79225 This volume is a product of the staff of the International Bank for Reconstruction and Development / The World Bank. The World Bank does not guarantee the accuracy of the data included in this work. The findings, interpretations, and conclusions expressed in this paper do not necessarily reflect the views of the Executive Directors of the World Bank or the governments they represent. The material in this publication is copyrighted. FINANCIAL SECTOR ASSESSMENT PROGRAM UPDATE MEXICO TECHNICAL NOTE ON THE PENSION ANNUITY MARKET NOVEMBER 2006 THE WORLD BANK INTERNATIONAL MONETARY FUND FINANCIAL AND PRIVATE SECTOR DEVELOPMENT MONETARY AND CAPITAL MARKETS VICE PRESIDENCY DEPARTMENT LATIN AMERICA & THE CARIBBEAN VICE PRESIDENCY 2 Contents Glossary .....................................................................................................................................4 I. Introduction ............................................................................................................................5 II. The 1992 and 1997 Pension Reforms ...................................................................................5 III. The Market for Pension Annuities.......................................................................................8 A. Market Structure and Growth ...................................................................................8 B. Pension Annuity Products, Pricing, and Competition.............................................11 C. Evolution of Liabilities............................................................................................15 D. Evolution of Assets and Investment........................................................................18 E. Market Performance ................................................................................................25 IV. Development Prospects For The Pension Annuity Market ...............................................33 V. Conclusions and Policy Considerations..............................................................................39 References................................................................................................................................44 Tables 1. Contributions Under SAR-92 and SAR-97 (Percentage of Base Salary) ..............................6 4. Pension Annuity Providers and 2005 Market Shares ............................................................9 5. Evolution of Market Structure, 1997–2005 .........................................................................10 6. Insurance Sector Business Lines Growth, 1997–2005 ........................................................10 7. Pension Annuity Market Growth, 1997–2005 .....................................................................11 8. Evolution of Separate Technical Provisions, 1997–2005 (MXN mln.)...............................16 9. Investment Limits by Type of Security for Technical Provisions .......................................20 10. Investment Limits by Type of Issuer for Technical Provisions.........................................20 11. Investment of Technical Provisions, 1997–2005...............................................................22 12. Inflation and Currency Risk in Technical Provisions, 1997–2005 ....................................22 13. Average Maturity of Government Bond Portfolio (Years)................................................23 14. Average Maturity of Private Sector Bond Portfolio (Years) .............................................23 15. Evolution of Average Underwriting Costs, MXN Million, 2001–2005 ............................27 16. Evolution of Average Non-Life Loss Ratios in Select Countries......................................28 17 Weighting System for Asset Liability Mismatches ............................................................31 18. Pension Annuities Solvency and Profitability Indicators (1997–2005).............................32 19. Disability Benefits Under LSS-73 and LSS-97 .................................................................35 20. Monthly Disability Benefit Comparison Under 1973 and 1997 Laws (MXN ) ................35 22. Regulatory Framework for Pension Annuities ..................................................................46 3 Figures 1. Evolution of Total Technical Provisions (Real 2005 MXN mln.).......................................17 2. Evolution and Financing of Total Assets (Real 2005 MXN mln.) ......................................19 3. Evolution of Average Underwriting Performance...............................................................27 4. Evolution of Sovereign Risk and Inflation ..........................................................................29 5. Evolution of Investment Performance and Key Interest Rates............................................30 6. Impact of SAR-02 Reform on IV Premium Growth............................................................36 Boxes 1. Chilean Annuities are Good Value Products Even With Price Deregulation......................15 Appendixes I. Regulatory Framework for Pension Annuities .....................................................................46 4 GLOSSARY AFORE Administradora de Fondos para el Retiro CBIC Certificados Bursátiles de Indemnización Carretera CNSF Comisión Nacional de Seguros y Fianzas CONAC Colegio Nacional de Actuarios de México CONAPO Consejo Nacional de Población CONSAR Comisión Nacional del Sistema de Ahorro para el Retiro CR Combined Ratio = LR + OR + UR IBNR Incurred But Not Reported Claims Reserve IMSS Instituto Mexicano del Seguro Social INFONAVIT Instituto Del Fondo Nacional De La Vivienda Para Los Trabajadores IOSCO International Organization of Securities Commissions ISSSTE Instituto De Seguridad Y Servicios Sociales De Los Trabajadores Del Estado IV Invalidez y Vida LGISMS Ley General de Instituciones y Sociedades Mutualistas de Seguros LR Loss Ratio LSAR Ley de los Sistemas de Ahorro para el Retiro LSS-73 Ley de Seguro Social de 1973 LSS-97 Ley de Seguro Social de 1997 NPR Net Premium Reserve (or mathematical reserve) OR Operacional Expense Ratio PMG Pensión Mínima Garantizada RBS Requerimiento Bruto de Solvencia RCV Retiro, Cesantía en Edad Avanzada y Vejez RIRT Reglas para la Inversión de las Reservas Técnicas RMA Rendimiento Mínimo Acreditable RT Riesgo de Trabajo SAR Sistema de Ahorro para el Retiro SAR-02 Sistema de Ahorro para el Retiro (reforma de 2002) SAR-92 Sistema de Ahorro para el Retiro (reforma de 1992) SAR-97 Sistema de Ahorro para el Retiro (reforma de 1997) SHCP Secretaria de Hacienda y Crédito Publico SIC Sistema Internacional de Cotizaciones SIEFORE Sociedad Especializada de Fondos para el Retiro SINCAS Sociedades de Inversión de Capitales UDIBONOS Bonos De Desarrollo Del Gobierno Federal Denominados En Unidades De Inversión UPR Unearned Premium Reserve UR Underwriting Expense Ratio 5 I. INTRODUCTION 1 1. This paper analyzes the performance and development of the Mexican pension annuity market in Mexico that stemmed from the 1997 pension reform. The Mexican experience displays interesting characteristics that provide lessons for other countries that still need to design the decumulation phase of their newly established second pillars. At the same, time it raises some technical and policy concerns that need addressing as they could hamper, in the future, the healthy development of the market. 2. This paper benefited from interviews with officials in the Insurance Supervisory Authority (CNSF), the Ministry of Finance (SHCP), the Pension Supervisory Authority (CONSAR) and the Social Security Institute (IMSS) as well as with management of specialized annuity companies. It could have not been prepared without the written material provided by the CNSF, listed in the reference section at the end of the paper. 3. The reminder of the paper is structured as follows: Section II briefly summarizes the 1992 and 1997 pension reforms from which the pension annuity market derives; Section III analyzes the evolution of the industrial organization, annuity product design and competition, the evolution of assets and liabilities and investment, as well as the regulatory framework for the aforementioned items, and the performance of the market; Section IV analyzes the development prospects of the market in light of the more recent 2001 and 2002 reforms of the 1997 social security law. Conclusions and policy recommendations follow. II. THE 1992 AND 1997 PENSION REFORMS 4. In 1992, Mexico reformed the pension system for workers in the private sector 2 and in the public sector 3 introducing mandatory defined contribution individual accounts complementary to the existing defined benefit schemes. The reform is known as SAR-92. In December 1995, a proposal for a new Ley del Seguro Social (LSS-97) was submitted to Congress. This was passed in the same month and was effective as of July 1997. The reform of 1997 is known as SAR-97 and covered only private sector workers. The main component of the second reform was the abolition of the old age defined benefit scheme for private sector workers. 5. Table 1 summarizes the impact that the SAR-92 and SAR-97 reforms had on the old benefits managed by the IMSS. The same table lists in column one the five subaccounts for the various benefits provided by the system and listed in column two. SAR-92 established 1 This note was prepared by Gregorio Impavido and benefited from comments by SHCP, Manuel Aguilera, Norma Alicia Rosas, Manuel Calderón, Héctor Rodríguez-Cabo (all CNSF), and Augusto de la Torre. 2 Private sector workers are covered by the Instituto Mexicano del Seguro Social (IMSS). 3 Public sector workers at the federal level are covered by the Instituto De Seguridad Y Servicios Sociales De Los Trabajadores Del Estado (ISSSTE). 6 two individual accounts for old age (retiro) benefits and housing (vivienda). The SAR-97 reformed the old defined benefits of disability, old age, and life managed by the IMSS. These were divided into two separate lines of benefits for old age and severance at advanced age (retiro, cesantía en edad avanzada and vejez in the RCV subaccount), on the one hand, and disability and life (invalidez and vida in the IV subaccount), on the other hand. Table 1. Contributions Under SAR-92 and SAR-97 (Percentage of Base Salary) SAR-92 SAR-97 Period 1992 – Period 1997 – Managed during accumulation Subaccount 1997 onwards period by: Retiro 1/ 2.0 percent 2.0 percent Cesantía y Vejez 4.5 percent AFOREs, RCV 2/ SIEFOREs MXN 2.76 per Cuota Social 3/ working day Invalidez y Vida IV 2.5 percent 2.5 percent IMSS 4/ Riesgo de Min. 0.25 percent, RT n.a. IMSS Trabajo 5/ Max. 15 percent V Vivienda 1/ 5.0 percent 5.0 percent AFOREs, INFONAVIT Notes: 1/ Employer funds 100 percent of this contribution; 2/ Employer funds 3.15 percent, employee funds 1.125 percent, Federal Government funds 0.225 percent; 3/ Federal Government funds 100 percent of this contribution. The value reported is indicative of end of 2005. This is indexed to inflation and updated every quarter; 4/ Employer funds 1.75 percent, employee funds 0.625 percent, Federal Government funds 0.125 percent; Minimum and maximum as defined in Article 72 of LSS-97. Source: IMSS, CONSAR. 6. Old age benefits (subaccount RCV) are now defined contribution benefits based on individual accounts managed by dedicated pension fund administrators (AFOREs) with monies invested in legally independent and dedicated pension mutual funds (SIEFOREs) under the supervision of a dedicated pension supervisor (CONSAR). Contributions to the RCV account amount to 6.5 percent of the worker’s base salary plus a flat contribution from the Federal Government of MXN 2.76 per working day as of end of 2005. Disability, life and survivorship benefits (subaccount IV) are still defined benefit administered by the IMSS but with a revised benefit formula. Contributions to the IMSS for this line of benefit amount to 2.5 percent of the worker’s base salary. Workers’ compensation (subaccount RT) remains administered by the IMSS with variable contributions as defined in Article 72 of LSS-97. Finally, housing (subaccount V) contributions amount to 5 percent of worker’s base salary and are managed by the housing financial agency for private sector workers (INFONAVIT) while AFOREs conduct record keeping for this account. 