Insurance:

There are about 900 insurance companies in Russia. The total amount of insurance premiums grew 3.5 times in the last four years, according to Finance Ministry data, and is expected to reach 750 billion rubles ($28.94 billion) by the year-end.Russia's fourth-largest insurer, RESO-Garantia, is seeking to raise up to $2.5 billion in an initial public offering in 2007. Another insurer Ingosstrakh, controlled by tycoons Oleg Deripaska and Alexander Mamut, has put its IPO plans on shelf.

The state maintains a 25% stake in the country's main insurer, RosGosStrakh, the former monopolist under the Soviet administration. However, summer 2007 has seen moves to reduce that stake further. Alexei Savatyugin, a senior Finance Ministry official who is also the insurer's chairman, said a reduction of state holding "..can be done either through a privatization mechanism ... or through an additional share issue," Mr. Savatyugin told a news conference he was proposing same to the Economic & Finance Ministries.

Pensions & Financial Services

One of the major challenges facing Russia revolves around demographics. In 1992, Russia’s population was estimated at 148.7 million. Goskomstat, the state statisticsorganization, estimated the population as of mid 2004 at 143.8 million. The U.S. Census Bureau estimates that Russia’s population will decline by 14 million people between 2000 – 2025 while the U.N. Population Division’s medium term projection suggests a drop of over 21 million over the same period.

In terms of pension provision, and care for the elderly as respective and commercial projects, the issues are: a growing number of retirees, individuals born shortly before or after World War II, falling birth rates in the indigenous population and relatively low level of pensions supported by local governments.
The former Soviet pension system was based on a pay-as-you-go (PAYG) principle, allowing for the provision of decent pension benefits (with a replacement ratio up to 75%) to retirees. As birth rates in Russia in the early 1990s decreased dramatically, the ratio of working individuals to retirees decreased from 5 or 6 working individuals per retiree in 1970s and ‘80s respectively, to currently 1.6 working individuals to 1 retiree, making it impossible to keep the PAYG principle.

Pension Reform

Pension reform was necessary in Russia for a number of reasons.  First, the previous system that provided for the payment of pensions through taxes paid by employers could no longer maintain an acceptable level of pension. The number of pensioners is growing while the number of employed people who can support such pensions is decreasing rapidly. Secondly, the size of pensions is loosely related to the size of salaries, something that does not encourage salaries to become more legal and transparent. However, companies are coming to market.

Russia is diverting from the distributive principle toward the distributive and accumulative principle.  This means that instead of all of an employed person’s deductions contributing to a unified social tax to pay pensions to existing pensioners, a part of these deductions will go to this employed person’s personal account and will be invested in various financial instruments determined by the government. As such Russia’s economy will receive investment resources, while employees and employers will be interested in having salaries paid legally. This is the root of second pillar reform in Russia’s pension system.

Pension Reform launched in Russia in 2002 established a 3 pillar pension system: basic, insurance and accumulative – for those born in 1967 and later.

First Pillar
The first pillar of the Russian pension system comprises base and insurance elements, financed via employers’ social security contributions (UST). First pillar pension benefits (approximately US$90 per month) are guaranteed by the State to each Russian citizen. First pillar benefit payments are made by the State Pension Fund of Russia. The first mandatory pillar is two-fold. It provides a flat-rate minimum for all, which equals to approximately $381 per month and is financed on a pay-as-you-go basis.

Second Pillar

The second pillar of the Russian pension system comprises the cumulative element, currently formed for those individuals born from 1967 onwards and employers’ social security contributions. Unlike the first pillar, the second pillar is transferable to private providers – private asset managers or non-state pension funds depending on each individual’s preferences. Approximately 58.7m Russian citizens are eligible to transfer the cumulative part of their labor pensions, though currently only about 4% have actually done so.

The effectiveness of Russian Pension Reform is hampered by low awareness amongst the general public of the opportunities provided therein, fed by the lack of basic financial culture among the vast majority of citizens, and little effort by the state to advertise Pension Reform. There is also clearly a lack of interest by Russian and foreign operators to invest into the reforms, the success of which very much depends on significant advertising and distribution budgets being invested. As a result, little progress has been made in terms of educating the market and the general public and the reforms have failed to have the desired effects as initially intended by its authors. Instead of creating a savings culture through the promotion of the concept of individual accounts managed by private operators, most assets under the new second pillar system remain with the state due to the “monopoly role” of state-owned asset manager VneshEconomBank (VEB).

113 non-state pension funds and 55 asset management companies were admitted to the second pillar. These numbers look impressive at first sight, but upon closer inspection it can be noticed that these are mostly “captive” organizations, which have used their “administrative resources” and a minimum of investment to enroll their staff. The fees that the Asset Managers or Non-State Pension Funds are allowed to charge by law are too low to make their respective businesses sustainable in the longer term. For comparison: if in Bulgaria or Poland pension operators are charging up to 5% on any pension contributions made under the second pillar, as well as fees on Assets under Management, under Russian law operators are not allowed to charge anything at all when the funds are contributed. Only if investment income is positive, can the operators claim any fees: a Russian Non-State Pension Fund for example can only charge 15% on annual investment income plus revaluation of securities.

