As part of the pension reform recently approved in Chile, the government introduced a centralized auction mechanism to provide the Disability and Survivors (D&S) Insurance that covers recent contributors among the more than eight million participants in the mandatory private pension system. This paper is intended as a case study presenting the main distortions found in the decentralized operation of the system that led to this reform and the challenges faced when designing a competitive auction mechanism to be implemented jointly by the Pension Fund Managers (AFP). When each AFP independently hired this insurance with an insurance company, the process was not competitive: colligated companies ended up providing the service and distortions affected competition in the market through incentives to cream-skim members, efforts to block disability claims, lack of price transparency, and the insurance contract acting as a barrier to entry. Cross-subsidies, inefficient risk pooling, and regulatory arbitrage were also present. The Chilean experience is relevant since other privatized systems with decentralized provision of this insurance may show similar problems as they mature. A centralized auction mechanism solves these market failures, but also gives raise to new challenges, such as how to design a competitive auction that attracts participation and deters collusion. Design features that were incorporated into the regulation to tackle these issues are presented here.
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