7. As far as the accumulation phase is concerned, Table 2 summarizes the growth of the AFORE system since the 1997 reform. Currently around 10 percent of GDP is accumulated in the new system. To these reserves, it is necessary to add the reserves accumulated by the 7 IMSS for the lines of benefits of IV and RT to have a sense of the potential demand for annuity products that can be provided by the private sector. Table 2. Accumulated Savings in the AFORE System Number of RCV Voluntary Housing Year Total AFOREs account 1/ account 1/ account 1/ (Percentage of (MXN 000,000) (MXN 000,000) (MXN 000,000) GDP) 1998 13 54,470.5 46.7 51,419.0 2.75 percent 1999 14 104,194.8 331.3 81,039.7 4.03 percent 2000 13 158,806.2 846.0 110,294.0 4.91 percent 2001 13 242,242.2 1,513.8 148,148.2 6.74 percent 2002 11 315,322.4 1,900.5 178,808.2 7.91 percent 2003 12 392,881.8 2,221.3 210,071.6 8.78 percent 2004 13 469,145.8 2,031.0 246,336.9 9.40 percent 2005 18 577,008.7 1,981.4 284,599.1 Note: 1/ As of December of each year. Source: CONSAR, IFS. 8. As far as the decumulation phase is concerned, the SAR-97 reform treats differently members of the transition cohort from members of the “new cohort.” If a new entrant to the labor force after July 1997 (the so called “new cohort”) becomes disabled or dies, she or her beneficiaries must buy an annuity from a private insurance sector specialized annuity provider. If a member of the new cohort retires at old age (65 years or older) or due to severance at old age (at least 60 years old) she can choose between a programmed withdrawal offered by an AFORE or an annuity offered by a specialized annuity provider. It is important to mention that, if the accumulated balance at retirement is less than what is needed to obtain an annuity greater than or equal to the minimum guaranteed pension (PMG), the worker is required to select a programmed withdrawal. When resources are exhausted, the Government is responsible for paying the PMG to the worker. 4 9. Members of the transitional cohort with at least one contribution at the time of the reform can opt for old age retirement benefits under the provisions of the LSS-73 while if they become disabled or die, they or their beneficiaries were originally required to buy an annuity from a private insurance sector specialized annuity provider.5 Hence in general, benefits are either provided by private sector pension annuity companies or by the IMSS or by the Federal Government depending on the type of benefits and annuitant being considered (more on this is provided in Section IV). 4 It is worth mentioning that when a pensioner with a PMG dies, IMSS has to buy a survivor annuity for his/her beneficiaries from a private sector annuity provider. 5 This, as it will be explained later changed in 2002. Notice also that for simplicity we are not discussing the provision of the minimum pension guarantee discussed further in Section IV. 8 10. The rationale behind mandating the purchase of IV and RT benefits in the private sector while allowing transitional cohort the option to choose between the old and new old age benefits was related to the fact that, at the time of the reform, old age benefits under the LSS-73 were on average more generous than under the LSS-97, RT benefits were more or less equivalent under the two laws, and IV benefits were on average more generous under the LSS-97 than under the LSS-73. In addition, this would have allowed for the development of a private sector annuity market in Mexico by the time the new entrants to the labor force after 1997 started retiring. These are currently only 37 percent of the IMSS members as reported in the next table. Table 3. Transitional and New Generations in the Pension System (Year 2004) Workers Number Distribution Transitional generation 7,743,057 63 percent Actual generation 4,604,993 37 percent Total 12,348,050 100 percent Source: IMSS 11. Due to the difference in generosity between the old and new old age benefits, it is expected that all retirees in the transition cohort will elect the on average more generous old age benefits provided for under the LSS-73. In other words, the short- to medium-term prospects for development of the annuity market in Mexico very much depend on the accumulated funds in the IV and RT lines of benefits only. 12. The next section will analyze the evolution of the pension annuity market as derived from the SAR-97 reform between 1998 and end of 2005. While the term “pension annuities” is used to indicate all annuities derived from the SAR-97 reform, it is often used to indicate the only de facto existing market of IV and RT annuities. The market for old age (retirement) annuities is currently non-existing due to the fact that workers at the time of the reform have the option to elect the (on average) more generous old age benefits under the pre-reform provisions (see more on this issue in Section IV). Therefore, in the rest of this paper the term “annuity” will be used for IV and RT annuities, unless otherwise indicated. III. THE MARKET FOR PENSION ANNUITIES A. Market Structure and Growth 13. With the SAR-97 reform 13 insurance companies were licensed to provide pension annuity benefits in 1997. At the end of 2005, 11 specialized pension annuity companies were active in the market. Seven of these companies were subsidiaries of foreign companies (F) while four companies were part of financial groups (GF). The following table lists the companies operating in the market as of end of 2005 and their market shares in term of written premiums. 9 Table 4. Pension Annuity Providers and 2005 Market Shares (Percentage of Market Premium) Company Market share Pensiones BBVA Bancomer, S.A. de C.V., Grupo Financiero BBVA Bancomer 1/ 2/ 19.7 Pensiones Inbursa, S.A., Grupo Financiero Inbursa 2/ 17.0 Profuturo GNP Pensiones, S.A. de C.V. 15.6 Pensiones Banamex, S.A. de C.V., Grupo Financiero Banamex 1/ 2/ 10.5 Pensiones Banorte Generali, S.A. de C.V., Grupo Financiero Banorte 2/ 9.0 HSBC Pensiones, SA. 1/ 6.8 Pensiones Comercial América, S.A. de C.V. 6.6 Metlife Pensiones México, S.A. 1/ 6.1 Principal Pensiones, S.A. de C.V. 1/ 4.4 Allianz Rentas Vitalicias, S.A. 1/ 2.9 Royal & SunAlliance Pensiones (México), S.A. de C.V. 1/ 1.4 Total 100.0 Notes: 1/ Foreign subsidiary. 2/ Belonging to a financial group. Source: CNSF. 14. The structure of the market changed in the first nine years of operation in two main ways. Initially, the 1997 LGISMS reform stated that insurance companies licensed to practice life insurance were allowed to offer pension annuities for a five years transition period. After that period, those insurance companies would have had to separate annuities operations in specialized pension annuity companies. The 1997 LGISMS also established that, during this transitional period new insurance companies that would like to offer pension annuities would be licensed as specialized insurers. While in 1997 50 percent of the companies licensed where composite companies, after 2002 only specialized companies were left operating in the market. The rationale for the choice of specialized annuity providers was, on one hand, to avoid the contagion effect from composite life and non-life insurance companies operating annuities, and on the other hand, the implicit government guarantee associated with a benefit provision for which participation was mandated by the Federal Government. Notwithstanding the political economy argument of the choice, general life insurance companies would have been better placed to hedge the systemic improvements in longevity risk in the annuitant portfolio with the mortality risk in the pure life portfolio. 15. Another way in which market changed over the year is reflected by the increased importance of subsidiaries (especially foreign) and a decreased importance of financial groups. The following table summarizes the changes in market structured that took place since the SAR-97 reform. 10 Table 5. Evolution of Market Structure, 1997–2005 1997 1998 1999 2000 2001 2002 2003 2004 2005 Foreign Subsidiaries 4 4 5 5 5 7 6 7 7 Local Financial Groups 6 5 5 5 5 3 2 2 2 Other 3 4 4 4 4 3 3 2 2 CR5 (percent) 85.3 77.0 73.7 71.4 72.2 72.0 72.5 72.9 71.8 Source: CNSF 16. Market concentration has been decreasing but remains fairly high. The participation of the largest five providers in total gross premium written (CR5) has decreased from 85 percent to 72 percent between 1997 and 2001 and remained stable since that year. 17. The pension annuity market in Mexico is very small. This is due to the fact that the pension reform that created it was conducted only in 1997 and because the Mexican insurance market in general has low penetration and density (1.7 percent of GDP and MXN 1,389 per capita, respectively in 2005). Table 6 reports the evolution of the major business lines of the Mexican insurance market between 1997 and 2005. The gross premium related to the annuity market increased from 3.2 percent to 13.2 percent of total insurance gross premium income between 1997 and 2001 while it decreased again to 3.3 percent in December 2005. Table 6. Insurance Sector Business Lines Growth, 1997–2005 (Percent) 1997 1998 1999 2000 2001 2002 2003 2004 2005 Motor 25.8 25.5 23.8 25 24.7 24.2 26.9 24.4 25.1 Other P&C 25.9 20.4 18 16.8 17.4 18.5 21.4 20.3 18.9 Life 35.2 31.7 36.1 34.2 33.7 39.1 36 38.9 37.9 Accidents & Health 9.8 8.9 9.4 10.6 10.9 10.9 12.9 12.7 14.8 Pensions 3.2 13.5 12.7 13.2 13.2 7.3 2.7 3.7 3.3 Total GPI (MXN 78,639 94,811 101,001 110,320 125,699 140,928 128,063 142,640 138,377 mln) 1/ GPI/GDP (percent) 1.3 1.5 1.6 1.6 1.8 2.0 1.8 1.9 1.7 GPI/Pop. (MXN ) 839 999 1,051 1,133 1,273 1,408 1,263 1,389 1,331 Note: 1/ Real 2005 pesos. Source: CNSF, IFS, WDI. 18. Table 7 summarizes the growth of the pension annuity market in terms of key variables between 1997 and 2005. The number of annuitants for the benefits of IV and RT increased every year between 1997 and 2002. Afterwards, figures decreased sharply. The number of eligible annuitants increased from 6,068 in 1997 to 30,778 in 2001. The number of individuals who had bought a pension annuity from private sector providers increased from 4,410 in 1997 to 30,824 in 2001. In the ensuing years the number of eligible individuals and actual annuitants decreased to around 7,900 in 2005. 11 Table 7. Pension Annuity Market Growth, 1997–2005 1997 1998 1999 2000 2001 2002 2003 2004 2005 Eligible Insured 6,068 23,905 24,782 27,384 30,778 14,879 5,998 6,365 7,917 Annuitants 4,410 23,457 24,599 27,188 30,824 15,798 6,153 6,187 7,927 GPI (MXN mln.) 1/ 2,522 12,913 13,389 14,529 16,641 10,261 3,497 5,225 4,504 o/w IV (percent) 96 90 87 86 86 86 86 85 85 GPI/GDP (percent) 0.08 0.33 0.29 0.26 0.28 0.16 0.05 0.07 0.05 GPI/Pop. (MXN ) 26.9 139.0 139.3 149.0 168.3 102.4 34.4 50.8 43.6 Note: 1/ Real 2005 pesos. Sources: CNSF, IFS, WDI. 19. The same pattern can be observed in the value of pension annuity premiums with the exception of 2004 when a spike in premiums written can be observed.6 Between 1997 and 2001, gross written premium increased from MXN 2,522 million (annualized) to MXN 16,641 million. In the ensuing months it decreased to reach MXN 4,504 million in 2005. The 2004 increase in premiums was due to an increase in IV and RT pension annuities approved by the congress in that year that required retroactive payments for insured individuals as of March 2004. Within the period between 1997 and 2005 the share of premiums for IV benefits decreased from 96 percent of total premiums in 1997 to 85 percent in 2005. 20. Pension annuity market penetration increased from 0.1 percent to 0.3 percent of GDP between 1997 and 2001 while afterwards it decreased until reaching five basis points in December 2005. Again a similar pattern can be observed in terms of market density. 