LIFE INSURANCE MARKET DEVELOPMENT IN BALTIC COUNTRIES: PENSION REFORMS POTENTIAL MARKET FOR LIFE INSURERS. By Janis Bokans

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1 LIFE INSURANCE MARKET DEVELOPMENT IN BALTIC COUNTRIES: PENSION REFORMS POTENTIAL MARKET FOR LIFE INSURERS By Janis Bokans The process of significant political and economical reforms in the Baltic States caused the necessity to reform pension systems too. Estonia, Latvia and Lithuania 10 years ago was parts of one state - USSR and after restoration of independence inherited the same social security system. After ten years there are differences in pension systems, though all three States are developing so-called three pillar (tier) pension reform concepts. In the 1995 Latvia Government adopted and Parliament accepted Concept of the Pension Reform. The general objective of the reform is to set up financially stable income related pension system. According to the Concept of the Pension Reform following pillars are to be introduced: 1 st pillar State mandatory non-funded social insurance pension scheme (on PAYG base); 2 nd pillar State mandatory funded social insurance pension scheme; 3 rd pillar private voluntary pension scheme. The first pillar is constructed as defined contribution scheme. Each participant of first pillar have own social insurance account where all contributions are registered (so called notional capital ). The pension amount is directly related to the amount of social insurance contributions paid throughout the working life. The general formula for first pillar pension is: P = where K is notional capital and G expected lifetime after retirement (stated Government Decree). First pillar scheme is managed by State Social Insurance Agency and there is no space for private operators. The legislation concerning second pillar passed parliament in February 2000 and will be in power from July The second pillar in fact is very close linked with first one. The essence is that part of mandatory social contribution is channelled for funding. Administration of funded pensions scheme shall be performed by State Social Insurance Agency, which keeps individual accounts. SSIA will in effect function as pension fund, with asset management contracted out. The law states that second pillar funds shall be managed by private fund managers (for transition period - State Treasury). Only investment companies K G

2 with special permission (license) can be the fund managers for second pillar. There are two options for pensioners to use second pillar pension capital at the retirement. First one is to add second pillar capital to the first pillar notional capital to rise up first pillar pension. The second one is to purchase life-long annuity from private insurance company. The second pillar will be mandatory for the age group under 30 at the moment of the law taking force and voluntary for the age group from 30 to 49. Consequently the first clients purchasing annuities in insurance companies with second pillar pension capital can be expected after years in Latvia. Originally (in the Pension Reform Concept 1995) the third (voluntary) pillar was described as unspecified savings products to which tax preferences are applied. However the exigency for special voluntary pension savings financial institution was recognised. Thus Law On private pension funds was adopted by parliament in June 5, 1997 and is effective from July 1, A Private Pension Fund in the notation of law "On Private Pension Funds" is a non-profit joint stock company, which in accumulates and invests voluntary money contributions made by and on behalf of pension plan members with a purpose to accumulate additional pension capital. Pension Funds are open or closed. The members of the pension plans in closed pension funds my be only the persons, which at the moment of affiliation to the pension plan are the employees of the founder (employer). The founders of the open Private Pension Fund my be only commercial banks, investment companies and life insurance companies. The open pension fund can offer services to everyone. Consequently, employers can establish their own closed pension funds or use services of the open funds (for instance in the case of small enterprise). A pension plan is a set of systematised rules for the capital accumulation with the pension fund, investment and benefits payments. Each pension plan has separate balance sheet and income/expenditures statement, incorporated in pension fund respective documents. Pension plans mainly differs by investment policy. Pension plans under the law in general must be defined contributions type. Contributions can be made by participants of pension plans themselves and/or by employers on behalf of employees. The asset management function must be contracted out. Only the bank, life insurance company, investment company or broker company can perform management of the pension plan assets. The assets of pension plans must be kept at the custodian bank. The law On private pension funds stipulates that the accrued pension capital is not available to the participant prior age 55. After the participant of the pension plan have three options: 1) the accumulated pension capital is transferred to the State Social Insurance Fund, where it is remitted to the individual account of the socially insured person and combined with the notional pension capital (pursuant to the law "On 2

3 State Pensions"), when the state PAYG pension benefit amount is calculated subject to the law "On State Pensions", 2) the annuity policy with the life insurance company is purchased, 3) the accumulated pension capital is paid out as lump sum. Consequently private pension fund provide capital accumulation only, there are no option to receive annuity from pension fund. Once again the most important issue are taxation rules. General formulae for private pension funds in Latvia are EET. There are considerable deduction in personal income tax (if contributions are made by person themselves), corporate income tax and social tax (if contributions are made by employer on behalf to employees) for contributions in private pension funds. Contributions up to the 10% to gross salary are tax-free. It is important to note that tax incentives concerning corporate income tax and social tax are attributed to the total contributions for private pension savings, long term life insurance and health insurance. The preference of private pension funds is in case of personal income tax. There are no personal income tax incentives for purchase of long term life insurance (including pension insurance) and health insurance. Thus insurance companies are placed in more disadvantageous situation with comparison to private pension funds and consequently are not considered to be full-scale component of the pension system. Following is the summary of private pension funds operations in Latvia at the end of 1999: Number of PPF 3 (2 open PPF, 1- closed PPF) Number of pension plan s participants 5666 Total assets of pension plans 3,9 ml.lvl (6,5 ml.usd) Assets to the GDP 0,1% In Lithuania pension reform process started in 1991 with establishment of National Social Insurance Fund. Although Pension Reform Concept Paper proposed the implementation of three pillar pension system, now only reformed first pillar and third pillar legislation are in place. The discussions concerning second pillar are still under way. The first pillar is financed by the mandatory social insurance contributions and operates on PAYG base. The general pension formulae is: 3 = % + where B is basic pension (related to minimum standard of living set by Government) and E is earnings related part (depends on years of service and annual income). Alongside social insurance pensions in Lithuania there are several state pension schemes financed from general revenues for military and police servants, for scientists, etc. ( 3

