1. Disability and Survival Insurance Diagnosis and Reform
Gonzalo Reyes
Research Division Lead
Superintendency of AFPs
FIAP Seminar
Lima, Peru, May 28, 2008

2. How does the Disability and Survival Insurance (DSI) Currently Work?
This insurance complements individual savings for financing a disability pension (in case of partial or total loss of the ability to work) or survival (in case of the member’s death)
Part of the commission paid by contributors to the AFP system (approximately 1% of the taxable income) finances the cost of the DSI of active members
Classification of invalidity is performed by a network of medical committees: doctors financed by SAFP and other expenses by the AFPs
DSI expenses arise from:
Contributions = Necessary capital – (balance+BR)
Transitory pensions
Costs of the classification process
Contributions

3. How does the Disability and Survival Insurance (DSI) Currently Work
How does the Disability and Survival Insurance (DSI) Currently Work?(II)
Each AFP must take out this insurance for itself since the AFPs are responsible for providing their members with the DSI benefits (additional contributions, transitory pensions and contributions).
Each AFP is free to choose the Insurance Company and the contract it prefers.
The AFPs charge their members a fixed price which includes the DSI cost; but the real cost paid to DSI can only be known expost.
DSI currently represents 50% of the operational costs of the system.

4. How does the Disability and Survival Insurance (DSI) Currently Work
How does the Disability and Survival Insurance (DSI) Currently Work?(III)
When pools of insured individuals exist, the risk can be divided into two types:
Modelable risk …
… on which estimated values and variations can be calculated
Catastrophic risk …
… when it corresponds to an event of unknown probability and severe effects

5. How does the Disability and Survival Insurance (DSI) Currently Work
How does the Disability and Survival Insurance (DSI) Currently Work? (IV)
The AFPs currently self-insure the modelable risk, with only the catastrophic risk remaining in the hands of the Insurance Companies, through the maximum, or “stop loss” premiums
In each contract, the costs and accumulated net premiums are calculated every 6 or 12 months, with the difference being paid in such a way that the companies only receive the cost associated to the accidents.
The companies only make money on the financial income, but they can suffer severe losses if the “stop loss” is violated.
The catastrophic risk being bought also has, on occasions, some limitations (it does not include natural disasters, wars, chemical disasters and others).

6. Diagnosis of the current DSI situation
Cost control:
Member selection
Monitoring of the classification process
Discouraging the use of the disability pension
Crossed subsidies:
From women to men
From young people to elderly people
Competition in the AFP system:
Very important for the system’s costs
Incentives to competition through skimming off
Barrier to the entry of new AFPs
The AFPs act as insurance companies without being regulated as such
Transparency of the system:
Hides the true pension cost
Distorts price comparison between AFPs.

7. Improvements to the Disasbility and Survival Insurance
The above diagnosis gives rise to a proposal for changing the DSI to correct its weaknesses by :
Increasing fairness
Generating conditions for greater competition and efficiency
Improving the transparency of the system
The changes consist in:
A sole premium, regardless of AFP membership.
Separate provision of DSI by insurance companies
Different costs for men and women

8. Motivation: Increase impartiality between members
The premium paid by each member depends on current AFP membership.
Due to the high cost of the DSI, there are strong incentives for the AFPs to individually control the costs of the system. This can be done by:
Monitoring the disability classification system (efficient)
Making access to disability classification more difficult (potentially unfair)
Avoiding the enrollment of potentially high accidentability members (especially older individuals) which is added to incentives to skim off low income or low density individuals (inefficient)
A DSI independent of AFP membership would enable a sole pool financed by all members in accordance with their income, thus avoiding the incentive to skim off on the basis of accidentability

9. Motivation: Increase gender fairness
Women generate lower disability and survival costs due to lower accidentability, greater longevity and a different definition of survivors with a right to a pension.
Nonetheless, they pay the same DSI cost: crossed subsidy.
Legal reform separates the cost between men and women by charging a sole premium, but “refunding” the cost difference to women in their individual accounts.
Without a uniform premium, the impact this measure would have on the pension savings of women would depend on the AFP they are members of.
The over-contribution rate could vary as much as 30% depending on AFP membership
A DSI independent of AFP membership enables the “refunding of DSI over-contribution” to women’s accounts regardless of their AFP.

10. Motivation: Generate conditions for greater competition and efficiency
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Persistent differences in the cost of the DSI between different AFPs have been observed over time

11. Motivation: Generate conditions for greater competition and efficiency
The crucial importance of DSI in the operational costs of the AFPs imply an important use of resources and private operating scale.
It generates incentives to focus the commercial strategy on skimming off, discouraging the membership of individuals with a greater expected accidentability cost.
In a mandatory system, this is a zero-sum game and consumes resources inefficiently.
An independent DSI enables greater AFP efficiency, since they will only concentrate on managing their “core business” of pension resources

12. Motivation: Generate conditions for greater competition and efficiency
Since the AFPs, to a certain extent, act as insurance companies, regulation should adapt to that situation.
Current regulation, based on the core activity of the AFPs, may not be efficient.
An independent DSI prevents the AFPs from acting as insurance companies, making regulation more efficient.