21. Section IV of this paper provides a detailed discussion of the factors behind the mentioned major change in the trends in the pension annuity market after 2001. B. Pension Annuity Products, Pricing, and Competition 22. Pension annuities stemming from the 1997 reform are all immediate premium level annuities indexed to inflation (CNSF 2006g). The products have two components: (a) an annuity for retirement, unemployment at old age, disability, incapacity, worker’s compensation, orphans, widows and widowers; and (b) a survivor benefit for eventual beneficiaries existing when the right to a pension annuity is acquired. In calculating premiums, pension annuity companies calculate separately the premium related to the annuity and the premium related to the survivor benefit. The calculation of the survivor benefit considers the death conditional probability of the pensioner. 23. Two sets of gender specific mortality tables are used for insured members that are invalid or not invalid and a unique technical rate of 3.5 percent real has to be used. For male 6 That was due to an amendment to the LSS-97 that increased the pension amount to those pensioners satisfying the legal requirements established by that amendment. This implied a transfer of almost $1,700 million MXN of single premium to the annuities companies. 12 and female disabled pensioners (IV benefits), the two mortality tables used are the EMSSIM- 97 and the EMSSIH-97, respectively. These tables were developed by the IMSS. For non- disabled male and female pensioners the mortality tables used are the EMSSAM-97 and EMSSAH-97, respectively. These tables were prepared by the CNSF on the basis of information provided by the Population National College (CONAPO). These are gender specific dynamic tables approved by the special committee formed under Art. 81 of the LSAR for this purpose (CNSF 2006). The methodology used for the creation of these tables was revised by the Mexican College of Actuaries (CONAC). 7 24. Other factors influence the pricing of annuities. Since annuities are indexed every February to the inflation of the previous fiscal year a system of factors was developed to consider that (a) it is possible the month of February falls between the date in which the insured individual acquires pension rights and the date when the IMSS declares the insured individual invalid; (b) pension benefits can be granted at any time during the month and companies need to credit the inflation every month. In addition, two types of mark ups are added to the premium: (a) a 2 percent mark-up (which is accumulated in the contingency reserve discussed in Section C is added to the premium as an extra buffer to compensate for possible statistical deviations in the mortality table; and (b) a 1 percent mark-up is added to finance acquisition costs incurred during the sale of the annuity and administration costs incurred during the payment of the annuity. 25. Since demographic and technical parameters used for pricing annuities are fixed by regulations, any new annuitant has access to the same IV and RT annuity irrespective of the provider elected. This is ensured by a requirement for all companies to use a single pricing system (known as “SUC”) 8 for calculating immediate premiums. The SUC is nothing more than a piece of software that captures the relevant data of the individual and his/her beneficiaries and uses all pricing parameters prescribed by regulations. The rationale behind the single methodology for pricing annuities is related to the fact that, on the one hand, the LSS-97 establishes defined benefits for IV and RT pensions, and on the other hand, grants the right to pensioners to choose an annuity company. In addition, this methodology strives at eliminating unfair commercial practices towards retirees and towards the IMSS that ultimately pays premiums through its accumulated IV reserves. 26. In order to compete for clients, companies offer additional benefits to the basic IV and RT annuities. In the case of life insurance benefits, the annuities companies have to purchase additional benefits from other insurance companies authorized to operate life insurance business. Notice that the offer of additional benefits does not affect the price offered to the insured individual for the basic pension benefit. In other words, companies 7 Colegio Nacional de Actuarios de México (CONAC). 8 Sistema Único de Cotización (SUC). 13 absorb all costs for additional benefits and finance them through the spread between the technical rate and the expected return on assets. 27. These additional benefits are tightly regulated in order to ensure that they are in line with the solvency profile of the company, and to avoid undue commercial practices Additional benefits need to be registered in the CNSF before being offered to the pensioners. The additional benefits registered at the CNSF are posted on its website. They can only fall in one of two categories: additional economic benefits constituting increments on the basic pension; and, life insurance products bought for the pensioner or their beneficiaries. In general, additional benefits can be offered during the duration of the basic pension benefit. In the case of additional economic benefits, pension annuity companies are required to constitute the corresponding reserves 9 considering a technical interest rate of 1 percent in real terms. On the other hand, life insurance benefits have to be purchased from other insurance companies paying a single premium, and this amount is registered as acquisition cost of the annuity company. 10 It is important to point out that the same mortality table used for basic benefits is used for additional economic benefits (CNSF 2006h). 28. The regulatory framework for pricing of pension annuities in Mexico has the potential for making the basic annuity offered an unbalanced product. This is a risk for both providers and annuitants. 29. For providers there is a concrete possibility that technical profit margins are quickly eroded if technical rates are not adjusted rapidly. For instance, the long term real interest rate in the case of 10 yr Udibonos 11 has decreased from around 7.14 percent in October 1999 to 4.30 percent in December 2005 and has been increasing gradually to reach a level of 5.09 percent in June 2006; 12 in the case of 20 and 30 yr PICs 13 the long term real interest rates have passed from 6.14 and 6.12 in October 2001 to 5.96 and 5.92 in November 2002 respectively and in the case of 20 and 30 yr CBICs 14 the long term real interest rates 9 More precisely, this is the mathematical or net premium reserve as it will be explained in Section III.C. 10 In the case of life insurance benefits the corresponding reserves are constituted by the life insurance companies (sellers). 11 Pension annuity companies have large positions of Government bonds known as UDIBONOS (Bonos De Desarrollo Del Gobierno Federal Denominados En Unidades De Inversión), PICs (Pagarés de Indemnización Carretera con aval del Gobierno Federal) and CBICs (Certificados Bursátiles de Indemnización Carretera con aval del Gobierno Federal) that have maturities between seven and 28 years. 12 For 10 year UDIBONOS, the auctions average result reached the lowest real annual interest rate level (3.89 percent) in October 2003. Source: Banxico. 13 The highway indemnification promissory notes, know as PICs were issued until December 2002, as part of the support program for the rescue of the highways under Concession. These notes were endorsed by the federal government. The annual interest rates correspond to the auctions results. Source: Banxico and Banobras. 14 CBICs were issued since January 2003. The interest rate considered is the CBIC real annual interest rate of the monthly auctions results. Source: Banxico and Banobras. 14 decreased from 6.16 and 6.21 percent in January 2003 to 4.59 and 4.68 percent in December 2005 in that order; while the technical rate of 3.5 percent real has not been modified (see Section E). 30. The mortality tables used are experimental tables based on population averages and annuity companies would need to develop their own annuitant mortality tables when sufficient mortality experience is accumulated. This is especially urgent since pension policy changes introduced in 2002 have altered the demographic assumptions at the basis of the pricing framework adopted in 1997 so that the IV annuitant pool is quickly degenerating (see Section IV). Since 2000 the CNSF has prepared some studies in order to analyze the sufficiency of the experimental market tables. However since 2002, the trends of the mortality have changed and it is necessary to collect statistical market information for at least five years to propose a new table. 31. Finally, the fixed pricing rules, determined by the legal constrains mentioned previously, may expose annuitants to undesired provider risk as the solvency situation of any given company is not reflected in the price of the annuity it offers. 15 In a low long term real interest rate environment and without the timely adjustment of the regulatory technical rate, the inability of companies to establish sound premium rates 16 may expose themselves and annuitants to undesirable level of risk. 32. For annuitants, fixed technical parameters are no guarantee of good pricing of annuity products in an environment of changing circumstances. 17 Of course, the fixed parameters do not change the monthly amount received by the annuitant, which is a defined benefit established by law as a function of typical parameters, such years of service, age, salary history, etc.). But they do affect the cost of the annuity to the retiring worker. The Chilean experience, described in Box 1, would suggest that annuitants can receive a good value for their premia in a highly competitive and efficient market even if technical parameters are deregulated. 15 Clearly this observation should be weighted by the fact that product pricing is the result of complex interactions between operational objectives of a company, such as profit, market share and market positioning, and security objectives, such as reinsurance, investment philosophy and reserving (when not regulated). When companies are free to charge prices on the basis of sound rates, these prices are usually more dynamic and their relationship to sound rates may vary from time to time with the state of the market and with the expectations of management and shareholders. In other words, prices may not need to always reflect the solvency situation (although they are expected to be highly correlated with it) of a company. 16 Sound rates are based on sound insurance principles and have regard to the portfolio being written and the changing social, economic, legislative and technological environment. 17 Which in the case of mexico is simply determined by the defined benefit nature of the IV and RT pensions. 