DISABILITY AND SURVIVORSHIP INSURANCE: THE CASE OF CHILE

Transcription

1 DISABILITY AND SURVIVORSHIP INSURANCE: THE CASE OF CHILE gonzalo reyes 1 1 Head of the Research Division, Superintendence of Pensions, Chile. 313

2 We shall be discussing the case of the Chilean reform within the framework of the recent social security reform. This is a very broad reform to the Chilean system, where many points were fine-tuned in order to improve performance, increase coverage and promote competition within the system, and it includes a change in how the Disability and Survivorship Insurance (DSI) works. We will show here the diagnosis that gave rise to that change and we will discuss the characteristics of the legal reform that we hope will begin to be implemented as from the year I. CURRENT OPERATION OF THE DSI IN CHILE 2 The DSI is an insurance that complements individual savings to finance a disability or survivorship pension. Disability is declared in the event of the total or partial loss of the ability to work as a result of a common illness disability caused by occupational disease or work-related accidents has a separate regime in Chile the survival benefits are paid to the beneficiaries of the member, defined by law, in case of his/her death. At present, this insurance is financed on the basis of a portion of the commission paid in by the members to each AFP and which is, on average, approximately 1% of the assessable income. This proportion has been increasing over time. The assessment of disability is made by a network of medical boards specially created for this purpose, consisting of doctors hired and funded by the Superintendence of Pensions. The other costs, the administrative and operating costs of the medical boards themselves and of any medical examinations required in the course of the assessment process, are payable by the administrators. 2 Castro (2005) gives an analysis and description of the operation of the Disability and Survivorship insurance that serves as background for what is presented here. 314

3 PENSIONS for the future: DEVELOPING INDIVIDUALly FUNDED PROGRAMS THE CASE OF CHILE gonzalo reyes The cost of the system as a whole comes from what are known as contributions, which correspond to the difference between the capital needed to finance the disability or survivorship pension, which is a defined benefit, and the balance plus the recognition bond that the person owns in his/her individual account. Another component of the insurance is the payment of transitory pensions. At present, the system contemplates an initial disability rating and a period of three years in which the person may be re-assessed. The transitory pensions, which are payable by the administrator and which are covered by the insurance company covering the claim, are paid during the first three years. To these costs are added the cost of the entire assessment process, which is a cost of the system as a whole and, finally, the contributions that are triggered when the second disability assessment states that a person is not entitled to receive a pension, in other words, the case passes from one of total or partial disability to a failure to qualify as disabled. In these cases, the law includes an amount paid into the individual account to compensate for the three years when no contributions were being paid into the account. At present, each AFP on its own must take out this insurance, since the law makes each AFP responsible for the payment of the pensions and contributions for its own members. The AFPs are free to choose the company and type of contract they prefer. The cost of the insurance for the members is included in the price charged by the AFPs. However, in practice, the true cost of the DSI, which corresponds to the four components that I have just mentioned, can only be known ex post. In other words, although the AFP charges a commission, the part of that commission that is earmarked to finance the insurance can only be known once the claims occur. These calculations indicate that today this insurance represents approximately half the operating costs of the system. Analytically, with a population of insured people, we can divide the risk into two types: one is the risk that can be modelled, in other words, the AFP is aware of the characteristics of its members and, can therefore propose a model which, with some hope and distribution, can serve to estimate the costs associated with the accidents/ events that might affect this group of members. But there is also catastrophic risk, which refers to those events that escape the model, occur extremely infrequently and are events with unknown probability that produce a very great impact, such as a systemic risk like a national catastrophe, for example. The current practice of the AFPs in the contracts they sign with the insurance 315

