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This volume is a product of the staff of the International Bank for Reconstruction and
Development/The World Bank. The World Bank does not guarantee the accuracy of the
data included in this work. The findings, interpretations, and conclusions expressed in
this paper do not necessarily reflect the views of the Executive Directors of the World
Bank or the governments they represent.
The material in this publication is copyrighted.
FINANCIAL SECTOR ASSESSMENT PROGRAM
MALAWI
TECHNICAL NOTE
CONTRACTUAL SAVINGS:
INSURANCE AND PENSIONS SEPTEMBER 2008
INTERNATIONAL MONETARY FUND MONETARY AND CAPITAL MARKETS
DEPARTMENT
THE WORLD BANK FINANCIAL AND PRIVATE SECTOR DEVELOPMENT
VICE PRESIDENCY
AFRICA REGION VICE PRESIDENCY
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Contents
OVERALL ASSESSMENT ............................................................................................................1
I. GENERAL INSURANCE ...................................................................................................2 A. Penetration and Market Structure .............................................................................2
B. Product Diversification .............................................................................................4 C. Portfolio Structure and returns ..................................................................................4 D. Regulation and Supervision of General Insurance ....................................................5 E. Micro Insurance .........................................................................................................6
II. LIFE INSURANCE AND PRIVATE PENSIONS ...................................................................8
A. Market structure and Penetration ..............................................................................8 B. Products .....................................................................................................................8
C. Pension Fund Management .......................................................................................9 D. Regulation and Supervision of Life Insurance and Private Pensions .....................10
III. PUBLIC PENSIONS .....................................................................................................11 A. Current PAYG system for Civil Service and Military ............................................11
B. Shift to a Contributory Pension scheme ..................................................................15
IV. SUMMARY AND RECOMMENDATIONS.......................................................................17
V. REFERENCES ................................................................................................................18
ii
ACRONYMS
IAIS International Association of Insurance Supervisors
ICP Insurance Core Principles
K Kwacha (1 US $ = 139 K)
MRA Malawi Revenue Authority
NASFAM National Smallholder Farmers Association of Malawi
NGO Non Governmental Organization
OIBM Opportunity International Bank of Malawi
PAYG Pay-as-you-go
RBM Reserve Bank of Malawi
1
OVERALL ASSESSMENT 1
The penetration level of the insurance and pension sectors in Malawi is low, but it seems
adequate as compared with other countries in similar stages of development.
Concentration and costs are high, the regulatory framework is outdated or inexistent and
supervision is weak.
An innovative pilot experience of weather micro-insurance is a good example of private-
public partnership to reduce vulnerability and extend benefits, but the coverage is still
low. The project faces several challenges, one of them being the need to invest in weather
technology. Cost benefit analysis of public projects in this area should take into
consideration the possible positive social benefits of income security for vulnerable rural
population. The analysis needs to take into account that possibilities to increase micro-
insurance penetration may be affected by the level of education of farmers, as well as
their specific knowledge of insurance products and their confidence in insurance
companies.
Life insurance and private pension plans have an acceptable level of development as
substitute of the non existing mandatory pensions for private sector workers, but they
need a stronger supervision and regulation to enhance their benefits. Rules should seek to
promote portfolio diversification, higher portability of pensions and old age income
security through well defined benefit rules (included indexation).
RBM has limited capacity as integrated supervisor for the whole financial sector. It faces
strong constraints to perform its role as insurance supervisor, and is far from being able to
do it with private pensions. If the government adopts decisions extending the competence
of RBM to private pensions, a careful evaluation of resources needs to be done and a
capacity building plan has to be adopted. In any case, RBM needs to develop more
effective tools to perform its duties with limited resources, including the shift to a risk
based supervision approach.
The public PAYG pension scheme for the civil service is too onerous and the projected
long term financial situation shows an increasing burden on the public budget. A series of
parametric reforms triggered by the wage reform for the civil service of 2004 have been
ad hoc and non systematic. The parametric changes have represented changing rules over
time, and further changes will probably happen, since the financial projections show an
increase in the pension burden. In spite of the generous parameters of the public PAYG
scheme, inflation erodes pensions and most benefits are paid as lump sums, affecting the
ability of the pension system to provide lifetime income protection.
It is recommended that the government of Malawi: a) Enact pending legislation to
strengthen the regulatory framework and the supervision capacity of the insurance and
private pension sectors; b) Enhance the capacity of the supervision authority through an
adequate training program; c) Evaluate a parametric reform for the civil service pension
1 This Note was prepared by Gustavo Demarco, World Bank.
2
scheme including a redefinition of the accrual rate, vesting period, retirement age and
indexing rules that are compatible with long term target expenditures.