15 Box 1. Chilean Annuities are Good Value Products Even With Price Deregulation The situation in Mexico is totally different from Chile, for instance, where prices are not regulated. In Chile there is evidence that annuities with longer expected durations have lower money’s worth ratios than annuities with shorter expected durations, and that larger premiums buy annuities that on average are of better value than smaller ones. This is consistent with the view that insurers are concerned with the higher reinvestment and mortality risks presented by long durations and, in the case of size, the effect of fixed expense loadings. Also, nearly half of the variation in individual money’s worth ratios is not explained by individual characteristics. The wide spread between the highest and the lowest annuity is intriguing, and is specially wide for lower premium annuities, indicating that market search may be inefficient among lower income retirees. Finally, annuitants with the same characteristics such as age, premium, and gender frequently receive different annuities. The high variability in money’s worth ratios (especially at low premia) has led to the conclusion that brokers and sales agents can unduly influence the selection of products. This led to the introduction of a new electronic quotation system designed to improve transparency in the market for retirement products, and ensure that retirees effectively obtain the best quotes. This is an innovative and promising reform, the results of which should be closely monitored by regulators in other countries. The recent introduction of caps on broker commissions proved controversial but is another experience that merits close monitoring as well. In any case, the variability in annuity prices in Chile should not suggest that prices should not be de-regulated in Mexico. Despite price variation, Chilean annuitants have generally received a good value for their premia so far, as indicated by average money’s worth ratios on their indexed annuities around 1.04 – 1.08 in recent years. These are significantly higher than the unitary value considered as an actuarially fair annuity. Money’s worth ratios increase with age, and they are lower for joint annuities and guaranteed annuities. These results reflect the exposure of the provider to mortality and reinvestment risk, and the higher risks in contracts with longer duration. Average money’s worth ratios in Chile have been high by international comparison. In most other countries money’s worth ratios range from 0.9 to 1 for nominal annuities, and from 0.8 to 0.85 for indexed annuities, in the few countries that offer inflation protection, such as the UK. The higher money’s worth ratios of indexed annuities in Chile are in part due to the availability of a large supply of financial assets indexed to prices, including higher yield assets such as mortgage, corporate and infrastructure bonds. This has allowed annuity providers to hedge inflation risk efficiently while also extracting higher real returns and sharing them with annuitants. Such high ratios are considered the result of a very competitive environment but likely to be unsustainable in the long run. Despite the fact that ratios will need adjusting in the future, they are likely to remain competitive if compared internationally. C. Evolution of Liabilities 33. Mexican pension annuity providers need to form a variety of technical provisions 18 for both pension and additional benefits. 19 Due to the fact that pension annuities are all immediate premium annuities, the largest provision is obviously the net mathematical (or 18 The methods for the formation of such reserves are detailed in SHCP (1997). 19 The share of technical provisions for additional benefits was only 2 percent in 2005. 16 premium) reserve (NPR) (reserva de riesgos en curso). 20 This is formed with the immediate premium of IV and RT benefits and it backs the provision of annuities considering a technical rate of 3.5 percent in real terms. Companies have also to constitute the premium reserve corresponding to additional economic benefits in which case the use of a technical rate of 1 percent in real terms is required. The reserve is gradually “earned” when benefits are paid and it has always represented between 95 percent and 97 percent of total reserves in the 1997 – 2005 period. The contingency reserve (reserva de contingencia o de previsión) is used to cover possible statistical deviations in the expected loss ratio and it is formed with 2 percent of the mathematical reserves for pensions and additional benefits. 21 The special mathematical reserve for basic benefits (reserve matemática especial) is used to cover possible systemic improvements in the longevity of the annuitant pool for non invalid pensioners. The reserve for fluctuation in investments (reserva para las fluctuaciones en inversiones) is used to cover for unexpected fluctuations in the return on the investment of the reserves. This reserve is constituted by a portion of the excess investment rate of return of the market portfolio over the technical interest rate (3.5 percent real). Finally, the loss reserve (reserva para obligaciones pendientes de cumplir), is used for liabilities that providers have with their pensioners. The next table reports the behavior of the different types of reserves just mentioned within the period 1997–2005. Table 8. Evolution of Separate Technical Provisions, 1997–2005 (MXN mln.) 1/ 1997 1998 1999 2000 2001 2002 2003 2004 2005 NPR 2,332.4 14,774.8 27,417.3 40,728.7 55,791.0 63,875.1 65,429.0 68,592.6 70,624.7 Pending NPR 51.5 37.2 55.3 60.8 43.2 10.6 7.20 10.8 7.5 Contingency 46.7 295.0 548.3 814.5 1,115.0 1,277.0 1,308.0 1,371.0 1,412.0 Special Mat. 0.3 9.6 32.7 82.1 139.5 226.2 315.5 445.0 574.4 Inv. Fluct. 1.8 33.7 156.2 234.1 333.6 628.0 744.9 747.1 817.8 Loss Reserves. 7.4 9.7 15.2 33.8 70.6 97.1 133.2 167.5 203.6 NPR/Total (percent 96 97 97 97 97 97 96 96 96 Note: 1/ Real 2005 pesos. Source: CNSF. 34. Technical provisions also display a similar pattern of high growth until 2001 and much lower growth afterwards reported before for premiums in Section A. Between 1997 and 2001 technical provisions increased from MXN 2,440 million to MXN 57,493 million while reaching only MXN 73,640.41 in December 2005 as shown in the next figure. 20 The NPR is the long plan equivalent of the unearned premium reserve (UPR) for P&C insurers. 21 Annuity premiums include a 3 percent of surcharge composed by 2 percent for mortality deviations and 1 percent for administrative and acquisition cost. 17 Figure 1. Evolution of Total Technical Provisions (Real 2005 MXN mln.) 80,000 70,000 60,000 50,000 40,000 30,000 20,000 10,000 0 1997 1998 1999 2000 2001 2002 2003 2004 2005 Source: CNSF. 35. A major change was introduced in 2002 in the regulation with respect to the valuation of technical provisions of life, accident and illness, and P&C lines of businesses by amending Article 47 of the Insurance Law (LGISMS). In essence, the new rules state that the valuation of technical provisions has to be conducted on the basis of actuarial standards requiring an actuarial valuation of future risks. 22 In the case of annuities, it was established in 1997 that the valuation of technical provisions should be made on the basis of the actuarial methodology issued by the Ministry of Finance. 23 For pension annuity companies that underwrite inflation indexed products, the methodology applicable to the formation of the net 22 Regarding the unearned premium reserve for all lines of business (excepting annuities) the old methodology for the calculation and valuation of the technical reserves was based on premiums. Insurance companies that followed this regulation scheme could face actuarial insufficiency of technical reserves, because reserves relayed only on the adequacy of premiums. Consequently, if the risk premium was insufficient to pay claims, the technical reserve would also be insufficient. In addition, in high competitive markets some insurers would lower premiums in order to retain costumers, making it difficult to control if premiums are exactly associated to the risk assumed by the insurance companies. (Premium manipulation does not relate to the annuity market as pricing parameters are fixed by regulation. The observation made relates to the general rationale behind the choice to change accumulation and valuation methodologies for the whole insurance industry). The new rules (CNSF 2003, 2003a, 2003b, 2004, and 2005) containing specific instructions for the actuarial valuation of the NPR were implemented in 2004. All companies are now required, for each line of business, to file with the CNSF an actuarial methodology for the valuation of the adequacy of reserves. Regulations also include a minimum requirement level for the technical provisions. In the case of claims reserves, companies are also required to use an actuarial method for the estimation of reported claims without a precise valuation of the loss (CNSF 2003c). The methodology must estimate the technical provisions as the expected value of future claims derived from all the policies in force from the valuation date until the expiration date of every policy. The methodology must specify a projection model of future claims, based on the trends of claims observed by the company in the previous years. In case a company does not have adequate statistical data, it must file a temporary methodology also approved by the CNSF who also has the power to assign a methodology for as long the company files one considered as adequate. 23 This methodology is detailed in SHCP (2000). 18 premium reserve includes additional provisions aimed at avoiding eventual revaluation of the reserve due to changes in inflation. 24 In all cases, since 2004, the valuation of the technical provision must be reviewed and signed by an actuary that must be certified by the National College of Actuaries (CONAC) or approved by the CNSF. Consequently, standards of actuarial practices where developed by the CONAC, and one of them indicates the principles that actuaries must apply to calculate the technical provisions. These standards were published by the CNSF in Circulares S- 10.1.8 and F-6.6.4. D. Evolution of Assets and Investment 36. Total assets in the pension annuity market follow closely the behavior of liabilities given the long term nature of the pension annuity business. For instance, average total assets in the last nine years have been 90 percent financed by liabilities and only 10 percent by paid up capital; the liability share is clearly increasing with time until the annuitant population matures. Since assets closely follow the pattern of liabilities, assets too grew rapidly until 2001 and less rapidly since then due to the decreased income after that year as previously reported for premiums and technical provisions. In the first five years since the reform, total assets reached MXN 60,000 million while in the last four years they increase about only MXN 21,000 million. 37. Figure 2 shows the evolution of total assets and its sources of financing: liabilities and capital. Notice that the drastic increase in capital registered in 2003 was due the decision of one company to transfer to capital excess resources and results in participation in subsidiaries. The same company in 2004 registered another increment in capital as a result of its participation in subsidiaries. In 2005, the same company disinvested around MXN 7 billion. Due to the fact that capital excess resources were stocks not listed on the Mexican stock exchange market, there was no effect on the solvency of the annuity market. 24 Notice that liabilities are inflation indexed by regulation. Hence, the methodology for forming the NPR needs containing an element that neutralizes the effect of the revaluation of the reserve due to changes in inflation. The following formula shows gives the value of the NPR reserve at the end of every month: V m =( m −1V + 1 GPI m − 1 C m )(1 + ΔINPC m )(1 + i ) 1 12 2 2 where Vm is the NPR reserve at the end of month m; m −1V is the NPR reserve at the end of the previous month; GPI m is the gross premium income of the policies issued during the month m; C are the claims paid during the month m; ΔINPCm is the change in the price index during the month m; and i is the technical rate of 3.5 percent real that companies need to use in pricing their product. The difference (Vm − m −1V ) = RMAm is the monthly minimum accumulation rate (rendimiento mínimo acreditable) that companies need to use to form the UPR reserve. Notice that the use of ½ for premiums and claims implies that these are uniformly distributed within the month. 