Tag Archives: profits

Vested Interests in Health Care: Spectacular Profits and Earnings for At Least Some Insurers and Providers

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Cigna share price, Dec 1, 2003 to Dec 16, 2013.001

Ten-Year returns:  CIGNA = 361%;    S&P 500 Index = 70%

A.  Introduction

Earlier posts in this series on health care have documented how incredibly expensive the US health care system is (with costs almost $1 trillion more than would be the case if the US spent as a share of GDP what the second highest spending country does), and that the prices for the same procedure at different hospitals can vary by a factor of ten or even more.  Future posts will explore why this is the case.  But at this point it is worth reviewing how this US system of nominally competing private health insurance companies and health care providers nevertheless produces winners with truly astounding profits and personal compensation for those at the top.

The focus here will be on some of the numbers, documenting how at least some individuals and firms are doing very well in this non-transparent, non-competing, system.  The final section will add how this is taking place not because such insurers and health care providers are especially efficient at what they do, but rather because they are able to take advantage of a system of great inefficiency and waste.  And such winners now have a vested interest in keeping this badly functioning system in place.

B.  Spectacular Profits and Earnings of At Least Some Insurers and Providers

1)  To start, one can look at the stock market returns to investors in the major private health insurance companies.  The graph at the top of this post shows the ten year return (from December 2003 to December 2013) on an investment in the health insurer Cigna.  Such an investment would have received an overall ten year return of 361% (not counting dividends, which would have added to this).  That is, an investment of $10,000 in December 2003 would have grown to $46,100 by December 2013 (plus dividends).  Over this same period, the S&P 500 index (the generally used index of the overall stock market in the US, and shown as the orange line in the graph) would have grown by a pretty good 70%.  The Cigna return was more than five times as much.

2)  Other publicly traded health insurance companies have also done well.  Over this same ten year period, an investor would have received a return of 145% from an investment in Wellpoint, a return of 171% from an investment in UnitedHealth, a return of 318% in Aetna, and a return of 352% in Humana.  All of these are well in excess of the S&P 500 index return over this period.

3)  Wendell Potter, a former head of communications at two of the top health insurers (Humana and Cigna) who is now decidedly anti-insurance, presents in his 2010 book Deadly Spin figures on how much health insurance executives have been compensated.  Citing other sources that drew on corporate filings, he noted (page 139) that in 2007 the CEOs at the ten largest publicly traded health insurance companies received a combined total compensation of $118.6 million (an average of $11.9 million each).  From other corporate filings with the SEC, Potter noted (page 141) that between 2000 and 2008, the ten largest publicly-traded health insurers paid their CEOs a total of $690.7 million.  And in 2009, Wellpoint alone employed 39 executives who each collected total compensation exceeding $1 million.

4)  But annual compensation of even $10 million or more can substantially undercount what the CEOs of these health insurers ultimately receive.  According to a filing with the SEC, the Chairman and CEO of the health insurer Cigna retired at the end of 2009 with a retirement package worth $110.9 million.

5)  But the retirement package of the Cigna CEO was not the most generous among his peers.  The embattled CEO of UnitedHealth Care stepped down in late 2006 after being forced by the SEC to forfeit stock options worth $620 million.  The stock options in the company had been illegally backdated to make them especially profitable.  However the CEO was allowed to keep stock options worth $800 million, which was in addition to the $520 million he received in compensation from UnitedHealth while he ran the company from 1991 to 2006.  That is, this one individual received total compensation worth over $1.3 billion during his tenure as head of this private health insurer.

6)  Hospital providers have also done well.  Steven Brill, in his widely read article titled “Bitter Pill” published in Time Magazine in February 2013, calculated that in 2010 the prestigious MD Anderson Cancer Center in Houston, a non-profit that is formally part of the University of Texas system, had an operating profit of $531 million in fiscal year 2010.  This was equal to 26% of its revenue of $2.05 billion that year, which is a very generous margin for a service industry.

7)  Brill also noted the the total compensation of the president of the MD Anderson Cancer Center was $1.845 million that year (plus he earned more from other interests).  And he reported that six administrators at the Memorial Sloan-Kettering Cancer Center in New York earned over $1 million each at that one institution.

