DEVELOPING THE MARKET FOR RETIREMENT PRODUCTS:THE CASE OF CHILE

Washington DCApril, 2005

INTRODUCTION

The need to understand better annuities markets and the roadmap for development Pension reforms involving greater reliance on private sector

and defined contribution (DC) schemes Payout phase emerging

Some research on annuities, but excessively focused on specific topics and countriesBasic questions not yet addressed The World Bank annuities projectThe first case study: Chile

Basic Questions Being Addressed by ProjectCan a market for retirement products be created from a low initial base? Can the insurance sector in emerging countries deliver

retirement products, especially annuities? Do companies have internal capacity to manage risk? Do companies have access to financial instruments to manage risk?

What are the weak/strong aspects of different institutional/regulatory arrangements? Arrangements: competitive, risk-sharing, monopoly Product regulation: product menu, design, marketing rules Provider regulation: entry, investment, capital, exit rules

VARIETY OF COUNTRY EXPERIENCES EXAMINED TO ADDRESS THESE QUESTIONS:

Competitive model, many private providers Chile, Switzerland, Australia, UK, Selected Emerging Countries

Risk-sharing arrangements Denmark, TIAA-CREF

Single Provider Sweden

THE CHILEAN CASE

Importance of the Chilean CaseOverview of the Chilean Annuities Market Growth Structure Performance

Identifying the RisksInternal Risk Management by ProvidersProduct RegulationProvider RegulationConclusions and Lessons for Other Countries

AN OVERVIEW OF THE CHILEAN MARKET: Growth

Insurance Premia: Total, Life, Non-Life, and Annuities(in % of GDP), 1990-2003

0.0%0.5%1.0%1.5%2.0%2.5%3.0%3.5%4.0%4.5%

1990 1992 1994 1996 1998 2000 2002

Total Premia Life Premia Annuities Premia

AN OVERVIEW OF THE CHILEAN MARKET: Growth

Pension and Insurance Assets (% of GDP), 1990-2003

0

10

20

30

40

50

60

70

1990 1993 1996 1999 2002

Pens

ion

and

Insu

ranc

e Ass

ets

0

5

10

15

20

25

30

35

40

Rat

io In

sura

nce/

Pens

ions

Pension Funds Insurance Companies Insurance/Pension Assets

  Chile Latin America

High Income OECD

Insurance Premium

4.6 2.2 7.9

Life 3.5 0.7 4.6

Annuities

1.9 - -

PWs 0.5 - -

Other 1.1 - -

Non-Life 1.1 1.5 3.3

Insurance Premiums in Chile and Other Regions

AN OVERVIEW OF THE CHILEAN MARKET: Retirement Conditions

Normal Age Retirement65 for men, 60 for women

Early RetirementBalance has to be at least equal to: 70% of average

real wage and 150% of MPG

DisabilityCertification by medical committee

SurvivorshipDeath of main beneficiary

AN OVERVIEW OF THE CHILEAN MARKET: Types of Pensioners

Year Total Normal Old Age Early RetirementDisability + Survivors

   Number

% of Total Number

% of Total Number

% of Total

1985 7,609 2,647 34.8% - 0.0% 4,962 65.2%

1995 190,400 55,591 29.2% 69,537 36.5% 65,272 34.3%

2004 520,793 133,343 25.6% 220,929 42.4% 166,521 32.0%

AN OVERVIEW OF THE CHILEAN MARKET: Menu of Products

Lump-sumsAccess conditions restrictive

Phased Withdrawals (PWs)Regulated formula based on life expectancyProvided by AFPs

AnnuitiesFreely priced, but fixed, indexed, joint for marriedProvided by LICOs

Temporary WithdrawalsWithdrawal with deferred annuityProvided by AFPs and LICOs

AN OVERVIEW OF THE CHILEAN MARKET: Demand for Retirement Products

Year Total PWs TWs Annuities

   Number

% of Total Number

% of Total Number

% of Total

1985 7,609 7,373 96.8% - 0.0% 236 3.2%

1995190,40

0 98,699 51.8% 6,803 3.6% 84,898 44.6%

2004520,79

3 196,242 37.7% 6,193 1.2% 318,358 61.1%

AN OVERVIEW OF THE CHILEAN MARKET: Demand for Retirement Products

High degree of annuitization: More than 60% of all retirees annuitizeHigher percentage excluding disability and survivorship pensionsEarly stages—disabled and survivors “jumpstarted” the annuities market1990s and 2000s: close connection between early retirement and annuitization

