proceedings of the international workshop on strengthening...

Proceedings of the International Workshop on Strengthening Pensions and Insurance Markets in Indonesia

Shangri-La hotel Jakarta, Indonesia March 21-22, 2006

STRENGTHENING PENSION AND INSURANCE MARKETS IN INDONESIA iii

Table of Contents

Table of Contents...................................................................................................................................... iii Acknowledgements.................................................................................................................................. vii Overview .................................................................................................................................................... 1 Welcome Speech ...................................................................................................................................... 7 Welcoming Remarks................................................................................................................................. 9 Key Note Speech ....................................................................................................................................11 The Role of Institutional Investors in a Bank Dominated Economy.....................................................11

Overview and Global Trend in Insurance and Pension Markets: Benchmarking Indonesia by comparison with the Experience of Other Countries and Regions ...........................................................20

Overview of Global Trends in Insurance Markets – Benchmarking Progress in Indonesia................21 Global Trends in Pension Markets.........................................................................................................43 Keynote Speech......................................................................................................................................49

Risk Based Supervision Trends in Insurance and Pension Funds ...........................................................54

Risk-based Supervision for Insurance Companies and Pension Funds ..............................................55 Risk-based Supervision, Solvency II ......................................................................................................62 Q & A Session Summary.........................................................................................................................74

Aligning fiscal, social and prudential policies in Insurance and Pensions ...............................................77

Aligning Policies the Role of Taxation ....................................................................................................78 Q & A Session Summary.........................................................................................................................90

New Challenges for Pensions and Insurance Enhancing Credibility of the Insurance Industry..............93

Risk-Assessment and Mitigation in Insurance Industries: The APRA Experience ...............................94 Enhancing Credibility of the Insurance Industry: The Stakeholder View of the Capital and Risk Balance..................................................................................................................................................100 Q & A Session Summary.......................................................................................................................107

Adjusting to the New Pension Environment.............................................................................................109 Adjusting to the New Pension Environment: .......................................................................................117 Learning from Experience in Asia ........................................................................................................117 Q & A Session Summary.......................................................................................................................124

The Insurance and Pension Markets:.......................................................................................................126

Rural Insurance.....................................................................................................................................127 Insurance Products to Increase Market Penetration..........................................................................129 Q & A Session Summary.......................................................................................................................134

Pension Funds Markets Adapting Pension Plans to Currents Needs.....................................................136 Adapting Pension Plans to Current Needs ..........................................................................................141 Q & A Session Summary.......................................................................................................................154

Institutional Strengthening: A key issue..................................................................................................156

Institutional Strengthening: Insurance ................................................................................................157 Institutional Strengthening...................................................................................................................161 Q & A Session Summary.......................................................................................................................167

Governance of Pension Funds..................................................................................................................168 Institutional Strengthening and Governance of Pension Funds ........................................................176

iv PROCEEDINGS INTERNATIONAL WORKSHOP 21-22 March 2006

Investing Insurance and Pension Assets .................................................................................................183

Q & A Session Summary.......................................................................................................................192 The Way Forward .......................................................................................................................................194

Developing Pensions and Insurance Markets – The Indonesian Challenge in Global Context........195 Q & A Session Summary.......................................................................................................................205

List of Figures

Figure 1: Asia 55% of Global population, one-third PPP GDP 25% trade weight ................................11 Figure 2: Asia Still Dependent on Bank Financing................................................................................12 Figure 3: Assets of Banks versus insurance companies, mutual and pension funds ........................12 Figure 4: Asian Demographics: Growth co-related with rise in Working Age Group............................13 Figure 5: Global Assets under Management.........................................................................................13 Figure 6: Who accounts for Most Financial Assets...............................................................................14 Figure 7: Sequencing and Hierarchy of Domestic Financial Markets..................................................17 Figure 8: Global Financial Sector Trends ..............................................................................................21 Figure 9: Global Growth in Insurance Premiums ..................................................................................22 Figure 10: Share and Potential of Emerging Markets ..........................................................................23 Figure 11: Real Insurance Premium Growth.........................................................................................23 Figure 12: Average Real Premium Growth ............................................................................................24 Figure 13: Insurance Penetration and Density by Region....................................................................24 Figure 14: Insurance Penetration and Density by Region II and III......................................................25 Figure 15: Demographics in South East Asia........................................................................................26 Figure 16: Total Fertility Rate Trends ....................................................................................................26 Figure 17: Life Expectancy 1975-2025 ................................................................................................27 Figure 18: Savings Growth .....................................................................................................................27 Figure 19: Features of Indonesian Insurance Landscape....................................................................29 Figure 20: Indonesian Insurance Assets ...............................................................................................29 Figure 21: Indonesian Insurance Assets and Investments ..................................................................30 Figure 22: Insurance Portfolio of Life Insurance...................................................................................30 Figure 23: Cursory Evidence: Possible Effects of Pension Reform......................................................32 Figure 24: Public and Private Pensions in Selected Economies..........................................................33 Figure 25: Features of the Pension Sector – Quick Global/Regional Comparisons...........................34 Figure 26: Pension funds sector is growing but small in nominal amount .........................................35 Figure 27: Investments of Pension funds have increased, but limits exist on where to invest .........35 Figure 28: Investment portfolio of pension funds to total assests ......................................................36 Figure 29: Investment Behavior of Pension Funds...............................................................................36 Figure 30: Number of Private Pension Funds in Indonesia is declining..............................................37 Figure 31: Number of Pension Funds with DB/DC Schemes...............................................................37 Figure 32: Number of Participants to Pension Funds Program ...........................................................38 Figure 33: Tax Structure.........................................................................................................................38 Figure 34: Private Pension Funds in the Future ...................................................................................39 Figure 35: Corporate Bond Trends ........................................................................................................40 Figure 36: Growth of East Asian LC Government Bond Markets, 2004..............................................41 Figure 37: Growth of East Asian LC Corporate Bond Markets, 2004..................................................41 Figure 38: Growth of East Asian LC Government Bond Markets, June 2005.....................................42 Figure 39: Growth of East Asian LC Corporate Bond Markets, June 2005 .........................................42 Figure 40: Corporate bond Trading Volume Grwoth, 2004..................................................................42 Figure 41: Issuer Concentration for Corporate Bonds..........................................................................42 Figure 42: Corporate Bonds Trading Volume Growth, 2005................................................................42 Figure 43: PRA Basic Strategy ...............................................................................................................58 Figure 44: New Challenges – Catastrophes..........................................................................................63 Figure 45: New Challenges - Dependencies .........................................................................................63 Figure 46: Current European Solvency Rules .......................................................................................64 Figure 47: What are the Grand Rules?..................................................................................................66

STRENGTHENING PENSION AND INSURANCE MARKETS IN INDONESIA v

Figure 48: What are the Grand Rules?..................................................................................................67 Figure 49: Overall Project Timetable .....................................................................................................67 Figure 50: COSO I....................................................................................................................................68 Figure 51: COSO II...................................................................................................................................68 Figure 52: Increasing Role of Risk Management..................................................................................69 Figure 53: Defining the Reserves ..........................................................................................................70 Figure 54: SCR – Risk Mapping According to CEIOPS/IAA...................................................................71 Figure 55: Supervisory practices (regarding solo companies) .............................................................72 Figure 56: Life Penetration Related to the Size of the Middle Class...................................................78 Figure 57: Institutional investment depends on level of economic development. .............................78 Figure 58: Growth of Institutional Investment in Transition Countries................................................80 Figure 59: Comprehensive Tax Increases Government Savings..........................................................82 Figure 60: Most Countries Use EET or TEE............................................................................................83 Figure 61: net tax cost per unit of contribution ....................................................................................83 Figure 62: Overall budgetary cost arising from contributions made in 2000 .....................................84 Figure 63: Indonesian Life Insurance System shows pure persistency ..............................................85 Figure 64: Impact of Reserving Method and Treatment of Initial Expenses .......................................87 Figure 65: Comparative Life Office Taxation.........................................................................................88 Figure 66: PAIRS - Quick Reprise ...........................................................................................................95 Figure 67: Major Prudential Risk ...........................................................................................................95 Figure 68: Capital: The Driver of Insurance Control Cycle..................................................................101 Figure 69: Governance Structure ........................................................................................................102 Figure 70: Risk Measurement: The Insurance Claims Process .........................................................103 Figure 71: Total Fertility Rate...............................................................................................................110 Figure 72: Market Capitalization and Contractual Savings................................................................110 Figure 73: Relationship between percentage of population and public pension spending.............111 Figure 74: Returns versus bank deposits ...........................................................................................114 Figure 75: 2000 and 2050 Population Age Pyramid UN Projections................................................115 Figure 76: System Dependency Ratio .................................................................................................115 Figure 77: Population Pyramid 2006 and 2050.................................................................................117 Figure 78: Indonesia – Pension System..............................................................................................118 Figure 79: Retirement Benefits in China.............................................................................................118 Figure 80: Financing Social Insurance Pensions ................................................................................119 Figure 81: DB versus DC ......................................................................................................................120 Figure 82: Pensions in Asia..................................................................................................................121 Figure 83: Where is the Money?..........................................................................................................121 Figure 84: Differences between Traditional and Micro-Insurance.....................................................130 Figure 85: Product Design Proposed...................................................................................................131 Figure 86: Hong Kong DB Scheme Statistics......................................................................................144 Figure 87: Annual Contributions and Assets under Management in DB Schemes .........................144 Figure 88: Hong Kong (China) MPF – Law and Regulations ..............................................................145 Figure 89: Hong Kong (China) MPF System Framework ....................................................................145 Figure 90: Company Set-up..................................................................................................................147 Figure 91: Membership Projection ......................................................................................................148 Figure 92: Company Set-up..................................................................................................................148 Figure 93: Employers with ORSO scheme...........................................................................................149 Figure 94: Employers without ORSO scheme .....................................................................................149 Figure 95: Implementation – Communications and Operations Efficiency.......................................150 Figure 96: YTD Distribution of AUM in MPF.........................................................................................150 Figure 97: Investment Fund Development – Structure of Investment Funds...................................151 Figure 98: Repercussions of Regulatory Changes – The Ripple Effect .............................................151 Figure 99: Relationship between Accounting Standards and Industry Strength ..............................165 Figure 100: Corporate versus Pension governance ...........................................................................168 Figure 101: Proposed Pension Governance Structure.......................................................................171 Figure 102: compares the distribution of risk between different types of formula..........................177

vi PROCEEDINGS INTERNATIONAL WORKSHOP 21-22 March 2006

Figure 103: Attribution of value added................................................................................................179 Figure 104: The actuarial control cycle – A basic governance tool ...................................................182 Figure 105: Interest rate guarantees in the Japanese market ..........................................................187 Figure 106: “Products Design..............................................................................................................188 Figure 107: Comparison of the two pension funds according to the three main risk factors..........189 Figure 108: Best Asset by Period Duration .........................................................................................189 Figure 109: Example of Concrete Asset Liability Management .........................................................190 Figure 110: Mathematical Reserves ...................................................................................................190 Figure 111: Returns and Risks ............................................................................................................191 Figure 112: Summary of Sectoral and Thematic Findings.................................................................197 Figure 113: Standards and Codes: Institutional and Market Infrastructure Scores ........................198 Figure 114: Corporate Governance Scores.........................................................................................198 Figure 115: Financial Regulation and Supervision.............................................................................199 Figure 116: Enforcement Scores.........................................................................................................199 Figure 117: Performance of Public Pension Funds ............................................................................200 Figure 118: Indonesian Insurance Sector – Actuarial Skills ..............................................................204

STRENGTHENING PENSION AND INSURANCE MARKETS IN INDONESIA vii

Acknowledgements The Government of Indonesia has been placing increasing emphasis on development of the Non-bank Financial Institutions (NBFIs). As part of this effort, and as part of the World Bank’s support to the Government in this area, a series of four workshops was held during 2005-06 focusing on various issues facing NBFIs. These proceedings are a record of the discussions at the third workshop focusing on insurance and pensions industries. These proceedings have been prepared jointly by the Bureau of Insurance and Bureau of Pension Funds, Ministry of Finance, Government of Indonesia and a World Bank team.

A number of people and institutions were involved in planning and implementation of the workshop. Bureau of Insurance and Bureau of Pension Funds, Ministry of Finance, Indonesia as well as the World Bank Jakarta Office would like to extend their gratitude to speakers, panelists, moderators as well as participants who made this workshop successful with providing their valuable inputs during the workshop.

Key people from the Government of Indonesia who helped organize the workshop and prepare these proceedings include Messrs. Darmin Nasution (former Chairman of BAPEPAM-LK, Director General of Financial Institutions, Ministry of Finance), Mulabasa Hutabarat, Firdaus Djaelani, Dumoly F. Pardede, Sunu Kartiko, Ahmad Nasrullah, Salusra Satria, Imam Arif Ir. Sugianto MA, Yongky Benjamin and Ramang H. Demolinggo. Thanks are also due to Dr. Fuad Rahmany, Chairman, Bapepam-LK, for his support of this publication.

The World Bank team working with the Government on NBFI development issues was led by P.S. Srinivas, Lead Financial Economist, World Bank Jakarta. Key contributors to the workshop and the proceedings included Rodney Lester, Craig Thorburn, Demet Cabar, Yoko Doi, Djauhari Sitorus, Dinni Prihandayani, Radhika Dhawan, Margie Djajakusuma, and Indra Irwanan.

All four seminars in the series were partially financed from a grant from the ASEM Trust Fund for Developing Capacity in the Capital Market and Non Bank Financial Institutions. The Canadian Embassy in Jakarta together with Sun Life Financial and Manulife Financial also provided financial support. This workshop was also supported by the World Bank Institute, Indonesia Life Insurance Association, General Insurance Association of Indonesia, Association of Financial Institutions Pension Funds and the Association of Pension Funds.

STRENGTHENING PENSION AND INSURANCE MARKETS IN INDONESIA 1

Overview

Craig Thorburn Senior Financial Sector Specialist, World Bank

As part of the Government’s increasing focus on the development non-bank financial institutions in Indonesia – and the World Bank’s ongoing support to the Government in this effort – a seminar focused on the development of insurance and pension funds was held in Jakarta on 21 and 22 March 2006. These proceedings are a record of the discussions at the seminar.

The seminar concentrated on bringing international experiences to Indonesia and discussing key policy initiatives available to the authorities to ensure that the long term segment delivers on the promises that it makes to customers, and to realize its contribution to the wider well-being of the Indonesian community reducing poverty and engaging in a full role in promoting economic growth for the benefit of the whole of the society in Indonesia.

This seminar brought together a group of international, regional and local experts to look at the opportunities and challenges facing the insurance and pension sectors in Indonesia. It commenced with an overview of global trends in the sectors after welcome addresses from key presenters from both World Bank and Indonesian government officials including the Minister of Finance, Ibu Sri Mulyani Indrawati, and the Chairman of BAPEPAM and Director General of Financial Institutions in the Ministry of Finance, Bapak Darmin Nasution. All speakers emphasized the importance of the seminar at this particular point in the development of the financial sector in Indonesia.

The theme of the first day of the seminar focused on current trends and developments locally and globally in the insurance and pension sectors. Plenary sessions concentrated on themes that applied to both the pension and insurance segments of the financial sector. They included analysis of international trends in the sectors and markets, experiences in taking a more risk-based approach, and the usefulness of aligning fiscal policies with social goals. On the second day, the program built on the previous day’s discussion through a series of parallel sessions under the thematic heading “Moving Forward”. The sessions examined challenges to sector growth, effective implementation of policies to strengthen institutions, and investments. The results of a recent World Bank study were also presented.

Why are Insurance and Pension Markets Important in Indonesia?

The value of a diversified financial sector was restated as a common goal. Indonesia has a bank dominated financial sector and this feature represents a risk. Increased participation in the financial sector by a wider range of varying types of institutions is a way to reduce this risk and improve the ability to deal with financial shocks and periods of uncertainty. To this end, the growth and development of the non bank sector, including long term institutions such as insurance companies and pension funds, is seen as a key objective to avoid the kind of impacts that were experienced in the financial crisis.

The insurance sector measured by assets or premium relative to GDP is small by international standards. Pension sector assets are also well below comparable countries in the region and the number of participants in pension schemes is particularly low especially when the civil service is considered as part of the equation. In both cases, it is clear that there is considerable room to grow and become more effective.

2 PROCEEDINGS INTERNATIONAL WORKSHOP 21-22 March 2006

The contribution that the sectors should be making to the well-being of the people of Indonesia by providing products that help them to manage risk is well understood. Indonesia has seen the hardship that comes from natural catastrophes. Individual risks also need to be managed ranging from the risk of untimely death, insecurity in old age, ill-health, or property related risks all able to be covered by insurance so that individuals and businesses can get on with doing what they do best.

The influence of the sector in providing products that help other parts of the economy do business was also emphasized. The interrelationships between insurance and pension sectors and employment markets was one such example indicating that careful policymaking is necessary, but also that wide ranging benefits can flow from well functioning policy settings.

Both insurance companies and pension funds have the potential to play a much greater role as long term institutional investors. Increased size is one way to increase the role of the sectors as investors but the current investment approach that overly emphasizes short term bank deposits was also identified as a key area for attention.

Key Drivers for Change

Many speakers attributed the more detailed international trends and developments to the overarching theme – population ageing. In this respect, Indonesia is relatively well placed with a young population and many speakers suggested that this would present policymakers with an advantage. The industry has a significant opportunity reflected in the relatively young population structure and the expectation that ageing will be later and slower in Indonesia than some other countries in the region.

International developments, in particular toward more risk based financial reporting, solvency, and regulation, had also driven changes seen on the global stage and it was emphasized that these changes could also be reasonably to come to Indonesia given the benefits of closing the gap between international best practices and current local practices. In particular, by closing the gap between Indonesian practices and international standards, Indonesia can make rapid progress and access the benefits of a better functioning and contributing sector. In particular, given that both sectors are small by international standards, there is a very significant opportunity for Indonesia to access foreign skills and resources to “leap-frog” the sector development path.

Locally, the need to address key issues would also act as a motivator of change in the sectors. Investment practices, increased coverage in the pension sector, realigned taxation systems, improved risk management, and the need to have accessible products were all proposed as changes that may reinforce global trends.

It is likely that some consolidation will be one of the consequences of change, particularly in the insurance sector, however this was largely seen as a potential opportunity rather than a threat as new skills and expertise may be able to be better accessed.


Consensus Themes

A considerable consensus emerged on both strategic and tactical opportunities that are available to the government and the sector. These centered on:

Improving the system of Corporate Governance; Adopting a more risk-based approach to supervision and management of entities, and

associated efforts to improve technical skills; Addressing the inappropriate asset mix currently too heavily oriented to short term bank

deposits; Increasing the size of the sectors through increased coverage and new initiatives to serve a

wider market; Improving the level of public confidence, financial education and, in particular, insurance and

pension awareness, in the population; Improving the tax regime.

Corporate Governance

The corporate governance system in Indonesia for insurance and pension funds is critical to development. To this end, the recent initiative by the association of employer pension funds to develop a set of good pension governance standards is a welcome initiative. Key opportunities were identified where the corporate governance can be improved in insurance and pension sectors independent of wider improvements.

Wider improvements are also important. Investment opportunities for the sector imply that the investability of the corporate sector improves and corporate governance is a critical element to this improvement.

For the pension sector, clarifying the roles and responsibilities of the various bodies that oversee pension schemes was identified as an opportunity. In addition, the current structure with a number of separate and variously responsible bodies makes it difficult for financial conglomerates to deliver packaged solutions to customers and restricts free entry into these markets – something reported as being desirable.

The role of effective corporate governance in sound risk management was also identified for the sector. Key challenges for insurance companies and pension funds exist that rely on sound and well functioning corporate governance from boards, supported by professionals such as actuaries and auditors, and a sound system of internal control and reporting of performance against business objectives. Increased disclosure and transparency was noted as being consistent with improved corporate governance in both sectors.

Adopting a More Risk-Based Approach to Supervision and Entity Management

Moving to a more risk based supervisory approach is seen as consistent with international trends and of particular value to improve the international standing of the sector. BAPEPAM has been working with consultants to develop their supervisory approach. International experiences brought to the conference highlighted that developing risk based supervision is not a short term task, requiring a considerable amount of supervisory training, procedural development, and technical infrastructure within the supervisory agency – in fact a complete revision of the methods of operation and approach of supervisors.

Risk based supervision also operates in partnership with sound risk management processes and corporate governance within firms. It was reported that the current technical approaches may need to be upgraded. Industry consolidation is to be expected in an environment where capital


and operational investments have to be made. On balance, the introduction of international partners was seen as an opportunity to access outside expertise and capital recognizing that it may be a difficult decision to take.

It was reported that the broad assessment of the Indonesian financial laws are that they are well structured and fairly complete. This assessment includes the results of specific reviews of insurance and pension laws.

Implementation of the intent of the law is, however, less well developed. Consistent with a risk oriented approach, technical capacity, systems, infrastructure, and sound corporate governance all contribute to effective implementation.

Supervisors have been reorganized to improve their effectiveness but, as is the case with all mergers, the immediate challenge is to increase the technical and supervisory skills of the staff. Whilst speakers noted the future plans to establish the OJK, it was felt that supervisory training for current staff in the current organization would be a sound investment for the future. An existing training program is underway for supervisors and remains a key priority.

Similarly, if risk based approaches are to be applied in the supervision as well as in companies and funds, then it is necessary to have the technically competent expertise within companies to identify, measure, manage and report on risks. Together, however, with competent risk based supervision and sound risk management in firms, then the outcome should be optimal taking into account a speed of change that is suitable to balance the costs and benefits available to Indonesia.

Appropriate Assets to Reduce Risk and Deliver Promises

One key source of risk was identified and given specific attention. The investment mix adopted by pension funds and insurance companies is heavily oriented toward short term bank deposits and this stands out when the nature of the benefits provided by these entities is considered. Some speakers advocated change on the basis that the current asset structure was clearly sub-optimal and a source of risk. Others emphasized the need to adopt more scientific asset liability management approaches to develop a sound investment policy and strategy and pointed to the need to have effective reporting and internal control systems to ensure that the strategy was well executed.

Investability, noted above, is also a factor. As the sector seeks new investment opportunities it is also incumbent on the wider economic sector to enhance its attractiveness to institutional investors. To an extent, as the sector plays a role as an institutional investor it can also be expected to be a force for good corporate governance and performance and improved liquidity and transparency in markets.

Either way, there was consensus that the outcome of a review would be a more diverse and longer term oriented asset mix. Those taking the shorter term quick fix tended to advocate investment in equities and assets outside Indonesia. Those taking a longer term view emphasized more domestic but still long term assets recognizing that the markets for these products also needs to develop. This balance of views is consistent with the same debate in other countries. Ultimately, a well balanced investment strategy based on sound technical analysis of risk is likely to include both a range of domestic and external assets.


Increasing Coverage

One key to increasing the role of the sectors in the investment markets, and to create the climate where the supply of suitable long term investment assets are available, is to grow the sector so as to create sufficient demand. Increased coverage also contributes to the goal of having the sector effectively serve the clear customer needs in the Indonesian population.

With respect to the pension sector, the need to increase coverage was a point raised regularly by presenters. Discussion included the potential of reforming the severance pay regime to fit better into a retirement incomes policy including finding ways to channel contributions made to these benefits toward benefits oriented more toward retirement incomes rather than lump sums. The performance of JAMOSTEK was identified as needing improvement recognizing that it had not achieved the objectives intended. Launching a more conducive approach to occupational pension funds to encourage their development, including products that could be manufactured and promoted buy financial institutions, was also suggested recognizing that the current corporate governance system for pension funds is not particularly conducive to retain pension product development and delivery. Contracting out of Jamostek and the severance pay arrangements into an alternative privately managed defined contribution arrangement with obligations to provide fully portable retirement income benefits would be worth considering.

Inspiration can be taken from the presentations made regarding successful micro insurance schemes in other countries. The Indonesian population has clear insurance needs but the design of suitable products and the processes to deliver them can be a challenge to insurers who think solely within a traditional business model. International experience from micro insurance schemes is that these challenges can be overcome.

Public Confidence Coupled with Increased Financial Awareness

Public confidence relies on well managed secure institutions that keep their promises. It is also supported by resolving the current market situation where it is necessary to restore the financial health of those pension funds and insurance companies that are undercapitalized relative to the risks that they face so as to establish them on a sound footing. Discussion of the detail of processes for consolidation in the insurance sector and reform of the pension sector requires supervisory strength, and the support for hard but necessary decisions was evident in the tenor of the discourse at the seminar.

Pension funds globally are facing a trend to increase their relevance, transparency and value to members. Reducing costs, effective but prudent use of outsourcing, and member communication are all part of this direction. More fundamentally, the trend toward defined contribution schemes and improved portability has made the retirement system more effective for members. With very low penetration, and a domination of defined benefit schemes for those that are members, these initiatives may also help to enhance and improve the relevance of pension funds to Indonesians as well.

Funding standards for pension schemes and capital requirements for insurance companies also were given some discussion recognizing the international trends to elaborate standards to protect members in the event of difficulties being experienced by the employer sponsor.

Public education was identified by policymakers and international experts as an area where investment of effort could realize significant returns. Senior government experts called for a strategy, in partnership between the authorities and the industry stakeholders, to achieve this aim.


Some improvements to the Taxation Regime

Specific impediments exist within the taxation regimes in both insurance and pension sectors that would merit attention.

Pension taxation is not currently on a basis that would encourage long term participation. The move to a clear TEE regime was proposed as it would remove the currently applying double taxation inherent in the pension fund tax system in Indonesia without creating a material fiscal concern for the government. A similar approach was proposed for life insurance taxation so as to ensure that a comparable and equitable arrangement was put in place. The alternative EET regime was also considered and is theoretically attractive but would require careful consideration and currently appears to be a second choice option, albeit that the arguments are finely balanced. Difficulties in implementation would appear to be greater if an EET approach is selected although they may not be insurmountable.

For non life insurance, the main taxation issue that emerged was the treatment of IBNR and IBNER provisions where it was advocated that these should be established out of pre-tax earnings. The treatment of equalization provisions was less central given that emerging international accounting standards will eliminate these provisions in any event.

There was a consensus that administration of the tax law has to be made more transparent, uniform and certain. Concerns were raised that taxation outcomes is more dependent on the interpretation of the individual assessor than is desirable.

A Comprehensive Program

The seminar opened with the aim of facilitating a dialogue on the direction for the industries in the future. It concluded having achieved a clear view that the sector can and should play a stronger role in Indonesia. It was considered that the reasons for improvement were multiple and compelling creating an enormous potential benefit for the country and its people.

But such a program was also recognized to be one where effort and investment is required. International and local experts need to work together, as does both the public and private sector stakeholders. Ultimately, there is a readiness evident in all presentations from the authorities, and in the participation of the industry in the conference, to progress to a clear and active strategy to develop the sectors. With such a significant opportunity available, the cost benefit considerations are clear.


Welcome Speech

Andrew Steer Country Director, the World Bank Indonesia Office

Welcome everybody to this very important conference. It is a great honor, Bapak Darmin, to be working with you and the Ministry of Finance in your role as both the Director General of Financial Institutions and Head of Bapepam.

There are some of the leading thinkers on Insurance and Pensions throughout the world in this room. These key players will make the transformation of Insurance and Pensions in Indonesia possible. The study of Economics states that you need one instrument to aim at one thing. You should not try and accomplish two or three things with one instrument. But the great thing about pensions and insurance is that if you get it right, you can do a lot more than one thing. In fact, one can accomplish three goals with a reformed pensions and insurance system.

First, you provide better pensions and better insurance and that is very necessary in a country like Indonesia where vulnerability is so great. Today only 10% of the population of Indonesia has formal pension schemes or insurance, and half of that 10% are civil servants. This is not enough. There are tens of millions of people in this country that suffer vulnerability and a well performing pensions and insurance system can help address that. This is the first reason why it is imperative that something be done: to help the people of Indonesia and the economy of Indonesia.

There is a second reason. Within these sectors there is the potential for a massive financial contribution to the urgent investment needs in Indonesia. Around the world we are seeing a remarkable tapping of insurance and pensions systems to finance investment. Countries like Malaysia, where Andrew Sheng comes from, have done a remarkable job in this regard. In Latin America, pension and insurance systems play a much much larger role in financing vital infrastructure. In several developing countries, pensions and insurance assets exceed 50% of GDP whilst today in Indonesia they account for just 7% of GDP.

I was in Bali for the Euro money conference. The good news is that the number of investors that signed up for that conference was twice what it was two years ago and the overall mood was extremely positive in Indonesia.

But as we all agreed there is a vital need for Indonesia to be able to avail itself of its own long term savings as we move forward to investing more than one hundred billion dollars in infrastructure over the next 5 years. So the first reason we need reform is to help the citizens of Indonesia manage their risks. The second is we need reform to finance the urgently needed investments in Indonesia.

Third, we need reform because the financial crisis has taught us that a diversified financial system is essential if you want to manage your macro economy and your financial risks well. So it is very important indeed that rather than depending so excessively on the banking system as we do today, there will be a much richer financial system.

So Indonesia today has reached the stage where it needs all of these three things. And that’s what this conference today is all about. Today, only about 150 trillion rupiah in assets, about fifteen billion dollars sits in insurance and pensions systems. This is a lot of money and needs to be used more wisely or at least for more productive investments than it is today. More importantly this number needs to be increased.

So I would like to welcome you here today. I would like to thank very much the government of Canada, Indonesia and the other sponsors Manulife and Sun Life Financial and our other sponsors that are listed here. I wish you a very productive time. We are looking forward to Minister Sri Mulyani speaking to us later on this morning but first it’s a great honor to invite Pak


Darmin Nasution to give his overview of the insurance and pension system. After that we will have a key note address from Andrew Sheng. Welcome to all of you.


Welcoming Remarks

Darmin Nasution Chairman of BAPEPAM

Director General of Financial Institutions Ministry of Finance, Republic of Indonesia

It is an honor for me to be here today to speak to important people in the insurance and pension industry. This workshop indeed reflects our concern about the development of financial institutions in this country, particularly the insurance and pension funds industry.

As the economic condition of our country regains its strength after the crisis there is a need for financial resources to capitalize the real sector. Here insurance and pension funds play an important role and hence their growth and stability is essential to increase the speed of economic growth. It is important to know that this matter has become of international interest and we have been assisted by international institutions such as the World Bank and the Asian Development Bank in coping with this issue.

Now I would like to share my views on some vital elements for the development of this industry. Over the past five years, assets of the insurance and pension industry have increased significantly. The average growth of insurance assets was 27% per annum, and pension fund assets grew at a rate of about 20% per annum. As of June 30 2005, both sectors have accumulated 135 trillion rupiah of assets, 74 trillion rupiah from insurance and 61 trillion rupiah from pension funds. This is of course still very small compared to our GDP. It comprises only a little more than 5%. Bapak Anwar says 7% of our GDP. Moreover the growth of this industry tends to slow down. In fact, if we see the number of insurance companies and pension funds, it is apparent it is a declining trend. This is due to many factors such as the legal environment that still needs improvement and financial difficulties faced by shareholders in the insurance case and employers in the pension funds case.

The insurance industry is large but still fragile. We have many life and non life insurance companies with low capital resulting in low capacity. We all realize that insurance is a business of managing risk. If the capital maintained is very small, it is questionable how long this industry can survive in the midst of strong competition among financial institutions. This question is valid for pensions also. About one third of defined benefit pension funds are insolvent and another one-third are solvent but unable to fund their actual liabilities. In other words only one third of defined benefit pension funds can meet their promise to participants. This is a serious problem since over 85 % of employers pension funds are defined benefit.

Operational risk is another issue for the insurance and pension sectors. Some insurance companies do not implement good corporate governance and suffer from a shortage of good employees. Small insurance companies tend to have limited resources to operate properly and their best people leave them for bigger companies that offer better salaries. Since human resources is a critical factor to build the trust and image of insurance industry, these small insurance companies will soon fall into a bigger problem. For the pension sector the main problems are awareness and knowledge of people involved in the business. Some of the administrators do not have sufficient knowledge about the special characteristics of pension funds. It is often found that employers pay scant attention to their pension funds. These combined problems lead to poor pension governance.

Therefore, there is plenty of room for improvement. There are some things that regulators and practioners can do. Firstly, developing regulations that are conducive to the development of a sound insurance and pension industry is essential. A review by ADB consultants shows that in


general regulations of insurance and pension funds are in line with OECD principles. However, some regulations need to be revised so that they conform to the latest international standards.

The adoption of international best practices is also on our agenda to make the insurance industry become internationally recognized. We are determined to continuously revise our regulations so that they comply with the principles issued by the International Association of Insurance Supervisors. We plan to revise the minimum capital requirement for insurance. These new regulations not only apply to insurance companies but also to all insurance supporting sectors, such as brokers, agents, adjusters and actuarial consultants. To ensure all players meet the capital requirements, the implementation will be applied gradually. With respect to pensions, the change of regulations is aimed at loosening entry requirements and providing greater flexibility for program design.

Secondly the regulator, with the help of many parties, needs to create a strategic plan to promote public awareness of insurance and pension products. The strategic plan should be formulated based on a comprehensive analysis of influencing factors. This includes analysis of the economic environment and the market needs for financial products. Once such a plan is established, the action plan for immediate, medium and long-term time frames needs to be developed. The regulator does not have promotional skills so support from practitioners and professionals will be significant ingredients of success.

The third aspect that we could work on is capacity building. Competency has become a prerequisite for those who manage insurance and pension funds. This requirement is relatively new for pension funds and so the compliance level is still to reach 100%. There is still around 17% of noncompliance. Last week we gave a strong warning to pension fund administrators who have not meet the requirements and hopefully they will start to do so. We also encourage insurance companies to make a greater investment in human resource development. We have required each company to employ an insurance expert in every business line. The importance of intellectual capital is not restricted to the industry but also applies to the regulator. Our consultants from the World Bank and ADB have conducted a training needs assessment for BAPEPAM and DGF5. Some of the training proposed has been carried out and other such initiatives will be arranged in the future.

Next is governance. The industry should move closer to OECD guidelines for insurance and pension governance. For pensions, the role of the supervisory board should be strengthened. Pension funds, particularly large pension funds, should start to formulate risk management strategies and processes for their business. I am aware that currently the association of employer pension funds is following good pension governance standards. Their action needs to be supported by all of us.

Lastly in order to better safeguard the interest of policyholders and pension fund members and to promote the stability and accountability of the industry, supervision should be carried out using the right approach. Risk-based supervision seems the right way to meet the objective of supervision. We plan to move to risk-based supervision in line with the ministry of finance roadmap to OJK. We will make a gradual change in our supervision system. Right now are we developing risk-based supervision that reflects the environment of the insurance and pension industry. This work is being carried out simultaneously in the directorate of insurance and pension funds. With the help of our consultant, especially from the Australian Prudential Regulatory Authority (APRA), risk based supervision means that the regulator relies more on the industry to conduct self supervision. Therefore, preparation to implement risk-based supervision should be made by regulator as well as practitioners. I know it sounds like hard work but I believe our good intensions, our skills and knowledge will promote the growth of this industry. Ladies and Gentlemen, what we do today is one step and for this opportunity I would like to say thank you for your participation.


Key Note Speech The role of institutional investors in a bank dominated economy

Andrew Sheng Former Chairman of the Securities & Futures Commission, Hong Kong (China)

Overview

Asia needs a long-term capital market. On January 1 2006, nineteen percent of Americans had reached their sixtieth birthday. The world in developed markets is aging while developing markets, such as Indonesia, are still young. To prepare for an ageing population, the economy demands long-term savings.

Secondly, long-term institutional investors can play major role in risk-reduction and resource mobilization in Asia. During the Asian crisis the banks got into a huge maturity mismatch by lending long and borrowing through short-term means. A capital market helps balance this kind of situation out.

Thirdly, since Indonesia has a small insurance and pension sector by international standards, there is a great opportunity to leap-frog development in capital market using foreign skills and resources.

The opportunity for reform is there. The important thing is how to do it. Globalization and demography are changing the world. The rise of China and India and the recovery of Japan will mean that Asia will play a major role globally. It is already doing so by being a net saver but its capital markets are weak when compared to the U.S and the E.U. Reform of Asian financial markets is inevitable to avoid a repeat of the mistakes of the Asian crisis. This requires further opening to meet efficiency and global standards of financial stability. International accounting standards are now being promulgated. Reform of regulation and financial structures require careful analysis of risks, rewards and resources, properly managed and sequenced.

Now turning to some quick statistics. Asia accounts for 55% of world population, one third of GDP, 25% of trade but only 15% of market capitalization in capital markets. If you deduct Japan, which is 9%, then the rest of Asia accounts for only 4% in terms of market weight. This is not much. Most Asian economies are still dependent upon bank financing. Bank financing is nearly 200% of GDP in some Asian countries. In contrast, equity markets are very speculative and bond markets are still tiny (see figure 2)

Figure 1: Asia 55% of Global population, one-third PPP GDP 25% trade weight

MSCIPPP-GDP Exports Population Weighting

Japan 7.3 6.0 2.1 9.384 Tigers 3.3 9.4 1.3 1.82China 12.1 4.0 21.0 0.26India 4.7 0.9 16.7 0.12Other Asia* 5.4 4.5 14.5 1.57

Total ASIA* 32.8 24.8 55.6 13.15

US 21.4 13.6 4.6 55.30EU 19.9 37.7 6.2 17.14Others 25.9 23.9 33.6 14.41TOTAL 100.0 100.0 100.0 100.00 ________________________ * Excluding Australia and New Zealand Source: IMF, World Economic Outlook, April 2002


Figure 2: Asia Still Dependent on Bank Financing

Bank Assets Equity Market Bond Market1998 2002 1998 2003 1998 2002

China 139 140 25 36 12 33Hong Kong 214 149 206 451 32 27India 69 36 24 42 21 33Japan 145 107 64 68 101 169Korea 233 115 35 49 53 81Singapore 220 112 112 144 20 66Taiwan 226 125 97 133 41 33Thailand 176 82 30 83 23 38Germany 273 155* 51 58* 97 90*US 65 78 158 130 141 156

________________________ Remark: * 2001 figure Source: World Bank, IMF, WFE, FIBV, CEIC, Bloomberg, BIS, International Financial Statistics, various central banks and government websites The assets of banks, insurance companies, mutual and pension funds are still small (see figure 3).

Figure 3: Assets of Banks versus insurance companies, mutual and pension funds

77.7126.5

207

270.8

0.3 10.2 19.548

7.156.4 66.6

8.3 19.2

221.3

050

100150200250300

Philippines Thailand Malaysia Singapore

Banks Insurance Companies Pension Funds Mutual Funds

159.9

346.8 339.6

67.145.2 55.6 82.557.3 70.413.9

67.644.2 67.4

0100200300400

Japan UK Germany US

ASEAN

G-8

Other Asian

Economies

225151.2

217.6

74.76 25.6 7.817.7 1.1

341.1

20.1 1.5 2.40

100200300400

HK S.Korea China Indian/a n/a n/a

n/a n/a

n/a n/a

The Asian growth story, the Asian miracle, is essentially a demographic story. The region is spurred by a young population entering into world trade with high savings. But the region still needs to learn how to balance real growth and financial growth. The Asian crisis is proof of how quickly economies can loose money earned through manufacturing and trade if the two kinds of growth are not balanced.

Consider the share of total population in two Asian countries, China and Japan. China’s high growth rate is because the country’s demographics are roughly 20 years behind Japan. Japan is


already beginning to age, rapidly so after 1990. China is still growing and the bulk of the working age population would continue to grow up to 2010. But because of the one child policy, China’s ageing will accelerate whereas Japan will still have steady growth for many years to come (see figure 4).

Figure 4: Asian Demographics: Growth co-related with rise in Working Age Group

________________________ Source: UN Population Statistics At the end of 2003, the international banking assets under management were USD 23.6 trillion1. But if you add up the bond markets, the insurance funds, the pension funds, the investment companies, the mutual funds, the hedge funds and other institutional investors, these outher funds are larger than the banking system (see figure 5)

Figure 5: Global Assets under Management

International Banking Assets (BIS data) 23.6International debt securities 14.6Insurance companies 13.5Pension Funds 15.0Investment Companies 14.0Hedge Funds 0.8Other Institutional Investors 3.4

Memo: OTC Derivative Contracts (notional) 270.1

⇒ Capital market institutions as a group larger than international banking assets

________________________ Source: BIS, IMF

Indonesia requires long-term funds to build its social infrastructure. It is not possible to borrow entirely in foreign currency. You need to borrow in rupiah to lend in rupiah. This will be a huge risk for Indonesia to manage if the capital market doesn’t exist.

1 Source: BIS


So where is the money? If you look at the international banking assets, the insurance pension funds, investment companies, the United States accounts for 54% of the world total, Japan 16%, UK 18%, and Germany 12%. So the bulk of the money is still in G4 countries (see figure 6).

Recent years have seen massive changes in regulatory standards worldwide. There have been changes in the accounting standards. There has been a convergence between the International Standards Accounting Board and the US GAAP. There have been massive changes in corporate governance such as the Sarbanes-Oxley Act and the European Directives. The Basle II Capital regime has been developed; the IOSCO standards have been introduced. The International Association of Insurance Supervisors is working on international standards for insurance. The corporate sector has realized that misconduct, as seen by companies like Enron, costs billions in terms of civil litigation. So governance is everything.

Figure 6: Who accounts for Most Financial Assets

9

53.7

19,251

7,026

5,994

4,833

1,398

United States

16.0

5,724

493

928

2,969

1,334

Japan

100-12.018.3% of total

-35,8624,3206,567Total

25.59,1291,063547Investment companies

23.98,5754621,191Pension Funds

29.410,5471,0091,736Insurance

21.27,6111,7863,093Int. Banking assets

% of totalTotalGermanyUK

________________________ Source: IMF International Capital Markets, 2005

The Asian Model

The Asian model has seen massive imbalances of growth and has the following characteristics.

The post-war growth model has been unbalanced, based on control of savings to fund exports and industrialization.

Banks were trade oriented, but evolved towards housing and infrastructure finance. Deep bond markets did not develop because fiscal surpluses and low yields did not attract

savings. Retirement funds were mainly state-sponsored and devoted to fiscal funding. The insurance sector was dominated by state and foreign firms. Securities markets were dominated either by families or state-owned enterprises, and were

more speculative rather than playing a strong role in fund-raising and corporate governance.

Where is the region now? The financial system is there to help delineate, transfer and protect property rights over the whole demographic cycle. It is not useful if you save money close to retirement if the money could be lost through pension funds, insurance companies and mutual funds. An individual wants a long-term insurance and pension fund sector that will protect his or her savings through life. Hopefully, they want their savings not to be eroded by inflation or corporate misconduct.


In reality, what Asia has done since it has a young population, is transfer 2.5 trillion of assets to the developed market because the region’s own market cannot digest these funds. This kind of financial transaction is called a total equity return swap. Asia runs a current account surplus with the West, mainly Europe and America. The region places USD 25 trillion of official reserves outside the region, of which USD 2.5 trillion is placed in US treasury bonds and earns 4.5%. The money comes back through foreign pension and insurance funds investing in emerging markets through foreign direct investment, leveraged to earn 10 to 15 per cent per annum. As a swap of risk it is not a bad swap. But in the long-term, if Asia is to narrow that intermediation gap, it needs to re-invest in its own markets in long-term investment options and better finance its own development.

Asian capital markets remain bank-dominated with limited growth in institutionalization of funds and capital market skills. Asia needs to strengthen the institutions. The six `is:

Accurate, timely and accessible information; Properly aligned incentives; Educated investors; Efficient intermediaries; Strong issuers ; and Efficient and robust infrastructure

All of this needs to be looked after by a strong prudential framework with enforcement. It all comes down to designing and implementing a system that protects property rights over the whole demographic cycle.

The Asian miracle was all about a young demographic entering into the free trade age. Asia is beginning to age, especially north Asia. The Japanese population is aging and the retirees require real returns on which to retire. Many Asian retirement funds function on the “pay as you go” (PAYG) principle. Their inability to earn good returns is a tax on future generations. In the days of low inflation, if the upfront fee is between 3 and 4% and the annual return on a mutual fund is 2%, are you making money or loosing money? You end up taxing the saver. So the intermediation costs needs to get to a reasonable level at which risks and costs are balanced. This is not to say that mutual fund managers and other asset managers should not be paid well.

The rest of Asia is still very young, with a high saving rate geared to build strong institutional retirement funds. But it needs to build these institutions quickly as the global economy is changing rapidly. Institutional savings will ultimately improve liquidity of bond and equity markets and play a key role in risk-management and corporate governance. However, there are problems that need to be dealt with.

Price discovery: The high liquidity and low risk spreads do not reflect underlying risks. Resource allocation: If resource allocation is so good then why is Asia still bank dominated?

