Living Dangerously.

Indonesia's improving economy and vastly underdeveloped insurance market invite foreign investors, but violence and instability make it a risky proposition.

Next to India and China, Indonesia represents one of the largest potential insurance markets in Asia. The country's 13,000 islands are home to more than 210 million people, only about 10% of whom have life insurance. In the past decade, Indonesia has experienced amazing developments politically, socially and economically. The uncertain outcome of these changes will dictate how Indonesia's insurance sector develops in the coming years.

Before the East Asian financial crisis, Indonesia was considered to have one of the region's best-performing economies, having sustained rapid economic development for three consecutive decades. Between 1985 and 1995, the country's economy grew at a steady rate, poverty dropped from 60% of the population to 11% and living standards improved significantly. In 1997, with the onset of the financial crisis, Indonesia's economy reversed course. By early 1998, its currency, the rupiah, had depreciated significantly, inflation had risen, and the banking system had collapsed. Some 2.5 million people lost their jobs, and the percentage of people living below the poverty line increased by 50%.

A prolonged political crisis aggravated the impact of Indonesia's financial crisis. Food shortages and inflation sparked deadly anti-government demonstrations, and in May 1998, at the height of the conflict, President Suhar-to was forced to step down, ending his long tenure at the head of Indonesia's government. Suharto's successor, B.J. Habibie, promised economic reform, but he was unable to prevent more rioting between soldiers and students. In 1999, hundreds of people in East Timor were massacred, and sectarian violence broke out on the islands of Ambon And Kalimantan. President Abdurrahman Wahid, elected in Indonesia's first democratic presidential elections in October 1999, has been unable to stem religious violence rocking regions of the country.

Despite such turmoil, foreign investors have remained interested in Indonesia. The Indonesian Bank Restructuring Agency reached a deal with a Malaysian builders group to invest several hundred million dollars in road construction, and Malaysian developer SAJ Holdings has begun planning a $1.5 billion water project in the Riau region. New investments, such as these by major international companies, coupled with increasing consumer confidence suggest that Indonesia once again may be making progress toward sustained economic development and growth.

Insurance Growth

Against this backdrop of rapid economic growth, financial crisis and political turmoil, Indonesia's large and underdeveloped insurance sector has fared relatively well. During the period of economic stability in the late 1980s and early 1990s, the insurance sector enjoyed brisk development. In 1994, the total profit of all of Indonesia's insurance companies was 568 billion rupiah, about $258.5 million at that time. More than half of this amount was earned by state-owned insurance companies. Gross premiums in the life insurance sector increased at an impressive rate of 33% annually between 1991 and 1995, reaching 2.1 trillion rupiah, or about $919.4 million, in 1995. Despite this increase, the contribution of gross premiums to gross domestic product as of 1995 was still relatively low at 1.64%.

Between 1991 and 1995, the number of insurance companies competing in Indonesia's insurance markets also increased significantly. In 1991, Indonesia had 41 life insurance companies, including one state-owned firm, 36 private national firms and four joint ventures. By 1995, Indonesia's life insurance sector included 50 firms, including 12 joint ventures. As of March 1997, the country's insurance market consisted of 59 life insurance companies (40 national companies and 19 joint ventures) and 101 nonlife insurance companies (81 national companies and 20 joint ventures).

The sector has continued to grow recently, both in premium and in the number of competing insurers. According to the Insurance Council of Indonesia (DAI), premium income from life insurance increased by nearly 33% in 1998 and enjoyed an even stronger performance during the first half of 1999. During those six months, total premium income of 1.89 trillion rupiah (equivalent then to about $276 million) reached 60% of the entire premium income for all of 1998. New premium income for the period was 1.163 trillion rupiah, including 1.05 trillion rupiah from individual insurance.

Further, new investments made by life insurance companies in Indonesia during the first half of 1999 dropped significantly, totaling only 305 billion rupiah compared with 3.11 trillion rupiah in 1998, due to the decrease in investment in U.S. dollar-based assets. This reflects the liquidity crunch that affected the entire Indonesian economy.