8) To coincide with the Steven Brill article, Time published figures on returns being earned by other major non-profit hospitals in the US.  The operating profits of the ten largest such hospitals (as measured by number of beds) varied from $118 million to $770 million (in the most recent year for which data is available).  The CEOs of these hospitals received between $2.1 million and $6.0 million in compensation from the hospitals (plus in general earned more from other interests as well):

Health - Profits & CEO Compensation at Non-Profit Hospitals, 2010.001

It should be added that not all hospitals are profitable.  The point, rather, is that at least some are highly profitable.

9) Using records that must be filed with the government each year, the California Nurses Association found that 100 executives at non-profit hospitals in California earned over $1 million each in 2010.  Four hospital groups accounted for 69 of these 100 high-earning executives, with the Sutter Health Network alone accounting for 28.  The top CEO compensation was $7.7 million in that year, and four CEOs earned $4 million or more.

C.  Yet Waste and Inefficiency is High

High profits and earnings could perhaps be justified if they were a consequence of highly efficient operators, providing an important service at low cost.  But that is not the case in the US:

1)  Overall Costs:  First, as has been noted before and discussed in the earlier blog post cited above, the US health care system is by far the most expensive in the world, with spending as a share of GDP which is 50% higher than in the second most costly country.  With almost $3 trillion being spent on health care in the US this year, that implies the US expenditures are about $1 trillion more than they would if it were spending (as a share of GDP) what the second highest country was spending.  And the US is spending $1.4 trillion more than it would if the US spent what the average OECD country does.

Yet as that blog post also noted, the results the US gets from such high spending are mediocre at best.  The infant mortality rate in the US is higher than in any other OECD country other than Mexico, Turkey, and Chile.  And life expectancy is only higher than in several OECD members with far lower income from Eastern Europe and Latin America.

If the US had an efficient health care system, it would not be spending so much for such poor results.

2)  Hospitals:  At least certain hospitals and their CEOs receive high incomes, as noted above, but there is no indication that this comes from being especially efficient.  Rather, the market in which they operate is highly fragmented, and as was documented in an earlier blog post, the variation in the prices they receive for similar medical procedures can vary by a factor of ten (or even more) between them.

As any economist will tell you, a normal market should not function that way.  In a normal market, one would not see much variation among prices (and what variation there is would be linked to some assessment of quality by the purchaser).  Economists call this the Law of One Price.  In such a market, profits will be earned by a provider who can provide the service at a lower cost (by being more efficient) and then selling it as this one price.  Furthermore, these more efficient producers, earning a higher profit than others who must also sell at this same price, will then expand to provide more of the product or service at this profitable price (profitable to them).  They will gain market share at the expense of the less efficient.  The price will drop, and over time the less efficient will be driven from the market, leaving the more efficient providers selling at what would then be a lower price than before.  In the end, only the most efficient providers will survive, and will earn a normal profit similar to that earned elsewhere and in other industries.

This process clearly does not happen in the market for health care provision.  Future blog posts will discuss why.  But briefly, the wide variation in prices makes it possible for even high cost medical providers to survive and even to thrive, and rewards those who are skillful at managing within this fragmented system.  It also rewards hospitals and other medical providers who enjoy market power vis-a-vis the insurer (by being one of only a few providers of this service within the region, for example by a hospital chain that might dominate the local market).  They will then be able to demand a high price, which the insurers (and ultimately the patient) will have little choice but to agree to.  Insurers, from their side, similarly seek to dominate any given local market.  Which side gains the upper hand depends on which is more successful in gaining market power against the other.

3)  Pharmaceuticals:  The pharmaceuticals industry also illustrates how an ability to exploit the rules in the system can lead to lead to big, indeed gargantuan, profits.  A good example was described in a recent Washington Post article, on the use of an expensive drug produced by Genentech for the treatment of age-related macular degeneration (AMD).  AMD is the most common cause of blindness among the elderly.  The Genentech drug, called Lucentis and developed through genetic engineering, is currently the most effective treatment for AMD.  Essentially the same drug, called Avastin for this purpose and also made by Genentech, is used for the treatment of certain cancers.  It can also be used to treat AMD, and many doctors notes it does this equally well as it is really the same drug.  But Lucentis costs $2,000 per dose, while Avastin, when used in the dosage required for AMD, only costs $50 to $60 per dose.