This is a fundamental question. Risk management: Has risk management in Asian markets improved to the extent that non

performing loans are declining? Corporate governance. Do banks and the capital markets provide sufficient checks and

balances on borrowers and corporate sector?


Objectives of Reform

Primary Objectives

The primary objectives of reforms should be:

Improved resource allocation – So that insurance companies and pension funds broaden and deepen capital markets, and meet the needs of Indonesia in the area of risk management and social security and retirement savings.

Better price discovery - institutional deepening in insurance and pension funds will increase competition in the demand and supply of funds. Long-term funds will demand better risk spreads in their area of investments. Competition for funds becomes healthy and professionals have access to better information and market skills. Experience in the Malaysian and Singaporean markets shows that the state authorities are much larger than the retail sectors. Since they tend to be more conservative in their trading activities, it leads to limited liquidity in the market, which in turn leads to an under developed bond market.

Better risk management – Risk management is about product diversification, institutional diversification and geographic diversification. Diversification reduces concentration risk, improves market skills and. through joint-ventures with foreign firms, provides access to global market expertise and global investors. Excessively bank-dominated economies concentrate risk instead of distributing it. The Indonesian market is large enough to have a greater regional and global impact.

Improved corporate governance – The professional skills of long-term institutional investors would raise demand for higher standards of corporate governance. You cannot upgrade skills without some foreign participation. This is the key to greater economic efficiency.

Secondary Objectives

In addition, secondary objectives of reforms should be: A deeper pool of long-term savings will improve debt and equity markets. Without long-term

savings this is not possible. Indonesia needs stable long-term institutions to finance social infrastructure. Strong debt and stock markets with high institutional depth is important to Indonesia’s future financial sector development. There has been only small improvement in the depth of markets throughout Asia. Take the example of Hong Kong (China), a country that has relatively deeper markets than most of Asia. Even Hong Kong (China) has only a few institutional investors. On the other hand, in Japan, London, or New York, there are thousands of fund managers. This is just not good enough. You cannot have a market consisting of only a handful of players. A market is made of many different types of institutions and that’s why London and New York are so much stronger than Asia.

Competitors to banks will improve investor choice. As the population ages, savers will want more choice in terms of risk profiles and maturity. Risks can be managed better when different individuals have different choices to manage their risks. At this moment, the choice is to put most of your money in the bank.

A deeper domestic institutional pool provides for stable monetary management Banks are prone to maturity and liquidity risk. Long-term institutional investors help provide stability of funding and therefore assists overall financial stability.

Institutional deepening creates demand for more sophisticated markets. Success breeds success. Retail markets tend to be volatile. Institutional strengthening creates demand for asset-backed and derivative markets, attracting both talent and funding from overseas. Once again Indonesia cannot do this in isolation and without foreign help. The IMF has presented a sequencing of the development of financial markets which is a good reference point (see figure 7).


Figure 7: Sequencing and Hierarchy of Domestic Financial Markets

Asset-backed securities and

derivatives

Corporate bond and equity markets

Government bond market

Treasury bill market andforeign exchange markets

Money market

________________________ Source: Karacadag, Sundrarajan 7 Elliot, 2003

Prerequisites of Efficient Markets

The following is a list of what I consider to be prerequisites for efficient markets:

Free entry of participants and products; A high degree of transparency and a low level of information asymmetry; Efficient operations by solvent participants under international rules of the game at low

transaction costs; An absence of incentive distortion or bias that moves markets in an unhealthy direction e.g.

moral hazard or subsidies; Efficient regulation at low regulatory costs; Orderly exit of insolvent participants [obsolete products and insolvent operators create huge

dead weight costs on market]; and Accountability [feedback and exit for bad players].

Lessons of Asian Financial Reforms:

Looking at other reform efforts, we are able to learn some lessons. I would like to share a couple of points with you today.

Developing Secondary Mortgage Markets: The Cagamas2 and the Hong Kong (China) Mortgage Corporation3 helped deepen the debt market and reduce bank maturity mismatches in each country. If the system has a liquidity mismatch then, at the first sign of trouble such as speculation on the basic currency, weaker banks will collapse as no bank can withstand a sudden withdrawal of deposits. What helps to avoid this problem is a secondary mortgage market. Secondary mortgage markets create an asset backed by mortgages so that the debt market can help intermediate the risk. The market functions like a shock absorber. It

2 Cagamas is the Malaysian National Mortgage Corporation. For more information on Cagamas, see www.cagamas.com.my 3 The Hong Kong Mortgage Corporation web site is www.hkmc.com.hk


is a very fundamental instrument but it has been extremely successful both in Malaysia and Hong Kong (China).

Investing Provident Fund Assets: The Malaysian Employees Provident Fund (EPF) and Singapore’s Central Provident Fund (CPF) have been successful in mobilizing savings (with assets at 50 to 60% of GDP), but their large size and buy and hold strategies do not add to market liquidity to the extent that they otherwise might. In fact, the Hong Kong Mandatory Provident Fund (MPF) collects money on a monthly basis and gets it managed by the private sector. In the MPF case, the investor has a choice of different investment funds.

Local Insurance Company Problems Continue: Larger Insurance companies that are well run are still predominantly non-Asian. Truly Asian insurers are still domestic, small and struggling to reach efficient and effective risk-management levels. They have not been able to invest in specialist skills. Domestic insurance company problems are linked to weak governance and low skill levels. Huge investor education is needed to prevent abuse, such as coercing investors to buy products which are not suitable for them.

Use of foreign skills to strengthen domestic competition and consolidation is inevitable: How we persuade domestic players to accept this ‘cooperation cum competition game’ is key. Here is a story about why foreign skills are so important. Twenty years ago in 1986 there were two islands – one was off Europe and the other off Asia – the United Kingdom and Japan. In 1985, Japan was a world-class manufacturer and a world beater in exports. The United Kingdom was going through some pain in its industrial sector. The UK opened up with a big bang. London is now colonized by American and European banks and insurance companies. Britain now manages global funds whilst Japan remains with a very domestic-oriented financial system and has paid for it through 15 years of structural adjustment in the financial sector. The winner is the country that attracts foreign talent into your economy, globalizes with and benefits from that talent. This is not an emotional subject but really about risk distribution. Indonesia is a large economy and can afford to open up a little. Without that foreign input of talent, skills, procedures, and risk-management, the country will struggle.

So ultimately reform is a process. For reform to succeed you need a process to manage that reform. Malcom Sparrow, a Harvard professor specializing in regulatory reform, says pick important problems, fix them, and tell everyone. The strategic calculation of reform is to estimate the 3 ‘r’s:

Risks - what are the risks of failure or stalemate? Rewards - do benefits clearly outweigh risks? Resources - reform skills and political capital are scarce. Do not squander them on low

benefit reforms. So which problem does one pick? There is a difference between a technical solution and political solution. Technical solutions are not necessarily the best political route. One must get feedback and move when you can. It is also important to prioritize and sequence reforms. It is possible that, over a five year period, one can only achieve three major breakthroughs.

In Indonesia in 2002, the pension fund assets were only 5 % of the GDP, compared to 49% in OECD countries, 64% in Singapore and nearly 60% in Malaysia. In Indonesia, more than half the funds are put back in the banking system as deposits. This implies risk concentration, not diversification. So the risk is still concentrated on the banking system.

In 2003, total life and non-life insurance assets were only 2.8% of GDP, compared with 43% in Japan and 19.2% in Malaysia. Life insurance asset size is actually smaller than non-life assets. This is opposite to the common trend overseas. For instance, in Malaysia the ratio is 15.1:4.4 for life insurance to non-life insurance assets. In Indonesia, on average, 31.2% of assets of insurance companies are put back into banking system as deposits.


Much thought needs to be given to the subject of how to open up the sector. If it is not available locally, you need to think about inviting in foreign talent. You also need to focus on the sequencing issue. Most of us spend time on fixing things that are urgent but not important. This is why the prioritization is necessary. How do you do this?

Indonesia has a bank-dominated system which is now opening up. The insurance and pension industries are still small relative to the banking industry, with structural issues of depth, but considerable potential for growth. Because insurance companies are still small and numerous, consolidation is inevitable. Globally, banking is consolidating, funds are consolidating. Markets are consolidating because skills, information technology and distribution networks are expensive. Consolidated supervision of the financial sector is still on the cards. But the market requires faster growth of capital markets relative to the banking industry hence the current opportunities to allow foreign direct investment to help leapfrog the skills gap and help with consolidating and strengthening the insurance and pension industries. Islamic finance and insurance are also growing trends with domestic and global interests involved.

Conclusion

Asian capital markets are integrating, as Asian savings seek regional placement, but it will integrate according to global standards. In the Asian time zone, stock markets have to change from “national” markets selling only national products to Pan-Asian product distributors. Asia has a huge opportunity as the third time zone. Asia is the highest concentration of growth economies and the highest concentration of young economies with high savings but our stock markets are basically domestic markets selling national goods. Indonesia sells manufactured products globally but how many financial products are sold globally? Globalization has benchmarked all domestic financial systems. You need to compete according to global performance, otherwise you become marginalized. Getting foreign skills involved in building domestic strength is inevitable. Closed systems cannot compete against open systems. Corporate competitiveness cannot be built without a strong financial services sector. The opening of the system is painful but if you want to build a strong economy, you need a strong financial sector.


Overview and Global Trend in Insurance and Pension Markets: Benchmarking Indonesia by comparison with the Experience of Other Countries and Regions


Overview of Global Trends in Insurance Markets – Benchmarking Progress in Indonesia

Ramesh Subramaniam Principal Economist, Indonesian Resident Mission

Asian Development Bank

Global Financial Market Trends and How do Emerging Markets Compare?

The quest over the past several years, particularly since the crisis has been to explore means of financing long-term investments. However, at the same time the social security concerns also have been in the forefront on pension and insurance reforms.

Let us look at some global financial sector indicators and then compare emerging markets, particularly Asian emerging markets with these trends (see figure 8). This data is from a World Bank financial sector database and provides data on a number of indicators over a long time span starting from about 1960. There are some key indicators here on bank deposits to GDP, stock market capitalization and bond market capitalization and the last two columns give you figures and trends on life insurance premiums and non-life insurance premiums. The purpose is to give a relative sense.

Figure 8: Global Financial Sector Trends COUNTRY Bank Deposits/GDP Stock Market Cap/GDP Bond Market Cap/GDP Life Premium/GDP Non-Life Premium/GDP 1990 2000 2004 1990 2000 2004 1990 2000 2004 1990 2000 2004 1990 2000 2004 ASIA China, P.R. of 42.3 40.3 8.5 22.3 29.4 0.2 0.9 2.1 0.6 0.9 0.9 HKG, PRC 107.2 375.6 486.3 1.5 25.9 28.3 1.6 3.6 8.0 1.4 1.1 1.4 Indonesia 29.8 44.7 38.9 4.4 27.9 24.9 0.4 31.3 24.1 0.2 0.5 0.6 0.6 0.6 0.7India 31.4 42.9 51.1 10.4 36.7 48.4 19.9 23.8 31.7 1.0 1.7 2.4 0.5 0.5 0.6 Korea 32.6 60.8 68.8 48.2 56.2 56.1 34.1 52.5 74.9 9.0 8.9 7.1 2.0 2.9 2.9 Malaysia 52.1 83.8 88.7 100.7 146.2 152.6 69.8 78.3 89.3 1.3 3.0 3.6 1.7 1.8 1.9 Philippines 24.0 49.3 48.4 20.6 66.0 30.6 22.1 27.9 28.7 1.2 0.8 0.9 0.8 0.6 0.6 Singapore 74.3 101.2 104.4 95.8 193.4 149.0 27.8 43.0 58.6 1.7 3.2 6.0 1.3 1.1 3.0 Thailand 56.8 91.6 79.7 29.2 36.2 72.3 9.7 25.7 38.9 0.9 1.5 1.9 0.8 1.0 1.6 Vietnam 28.2 48.1 0.3 1.3 0.4 0.7 LATIN AMERICA Argentina 5.5 27.1 21.3 2.7 44.0 28.2 9.8 15.9 15.4 0.2 0.9 0.9 2.2 1.5 1.8 Brazil 15.3 22.0 21.8 6.7 37.9 46.9 2.3 49.5 55.8 0.2 0.4 1.4 1.2 1.7 1.6 Chile 28.2 38.8 32.2 38.3 85.8 108.6 29.1 45.1 44.3 1.6 2.7 2.8 1.1 1.1 1.5 Mexico 14.1 24.6 23.0 10.6 24.2 21.9 21.0 12.6 24.1 0.4 0.8 0.8 0.7 0.9 1.0 OTHERS Russian Federation* 12.9 17.4 24.6 2.0 21.6 43.1 0.4 3.3 2.7 0.6 2.2 South Africa 48.3 50.1 59.9 120.8 177.0 170.4 100.2 47.8 43.2 7.7 14.6 11.4 1.9 2.7 3.0 SELECTED OECD ECONOMIES Australia 49.0 64.1 73.0 40.6 103.7 108.4 35.6 49.0 53.0 3.8 6.1 4.1 3.5 3.4 3.8 Canada 43.5 55.4 63.0 46.9 115.7 106.4 72.3 81.6 75.4 2.7 3.2 3.0 2.7 3.1 4.1 Germany 53.8 90.3 96.7 21.7 72.7 42.2 51.6 95.0 80.3 2.2 3.0 3.1 3.5 3.6 3.9 Japan 100.0 110.5 120.5 121.7 82.0 73.2 85.9 124.1 181.6 6.2 8.7 8.4 2.3 2.2 2.3 Switzerland 102.4 131.4 133.8 70.6 303.0 217.5 57.8 65.9 67.6 4.4 7.6 6.7 3.4 4.6 5.0 United Kingdom 87.8 101.2 115.0 85.2 192.7 123.0 36.8 50.7 43.9 6.1 13.0 8.9 3.4 4.2 4.9 United States 59.6 54.7 58.8 57.5 163.5 131.6 122.0 146.1 157.2 3.5 4.4 4.2 5.0 4.3 5.2

________________________ Source: World Bank Financial Sector Dataset, February 2006

Banks obviously still play a very dominant role in these economies but if you look at the data and go through the trends, the relative presence of banks is growing more slowly than in the 60’s and 70’s. Due to various country specific factors equity markets have boomed and bond markets have deepened. But there is a considerable degree of shallowness in the market and clearly public debt has dominated. There are specific instances where corporate bond markets have


grown considerably. For instance, in Hong Kong (China), The Republic of Korea, Malaysia, Australia, and the US this is the case. Over the past few years, the Indonesian market has seen a slow and steady growth, although the market continues to be small.

If you consider penetration ratios, the Asian region has some clear leaders in the insurance sector: Korea, Malaysia, and Singapore. South Africa is another major player in developing markets although all of these are subject to special considerations and interpretation. In growth terms, India and China are leading the pack and are the spectacular stars in the insurance sector.

With respect to data on global growth of insurance premiums, the mid 1980’s was a golden period in terms of inflation-adjusted insurance premium growth (see figure 9). The growth rate averaged 5% to 20% on an annual basis and rates closed in the range of 2% real growth per annum.

Figure 9: Global Growth in Insurance Premiums

________________________ Source: Swiss Re Chartroom This is an indication that much of the growth in recent times is driven by emerging markets (see figure 10). The share of Asia in every segment is large. For example, Asia accounts for 74 % of the emerging markets share in life premiums.

Now consider another comparison of trends between how real GDP has grown in selected sets of emerging markets. Much of the recent growth in premiums is from emerging economies. This applies to Asian economies, in particular (see figure 11). As mentioned earlier, this growth is driven by micro economic recovery and the recent growth in India and China. However, there are some other dominant elements as well. The leaders are the larger economies although Indonesia is picking up (see figure 12). The circles on the chart represent the relative size of the insurance life and non-life sectors; Japan and South Korea are the dominant players here. The data looks at how the average real premium growth over the past decade and a half has driven the large shares in terms of insurance penetration that is currently observed.


Figure 10: Share and Potential of Emerging Markets

______________________________ Source: Swiss Re (P. Ozendo, 2005)

Figure 11: Real Insurance Premium Growth

______________________________ Source: Swiss Re (P. Ozendo, 2005)


Figure 12: Average Real Premium Growth

The next data set is a comparative summary to see where we stand in 2004 in terms of insurance penetration ratios and premiums per capita (Insurance Density). It consolidates data across the different life and non-life segments. If you look at Indonesia, growth has been solid at 13% (see figure 13). If you look at the life segment, the cumulative growth has been even higher but this market is tiny in comparison to other markets in Indonesia or across the other financial sectors in Asia. Premium in relation to GDP is 1.3% in Indonesia. Premium per capita in Asia is USD 194 and in South and East Asia USD 68. In Indonesia, it is a low USD 15.

Figure 13: Insurance Penetration and Density by Region 2004

premiums (in USD

mn)

2004 real growth

rates

World market

shares, 2004

Premiums in % of

GDP, 2004

Premiums per capita

(in USD)

America 1,216,900 1.8% 37.5% 8.3 1,404 North America 1,167,576 1.4% 36.0% 9.2 3,601 Latin America and the Caribbean 49,323 10.5% 1.5% 2.5 91Europe 1,198,184 3.2% 36.9% 7.9 1,428 Western Europe 1,156,511 3.1% 35.7% 8.4 2,359 Central and Eastern Europe 41,673 5.6% 1.3% 3.0 125Asia 736,036 2.1% 22.7% 7.4 194 Japan 492,425 -0.9% 15.2% 10.5 3,875 South and East Asia 229,558 9.0% 7.1% 5.2 68Of which: Indonesia 3,307 13.00% 0.10% 1.3 15 Middle East and Central Asia 14,052 2.6% 0.4% 1.7 48Africa 37,609 -1.3% 1.2% 4.9 43Oceania 55,177 3.2% 1.7% 7.7 1,737World 3,243,906 2.3% 100.0% 8.0 502

________________________________ Source: Swiss Re, Economic Research & Consulting, Sigma No 2/2005 Indonesian Insurance in 2004, MoF and FIIA


Look at how insurance penetration has grown over the last couple of decades (see figure 14). The line on the top is the non-life ratio and the line below is life premium ratio. Indonesia is one of the few countries in emerging Asia where non-life penetration has been higher than life insurance penetration. The trend to note is the flattening of non-life contribution; but life insurance penetration is growing systematically. The point is that markets like Singapore and Korea have deeper insurance markets although the trend is flattening out. Countries like China, India, Malaysia, and Thailand have low penetration rates – in the range of 2% to 4% - but the trend line is moving upward.

Where do we place Indonesia in this context? Indonesia and the Philippines are among the lowest in terms of insurance premiums to GDP (penetration). Indonesia is lower than the Philippines. The positive point is that with the size of the population, as well as the significant economic potential of this country, the sector holds vast potential for the future.

Figure 14: Insurance Penetration and Density by Region II and III Indonesia Insurance Penetration

0.0%0.1%0.2%0.3%0.4%0.5%0.6%0.7%0.8%0.9%

1979

1981

1983

1985

1987

1989

1991

1993

1995

1997

1999

2001

2003

Pre

miu

m/G

DP

Korea Insurance Penetration

0.0%

2.0%

4.0%

6.0%

8.0%

10.0%

12.0%

1979

1981

1983

1985

1987

1989

1991

1993

1995

1997

1999

2001

2003

Prem

ium

/GD

P

Malaysia Insurance

0.0%0.5%1.0%1.5%2.0%2.5%3.0%3.5%4.0%

1979

1981

1983

1985

1987

1989

1991

1993

1995

1997

1999

2001

2003

Prem

ium

/GD

P

Philippines Insurance

0.0%

0.2%

0.4%

0.6%

0.8%

1.0%

1.2%

1.4%

1979

1981

1983

1985

1987

1989

1991

1993

1995

1997

1999

2001

2003

Pre

miu

m/G

DP

9

India Insurance Penetration

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

1979

1981

1983

1985

1987

1989

1991

1993

1995

1997

1999

2001

2003

Prem

ium

/GDP

Singapore Insurance Penetration

0.0%1.0%2.0%3.0%4.0%5.0%6.0%7.0%8.0%9.0%

10.0%

1979

1981

1983

1985

1987

1989

1991

1993

1995

1997

1999

2001

2003

Pre

miu

m/G

DP

Thailand Insurance Penetration

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

1979

1981

1983

1985

1987

1989

1991

1993

1995

1997

1999

2001

2003

Pre

miu

m/G

DP

China Insurance Penetration

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

1986

1988

1990

1992

1994

1996

1998

2000

2002

2004

Pre

miu

m/G

DP

____________________ Source: World Bank Financial Sector Dataset


Demography and Economics: Indonesia and Comparable Economies

A common picture across Asia is declining fertility rates, increasing longevity and increasing old-age dependency ratios (see figure 15). This implies that the problems faced by other countries will be faced across Asia. That makes it necessary for the region to look at social security reforms. The proportion of the population above 60 years of age in Indonesia and Malaysia by the year 2025-2030 will be above 14%, compared to an average of 3% to 3.5% in 1990-95.

Figure 15: Demographics in South East Asia

__________________ Source: M. Asher, “Social Security Reform Imperatives: The Southeast Asian Case”, National U of Singapore

Additionally, fertility rates are declining (see figure 16).

Figure 16: Total Fertility Rate Trends

0.0

1.0

2.0

3.0

4.0

5.0

6.0

7.0

8.0

Pakis

tan

Philip

pines

Bangla

desh

India

Malaysi

a

Myanmar

Viet N

am

Indon

esia

Sri Lan

ka

Mongo

lia

Kazakh

stan

Thailan

d

Singap

ore

S. Kore

aChin

aJap

an

Hong K

ong

Around 1970 Around 2000 __________________ Source: First initiative study Indonesia, Y. Guerard, May 2005 Indonesia is right in the middle of the pack, if you leave a small country like Mongolia out of the picture. Indonesia has a higher life expectancy than the current global life expectancy reported (see figure 17).


Figure 17: Life Expectancy 1975-2025

__________________ Source: First Initiative Study Indonesia, May 2005

On the economic front, China and India have been growing rapidly with growth rates of 8% to 9%. Indonesia has achieved 5% real GDP growth from 2002-2004. Slow but steady microeconomic recovery and reasonable economic fundamentals have driven growth.

Although savings are high, the savings rate is not yet back to pre-crisis levels (see figure 18).

Figure 18: Savings Growth

30.6

14.5

37.339.7

43.3

29.1

42.5

37.3

31.8

17.3

33.0

47.3

31.7

39.036.5

25.3

20.9

33.4

43.8

31.6

44.7

35.0

48.0

0

5

10

15

20

25

30

35

40

45

50

Indon

esia

Philipp

ines

Thail

and

Malays

ia

Singap

ore

Hongk

ong

China

South

Korea

1995 2000 2004 __________________ Source:ADB Key Indicators 2005

Although disposable income is increasing, savings are higher across the region. It is interesting to note that the ratio (savings to GDP ratio) is rather low in Indonesia and has been declining. It is down by almost 5% over the period from 1995 to 2004. In the Philippines the rate is even lower since there have been some systemic problems in the country. These two countries are lagging


behind the region and this has implications for product development and attracting investment into the pension and insurance industry.

Therefore, the growth of the insurance and pension industry will be supported and tested by domestic, regional, and global developments in interest rates and inflation and private consumption and accelerated possession of household assets. All of these countries in the region have massive infrastructure investment needs, yet resource mobilization and greater private sector participation remains a major challenge.

Key Features of Insurance Market in Indonesia

The insurance sector at the end of 2004 accounted for about 7% of total financial system assets. This is low, but higher than the 2.8% accounted for by pension funds (See figure 19).

Small Sector: The insurance sector is one of the smallest in the region. The gross premium was Rupiah 41.4 trillion in 2004, though there has been an average annual growth of around 25% since 2000. Life premium per capita spending is very low at about USD 9.6.

Non-life larger share: Indonesia is one of the very few countries where non-life insurance has accounted for a larger share of GDP than life insurance premium, although the life sector has posted faster growth more recently.

Market Overcrowded: Considering the small size of the market, it is certainly overcrowded, although there has been consolidation recently. There were 175 firms in 2001 down to 157 in September 2005. The life segment is more concentrated than non-life. Recent data indicates that the top ten firms account for about three quarters or about 73% of the premium income reported, which stands at about 18 trillion rupiah in 2004 (about USD 2 billion). The non-life segment is a little less concentrated. In the non life sector, the top ten firms account for about two thirds of the overall sector.

Additionally, there are a large number of small players with increasingly thin operating margins. This raises concerns about the overall financial health of some of the companies. Recent data indicates that there are a number of inactive firms that do not comply with regulatory solvency requirements. In this context, it is noted that there has been some improvement in the enforcement trend over the years.

Joint ventures: Joint ventures have brought more diversity over the past few years to the Indonesian market and that in turn has lowered market concentration. So the market is fairly liberalized with foreign firms operating through joint ventures, although near full ownership should be feasible.

State-ownership: The role of the State with respect to ownership of insurers is not as high as you see in some other countries in Asia. Non-life assets in state owned companies accounts for about 14% of overall assets and has declined about 2% since 2001. This is about the same as joint-venture companies. The private sector accounts for 68% of assets and reinsurers account for about 4% of assets. Assessing ownership in the life insurance sector is a bit more difficult because there are some unique features in the sector.

There is considerable potential in the life insurance sector to achieve economies of scale. One possible fallout of a lack of scale is the recent relatively high outflow of reinsurance premiums although there may be other interpretations of this trend. The deficit in that sector has been increasing over the past few years. In 2004, there was a deficit of about 4 trillion rupiah (USD 450-500 million dollars).

There are a large number of firms in the insurance sector resulting in stiff price competition and in tight margins. Price wars have been common. It is a difficult issue and obviously, there are


welfare issues on both sides. In this sector, efficient risk pooling can offer many benefits in terms of resource mobilization. The challenge is to find the ideal model to adopt.

Figure 19: Features of Indonesian Insurance Landscape

100%1,738 12,839 TOTAL0.5%9.3 9,106 Rural Financial Institutions

0.2%2.7 60 Venture Capital cos

3.6%62.8 152 Private Bonds Issuer

0.4%7.8 173 Securities Firms

6.0%104.1 246 Mutual Funds

6.8%117.6 143 Insurance Companies 2)

2.8%49.4 327 Pension Funds 1)

0.9%15.3 106 Syariah /Islamic Bank &BPRS

0.4%7.6 1 Perum Pegadaian (Pawnshop)

4.3%74.9 230 Multi finance / leasing

0.8%14.4 2,162 People Credit Banks (BPR)

73.2%1,272.1 133 Commercial Banks

Percent of Total Asset

Asset (RpTrillion)NumberType of Institutions

100%1,738 12,839 TOTAL0.5%9.3 9,106 Rural Financial Institutions

0.2%2.7 60 Venture Capital cos

3.6%62.8 152 Private Bonds Issuer

0.4%7.8 173 Securities Firms

6.0%104.1 246 Mutual Funds

6.8%117.6 143 Insurance Companies 2)

2.8%49.4 327 Pension Funds 1)

0.9%15.3 106 Syariah /Islamic Bank &BPRS

0.4%7.6 1 Perum Pegadaian (Pawnshop)

4.3%74.9 230 Multi finance / leasing

0.8%14.4 2,162 People Credit Banks (BPR)

73.2%1,272.1 133 Commercial Banks

Percent of Total Asset

Asset (RpTrillion)NumberType of Institutions

__________________ 1) For 2003 and only 327 out of registered 393 submitted data 2) Insurance consist of life, non-life, re insurance, and social incl. Jamsostek “The number could be double counted as a cross ownership among instituions

Insurance Sector Assets

Assets have doubled since the crisis in 1997 and 2004 (see figure 20). The life insurance segment has grown consistently while the non-life sector has stayed almost flat. Social insurance and civil insurance have been growing because of their mandatory nature.

Figure 20: Indonesian Insurance Assets

02468

10121416

1997

1998

1999

2000

2001

2002

2003

2004

US D

olla

rs, b

illio

n Civil Service and ArmedForcesSocial Insurance

Non-Life & Reinsurance

Life Insurance

__________________ Source: “Indonesian Insurance in 2004”, MoF & FIIA; ADB TA5985-REG: Strengthening Asian Financial Markets

The following data indicates where insurance companies are investing their assets (see figure 21). Between 2000 and 2004, assets have tripled. The ratio between investor and non-investor assets has not altered materially. The right hand side panel gives an indication of how investments in different categories have moved. Bonds and stocks have shown considerable growth.


Figure 21: Indonesian Insurance Assets and Investments

32.4

100.79.2

19.3

0

20

40

60

80

100

120

140

2000 2004

Insurance Assets

Rup

iah,

trill

ion

Investments Non-invested Assets Indonesia Insurance Investments, 2000/2004

05

10152025303540

Bonds Stocks TimeDeposits

Mut Fund PP Others

Investment Instruments

Rup

iah,

trill

ion

__________________ Source: “Indonesian insurance in 2004”, MoF & FIIA The following data looks at life insurance companies in terms of their asset distribution. It includes the share of Jamsostek, which is counted as part of the insurance sector in the calculation of insurance assets (see figures 22). Government and private sector bonds account for the large proportion of 45% of Jamsostek’s total assets.

Figure 22: Insurance Portfolio of Life Insurance

19.0%81.0%

INVESTMENT PORTFOLIO OF LIFE INSURANCE COMPANIES TO TOTAL ASSETS (end of December 2004, in Billion of Rupiah and Percent)

TOTAL ASSETSPercent

100% of total assets = Rp 44,878.5 Billion

TYPE OF INVESTMENTS TOTAL INVESTMENT:Billion of Rupiah Rp 36,385.3 Billions

1,1642183

3,893

10,588

9,241

837

7,786

Private Shares and Bonds –25.4%

Government secured bonds –29.1%

Direct Placements – 6.0%Land and Buildings 3.2%

Time Deposits and Certificate of Deposits in Banks (21.4%)

Policy loan 2.3%

Other Investments (incl. Policy loan)

Mutual Funds – 10.7%

693

Investment Assets NonInvestment

Assets


3.0%97.0%

INVESTMENT PORTFOLIO OF JAMSOSTEK TO TOTAL ASSETS (end of December 2004, in Billion of Rupiah and Percent)

TOTAL ASSETSPercent

100% of total assets = Rp 32,516

TYPE OF INVESTMENTS Billion of Rupiah

3,251 Shares in Capital Market & Mutual Funds

Cash and Time Deposits in Banks (40%)

Other Investments

Investment Assets NonInvestment

Assets

Total Investment:Rp 32,516 Billions

13,000

Government and Private Bonds (45%)

1,625

16.433

Potential Drivers of Development in Indonesian Insurance

We now turn to examine the potential drivers of future development for the sector. Market, Product, and Policy Environment. In the context of market, product and policy issues I would make the following points: Macroeconomic stability and the need for further deepening of the financial sector are

crucial. It is noteworthy that although the non-life insurance sector has had higher penetration ratios historically, declining fixed investments, and foreign direct investment have slowed growth in assets.

Enhancing Awareness: The lack of effort in awareness building and advertising is perplexing. As a viable middle-income class develops, there is a need to channel savings effectively. The heavy cost of advertising is cited as one reason for this lack of effort but that is possibly derived from the large number of small firms making costs difficult to sustain. Information has a big role to play in deepening the insurance sector and investment in awareness building should generate strong returns.

Product development and diversity. This could include mandating insurance in particular classes of business. Consumer protection regulation should not stifle product diversity and innovation.

Strengthening pension markets through product development and regulatory requirements (Appendix presents backgrounder).

Strengthening capital markets – developing long-term and secondary markets.

The following graph shows a very selective sample of countries taken from a World Bank financial center dataset. It takes those countries, which had a reasonable amount of pension reform and plots them (see figure 23). This is a simple scatter diagram plotted over the past four decades in terms of life insurance premium to GDP. Although it could do with some control measures, the point is that pension reform obviously has a positive influence on life insurance sector development.


Figure 23: Cursory Evidence: Possible Effects of Pension Reform

0.0%2.0%4.0%6.0%8.0%

10.0%12.0%14.0%16.0%

1960 1970 1980 1990 2000

Life

Pre

miu

m/G

DP

__________________ Source: World Bank Financial Sector Dataset, February 2006

Strengthening Regulatory Framework:

The second area of focus is the regulatory regime. Here it is relevant to consider:

Enforcement is improving slowly although compliance is still an issue. There is effective risk management in place yet the burden has not shifted away from need for ensuring good governance.

There is a plan to raise the minimum capital requirements on the sector. The focus should be on enhancing efficiency by exploiting economies of scale and adopting realistic and sound minimum capital requirements.

It is important to have a level playing field, particularly ensuring consistency in approaches. One cannot have different players operating at different levels of capital and providing the same range of products and services. In the interim, consumer protection becomes important. If differences exist in the market, ensure that policyholders know what they are getting into.

Improve quality of supervision continuously at the industry level and the individual firm level. Harmonizing the Indonesian policy and legal framework with Indonesian and IAIS Core

Principles. There have been some oversights in this area. Reform of non-bank financial sector regulation is taking place and hopefully the independence issues will be addressed, which is a key requirement of the IAIS principals.

The Ministry of Finance has made a lot of progress in terms of creating a fit and proper approach for insurance companies. This should be a proper test in contrast to the negative test approach applied to individuals. The fit and proper criteria test should also be applied to all appropriate individuals and include external auditors.


Appendix: This appendix is attached to provide supplementary information.

Recent trends in the Indonesian pension industry

Pension system needs to be strengthened considerably .It has benefits in the form of social protection, deepening insurance markets, and strengthening capital markets.

Capital markets have become stronger, but further deepening is necessary - in particular with respect to corporate bond markets

Massive infrastructure investments are needed. Contractual savings institutions have a great opportunity in this area.

The Structure and Economics of Pensions in Asia: Broad and Cursory Look

There is relatively a short history of social security and pension systems in the region. This is due to a couple of general operating assumptions amongst policy-makers, that:

Rapid economic growth in emerging economies makes up for any concerns related to old-age income security

The State need not be concerned about the non-State sector – i.e. needs of those outside of civil service are left to the private sector or family spheres.

As a result, coverage has been low and pace of growth slow. Generally, two types of systems have emerged, at the risk of generalizing:

South and Southeast Asia

Provident Fund approach; No comprehensive SSN schemes, very limited social risk pooling (The philippines is somewhat of an exception); slow emergence of SSN in some countries like Indonesia and Thailand.

East Asia SSN type promise: While social risk pooling is present, system is too generous for private sector to come in. Key concern is fiscal sustainability.

Figure 24: Public and Private Pensions in Selected Economies

The Structure of old age security or social protection schemes has evolved based on historic and country-specific circumstances largely. Here is a very basic and cursory look:

10% of LF for SSN; 20% for pensionSSN type pooling; GPF; and new NPFThailand

10% of POP; 20% of LF; JAMSOSNAS Law has proposed SSN type program

Jamsostek for private sector; range of occupational+FI plans; separate plans for civil service & military

Indonesia

Potentially universal; but serious non-compliance

SSS & GSISPhilippines

12% of POP; 46% of urban LF2-Pillar DB+DC; transition from enterprise-based to safety net

China

58% of LFCPF for private sector; GPF has absorbed PAYG

Singapore

+40% of LFEPF for private sector; public sector almost PAYG

Malaysia

CoverageType of SchemesCountry


Figure 25: Features of the Pension Sector – Quick Global/Regional Comparisons In terms of assests, pension funds in Indonesia account only for about 2.5% in Indonesia, considerably less than other OECD, Latin American or regional economies

37.39.347.3Brazil

-7.81.7Kazakhstan

4.9

2.2

17.1

8.8

64

2.5

Share of GDP

30.031.2Mexico

4.810.3Korea

6.027.6HKG, China

22.510.2Thailand

55.356.5Singapore

14.84.4Indonesia

Share of Market Capitalization

Total Pension Fund Investment (2002, $ bil)

Country

__________________ Source: OECD Global Pension Statistic Database, March 2005

Chronology of Development of Private Pensions in Indonesia

Law on Pensions to pay pension for civil servants

1956 Law 11/69 on Pension funds for civil servants. 1969 PT Taspen was assigned to administer pension for civil servants 1985 PT Taspen started to use its managed funds to pay a portion of pension of the civil

servants (share is 21% of benefit payment) 1994 PT Asabri (formed in 1971) assigned to administer pension funds of the armed forces

member and its civil servants employees 1981 Law on Social Security for Workers issued with Jamsostek (previously was PT ASTEK –

established in 1977) established to manage compulsory PF of private sector workers. 1992 New Pension Funds Law 11/92 was issued to clearly define a voluntary private pension

funds including the program for self-employed through a defined contribution plan. The Pension funds Law 11/92 stipulates two types of pension funds.

1992 The employer pension funds (DPPK) and the financial institution pension funds (DPLK) which is may be established by bank or life insurance company.


Figure 26: Pension funds sector is growing but small in nominal amount Total assets end of year I trillion of Rupiah

10.713.3

16.2

22.2

26.930.0

42.2

47.9

34.9

1995 1996 1997 1998 1999 2000 2001 2002 2003

Figure 27: Investments of Pension funds have increased, but limits exist on where to invest

31

1997

1998

1999

2000

2001

2002

2003

Investment of Pension Funds(Total Investment in Trillions of Rupiah)

21.1

25.9

27.8

33.6

39.7

47.2

15.4

-Finance Minister Decree No. 511/KMK.06/2003 onInvestment of the Pension Funds Companies

Article 6: Pension funds could only invest on:-Bank’s product: Time Deposit/ On call deposit/ Certificate Deposit-Stock Market: Listed Shares/ Listed Bonds-Direct Placement on the shares issued by Indonesian statutory bodies- Debentures issued by Indonesian bodies- Land and Buildings in Indonesia-Mutual Funds-SBI or Government of Indonesia Debentures Article 9:-Investment on shares and debentures in total not exceeding 20% of total investment funds-Investment on land and building, max. 15%Article 11 & 12:-Investment in the Government debentures/ bonds is allow to exceed 20%-Investment in a loss company + in direct placement to unlisted + in land and building should not exceed 35% of total pension funds


Figure 28: Investment portfolio of pension funds to total assests (end of December 2003, in billion Rupiah and percent)

3

4.4%95.6%

TOTAL ASSETSPercent

100% of total assets = Rp 49,447 Billion

TYPE OF INVESTMENTS Billion of Rupiah

2.483

2.3511,0711,892

650Shares in Capital Market

Government Issued Bonds

Direct PlacementsLand and Buildings

Cash & Time Deposits in Banks (56.8%)

SBI (BI Certificate)

Other Investments

Mutual Funds

(Rp 47,225 billion ofInvestment Assets)

NonInvestment

Assets

Total Investment:Rp 45.738 Billions

26.283

9,127

73

1.957

Corporate Bonds (19.3%)

Figure 29: Investment Behavior of Pension Funds Generally, keep loads in cash/deposits; invest some in bonds. Stark contrast with almost with any other economy

__________________ Source: OECD, Global Pension Statistics Project


Pension Sector Investments

At the end of 2003, pension funds invested 57% of their portfolio in bank deposits, 19% in corporate bonds, and 7% in equity.

The asset composition of pension funds is contrary to what is the conventional asset-mix of long-term savings institutions. In particular, defined contributory schemes have invested more in time deposits than defined benefit schemes (roughly around 80% for the former, and about 65% for the latter).

Besides regulatory constraints, skills need to be enhanced Professional fund management needs to be geared up in both “public” and the private funds

Figure 30: Number of Private Pension Funds in Indonesia is declining

3131292925-Financial Institution Funds (DPLK)

307314314344325-Employers Funds (DPPK)

IV. Number of companies that are Operationally active



III. Licenses Liquidated/Revoked



II. New Licenses Approved



I. Licenses have been issued

20032002200120001999

Number of Registered & Active in Operational in Indonesia

__________________ DPPK = Dana Pensiun Pemberi Kerja (Employer Funds) DPLK = Dana Pensiun Lembaga Keuangan (FI Funds) Source: Ministry of Finance

Figure 31: Number of Pension Funds with DB/DC Schemes

6668727769Total Defined Contribution (Iuran Pasti)

272277271296281Total Defined Benefit (Manfaat Pasti)

3131292925- Defined Contribution (PPIP)

00000- Defined Benefit (PPMP)


3537434844- Defined Contribution (PPIP)

272277271296281- Defined Benefit (PPMP)


20032002200120001999

__________________ Source: Ministry of Finance


Figure 32: Number of Participants to Pension Funds Program

1,756,623 1,686,768 1,543,007 1,358,486 Total Participants

412,213 377,426 283,127 207,787 - Group Employed Workers/Labors

261,636 218,963 172,609 128,426 - Self Employed Workers

-Financial Institution Funds (DPLK)

1,082,774 1,090,379 1,087,271 1,022,273 -Employer funds (DPPK)

2003200220012000

__________________ Source: Ministry of Finance

Figure 33: Tax Structure

Pension Funds Company

Revenue:+ Dividend

+ Bonds Coupon Interest

+ Interest from Deposit

+ Capital Gain of stocks in Capital Market

+ Commercial Papers (interest income received)

+ Land and Buildings

+All other income received subject to general tax income

+ Mutual Funds Unit (Reksa Dana)

(MANAGEMENT COST)Net Revenue is non

taxable

PORTFOLIO INVESTMENT

ASSETS

Stock Securities

Bonds

Time Deposit

Stock Securities

Commercial Papers and Debentures

Land and Buildings

Other Investments

Unit in Mutual Funds Companies (ReksaDana)

General tax 10-30%

Final Tax 20%

Final Tax 20%

Final Tax 0.1%of transaction value

General tax 10-30%

Final 5% of sale value

General tax 10-30%

Non Taxable 0%

Investment Funds

ParticipantsContribution

is income deductibles

BENEFIT TO THE PARTICIPANTS IS SUBJECT TO

PERSONAL INCOME TAX


Figure 34: Private Pension Funds in the Future

Complexity of plan configurationComplexity of plan configuration

Performance monitoringPerformance monitoring

Administration costAdministration cost

Diversification of Investment assetDiversification of Investment asset

administrationadministration

Use of expert/ consultantsUse of expert/ consultants

Investment management / Fund Manager

Investment management / Fund Manager

TRADITIONAL WAY GOING FORWARD

Managed in-house and has own expertise

Rare or Occasional

Fully managed in house

Basic Range of time depositAnd fixed income bonds

Costly and no relationshipto Fund performance

Lack of good quality managementwithout clear responsibility

Simple structures

Minimal in-house (only oversight) and fully outsourced to the funds manager in a competitive wayFrequent use of range of Consultant

Outsourced for efficient reason

Invest heavily in equity / capitalMarket with international DiversificationDirectly linked with the fundPerformance

Professional manager with legal Liability in performing their duty

Multiple plans and options

Recommendations for Strengthening Private Pensions in Indonesia

Developmental/Regulatory Constraints

Public Pension Funds dominate, though the investment performance of private funds has generally and consistently been better

Employers tend to abandon ideas of establishing voluntary pension programs due to their focus on fulfillment obligation to the mandatory provident funds in Jamsostek only.

New labor law enacted in year 2003 is becoming a hurdle to the development of private voluntary pension funds plan as it contains obligation for employer to set up severance benefits on termination, but not providing supplementary pensions.

Low Retirement Age (55 years, as set by Ministry of Manpower) Clarity needed on who supervises the financial institutional pension funds (DPLK) products

which are provided through the banks or insurances companies Regulatory Governance Critical: Managers of pension funds (Pengurus) have to get a

Bapepam license; but the rest of the staff and the operations manager should also be subject to more extensive regulations and certification.

Clarity needed on Governance Structure: Both supervisory and executive boards need to be made liable and responsible for company/fund affairs and outcomes. This is a long-standing Company Law problem.

Recommendations:

Encourage greater private provision of pensions, through policy, institutional and regulatory incentives.

Enhance public confidence through strengthening regulation and supervision. Critical need to shield fund governance and investments from political interference,

particularly if funds get involved in large-scale project financing. Promote professionalism outsourcing to the experienced asset managers. Initiatives need to

be thought through to promote fund management industry.