The DAI reported that at least six new life insurance companies began operations in 1998. With the new additions, the total number of companies operating in Indonesia's life insurance market remained at 59. But this number now included 23 joint ventures. The Indonesian government has encouraged such partnerships and has developed a set of laws and regulations setting out guidelines to facilitate foreign insurers entering the market. Despite these efforts, shortages of capital and a lack of qualified human resources continue to impede industry development. To overcome these obstacles, many of Indonesia's private insurers have entered joint ventures with foreign partners that have provided badly needed experience and capital.

Regulatory Framework

Indonesia's insurance industry is regulated by a national law and a number of regulations set out and enforced by the Ministry of Finance. Law No. 2 Year 1992 Concerning Insurance Business and Government Regulation No. 73 for Insurance Business Conduct comprise the backbone of Indonesia's insurance law. They are supplemented by regulations regarding company and broker licensing, insurance practices and financial soundness.

The main scope of these laws and regulations focuses on financial aspects of the insurance business--such as solvency, investment rules, reserves and reinsurance support--and on conduct issues, such as insurance policy wording, product development, establishing premiums and claim settlement. The Ministry of Finance's overall aim in regulating the sector is to fulfill the 1992 law's objective of developing a sound and accountable insurance sector to support the nation's economic activity and protect policyholders.

Foreign Investment

Consistent with Indonesia's general policy on foreign investment, foreign insurance firms are welcome to conduct business in Indonesia by entering a joint venture with a local insurance company. The Ministry of Finance has developed this policy because it believes that the local partner and the insurance sector as a whole will benefit from the increased capital, knowledge and technology transfer that will take place when joint ventures are formed between domestic and foreign insurers. Accordingly, the Ministry of Finance applies Indonesia's insurance laws equally to all companies operating in the sector regardless of whether the ownership base includes a foreign partner.

There are several ways for a foreign insurance company to enter the Indonesian market. It could purchase equity in a 100% Indonesian company acquire shares in an existing joint venture insurance company or increase the equity in an existing joint venture either by subscribing new shares or by transferring shares from an existing local shareholder. Regardless of which method is chosen, the foreign firm will be subject to an 80% cap on its equity participation. It is impossible for a foreign firm to own 100% of an insurance business in Indonesia.

Foreign insurers that wish to buy into an existing 100% Indonesian-owned insurance company must meet numerous criteria. The foreign investor must be an established insurance company in another country and submit a letter from the supervisory agency in that domicile stating that the firm has a good reputation and holds a valid insurance license. The firm also must submit to the Ministry of Finance audited financial reports from the last two years demonstrating that the company has equity of at least twice its participation in the Indonesian venture. The Ministry of Finance may require the Indonesian company to issue new shares to the investor rather than having the investor take part of the currently outstanding shares. This requirement would ensure that the acquisition introduces new capital into Indonesia's insurance sector.

Foreign companies establishing joint ventures can partner only with local insurance companies that have the same line of business (either life or general). The 1992 insurance law restricts an insurance company's scope of business. A life insurance company may conduct only the business of life insurance, health insurance, personal accident insurance and annuity business. It cannot operate a loss insurance business or a reinsurance business. Further, insurance business can be carried out only by legal entities that are in the form of state-owned companies, cooperatives, limited-liability companies or mutual companies founded by Indonesian citizens or Indonesian legal entities.

Licensing Process

The Ministry of Finance's process for obtaining a new insurance license can be separated into two phases. First, the insurance company must obtain principal approval of its business. Then the company must apply to obtain a business license from the Ministry of Finance.

