Risk Management

1
Risk management and regulation of defined
contribution schemes
Mexican pension reform and risk management
framework
2
Background
Pension system in Mexico
3
Background

• The Mexican Social Security Institute (IMSS) was
  created in 1943 to administer 4 social security
  programs
• work injuries
• old age, disability, survivorship, and
  unemployment in old age
• sickness and maternity
• nurseries and social benefits

4
IMSS

• 14 million affiliated workers
• 50 million beneficiaries
• 2 million pensioners
• IMSS is the second fiscal authority in the
  country, collecting more than 9 bn. USD of
  contributions from workers and employers
• IMSS annual budget is over 17 bn. USD
• child care to 115 thousand children
• 33 of population born in IMSS hospitals

5
Diagnosis

• In 1995, a review was conducted to assess, among
  other issues, the financial viability of the
  pension system
• It was estimated that, in order to sustain the
  PAYG system, contributions would have to be
  increased from 7.0 to
• 10 for the period 2000-2009
• 15 for the period 2010-2019
• 25 for the period 2020-2030
• 
  Including 2.5 of disability and
  survivorship

6
New law

• As a result from the diagnosis and after
  intensive public consultation and debate,
  Congress repealed the existing Social Security
  Law (last amended in 1973) and introduced an
  important pension reform

7
New law

• The new Law replaced the defined benefits PAYG
  publicly managed pension system with a defined
  contribution, individual accounts, privately
  managed system
• The new Law introduced a minimum pension
  guarantee (equivalent to one minimum salary) and
  a grandfathered previously affiliated workers

8
Old vs. new pension systems
Old pension system
New pension system
Insurance coverage Pension Scheme Financing Funds Management Insurance coverage Pension Scheme Financing Funds Management
Disability, Old Age, Unemployment in Old Age and Survivorship Defined benefits PAYG publicly managed by IMSS Old Age, Retirement, Unemployment at Old Age Defined contribution Fully funded, individual accounts Funds managed by private fund managers Annuities are purchased with available funds at retirement
Disability and Survivorship Defined benefit Collective funds to purchase annuity from private insurance company
9
Transition

• Transition costs absorbed via general taxation
  and payroll taxes
• Federal Government absorbed pension liabilities
  generated as of June 30,1997
• Individual accounts funded through tripartite
  payroll taxes
• Generation in transition incorporated
  immediately to the new pension scheme
• IMSS continues as pension payment agent

10
Fund managers

• Specialized companies were created to manage
  pension funds (AFORES)
• Investment vehicles (SIEFORES) were also created
  to isolate funds from AFORES and prevent
  bankruptcy risks
• The housing agency (INFONAVIT) also acts as fund
  manager and funds saved in the housing
  sub-account are also used to purchase the
  annuity, at the time of retirement, if housing
  benefit was not used during the workers active
  life

11
Players

• The pension system also involved a new improved
  fiscal and data collection process (based on a
  central processing agency, PROCESAR)
• 17 AFORES were originally set up, 12 remain
  after initial consolidation, all AFORES reported
  a net profit in 2001
• Assets have grown to 27 bn. USD, equivalent to
  4 of the 2001 GDP equivalent to 60 of
  international reserves
• Annuity insurance companies were also created
  and now manage 6 bn. USD in assets
• AFORES are regulated by an independent
  supervisory body (CONSAR)