Broaden range of investment. Allow greater diversification and international investments. Improve administrative efficiency: Actuarial forecasting, record keeping, efficient

management of DB Plans. It is unclear how this can be done. Capacity development support? Public Education and awareness is immensely important. JAMSOSNAS Law introduces a whole new, complex dimension. Lots of regulatory clarity will

be needed on how the proposed multi-pillar arrangement will evolve. Broaden participation not only to cover formal workers but also informal workers (as provided

for in JAMSOSNAS Law). However, loopholes and gaps in contribution need to be managed Consider providing more tax advantages to pension funds to avoid competition from mutual

funds that benefit from better tax treatment and lower regulatory burden

APPENDIX ON INDONESIAN CAPITAL MARKETS

Figure 35: Corporate Bond Trends

1999 2000 2001 2002

p(Billion Rupiah)New Bonds Issued

Billion Rupiah

2,084 2,494

6,000

25,512

10,412

7,22714,180

21,521

45,390

53,913

18,83118,885

0

5,000

10,000

15,000

20,000

25,000

30,000

0

10,000

20,000

30,000

40,000

50,000

60,000

New Bonds Issued Outstanding Bonds Issued

20042003 435,301

419,535

394,429403,442

431,800

26959

534

1,292

2,103

0

1000

2000

3000

4000

2000 2001 2002 2003 June 20040

100,000

200,000

300,000

400,000

Trading Value in Total Daily Average Trading Value


435,301419,535

394,429403,442

431,800

26959

534

1,292

2,103

0

1000

2000

3000

4000

2000 2001 2002 2003 June 20040

100,000

200,000

300,000

400,000

Trading Value in Total Daily Average Trading Value __________________ Source: Surabaya Stock Exchange (BES)

Figure 36: Growth of East Asian LC Government Bond Markets, 2004

Figure 37: Growth of East Asian LC Corporate Bond Markets, 2004

__________________ Source: Asian Bond Monitor, April 2005, ADB http://asianbondsonline.adb.org


Figure 38: Growth of East Asian LC Government

Bond Markets, June 2005 Figure 39: Growth of East Asian LC Corporate

Bond Markets, June 2005

__________________ Source: Asian Bond Monitor, November 2005, ADB http://asianbondsonline.adb.org

Figure 40: Corporate bond Trading Volume Grwoth, 2004

Figure 41: Issuer Concentration for Corporate Bonds

__________________ Source: Asian Bond Monitor, April 2005, ADB http://asianbondsonline.adb.org

Figure 42: Corporate Bonds Trading Volume Growth, 2005

__________________ Source: Asian Bond Monitor, November 2005, ADB http://asianbondsonline.adb.org


Global Trends in Pension Markets

Paul Thorton Consulting Actuary

Watson Wyatt This presentation looks at “global trends” so is a potentially very broad subject. To provide some order, the issues of benefit design, investments, funding, administration, governance, the payment of pension benefits and financial reporting are all areas selected for discussion.

Global Trends in Benefit Design

A). Shift from Defined Benefit

Globally we are seeing a clear trend towards defined contribution provision and away from defined benefit provision. There are some countries, like Australia and South Africa, where the traditional final salary pension scheme has all but disappeared in the private sector, although a few examples in the public sector remain. Elsewhere in the world, the final salary design is under some threat. The reason for this threat is a combination of issues. Rising costs partly due to the fact that members are living longer and partly due to low inflation and low rates of return on investments. Another reason is the tax treatment in some countries. This combination of factors makes the process costly. The volatility of pension cost in company financial reports arising from the adoption of new international accounting standards also makes it difficult for employers to carry final salary schemes.

Newer scheme designs involve more sophisticated types of schemes rather than simply changing to a pure defined contribution design. Initially there was a move to go very simply from final salary to defined contribution but in the past few years there is a greater focus on intermediate designs. The issue here is that a final salary pension scheme leaves the employer carrying all the risk; longevity risk and investment risk in particular. Defined contribution scheme designs transfer all those risks to the member of the scheme. The member ends up carrying the investment and the longevity risk. Amongst larger employers, new designs are being introduced that balance out the risks adopting a more intermediate position. One example of an intermediate scheme design is where the benefit formula reflects the average of earnings over the member’s full career. Another is a cash balance plan, presented like a defined contribution scheme but with some investment guarantees on the accumulation of the funds provided by the employer.

b) Reducing Overall Cost

In OECD countries with well-developed pension markets, employers are pulling back the cost of pension provision. Costs have been steadily rising as a result of increasing longevity and lower rates of inflation. To address the cost issue, employers have been looking to the members of schemes to meet a larger proportion of the total cost. In the past, many private-sector final salary schemes were non-contributory meaning that the members of the scheme paid nothing towards the costs. In other words, there might be a standard five or six percent member contribution rate, and increasingly members need to pay higher rates of contribution.

c). Portability and Transferability

Portability and transferability are particularly relevant in a developing economy with a young population. It is important that employees can change jobs without significant loss of value of the pension rights that they have built up. They should feel safe in leaving behind some preserved pension rights or it should be easy for them to transfer them to a new employer.


In conclusion, overall the field of benefit design is seeing greater creativity. We are seeing retirement ages raised to address the longevity issue and an added emphasis on portability and transferability. In addition, benefits are regarded as part of the total employment reward package and there is a concept of flexible benefits packages, which is gaining in popularity. Here members can make some choices between how the money spent on re-numeration is allocated. It becomes easier in a defined contribution scheme to give the member some choice about the level of contributions paid into the scheme on his behalf.

Global Trends in Investment

a) Asset Liability Modeling

In more developed pension markets well-diversified investment allocation policies can be developed and implemented, usually with a heavy emphasis on equity investment and often with a strong emphasis on equity investment outside the country. Typically, there is much less reliance on deposits and fixed interest type investments for the investment of funds. This is in contrast to pension funds in Indonesia where around half the assets are invested in short-term deposits. The reason for a broader allocation to equity investment and then foreign investment is with the objective of achieving higher returns. That in turn has led to some investigations of the appropriate asset strategy for the liability of pension schemes.

Over recent years, there has been much greater awareness of the importance of choosing assets that match liabilities (ore at least reduce the extent of mismatch). This is both more important and more practical for schemes such as final salary schemes that are closed to new members, or further, are closed to future accrual of benefits for existing members. As a scheme closes to future contribution flows, it starts to mature and it is important to reflect that maturity in the investment strategy.

The approach typically adopted in developing an investment allocation strategy that gives attention to matching of assets and liabilities is to use stochastic modeling. Computer simulations run many future scenarios looking at historical median returns and deviations in different investment categories. By studying the probability distribution of future scenario outcomes it is possible to estimate the level of risk that exists in adopting a particular investment strategy. The manager can move to an investment strategy that has a level of downside risk that is comfortable for the sponsor.

b). Shift from Equities to Bonds

The results of stochastic modeling are now evident in developed countries. There is a shift away from equities and towards bonds in order to better match maturing liabilities of final salary schemes. There is also a trend towards some complex investment solutions provided by investment banks in which the interest rate and inflation risks in pension liabilities are removed through a swap transaction. Here the investment bank is providing some capital and taking a fee but reducing risk from the pension fund viewpoint.

Often such a swap transaction results in a more manageable investment strategy, where some of the risks reduce and the focus of asset management is then to obtain alpha investment returns, sometimes using complex financial instruments such as credit derivatives. In the past few years, there have been some sophisticated ideas to deal with managing liability risk. The capital market is responsible for these ideas. There has been a lot of creativity from the banking sector in offering products that help deal with pension risks.

c) Search for Alternative Investment Classes


Increasingly, pension funds all over the world have access to greater diversity in investment categories. Initially, the focus was on domestic equity and domestic government bonds. Now a typical portfolio includes domestic equities, foreign equities, as well as fixed-interest government bonds and index-linked government bonds which are price-indexed., As well as government bonds, we are also beginning to see corporate bonds that are indexed to prices. There is investment in property and increasingly investment in hedged funds, private-equity vehicles and commodity funds. The story of global trends in investment is much closer attention to the liability profile, much greater diversification, and more sophisticated solutions to the pension risks.

Global Trends in Funding

A). Greater Recognition of Investment and Mortality Risk

Funding is one area that has been under some debate in many countries. Today there is a much greater recognition of the investment and mortality risks inherent in pension funds. This is evident both in the view of trustees or the plan administrators looking after the interest of the members, and in the view of the sponsoring employer, who at the end of the day is carrying those risks.

Funding now is much more about managing the risks involved in pension liabilities, and less about simply setting aside some money that, over time, will accumulate to meet the liabilities.

b) Evaluation of Employer Covenant

Plan administrators or trustees are evaluating the employer covenant much more carefully. There have been sufficient examples of major businesses that have got into difficulties and have been unable to afford their commitments to support the pension liabilities. Therefore, the plan administrators are trying to create a pension plan that is self sufficient, or at least less reliant on the on-going survival of the business of the employer sponsor.

c) Funding Standards set by Regulators

Regulators are steadily raising funding standards that rely less on the survival of the business of the employer sponsor. These regulations require sponsors to set aside money to meet the liability that is expected to emerge in due course. Regulators are looking at funding standards relative to other measures rather than just the long-term cost of the liabilities. They are looking at the cost of buying out liabilities with insurance companies and at the effects of financial reporting measures.

d) Acceptability of Contingent Funding

In this process, there is also a corporate finance approach to examining how employer sponsors can afford to meet pension schemes costs. This approach brings in concepts from corporate finance, such as examining options that assess or improve:

the ability of a company to issue corporate debt to raise money to improve funding of the pension scheme;

the ability to have letters of credit provided by a bank in the event of insolvency of the employer sponsor;

Provision of contingent funding by putting in funds in an escrow account that could be required by regulation, or to have assets pledged to assist in meeting the liabilities.

On a worldwide basis, one is seeing a lot of work done on managing the funding of pension liabilities and a lot of involvement from regulators.


Global Trends in Administration

Worldwide, medium-sized employers are using specialist providers to carry out the administration of their pension schemes. For small employers, administration is outsourced fully to a third-party administrator. Large employers sometimes run administrative services in-house using sophisticated software developed by a specialist pension administration software house. The reason for that is simple. There are enormous economies of scale if software is written by a business specializing in benefit administration or if benefit administration is carried out by a firm that does the same for many employers.

There are strong competitive pressures in the market for administrative services. However, to deal with cost implications, increasingly some of the administrative work, and certainly the writing of software, is outsourced to such places as India. Overall, this field is becoming a specialist area and it is less common now for companies to do their pension administration in-house due to economies of scale and access to specialist expertise garnered through outsourcing.

Global Trends in Governance

There are many trends in the governance of pension liabilities and pension schemes. There are variations depending on the country where the pension scheme is situated. However, there are a few general themes.

Increases in general accountability to members and to the supervisory authority. Much greater transparency in management decision making. Higher standards of disclosure of benefits that members can expect to receive, and whether

or not funding is adequate at each point in time. Increasing reliance on specialist advisors such as actuaries, lawyers, and investment

bankers. A higher level of expertise needed to deal with the nature of the liabilities, increasing the level

of security to members through a greater assurance that their benefits will be funded adequately and underlying assets will be well invested. A higher level of expertise also addresses the concerns of employers about managing the inherent risk in providing pension liabilities.

Countries such as the UK have a trust-based system for plan administration. In this case, separate trustees hold the funds externally from the employer. There are changes in the dynamics of how trustees are working. Increasingly, trustees are seeing themselves as operating at arms length from the employer, rather than as a part of the employer’s organization.

Challenges of Pension Provision

Demographic changes are creating an upward pressure on retirement ages. In particular, OECD economies have aging populations and this has big implications for funding. The rate of improvement in longevity has accelerated in the past five or ten years. Longevity and the steady rate of improvement in longevity were relatively predictable. Not so any longer. Now there is a wide range of possible future paths for longevity. On the one hand, there is the effect of medical research, improvements in living standards, and a better understanding of the risk of smoking, all leading to improvements in health and longer life spans. On the other hand, you have problems of obesity in some developed economies. There is always the risk of major epidemics having an impact on the human population. Additionally, there are changes in family structures, an aspect


that differs enormously by country. But pension design needs to reflect changing family structures and ensure that pension provisions are directed where needed.

The second major challenge is economic change. Recently, the world has seen an era of low inflation and low investment rates. This makes pension provision more costly because in real terms, relative to the cost of living, the benefit becomes more valuable. In a period of high inflation, pension purchasing power is steadily eroded, and therefore the cost is held down.

Impact of International Financial Reporting

The International Accounting Standards Board (IASB) is driving a move towards so-called fair value accounting, where liabilities are marked to market and an emphasis is on comparability of financial reports across entities. Use of the corporate bond discount rate as a reference for valuing and reporting pension costs creates distortions when bond yields are low and leads to considerable volatility of reported cost from year to year. The net effect is that it makes the reported cost of the pension scheme much less predictable in company accounts. If plan administrators try to move towards an asset strategy that diminishes volatility by investing more in bonds, they find it becomes more costly. For this reason, financial reporting standards have definitely thrown out some major challenges.

Financial reporting standards need to change to reflect the long-term nature of pension provision. Overall, in my opinion, financial reporting standards have been too much of a driver and are serving the best interests of shareholders and business rather than the needs of society; the balance is distorted.

Conclusion

There are four relevant conditions for sustainable pension provision.

Political: Encouraging private pension provision is essential. I do not mean passive encouragement. I mean active encouragement. Governments need to demonstrate that private provision is important and welcome, and that measures will be taken to facilitate employers and members of schemes to build better pensions. Depending on the political system in each country, there needs to be a cross-party accord since it could be a politically sensitive area.

There needs to be a clear strategy for state provision. Whatever the system followed by the state, it needs to be clear so that employers and individual scheme members can work within that strategy and make long-term plans, confident that it will be worthwhile. There needs to be a fiscal incentive such as strong tax advantages to compensate for the long-term nature of pension provision and the fact that employees have to lock their money away until retirement.

In conclusion, it is important that there are no hidden agendas. An example of a hidden agenda would be to create pension assets controlled by the government so that they can be used for social means rather than the best interest of the beneficiaries.

Economic: Factors such as economic stability and access to investment markets are important conditions for sustainable private pension systems. There needs to be positive real rates of return in the long term so that real investments are worthwhile. There also needs to be freedom of investment policy particularly including the ability to invest outside the jurisdiction.

Regulatory: It is essential to have a strong legal framework and a system of fiduciaries that can be trusted to administer plans. International accounting standards are not entirely benign. Regulators and supervisors who understand the issues that employers face in providing pensions can be sympathetic. This is not to imply that they should roll over but they should be firm and fair.


It is possible for an exceptionally strong regulator to wreck an economy or completely stifle pension provision. A balance is required. Regulators should involve the actuarial and other professions in developing sustainable systems. Over the past 18 months, a new organization called the International Organization of Pension Supervisors (IOPS) has become more established. It is a counterpart to the International Association of Insurance Supervisors (IAIS). This body will increasingly drive effective regulation.

Market: The conditions have to be right for sustainable pension provision. There needs to be a free market with excellent insurance products. Currently, there is a limitation in Indonesia that restricts product offerings to packaged pension schemes. There needs to be a competitive market in which employers and members of schemes have choices. There needs to be full disclosure of the costs and charges involved in offering pensions. The sales force should be regulated to avoid suffering some of the market abuses seen in other countries. At the end of the day you need members of pension schemes to understand how they work and to understand how they can exercise the choices available to them.


Keynote Speech

Sri Mulyani Indrawati Minister of Finance, Indonesia

The government of Indonesia recognizes that in order for us to rebuild Indonesia into a more stable nation we need to focus on traditional institutions like the banking system. But there is also a role that institution like insurance companies, pension funds, capital markets, play. There is a lot of room for us to catch up and close the gap between us and the international standards. Much more needs to be done – in terms of policies or programs – for us to reach the required level of development. So with this recognition the economic team in the government, together with the central bank, has already announced that we are in the process of formulating reform in this area.

When we talk of reform, it is not the financial reform or continuing reform of the banking system which was forced by the crisis back in 1997 and 1998. Although it is almost ten years ago, much more still needs to be done to fix the financial system and especially the banking system. The process is not yet final. But we are not going to focus only on this area. The non-bank financial institutions demand the same attention and that is why we are now establishing a joint team between the coordinating ministers, the minister of finance and the central bank. We are inviting all the best brains in this country as well as around the world. This is the attitude of my ministry. If you share your problems then you have people helping you with solutions.

So this workshop is a vehicle for me to convey to you the problem, to tell you what we are facing. I don’t have any pretensions about knowing exactly what to do and that’s why we are here talking with the industry and with those who have been dealing with this area for many years. It is very useful to compare our case with other countries. It is also very, very important. Then the next and the most important step is formulating all those experiences into one program which is doable and can be perceived as the stepping stone. So this workshop is an important medium for all of us to shape industry, to shape policy and then to create solutions for sustaining robust economic development.

I believe firmly that Indonesia should develop a strong pension and insurance industry so that they can play their rightful role in accelerating development in Indonesia. The insurance and pension industries serve several purposes. A sound insurance industry provides security for Indonesians through a whole range of risk management products for individual and firms. A sound pension industry that is accessible to all provides security of income during retirement. Insurance and pension products can also improve labor markets as they are an integral part of overall labor compensation. And finally, the insurance and pension industry mobilizes long-term domestic resources from the population. If these can be effectively invested and managed, they can play a huge role in accelerating growth. Indonesia needs all these functions of a sound insurance and pension industry.

Before I go further into details of what we think are the major thrusts of government with regard to this area, it is clear that the insurance and pensions industries are deeply effected by micro-economic development. The insurance and pension industries are also affected by the development in the broader financial sector. What has been happening here? The performance of our banking sector has been improving over the past several years. We have to admit that since the crisis there is progress and improvement in this area. Much more needs to be done but we are clearly better off than we were a few years ago.

After the crisis we have sold all IBRA banks back to the private sector. These banks are now doing well and are some of the most profitable banks in the region. The capital adequacy ratios as well as quality of management have improved. Non-performing loans in the private sector banks have


gone down significantly. Although much of the bank lending is going to consumer loans, overall bank lending is growing strongly.

We have been divesting the minority equity stakes in the state banks, beginning with Mandiri and BRI. I recognize that there have been some difficulties with NPL’s in some state owned banks. As the majority shareholder, the government will take firm action to resolve this issue. We have been discussing this issue with the management of the state-owned banks and we hopefully will come up with an action plan which is consistent with good governance and good management principles.

There is one aspect with respect to the banking sector that is very relevant to our discussion here; banks are simply not in a position to provide any long-term resources for development. This is because more than 90 % of bank deposits are less than 1 month in maturity. With this liability structure, banks simply cannot provide sufficiently long term loans for investment purposes.

For infrastructure, for example, and other investments which require long maturity we need to develop financial institutions that can provide such resources. In other countries these institutions are capital markets, pension funds and insurance companies. This is the reason why creating a policy package for this industry is the most important element to resolve the development issue in Indonesia.

The crisis back in 1998 gave us a very valuable lesson; we should not be depending purely on banks. We need a well-diversified financial sector. The private sector needs access to different kinds of capital. Capital markets and institutional investors can make risk capital available, short tem financing from banks as well as longer term financing from the markets should be available.

A diversified financial sector is necessary to improve intermediation between savings and investment. It also provides long-term domestic resources for investment in areas such as infrastructure and other development programs. Finally a greater diversity of financial institutions reduces the vulnerability of the overall financial sector to future shocks. Therefore, for us, the overall area of the development of non bank financial institutions is important.

We want capital markets, insurance, pension funds, mutual funds, leasing and venture capital; different types of financial institutions; to grow and flourish. We know that each of these institutions serves a particular need and that all are important for a vibrant economy. Our emphasis has often been on banks, often to the exclusion of other areas. We will correct those perceptions as they are not true. We want to develop the non-bank financial institutional sector so that it can support Indonesia’s development.

Several things need to be done to accomplish this. One major step to demonstrate our commitment to develop the non-bank financial institution sector is to merge BAPEPAM and DJLK, to create the new BAPEPAMLK. This integration of regulators and supervisors of all non-bank institutions will provide a boost to the industries. The new institution will be functionally structured with the ability to share experiences and information across various types of institutions.

We also hope that this integration will help create a more level regulatory playing field. This is also the first step in a process towards a single integrated financial regulatory authority, the OJK, with the power to oversee all financial institutions in Indonesia.

With the global trend towards universal banking and financial supermarkets, it is important to have integrated supervision especially in countries where regulatory and supervisory skills are scarce. This is important to make sure that things do not fall through the cracks. We plan to continue to make progress towards this objective so that we can have the OJK in place by the 2009. I am well aware that the pension and insurance industries in Indonesia today are small compared to the banking industry which has nearly 1100 trillion in deposits. Pension funds and insurance companies have about only 170 trillion in assets, about 7% of our GDP. This is not a


small sum, but compared to several other countries, where these industries form 50% of GDP or more, we have still a very long way to go. These industries also currently offer their benefits to only a few Indonesians. Less than 30 million Indonesians have a life insurance policy. The entire insurance industry offers less than 35 million policies, the pension system effectively covers less than 14% of the overall labor force of 104 million people. This includes 4.6 million civil servants where coverage is historically near to 100%. Although nearly 33 million former sector workers are meant to contribute to jamsostek, only 7% are registered and even less actually contribute regularly.

The entire private pension industry has less than 3 million participants. This means that the vast majority of Indonesian’s have little long term security. There is a joke going around that even the ministers of Indonesia are not insured. As Indonesia resumes its growth after the crisis and regains its rightful place in the global economy this situation is simply unacceptable.

So what needs to be done? The answer does not lie in making things mandatory. We have tried that approach and the low compliance with jamsostek is a lesson for us all. We have mandated participation in jamsostek but less than one quarter of the people who are required to participate actually do so. This means, if the people don’t like something, especially the vast majority of workers, they will find a way around it.

One way to deal with this is to change the mindset of the people through education. The tendency is to leave it to God. The answer lies in making these industries attractive to the public. Potential pension fund investors should find these industries an attractive place to save. Purchasers of life and non life insurance policies should find these products useful. This way customers will ultimately make this industry work. It is obvious that making the industries attractive is a much better solution but the question is how.

There is one other element that is particularly important in Indonesia. Traditionally, Indonesian society has relied on extended families to cover risk. Like my mother. She has ten children and she says “why do I have to pay for a pension and so on? My children will look after me”. This is true because, for us, this is the only time we can return all their investment of attention and love. So this parent-child relationship is the first challenge that the pension and insurance industries needs to counter.

While we are very proud of our strong family ties that have survived generations and even globalization, we should also be aware that these ties are getting strained over time. While my parents have 10 children, we are now having only two or one or three children. They are not going to take care of their parents. Maybe after the next generation we will have a different idea altogether. I think my parents are safe with us but I don’t know whether my children will be safe with their kids.

So it is important that people learn the value of protecting themselves against insurable risk by using products that are or should be readily available in the market. Today, neither workers nor employers are adequately educated about the need for financial security in retirement and the advantages of building income-generating assets early in their career. This has to change. Regulators, underwriters and intermediaries also need to upgrade their knowledge so they can offer the best possible products, protection and prudential regulation to industry.

Quality-training facilities for the development of human resources in this industry are a must. The government and the industry need to work together with the support of donors, such as the World Bank, ADB, House Aide and others so that we have a strong and concerted educational campaign to teach people the advantages of using insurance and pension products.

I would like to propose that we form a high level insurance and pension advisory council. This council would lessen the burden on the minister of finance. So in that sense it stems from self


interest. The council would have representation from industry and high-level participation from the government.

In addition to the important social benefits there are important fiscal considerations that drive the focus on development of the insurance and pensions industries. I am very keen to develop the domestic government bond market so that we can develop local finances as far as possible. At a meeting with Secretary of State Condoleeza Rice, she asked us about the state of the economy. I said, “Well Ms Rice, Indonesia is not as lucky as the United States. You have a ballooning deficit and the rest of the world is glad to finance the deficit of the United States. Indonesia has to manage our own deficit because there is only a thin layer that is willing to finance us. If they are willing to finance us there is a very high cost associated with it.” So for us it is very important to develop the local bond market.

In many countries around the world it is the pension and insurance industries that hold large quantities of government bonds. If I look at the portfolio of government bonds, the share of insurance and pension funds is still quite low compared to other investors.

This is not yet the situation in Indonesia. Nearly half of the assets of the pension and insurance industries are put into bank deposits. This is not an optimal investment strategy and needs to be changed. Many investors are beginning to become interested in buying government bonds. Of course there needs to be an adequate focus on risk management by managers in the insurance and pension industries.

There has been a lot of focus recently on pension and insurance firms as a source of long term investment for infrastructure projects. Insurance companies and pension funds are seen by many as some sort of magic wand that you can wave if you are stuck with a problem. Everyone says “can you bail out Garuda? Can we borrow from Merpati? Can you inject funds for the PLN? Can you lend money to the toll road?” People think that the money is lying idle there.

So the demand and the need is there. We need to solve the problem without creating a new one. I don’t mind if insurance companies and pension funds put their money into sound investments, especially infrastructure, as long as you are sure that those projects will give a secure return.

We are keen to attract institutional investors into infrastructure and are considering creating an infrastructure fund that can act as an intermediary between pension funds, the insurance firms and the infrastructure projects.

While this is a priority, it is not the only reason to develop the industry. We want the private market to be able to provide risk-management products and income security to Indonesians. If these industries are strong and vibrant then the funds for government bonds and infrastructure development will come naturally.

So what needs to follow? For the pension fund industry, we need to develop a coherent overall policy framework. We need your help for this development. The system we currently have clearly caters to a very small fraction of Indonesians. The government cannot be in the business of providing this cover to all. It will be expensive and unaffordable. The best thing to do would be to create an environment where people will find it attractive to safeguard their own old age. For this we need to develop a roadmap that lays out what the government would like the pension fund industry in Indonesia to look like going forward.

The performance of Jamsostek effected people’s perception toward pensions. We need to make sure that this institution becomes stronger. We also need to ensure that the other government pension plans for civil servants are functioning as well as possible and examine the experiences of other countries to see if there are any lessons that could be applicable to Indonesia’s own reform process.


Pension policy is very much affected by labor law. We have to take a close look at this law keeping in mind our objective of increasing employment in Indonesia. We should make sure that we create an environment where employment is promoted and the employer is able to provide pensions.

We need to clarify and rationalize the liability of employers for severance pay under the labor law, which is often used as a reason to reduce pension payments and employer’s liabilities toward pensions.

We also need to have a sound and appropriate tax regime that would provide the right incentives to the employers and employee to save for the long term. This does not mean we need tax breaks. We just need to rationalize existing rules and their enforcement so that they are more in line with what some other countries may have done to help develop the pension industry.

We are also keen to help the insurance industry grow. The regulatory concerns over the past several years have begun changing our philosophy. Our primary emphasis is now on protecting customers. We will continue to take firm action against weak firms. A few rotten apples should not spoil the whole basket. If sound firms grow in a healthier manner, they will almost definitely absorb any losses to customers or employment that may occur due to the weak firms.

It has been brought to my attention that there are some in the industry who believe that there are some tax issues that might affect the insurance industry. The main objective of the tax regime should be to avoid discriminatory treatment, double taxation and ensure a level playing field where taxation is not distorting economic decisions or hampering competition.

While I have my tax department to look into it, I believe the overall tax regime for insurance is proudly in line with international norms. The main issue is one of tax administration and improving predictability and certainty. This is an important priority for me across the board - not just for the insurance industry - and is actually the battle of the reform now. We are trying our best to reform tax administration.

We need a special emphasis in the area of catastrophe and disaster insurance. A large part of population of Indonesia is vulnerable to natural disasters. In recent years in several countries around the world, insurance products that can protect the public against such disasters have been developed and tested. I would like to have these products developed and applied in the Indonesian context. This is very important for us when designing a budget. We know that natural disasters are a constant factor in Indonesia. So I would like to see a market developing for these products so that the burden of protecting the people is shared between the government, the market and the public.

Indonesia certainly has a unique opportunity to reform its pension and insurance systems. This industry can provide security to Indonesia, it can generate employment for a large number of people and it can mobilize long-term domestic resources that can be invested for development. For these reasons the government, the industry, the public and some of the multilateral institutions and donors need to work together. This workshop is the first step in this process.

Finally I would like to say thank you to the World Bank and other donors who have helped us in developing the policy for these industries.


Risk Based Supervision Trends in Insurance and Pension Funds


Risk-based Supervision for Insurance Companies and Pension Funds

Charles Littrell Executive General Manager, EMG Policy, Research, and Statistics

Australian Prudential Regulation Authority (APRA)

Overview

Broadly speaking there are two philosophies of regulation: rule-based and risk-based. Confronted with these two approaches, a dilemma faces the regulator. If Indonesia is to be a more successful society, then the insurance and pension business must grow. To grow, they must be safe. If they are too safe, they will not grow. Therefore, the prudential regulator needs to find a middle path between safety and too much risk-aversion that chokes the industry. This is the reason why the supervision of the industry in parts of the world has moved from rule-based to risk-based supervision. These two philosophies are not competitors but complimentary. The rule-based approach is characterized by a central mission founded on a desire for regulated entities to follow a specific set of rules often set out in legislation. This approach relies on a traditional government role of law enforcement. In theory, and often in practice, rule-based regulations succeed by using a punishment and deterrent model. It embodies the principal that the potential benefit of breaking a rule is not worth it because the expected cost of being caught for that violation is higher.

A rule-based regulator’s main tools are legal and most rule-based regulatory agencies are dominated by lawyers or at the very least by legal thinking. The questions are focused on the past and the present; that is, –‘has this entity violated the rule?’ or ‘is it currently violating a rule?’. Finally, rule-based regulators work best when their enforcement actions are in public otherwise the entire model based on deterrence does not work.

In recent years, an alternative model of risk-based regulation and supervision has emerged to support but not replace rules-based regulation. In a risk-based approach, the goal is to reduce the risk of failures by before the risks emerge rather than deterring failure by punishing entities. Under a risk-based approach, success results when risky behavior is modified legally, before that behavior leads to failure. In fact, the core difference between the two kinds of regulations is between responding to a specific violation and responding ahead of that violation. Since the risk-based approach relies upon behavior modification before any laws or regulations are violated, persuasion and negotiation are key skills for the supervisor. A rules-based supervisor often says ‘do what I require or you’ll be punished’, a risk-based supervisor starts by saying ‘do what I suggest because is in your best interest’. To make persuasion and motivation work, risk-based supervisors must identify and respond to emerging risks well before they become critical. Therefore, risk based supervisors focus on the present and the future. Rather than only using legal tools, risk-based supervisors tend to draw from accounting, economics, actuarial and statistical professions. All these disciplines focus on different methods essential in projecting the future.

The Australian Prudential Regulatory Authority (APRA) senses that risk-based approaches work best in countries with reasonably well-developed markets and legal systems. Market participants are more adept at interpreting and responding to signals if markets are sophisticated.

Finally, risk-based supervisors normally prefer to work in private through persuasion. Most regulatory entities are easier to deal with if their decisions and agreements are not going to end up in the newspapers.


Risk-based versus Rules-based

The debate between the two kinds of regulation and supervision is pointless; like a debate on which is a better tool, a hammer or a saw. If you want a nail hammered, a hammer is a better tool. If you want a board cut, a saw is a better option. If you want to build a house – and regulations are that complicated – then you need both a hammer and a saw and many other tools. Therefore, it is about using the right tool under the right circumstances.

Rule-based regulation and supervision works better when the government strategy is to prevent social harm by punishing violators. Any matter involving criminal prosecution is handled better on a rules basis. Rule-based supervision is also the best choice when you have a single right calculable answer.

There is some disagreement on this point but it is my contention that the rule-based philosophy works best when there are multiple regulated entities or persons and the social cost of any single violation is not very high. In other words, you can afford to run a model that depends on punishment and deterrence because you can afford the first transgression.

Risk-based supervision is best applied in matters of arguable expert judgment. A question such as ‘how much capital should an insurance company hold?’ or ‘does this pension fund have the right risk management strategy?’ may have a minimum rule-based component however, essentially, these are questions of judgment and assessment.

In risk-based supervision, there is seldom one right answer. Therefore, the rule cannot be written in advance to mandate every answer. In general, risk-based supervision is more expensive than rules-based supervision because sophisticated systems and experienced people are needed to administer this approach. Therefore, risk-based supervision is most appropriate when the social cost of even a single failure is high. Rule-based supervision assumes that one transgression is affordable and risk-based supervision assumes that every single misdemeanor will be caught, although that is probably an impossible task.

It is critical to note that, in reality, there is no pure risk-based or pure rule-based supervision. Consider traffic police officers supervising a zone with a speed limit of 60km an hour. This looks like a straightforward rule-based supervision approach. But there are at least two risk-based elements in this situation. First, many traffic police officers will not actually ticket anyone at 61 km an hour. Second, the traffic police officers choose to sit in a spot where they are most likely to catch violators.

Take the opposite example. Consider APRA, primarily a risk-based supervisor. The core problem in APRA’s world is that most of the prudential failures come from people who are neither incompetent nor crooked. Therefore, APRA devotes about 90% of resources to risk-based analysis of emerging problems and risk-based responses to those problems. The final ten percent of the budget is devoted to enforcement. Every system has a few bad pennies that will not desist from criminal or negligent behavior. At the end of the day, risk-based approaches work best when there are rules underlying the system for individuals who are not responding appropriately to the risk-based approach. This is not a debate limited to financial supervision. If the discussion were about civil aviation safety, power plant safety or food and drugs safety, one would see the same balance of issues between risk-based and rule-based supervision.

Many countries have supervisory authorities with multiple objectives given to them by statute. The Australian government’s strategy is to have functional regulators so APRA only does prudential supervision. The Australian Securities and Investments Commission (ASIC) is a security regulator that does only behavior regulation. There is another agency that monitors financial crime. However, in Indonesia, the UK, and many other jurisdictions, prudential supervision, behavioral supervision and criminal enforcement all co-exist in the same agency. In this case, different departments and sectors of the same agencies have different balances between rules-


based and risk-based approaches. It is also important that the agency have enough flexibility to manage that shift and impact between different segments and the agency insures that each statutory task is matched up with the right balance between a risk-based and a rule-based approach.

There is a reasonable consensus amongst the world’s prudential supervisors that risk-based supervision is preferable in most circumstances. Prudential supervision is clearly about expert judgment. A good prudential supervisor should be among the leading risk-assessors in that country. In most countries, prudential supervision applies to relatively few entities. In both Australia and Indonesia, several hundred institutions are prudentially supervised and a few dozen of those tend to be large enough to affect the whole system should they fail. APRA strives for positive change through informed persuasion of responsible people and regulated entities. Most of APRA’s supervision takes place inside the minds of senior executives and board members of regulated institutions.

When dealing with uncooperative entities and people, APRA relies on rules based enforcement. For example, if someone sets up an unlicensed bank, you need to resort to rules-based supervision and call the lawyers asking the bank to stop operations.

At its heart, prudential supervision is simple. To achieve a good response from persuasion and education, supervisors must be experts at emerging risk identification and at balanced risk response. To make this work, the supervisor needs a strong rule-set, which requires strong government support over many years in building the right legislative, and regulatory infrastructure. Both risk-based and rules-based supervision need aspects of this sound rule set. The only difference between the two is that if you think of a switch for a light, then risk-based supervision is a dimmer switch – a bit more complicated and expensive – and rules-based supervision is the traditional on and off switch.

Definition of Prudential Risk

On the subject of risk-based supervision, it is wise to define the terms of risk. Clearly, a failure of a regulated institution to meet its financial promises is a risk, but not every creditor and every investor in a regulated institution is covered by prudential supervision. If an insurance company in trouble manages to pay off valid claims but the shareholders get nothing then this is unfortunate for the shareholders but not a prudential failure. If the same institution were not able to pay its valid claims, it would be a prudential failure.

The risk that is most difficult to judge is the defined contribution superannuation fund or pension fund. Legally, and in theory, an individual can make payments into a fund for their whole working life and at retirement get nothing and no legal promise is broken. The APRA view is, and most supervisors agree, that if this happens then the trustees and managers of the fund have failed in a significant way.

It is impossible for a prudential regulator to target zero failures and simultaneously allow a reasonable amount of risk-taking in the economy. Some of the former communist regimes in Europe have run zero-failure regimes but also had zero-innovation regimes. There must be some tolerance of failure if the industry is to grow. The way to deal with failure tolerance with a risk-based approach is to focus resources on the entities with a high-probability of failure and on larger entities. The idea behind this focus is to catch the failure earlier when it is still small so that the chance of resolving the problem is maximized. There is an essential element of judgment here about how much freedom is to be given to entities and how far to let them go before you start supervisory intervention. In the risk-based world, many issues can be arguable and therefore judgment plays an important role.


APRA Basic Strategy for Risk-Based Supervision

The following figure outlines APRA’s basic strategy (see figure 43). All work starts with data and analysis, usually a blizzard of data. Data is collected through statistical collections, onsite visits, expert reports etc. Then the supervisors perform a risk analysis. APRA uses a central risk model called Probability and Impact Rating System (PAIRS). In this model, supervisors assess the risk of a regulated entity based on two factors, the impact of failure and the risk of failure.

Once the probability of an impact failure signal is generated, APRA overlays a separate model called the Supervisory Oversight and Response System (SOARS). The PAIRS rating is then filtered through senior management to judge how quickly or aggressively APRA should respond to the problem. One of the core aspects of APRA’s strategy is that the supervisors drive PAIRS, which is the risk assessment but APRA’s management drive supervisors through SOARS in terms of how they actually respond to that assessed risk.

Figure 43: PRA Basic Strategy

APRA MISSION

–REDUCE FAILURE RATESPUBLIC BENEFITS:

–LOW LOSS RATES–CONFIDENCE

APRA MEDIASOARS

APPROPRIATE REGULATED ENTITY & RESPONSIBLE

PERSON BEHAVIOUR

SUPERVISORRISK ANALYSIS

SUPERVISOR ACTION

DATA &

ANALYSIS

MEMBER, MINISTERIAL OVERSIGHT

INSTITUTIONAL WILL

PAIRS

STATUTORY INFRASTRUCTURE

INDUSTRY STANDARDS

3

4

2

6

7

1

8

5

A key point to understanding APRA’s strategy is that supervisors do data gathering, most of the analysis and most of the supervisory response. One individual staff member performs multiple functions. Other supervisors run a system with an analysis bureau, a response bureau or an onsite bureau or offsite bureau. These different models work reasonably well and one should be chosen based on local circumstances. At the end of the day, there has to be a system that gathers data, analyses it, produces an assessment of the risk, and produces a coherent response to that risk.

Australian Experience: General Insurance

APRA was founded in 1998 and experienced two distinct phases in general insurance supervision. The first phase was from 1990-2002 and APRA did not cover itself in glory. The system saw six major insurance failures or near misses and the largest of those was the collapse in 2001 of the second-largest general insurance company, called HIH. In hindsight, APRA’s creation had some mistakes. Among other things, the agencies from which APRA was formed


were in many cities across Australia. When APRA centralized in Sydney, many insurance supervisors from Canberra did not make the move and so the regulator lost many experienced insurance supervisors. At that point, the amount of soon to be insolvent companies was not obvious. In addition, there was some confusion in amalgamating 11 different predecessor agencies into one agency and in dealing with this confusion the agency took its eyes of basic supervision.

Most importantly, the culture of insurance supervision was more of a rule-based culture. The standard rule-based response was that if an insurance company was in trouble, APRA rules prohibited the agency from doing anything but appointing an inspector. This was tantamount to a death sentence.

Things are different now. One of the biggest drivers of this change was the Royal Commission set up to examine the failure of the HIH Insurance Group. After HIH failed in 2001, both the government and APRA changed their approach to insurance supervision. The government passed a comprehensive legislative reform package improving a legislation that was thirty years old and therefore a bit tired and creaky. APRA then used the new legislation and associated regulation to re-license the entire industry, which took out companies that should not have been in the system and improved risk management in the industry. At the same time, the supervisor introduced new risk-assessment and response systems and changed the culture to one in which instead of feeling prohibited by rules to take action, the agency was empowered by rules to take necessary action.

Therefore, the agency switched at that point to a risk-based supervisory approach. The government provided APRA with funding to be used for hiring senior staff. Mid-career professional from industry were hired. The result was a much sounder insurance industry, and a much sounder pension and banking industry as well. There have not been any major failures since then, just a few minor ones. Keep in mind that the Australian economy is currently strong and the true strength of the system will be tested during a recession.

Australian Experience: Superannuation

APRA supervises most of the pension assets in Australia, except for a small sector of personal superannuation. The industry has undergone over a decade of massive change. In 1993, the Australian government changed the law to allow for compulsory savings of pension by workers. Currently, contributions are made at a rate of nine percent of wages for all workers. Interestingly, and unlike many other countries, Australia has matched compulsory savings with a great deal of freedom about where each pension fund member can invest these savings. Pension fund members can choose their pension fund supplier and the mix of investment that is adopted with that chosen supplier. There are three main delivery models. One delivery model is ‘for profit’ - banks and insurance companies that look very much like financial institution providers in Indonesia. A second delivery model is employer or industry funds which are run by employer groups and unions. The final delivery model group is the self-managed individual sector. Broadly, these are split a third each.

The other major issue in Australia is that superannuation was traditionally run by amateur trustees and has moved steadily over the past decade to a more professional management model. Ten years ago, APRA and its predecessors separately administered 5,000 individual funds, with about 50 million dollars of average balance in each of those funds. By mid next year there will be 300 trustees with about 2 billion dollars of average balances. So the Australian industry has moved from an amateur semi-professional industry to a much more concentrated and professional industry.


Overall, this rapid growth has been handled successfully. The industry has had a reasonable investment return. The amount of fraud has been limited to about tens of millions of dollars over the past several years in an industry with 800 billions dollars in assets. There have been a number of agency risks. In one particular case ‘for profit’ trustees have been under-investing in their back-office systems, leading to about half a billion dollars of unit pricing errors. This amounts to not keeping track of the amount of money in each investor account and the industry had to compensate members to correct these problems.

More substantially, the regulator is examining why the ‘for profit’ sector consistently underperforms the employer and ‘not for profit’ sectors. The ‘for profit’ sector has a fundamental conflict of interest between trying to make money for the banker-insurance company that controls the funds and trying to make money for the members. Under Australian legislation those funds are expected to work for the members first and the banker-insurance company second. It is not entirely clear that this always happens.

People Issues in Risk-based Supervision

In the risk-based supervision approach, the people requirements may differ from rule-based supervision. Risk-based supervision requires serious risk expertise and requires a higher degree of skill and proactive steps than is required for good rule compliance assessment. In APRA’s experience, the best way to achieve this is to balance long-term professional public sector regulators with more experienced, mid-career professionals. Therefore, pay scales are higher than public service pay scales.

To give an idea of how a risk-based supervisor will handle a situation, the tone of the conversation is, ”I have looked at this entity and am not entirely happy with risk-management procedures. They have a have a good policy but they do not follow it in practice. So I am going to engage with their board of directors and see if they can lift their game and if not I’ll increase their minimum capital requirement.” This is a subjective observation in a reasonably high-intensity response.

A rule-based supervisor will have a conversation along the lines of,” I checked the register of authorized sales representative against the register of the sales made by them, and some of the sales were made by people who were not authorized representatives. Therefore, they are going to be fined.” This is a perfectly valid conversation but it is possible at a junior level since the rule and the violation are perfectly clear.

To make this work, risk-based supervisors need a cultural support. It is difficult for an average 30-year old supervisor to walk into the boardroom, where the chairperson of the board might have access to political ministers. Therefore, APRA has a cultural support program, based on the balance between the need to do something and the need to follow internal procedures. The message to the supervisors is, if the internal procedures are followed and action required then the agency would support the supervisor until the end.

In APRA’s experience, an important question is whether external experts are competent or honest. They are competent and honest when they are working for you. At the end of the day, the most useful report for a supervisor is the one where the agency picks the expert and briefs the expert. If a regulated entity provides the report, or provides an expert opinion in-house, then it could be honest and competent but is also could be heavily conflicted. So it is not the quality of the expert which is of concern. Rather it is the agency risk position from which the expert is making their report.


Actuaries

APRA did not have too many actuaries and this was seen as a weakness during the time of insurance company failures. Now there are many more actuaries at APRA and fewer failures so there probably is a correlation. Actuaries are good at complex financial risk-analysis but not uniquely good. Many professions have developed tools to predict the financial future, such as economists, investment analysts, and CFA’s. For a prudential supervisor the actuarial prediction is about as useful as one from an economist, or a qualified financial specialist in another discipline. However, there is no certainty in predicting the future and what you get from other professions is variability, increase, or decrease in confidence but never certainty. Actuaries tend to use the word ‘certainty’ a lot. The other problem with actuaries is a culture that says that if two actuaries agree on something then it must be true. This is a very dangerous culture and so APRA values it’s actuaries but tries to match them up with a second view. This produces a much stronger result that any expert working on their own.

To summarize, a successful risk-based supervisor needs a clear mission, which involves a clear definition of the risk being supervised, the right people, and the right culture. If you match all this with the right tools, such as a risk model and a response model, then there is every chance of having a successful outcome.


Risk-based Supervision, Solvency II

Bruce Moore Partner-Actuarial Service Ernst & Young (E&Y) Asia

New Challenges

The risk landscape is changing rapidly for insurance companies. Volatile economic conditions, exposure to financial options and guarantees, terrorism, catastrophes, everything that can be imagined, puts tremendous pressure on the insurance industry. Although widespread insolvency has been avoided, there is a growing recognition that regulators need to address these risks. Many countries, compared to even a decade ago, are not as strong as they were.