I. GENERAL INSURANCE
A. Penetration and Market Structure
1. Gross premium in 2006 was K 3 billion, representing 1.13 percent of GDP. This
ratio is low as compared with more developed economies, but it is not very different from
market penetration indicators of other countries in the region, except South Africa.2
Figure 1. Insurance Market penetration in selected countries
Premia / GDP (%)
17.97%
2.59%1.27% 1.21% 1.13% 0.73% 0.47%
0%
4%
8%
12%
16%
20%
Sou
th A
frica
Ken
ya
Zambia
Sen
egal
Malaw
i
Ben
in
Ugan
da
Sources: World Bank WDI, Sigma 6/02 and RBM (2005)
2. The insurance sector in Malawi shows high concentration. In 2006, eight
companies operated in the market of general insurance; the largest manages 50 percent of
total assets and the two largest represent 80 percent. Most of the companies have local
owners, and only two of them are owned by foreign capitals (jointly representing 26.3
percent of the market). One licensed reinsurance company operates locally, but more than
70 percent of reinsurance is provided by foreign re-insurers licensed by the Reserve Bank
of Malawi (RBM).
3. Underwriting results are high (about 50 percent of total underwriting, although the
percentage was higher in the past).3 This is partly explained by high management
expenses, which may in turn be caused by inefficiencies, diseconomies of scale or by
2 It should also be noted that the information does not correspond to the same years, so the comparison is
only approximate and indicative. 3 Underwriting result is defined as the difference between premia and claims incurred plus commission.
Operating results include investment income and expenses minus management expenses, taxes and other
expenses.
3
market concentration. As observed in Figure 3, management expenses evolved together
(and in similar levels) with underwriting results between 2002 and 2006. It is also
noticeable that returns on investments are below the volume of expenditures.
Figure 2. Market concentration in the Insurance Sector of Malawi - 2006
Market structure in the General
Insurance sector of Malawi (Liabilities)
0
10
20
30
40
50
60
NIC
OUG
I
GAIL
Roya
l
Prim
e
Char
ter
Citize
n
Reun
ion
%
Source: FBM (2006)
Figure 3. General Insurance Market of Malawi
Performance indicators of the General
Insurance Market of Malawi
0
200
400
600
800
1000
2002 2003 2004 2005 2006
mil
lio
n K
Underwriting Results Net Investment income
Management expenses Taxes
Source: RBM (2005)
4. For the market as a whole, solvency and liquidity rates are within acceptable
levels, although RBM has expressed concerns in the particular case of some small
companies. While this situation should not represent a major risk for the insurance sector,
the limited supervision capacity of RBM results affected when even minor risks are
observed in the market, as will be discussed below.
4
B. Product Diversification
5. The analysis by branch also shows strong concentration: As in most middle or
low income countries, auto insurance represents the highest percentage of the portfolio of
the companies, usually associated with the mandatory nature of this type of insurance.
This is the case in Malawi, where it represents about 60 percent of total underwritings.
Out of the rest of the business lines, fire insurance comes next, but it only represents
about 20 percent of total underwriting. Personal Accident insurance (which includes
workers’ compensations) only represents 6 percent of gross premium. This pattern of
branch concentration is common in emerging economies with insufficiently developed
financial markets. Concentration in short term risk may be explained by a diversity of
factors, including regulatory requirements as well as the lack of instruments of longer
maturity.
6. The analysis of trends (Figure 4) shows that the evolution of general insurance is
largely driven by auto insurance, with the rest of the branches showing much less clear
patterns of evolution in the last five years. It is particularly remarkable that personal
accident insurance not only represents a low percentage of the market, but also it has
reduced its market share in the last years, while other insurance products expanded quite
significantly.
Figure 4. Insurance Underwriting by branch
General Insurance Underwriting by branch in Malawi
0
200
400
600
800
1000
2002 2003 2004 2005 2006
millio
n K
Motor Fire Personal AccidentsMiscelllaneous Total
C. Portfolio Structure and returns
7. Returns on investment of reserves are limited by the restrictive portfolio options.
Insufficient financial and capital market development impose a strong limitation to
portfolio diversification. In addition, regulations do not allow investing abroad, thus
imposing an additional constraint to asset diversification.
8. The returns on investments are not the result of active investment strategies.
Portfolios of insurance companies are not diversified, reflecting a feature that is common
to the rest of the financial sector. In fact, Table 1 shows a strong concentration in fixed
deposits, government securities and current assets. It has to be noticed, however, that a
5
large amount of investment is in “other” assets, which notably include amounts due by
policyholders and reinsurers, and therefore represent an additional burden to improve the
performance of investments.
Table 1. Insurance and Assurance Companies Selected Assets (million K)
End of
December
Fixed
Assets
Investment
Loans
Current Assets
Total
Assets Real Estate
Government
Securities
Fixed
Deposits Other
Cash and Current
Assets Other
2001 84.3 98.7 393.0 114.5 156.8 133.3 57.3 1,041.9 2,091.1
2003 67.8 142.2 549.9 308.8 86.0 14.1 22.1 1,001.6 2,196.1
2004 120.0 1,415.2 826.8 4,385.2 2,239.3 61.8 -7.2 1,787.5 10,828.6
2005 332.6 722.1 1,013.1 5,816.2 4,737.1 74.3 25.4 2,158.3 14,883.9
2006 (Sep) 584.9 1,549.1 3,830.6 5,201.7 14,516.7 170.3 3,783.8 42.1 29,679.1
Source: Reserve Bank of Malawi (2006), based on information provided by Insurance Companies
9. Possibilities to diversify portfolio in small economies like Malawi are severely
limited by the capacity of local the financial and capital markets to provide investment
options. Removing restrictions to invest abroad may offer not only more diversification
options but also a more adequate instrument to expand long term insurance mechanisms
such as life insurance and private pensions.
