THE CHILEAN ANNUITIES MARKET

Marco Morales, Roberto Rocha, Marco Morales, Roberto Rocha,

and Craig Thorburnand Craig Thorburn

Santiago, ChileSantiago, Chile

March 29March 29--30, 200630, 2006

Introduction

Annuities market analysis usually focused Annuities market analysis usually focused on few countries (US, UK, Australia) and on few countries (US, UK, Australia) and issues (adverse selection, thinness of issues (adverse selection, thinness of markets)markets)

Lack of sufficient analysis about Lack of sufficient analysis about determinants of performance (determinants of performance (MWRsMWRs, , annuity rate), especially in other countriesannuity rate), especially in other countries

Lack of sufficient analysis on regulatory Lack of sufficient analysis on regulatory issues, alternative institutional settings issues, alternative institutional settings

Introduction

The Chilean market is an interesting case to The Chilean market is an interesting case to study the development of markets for study the development of markets for annuities and annuities and PWsPWs, after its pension reform , after its pension reform of 1981of 1981

The large size of the market, and access to The large size of the market, and access to data due to strict disclosure rules, allows for data due to strict disclosure rules, allows for a more ina more in--depth examination of the depth examination of the performance of the annuities marketperformance of the annuities market

AN OVERVIEW OF THE CHILEAN MARKET: Growth

Insurance Premia: Total, Life, Non-Life, and Annuities(in % of GDP), 1990-2004

0.0%0.5%1.0%

1.5%2.0%2.5%3.0%

3.5%4.0%4.5%

1990 1992 1994 1996 1998 2000 2002 2004

Total Premia Life Premia Annuities Premia

AN OVERVIEW OF THE CHILEAN MARKET: Growth

Pension and Insurance Assets (% of GDP), 1990-2004

0

10

20

30

40

50

60

70

1990 1992 1994 1996 1998 2000 2002 2004

Pen

sion

and

Ins

uran

ce A

sset

s

0

5

10

15

20

25

30

35

40

Rat

io I

nsur

ance

/Pen

sion

s

Pension Funds Insurance Companies Insurance/Pension Assets

Chile Latin America

High Income OECD

Insurance Premium

4.6 2.2 7.9

Life 3.5 0.7 4.6

Annuities1.9 - -

PWs 0.5 - -

Other 1.1 - -

Non-Life 1.1 1.5 3.3

Insurance Premiums in Chile and Other Regions

AN OVERVIEW OF THE CHILEAN MARKET: Types of Pensioners

Year Total Normal Old Age Early Retirement Disability + Survivors

Number % of Total Number % of Total Number % of Total

1985 7,609 2,647 34.8% - 0.0% 4,962 65.2%

1990 57,119 23,876 41.8% 5,790 10.1% 27,453 48.1%

1995 190,400 55,591 29.2% 69,537 36.5% 65,272 34.3%

2000 343,965 93,152 27.1% 132,221 38.4% 118,592 34.5%

2004 520,793 133,343 25.6% 220,929 42.4% 166,521 32.0%

AN OVERVIEW OF THE CHILEAN MARKET: Menu of Products

LumpLump--sumssumsAccess conditions very restrictiveAccess conditions very restrictive

Phased Withdrawals (PWs)Phased Withdrawals (PWs)Regulated formula based on life expectancyRegulated formula based on life expectancyProvided by AFPsProvided by AFPs

AnnuitiesAnnuitiesFreely priced, but fixed, indexed, joint for marriedFreely priced, but fixed, indexed, joint for marriedProvided by Provided by LICOsLICOs

Temporary WithdrawalsTemporary WithdrawalsWithdrawal with deferred annuityWithdrawal with deferred annuityProvided by Provided by AFPsAFPs and and LICOsLICOs

