the double digits, the wave of bankruptcies among health care providers has subsided and the outlook, according to experts at the conference, is for continued growth in most sectors of the industry.

As discussed by James Glassman, PhD, of JP Morgan Chase H&Q (New York) at the UCI conference, an important factor that drove the unprecedented economic boom, lasting through most of the 1990s and much of 2000, was productivity increases fueled by a historically high level of capital investment. As shown in Table 1, spending for equipment and software in the U.S. economy as a whole averaged between 5% and 6% of GNP in the 1960s, increased steadily to about 8% during the 1980s, and then skyrocketed to more than 10% of GNP by the end of 2000. The investment in technology has driven productivity to a level not observed since the late 1940s. Nevertheless, the economy itself is clearly slowing, in spite of favorable underlying drivers including low inflation and low levels of unemployment. Pessimists are concerned that the U.S. may be facing the same situation as Japan in the 1980s, portending a prolonged period of low growth or even a flat trend in the economy. However, optimists believe that the most important factor, namely the continued low rate of inflation, will prevent a prolonged recession, and indeed the Federal Reserve appears to be moving rapidly to reverse the current downturn.

For developers and suppliers of medical devices, and biotechnology companies focusing on the health care sector, the picture appears promising both in terms of market opportunity as well as for investment in technology development. Government spending on health care products and services through the Medicare and Medicaid programs is expected to grow, and the demand for health care products will continue to be driven by high hospital occupancy rates, the aging of the population, demand for new and more effective diagnostics and therapeutics, and the backlash against utilization limits imposed by managed care. Venture funding for new medical device start-ups and for biotechnology-based ventures is expanding, indicating a favorable environment for entrepreneurs. Finally, while e-health has fallen out of favor with many investors, along with most of the e-commerce industry, established health care providers and suppliers are beginning to make more effective use of the Internet to enhance their marketing efforts, improve customer service and educate patients to make them better health care consumers.

Spending grows, but for how long?

Health care costs are now increasing rapidly across the board, as indicated by an average increase in health insurance premiums of 8.3% nationwide in 2000 for private insurers. That rate of increase is the highest recorded since 1993, and continues a trend that first began in 1998. As discussed by Jon Gabel, PhD, of the Health Education and Research Trust (Washington), part of the growth in premiums is due to the underwriting cycle. Attempts by insurers in the mid-1990s to gain market share caused widespread price competition, resulting in many contracts being executed at premium levels that precluded profitability. Now, companies are correcting that situation with significantly higher premiums. Furthermore, underlying medical costs are increasingly rapidly, driven in large part by increased costs for drugs. According to a survey of employer health care benefit costs conducted by Gabel in 2000, 44% of the increase in medical costs in 2000 was attributable to higher prescription drug expense. About one-third of that was related to increased drug usage, and the remainder was due to consumption of higher priced, more effective drugs. Increases in the cost of physician services accounted for 32% of the increase in costs, increased hospital inpatient costs accounted for 21% and increases in hospital outpatient costs accounted for 3%. As discussed by Sheryl Skolnick, PhD, of Robertson Stephens (New York), another driver of increased health care costs is the diminished ability of health care plans to locally ration services provided to their members and to force members to use providers who agree to contract at the lowest prices. Furthermore, government efforts to contain health care costs have become less effective, as exemplified by the failure of the Medicare Plus Choice program that attempted to introduce managed care into the Medicare system, as well as recent legislation that reversed many of the cutbacks implemented in the Balanced Budget Act of 1997.

Funding for the Medicare and Medicaid programs, which provide health care benefits for 74 million Americans, is now set to expand rapidly over the next decade, as shown in Table 2 on page 59. The increases follow growth in Medicare spending of only 3% in 2000, and declines in program spending in both 1997 and 1999. However, as described by Joseph Antos, assistant director for health and human resources at the Congressional Budget Office (Washington), the factors responsible for spending decreases in the past, which included legislated reductions in reimbursement as well as programs to eliminate fraud and abuse in the Medicare and Medicaid programs, now are largely absent, and predictions call for caseloads to increase in the future. The government is now projecting a 20% increase in Medicare enrollment over the next 10 years, and a 100% increase over the next 30 years. In addition, there are new initiatives under way to expand funding for community-based long-term care, as well as to increase funding for Medicare patients in rural areas. Medicaid spending was also held in check due to welfare reform, but outreach programs are now reversing that trend. All of those factors are expected to drive up spending at a rate at least 1% higher than GDP growth for the foreseeable future, and even more rapidly over the next 10 years.