There are increasingly severe and frequent financial market crisis events in the past decade or two. Here are some examples of recent financial market crises:

1987: The stock-market crash; 1990: The Nikkei Crash, high yield tumble; 1992: The European Currency Crisis. The U.K suspends participation in European monetary

system, Italy devalues Lira, Spain devalues peseta; 1994: The US Fed raises the short-term target rate from 3 % in January to 8.3% in December; 1994-1995: The Mexican peso crisis, The Latin American crisis; 1997: The Asian crisis (Korean Composite Index falls 50%, Indonesian Rupiah falls 71%); 1998: The Russian crisis. The ruble falls 41% from August 25 to August 27; 1998: LTCM (depressed equity markets); 1999: The Brazilian crisis; Post 2000: The stock market bubble bursts and the dotcom industry collapses; Post 2001: The European life insurance industry is in crisis;

Catastrophes today are more severe than ever before, perhaps due to climate change (see figure 44). Regulators are developing methods to deal with this increased risk and one of the most important developments is called Solvency II. This is a new regulatory framework for solvency being developed in Europe. Most major global insurers are European and so the impact will be far-reaching. It is also likely that many countries will be fast followers of the European rules, just as many countries, including many in Asia, have become followers of the IFRS rules.

Globally, insurance companies are facing many more risks. The events of September 11th 2001 created insurance losses, stock market losses, credit losses, and real-estate value losses. The Dow Jones Index lost over thirty percent within one year. This event is partly to blame for the European life insurance crisis post 2001 (see figure 45). Both insurance companies and regulators need new tools to deal with this kind of complexity. Additionally, there is much more risk and complexity in the volatility of products that insurance companies offer.

The events of September 11, 2001 triggered financial turmoil.


Figure 44: New Challenges – Catastrophes Claim frequency is increasing Claim sizes are increasing Overall insured loss is increasing

Number of Large Losses 1973-2003

0

1

2

3

4

5

6

7

1973 1978 1983 1988 1993 1998 2003

Mean Severity 1973-2003 (bn USD)

02468

101214161820

1973 1978 1983 1988 1993 1998 2003

Insured Loss 1973-2003 (bn USD)

0

5

10

15

20

25

30

1973 1978 1983 1988 1993 1998 2003 __________________ Source: Swiss Re

Figure 45: New Challenges - Dependencies

September 11th, 2001

October 11, 2002Dow Jones @ 7197

May 25, 2001Dow Jones @ 11350

Context and History of Solvency II

Solvency II directives will be the next step in a process initiated years ago in terms of developing a common European market for insurance and developing rules approaching solvency. The Solvency II system aims to protect the policyholders. It provides supervisors with appropriate tools and powers and can be applied to life insurance, non-life, and reinsurance undertakings. It will improve competitiveness of EU insurers through better allocation of capital resources and can be applied without causing significant market disruption.

The current EU solvency regime dates back to the 1970’s and is neither risk-sensitive nor does it promote good risk management (see figure 46).


Figure 46: Current European Solvency Rules

The current formula does not differentiate between assets-backing insurance contracts invested one hundred percent in bonds, and portfolios backing insurance contracts invested seventy percent in bonds and thirty percent in equities. For unit-linked business, companies charge for expenses as a percentage of the value of the fund. If the funds’ value increases the company has to increase the solvency capital, despite increasing expense margins. If the funds values decrease, the company will lose income, but can decrease its solvency capital. The risk of variability in claims is lower with 1,000,000 term insurance policies than with 10,000 policies because of the mutualisation effects. Whatever the quality of the underwriting process, the risk factors will be the same for P&C companies until the premium risk is considered for solvency calculation. Some short-term technical adjustments have been made to Solvency I, which is the approach that has been common in many Asian countries until recently. Therefore, solvency II is not just a regulatory framework but also an important framework for managing insurance enterprises.

Europe looked at other frameworks for examples.

FTK: Financial assessment framework in the Netherlands SST: Swiss Solvency Test in Switzerland. FSA: FSA integrated Prudential Source Book (PSB) in the UK. NAIC: Nation Association of Insurers Commissioners risk-based capital in the US. GDV: 2002 supervisory model for German insurance undertakings. S&P: Standard & Poor’s European insurance group capital model JR: model developed by Mr. Jukka Rantala, formerly Chairman of the CEA Solvency II Working

Group, in the context of CEA’s work on standard approach. Singaporean model: Risk-based capital framework for insurance business Australia model: Insurance Reform Act (APRA) Canadian model: Minimum Continuing Capital and Surplus Requirements (MCCSR) for Life

business and Minimum Capital Test (MCT) for P&C business

Life insurance One third of the required solvency margin represents the guarantee funds and can not be less than a minimum

of EUR 3 million Solvency margin requirements:

4% x TP* x (total TP* net of reinsurance cessions / gross total TP*) 0,3% x sum at risk x (total sum at risk retained as the undertaking's liability after reinsurance / total sum at risk gross of reinsurance) Non-life insurance 18% x gross premiums ] € 0 million ; € 50 million 16% x gross premiums ] € 50 million; …[ 26% x gross amount of claims ] € 0 million ; € 35 million 23% x gross amount of claims ] € 35 million; …[ *TP: Technical Provisions

+

Eligible elements for the available solvency margin

Definition based elements Elements not included in that definition, but which are considered to be eligible

Elements that need prior approval of the supervisory authority

85%<

50%<

X (Net amount of claims / gross amount of claims)

X (Net amount of claims / gross amount of claims)

50%< As above Max ≤ x x or

≤ x x


According to a recent CEA (Comité Européen des Assurances) study, existing solvency and capital regulation frameworks can be classified in four categories:

Simple factor-based-models (static models). Application of a small number of factors to accounting positions in order to assess the capital requirement. This is the old European formula.

Risk factor-based models (static models). Application of fixed ratio to accounting positions (ratio calibrated to cover the underlying risk to a certain confidence level). This is like the U.S risk-based capital approach where there maybe forty or fifty different factors.

Scenario-based models (dynamic models). Measurement of the impact of specified scenarios on the net asset value through a discounted cash flow projection. The model "charter" clearly defines the scenarios.

Principles-based models (dynamic models). Insurance company is requested to arrive at its own view of the capital requirements based on its internal modeling following certain calculation principles put forward.

All existing frameworks do not necessarily treat the specificities of all major business lines. For example, only life insurance and non-life insurance is treated separately with Solvency I. Except for Solvency I, all existing frameworks differentiate the nature of risks. The scenario-based or principle-based models calculate the target capital inconsistently from one company to another at times. Therefore, a new approach was developed.

Developing Solvency II

The development of this new approach took place in a couple of phases. The first phase occurred between 2001 and 2003. It set out a grand framework for how the new system should work. The objective was to develop a high-level framework for the new solvency regime, to identify shortcomings in the existing framework, and to investigate the use of new methods and techniques for solvency assessment.

The grand rules consisted of a three-pillar approach, similar to the Basel II approach to solvency regulations for banks. The first pillar looks at quantitative capital requirements, the amount of capital needed. There are two measures: a minimum capital requirement (MCR), a simple formula, and a solvency capital requirement (SCR). The MCR is a rule-based approach and the SCR is a risk-based approach.

The second pillar looks at governance. This has been a significant global focus over the past five years. There needs to be improved internal risk control and risk-management approaches, and an improved supervisory review process. The third pillar is improved transparency and disclosure.

The grand rules look for a more risk-oriented approach. The International Actuarial Association (IAA) has developed a risk classification taxonomy that defines a number of risks and points to innovative methods to measure and manage these risks. Some of these risks are underwriting risk (pricing, claims) and market risk (such as foreign exchange and interest rate risks). Although the risks specified explicitly in the U.S. capital system are far more detailed than the European framework, the new EU approach calls for an aggregation of all risks for solvency purposes (see figure 47).


Figure 47: What are the Grand Rules?

• Aggregation of risks quantification for Solvency purposes

Total Risk

Asset Risk

Credit Risk

Insurance Risk

Capital Requirement• Risk Margin at 75th Percentile

• Ruin probability less than 0,5% (on going concern basis over one year)

Capital Requirement• Risk Margin at 75th Percentile

• Ruin probability less than 0,5% (on going concern basis over one year)Risk

Margin99.5th

quantile

Liquidity Risk

Operational Risk

•All risks to be considered•Diversification / dependency is crucial

Best Estimate

SCR

The IAA has played a key role in this more risk-focused approach by producing a paper that laid the groundwork (Available on www.actuaries.org).

There are many risks in the US risk-based capital framework but far fewer risks in the current European framework. In addition to identifying all the risks, it is important to take into account interactions between risks. There are estimates by the Chief Risk Officers forum, a European group of insurance company risk officers that the interaction between risks is worth a thirty percent reduction in the overall value of risk capital required. The new approach needs to consider the interactions.

The new solvency system contains two capital requirements with different purposes and calibrated accordingly. One is a rules-based minimum capital requirement based on the existing standards and the other is a risk-based approach. This could be a more complex but standardized formula, or it could be an internal company model of risk. The capital requirements are based on the risk of adverse change to best estimate of liabilities (see figure 48). The graph on the right gives an idea of the pieces. At the bottom is the best estimate of liabilities, then a margin for prudence to get up to a level of confidence of seventy-five percent and a regulatory reserve requirement. Above that is a solvency capital requirement. That is enough capital for the regulator to be satisfied. Then you need a little bit of surplus capital on top of that, just in case the regulator does come knocking.


Figure 48: What are the Grand Rules?

• Capital requirements based on the risk of adverse changes to thebest estimate of liabilities

SurplusCapital

SolvencyCapital

Requirement

PrudenceMargin

BestEstimate

of Liabilities

AssetsLiabilities

and AvailableCapital

CapitalRequirement

TechnicalProvisions

AvailableCapital

Value ofAdmissible

AssetsConfidence

level of technicalprovisions = 75%

Ruin probabilityof 0,5%

& one yearhorizon time

The process of developing the directive is a long consultative process involving, regulators, the industry and the professional associations. It will be done by 2008-2010 (see figure 49). Phase 1, as discussed, is the framework for consultation.

Figure 49: Overall Project Timetable

20102009

2008

2007

2006

2005

2004

2003Definition of the Framework for consultation

3 waves ofcalls for advice

QuantitativeImpactStudies

Drafting of the Directive

Finalization of the project of Directive for adoption

Adoption process of each member State

Directive adoptionprocess

Definition of implementingmeasures

Definition of practicalguidance

Solvency II in force

Phas

e IPh

ase I

I

Phase II had three pillars. The first is the development of the draft directive. The second is examining measures to be built in that directive through quantitative impact studies. The third is to get technical advice directly from regulators in various countries. It must be emphasized here that this is not just a European development.

Solvency 11 versus the Coso approach

COSO is the Committee of Sponsoring Organizations of the Treadway Commission. It is a US private-sector organization dedicated to improving the quality of financial reporting through


business ethics, effective internal controls, and corporate governance through two main steps. In 1992, COSO I issued an integrated framework for internal control. In 2004, COSO II issued an integrated framework for enterprise risk management. The COSO principles focus heavily on risk management and offer a robust framework to effectively identify, assess, and manage risk. COSO II starts from the internal control framework designed in COSO I.

COSO I is the framework used in the Sarbanes Oxley regulation in the US. It was issued to help entities assess and enhance their internal control systems and has since been incorporated into policy, rules, and regulations. It has also been used by many entities to better control their activities in moving towards achievement of their established objectives (see figure 50).

Figure 50: COSO I – INTERNAL CONTROL – INTEGRATED FRAMEWORK

Compli

ance

Opera

tions

Finan

cial

Repo

rting

FUNCTIONS

BUS

UNITS

Control Environment

Risk Assessment

Control Activities

Information and Communications

Monitoring

Compli

ance

Opera

tions

Finan

cial

Repo

rting

FUNCTIONS

BUS

UNITS

Control Environment

Risk Assessment

Control Activities

Information and Communications

Monitoring

COSO II gets more complicated. It has a high focus on risk-management and is a robust framework to effectively identify, assess, and manage risk. COSO II expands on internal control providing a more robust and extensive focus on the broader subject of enterprise risk management. There are four different layers, strategic high-level goals, operations, reporting and financial results, and compliance. Within that, seven different layers of internal environment are identified (see figure 51). Ultimately, the framework prepares enterprises to understand the amount of risk the entity can handle.

Figure 51: COSO II

Solvency II has its emphasis on improved risk management and internal controls. This is a worldwide trend; not just Solvency II but also Sarbanes Oxley (see figure 52).


Figure 52: Increasing Role of Risk Management

27

Current Solvency I framework

Current Solvency I framework

First Solvency II steps

First Solvency II steps

Pilar I Standard approach

Pilar II

Pilar III

Pilar I Standard approach

Pilar II

Pilar III

Pilar I

Internalmodel

Pilar II

Pilar III

Pilar I

Internalmodel

Pilar II

Pilar III

Solvency II Directive implementation

Solvency II Directive implementation

Riskmanagement

Riskmanagement

TimeTime-. Solvency margin requirements (Life / Non life insurance)

-. Bulk evaluation of risk management

-. Solvency margin requirements (Life / Non life insurance)

-. Bulk evaluation of risk management

200420042007…2007…

-. First steps in risk identification and analysis

-. First steps in technical reserve valuation

-. Quantitative impact studies …

-. First steps in risk identification and analysis

-. First steps in technical reserve valuation

-. Quantitative impact studies …

-. Exhaustive risk identification and assessment in all risk-classes

-. Risk capital measurement and allocation (standard / internal approach)

-. Supervisory practices and powers implemented

-. Exhaustive risk identification and assessment in all risk-classes

-. Risk capital measurement and allocation (standard / internal approach)

-. Supervisory practices and powers implemented

-Guidelines-Guidelines

Solvency II Framework

Directive

Solvency II Framework

Directive

Technical Provisions in Life and Non-Life

A) Ongoing Projects. Work in progress: Solvency II and IASB Project

1. Currently under IFRS (Insurance Project – phase 1).

Insurance contracts may be evaluated according to existing standards, subject to adequacy constraints described in IFRS 4 – for the time being.

Different countries use different criteria. Country like Singapore simply gave up and left the existing rules in place.

Investment contracts are mainly evaluated at fair value, as defined in IAS 39. 2. The status of the ultimate definition of insurance treatment under IFRS (Insurance Project – phase 2).

Definition of a new standard to address the “fair” valuation for insurance contracts. Consistency between the treatment of insurance and investment contracts. Norwalk Agreement – Convergence with US GAAP standards.

3. Timing of IASB Insurance Project and Solvency II Project is an issue:

IASB definition of insurance liability will be addressed in some years Interested parties are working for consistency

Which discount rate do you use? How do you model policy options and guarantees? How do you treat discretionary participation giving bonuses or dividends by companies? The same issues exist in Solvency II. The hope is that the same or almost the same solutions come out in both projects so the companies do similar things even if they differ at a level of detail between public reporting and solvency related calculation.

B) Technical Provisions– Quantitative

Defining the Reserves

Provisions should cover both expected payments for benefits and claims and part of unexpected payments, given a certain level of confidence.


Expected and unexpected components have to be determined and disclosed explicitly, and

could be calculated using different assumptions and/or different valuation techniques The unexpected component, or prudent risk margin, can be determined as the difference

between the expected component and the value needed to achieve the requested level of confidence.

Total provision can be represented by a graph of the probability distribution of the losses arising from the contract (see figure 53).

Figure 53: Defining the Reserves

LOSSESLOSSES

Total ProvisionTotal Provision

PR

OB

AB

ILIT

YP

RO

BA

BIL

ITY

Mean Level of confidence

Expected loss(covered) Uncovered

unexpected loss

Coveredunexpected loss

Safety Reserves: MCR and SCR

Reserves are just one component in the old approach to the balance sheet. The Solvency I capital or solvency margin requirement for life insurance companies is four percent of reserves and an amount per thousand of the sums insured. In the new approach, a prudence margin is calculated. This is a minimum capital requirement – the minimum risk-based approach. In addition, there is a solvency capital requirement to keep the regulators happy.

Objective of Capital Requirements

Minimum Capital Requirements -

Safety net. Level under which, even in the short term, companies cannot operate. Immediate regulatory intervention in case of breach. Does not necessarily represent the adequate level of capital.

Free Surplus - Depends on Strategy

Solvency Capital Requirements

Target level of capital to absorb unforeseen losses over a specified time horizon Assessed in a framework sensitive to risks faced by undertakings Available capital can temporarily be different than from SCR Standard formulas and internal models


Figure 54: SCR – Risk Mapping According to CEIOPS/IAA

Combined Risk Profile

(e.g., distribution of net assets in solvency framework)

Combined Risk Profile

(e.g., distribution of net assets in solvency framework)

• Risk types • Mortality risk • Morbidity risk (to be

included ) • Lapse risk • Expense risk • Risk

manifestation • Volatility around

mean • Level uncertainty• Trend uncertainty• Catastrophes

• Risk types • Mortality risk• Morbidityrisk (to be

included ) • Lapse risk• Expense risk

• Risk manifestation

• Volatility around mean

• Level uncertainty• Trend uncertainty• Catastrophes

• Risk types • Reserves • Premium • Risk

manifestation • Frequency • Severity • Catastrophes

• Risk types • Reserves • Premium • Risk

manifestation • Frequency • Severity• Catastrophes

Operational Risk

Operational Risk Market RiskMarket Risk Credit RiskCredit Risk

Life Life Non LifeNon Life

Underwriting Risk

Underwriting Risk

• Risk types

• Interest rate risk• Equityandpropertyrisk• Currencyrisk• Concentration risk• Liquidity risk• Risk manifestation

• Volatilityof marketprices andeconomicvariables

• Movementof value for options embeddedin lifecontracts

• Risk types

• Interest rate risk• Equityandpropertyrisk• Currencyrisk• Concentration risk• Liquidity risk• Risk manifestation

• Volatilityof marketprices and economicvariables

• Movementof value for options embeddedin lifecontracts

• Risk types• Default risk• Changes in

creditworthiness(individualsecuritiesandmarket) risk


• Volatilityof asset pricesdue to changes in creditspreadsand rating migrations up to default

• Risk types• Default risk• Changes in

creditworthiness(individualsecuritiesandmarket) risk


• Volatilityof asset pricesdue to changes in creditspreadsand rating migrations up to default

• Risk types• Inadequateor

failed internalprocesses

• People andsystem madedamages

• External events• Risk

manifestation

• Unexpectedlosses

• Risk types• Inadequateor

failed internalprocesses

• Peopleandsystem madedamages

• External events• Risk

manifestation

• Unexpectedlosses

• Risk type• liquidityrisk arising

whenassetscannot be realizedto face liabilitypayments

• Risk manifestation • Insufficiencyof

liquiditiesto meet liabilities

• Risk type• liquidityrisk arising

whenassetscannot be realizedto face liabilitypayments

• Risk manifestation • Insufficiencyof

liquiditiesto meet liabilities

Liquidity Risk Liquidity Risk

Dependencies

The figure (see figure 54) indicates the rule based approach in the solvency capital requirement, reflecting all types of risks and the interaction between them to come up with a level of risk capital.

Calculating SCR via internal models

The Solvency Capital Requirement (SCR) can be determined by developing a mathematical model of major risks that an insurance company is exposed to, and calibrating it. (EU Call for advice: Request No.10). Internal models can be used to represent the business of an individual undertaking more closely, resulting in capital requirements that are better aligned to the undertaking’s risk profile (Call for advcice: No.11 - §.3). An internal model may calculate the SCR after validation and approval by the competent authorities. Most banks, under Basel II, elected to use internal models. However, a number of them, particularly some of the smaller banks, have had a hard time getting regulatory validation for those models. It is possible that insurance Solvency II will run into similar issues.

Types of internal models:

Deterministic model – the company projects a small number of scenarios and estimates the effect of risk factors on the profit and loss for each one.

Probabilistic and stochastic model – the company projects a large number of random scenarios that attempt to capture the actual behaviour of risk factors, producing a simulated profit and loss distribution.


Key issues with Internal Models

An actuarial model provides a forecast for the whole distribution of the profit and loss of a portfolio instead of just one parameter of that distribution (VaR/TailVar) like the standard formula.

In principle, there is no limitation on the range of model approaches, but the undertaking must be able to justify its selection to the supervisor.

Supervisors need to validate internal models before they can be used. Internal models can deliver a wide range of benefits to supervisors, undertakings and

policyholders. Boards of Directors and Senior Management must be involved in understanding internal

models. Partial models can be used. Information technology systems should be able to support the review processes of internal

models.

Supervisory Review Process (see figure 55)

How do these new tools affect the relationship with regulators and supervisors and insurance companies? Moving from a rules-based approach to a risk-based approach means that the interaction between the supervisor and the insurance company is less clearly defined. These tools become a basis for discussion and there will be an ongoing review with regulators. The authority will evaluate the quantitative and qualitative elements of internal controls and risk management on an ongoing basis. Supervisory practices will include onsite and offsite assessments. The supervisors will need some powers and capacity to identify deteriorating conditions to take preventive measures and take immediate action where necessary to protect policyholders.

Figure 55: Supervisory practices (regarding solo companies)

39

On going basis review(with both quantitative &

qualitative elements)

Risk profile

Adequacy of the solvency capital requirementsProper use of assets to cover technical provisions

Inspections(both on-site & off-site)

Market conduct

Risk Management & Internal control

Financial conditions

Compliance with legislation

Third parties

Identification of deteriorating financial conditions

Preventive and protective measures

(timely and suitable)

Immediate action to protect policyholders’ interests

(based on clear and objective criteria, and publicly disclosed)

Governance


Purpose of the New Solvency System

The purpose of the new solvency system is to give the supervisor the ability to meet their supervisory objectives, particularly to protect the policyholder’s interest, in a way that is more flexible and deals with increasingly complex risks better than past systems. The system is intended to:

provide supervisors with appropriate tools and powers to assess the “overall solvency” of an institution, based on a risk-oriented approach.;

include supervision of quantitative elements and qualitative elements that influence the risk standing of the institution (managerial capacity, internal risk control and risk monitoring process, etc.);

facilitate efficient supervision of insurance groups and financial conglomerates; and increase the level of harmonisation of supervisory methods, tools, and processes inside the

EU.

What does all of this mean for Indonesia? It is safe to assume that solvency II is a likely precursor of the trend in regulation of financial institutions. If it is happening in Europe, these developments will happen here. It will take some years to deal with it and so it is advisable to start thinking of this now. This is not just a tool for regulation; it is an approach that could help businesses to better manage their risks.


Q & A Session Summary

On the inclusion of the catastrophe element in non-life insurance

There has to be a catastrophe element for non-life insurance companies. If a catastrophe occurs, it is not just the individual’s problem. It is the country’s problem and the national tax-payer’s problem. In some countries it is possible to either issue catastrophe bonds or buy re-insurance. This does not reduce the expected cost of these catastrophes, in fact it increases the cost slightly, but it spreads it out over time and makes it far more predictable and controllable. The idea is that while a catastrophe is a human catastrophe, it need not be a financial one. It would be challenging product to price and put out in Indonesia where there are a number of high-cost catastrophes.

The more relevant point is the development of sophisticated products for insurance consumers. As this occurs, as is evident in the U.S and Europe, insurance companies sell and buy products with complicated packages of cash flows. You need tools to ensure that the cash-flow that insurers buy can provide the cash flow the insurers promise to their customers. These tools for the assessment of cash flows are essential to create more complex capital markets and complex insurance products.

The impact of increasing sophistication in the Indonesian industry

Indonesia has a mix of domestic companies and subsidiaries of European and American companies. Most companies are small in size and are less likely to have the resources to support the high-level of sophistication needed as the market develops. As market sophistication increases, it will be difficult for companies to meet the financial capital requirement and the intellectual capital requirement. This makes a strong case for industry consolidation.

The Australian experience in the past decade could be a pointer to how to handle this consolidation. About five or six years ago, the capital requirement for a general insurance company was a simple calculation – the greater of a percentage of reserves and a percentage of premiums. Unfortunately, it produced a capital model where many insurance companies failed. The country then moved to a more complicated model that required a probability distribution of expected losses and a more complicated set of factors. Even a small change combined with a more robust requirement for risk management strategies was enough to shrink the number of institutions. Australia had about thirty reasonably substantial institutions and now has about five or six that control the great majority of the market. The country has seen similar effects in banking and pensions where imposing fairly modest increases in the regulatory or capital requirements produces dramatic consolidation of the industry.

It is not a good idea to have many unsophisticated insurance companies as is the case in Indonesia. This is not where the world is going. As you get more demanding prudential regulations and rules, small, unsophisticated companies will not be able to handle it.

There is a caveat argument to this. Market models will become more complex and require additional actuarial skills but that is not an entirely overwhelming situation. In China, the regulators are talking of every company doing an embedded value projection. But aside from the need for actuaries, the important question is how you live in this new environment. In the U.S, you need to have at least $US100 million in assets for optimal performance. To really compete in the market you need a diversified asset portfolio, including, for example, corporate bonds and different kinds of bond holdings. Trading in small amounts will cost too much, so the size of each holding needs to be relatively large.


However, when talking of the minimum size argument, it is important to bear in mind that the process of developing an insurance product becomes disaggregated. Some of the pieces are farmed out. This outsourcing approach exists in the U.S market. One viewpoint is that this is a natural result of deregulation. For example, most medium-size US life insurance companies could not offer a unit-linked policy if they have to use their own mutual fund. The fund would not have a brand name or a competitive size. This concept is also found in the Asian region - for unit-linked business the investment function is farmed out. Therefore such solutions will develop in the Indonesian market as well.

Outsourcing: Good or Bad

The Australian perspective

The APRA policy on outsourcing is neutral. There are a set of minimum standard rules for outsourcing. These rules include requirements about such issues as the content of contracts and a proper contingency plan if something goes wrong. The general strategy is that an organization needs to understand its core strengths and only non-core strengths can be outsourced. In theory, it is possible to run a virtual insurance company and outsource everything and just manage the balance sheet. In practice, this kind of company would not have any competitive advantage over other companies. An insurance company with an advantage in sales would run its own sales and distribution network but outsource all the underwriting and investment management. You could have another insurance company that wanted to focus on investment management and outsource sales through brokers or other distribution channels.

So from a prudential supervisor’s point of view, outsourcing is not particularly positive or negative. It is positive if the activity outsourced is to a reputable and high quality provider. It is negative if the conditions of the outsourcing are not well-managed. Outsourcing has a lot of potential to help companies focus on what they are best at doing. It also has potential to create companies that do not really have any particular point to their existence.

To take another example from Australian pension industry, a great many Australian pension funds consider their core competency to be their relationship with their members. These entities outsource investment management and custodianship and administration. The managers focus on picking the right investment managers, custodians and administrator, and ensuring that their members are well-informed about making the right choices for their pension savings. Insurance companies are more complicated in their operations than pension funds and it would be unusual to find an insurance company that outsourced all of their substantial operations. Of the five to six substantial operations in an insurance business, an insurance company would keep three to four of them at the minimum. Perhaps one to two of them if the company is consciously running a narrow strategy.

In conclusion, it is important for regulators to watch out for some pitfalls. This is a situation that regulators ran into with the Sarbanes Oxley Act. The responsibility for internal controls lies with the management of listed companies. This also includes responsibility for possible criminal penalties.

The company that is making use of outsourcing for some of its functions must have proper processes in place to ensure clean financial reporting and no slip-ups in internal controls.

The second question is also very simple. If you are an insurance company, you would like to attract customers to have their life and everything they have insured, so they’ll be covered. Looking at Indonesia with a very low GDP then every person is not likely to be able to afford


insurance, and also it will not be the priority for all people to have insurance. How do you suggest insurance and what type of insurance do you suggest for these Indonesians?

The third one is how to attract companies to provide a retirement plan and what kind of retirement plan is best for them to provide? The country already has a lot of experience in pension plans for civil servants like me from the government. We have a pension plan, but actually people are afraid to retirement because the retirement plan is not very good. It provides 75% of the base salary which is not very much. Say only 10 – 11 million people in Indonesia would have a pension plan. Thank you

Measuring risk for a country like Indonesia

Risk is a broad term and it comes down to what kind of risk is being discussed. For example, the mortality risk, the risk of someone dying, would be measured in the same way in Indonesia as elsewhere. Similarly, for sickness risk. Measuring investment risk is much more difficult in Indonesia than in developed markets because of the lack of depth in the market. There is too much reliance on short-term bank deposits and not enough on the bond markets or the equity markets. If you are in a market with a small number of investment choices, then the investment risk is higher. The best way to respond to this is to develop deeper and more varied investment markets. At the personal level, I would suggest that you make sure you have a loving family.

The question of affordability

Affordability of insurance is a real problem for a country like Indonesia. Insurance is not a priority when people have hungry children. In a poor country, it is not feasible to have the goal of insurance and pension for everyone. The World Bank has a concept of four pillars of retirement provision and at least two and half of those pillars do not include individuals investing their own money. A more pragmatic viewpoint is to focus on individuals who fall outside the current group that buys insurance. The sales effort has to be focused on people with something to loose and the pension market needs to be focused on people with regular income, enough to put some away.

There is a chicken and egg situation here. As the economy in Indonesia develops and as increasingly people move into the working and middle class, then pension funds and insurance businesses will grow. As it does so, it creates a stronger and more flexible investment base and supports growing employment in the economy. It is a virtuous cycle.


Aligning fiscal, social and prudential policies in Insurance and Pensions


Aligning Policies the Role of Taxation

Rodney Lester Senior Advisor

The World Bank Tax is relevant to the promotion of insurance and long-term savings. Advanced econometric research shows, for the first time, a clear causality from the development of the non-life insurance sector to economic development. This makes sense as non-life insurance enables entrepreneurs to engage in higher return, higher-risk activities. For life insurance, and in fact contractual savings, the picture is much more complex, reflecting the interaction with other types of savings and with the various transmission processes whereby savings become productive investments in the overall environment. In addition, there appears to be some threshold effects for contractual savings. They do not voluntarily appear until income levels reach a certain level.

This is consistent with the general finding that life insurance penetration is linked closely to the size of the middle class. OECD data gives further evidence, showing that the volume of funds under management by insurers and funds managers links closely to GDP per capita (see figure 56).

Figure 56: Life Penetration Related to the Size of the Middle Class

Income Distribution and Life Penetration

0

2

46

8

10

12

0 20 40 60 80 100

% Earning US$ 10K - 50K

Life

Pre

miu

m %

GD

P

The following chart shows the development of banks according to the development of economy, versus the development of the contractual savings sector (see figure 57).

Figure 57: Institutional investment depends on level of economic development.

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0 0.5 1 1.5 2 2.5 3 3.5 4

Ln GDP/ Capita

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um a

s %

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InstitutionalInvestorsBankDeposits


Banking is relevant to all but the most blighted cash-based economies. There are a few of those left in the world but not many. Banking serves a key role in ensuring liquidity and hence the great majority of deposits in developing markets are usually on demand. This means that if investment is to occur in plant and equipment, a major source of economic growth, it must come from savings in the enterprise sector, such as retained earnings and depreciation allowances. Alternatively, banks need to take excessive transformation risks. Banks in developing countries often also see a good part of their lending going in meeting fiscal deficits run by government, which may or may not be the best thing. It depends on how the government is spending the money.

A third source of investment financing is borrowing in foreign currency. It has proven to be highly risky – as Indonesia has discovered. Direct foreign equity investment is a better option but tends to be fickle, particularly in the critical area of infrastructure development. The developing world has an insatiable need to develop power and clean water infrastructure for the near and intermediate future.

The fourth and ideal source of funds is long-term domestic savings in insurance companies, pension funds, and collective investment vehicles such as mutual funds. However, these tend to be related to the level of GDP. The question is - can we hasten the process of creating domestic long-term funds? The available evidence points to the answer as being a yes – subject to the right institutions, incentives, and financial infrastructure being in place.

Savings

One of the major challenges in discussing long-term savings is defining the term. An example is the cost of education, which is treated as consumption in standard national accounts, but under any sane definition is really investment. In fact, there is clear evidence that workforce skill and technical innovation are the major determinants of productivity and economic growth. Thus, the best definition of savings is the allocation of resources into productive activity; in other words, the net real investment made during the accounting year. Investment also includes owner-occupied housing, as this provides a notional output equal to the implicit rental.

If we assume that the definitional issues can be dealt with, then the issue of what actually drives productive investment comes up. This is a very contentious area and economists debating the subject come up with a wide range of opinions. The standard model has three sources of savings – government, the enterprise sector, and households. The evidence available indicates that the enterprise sector’s investment activity is largely driven by the business cycle – in other words by consumption and output. It is independent of interest rates or tax structures, excepting at the the extremes. Thus, an inappropriate reduction of consumption can in fact have a negative impact on business investment – the so-called ‘paradox of thrift’. It is clear however, that interest rates and, by implication, tax structures can have a significant impact on other forms of investment such as housing development.

The government sector gets a large part of its savings from tax revenues. Some of this goes into productive investment, including roads, hospitals, and education. If a government runs a deficit it needs to borrow to make such investments, which mainly means from the household sector. Thus if a government provides tax breaks to households, it generally needs to be confident that the resultant increase in private savings will be more than the tax forgone. This is very important – governments are not going to give tax breaks unless they see a portion of this tax break flow to an increase in savings.

The household sector shows some interesting dynamics when it comes to savings. There is strong evidence that households will do almost anything to maintain their current levels of consumption. This means that if taxes increase or compulsory savings are introduced, then households will


reduce other forms of saving or borrowing. Thus, there is reason to believe that if compulsory savings are introduced in underdeveloped financial systems then overall savings will increase. However, consumption levels will be restored as sources of liquidity develop. As mentioned earlier, there is also strong evidence that saving rates go up when people earn more although there are also lifecycle influences at work here. Older countries tend to save more than younger countries.

What are the arguments for keeping savings in the hands of households rather than government, or even private enterprise? Perhaps the strongest is that private savings increasingly end up in the hands of institutions like pension funds and insurers, who are able to provide low-cost diversification, a degree of security and access to a wider range of investments. The economic argument is that these institutional investors are able to allocate resources more efficiently and to enforce greater levels of accountability on enterprise managements. Another argument is that institutional investors can afford to take a longer view and are better placed to provide long-term funds and generate higher returns than the household can. This is their competitive advantage over banks and one-reason banks get into the contractual savings business, either directly or as intermediaries.

Countering these arguments is the impact of risk-based capital, which encourages less risky investment allocations. There is also a counter argument in the increasingly popular alternative of transferring risk back to the saver. It is worth considering whether there is going to be any life insurance industry in the long run if they keep doing this. Certainly, the data points to scope for a rapidly increasing role for institutional investors, even in early transition countries. The following figure provides some OECD numbers that show the increase in institutional investment as a proportion of GDP in a number of transition countries. Growth of institutional investment can be particularly rapid in transition countries with supplementary pensions (see figure 58).

Figure 58: Growth of Institutional Investment in Transition Countries

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8

10

12

14

16

Hungary Mexico Poland Turkey

199319972001

____________ Source: OECD

In the case of Poland and Hungary in particular, it is apparent that contractual savings can grow with liberalization and the introduction of pension reform. Mexico is interesting because it is heading in the same direction after its pension reform. It did have a financial crisis in 1994 but has now recovered. In Indonesia there is strong evidence that the development of the share market is linked to the availability of institutional investors. In Indonesia’s case, the country has to date been largely dependent on foreign contractual savings.

Finally, here are the social issues. If all the savings are with the enterprise sector, government and the very rich, governments in civilized countries will need to engage in heavy reallocation of wealth. The welfare state of the 50’s and 60’s has not worked anywhere because of the moral hazard, inefficient public management and misaligned incentives, and will be increasingly unsustainable in countries with aging populations and declining birth rates. Thus, the prevailing


trend is towards individual self-reliance, often enforced by a carrot and stick approach by government. The latest manifestation of this is the trend towards officially sanctioned savings accounts to meet medical expenses – as in Singapore and China and advocated by President Bush in the USA. Any self-reliance system still needs to maintain a basic safety net, but this can conceptually be better targeted under a system of enforced, or heavily encouraged, personal savings. The greatest revolution to date has involved savings for retirement. However, before we get onto that we need to understand a little about taxation theory and practice.

Taxation of Savings

The basic principles underlying tax policy are neutrality, accrual, efficiency, and avoidance of double taxation of the same income. Neutrality means that all forms of savings are treated equally, regardless of their legal structure. Accrual means that income is taxed as it is earned, even if the cash flows have yet to occur.

Comprehensive taxation meets these criteria and maximizes government returns. It taxes all forms of savings related to income at the same time and at the same rate. This means taxing employer contributions, investment income, and any other unearned accruals arising from a decision to save. This approach can be difficult to implement in practice: income can accrue in advance of cash flows, it can conflict with social and equity considerations and basic politics, and in periods of high inflation, it can result in negative real returns since usually the notional investment income is taxed and not the real investment income. In addition, it implies that benefits once received should not be taxed again. This is not the case in Indonesia, where the taxation of life insurance and most other forms of short to medium term savings tends to follow the comprehensive tax regime.

However, a second approach has emerged in the past 15 years. This alternative approach involves taxing consumption only, with savings coming out of gross income. Under this approach, savings, including employer contributions and investment income, are seen as deferred compensation. Many funded pension systems now adopt a variant of this approach, known as EET (Exempt-Exempt-Tax), where savings are made out of pre-tax income. Investment income accumulates on a gross basis and the eventual related retirement income is taxed in full.

Other less pure approaches are also adopted for pragmatic reasons in many countries where there are poor accounting controls and a lack of transparency. These include the application of flat final taxes to investment income and the application of flat taxes to some proxy for income accrual, which could be premiums or solvency capital. The problem with such taxes is that they can apply when real profits are negative, and reduce the overall solvency of the system. This could be happening in Indonesia.

A purist tax approach can be modified to meet social objectives, such as encouraging people to save for retirement, to achieve social equity or to force cross subsidies. Equity considerations can arise. For example, labor income is taxed more heavily than capital income. This typically means capping of tax breaks for the very wealthy.

Cross subsidies occur when a particular form of savings is seen as being socially or politically desirable. The most common in many developing countries is housing. Most developing countries have some sort of high-subsidized housing system, which often leads to huge fiscal black holes. In the United States and other industrial countries in contrast, it is typically the pension system that gets the best breaks.


Funded Pensions

Many funded pensions systems operate under the EET regime. This is particularly true of the so-called second pillar systems that relate to a person’s employment and are coming up all over the world, in particular in Latin America and Eastern Europe.

The public policy problem with the EET system is that it defers government revenues. In other words, governments see a reduction of current income and have to borrow if they wish to maintain their programs. If the money just goes to households and then comes back to the government as debt, one can argue that the whole effort is a waste of time. However, there is a subtle difference between that system and one where the government is funded through taxation. Debt potentially places an obligation on the government to manage better and it could be counter-argued that, as with the enterprise sector, overall governance levels are improved if the household does the primary savings rather than the government.

A further issue is that EET, or TEE – which is mathematically equivalent - actually reduces overall government revenues compared to comprehensive tax. This is because the comprehensive tax actually taxes savings twice. In fact, it taxes savings three times if inflation is high: there are good arguments for exempting a good part of interest income from tax in high inflation environments.

The double taxation issue arises from the fact that contributions under an EET or TEE system are made out of after-tax income. Therefore, the investment income earned on those accrued contributions has already been reduced proportionately. In other words, the government has the balance of the savings in its own pocket and is notionally earning the income on it. Therefore, if the investment income in the hands of the saver is taxed, this is in effect double taxation.

This is a subtle point best explained by a table that comes from a World Bank pension reform primer, produced by our Social Protection people (see figure 59). In the following table 100 is paid towards a pension fund from pretax income under all taxation regimes. Under comprehensive tax, the initial contribution is taxed either at the beginning or at the end (for the purpose of understanding, it is easier to look at the TTE and assume it is equivalent to the ETT). Since the contribution is taxed, the investment income that goes to the savers is reduced and therefore less money invested when the initial contribution is taxed. However, with TTE you are reducing the personal investment income and further taxing it, which affectively means double taxation. In practice, dividends from taxed company profits are given a break sometimes, even under comprehensive systems. That is the only break we see under a TTE.

If overall savings are to rise, then households operating under an EET or TEE system must be compelled to save all the tax reduction compared to a comprehensive system. This is why these approaches are normally available in the case of mandatory or semi mandatory savings. In addition, there is a need for well-established reporting systems, consistent and honest tax mechanisms, strong legal and regulatory institutions and a good funds management infrastructure.

Most OECD countries adopt an EET system. Hungary adopted the TEE system (see figure 60)

Figure 59: Comprehensive Tax Increases Government Savings


Figure 60: Most Countries Use EET or TEE

_____________ Source: OECD Most countries with EET or TEE systems are seeing a reduction in the role of PAYGO (pay as you go). First pillars are funded through fiscal transfers, and often heading for disaster because of population ageing or falling fertility rates. In a couple of cases you have countries that always had small first pillars like the UK and Australia. Three countries, including New Zealand and two Scandinavian countries have comprehensive taxation, but these countries still have generous PAYGO first pillar systems (see figure 61).

Figure 61: net tax cost per unit of contribution

_____________ Source: OECD

Therefore, there can be some sort of trade-off occurring - comprehensive taxation but a generous first pillar or EET or TEE and a not so generous first pillar. The Czech Republic has an almost unique TET system and there are strong pressures to change it. Finally, in Australia, a system has evolved without much real thought and makes very little sense for either the saver or the government.

The OECD has done excellent work measuring the incremental fiscal costs of tax concessions to supplementary pension systems. The following table uses one of a number of ways of measuring


costs from comprehensive to consensual tax. This above figure shows the Czech Republic as having the largest incremental fiscal cost, mainly because the Czech Republic has a generous direct government subsidy. In other words, the government would actually pay people to save in the Czech Republic. However, this cost is being questioned because, while coverage of the population is high, the retirement income impact has been negligible. It is probably an addition of about two percent of final salary to the average pension. New Zealand has a low net cost because of its comprehensive tax approach and Mexico has a low marginal net cost because of its generous treatment of all savings vehicles, not just pensions. Australia has a relatively high net cost, largely because of the low tax rates that apply under each of the T’s in the TTT system that applies there.

If the stylized net costs as a proportion of GDP are considered, this impact is even more evident (see figure 62). The marginal fiscal cost of supplementary pensions can range up to two percent of GDP.

That compares with the fiscal cost of first pillars of up to five percent or more in some countries therefore it seems a reasonable tradeoff. As expected, the greatest cost is borne by countries with first pillars that are not particularly generous. This makes some sense as these countries have the greatest incentive to encourage non-state retirement incomes. They also tend to have good social safety nets for the genuinely indigent.

In the case of Indonesia, there is very good case for a TEE approach as opposed to the notional EET that currently applies. Given current budget realities, the government cannot afford to defer revenues in this country. In addition, this would also be consistent with the current reality of how pensions are taxed. As mentioned earlier, there is a notional EET system, but in practice, a final tax applies. Therefore, there is actually an ETE system but maybe TEE would be better than ETE. While the logic for a consumption based tax system - a system that taxes only once - for long-term retirement savings is clear, the issue becomes more complex when we move into life insurance.

Figure 62: Overall budgetary cost arising from contributions made in 2000

- % GDP

Life Insurance

Life insurance can be pure risk. The reality is that in most reasonably developed markets, at least ninety percent of life insurance involves savings. However, one can argue that most life insurance savings are for relatively short periods. This arises because of the sales methods, which are adopted during the early and mid stages of development of life insurance markets. Warm bodies are recruited off the streets to sell to families and friends, who often only pay the first few premiums. Some studies point to the real average duration of life insurance contracts being


around three years, allowing for lapsing and surrender, and not the seven years most people normally quote. This pattern seems to be the case in Indonesia (see figure 63).

Figure 63: Indonesian Life Insurance System shows pure persistency New Life Premiums US$ Bn

Total Life Premiums US$ Bn

Life Assets US$ Bn

Assets/ Annual premiums

% renewal premiums

Assets/ Renewal premiums

1999 0.41 0.78 2.37 3.1 46.6% 6.62000 0.40 0.76 1.95 2.6 47.4% 5.42001 0.42 0.88 2.17 2.5 51.9% 4.82002 0.60 1.28 2.94 2.3 53.0% 4.32003 0.77 1.62 3.84 2.4 52.4% 4.5

_____________________ Source: Y. Geurard

This chart shows new business premiums. The analysis also shows high discontinuance rates experienced by all three sectors, the state insurers, the private insurers and joint venture insurers.

If life insurance companies are to justify long-term savings treatment for their policyholders, they must improve the overall persistency of their business or, alternatively, those policyholders who persist for the long-term should receive a tax break. Full incentives encourage people to save for long-term. In fact, Indonesia is beginning to see the start of a revolution in its insurance distribution model with the emergence of bank-assurance. The fastest growing insurer in the country is the bank insurer and maybe the time is coming to adopt a consumption tax model for genuine long-term savings through life insurance. This would be good for the sector as it is unlikely that many Indonesian life insurance companies are actually profitable given the current discontinuance experience. The number of insurers that have exited the country in the past ten years reinforces this view.

