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DISABILITY AND SURVIVORSHIPINSURANCE:THE CASE OF CHILEGONZALO
REYES1
1 Head of the Research Division, Superintendence of Pensions,
Chile.
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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 2009.
I. CURRENT OPERATION OF THE DSI IN CHILE2
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.
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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
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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
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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 1.
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TABLE 1DIAGNOSIS OF THE DISABILITY AND SURVIVORSHIP
INSURANCE.
Area Effect
Equity Crossed subsidies between men and women.
Claims Rate Control 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 High incidence in cost structureIncentive for
skimming and inefficient competitionMakes it difficult for new
companies to enter the AFP market.
Regulation Regulatory arbitrage if AFPs cover the risks
directly.
Transparency 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 Reform3.
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 .
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be awarded to more than one company, with the purpose of
mitigating system-wide 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 system4.
4 For an analysis of gender gaps in the Chilean pensions system
see Berstein and Tokman (2005).
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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 1EVOLUTION OF THE COST OF THE DSI
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.
1.4%
1.3%
1.2%
1.1%
1.0%
0.9%
0.8%
0.7%
0.6%96 97 98 99 00
Year
Pre
miu
m (%
of p
ayro
ll)
AFP2AFP1 AFP3 AFP4
01 02 03 04 05
AFP5
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DISABILITY AND SURVIVORSHIP INSURANCE: THE CASE OF CHILEGONzALO
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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 system5.
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).
% o
f pay
roll
3.5%
3.0%
2.5%
2.0%
1.5%
1.0%
0.5%
0.0%AFP1 AFP2 AFP3 AFP4 AFP5
Equivalent commission Equivalent commission without DSI
2.7%2.5%
1.7% 1.6%
2.2%
3.1%
2.5%
1.2%1.5% 1.4% 1.4%
2.5%
AFP6
FIGURE 2EQUIVALENT COMMISSION WITH AND WITHOUT DSI (2006)
SOURCE: THE AUTHOR.
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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.
Insurance Companies
1 The members pay a commission corresponding to their AFP and,
separately, a single DSI commission which is the same for
everyone.
The AFPs coordinate activities to take out a DSI jointly.
4 The AFPs pay their members all the money that the insurance
companies contributed, without exception.
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.
3 The insurance companies pay the AFPs all the money needed to
cover the benefits of the DSI. No type of adjustment is used.
AFP
Members
FIGURE 3CENTRALIZED DISABILITY AND SURVIVORSHIP INSURANCE
SOURCE: THE AUTHOR.
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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 2009.
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BIBLIOGRAPHY
BERSTEIn, Solange and Andrea TOKMAn2005 Brechas de ingreso entre
géneros: ¿perpetuadas o exacerbadas en la vejez?. Working
document n° 8. Superintendence of AFP.
CASTRO, Rubén2005 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 REFORM2006
Final report. Volume I.
REYES, Gonzalo2008 Medidas pro-competencia de la reforma
previsional. Working documents.
Superintendence of Pensions. Santiago.
