Over the past two years, giant pharmacy benefit managers have discovered a powerful, but potentially controversial, new way to make money.

The PBMs have taken control of specialty pharmacies that supply some of the most expensive drugs in the world. As a result, some experts say, the long-embattled PBM industry could face a whole new set of conflicts going forward.

PBMs promise to save their clients money by managing their drug benefits for them. However, critics say, the PBMs could start pushing their clients to cover new biotech drugs simply because the high-margin transactions will fatten their own bottom lines. Expensive specialty drugs, used to treat chronic illnesses such as hemophilia and renal failure, often work like miracles but sometimes offer questionable benefits at best.

"The PBMs recommend to their clients which drugs should be covered," says Lawrence Abrams, a California economist who does some consulting work linked to the PBM industry. "And they could gain by encouraging more usage of biotech drugs than would be warranted based upon a cost-benefit analysis."

Following a recent flurry of acquisitions, all of the Big Three PBMs now operate major specialty pharmacies. PBM giant Medco ( MHS), which snatched up Accredo earlier this year, now portrays itself as the biggest specialty pharmacy. Caremark ( CMX) has ranked as a major player all along. And Express Scripts ( ESRX) recently inked a $1.3 billion deal to buy one of the biggest independent specialty pharmacies left.

Together, they have rushed to dominate an industry defined by its explosive growth. This year, Medco by itself expects to capture $4.5 billion -- or 8.3% -- of the booming specialty market. Going forward, the company then hopes to keep increasing its share of a business that is expected to grow by at least 20% a year. That's more than double the growth rate of the core pharmaceutical market.

Medco points to increased utilization of specialty drugs -- costing between $3,000 and $400,000 a year -- as a major driver.

"Specialty pharmacy is the fastest growing sector within healthcare today, and its drug spend is the fastest growing share of the total U.S. drug spend," says Medco spokeswoman Ann Smith. "As it is Medco's job to help manage both the cost and care of the pharmacy benefit for our clients and their members, it is a space where Medco wants to be No. 1, and -- with the acquisition of Accredo -- we are there."

But Abrams sees problems with such arrangements. Specifically, he questions whether PBMs will still recommend the use of so-called step therapy -- which calls for trying cheaper treatments first -- when they can make so much more money by supplying expensive specialty drugs instead.

"When the PBMs didn't own the specialty pharmacies, they were neutral on the matter," Abrams explains. "But now it's in their best interests for their clients to cover the most expensive drugs available. Can we trust PBMs to be objective on this?"

For their part, PBMs have pledged to better serve their customers by managing their traditional and specialty drug coverage alike. And even outside experts see some appeal to that one-stop arrangement.

Still, PBMs have been accused of shortchanging their customers by saving them less money than they should in the past. In response, they have promised fresh transparency -- which could threaten their traditional margins -- even as they shift more and more attention toward their specialty operations.

In the meantime, the Big Three each took a hit on Friday due to concerns about slowing growth. Medco fell 1.2% to $53.31. Caremark slipped 1.8% to $50.58. And Express Scripts dropped 2.6% to $80.67.

Nevertheless, all three continue to hover within close reach of their all-time highs.

Sticker Shock

During its recent biannual study of healthcare benefits, Aon's ( AOC) consulting arm specifically measured specialty pharmacy trends after identifying the topic as "an emerging concern for employers."

Aon found that employers had seen their premiums for specialty coverage jump by a whopping 22.5% -- compared to 13.1% for traditional drug coverage -- over the past year alone. Moreover, the firm noted, that spike came about even before hundreds of new biotech drugs, already in the pipeline, ever hit the market.

Aon says that specialty drugs account for about 5% of overall pharmacy spending right now. However, the firm expects that number to grow as additional biotech drugs become more readily available and commonly used going forward.

For its part, Medco has broadcast higher numbers already and even hinted at an outright explosion ahead.

"Approximately 1% or 2% of participants in a typical plan take these medications," Alan Lotvin, president of the company's specialty pharmacy division, told Employee Benefit News earlier this year. "But these members can be responsible for at least 25% of total drug costs -- with this percentage eventually increasing to 50%" going forward.

Pharmaceutical Strategies Group, the largest pharmacy benefit consulting firm in the country, continues to track this trend. In a special presentation last week, the firm highlighted stories by the Wall Street Journal on two specialty drugs -- costing tens of thousands of dollars apiece -- when offering its audience "a view towards the future."