4 companies is equivalent to self-insuring the risk that can be modelled. In practice, they expect a certain claims rate with a certain degree of confidence and they insure it, whereas the catastrophic risk is the one being insured by the insurance companies through a mechanism of maximum premiums. The typical contract between an AFP and an insurance company contains a mechanism for adjusting the premiums so that every six or twelve months, depending on the conditions of the contract, a calculation is made of the cost of the claims and the net premiums accumulated, in other words, the costs and income and the differences between the two. If there is a net balance in favour of the AFP because the claims rate was lower than the premium paid to the company, the surplus is returned to the AFP, while if there is too little to cover a certain premium payable as a result of claims, an extra premium is paid to the company until the maximum premium is reached. Therefore, today, these contracts are like an administration contract rather than the provision of insurance coverage as such, and the companies obtain profits for the financial income they may obtain, but they may also suffer major losses if the claims rate begins to exceed the maximum premium. II. DIAGNOSIS OF THE CURRENT SITUATION OF THE DSI As regards the diagnosis of the current situation we have first of all the presence of crossed subsidies; in particular, for example, from men to women, due to the different claim costs. Women tend to live longer, tend to have fewer disability claims, but both men and women pay the same contribution to the AFP, and therefore pay the same premium for the disability and survivorship insurance. The same thing occurs in the case of younger people to older people. As regards the control of the costs involved in the system, the AFP have various strategies in their hands, some of them positive and others negative. On the one hand, they can become involved in a strategy for the selection of members; in other words, if the cost of the insurance depends on the characteristics of the members in each AFP the latter will try to select those members that are less risky, such as younger people or people with higher incomes. This implies that there is a certain incentive in the system to try and skim members, and this is not efficient at the level of the system as a whole, because it is a zero sum game, in other words, the profits of some are equivalent to the losses of the others, but there are real costs involved. On the other hand, a positive way in which the AFP could try to control costs is through the monitoring of the assessment process, which, for example, would make it possible to limit frauds or reduce the error rate in disability assessments. In this 316

5 PENSIONS for the future: DEVELOPING INDIVIDUALly FUNDED PROGRAMS THE CASE OF CHILE gonzalo reyes way there will be less probability of granting benefits to someone who is not in a real position of disability. However, the AFPs can also try to discourage the use of the disability pension, offering the applicant the alternative of other products also offered by the same AFP, such as an early retirement pension. This strategy would be negative from the point of view of the system if it prevents people who really are entitled to a disability pension from even participating in the assessment process. As designed, the insurance also affects competition within the system. First of all, that insurance currently represents half the operating costs of the AFPs, which means that the AFP have to carry a heavy load that has nothing to do with the job of managing funds or accounts, which is its core business. As was mentioned earlier, the way in which this insurance operates produces incentives for competition by skimming off high grade contributors but it can also constitute a barrier for admitting new AFPs. In order to participate in the market, a new AFP must take out this insurance with an insurance company, but the new AFP by definition has no history of the quality of its members, and for this reason faces even greater uncertainty about what the cost of the insurance is going to be for itself, compared with an AFP that does have a history. For this purpose it is more difficult for them to take out this insurance, all of which has a high impact on costs. Another problem we notice is that when the AFPs begin to self-insure the risk that can be modelled, they are acting like an insurance company and from the regulatory point of view, what is known as regulatory arbitrage may be taking place: they are acting as an insurance company without having the necessary reserves or being regulated as such. In terms of transparency, the fact that the cost is known after the claims occur hides the true social security cost, that is, that within the commission there is a part that is not truly a cost. It is not something for which the member is being charged, but a premium paid for insurance coverage, which is an additional benefit of the system, but one that is not perceived as a benefit because it is part of the commission. This very fact distorts the comparison of prices between AFPs. If we have two AFPs with the same commission, but perhaps one has a higher quality membership portfolio in terms of this insurance, then it is less costly, but the truth is that they are charging more for the same service than another AFP for which the cost of insurance has a greater impact on its operating costs. The global diagnosis of the operation of the DSI and its effects on different important areas of the pension system are summarized in Table

6 TABLE 1 DIAGNOSIS OF THE DISABILITY AND SURVIVORSHIP INSURANCE. Equity Area Claims Rate Control Effect Crossed subsidies between men and women. Incentives for the AFP: - Positive: Monitoring the assessment process and providing advice to members who have no possibility of obtaining a disability rating - Negative: Trying to capture members with a lower claims rate, preventing disability assessment of potential beneficiaries. Competition Regulation Transparency High incidence in cost structure Incentive for skimming and inefficient competition Makes it difficult for new companies to enter the AFP market. Regulatory arbitrage if AFPs cover the risks directly. Cost of the DSI concealed in commissions charged by the AFPs. Difference in claims rate distorts comparison between AFP commissions. SOURCE: THE AUTHOR. III. MEASURES INCLUDED IN THE SOCIAL SECURITY REFORM. The diagnosis set out above is what motivates the proposal to make changes in the insurance in order to correct its defects. In other words, the purpose of such modifications is precisely to increase fairness, generate conditions for greater competition and efficiency and to improve the transparency of the system. Therefore, what has been decided in Chile s case is to design a system in which there is a single premium rate throughout the whole system, regardless of the AFP to which you belong, and that the DSI is provided separately by insurance companies, ensuring that they cover the risk and not the AFPs themselves. Furthermore, the system establishes a mechanism to separate the cost of the insurance between men and women, which was proposed by the Presidential Advisory Committee for Social Security Reform 3. The method regulated in the law to implement this mechanism obliges the AFPs to tender for the DSI together, according to the law. For this purpose, the AFP will have to draw up the bidding conditions in accordance with what is stipulated in a joint circular letter issued by the Superintendence of Pensions and the Superintendence of Securities and Insurance, which will regulate the mechanism and procedures according to which the bidding process will take place. The law establishes that the process will be carried out through open tendering in which those insurance companies that are already registered may compete and the insurance will be awarded on a price basis, in other words, to the best economic bid, although it may 3 See the final report at < 318