4 The Law on pension Funds in Lithuania came into force in 1 January Participation in pension funds is voluntary. The pension fund under the Law on pension Funds is a limited liability company. A pension fund may manage pension assets itself or may transfer the management of assets to an another asset manager, which is institution regulated by Law on Investment Companies. The pension assets must be kept in the depository. Contributions to the pension fund may be paid by the person itself or by employer on behalf of employees. The right to the pension benefit shall be acquired upon reaching age, which not be less than that set forth by the State Social Insurance Retirement Pension (first pillar pension age) by more than 5 years. Pension benefits may be paid in the following ways: as a lump sum; as an amount held in the pension account by paying it out in portions periodically (no less frequent than an a quarterly basis); by purchasing pension annuity in the life insurance company. From taxation point of view contributions into the pension fund and long term life insurance premiums are treated nearly equally. In both cases there are personal income tax and corporate income tax (in case if employer contributes on behalf of the employee) allowances. The only difference is in ceilings - for life insurance annual ceiling is the sum of four one-month minimum salaries established by the Government, in pension fund case 25% from person s yearly taxable income. There is quiet clear evidence that tax incentives are more favourable for pension funds, because high salaried persons will make more probably additional voluntary pension savings (in pension fund or in insurance company). There are no any pension fund established in Lithuania yet. The possible reason is quiet hard regulations and requirements to the pension fund establishment and operations. Seemingly there are no apparent advantage for possible founders (investors) to establish pension fund. In Estonia the Concept Paper for the Pension Reform was adopted in The Concept declared introduction of three-pillar pension system. In 1998 a set of laws was adopted the State Pension Insurance Act (implementation in 2000), Social Tax Act (implemented in 1999) and Pension Funds Act (implemented in 1998). The State Pension Insurance Act defines first pillar PAYG pension system financed by social tax. First pillar pension under the new State Pension Insurance Act consists from three components: 3 = % + / +, where B basic part, an amount fixed by the Parliament for each fiscal year, L length of service component, I component depending on registered social tax 4

5 paid after January During the transition period component L will gradually disappear and will be completely replaced by component I. The first pillar is managed by the state and there are no any components contracted to private operators. Unlike to Latvia in Estonia it is proposed to introduce second (funded) pension pillar on the base of pension funds. Second pillar pension savings than will be mould out of employees contributions to pension fund of his choice. The existing social tax will be divided between the first and second pillar. As mentioned before Pension Funds Act are in force from 1 August The essence of Estonia approach differs from Latvia and Lithuania cases. In Estonia pension fund is contractual investment fund managed by management company in fact pension fund is a special case of investment fund. Management company operates under the Investment Funds Act. A unit holder of pension fund has the right to demand the redemption of units if he or she is older than 55 years of age. There are two possibilities. First one receive redemption as a lump sum. Second one - transfer it to the insurance company to purchase pension insurance contract based on income tax incentives. Under mentioned contract pension (annuity) must be paid lifelong in equal or increasing sums at least once every three months. In Estonia case insurance companies are in more equal position with pension funds as it is in Latvia or Lithuania. The Estonia Insurance Law allows to life insurance companies to run not only annuity stage of pension contract, but the savings stage too: Article Pension Insurance Contract with Income Tax Incentive (1) Pension insurance contract with income tax incentive (hereinafter: favoured contract) shall be an insurance contract with obligatory provisions as promulgated by this law, the aim of which is to guarantee the payment of the sum insured to the Policyholder, commencing the date set by the contract. (2) An Insurer writing life insurance business, to which a license for favoured contracts has been issued, as prescribed by this law, shall be entitled to conclude favoured contracts. Article Obligatory Provisions of Favoured Contract (1) Policyholder and Insured may only be physical persons. (2) Based on the favoured contract, a Policyholder shall be obligated to pay insurance premiums until reaching the pension age prescribed by the favoured contract, commencing this moment an Insurer shall be obligated to pay insurance pension as prescribed by the favoured contract. (3) Payments of insurance pension shall commence the due date prescribed by the favoured contract (hereinafter: pension age), but not earlier than after the Policyholder reaches the age of fifty five or if the owner of the unit is fully and permanently disabled. (4) Insurance pension payments shall be made on regular basis, the 5

6 interval shall not be shorter than three months, until the death of the Policyholder, unless otherwise provided by the contract. In Estonia there is only one pension fund so far in March 1999 Hansa Asset Management obtained the license to set up Hansa Pension Fund. Currently 5 life insurance companies are licensed to sell pension insurance policies under favourable tax treatment. Conclusions Basically in Latvia and Lithuania life insurance companies will play the role as private annuity providers in reformed pension system. Different approach is in Estonia their life insurance companies are equal players with pension funds in the field of pension capital accumulation and will be annuity providers too. 6

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