AN OVERVIEW OF THE CHILEAN MARKET: Pattern of Annuitization

Shares of Old Age and Early Retirees in the Total Stock of Annuities, 1990-2003

0%

20%

40%

60%

80%

1990 1992 1994 1996 1998 2000 2002

Share of Early Retirement in Annuities Share of Old Age in Annuities

AN OVERVIEW OF THE CHILEAN MARKET: Market Structure

Very concentrated pension fund sector

Very competitive insurance sector

Differences in market structure reflected in measures of market performance

AN OVERVIEW OF THE CHILEAN ANNUITIES MARKET: MARKET STRUCTURE

Number of Life Insurance Companies,Annuity Providers, and AFPs, 1988-2003

05

10152025303540

1988 1991 1994 1997 2000 2003Life Insurance Companies Annuity Providers AFPs

AN OVERVIEW OF THE CHILEAN ANNUITIES MARKET: MARKET STRUCTURE

Market Concentration Ratios in Pensions and Annuities Herfindahl and Share of Three Largest Firms, 1988-03

0

500

1000

1500

2000

2500

1988 1990 1992 1994 1996 1998 2000 2002

Her

finda

hl R

atio

0%10%20%30%40%50%60%70%80%90%100%

Shar

e of

3 L

arge

st

AFP Herfindahl Annuity HerfindahlAFP 3 Largest Annuity 3 Largest

AN OVERVIEW OF THE CHILEAN MARKET: Market Performance

Performance of the AFP SectorHigh average returnsCosts and fees have declined but are still too highPerformance has been better for PW holders

Performance of the LICO/Annuities SectorHigh MWRs in recent yearsQuestions about sustainability: very thin spreadsStrong capital buffer from initial years partially eroded,

some decline in MWRs expected MWRs will probably remain comparatively attractive if

industry does not become very concentrated

Market Performance: MWRs

All cases 1.080 1.036 1.064

Male, Age 55 1.081 1.056 1.036

Male, Age 65 1.098 1.066 1.042

Female, Age 55 1.105 1.056 1.060

Female, Age 60 1.120 1.066 1.074

Joint Life (Male 65, Female 60)

1.089 1.058 1.062

  March 2002

March 2003

March 2004

Market Performance: MWRs

All cases 1.080 1.036 1.064Premium UF1,000 1.078 1.045 1.068

Premium UF3,000 1.099 1.047 1.075

Non-Guaranteed 1.092 1.045 1.071

Guaranteed 1.076 1.033 1.062No deferment 1.079 1.035 1.063

  March 2002

March 2003

March 2004

With deferment 1.080 1.036 1.067

Variable Coefficient t-statistic Other Statistics

Constant 72.42 88.48 Dep. Variable: MWR*100

Age 0.431 41.76 No. Observations = 4,198

Log (premium)

1.535 18.08  

Guarantee -0.132 -13.51 R2 = 0.558

Deferment 0.021 2.42 Adj. R2 = 0.557

Male Dummy 1.415 5.86 Prob. > F = 0.000

Female Dummy

4.182 38.56 Mean Dep. Variable: 106.1

2003 Dummy -4.976 -39.89 S.D. Dep. Variable: 4.83

2004 Dummy -2.433 -20.07  

Main Determinants of Individual MWRs

0.80

0.85

0.90

0.95

1.00

1.05

1.10

1.15

1.20

1.25

1.30

0 2000 4000 6000 8000 10000 12000 14000

Premium (UF)

MW

RDispersion of MWRs for Different Premiums

  Austral. Canada Switz. UK 1 UK UK US 2

  (James) (James) (James) (Can) (James) (Brown) (Brown)