AN OVERVIEW OF THE CHILEAN MARKET: Demand for Retirement Products

Year Total PWs TWs Annuities

Number % of Total Number % of Total Number % of Total

1985 7,609 7,373 96.8% - 0.0% 236 3.2%

1990 57,119 36,696 64.2% 148 0.3% 20,275 35.5%

1995 190,400 98,699 51.8% 6,803 3.6% 84,898 44.6%

2000 343,965 147,532 42.9% 6,632 1.9% 189,801 55.2%

2004 520,793 196,242 37.7% 6,193 1.2% 318,358 61.1%

AN OVERVIEW OF THE CHILEAN MARKET: Demand for Retirement Products

High degree of annuitization: 60% of all High degree of annuitization: 60% of all retiree annuitizeretiree annuitize

Higher percentage excluding disability and Higher percentage excluding disability and survivorship pensionssurvivorship pensions

Early stagesEarly stages——disabled and survivors disabled and survivors ““jumpstartedjumpstarted”” the annuities marketthe annuities market

1990s and 2000s: close connection between 1990s and 2000s: close connection between early retirement and annuitizationearly retirement and annuitization

AN OVERVIEW OF THE CHILEAN MARKET: Market Structure

Very concentrated Pension sectorVery concentrated Pension sector

Very competitive Insurance SectorVery competitive Insurance Sector

Differences in market structure reflected Differences in market structure reflected

in measures of market performancein measures of market performance

AN OVERVIEW OF THE CHILEAN ANNUITIES MARKET: MARKET STRUCTURE

Number of Life Insurance Companies, Annuity Providers, and AFPs, 1988-2005

0

5

10

15

20

25

30

35

40

1988 1990 1992 1994 1996 1998 2000 2002 2004

Life Insurance Companies Annuity Providers AFPs

AN OVERVIEW OF THE CHILEAN ANNUITIES MARKET: MARKET STRUCTURE

Market Concentration Ratios in Pensions and Annuities Herfindahl and Share of Three Largest Firms, 1988-05

0

500

1000

1500

2000

2500

1988 1990 1992 1994 1996 1998 2000 2002 2004

Her

find

ahl R

atio

0%10%20%30%40%50%60%70%80%90%100%

Shar

e of

3 L

arge

st

AFP Herfindahl Annuity HerfindahlAFP 3 Larges t Annuity 3 Larges t

AN OVERVIEW OF THE CHILEAN MARKET: Market Performance

Performance of the AFP SectorPerformance of the AFP SectorHigh average returnsHigh average returns

Fees have declined but are still too high (100 bps) Fees have declined but are still too high (100 bps)

Performance has been better for PW holders (lower fees)Performance has been better for PW holders (lower fees)

Performance of the LICO/Annuities SectorPerformance of the LICO/Annuities SectorVery high Very high MWRsMWRs and thin spreads in recent yearsand thin spreads in recent years

Questions about sustainabilityQuestions about sustainability

Strong capital buffer from initial years partially eroded, Strong capital buffer from initial years partially eroded, some decline in some decline in MWRsMWRs expected expected

MWRsMWRs will probably remain comparatively attractive if will probably remain comparatively attractive if industry does not become very concentratedindustry does not become very concentrated

