Pension Funds and Insurance Companies:Challenges and Lessons

Dimitri Vittas

Senior Adviser

World Bank

December 2003

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.

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.

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.

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.

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.

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.

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.

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.

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.

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.

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.

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.

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.

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.

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.

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.

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.

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.

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.