D. Regulation and Supervision of General Insurance
10. The regulatory framework of the insurance sector is outdated (1957) and it does
not reflect the current structure, operation and needs of the sector. An amendment to the
Insurance Bill was prepared by the Ministry of Finance and submitted to the government
for consideration of the Parliament. The project was discussed with stakeholders, who
support the initiative and visualize it as a key element to set a regulatory framework for
current operations. The initiative includes a revision of minimum capital requirements,
strengthening of the regulatory capacity of RBM and introduction of governance and
disclosure of information rules. However, beyond the optimism of the different actors for
a more updated regulatory framework, the limitations of RBM as insurance supervisor go
beyond the legal definition of competences.
11. The Non Banks Department of RBM, in charge of supervising insurance, is
staffed with 11 professionals to perform all on site and off site controls of insurance,
pensions and other non financial intermediaries. A self assessment of the Insurance
Supervision capacity conducted by RBM concludes that most of the 28 Insurance Core
Principles developed by IAIS (2003) are either not observed or partly observed.
Constraints to adequate staffing include budgetary as well as technical skills.
12. On site inspections are integral but they are not performed on a regular basis and
they do not adjust to written procedures. Findings and recommendations are
communicated to the companies, but RBM has no enforcement capacity to impose
disciplinary or corrective measures. Even if additional human and technical resources
were available, the supervision authority needs to adopt an alternative risk-based
supervision strategy in order to better focus on the areas or processes that show higher
degrees of vulnerability and to better allocate its limited resources. Written manuals of
6
procedures would make the inspection process predictable and help the private managers
to be better aligned with regulations.
13. Off site controls are based on quarterly returns requested to the companies. These
returns (balance sheets) have a standard format, but some of them are received in paper
and RBM has not yet set in place tools to perform tests with the IT support. Routine
controls impose a high burden on the limited resources of RBM. A shift to an alternative
approach to supervision will require, in any event, a consistent improvement in the
quality and frequency of information.
14. In order to perform a stronger role in a growing insurance market, RBM needs to
develop an action plan to substantially expand its limited supervision capacity. The
current staffing of the non banking institutions department is clearly insufficient, but a
potential expansion will also need a focused program to build institutional capacity.
Customized learning programs may be complemented with global training events offered
by academic centers, international institutions and cooperation agencies. Participation in
regional or global activities of the international associations of insurance and pension
supervisors might be a source of learning from best international practices and from the
experience of other countries.
E. Micro Insurance
15. The rural sector in Malawi represents more than 80 percent of labor force. A large
number of producers have limited or no access to financial products. In the case of
insurance, lack of coverage implies high vulnerability due to higher exposure to risks,
especially those associated with recurrent droughts. The development of mechanisms to
reduce the vulnerability to external shocks in low income countries has been an area of
concern of the World Bank for some years.4 One of the mechanisms successfully adopted
in some countries is indexed weather insurance. The system consists of a simple
mechanism that reduces the covered contingency to a range of values of an indicator or
index such as a weather index (typically reflecting rains in a year).
16. An incipient experience of weather micro-insurance product has been successfully
developed with the participation of the Insurance Association of Malawi. Through this
operation, 3,500 small farmers can have access to credit to buy seeds by insuring repay.
A weather index is used to decide on objective grounds if the insurer will totally or
partially re-pay the credit to the bank.
17. Micro-insurance projects face a number of difficulties that need to be sorted out.
One of them is to engage the private sector as provider in a line of business with lower
expected returns. In Malawi the use of weather indexes has proved to be successful at
reducing costs, since the companies do not need to deal with multiple individual claims,
and subjectivity is eliminated in assessing the contingency. A second important aspect
that was successfully sorted out in Malawi is the elimination of direct relationship
between the client and the insurance company. In fact, the small producers operate in
4 See, for example: Nehru, V. and M. Dorfman (2005).
7
groups (“farming clubs”), and an NGO (“National Smallholder Farmers Association of
Malawi - NASFAM”)5 deals with the lending institution (“Opportunity International
Bank of Malawi – OIBM”). Insurance companies have responded to this initiative by
providing the coverage with the intermediation of the Insurance Association of Malawi.
The Association distributes the policies among its members without need to deal
individually with any of them.6
18. This project, supported by the World Bank and other international donors, faces a
number of challenges. One of the problems that need to be addressed is to extend the
benefits beyond the currently limited coverage radius of 30 km from the weather stations
(located in airports). A crucial difficulty to implement indexed weather insurance in
countries like Malawi is the existence of multiple small microclimates and high
variability of weather between sub-regions. In cases like this, required investments to
extend the technology become critical.