Raiffeisen Pension Fund was the first international company to be granted permission to offer pension products under the second pillar, while the JV CIT Fortis opened in October 2006 and estimates the Russian pensions market at $12 billion (annual contribution). Raiffeisen remains very optimistic about the potential of second pillar market growth in Russia.

Branch network services are expanding into Russia’s regions. At the end of March 2007, the Siberian branch of Raiffeisenbank Austria signed an agreement on mutual signature authentication with the Russian Pension Fund. The document allows the branch to authenticate applications of insured persons on their choice of an investment portfolio (a management company) or on the transfer of their money from the state-owned Pension Fund to a private pension fund that offers obligatory pension insurance. The branch may accept applications for transfer from a private pension fund to the state-owned fund and from one private fund to another.

Third Pillar

The third pillar refers to non-state pension provision for both individuals and corporations, and will become the main mechanism for relocating the burden of pension provision from the state to individuals and employers.

The corporate pensions market is potentially 65m people. Similar to the second pillar, the notable characteristic of the third pillar pension market is a rather high penetration by captive non-state pension funds, which already cover approximately 80% of the market. Despite the fact that many large manufacturing enterprises are covered by captive providers certain segments of the market, mainly small-middle enterprises and enterprises with foreign ownership, have the highest potential for development:

Another open market segment, as far as the third pillar of the Russian Pension Reform is concerned, is the market for individual pension plans. Individual pension plans are offered by NPF Raiffeisen and distributed via ZAO Raiffeisenbank Austria branches in Russia.

Charter capital / Minimum capital requirements (both 2nd and 3rd pillars)

Another barrier to entry for both the 2nd and the 3rd pillar is the level of charter capital that is required to set up a new Asset Management company or Non-State Pension Fund. Minimum capital requirements should be linked to the volume of liabilities undertaken by the provider. If it is simply a fixed amount, then it essentially an entry charge rather than capital required to meet liabilities in the future. Similarly to insurance companies, the minimum capital requirements could be a percentage of pension reserves and/or pension contributions but not less than X amount.

This is where another important consideration comes to play. If there are capital requirements for a pension fund, then there should be stakeholders who are willing to pay it. It is not sensible to ask participants to pay the capital, because they already pay the insurance reserve. The most appropriate way to solve the problem seems to be giving a pension fund a commercial status (as opposed to their current non-profit status) and ask shareholders to pay the (increase in) capital. Otherwise only captive funds will be able to pay such increases, which would lead to an uneven playing field vis-à-vis non-captive funds.

Market Trends:

According to the Federal Insurance Supervision Agency (“FISA”) Report, owners’ capital of 1074 officially registered Russian insurance companies totaled some RUR 143 billion in 2005.  Only 26 companies controlled capital exceeding RUR 1 billion in 2005. AEB predicts that as the market grows, a number of companies will face financial shortcomings, hasten consolidation, which will in turn be accelerated if FISA continues to strengthen solvency controls.

Russia limits the percentage of foreign capital in the insurance industry (25% of total market capital). The cap was increased in 2003 from 15%, in force since 1997. At the present time the ratio of foreign capital to the total Russian insurance sector capital is well below the limit. Nevertheless in view of the decreasing number of players in the Russian market and in light of increased capital requirements and fresh foreign capital flow after WTO access, this existing limitation could create practical problems for companies already present in Russia.

Second pillar market potential may reach US$300BN by 2016, despite current legislative limitations on participation. Every year the general public’s awareness increases Raiffeisen NSPF sees a growing demand for the transfer of cumulative labor pensions to non-state pension funds.

In 2005/6employers’ interest has increased in corporate pensions, though mainly triggered by western companies present in the Russian market. Market penetration stats vary from source to source, ranging from 20% to 35% of total open market potential. Barriers to further penetration revolve around a lack of understanding of pension products by employees, and continuing developments in the tax and investments areas. Raiffeisen NSPF anticipates that provision of corporate pensions by employers will become an indispensable part of remuneration packages by 2008-2010, as more and more individuals born in the 1950s and ‘60s come closer to retirement.

Regulating Law

While the Law on Non-State pension Funds seems to define that investment risk is borne by insured, regulations issued following the Law assume that this risk is borne by providers, creating unfair treatment of Non-State Pension Funds compared to Asset Managers and the State Pension Fund. Lobby groups have suggested making the 2nd pillar more attractive to investors by allowing the NSPF charge a percentage of average assets under management (for instance 1% of AuM, as it is the case for Asset Management Companies in Russia), as well as a 3% fee on pension contributions received, to cover part of their upfront distribution and administration costs. This latter charge would be of a similar level to what 3rd pillar NSPFs charge for their activities. Recent initiatives undertaken by the Ministry of Social Affairs and Health to effectively abandon the 2nd pillar reform have also seriously damaged the trust of the public in this reform.