A new factor that could lead to even higher costs for the Medicare program is the possible implementation of a prescription drug benefit. The prospects for passage of prescription drug legislation and the likely structure of the benefit program were the topics of a special session at the UCI conference. A proposal for Medicare prescription drug coverage was first advanced by the Clinton administration, and another plan has been proposed by the National Bipartisan Commission on the Future of Medicare, chaired by Sen. John Breaux (D-Louisiana) and Rep. William Thomas (R-California). The Clinton plan is viewed as considerably more generous than the bipartisan plan, according to Judith Wagner, PhD, of the Congressional Budget Office, who discussed the topic at the UCI conference. The bipartisan plan, which is projected to cost about half as much as the plan proposed by the Clinton administration, relies heavily on competition in the private sector to contain prices.

The bipartisan plan would be modeled after the Federal Employees Health Benefits Program (FEHBP), although the recommended level of premium support is higher and would, at a minimum, cover the standard package of benefits. The FEHBP provides 80% to 90% coverage for prescription drug costs, and also provides catastrophic or stop-loss coverage that includes the cost of prescription drugs. According to another presenter at the conference, Robert Moffit, PhD, of the Heritage Foundation (Washington), it is likely that any program to implement Medicare prescription drug benefits will result in some level of price controls. The primary question is whether outright controls will be imposed, or if government-regulated competition will be the main tool used to keep prices in check. As described by Wagner, one model would have Medicare collect premiums and purchase drugs from pharmaceutical suppliers for consumption by Medicare beneficiaries, while another approach would involve competing private plans that would purchase drugs for beneficiaries, with those plans regulated by the federal government.

Much depends on the structure of the pharmaceutical industry itself, which is comprised of two segments, the proprietary branded drug segment and the generic drug segment. The branded drug industry operates as a legal, tightly enforced monopoly, maintained by patent protection laws and the regulatory process enforced by the Food and Drug Administration. Branded pharmaceuticals constitute a $110 billion industry. In contrast, revenues for the generic drug industry total about $10 billion. Average selling prices for generic drugs are typically about 8 cents per dose, while for brand name drugs prices range from 40 cents to $1 per dose, depending on whether or not multiple sources exist for the drug. In 1999, 50% of all drug ingredients were on the market alone with no competition. Along with patent protection, branded drugs also may qualify for orphan drug exclusivity for seven years, exclusivity for new dosage forms for three years, pediatric studies for six months and first generic entry for six months. In the biotechnology area, drugs typically enjoy an indefinite period of exclusivity since there is no FDA approval process in place for generic equivalents. As a result of all these factors, the prescription drug industry wields significant monopoly power, but is also able to undertake the highly risky process of developing new and more effective compounds. Nevertheless, since government plays a significant role in maintaining the current structure of the pharmaceutical industry, and thereby maintaining prices at a higher level, it will prove challenging to avoid altering the structure if the costs of a Medicare prescription drug program begin to strain the system's finances. Another issue is the possibility that funds available for other types of health care products and services could become scarcer if the Medicare system becomes heavily burdened with payments for prescription drugs.

Changing role for e-health, telemedicine

Another factor expected to play a role in determining the overall cost of health care in the U.S. is the implementation of e-health and telemedicine technology to improve operational productivity. A year ago, prior to the market collapse of dot.com companies, many observers were predicting that e-health would revolutionize health care delivery, making it more efficient and affordable and thereby providing a solution to the dilemma of health care consuming an ever increasing portion of GDP. Now, with valuations of e-health companies having fallen by as much as 90% in some cases and many e-Health business models proving unworkable, expectations have been scaled back considerably. Nevertheless, the Internet and telemedicine technologies are beginning to play an increasing, although incremental, role in the health care system. Consumer use of the Internet to purchase health care services is slowly taking hold, and pharmaceutical companies are increasingly using data from e-health companies to refine their direct-to-consumer marketing strategies. At present, as discussed by Chris Brandt of Cap Gemini Ernst & Young (Los Angeles, California) at the UCI conference, 75% of Americans do not make use of the Internet for health care services. While the percentage using the Internet is growing, as shown in Table 3, there remains a considerable opportunity to expand use of that delivery channel. Of those 30 million consumers who use the Internet for accessing health care services, 60% are well, 5% have been newly diagnosed with a disease, and 35% are afflicted with a chronic illness. A survey conducted among Pacific Care members in California found that 48% of consumers want the ability to e-mail their doctor, and 29% would switch doctors in order to be able to interact with their doctor via the web. At present, however, only 3% actually use e-mail to communicate with their physician, even though the number of physicians using e-mail increased 200% in the past year.