Why would any doctor then use Lucentis rather than Avastin for the treatment of AMD?  Because Genentech has only sought and obtained formal FDA approval for the use of Lucentis for AMD, while deliberately not applying to the FDA for the approval of Avastin for this purpose (it is, however, FDA approved for certain cancer treatments).  And in their compensation from Medicare for treating their elderly patients for AMD, the doctors will enjoy a much higher return from using Lucentis rather than Avastin since Medicare pays them a certain mark-up over cost.  This mark-up will be far higher in absolute terms for using Lucentis.  But by using Lucentis, the Washington Post calculates that Medicare has spent $5.7 billion more over the last five years than it would had Avastin been used.  Genentech has benefited enormously by its decision not to seek FDA approval of Avastin for treatment of AMD.

4)  Private Health Insurers:  Private health insurers, and their CEOs, have enjoyed often staggering returns, as noted above.  Such high returns could perhaps be seen as justified if these insurers provided their services efficiently and at low cost.  However, the costs incurred by private health insurers (and passed on to their clients) are high.

Figures on the net cost of private health insurers (i.e. administrative costs plus profits) are provided in the files on US health care costs issued each year by the Centers for Medicare and Medicaid Services (CMS).  The most recent data available go through 2011.  The “net costs” of private health insurers include all costs other than what the health insurers pay out to medical service providers on patient claims, and includes not only staff and office costs but also profits.  For brevity, this will sometimes be referred to simply as admin (or administrative) costs.

For 2011, the admin costs by private health insurers on private health insurance plans totaled $110.3 billion.  The benefits paid out under these plans came to $786.1 billion.  Thus the admin costs (including profits) amounted to 14.0% of the benefits paid.

The CMS data also provides such costs for Medicare.  The direct expenditures by government for administering this health insurance for the elderly totaled $8.2 billion in 2011, with benefits paid out of $521.6 billion, for a ratio of admin costs to benefits paid of 1.6%.  However, this would be a misleading figure as a substantial portion of Medicare is now administered by private health insurers under the Medicare Advantage program.  This program was expanded significantly in the 1990s and again with the passage of new legislation during the Bush administration, and in 2011 accounted for 25.3% of Medicare enrollees (see the table on page 168 of the May 2013 Medicare Trustees Annual Report).

The CMS data shows that private health insurers spent $24.5 billion in administering these Medicare Advantage programs.  One can then allocate Medicare payments to beneficiaries in proportion to the number of enrollees under either traditional government administered Medicare (74.7%) or under the privately administered Medicare Advantage (25.3%).  Assuming that the government’s $8.2 billion of admin costs was used solely for the programs it administered directly (even though a share would have been required to oversee the Medicare Advantage program), one can calculate the admin cost shares for the directly government administered side of Medicare, and for the Medicare Advantage program.

The result is that in 2011, the admin cost of the directly government managed portion of Medicare (for the 74.7%) came to 2.1% of benefits paid.  But for the privately administered side under Medicare Advantage (for the 25.3% enrolled there), the private admin costs alone came to 18.6% of benefits paid.  That is, private administration of Medicare programs was over nine times as expensive as direct government administration of such programs.

Future blog posts will discuss further why private administration of health care insurance is so expensive.  It is not simply profits, even though private health insurers have been substantially profitable.  It is also high costs from a business model that benefits from incurring costs to select a pool of insured clients who are relatively more healthy and hence are less likely to make insurance claims, and to deny claims when they can.

D.  Conclusion

Private health insurers and at least certain of the major health care providers have been hugely profitable in recent years, with the heads of these organizations often earning very large sums.  But such high profits and compensation have not been earned as a result of keeping down costs.  Costs in the US are especially high by international standards.  Rather, the high profits and compensation of those individuals at the top of their organizations have been made possible by a fragmented system, with little competitive pressure to bring down costs and prices.  The high returns go to those who are skillful at managing within such a system.

These high returns to at least some of the key players also creates powerful vested interests who benefit from a continuation of this high cost system.  Thus it should not be a surprise that powerful interests fear any major reform in the health care system, such as under Obamacare.  Even Obamacare, in the compromises it was forced to make in order to secure passage by Congress, was modest.  It focused on extending the availability of health insurance to those currently without insurance, with most of these to be enrolled in plans from the private health insurers.  There was no move to a single payer system such as from extending Medicare to the entire population, nor not even a public health insurance option which would be allowed to compete with the private health insurers.  There were only limited measures to try to contain health costs.  While it is still early, these limited measures appear to be having a positive effect on lowering costs, but they are not revolutionary.

