Using RBOs and Megafunds to Hedge Longevity Risk and Specialty Drug Costs

Abstract

Longevity risk, the risk that a member of a pension plan or an annuity holder lives much longer than anticipated, can cause shortfalls in funding for writers of insurance policies, annuities, and pension benefits. Reimbursement risk, the risk faced by health benefit providers in paying for expensive new drugs, can similarly cause shortfalls for health insurance firms and other benefit providers, particularly as the costs of specialty drugs increase. These risks can be acute when scientific breakthroughs increase new drug development rates. An emerging asset class, research-backed obligations (RBOs) (Fernandez et al. 2012; Hull et al. 2019), has the potential to provide a natural hedge for a broad class of such risks. This article demonstrates how to calculate simplified, first-order portfolio-specific hedge ratios. The author presents simulation results that demonstrate the benefits of such hedges for a hypothetical health insurance portfolio facing rapid increases in reimbursement risk due to the high cost of new specialty drugs.