19 Figure 2. Evolution and Financing of Total Assets (Real 2005 MXN mln.) 90,000 80,000 70,000 60,000 50,000 40,000 30,000 20,000 10,000 0 1997 1998 1999 2000 2001 2002 2003 2004 2005 Libilities Paid up Capital Source: CNSF. 38. Investment of technical provisions of pension annuity companies is subject to the same rules applicable to other insurance companies in Mexico. The regulatory framework for investments of technical provisions is contained in the RIRT (CNSF 2000) and Circulares S-11.1 to S-11.6, which in turn, expand on the general provisions contained in Articles 56, 57, 58, 59, 81 (Cap II, III and IV), 82 (Cap XIV), 91 and 92 of the Insurance Law (LGISMS). Such framework regulates the formation and operations of the investment committee, the list of assets that are admitted in representation (to cover) liabilities, rates for private companies’ values, currency and duration matching, custody requirements, investment administration and investment limits per issuer or security’s type. In what follows we focus on admitted assets, investment limits, liquidity requirements, custody and investment administration, inflation and duration matching rules, and credit risk limits. Admitted assets 39. According to the RIRT, assets admitted in representation of liabilities must belong to the following list (CNSF 2006a): • Securities registered in the SIC of the Mexican Stock Exchange. • Investments in equity and fixed income mutual funds with portfolios that include foreign securities issued by Central Banks or any other level of government by countries of the European Union, or countries belonging to the Technical Committee of the International Organization of Securities Commissions (IOSCO), as well as securities that are registered, authorized or regulated for general public sale by the Banking and Securities National Commission (CNBV) or the equivalent organizations of the above mentioned countries. 20 • Securities denominated in national currency issued by international financial institutions in which Mexico is a member. • Private equity investment funds in Equity Investment Societies (Sociedades de Inversión de Capitales, SINCAS), as well as in trusts whose purpose is to capitalize firms. It is important to notice that investment rules also include the following requirements: Investment limits 40. Investment limits comprise both limits, by type of instrument and by issuer, as summarized in the next two tables. Table 9. Investment Limits by Type of Security for Technical Provisions Investment type Limit (in percent) (1) Papers issued or backed by the Federal Government 100 (2) Papers issued or backed by credit institutions or international 60 financial bodies (3) Papers issued by SINCAS 1 (4) Papers issued or backed by institutions different from those in (1), 30 (2), and (3) (5) Papers issued or backed by institutions different from those in (1), 5 (2), and (3) exchange at the Mexican Stock Exchange (6) Discount and rediscount operations 5 (7) Credit with pledge bonds or papers guarantee 5 (8) Credit with mortgage guarantee 5 (9) Real state properties 25 (10) Repurchasing 30 (11) Foreign debt papers 2 Sources: RIRT and CNSF (2006b). Table 10. Investment Limits by Type of Issuer for Technical Provisions Investment type Limit (in percent) (1) Federal Government 100.0 (2) Banks or international financial bodies 18.0 (3) SINCAS 0.5 (4) Institutions different from those in (1), (2), and (3) 7.0 (5) Groups and institutions in the same economic sector (shares) 1/ 2/ 10.0 (6) Financial institution (shares) 1/ 5.0 (7) Stock and papers issued inter-related groups 18.0 (8) Foreign securities belonging to investment funds 1.0 (9) Securities registered in the SIC (Sistema Internacional de 1.0 Cotizaciones) of the Mexican Stock Exchange. Notes: 1/ Constitute standard risk for mutual insurance companies. 2/ For manufacturing, this limit can reach up to 20 percent. Source: RIRT and CNSF (2006b). 21 Liquidity requirements 41. In order for investment portfolios to maintain an adequate degree of liquidity, companies must cover short term technical reserves with equivalent assets. The determination of these short term obligations is obtained by assigning a percentage short term requirement to each type of reserve and the total must be covered with investments with maturities of a year or less or equity shares classified as highly traded. The shares of reserves that have to be invested in liquid instruments used to be based on prudent limits that varied from 100 percent for the loss reserve to 6 percent for the NPR, the contingency and the special mathematical reserves. Starting with 2006, liquidity requirements must be calculated according to the calculation derived from the asset⎯matching analysis for the pensions. 42. In addition, liquidity requirements for life operation must be calculated for each type of life insurance policies issued by companies and more specifically taking into account the proportion of technical provisions generated from short term insurance policies relatively to the proportion of technical provisions generated from long term life insurance. Custody and investment administration 43. All titles and securities referred in the regulations and issued in the country must be administered by credit institutions or securities firms, and must be kept in custody by depository institutions for securities. In the case of investments in foreign currency operated outside the country, only Mexican Financial Entities or its subsidiaries may act as intermediaries which may use, as custodians, the authorized depositary entities in the applicable jurisdiction in the foreign country. Matching rules 44. Solvency Margin Rules (Reglas para el Capital Mínimo de Garantía de las Instituciones de Seguros) were amended to include the matching of assets and liabilities for life insurance starting in January, 2006. For pension annuity companies these rules were established in 2000 and include duration, inflation and currency matching of liabilities and assets admitted in their representation. In general terms, for the annuity companies, obligations must be covered by assets same currency (indexed to the inflation) although there are specific exceptions: • Before 1999 investment rules prescribed the investment of technical reserve only in inflation indexed instruments. After 1999, companies were allowed to invest in nominal instruments with yield higher than inflation as long as they acquire derivative products to cover the inflation risk. After the year 2000 companies were allowed to invest up to 10 percent of technical reserves in foreign currency instruments issued or guaranteed by the Federal Government. • Institutions may cover obligations in foreign currency with their equivalent in local currency by means of acquiring derivative products exclusively for covering 22 exchange rate risk with authorized intermediaries and recognized markets by the central bank. Credit risk rules 45. In order to minimize the risk, all private debt securities as well as titles in investment funds used by insurance companies to cover technical reserves must have a minimum acceptable rating determined by a rating agency approved by the Banking and Securities National Commission (CNBV). 46. The following table reports the evolution of investment of technical reserves. Most of the provisions are invested in government bonds. Companies are required to fully hedge inflation and interest rate risk and only a very small currency mismatch is allowed by regulation between assets and liabilities. Since private sector issuers of inflation linked long term bonds are essentially non existent, this is done by purchasing inflation linked instruments with long maturities that are mostly issued by the Federal Government. Table 11. Investment of Technical Provisions, 1997–2005 1997 1998 1999 2000 2001 2002 2003 2004 2005 Other Inv. (percent) 1.5 1.5 4.7 4.9 6.8 7.8 10.6 15.3 11.8 Private Sec. (percent) 20.0 16.3 10.4 14.4 10.4 11.6 15.7 16.2 11.9 Government Sec. (percent) 78.5 82.2 84.9 80.7 82.8 80.6 73.7 68.5 76.3 Total (MXN mln.) /1 3,602 16,191 29,713 43,743 60,039 69,061 78,112 84,112 79,852 Note: 1/ constant prices as of December 2005. Source: CNSF. 47. The following table reports instead how the investment of technical reserves has shifted over time from nominal and foreign assets to real and domestic assets; thus considerably reducing exposure to inflation and currency risk. Table 12. Inflation and Currency Risk in Technical Provisions, 1997–2005 1997 1998 1999 2000 2001 2002 2003 2004 2005 Local nominal (percent) 36.1 40.7 14.0 4.0 5.1 4.8 0.2 0.5 0.4 Foreign nominal (percent) 3.9 1.3 1.6 2.6 2.4 2.3 2.2 3.6 0.8 Local real (percent) 60.0 58.0 84.4 93.1 92.2 92.6 97.4 94.2 91.3 Local and foreign nominal (percent 0.0 0.0 0.0 0.4 0.3 0.3 0.3 1.7 7.6 Note: 1/ with inflation rate guaranteed. Source: CNSF. 48. For accounting purposes investment portfolios can be classified in two types: (a) for sale; and (b) to hold until maturity. The first type of portfolio is used to finance operations and short term liabilities such as acquisition or operation costs and payment of benefits. Due to the short term nature of this portfolio assets are marked to market. The second type of portfolio is used to back longer term liabilities, the valuation of which is based on a constant 23 discount rate. It is natural to classify in these circumstances all reserves in at least the UPR as held to maturity. Due to the nature of this portfolio, assets are valued at maturity. On average, 90 percent of the portfolio of pension annuity companies is classified as held to maturity. Always for accounting purposes, liabilities regarding basic benefits are valued at the fixed technical interest rate defined in regulations which is currently 3.5 percent real. 49. However, in economic terms companies are required to set up asset liability management policies and hedge interest rate risk by duration matching assets with liabilities by the use of duration metrics. It was not possible to collect information on the evolution of the average duration mismatch between assets and liabilities. However, it was possible to collect information about the evolution of the average maturity of government and private sector bonds reported in the following two tables: Table 13. Average Maturity of Government Bond Portfolio (Years) 1997 1998 1999 2000 2001 2002 2003 2004 2005 y <= 1 0.00 0.00 0.38 0.39 0.52 0.23 0.18 0.27 0.26 1< y <= 5 3.42 3.09 2.96 2.43 2.24 3.83 3.03 3.32 2.48 5 < y <= 10 8.71 7.11 8.01 7.73 6.78 8.29 7.29 7.36 6.73 10 < y <= 15 12.36 12.30 12.15 11.63 10.63 13.72 13.18 12.74 12.34 y > 15 31.88 30.76 29.74 28.86 26.23 25.77 25.30 24.44 23.90 Total 6.14 7.51 6.73 13.07 14.71 16.36 14.76 14.88 14.53 Total bond portfolio 5.80 7.30 6.50 11.80 13.70 15.00 13.40 13.60 14.20 Source: CNSF. Table 14. Average Maturity of Private Sector Bond Portfolio (Years) 1997 1998 1999 2000 2001 2002 2003 2004 2005 y <= 1 0.00 0.00 0.11 0.14 0.12 0.46 0.36 0.24 0.51 1< y <= 5 3.09 3.34 2.14 3.27 4.11 3.95 3.40 2.55 1.97 5 < y <= 10 9.65 6.99 6.72 6.50 6.98 7.61 7.29 7.46 6.99 10 < y <= 15 13.59 11.80 11.94 11.04 11.93 14.33 12.65 14.05 13.79 y > 15 0.00 0.00 16.01 - 19.98 17.39 16.31 23.06 22.13 Total 3.70 6.53 2.81 5.04 5.89 5.81 4.71 6.94 11.51 Total bond portfolio 5.80 7.30 6.50 11.80 13.70 15.00 13.40 13.60 14.20 Source: CNSF. 50. Notice that average maturity of the whole bond portfolio has been increasing in the last nine years from less than six years to more than 14 years. The increase is more noticeable in the year 2000 when asset liability matching rules were introduced as part of the solvency margin calculation for annuity companies. While maturity of assets has increased, the average maturity of the liabilities, estimated with the expected longevity is of 37 years. 51. Given the maturity mismatch mentioned above, it is safe to assume also a duration mismatch between assets and liabilities and therefore, provide a preliminary assessment on the duration methodology used for measuring, monitoring and managing interest rate risk by 24 pension annuity companies. Duration (modified, or Macauly) is a good measure of sensitivity to marginal changes in interest rates of option-free bond portfolios. Duration is typically defined as the approximate percentage change in the price for a 100 basis point parallel shift in the yield curve. Pension annuity companies have large positions of Government bonds known as UDIBONOS (Bonos De Desarrollo Del Gobierno Federal Denominados En Unidades De Inversión), PICs (Pagarés de Indemnización Carretera con aval del Gobierno Federal) and CBICs (Certificados Bursátiles de Indemnización Carretera con aval del Gobierno Federal) that have maturities between seven and 28 years. These are fixed coupon non-callable bonds and therefore have no embedded options. 