More fundamental changes will be needed to bring down health care costs.  These will be explored in future blogs in this series on health care.

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Update on January 9, 2014:  Following my posting of the blog above, Dr. Alex Horenstein of the Department of Economics at the University of Miami brought to my attention a paper he has prepared (with co-author Manuel Santos, also of the University of Miami) which addresses some of these same issues.  It comes to broadly similar conclusions on the high profitability of the health care and health insurance sectors, but is a much more rigorous piece than this blog post.  While portions of the Horenstein – Santos paper are fairly technical, and the piece is still a working paper that may be modified, there is a good deal of additional material on these issues in the paper and some readers may find it of interest.

The Obama Bull Market in Equity Prices Continues

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S&P500 Index, March 9, 2009, to Nov 19, 2013

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   Bull Market Rallies Since 1940
  Ranked by overall growth in real terms
    Nominal % Real % Real Rate
Start Date End Date Change Change of Growth
Dec 4, 1987 Mar 24, 2000 582% 361% 13%
Jun 13, 1949 Aug 2, 1956 267% 222% 18%
Aug 12, 1982 Aug 25, 1987 229% 181% 23%
Mar 9, 2009 Nov 15, 2013 166% 141% 21%
Apr 28, 1942 May 29, 1946 158% 124% 22%
Oct 22, 1957 Dec 12, 1961 86% 76% 15%
Oct 9, 2002 Oct 9, 2007 101% 75% 12%
Jun 26, 1962 Feb 9, 1966 80% 69% 16%
May 26, 1970 Jan 11, 1973 74% 57% 19%
Oct 6, 1966 Nov 29, 1968 48% 37% 16%
Oct 3, 1974 Nov 28, 1980 126% 34% 5%
         

Equity prices reached record levels on November 18, with the S&P 500 index hitting 1,800 in mid-day trading and the Dow Jones Industrial Average hitting 16,000, before both closed lower.  While any such index numbers are arbitrary, it might be timely for a brief update of a blog post from March of this year on the boom in equity prices, to see where things now stand.  That blog post noted that equity prices have boomed under Obama, to the extent that the stock market rally that began soon after he took office has been one of the largest of the last seven decades.

Since March, that rally in equity prices has continued.  The graph at the top of this post shows the path for the S&P 500 stock market index (a capitalization-weighted index that is generally taken as the benchmark for the market), from its trough on March 9, 2009, to its most recent peak (in terms of its daily closing price) on November 15.  It has now increased by 166% in nominal terms, and by 141% in real terms, since that low-point just six weeks after Obama was inaugurated.

The table above fits the on-going rally into all the bull market rallies since 1940.  These rallies are defined as increases in equity prices of 25% or more in nominal terms before ending with a correction of 20% or more.  The calculations are based on figures originally provided by Barry Ritholtz on his web site (which were in turn based on Merrill-Lynch figures), which were used in my March blog post.

There have been 11 such rallies since 1940, and the Obama market rally is now the fourth largest among these.  Since it is still on-going, it could also move up further in rank.  And the pace of the increase has been rapid.  The real rate of growth in equity prices over the course of this rally (of 21% per annum up to this point) is the third highest of any of these rallies.

Conservatives continue to charge that Obama’s policies have been terrible for business and for the economy.  Yet if that were true, one would not expect equity prices to be booming.  I should hasten to add that this rally could, of course, end tomorrow.  Stock market rallies always come to an end.  But until it does, it is hard to reconcile the view of conservatives that Obama has been bad for business with what we see happening in the markets.

Taxes on Corporate Profits – Low, Falling for Decades, And Now Close to a Voluntary Tax

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Corporate Profit Taxes as Share of Corp Profits, 1950-2013Q1

Conservatives bemoan the US corporate profit tax rate, which at 35% for the statutory rate  is the highest among OECD members.  They insist the tax, which they consider to be high, is both unfair and harms US competitiveness.  While they acknowledge that the rates the US corporates actually pay are less, due to legal deductions and other mechanisms, what might not be clear is how low US corporate profit taxes have become.