In the future, Brandt sees an opportunity for e-health to play a particularly important role in improving the delivery of health care services that are purchased out of pocket, which accounts for $220 billion in spending in the U.S. In addition, health care delivery in alternate sites including the home will benefit from the implementation of Internet-based technology that allows improved monitoring of patients and a greater degree of interaction between physician and patient, possibly resulting in the virtual reintroduction of the house call. By 2004, predictions call for Internet-based health care transactions to reach $370 billion, representing substantial growth over the approximately $1 billion in revenues now being generated. While that projection may prove somewhat optimistic, there are some areas in which more efficient approaches to health care delivery could have a major impact in reducing costs. In particular, providing a higher level of information to consumers to allow more self-directed use of health care services may result in selection of more cost-effective treatment. As shown in Table 4, most (82%) of the population consumes only routine and preventative care services in a given year, accounting for 25% to 30% of health care spending. In addition, 17% of the population consumes services for the treatment of acute or chronic disease, accounting for 55% to 65% of spending, and chronic disease patients in particular are likely to value the opportunity to make better-informed choices about their care. Only 1% of the population, on an annual basis, falls into the catastrophic disease category, accounting for 10% to 15% of spending, and would typically not be able to shop for the best value for their health care dollar.

One approach that provides an increased level of health care information to the consumer with the goal of improving utilization of the most cost-effective care has been developed by e-Health Concepts (San Francisco, California). As described by Cindy Gentry, president of e-Health, at the UCI conference, the company's program is being implemented by Health Market (Norwalk, Connecticut) as an alternative to managed care. Health Market and e-Health Concepts have developed the plan in response to consumer, employer and provider dissatisfaction with existing managed care approaches. According to Gentry, existing plans foster financial instability among physician groups and hospitals due to reimbursement delays and levels of reimbursement that do not reflect true costs, while employers are faced with a third straight year of double-digit premium increases. Furthermore, consumers want choice of health care options and expanded access to care. The Health Market Self-Directed Healthcare program allows consumers to evaluate doctors via the Internet, compare fees and research medical conditions, while providing physicians with the ability to set their own fees and receive prompt reimbursement without paying a charge for the service. Employers gain the ability to control costs, in part by allowing employees to shop for their own services, as well as to reduce administrative costs and increase employee choices. The plan uses employee medical savings accounts to pay for routine care – with no co-pay, no deductible and no claims – along with fixed dollar amounts that are allocated based on diagnosis of a major medical condition. The consumer spends the fixed dollar amount using information provided via the Internet from the insurer. The plan eliminates managed care gatekeepers and pre-certification and review for surgeries and hospitalizations, while providing access to any health care provider.

Another Internet-based approach to improving the efficiency of health care delivery and lowering costs has been introduced by HealthAllies.com (Glendale, California). As described at the UCI conference by Andy Slavitt, president and CEO, the company's consumer-driven approach to health care delivery is designed as a complement to existing employer-paid benefit plans. The plan is targeted mainly at the $220 billion spent each year for uncovered health care services, services that typically are purchased at the highest (retail) price. By aggregating consumers of cash-pay services, and providing real-time comparison of provider rates via the Internet, the HealthAllies plan can provide savings of 20% to 71%. The approach allows delivery of benefits at the point of service and can avoid payment for unused services typical of existing managed care plans that charge a fixed premium. HealthAllies has enlisted 350,000 providers so far, and is signing up new providers at a rate of 10,000 per month. The company generates a revenue stream from fees paid by employers for the service.

Vivius (Minneapolis, Minneapolis) is about to introduce its version of a personalized health care system in pilot markets in Minneapolis and Kansas City. The company's goal is to establish a consumer-driven health care system operating in an open market. The company has received $17 million in venture capital funding and believes its plan is representative of the emerging third-generation of health care plans, following after first-generation indemnity plans and second-generation managed care. The Vivius plan uses employer-funded purchasing accounts that are completely controlled by the employee, a wrap insurance benefit and a web site that allows employees to evaluate and choose physicians based on cost and quality to create a personalized provider panel. The Vivius plan also avoids the need for physicians to file claims, and allows them to determine their own fees and control medical necessity decisions while still having patients directed to them. For employers, the plan reduces claim forms, provides the freedom to choose any physician or provider and allows employees to make better-informed purchases of services. Vivius generates revenues via a 4% transaction fee that is taken from payments made to providers.

