risk management and regulation of defined contribution schemes

Risk management and regulationof defined contribution schemes

Mexican pension reform

and risk management framework

Background

Pension system in Mexico

Background

The Mexican Social Security Institute (IMSS)

was created in 1943 to administer 4 social

security programs: work injuries old age, disability, survivorship, and

unemployment in old age sickness and maternity nurseries and social benefits

IMSS

14 million affiliated workers

50+ million beneficiaries

2 million pensioners

IMSS is the second fiscal authority in the country, collecting more than 9 bn. USD of contributions from workers and employers

IMSS annual budget is over 17 bn. USD

child care to 115 thousand children

33 % of population born in IMSS hospitals

Diagnosis

In 1995, a review was conducted to assess,

among other issues, the financial viability of the

pension system It was estimated that, in order to sustain the PAYG

system, contributions would have to be increased

from 7.0* % to: 10% for the period 2000-2009 15% for the period 2010-2019 25% for the period 2020-2030

* Including 2.5 of disability and

survivorship

New law

As a result from the diagnosis and after intensive

public consultation and debate, Congress repealed

the existing Social Security Law (last amended in

1973) and introduced an important pension reform

New law

The new Law replaced the defined benefits PAYG

publicly managed pension system with a defined

contribution, individual accounts, privately managed

system The new Law introduced a minimum pension

guarantee (equivalent to one minimum salary) and a

“grandfathered” previously affiliated workers

Insurance coverage

Pension Scheme

Financing & Funds Management

Insurance coverage

Pension Scheme

Financing & Funds Management

Disability, Old Age, Unemployment in Old Age and Survivorship

Defined

benefits

PAYG publicly managed by IMSS

Old Age, Retirement,

Unemployment at Old Age

Defined contribution

Fully funded, individual accountsFunds managed by private fund managersAnnuities are purchased with available funds at retirement

Disability and Survivorship

Defined

benefit

Collective funds to purchase annuity from private insurance company

Old pension system New pension system

Old vs. new pension systems

Transition

Transition costs absorbed via general taxation and payroll taxes

Federal Government absorbed pension liabilities generated as of June 30,1997 Individual accounts funded through tripartite payroll taxes

Generation in transition incorporated immediately to the new pension scheme

IMSS continues as pension payment agent

Fund managers

Specialized companies were created to manage pension funds (AFORES)

Investment vehicles (SIEFORES) were also created to isolate funds from AFORES and prevent bankruptcy risks

The housing agency (INFONAVIT) also acts as fund manager and funds saved in the “housing sub-account” are also used to purchase the annuity, at the time of retirement, if housing benefit was not used during the worker’s active life

Players

The pension system also involved a new improved fiscal and data collection process (based on a central processing agency, PROCESAR) 17 AFORES were originally set up, 12 remain after initial consolidation, all AFORES reported a net profit in 2001

Assets have grown to $27 bn. USD, equivalent to 4% of the 2001 GDP equivalent to 60% of international reserves Annuity insurance companies were also created and now manage $6 bn. USD in assets

AFORES are regulated by an independent supervisory body (CONSAR)

ResultsResults

New pension system

Historical investment results(in real terms, as of March 2002,

not considering commissions)

ALLIANZ DRESDNER 7.89 %

BANAMEX 9.10 %

BANCOMER REAL 8.97 %

BANORTE GENERALI 8.35 %

INBURSA 6.11 %

ING 9.14 %

PRINCIPAL 8.78 %

PROFUTURO GNP 8.71 %

SANTANDER MEXICANO 7.53 %

TEPEYAC 7.96 %

XXI 8.66 %

ZURICH 8.47 %

SYSTEM AVERAGE 8.54 %

Assets under management(as of March 2002,in millions of pesos)

