The Spark

Major inflection point looms for US health-care costs

The Spark: Major inflection point looming

What do two divergent inflation readings have to do with a blockbuster health-care deal?

Quite a lot, actually.

For starters, there is the potential $32 billion-plus deal for health insurance giant Humana, the bulk of whose earnings come from Medicare, the federal program that insures America's elderly.

Then, there is the gap between the two leading U.S. core inflation readings, which recently hit a six-year high.

The Federal Reserve's preferred gauge was up just 1.2 percent in April from a year earlier—just off its historical lows. Meantime, the more widely followed core consumer price index jumped 1.8 percent during the period.

A key reason for this gap is the price of medical care—and Medicare payments are a big chunk of that.

The CPI focuses mainly on out-of-pocket health-care costs, being an index of what consumers themselves are paying. The Fed's preferred gauge, the price index for personal consumption expenditures (PCE) covers "all goods and services consumed by households regardless of who paid for them," or even if there was any explicit payment, as Morgan Stanley puts it.

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That means health-care services make up roughly 20 percent of core PCE, because they cover the consumption of health care paid for by somebody else—namely, by Medicare, Medicaid and employers. By contrast, health-care services account for only about 8 percent of the core CPI.

(The "core" readings for each index simply strip out food and energy prices, which are notably volatile, to better gauge underlying prices pressures across the economy.)

The total price of providing Americans health care, then, is best reflected in the PCE, and has actually been putting downward pressure on that index for years now. It's also driven that yawning gap between the super-low PCE readings and the higher CPI ones.

Downward pressure? Indeed, owing in large part to hefty cuts in Medicare payments that go back to the 2010 implementation of the Affordable Care Act, or "Obamacare."

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Since then, "the government has reduced payments to Medicare Advantage plans by nearly 15 percent," said Cantor Fitzgerald analyst Joseph France. Medicare Advantage refers to the administration of Medicare payments through private health insurers.

The effect on the Fed's preferred inflation gauge has been especially large.

Core PCE services inflation, in fact, "has been stable for several years in a 2% to 2.5% range," if health care is excluded, according to Morgan Stanley. The March reading, by that metric, was up 2.3 percent from a year earlier, the firm calculates—comfortably above the Fed's targeted 1.5 to 2 percent range for core goods and services inflation.

Enter Humana, which The Wall Street Journal last month reported is exploring a sale to one of its rivals, and "is seen as a prize because of its powerful Medicare franchise."

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Humana is the second largest provider of Medicare Advantage plans, with about 3.2 million enrollees (as of April 1 payment data), according to Stifel Nicolaus & Co. The largest is UnitedHealth, with just under 3.5 million.

Surprisingly, these Medicare giants have weathered the enormous payment cuts relatively well. Humana even managed to increase its key profit margin in the first half of 2010 when the first major cuts hit, said Stifel analyst Thomas Carroll. The sheer number of Americans hitting age 65 and enrolling in plans has helped to offset the government's payment cuts.

And now, a bright spot for big insurers may be at hand: a major inflection point with regard to Medicare payments.

"In 2016, we're expecting to see the first positive rate increase for Medicare Advantage for the players like Humana that we've seen in years," Carroll said last month on CNBC's "Closing Bell."

Likely winners of Humana

That realization was announced in April by the Centers for Medicare & Medicaid Services, indicating that final 2016 Medicare Advantage rates will rise by 1.25 percent, according to Deutsche Bank analyst Scott Fidel. He estimates Humana will be the largest beneficiary, with a 1.7 percent "all-in" rate increase next year. UnitedHealth meantime is expected to see an increase of 1.2 percent, Aetna 1 percent, Anthem 0.4 percent and Cigna "flattish."

"The government has extracted its pound of flesh," as one analyst put it, "and now it's back to normality."

That, understandably, makes Humana, which draws some 65 percent of its revenue from Medicare Advantage, an attractive target.

So, too, does the exploding population growth of the Medicare-eligible age cohort. The U.S. population age 65 and up is seen growing 53 percent by 2020, to 55 million, from 36 million in 2006, notes Stifel. By comparison, the under-18 population is seeing growing just 8 percent, to 80 million.

It also suggests the downward pressure from health-care services in the PCE index may be abating—a turning point critical to Fed members debating the timing of their first interest-rate hike in over a decade.

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That said, medical costs may not go back to rising quite as quickly as they once did in the "old-normal" days.

The introduction of digital medicine, "value" versus traditional "fee-based" payments, a healthier "young elderly" population, and a potential crackdown on "upcoding" of Medicare payments could all contribute to a lower rate of cost inflation this time around.

Digital health tools, in fact, could save the U.S. health-care industry more than $100 billion over the next four years, Accenture just projected. The consulting firm estimates that mobile diagnostic tools and other approved technological systems reduced costs by $6 billion last year already through reduced emergency room visits, improved medication adherence and other behavioral changes.

Take Humana's "Cue," for instance, a new app designed for the Apple Watch, which simply reminds wearers to stand up, drink water, stretch or go outside.

Others, like GoBiquity's "GoCheck Kids" App, go much further, using iPhone photos of children's eyes to detect serious eye problems at their earliest, most difficult and most critical age for prevention.

It's a point worth remembering at Apple's snazzy 2015 Worldwide Developer's Conference: This technology isn't just about getting the most bang for your buck out of the iPhone.

It's also helping to maximize the value—and minimize the cost—of the U.S. health-care system.