12
New pension system
Results
13
Historical investment results (in real terms, as
of March 2002, not considering commissions)
ALLIANZ DRESDNER 7.89
BANAMEX 9.10
BANCOMER REAL 8.97
BANORTE GENERALI 8.35
INBURSA 6.11
ING 9.14
PRINCIPAL 8.78
PROFUTURO GNP 8.71
SANTANDER MEXICANO 7.53
TEPEYAC 7.96
XXI 8.66
ZURICH 8.47
SYSTEM AVERAGE 8.54
14
Assets under management (as of March 2002, in
millions of pesos)
Voluntary contributions
Old age
Housing
Total
ALLIANZ DRESDNER 9,453 16 5,459 14,928
BANAMEX 62,059 482 37,177 99,718
BANCOMER 57,113 485 34,658 92,256
BANORTE GENERALI 14,943 94 8,317 23,354
INBURSA 18,961 192 11,676 30,829
ING 22,516 57 13,239 35,811
PRINCIPAL 6,302 9 3,758 10,068
PROFUTURO GNP 25,254 151 15,387 40,792
SANTANDER MEXICANO 23,628 134 14,475 38,238
TEPEYAC 2,964 8 1,642 4,613
XXI 16,264 200 9,899 26,363
ZURICH 2,392 6 1,318 3,715
TOTAL 261,849 1,834 157,005 420,685
15
Portfolio composition International comparison
- As of December 2000 - Country/Instrument Argentina Chile Mexico Peru
Government bonds 56.0 35.7 92.6 9.0
Financial institutions instruments 15.6 35.1 2.0 34.0
Commercial paper 2.8 4.0 5.4 18.6
Equity 12.3 11.6 0.0 29.0
Funds 8.2 2.4 0.0 0.7
Foreign bonds equity 4.5 10.9 0.0 6.7
Total (millions USD) Source Andersen survey 20.381 35.886 17.385 2.978
In Mexico, the portfolio composition has changed
in the last two years, investments in Government
instruments are now down to 85.8 (as of March
2002)
16
New pension system
Opportunities
17
Mobility competition (transfered accounts
between AFORES, as of March 2002)
of real returns
ALLIANZ DRESDNER 7,952 -11,542
BANAMEX 67,985 -55,981
BANCOMER REAL 49,690 -44,726
BANORTE GENERALI 18,452 -21,957
INBURSA 5,753 -5,520
ING 23,721 -28,163
PRINCIPAL 2,476 -5,654
PROFUTURO GNP 25,712 -48,242
SANTANDER MEXICANO 39,932 -39,553
TEPEYAC 3,879 -4,009
XXI 20,498 -3,080
ZURICH 4,102 -1,725
TOTAL As a of affiliates 270,152 1.1 -270,152
of salary
of balance
18
Commission structure
of real returns
of salary
of balance
ALLIANZ DRESDNER 1.60 0.50  
BANAMEX 1.70    
BANCOMER 1.69    
BANORTE GENERALI 1.45 1.00  
INBURSA   33.00
ING 1.68    
PRINCIPAL 1.60 0.45  
SANTANDER MEXICANO 1.60 1.00  
TEPEYAC 1.60 0.15  
XXI 1.45 0.20  
ZURICH 1.65 0.50  
19
Assets under management (as of March 2002, in
millions of pesos)
Voluntary contributions
Old age
Housing
Total
ALLIANZ DRESDNER 9,453 16 5,459 14,928
BANAMEX 62,059 482 37,177 99,718
BANCOMER 57,113 485 34,658 92,256
BANORTE GENERALI 14,943 94 8,317 23,354
INBURSA 18,961 192 11,676 30,829
ING 22,516 57 13,239 35,811
PRINCIPAL 6,302 9 3,758 10,068
PROFUTURO GNP 25,254 151 15,387 40,792
SANTANDER MEXICANO 23,628 134 14,475 38,238
TEPEYAC 2,964 8 1,642 4,613
XXI 16,264 200 9,899 26,363
ZURICH 2,392 6 1,318 3,715
TOTAL 261,849 1,834 157,005 420,685
20
Risk Management
21
However, it is necessary to adapt the general
definition to the particular circumstance
Particular definition of risk
The likelihood that a particular threat using
a specific attack, will exploit a particular
vulnerability of a system that results in an
undesirable consequence
( Definition from National Information Systems
Security INFOSEC) Glossary, NSTISSI No. 4009,
Aug. 1997)
The definition of risk depends on the field of
study, the particular circumstances and it is
subjective
22
Definition of risk management
The process concerned with identification,
measurement, control and minimization of risks
in particular field (i.e. information systems)
to a level commensurate with the risk
appetite
23
Risk Management Process
Identify the Risk Areas
Re-evaluate Risks and Control actions
Assess the Risks
Risk Management Cycle
Develop Risk Management Plan
Implement Risk Mitigation Actions
Risk Assessment
Risk Mitigation
24
Risk tolerance or appetite
Ignore
Control
Risk management depends on subjective values
25
The Four Ts
Transfer A risk control technique that involves
the contractual shifting of a
pure risk from one party to another. Contractual
agreement and payment for
insurance. Transform modification of the risk
nature to make it safer, through
coverage products, like FRAs, future
contracts, swaps, hedge
positions, etc. Terminate through control
actions eliminate risk (sometimes it is very
expensive or due to the nature of
the risk, impossible to
eliminate) Tolerate risk has been detected,
can be monitored, cost-benefit analysis
shows no actions required (but have
contingency plans)
26
Value at Risk (VaR)
Summarized measurement of market risk

• Deals with market risk ( i.e. changes in
  interest rates)
• VaR is a method to quantify the risk using
  standard
• statistical techniques.
• VaR measures the worse loss in a certain
  period under
• normal market conditions given a certain
  confidence level.
• Structured approach (methodology) to think
  critically about
• risk.
• Common methods Markowitz and Montecarlo

27
Other common risk types

• Credit Occurs when counterpart is unable to
  fulfill its
• contractual obligations due to
  financial problems.
• Liquidity When a transaction cannot be
  fulfilled at
• prevailing market prices due
  to low bursatility
• or market volume
• Operational Refers to the resulting losses of
  inadequate
• systems, administrative
  faults, defective controls,
• fraud, or human error.
• Legal When one counterpart does not have
  the legal or
• regulatory authority to
  adequately complete the
• transaction.