19. Further difficulties to the extension of weather insurance have been reported in a
recent study conducted by X. Gine and D. Yang (2007). The study reports negative
correlation between new technology adoptions (hybrid maize seeds) with insured versus
non insured loans. While the authors do not identify a single factor to explain the
empirically lower take-up of insured vs. uninsured loans, farmers’ education and limited
understanding of insurance products have been identified as severe limitations to the
expansion of weather micro-insurance in Malawi.
20. Recommendations for the General Insurance market:
Market concentration, high costs of intermediation, ad hoc adjustment of
contracts and limited investment options are sufficient reasons for a
sounder regulatory and supervisory structure in the insurance sector of
Malawi.
A new regulatory framework is critical to enhance the capacity of RBM to
supervise the insurance market, being able to address more adequately the
controls that need to be set in place in order to minimize the impact of
market concentration and address the problems of limited information.
RBM needs to improve its supervision capacity through adequate staffing,
capacity building, adopting of standard supervision procedures and use of
modern IT supported supervision tools.
Further improvements should be introduced in the regulatory framework
as a necessary condition to support the expansion of insurance market, to
increase operations in the less traditional branches and to improve
5 NASFAM provides technical assistance and marketing to nearly 100,000 farmers in Malawi. OIBM is a
microfinance lending provider for improved seeds.
6 Currently all eight licensed insurance companies are members of the Insurance Association of Malawi
8
investments by offering a more diversified menu of investments,
potentially expanding the space for foreign investments.
The experience of weather insurance should be monitored and supported
by the government as a clear example of the capacity of private sector
mechanisms to reduce vulnerability of poorer groups. A cost-benefit
analysis may be conducted to determine the feasibility of investing in
extending the network of weather stations, as well as investing in
educational campaigns to educate farmers on the advantages of insurance
products.
II. LIFE INSURANCE AND PRIVATE PENSIONS
A. Market structure and Penetration
21. Individual life insurance has experienced some growth in the last years; but
private pension administration and asset management is dominant in the portfolio of life
insurance companies.
22. While pension provision for private sector workers is not mandated by law, about
450 private pension plans currently operate, covering 150,000 active workers.
Contributions are defined by each plan in the trust deed, but a common practice is 15
percent of payroll (10 percent paid by the employer and 5 percent by the employee).
23. Coverage of the private pension system is low as compared with other countries
that have mandatory pension schemes. However, very few low income countries have
been able to develop a voluntary market for private pensions like the Malawian. While
expansion of the market would be highly desirable, the economic structure of the country
(with more than 80 percent of rural population) imposes a natural ceiling to the expansion
of the system.
24. Private pension management is also highly concentrated. Three insurance
companies operate in the market (NICO, Old Mutual Life Insurance and Vanguard). The
largest two administer 90 percent of the pension plans (315 out of the current 350). Other
pension plans are “self managed” by the employers, but in practice most of them are
administered by a trust (“Indetrust”) that includes around 100 Plans and only specialized
financial sector companies (like banks) manage their own pension programs. Specialized
management is a positive condition for an unregulated market like the Malawian, but this
certainly does not preclude non explicit governance issues or conflicts of interest in the
fiduciary responsibilities of pension fund managers.
B. Products
25. Private pension plans in Malawi are funded occupational schemes. Employers
contribute to the plans on a voluntary basis, so the level of contribution (and, therefore,
the amount accumulated by individuals) varies from one plan to another. Pension fund
managers do not set the rules of the plans. However, the managers offer the option of
“pool funds” that are centrally managed with similar rules, and most of the employers
9
prefer this option to the customized “segregary funds”. In the absence of regulations,
market concentration contributes to homogenizing the market and it is a “second best”
option to a common set of rules, with standard contribution rates of 15 percent (10
percent paid by the employer and 5 percent deducted from payroll).
26. The plans are not integrated, and pension rights are not portable. Workers who
move from one job to another may not have the option of continuing contributing, they
may move to a plan with different rules, or they may simply use the fund accumulated in
the old job and start a new job without any retirement savings. Most commonly, workers
who move to another job receive a lump sum that may serve to any short term purpose, in
detriment of the long term objectives of pension arrangements.
27. According to Tax Act regulations, benefits are paid upon retirement (age 60) in
the following way: 1/3 as gratuity (lump sum) and other 2/3 as annuity provided by the
insurance companies or the funds. However, pensions below K 36,000 per year (raised to
120,000 effective July 2007) can be fully withdrawn as a lump sum.
28. The development of a market for annuities faces a number of challenges. For an
economy with high history of inflation, lack of explicit regulations regarding indexing or
adjusting procedures is a serious drawback. Although there are no general patterns, there
are usually two types of annuities: a) fixed, and b) progressive. In the first case, the
amount of the annuity is defined “constant”; in the second, the initial capital withdrawals
are lower and gradually adjust to higher amounts. In both cases, ad hoc adjustment
mechanisms are often set in place to reflect the performance of investments. This is an
indirect but non transparent mechanism of adjustment to the loss of value of the Kwacha.
