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Regulation's Impact On Innovation: A Two-Edged Sword

Rita E. Numerof, Ph.D.
Medical Progress Today
May 15, 2009

The extent to which the pharmaceutical and medical device industries are regulated has consistently increased over the years. This trend is, at least in part, responsible for the decline in innovative new products (as measured by the number of approved new molecular entities and original pre-market approvals). And in the current environment of activist government the movement toward more regulation, and more stringent enforcement, seems certain to accelerate.

But there is one aspect of increasing regulation that trumps all others in terms of its potential impact on innovation—comparative effectiveness research.

In 2008, Senators Max Baucus (D-Mont.) and Kent Conrad (D-N.D.) proposed legislation that would have created the Health Care Comparative Effectiveness Research Institute. The bill proposed a quasi-governmental institute for prioritizing and funding (to the tune of $300 million per year) research into the relative effectiveness of various treatments, with the goal of making healthcare spending more efficient.

The bill never made it through the legislative process, but the concept was in the ether, and when the stimulus bill (The American Recovery and Reinvestment Act of 2009) was passed it contained a provision for comparative effectiveness research as well—with some key differences. First, funding was set at $1.1 billion, though without a guarantee of ongoing support. Second, there was no pretense that this research would be prioritized and funded through a non-governmental entity—this money goes directly to the National Institutes of Health and the Department of Health and Human Services, to fund research as they see fit (after considering the recommendations of the Federal Coordinating Council for Comparative Effectiveness Research, also created within the bill, apparently because giving new responsibilities to existing bureaucracies is not permissible unless a new bureaucratic entity is created to oversee it).

Why is this likely to have a tremendous impact on innovation? There are two reasons. First, despite assurances to the contrary, comparative effectiveness is almost certain to be used to evaluate the cost-effectiveness of alternative treatments. Even if comparative cost data is not collected in the course of research, the outcomes that are measured can be associated with costs after the fact; and given the near-desperate desire of the Center for Medicare and Medicaid Services (CMS) to control the cost of healthcare, it's difficult to envision this move being a long time in coming. That would have a profound impact on the relative risk of innovative and derivative products, and hence on the extent to which innovation occurs.

Second, this represents only the first foray by the U.S. government into comparative effectiveness research. We can count on ongoing, even increasing, effort in this arena, because it does, in fact, pay off. The ability of the UK's National Health Service (NHS) to control costs relies heavily on guidance issued by the National Institute for Health and Clinical Excellence (NICE). This guidance is based on explicit evaluation of the costs and benefits of competing treatments—in other words, on comparative effectiveness research with costs worked into the mix, with the goal of getting the most bang for the pound. And despite the myriad complaints lodged by the British people against NHS, in this respect it has been extremely successful—it currently spends about $2,450 per person per year, compared to about $8,000 per person per year spent on healthcare in the U.S.

If the rise of comparative effectiveness research results in the adoption of a set of NICE-style guidelines by CMS, there will be significant negative impacts on innovation. The U.S. is the largest market in the world for innovative treatments, largely because there is a willingness to pay for them. If CMS starts to evaluate the cost of these treatments more closely, there will be significantly less willingness to pay.

That translates into increased risk for the developers of innovative new treatments, because it presents a new hurdle to market success—a product no longer has to be merely safe, effective, and appealing to physicians and their patients, now it has to be cost effective, as well. Within the NHS, this frequently means that new treatments are rejected, or are considered appropriate only under very restricted circumstances. The UK is a large market for healthcare services, but the U.S. is much larger; receiving payment at full market price within the U.S. is extremely important if the developers are to cover the full costs of developing the drug or device, which includes the costs of the multiple failures that are typically required before a successful new product comes to market.

By their nature, innovative drugs and devices present more risk of failure than derivative products do, and raising the bar not only increases the chances that any given product will fail, but increases the number of failures each success has to "cover" for the company to maintain profitability. What's more, "successful" products may become less so, on average—strong restrictions on the population for which a product is approved and the circumstances under which it can be used, extremely common in NICE guidelines, greatly reduce the size of the potential market. This makes it even more difficult to recover these costs.