7 PENSIONS for the future: DEVELOPING INDIVIDUALly FUNDED PROGRAMS THE CASE OF CHILE gonzalo reyes be awarded to more than one company, with the purpose of mitigating systemwide risk and distributing the coverage of the risks among more than one company during each period of the contract. Also, the system of observer doctors, currently managed in the context of the AFP Association, would pass into the direct control of the companies awarded the contract, in order to control the risk related with disability assessment. The insurance will be financed through a uniform premium rate that will be charged to all contributors to the system on an equal basis, regardless of the fact that in different companies there may be different premiums. For example, there may be two winning offers that share the coverage in equal parts, one for 1% and another for 1.1% as a premium rate, but all members are charged an average premium of 1.05% and it is distributed among the different companies according to the offer they were awarded at the bidding. In operative terms this collection will be made through the AFP, which must deposit the difference between the average premium paid by men and women in the women s accounts and then transfer the additional contributions corresponding to the companies. Specifically, an insurance that is independent of the AFP will allow for a single pool, on the scale of the entire system and financed by all members through a premium established as a percentage of income, the assessable wage. This aspect would eliminate the incentive to skim on the basis of the claims rate because everyone is going to pay the same cost, regardless of the AFP to which they belong. In terms of gender fairness, what is being proposed is a separation of the cost between men and women by charging a single premium. How is the system going to be implemented? The corresponding premium will be charged, for example, at the rate needed to finance the insurance of the male contributors, which we assume will be a higher premium given that there is a difference between that premium and the one that would have been necessary to finance the insurance in the women s group. Instead of charging a lower premium to women, they will be reimbursed the difference, paying it into their individual capitalization account. That is to say, instead of charging women a lower price, the same premium will apply, but as a contribution surcharge payable into their individual account. The justification for this measure is that this also compensates other unfair gender-based treatment in the system. In order to benefit women s pensions, a greater accumulation in the individual account is allowed in order to finance higher pensions and compensate the fact that women have a lower contribution density, lower income on average and tend to retire earlier from the system 4. 4 For an analysis of gender gaps in the Chilean pensions system see Berstein and Tokman (2005). 319

8 And given that this mechanism has been designed, it is necessary to mention that its correct application requires a system-wide single premium rate. This is so, because if we had differences in costs between the different AFPs, this contribution surcharge would be different depending on the AFP to which the person belonged, and what we see in practice is that this difference could vary by 30% between the different AFPs. Therefore, in order to implement this measure it was considered necessary to have an independent insurance, so that the contribution surcharge rate is one and the same for all women. As Figure 1 shows, there are consistent and persistent differences in the cost of the insurance over time between the different AFP, for different years. There are AFPs that are persistently more expensive or have a worse claims record, and others that are cheaper every year. FigurE 1 EVOLUTION OF THE COST OF THE DSI 1.4% 1.3% Premium (% of payroll) 1.2% 1.1% 1.0% 0.9% 0.8% 0.7% 0.6% Year AFP1 AFP2 AFP3 AFP4 AFP5 SOURCE: THE AUTHOR This is evidence that the actual claims profile of the members differs between the different AFPs, something that may be due to the commercial strategies developed by each of them, some being more successful in attracting clients with low claims rates. In order to improve the competition between them, we believe that the independent DSI would focus competition more strongly on the mandatory savings part, which is the core business of the AFP, and not on a competition that depends to a great extent on the cost per member in terms of the DSI. 320