29. In absence of adequate mechanisms to adjust pensions, people have a strong
preference to receive their payments as lump sums as opposed to annuities. The decision
is quite rational, but it compromises the main objective of a pension system: to provide
income protection in the old age (and after disability or death of a worker). Due to
myopia of individuals, most countries in the world had to introduce savings for retirement
on a mandatory basis, and even those with well developed private retirement savings
programs have restrictions to withdraw the amounts accumulated as lump sum.
30. While regulation is not the only factor to promote the development of a market for
annuities, it is a pre-condition to support this development. In Malawi, a recent
amendment to the Taxation Act, echoing public expectations, has substantially increased
the maximum amount that retirees are allowed to receive as a lump sum from 36,000 K
per year to 120,000K. Given the observed strong preference for present consumption in
view of the inadequacies of annuity products, it is expected that very few beneficiaries
will opt to receive their pensions as monthly installments.
C. Pension Fund Management
31. In the absence of regulations for private pensions, information is very limited and
only in some cases pension fund managers disclose their information voluntarily. As a
10
general rule, however, it is very difficult to produce any analysis of the sector with so
limited access to information, even for the public agencies in charge of supervising.
32. Limited investment options and prohibition to invest abroad also restrict portfolio
diversification of pension funds. There is no information for the whole market, but a
leading pension fund administrator has the following portfolio structure: a) Treasury
Bills: 25 percent; b) Deposits: 10 percent; c) Loans: 14 percent; d) Shares: 39 percent; e)
Real Estate: 12 percent. Limits to diversify portfolios structure affect the possibility to
diversify options for different groups or to invest in longer term instruments, as it would
normally be expected for pension funds.
D. Regulation and Supervision of Life Insurance and Private Pensions
33. The regulatory framework and supervision of Life Insurance and Private Pensions
are even weaker than in the case of General Insurance. As a consequence of the
regulatory and supervisory vacuum, availability of information is very limited.
Accumulated funds are estimated in about K 45 billion (around 15 percent of GDP), most
of which are managed as pools by Life Insurance Companies or a trust. The annual flows
of contributions to the funds are estimated in an amount close to K 5 billion.
34. Private Pension schemes in Malawi are extremely under-regulated. The few
existing rules at present are included in the Taxation Act, and include the obligation to
register, to submit annual reports and to report new pension payments to the Malawi
Revenue Authority (MRA).
35. The Income Tax Commissioner of MRA exerts the only formal supervision over
the pension plans, but it lacks operational and enforcement capacity. There is only one
person assigned to this task, and IT support is inexistent. Private pension plans are
required to send their financial statements to MRA every year, as well as any amendment
to the plan. However, due to the severe constraint of resources and technology, the
information is neither processed nor used for any control purpose.
36. One of the main obstacles to develop the market for private pensions is the
overlapping between this benefit and the severance pay. Although both types of benefits
are conceptually different, in the absence of a mandate to contribute to a pension scheme,
severance pays are increasingly used as a substitute of pensions. This practice has been
extended to the extreme case of unduly duplication of benefits upon retirement and the
consequent reluctance of employers to continue financing voluntary pensions. According
to a Judiciary statement, this situation is the consequence of the ambiguous text of the
Labor Act and can only be solved with an amendment of this act.
37. The Ministries of Labor and Justice have been working together in the preparation
of an amendment to the current legislation. The new bill would allow employees to
choose either severance or pension benefits. While this solution would correct the
duplication, it does not appear to address the specificity of both types of benefits. The
political economy of this legal reform, however, seems to be an even harder obstacle, and
the duplication of benefits does not appear to be corrected in the near future.
11
38. Taxation rules for voluntary pensions are usually considered mechanisms to
entice the market development. Although there is no general agreement regarding the
expected impact, it is clear that taxation rules must be coherent and double taxation
should be precluded. In its origin, the system did not tax contributions up to a certain
level, and taxed the benefits, also above a certain minimum. The erosion of the ceilings
by inflation distorted tax collection, and corrective mechanisms set in place have been
“ad hoc”, responding to short term needs rather than long term planning. The structure of
taxation is thus complex and unclear. The system should move back to clearer (standard)
criteria of taxation with explicit mechanisms to adjust ceilings.
39. Recommendations:
At minimum, preserving the existing incentives for voluntary pensions
requires a clear regulatory framework as a necessary (but not sufficient)
condition; this should include a clear delimitation of the coverage of
pensions vs. severance pay, and stable and transparent taxation rules.
Adoption of adjustment mechanisms to correct the effects of inflation on
the amounts of pensions will preserve the income of retirees and prevent
the use of “ad hoc” discretionary solutions and distortions.
Similar considerations as in general insurance regarding the supervision
capacity of RBM.
III. PUBLIC PENSIONS
A. Current PAYG system for Civil Service and Military
40. Pension provision for the Civil Service and Military is organized as a pure Pay-as-
you-go (PAYG) scheme that covers about 125,000 active workers and pays benefits to
about 30,000 beneficiaries.