Challenges of Life Insurance

1. Policyholders versus shareholders: The first challenge is disentangling the taxation of policyholders from the taxation of shareholders. In most countries, life insurance assets are part of the same balance sheet as shareholder assets. This opens up all sorts of opportunities for tax management. There are strong arguments for legally separating shareholder and policyholder funds as in India, Australia, South Africa, and a number of other countries. Particularly so, when you have a composite insurer selling both life and non life insurance.

2.) Prudential versus tax accounting. Most life offices provide guarantees, or embedded options to their policyholders, such as capital guarantees upon death, capital guarantees upon disability, or capital guarantees at the time the policy matures. So the company needs to maintain safety margins in their reserves for the risk of those guarantees. However, safety margins are not usually consistent with economic or fair value measurement of profit. Thus, there is an argument for valuing reserves differently for taxation and prudential purposes.

3. Measuring accrued profits. A life insurance policy typically costs more to enter onto the books because of commission, distribution costs, and marketing costs, than is received in premium in the first year and sometimes even the first two years. The acquisition cost can be up to two years of premium. Therefore, borrowing from capital makes up the deficit. Thus, on a cash-flow basis, the life insurer makes a loss in its first year and perhaps even with a carryover to the second year. However, presumably a life insurer would not underwrite a new policy unless it had a positive net


present value. So what is the real first-year profit, the negative cash flow, or the positive net present value? A good part of the famous or infamous, actuarial black box deals with this question.

4. Definition of profit. In a bank this is easy. The funds subscribed are capital and do not enter the profit and loss account. However, under life insurer accounting, premiums are normally treated as revenues and are offset by increases in mathematical reserves for future commitments. In addition, there is no internationally agreed treatment of asset and liability valuation for insurers, although there is a strong push from academics and some accountants for a fair value approach. Continental Europe and North Asia are strongly resisting this. Thus, there are at least two very different international views of how life insurance profits are measured. At a deeper level of detail, there are probably as many views as countries.

Other issues, which come into life insurance taxation, include reinsurance, the treatment of bad debts, and the impact of changes in pricing assumptions, tax carry forward and back and the treatment of mutual insurers, including micro insurance.

Generic Models for Life Insurer Taxation

In practice globally, life office taxation is a mess and there is no consistent pattern. However, there are a few broad generic models.

1) Bank Model: The first one treats life insurers as if they are banks. Life premiums have a large capital component and that is equivalent to a deposit in the bank. Expense-loadings in premiums balance emerging expenses. The model, called the “I minus E” model, looks at investment income, and the expenses incurred in receiving that investment income, and allows for an offset for double taxation of dividend income. It characterized much of the former British Empire.

2.) Final Tax: A variation is to tax investment income at a concessional rate – the final tax. You just apply the tax rate to the investment income but ignore the expenses. Typically, that tax rate is a little less than the income tax rate. This is broadly the current Indonesian approach in practice.

3). Standard Insurer Accounting Model: A third approach uses the standard insurer accounting model, with the possible removal of prudential safety margins. This is the model being used most countries. It allows for the fact that the liability side of an insurer’s balance sheet is a matter of opinion, unlike banking, and that assumptions will change over time. It also allows for an EET or TEE approach to be adopted more easily than under “I minus E” for the policyholder savings roll up. In other words, mathematical reserves can be rolled up at the gross investment return, not the net investment return, under the insurance accounting method. Actuaries have a number of methods available to do this kind of roll up. If someone takes their benefits earlier, under an EET or TEE internal roll up in a life company, they can be taxed at a penal level either on a withholding basis or to the individual directly.

4). Tax as a proxy for profit. The remaining outstanding issue is profit definition, including the treatment of front-end acquisition costs and valuation of assets and liabilities. For acquisition costs, there are three possible approaches. First, to expense the acquisition costs in the year the cash flows occur. The second alternative is to spread the costs over the whole term of the contract. Thirdly, an option is to spread the costs according to some measure of service provision. The approach to the treatment of the acquisition cost can make huge differences in the emergence of profit both for accounting and tax purposes.

A problem with the first two approaches is that they do not measure profits accurately. In many cases, life offices also make profits and losses from variations from the expense, mortality, and discontinuance assumptions. In New Zealand, a variant of “I minus E”, known as “I plus U minus E”, also includes profits from these elements. Another problem with the “I minus E” approach is that it assumes a comprehensive tax approach. It is equivalent in some ways to a comprehensive


tax approach because life insurance premiums are normally paid out of after-tax income. As discussed earlier, a comprehensive tax involves a subtle but notional double taxation of savings.

One option is to adopt a realistic value for liabilities, possibly with a small safety margin, and to value assets at fair value unless they are clearly linked to the liability. If the Indonesian mutual fund industry had adopted this approach it would not be facing the current problems. It is not feasible to value at book value if investors can redeem on the spot. The only consolation for the Indonesian mutual fund industry is that it is not the first country to fall into this trap. Countries like Korea went through similar problems in the late nineties.

The following graph shows the impact of reserving methods on the profit emergence for life insurance companies (see figure 64). The figure covers the whole range, from cash flow accounting to a method that values policy liabilities on a realistic basis using the original pricing assumptions. As is evident, the first year profit can vary from negative 11, representing an accrual of the savings element plus a write-off of acquisition costs under a pure net premium approach to plus 0.1 allowing for recovery over the policy term using a gross premium approach to fitting in a wide range of possible taxation basis.

Figure 64: Impact of Reserving Method and Treatment of Initial Expenses

______________________ Source: OECD

In practice, life insurance accounting typically spreads the front-end costs over a relatively short period rather than the whole period of the policy, reflecting the reality that the actual duration of life policies is usually shorter than the period shown in the contract wording. This means creating an asset. If shown explicitly it is called a deferred acquisition cost (DAC) and if offset against mathematical reserves it is called a Zillmer or Sprague adjustment. Most tax experts would argue that deferral of acquisition costs represents a more accurate measure of profit accrual than immediate expensing. However many jurisdictions do allow immediate expensing. International accounting standards are likely to ban DACs – in other words to force immediate expensing in the reported accounts. This is an interesting divergence of accounting and tax doctrines.

Comparative Life Office Taxation

The following graph shows how life offices are taxed in a range of countries (see figure 65). The Indonesian approach is to tax accounted profit. In other words, it looks like a normal accounting approach. In addition, policyholders are subject to a penalty withholding tax of fifteen percent on


any gains if they withdraw their funds within three years. Considering how the insurance sector in Indonesia is currently operating, it is not particularly profitable. Given that acquisition costs are expensed quickly, it unlikely that too much profit is being declared by the Indonesian life insurance sector. Therefore, in practice Indonesia also has a final tax system for life insurance as well as pensions.

South Africa, a model of interest to Indonesia, adopts a TEE approach to policyholder accruals, and taxes profits in the hands of shareholders. Income is allocated to shareholders and various policyholders and the best estimate valuation of liabilities is applied for tax purposes. India has a similar approach to South Africa, where there is a separation of shareholder and policyholder accounts. Tax is applied to the income of shareholders, there is a gross roll-up for policyholders, and acquisition costs are expensed up front. Singapore has a similar model. It is no coincidence at all that these countries have a common British heritage.

Figure 65: Comparative Life Office Taxation

Capped deduction for those on lower incomes, 10.2% servoce tax on risk portion.

Exempt –gross roll up -EpEE

Statutory basis –gross premium method - DAC expensed immediately

SH profit by allocation of total income

India

Some deductibility within a global limit.

Exempt – net roll up - EpTE

Minimum statutory basis –DAC expensed immediately

SH profit by allocation of total income

Singapore

Not deductible, nil premium tax

Exempt –gross roll up -TEE

Conservative best estimate -DAC by official formula

SH profitSouth Africa

Not deductible, nil premium tax

Exempt after 3 years –gross roll up-TEE

Statutory net premium basis –DAC set by actuary

SH profit subject to minimum based on final tax

Indonesia

PremumsProceedsReserving and DAC

Tax basis

Source: PwC Global Survey 2005

Issue of taxes applied to a proxy for profit or to value-added.

The proxy tax can be applied to both premiums and capital. However, while there may be some justification for applying value-added tax (VAT) to non- life insurance, the value-added has proven to be practically impossible to define. In fact, VAT is not normally applied to insurance. Instead, a flat service tax is normally applied. One view is that taxes on non-life insurance premiums can have a negative effect if they are too high, increasing risk levels in the community and possibly even reducing economic growth. Ideally, taxes should not be applied at all to life insurance premiums, unless they are small, typically less than one percent, and used to support an independent and strong supervisory authority. Of the countries listed in this slide, only India applies a premium tax to life insurance, and this is only applied to the risk proportion of the premiums. Part of this tax is actually intended for consumer education, which is a key driver of increased savings.

What is appropriate for Indonesia? A study funded with World Bank assistance is to be released soon. However, here are some thoughts on what could come out of the study. It is known that life office tax tends to be arbitrarily applied by tax officers in Indonesia. It is inconsistent between one life insurance company and another. There is also some suspicion that some life insurers maybe shielding their profits and certainly life office accounting standards and auditing have a long way to go in this country. This is why tax authorities have adopted a final tax basis. It is the only hard number around and it ensures some revenues come out of the sector. However, this is not consistent with global trends or encouraging savings.


If a more accurate approach based on actual profits is to be adopted, there needs to be much stronger actuarial and accounting capacity in this country. An alternative is an “I minus E” approach, but perhaps this is a bridge too far to cross. Certainly basing tax solely on normal life office accounted profits is probably not going to be accepted by the authorities in the short-term at least.

Non-life taxation and the management of funded second pillar pensions

Non life insurance is like any other commercial activity, except that the costs and revenues balance can be hard to estimate as the actual claims outflows can occur well into the future. For example, marine liability and motor third party are two classes of insurance where claims can be paid out some time after they occur and some time after the premium is paid. In addition, there can be a time lag in reporting claims. These facts lead to the well-known issues of “incurred but not reported” claims (IBNR) and “incurred but not enough reported” claims (IBNER). A small number of jurisdictions, including Indonesia, will not allow these as expenses for tax purposes. This is technically wrong as the claims have occurred and are a genuine matching cost. Indonesia should fix this.

However, one concern for jurisdictions is lack of transparency in how the IBNR and IBNER provisions are actually calculated. Applying maximum additions to the case-based claims provisions can over-come this until the actuarial profession is well developed enough to provide reliable estimates of claims costs.

The situation with catastrophe and equalization reserves is less clear as the International Financial Reporting Standards will not recognize them. Such reserves should only be allowed for monoline credit insurers that operate on a known multiyear cycle. They should not be allowed for normal insurers. However, catastrophe reserves are important for a country and can be held in national pools, which are not subject to normal accounting and tax rules. This is the situation that applies in New Zealand and Turkey.

Turning to the management of second pillar pensions: it would not be advisable to look at the Singapore or Malaysian central provident fund routes. These models place too much power in too few hands, lend themselves to directed investment, which rarely, if ever is optimal from a growth perspective, and are an invitation to corruption. Central Provident Funds are completely opaque to their contributors and some well-known commentators in Singapore have been highly critical of their own scheme.

To quote Professor Asher: “The non-transparency and non-accountability of the Singapore Central Provident Fund balances, along with an administered rate of interest, has turned the CPF from a defined contribution fully funded scheme to a notional defined benefit (NDB) scheme, financed on PAYG basis.” The Singapore CPF is a way of increasing government savings, not household savings. It is impossible to tell who may have benefited given the opaque nature of the Singapore CPF. Indonesia does not need such a structure and the second pillar pensions, at least at the funds management level, should be handled in a competitive, efficient, and transparent manner.

The main conclusion from this analysis is that the basic premise of taxation is neutrality, taxation of accrued profits and avoidance of the double or triple taxation. This is relatively easy to apply in the case of pensions but much harder in the case of life insurance companies. Additionally, IBNRs should be allowed as a tax expense for non-life insurers but not catastrophe or equalization provisions. Finally, Indonesia should avoid a Central Provident Fund approach at any cost.



Tax reform in Indonesia for the insurance and pension industry

The insurance industry fully supports the tax reform process. It is the key success factor for developing the insurance and pension industries so is necessary for long-term fund accumulation for government projects such as infrastructure development. There is also the need to create a level playing field, market consolidation and to increase the insurance penetration for national prosperity. The strategic intent of the Indonesian insurance association is to reposition the insurance sector as one of pillars of the economy and the driving force of public awareness for financial family planning and as an employment provider. The proposed tax reform will create significant growth in the Indonesian industry although the key success factor is that the government should carry out these changes in the field for the industry to benefit. It is important to note that the annuity situation in this country is wrong. You cannot tax the lump sum out of Jamsostek, invest in annuities, and then tax the annuities. This is double taxation. This needs to be fixed immediately as it is a technically an incorrect application of tax.

EET versus TEE; The right choice for Indonesia

Some experts suggest that Indonesia change from the EET (exempt-exempt-tax) to a TEE regime. If it is changed, what are the benefits for the retiree or for the pensioner? Additionally, what is the benefit for the life insurance industry as well as the government? There needs to be the right amount of debate before choosing the right system for Indonesia.

An industry viewpoint is that EET is good enough and there is no need to change the system to TEE. The problem with the EET system currently is just implementation.

There is some concern that switching to TEE from EET will weaken the pension system. There is a sweetener in the current system. If an individual contributes to a pension fund now, they do not need to consider that contribution as taxable income. Therefore, there is the concern that it could weaken the pension market since one of the joys of a pension fund is that the individual does not need to pay tax. Additionally, there is a complexity for the change in approach. One viewpoint suggests that EET should be applied to both the pension and the insurance industry to strengthening the market. In fact having EET for the insurance industry might encourage people to get a tax identification number to claim the insurance premium. Currently, a negligible few have a tax identification number.

In some ways, EET is preferable, as governments cannot renege on a deal, which keeps the government honest whereas under the TEE basis the government can follow the Australian government’s lead, which is not the best thing to do. Australia starts with an upfront tax, taxes the middle and then at the end.

The problem is that under both the pension and insurance final tax system, the actual tax that is applied is just a flat tax. A range of flat taxes applies in Indonesia to different forms of investment income. Therefore, the government is actually used to getting an income from the insurance sector by one means or the other. This result is a mess since every tax officer is using a different basis of tax. In the end, the government ends up getting a tax from every insurer, even the loss-making companies. So the question is - how do you get the government to let go of a system when it is used to getting tax from the insurance sector? This is why TEE maybe a sort of a transition path to an EET. This would allow the government to get some tax and bring the country a step closer to EET. Essentially, the question is whether you can trust the government not to hit the second E and the third E with a T, as in Australia.


The other issue is the way the tax is applied. It is much easier to apply tax to an easilly measurable number like a premium. The T upfront means that the premium is paid out of after-tax income -- the current situation. The implication for policyholders is that the final tax is applicable on investment income. However, one needs to be careful about measuring profits for shareholders. This is the reason there needs to be a much stronger actuarial profession and a stronger accounting and auditing profession. It would be easy to move TTE just by removing the final tax but there needs to be a clarification of how the shareholders profit is determined. The ideal system would be an EET system for genuine long-term savings through life insurance but the necessary conditions to keep the government happy need to exist.

One reason why Australia adopted TEE is that in the earlier system, the agents and not the policyholder captured most of the released benefits. In other words, when a tax concession appears upfront, it ends up as increased commission to agents and not increased benefits to the policyholder. This would be a big challenge for Indonesia. It is important to ensure that the released amount does not end up in increased distribution costs. Since pensions are employer-based, the industry will not face the same problem. However, for life insurance, if the government succeeds in keeping the extra amount in the hands of the policyholder it will have a dynamic effect on the industry.

The World Bank is currently doing a study on the taxation of life insurance companies in Indonesia and so the conclusions are still to be determined. Yet most agree that it would be great to have EET for second pillar pensions and even third pillar pensions and long-term life insurance savings. The problem lies in the implementation. However, if there is any chance of getting the EET into this country for long-term savings, then it should be done. It will have a strong multiplier effect on the economy. To attract those accumulated pension funds into the country, there should be strong institutions.

Institutional investors

Research shows that consumer education can be a major driver for long-term savings. Young people do not save a lot. However, if the government can get people in their thirties and educate them about life-cycle patterns, the impact on savings can be amazing. Recently there has been a lot of research on this subject. The fiscal stress with first pillar pension systems is becoming extreme in many countries and there is an official pressure to encourage individuals to save from a relatively young age. It will be an ideal situation if education can be re-enforced with an EET tax system.

In the past twenty-five years, institutional investors have become the dominant force in long-term savings globally, benefiting governments as it is much easier to tax institutions rather than individuals. There are three million taxpayers in this country. It is worse in India. In a country of 1.1 billion people, there are seventy five thousand taxpayers. The point is that there is an extremely small base of taxpayers in some countries. Therefore, if people save through institutional investors, government access to taxable revenues is higher. Along with the stock market and equity investments, Indonesia needs to grow its institutional investor base. An ideal situation is to rely on domestic institutional investors rather than relying on overseas countries. Asia gets a four percent return on the money sent to America and the American investors get a fifteen percent return investing back into Asia. The region is paying a huge price for that total return swap. The region needs to develop its domestic savings so that it can get a return of fifteen percent with a bit more risk and four percent with very little risk.


Attracting long-term investment

The government needs to support this industry to attract long-term funds to support the infrastructure sector. The demand for funds in this sector is about 145 billion rupiah over the next five years. Currently, the insurance and pension industries are only 135 trillion rupiah and banking has 1125 trillion rupiah.

Countries like the United States and Australia grew through foreign investment. Indonesia has enormous potential and has the fourth-largest population in the world. Corruption and lack of consistency in rules continue to deter investors. Therefore, domestic saving needs to develop in the long-term. Domestic saving is the most stable source of saving an economy can have. A large part of the answer for Indonesia has to be through foreign investment in this country. There is three billion dollars of private equity sitting in Australia looking for a home. There is hundreds of billions of private-equity available for investing globally but almost none of it is coming to Indonesia.

To attract foreign investment Indonesia needs to develop trustworthy financial institutions. An effective judicial system and honest bankruptcy laws that work are also important. Bankruptcy is a big issue globally. For example, in Eastern Europe crooked judges will help people tunnel money out of bankrupt organizations. It is up to Indonesia to make itself attractive to the huge amount of private equity and funds looking for a home.

Another avenue for investment is large retirement funds accumulated by the baby boomers. The best place to invest these funds is the developing world although the developing world is doing everything to scare off that money. Currently, the world of investment is going through a love affair with South America, even though Argentina reneged on a lot not so long ago. There is some money returning to some of these countries. However, to do the same Indonesia needs to get its institutions and infrastructure right. If the country gets the courts fixed, the bankruptcy situation fixed, a functioning accounting system, and some transparency into the system, it has a good chance of attracting foreign investment.


New Challenges for Pensions and Insurance Enhancing Credibility of the Insurance Industry


Risk-Assessment and Mitigation in Insurance Industries: The APRA Experience

Charles Littrell Executive General Manager, EMG Policy, Research, and Statistics

Australian Prudential Regulation Authority (APRA)

APRA History

APRA has dealt with much failure in its early history. There were continuous problems from 1998 to 2002 and the industry was captive to global and local cycles. The second-largest general insurance company HIH was one such spectacular failure and is the subject of a Royal Commission enquiry. The company ended up paying about 20 cents to a dollar on its policy claims and the total cost was about five million Australian dollars. HIH was not an isolated event. In addition, a company called GIO, the former state government insurance office in New South Wales had a substantial deficiency in its reserves. The AMP Corporation made this discovery when it acquired GIO and therefore AMP shareholders incurred the losses instead of GIO policyholders.

A major medical liability insurance company also failed during that period. The UMP AMIL group insured ninety percent of doctors in New South Wales, the largest state in the country, and sixty percent of doctors nationally. The closure of the company would have caused irreparable harm to the Australian medical industry since doctors cannot practice without insurance. However, with the help of a government-designed support package, UMP came out of provisional liquidation. It is the only company in Australian history to enter provisional liquidation and recover instead of going onto full liquidation.

Subsequently, international experience with general insurance has also been difficult. It was extremely disappointing for APRA to discover that major international insurance and re-insurance companies were involved in deceptive accounting and transactions that had little to do with risk transfer but were focused on regulatory arbitrage. APRA is currently running a number of enforcement actions.

Australian life insurance companies moved away from capital guaranteed business in the nineties. Therefore, the industry has not suffered any failures in recent years. Although there have been some cases of major companies suffering capital reduction due to failed acquisition or expansion policies.

Post 2002, the industry reached a more stable stage compared to APRA’s formative years. The Australian general insurance industry is now more concentrated with large professional insurers. Five insurance groups control the great majority of the market. Four of those groups are publicly listed Australian Corporations and the fifth is a major international insurance company. APRA input has improved their risk-management practices and capital strength. APRA hopes that the industry has become less cyclical, particularly with respect to its pricing cycle. Currently industry premium rates are softening and it will become apparent in the next two years if the industry has mended its past practice of over pricing on the upside and under pricing on the downside.

The life insurance industry on the other hand has continued its long-term trend of being part of the wealth management industry with a bit of risk management on the side.


APRA approach to prudential supervision

APRA’s approach to financial supervision is risk-based. The amount of time the supervisor invests in a given institution and the treatment meted out depends on two factors. The first and most important factor is the assessment of the probability of failure. Unlike many regulatory bodies, APRA assesses a numeric probability of failure for the regulated institution. The second aspect, although less important, is the estimated impact of the failure which is largely based on the regulated institution’s asset composition. APRA maintains a central risk model called “PAIRS” (Probability and Impact Rating System). The following graphic is a simple representation of the front-end of the PAIRS model (see figure 66).

There is a substantial amount of intellectual property underlying the PAIRS approach. Many supervisory agencies have to work with central risk models but APRA considers PAIRS very robust and unique. Essentially APRA requires supervisors to judge many issues in terms of the distribution of risk, the entities ability to manage that risk and the amount of capital cover for uncertainty.

Figure 66: PAIRS - Quick Reprise

Main page heading

8855221111

Low

18181010443311

Medium

5757323214148844

High

179179101101454525251111

Extreme

EXTREMEHIGHHIGHMEDIUM

LOWMEDIUM

LOW

IMPACT

RISK

Major Prudential Risks

The following graphic has the aggregate APRA assessment of the sources of risk and the four industries supervised (see figure 67). There is considerable variation between individual institutions but the numbers give a general sense of where the risk comes from in the major industries.

Figure 67: Major Prudential Risk

108105RELATED PARTY

117118STRATEGIC

12575LEGAL

36232417OPERATIONAL

002041INSURANCE

23181811BALANCE SHEET/LIQUIDITY

8391012CREDIT

PENSION FUNDS

LARGE BANKS

LIFE INSURANCE

GENERAL INSURANCERISK TYPE


Industries vary by risk a great deal. Credit and insurance risk dominates the banking and general insurance industry respectively, whilst the life insurance companies face a broader spread of risk by type.

The life insurance industry insurance risk is moderate because the industry is moving away from guaranteed minimum returns, essential for providing investment-linked products. The liquidity risk is also low as the customer holds the risk and it does not show up on the balance sheet of the life insurance company.

As the regulator evolves, it increasingly finds that the banking business and the general insurance business have a lot in common and the life insurance and pension businesses have a lot in common. The APRA policy framework often has the same rules for banking and general insurance. Many APRA supervisors train in two industries. Often, training in the banking industry and in general insurance or the pension and life insurance industries works well. This is not true for the life insurance and general insurance industries since the industries are very different.

In Australia, life insurance and pensions are becoming complementary and now ninety percent of a balance sheet of the life insurance sector represents pension investments. The point is that, increasingly, life insurance is merely one way to provide pensions but there are other channels as well.

There is a lot of industry variance on credit and insurance risk and every industry has a lot of operational risk. This is not surprising since problems can arise in individuals and systems leading to loss and even failure. The second-largest loss in APRA history is due to a problem with unit pricing, about half a billion Australian dollars, resulting from a pure operational risk. There have been a number of similar information technology failures leading to fraud. It is remarkable how often things can go wrong even when the entity does not mean for the error to happen. This needs to be reflected in the industry risk assessment.

In Australia there are limited strategic and related party risks as the industry is concentrated into four to six major players owned by Australian public companies. Thus, there is limited international parent risk and conglomerate cross-ownership risk. Countries that are not in this position will deal with a lot more risk in the last two rows of the chart.

APRA General Insurance Experience

APRA’s general insurance experience indicates success comes from careful attention to claim provisioning. This is the most important issue in ensuring a sound general insurance company. Re-insurance arrangements, particularly the unusual kind, are often the second most important issue for a general insurance company. At the heart, the HIH failure was a failure of claim provisioning. Many insurance companies globally run into this problem since claim provisioning is difficult, particularly for liability and other long-term claims. In 2002, APRA updated industry rules and now claim provisioning needs to cover at least seventy-five percent of expected claims.

More importantly, APRA has changed its capital calculation. Prior to the new system, the regulatory capital requirement was the greater of a percentage of claims provisions and a percentage of the premium. This led to a problem – if the company cuts prices and cuts the claims provisioning it would also cut its capital requirement. This is exactly the opposite of what a prudential supervisor wants. Therefore, now the capital model works based on prospective cash flows and includes the cash flow of committed business as well as business already written. This model generates about double the requirement of the previous model and serves as a positive incentive for institutions to manage their business soundly.

A decade ago, the general perception was that large European re-insurance companies are a reliable source of credit and well managed. It is accepted wisdom now that insurance companies


must carefully consider a re-insurance company in terms of willingness and capacity to pay claims. APRA’s capital rules take into account this change. It is also true that business practices between the direct insurance companies and re-insurance companies leaves a lot to be desired. For example, both APRA and the FSA in the United Kingdom have rules saying that insurance companies and re-insurance companies must sign the re-insurance contracts. This rule is indicative of how pathetic the situation is. Legal and financial contracts should be signed as a matter of course. Resistance to regulated business practices is the reason that companies fail and APRA shows no tolerance for this attitude.

Some international re-insurance companies engage in questionable, deceptive, and possibly criminal conduct. In Australia, this has mainly come up when primary insurance companies inflate their capital position. The most common method is that one will see a conventional re-insurance policy written and a letter issued on the side where the insurer promises never to draw on the re-insurance and the auditor sees just the primary re-insurance policy. This is blatant deception. In North America and Europe, a number of leading companies and individual executives have got into trouble for questionable behavior ranging from bid rigging to facilitation of deceptive accounting practices to undisclosed commissions.

Supervisors need to scrutinize re-insurance arrangements, particularly non-standard re-insurance arrangements. In Australia, APRA stopped this industry practice by introducing a rule saying if a primary insurance company wants to enter into a non-standard re-insurance contract; it has to be shown to the regulator first. Hopefully, the rules can go in a few years, once the industry has cleaned up.

The inescapable conclusion is that international insurance and re-insurance business is not as honest as it should be. The Swiss and German insurance and re-insurance companies have been particularly deceptive over the past decade. This needs to be fixed despite the fact that these companies are making more money than they can count. If the business cycle turns, the gap will become obvious. In conclusion, general insurance companies become prudentially distressed for many reasons; prime among them is questionable management. It is easy to say that a company does not need such a large claim provision and it can be cut back a little. Doing this two to three years in a row puts the company in a dangerous situation.

A few years ago, the general insurance industry was deemed to be run by salespersons, contrasted with banks, which were run by professional risk managers. This is why the banking industry is considered safer than the insurance industry. Currently in Australia, many general insurance companies are staffed with risk managers. Good advice to any regulator is to check the background and experience of the top management in the company. If the manager has an actuarial background he might be boring but will be safe. If it is a person with a sales background then the company could be in for an interesting time.

The point is that the regulator needs to a look at an institution and ask if the sales culture dominates the risk culture. The business needs to grow in a safe manner. The key for management is to balance the two cultures and for the regulator to monitor this balance.

There is one more point to consider. In Europe, there have been many cases of general insurance companies investing heavily in equities as opposed to fixed interest. This is a risky way to do business. One viewpoint says that insurance companies and pension funds are over-invested in bank deposits and government bonds. This may be true but is probably a safer way for a general insurance company to manage funds. If equity prices soften when claims increase it will lead to problems.


Where Life Insurance Companies Go Wrong

Life insurance companies face the conflict between a risk and a sales culture even moreso than general insurance companies. Additionally, there is the classic contest of wills between the life agent and the actuary.

The arithmetic of life insurance in Australia, unlike many countries, is reasonably comforting. Life insurance normally includes an investment component which can be a commitment over many decades. If there is an annuity or a whole life policy there will be a need for some other fixed return or minimum return policy. The life company should be holding a large capital component against that multi-decade fixed commitment. If it is offering an investment-linked product, the required capital for the life insurance company is much lower. Australia follows the strategy of shifting investment risk from the insurance sector and pension sector to the household sector. That may or may not be a good deal for the household sector but it certainly makes the life insurance company and pension funds a lot safer.

In almost every country commissioned sales agents sell life insurance. This creates an obvious conflict of interest. The United Kingdom has seen many scandals over poorly sold products and companies have paid compensation of 20 billion pounds for miss-selling practices by agents. Most of these products were pension products sold by insurance companies through agents. This practice is common in many countries, including Australia. It possibly exists in Indonesia as well. This can cause several problems in developed countries since individuals can sue.

Actuaries: A word of caution.

In APRA’s experience, actuaries provide a valuable professional service but it is not sufficient for a prudential supervisor or for company management to rely only on actuarial analysis. One would never go to an investor and say – here is the earnings forecast by an equity analyst and it looks good and so invests in this company. Actuaries, analysts, and economists have similar tools and similar limitations.

The conclusion is that actuaries must be valued but they are not infallible. Actuarial analysis is not an excuse to stop thinking of the business as whole. Actuaries can be relied on to do a good job from the assumptions to the final number. The arithmetic is fine but the assumptions may not be. In the case of pensions, the assumption about earnings growth may not be entirely appropriate. In the case of general insurance, the assumptions for claim provisioning are fraught with variability. Therefore, it is important to examine the assumptions and variance in any analysis instead of taking it at face value.

The importance of disclosure

APRA has a sister agency called ASIC (Australian Securities and Investment Commission). It is a securities regulator and a consumer financial education regulator. This agency manages disclosure issues. APRA is not primarily focused on disclosure. Australia has a public register of licensed insurance companies, pension funds, banks, as occasionally a fraudster is tempted to set-up a bank or an insurance company. Therefore, the details about any company are useful from a disclosure perspective. To go beyond that, for example to the disclosure of an individual institution’s PAIRS ratings, is not particularly useful. APRA feels the ratings work better when kept private. Despite all the rhetoric about consumer education the average person does not understand the contract he or she is buying. This is why regulatory intervention is necessary to ensure that individuals get a minimum standard of safety on any contract. In conclusion,


disclosure is not a substitute for prudential supervision. It concerns a security regulator more than a prudential supervisor.

Conclusion

General insurance risks are tougher to predict than banking risks. Banks have some general idea of what their assets are worth, whether a loan is performing and secure. Whereas, in general insurance there is an estimation of claims from a property portfolio or a catastrophe liability portfolio but that number can be off by a factor of two or three, depending on the nature of the estimate.

Therefore, general insurance is always going to be a more capital intensive and a more volatile industry than banking. This is not a reflection on the competency of management but simply of the high degree of variability in cash flows. Over the past ten years the ethics and honesty of those managing insurance businesses has been less than expected in Australia. APRA has dealt with it largely but careful supervision is needed, particularly of the risk versus sales culture.

In life insurance, offering long-term guaranteed payment streams is a risky business and a lot of capital and sophisticated risk management is needed to support such a business.

Every nation is entitled to a productive insurance industry. Australia has it and Indonesia is moving in that direction.


Enhancing Credibility of the Insurance Industry: The Stakeholder View of the Capital and Risk Balance

David Finnis Senior Actuary

Insurance Australia Group (IAG)

In the move from a rules-based approach to a risk-based approach, the actuary is becoming the new lawyer. An actuary is in a position to interpret risks the way a lawyer interprets rules. The basic message here is that an actuary can improve the certainty of risk measurement and, by improving that certainty, enables some convergence between the analysis of risk and the capital being provided to support that risk. It is important that the actuary is aware of the limitations of his analysis: “certainty” for an actuary means “shades of grey”. An actuary considers certainty on a scale of zero to ten and attempts always to move closer to a final ten but there is no such thing as complete certainty.

As an investment, the insurance business is a capital-hungry one. The requirement for capital is a result of the variable nature of the claims. There are attritional claims and catastrophe events to consider. Then there is a latent claim cost. A good example of this is asbestos-related claims. The insurer does not realize the extent of the exposure when he starts covering the industry. There is a high regulatory cost due to the nature of the business that takes up some capital. There are uncertain investment returns and political factors to consider. A change in the political background can affect the incidence of claims through a change in the law. There are competitive influences. In addition, there is the re-insurance cost to consider.

On the positive front, if an appropriate amount of capital is set aside for the business, then a reasonable return on that capital can be established and loaded into the premium as a profit margin. Actuaries have an objective approach to profit margins. Actuaries think of profit as the risk-related return on capital supporting the business. From the perspective of asset-liability management, it is important to look at the volatility of returns on investments and compare them with the volatility of returns on the liability side of the balance sheet. A scientific approach to liability calculation and provisioning can obviously improve the tangibility of that comparison. The balanced capital support refers to the balance between protecting the policyholder and other stakeholders. Finally, insurance has an important role to play in oiling the wheels of the economy. The insurance business enables other businesses to be more efficient. It enables businesses to pass on risks to the insurance industry and focus on running their core business smoothly.

Australia had a liability insurance crisis a few years ago. Liability and casualty insurance was in short supply. Companies faced a problem obtaining the appropriate public liability insurances leading to considerable public panic.

The agenda includes improving confidence in risk measurement and business returns through actuarial controls. Australia has a clear risk management structure to assess the management of the risk and has an efficient way of targeting and allocating capital needs of the business. The country also looks at ways of reducing the volatility and the asset-liability management or matching processes.

Using re-insurance to minimize claim volatility and various aspects of operational risk management is a challenge for an actuary since it does not follow the standard actuarial modeling rules.


The centre of all insurance businesses is a capital requirement (see figure 68). Emerging from this capital requirement is claims provision and reserving. This leads to an efficient and more tangible approach to pricing and premium rating then to the risk management of the business and then to performance management and data improvement. The quality of data improves when the right questions are asked in the performance management and risk-management processes. From improved data, one can improve the claim estimation reserving process and through an intuitive approach, one can achieve a better approach the risk management in the business. Very often insurance companies have scant regard for risk management. If the data is not available when required then it is likely that the company has not been through this control cycle.

Figure 68: Capital: The Driver of Insurance Control Cycle

Risk Management

Claims Estimation and

Reserving

Performance Management &

Data Improvement Pricing/Premium Rating

Capital

The need for capital

The definition of capital is total assets less total liabilities but care is required when using this definition for capital management. Often companies include intangibles like brand value or goodwill as assets and this needs to be withdrawn when defining capital from a capital management perspective. If the company is using a margin in the provision that is beyond the minimum supervisory margin requirements, then, in Australia, these margins are effectively pseudo capital. Capital provides a support in the face of unexpected claim outcomes and provides a base to grow. It provides security to policyholders and if measured accurately provides for optimal capital management. Capital plays a central role in insurance provision through diversification of risks. The more varied the risks underwritten, the lower is the capital need per unit of risk (all other things being equal).

Capital management comes down to balancing shareholder concerns for profit and policyholders needs for security. Both policyholders and regulators prefer more capital since it provides for better security and higher credit ratings. Shareholders prefer less capital as it means higher returns. Stakeholders need the best available return in the business to protect the policyholder’s rights. However, less capital also means higher risk and therefore a compromise that balances out both viewpoints is needed. This compromise is called the Target Capital.

The Insurance Australia Group (IAG) has an internal model based on probable outcomes that enables the company to determine the appropriate capital requirement based on an actuarial approach. The model uses a set of assumptions and a rigorous iterative process. The board of the company and senior management vet these assumptions before they are used to set-up the capital requirement. The Australian regulator, APRA, provides a risk-based minimum capital


requirement. Therefore, the IAG or any company can relate the target capital to the minimum capital requirement and pick a range above that number.

Risk Management Structure and Approach: The IAG Perspective

The governance structure is a basic essential for any risk management process (see figure 69).

Figure 69: Governance Structure

Board of Directors

GoalsPolicies

Performance monitoringConformance monitoring

Audit Committee

External Financial ReportingExternal audit engagement

Internal audit plan/co-ordinationFinancial/capital governance

Chairman’s Committee

RemunerationBoard composition

HR policiesSocial responsibility

Risk Management andCompliance Committee

Risk Management StrategyOperational Risk management

Asset/Liability controlsUnderwriting, Pricing and

Premiums Control

A Board of Directors sets the company goals, the strategy for achieving these goals, and the company’s risk appetite. The board also monitors overall performance and conformance with policy. IAG has three independent committees, comprising Board Members and Members of Executive Management. The first committee looks at audit requirements, external financial reporting, the internal audit process, and the financial and capital management of the company. The second group is the Chairman’s Committee that looks at the remuneration of senior executives and human resources policy to ensure that the company is attracting the right kind of people. The committee also looks at social responsibility, which is an important part of doing business for IAG. The company considers involvement in socially responsible programs as good for business. The idea is if potential and current customers can start thinking of risk mitigation, it will reduce claims costs in the long term. The company can also offer a lower premium to clients that take risk management seriously.

The third committee is the risk management and compliance committee. This committee looks at risk-management strategy and provides APRA, the prudential regulator, with the required data. There is an operational risk committee, which is a sub-set of the risk-management committee. In addition, there is an asset and liability committee, which looks at asset strategy and setting liabilities for claims and unexpired premiums. It also sets strategy for the inter-reaction between the two. Finally, there is an underwriting pricing and premium control committee to ensure that company has the right risk management to support new business.

The risk management structure is prepared to manage different kinds of risks

The corporate and strategic risk framework supports the corporate planning network. The capital management risk focuses on calculation and maintenance of the appropriate

target capital for the company. The underwriting reserving risk maintains the underwriting principle to manage claims. Claims management maintains a high standard of management of the payment of claims.


The liquidity risk ensures enough cash flow to meet all reasonable potential outcomes from

the business. Investments and derivatives cover IAG asset-management and responsibilities that includes

the asset and liability process. Re-insurance risk covers the management of the capital. IAG has a subsidiary re-insurance

company, which deals with the reinsurance needs of the business and manages the cession of that risk to the external re-insurance market. The goal is to improve the efficiency of reinsuring company risk.

Credit quality risk looks at credit quality in terms of investment and also the re-insurance that we used, premium funding use by intermediaries and all sorts of sources of credit risk.

The most difficult one from all perspectives is operational risk, which identifies and defines risk in a range of operational areas and re-enforces the required policy.

There is value in the actuarial approach to the insurance claim reserving process or claims provisioning (see figure 70).

Figure 70: Risk Measurement: The Insurance Claims Process

Complete

Amount of Information

NilTime

Occurrence Notification Quantification Settlement

All claims occur at a point in time. There is a time lag between the time the claim occurs and the time that it is reported. Gradually, that information comes in until the claim is finally settled. There are different kinds of claims and different processes. An actuary groups similar kinds of risks together in a manner that makes sense. This is the actuarial approach to claims estimation discipline. Past experience of similar risks is a guide to future outcomes from existing outstanding claims. Relevant trends in average cost and frequency may be included in the methodology and risk margins can be added to allow for uncertainty in outcomes. Where there is no significant experience available, the actuary uses industry benchmark data and examines the exposure to risk, particularly in areas where the risk of claim is relatively infrequent.

Australia uses an actuarial certification process. The regulator requires an actuarial report on all outstanding claims and estimates of the claims liability to be submitted to the board of directors. The board does not have to accept the estimate but needs to explain any rejection. This estimate is not a matter of absolute certainty but offers a “darker shade of grey’ on the possible outcome of claims.

The process itself provides a standardization of the approaches and improves the confidence in claim reserves in the market. The Australian actuarial profession was initially worried about this standardization, thinking that it would restrict the profession’s freedom and the ability to analyze risks in different ways. However, in practice, the approach is working well at this stage. Instead of


restricting freedom, the approach enables individual actuaries to understand how other members of the profession are approaching the claims reserve.

Risk Measurement – Pricing the Risk

In the control-cycle outlined earlier, the claims information is used as an input to the premium and pricing of risk process. The risk premium consists of the risk of the frequency of claim, expectation time, and the average cost of that claim. A few other specific costs load into the premium comprised of acquisition and maintenance expenses (including commission), taxes, levies, and duties. There are reinsurance costs and the profit margin.

Once the claim reserves, the prices, and premium rates for the business are set, it is necessary to monitor the rates. Actuaries are wrong as often as they are right. There is always going to be uncertainty. However, a risk-management, measurement, and monitoring process that enable the actuaries to pick-up differences as they arise can improve the data process. It leads to an improvement in the process for analyzing risk and produces data upgrades as required. The system triggers off alarms as and when required.

Asset and Liability Management

The practical approach says that low-risk investments should support insurance provisions. “Low-risk” means government securities. There is more freedom for capital (net asset) investment, for example, to invest in equities. From a theoretical basis, there is a need to examine the interaction between assets and liabilities. It suggests that assets should mirror the liability by type and term. For example, the liability is not completely risk-free if it is three years in the future. This kind of liability will be subject to inflation. To look at matching the asset and liability position, which is what ethics demands, is difficult in the general insurance industry. There is uncertainty about the term of the liabilities. In addition, the asset needed to match that liability term may not be available.

Reinsurance

The principle of reinsurance is to use reinsurance in cases where the reinsurance premium is less than cost of servicing the alternative capital. In practice, there are many other considerations.

Increase new business capacity Reduce “strain” by sharing the risk Limit effect of catastrophe claims Diversify risk Transfer investment risk Gain knowledge of products and markets Cede unwanted business Improve financial management Limit total claim cost (mainly relevant for small insurers) Observe government requirements

Sources of Reinsurance

The traditional source of reinsurance is international markets. The major players in this field are Swiss Re and Munich Re. Hurricane Katrina has had a negative and a positive effect on the international reinsurance industry. The negative effect is that it increased the reinsurance for this


kind of catastrophe for North America. The good news is that insurers are looking for ways to diversify that risk and other parts of the world, such as Indonesia, so you can benefit from that diversification. In Australia catastrophe reinsurance costs actually reduced after Katrina, because the industry is seeing a greater desire for Australian risk from the international reinsurance companies.

In theory, the capital market can deliver many benefits and could provide reinsurance coverage. In practice, it is very difficult to establish the critical mass required. Catastrophe bonds and derivatives are the usual methods. There is also the option of captive insurance. Various Asian countries make it necessary to reinsure some of the risk within the country in various different ways.

Catastrophe reinsurance has special needs in countries like Indonesia. The standard ten percent reinsurance model has a passive effect in dealing with reinsurance needs. Indonesia needs to see a more focused approach for management of catastrophe risk.

Operational Risk Management

Operational risk management is a difficult area for actuaries. Actuaries look at past experience and project that into the future. This works well for a particular kind of operational risk that is high frequency and yet has a low average cost of loss severity. But a rare operational risk that shows up infrequently needs scenario analysis. In Australia, for instance, fraud and security risky is a key issue. The Insurance Australia Group employs over 200 people to look at fraud and security risk. Australia has several instances of fraud in the consumer community.

The second kind of risk in this category is agency management risk. This risk comes up when an agency takes over a business. In this case, there needs to be clarity about who owns that business and ensure that agency management is carried out in a manner that reflects that position.

General capital management issues can be explained through a tower of capital. Capital needs are a combination of a number of requirements.

Reinsurance: Rented Capital Benefit realised through smarter reinsurance programs

Additional Economic Capital to maintain “Target Capital” needs

Statutory Capital: This is dependent on the regulator’s “Minimum Capital” requirement

Risk Margins: There can be a theoretical reduction from diversification although this is subject to regulatory constraints

Net Central Estimates

A model of target capital needs is created using this information and is expressed as a range of acceptable target amounts. Some examples include:

Minimizing the “Risk of Ruin” less than once every 500 years. Staying above statutory minimum requirements with a high probability (at least 99%) Restricting the chance of a need to inject capital (where the “injection point” may be based

on a multiple of minimum capital needs) Longer term horizon measures

In conclusion, actuarial influence will add certainty to the assessment of risk. The definition of certainty is measured in shades of grey here - from the zero position to the one position. This


leads to a more efficient management of risk. There are two potentially different jobs in any insurance company -- one is the capital management process the other one is the risk management process. The goal is to convert two jobs into one process. Effective analysis of risk makes this easier and improves overall market confidence. The market becomes aware of risk in more tangible way and is more confident about supplying capital to manage that risk and own businesses that deal in that risk.