The US Government Accountability Office (GAO, the audit and investigating agency that  works for the US Congress) released on July 1 a report on what US corporations in fact pay in corporate profit taxes.  Using tax return data (but aggregated to preserve confidentiality), the GAO found that profitable US corporations in 2010 paid federal corporate profit (also called income) taxes at a rate of just 13%, despite the statutory rate of 35%.

If one includes corporations that reported a loss in 2010 (and hence had zero or only little profit taxes due, leaving the numerator the same but whose losses then reduce the denominator in the ratio), the average federal tax rate came to only 17%.  Furthermore, the total tax including not just US federal taxes, but also US state and sometimes local taxes as well as profit taxes paid abroad, came to only 17% in 2010 for the corporations reporting profits, and 22% when one includes the loss-makers.

All these rates are far below the statutory federal corporate profit tax rate of 35%, which has been in place since 1993.  There are state and sometimes local corporate profit taxes on top of this, with rates that vary from zero in certain states (such as Nevada), up to 12% for the top marginal rate (in Iowa).  The state taxes average about 6 1/2%.   Taking account of just federal and state taxes, the corporate profit tax rate on average should be over 41%.

The GAO investigation was carefully done, and has raised again the point that while the US corporate profits tax rate might appear to be high, it bears little relationship to what corporations actually pay.  And the trend over time is decidedly downward.  The graph above uses data from the National Income and Product (GDP) Accounts, produced by the BEA of the US Department of Commerce to show what corporate profit taxes have been as a share of corporate profits since 1950.  While these figures will not be exactly the same as what actual tax return data will show (due to definitional differences in what is included in taxes and especially in how corporate profit is defined, as well as due to timing differences arising from the distinction between when tax obligations are accrued and when they are paid), the trend is clear.  Corporate profit taxes as a share of corporate profits have been falling steadily, from over 50% in 1951 to only 20% recently.  These estimates from the GDP accounts are consistent with the recent GAO figures based on tax return data, where one should note that the BEA estimates will include loss-making firms as well as profitable ones in their averages.

The fall in the actual rate paid to just 20% in recent years also undermines the argument that a high US corporate profits tax rate has undermined the incentive to produce.  Economic performance was better when the profits tax rate paid was much higher than now.  The US corporate profits tax rate averaged 44% in the 1950s and 1960s, yet economic growth was strong then.  As an earlier post on this blog discussed, economic growth performance in the US was substantially better in the 30 years before 1980 than in the 30 years after.

Furthermore, there is little support in the figures that the US corporate profits tax rate at 35% puts the US at a competitive disadvantage vis-a-vis the other OECD members.  While the 35% rate is indeed the highest, the second highest is 34.4% and the third is 33.99% (see the OECD source cited above).  Fifteen of the 33 OECD members covered had rates of 25% or above, and a further 10 had rates of 20 to 24.9%.  More importantly, all of these OECD members, other than the US, imposed a value-added tax on top of their corporate profits tax (and other taxes).  These additional value-added taxes were as high as 27%, and 23 of the 33 OECD members (including essentially all of Europe) had value-added tax rates of 18% or more.  Value-added taxes will be taxes on corporate profits (as well as on labor income), and should not be ignored when one is looking at the overall rate of tax on corporate profits.

The ability to avoid taxes on corporate profits has been receiving increasing attention in recent months.  Historically, much of this avoidance has been achieved through explicit provisions written into the tax code by Congress for certain subsidies or other government expenditures, which the Congress did not want to explicitly provide for or acknowledge in the budget.  Examples include credits for investing in certain locations or for certain purposes (such as R&D), or accelerated depreciation allowances as a mechanism to spur investment.  The objectives might well be worthwhile, but by hiding in the tax code what are in reality subsidies, and then keeping them secret due to the privacy of tax return data, such subsidies are likely to be both inefficient and misguided.  If subsidies are warranted, it would be better to provide them openly and transparently through the budget.

More recently, large corporations have learned how to use international operations as a means of hiding profits from jurisdictions where they would be subject to tax.  Some examples of what US firms have done in the UK to avoid paying taxes there have been recently in the news, and provide good examples of what modern firms can do anywhere, including in the US.