41. There are minimum conditions of age and years of service to be eligible for a
pension, but the conditions may substitute each other in some cases. A civil servant will
be eligible if he/she has: a) 60 years of age and minimum of 10 years of service; or: b)
minimum of 20 years of service, regardless of the age. At 10 years of service, a lump sum
is paid as termination benefit. With less than 10 years of contribution there is no right to
any benefit. In the case of the Military, a minimum of ten years of service is required, and
there is no minimum retirement age.
42. Although there are no contributions to the public pension scheme, an “implicit
contribution rate” was estimated by Gillingham et al. (2006) as equivalent to 22 percent
to 30 percent of salaries, depending on the assumptions of sustainable returns.7 As
7 The rate of 30 percent corresponds to a rate of return of 2 percent per year, while the rate of 22 percent
corresponds to 4 percent. In both cases, implicit cost of life insurance for disability and survivorship
pensions were included. (Gillingham, R. et al, 2006).
12
compared with any international standard, these rates are very high and reflect the
generosity of the system.8
43. Before year 2004, pensions were calculated as a percentage of the basic salary.
An accrual rate of 3.3 percent per year of service was used to compute pensions. Basic
salaries did not include allowances or gratuities, so pensions were equivalent to about 1.1
percent of gross salary per year of contribution.9 Total pensions in 2003 represented 0.70
percent of GDP.
44. In year 2004, a wage reform for the civil service re-defined salaries to include all
concepts as remuneration, producing a significant increase of the salary base for taxes
and pensions. The unexpected effect on pensions was corrected with the ad-hoc
mechanism of replacing the last salary by the average of the last five years of service for
pension calculation. The effect of this measure was to reduce the replacement ratio (as
percentage of the last salary) in the first year after the reform, although the overall
pension bill significantly increased. As time passed, however, this ad-hoc mechanism
would lose all effectiveness. The accrual rate was later re-defined to (partially)
compensate for the definition of the reference wage.
45. The wage reform of the civil service triggered a discussion on longer term issues
that had been so far absent in the pension policy discussion in Malawi: Would the civil
service pension scheme be able to provide affordable and equitable pensions in
sustainable conditions?
46. A contributory PAYG pension scheme is sustainable in the long term if the
present values of pensions and contributions are equivalent in that timeframe.10
In the
case of non contributory schemes the concept of sustainability needs to be re-defined: in
the absence of contributions, a target (maximum) pension payment as a percentage of
GDP could be used alternatively. Before 2004, the cost of the civil service pension
scheme was 0.7 percent of GDP.11
Regardless of any long term factor that might have
affected the sustainability of the public pension system in 2004, the wage reform
produced a phenomenal increase in pension expenditures
47. Since 2004, the basis of calculation was changed to the average of the worker’s
salaries perceived during the three years prior to retirement. In order to compensate for
the higher salary based used, the accrual rate was redefined as 2.5 percent per year for
lower salaries and 2.2 percent for higher salaries. This change in the rules of the system
8 The basic parameters of a PAYG system are: contribution rate, accrual rate, retirement age, vesting period
and indexing rules. Given a sustainable rate of return for the pension system, there parameters are inter-
related. In a sustainable PAYG pension scheme, some of the parameters may be discretionally defined,
according to the objectives of the pension system, but at least one of them will necessarily result
endogenous. 9 This percentage is the result of applying 3.3 percent to a basic salary that represented about one third of
the gross salary. 10
Holzmann, R. and R. Hinz (2005) 11
Gillingham et al. (2006).
13
implied a shift from a mainly redistributive pension scheme that paid basic benefits to an
earnings related scheme.
48. As seen in Figure 5, however, salaries in the public sector grew faster than public
pensions, even after year 2004. This can be explained by a number of reasons, such as the
following: a) the adjustment in the accrual rate factor; b) the use of average salaries
without indexation as base income for pension calculation purposes; c) the lack of
indexation rules; and d) the relative immaturity of the pension system.
Figure 5. Salaries and Pensions of the Public Service
Malawi - Salaries and Pensions of the
Public Service
0.00
5.00
10.00
15.00
20.00
25.00
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
Bil
lio
n K
wach
as
Salaries Pensions
Source: Reserve Bank of Malawi (2006)
49. The lower accrual rates are insufficient to prevent by themselves an explosive
evolution of pensions as the system matures and covered population structure evolves. In
fact, when compared with international standards, an accrual rate of more than 2 percent
per year of service is high, and in the case of contributory systems it can only be
associated with high contribution rates if the system has to be financially sustainable.
50. The fact that the Malawian pension system is a pure PAYG scheme precludes an
explicit discussion of long term sustainability, but in essence, long term financing
problems may be similar to those of a contributory scheme if the parameters are too
generous. In a contributory scheme, the inconsistency (long term non sustainability) will
be manifest in the mismatch between revenues and expenditures. In a non contributive
scheme, it may take the form of an explosive growth of benefit payments.