ALLIANZ DRESDNER 9,453 16 5,459 14,928

BANAMEX 62,059 482 37,177 99,718

BANCOMER 57,113 485 34,658 92,256

BANORTE GENERALI 14,943 94 8,317 23,354

INBURSA 18,961 192 11,676 30,829

ING 22,516 57 13,239 35,811

PRINCIPAL 6,302 9 3,758 10,068

PROFUTURO GNP 25,254 151 15,387 40,792

SANTANDER MEXICANO 23,628 134 14,475 38,238

TEPEYAC 2,964 8 1,642 4,613

XXI 16,264 200 9,899 26,363

ZURICH 2,392 6 1,318 3,715

TOTAL 261,849 1,834 157,005 420,685

Old ageVoluntary

contributions Housing Total

- As of December 2000 -

Country/InstrumentArgentina Chile Mexico Peru

Government bonds 56.0% 35.7% 92.6% 9.0%

Financial institutions’ instruments

15.6% 35.1% 2.0% 34.0%

Commercial paper 2.8% 4.0% 5.4% 18.6%

Equity 12.3% 11.6% 0.0% 29.0%

Funds 8.2% 2.4% 0.0% 0.7%

Foreign bonds & equity 4.5% 10.9% 0.0% 6.7%

Total (millions USD)Source: Andersen survey

20.381 35.886 17.385 2.978

Portfolio compositionInternational comparison

In Mexico, the portfolio composition has changed in the last two years, investments in Government instruments are now down to 85.8% (as of March 2002)

OpportunitiesOpportunities

New pension system

Mobility & competition(transfered accounts between AFORES, as of March 2002)

% of salary % of balance% of real returns

ALLIANZ DRESDNER 7,952 -11,542

BANAMEX 67,985 -55,981

BANCOMER REAL 49,690 -44,726

BANORTE GENERALI 18,452 -21,957

INBURSA 5,753 -5,520

ING 23,721 -28,163

PRINCIPAL 2,476 -5,654

PROFUTURO GNP 25,712 -48,242

SANTANDER MEXICANO 39,932 -39,553

TEPEYAC 3,879 -4,009

XXI 20,498 -3,080

ZURICH 4,102 -1,725

TOTALAs a % of affiliates

270,1521.1%

-270,152

Commission structure

ALLIANZ DRESDNER 1.60 0.50

BANAMEX 1.70

BANCOMER 1.69

BANORTE GENERALI 1.45 1.00

INBURSA 33.00

ING 1.68

PRINCIPAL 1.60 0.45

SANTANDER MEXICANO 1.60 1.00

TEPEYAC 1.60 0.15

XXI 1.45 0.20

ZURICH 1.65 0.50


Assets under management(as of March 2002,in millions of pesos)

ALLIANZ DRESDNER 9,453 16 5,459 14,928

BANAMEX 62,059 482 37,177 99,718

BANCOMER 57,113 485 34,658 92,256

BANORTE GENERALI 14,943 94 8,317 23,354

INBURSA 18,961 192 11,676 30,829

ING 22,516 57 13,239 35,811

PRINCIPAL 6,302 9 3,758 10,068

PROFUTURO GNP 25,254 151 15,387 40,792

SANTANDER MEXICANO 23,628 134 14,475 38,238

TEPEYAC 2,964 8 1,642 4,613

XXI 16,264 200 9,899 26,363

ZURICH 2,392 6 1,318 3,715

TOTAL 261,849 1,834 157,005 420,685

Old ageVoluntary

contributions Housing Total

Risk ManagementRisk Management

Particular definition of risk

The likelihood that a particular threat

using a specific attack, will exploit a

particular vulnerability of a system that

results in an undesirable consequence( Definition from National Information Systems Security INFOSEC) Glossary, NSTISSI No. 4009, Aug. 1997)

The definition of risk depends on the field of study, the particularcircumstances and it is “subjective”

However, it is necessary to adapt the general definition to the particular circumstance

Definition of risk management

The process concerned with identification,

measurement, control and minimization of

risks in particular field (i.e. information

systems) to a level commensurate with the

risk “appetite”

Risk Management Process

Identify the

Risk Areas

Assess theRisks

Develop RiskManagement

Plan

Develop RiskManagement

PlanImplement Risk

MitigationActions

Implement RiskMitigationActions

Re-evaluateRisks and

Control actions

Re-evaluateRisks and

Control actionsRisk

ManagementCycle

Risk Assessment

Risk Mitigation

Risk tolerance or “appetite”

Control

Ignore

Risk management depends on subjective values

The Four T´sTransfer: A risk control technique that involves the contractual shifting of a pure risk from one party to another. Contractual agreement and payment for insurance.

