Pension Funds and Insurance Companies: Challenges and Lessons

1. Pension Funds and Insurance Companies:Challenges and Lessons Dimitri Vittas Senior Adviser World Bank December 2003

2. Pension Funds and Insurance Companies • NBFIs are a mixed bag of institutions. • Pension funds and insurance companies are the most important: • in terms of mobilization of long-term resources • potential impact on capital market development • acting as countervailing force to commercial banks. • They can help finance factoring and leasing companies and also promote housing finance and equity and debt market development.

3. Development and Regulatory Challenges • They take a long time to develop. • Magic of contractual saving and interest compounding. • They start slow but they build large assets over time. • Their success depends on stable macroeconomic policies, low inflation, fiscal balance. • They require prudent management and the offer of affordable benefits. • They require stable banking system, robust regulatory framework and effective supervision.

4. Private versus Public Management • Public sector ownership has caused poor performance in many developing countries. • Pervasive controls on insurance companies, covering premiums, investments, benefits, and reinsurance, have impeded the emergence of strong, efficient and well capitalized companies. • Public management of the assets of pension and provident funds, including social security institutions, has produced highly negative real returns. • Use of contractual savings as a captive source of funding large government deficits.

5. Reform Agenda in Africa • Downsize public pillar. • Improve assets management of public pension funds by building strong fund governance. • Appoint executive board of trustees with clear mandate and safeguards against political interference. • Create room for private pension funds and promote private sector presence in insurance sector. • Eliminate captivity of contractual savings, encourage modern efficient assets management, and allow investment overseas. • Build robust regulatory and supervisory capacity.

6. Build Efficient Institutions • The key to the success of the reform agenda is the building of efficient institutions. • Pension systems and insurance business are highly complex. They cover long-term contracts and are faced with considerable risk and uncertainty. They need to be based on public trust. • Building efficient institutions that are able to adapt and respond to emerging new challenges is very important. • Mauritius offers a very good example of the dynamic and durable benefits of building efficient institutions in both pensions and insurance.

7. Mauritius Pension System • Multi-pillar structure. Both public and private. • Basic Retirement Pensions. • National Pension Funds. • National Saving Funds. • Occupational Pension Funds. • Life Insurance Companies. • Housing Assets. • The system is generally well developed and managed.

8. Large Contractual Savings • Large accumulation of financial assets. • NPF 17% of GDP. • NSF 2%. • Insurance companies 18%. • Occupational pension funds 11%. • Total 48% of GDP. However, double counting of 7%. • Net assets: 54 billion MUR or 41% of GDP. • Large potential impact on financial sector development, economic growth and security of long-term benefits.

9. Basic Retirement Pension • Offers 20% of average wage to all elderly (more to the very old). • Current cost is low at 3% of GDP, but on unchanged policies likely to grow in the future and reach 6% in 2020 and 11% in 2050. • Need to contain its future costs because of aging. • Gradually raise retirement age. • Offer means-tested benefits, either affluence test (exclude those above specified level) or subsistence test (include only those below) or a combination of tests with gradual claw backs.

10. National Pensions Fund • Well run system: high coverage (60%); low contribution rate (9%); low operating costs (39 bp); high returns (11.72%) in 2001. • But based on opaque points system. • And failure to attain promised replacement rate of 33.3%. • Possible move to NDC scheme. • Appoint independent Board of Trustees and encourage professional assets management.

11. Occupational Pension Funds • Several types and many schemes. Total coverage between 80,000 and 100,000 employees. • Schemes for civil servants and employees of local government. • Over 100 schemes for employees of statutory bodies. • Over 1000 schemes for employees of private sector firms. • Need to reform civil service schemes but private funds well managed.

12. Performance of Occupational Pension Funds • Good overall performance with some exceptions. • Generous benefits raising questions about long-term affordability. • High assets diversification but underweight in government bonds and corporate debentures. Illiquid investments in equities and real estates. Large role in housing loans to members. • Low costs and high returns.

13. Regulation and Supervision of OPFs • Reasonable rules on vesting and portability. • Compliance of sponsors with actuarial and accounting standards, especially MAS 25 (IAS 19). • Though no requirement to hire qualified auditors and publish audited accounts. • Fragmented regulatory framework. • Lack of supervision and transparency.

14. Need for New Regulatory Framework • Consolidate legal framework into new, modern act. • Emphasize: • fund governance; • appropriate funding levels; • rules on vesting and portability; • assets segregation and safe custody; • assets diversification (with limits on self-investment); • market valuations; • actuarial, accounting and auditing standards; and • “whistle blowing” duties.

15. Need for Effective Supervision • Strengthen supervision under FSC. • Improve transparency, require quarterly financial reporting in electronic form. • Protect workers’ rights. • Reform NPF. Bring under FSC. • Provide choice to employers and employees.

16. Development of Insurance Sector • Free from pervasive premiums, products , investments & reinsurance controls. • Reliance on solvency monitoring. • Use of international accounting & actuarial standards. • General insurance makes good use of reinsurance. • Motor insurance largest branch in general business. • Reasonable loss ratios and claims settlement. • Life insurance is well developed, benefiting from tax incentives as well as pension funds and housing finance.

17. Investments of Insurance Companies • Diversified portfolio. • Underweight in government bonds but strong presence in housing loans and corporate bonds and equities. • Strong demand for long duration assets to cope with reinvestment risk. • Limited investments overseas despite high ceiling.

18. Insurance Regulation and Supervision • Marked improvement in recent years. • Need for greater emphasis on risk-based supervision and risk management. • Most companies are well managed but some small companies appear weak with low earnings, high costs and slow claims processing. • Need to develop early warning systems and regulatory ladders to take early action against weak companies. • Growing reliance on actuaries and auditors to identify problems.

19. Main Lessons for Africa • Development of strong contractual savings sector is feasible in a small economy. • Need for economic and political stability. • Respect of property rights. • Good mix of public and private provisions. • Robust regulatory framework and effective supervision. • Focus on building efficient institutions that are able to respond to emerging challenges in a dynamic environment.

20. Implications for Capital Markets • Develop long-term government bonds. • Avoid roll over risk and offer long duration assets to institutional investors. • Promote transparency of securities markets and efficient trading, clearing and settlement facilities. • Support financing of housing through direct loans, mortgage bonds or mortgage securitization. • Develop professional expertise in accounting and auditing, actuarial science, assets management and other areas.