28
Stress Testing

• This method, denominated some times like
  scenario analysis,
• examines the simulated effect on the
  portfolio of significant
• movements in key financial variables.
• All the assets of portfolio are evaluated
  using the new assumptions, and the yield of
  portfolio is re-calculated.
• Naturally, different scenarios generate
  different returns.
• When specifying the probability for each
  scenario, a distribution
• of yields of the portfolio is created,
  which the VAR can be
• obtained.
• The advantage of this method is that it can
  review situations
• completely different to the historical
  data.

29
Asset liability management

• Problem defined as ability of assets to
  match or pay
• liabilities, not just investment of assets
• Ultimate surplus assets remaining once
  liabilities paid
• 3 dimensions, market value, surplus, variance
  of surplus
• ensure positive mean of surplus and a
  reasonable probability that it will be positive
• computer simulation (many scenarios)
• limit number of asset classes -gt optimize
  strategic allocation (individual asset through
  traditional techniques)

30
Regulations (based in Basel Committee resolutions)
Issue date

• Board participation
• Risk Committee
• Risk Management Unit (RMU)
• Risk manual (with limits)
• Procedures for measurement, monitoring and
  control
• Models, methodology and measurement systems
• Sensitivity analysis
• Stress testing
• Contingency plans
• Independence of RMU
• VaR
• RMU responsible for compliance
• Risk audit

IMSS Financial Investment Unit December 1999
Banking system December 2001
AFORES (Circular 15-5) December 2001
31
Ed Tamagnos 6 Principles

1. Clarity of objectives
2. Independence from political interference
3. Accountability to insured persons
4. Professional Management
5. Low operating costs
6. Prudence in investments

32
12 Principles
Edward Tamagnos
Méxicos recommended

• Clarity of objectives
• Independence from political interference
• Transparence accountability to
• insured persons
• Professional Management
• Low operating costs
• Prudence in investments

• Program Efficacy (yield goals)
• Systemic efficiency (market
• competitiveness)
• Alignment of interests and incentives
• Integral process (big picture
• assets and liabilities management)
• Supervision and regulation
• competence
• Solid corporate governance

33
Asset liability management

• Problem defined as ability of assets to
  match or pay
• liabilities, not just investment of assets
• how much asset needs to grow
• Ultimate surplus assets remaining once
  liabilities paid
• 3 dimensions, market value, surplus, variance
  of surplus
• ensure positive mean of surplus and a
  reasonable probability that it will be positive
• computer simulation (many scenarios)
• limit number of asset classes -gt optimize
  strategic allocation (individual asset through
  traditional techniques)

34
12 Principles
Edward Tamagnos
Méxicos recommended

• Clarity of objectives
• Independence from political interference
• Transparence accountability to
• insured persons
• Professional Management
• Low operating costs
• Prudence in investments

• Program Efficacy (yield goals)
• Systemic efficiency (market
• competitiveness)
• Alignment of interests and incentives
• Integral process (big picture
• assets and liabilities management)
• Supervision and regulation
• competence
• Solid corporate governance

35
Mobility competition (transfered accounts
between AFORES, as of March 2002)
of real returns
ALLIANZ DRESDNER 7,952 -11,542
BANAMEX 67,985 -55,981
BANCOMER REAL 49,690 -44,726
BANORTE GENERALI 18,452 -21,957
INBURSA 5,753 -5,520
ING 23,721 -28,163
PRINCIPAL 2,476 -5,654
PROFUTURO GNP 25,712 -48,242
SANTANDER MEXICANO 39,932 -39,553
TEPEYAC 3,879 -4,009
XXI 20,498 -3,080
ZURICH 4,102 -1,725
TOTAL As a of affiliates 270,152 1.1 -270,152
of salary
of balance
36
Flexibility to compete
37
12 Principles
Edward Tamagnos
Méxicos recommended

• Clarity of objectives
• Independence from political interference
• Transparence accountability to
• insured persons
• Professional Management
• Low operating costs
• Prudence in investments

• Program Efficacy (yield goals)
• Systemic efficiency (market
• competitiveness)
• Alignment of interests and incentives
• Integral process (big picture
• assets and liabilities management)
• Supervision and regulation
• competence
• Solid corporate governance