The first story was about a lymphoma medication that sells for $28,000 a dose even though, the Journal says, it "doesn't necessarily work." The second was about a new AIDS drug costing more than twice as much as any other treatment on the market, the Journal says, "setting the stage for a wrenching debate over who will get it and who will pay for it."

More recently, the Journal reported just last week that Britain -- which offers government-funded health insurance -- may soon begin turning down new requests for at least one popular biotech drug altogether.

"There is not a bottomless pit of resources," Phil Wadeson, a British health official explained to the Journal. "We reached the point a while ago where there is far more medical intervention available than any healthcare system can afford."

The 'New Conflict'

Here in the U.S., private employers often pick up the tab. However, with many of them struggling to cover soaring healthcare costs -- and General Motors ( GM) last week announcing thousands of layoffs partly as a result -- some experts believe that those companies should look for new ways to cut some corners as well.

Abrams views specialty drugs, including certain "cancer suppressors," as a good place to start. He says that employers have found themselves paying $100,000 for treatments that simply prolong lives by a couple of months and wonders whether they should be providing that coverage at all. But he worries that PBMs, enticed by the fat margins they can obtain, will skirt their duty to save their clients money and push them to cover even more questionable drugs going forward.

Caremark could not be reached for comment last week, and Express Scripts declined to participate in this story. However, Medco clearly suggested that it will help its clients save money on specialty drugs.

"Recognizing that biologics are expensive, manufacturers will need to demonstrate that that their products bring additional value that impacts both patient outcomes and total healthcare costs," Smith says. "Remember, however, that the cost of the drug should not be the only factor under consideration. A drug may seem costly, but if it is delivering optimal therapeutic care -- and keeping the patient out of the hospital where costs could really spiral -- it is well worth the spend."

Still, Abrams sees a "new conflict of interest" -- replacing the old issue of transparency -- for the PBM industry. The shift comes after PBMs, accused of secretly pocketing drug rebates in the past, have begun passing on more of the rebates to their clients and seeking new sources of profits for the future.

"We've just been catching up with the last conflict, and now there's this new one," Abrams declares. "I think that health plan sponsors should try to start thinking ahead of the curve this time."

Aon Consulting has been trying to prepare employers for the changes that lie ahead. But Randy Vogenberg, who serves as senior vice president of the firm, suggests that many of those employers still have a lot to learn.

"People don't understand what biotech is or how it affects their company," Vogenberg says. "Biotech is not yet a huge driver of drug spending -- although it gets a lot of press -- but it will emerge very quickly as a major driver" going forward.

Given all of the biotech drugs currently in the pipeline, Vogenberg estimates that specialty pharmacy costs will begin hitting employers with real force between 2008 and 2010. Therefore, he is trying to help employers understand -- and address -- their exposure right now.

Ultimately, Vogenberg wants to help employers make their own decisions before others, like PBMs, make those choices for them.

"Employers are always focused on what everything is going to cost," Vogenberg says. "They're not looking at what kind of coverage they need or even want. For our clients, that's the starting point."

Abrams, for one, hopes they learn a lot. In the meantime, he feels pretty sure that PBMs will continue to look out for themselves.

Their push into the specialty market will certainly help. Moreover, some believe, they couldn't have timed that move any better. After all, they are taking over a high-growth business just as their shift toward transparency -- triggered by multiple government probes -- has started to threaten their popular strategy of old.

Abrams assumed some time ago that Medco, in particular, would have to find new sources of money going forward.

"How can Medco maintain its aggregate gross profit margin if it passes through 100% of rebates received to clients?" he asked. "The possibilities for additional price increases on specific services, such as mail order or claims, will have been exhausted by 2007."

Of course, Aon has predicted that specialty pharmacy spending could really begin to rocket the very next year.

More from Stocks

One-on-One With Carnival Corporation CEO Arnold Donald (Watch)

One-on-One With Carnival Corporation CEO Arnold Donald (Watch)

Replay: Jim Cramer on the Markets, Tiffany, Micron Technology and Union Pacific

Replay: Jim Cramer on the Markets, Tiffany, Micron Technology and Union Pacific

Carnival CEO Arnold Donald: China Will Become the Largest Cruise Market

Carnival CEO Arnold Donald: China Will Become the Largest Cruise Market

Stocks Finish Higher After Release of Fed Minutes

Stocks Finish Higher After Release of Fed Minutes

Has Wall Street Completely Lost Its Mind on General Electric?

Has Wall Street Completely Lost Its Mind on General Electric?