A financial instrument that gets patients and health insurers on the same side
A new financial instrument has the potential to speed the development of new drugs for seriously ill patients while strengthening the claims-paying capacity of health insurance companies required to cover innovative, expensive treatments.
CAMBRIDGE, Mass., May 6, 2016 –Accelerating innovation in drugs that extend the lives of patients with cancer or rare genetic diseases creates intense demand for these therapies, and with this demand comes a unique challenge for health insurers.
Insurance companies must set their premium charges based on the likelihood of their customers suffering serious illness and on estimates of the cost of treating those illnesses. What happens when breakthroughs in drug development create many new treatments, extending lives and increasing treatment costs? How can insurers meet their obligations to policyholders when medical breakthroughs run ahead of anyone’s expectations?
Unlike some other forms of financial risk, there have historically been few tools that insurers can use to hedge this “reimbursement risk.” However, new research suggests that the same tool that can improve the financing of precisely these hard-to-predict, potentially life-saving therapies may also help health benefits providers hedge “reimbursement risk.”
Aligning the interests of patients and insurers
A new paper by MIT Sloan Senior Lecturer in Finance, Roger M. Stein, reports results that suggest that a new asset class, developed by Stein and his collaborators in the MIT Laboratory for Financial Engineering, may meet this need for investment vehicles whose performance is tied to breakthroughs in pharmaceutical research.
These “research backed obligations” (RBOs) have the potential to align the interests of patients and insurers, by tying expected returns on the instrument to progress in treating rare diseases and some forms of cancer.
RBOs allow investors to buy stakes in diversified pools of early-stage candidate therapies under development from multiple research teams. Health insurers could purchase research-backed obligations, which also have the potential to provide partial protection from increased costs that could result if the insurers had to cover a surge of new specialty drugs.
“This type of investment vehicle may serve as a form of hedge for health insurance companies,” Stein said. “If a lot of successful drugs are introduced from the portfolio, the security can be expected to gain in value. And if an insurer owns this security, these resulting gains could smooth out some of the unexpected shocks the companies would experience from unexpectedly large volumes of new drug innovation. This would imply that patients benefit, and insurers are protected, when successful new drugs are introduced.”
Stein demonstrated the effectiveness of research-backed obligations in hedging reimbursement risks by developing an analytical model and then extending this through computer simulations to reflect the situations insurers face.
In most instances, the financial instruments protected insurers, partially or in full, he found. The study is detailed in the MIT Sloan School of Management working paper, “A simple hedge for longevity risk and reimbursement risk using research-backed obligations.”
Financial enigineering
Dr. Stein is a research affiliate at the MIT Laboratory for Financial Engineering. He and a number of colleagues several years ago developed the concept of research-backed obligations as a way to use financial engineering as a tool to promote large-scale funding for breakthrough drug development. Stein described some of this early work in a 2013 TED Talk.
The process of bringing a drug to market today is a long and costly process in which many more projects fail than succeed. Although the payoffs for success are high, potential investors are often deterred by the high risk of failure.
The MIT team, working with doctors and other medical professionals, crafted the idea of research-backed obligations as a solution to this problem. The financial vehicles aggregate candidate experimental drugs with proposals for novel drug development in much the same way mortgage-backed securities brings together large pools of mortgages to reduce overall risk.
“Candidate therapies are individually very risky and unlikely to succeed, but when they do succeed, they can be very profitable,” Stein said. “If you group a sufficient number of them in a properly structured portfolio, it is possible to reduce the risk , while still realizing a reduced, but still attractive expected return”
Research-based obligations do not exist yet, although financial and medical specialists experts have been working privately and with policy-makers to make them a reality.
US Representatives Juan Vargas of California and Thomas J. Rooney of Florida have introduced legislation that would allow the National Institutes of Health to establish a privately owned and operated investment fund for rare disease therapeutics. The fund would function in a similar manner as the research-backed obligations proposed by the MIT Laboratory for Financial Engineering.