51. The current accrual rates for the public service pensions in Malawi is even more
generous if we take into account the comparatively short vesting period in the current
regulations. In fact, workers may be eligible for pensions since they have only 10 years of
contribution. Lower total replacement ratio is not enough as disincentive for early
retirement, since the accrual rate is constant along the whole career.
14
52. The use of averages is another usual mechanism to lower the pensions as opposed
to the last salary.12
Generous accrual rates were applied in the past to base salaries.
Change in base salaries affected pension calculations. Adjustment was made by reducing
the accrual rate from 3.3 percent per year to 2.5-2.2 percent calculated on average of last
3 years.
53. Pensions are paid upon retirement as a monthly payment, but part of the total
benefit (up to 25 percent of full pension) may be received as a one time payment or
“Gratuity”. A reduced pension with a present value of the remaining 75 percent is paid
monthly.
54. Inflation erodes pensions. In Malawi, as in several other countries, the absence of
indexation mechanisms is an instrument to adjust pensions to an affordable level for the
public budget. However, this adjusting mechanism is both inequitable and inefficient. In
fact, the absence of automatic adjustment mechanisms introduces an unintended income
redistribution effect from the older pensioners to the recent retirees. By this distributional
effect, only recent retirees receive the promised generous pensions, but these will result
substantially reduced by inflation and lack of indexation.
55. Automatic indexation is needed in order to preclude non desired income
redistribution from older to new pensioners. Since this would impact the financing of the
system, the parameters need to be adjusted to reflect the long term sustainable level of
pension that the budget is able to maintain. As Figure 6 shows, the introduction of
indexation mechanisms will result in an increasing fiscal burden of the public pension
system, unless the parameters of the system are revised accordingly. As observed in the
graph, under the assumptions adopted for projection, wage indexation will increase the
burden of the public pension system by 10 percent in only 5 years. Gillingham et al
(2006) also show that preventing an explosive expansion of pension expenditure is
possible if the key parameters of the system (accrual rate, reference income, retirement
age) are adjusted accordingly.
12 In theory, this mechanism can be used to reduce the risk of salary fluctuation, but this argument is weak
when applied to public pension schemes. It may also be used to reflect more accurately the worker’s
contributory history, or to better define the target income to be replaced by pensions.
15
Figure 6. Public Pensions Projected with Different Indexation Mechanisms
Malawi: Public Pensions projected
with different indexation mechanisms
0
0.5
1
1.5
2
2.5
2003
2004
2005
2006
2007
2008
2009
2010
2011
% o
f G
DP
Baseline Wage indexed benefits
Price Indexed benefits
Source: Gillingham et al (2006), based on information provided by the Ministry of
Finance of Malawi
B. Shift to a Contributory Pension scheme
56. The pension system for civil service and militaries was designed as a pure PAYG
non contributory scheme in which the system’s liabilities are the sole responsibility of the
government as employer.
57. Since the government became aware of the need to introduce reforms in order to
make the current system sustainable, a number of alternative projects have been under
analysis. Among them, three main groups deserve special consideration: a) Shifting to a
funded contributory scheme; b) Moving to a contributory PAYG scheme; c) Parametric
reforms of the current pure PAYG scheme.
58. The shift to a funded contributory scheme is the most radical option. For several
years after the Chilean pension reform of 1981, such a paradigm has deserved particular
attention from countries trying to move away from the trend to chronic deficits in the
pension systems. The system has also been promoted as a catalyst of private savings and
growth. In recent years, closer attention is being paid in the international debate on
pension reforms to the “enabling conditions” that need to be verified before adopting
such radical reforms.13
In the case of Malawi, with poor financial market development,
insufficient experience in the provision of annuities and weak supervision, conditions are
not yet verified for such a radical option, as noted by Gillingham et al (2006).
13 Holzmann and Hinz (2005).
16
59. The shift to a PAYG contributory scheme faces two main obstacles. The first is
the need to invest public reserves, which will impose additional demands in governance
and institutional development.14
The second difficulty is to make contribution rates
explicit. As mentioned above, necessary contribution rates for the current pension system
are very high and they might be considered unacceptable. It should be noted, however,
that while the existing system does not impose an explicit cost to the employer (i.e., the
government), the implicit cost should not differ from those of the non contributory PAY
scheme so long as the parameters of the system are not substantially reviewed. While this
does not happen, the Civil Service Pension Scheme will impose a similar burden to the
budget, and this will increase as the system matures and more workers retire.
60. A consistent parametric reform of the pure PAYG should follow the principles of
sustainability, affordability and equitability. Discretionary manipulation of parameters is
not effective to address these reforms, even if the changes are in the right direction. This
was the case with recent reforms adopted in Malawi: the direction was right but they
were adopted on an “ad hoc” basis, under a weak regulatory framework and without the
participation of key social partners.
