The Dynamics of Pharmaceutical Regulation and R&D Investments

What is it about?

The paper uses a real option approch to model investment decision to investigate the properties of two widely used approaches to regulate the reimbursement of new pharmaceutical products: standard cost-effectiveness thresholds and performance-based risk-sharing agreements. The use of the latter has been quickly spreading and often criticized in recent times. Our results show that the exact definition of the risk-sharing agreement is key in determining its economic effects. In particular, despite the concerns expressed by some authors, the incentive for a firm to invest in R&D may be the same or even greater than under cost-effectiveness thresholds. The greater flexibility on the timing of commercialization allowed by risk-sharing schemes plays a key role, by increasing the value of the option to invest in R&D under uncertainty. Under this scheme, a higher value for the firm is associated with earlier access to innovations for patients. The price for this is less value for money for the insurer at the time of adoption of the innovation.

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Why is it important?

Total pharmaceutical expenditure across OECD countries was estimated at over USD 700 billion in 2009, accounting for around 19% of total health expenditure. Between 2000 and 2009, average spending on pharmaceuticals rose by almost 50% in real term. Although in several countries this is not the most rapidly growing component of health care expenditure, its regulation is receiving particular attention. Motivations for such pervasive regulation include market failures at several levels and the need to manage a complex trade-off between incentives to R&D investments for the industry, access to pharmaceuticals for patients, and value for money of public expenditure. The identification of the ideal equilibrium is subject to some controversy. Opponents of strict regulation argue that it may adversely affect incentives to develop new and better products, and possibly cause crowding-out of price competition. These concerns seem to be supported by growing evidence of a negative trend in productivity of the industry's R&D spending. Although most of the research on pharmaceutical regulation has explored the welfare properties of alternative solutions focusing on the use of new drugs, some contributions have gone further, studying its impact on the industry's propensity to invest in R&D. Regulation of prices has received the greatest attention in this literature. The key trade-off is between static efficiency - making drugs accessible to all those who need them - and dynamic efficiency - ensuring that a firms' profits are robust enough to sustain R&D investments. We depart from this literature in both the regulatory policy we focus on and the methodology we adopt. Our interest is not in price setting regulation, but in the rules that define under what conditions an insurer reimburses a new drug. In particular, we compare a well-established type of regulation based on a maximum threshold for the Incremental Cost-Effectiveness Ratio (ICER), with a performance-based risk-sharing agreement. Under the former, only technologies for which the increase in costs per unit of effectiveness gained falls below some predefined threshold are reimbursed. With performance-based risk-sharing agreements regulation operates at a later stage: the firm will not be (fully) paid by the insurer if the effectiveness of the product in use falls below a certain level. Risk-sharing agreements have recently gained increasing attention as means to mitigate the impact of uncertainty on the true effectiveness of new drugs, which is often still great at the time of approval. With these types of agreements regulator focus shifts from the stage at which the insurer decides whether to reimburse a new product, to the time when it is used by patients. Similar contracts are of potential interest to both public and private insurers. It is no surprise then that although the debate on this form of regulation has been mainly at the European level, interest is also growing in the U.S. Concerning methodology, some characteristics of the complex process of innovation and diffusion of pharmaceuticals do not seem to have been taken into full account so far in studying regulation. R&D investments are typically sunk costs on which the firm makes decisions under substantial uncertainty. Moreover, insurers' decisions on the reimbursement of new drugs will also be made under uncertainty, as evidence of the true effectiveness is typically scarce at the time of launch of innovations . The real option approach provides a suitable tool to study optimal behaviour related to irreversible decisions made under uncertainty To the best of our knowledge, this is the first dynamic model to investigate the implications of regulation of the adoption of new pharmaceuticals on different stages of a drug's life cycle, accounting for uncertainty related to: (i) the success of the R&D investment (borne by the firm), (ii) the true effectiveness of the new drugs in clinical use (borne by the insurer). The timing with which patients gain access to innovations is a crucial policy objective and has been mentioned as one of the motivations for risk-sharing agreements. The adoption of a real option approach implies an explicit characterization of the time dimension in our analysis. We compare the two regulatory schemes under discussion with respect to specific policy goals and discuss the trade-off among them. The results show that, in comparison with cost-effectiveness thresholds, risk-sharing agreements reduce the risk faced by the payer during commercialization. This is obviously beneficial to the insurer. However, concerns have also been expressed that this may end up weakening the firm's incentive to undertake new development projects. Our analysis shows that it is not the replacement of cost-effectiveness thresholds with risk-sharing agreements per se to imply this, rather, the results depend on the specific terms of the agreement. In particular, a risk-sharing agreement may provide the same, or even a greater incentive to invest in R&D while allowing earlier patient access to the innovation. A necessary condition for this to be the case is that insurers agree to reimburse products whose value for money at the time of adoption is less than it would be if regulation were based on cost-effectiveness thresholds. Uncertainty plays a crucial role: the greater flexibility on the timing of commercialization allowed by risk-sharing agreements has a positive impact on the value of the industry's option to invest in R&D. However, this also implies that an increase in uncertainty tends to reduce the comparative advantage of risk-sharing agreements in allowing early access to innovations for patients.