This puts pharmaceutical and medical device companies in a very difficult situation. They need to develop new drugs and devices—that's what they do—but innovative products have just become exceptionally risky, and possibly uneconomic. Their rational response might be to become "high throughput" producers of derivative products, dropping their pursuit of the big innovations, and focusing on products that can make money at a low price point. This implies a bias toward products that can be developed quickly and cheaply, that are likely to have safety profiles similar to currently marketed drugs and devices, and that can find a niche among those who are less-than-perfect candidates for other available options. It creates impetus for innovation in manufacturing processes, rather than products. This is valuable work, but it isn't the kind of innovation that pushes the frontiers of medical treatment.

And it should be noted that this effect applies not only to established companies, but to startups as well. These companies may not rely on profits to fund their research, but they do rely on investors to support their attempts to develop innovative new products. Reducing the expected return on those investments decreases the capital that will be available, and the number of small R&D-focused firms that can be supported. One of the most active sources of innovative new products will be significantly impaired.

On the other hand, there is also danger in focusing solely on derivative products. By their nature, they will generally justify only incremental additional reimbursement, and in some cases may not justify additional reimbursement at all. This is especially likely if government decides that there isn't enough "real innovation" going on, or if budgets get very tight.

Companies might respond in two ways. Following the lead of regulators, they will rush to engage in innovation where it is perceived that reimbursement policies are more rewarding. This is likely to be in select product areas where it is difficult for regulators to "just say no" without significant push back from patient's groups.

Alternately, efforts will turn even more strongly than today toward ways to reduce the risk of highly innovative development efforts—toward finding better ways of screening drugs (perhaps through biomarkers), of modeling the durability and performance of devices, and of the interaction of products with the body. This would mean better health outcomes on any budget, and would represent an increase in truly valuable innovations. If it succeeds spectacularly it would usher in a new era of lower-cost innovation in drug and device firms.

The question is, can regulators—through cost-effectiveness research—find the "sweet spot" that encourages increased productivity in the industry? It seems unlikely. The more that cost-containment policy is effective, the more disincentives there are to innovate. Over the long term time, as wealthy societies in the U.S. and Europe age, there will undoubtedly to be a backlash against such policies. But in the short and medium term, there are likely to be waves of consolidation and a steep reduction in innovation as the pharmaceutical and medical device industries contract to deal with the government's monopsony pricing power. As in other highly regulated industries, the reduction in competition provides another disincentive to innovate.

The world values innovative new drugs and devices, but it does not value them infinitely, and we are now coming up against the unwillingness of even the most generous public payers to bear their costs. Clinical effectiveness research, and the regulation that is likely to follow it, is the first step in their systematic plan for saying "no". Depending on how this research is used, it may result in more focused research and development with increased focus on providing real economic and clinical value (though at a significant cost to the total productivity and innovativeness of the industry), or it may create a strong disincentive to product innovation of all kinds. It's a two-edged sword that cuts both ways, but will certainly cut deep.

The only other alternative, which is only hinted at in Europe and some programs in the U.S. (like Medicare Part D drug coverage for seniors) is to create more market-based incentives that allow consumers to choose between more expensive (but innovative) products and cheaper generics. Wealthier segments of society could also be asked to pay more for health care innovations that, over time, become less expensive as they lose patent protection and become more widely adopted. This type of differential pricing strategy has the potential to reconcile the twin goals of cost containment and innovation at a market-clearing price.

Rita E. Numerof, Ph.D., is President of Numerof & Associates, Inc. (NAI). NAI is a strategic management consulting firm focused on organizations in dynamic, rapidly changing industries. We bring a unique cross-disciplinary approach to a broad range of engagements designed to sharpen strategic focus, increase revenues, reduce costs, and enhance customer value. For more information, visit our website at Dr. Numerof can be reached via email at or by phone 314-997-1587.

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