The Italian state pension system is close to collapse, but the country's life industry has become addicted to selling unsuitable but lucrative structured products. Can AIP reinvent long-term saving in time to help rescue Italy's ageing population?
Mario Greco, chief executive of Assicurazioni Internazionali di Previdenza (AIP), likes to recall an Italian newspaper survey which asked individuals about their expected retirement income. The average response was 80% of final salary. "They don't understand that they're already below 50%," he says. And the number is likely to decline much further, an inescapable consequence of demographics. According to United Nations statistics, there are currently about four working age Italians for every pensioner over 65. By 2050, only three working age taxpayers will be available to support every two pensioners.
With such demographic trends, and a persistent national deficit, the generous state pension currently assumed by most Italians is unsustainable. "There is a clear situation that the Italian state pension system is close to collapse," Greco points out. The sooner Italian savers realise this, the better, he insists. "There is no clear understanding on the customer side that there is a pension crisis, but this is a fact."
Such ignorance is partially the responsibility of his own industry, concedes Greco. "There is no perception because the supply side - banks, financial services companies and insurance companies - have not started making the situation clear to their customers." In particular, the Italian life industry is all but invisible as a long-term savings or pensions provider, despite being large and profitable. "It's a market where life insurance has been growing rapidly in the past few years, but for what I think are the wrong reasons," says Greco. "It was just a market for financial products sold under the life banner."
Created by retail banks and derivatives dealers, this market in structured retail products is typically viewed as a phenomenal Italian success story, but it has stored up problems for the life sector, argues Greco. "Around five or six years ago, banks started discovering this world of life insurance policies as a way of doing cross-selling from their platforms. But they did not understand what the real life product was."
Instead of giving Italians the life and pensions products they actually needed, the banks (often connected to life companies via bancassurance groups) exploited the business for short-term gain, believes Greco. "They used life policies as a scheme for selling financial products to their customers," he complains. "The banks were simply shifting the assets of their clients out of government bonds or corporate bonds into products sold as life policies, but which were in fact structured financial products."
According to Greco, this cross-selling phenomenon has put the life industry on the back foot, just when Italians need to be persuaded to save for their pensions. "Life products were and are perceived as highly volatile. You put the money in, and after a few years you can get a positive or negative return compared with the initial investment, which is typically not the case with true life products, but it is the case with this kind of structured investment product."
And with improved transparency, things may get worse before they get better, Greco predicts. "There has been a poor education of customers which will take some time to clean out of the market, because customers will become scared as soon as they start discovering the results of the investments they made years ago. They will not want to repeat this in the future."
With Italian savers only dimly aware of the pensions crisis, and the life industry still focused on unsuitable structured products, Greco says that both sides need to change. "I think the supply side and the demand side will have to accept this idea that they should work out a solution to the Italian pensions crisis together. They need to provide pensions support for those reaching retirement in the next 15-30 years."
For his part, Greco has set out to build a company capable of filling the life industry's side of such a bargain. A former partner at consultants McKinsey, Greco was the CEO of Italian life company Riunione Adriatica di Sicurta (RAS) until April 2005 when he parted company with RAS's German owners Allianz and brought his management team to AIP. Controlled by Italian banking group San Paolo IMI, via a holding company called New Step that also owns the majority stake of Banca Fideuram (the financial advisers network), AIP is an agglomeration of several life and non-life businesses, notably the San Paolo Vita and Fideuram Vita brands. If all goes to plan, AIP/New Step will float on the Italian stock market some time in 2006.
There are three components to AIP's strategy. The first one is to undo the damage wreaked by the Italian structured products boom, and restore customer faith in the life industry. Here the regulators have already taken the initiative. In particular, Greco applauds moves by Italy's insurance regulator ISVAP to improve product transparency. From January 2006, providers will have to provide prospective policyholders with information about minimum guarantee rates, annuitisation and crucially, the costs of deferring or switching a contract as well as total expense ratio.
"The total expense ratio issue is very important," says Greco, "Because there was a history of loading the products with very high commissions which were totally opaque to customers." In other words, the dizzy promises made in structured product brochures were based on a false premise, he explains. "For example, the customers don't understand that if they give you EUR100, you don't invest EUR100. You probably invest much less, because in the first year you pay for distribution and management fees, so that the cash flow can sometimes even be negative. Just for the customer to reach par value can take years."
By forcing life companies to reveal such information, the regulator is doing more than helping investors. Inadvertently or not, ISVAP is shaking up the Italian life industry's distribution structure. Greco says: "Now, with the information that all companies will have to disclose at the contract negotiation phase, on total expense ratio for example, everybody will be forced to have a different structure - where if they pay money to a distributor they do it on their own balance sheet, not at the expense of the client."
In the current market, a culture of mis-selling is rife. As Greco complains: "The phenomenon of bancassurance in Italy has been quite negative from the point of distribution. Compared with other countries, the majority of sales here were made via channels where it was not clear whether salespeople had the reputation or financial background to sell this type of product." According to Greco, "Some of the distributors were incentivised to switch customers from one product to another, and to churn the customer - all at the customer's expense."
The results of such a culture are evident in the life portfolios of major Italian life companies. To save for a reasonable private pension, a contract with duration of around 20 years is required. However, Greco points out that the average portfolio duration at RAS is seven years, while at AIP it is closer to five years - damning evidence that until now, Italian life companies have not provided customers with the savings products they needed.