To get principal approval, the insurance company should submit a written application to the Ministry of Finance, attached with evidence that the company has met all of the requirements of Government Regulation No. 73. That regulation requires articles of association approved by the relevant government agency, a structure of organization clearly distinguishing functions and job descriptions, qualified experts in their relative fields and descriptions of the insurance programs to be marketed. If the insurance company involves a direct investment by a foreign party, the company should submit the draft of the joint venture agreement, an agreement on Indonesianization of the share ownership and audited financial statements for the last two years for both the foreign and Indonesian party. The company also needs to submit a working plan that describes the insurance products that will be released into the market, together with the market share for each product and plan for human resources and infrastructure needed. In addition, the company must have a plan for training and education provided for the local employees in marketing and technical areas.

Once a company obtains principal approval, it can submit a written application for a business license. The application must demonstrate the company's compliance with numerous requirements regarding financial statements, director and expert qualifications, paid-up capital and the human resources plan.

The Ministry of Finance does not have a formalized process for foreign companies acquiring shares in an existing Indonesian insurance company. The entering firm should consult with the Ministry of Finance and notify it of the acquisition before the transaction is completed. In practice, the notification will serve as an application, which the Ministry of Finance has the power to reject. But it is likely to approve the transaction if all of the legal requirements regarding the transaction are met, the acquisition requirements in the company law are met and the acquisition does not jeopardize the rights of the insured or the financial position of the domestic firm.

Investment Restrictions

A financial-soundness regulation adopted in 1999 limits the types of investments that insurers can make. The regulation ensures that insurers achieve diversity in their investments by placing limits on the percentage of funds that can be invested in any one entity or type of investment. For example, investment in either real estate or stocks or bonds listed at the Indonesian Stock Exchange cannot exceed 20% of total investment. Also, no more than 25% of total investment can be placed in any one party other than in marketable securities issued or guaranteed by the Indonesian government or Certificate of Bank Indonesia.

Unlike in China, India and the Philippines, Indonesia allows insurers to make limited overseas investments. This concession is valuable to foreign insurance firms that are justifiably apprehensive about investing funds in Indonesia. Insurance companies may invest overseas through direct participation in an insurance company or by purchasing listed stocks and A-rated bonds. But the investment in an overseas country cannot exceed 20% of the insurance company's total investment, and the investment in each issuer cannot exceed 10% of total investment.

In addition to the 80% cap on foreign equity, foreign insurance companies need to consider two other matters before entering the Indonesian insurance market. A 1993 regulation requires that the Indonesian interest in insurance joint ventures reach 51% within a period of 20 years from the date of incorporation of the company. Increasing the Indonesian party's ownership can be achieved by a number of methods, including selling shares from the foreign party to the Indonesian party, increasing the Indonesian party's paid-up capital or going public.

Regulatory Hurdles

Thus far, the Ministry of Finance has not actively enforced this provision. But the divestment requirement could have serious implications for what the maximum long-term profit a foreign firm could obtain by entering the Indonesian market. If the Ministry of Finance were to begin enforcing this provision, a multinational firm could expend substantial resources securing a position in the Indonesian market only to have up to 31% of its equity divested by law in the future when the business becomes profitable. Enforcing such a provision today would not advance the government's goal of attracting quality insurance firms to invest in a politically and economically unstable Indonesia. But it would make sense for the government to enforce the provision later if Indonesia's insurance sector continues to stabilize and develop to the point where foreign investment is no longer needed.

A second important provision attempts to ensure that joint ventures have adequate capital for continuing business operations. Under a 1999 regulation on business conduct, an insurance company with foreign-equity participation may be permitted to change its ownership in excess of the 80% limit on foreign equity, provided the Indonesian partner maintains its amount of paid-out capital. The rule allows joint ventures to dilute the percentage of the Indonesian shareholding when the company needs more capital and the Indonesian partner cannot contribute in proportion to its equity stake. This provision is applicable only to an insurance or reinsurance company with direct investment by a foreign partner whose percentage of ownership has already reached 80%. The rule enables firms to increase foreign capital to meet existing business conditions, without being constrained by the local partners' lack of liquidity or capital.

It is still unclear what impact the Asian Free Trade Agreement and the Asia Pacific Economy Counsel will have on the present 80% foreign-equity cap and 51% divestiture requirement. But interested parties will need to consider the potential effects of these agreements on foreign investment in Indonesia.

