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Tomas J. Philipson
Senior Fellow; Daniel Levin Professor of Public Policy Studies, Irving B. Harris Graduate School of Public Policy Studies, University of Chicago
Health and Medical Research and Public Policy
Dr. Tomas J. Philipson is the Daniel Levin Professor of Public Policy Studies in the Irving B. Harris Graduate School of Public Policy Studies at the University of Chicago and an associate member of the Department of Economics. His research focus is health economics.
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Saving lives through financial innovation: FDA swaps and annuities

By: Tomas J. Philipson
March 02, 2015
   
   

The cost of capital to conduct medical R&D is high because investors must be compensated with high returns to offset the risky and long drug development process. This cost of capital could be reduced, and thus medical innovation spurred, by better financial mechanisms for sharing risks between medical R&D investors and outside capital markets. FDA Swaps and Annuities is a step in the right direction.

Profit in the global health-care industry is highly concentrated in the United States, the largest market for biopharmaceuticals and medical devices in the world. As a result, most health innovators around the globe seek approval from the Food and Drug Administration (FDA) to sell their products in the US. However, the costs and risks inherent in the FDA’s approval process are substantial. The average development cost for drugs and biologics (medicines derived from living organisms) is $1.2 billion, spread over about 10 years of development, testing, and review. The odds of success are slim. Only about 13 percent of products starting the process are approved for sale in the US. Thus, medical innovators often have a hard time competing for the attention of investors with, say, innovators in tele-communications, a field where billion dollar companies can be created within a year or two.

The FDA’s rigorous testing of medical products is essential to ensure the safety of medicines and devices offered to the public. Indeed, until clinical trials are completed, it is uncertain whether a drug or device will work in humans. However, the process also creates substantial uncertainty for investors. Hedging tools similar to those used in other financial sectors offer a possible solution and may attract a larger number of investors to a sector that would benefit from an infusion of more private capital. When attempting to win FDA approval, investors face two risks that are outside their control. First, they may earn nothing if the products fail any of the hurdles of the FDA process. In terms of the capital invested, this zero-return failure is analogous to a default on a bond or loan. Second, the time-consuming process reduces investors’ return because it shortens the length of time a patented product has market exclusivity. This discounts the returns heavily, since potential early and non-discounted profits lost cannot be recaptured. These financial risks are outside the control of investors who fund the trials because, until trials are performed, a product’s efficacy or quality remains unknown.

At present, there are no markets that enable investors to share, or hedge against, these exogenous risks. This problem is comparable to the inability of corporate bondholders to hedge default risks before the introduction of the credit default swap (CDS). CDSs were originally developed by lenders to insure their loans against defaults. They were developed to lower overall interest rates and did so greatly. A similar type of insurance could be designed for medical R&D investors to protect them from non-approval, a result that, in principle, mimics a default.

To lower the risks of product development and increase the amount of capital flowing into medical innovation, Joel Kurtzman and I headed a year-long effort at the Milken Institute to define, develop, and conceptualize new financial instruments that allow investors in medical products to share development risks with outside investors. The resulting Milken Institute report, Hedging pipeline Risk in Pharma: FDA Swaps and Annuities, lays out the general rationale for better risk-sharing in medical R&D and discusses two particular mechanisms through which this can be done.

The first mechanism, which we labeled “FDA Swaps,” would work as insurance against non-approval throughout the multi-phase FDA process. The basic idea, much as for credit default swaps that insure investors against non-payment of a loan, is that the buyer of the swap pays a monthly premium to the seller in exchange for insurance against non-approval of an R&D investment. If the drug is not approved, the buyer is paid an amount specified by contract, similar to when a loan defaults under a CDS.

FDA swaps would insure investors against the risk of non-approval, while “FDA Annuities” would operate as insurance against a lengthy approval process. For small-molecule drugs, the first three FDA phases of clinical development are estimated to take on average about 24 months, 30 months, and 42 months, respectively, with the final NDA approval taking around one additional year. However, there is a large and non-predictable variance among these average approval times, and delays at FDA mean foregone earnings to investors. Extremely long delays (the right tail of the distribution) can be a devastating blow to the overall profitability of a product. Just as a regular annuity insures an old person against a long lifetime, so could FDA annuities against long regulatory lifetimes.

The question arises of who would take the other side of these hedges. Generally, participants in derivative financial markets are often divided into two categories. The first is hedgers who participate on the supply- or demand-side of the real market on which the instrument is contingent on – for example, farmers and food manufactures for corn futures. The second is speculators who do not have a stake in the underlying market. Speculators often serve a very useful role of providing liquidity for hedgers, and this may well be the case if medical R&D contracts were to be developed. This is because it is unlikely that aggregate approval behavior of the FDA, driven largely by the behavior of molecules in humans, varies with aggregate economic behavior, such as the business cycle or aggregate market risks driving risks in other asset classes. Because of the potential lack of correlation of FDA risk with other asset classes, this “zero-beta” risk may be attractive to add to portfolios for diversification purposes.

More importantly, recent acquisitions provide some insight into the potential value and market liquidity of these types of contracts. In deal structures involving so-called contingent value rights (CVRs), buyers make additional payments once an acquired company hits a future regulatory benchmark. For example, Celgene’s $3 billion acquisition of Abraxis BioScience in 2010 included a CVR provision, conditioned upon regulatory approval of the cancer drug Abraxane for various indications. In addition, in the 2011 sale of Genzyme Corp. to Sanofi-Aventis SA for $20.1 billion, the CVR provision was largely tied to the regulatory performance of Campath, another cancer medication. These types of CVRs were essentially an “earn-out” structure of a sale, but specific to the development risk of a product rather than overall company performance risk. The interesting aspect of these CVRs was that they were listed separately on exchanges and traded upon with great liquidity. This suggests that FDA swaps and annuities could be as well.

In the world of medical innovation, the ultimate goal of using new hedging mechanisms would not be to offer protection for investors. Rather, by lowering the cost of capital to the innovators seeking funds from investors, they would help accelerate the development of new medicines and devices that improve individual lives and ease the broader burdens of disease. The real beneficiaries of financial innovation in medical innovation are thus patients.

This article first appeared on Forbes.com.