Male, Age 55 - - -   - 0.921 0.934

Male, Age 65 1.013 0.981 1.046   0.977 0.908 0.927

Female, Age 55 - - -   - 0.928 0.937

Female, Age 65 1.002 0.976 1.037   0.979 0.907 0.927

Joint 0.988 0.980 0.985 0.981 0.987 - 0.929

MWRs of Nominal Annuities in Other Countries

MWRs of Indexed Annuities in Other Countries  Austral. Canada Switz. UK 1 UK UK US 2

  (James) (James) (James) (Can) (James) (Brown) (Brown)

Male, Age 55 - - -   - 0.867 -

Male, Age 65 - - -   0.887 0.854 0.822

Female, Age 55 - - -   - 0.876 -

Female, Age 65 - - -   0.877 0.857 0.782

Joint - - -   0.880 - -

MWR ConclusionsHigh by international comparison Wider supply of indexed instruments, other factors

Lower for shorter durations (young ages, joint) Higher longevity and market/investment risks for provider

Higher for larger premiums, suggesting: Lower unit costs dominate over mortality differentials More competitive market at higher premiums (reflecting

higher income and education levels)

Wide dispersion for smaller premium levels Poor market search by prospective annuitants with lower

income and education levels

Market Performance: Spreads (1)

Average Annuity Rate and Risk-Free Rate (% p.a.)1993-2004

2%

3%

4%

5%

6%

7%

8%

1993 1995 1997 1999 2001 2003

Annuity Rate Risk-Free Rate (PRC20)

Market Performance: Portfolio Composition

1991 1995 2000 2004

Government Sector 38.3 40.3 28.7 17.3

Financial Sector 23.0 28.4 45.1 34.6

Mortgage Bonds 13.9 18.6 24.2 16.7

Other Mortgage-Backed 3.0 6.0 10.1 17.9

Company Sector 29.0 22.1 15.3 35.5

Shares 8.9 10.2 3.4 3.2

Bonds 20.1 10.7 10.7 31.2

Real Estate 7.8 7.7 7.4 7.3

Other Assets 2.0 1.5 3.6 5.5

Total 100.0 100.0 100.0 100.0

Market Performance: CommissionsCommission Rates (% of Premium), 1990-2003

0%

1%

2%

3%

4%

5%

6%

7%

1990 1992 1994 1996 1998 2000 2002

Market Performance: Spreads (2)Adjusted Annuity Rate and Marginal Return

on Fixed Income Portfolio (% p.a.), 1993-2003

2%

3%

4%

5%

6%

7%

8%

9%

1993 1995 1997 1999 2001 2003

Annuity Rate PRC20 Adj. Annuity Rate Marginal Return on FI

Market Performance: ROEsReturns on Equity (ROE) of AFPs and Life

Insurance Companies (%), 1992-2004

-20%-10%

0%10%20%30%40%50%60%

1992 1994 1996 1998 2000 2002 2004

ROE of AFPs ROE of Life Insurance Companies

5eMarket Performance: Estimation of the Average Annuity Rate

Fixed Effects with Robust Standard Errors; Total Panel Observations: 693R2 = 0.7995; Adj. R2 = 0.7890; F-Statistic = 76.2162 ; P-Value(F-Statistic) = 0.0000

5e

5e

Variable Coefficient Std. Error t-Statistic

C 3.0760 0.2187 14.0668

RISK-FREE RATE 0.3639 0.0209 17.4077

SOFI 0.0029 0.0009 3.1772

SOA 0.0086 0.0038 2.2509

LEVERAGE 0.0110 0.0039 2.7967

MKT SHARE -3.4900 0.5727 -6.0937

AVER. PREMIUM 0.0002 2.57 * 6.8931

COMM. RATE -0.0441 0.0180 -2.4431

HERFINDAHL -5.1390 0.7219 -7.1191

Market Performance: Main Conclusions

Chilean annuitants getting today better deal for their premiums than annuitants in most countries Performance was probably worse in the 1990s

High MWRs of indexed annuities can be partly explained by wider supply of indexed instruments Inflation hedge with higher yield instruments

Question is whether these high MWRs can be sustained. Probably not. Some decline of MWRs likely.

Market Performance: Can the behavior of annuity providers be explained?