To strengthen the insurance industry and bring Indonesia up to date with international standards, the Ministry of Finance increased the required minimum paid-up capital for a new insurance company to 100 billion rupiah (about $10.5 million) in 1999. This capital requirement is a significant increase of the previous minimum paid-up capital requirement of 4.5 billion rupiah for life insurance companies and 15 billion rupiah for general insurance companies. Firms awarded principal approval of their business licenses before the new requirement took effect may maintain the previous capital structure. Twenty percent of the minimum capital requirement has to be deposited in an approved bank in the Ministry of Finance's name, and the money is kept there until the company is dissolved or liquidated.

Insurance firms also must meet specific minimum solvency requirements. An insurance firm must maintain an excess of assets over liabilities equal to at least 120% of the total loss risk to ensure solvency. Due to the fluctuating currency and the credit problems of an economy in turmoil, assets may have values different from those booked. Therefore, the Ministry of Finance set out new reserve requirements in 1999 designed to cover the loss risk that is "likely to result from deviation of management of the assets and liabilities."

Expected Contributions

Finally, foreign firms considering entering Indonesia's insurance market must consider the government's expectation that firms investing in the country will contribute technology and knowledge. The government expects foreign investors to train and develop local workers to prepare them to fully participate in the specific industry. In order to fulfill this expectation, foreign firms must have training programs in place that are aimed at training local workers to replace foreign personnel.

In the insurance sector, foreign firms are expected to contribute knowledge in the areas of reserve calculations, product development, loss development and loss ratio, and computerization of accounting record systems. Further, insurance companies are expected to provide a training and education fund of 5% of total employee expenses and develop and carry out a training and education program to improve the knowledge and skill level of the local employees.

The Outlook

Currently, the political and economic situation in Indonesia is uncertain. Tensions in East Timor and other regions remain high. The East Asian financial crisis has yet to run its course. President Wahid faces a mountain of economic and social problems that have kept Indonesians living on a knife's edge.

Nevertheless, Indonesia's insurance sector may once again be an attractive venue for foreign investment in the near future. Nine out of 10 of Indonesians do not have life insurance. If the country can recover from the financial crisis and regain stability, the insurance market can be expected to grow rapidly as it did before 1997. Insurance firms entering the market will benefit from Indonesia's policy of encouraging foreign investment and the well-defined set of laws and regulations governing the industry. Moreover, the 80% cap on foreign equity and the accompanying provision allowing for further capital increases will enable foreign insurers to control the joint ventures they enter and make sure that their operations are adequately funded.

Even considering these advantages, foreign insurers should proceed cautiously before investing in Indonesia. In addition to the uncertain political and economic conditions, firms also must consider whether they can find suitable joint-venture partners and investment opportunities for policyholder funds within Indonesia. Moreover, it is uncertain whether the Ministry of Finance is likely to begin requiring foreign insurers to reduce their equity position to a minority stake within 20 years of operation as the insurance law dictates. Of course, the unwritten costs of corruption also need to be factored into the investment decision.

These questions set against the sheer size and lack of development in the market make it very difficult to determine whether investing in Indonesia's insurance sector is a prudent course of action at this time.

William A. Wilson III is co-head of the Asia Practice Group of the international law firm Kelley Drye & Warren LLR. Paul Zarnowiecki was a law clerk in Kelley Drye's Hong Kong office during the spring of 2000.

Indonesia at a Glance

Gross domestic product (1998 est.): $602 billion

Population (1999 est.): 216,108,345

Life expectancy at birth: 62.92 years

Total insurance premiums (1997): $2.63 billion

Nonlife insurance premiums (1997): $1.38 billion

Life insurance premiums (1997): $1.25 billion

Total insurance premiums per capita: $13.10

Nonlife insurance premiums per capita: $6.90

Life premiums per capita: $6.2

Source: The World Factbook, Swiss Re sigma, No. 3/1999