A simple hedge for longevity risk and reimbursement risk using research-backed obligations
Longevity risk is the risk that the promised recipient of lifetime cashflows ends up living much longer than originally anticipated, thus causing a shortfall in funding. A related risk, reimbursement risk is the risk that providers of health insurance face when new and expensive drugs are introduced and the insurer must cover their costs. Longevity and reimbursement risks are particularly acute in domains in which scientific breakthroughs can increase the speed of new drug development. An emerging asset class, research-backed obligations or RBOs (cf., Fernandez et al., 2012), provides a natural mechanism for hedging these risks: RBO equity tranches gain value as new life- extending therapies are developed and do so in proportion to the number of successful therapies introduced. We use the stylized case of annuity underwriting to show how RBO equity could be used to hedge some forms longevity risk on a retirement portfolio. Using the same framework, we then show how RBO securities may be used to hedge a much broader class of reimbursement risks faced by health insurance firms. We demonstrate how to compute hedge ratios to neutralize specific exposures. Although our analytic results are stylized, our simulation results suggest substantial potential for this asset class to reduce financial uncertainty for those institutions exposed to either longevity or reimbursement risks. For example, our simulation results indicate that the correlation between the return on RBO equity and the reimbursement shortfall for a health insurer is about 0.66 under reasonable assumptions. Even under extremely conservative assumptions, this correlation is still 0.34, suggesting that RBO equity offers substantial hedging benefits, producing more favorable outcomes in about 87% of scenarios.