Both measures of performance reveal aggressive pricing by providers Use of outdated tables by providers unlikely Serious governance problems unlikely Maybe providers counting on future interest rate increases Maybe providers are adopting deliberately aggressive

pricing policies to gain market share

Industry solvent, due to strong capital build-up in the first 15 years, but some market adjustments, lower MWRs likely

Internal Risk Management

Mixed success in coping with underwriting risks Structure of annuity prices seems reasonable, overall levels seem

excessively high

Reasonable strategies to address market risks Matching fixed indexed liabilities with portfolio of fixed income indexed

assets Efforts to reduce duration gap, although constrained by limitations in the

supply of instruments

Reasonable strategies to address credit, pre-paymt risks Investment in high grade corporate bonds; switch from mortgages

Strategies to address operational risks not assessed; Liquidity risks not important,

Product Regulation: The Menu of ProductsConservative menu, designed to avoid inadequate retirement incomes, excessive recourse to MPG Lump-sums restricted Annuities have been fixed, indexed, joint for married males PW formula rules out total exhaustion of funds

Although menu is relatively restricted, it is consistent with the central role played by the Chilean second pillar, provides reasonable range of choices

Product Regulation: Marketing Rules

Some rules in the 1990s designed to ensure transparency and minimum market search (minimum # of quotes) did not work very well Excessive dispersion of annuities Excessive abuse with cash rebates

New Pensions Law passed in 2004 Introduces caps on commissions Introduces innovative quotation system Should lead to more transparency, less dispersion Some problems still remain

Provider Regulation: Capital Rules

Minimum capital and maximum leverage

Regulated valuation of technical provisions

Additional CALCE provision penalizing mismatching due to duration gap, currency, indexation, fixed/variable

Assessment of Capital Rules

Rules have served well, were innovative when introducedProvisions based on outdated table but with conservative interest rate, but are now low when considered in isolation.Increasing provisions to an economic valuation would reduce equity levels and increase reported leverage Refinement to regulation should be pursued to better reflect the current realities

Capacity to absorb provisioning increases

CONCLUSIONS

The growth of the market for retirement products, especially annuities, has been impressiveThe high degree of annuitization is explained by institutional/regulatory arramgements: pension reform, restrictions on lump-sums, absence of a

front-ended DB scheme, level of the MPG, influence of brokers

Adverse selection cannot be tested, but it does not seem to have been strong enough to disrupt market development

CONCLUSIONS

Market has performed well for consumers, as indicated by the high MWRs, higher than ratios in other countries, especially indexed annuitiesHigh MWRs can be partly explained by access to a diversified supply of indexed instruments, and very competitive environmentHowever, it is questionable that MWRs can be sustained at current levels for a long period. Some decline to be expectedExcessive dispersion for smaller premiums

CONCLUSIONS

Regulatory framework has been generally reasonable, and has evolved positively: Product regulation restrictive but adequate for Chile. Marketing regulation has evolved in response to

questionable practices: New quotation system. Intermediary regulation reasonable. Capital rules

penalizing mismatching were innovative, provided initial strong buffer, although were weakened over time by the use of an outdated mortality table.

Longevity and investment risks remain challenging for participants and regulators.

LESSONS FOR OTHER COUNTRIES

Feasibility of building the market for retirement products from a low initial baseHigh MWRs to a good extent due to diversified supply of indexed annuities, with reasonable durationsNeed to develop capital market Need for fiscal discipline, to open room for private

instruments Need for pro-active regulatory approach to develop

securities markets

LESSONS FOR OTHER COUNTRIES

Chilean approach to product regulation is appropriate for countries that assign a central role for second pillar; may be relaxed in other casesChilean experience with marketing regulation provides valuable lessons. Outcomes of the new quotation system should be monitoredStrict capital rules that penalize mismatching are a valuable tool to build a strong capital buffer in the early stages of market development

LESSONS FOR OTHER COUNTRIES

Even good product and intermediary rules can weakened by failure to update key parameters, especially mortality tablesGuarantees are maybe inevitable in a system like the Chilean. Offsetting the possible moral hazard requires a minimum of co-insurance, strong capital, intervention, and resolution rules, strict enforcementNeed to evolve to a risk-based supervision system over time, as market develops