Although a government-regulated product called Forme Individuali Pensionistiche (FIP) was launched two years ago, which allows tax deductions against contributions, it discourages annuitisation, and sales volumes have been small. As Greco concedes, "We need to introduce a completely different set of products into the market. The market doesn't have any specific private pension product yet."
For many years, the great white hope of the Italian savings industry has been the reform of Trattamento di Fine Rapporto (TFR), which represents an amount of money that the employee receives either at retirement age or if they change job (it can also be transferred to the new employer). It corrresponds to roughly 6.9% of the yearly salary (6.4% paid by the employer and 0.5% by the employee) and it is annually revaluated according to the formula: 1.50% + 75% of Italian inflation rate. This revaluation is born by the employer and there is no direct government guarantee, but a public fund has been established in case of default of employer. All Italian employees (lavoratori dipendenti) receive TFR. The Berlusconi government has now decided that from January 2008, employees will be able to opt out of TFR and place the funds in a private or occupational pension scheme. Employers will be given a tax incentive to add their own contributions to opted-out TFR funds.
Although he has been watching the political debate over TFR closely, Greco points out that with a minimum annual guarantee rate of 3.1%, there are compelling reasons not to voluntarily leave TFR. "Our hypothesis is that most employees would stay in TFR because it's such a good product. If they understood a little of what the TFR really is, they would never leave it." By contrast, endowment products currently sold by AIP have a minimum guarantee rate of only 2%.
Beating the TFR guarantee is something of an obsession with Greco and his team. As AIP's chief financial officer Alberto Minali explains, providing such a TFR guarantee for all but the longest duration policies is virtually impossible and economically unsustainable.
"According to our internal estimates, we can offer people older than 50-55 something close to TFR but not equal to it. We can beat TFR only for the younger population, but they are not so numerous in the savings market."
Fortunately for AIP's business model, Italy has millions of self-employed and small company employees who are not eligible for the TFR guarantee. With no need to wait until 2008, Greco wants to sell them long-term products as soon as possible. "We think that in 2006/07, there is certainly a market in pension products for independent workers," he says. "This is a pretty broad market in Italy." Employees already covered by TFR but who want to start a separate private pension will also be targeted by AIP.
With such markets in mind, the company has several products under development. First and foremost is a personal pension, offering a TFR-beating guarantee together with decent potential upside. To provide the guarantee, AIP will use hypothecation techniques developed in the UK that allocate guarantee reserves to policyholders based on age.
"We create a sort of individual pension fund for each of these generational cohorts," Minali explains. "So we take the entire population target, split them into cohorts over the working age, develop an asset allocation function for each cohort, and manage guarantees for them on a running basis."
To deliver this product, AIP faces two challenges, says Minali. "One is on the investment side. At the moment it is not clear where we can invest our money. We can invest it in traditional asset classes, for instance, equities, government and corporate bonds; but we would also like to use commodities, which have a very nice decorrelation effect, and also real estate." Here AIP is waiting for Italian pensions regulator COVIP to rule on asset admissibility requirements.
There is also the guarantee to worry about. "The other technical issue is how to hedge against inflation, because TFR is linked to the inflation rate," Minali explains. "The simplest answer is to buy inflation-linked bonds, but these have not performed so well recently and it is not legally possible in a pension fund to buy them before cashing in the contributions." Here, Minali wants the help of the investment banks. "We are looking at inflation derivatives in order to get what we need." But he warns the dealers not to expect a structured products-style bonanza where individual policyholder payoff profiles are backed out with a derivatives transaction. "The derivative hedging mechanism will be transacted on the total pot," he says, "Because we want to exploit some mutuality effects and pricing effects."
And there are more products in the pipeline, according to Minali. "We are working on some innovative products, similar to those sold in the US as variable annuities. We are working on decomposing these products into option components, and to see if it is possible under current market conditions to repackage them efficiently. It's the sort of product that can give you the capital as an annuity, linked to the equity indices as underlying."
Serving as a kind of hybrid between Italian mutual fund investments and currently nonexistent private pension products, these products will take the company into uncharted territory, says Greco. "There is no history of any products similar to this in Italy, and we have to see how these products will fit into the existing regulations. But I trust that this could become an answer to the pension problem and therefore go ahead."
How will AIP's bold product development programme affect its capital position? In terms of insurance regulation, Italy is one of Europe's more conservative regimes. The technical rate of policies is used as a discount factor to compute book value liabilities, and discretion in allocating bonuses to policyholders is restricted in comparison with other countries. According to Minali, "This generates a lot of conservatism in the numbers reported by Italian life companies. The simple fact that assets of with-profit funds (segregated fund) are not marked at their market value means that, generally speaking, there are a lot of hidden capital gains in the life segregated funds, and the balance sheet numbers are pretty safe." Also the possibility that management can steer financial returns by realising capital gain and losses reduces the volatility of the segregated fund's returns and therefore the risk for the policyholder.
Market consistent embedded value is a major internal project for AIP, he says. "We are trying to develop a comprehensive risk and value governance tool, which is a risk-based capital model with market-consistent embedded value (EV). On the same platform we will develop an ALM tool to give us a strategic optimal portfolio for each segregated fund of AIP and for managing our proprietary book. There will be a mutual relationship between the way we calculate the EV of our portfolio and the way we allocate the risk capital to different businesses, and how our management sets the performance benchmarks of the company."