Letter of the law: The legal framework is catching up with sector growth

After taking over from the Indonesia Capital Market and Financial Institution Supervisory Agency, the new Financial Services Authority (OJK) is leading a regulatory overhaul of the sector. More aggressive than its predecessor, OJK is implementing new governance rules for underwriters and has set new premium tariffs and caps on commissions for highly competitive motor and property classes – all ahead of a major overhaul of the existing 1992 Insurance Act, which was under debate at the House of Representatives (DPR) in early 2014. While legislative progress remains uncertain in an election year, the new insurance regulator is demonstrating its intent to sanitise business practices and set the sector on a solid path for sustainable growth.

Corporate Governance

Even before OJK’s establishment in October 2012, the Ministry of Finance issued Regulation No. 152 on corporate governance for insurance firms, requiring the new regulator to subject all directors and commissioners to “fit and proper” tests. The rules require all directors and at least half of a board of commissioners to reside in Indonesia, while all underwriters and reinsurers must employ a minimum of three directors and three commissioners, of which at least one must be independent. Directors cannot hold multiple directorships, both in Indonesia and abroad, although they can act as commissioners at another firm.

The tests have also been expanded to controlling shareholders of insurance firms, defined as investors with over 25% stakes in underwriters. By giving OJK a hand in board appointments, the rule significantly strengthens the new regulator’s oversight of corporate governance structures. However, following concerns raised by two insurance associations surrounding the existence of multiple subsidiaries and alliances between underwriters, OJK is revising its governance standards to apply to the holding group level as well.

Setting Tariffs

Aside from strengthening its oversight of both life and non-life underwriters’ governance structures, the regulator is moving to sanitise underwriting standards to bolster insurers’ risk management and support improved pricing of key non-life risks. In December 2013 OJK issued long-awaited tariffs that set floors and ceilings on premiums in the key motor and property classes. Although a 2003 Ministry of Finance circular requires underwriters to set premium rates according to their risk and loss profile for the policy class over the previous five years, underwriters have tended to offer significant discounts on more competitive classes like property and motor through excessive commissions to intermediaries and premium rebates.

In a highly competitive and fragmented market where insurers extend up to 50% discounts on property rates in certain areas through high commissions to product marketers, according to ratings agency Fitch, most insurers see the new rules as a positive development for the sector as a whole. The OJK’s move came after a failed attempt by members of the General Insurance Association of Indonesia, following significant floods in January 2013, to set tariffs for the industry using three geographic zones for different motor tariffs and flood-related property policies. Rates were set to fluctuate between a low of 0.04% of insured sums in low-risk zones that have seldom been flooded, such as East Jakarta, and a high of 0.52% in high-risk zones, such as North Jakarta. Together, these new rates represented a 20-30% increase over 2012 pricing.

After Indonesia’s Business Competition Supervisory Commission ruled it a breach of the anti-monopoly Law No. 5/1999, which requires OJK to be the tariff setter, the OJK established 120 different zones according to flooding risk and varying rates for 120 types of building construction. The new rules also require risks to machineries to be spun off as standalone policies, and limit marketing commissions at 15% of premiums for property and flood policies and 25% for motor insurance. Companies failing to comply with the new tariffs run the risk of seeing their licence suspended.

Although the new tariffs will likely impose higher premiums on policyholders to cover the same risk covers, according to Fitch, they will insure sustainable underwriting practices and insulate insurers from potentially unsustainable losses. “This could also help to create a balance between prices charged and risks taken by the insurers,” according to a Fitch update in February 2014. Additionally, the development of new earthquake index insurance products by the specialised catastrophe reinsurer Maipark should enhance insurers’ catastrophe underwriting capacities. Development of new products in general is essential for new players. “The key is this market is how to establish quality products and distribute them as quickly as possible, and in this sense local players actually have an advantage due to a pre-established branch network,” said Indra Varuna, the president director of Adira Insurance.

Legislative Reform

While these piecemeal reforms are effecting some change, a far broader overhaul of the sector covering areas as disparate as licensing, corporate governance, business conduct and consumer protection was being debated in the DPR in early 2014. Revisions to the existing 1992 Insurance Act have been awaited for several years, yet the establishment of OJK has made the review pressing in order to define more detailed functions for the new regulator, including creating powers to issue regulations and implementing rules for the new act once it is passed. In March 2013 a draft bill was circulated to the DPR that included key proposals for wide-ranging reforms.

It would force insurers currently selling takaful, or Islamic insurance, through a window to spin off the business into a separate entity – Indonesia is currently the last market to allow such windows. Underwriters will also have to create the new position of controller, nominations for which must be approved by OJK. Controllers will be responsible for determining the composition of management and key policies. Underwriters will also be mandated to create an in-house security fund to insulate policyholders in the event of liquidation, as well as participate in a policyholder guarantee system operated by the Deposit Insurance Corporation (LPS), which currently administers the only bank deposit insurance scheme. Implementing regulations will be required by the OJK to determine the make-up of the security fund, while the LPS will define the details of the policyholder guarantee scheme. Strengthening the enforcement powers of OJK, the bill introduces much tougher sanctions under the regulator’s purview, ranging from warnings and fines to rescinding registration and barring offending individuals from key executive positions.

The bill also clarifies key ambiguities in the current insurance act. While the use of third-party administrators is not specifically covered in the 1992 Insurance Act, the new bill allows insurers to use third parties to acquire businesses and provides for the transfer of some business management roles to operators outside the company. The new bill would also require OJK to establish an independent rating and statistics agency that would determine benchmarks for premiums, as well as collating industry statistics. Aside from consumer protection and governance provisions, there is concern about implementing related laws on the ground.

Points of Contention

While these provisions command widespread support as they strengthen the regulator’s enforcement powers and sanitise business conduct, debate has focused on proposals to introduce new caps on foreign ownership of insurance firms. Rather than easing caps on foreign direct investment (FDI) ahead of ASEAN-wide liberalisation in 2015, the bill proposed new restrictions requiring foreign investors to own stakes in underwriters only through public capital markets, rather than direct unlisted equity stakes.

Although some legislators had proposed reducing the cap from the current 80%, albeit not retroactively, this is unlikely to be included in the final bill given the scope for further FDI-financed mergers and acquisitions.

Debate over this issue, coupled with other legislative priorities, has delayed passage of the bill, which was originally planned for 2013. While the draft was in its final reading at the DPR in March 2014, it remains uncertain whether it will be passed prior to legislative elections in April 2014. “Political manoeuvring will surely increase in the run-up to the 2014 national elections; a close watching brief is needed for both current insurance regulation and political attitudes to possible future regulation,” according to legal firm Clyde & Co.’s “Global Insurance Legal Developments 2013” report.

Although legislative reform always runs the risk of introducing new restrictions on investment, particularly in an election year, the insurance industry remains broadly supportive of the broader effort to reform. The new regulator’s more assertive stance reflects a generally recognised need to update rules that were defined prior to the significant growth in insurance after 1992.