Drug benefits may be an Rx for profits

The question pops up regularly during investor calls with UnitedHealth Group: Will the insurer bring its valuable drug-benefits business back in-house?

The answer is important for Medco, of Franklin Lakes, N.J., one of the nation's largest prescription benefits managers. It has a 10-year contract to manage a chunk of UnitedHealth's drug benefits that expires in 2009. But as the deadline looms and its core health insurance business looks increasingly anemic, it's important for UnitedHealth too.

The question is likely to resurface when Minnetonka-based UnitedHealth releases first-quarter earnings April 22.

UnitedHealth buys $21 billion in drugs each year on behalf of health plan members and more than half of that is already managed in-house. Bringing the rest back in would be "strategically significant with plenty of rewards down the road," said David Heupel, a portfolio manager for Thrivent Asset Management.

It's a tough time for health insurers, who face rising medical costs and stagnant or shrinking commercial enrollment. Large employers, frustrated after years of steep premium increases, are trimming benefits, meaning insurers sell less insurance per member.

In UnitedHealth's case, poor service at PacifiCare -- a large California plan acquired in 2005 -- has exacerbated problems. That, plus stiffening competition, led UnitedHealth to predict a loss of 550,000 members in the first quarter, from 25.5 million.

Investor concerns reached a crescendo last month, when Wellpoint Inc. -- No. 2 after UnitedHealth -- lowered its profit outlook, citing higher costs from a bad flu season. Stocks of the major health insurers are trading at their lowest valuation in 10 years. UnitedHealth stock fell more than 15 percent in a single day.

At the time, UnitedHealth said there "may be pressure on first-quarter and full-year 2008 results," but it was too early to draw conclusions. It has projected full-year revenue of $83 billion and earnings per share of $3.94 to $4.

Investors are also worried about whether the Federal Reserve's move to lower interest rates has hurt short-term investments held by insurers.

Growing drug business

By contrast, it's boom time in the drug-benefits field, as Americans age and get chronic illnesses.

Also, as blockbuster drugs go off-patent, people are switching to cheaper generics. This is good for consumers and for pharmacy benefit managers (PBMs).

There's sometimes a lag before payments adjust, when PBMs get paid the old rate even though they're already supplying generics. Even after that window closes, generics offer wider margins for PBMs, because there's now competition among manufacturers instead of the monopoly enjoyed by a brand-name drugmaker.

UnitedHealth has a long history with drug benefits. In 1987, it was one of the first to connect retail pharmacies, drug companies and mail-order services through a subsidiary called Diversified Pharmaceutical Services.

UnitedHealth later sold that to pharmaceutical giant SmithKline Beecham, now GlaxoSmithKline, for $2.3 billion. Then-CEO William McGuire used some of the proceeds to buy MetraHealth -- made up of the health businesses of MetLife and Travelers -- transforming UnitedHealth overnight from a regional to a national player.

For more than a decade, UnitedHealth was content to let others manage its drug benefits.

Then two years ago, it inherited a division called Prescription Solutions along with its purchase of PacifiCare. That division now manages the drugs of 2 million seniors from PacifiCare and an additional 4 million seniors from UnitedHealth's Ovations business.

Revenue at Prescription Solutions jumped more than three-fold, to $13.25 billion in 2007, with operating earnings of $269 million.

Prescription Solutions is now one of a clutch of star performers within UnitedHealth that includes Ingenix, an information technology arm; OptumHealth, which handles disease management, and OptumHealth Financial Services.

John Penshorn, UnitedHealth's senior vice president for investor relations, said the company hasn't made a decision on whether to bring the rest of its drug business back in-house.

But he said: "We're clearly setting this business up for growth."

Chen May Yee • 612-673-7434