13. Motivation: Generate conditions for greater competition and efficiency
Finally, an AFP wishing to enter the market encounters entry barriers associated to the mandatory provision of DSI for its members:
It must specialize in managing the DSI which involves actuarial calculations, contract management, management of observer doctors in medical committees, market risk management due to the possibility of accidents, projection of financial income rates etc.
If it has a small portfolio, it may not meet the DSI risk diversification efficiency bars.
An independent DSI facilitates the entry of new actors into the market

14. Motivation: Improve the transparency of the system
The current importance of DSI is that the commission ranking could be altered if the cost of the DSI were excluded
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15. Motivation: Improve the transparency of the system
Members have the right to know how much they pay for each one of the social protection services they subscribe to such as the AFPs, unemployment fund managers, private health insurance, mutual funds, DSI and others.
Public policy promoters need to be clearly informed of:
The total cost that the AFPs pay for this insurance
The implicit profit they obtain through the DSI
The profits that the insurance companies gain thereby
The real size of the risk that the AFPs are outsourcing
An independent DSI enables generating and disseminating a sole cost known to all and having a clearer picture of the financial situation of the AFPs with respect to their main line of business.

16. Sole DSI bidding Transparency Competition Commercial strategy
In summary:
Transparency
Competition
Commercial strategy
Regulatory risk
Gender impartiality
Costs
The correlation between the expected cost of claims and some observable variables at an individual level, such as salaries and occupational ranking, aggravate the incentives the AFPs have for trying to obtain the membership of certain groups of individuals (young people, high income, salaries) which in terms of the system is a zero-sum game that implies spending of resources.
The cost of the insurance is lower for women than for men, since the former have lower accidentability rates. The bidding proposal separated by gender will mean different contribution rates for women depending on their AFP membership
The project seeks to make the effective price of the DSI more transparent and visible and also includes another series of measures that impact on its cost. Some of them lower it and others raise it, but the latter always entail greater benefits that are necessary for meeting the reform objectives.
The current design of DSI does not allow members know how much pay for services, since the charges for this concept and payments to insurance companies are the result of complex calculations and projections.
In the way the DSI currently works, the AFPs are assuming an important part of their members’ disability and death risks without an adequate regulatory trade-off as insurance agencies.
The costs of disability insurance and Survival account for 50% of the operational costs of AFPs. This leads to the DSI play a leading role in organizing industrial AFP.

17. Sole DSI bidding Proposal: Bidding mechanism
The AFPs must put the DSI out to tender jointly.
The bidding will be governed by the rules and regulations established by law and the Bidding Conditions.
The bidding conditions must adhere to the rules and regulations issued by the Superintendency.
Life Insurance Companies incorporated on the date of the bidding will be able to participate therein..
The insurance will be granted to the company that submits the best financial offer and can be granted to more than one company
Insurance Companies maintain a presence in the disability classification process through observer doctors.

18. Sole DSI bidding Proposal: Financing
Members’ contributions destined to financing the insurance will be uniform, regardless of the premiums established in the contracts that the AFPs sign with each company.
Members would start by buying not only a catastrophic insurance, but also an insurance for the modelable risk.
Thus, very simple contracts are achieved with a sole price that must be reported to the company annually and a contract bidding system that facilitates competition between the insurance companies
The AFPs must transfer the contribution destined to the financing of the insurance to the winning companies.
In case there is a difference, arising from members’ gender, between the contribution destined to financing the insurance and the premium necessary for financing it, the AFPs must pay the difference into each one of the accounts of the members who paid a contribution greater than such premium

19. Sole DSI bidding Current situation Graphic representation Member AFP
Insurance Co.
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Insurance Co.
Member
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Insurance Co.
Member
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Insurance Co.
Member
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Insurance Co.
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Insurance Co.
Member
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Insurance Co.
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Insurance Co.

20. The AFPs coordinate for jointly commissioning a DSI
Sole DSI bidding
Graphic representation
Proposed situation
2. The total commissions paid by members is exactly equal to the total amount of money they must transfer to the companies monthly. In exchange, the AFPs transfer part of their contributions to the insurance companies every month.
1 Members pay their AFP’s commission and separately, a sole DSI commission which is the same for all.
The AFPs coordinate for jointly commissioning a DSI
Insurance Cos.
AFP
Members
AFPs refund women’s over-payment of the premium to their balance
4 The AFPs pay the members all the money that the companies contributed, without exception. Only in the case of the bankruptcy of a company will the AFP be responsible for payments.
3. The insurance companies give the AFPs all the money necessary for paying the DSI benefits. Adjustments of any kind are no longer used.

21. Sole DSI bidding Competitive design of the bidding:
Challenges:
Competitive design of the bidding:
Bidding mechanism
Encourage participation
Information transparency
Efficient design of the insurance contracts.
Correct incentives
Timely and exact payment of the premiums and claims
Control of the accidentability costs of the system.
Observer doctor system
Proper functioning of the medical committees

22. Disability and Survival Insurance Diagnosis and Reform
Gonzalo Reyes
Research Division Lead
Superintendency of AFPs
FIAP Seminar
Lima, Peru, May 28, 2008