Innovation and Industries: Health Care

This article originally appeared in Motley Fool Rule Breakers in November 2013.  The numbers have been slightly updated to account for changes during 2014.

The U.S. health care system badly needs a Rule Breaking checkup.

My diagnosis? Forward-thinking investors can profit from its inefficiencies.

Consider this: Health-care expenditures have outpaced the rest of the economy for four decades and now cost our country $3 trillion each year (that's 16% of GDP). The system itself is also chronically complex. An intricate web of drug manufacturers, pharmacy benefit managers, health-care providers, and managed care organizations account for lots of headaches and lost time. PricewaterhouseCoopers calculates that about half of all health-care costs -- $1.2 trillion per year -- is the result of wasteful and unnecessary spending.

The Opportunity

The Patient Protection and Affordable Care Act, or ACA, aims to reduce that unnecessary spending. The ACA is one of the most comprehensive overhauls to the health-care system since Medicare was introduced in 1966 -- the legislation is more than 33,000 pages long and would stand seven feet tall if you stacked it upright. But we can boil it down to two explicitly stated goals:

1. Improve the quality and lower the costs of health care.
2. Increase access to affordable care.

So let's put on our Rule Breaking hats and look for pockets of the health-care value chain that can improve quality and lower costs or increase access to affordable care.

Improving Quality and Lowering Costs: Pharmacy Benefits Managers

About 215 million Americans have prescription-drug benefits, and there's a lot of behind-the-scenes work required to keep that system rolling. At the intersection of drug manufacturers, pharmacies, and insurance companies, pharmacy benefits managers, or PBMs, process prescription-drug claims. PBMs came to exist because they managed multiple insurance networks concurrently, so they were able to negotiate lower drug prices than any single network could on its own. After negotiating prices with the manufacturers, PBMs added a bit to the drug's cost for themselves (the "spread'), and then distributed the drugs to end-users through pharmacies or mail-order programs. PBMs billed the insurance companies for each claim.

The industry consolidated to further strengthen its buyers' power, and dominant firms came to rule. Even with an estimated 1,300 American PBMs, just three companies -- Express Scripts (NASDAQ: ESRX), CVS Caremark (NYSE: CVS), and OptumRx (a division of UnitedHealth Group (NYSE: UNH)) -- controlled 80% of the market share in 2013.

The idea to consolidate made sense, but the incentives became opaque. PBMs were tight-lipped about the rebates they received from manufacturers, and insurance networks were clueless about the magnitude of the spreads. Drugs would come off-patent and lower-cost generics would became available, but PBMs would stick with the higher-spread branded drugs for the plans. Were the big three PBMs really saving the insurance companies any money, or were they just taking a disproportionate share of the pie?

Company We're Watching

Rule Breakers recommendation Catamaran (NASDAQ: CTRX) found a way to disrupt the industry.

Like its predecessors, Catamaran used its massive network base to negotiate deals with drug manufacturers. But then it passed along the savings to its insurance network customers, charging only a fixed price for each transaction. Insurance networks of all sizes could now use Catamaran's platform and scale to build the best plans for their members, with full transparency of how much it would cost them.

First recommended in Rule Breakers in 2009 as SXC Health Solutions, Catamaran has grown from an unknown small cap into the industry's fourth-largest player. But if you haven't invested in Catamaran, don't feel as if you've missed the boat. Catamaran continues to acquire and integrate smaller PBMs, improving profitability along the way. The company also keeps winning new business, including a massive 10-year partnership with Cigna (NYSE: CI). And given the ACA's expanding prescription-drug coverage, Catamaran is sailing with the wind at its back.

Increasing Access to Affordable Care: Public Health Exchanges

It's tough for hospitals to make an honest buck -- two-thirds of them in the United States are operating at a loss. Hospitals are required to provide emergency health-care treatment to anyone, regardless of citizenship or ability to pay, and that can ding the bottom line. Medicare reimbursement payments don't always cover the cost of treatment, and that hurts, too.

So to offset the costs, hospitals raise their rates for private insurers who can pay, who in turn raise their premiums for members. In short, there is a lot of passing the buck.

One way to stop the bleeding is to expand the base of those insured, and that's what the ACA aims to do. A larger pool of payers would bring in more premiums, which should offset the increase in health-care costs (as long as healthy people join alongside the less healthy).

The government had started to nudge everyone into having insurance. Beginning in 2014, people who choose not to have health insurance will be fined. And public health exchanges allow insurance companies to offer plans directly to people over the Internet. The information is universally distributed and publicly available -- which increases competition. Remember "perfect competition" from economics class? It pushes down suppliers' profits and transfers the benefit to the buyers, so the exchanges should make insurance more of a commodity.

And the exchanges should "learn" with time. Once insurers better understand their competition, their own costs, and the risks associated with each market, they will price premiums more efficiently. Incumbent insurance networks with legacy revenue streams will suddenly find many new entrants encroaching on their turf. McKinsey found the following on Oct. 15, 2013:

• Nationwide, 80 new entrants were offering plans in the individual markets
• New entrants now represent 28% of all companies and 16% of all offered plans

Companies We're Watching 

With increased competition likely to drive down premiums, insurance networks probably aren't the best way to win in this game. But the addition of several new entrants means that there will be a lot higher volume of insurance transactions. One group of companies to keep an eye on are those who operate the exchanges.

In addition to the government-run public exchanges, private exchanges (tailored to specific companies) are coming into their own. Private exchanges were designed by consulting group Aon (NYSE: AON) as a way for companies to pay a fixed amount for their employees to select their own insurance coverage. Aon is impartial to the plans that are offered or their prices. It makes money by designing, implementing, and running the exchange -- very similar to stock exchange brokerages.

Walgreen (NYSE: WAG) was the latest big company to make the plunge, announcing in September 2013 that it would transition its 160,000 employees to a private health exchange run by Aon Hewitt (a division of Aon). Aon reported that enrollment in their Active Health Exchange has already tripled during 2014 (versus last year) -- now with 18 large employers and over 600,000 employees covered.  

You'll want to keep an eye on companies like Aon and its smaller competitor e-Health (NASDAQ: EHTH). They're playing a much larger role in the way Americans choose health insurance.

The Foolish Bottom Line

It seems that talk about the Affordable Care Act is incessant these days. But try to block out the noise and keep in mind the two overall goals: more insured Americans and lower costs. The innovative companies with a means to those ends will play a role in improving the country's health-care system -- and quite possibly your portfolio.