25 In other words, measuring the interest sensitivity of a portfolio of CBICs with duration is correct. 26 Duration is also a good measure to measure the interest rate sensitivity of the liabilities of pension annuity companies in Mexico as liability cash flows are not interest rate sensitive. 52. However, while duration is a good measure of interest rate sensitivity it is not a perfect measure. Its major limitation relates to the fact that it is a good approximation of price changes only (a) when interest rate risk stems from only parallel shifts in the yield curve; and (b) when interest rate risk stems from only small changes in interest rate. Due to these limitations, the CNSF may want to extend the metrics required by pension annuity companies to measure interest rate sensitivity. 53. A first metric used to address the second limitation mentioned above is convexity. Convexity is a second-order term that measures the change in price from the duration estimate for a small change in rates. For instance, for a positive duration instrument with no embedded options, positive convexity means that the duration extends (increases) when interest rates fall, and the duration shortens (decreases) when interest rates rise. 27 Duration and convexity would take care of the asymmetric percentage change in prices of bonds when the yield curve shifts upwards or downwards. In other words, the two metrics together can measure interest rate risk for large interest rate changes. Typically, in an ALM strategy it is required that the convexity of assets be larger than the convexity of liabilities. If this is the case, when interest rates increase, the value of assets decreases by less than the value of liabilities while when interest rates decrease, the value of assets increases by more than the value of liabilities. 25 A bond with an embedded option is generally a bond the expected cash flow of which changes when interest rates change. Typically this happens in variable coupon bonds, in bonds that can be called by the issuers or in mortgage backed bonds where there is a prepayment risk that is a function of the level of interest rates. 26 For bonds with embedded options like mortgage backed securities, variable coupon bonds or corporate callable bonds other interest rate sensitiveness measures need to be used. 27 All fixed cash-flow bonds have positive duration and positive convexity. Securities with embedded options may have regions with negative or reduced positive convexity. For example, home mortgages can have negative convexity as rates lower and increase the likelihood of prepayments, resulting in lower duration as rates fall, and convexity may turn positive from lower likelihood of prepayment or extension resulting in greater duration as rates rise. 25 54. A second metric commonly used to address the first limitation mentioned above are key rate or partial duration. Hardly does the yield curve shifts in parallel. More often the curve twists (it becomes flatter or steeper) or changes in curvature (butterfly shifts). Key rate duration, or partial duration, measure the local sensitivity to a shift in just a portion of the yield curve. Key rate duration or partial duration are useful metrics when one wishes to measure a portfolio's sensitivity portfolio to movement in various parts of the yield curve. 28 By matching partial durations of asset and liability portfolios it is possible to obtain a substantial degree of protection against nonparallel shifts in the yield curve. In addition, key rate shifts are constructed so that their sum equals a parallel shift and thus the sum of key rate durations is equal to effective duration for fixed cash flow instruments. 29 55. Finally, while requiring companies to be fully duration matched aims at immunizing assets and liabilities, this may not be consistent with other company policies such as surplus management policies or yield enhancement policies. For instance, companies may be interested in immunizing the surplus from changes in interest rate and therefore they would match assets and liabilities in terms of dollar duration, rather than simpler duration. 56. Alternatively companies may want to adopt yield enhancing tactics by having shorter asset duration if they believe interest rates will be increasing. The considerations just made are purely tactical and provide an argument for allowing companies to maximize their competitive advantage. This does not mean that other measures should not be preferred from the supervisory point of view. However, they constitute a valid argument for supervisory authorities for using a diversity of risk metrics for prudential rules. E. Market Performance 57. Company performance is determined by jointly underwriting and reserve investment performance. In this section we discuss separately underwriting and investment performance and their impact on solvency of pension annuity companies. Underwriting performance 58. Underwriting performance is usually measured by four basic ratios: the loss ratio (LR), the operational expense ratio (OR), the underwriting expense ratio (UR), and the combined ratio (CR). The LR measures net accrued claims as a proportion of net earned premiums, i.e., gross claims paid less claim provisions at the beginning of the year plus claim provisions at the end of the year less the receipt from reinsurers over gross premiums received less premiums ceded (net or retained premiums) less premium provisions at the end 28 Key rate and partial durations are essentially the same concept. The only difference is that key rate durations are calculated by shocking the spot rate curve while partial durations are calculated by shocking the yield curve. 29 See Ho (1992), Reitano (1992), Fabozzi and Fong (1994), and Dettatreya and Fabozzi (1995) for various alternative metrics that follow the approach just described. 26 of the year plus premium provisions at the beginning of the year. It shows the percentage of premiums that are paid back to the insured and a high ratio normally indicates an efficient and competitive industry while a low ratio would indicate relative inefficiency. Notice that since payments for claims are spread in the pension annuity market over a number of years, insurance companies make transfers to loss reserves to cover future payments. Differences in reserving policies for tax and other purposes reduce the usefulness of the loss ratio as an index of efficiency. Hence, an index average over two or more years is often taken. The OR is computed as general administrative expenses (wages and other labor costs, rental and other utilities), plus marketing and other support services like IT and legal services as a proportion of gross premium income. The UR is computed as general underwriting expenses like net commissions paid (i.e., commissions paid to agents less commissions received from reinsurers) as a proportion of gross premiums and in the case of pension annuity providers in Mexico, premiums for the purchase of additional benefits need to be added. Gross premium is used as the basis for calculating the OR and the UR because acquisition costs and general administrative costs are incurred for the generation of gross premiums, and not just retained premiums. The CR is simply the sum of the three rations just mentioned. Notice that it is common practice worldwide to sum indices with different denominators, despite this being mathematically incorrect, as the LR typically represents more than 90 percent of the CR. In other words, the possible distortion introduced by this practice can be easily ignored. 59. Figure 3 reports the evolution of the average underwriting performance between 1997 and 2005 for the Mexican pension annuity market. Underwriting performance displays a similar pattern of progressive deterioration we are now familiar with other variables. Average loss ratios in 1997 exceeded 140 percent due to the fact that many companies were trying to establish a reputation in the annuity market and gain market shares by offering very generous additional benefits. After this initial year underwriting performance has always been positive but progressively deteriorating until 2002 when it exceeded 100. The general trend in increasing underwriting and operational costs is due to the decrease in gross premium income since 2002 and the need to invest in a more qualified and professional sales force. In an environment of decreasing investment performance (see later) companies could not afford to compete on the basis of generous additional benefits anymore. In other words, substantial training and expanded sales forces were needed to attract new customers. This is particular evident in 2003 when companies realized that the growth of new business was going to be lower than expected and needed to adapt to the less profitable environment by improving their distribution channels. 27 Figure 3. Evolution of Average Underwriting Performance 160 140 120 100 80 60 40 20 - 1997 1998 1999 2000 2001 2002 2003 2004 2005 LR OR UR Source: CNSF 60. It is important to notice how the worsening underwriting performance of pension annuity companies in Mexico is not due to inefficiencies. The real reason for the worsening underwriting performance since 2002 is the drastic fall in gross premium income (the reasons for which are discussed in detail in Section IV) and the delayed cost structure adjustments that companies have introduced. The next table reports the evolution of gross premium income and underwriting costs divided in pure underwriting costs and costs related to premiums for additional benefits. It essentially reports the UR data showed in the previous figure. Table 15. Evolution of Average Underwriting Costs, MXN Million, 2001–2005 2001 Percent 2002 Percent 2003 Percent 2004 Percent 2005 Percent GPI 16,640.59 10,261.26 3,501.71 5,224.7 4,504.33 Pure 403.90 2.4 288.70 2.8 173.96 5.0 162.5 3.1 203.26 4.5 Underwriting Additional 1,178.58 7.1 695.98 6.8 332.21 9.5 156.14 3.0 177.67 3.9 Benefits Total 1,152.48 9.5 984.68 9.6 506.18 14.5 318.64 6.1 380.93 8.5 Underwriting Note: 1/ Real 2005 pesos. Source: CNSF. 61. The sudden increase in the underwriting expense ratio (the same could be said as far as operational expenses, not reported in the table, are concerned) in 2003 was due to the sudden drop in premiums from 2002 onwards that was only partially offset by the decrease in underwriting costs over the same period. Gross premium income in 2003 was 34 percent of gross premium income of 2002. Pure underwriting costs (agent fees) in 2003 were only 28 60 percent of the value of 2002 while premiums for additional benefits decreased in 2003 to 48 percent the values of 2002. In other words, companies were rather quick to adjust the generosity of additional benefits but not as quick in adjusting the commission levels paid to agents. Such adjustments took place only between 2004 and 2005 that brought the overall underwriting expense ratio to 8.5 percent, a level lower than in 2001. Investment performance 62. The problem of combined ratios is that they are frequently negative (or equivalently, above 100 percent as shown in). In other words, they are not very informative of the profitability of a company if not analyzed in conjunction with the investment performance. As a way of example, the following table reports a summary analysis of profitability of non- life markets in select industrialized countries. Notice how the combined ratio is almost constantly above 100 percent, meaning that markets are profitable only with good investment performance. Table 16. Evolution of Average Non-Life Loss Ratios in Select Countries (In Percent) USA CAN GBR DEU FRA JPN ‘94 – ‘04 ‘94 – ‘04 ‘94 – ‘04 ‘94 – ‘04 ‘95 – ‘04 ’96 – ‘04 Loss ratio 78.7 73.3 73.0 71.3 80.8 61.2 Expense ratio /1 26.4 29.8 31.2 27.5 23.3 38.1 Policy holder dividend ratio 1.1 n.a. n.a. n.a. 1.1 0.1 Combined ratio 106.2 103.1 104.2 99.9 105.2 99.4 Investment performance 16.2 13.8 16.8 15.4 13.4 4.7 Profit margin (pre tax) 9.2 10.4 12.8 12.7 7.0 4.4 Note: 1/ This is comparable to underwriting expense and operational expense ratios for the Mexican pension annuity industry. Source: Holzeu Lechner (2006). 