Fair treatment for poorly-capitalized companies in the industry

Global experience indicates that if a troubled insurance company cannot get itself out of trouble the regulator needs to intervene as quickly as possible. The sort of intervention depends on the state of the insurance industry. If there is a choice between no insurance industry and a poorly-capitalized one, there needs to be a balanced intervention. A regulator should strive for a balance between the right of the policyholder to have claims paid and the right of the company not be treated unfairly by the regulator. In Australia the regulator is very firm about the amount of capital required to run the business. Every country handles this situation with a different balance and definition of fairness.

The capital strength in the Indonesian industry has improved substantially in the past few years. Indonesia has some marginally and poorly-capitalized companies but also some well capitalized companies. Now the companies that are left behind cannot complain about being treated unfairly.

Corporate Governance

There is no standard practice for a regulatory approach to corporate governance. When HIH failed in Australia, the company’s corporate governance system was carefully examined. In principle, the company had a sound structure but the application was poor. At the time, APRA was a new organization and not completely conversant with the management process requirement. APRA’s approach to supervising corporate governance is now much stronger. The supervisor goes through the board minutes and reviews the process carefully. The formal governance policy is scrutinized but so is the application procedure. This rigor was lacking in the earlier approach.

Therefore, the regulator needs to ensure that the corporate governance structure is actually being applied in the manner that is set out in the risk-management and corporate governance policy strategy. As long as these actions take place, it matters less whether it is done through a regulated process.

Risk-based capital measurement and the requirement for minimum paid-up capital

Indonesia has a risk-based capital measurement regulation and this raises the question of whether a minimum paid-up capital is required in this kind of regulation. In Australia, the new risk-based management capital approach was introduced in 2002. That approach substantially increased the amount of regulatory minimum capital required. This has worked better than the previous system. If the company takes on new risk, it will require new capital. If the company reduces the risk, the capital requirement will decrease. The Australian system has specific rules about the amount of claims reserves a company should have.

Those rules tend to favour larger and more diversified companies. Focused, small companies have a higher variance in their claims and therefore need higher reserves. The regulator also has explicit capital rules which are neutral towards small and large companies but not neutral between classes of business. Long-term business requires more capital than short-term business. There is a split in the approach to risk and so far this system works better than the previous one. In Indonesia, the rules seem to be sensible in the context of global trends in risk-based capital.

The Australian system looks at risk in two different ways. One is to look at risk from an internal modelling perspective. To IAG, for example, risk is specific to the company. It depends on the way


the company runs the business. If that perspective tells the company that the capital requirement is fifty percent more than the minimum level designated by APRA then obviously the company would do so. If the model indicates that the capital requirement is ninety percent of the APRA minimum, then that is an option as well. The company can apply to APRA to have the internal model authorized. Convincing the market is a difficult job but in principle the company can move towards the appropriate capital for the business.

There is one step the company can take when the risk-based capital of the company is close to the minimum regulatory capital. The company can model the risk internally using dynamic financial analysis and a range of different techniques and it can demonstrate that the real risk-based capital is less than the regulatory proxy determined by industry factors. In this case, maybe, the real risk is less than the market proxy suggests. In practice, this is difficult because the market tends to believe the regulators proxy. The only course is to increase the capital at the end of the day.

Disciplinary action against actuaries

In Australia, there is a defined disciplinary process that enables anybody to make a complaint about an actuary. In theory, if an actuary engages in criminal conduct or fraud or deception, it is a matter for the police and the public prosecutor’s office. In practice, actuaries have issues with management. In the case of HIH, the lead actuary is banned from the industry and can no longer practice. A junior actuary, who was aware that the data was incorrect, but did nothing about it, will be eligible to practice in 2009. A number of other individuals have been sanctioned.

APRA has a process in the general insurance business called ‘approved actuaries’. An actuary cannot practice in the general insurance business without prior approval by APRA. Life insurance companies have a similar process called “appointed actuaries’. The Australian approach for actuaries that do not comply with the standards of the profession is to get them out of the business.

Traditionally, the discipline process applied by the professional associations for actuaries, accountants and lawyers has not been satisfactory from a regulator’s point of view. But to its credit, the actuarial profession has tried to revise the disciplinary process, and hopefully will be able to impose some industry self discipline.


Adjusting to the New Pension Environment

Yves Guerard

Secretary General International Actuarial Association

The fundamental objective of a pension system is to provide financial security during retirement. It implies providing life annuities that meet the agreed target income replacement ratio for the full post-retirement period. Taxes and expenses often neglected factors. The target replacement ratio should be on a net-to-net basis (after taxes). The expenses of managing a pension scheme increase costs or reduce benefits and need to be minimized through proper plan design and infrastructure. The total benefit need not come from a single source. There needs to be a balance between public and private provision provision, and resources from individual savings, and other income-generating assets.

Prior to law 40, there was the law 11 of 1992, the labor social security law 3 also from 1992, and the labor law 13, which has been amended repeatedly. The key characteristics of Indonesia are:

Low coverage and low levels of long-term assets characterize the country. Indonesia has 100 million workers with no real social security system. The coverage of the formal sector is just twelve percent.

Low accumulation of long-term savings (3.5% of GDP). A big part of this is represented by the government employees programs, mainly on a pay-as-you-go basis.

Low coverage and under reporting in the existing Jamsostek mandatory savings program. It is fully funded but generates low long-term asset accumulation because the money is paid out as lump sums at retirement or earlier termination.

A voluntary occupational defined benefit (DB) or defined contribution (DC) plans, or individual defined contribution plans operated on a funded basis but private coverage is very limited.

Generous termination and long service benefits are mandatory under Labor Law 13, and therefore apply to the entire workforce, but are mostly unfunded and do not contribute to long-term asset accumulation.

Mandatory Benefits under Labor Law 13

These are very generous severance and long service benefits. A study from the Pajajaran University ranks them amongst the highest in the world. The Labor Law mandates them for private sector employers.

Not legally deemed a pension plan under Law 11 but provides lump sum termination benefits at retirement and is very similar to Jamsostek benefits.

Even though rarely prefunded, accounting rules require annual reporting on an accrual basis. The burden may represent up to eight percent of payroll in addition to Jamsostek mandatory

contributions. This gives a high degree of competition to voluntary schemes. The number of employer

pension plans has been decreasing from a peak of 344 in 2000. The number of employer pension plans has been a small number for a country the size of Indonesia and is getting smaller.

The main causes of plan closure were bankruptcy and financial difficulties of the sponsor, especially because of the 1997-98 financial crises.

However even though the economy picked up, there was virtually no creation of new occupational plans.


Growth in participation occurred only in financial institution pension funds. About 2,500

employers have registered some or all of their employees in these funds and pay contributions on their behalf instead of creating their own occupational scheme.

Indonesia is facing a strategic challenge. Fertility and mortality rates have fallen. Life expectancy has increased. The combination of the two pushes the dependency ratio up. Indonesia needs to prepare for adverse demographic forces, although currently it has a very young population. Indonesia needs to build up the retirement income system and increase contractual savings to grow long-term assets and make Indonesia less than 85 percent bank-centric. Countries that have a more equal balance of between banking and capital markets are stronger.

As in many countries, the drop in fertility relates coincides with urbanization (see figure 71). The numbers show that fertility rate is dropping faster in Jakarta.

Figure 71: Total Fertility Rate J

1.5

2.0

2.5

3.0

3.5

4.0

4.5

5.0

5.5

6.0

1967-1970 1971-1975 1976-1979 1981-1984 1986-1989 1991-1994

Jakarta Indonesia

The following graph shows the correlation between market capitalization and contractual savings. Contractual savings are important to increase capitalization (see figure 72).

Figure 72: Market Capitalization and Contractual Savings

9

1996 (% GDP)MC/GDP

CS/GDP0 .5 1 1.5

0

.5

1

1.5

2

AUS

AUT

BEL

CAN

CHE

CHL

DEU

DNKESPFIN

FRA

GBR

GRCHUN

ISLITA

JPN

KOR

NLD

NOR

NZL

PRT

SGP

SWE

THA

USA

ZAF

Long term assets can better sustain economic growth in particular infrastructure


The country has some options to fix the situation.

Transform Jamsostek savings and Labor law 13 benefits into retirement income thus generating long-term assets. Instead of paying benefits as a lump sum, the country could use insured life annuities or a payout mechanism like a life income fund for structured settlement. This is used in Canada, although for Indonesia it would be insufficient to meet the challenge but would be a start.

Relaunch the growth of voluntary occupational plans or maximize the use of FIPFs since current private coverage is way below expectations.

Increase coverage through a national social security program providing Basic protection to a large part of the labor force, Poverty alleviation through redistribution. Insurance against longevity through life annuities.

Countries with a larger proportion of the population in higher age groups need to spend proportionately more on public pensions (see figure 73). This could be a concern for Indonesia and it is important to start right away to meet that concern.

Figure 73: Relationship between percentage of population over 60 years and public pension spending

Percentage of population over 60 years oldPercentage of population over 60 years old

5 10 15 200

4

8

12

16Pension spending as percentage of GDP

Jamaica

Israel AustraliaJapan

AustriaItaly

Sweden

U.K.

FranceLuxembourg Greece

China

Uruguay

PanamaCosta Rica

U.S.

Poland

Goals for a National Strategy

Different countries have different solutions but there needs to be a national strategy to meet with some basic goals.

Primary goals: Adequacy and Equity: fairness, efficiency, redistribution Feasibility and expandability: administrative issues, UNI, scalability, flexibility, addressing the

informal sector. Sustainability and robustness: affordability, financial soundness, resilience to shocks from

economic, demographic, and political risks. Diversification and customization: multi-source, individual choices, and flexibility. Secondary goals: To create developmental effects by Minimizing negative impacts (e.g. labor market) Leveraging positive affects (e.g. financial market development).


An important further objective could be to combine public and complimentary private sector systems. Globally, the public system tries to meet the adequacy objective of poverty alleviation. There is a nominal amount predicated on a percentage of the participant’s average earnings set at a level at or near the minimum wage such that the wage earner near the minimum wage gets an adequate replacement ratio and is not expected to participate materially in the complementary system. The second objective is to facilitate a higher replacement rate for other wage earners. This is not a public responsibility and should be met by earnings-related funded programs. These are provided by public or private systems and are voluntary or mandatory. The more important point is that there should be some competition to ensure efficiency.

A third objective is covering non wage earners and the informal labor force. This is a much bigger challenge. The sector can be covered but probably only based on nominal amounts. It is hard to determine earnings in this sector.

Ambitious and High Risk National Programs: Law 40 of 2004

The law was adapted in September 2004 and is an ambitious piece of legislation. It is still to be implemented and proposes a high-risk national program.

The national strategy for Indonesia has been pre-empted by law 40. It aims at a comprehensive social security system, creates high expectations by claiming to provide a wide and universal coverage. It entrenches a monopoly and oligopoly of providers and links management of assets to benefit administration. A tactical solution would be a sequencing of decisions that would re-open the market.

The law has a highly succinct framework. It stipulates five universal programs to be implemented nationally.

Heath services (not insurance) Workers compensation (occupational accident) Retirement savings (DC) Retirement pensions (DB) Death benefits (Funeral expenses)

It has a two-level structure for implementation:

A National Social Security Council (DJSN) advising the President and has no coercion power over the system.

Four monopolies to manage assets and benefits administration.

It mandates universal participation and compulsory contributions by employers and workers but the law does not stipulate the amount of contribution or amount of benefit. It is open-ended on amounts and benefits beyond generic references and therefore leaves significant uncertainties.

The law speaks of the national system and states that the aim is to provide cover gradually, across the country, all components of labor force, formal and informal, poor and economically disabled. The name of system indicates that programs are to be managed “nationally” but it is not clear if there will be uniform treatment across regions or centrally defined rules. There is no clear transition path from existing programs and differences in compensation structure. The integration of the public sector labor force is unspecified. This is a very important consideration as there are almost five million people covered in the civil service pension plan. The concept has to be reconciled with the monopoly granted to four administrators, each potentially managing up to five funds.


Another challenge of Law 40 is to manage expectations. Article 3 states: ”The National Social Security System has the objective to provide assurance of the fulfillment of basic needs of life for every member and/or his/her family.” That is a beautiful objective but not feasible in my opinion. The use of general and generic terms such as “humanity”, “social justice”, “decent life” and basic principles such as redistribution, non-profit, openness, prudence, accountability, sound good in the constitution but can lead to practical and legal difficulties when it comes to detailed pension system legislation. International experience shows that countries have encountered problems when they promise too much. This is the reality in Indonesia. It is my opinion that the country now or in the near future cannot afford a very expensive program.

The monopolistic approach of Law 40 does not make room for competition nor for mobilizing resources from the private sector. Experience suggests that diversification of the sources of post-retirement income is helpful to increase robustness and resilience as demographic evolution increases the burden on the state. Some burden needs to be shifted to the private sector which must gradually build up additional capacity to produce goods and services to be consumed by an increasing number of retirees. Complementary private schemes, personal or employer based, can allow a better fit between individual needs and preferences and hence contributes to increasing the efficiency of the system as a whole.

There are many variations around the world. A recent publication of the World Bank in 2005 titled Old Age Income Support in the 21st Century tries to summarize these differences.

Zero Pillar- Non-Contributory Social Assistance for Lifelong Poor. First Pillar - Publicly financed and managed PAYGO system to provide basic income

protection. Second Pillar - Mandatory funded individual account system creating direct linkage between

contributions and benefits. Third Pillar - Voluntary pension savings, individual or occupational, DB or DC, privately

managed. Fourth Pillar – Family and Inter-generational support for the elderly.

One of the most important aspects of this structure is the challenge of managing the balance between re-distribution and savings. This can be accomplished in a number of ways.

Balance the national retirement financing strategy. Minimize the assets in publicly managed re-distributive components addressing poverty alleviation. It can be financed by a long-term percentage contribution that respects intergenerational equity. Assets in funded components, public, or private, should be under private management for better economic allocation and higher wealth accumulation.

Points to the importance of expanded private coverage and professional management of pension assets.

Existence of basic protection impacts on employers’ strategy for design and funding of complementary occupational or individual plans that address the need for higher replacement ratios at higher earnings levels.

Across the world, the performance on publicly managed assets is disappointing (see figure 74)


Figure 74: Returns versus bank deposits

-1.8%

-12%

-10%

-8%

-6%

-4%

-2%

0%

2%

4%

Japan

Korea

Philippines

Sweden US

Malays

iaIndia

Costa R

ica

Morocc

o

Singapore

Canad

a

Jamaic

a

Kenya

Guatem

ala

Sri La

nka

Ecuad

or

Egypt

Venez

uela

Zambia

Uganda

Avera

ge

Robert Pallacios, Managing Public Pension ReservesWorld Bank , September 24th 2001

Under these circumstances, the national strategy can take a number of steps.

Provide adequate basic retirement income protection on a fair and equitable basis to the whole labor force. The dual stipulation in Law 40 of DC Savings and DB life pension needs to be reviewed. Educational programs to mitigate individual preferences for lump sums toward life pensions will help. There is not much point in building a complex system to accumulate capital at retirement and see that capital wasted in a few months due to a lump sum payment.

Make room for the growth of complementary occupational or individual programs (Employer Plans and FIPFs) to provide replacement rates based on standard of living through accumulation of long-term assets that can then fund life annuities.

Mobilize existing long service benefits from Law 13 and Jamsostek lump sum accumulations to generate basic retirement income.

Replace Labor Minister ruling of May 29th 1995 stipulating retirement at 55 with a gradual age increases reflecting expected life expectancy to stabilize costs. Without this initiative, the dependency ratio of those age 55 and over compared to the working age population will rise from a current level of seventeen percent to forty percent by 2050. Overall, people who are working until a later age are better for the economy.

The population pyramid is getting fatter as fertility decreases and longevity increases (see figure 75). The pyramid on the right is wide at the base supporting proportionately fewer old people. In time, the situation is reversed.

The point here is that the future will be different from the present and countries need to start preparing for the future because dependency ratios will increase. One way to mitigate the increase in dependency ratios is to address the issue of the normal retirement age. There is a dramatic difference between the old age dependency ratio when the normal retirement age is sixty-five compared to a normal retirement age of fifty-five as it is now (see figure 76).


Figure 75: 2000 and 2050 Population Age Pyramid UN Projections Indonesia Population

Age PyramidUN Projections - 2050

-15000 -10000 -5000 0 5000 10000 15000

0-4

10-14

20-24

30-34

40-44

50-54

60-64

70-74

80+

Male Female

Indonesia Population Age Pyramid

2000

-15000 -10000 -5000 0 5000 10000 15000

0-4

10-14

20-24

30-34

40-44

50-54

60-64

70-74

80+

Male Female

Figure 76: System Dependency Ratio

0%

10%

20%

30%

40%

50%

60%

70%

80%

2003

2011

2019

2027

2035

2043

2051

2059

2067

2075

2083

2091

2099

RA = 55 RA = 60 RA = 65

Conclusion

The public responsibility should be focused on adequacy, an adequate level of basic protection. It should not be to ensure personal living standards. That is the responsibility of individuals and their employers. Even with Law 40, modeling can determine the basis of a consensus on the National Social Security System that could relaunch the growth of complementary employer pension funds and FIPFs.

The aim of the national system is the mandated basic direct benefit pension, set at an adequate level for poverty alleviation. This can be achieved through a flat benefit for the formal labor force with a short transition period. This should be exportable to non-wage earners, the informal labor force, poor and economically disabled. A flat benefit pension can be better modulated, produce faster results at affordable costs with lower risks. An earning-related program, DB or DC, requires a complex set-up and robust administration to deliver benefits after a longer implementation delay and a longer period to achieve maturity of benefit level entitlements and with higher risks. Complementary programs to achieve higher replacement ratios targeting the individual’s


standard of living can be offered on a competitive basis by a combination of private and public programs. Indonesia needs to get started sooner rather than later.

My proposal is to end the moratorium on wide private sector service provider participation now by having a preliminary agreement on the levels of benefits that are reserved for the gradual implementation of a national system. This definition would open the market for the private sector to immediately start accumulating long-term assets under complementary programs. There is no need to wait for the final agreement on financing or implementation schedule of Law 40. This can be done in later phases.

The second area of attention would be to include an assessment of the impact on the labor force, competition, and fiscal equilibrium. These assessments would support agreement on the timeline for full implementation. Timing is an issue here, both for competitiveness of the economy and for poverty alleviation. The highly complex reform of Jamsostek and integration of Labor Law 13 benefits in the basic protection scheme can also be done in later phases in my opinion.


Adjusting to the New Pension Environment: Learning from Experience in Asia

Bob Charles

Head of Recruitment Benefits for Asia Pacific Watson Wyatt Consulting

There are three key issues in pension reform. Primary issues can be the most difficult to address and the most important. How large should be the role of social security? The second issue is the role of employers in pension provision. The third issue is the challenge of providing pensions to people outside the formal system – the unorganized sector. All over Asia and the world, governments are grappling with issue of pension reform. There is no perfect solution and no perfect formula. Asia’s big problem is that it is aging very rapidly, providing some stress to the social security framework. Countries like Korea, Japan, Hong Kong (China) and Singapore are all aging far more rapidly than Indonesia. Pension and social security costs in these countries are increasingly unsustainable.

The region has no shortage of savings but they are channeled towards short-term investments. There is an overwhelming reliance on short-term bank deposits and insufficient allocation to long-term investment instruments. The challenge in many Asian countries, including Indonesia, is to build a capital market to go hand in hand with pension provision. It is not feasible to have a funded pension system unless you have somewhere suitable to invest the contributions for the future.

Indonesia

Currently the workforce in Indonesia is young (see figure 77). As per UN estimates, the population continues to be balanced even in 2050. Indonesia is aging but certainly not at the rate of other Asian countries. This gives Indonesia a strong competitive advantage in the pension sector and an overall advantage over neighboring countries with older populations.

The country has a well-balanced and diversified social security system compared to certain other countries in the region like Korea and some other OECD countries (see figure 78). But it also has a less well-developed history of providing retirement benefits to employees. Clearly, there are problems in all the pillars of the system. For instance, Jamsostek is riddled with problems and has not been able to meet the goals the government set out.

Figure 77: Population Pyramid 2006 and 2050

05,00010,00015,00020,000Male population in '000

0-9

10-19

20-29

30-39

40-49

50-59

60-69

70-79

80-89

90-99

Total population: 225.3 millionSource: UNDP Population Projections

2006

0 5,000 10,000 15,000 20,000Female population in '000

0-9

10-19

20-29

30-39

40-49

50-59

60-69

70-79

80-89

90-99

Total population: 225.3 millionSource: UNDP Population Projections

2006

05,00010,00015,00020,000Male populat ion in '000

0-9

10-19

20-29

30-39

40-49

50-59

60-69

70-79

80-89

90-99

Total population: 311.3 mill ionSource: UNDP Population Projec tions

2050

0 5,000 10,000 15,000 20,000Female populat ion in '000

0-9

10-19

20-29

30-39

40-49

50-59

60-69

70-79

80-89

90-99

Total population: 311.3 mill ionSource: UNDP Population Project ions

2050


Figure 78: Indonesia – Pension System

Labour law payments

Labour law payments Employer plansEmployer plansJamsostekJamsostek

Mandatory termination lump sumSeveral components:

Severance payService payCompensation

Up to 40 months pay

Dana pensionsNew defined contribution environment (DPLK)

Mandatory Provident FundContributions

Employer: 3.7%Employee: 2%

Indonesia already has a diversified pension systemIndonesia already has a diversified pension system

China

China is an important case study as pension reform is high on the political agenda. As expected, the system is built very strongly on the foundation of social security (see figure 79). Social security in China is extremely comprehensive for employees in the formal sector (excluding workers in the rural economy and migrant workers). It includes health insurance, unemployment insurance, as well as pensions. Pensions are divided into two segments. There is a defined benefit old age pension and a defined contribution system. Most employers in China pay twenty two percent of the payroll towards social security just for pensions, and another eighteen percent of the payroll for health care and other benefits. It is an expensive system although not a very successful one. Benefit levels do not match contributions paid. A large part of the contribution is used to bail out historical problems in the system. About 30 million workers were laid off in the nineties and a majority of the contributions goes towards subsidizing this group. The system is already running a significant deficit. The assets fall short of the liabilities by about $US200 billion. As China ages, which it will do very dramatically in the next few years, this under-funding will only get worse (see figure 80).

Figure 79: Retirement Benefits in China

Vol

unta

ryS

tatu

tory

SocialInsurance

Pillar I

Employer

Pillar II

Personal

Pillar III

Enterprise Annuity/Supplementary Retirement Plan

Individualsavings

Defined Benefit:Social Pool

Defined Contribution:Individual Account

National Social Security Fund


Figure 80: Financing Social Insurance Pensions

How sustainable is the system?How sustainable is the system?

RMB billions p.a.

050

100

150

200

250

300

350

400

450

2004 contributions+ subsidy

2004 benefits

RMB trillions

0

0.5

1

1.5

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2.5

Assets

Actuarialliabilities

China’s problems indicate that there are pitfalls in setting up something too comprehensive. If the social security system is too ambitious and the financing insufficiently sound it can lead to severe problems.

The Chinese government is well are of the predicament and is introducing a series of reforms to reduce benefit levels. The latest reform was in January 2006 called Document 36. There were further cutbacks in the defined benefit part of the system. The government tried to improve confidence in the defined contribution part of the system by forcing the provincial governments that administer the system to hold real assets in respect to the contributions that employees pay into the defined contribution accounts.

This is good theory but there remains skepticism on whether it is going to solve the problem, partly because the financial amount is so big and there are concerns that it may be out of control. Secondly, the central government leads the system in China but the provincial governments administer it. It will not be so easy for Beijing to convince provincial governments to comply with new rules.

The second strand of the Chinese response is not only to scale back social security, but also to encourage and build up employer pension provision, which has been crowded out by large social security benefits in the past. Last year the government introduced the concept of the enterprise annuity, a voluntary pension plan system for employers. Many employers in China have shown an interest in this new plan. Employers may contribute about one month’s salary and the system has a flexible plan design. There are some tax incentives to encourage employers to contribute but more important is the confidence the system is building. Most employees had lost faith in the current system and given hope of any true gain. Introducing a new pension concept such as the enterprise annuity goes a long way toward instilling confidence in social security. The system is transparent and there are controls to make sure that the funds are invested in a secure manner.

The new system has generated a great deal of interest from the fund management industry. China is a good example of how pension reform can go hand in hand with developing a financial services industry. The scope for fund management is tremendous. Take a hypothetical example. If there are 250 million urban workers and employer contributions average ten percent of salaries and the average salary of those in a pension plan is $US5,000 per annum then with just a five percent take up of enterprise annuities this means contributions of $US six billion per year. (250 million x 4,000 x 10% x 5% = 6 billion per year).


The key lesson in China’s experience is that an overtly ambitious pension system can be unsustainable.

There is concern that family support is declining across Asia, including in China. However, these concerns in China may be overstated. The problem is a demographic problem and not a social one. China has a one-child policy. The 1+2+4 family pyramid in China (one child, two parents and four grandparents) makes it difficult to support the previous generation. Family support is easier to deliver with a younger population.

Healthcare is also very important. It leads to the question – should the state be spending so much on social security or should it be encouraging the population to save for their own retirement and focus on healthcare benefits? The issue will become increasingly important in an ageing society.

Employer Pensions

Employer provision is a good thing. There is no argument about that. Throughout history, employer provided benefits have had an important place for various reasons stemming from recognition for life-long service, to protection for dangerous jobs, union demands, and tax incentives and more recently, market competitiveness.

The following graphic shows the breakdown of assets in defined benefit and defined contribution plans across Asia (see figure 81).

Figure 81: DB versus DC 0% 20% 40% 60% 80% 100%

AustraliaChina

Hong KongJapanKorea

MalaysiaNew Zealand

Philippines

SingaporeTaiwan

Thailand

DB DC

___________ Source: Watson Wyatt, Benefits international article, 2005

The following graphic explains how employer pensions work across Asia (see figure 82). Countries such as Indonesia, India and Korea have the severance pay concept or the labor law system. It is a common form of retirement coverage across Asia but recently the region has been moving away from labor law entitlements towards funded pension benefits. This shift is occurring in countries like Singapore, Taiwan (China), and Malaysia, where the pension system is funded but is based on government central control.

The more recent trend in countries like Australia and Hong Kong (China) has been a funded retirement system. Here the government sets the rules but the actual accumulation of funds is operated by the private sector rather than controlled by government. It seems to be the preferred model of the future.


Figure 82: Pensions in Asia

Government Controlled

Severance Pay

− Indonesia− India− Malaysia− Singapore− Taiwan (2005)

− Indonesia− India− Philippines− Korea− Taiwan− Thailand

Mandatory Funding*

− Australia− Hong Kong

*Private Sector Asset Management

Voluntary Funding

− Indonesia− China− India− Japan− Korea− Malaysia− Philippines

Aside from Japan and Australia, the amount of money in pension funds is still small in most countries relative to the size of the economies (see figure 83). In ten to twenty years, the amount of money in funded pensions in a few countries like China, Thailand, and The philippines will be much larger. Hopefully, this will also be the case in Indonesia.

Figure 83: Where is the Money? $0 $100 $200 $300 $400 $500 $600 $700 $800

Japan

Australia

Korea

Malaysia

Singapore

Hong Kong

China

Thailand

Taiwan

Indonesia

Philippines ____________________ Source: Watson Wyatt study, 2005

Taiwan (China) and The Republic of Korea

These two countries have moved from a system very similar to Indonesia toward a funded pension system. Taiwan (China) changed its law year in 2005 from a labor law benefit (Labor Standards Law) providing a lump sum on leaving the company to a labor pension act (Labor Pension Act) that is a mandatory defined contribution system. By law, every employer has to pay six percent of payroll as a contribution to a pension fund. The issue with labor law, and one of the reasons that these countries are moving away from this system, is that the system does not provide an income for retirees for the entire remaining course of their lives. It is a lump sum paid when the individual leaves the company. This design works if the individual stays with the same


company for the whole of their working life. In Indonesia, many people do stay with one company for most of their working life. But as the economy develops, people tend to change jobs more frequently. For example, in Taiwan (China) and Korea, the average length of service with a particular employer is about five years. In this situation, labor law benefits are not an effective way of building retirement assets. Also of concern was the rise in employer costs.

In Taiwan (China)’s case, the move was relatively easy because the system provided generous labor law benefits, forty-four months salary on retirement. In order to qualify for that benefit, the individual had between fifteen to twenty five years of service. However, workers in Taiwan (China) tend to change their jobs frequently and this meant that most got nothing from the system.

The new defined contributions system is voluntary. The existing employers had a choice. In practice, over ninety percent of employers opted for the new system. It got off to a good start.

Some of the system’s success has to do with portability. The government centrally administers the system and when employees change jobs they do not have to change pension funds as the money is still invested with the government authority. Centralization can have a significant disadvantage as well. The government controls all the money and experience shows that returns from government-controlled funds tend to be low. There are similar issues with Jamsostek in Indonesia.

Korea is closer to the issues Indonesia might face when changing from a labor law system. Korea’s labor law system was very popular and therefore the government faced some resistance from employees when proposing a change. The government offered employers and employees three choices between continuing to provide severance benefits under the old system, or provide funded defined benefit pensions or funded defined contribution pensions. It is still not clear whether this approach works as smoothly as the one in Taiwan (China). Therefore, while Taiwan (China) needs to open up asset management, Korea’s voluntary approach may have limited impact.

India

The Indian pension system is similar to the one in Indonesia. There is a mandatory defined contribution system provident fund, which in many ways is similar to Jamsostek. The government controls it and the contribution required is higher than Jamsostek. Both the employer and the employee contribution is twelve percent of basic pay. The system also has a benefit called gratuity which is essentially a labor law benefit often funded by an insurance company. Finally, the country has a voluntary pension system where the employer contribution is fifteen percent.

The Indian system has two challenges. There are massive public sector pension liabilities. The pensions for civil servants, state government workers, and railway employees have been very generous for the past. The estimate of the shsortfall is between fifty and one hundred percent of GDP. This cost is now crippling some state governments where the cost of pensions is higher then the wage bill. The second challenge ifor the government is how to provide for workers in the informal sector. This is also a problem faced by Indonesia.

When faced with such a massive problem, it is important to be realistic. For agricultural workers, struggling to feed their families, providing pension benefits is not a priority. Social security in the form of education or health care maybe just as or even more important for these people. India has tried to produce a combined solution to the two problems and introduced a new defined contribution system applicable to new government employees from 2004. There has been some implementation issues and the plan is not yet fully up and running.

The government runs the plan but employees can choose from a selection of private sector fund managers. The intention is to have the best of two worlds. The system is portable as the plan is


centrally managed and employees do not have to worry about changing records when switching jobs and private sector fund managers handle the investment. Over a period, the pension system will be fully funded. The intention is also to include the informal sector through institutions such as the post office. Workers will be able to deposit small sums of money for their retirement. This is an optimistic goal and the informal sector is not going to participate hundred percent. But if the system is in place and there is transparency in the collection system, then it is possible to set a framework where rural workers and workers in the informal sector who do have the wherewithal to make a contribution are able to do so.

In my view, India is a good example of how not to conduct regulation. The country has a separate regulator for provident funds, the equivalent of Jamsostek for insurance companies in Indonesia, which are involved in pension provision. The pension funds and the tax authorities are entirely separate from these regulators. This has created serious confusion recently. The pension system in India operates on an EET basis but in the 2005 budget, the tax authorities introduced a new tax of thirty three percent on pension contributions. A large number of companies simply shut their pension schemes because it was no longer economic to run them. A year later, the government withdrew the tax, which has made the government look foolish. The point here is that it is important to have co-ordination across the regulators.

In conclusion, pension reform is difficult. Often trying to do too much can result in doing nothing. Social security is necessary in all countries but it is important to make sure that it is focused on real poverty reduction rather than trying to do everything for everybody. It is the only practical way to make the system work. Given this fact, the government needs to do more to encourage employer’s pension provision. In the Indonesian context, whether that means reducing labor law benefits and increasing employer pension benefits, or encouraging employers to use pension funds as a means of financing labor law liabilities. It is important to solve interaction issues between pension and labor laws for a vibrant employer pension market.



Labor Law 13

There are two types of law 13 benefits. There is the severance benefit and the benefits for long service. Long service benefits are more in the nature of retirement benefits. Reform is a challenge in every country. It needs to be explained that these benefits will come as a life pension, instead of a lump sum payment. The labor law representative has gone on record saying that lump sum payments disappear in three months. There is some understanding within the bureaucracy about the benefits of a life time form of pension as a benefit but the workers would need to be educated.

Increasing Retirement Age

Retirement ages have to increase, particularly in countries where governments have been making promises of social security at ages that now look much too young. Around the world, the concept of fixed retirement ages is starting to look a bit out of date and increasingly there are laws introduced in some countries which allow workers to keep working if they want to. Such a system gives people flexibility to make a choice and the pension system can be responsive to that choice.

It is not feasible to increase the retirement age by three to five years of age overnight. These changes need to be introduced gradually. The future expected rate of increase in life expectancy is open to debate but some estimates suggest a global rule of thumb of about one year every five years. So the retirement age needs to increase a bit faster than this to keep up and provide some fiscal gain at the same time. Countries have often increased the retirement age by one year every two to four years so that they move from fifty five to maybe sixty five over a period of twenty years. The US took twenty years or more to add two years to the retirement age. But the fact is that Indonesia needs to start now because the retirement age is already too low. Longevity is increasing and the system and people need to start preparing.

The argument that a higher retirement age produces unemployment, or does not generate jobs for young people, is false. There is a lot of data that proves the contrary. In fact, an economy that is prosperous creates many more jobs and the people who can monitor and train large work forces are the people with long experience. The economy will be better off if funds are utilized to encourage healthy people to continue to work rather than providing them with retirement benefits to do nothing.

Companies that are keen to provide pensions designed to their own requirements do not feel comfortable about having to pay contributions to Jamsostek. It is an issue in some countries, certainly in India. The contribution toward retirement is large and is sometimes resented by employers. In situations like Jamsostek, where the government is involved both providing benefits and regulating benefits (what employers need to pay and the extent to which the employers can replace their own pension arrangements with the governments arrangement), the government ends up competing with private pension plans. This tends to be a difficult situation. If the government is competing with private pension plans, then it gets difficult for the government to let private provision increase.

The best thing for regulators to do over a period of time is to focus on regulations but not provide benefits. This situation can be tricky to get out of.


Definition of the contribution base

The six percent contribution in Taiwan (China) is paid on all cash remuneration benefits. It includes salary and bonuses. In India the contribution rates are high; the contribution is twelve percent each from the employee and the employer. This works out to be a significant retirement nest egg for some employees. However, this contribution is only on basic salary and some employers and employees pay a total of only twenty percent (or as little as possible) on basic salary so, when other benefits are included in the base for comparative purposes, the pension contribution rate is much smaller.


The Insurance and Pension Markets


Rural Insurance

Phuong Chung

Regional Vice President and Chief Actuary AIG

Product Design in a Rural Economy

Over sixty percent of Indonesians live in rural areas. The income in rural areas is uneven and dependent on vagaries such as the season, land clearing, and chickens laying eggs. Evidence and documentation of identity is hard to come by. Insurance product design can be a challenge in this situation and needs to complement reality instead of trying to change it. For economically disadvantaged individuals, insurance is not about income-replacement for life. It is to do with their encounter with catastrophe, an accident or severe illness, and then getting back on their feet. It is all about eking out a living.

In this scenario, a low sum assured works better than a large sum. Larger sums tend to create skepticism about the probability of claim payment and the premium is too expensive. Expenses need to keep low to avoid unnecessary loading of the premium. Key expenses are distribution expenses, underwriting expenses, claim expenses, premium collection and administration expenses. For example, if there is a drought or an untoward incident that affects an individual’s income, the premium payment may be irregular. This can be a challenge in some countries. In India, due to religious reasons, cremation is almost immediately after death. In such countries there needs to be an efficient way to verify and fulfill claims.

AIG struggled with the issue of group covers or individual covers. Groups tend to be more cost-efficient for the insurance company to deal with but the group needs to be well defined or else the company will have to deal with the problems of anti-selection. There are many groups in a vast country like India and Indonesia formed for different reasons such as self-support or for running a business. It is efficient to piggyback on these groups and their infrastructure particularly if the administration is efficient. An insurance company should work with stable groups because demographic changes within the group have the potential to upset the company’s billing, risk management, and loss reserving. Mandatory groups are better than voluntary groups. As long as the sum assured is low and the premium is low, it is usually relatively easy to convince the group to facilitate providing a mandatory cover.

An individual cover has higher portability. Individuals tend to be more mobile now than ever before and can lose out if the insurance company does not track them efficiently. This model can have a savings element but it is not advisable to jump from providing basic protection to providing a pension from age 65. The savings element should be short-term and specifically targeted at short-term needs – like buying a cow. Otherwise too many clients lose when the policy lapses.

Product design must include accident and health elements. This must be designed either top provide a simplified policy acceptance and issue or even a guaranteed acceptance and issue, preferably the latter; otherwise, it takes away infrastructure meant for underwriting of funds. There needs to be an appropriate amount of targeted, focused, and short-term exclusions. Exclusions help underwriters but can be an issue at claim time. Shariah insurance is a unique aspect of the Indonesian market and can be leveraged to provide insurance for the masses.


Distribution

Distributing insurance to the masses is an expensive proposition. Building a distribution channel for a vast country like India or Indonesia is an expensive proposition. This cost needs to be managed carefully since premium rates in these markets cannot be loaded with high expense margins to meet costs. If the channel targets priority markets such as semi-rural areas or specific islands, it will be more effective.

The other option is to borrow or collaborate with a local distribution channel. Hindustan Lever, an Indian company and part of the Unilever group, has a majority share in the soap and shampoo market. The company has a stranglehold over the rural market and the company’s success – and distribution system - is built over decades. It is impossible to replicate it overnight. And soap and shampoo is not insurance. Insurance will take more time and more resources but it is possible to collaborate with a company like Hindustan Lever, or a non-profit company, with a similar reach.

Risk management and premium collection

The rural insurance business is all about cash. There are no credit cards, no banking facilities, and no cheques. The insurance company needs to rely on the partner to help collect this premium in cash. Often, there will be re-conciliation issues. Technology offers some solutions as demonstrated by an Indian tobacco company, called ITC.

The Indian farmer often is taken advantage of by intermediaries since he has no idea of market prices for the crop. ITC has set up a roving KIAS that branch out in rural areas during harvest time. KIAS uses solar batteries or generators to generate power for kiosks and computers that connect to the main server. The kiosks give the farmer accurate information on crop prices in the global, national, and regional market. Thus, the farmer has access to up-to-date market information and is less likely to be cheated by intermediaries. Now if an insurance company can piggyback on this technology and distribution, it will be possible to distribute insurance, collect premiums, and reconcile accounts efficiently.

In terms of products, single premium products or marginal products help reconciliation and collection. A marginal product is just a product that involves a series of single premiums. Additional premium payments lead to additional benefits however there is no loss incurred if payments stop.

Rural data for pricing and liability calculation is very difficult to come by. For example, data on rural mortality is usually non-existent. One recommendation is that the government put together an industry risk pool. The industry is willing to take some risk but beyond a particular level of losses the government can assist through a pool. The government would pay for the loss first and in the future collect an additional premium from the industry to pay for those losses. It is a good way to smooth out initial fluctuations and help the industry get started in covering rural masses.


Insurance Products to Increase Market Penetration

Mohammed Riaz

Senior Manager Business Partnerships – AVIVA Life Insurance Company, India

Indian Market Overview

One of the fastest growing economy in the world Financial sectors are well regulated Reserve Bank of India - Banking Securities and Exchange Board of India - Equity market Insurance Regulation and Development Authority - Insurance Pension Fund Regulatory and Development Authority – Pensions Insurance penetration in 2004* was 3.17 percent of GDP. Insurance World Ranking* - 19th Industry size *- US $ 21.25 Billion Life - 80% Non Life - 20% India’s share in global business* 0.31% Number of Life Companies** 15 Number of Non Life Companies ** 14 Industry growth rate (Nominal)* 17%

In India, failure to meet rural insurance targets meets with stiff penalties from the regulator. To meet these obligations, AVIVA has a partnership with the leading micro-finance company in India, called BASIX. A common problem in disadvantaged societies is that once the main income earner is lost, the family plunges back into poverty. Micro insurance can have a big impact in societies like this. Micro insurance is insurance for under privileged people within a certain income category who otherwise seem not to be insurable. The impact is best explained by Ramu’s story.

Ramu made 20 rupees a day, less than a half dollar to support a family of two children and a wife. He had a cycle repair shop but could not take on jobs that are more complicated since he did not have specific kinds of equipment. This cost Ramu some business. BASIX loaned him 5,000 rupees (USD 110) to buy equipment and he was able to overhaul cycles in the village itself. He also bought a few extra cycles and started a taxi service. His income jumped from half a dollar a day to USD 5 a day. The loan had life insurance built into it. If Ramu passed away, his family would get one and a half times the loan amount.

Unlike Indonesia, India has few insurance companies as the regulator has set a steep minimum capital requirement to start an insurance business in India. Not many global insurance companies will put that capital in an emerging country. Currently there is also a foreign stake limit at twenty-six percent of the total company equity. The industry has been growing robustly and future growth could come from the “bottom of the pyramid”. This is where micro-insurance is useful.

Traditional insurance is all about lifestyle protection. If the main income-earner dies then the insurance ensures that the family’s lifestyle is protected. However, for the disadvantaged, it is about livelihood (see figure 84). Micro insurance is about social orientation and responsibility but that is not enough to make this business grow. A business needs to make a profit in the long run to render it sustainable. The target customers are very different and reinsurance is not easily


available for micro insurance. The urban audience has a large range of products to choose from, whilst the micro-insurance has a limited suite of products.

Figure 84: Differences between Traditional and Micro-Insurance

Traditional Insurance Micro Insurance

The urban customer baseThe unorganised customer base

30% of the indian population

70% of the indian population

Have well defined cash flows

Dependence on sustainable livelihoood opportunities

Objective Commercial orientationSocial and commercial orientation

Need Lifestyle and income protection

Livelihood protection

Risk exposureClients sort to cover risks by paying adequate risk coverage

Greater exposure to risk coupled with lack of risk mitigation opportunities

Available product suite

Provision for varied wants ranging from life to health to disability

Minimal product suite available

Reinsurance Easily available Not available always

Target customer

The future of MI in India

There are 250 million poor people in India, about the size of Indonesia’s population, and thirty three percent of them have the propensity to save. The unorganized sector contributes almost seventy percent of Indian GDP (USD 67 billion). Of the total 670 million rural Indians, six percent are covered under insurance. About half – 300 million – can afford to buy life insurance, health insurance and pension products. Micro finance is a very successful model in India and has achieved more than the government in fifty years of independence. This sector is the ideal platform for micro insurance delivery. Once there is sufficient credit available in this segment for enhancing livelihood, micro insurance is the next logical step.

India has the framework in place for micro insurance. The Indian regulator has mandatory rural and social sector targets and is committed to increasing rural penetration. By the sixtieth year of operation, sixteen percent of total policies should come from the rural areas. The regulatory authority, IRDA, has announced micro insurance regulations. These identify the problems in the sector and help insurance companies overcome certain compliance requirements. It eases out certain restrictions imposed by the Insurance Act of 1938. In addition, the regulator has proposed a single window service to clients and proposed a tie-up between life and non-life insurers for provision of composite insurance. In a big move, the regulator has allowed composite insurance for the first time.

Insurance companies have savings and investment oriented products with a specific rural market orientation. A bundled insurance product is an attractive proposition for rural markets. Rather than price each product separately, insurance companies are thinking in terms of the lifetime value of the customer or family.

India is a huge country, as is Indonesia. Volume can be a big advantage here. Micro insurance becomes viable when you diversify and the economies of scale help the viability of the business. The business case needs to have a long-term perspective of between ten and twenty years and both shareholders and company management should have the patience to see this model through.

AVIVA functions entirely on a partnership basis in India. The company has its own agency to sell out of eight branch offices. But, primarily, business partners are the channel for delivery. The best way to execute the micro-insurance model in India is an agent and partner model. Partners can


include non-governmental agencies, government institutions, co-operative societies, village-local administration, self-help groups, federations, banks, information technology kiosks, and rural marketing organizations. The partner needs to have the following requirements.

Partner requirements

Trust is the most important element and extremely relevant for the rural population, who tend to be suspicious of large companies selling them products.

Products need to be easily understood by the end customer Customer friendly processes are required Ability to deliver composite products at low cost Available margins are needed to recover the high distribution costs Training and Capacity building needs to be incorporated in the model Technological advances can be useful to access Customer awareness programs can be incorporated

Challenges in Product Design for Micro Insurance

Associated parameters with the design and delivery of product are:

Pricing Challenges: Devising affordable and sustainable products that provide for the needs of both the institutions and the end clientele. Experience shows that the rural customer may be willing to pay more than the urban customer if the service is good. The ability of the market to pay must be determined when pricing the product.