The plans developed by HealthAllies.com, Health Market and Vivius represent approaches to Internet-based health care that, at least in principle, are designed to avoid the primary deficiency of the previous generation of e-health companies, which was their lack of perceived value to providers. Physicians, in particular, have generally failed to realize any benefits or added capabilities from e-health, although there have been some successes. The new generation of e-health companies, on the other hand, seeks to address some of the key drawbacks of the existing health care system by doing away with medical necessity reviews, reducing paperwork, speeding reimbursement and putting control back in the hands of physicians. At the same time, all of the approaches share the common feature of increasing the role of the consumer in the health care purchasing process, with the goal of making the patient more aware of costs versus benefits of services received. The rapid growth of HealthAllies, one of the first to launch its service, indicates that, at least initially, there is strong receptivity in the market to the third-generation concept for health care delivery.

Investors returning to health care

The improving financial picture for health care has resulted in renewed investor interest in managed care and hospital stocks. In addition, fundamental growth has returned to the industry, with many hospitals operating at close to full occupancy, and a number of hospital capacity expansions under way. Cash flow has improved for most providers because payments are now being made on time, and reimbursement levels are no longer under the extreme pressure that existed a few years ago. As in other sectors of the economy, capital investments should drive productivity improvements over the next few years. In particular, the integration of health care delivery, which will be a key factor in lowering overall costs of the health care system, is now beginning to become a reality thanks to web-based integration tools that are cheaper, faster and more effective than previous solutions. As a result, health care providers are expected to achieve increased profitability, and the relative stability of the sector coupled with improving financials should drive continued investment and rising valuations. Finally, e-health strategies are beginning to be implemented effectively by established health care companies, as opposed to dot.coms, a trend that is expected to improve the operational efficiency of existing companies and improve their value.

Venture capital investment in the health care sector is also growing on an absolute basis, a trend that is likely to drive long-term growth in the market. One sector that is attracting renewed interest is biotechnology. Whereas only five biotechnology companies were valued at over $1 billion five years ago, there are now over 40 in that category. Growth in biotechnology company valuations is the direct result of investments made over the past eight to 10 years, which is the timeframe needed in order for investments to bear fruit in the industry. Furthermore, the biotech sector is once again proving to be fertile ground for start-up ventures, with 20% of all initial public offerings (IPOs) completed in 2000 attributable to biotech companies, although most, excepting service companies, lost value. Analysts expect that figure to rise to as much as 25% in 2001, although this year also is likely to bring the start of a cooling-off period for IPOs in the sector.

In the medical device sector, prospects have not yet improved significantly. Most medical device companies address relatively small market opportunities as compared to those targeted by biotech and pharmaceutical companies. One area that is attracting considerable interest is the use of hand-held wireless computers by physicians for automation of prescription ordering and other patient management tasks. Analysts are somewhat skeptical that such companies will succeed, in part because it is not yet clear who will provide the up-front investment in hardware and software needed to allow such systems to achieve a critical mass of placements. However, investors in general are returning to the health care sector, as discussed by Don Milder of Versant Ventures (Newport Beach, California) at the UCI conference. The main factor driving higher levels of investment in health care-related ventures is the growing disenchantment with dot.com and Internet-based ventures, driving investors to favor companies involved in more stable industry segments with attractive long-term growth prospects. As shown in Table 5, there has been a precipitous drop in the percentage of venture funds invested in the health care sector over the past three years, although the absolute dollar amount invested in health care has grown rapidly. Total venture investment has increased substantially due to funding of technology companies (dot.coms and related ventures). If the trend for investors to focus more on health care investments continues, there should be a large amount of capital available to fund new ventures in the medical products and services sector, Milder said.

Areas of opportunity in the health care sector, according to Milder, include biotech and medical devices, while investments in health care services and e-Health are out of favor. Within the biotech sector, specific areas that are attracting investor interest include genomics and proteomics, automation tools and informatics, in-licensing of clinical compounds and drugs, and preclinical drug discovery. In the medical device sector, attractive segments include cardiovascular, neurovascular and orthopedic devices. Overall, the next few years appear promising for companies in the traditional health care arena as well as for new technology-based medical ventures, both from the standpoint of availability of investment capital as well as improving economic trends.