63. Hence, the final element of a company performance is given by the rate of return that can be generated from reserves. As previously mentioned, pension annuity companies invest reserves in Government debt. With increased fiscal discipline, sovereign risk and inflation pressure decreased considerably. The next figure reports the evolution of inflation and sovereign risk for Mexico. This is measured by the JP Morgan EMBI+; i.e., the interest rate difference between Mexico and U.S. Treasury Bills. As of November 22 2005, this was at historical lows of 112 basis points. 29 Figure 4. Evolution of Sovereign Risk and Inflation Source: CNSF. 64. The improved macroeconomic environment enabled the central bank to decrease interest rates and the next figure reports the evolution of companies’ financial results and reference interest rates such as the rate of Cetes 30 and CPP 31 . Given the exposure to interest rate sensitive instruments, the investment performance of annuity companies has deteriorates as shown in the next figure. After reaching a record investment return performance of 20 percent nominal in 1998, average nominal rates over the 2002 and 2005 period have decreased to 6.1 percent. 65. Pension annuity companies have large positions of Government bonds known as UDIBONOS (Bonos De Desarrollo Del Gobierno Federal Denominados En Unidades De Inversión), PICs (Pagarés de Indemnización Carretera con aval del Gobierno Federal) and CBICs (Certificados Bursátiles de Indemnización Carretera con aval del Gobierno Federal). The long term real interest rate, in the case of 10 yr Udibonos have passed from 7.14 percent in October 1999 to 4.30 in December 2005 and to 5.09 percent in June 2006; in the case of PICs the long term real interest rates have passed from around 6.13 percent in October 2001 to around 5.94 percent in November 2002 and in the case of 20 and 30 yr CBICs the long term real interest rates decreased from 6.16 and 6.21 percent in January 2003 to 4.59 and 4.68 percent in December 2005, in that order. 30 CETES (Treasury Certificates) Zero coupon bills denominated in pesos issued by the Mexican Government. CETES are the Mexican counterparts of U.S. Treasury bills. 31 CPP (Commercial Bank's Average Cost of Term Deposits) covers term deposits, certificate of deposits, other current account deposits (other than demand deposits), banker's acceptances and commercial paper with bank guarantee. 30 Figure 5. Evolution of Investment Performance and Key Interest Rates 30 25 20 15 10 5 0 1997 1998 1999 2000 2001 2002 2003 2004 2005 Average investment return Cetes CPP Source: CNSF 66. Clearly, especially for new business, the decrease in yield on fixed income paper is lowering the profit margins of the pension annuity sector. However, this has so far not translated in lowered solvency margins as discussed in the next section. Solvency 67. Beside the technical provisions that companies must constitute in order to meet obligations arising form contracts with policyholders, solvency rules contained in the LGISMS require companies to establish a Minimum Guarantee Capital (Capital Mínimo de Garantía, CMG). The CMG is used to face possible deviations as a result of variations from expected claims, the breakdown in payments due to insolvent reinsurers, and adverse fluctuations in asset valuation as well as mismatches between assets and liabilities. In this respect the CMG requirements seek to strengthen the financial solvency and viability of institutions as a function of their volume of operations as well as the type or risks underwritten. 68. CNSF (2006b) contains a detailed description of the solvency rules applying to all insurance companies in Mexico. It is interesting to notice that, the methodology for the estimation of the CMG also incorporates a requirement to cover possible losses resulting from the exposure to credit, inflation and interest rate risk in the investment of technical provisions. In order to do this, the CNSF establishes a system of asset liability matching that includes weights to measure the impact that eventual mismatches would have on capital. The weighing system is a function of the availability of investment instruments of different 31 maturities in the market and it depends among other things on the volume and frequency of issues in the primary market, availability and liquidity on the secondary market. 69. Table 17 reports the weighting system provided by the CNSF to the industry to weigh eventual mismatches between assets and liabilities in the calculations of the CMG as of March 2006. The weighting system is regularly updated by the CNSF and communicated to the industry when the situation in the financial market requires it. Notice that the weighting system decreases with time reflecting the lack progressive unavailability of longer-term instruments. Table 17 Weighting System for Asset Liability Mismatches Year of Projection Wk k <= 5 1 5 < k <= 6 0.96 6 < k <= 7 0.94 7 < k <= 8 0.85 8 < k <= 9 0.78 9 < k <= 12 0.51 12 < k <= 14 0.46 14 < k <= 15 0.42 15 < k <= 17 0.37 17 < k <= 18 0.30 18 < k <= 19 0.25 19 < k <= 20 0.24 20 < k <= 21 0.23 21 < k <= 23 0.20 23 < k <= 24 0.19 24 < k <= 25 0.17 25 < k <= 27 0.13 27 < k <= 28 0.08 28 < k <= 29 0.02 29 < k <= 30 0.01 k > 30 0.00 Source: CNSF. 70. Ideally, all weight should be equal to one and if this were the case, the CNSF estimates that companies would need to set aside an extra amount of capital equivalent to 25 percent of current technical provisions (or MXN 18,410 million). The methodology used to calculate additional capital requirements in the presence of asset liability mismatches appears to follow a regulatory maturity gap approach to asset liability management. It is not clear how this complements or substitutes the economic duration approach that companies need to follow when measuring and monitoring risks. For instance, no reference was found in regulations on the impact that such economic ALM framework based on duration metrics has 32 on capital. Besides, a maturity gap analysis that by regulation puts zero, or tending to zero, weights on maturity mismatch on long term maturities may underestimate the interest rate risk stemming from yield curve movements in the same region; i.e., there may be a need to complement this with an economic maturity gap analysis that uses unit weights at all maturities. In any case, maturity gap analysis (weighted, like in Mexico, or not weighted, as generally used) is a marked improvement on any ALM framework observed in all jurisdictions in the region, and clearly a vast improvement on ad hoc fixed paid up capital rules. However, it is no substitute of a full fledged ALM framework for ongoing monitoring and controlling the various types of risks that stem from the asset and liability side of the balance sheet. 71. As a result of the underwriting and investment performance of pension annuity companies over the last nine years, as well as the specific structure of assets and liabilities that obviously affect the solvency margin, the regulatory solvency position of pension annuity providers (measured in terms of MXN in excess of the required CMG) and other performance indicators like ROE and ROA have improved over time as reported in the next table. Table 18. Pension Annuities Solvency and Profitability Indicators (1997–2005) 1997 1998 1999 2000 2001 2002 2003 2004 2005 Solvency Margin (MXN million) 667.2 292.5 811.3 862.0 570.8 829.1 2,176.8 1,761.2 2,927.5 ROE (percent) -8 -29.2 -20.2 -19.8 -6.4 15.6 22.5 26.1 24.3 ROA (percent) -2.9 -3 -1.2 -0.9 -0.3 0.7 2.9 4.0 1.9 Source: CNSF. 72. There is a seeming contradiction between, on the one hand, the sudden decrease in premiums since 2002, the worsening of the underwriting profitability and the decrease in investment yield and, on the other hand, the improvement over time in the solvency margin. One possible explanation for this is that the size of assets corresponding to the more important portfolio of business (in relative terms) is still growing quickly enough to compensate for the other negative trends mentioned before related especially to the reduced new business. Another possible explanation is that companies are still obtaining high levels of ROE and ROA for assets invested at higher yields in the past. Alternatively, it is possible that the worsening of the underwriting performance, together with lower long term yield on fixed income paper has indeed translated in lower economic solvency margins for the industry in the medium term. However, this is not disclosed by the regulatory solvency margin due to its low weights on long term mismatches between assets and liabilities. The adoption of other forms of solvency margins based on economic capital, at least for 33 prudential purposes, would enable the CNSF to better monitor the economic solvency of the industry and take eventual appropriate remedial actions. 32 IV. DEVELOPMENT PROSPECTS FOR THE PENSION ANNUITY MARKET 73. In the previous section two distinct periods were identified in the evolution of key variables and performance of the pension annuity market in Mexico. Between 1997 and 2002 the annuity market witnessed rapid growth while starting with 2002, the volume of gross premium income drastically dropped. In this section we shed light on the reasons for such change in market growth. 74. Disability pension benefits provided for under the LSS-73 were based on the nominal average base salary of the last 500 weeks of contributions. Art 167 of the LSS-73 defined the methodology for calculating such benefits linking them to the individual’s years of contributions according to a table published in the same article. Benefits were originally indexed to the minimum salary in the Federal District. In addition to the disability pension, insured members were eligible for pension increments on the basis of family allowances and other forms of social assistance. 75. With the 1997 reform, the new IV benefit is defined as 35 percent of the average individual base salary during the last 500 weeks of contribution and indexed to the INPC. Minimum IV pension under the new rules is defined as the minimum salary in the Federal District as of July 1, 1997 which is itself indexed to the INPC. Similarly to the provisions of LSS-73, insured members are eligible for IV pension increments on the basis of family allowances and other social assistance. The IV benefits provided for under LSS-97 were designed to be on average more generous than the disability benefit provided for under LSS-73. Also, with the reform, IV immediate premium annuities were going to be purchased by the IMSS, with the accumulated reserve stemming from a 2.5 percent contribution rate, from private sector specialized pension annuity providers. 32 Notice, that the CNSF has completed and implemented a dynamic solvency model, an important step toward the adoption of statutory solvency rules envisioned within the Solvency II framework. The model uses historical data to construct claim distributions for different lines of business. It allows the CNSF to calculate the probability of capital shortages of each insurance company by stressing variables that affect its underwriting and overall profit. The output of this exercise guides conversations with the industry to monitor the solvency situation and the adequacy capital requirements and technical reserves. Two issues related to this dynamic model are worth mentioning here. The model is not yet a true dynamic ALM where assets and liabilities are modeled jointly. At present asset risk is modeled only through the use of VaR techniques and separately from liabilities. Also, the model does not exploit possible correlation among the liability distributions of different lines of business and each claim distribution is treated as independent from the others. As far as the first issue is concerned, the CNSF is working towards a more general model that integrates assets and liabilities. As far as the second issue is concerned, the CNSF argues that little correlation exists in practice among claim distributions of different lines of business. While such property of the model would be desirable, it would provide only marginal value added. (See CNSF 2006e) 34 76. The structure of the new pension system allowed to promote the development of a private sector annuity market before new entrants into the labor force started retiring and demanding old age pensions. 