61. Examples of parametric reform options are presented by Gillingham et al (2006).
With strong limitations due to the lack of reliable databases, the authors project two
alternative reform scenarios: a) baseline with wage indexation; b) accrual rate of 2
percent, price indexation and discount of lump sums (lower cost options). The result in
the first scenario is an increase of pension expenditures to 3.14 percent of GDP in 2025
(starting at 0.7 percent in 2004). The less expensive option is, however, also costly since
expenditures rise to 1.72 percent of GDP. It should be noted that the higher costs would
be equivalent to an increase in contribution rates, already high at the onset of the reform.
Higher retirement age, while consistent with the parametric reform, should not be
considered as an effective instrument to substantially reduce pension expenditure
(Gillingham et al, 2006).
62. Sustainable and affordable combinations of PAYG parameters need to adjust to
the equilibrium equation:
A (a,t) = c / [g (a,t)], where
A (a,t) is the accrual rate for retirement age “a” at time “t”, and:
g (a,t) = g [ s(a,t), r], where
s (a) is the probability of survivorship at age “a”,
r is the sustainable return rate of the PAYG scheme, and:
14 Musalem, Alberto and Robert Palacios (2004).
17
Indexing rules are necessary to preserve the real value of pensions, but this in turn will
require further reduction of accrual rates in order to have (implicit) contribution rates
acceptable for international standards.
63. Recommendations:
The reforms introduced in the civil service pension scheme in recent years
are in the right direction but they were designed on an ad hoc basis, and
further analysis of the long term implications needs to be conducted in
order to design a set of parameters that is consistent with the principles of
sustainability, equitability and affordability.
The shift to a contributory scheme may be an important next step to make
the system more transparent; however, governance and investment
policies, as well as the institutional and regulatory framework need to be
set in place before this reform takes place.
Enabling conditions are not verified in Malawi for the introduction of a
systemic shift to a funded pension scheme; in the near future, it is
recommended to limit these schemes to the voluntary tier of the pension
system.
Parametric reforms should include indexation rules, which will in turn
require further review of accrual rates and eligibility conditions to long
term affordable levels.
IV. SUMMARY AND RECOMMENDATIONS
64. The insurance and private pension sectors in Malawi show a low level of
penetration, but they seem acceptable in comparison to other countries in similar stages
of development. Concentration and costs are high, the regulatory framework is outdated
or inexistent and supervision is weak.
65. There are some innovative experiments with (weather) micro-insurance, the main
challenges being its extension through the adoption of necessary investments and
increasing education in the uses and possibilities of insurance mechanisms.
66. Life insurance and private pensions plans are not regulated, portfolios are not
diversified, and benefit rules (included indexation) are defined on an “ad-hoc” basis.
67. The parameters of the current PAYG pension scheme are very generous and they
severely compromise an evolution at socially acceptable costs. Conditions are not
verified to shift to a funded scheme, and a possible move to a contributory PAYG scheme
would not solve the basic parametric inconsistencies. The move to a sustainable pension
scheme will inevitably imply the need top review the benefit formula and adjust the
accrual rate.
68. In spite of the generous parameters of the public PAYG scheme, inflation erodes
pensions and most pensions are paid as lump sums, affecting the ability of the pension
18
system to provide lifetime income protection. Explicit indexing mechanisms are
recommended, once the sustainable parameters for the system are adopted.
69. In order to address the issues mentioned above and to promote sound and
sustainable growth of the insurance and pension systems, it is recommended that the
government of Malawi:
Enact pending legislation to strengthen the regulatory framework and the
supervision capacity of the insurance and private pension sectors.
Develop a capacity building program to improve the quality of
supervision, including training in the adoption of a risk based supervision
strategy.
Reassess the sustainability and affordability of public pension scheme and,
in light of the results, review retirement age, accrual rate and indexation
mechanism.
V. REFERENCES
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Carmichael, Jeffrey (2005): “Malawi: NBFI Capacity Building Strategy. Final Report”.
FIRST Initiative-Carmichael Consulting Pty. Nerang, QLD, Australia. Mimeo.
_________________ (2006): “Malawi: Strengthening the Legal Framework for NBFIs
and providing preliminary advice on Pension Reform. Final Report”. FIRST Initiative-
Promontory Financial Group Australasia. Singapore. Mimeo.
Gillingham, Robert, Thomas Dalsgaard and John Greenlees (2006): “Malawi: Reform of
the Civil Service Pension System. Aide Memoire”. International Monetary Fund, Fiscal
Affairs Department. Washington DC.
Gine, Xavier and Dean Young (2007): “Insurance, Credit and Technology Adoption:
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Holzmann, Robert and R. Hinz (2005: “Old-Age Income Support in the 21st Century: An
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International Association of Insurance Supervisors (IAIS) (2003): “Insurance Core
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Musalem, Alberto and Robert Palacios (2004): “Public Pension Fund Management”. The
World Bank. Washington DC.
19
Roth, Jim, M. J. Mc Cord and D. Liber (2007): “The Landscape of Microinsurance in the
World’s 100 Poorest Countries”. The Microinsurance Centre. Appleton, Wisconsin.
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______________________ (2005): “Insurance Annual Report 2005”. Blantyre. Mimeo.