Market Performance: MWRs

March 1999 March 2002 March 2003 March 2004 March 2005

All cases 0.978 1.080 1.036 1.064 1.062

- maximum 1.148 1.222 1.181 1.276 1.223

- minimum 0.755 0.872 0.872 0.876 0.706

Male, Age 55 0.981 1.081 1.056 1.036 1.042

Male, Age 65 0.996 1.098 1.066 1.042 1.067

Female, Age 55 0.994 1.105 1.056 1.060 1.064

Female, Age 60 1.021 1.120 1.066 1.074 1.083

Joint Life (Male 65, Female 60) 0.998 1.089 1.058 1.062 1.069

Premium up to UF1,000 0.980 1.078 1.045 1.068 1.067

Premium above UF3,000 0.997 1.099 1.047 1.075 1.071

Non-Guaranteed 0.990 1.092 1.045 1.071 1.073

Guaranteed 0.974 1.076 1.033 1.062 1.059

Without deferment 0.979 1.079 1.035 1.063 1.061

With deferment 0.974 1.080 1.036 1.067 1.064

Variable Coefficient t-statistic p-values Other Statistics

Constant 62.39 86.31 0.000 Dep. Variable: MWR*100

Age 0.41 45.70 0.000 No. Observations = 6,526

Log (premium) 1.62 22.07 0.000

Guarantee -0.13 -16.04 0.000 R2 = 0.639

Deferment 0.02 2.24 0.025 Adj. R2 = 0.638

Male 1.35 8.98 0.000 Prob. > F = 0.000

Female 4.02 40.59 0.000 Mean Dep. Variable: 104.9

2002 10.66 76.10 0.000 S.D. Dep. Variable: 5.60

2003 5.70 38.72 0.000

2004 8.25 58.67 0.000

2005 6.51 44.72 0.000

Main Determinants of MWRs

Austral. Canada Switz. UK 1 UK UK US 2

(James) (James) (James) (Can) (James) (Brown) (Brown)

Male, Age 55 - - - - 0.921 0.934

Male, Age 65 1.013 0.981 1.046 0.977 0.908 0.927

Female, Age 55 - - - - 0.928 0.937

Female, Age 65 1.002 0.976 1.037 0.979 0.907 0.927

Joint 0.988 0.980 0.985 0.981 0.987 - 0.929

MWRs of Nominal Annuities in Other Countries

MWRs of Indexed Annuities in Other Countries

Austral. Canada Switz. UK 1 UK UK US 2

(James) (James) (James) (Can) (James) (Brown) (Brown)

Male, Age 55 - - - - 0.867 -

Male, Age 65 - - - 0.887 0.854 0.822

Female, Age 55 - - - - 0.876 -

Female, Age 65 - - - 0.877 0.857 0.782

Joint - - - 0.880 - -

MWR ConclusionsHigh by international comparisonHigh by international comparison

More favorable for cases where the expected duration is More favorable for cases where the expected duration is shorter (e.g., older ages, males) reflecting less exposure shorter (e.g., older ages, males) reflecting less exposure of provider to market and longevity risksof provider to market and longevity risks

Higher for larger premiums suggestingHigher for larger premiums suggesting

Better market search by better educated, more Better market search by better educated, more sophisticated clientssophisticated clients

Lower unit costs more important than longevity Lower unit costs more important than longevity differentialsdifferentials

Wide dispersion of results within sample, particularly Wide dispersion of results within sample, particularly for smaller premium levels, is noticeable.for smaller premium levels, is noticeable.

Market Performance: Spreads (1)

Average Annuity Rate and the Risk-Free Rate (% p.a.)1993-2005

2%

3%

4%

5%

6%

7%

8%

1993 1995 1997 1999 2001 2003 2005

Annuity Rate (RV-04) Risk-Free Rate (PRC-20)

Market Performance: Portfolio Composition

1991 1995 2000 2003 2005 Government Sector 38.3 40.3 28.7 17.6 16.5 Financial Sector 23.0 28.4 45.1 37.6 34.6 Mortgage Bonds 13.9 18.6 24.2 18.8 12.8 Mortgage-Backed Securities 3.0 6.0 10.1 10.1 9.1 Company Sector 29.0 22.1 15.3 33.4 38.5 Shares 8.9 10.2 3.4 2.9 3.9 Bonds 20.1 10.7 10.7 29.3 33.5 Real Estate 7.8 7.7 7.4 7.3 7.5 Other Assets 2.0 1.5 3.6 4.1 6.8 Total 100.0 100.0 100.0 100.0 100.0

Market Performance: Commissions

Commission Rates (% of the Premium), 1990-2005

0%

1%

2%

3%

4%

5%

6%

7%

1990 1992 1994 1996 1998 2000 2002 2004

Market Performance: Spreads (2)

Annuity Rate, Adjusted Annuity Rate, Central Bank Bonds and Corporate Bonds (% p.a.), 1993-2005