33 77. Such rationale was also followed by Chile that experienced a rapid growth of the annuity market and currently has a very competitive annuity market providing very good annuity values to retirees (Section III. B). Countries that have introduced a second, private pillar as part of their pension reform, and that have shifted disability and survivorship insurance to the new pillar, either partly or totally, may also experience this rapid growth effect. Some reforming countries in Central and Eastern Europe have decided to maintain disability insurance in the first, public pillar, because of concerns about the capacity of the insurance industry to deliver this benefit efficiently, and because of the perception that disability and other programs such as health and sick pay can only be well integrated in the public sector. These concerns may be legitimate and may justify keeping disability in the first pillar in several countries. However, this policy will also imply a slower growth of the annuities market. 78. Since 1997, several reforms were implemented that altered the philosophy underpinning the provision of IV benefits after the 1997 reform. In 2001, the indexation base of pension benefits provided for under LSS-73 was changed from the minimum salary in the Federal District to the INPC. Since, average wage growth after the 1997 reform has been lower than inflation this reform increased the generosity of the 1973 benefits relatively to the 1997 benefits. 34 In 2002, a second reform of the LSS-97 was passed allowing individuals who retired under the provision of LSS-73 to withdraw as a lump sum the balance of the 2 percent accumulate contributions for old age pension in the RCV subaccount. 35 The permission to withdraw the accumulated balance from the old age contribution in the RCV accounts increased the generosity of the pension provisions under LSS-73 relatively to the now reformed provisions under LSS-97. In addition, the IMSS was given the authority to interpret the provisions under the LSS-97 and it extended the option of electing benefits under LSS-73 also to IV benefits. 79. After the 2002 reform, known as the SAR-02 reform, insured members could then choose between two types of disability benefits as summarized in the following table. 33 It is worth re-calling at this point that the so called “transitional cohort,” i.e., individuals with at least one contribution at the time of the 1997 reform, is allowed to opt for the old age pension provided for under LSS-73. 34 Wage inflation is traditionally higher than price inflation over long period of times. Clearly, the statement is valid only with respect to the specific period of time mentioned. 35 This refers to the accumulated balance of the 2 percent contribution after 1997 in the RCV sub-account. (see first line, third column in Table 1) Notice that the SAR-97 reform had already allowed individuals opting for benefits provided for under LSS-73 to withdraw as a lump sum the accumulated balance between 1992 and 1997 in the SAR-92 account (see first line, second column in Table 1. 35 Table 19. Disability Benefits Under LSS-73 and LSS-97 LSS-73 LSS-97 Salary base Average of last 500 weeks of Average of last 500 weeks of contributions not indexed contributions indexed to the INPC Basic pension Following table in Art 167 of 35 percent of salary base LSS-73. Minimum pension Minimum salary of the Federal Minimum salary of the Federal District at the time of pension. District as of July 1997 indexed (MXN 1,402 as of July 2004) to INPC (MXN 1,551 as of July 2004). Pension indexation INPC (As per reform of 2001) INPC SAR-92 (92-97) account Balance payable in the form of SAR 92-97 balance payable in lump sum the form of lump sum Old age cash balance in RCV Balance payable in the form of Not applicable subaccount lump sum (As per reform of 2002) Source: Fernandez Reyes (2004). 80. The increased relative generosity of the 1973 provisions and the fact that the IMSS granted the option of electing IV benefits under such provisions and opted for tightened eligibility and disability rules, changed the growth prospects of the market and premium growth decreased in the years since 2002 relative to previous years as shown in the next figure. 81. The only thing left to be explained now is why insured individuals would stop electing disability benefits under the LSS-97 provisions when, on average, these were designed to be more generous than the disability benefits provided under LSS-73, as mentioned before. The following table compares the disability pension that an insured individual would obtain under the provisions of LSS-73 and LSS-97. In order to compare the heterogeneous benefits under the two laws, the old age balance payable in the form of a lump sum from the RCV subaccount when individual elect the LSS-73 was transformed in IV annuity and added to the basic pension the individual would be entitled. Table 120. Monthly Disability Benefit Comparison Under 1973 and 1997 Laws (MXN ) 1973 Law 1997 Law Years of contributions Average salary 5 10 15 20 25 1,500 1,409 1,418 1,431 1,449 1,476 1,551 3,000 1,415 1,433 1,459 1,750 2,066 1,551 4,500 1,422 1,449 1,709 2,236 2,786 1,575 6,000 1,428 1,464 1,902 2,666 3,462 2,100 7,500 1,434 1,480 2,157 3,149 4,180 2,625 9,000 1,441 1,495 2,443 3,656 4,917 3,150 10,500 1,447 1,511 2,850 4,266 5,736 3,675 12,000 1,611 1,684 3,257 4,875 6,556 4,200 13,500 1,802 1,894 3,665 5,485 7,375 4,725 Source: Fernandez Reyes (2004). 36 82. The comparison exercise reported in the previous table suggests that on average, the large majority of individuals (the shaded area) would prefer the benefits under the LSS-97. Only individuals with more than 15 years of contributions and more than twice the minimum salary (the average salary in Mexico is between four and five times the minimum salary) would prefer benefits under the LSS-73 the relative generosity of which was increased by the 2001 and 2002 reforms. 83. Several reasons can be attributed to the seeming irrational behavior of insured individuals that caused the annualized average decrease of 28 percent in premium since 2001 displayed in Figure 6. Figure 6. Impact of SAR-02 Reform on IV Premium Growth 18,000 500 16,000 400 14,000 12,000 300 10,000 200 8,000 6,000 100 4,000 0 2,000 - -100 1997 1998 1999 2000 2001 2002 2003 2004 2005 Premiums (lhs) Growth (%) (rhs) Source: CNSF 84. The IMSS may not be informing the insured individuals about the available options of IV benefits. A casual interpretation of Article IV of the transition provisions of LSS-97 (and IMSS’ position) would indicate that the IMSS is not required to compare benefits under the two laws unless insured people require the institute to do so. Unfortunately, the LSS-97 is badly written in several articles and this case is not an exception. Clearly, only jurisprudence can establish the correct interpretation of the specific article before mentioned. 85. In addition, the IMSS is recently making increased use of temporary disability pensions. Eligibility rules for disability benefits were tightened in 2004 and the IMSS is supporting a policy of rehabilitation before declaring individuals invalid. Temporary disability pensions are provided by the IMSS for two years and renewable indefinitely. This has had two major consequences: (a) the number of potential annuitants in the private sector is further reduced; and (b) the pool of annuitants that is covered by pension annuity providers is deteriorating. 37 86. The decrease in the long term interest rate and the lower number of new annuitants are reducing profit margins of annuity companies not least because during the early years of marketing of a new product, companies tend to underprice in an effort to gain market share. 36 The lower profitability of the initial products is recuperated through the yield on income paper and the business growth. We have produced in this paper evidence of average deterioration of underwriting performance. Hence, IMSS’ behavior has reduced the opportunity of higher profits for insurance companies by reducing the scope for business growth. 87. The deterioration of the pool of annuitants also impacts profitability. Insurance companies make money by pooling different types together and charging a price that on average is neither too high nor too low: i.e., a price that on average generates reasonable profits. Within the pool, stochastic variations across types are averaged out and the money lost by insuring an individual who ex post lives (say) longer than what ex ante expected is recuperated by insuring an individual who ex post lives less than what ex ante expected. To the extent that the ex post variation in outcomes is only due to stochastic elements, the pool is said to be stable and insurance companies can profitably insure individuals. IMSS’ behavior has introduced a systemic element in the pool of annuitants. The use of temporary pensions delays entry of disabled individual in the pool. Since seriously disabled individuals tend to die early, the delayed entry in the pool implies that, on average, individuals insured by private sector companies tend to live longer than expected. In other words, even if we assume that the initial technical parameters that the regulations require companies to use were correct, they are likely to result in a non profitable, or less profitable product once delayed entry is taken into consideration. 88. But why would the IMSS encourage individuals to elect benefits under the LSS-73 law even if this is against their interest? In order to explain this, it is necessary to analyze the possible states of the world for an individual in the transition cohort (i.e., who has the option to elect IV benefits under the two laws) who is declared invalid by the IMSS and determine the payoffs for the Federal Government, the IMSS and the insured individual in all these states. This is done with the aide of the next table. 89. The simplest case is when the individual elects benefits under LSS-73. This is described in the last column of the next table (Case E). Independently of whether the base pension (PB) calculated with the use of Art 167 of LSS-73 is higher than the minimum pension guarantee (PMG) the individual withdraws the cash balance in the SAR-92 account and the old age cash balance in the RCV subaccount. The rest of the cash balances in the housing and RCV subaccounts are collected by the Federal Government that will grant the annuity or the minimum pension (if the base pension is lower than the minimum pension 36 In the Mexican case “underpricing” appears to have taken place through the offer of generous additional benefits to those defined in the LSS-97. 38 guarantee). In both cases, the IMSS is not required to transfer to the Federal Government the portion of the reserve accumulated by the 2.5 percent contribution of the insured individual declared invalid. Table 21. Choice of IV Benefits Under LSS-73 and LSS-97 For Transitional Cohort LSS-97 LSS-73 CB>MC CBPMG - IMSS buys PB - IMSS buys PB - Insured collects SAR-92. - Insured collects SAR-92. - IMSS collects CB in housing - IMSS collects CB in housing Case E. and RCV subaccounts and RCV sub-accounts. - IMSS retains the difference - IMSS complements the - Fed Gov pays BP or PMG. with the MC. difference with the MC. - IMSS' reserve is untouched Case C. Case D. - Insured collects cash balance in SAR-92 and old age in RCV PB