Risks covered: Life, health and disability insurance as also asset insurance Sum Assured: Limits have been well defined by the regulator IRDA Target segment: The unorganized sector comprising of the largely poor and illiterate clientele Mortality rates: Tables not available specifically for the target clientele

Product design (see figure 85)

It is a challenge for insurance companies to ensure that products are correctly priced. The product features are basically life cover, loan cover, although credit insurance is becoming popular in India. Riders like permanent total accident to disability, or permanent total disability, accidental death, or double accidental death benefits. The products can also grow to include health cover, hospitalization expenses, disability covers.

Figure 85: Product Design Proposed Product features as required by the client:

Life CoverLoan CoverRiders (DAB, PTD)

Post mI regulations (bundling of risks)Life CoverHealth CoverHospitalization expenses (for the insured and the family)Disability Cover (Temporary/Permanent) Family coverAsset Insurance

Micro Pensions


There are two advantages of micro insurance for the rural market in India. It contributes to the GDP of the country through an increase in economic activity. The second is that protecting an individual’s assets will stop migration from rural to urban areas. In India, cities like Mumbai are choked and suffering due to the influx of population from rural areas.

Product Delivery

An insurer seeks the following from its partner:

For effective delivery, successful integration with partners existing product or service portfolio is important. This is called bundling. It works since it is mandatory for every person taking a loan from the microfinance institution to be covered.

A client base justifying economies of scale A dedicated workforce able to sell the concept of insurance to their clients An MIS system capable of handling timely data inputs critical for insurance-delivery like

premium collection, remittance, lives covered, product type, claims reporting. Effective screening mechanisms for isolating insurance related risks. AVIVA has not dealt with

a large amount of anti-selection in the past.

AVIVA’S Micro Insurance Initiative

AVIVA has been involved in the micro insurance business since 2002. It is as old as the company’s operations in India

Over the years, AVIVA has collaborated with prominent development institutions such as BASIX, Self Employed Woman’s Association, Village Welfare Society, and Krishna Bhima Samrudi Local Area Bank – all micro finance institutions.

AVIVA's track record: Covered in excess of 5,000,000 lives under the group and retail modes since inception. In excess of 850 claims settled (Claim settlement record in excess of 95 percent) Close to Rs. 10.00 million paid out in claim settlement since inception. A total risk covered to the tune of Rs. 6.00 billion. Claims turnaround time: an average of ten to fifteen days.

Delivery Model for Micro Insurance – The AVIVA Experience

AVIVA has been in partnership with a leading micro finance and livelihood development institution since 2004. BASIX has forty unit offices in eight Indian states. The institution plans to spread to 100 offices servicing one million customers by the year 2010. Some highlights of the relationship.

Over Rs 1.00 Billion has been lent and the recovery rate is 98 percent. BASIX currently offers doorstep service to client in over 10000 villages. AVIVA & BASIX offered loan cum protection plans to all the borrowers in 2002. There are over

250,000 lives covered under the product. AVIVA trained over 400 strong field staff from BASIX in retail insurance. BASIX offers individual products to its customers. AVIVA has sold over 19,318 individual

polices through BASIX in past two years. BASIX has developed a software IDIAS (Insurance Delivery and Administration System) for

delivery of insurance.


Micro insurance works best when delivered on an individual platform rather than on a group platform. The products need to look at the seasonality of income flows. Long-term savings mobilization takes place as the company builds credibility in the market. However, the field of micro insurance is fraught with challenges. There are age identification and proof of identity issues. There is no medical infrastructure available to underwrite the risk and training and capacity building can add up to huge costs.

AVIVA had a product with a premium for 200 rupees where the sum assured was 25,000 rupees. The premium was stretched out over five to ten years. However, there was little incentive for the partner to collect this small premium since the commission on the amount was low. AVIVA changed the product design. The company kept the basic principle of the product the same, cover for five or ten years, but introduced a two-year, premium-paying term, with a six-month premium holiday. The required premium per policy increased slightly but it freed the customer and the company from the worry of a lapsed policy.

The company changed the product and brought in technology to deal with some challenges. Policy issuance took fifteen to twenty days. During this time if there was an accidental death the premium was returned to the customer. If the policy did not exist on the company processing system, the company was not liable to pay the claim. The solution was to improve the connectivity between BASIX systems and the AVIVA system through the plain telephone line. This required a simple in-house software-programming job.

Rural business is highly cash-oriented and routing payments to AVIVA has been a daunting task due to a weak banking infrastructure in rural India. BASIX receives the cash on behalf of AVIVA and deposits it on consolidated basis at the BASIX head office and into the AVIVA account.

As the volume of rural business increases, there is the possibility that the data traffic from BASIX might disrupt the urban operation. AVIVA is developing a platform, Integrators, which sweeps data from BASIX server and up loads the same on AVIVA’s policy processing system, maximizing system efficiency. Now an insurance policy is issued and in-force exactly forty-eight hours after the premium is received at the BASIX unit office. BASIX unit offices dispatch the proposal to AVIVA’s nearest operations hub. Proposals are scanned at the operations hub and sent to the AVIVA head office for verification and policy bonds are dispatched in bulk to the BASIX unit office directly. BASIX field staff deliver the policy bond to the client and explain the policy terms and claims process. AVIVA pays a delivery incentive to BASIX field staff. Claims are reported on IDIAS and AVIVA updates the claims stages and documents required, if any. BASIX will indemnify AVIVA on fraudulent claims.

AVIVA has sold about 20,000 retail policies through BASIX and covers about 250,000 lives under a group insurance contract. The ratio is expected to change in favor of individual policies. The goal is to cover one million lives by the end of 2008 using this technology.

In the future, the company plans to introduce composite insurance so that the income generating ability of a person does not decrease due to a catastrophe. AVIVA is also planning to offer micro-pension products once the regulation is introduced.



Insurance Products to Increase Market Penetration

India suffers from many catastrophes, especially floods, earth quakes, and droughts. The policy has a two-year accident only benefit and after that there are no exclusions. In terms of life insurance the only exclusion allowed by the regulator is the exclusion of death by suicide. However, BASIX has a credit-linked policy that covers suicide death.

Individuals in rural areas have a short-term time horizon. Buying a cow, a house, sending a child to school. They do not have a fifteen and twenty-year perspective. Forcing a change in this psyche does not work. The product design must also consider factors related to ability to pay. What percentage of the income can be kept aside to pay the premium? However, as the awareness and income level increases, the micro insurance customer becomes a traditional insurance customer. Initially, the terms of the policy have a short perspective and then gradually increase. A micro insurance policy can also have a twenty-year term.

The micro insurance model in India is an agent-partner model and not a direct agency model. The advantage in India is that the regulator is very proactive in terms of delivery of the insurance business. After an exhaustive discussion for three years, the regulator came up with micro-insurance guidelines that allow a considerable amount of policy processing and underwriting to be carried out by the partner. The partner can underwrite fraudulent claims.

For a normal agent, the licensing process is one hundred hours of training and a requirement to pass an exam. For micro insurance agents, the company can appoint a good non governmental agency that works in rural areas.

In markets where the risk is not well defined, or where the risk is not insurable, government intervention is required. This is the case in countries like India and Indonesia. This makes it difficult for the insurer to tap the reinsurance market. The premium is too small and the risk is not easy to understand. Reinsurance companies like Swiss Re have a good handle on risks in most countries except in markets like rural India. Currently there is no provision for reinsurance for the micro insurance business in India. However the portfolio of micro insurance business for each insurance company is small. The levels of sum assured are a maximum of $US1000. These companies can handle the risk of a catastrophe.

Any business model for the delivery of micro insurance has to be self sustaining. Grants and aid tends not to work because there can be issues with the final delivery.

There is a problem regarding the rates and requirements that effect policy lapses in rural markets. The solution is to change the product design. AVIVA did this with a product in India. It changed the premium payment schedule from five to ten years, to two years. That reduced the lapse rates. Tweaking product design can help to maximize persistency. Having the right partner helps a great deal with persistency as well. AVIVA has over ninety percent persistency in rural markets. AIG handles this problem by keeping its products simple. It has a lot of single premium products in its portfolio.

There is no risk pool available in India. The regulator makes micro insurance mandatory so insurance companies have to find a way to make the business profitable and sustainable in the long-run. Indonesia does not have a government mandate and no risk pool. If Indonesia had a pool, backed up by the World Bank or the government, it would be an incentive for companies to take on micro insurance.


Capacity-building and Training

AVIVA is currently investing in a business model with BASIX that can be replicated with other partners as well. A key component of our investment in this business model is training and technology. AVIVA is investing in capacity-building in BASIX since it is not possible for AVIVA to devote an excessive amount of managerial time to micro insurance. AVIVA has outsourced the capacity-building and training for BASIX to trainers, trained in rural market expertise by AVIVA.

BASIX has a training champion philosophy. This training champion ensures that information is passed on to new staff members. There is an e-group which involves knowledge-management and sharing information. There is an effort on the part of the partnership institution and the insurance company together to overcome the challenge of training. The Indian regulator, the Insurance Regulatory and Development Agency (IRDA), has issued 110 licenses to employees of BASIX trained by AVIVA over the past two years. These employees are trained on online systems and take an online examination. However, micro insurance regulation will make training a lot easier.

India has non-life micro insurance products but the life insurance business has dominated India and the same is true for the rural sector. The awareness level of non life insurance is very low in the country. There are fourteen non-life insurance companies in India trying to change this situation. In consultation with the World Bank, a derivative product for weather insurance was launched in India recently. Crop insurance in India, as in most countries, is not an easy task. It is difficult to assess crop damage and that is one reason why crop insurance is unprofitable worldwide. On the other hand, it is easy to assess whether there has been adequate rainfall. There is meteorological data available. Weather insurance can be applied to a wide range of income protection options. AIG has a sister company that does rural insurance. The company did try crop insurance using satellite technology but it was difficult.


Pension Funds Markets Adapting Pension Plans to Currents Needs

Paul Thornton

Consulting Actuary Watson Wyatt

Defined contribution (DC) schemes are replacing defined benefits (DB) schemes worldwide. In a defined contribution scheme, the employer commits to paying a percentage of wages into the pension plan. Contributions are then invested and the accumulated value of contributions and investment returns on them determines the benefit. From an employer perspective, this is more predictable than a defined benefit regime but the system has some other benefits in terms of portability. Moving away from a defined benefit system and containing DB scheme liabilities has been a challenge in many countries. There are three aspects to this challenge.

Cutting back pension funds

The first step is to close off the DB scheme restricting it to the members who are currently members, and to create a new scheme for new employees. In this way, existing members who are entitled to final salary benefits continue to be entitled to them but new employees join a new scheme. Usually that new scheme is a defined contribution scheme.

Containing Liabilities: The next step is to contain the DB liabilities. It is best to freeze pensionable salaries. These “salaries for benefit purposes” need to increase with the cost of living rather than the individual’s career progression. This is limiting to the extent that liabilities continue to increase but are limited to cost of living increases rather than increases in wages including the effects of career progression.

Close the scheme to future accrual of benefits: This means that the existing members continue to be entitled to final salary pensions based on their service until the date scheme is closed. But for future years of service, individuals join the new scheme that is usually a defined contribution scheme. They start to accrue benefits on a different basis. This also limits the build up of future liabilities in the DB scheme.

Winding up Pension Funds

In the UK and US, employers are closing their fund completely and the assets in the pension fund are used to determine the benefits provided at the time of closure. The next stage is to limit the employer’s liability for final salary pensions. This issue can be difficult where legislation controls how this can be done. In the UK for example, an employer that gets to this stage probably has to put some extra money into the fund to make sure that it is funded to the level that it can afford to go to an insurance company and buy out all the liabilities. Usually such legislation makes it too costly for the employer to contemplate the move.

The final stage involves winding up the scheme completely, using the assets in the fund to go to an insurance company and buy annuities to take over the liabilities completely. Again, this is a very expensive step.

These are some of the measures that are available to cut back DB liabilities once a company has got to the final stage. One way to do this is if one company takes over the other, the acquirer


takes over the pension liabilities of the first company. In the past, this was a relatively straightforward way of moving pension liabilities. Not any more. Legislation protecting the members involved makes this a complicated operation in the UK and the US.

The second method is to go to an insurer. In Indonesia, this could mean going to foreign insurers as the country does not have many local insurers that can wind up a pension scheme in my opinion.

In the UK, for example, it is possible to create an independent pension fund quite separate from the employer by using a special purpose vehicle. The regulations in the UK ensure that it would have to be backed by assets to ensure solvency in a similar way to an insurance company but not exactly the same. In a number of countries there is a safety net, a state-based insurance arrangement. Therefore, if the employer becomes insolvent and the pension fund does not have enough money to go to an insurance company and buy out the liabilities, the state-based insurance arrangement covers the liabilities to a greater or lesser extent. There is the Pension Benefit Guarantee Corporation in the US and more recently the Pension Protection Fund in the UK4. Countries like Sweden and Germany have somewhat similar arrangements. In the state-based insurance arrangements, the benefits provided are not at the same level as was promised by the scheme when it was ongoing. Therefore, the members suffer some loss but are protected to some extent. The problem is that these arrangements can be very vulnerable and fragile depending on the way they are designed and funded.

In conclusion, in the winding up stage buying out pension benefits by insurance companies can be expensive due to the insurers’ margins for solvency, longevity, and profit. Special Purpose Vehicles are emerging as an alternative. There is a strong demand from institutions to reduce longevity risk. There should be a strong developing market for re-insurers to reduce longevity risk. The state insurance arrangements existing in the USA, Germany, and UK are inherently fragile without state backing and open to moral hazard unless well designed. Companies may under-fund the pension system, become insolvent, and transfer the under-funding to the state insurance system. Indonesia should be wary of implementing this.

Conversion from Defined Benefits to Defined Contribution

Another method of limiting pension liabilities and making them more affordable is to convert the formula of the scheme from defined benefit to defined contribution. It need not come down to having a final salary scheme or a defined contribution scheme. There are other hybrids available.

Career average: In the career average design, instead of the formula relating to the salary at retirement, the formula relates to the average of salaries for the member over the whole career. Usually, the member salaries are indexed in line with the cost of living to make sure that they average in real terms and not in nominal terms. That is a scheme design prevalent in some developed countries.

Cash balance plan. This is similar to a defined contribution scheme but it usually involves an investment guarantee that the employer finances to make sure that the benefits produced are protected from investment risks to some extent. This would be a better scheme in the Indonesian context.

Usually, to convert an existing final salary or defined benefit entitlement to a defined contribution requires the consent of each scheme member. In countries where this exists, South Africa for example, one of the biggest issues is – who does the surplus assets of the pension fund belong to? To the member or the employer? This is not a simple question and there are years of legal

4 More information can be found about these two organizations from their web sites.


arguments in South Africa that eventually resulted in legislation to settle the issue. Therefore, it is possible to convert existing defined benefit entitlements into defined contribution entitlements but it is not a simple process.

Pure defined contribution plans place investment and longevity risk with the members. If the investment markets perform badly or longevity improves, the cost of the scheme rises. In this case, the accumulation of defined contributions is not as great as would have been the case. If longevity improves, the cost of buying pension at retirement becomes more expensive. Therefore, defined contribution schemes are not ideal from a member’s point of view but on the other hand, it is a much simpler system to operate and for many members to understand. It avoids any friction in the labor market because it makes it easier for employees to change employment and carry their pension entitlements with them from one scheme to another. This is the reason defined contribution schemes work better in countries, such as Indonesia, with a young mobile population. Both defined benefit and defined contribution schemes, cash balance is one example, are preferable in the end, particularly for larger employers that can manage the complications.

Risk Control

There are various aspects to risk control. The concept is not as complicated in pension funds as in insurance companies.

Funding Principles: The basic principle of funding is to set aside some assets that will accumulate with investment returns and meet the liabilities promised under the pension scheme. The purpose of funding is to ensure that pension promises are not entirely dependent on the employer still being around in the future. For this purpose, the assumptions should reflect the investment return achieved when the money is paid. It should reflect the appropriate way of investing that money. If the fund is going to close in the future and the liabilities are going to mature, then the funding needs to anticipate the appropriate investment policy when the time comes.

These concepts are far off from Indonesian pension funds currently. Indonesian funds currently are heavily invested in cash deposits or short-term deposits whereas the asset-matching approach indicates a more diversified portfolio spread around domestic equity, foreign equity, property, government bonds, corporate bonds, as well as cash.

There is a technical approach being developed to deal with the maturing of liabilities called the deal discount method. In this method assumptions are chosen to reflect the period that the assets are accumulating up to the retirement of the member. Separate assumptions are made about the investment during the period in which the pension is to be paid. Therefore, there are separate assumptions pre and post retirement. The advantage of using this method is that, as time goes by, in a closed pension fund, it is possible to automatically adjust to members eventually becoming pensioners. There are techniques for dealing with the closure of pension funds and anticipating changes in investment policy in future years.

Another key area around funding is to have margins of prudence. This is best approached through a stochastic method. The best estimate of future returns is to look at historical data in different investment markets, the median return achieved over time and the chance of deviation in those returns this way there is a probability distribution. One needs to assume that the future might be somewhat like the past. In a full asset-liability modeling approach, the different assets that the scheme is invested in are combined and a probability distribution of future returns is calculated. A safe mid-point is decided once a distribution curve of future returns is reached. This way, instead of funding on the best assumptions, you fund on the most prudent assumptions.


Funding Targets: The next aspect of funding is addressing the funding target. The regulators are paying increasing attention to this area and setting standards for funding, which may be higher than simply saying - this is the actuary’s prudent estimate of funds needed to meet liabilities. The reason that regulators are setting higher standards is to decrease reliance on the employer still being around in future years.

One such higher level is the discontinuance level, typically measured by the cost of buying out the liabilities with an insurance company. Another measure is to look at financial reporting standards. The international standdards are IAS 19 and FAS 87. The minimum level is the actuarial funding assumptions.

Different forms of security: The next area of funding is to look at the period over which a shortfall can be corrected. Here, the issue is about the strength of the employers business and how quickly the plan administrators act to have the funding brought to one hundred percent of the requirement. The UK currently has an ongoing debate about new legislation that addresses this question. Historically, pension funds have met short falls over a period of fifteen years but there is pressure to shorten that period to less than ten years.

There is an animated discussion in countries like the UK on how employers can secure the funding of pension schemes if there is a shortfall, over and above simply putting money into the pension fund. Often employers may not be able to afford the kind of payments required for a pension fund in deficit. A special payment is a one off payment to top up a pension fund. A series of payments are contributions made over time to top up a pension fund. These are the two basic choices but other alternatives are being explored due to the funding shortfalls in the UK and US. Examples being explored include the case where the employer puts the money into an escrow account rather than a pension fund. This is kept separate from the rest of the business and will be called upon if needed for pension liabilities. If not, it is returned to the employer. Another alternative is for a bank to provide a letter of credit in the event of employer insolvency. A further alternative is to have assets pledged in the event of insolvency with the corporation diverts the property to the pension fund.

Managing Investment Risks: Assets such as equities and property, hedge funds, and private-equity funds are return seeking. These are high-return and low-certainty types of assets and are best matched with long term pre-retirement liabilities. Other assets are regarded as relatively risk-free. These include government bonds where future payments are predictable and highly likely to be paid. They match fixed liabilities very closely. For funds that comprise members with pensions in the course of payment, the matching investment strategy is heavily oriented towards government bonds or possibly corporate bonds. For a pension fund with active contributory service members, a matching strategy includes a larger proportion of equities. In Indonesia, the current investment mix of pension fund is heavily reliant on short-term deposits, largely a low risk category. However, short-term deposits do not match long-term liabilities and so the pension funds in Indonesia incur an interest-rate risk and inflation risk by investing in short-time deposits.

By looking at the liability profile of the scheme and the mix of active members and pensioners and by doing actuarial modeling one can arrive at the right asset mix for the fund in total. This is called stochastic modeling. By altering the mix of investments in that asset class, one can see what happens if the proportion of property is reduced or increased. It demonstrates the value of diversifying the investment mix and holding different asset categories but it also helps the plan administrator arrive at the right mix and investments.

Administration: The issue here is to achieve economies of scale by outsourcing to specialists providing administration. Alternatively, it is possible to have third-party specialists create in-house administration software. It is usually too expensive for employers to do their own administration. Administration is not just about record-keeping and calculating benefits but also about communicating to the members about their entitlements and options. If a company has software


that allows members to plan and create their own contributions, then financial planning can be taken to a completely new level.

Annuitisation

Annuitisation is a process whereby, on retirement, members have to purchase an annuity to get a lifetime income instead of a lump sum. It tends to be unpopular with members unless it is dealt with on their behalf in the final salary scheme. If members have to take accumulated funds in a defined contribution scheme and use it to purchase annuity, it is considered expensive.

People tend to under estimate how long they will live. Estimates do not take into account improvement in mortality and health care. They also put a lot of reliance on family support. The whole purpose of a pension system is to enable the population to be less dependent on children.

In the countries where it is not compulsory to purchase annuities so as to provide for the pension payment, people tend to consume the lump sum very quickly and become reliant on the state to provide retirement income security. This is a moral hazard. A better way of getting an income in the form of an annuity is to buy it from an insurance company. If the insurance companies are given the right encouragement the annuity market can develop in Indonesia.

Some alternatives to annuities are being explored in other countries. One such alternative is a pool for members. There is less certainty about benefits but the pooling enables the investments to be maintained in real assets longer.

The final point on annuitisation is that there needs to be a consistent tax structure and Indonesia needs to get rid of some tax anomalies. Indonesia charges a tax at the point of purchasing an annuity. This is a deterrent and illogical.


Adapting Pension Plans to Current Needs

Wilson Lam Vice President

Regional Operations and Pension Actuary AIG Global Pension - Asia

China

Statutory Basic Pension (Defined Benefit Annuity) Migrate to Supplementary Pensions (Defined Contribution for limited number of trial-run

companies and provinces, tax incentives on contributions and investment income) Effective May 2004, introduction of trust based corporate annuity (DC voluntary arrangement

with tax incentives on contributions and investment income) China may allow insurance-based DC and/or DB pension policies on a supplementary basis –

voluntary (tax incentives are still under negotiation).

Since the service provider licenses were granted in September 2005, the enterprise annuity did not move at the pace that most service providers expected. One possible reason is that the regulator needed to compromise many interests and that resulted in a redundant structure. It is a trust-based arrangement with different entities running one pension plan, such as custodian, trustee, and administrator. The market is ready to move because it cannot be extended to small and medium enterprises, and bundled products offered by single entities do not work. Regulations in China put up fee constraints and limit the maximum fee that each service provider can charge. The system ends up with too many layers and there is no single way one single entity can bundle a product efficiently. It is important to emphasize that the most efficient system is not the one with the minimal expenses. It is the one where the net yield after expenses results in the highest transfer to the member’s asset accumulation.

Taiwan (China)

Statutory Labor Benefit Act (DB Lump Sum with funding, tax incentives on contributions, investment income and benefit payments)

Effective June 2005, three options of arrangement are allowed. Option 1: participate in central DC pension arrangement Option 2: maintain the DB arrangement Option 3: corporations with a staff of over 200 can run private DC pensions arrangement but

must have employee consent and have a product with floating guarantee. Members can swap among the three options.

In this case, the regulator controls the money. Therefore, in order to have access to the tax incentives, there is a minimum contribution requirement of 2.5 percent of salary to the central government. Most companies try for this minimal contribution level to the central fund. At the same time, the majority of this funding is used to pay currently due retirement benefits. The asset accumulation at the central fund is minimal resulting in a small progress. Most companies do it on a pay as you go basis.

In June 2005, the government introduced some good systems including proper financial pension expense disclosure albeit that this disclosure is just on paper. Unfortunately, to the


disappointment of the service providers, the majority of funds will still be controlled by the regulator and allocated to privately-run fund management companies. This is the reason that foreign institutions are not keen to enter the Taiwanese pension market.

India

Statutory Gratuity Policy (Trust based DB Lump Sum run by private insurance company or self-funded).

Voluntary Superannuation Fund (Trust based DB lump sum, or DB annuity or DC arrangement).

Tax incentives on contributions, benefit payments, and investment income.

India used to be a monopoly system run by a life insurance company. Financial reform allowed foreign investors into the country in 2000. India’s gratuity policy is more or less like Indonesia. It is a severance pay product that is a defined benefit lump sum payment. The current market for this product for larger companies normally is represented by proper funding but smaller companies still adopt the pay-as-you-go basis.

Another option in India is the voluntary superannuation fund. Unfortunately, it is not as popular as it could be. If it were more popular it would save a lot of tax incentives.

Developing the pension market further depends on the depth of the securities markets. One major change in India was the introduction of unit-linked products. LIC, the monopoly service-provider until recently, offers a good product and has accumulated high yield assets and provided a high investment return. The company managed to get a better yield compared to new entrants on a fixed income portfolio. In order to share statutory benefits many service providers had to introduce this “new era” product, the unit-linked product. The fixed interest investment strategy has worked well in years when interest rates fall drastically. In the past few years, the equity market in India has also gone up drastically and the pressure for unit-linked products has moved to other private service providers as well.

One personal observation for India is that the regulator tends to introduce rules without consulting the service providers. Recently, a rule was introduced that says that if a service provider receives a cheque by four o’clock, the money needs to be invested on the same day. In the pension industry, this arrangement is practically impossible but it is already included in the draft regulations. China has an efficient system for the mutual fund market. The bank is the collecting agent and money received by the bank is electronically transferred to the mutual fund company on the same day.

Thailand

Statutory Severance Benefits (DB lump sum). Voluntary Direct Credit arrangement. Can use Direct Credit arrangement as alternative funding for Gratuity. Tax incentives on contributions, benefit payments, and investment income.

Most employers, particularly small and medium enterprises, tend to delay decisions. This has resulted in slow progress toward building a pension sector in Thailand.


The Republic of Korea

Statutory Severance Benefits (DB lump sum, mainly self funded) Voluntary Retirement Insurance Arrangement (“RI”) as an alternative to Severance Benefits

(DB or DC with tax incentive) Effective December 2005, new Employer Retirement Saving Arrangement (“ERSA”). Voluntary ERSA - DB lump sum or DC to gradually replace RI. Can still maintain self funded severance benefits but tax incentive is decreasing.

Korea has similar problems as Taiwan (China). The regulator tried to do a few things to improve the funding or financing of severance pay arrangements, called a retirement insurance arrangement. By law, employers are allowed a certain percentage to be set up on their balance sheet as a provision. The cost of establishing this provision is tax exempt. The balance is put into retirement allowance and employers enjoy another level of tax exemption. With this arrangement, profitable and large enterprises tend to put more money into retirement insurance arrangements. However, the guaranteed product required by the regulator when offering this product is a critical problem in this arrangement. Although no explicit law states the kind of guarantee offered, the overall guaranteed products approved by the insurance authorities are risky from a service provider’s point of view, resulting in a minimum number of foreign insurance companies entering this particular market. So far, the new system, effective December 2005, the Employer Retirement Saving Arrangement, has seen universal progress because it is a voluntary system.

The assistance from the regulator to improve the market is not that great. This is why, when AIG entered the market, the company was careful about entering the market too early. Currently, the monthly investing to a pension fund is still fixed income as required by the regulator.

Hong Kong (China)

Statutory Severance Pay and Long Service Payment (DB lump sum) Voluntary Pensions under Occupational Retirement Savings Ordinance “ORSO” (DB lump

sum, DB annuity and DC) Effective December 2000, implementation of Mandatory Provident Fund (“MPF”) that can be

used to offset Statutory Severance Pay and Long Service Payment. Under MPF, tax incentives for both ER and EE contributions, benefits payments and

investment income.

Hong Kong is slightly ahead of the other Asian countries. It has moved from a severance pay or a long service payment arrangement that was a defined benefit similar to Indonesia and India. Ten years ago, the government introduced a law called Occupational Retirement Savings Ordinance (ORSO) to encourage voluntary savings. The law provided tax incentives for foreign trade pension arrangements. This is why Hong Kong has all kinds of products, DB lump sum, DB annuity, and DC.

By the year 2000, the MPF implemented tax incentives for employer contributions, employee contributions, investment income, and benefit payments. Unlike Jamsostek, MPF’s compliance rate is already ninety percent.

Here are some interesting statistics on the DB trend in Hong Kong (see figure 86). Before the year 2000, employers had the option of staying on DB or migrating to the MPF defined contribution arrangement. There has been a steady decline in DB plans. There was a financial crisis in the two years 2001 and 2002 and the equity market dropped drastically. This led to a major financial burden for companies offering DB plans and that is the reason for the sudden


drop in DB plan numbers in those years. After the equity market rebounded, the number of DB plans stopped declining. However in 2005 freezing the DB plan and converting it to a DC plan has returned as a trend. This is why the number of DB plans dropped again.

Figure 86: Hong Kong DB Scheme Statistics

• Number of DB Scheme in Hong Kong

1200

1300

1400

1500

1998 1999 2000 2001 2002 2003 2004 2005

Year

Num

ber o

f DB

Pla

n

________________________ As at Mar 31 of each year, where as for 1999 & 1998 were as at Sept 30 and Dec 31 Source: MPFA Annual Reports 2000 - 2005

The annual contribution to DB plans follows a similar trend. The assets in Hong Kong DB schemes jump significantly from 2004 to 2005. Some of the increase is due to the recovery of the equity market (see figure 87).

Figure 87: Annual Contributions in DB Schemes in Hong Kong (China) and Assets under Management in DB Schemes in Hong Kong (China)

4

6

8

10

12

2000 2001 2002 2003 2004 2005

Year

Ann

ual C

on't

in D

B S

chem

es(H

K$

Bill

ion)

60

70

80

90

2000 2001 2002 2003 2004 2005

Year

AU

M in

DB

Sch

emes

(HK

$ B

illio

n)

________________________ As at Mar 31 of each year Source: MPFA Annual Reports 2000 - 2005 The evolution of the Hong Kong system starts from ORSO, then in January to October 2000 the ORSO interface and then the ORSO MPF from December 2000.


Figure 88: Hong Kong (China) MPF – Law and Regulations

Date Event

Apr 1995 - Study on MPF by Government

Aug 1995 - Enactment of Mandatory Provident Fund Schemes Ordinance

Sept 1998 - Establishment of MPFA

May 1999 - Enactment of Subsidiary Legislation

Jan 2000 - The MPFA took over the function of Occupation Retirement Scheme

Dec 2000 - MPF Implementation

As a service provider, AIG has been waiting for implementation for five years. Based on the experience in China, Taiwan (China), Korea, the time taken from regulation to proper implementation, is three years minimum and five years on an average.

MPF has a framework, although not the best, from the compliance point of view and the perspective of the service provider. The MPF ordinance sets up a number of rigid compliance rules, including an investment timeline, and a timeline of settling benefit payments. All these issues can be a major threat to the service provider. The regulation provides for the MPF to regulate the trustee and let the trustee communicate with an administrator and custodian. The best feature of the MPF structure is the pooling of resources (see figure 89).

Figure 89: Hong Kong (China) MPF System Framework

MPF SchemeInvestmentManager Auditor

Custodian AdministratorTrustee

Employer Employee

MPF System Framework - Eligibility Requirement for Service Providers

A trustee of MPF assets must:

Be a registered trust company in Hong Kong (China) or its equivalent in an overseas jurisdiction.


Have paid up share capital of at least HK$150M (approximately $US19.23 million) and own

net assets of at least the same amount (this could be fulfilled by an associate that continuously supports the applicant company)

Owns assets held in Hong Kong (China) of at least HK$15M (approximately $US1.92 million). Have at least five directors, one of which must be an independent director, and all of its

directors must be persons of good reputation and character. Appoint a CEO and a majority of the directors with skill, knowledge, experience, and

qualifications on administration of provident fund schemes.

An investment manager of scheme assets must be:

Incorporated in Hong Kong (China). Have a paid up share capital of at least HK$10M (approximately $US1.3 million) and net

assets of at least the same amount. Registered as an investment adviser with the Securities and Futures Commission.

A custodian of scheme assets must be:

An authorized financial institution (i.e. an authorized bank in Hong Kong (China)). Or a registered trust company incorporated in Hong Kong (China) with a paid up share capital

of at least HK$150M (approximately $US19.23 million) and net assets of at least the same amount.

Or a registered trust company incorporated in Hong Kong (China) with a paid up share capital of at least HK$50M (approximately $US6.41 million) and net assets of at least the same amount, and receives continuous financial support from an associate which is a substantial financial institution that satisfies a certain capital adequacy requirement.

Case Study - Preparation for MPF in Hong Kong (China)

From the Service Provider perspectives, establishing an operation to participate in the new MPF system involved the following critical elements:

Company Set Up Product and Scheme Approval System Search Recruitment Education and Training Process Marketing and Promotions

Moving from a voluntary system to a mandatory system is a big job. Collection of member statistics is big challenge, particularly in countries like Indonesia, which are spread out. Hong Kong (China) is a small island, but capturing membership data on two million members every month is no easy task. Very often, people do not submit electronic data but paper information, letters, faxes and mail. The system needs trained resources to function smoothly and educating people in a short time frame is a big issue. The positive factor for the MPF is that decision-makers are employers and can seek major negotiations that benefit their employees. At the same time, they can push the service provider to improve systems and products.

Before a company can set up a MPF product there are compliance issues to consider. In the past, employers did without professional compliance teams and a company worked on what they thought was best. The introduction of the MPF has the potential to create ten million jobs and currently has already created five million jobs. Here is a staff break-up of a company moving to the MPF system (see figure 90).


It is important to emphasize administration. To support a defined contribution arrangement with multiple investment choices in multiple currencies and with multiple fund managers with different settlement timelines needs an efficient administration system. Initially, only a few service providers could offer fund switching on the web, for example, but now it is a basic function offered by all service providers.

Figure 90: Company Set-up

At Peak CurrentSales & Marketing 50 20Admin, Operations & I.T. 230 150Accounts & Finance 30 30Compliance 10 7Training 10 2Total 330 209

Number of EmployeeDepartment

PREPARATION TASKS

I will now provide some indication of the tasks we had to do to prepare for the market.

1. Steps for Product and Scheme Approval

Tasks

Master Trust Deed. Principal Brochure and Offering Document. Application submission to regulator.

2. Steps for System Search

Tasks

Identify needs Decide on in-house or external system solution Search for vendor GAP analysis System enhancement list Administrative System Solutions Client System Solutions Interface preparation Staff recruitment and training

3. Membership Projection

We used a ratio projection of members as a function of the intermediary numbers and the productivity of those intermediaries. This calculation was based on our target market share.


Figure 91: Membership Projection

Number ofIntermediaries

Number ofCases

Total Number ofMembers

Per Intermediary 1 4 36

Total 6,000 24,000 216,000

4. Headcount Justification

We also used the ratio of staff to members to manage administrative objectives and efficiencies.

Figure 92: Company Set-up

Year-end Total No.ofMembers* No. of staff Member per

staff ratio2001 314,000 159 1,9752002 370,000 148 2,5002003 432,000 147 2,9392004 477,000 152 3,138

Jun 2005 506,000 156 3,244

5. Education Process

AIG targets a ten percent market share and the average size of the small and medium enterprise is nine employees per company. If each intermediary generates four cases, AIG needs six thousand intermediates. In this case study, AIG conducted a six-month pre-MPF launch training directed at six thousand intermediaries with a staff of three hundred. The training included regulatory training, product training, and administrative procedures training.

Training agency units so that they can present a consistent product, including explanations of detail regulations, is a major challenge. As long as membership is increasing, most of the operating expenses are relatively fixed.

In the initial stages when AIG started implementing the MPF, the mass market received only a standard service. There was no courtesy call and all communication was by mail. Since then, standards have improved and there is a customer service representative calling the client for follow-ups. A critical challenge for the service providers in Hong Kong (China) is conserving the business and improved customer service helps to achieve this objective.

There is an automatic pressure on service providers to educate the members and client companies since employees make a recommendation to the employer on the service provider. This is why AIG trained six thousand agents in six months and each has to pass an examination.

6. Marketing and Promotions

AIG does every conceivable kind of promotion. Television, radio, and road shows. The Internet and call centers are also used to communicate. There are member-briefing sessions for every employer to explain MPF, the implications, the liabilities and the rights of every member. All of


this needs to be accomplished in six months. The average training time to effectively run this system is one month, which is impossible without some form of technology advancement. This helps AIG desist from a never-ending hunt of talent in the market. In fact, competitors have approached most of AIG’s senior staff with salary increases of twenty-five to fifty percent. This is the advantage of a privately run system rather than everything coordinated by a single system.

Implementation

There is an existing system and a new system. The following charts compare the benefits between the old system and the new MPF system (see figure 93 and figure 94). AIG sometimes offers an interface system for clients to automatically interface with the payroll system and update the contribution file free of charge.

Figure 93: Employers with ORSO scheme

• Interface process to ensure regulatory compliance

Intermediaries & Staff EmployerEducation & Planning

• Pros & cons of scheme retention• Scheme comparisons• Benefit illustration • Exemption application• Scheme set-up• System solution• Administrative arrangement

Employee

Com

munications

Communications

• AIAPT’s interface process: 2,000+ schemes, totaling 100K members• Lead-time for interface completion: 6 months

Figure 94: Employers without ORSO scheme

• Education process to ensure regulatory compliance

Intermediaries & Staff EmployerEducation & Planning

• Pros & cons for additional voluntary contributions

• Scheme set-up• System solution• Administrative arrangement

Employee

Com

munications

Communications


In my view, a privately run system speeds up the process of implementing a complicated system. Pensions are a long-term arrangement affecting both the employer and employees. Therefore, communication is the key to a successful implementation of a system. This requires sophisticated system capacity and committed intermediates (service providers), to explain details to the employers and members (see figure 95).

Figure 95: Implementation – Communications and Operations Efficiency

Service

Provider

Employer

Employee

I&WSystems

Front-endSystems Call Center

AccountingSystems

EnquirySystem

Core AdminSystem

Investment Fund Development - Structure of Investment Funds

In Asia, most products provide simple investment portfolios. Even in Hong Kong (China), in AIG’s pre-MPF portfolio, clients had ninety percent of their assets in fixed income funds with a guarantee and just ten percent of assets in equity funds. The MPF is a privately run system and members have no right to cash out before retirement. The government, along with service providers, encourages long-term investments that should out-perform inflation. As a result, currently over thirty percent of investments chosen by members are in equity and, overall, fifty percent of assets are in equity investments (see figure 96).

Figure 96: YTD Distribution of AUM in MPF

Bond Fund1%

Guaranteed Fund14%

Money Market Fund1%

Capital PreservationFund15%Equity Fund

17%

Life-style Fund51%

Market Trend

_____________ As at Dec 31, 2005 Source: MPFA


In Hong Kong (China), most service providers have a three-layer investment fund structure. The first is a constituent fund allowing a fund of funds approach. Underneath the constituent fund level is a mutual fund directly invested in the market. Initially, most service-providers offer a minimum range of investment options, called a lifestyle fund with a different mix of equity and fixed income (see figure 97).

Figure 97: Investment Fund Development – Structure of Investment Funds

• Life-style Funds (Fund of Funds)

MPFConstituent Fund

APIF 1

DirectInvestment

APIF 2

DirectInvestment

APIF 3

DirectInvestment

APIF: Approved Pooled Investment Fund

Investment Mandate 1




APIF 4

DirectInvestment

The key is that these equity investments are global. As no single manager has the capacity of knowing global investment options, in the “fund of funds” approach each fund focuses on certain geographic locations. The standard fee on MPF constituent funds is in the range of 1.5 percent to two percent. Net fund performance consistently outperforms any composite index.

Repercussions of Regulatory Changes

Regulatory changes have a major impact on service providers, employees, and employers under the mandatory system. The reason is that a simple change has a ripple effect down the system (see figure 98). For example, the Hong Kong (China) MPFA, due to the political pressures, changed the definition of a parameter relevant to income - income exempt from employee contributions changed from four thousand Hong Kong dollars to five thousand Hong Kong dollars. This one change took eighteen months to plan, communicate, and implement.

Figure 98: Repercussions of Regulatory Changes – The Ripple Effect

Service Provider

Regulator

Communications Materials• Principal Brochure• Forms• Marketing Brochures• Communication Letters• Presentation Materials• Member Briefing Videos• Admin Guide

System & UAT• Core Admin System• Front-end Systems• Internet• IVRS• Client Support Systems

Regulator Approval


Risk Encountered during MPF Preparation and Implementation

To conclude, as my time is limited, I will provide the list of risks that we identified and had to manage for your information.

1. Company Set-up

Economy of scale Cost of running, maintaining & managing pension plan Hiring experienced staff Parties involved Service Providers , Enterprise

2. Education

Lack of understanding of pension fund Lack of awareness of retirement planning Insufficient communications Deduction of contribution from payroll may be viewed as salary reduction or cut. Handling of termination benefits. Misselling of products and services. Parties involved Regulator, Service Providers, Enterprise

3. Implementation and Operations

Enrolment Missing employee data and missing documentations Default and Incorrect Contribution Enterprise deducted employee payroll & subsequently did not make contribution Incorrect calculations lead to late settlement & may have investment loss Termination Unsettled contributions will lead to delay in benefit payout Unclear handling of benefit for terminated employee (i.e. if new employer has no annuity

plan, what should the employee do with their benefits?) Operation efficiency. Operation flow and system development. Staff training. Regulatory compliance and service standard. Parties Involved Service Providers, Enterprise

4. Investment Fund Knowledge and Options

Lack of investment knowledge by enterprise and employees Stringent investment requirement Lack of investment choice & diversification May not meet objective of enterprise and employees May not beat inflation. Safekeeping of assets and control. Parties Involved Service Providers, Enterprise


5. Regulatory Changes

Yesterday’s regulations may not fit tomorrow’s needs Taxation Inappropriate advising on pension fund Continuous education on changes Parties Involved Regulator, Service Providers, Enterprise

Risk Management Measures

1. Company Set Up

One-stop service providing bundled products and services Standardize procedures require less hands-on daily administration handling Provide sufficient training Transparency of fees and charges Healthy competition by service providers results in lower cost to employees.

2. Education

Government and service providers to share burden of education via: seminars, trainings, advertising, exhibitions, TV Programme.

3. Implementation and Operations

Regulator can impose more stringent controls (e.g. penalty on late and non payment of contributions)

Regulator can also “police” service providers or enterprise more frequently to ensure compliance and best practices are met.

Standardize administration procedures can facilitate operations efficiency Develop all-rounded administration systems & infrastructure

4. Investment Fund Development

Allowance of investment in pooled funds Multi-funds product structure Less restrictive investment requirements Provide investment training and education To assist customer to identify investment needs Clear fund accounting process and control Regulator set mechanism to protect assets (i.e. product approval, audit, etc)

5. Regulatory Changes

Periodic changes to regulation to fit times Utilize external consultants to provide market studies & trends On-going education & communications Regular meetings with service providers for updates & brainstorming Tax incentive for enterprise to set up pension plan Continuous Professional Development (“CPD”) Program



Definition of a lifestyle fund

At the time of the initial introduction of the MPF, most members had little investment knowledge. Therefore, rather than have individuals choose equity, AIG decided to package a product with different combinations of equity and bonds. The conservative fund has seventy percent of assets in fixed income, thirty percent in equity. A balanced fund has a mix of fifty percent for each asset. An aggressive fund has ninety percent in equity and ten percent in fixed income. These are all internationally diversified using the fund of funds approach. Each member fills in a questionnaire to decide their risk profile. It is called a lifestyle fund as research shows that the investment style depends on the age and lifestyle of the investor. A younger person has a more aggressive approach to investing than an older person in their forties and fifties.

Each underlying fund is a mutual fund called a balanced fund with a balance between fixed income and equity. The major difference under the MPF and the fund of funds approach is, instead of one single fund, which is internationally balanced, there are multiple mutual funds diversified according to geographic locations. Some of the funds are in Asia, some in Japan, and some are in the American market. Some of the funds may be balanced funds, some may be fully invested in particular markets and instruments such as one hundred percent equity or one hundred percent fixed income.

Winding up of a fund

What happens if pension is transferred as part of a corporate transaction? This depends on the laws of each country. In the UK, the emphasis is on member entitlements. Therefore, if pension liabilities are transferred as part of a corporate transaction, the actuary has to sign a certificate assuring that member benefits are not damaged. That means that the employer in the new pension fund has to assume the liabilities as part of the corporate transaction. If the corporate transaction involves taking over an under-funded pension scheme, that should be reflected in the terms of the deal.

On the other hand, if an individual member changes his job and transfers pension from one scheme to another then the new scheme offers benefits in exchange for the transfer payment. The member decides if this is what he wants to opt for. In an individual case, the value of pension rights are worked out in the old fund and converted into the benefits of the new fund.