38
Commission structure
of real returns
of salary
of balance
ALLIANZ DRESDNER 1.60 0.50  
BANAMEX 1.70    
BANCOMER 1.69    
BANORTE GENERALI 1.45 1.00  
INBURSA   33.00
ING 1.68    
PRINCIPAL 1.60 0.45  
SANTANDER MEXICANO 1.60 1.00  
TEPEYAC 1.60 0.15  
XXI 1.45 0.20  
ZURICH 1.65 0.50  
39
12 Principles
Edward Tamagnos
Méxicos recommended

• Clarity of objectives
• Independence from political interference
• Transparence accountability to
• insured persons
• Professional Management
• Low operating costs
• Prudence in investments

• Program Efficacy (yield goals)
• Systemic efficiency (market
• competitiveness)
• Alignment of interests and incentives
• Integral process (big picture
• assets and liabilities management)
• Supervision and regulation
• competence
• Solid corporate governance (Enron,
• Worldcom, Capital Hedge Fund)

40
Players

• The pension system also involved a new improved
  fiscal and data collection process (based on a
  central processing agency, PROCESAR)
• 17 AFORES were originally set up, 12 remain
  after initial consolidation, all AFORES reported
  a net profit in 2001
• Assets have grown to 27 bn. USD, equivalent to
  4 of the 2001 GDP equivalent to 60 of
  international reserves
• Annuity insurance companies were also created
  and now manage 6 bn. USD in assets
• AFORES are regulated by an independent
  supervisory body (CONSAR)

41
12 Principles
Edward Tamagnos
Méxicos recommended

• Clarity of objectives
• Independence from political interference
• Transparence accountability to
• insured persons
• Professional Management
• Low operating costs
• Prudence in investments

• Program Efficacy (yield goals)
• Systemic efficiency (market
• competitiveness)
• Alignment of interests and incentives
• Integral process (big picture
• assets and liabilities management)
• Supervision and regulation
• competence
• Solid corporate governance (Enron,
• Worldcom, Capital Hedge Fund)

42
12 Principles
Edward Tamagnos
Méxicos recommended

• Clarity of objectives
• Independence from political interference
• Transparence accountability to
• insured persons
• Professional Management
• Low operating costs
• Prudence in investments

• Program Efficacy (yield goals)
• Systemic efficiency (market
• competitiveness)
• Alignment of interests and incentives
• Integral process (big picture
• assets and liabilities management)
• Supervision and regulation
• competence
• Solid corporate governance (Enron,
• Worldcom, Capital Hedge Fund)

43
Conclusions
44
In risk management and regulation of defined
contribution schemes
There are many approaches, diverse techniques and
management frameworks However .
45
Risk matrix
Risk types, i.e. legal, credit, operational,
market, etc.
Appetite
Identification
Monitoring
processes
Control
Reporting
Audit
Models
Methodology
Organizational structure
Regulation
Governance
46
Priority approach
Yes, understand severity and probability but
consider first risk appetite
47
Step approach

1. Strategic objectives (derived from business plan)

Determine risk apetite

1. Initiate risk management process

1. Risk management infrastructure

People
Data
Models
Procedures
IT
48
Big, Big Picture
49
Big, big picture or risk management cartography
12 Principles (Tamagnos 6 Mexicos 6)
Ed Tamagnos 6 Principles

BASEL COMMITTEE (CONSAR regulations 15-5 and
CNBV 1423)
Efficacy
Risk types
Sound corporate governance
Clarity of objectives
Contingency planning
legal
market
systemic
regulatory
Prudence in investments
Risk Committee
Basic Risk Management Process
Risk Manual
Models
Sensitivity Analysis
Independence from political interference
Competence in supervision and regulation
Systemic efficiency (competitiveness)
Stress Testing
Segregation of Duties
Low operating costs
liquidity
operational
credit
Models and Measuring Systems
Risk Management Unit
Transparence accountability to insured persons
Professional Management
Alignment of interest and incentives
Complete view (asset-liability)
50
Big, big picture or risk management cartography
12 Principles (Tamagnos 6 Mexicos 6)
Ed Tamagnos 6 Principles

BASEL COMMITTEE (CONSAR regulations 15-5 and
CNBV 1423)
Efficacy
Risk types
Sound corporate governance
Clarity of objectives
Contingency planning
legal
market
systemic
regulatory
Prudence in investments
Risk Committee
Basic Risk Management Process
Risk Manual
Models
Sensitivity Analysis
Independence from political interference
Competence in supervision and regulation
Systemic efficiency (competitiveness)
Stress Testing
Segregation of Duties
Low operating costs
liquidity
operational
credit
Models and Measuring Systems
Risk Management Unit
Transparence accountability to insured persons
Professional Management
Alignment of interest and incentives
Complete view (asset-liability)