Asset and liability cash flows for each maturity bracket are then compared. A matching factor of 1 is used if asset flows are equal to or exceed the liability flows; a value of less than 1 is assigned to any bracket where the liabilities exceed the assets implying an increased capital requirement. Data for 2004 show that the matching factor, known as CP in Chile, was close to one for brackets 1 to 7, ranging up to maturities of 16 years, but fell drastically for higher brackets, reaching a low of 0.203 for the highest bracket, which covers maturities of 29 years or longer.

The third step is to calculate the basic financial reserve, which is given by the discounted value of matched and unmatched liability flows. Matched liability flows are discounted at the market rate of interest that prevailed at the time each contract was issued, while unmatched flows are discounted at a technical rate of 3 percent which is prescribed by the regulators. The market rate is the same for all companies but varies by contract depending on its time of issue.

The fourth step is to calculate the basic technical reserve, which involves the discounting of liability flows by the rate of interest used in determining the annuity pricing of each contract. The technical rate of discount is not just different for each company but it is different for each contract in each company. However, the basic technical reserve for each contract cannot be lower than the corresponding basic financial reserve.

The CALCE reserve is then obtained as the difference between the basic technical reserve and the basic financial reserve. Companies are required to show on their balance sheet the basic financial reserve and the CALCE reserve. The basic technical reserve is not shown but is used for determining the size of the CALCE reserve.

This complicated approach was used because insurance regulation was based on projected asset and liability cash flows rather than market values. Insurance companies were not required to use mark-to-market asset valuation, partly because the companies followed a 'buy and hold' approach and held debt instruments to maturity (Rocha and Thorburn 2007:123; 135). The insurance regulators are now taking steps to introduce risk-based supervision that will focus on market valuation of assets and use of market rates of interest for valuing liabilities.

It is not clear how the CALCE rule will be modified or whether it will be discarded completely in favor of the full market valuation and traffic light system that has been introduced in Denmark and other continental European countries as well as several Anglo-American countries. Despite its shortcomings, the CALCE rule played a useful role in forcing insurance companies to maintain an adequate level of reserves that reflected the degree of asset/liability mismatching. Nevertheless, the dearth of long-term assets with maturities over 16 years, while annuity liabilities can run for much longer periods, has exposed insurance companies to significant investment as well as longevity risks.

In addition to the CALCE reserve, insurance companies were required to operate with a leverage of no higher than 15, which implied a required equity ratio of 6.7 percent. The leverage limit was recently raised to 20, lowering the required equity ratio to 5 percent. However, in the absence of a requirement to use market values for assets and market interest rates for valuing liabilities, the measurement of equity is itself subject to a considerable degree of arbitrary valuation. In 33