Legislation/Lobbying Positions

The Association of European Business in Russia (AEBRus) 2007 Position Paper states that the Russian pension system in its current state cannot facilitate the working public in accumulating sufficient savings to fund decent pensions upon retirement.

The Federal law in force since 17th January 2005, removed barriers and limitations for EC companies to establish daughter companies for insurance operations in the life and non-life fields. Development of a transition plan for selected classes of business, through which foreign companies will be allowed to sell through a branch in Russia is underway. Realistically, progress in this field can be reached only after changes and amendments to the Russian civil and/or insurance law with regard to the legal status of foreign branches in Russia authorized for insurance activity.

The AEB cites a lack of sufficient tax incentives for the development of pension insurance and long-term life insurance. The transition to taxation of pensions rather than pension insurance contributions is a positive for the industry, though seemingly ubiquitous discrepancies between the insurance law and tax law complicates the legislative environment. Only a few commercial sources of information are available for insurance policyholders to obtain market and company information. The lack of essential information on insurance operations, including CMTPL, mislead policyholders in their choice of insurance company

Critical information on the penalties given by FISA against insurance companies is also unavailable for policyholders. The situation has to be improved to avoid further disappointments and to create a competitive environment in the market.

• Cap on contributions: The laws regulating the 2nd pillar provide for caps on total contributions into individual accounts for each employee. Currently the cap amounts to RUR 16,320 (US$ 624) per annum and will be increased in 2008 to RUR 24,480 (US$ 936). This creates a big obstacle for pension providers, as this relatively low annual contribution makes it is very difficult to convince in particular high income earners to outsource their funds from the State Pension Fund to a private operator, not least as the process to do so remains relatively cumbersome and paper-intensive.

• Replacement ratio: As a result of the above point, as the amount that can be transferred to private operators is relatively low, the participants will be faced with a low income replacement ratio after retirement. In particular, not allowing the higher earners to increase their annual contribution to the 2nd pillar, will lead to a very low replacement ratio for them.

Voluntary Pensions / 3rd Pillar

Apart from a general overhaul or further reform of the 2nd pillar, a lot could be done to further improve and support the 3rd pillar of the pension system, i.e. voluntary Non-State Pension in Russia. Voluntary pension savings in Russia stand a real chance of being accepted as a long-term savings product provided that the public feels that this market is properly regulated and its interests are protected. This can be done by further improving the regulatory environment and by educational efforts (particularly amongst Russian employers) as well as by attracting more foreign investment into this sector. Also, both employers and employees should be properly incentivised through the tax system to accumulate additional savings for retirement in voluntary pension plans. While the ongoing tax reform continues to reduce non-transparent relations between employers and employees (e.g. tax avoidance through life insurance), it is important to promote new forms of relationships between these parties. Voluntary pension plans are part of such new arrangements.

Immediate steps that could be taken on voluntary pensions:

Non-State Pension Funds currently face a number of practical problems that could be immediately addressed to promote this sector. These are as follows:

• A lack of tax incentives for voluntary pension plans, both on the level of employers and also employees/individuals. There are also some current tax provisions that are harmful, such as the requirement for employers to pay Unified Social Tax on pension contributions. 

• The restricted usage of the insurance reserve, which NSPFs are required to form, which creates an unreasonable burden on pension funds and their clients. This makes the products offered by NSPFs relatively unattractive and hinders their promotion to the general public. If the insurance reserve could be used not only to cover the longevity risk, but also investment losses, the product would be a lot more interesting for the clients and providers.

•  The current interpretation of the Law on Non-State Pension Funds and the applicable accounting rules, requires NSPFs to give a “0%-guarantee” on pension contributions received, and investment return allocated, on an annual basis. This again puts a heavy burden on the pension funds and discourages them from implementing a more flexible (and thereby higher yielding) investment strategy. If the “0%-guarantee” were to be applicable at maturity only, overall investment returns would stand to improve.

Although a number of very welcome changes have recently been made to the asset management regulations for non-state pensions fund (basically expanding the classes of asset that NSPFs can invest in), no clear regulatory instructions and guidelines have been issued to date to explain how NSPFs should operate under these new regulations. For example, while diversification into foreign assets (e.g. OECD state paper) is now in principle allowed, operators are basically so far left in the dark on how exactly such investments can be made. Furthermore, the new regulations currently prohibit investments into real estate, while it is not clear whether this is only a temporary restriction. NSPF are therefore currently in a “wait-and-see” mode in tems of their asset management strategies until these issues have been clarified by the local financial market regulator (note: deadlines set in the regulations require additional guidelines to be issued by August 2007).

Finally, also a change in the fee structure for 3rd pillar pension funds, similar to the one proposed under the first bullet of the 2nd pillar section of this Paper, would be most welcome.