Transform: modification of the risk “nature” to make it safer, through coverage products, like FRA´s, future contracts, swaps, hedge positions, etc.

Terminate: through control actions eliminate risk (sometimes it is very expensive or due to the nature of the risk, impossible to eliminate)

Tolerate : risk has been detected, can be monitored, cost-benefit analysis shows no actions required (but have contingency plans)

• Deals with market risk ( i.e. changes in interest rates)

• VaR is a method to quantify the risk using standard

statistical techniques.

• VaR measures the worse loss in a certain period under

normal market conditions given a certain confidence level.

• Structured approach (methodology) to think critically about

risk. • Common methods Markowitz and Montecarlo

Value at Risk (VaR)

Summarized measurement of market risk

• Credit : Occurs when counterpart is unable to fulfill its contractual obligations due to financial problems.

• Liquidity : When a transaction cannot be fulfilled at prevailing market prices due to low “bursatility” or market “volume”

• Operational: Refers to the resulting losses of inadequate systems, administrative faults, defective controls, fraud, or human error.

• Legal : When one counterpart does not have the legal or regulatory authority to “adequately” complete the

transaction.

Other common risk types

Stress Testing• This method, denominated some times like scenario analysis, examines the simulated effect on the portfolio of significant movements in key financial variables.

• All the assets of portfolio are evaluated using the new assumptions, and the yield of portfolio is re-calculated.

• Naturally, different scenarios generate different returns. When specifying the probability for each scenario, a distribution of yields of the portfolio is created, which the VAR can be obtained.

• The advantage of this method is that it can review situations completely different to the historical data.

• Problem defined as “ability of assets to match or pay liabilities”, not just investment of assets

• Ultimate surplus = assets remaining once liabilities paid

• 3 dimensions, market value, surplus, variance of surplus

• ensure positive mean of surplus and a “reasonable” probability that it will be positive

• computer simulation (many scenarios)

• limit number of asset classes -> optimize strategic allocation (individual asset through traditional techniques)

Asset – liability management

Issue date

IMSS Financial Investment UnitDecember 1999

Banking systemDecember 2001

AFORES(Circular 15-5)

December 2001

Regulations (based in Basel Committee resolutions)

Board participation Risk Committee Risk Management Unit (RMU) Risk manual (with limits) Procedures for measurement, monitoring and control Models, methodology and measurement systems Sensitivity analysis Stress testing Contingency plans Independence of RMU VaR RMU responsible for compliance Risk audit

Ed Tamagno’s 6 Principles

1. Clarity of objectives

2. Independence from political interference

3. Accountability to insured persons

4. Professional Management

5. Low operating costs

6. Prudence in investments

12 Principles

• Clarity of objectives

• Independence from political interference

• Transparence & accountability to insured persons

• Professional Management

• Low operating costs

• Prudence in investments

Edward Tamagno’s México’s recommended

• Program Efficacy (yield goals)

• Systemic efficiency (market competitiveness)

• Alignment of interests and incentives

• Integral process (“big picture” & assets and liabilities management)

• Supervision and regulation competence

• Solid corporate governance

• Problem defined as “ability of assets to match or pay liabilities”, not just investment of assets

how much asset needs to grow• Ultimate surplus = assets remaining once liabilities paid

• 3 dimensions, market value, surplus, variance of surplus

• ensure positive mean of surplus and a “reasonable” probability that it will be positive

• computer simulation (many scenarios)

• limit number of asset classes -> optimize strategic allocation (individual asset through traditional techniques)

Asset – liability management

12 Principles














Mobility & competition(transfered accounts between AFORES, as of March 2002)