Transfer pricing, while technically illegal, has historically been one mechanism to do this.  This appears to have been one of the ways (among others) that Starbucks was able to run highly profitable coffee shops in the UK, but pay nothing in UK profit taxes.  Starbucks of the UK would “purchase” coffee beans from a Starbucks subsidiary legally based in Switzerland, which would in turn purchase the coffee beans from around the world.  Since commodity trading in Switzerland pays very little tax on the corporate profits generated in such trading, Starbucks could pay the international price for coffee beans through its Swiss subsidiary (even though the beans would never pass physically through Switzerland), and then charge the UK subsidiary a higher price for the beans.  This would increase the costs (and hence reduce the profits) of the UK subsidiary, while generating high profits on coffee bean trading in its Swiss subsidiary, where little or no tax was due on such operations.  And this could be done in essentially any jurisdiction which does not tax corporate profits.

There were other mechanisms as well that Starbucks appears to have used, including intra-company loans from one subsidiary (based in a low tax jurisdiction) to a subsidiary in a jurisdiction (such as the UK) where corporate profit taxes would be due.  This is very similar to transfer pricing on supplies, although here it would be for the supply of capital.

Through these and other mechanisms, Starbucks has been able to avoid, probably legally given the tax code as written, most corporate profit taxes on its UK operations, even though it had consistently reported to analysts on Wall Street that its UK operations were highly profitable.  This became such a public relations disaster that in June the company announced that it would voluntarily pay UK profit taxes of £10 million in 2013 and a second £10 million in 2014.  Starbucks has shown how corporate profit taxes have become in reality voluntary taxes, paid only to avoid image problems.

Starbucks provides a good example of what modern corporates can do, even though it operates just a simple business of selling coffee.  High-tech firms such as Apple are more often in the news since they have generated high profits yet have legally been able to avoid paying taxes on these profits at anything close to the 35% statutory rate.  For example, and as reported in a recent Senate investigation, Apple was able to exploit a difference in how corporations are defined in terms of their tax liability in a country, in order to generate profits in an Irish subsidiary which would not be subject to tax in either Ireland or the US.

More generally, US corporates do not have to pay US corporate income tax on profits generated in overseas operations until these profits are brought back to their US companies.  This is unlike the case for US citizens, who must pay each year income taxes on income generated everywhere in the world, and not just the US.  Because of this provision in the US tax code, Apple and other US corporates have kept accumulated profits legally overseas, so as to avoid paying US profit taxes on them.   The total for large US corporates reached an estimated $1.9 trillion as of the end of 2012, with Apple alone accounting for $102 billion.  Republicans have pushed for a tax amnesty on the repatriation of such funds, as was done once during the presidency of George W. Bush.  But such tax amnesties of course then generate the incentive to hold such profits in untaxed offshore accounts again, in the expectation that an administration in the future will once again grant such an amnesty.

And it has now become straightforward to structure a system of corporate subsidiaries so that almost any company can, if it wishes, make it appear that profits in the US (or indeed any other country, where corporate profit taxes would be due) are close to zero, and instead are high in some low tax or even untaxed jurisdiction such as the Cayman Islands.  Transfer pricing is one such mechanism, although technically illegal as prices between corporate subsidiaries are supposed to be “arms-length” market prices.  But these are effectively impossible to enforce.  How does a tax-audit determine what the price should have been for some specialized input (such as a component going into an iPad), for which no market exists?

But there are other means as well.  High tech firms such as Apple can, for example, transfer ownership of some patent to an Apple subsidiary in the Cayman Islands, and then require the Apple US firm to pay a royalty to the Apple Cayman Islands firm.  Or Starbucks can transfer ownership to the Starbucks brand name similarly to a subsidiary in some low tax or no tax off-shore jurisdiction, and then have the US subsidiaries pay that off-shore subsidiary for the use of that brand name.

The legal “technology” for corporate tax avoidance has therefore come to the point where what is in fact paid in corporate profit taxes can be close to voluntary.  Starbucks in the UK is the most clear case so far.  Governments are concerned, as these mechanisms can now undermine, quite legally, collections on what was at one point an important tax.  The OECD now has a working group looking at possible reforms to address the currently legal ability of modern corporates to avoid taxes through their international operations, with a report scheduled to be released in July.  But it remains to be seen whether politically possible changes in the tax code will be able to ensure such loopholes are closed.