1. DEVELOPING THE MARKET FOR RETIREMENT PRODUCTS: THE CASE OF CHILE Washington DC April, 2005

2. 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 countries Basic questions not yet addressed The World Bank annuities project The first case study: Chile

3. Basic Questions Being Addressed by Project Can 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

4. 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

5. THE CHILEAN CASE Importance of the Chilean Case Overview of the Chilean Annuities Market Growth Structure Performance Identifying the Risks Internal Risk Management by Providers Product Regulation Provider Regulation Conclusions and Lessons for Other Countries

6. AN OVERVIEW OF THE CHILEAN MARKET: Growth

8. ChileLatin America High Income OECD Insurance Premium 4.62.27.9 Life3.50.74.6 Annuities 1.9-- PWs0.5-- Other1.1-- Non-Life1.11.53.3 Insurance Premiums in Chile and Other Regions

9. AN OVERVIEW OF THE CHILEAN MARKET: Retirement Conditions Normal Age Retirement 65 for men, 60 for women Early Retirement Balance has to be at least equal to: 70% of average real wage and 150% of MPG Disability Certification by medical committee Survivorship Death of main beneficiary

10. AN OVERVIEW OF THE CHILEAN MARKET: Types of Pensioners YearTotalNormal Old AgeEarly Retirement Disability + Survivors Number % of TotalNumber % of TotalNumber % of Total 19857,6092,64734.8%-0.0%4,96265.2% 1995190,40055,59129.2%69,53736.5%65,27234.3% 2004520,793133,34325.6%220,92942.4%166,52132.0%

11. AN OVERVIEW OF THE CHILEAN MARKET: Menu of Products Lump-sums Access conditions restrictive Phased Withdrawals (PWs) Regulated formula based on life expectancy Provided by AFPs Annuities Freely priced, but fixed, indexed, joint for married Provided by LICOs Temporary Withdrawals Withdrawal with deferred annuity Provided by AFPs and LICOs

12. AN OVERVIEW OF THE CHILEAN MARKET: Demand for Retirement Products YearTotalPWsTWsAnnuities Number % of TotalNumber % of TotalNumber % of Total 19857,6097,37396.8%-0.0%2363.2% 1995190,40098,69951.8%6,8033.6%84,89844.6% 2004520,793196,24237.7%6,1931.2%318,35861.1%

13. AN OVERVIEW OF THE CHILEAN MARKET: Demand for Retirement Products High degree of annuitization: More than 60% of all retirees annuitize Higher percentage excluding disability and survivorship pensions Early stages—disabled and survivors “jumpstarted” the annuities market 1990s and 2000s: close connection between early retirement and annuitization

14. AN OVERVIEW OF THE CHILEAN MARKET: Pattern of Annuitization

15. 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

16. AN OVERVIEW OF THE CHILEAN ANNUITIES MARKET: MARKET STRUCTURE

18. AN OVERVIEW OF THE CHILEAN MARKET: Market Performance Performance of the AFP Sector High average returns Costs and fees have declined but are still too high Performance has been better for PW holders Performance of the LICO/Annuities Sector High MWRs in recent years Questions about sustainability: very thin spreads Strong 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

19. 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

20. Market Performance: MWRs All cases 1.080 1.036 1.064 Premium 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 1.062 No deferment 1.079 1.035 1.063 March 2002 March 2003 March 2004 With deferment1.0801.0361.067

21. VariableCoefficientt-statisticOther Statistics Constant72.4288.48Dep. Variable: MWR*100 Age0.43141.76No. Observations = 4,198 Log (premium) 1.53518.08 Guarantee-0.132-13.51R 2 = 0.558 Deferment0.0212.42Adj. R 2 = 0.557 Male Dummy1.4155.86Prob. > F = 0.000 Female Dummy 4.18238.56Mean Dep. Variable: 106.1 2003 Dummy-4.976-39.89S.D. Dep. Variable: 4.83 2004 Dummy-2.433-20.07 Main Determinants of Individual MWRs

22. Dispersion of MWRs for Different Premiums

23. Austral.CanadaSwitz.UK 1 UK US 2 (James) (Can)(James)(Brown) Male, Age 55 --- -0.9210.934 Male, Age 65 1.0130.9811.046 0.9770.9080.927 Female, Age 55 --- -0.9280.937 Female, Age 65 1.0020.9761.037 0.9790.9070.927 Joint 0.9880.9800.9850.9810.987-0.929 MWRs of Nominal Annuities in Other Countries

24. MWRs of Indexed Annuities in Other Countries Austral.CanadaSwitz.UK 1 UK US 2 (James) (Can)(James)(Brown) Male, Age 55 --- -0.867- Male, Age 65 --- 0.8870.8540.822 Female, Age 55 --- -0.876- Female, Age 65 --- 0.8770.8570.782 Joint --- 0.880--

25. MWR Conclusions High 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

26. Market Performance: Spreads (1)

27. Market Performance: Portfolio Composition 1991199520002004 Government Sector38.340.328.717.3 Financial Sector23.028.445.134.6 Mortgage Bonds13.918.624.216.7 Other Mortgage-Backed3.06.010.117.9 Company Sector29.022.115.335.5 Shares8.910.23.43.2 Bonds20.110.7 31.2 Real Estate7.87.77.47.3 Other Assets2.01.53.65.5 Total100.0

28. Market Performance: Commissions

29. Market Performance: Spreads (2)

30. Market Performance: ROEs

31. Market Performance: Estimation of the Average Annuity Rate Fixed Effects with Robust Standard Errors; Total Panel Observations: 693 R 2 = 0.7995; Adj. R 2 = 0.7890; F-Statistic = 76.2162 ; P-Value(F-Statistic) = 0.0000 VariableCoefficientStd. Errort-Statistic C3.07600.218714.0668 RISK-FREE RATE0.36390.020917.4077 SOFI0.00290.00093.1772 SOA0.00860.00382.2509 LEVERAGE0.01100.00392.7967 MKT SHARE-3.49000.5727-6.0937 AVER. PREMIUM0.0002 2.57 * 6.8931 COMM. RATE-0.04410.0180-2.4431 HERFINDAHL-5.13900.7219-7.1191

32. 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.

33. 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

34. 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,

35. Product Regulation: The Menu of Products Conservative 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

36. 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

37. 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

38. Assessment of Capital Rules Rules have served well, were innovative when introduced Provisions 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

39. Capacity to absorb provisioning increases

40. CONCLUSIONS The growth of the market for retirement products, especially annuities, has been impressive The 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

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

42. 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.

43. LESSONS FOR OTHER COUNTRIES Feasibility of building the market for retirement products from a low initial base High MWRs to a good extent due to diversified supply of indexed annuities, with reasonable durations Need to develop capital market  Need for fiscal discipline, to open room for private instruments  Need for pro-active regulatory approach to develop securities markets

44. 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 cases Chilean experience with marketing regulation provides valuable lessons. Outcomes of the new quotation system should be monitored Strict capital rules that penalize mismatching are a valuable tool to build a strong capital buffer in the early stages of market development

45. LESSONS FOR OTHER COUNTRIES Even good product and intermediary rules can weakened by failure to update key parameters, especially mortality tables Guarantees 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 enforcement Need to evolve to a risk-based supervision system over time, as market develops