ALLIANZ DRESDNER 7,952 -11,542

BANAMEX 67,985 -55,981

BANCOMER REAL 49,690 -44,726

BANORTE GENERALI 18,452 -21,957

INBURSA 5,753 -5,520

ING 23,721 -28,163

PRINCIPAL 2,476 -5,654

PROFUTURO GNP 25,712 -48,242

SANTANDER MEXICANO 39,932 -39,553

TEPEYAC 3,879 -4,009

XXI 20,498 -3,080

ZURICH 4,102 -1,725

TOTALAs a % of affiliates

270,1521.1%

-270,152

Flexibility to compete

12 Principles














Commission structure

ALLIANZ DRESDNER 1.60 0.50

BANAMEX 1.70

BANCOMER 1.69

BANORTE GENERALI 1.45 1.00

INBURSA 33.00

ING 1.68

PRINCIPAL 1.60 0.45

SANTANDER MEXICANO 1.60 1.00

TEPEYAC 1.60 0.15

XXI 1.45 0.20

ZURICH 1.65 0.50


12 Principles













• Solid corporate governance (Enron, Worldcom, Capital Hedge Fund)

Players

The pension system also involved a new improved fiscal and data collection

process (based on a central processing agency, PROCESAR) 17 AFORES were originally set up, 12 remain after initial consolidation, all AFORES reported a net profit in 2001

Assets have grown to $27 bn. USD, equivalent to 4% of the 2001 GDP equivalent to 60% of international reserves Annuity insurance companies were also created and now manage $6 bn. USD in assets

AFORES are regulated by an independent supervisory body (CONSAR)

12 Principles













• Solid corporate governance (Enron, Worldcom, Capital Hedge Fund)

ConclusionsConclusions

In risk management and regulationof defined contribution schemes

There are many approaches, diverse techniques

and management frameworks

However ….

GovernanceGovernance

RegulationRegulation

Organizational structureOrganizational structure

MethodologyMethodology

ModelsModels

AuditAudit

ReportingReporting

ControlControl

MonitoringMonitoring

IdentificationIdentification

AppetiteAppetite

Risk types, i.e. legal, credit, operational, market, etc.

Risk matrixp

roce

sses

Priority approach

organization threateninghigh probability high severity

high probability medium severity

medium probability medium severity

low probability medium severity

low probability low severityYes, understand

severity andprobability but consider first risk appetite

III. Risk management infrastructure

Procedures People Models IT Data

Risk Identification Measuring Monitoring Control Reporting

II. Initiate risk management process

I. Strategic objectives (derived from business plan)

Determine risk apetite

Step approach

Big, Big PictureBig, Big Picture

“Big, big picture” or risk management cartography

Ris

k C

om

mit

tee

Co

nti

ng

ency

pla

nn

ing

Sen

siti

vity

An

alys

is

Seg

reg

ati

on

of

Du

ties

Risk Management UnitModels and Measuring Systems

Str

ess

Test

ing

Ris

k M

anu

al

BASEL COMMITTEE (CONSAR regulations 15-5 and CNBV 1423)

liquidity

legal

operational

market

credit

Ed Tamagno’s 6 Principles

Cla

rity

of

ob

ject

ives

Ind

epen

den

ce f

rom

po

liti

cal i

nte

rfer

ence

Transparence & accountability to insured persons

Professional Management

Lo

w o

per

atin

g c

ost

s

Pru

den

ce i

n i

nve

stm

ents

12 Principles (Tamagno’s 6 + Mexico’s 6)

Eff

icac

y

Sys

tem

ic e

ffic

ien

cy

(co

mp

etit

iven

ess

)

Alignment of interest and incentivesComplete view (asset-liability)

Co

mp

eten

ce i

n s

up

ervi

sio

n a

nd

reg

ula

tio

n

So

un

d c

orp

ora

te g

ove

rnan

ce

systemicregulatoryRisk types

Models

Basic Risk Management Process

risk management and regulation of defined contribution schemes

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