2%

3%

4%

5%

6%

7%

8%

9%

10%

1993 1995 1997 1999 2001 2003 2005

Annuity Rate (RV-04) Adjusted Annuity Rate PRC-20 Corporate Bonds

Market Performance: ROEs

Returns on Equity (ROE) of AFPs and Life Insurance Companies (%), 1992-2004

-20%-10%

0%10%20%

30%40%50%60%

1992 1994 1996 1998 2000 2002 2004

ROE of AFPs ROE of Life Insurance Companies

5−eMain Determinants of the Average Annuity Rate

Fixed Effects with Robust Standard Errors; Total Panel Observations: 693R2 = 0.7995; Adj. R2 = 0.7890; F-Statistic = 76.2162 ; P-Value(F-Statistic) = 0.0000

5−e

5−e

Variable Coefficient Std. Error t-Statistic

C 3.0760 0.2187 14.0668

RF 0.3639 0.0209 17.4077

SOFI 0.0029 0.0009 3.1772

SOA 0.0086 0.0038 2.2509

LEV 0.0110 0.0039 2.7967

MSHARE -3.4900 0.5727 -6.0937

AP(EARLY) 0.0002 2.57 * 6.8931

CR -0.0441 0.0180 -2.4431

HER(EARLY) -5.1390 0.7219 -7.1191

Market Performance: Can the behavior of annuity providers be explained?

Measures of performance reveal a very Measures of performance reveal a very competitive/aggressive annuities marketcompetitive/aggressive annuities market

Use of outdated tables by providers unlikelyUse of outdated tables by providers unlikely

Serious governance problems unlikelySerious governance problems unlikely

Maybe providers counting on future interest rate Maybe providers counting on future interest rate increasesincreases

Maybe providers are adopting deliberately Maybe providers are adopting deliberately aggressive pricing policies to gain market shareaggressive pricing policies to gain market share

Some market adjustments likely, started alreadySome market adjustments likely, started already

PRODUCT REGULATION: Marketing

Some rules in the 1990s designed to ensure Some rules in the 1990s designed to ensure transparency and minimum market search transparency and minimum market search (minimum # of quotes) did not work very well(minimum # of quotes) did not work very well

Excessive dispersion of annuitiesExcessive dispersion of annuities

Excessive abuse with cash rebatesExcessive abuse with cash rebates

New Pensions Law passed in 2004New Pensions Law passed in 2004Introduces caps on commissionsIntroduces caps on commissions

Introduces innovative electronic quotation systemIntroduces innovative electronic quotation system

Should lead to more transparency, less dispersionShould lead to more transparency, less dispersion

Some problems still remainSome problems still remain

CONCLUSIONS, RECOMMENDATIONS, LESSONS FOR OTHER COUNTRIES

CONCLUSIONSCONCLUSIONS

The growth of the market for retirement products, The growth of the market for retirement products, especially annuities, has been impressiveespecially annuities, has been impressive

High competition of the annuities market have High competition of the annuities market have taken place through the annuity rate and broker taken place through the annuity rate and broker activityactivity

The reduction in broker commissions and illegal The reduction in broker commissions and illegal rebates in the 2000s enhanced the role of the rebates in the 2000s enhanced the role of the annuity rate annuity rate

CONCLUSIONS, RECOMMENDATIONS, LESSONS FOR OTHER COUNTRIES

CONCLUSIONSCONCLUSIONS

Market has performed well for consumers, as indicated Market has performed well for consumers, as indicated by the high by the high MWRsMWRs, higher than ratios in other countries, higher than ratios in other countries

High High MWRsMWRs can be explained by access to a diversified can be explained by access to a diversified supply of indexed instruments, and very competitive supply of indexed instruments, and very competitive environmentenvironment

However, questionable if However, questionable if MWRsMWRs can be sustained at can be sustained at current levels for a long period. Some decline to be current levels for a long period. Some decline to be expected.expected.

There is some evidence that dispersion of There is some evidence that dispersion of MWRsMWRs has has decreased with the new quotation systemdecreased with the new quotation system