9 PENSIONS for the future: DEVELOPING INDIVIDUALly FUNDED PROGRAMS THE CASE OF CHILE gonzalo reyes In terms of the AFP s market competition, it is also expected that separating the DSI would facilitate the participation of new actors in the market, because, given that the new AFP has a small portfolio, it may possibly be at a disadvantage when taking out this insurance in terms of its capacity to diversify risk and, by not having a history, it is also at a disadvantage because it does not have historical information to enable it to work out the cost of the insurance more accurately. Consequently, making the insurance independent would make it easier for new companies to enter the AFP system 5. FigurE 2 EQUIVALENT COMMISSION WITH AND WITHOUT DSI (2006) 3.5% 3.0% 2.5% 2.7% 2.5% 2.2% 3.1% 2.5% 2.5% % of payroll 2.0% 1.5% 1.0% 1.7% 1.6% 1.2% 1.5% 1.4% 1.4% 0.5% 0.0% AFP1 AFP2 AFP3 AFP4 AFP5 AFP6 Equivalent commission Equivalent commission without DSI SOURCE: THE AUTHOR. Also, the separation of the DSI, being provided by insurance companies, would make regulation more efficient because it would correspond to the type of company that is already regulated to provide insurance. As regards the transparency of the system, the fact that the cost of the insurance is not charged to the member as a separate premium hides its costs and distorts the ranking of prices based on commissions. In fact, as Figure 2 shows, if we compare the social security cost based only on the commission charged, we see an AFP that is significantly more expensive than the others, but if we remove the cost of the insurance that same AFP is no longer the most expensive in the system, and becomes the third most expensive. In fact, what that extra commission is doing is financing a higher cost for insurance and this therefore distorts the system s ranking of commissions. 5 For a more detailed analysis of this and other complementary measures that seek to improve competition in the AFP system see Reyes (2008). 321

10 The single tender of the insurance definitely improves transparency, because it makes it possible to find out the real cost, improves competition, improves the commercial strategy, does not generate an incentive for skimming the market and also improves regulation, gender fairness and costs. While AFPs currently cover their own members and take out insurance with the insurance companies of their choice, Figure 3 shows the operation of the centralized DSI when the new law comes into force. We can see that the AFPs as a whole will take out the DSI cover by means of a price-based competitive tendering system. Once the cover has been assigned and its price thus fixed, the AFPs will collect the premium from their members and will transfer these to the insurance companies, which in turn will pay the AFPs the resources needed to finance the cost of claims. In operational terms, the AFPs will also pay their members either the additional contribution into the capitalization accounts or the transitory pensions as applicable, as well as the contribution surcharge that may apply in the case of women. FigurE 3 CENTRALIZED DISABILITY AND SURVIVORSHIP INSURANCE 1 The members pay a commission corresponding to their AFP and, separately, a single DSI commission which is the same for everyone. The AFPs pay back the premium surcharge paid by women, into their balances. 2 The total commissions paid by the members is exactly equivalent to the total funds that they have to transfer to the insurance companies each month. The AFPs coordinate activities to take out a DSI jointly. Insurance Companies Members 4 The AFPs pay their members all the money that the insurance companies contributed, without exception. AFP 3 The insurance companies pay the AFPs all the money needed to cover the benefits of the DSI. No type of adjustment is used. SOURCE: THE AUTHOR. 322

11 PENSIONS for the future: DEVELOPING INDIVIDUALly FUNDED PROGRAMS THE CASE OF CHILE gonzalo reyes IV. CONCLUSIONS Although the law set the bases for the new design for taking out the DSI, many details of the bidding process and its operation will be defined in secondary regulations and in practice. This presents multiple challenges for the successful implementation of this change in the law. First of all, the regulations governing the bidding process must attempt to design the process in such a way that it is a competitive mechanism, which encourages participation and which has rules to guarantee the transparency of the information that is provided to the insurance companies so that they can calculate the system-wide cost of the insurance correctly and fix the prices accordingly. Another challenge is the efficient design of the contracts themselves, so that they include the correct incentives, preventing the use of skimming but also managing to control system costs and claims rates. Mechanisms must be sought to ensure that claims rate controls are not hampered by the mere fact of modifying the way in which the insurance is purchased, but rather kept under strict control by the corresponding agencies: the system of observer doctor at the level of the medical assessment boards, the adequate operation of such medical assessment boards and the supervisory role of the Superintendence of Pensions in the system of medical commissions as a whole. To sum up, on the date of this presentation, the regulatory bodies are busy preparing the regulations and making the necessary analyses to implement this new form of effecting the DSI in Chile, whose validity and application was defined in the social security reform law as from the month of April

12 BIBLIOGRAPHY BERSTEIN, Solange and Andrea TOKMAN 2005 Brechas de ingreso entre géneros: perpetuadas o exacerbadas en la vejez?. Working Document N 8. Superintendence of AFP. CASTRO, Rubén 2005 Seguro de Invalidez y Sobrevivencia: qué es y qué le está pasando. Working Document N 5. Superintendence of AFP. PRESIDENTIAL ADVISORY COUNCIL FOR SOCIAL SECURITY REFORM 2006 Final report. Volume I. REYES, Gonzalo 2008 Medidas pro-competencia de la reforma previsional. Working Documents. Superintendence of Pensions. Santiago. 324