Clarification about the portfolio in the MPF scheme in Hong Kong (China)

The portfolio in the case study is purely the AIA portfolio, which is uniquely different from most service providers. Some other funds use a balanced approach, fifty percent in equity, and fifty percent in fixed income. AIG is a life insurance company with pension products. The company offers a bundled product as AIG customers prefer an insurance and pension arrangement. They are conservative investors, which is why all products initially offered by AIG had an interest guarantee of about five percent. Subsequently, this guarantee has been lowered to three percent but AIG is the only service-provider that offers this product. At this moment, AIG has ninety percent of assets in guarantee funds. The company did try launch an equity fund but with little success.


Under the MPF, all funds have to be marked to market on a daily basis and regulated. There are many tight regulations, in terms of reserve requirements. This is why, at the time when AIG implemented this product, member characteristics were different. Under the pre-MPF era, the investment choice lies with employers. Under MPF, AIG anticipated a major change in member decisions, and decided to conduct many member briefings for education.

Hong Kong (China) has about twenty service providers, ranging from insurance companies and banks to mutual companies. There is also an employer sponsor plan, where the employer can set up their own trust for their own group.

As the Hong Kong (China) government decided to run the MPF on a private basis, there is no centralized administration system requirements.


Institutional Strengthening: A key issue


Institutional Strengthening: Insurance

Bruce D. Moore Partner-Actuarial Services Ernst & Young (E&Y) Asia

This text is more in the nature of a summary of the key issues raised by the presenter.

IBNR (Incurred but Not reported Reserves) and special reserves: General Issues

1. Does the industry have a formula approach or does the industry use triangles to project ultimate losses on claims that have already incurred? Many countries in the early stages have a formula approach, such as Japan and China. It is clear that the industry should move to an actual payment type approach. The question is how quickly and what should the approach be?

2. Does the industry do discounting? Is there a market value margin or a provision for covering seventy-five percent of the scenario?

3. Gross versus net. There is a need to show the financial statements gross and net of re-insurance. Gross amounts tend to be more volatile because they are not capped by re-insurance.

4. Special Reserves can be catastrophe or equalization reserves. There are many long-term products sold by non-life companies that need special reserves. The IFRS insists on disclosure for reserves as a key part of the rules in insurance. The rules apply in Singapore, Hong Kong (China) but not yet officially in China. IFRS will come to Indonesia soon.

5. Role of the actuary in non-life insurance companies. Increasingly the International Actuarial Association is encouraging an active role for non-life actuaries to certifying reserves in non-life insurance company financial statements.

China

China has many problems with IBNR reserves. This might be surprising to hear because the business is not focused on liability risk and has been mostly about property damage. However, China also has a formula-driven approach to reserves. The IBNR has been one to four percent of the premium, which is the maximum allowed by the Ministry of Finance. These rules are obviously driven by tax considerations to limit the deduction, as a one percent deduction makes little sense.

Theoretically, if the reserve is increased there will be a problem in the subsequent accounting year. However, with growth rates of thirty percent a year in China, that is not a problem. Each year, the amount being allocated from the current year’s business more than offsets the adverse developments of the past business. Since everyone is making money and growing, and no-body understands the concept of reserves, nobody feels the need to raise the reserving and premium rates. This is the current situation in China.

There has been a proposal for the past few years for China to move to IBNR type reserves calculated on a triangle type basis. It will finally be effective by the end of 2006. Most Chinese actuaries can get through US actuarial exams and so this is not a technical challenge but a political challenge. The regulator has realized that delaying the implementation has had an adverse effect on the market. During the delayed implementation the hole has just gotten bigger. Companies listed in Hong Kong (China), such as PICC and Ping An, have been disciplined for many years but most companies will face a problem next year.


The industry realizes this and has been trying to attract foreign capital for the past few years, hoping that foreign investors can put in money before the higher reserve policy is implemented. However, it is not going to be easy and Chinese companies have been turned down many times. Foreign companies will rely on due diligence by an accounting firm and an actuarial study by a qualified international actuary before they put in any money.

Experience Studies

Experience studies are necessary. An actuary looks at technical issues as part of their routine and no-one questions the need to do so. The next step for insurance companies is to prepare a “gain and loss by source” analysis. This approach analyzes gains or losses with reserves based on realistic assumptions. In a sense, it is the same thing as an experience study and ties in the overall effect of all changes to the effect on the financial statement.

There are various versions of this sort of analysis. If the company is using a more conservative regulatory basis then the analysis is less instructive. Mortality and interest are going to be different. An option is to look at the actual versus planned source of earnings. Alternatively, embedded values and achieved profit can be analysed. This analysis is common in the UK and is becoming more common elsewhere. Even in China, the regulator is considering the embedded value reporting as a standard. Therefore, there are ways to tie experience studies to financial results.

Market Concentration and Competition

How many competitors is enough? The answer to that is the number of players in a market is not the issue. The issues are mergers, conduct of business, disclosure, consumer education – these ensure effective competition.

In the U.S, there has been a fragmentation of business or what management consultants call decomposition of the value chain. The various segments are broken up into product, customer, and function. It is a sort of three-dimensional set-up with cubes and there are companies specializing in each function, and other companies outsource to these specialist companies whether they would appear to be competitors in the wider market or not. This is a common occurrence in de-regulated markets.

Relationship to state-owned enterprises (SOEs)

The Chinese experience with SOEs is unique and the country has a different gradation of SOEs. The People’s Insurance Company of China is an SOE and could be described at one time as the Ministry of Property and Casualty Insurance, although now listed Hong Kong (China). Bao Steel, a government steel company partly owns China Pacific Insurance Company. SOEs can mean a number of things aside from the case where the government own the shares directly. The government could be a customer or a service provider for example. Investments may be going into SOE’s (for Chinese insurance companies the investments mainly go to the state-owned banks). At the very top, the government could provide a human resource pool for hiring. It is a difficult thing to unlock.

China is seeing gradual modernization and a steady improvement of competitive skills. The Chinese companies are also pressing ahead with Initial Public Offerings (IPOs). In China, investors want to take up majority positions in companies and not control minority stakes. These relationships often mean a strategic investor like a bank or insurance company brings in the money and foreign expertise necessary for change.


Merger, Acquisition and Consolidation Position

The last five years has seen a reversal of fortunes for large West European companies. Five years ago, these companies were flush with funds and went around the world expanding rapidly. Since then, there has been some move back and reshuffling. Small companies have been sold in some markets. There have been more cases of insurance companies owned by non-insurance groups.

Although, the influence of the regulator in mergers and acquisitions has been limited worldwide, Taiwan (China) has some pressure to build big financial conglomerates. It is still not clear whether this will ultimately achieve what the government wants.

It is hard to imagine Indonesia being a target for foreign investment of the same order as China is currently, but Indonesia could ultimately do better. China is currently credentializing investors and preparing for IPOs. There is a great deal of activity going on in China with investment banks and accounting firms trying to bring in market discipline. There is an on-going move towards greater internal controls, technical discipline, and financial discipline, particularly with companies listed in Hong Kong (China), although the majority stake may still be controlled by an entity on the mainland.

Consolidation and Resolution: Japan

Japan had a problem that some other countries had to a lesser extent – the problem of negative interest rate margins. However, the country stayed in denial, like China and the importance of IBNR, and this led to huge problems in the system. The Japanese companies did not believe that the negative interest rate margin would be a problem. If a company expected value is negative then it is necessary to take some risks. When risky investments do not work (such as Turkish government bonds), then companies turn to questionable means.

There is an example of two Japanese companies with an aptitude to make an average investment of $US 10 million and lent each other $US 300 million. No money changed hands but capital went up by $US300 million in each company. The then regulator was reluctant to pull the plug and left it too late. The next step is to have a white knight take-over. The problem with Japan is that they are all too big to take over and so international players could not save those companies. Then the company goes bust and there is a bidding process for it. Often by this time, the white night will have already purchased the sales force, which meant that there was only one logical bidder for the bust company and that was the winner. Since the company was insolvent, the guaranteed interest rate having reduced the solvency, the fund put money in, and the customer was stuck with a surrender penalty and a reduced guarantee. It was a high-risk transaction but in the end turned out to be a good deal for the companies that were large enough to do this.

The lesson here is that there is nothing gained by waiting this long to let the company crash. A fair amount was lost because the industry was crippled for a while. If the regulator just faced the situation earlier, it would have been a more effective industry.

Conclusion – Issues for a stronger Insurance Industry.

Solvency monitoring systems Financial reporting requirements Market conduct regulation Consumer education Level playing field


In summary, the lesson to be learnt here is that wishing things will go away or fix themselves does not work out and the situation generally tends to get worse. It is better to face the situation and then fix the situation.


Institutional Strengthening

Cindy Forbes Senior Vice President and Chief Financial Officer

Manulife Asia and Japan

International Accounting Standards

These are the prime drivers of international accounting standards. There are two main accounting groups that are currently influencing the direction of international accounting standards:

International Accounting Standards Board (IASB) US Financial Accounting Standards Board (FASB)

The main actuarial group is the International Actuarial Association or IAA. In addition, two lobby groups are actively trying to influence the direction of international accounting standards.

CFO Forum (CFO) constituted largely of the CFOs of European insurers; and Group of North American Insurance Enterprises (GNAIE). This group tends to express opinions

from US companies and some Japanese companies.

The IASB and FASB have issued a joint statement affirming they will work to a common conceptual framework. All accounting organizations are moving to a ‘fair value’ approach on the basis that they consider that it provides more relevant and understandable information than historical cost measures.

Phase I of the IASB projects for Insurance (IAS 4) has high-level requirements that requires separate accounting for insurance contracts. It defines what an insurance contract is, and defines what a deposit contract is and has different accounting standards for both. Phase I allows the use of local GAAP for insurance contracts. This is why it has not had much of an impact on the countries that have adopted it, such as Singapore and Hong Kong (China).

Effective this year those countries that have adopted IFRS can also adopt IAS 39, which is a US gap approach to accounting for financial instruments.

Phase 2 of the insurance project is under development and the focus is a global approach to the valuation of insurance contract liabilities. The discussion draft is expected at the end of 2005. Another eighteen months in discussion and maybe another year before finalization is they manage the current schedule. It will come into effect 2008 or 2009.

International Accounting - Principles

The two lobby groups, trying to influence the development of the International Accounting Standards agree with the following principles. It is not assured that the accounting bodies will adhere to this, but there are some interesting conclusions to draw by just examining these principles and comparing the prevalent approach to insurance reserving across the region, which is a net level premium type reserve. How does traditional statutory reserving compare to the standard being put forward for the international accounting standards?

1. Profit recognition should be in line with the release from risk (CFO and GNAIE). This means that the company is holding a margin in reserve to cover risk and therefore if the company’s risk ceases that margin should be released. If you looked at net level premium reserve to some


degree that would probably be the case. But to the extent that the company has taken into account only a few of the risks that a company is exposed to, they may not be released linearly with or in line with the release from risk.

2. Liability based on discounted approach (CFO and GNAIE). Standard liability should be discounted for the life insurance industry. For the general insurance industry that may not have been the case.

3. No gains or losses at issue (CFO and GNAIE). When a company sells, a contract there should not be any gain or loss. Economic loss will be reflected on initial measurement. You could get a gain if a company is allowed to recognize the present value future profits. You could get a loss if the company is not allowed to recognize its acquisition expenses. Usually with a traditional statutory type evaluation, there is a loss issue, as the Nett Premium Reserves do not treat acquisition expenses fairly. One of the hallmarks of the International Accounting Standard is that a company should periodically ensure that its reserves are adequate in total.

4. Assumptions should be periodically unlocked (CFO and GNIE). It is important from the governance point of view that industry reserves be reset periodically based upon emerging experience. Traditional statutory reserves are quite conservative but they are not necessarily adequate in all circumstances. The experience in Japan makes a good argument for resetting of reserves. Companies in Japan held traditional statutory reserves with the interest rate based on the prevailing rate on the policy. That might be six percent but the rates were down to one and a half percent. Clearly, these companies were not holding adequate reserves and the balance sheet was not recognizing the present value of the negative interest spread in the new liability book. This allowed companies to stay afloat longer than they should have. This damage to the policyholder was greater than it would have been, had the regulator recognized the negative spread earlier. If company management had been forced to look at the present value, and the negative spread early on, the pricing could have been repaired. Investment practices needed changing. The fact that the reserve basis was not reset allowed the management to mislead themselves and the market.

5. Measurement should be portfolio based (CFO and GNAIE). If the company is evaluating liabilities taking in to account the cash flow of its assets then it is necessary to look at the portfolio on an aggregate basis rather than policy by policy.

6. DAC should be used when allowed. There is no problem with differing and amortizing acquisition cost as long as there are controls in place to ensure that the value the liabilities is being held at, is adequate5.

7. Policyholder behavior should be reflected (CFO and GNAIE). This means taking into account things like lapse rates and premium persistency. When looking at a traditional statutory reserve, usually the cash surrender value is less than the reserve, so ignoring the lapsation is conservative. Ignoring lapsation is not conservative when moving to other forms of evaluation.

8. Liabilities should reflect the value of the financial options and guarantees (CFO and GNAIE). This means, if a company has guaranteed annuity options for example (prevalent in the UK where it did a lot of damage), or even guaranteed cash values where policyholders can remove their cash value, then the assets should reflect these guarantees. The value of these guarantees need to be included in the reserves to come up with a full and fair value of liabilities. This would give full transparency to investors, regulators, and management.

9. There should be a principles-based approach to participating plans, reflecting the different models of discretionary participation in different territories (CFO).

5 It should be noted that the validity of the DAC is one area of considerable difference of opinion between the principles of the CFO and GNAIE and those already stated by the IASB.


10. Assets and liabilities should be measured on a consistent basis (CFO and GNAIE). Sometimes, assets are on the marked to market basis, but the liabilities are on a book value basis. This creates volatility in capital and income. It does not give investors or management a clear picture about the business.

11. Embedded value-based measures may be disclosed as supplementary information (CFO). This concept is more popular in Europe than North America. The IAS will support embedded value reporting but more as a footnote rather than on a primary reporting basis.

Solvency in an IAS World

Accounting standards determine actual capital. Each jurisdiction may deal differently with the issue of whether the value of liabilities under IAS is sufficiently conservative for solvency and regulatory purposes. Available capital is determined by the difference between the value of the asset under the accounting system and value of the liability on the accounting system. However, from a regulatory point of view the international accounting standard approach to valuing liabilities is not conservative enough, so there may be a different basis for regulatory capital and solvency including a proposal of additional margins.

Solvency standards determine required capital. Solvency convergence is coming closer. The EU is working on Solvency II. The US is moving towards a principles-based solvency standard. The International Association of Insurance Supervisors (IAIS) is developing solvency principles. Some regulators in some countries have been asking industry to enforce risk-based Solvency regulations.

Current Accounting Regimes Reserving Approaches

Most countries in the region use traditional net level premium (NLP) type reserves with prescribed interest and mortality assumptions. Assumptions generally incorporate an embedded but unknown amount of conservatism. There is no explicit allowance for lapses, and limited allowance if any for acquisition and expense. The assumptions are set at the time of issue of the contract and never changed. This can lead to lack of conservatism after issue if the assumptions are not met. The historic statutory reporting basis focused on solvency and not a reasonable pattern of earnings emergence.

Countries that use this approach are:

Indonesia Japan China The philippines Malaysia Thailand Taiwan (China) Vietnam

This year Hong Kong (China) adopted IFRS, which is the IAS. The country has adopted an interesting approach for liability valuation. The industry continues to use their net level premium (NLP) reserves but rather than using the prevailing interest rate at issue, the industry uses the current rate. This approach, called re-measured NLP, works for companies that are subject to ISA 39. This means that reserves respond to changes in interest rates like fixed income assets. It provides a partial offset to volatility between assets and liabilities, introduced by IAS 39 (mark to


market of financial assets). In Hong Kong (China), GAAP companies can elect any number of accounting basis for liabilities as long as it meets certain standards and a rationalle disclosed in footnotes to the statement.

Singapore follows a gross premium reserve system (RBC) system. This approach uses the best estimated of current assumption plus a margin for adverse deviation, such as mortality, morbidity, maintenance expenses, lapse, premium persistency, etc for each contingency, and all are taken into account. Cash flows are then either discounted at market yield or discounted at the portfolio yield, depending on whether assets are at market value or book value.

Today’s Accounting Regimes Required Capital Approaches

Fixed percentage of sum assured reserves

Many countries around the region use the straight formula approach (percentage of reserves). Increasingly, companies are moving to risk-based capital (RBC), which Indonesia has already adopted. The advantage of RBC is that the company has to hold the capital base on the amount risk they have on the balance sheet. This is the approach in China, the Philippines, Malaysia, Vietnam, and Thailand.

Risk Based Capital

Specific capital factors that apply to each type of risk are asset default, cash flow mismatch and interest rate risk, foreign exchange mismatch, asset concentration risk, claims risk, reinsurance risk, minimum guarantee risk, and pricing risk. Some of these factors give benefits for diversification between risks within portfolios. This is the approach in Indonesia, Japan.

Given limited time, the following bullet points were noted. Current Accounting Regimes Supplementary Solvency Measures

DST in Hong Kong (China) and Singapore. Multiple year financial projections in Japan and Indonesia. Cash flow testing effective in Taiwan (China) and China in 2006.

Relationship between Accounting Standards and Industry Strength (see figure 99)

1. Total balance sheet requirement is important.

Sum of Reserves and Capital Should cover 95-98+ percent of outcomes

2. They should also be consistent

Required capital in a regime with very strong reserves such be lower Generally reserves should cover 80+% of outcomes


Figure 99: Relationship between Accounting Standards and Industry Strength

IAS 4 & 392006YYPhilippines

MTM on assets 06YY (CFT 06)Taiwan

IFRS Adopted

IAS 4 & 39

IAS 4 Exp Draft/IAS 39 2006

IAS 4 & 39

Capital StandardReserve Standard

YYThailandYYVietnam

YYJapanYYSingapore

2008

Y

RBC

Y

YY(Remeas’d)

Y

NLP

Y

YY + DST

FormulaGPV

Hong Kong

Indonesia

Malaysia

China

3. Traditional NLP plus Formula Capital

Conservative at issue Doesn’t respond to changing circumstances (such as falling rates) Required capital independent of the amount of risk assumed by a company. The approach has stable results with low volatility and less sophisticated financial models

and processes required. The stability is reduced when assets are on mark to market basis while liabilities remain on a book value basis.

However, as assets are usually shorter than liabilities, fair value on both sides of the balance sheet may be volatile as well.

The Hong Kong ‘remeasured’ NLP adopts current market rates and is an adaptation of this approach that compensates for IAS 39.

4. Gross Premium and RBC

Conservatism determined by level of margins. Best estimate assumptions change as experience develops. The approach requires regular

experience studies in order to set appropriate reserves. Required capital varies with riskiness of business and management practices. If treatment of assets and liabilities are not the same, it leads to spurious income volatility. Regardless, of greater volatility of results, a higher degree of sophistication is required in

models and processes.

Hallmarks of an Insurance Sector

1. Reserves based on current estimate assumptions with appropriate margins for adverse deviation updated periodically for emerging experience.

Management discovers the impact of current experience on a more timely basis Able to better understand the financial implications of decisions. Pricing of products incorporate reserve requirements, this leads to more informed pricing. Experience study infrastructure required to support reserving and pricing. Important that current estimate assumptions are linked to assets supporting liabilities – cash

flow testing a good tool to ensure that assets are sufficient to support liabilities.

2. Risk Based Capital Regime


Capital requirements based on the risk the company chooses to take. Appropriate required capital Management more informed about the risks they are taking Gives regulators an earlier warning and allows them to become involved earlier. As a result,

less severe action may be required.

3. Knowledgeable Regulation

More complex reporting and monitoring systems require more sophistication.

4. More reliance on Actuarial Profession

More reliance on the professionalism of the actuary to set reserve assumptions appropriately Requires a well-educated actuarial profession, strong professional standards, and a

disciplinary process. Peer review often a requirement in these systems.

5. Dynamic Solvency Testing

Reserves and Capital are point in time measures DST evaluates company solvency under a number of adverse scenarios



Governance is a typical problem in many Asian cultures. Second tier Chinese companies, in particular, are run the as a personal fiefdom. Even some of the big names in the insurance business seem to be ready to bend over and do things that they would never do in any industrial country. Some U.S companies can do with a stronger board. Very often, the person at the top is a government appointed person, creating a political atmosphere. However, no one is willing to take hard decisions and is just waiting for their watch be over and move onto the next job.

Japanese experience

When a certain insurer becomes insolvent, then the industry insolvency fund has to put money in. This is an issue for negotiation for all parties. The existence of a sales force is good, particularly if the policyholder takes a haircut, as selling the sales force could raise some money generating some value for the policyholder. A typical Japanese re-structuring - instead of the four, five and six percent annual investment return the policyholder had been guaranteed, they would have a return of one and a half to two percent and a surrender penalty of fifteen percent. There would be no policy dividends for a long time, if ever. The government would kick in with a tax write-off built into the deal. The government took over once the old management was out. This framework was consistent among all companies.

Japan had an industry insolvency fund, which politically gave the government some right to step into the bad cases. This way the industry had some money to bail out. Although, the government did not explicitly kick in with money but it seemed to work that way. There was an allowance for writing off goodwill, and a tax subsidy and the government negotiated on behalf of the policyholder.

Clarification on – Cindy Forbes Principles of Accounting (Point 8)

Liabilities should reflect to the value of the financial option and guarantees.

Can the insurance company set the cash value higher than the reserve? It is not possible for the cash value to be higher than the reserve under traditional NOP type approach. But in the gross premium evaluation, the reserve could potentially be less than the cash value depending on the assumption. It is not likely but possible that for a traditional product that the reserve is less than the cash value.


Governance of Pension Funds

Amir Abadi Jusuf Chairman

AAJ Associates

Corporate Governance Structure

The importance of good governance for corporations is widely acknowledged. Indonesia has laws and guidance on good governance for corporations supported by commercial and financial incentives for implementing good governance. Reputation is one such incentive.

Pension funds in Indonesia have a high volume of liquid assets (USD 5 billion in 2003) that need to be maintained for delivering of the promised future benefit for participants. The government has supported the governance of pension funds through a highly regulated framework. However, there is no specific guidance on good governance going beyond rules and regulations.

The corporate governance structure in Indonesia has the board of commissioners, the board of directors appointed by the general shareholders meeting (see figure 100). This is the organization responsible for governing the company and the organization.

The pension funds institution has a sponsor, the ‘Pendiri’. The supervisory board, the ‘Pengurus’ and the administrator are involved in the governance process. The difference between the two structures is that the shareholder has the final decision in the case of corporations. In pension funds, there are plan members and beneficiaries but no shareholders. The participants and beneficiaries are the major stakeholders of pension funds. In a corporate structure the shareholders have the power to decide the head of the organization whilst in a pension fund structure, the plan members has limited power to get involved.

Figure 100: Corporate versus Pension governance

RUPS

ManagerManager Manager Manager

GMOS

BOC

BOD

ManagerManager Manager Manager

Employee

Corporation

Sponsor

Administrator

ManagerManager Manager ManagerManagerManager Manager Manager

Supervisory

Employee

Pension Funds

Pension funds in Indonesia are established and run under the Pension Law No.11 of year 1992 and supported with many government regulations and ministerial decrees. The basic concept summarized from laws and regulations are:

Sponsor establishes the pension funds and in the case of a default has the obligation to meet funds required at the time of delivering promised benefits.

Administrator (Pengurus) manages the pension funds to ensure delivery of promised benefits to participants and beneficiaries.

Supervisory Board (Pengawas) provides the oversight on the tasks carried out by Administrator.

Investments must be managed prudently by the Administrator


Administrator holds the ultimate responsibility for all actions and decisions taken on the

management of pension funds.

New regulations, litigation threats, volatile markets, reform of plan design, and funding concerns are just a few of the many challenges confronting Pension Fund Administrators. There are poor investment decisions due to the lack of planning and analysis. Most fund managers have a tendency to put all eggs in one basket and play it safe by investing mainly in bank deposits. As a result, the fund is saddled with low returns. There is not enough examination of feasibility and risks of alternative investment strategies. Funds create and acquire subsidiaries with poor performance and without adequate monitoring and purchase properties with unclear legal status. In some funds, the administrator is an active employee of the sponsor. This has a bearing on the governing process of pension funds and the protection of participants. There is some ambiguity in the roles and responsibilities of the Administrator and the Supervisory Board. Investment decisions need Supervisory Board approval, although the responsibility of faulty decisions lies with the Administrator. The leader’s behavior has set the wrong tone to subordinates on proper conduct, control, and monitoring.

Guidelines for Pension Fund Practice

Except for prevailing laws and regulations, currently there is no specific guideline of pension governance practices for the pension fund industry in Indonesia. However, several organizations, such as OECD and CAPSA (Canada) have issued pension fund governance guidelines. The pension fund industry in Indonesia can adopt the principles from those guidelines to certain extent. However, the adoption should also consider differences related to the Governing Body. In some countries, the Governing Body is a single board. In Indonesia [based on Pension Law] there are Administrators for managing the pension fund and Supervisory Board for overseeing the role of Administrators.

Overview on OECD guidelines

The OECD guidelines for pension fund governance were endorsed in 2002. The aim was to provide guidance to countries to regulate the governance of pension funds, which include the legal form and structure of the pension entity as well as the interactions and relationship between the different parties involved in the management of the pension fund and the plan members.

They apply to autonomous, collective, and group pension funds that support private occupational pension plans.

The central figure in pension fund governance is the governing body. This is the person, group of persons, or legal entity responsible for the management and safeguarding of the pension fund.

The governing body is subject to various forms of external monitoring. The governing body is

subject to various forms of external monitoring by plan members, independent professionals, and regulator.

The guidelines fall into two main groups: guidelines for the governance structure, and guidelines for governance mechanisms


Governance Structure

“The governance structure should ensure an appropriate division of operational and oversight responsibilities, and the accountability and suitability of those with such responsibilities. “

Identification of responsibilities: Clear identification and assignment of operational and oversight responsibilities in the governance of pension fund.

Governing body: A governing body exists to administer pension fund and has the ultimate responsibility that is consistent with the pension fund objectives.

Expert advice: Use of external resources to carry out certain tasks is permissible.

Auditor: Independent auditors appointed to carry out periodic audits and inform related parties on the results.

Actuary: Actuaries appointed to conduct actuarial calculations and assess the sufficiency of funds and inform related parties on the results.

Custodian: Holds records and ensures safekeeping of assets owned by the pension fund.

Accountability: Governing body is accountable to plan members, beneficiaries, authorities and plan sponsor, and has legal liability.

Suitability: Governing body subject to minimum suitability standards.

Internal Controls: Appropriate controls are in place to ensure operational and oversight functions are carried out in accordance with the pension fund objectives and regulatory framework.

Reporting: There should be a reporting channel among those involved in the administration of the pension fund.

Disclosure: Governing body should disclose relevant information to appropriate parties in a clear, accurate, and timely manner.

Redress: Access to statutory redress mechanism for plan members and beneficiaries should be available.

Good Pension Governance

“Pension funds should have appropriate control, communication, and incentive mechanisms that encourage good decision making, proper and timely execution, transparency, and regular review and assessment.”

Transparency Accountability Responsibility Independence Fairness Establishes framework for dividing the responsibility and accountability among all

participants in the governance process. Provides guidance on the all facets of pension plan management, including communication,

benefit administration, reporting, security, funding, investments, and compliance. Provides qualified and careful oversight while enhancing protection for participants and

beneficiaries.

For participants and beneficiaries it enhances the perception of fairness and security. For the sponsor it minimizes opportunity costs and volatility of contributions. For the administrator it


minimizes the risk of improper management and possibility of future litigation. The following graphic shows the proposed pension governance structure.

Figure 101: Proposed Pension Governance Structure

… requires a supportive regulatory framework, adequate controls and

risk management, good asset management, clear and protected rights and

responsibilities of all parties related to the

administration of pension fund institutions and also for the pension fund participants [and

beneficiaries] and sufficient supervision,

monitoring and reporting

Sponsor

SupervisoryBoard

ReportingRelationship

Government

MonitoringRelationship

ParticipantsEmployeeExternal Goods & Services Contractors

AppointmentRelationship

Administrator Stakeholders

Administrators

Co-Sponsor

Regulator

Proposed Role and Responsibilities

As part of the good governance mechanism, a clear and segregated role and responsibility between those that administer and oversee the pension funds institutions need to be established.

Sponsor

Appoint Administrator (but not the Chairman of Administrators), and member of Supervisory Board.

Oversee the operations of Administrators. Determine the investment plan, work plan, remuneration of administrator, and create or

terminate a sponsor partnership. Directors from Sponsor must not be acting as representative of participants in the

Supervisory Board. Administrators

Directly responsible to Sponsor Select and appoint professional managers for day-to-day administration. Currently, the

administrator also acts as management. So the ‘Pengurus’ and the ‘Board of Director’ are the same entity.

Responsible for strategic policies and oversight.

Supervisory Board

Not a decision making body except for specific responsibilities. Should not be involved nor interfere in administration in order to remain a neutral observer in

its monitoring role.


May become a whistle-blower in case of severe and persistent poor performance of the

Administrator. Enhance the credibility of the pension plan by serving as channel of communication between

Administrator and Sponsor. Can help with timeliness and socialization of reports.

The Ingredients of Good Pension Governance

1. The regulatory framework should have available appropriate legal documents and a framework to support the operation. The purpose of establishment should be binding and relevant to the purpose of pension fund as mandated by law.

2. Roles and Responsibilities.

Clear description on the roles and responsibilities of all parties involved in the administration of pension fund.

Clear delineation between the rights and responsibilities of Sponsor and Administrator, and between those that have the operational function and the oversight function.

Rights and responsibilities must match with the prevailing legal framework and be sufficiently influenced to the degree of legal responsibility as set in the legal framework.

3. Administrators and Supervisor

Build a group of Administrators and Supervisory Board that collectively can fulfill expected roles and responsibilities and generate value to participants and other stakeholders.

A fair, transparent, and merit-based selection and appointment mechanism for Administrator and members of the Supervisory Board. Also, in appointing employee and outsourcing.

Administrators are to be aware of their fiduciary obligations, thus ensuring actions on behalf of the institution’s interest, and of the participants and beneficiaries’ interest.

4. Policies and Procedures

Policies and business process procedures need to be developed and practices need to be monitored constantly.

Codes of ethics, conflict of interest, and fraud policy should be developed, put in place, and any violation should be taken seriously and dealt with.

Whistle-blower policy and mechanism.

5. Strategic Management

Sufficient planning should be made on a long-term basis, then broken down to short-term operational planning and then detailed action plans.

Implementation should be monitored and deviation from the plans should be analyzed and reported.

6. Control activities

Adequate internal control and risk management should be in place to identify potential red flags that could cause disruption.

Develop control measures, and examine the efficiency of the control measures, to alleviate risks exposed.

The control and risk management process treated not as one-off action but continuously.


7. Investment strategy

Prudent investment based on sufficient and timely information Develop an asset mix strategy with investment yield benchmarks for each asset class. Develop benchmarks based on historical performance, and current and projected future

conditions of each asset class. Asset allocation should be made by considering the targeted expected return on total

investments and the rate of return needed to be able to maintain sufficient funding and deliver the promised benefit.

8. Plan Members Protection

Plan Members’ (Participant & Beneficiary) rights should be protected Adequate disclosure and access to information should be provided on the institutions’

performance Equal and non-discriminately treatment of all plan members should be provided Redress mechanism to rectify any issue between plan members and the pension fund

institution should be readily accessible.

Conclusion

Good pension governance is a journey. It includes understanding the importance of good governance, awareness of fiduciary responsibilities, supporting the regulatory framework, establishing guidelines on governance, commitment and enforcement, and the continuous implementation of these aspects.

A system to direct and control to increase assurance that the operation is managed efficiently and legal and social responsibilities fulfilled.

There is no one size fits all in good governance. Each country can design the most appropriate system to fit its unique characteristics, so long as it upholds the basic principles of transparency, accountability, fairness, responsibility and independency

Every individual involved in the decision-making process needs to act on good faith and for the benefit of stakeholders.

A dynamic process, which is a means to an end. A paradigm shift to new state of mind. A pro-active self-improving behavior. Mandates operational processes to control risks manage investments and pursue the

implementation of good practices.

Appendix: GPG Core Principles

1. Administrator Responsibilities

The responsibilities of the Administrator to Plan members, beneficiaries, the Employer, and other stakeholders should be clearly defined and distinct from the responsibilities of the Employer as Plan Sponsor.

A basic fiduciary duty is to administer the plan with due diligence in the sole interest of the members and to adequately seek optimization of the decisions.

The Administrator of the Pension Plan should conduct regular reviews of plan governance.


2. Governance Objectives

Governance objectives should exist for the oversight, management, and administration of the Plan, including the Fund, building on Sponsor’s objectives, plan rules, and regulatory requirements.

Members of the governing body of the pension plan should be subject to appropriate standards of fitness and propriety to ensure a high level of integrity and professionalism in the administration of the plan.

3. Delegated Roles and Responsibilities

Clear documentation of the roles, responsibilities, and accountability of all persons involved in the governance process.

Operational functions include collection of contributions, record-keeping, actuarial analysis, funding, and financing policy, asset-liability management, investment strategies, asset management, and disclosure to plan members, tax, and regulatory compliance.

Reporting channels between all persons and entities involved to be clearly defined to ensure effective and timely transmission of relevant and accurate information.

4. Knowledge and Skills

The Administrator must ensure all personnel and professional advisors meet qualification standards and apply the appropriate knowledge and skills in discharging their responsibilities.

In the absence of sufficient internal expertise to carry out certain functions, especially with regards to the management of assets or the conduct of actuarial studies, the Administrator should seek expert advice, appoint professionals or outsource the activity

5. Performance Measures

The Administrator must establish performance measures and monitor the performance of persons who have decision-making authority in the governance process.

The process should cover the selecting, compensating, monitoring, and where necessary replacing staff as well as external service providers.

Performance objectives should extend beyond financial results to encompass the level and quality of services offered to members and beneficiaries.

6. Availability of Information

Records should be maintained and systems should be in place to ensure that accurate statistics and secure data are accessible on a timely basis to enable benefit calculations.

Actuarial studies as well as proper analyses of emerging demographic experience or financial performance make available, as required, relevant management information to identify policy options and optimize the decisions

7. Control of Risks

An internal control framework, commensurate with the plan’s circumstances, is used to monitor the management of pension plan’s risks.

Financial risks comprise the solvency and the adequacy of the assets, the setting and implementation of the investment policy, the diversification, dispersion and matching of assets as well as the variability of required contributions under adverse circumstances.


Procedures should be in place to deter, detect, record, report, remedy fraud or diversion of

pension assets, benefits, or contributions, and prevent money-laundering activities.

8. Oversight and Compliance

The Administrator applies appropriate mechanisms to oversee and ensure compliance with the legislative requirements, pension plan documents, and administrative policies.

Compliance includes accuracy and fairness in the interpretation of the rules and the accuracy of benefit calculations.

Complaints handling mechanisms and internal redress channels should be available to plan members and beneficiaries in addition to statutory alternatives.

9. Transparency and Accountability

The governance process should be disclosed to plan members and other stakeholders to achieve cost-effectiveness, transparency, and accountability.

Decisions taken by the Administrator, or on its behalf, should be recorded on written reports. Reports by independent auditors should be produced regularly and their results

communicated to the members and other stakeholders as well as to regulatory authorities

10. Code of Conduct & Conflict of Interest

The Administrator shall establish and regularly update a code of conduct and a policy to address conflicts of interest.

Decision makers are accountable for their decisions. Appropriate controls should prevent the improper use of privileged or confidential

information. Internal review mechanisms should verify and sanction compliance.


Institutional Strengthening and Governance of Pension Funds

Yves Guerard Secretary General

International Actuarial Association

Key Drivers of Pension

Good pension governance is a basic requirement. A pension plan should deliver on promises at a minimum cost and minimum risk for all stakeholders, while meeting beneficiary’s reasonable expectations. Some of the responsibilities are allocated to the sponsor and others are allocated to the administrator, and it is a fundamental principal of good pension governance, as of good corporate governance, that the responsibility be clearly attributed.

Responsibilities of the sponsor

Clear and appropriate promises Affordable cost commitments Management of the financing path Selection, appointment and monitoring of Administrators Definition of acceptable investment risk

Responsibilities of the Administrator

Efficient and fair administration. Selecting good managers and service providers Securing adequate professional expertise Optimizing investment risks and returns.

The Sponsor and the Administrator

Pension Law Article 10 indicates that in Indonesia the administrator (Pengurus) is appointed by and responsible to the founder (Pendiri). The Minister may prescribe qualifications and requirements for individuals, or entities, to be allowed to be appointed as Administrator. Frequently, in Indonesia, the administrator is a group of three to five persons.

Creating a geographic and physical distance between the head office and the administrator’s premises is not a substitute for good governance. The pension law requires that pension assets be kept separate and distinct from employer assets, out of reach of the creditors of the employer, be held by a custodian, and used only for plan purposes. The geographic distance only interferes with good communication and economical access to common resources.

Multi-layered risks

Good governance includes designing a good system, which is easy to govern.

Program risks mitigated by design that entails different types of risks Investment risks defined by investment guidelines that set the risk and reward balance. Sponsors appoint the administrator and can minimize operational risks by ensuring proper

qualifications and good governance.


Control of risks requires good communications between sponsor, administrator, and other

professionals. Good governance extends to professionals and other providers serving the program. Good

governance cascades from the top down to agents in the administration.

Risk control requires good communication between the sponsor, the administrator and other professional and communication. This is why creating geographical distance is not conducive to better communication. Good governance is an umbrella covering all people involved.

Employer’s Pension Plan

As the name indicates, it is a plan created by an employer for employees. There should be a close relationship between the administrator, the sponsor, and the professionals involved. The pension program is an important component of the human resources and compensation policy. The sponsor and the administrator share a common mandate and build financial security in retirement for the plan participants.

The execution of the pension plan is delegated to the administrator but the sponsoring employer remains responsible for the good health of the pension plan and should remain closely associated with monitoring its performance. Therefore even though it is delegated it ultimately remains the employer’s responsibility.

Mitigate risks by plan design

One of the big risks in a pension plan is created by the design of the plan. There are many ways to design the pension plan that attributes risk in different ways. Plan design can be more or less risky for the sponsor. A Defined Benefit based on final pay with generous wage indexation and broad ancillary benefits are most risky. Unfortunately, that is the most frequent formula in Indonesia. DB based on final average, with price indexation and simple survivor benefit would be less risky. DB based on career average with pre and post retirement indexation or target plans is much less risky. This less risky form is not used frequently in Indonesia. These plans could be seen as an equivalent to a notional defined contribution plan that is also equivalent to an index career formula. Defined Contribution (DC) that runs through an employer plan or FIPF limits the employer risk but shifts the risk to the beneficiary and therefore the sponsor of that plan has an increased fiduciary responsibility.

Figure 102: compares the distribution of risk between different types of formula

BBBDC

BBSTarget DC

BSSCash balance

SSS/BCareerrevalued

SSSDB

AnnuitizationPre-retirementinvestment

Pre-retirementsalary

Type of Plan


The sponsor and part of the management of human resources of the employer set the pension policy. The value of the pension plan is part of compensation package and the tax preferences make it an efficient form of compensation. An important consideration is that the normal retirement age needs to be consistent with retirement and recruitment policy. Provisions for early, deferred and disability-related retirement need be harmonized. The pension plan is an ideal tool for succession planning and rightsizing of the labor force. In many countries, “employers of choice” use a pension policy to attract employees with right attitudes and qualifications, thus reducing training costs.

Investment Risks

The second category of risk that good governance addresses is the investment risk by measuring the performance of managers.

There must a clear statement of investment objectives. It is important that the investment be carried out in the best interests of the plan, explicitly prohibiting other criteria. The spirit of a pension policy is to resist the urge to become an entrepreneur instead of an investor. The investment guidelines should make the agreement between stakeholders -- employer, employees, retirees, managers, custodian, and trustees – explicit. The guidelines should give some control to the asset manager, but that control must be within certain defined boundaries.

A must for good governance is the attribution of performance and evaluation of results from benchmark asset allocations. The investment objectives and strategy translate into a detailed investment plan incorporating an exit as well as an entry strategy and taking into account current market conditions and economic analysis and the current portfolio, regulatory framework, cash-flow projections and liquidity needs. The exit strategy is important since, in Indonesia, investments are made and forgotten too frequently, even though the market conditions may have changed.

Statement of Investment Policies and Procedures

The investment guidelines indicate more than calculating a simple percentage return.

Asset classes Diversification of portfolio Asset mix Benchmark for anticipated return Securities lending Voting rights Liquidity requirements Use of Derivatives Borrowing Policy review and reporting Management controls

The fixed return target is replaced in most countries by a formula that relates the target and risk to the market. Fixed return targets (X percent, inflation, + five percent) imply an unknown degree of risk and this has been replaced by the concept of market driven benchmark portfolios. A fixed target may be extremely easy to meet in a good year and impossible in a bad year for the market. Therefore, the target must be related to the market, which will better control the risk to be assumed.


The policy guideline should be guidance for the actuary and not the reverse. This implies that the actuary examines the policy guideline for the pension plan and adjusts the assumption and not the reverse. A guideline should have a basis to translate investment guidelines into measurable objectives and enable performance comparison and analysis.

Having a strong policy guideline will enable a pension fund to attribute the value added by investment managers and facilitate monitoring compliance with the regulatory framework. There is a mathematical formula to analyze the performance of the portfolio and see what is attributable to the market and what is attributable to the manager; and between what attributable to the strategic decision regarding the portfolio mix and the tactical decision of the selection of security (see figure 103). Through this formula, one can check a manager’s performance, strengths and weakness, and this information can then guide decisions in a governance context on when to replace investment managers.

Figure 103: Attribution of value added

Total expected return= Σ (Wi x Hi)Total actual return= Σ (Ti x Ai) Benchmark return= Σ (Wi x Ri)

Wi = series of benchmark percentages, Hi = series of historical returns by category, Ri = series of index market returns Ti = actual asset mix achieved by the managerAi = series of actual returns on the invested portfolios

Market fluctuation is Expected returns Σ (Wi x Hi) minus Benchmark returns Σ (Wi x Ri)

Manager value added (or subtracted)Difference due to asset mix: Σ (Wi – Ti) x RiDifference due to securities selection: Σ Ti x (Ri – Ai)

« i » is a specific period

Structure for Managing the Pension Fund

In recent years, a common trend is to split the benefit administration from the management of assets because it requires a different structure and a different type of qualification. By splitting the two, one is allowed to focus on the qualification of people relevant to their duties.

Skills for benefit administration

transaction intensive lower risk operation mostly clerical personnel IT support for database maintenance direct contact with participants

Skills for Asset management

high-risk activity. requires strong governance structure. mostly professional personnel. IT support for sophisticated evaluation and online transactions. trend is to outsourcing totally or partially.


Outsourcing is a tool to implement good governance. Globally, the majority of pension plans outsource their investment management function. There is a growing trend to outsource administration to specialists with sophisticated technology support. Call centers are becoming more popular. Pension insurance represents totally outsourcing to the insurer. In Indonesia, it is not possible to entirely outsource to an insurer but there is hope that this law will be modified and that insurance companies could play a much greater role in the development of pension plans. This will simplify the governance issue for both the sponsor and the administrator.

Insolvency Risk

The main risk for the pension plan is the risk of insolvency. Avoiding this risk needs a strong financing strategy. An explicit and transparent financing strategy will help manage expectations, provide benchmarks and reduce risks. The funding and solvency regulatory framework allows for flexibility in amortization of deficits and utilization of surplus. For the sponsor, an increase in the cost and the contribution is always bad news. However, when the bad news is a surprise, it is worse. Therefore, with a financing strategy one can plan a contribution, which evolves from year to year. If one examines the funding and insolvency regulatory framework, it allows for flexibility in the amortization of deficit and utilization of surplus and so it is possible to smooth out the pattern of contributions, because the contribution is computed in accordance with estimates derived from a variety of methods that must comply with the regulatory framework but allow some flexibility.

This requires a good exchange of information between the sponsor and the founder, the administrator and the actuary. Therefore, good communication will help in having financing path that delivers on expectations.

There is no miracle. Costs are not modified by estimates or assumptions but the impact of the cost is distributed across years and may sometimes affect the financial health of the sponsor. Acceptable Defined Benefit risk can be expressed as “pain” caused by adverse variation in contributions: 0, 1%, 0,5%, 3%, 5+% of payroll. A 1/10th of one percent of wages increase in the contribution rate is a small risk that can be digested easily. Half of one percent is already significant and it can be the difference between a labor settlement or a labor strike. Three or five percent can be the difference between the sponsor being unprofitable or profitable and therefore becomes more painful.

Using professional expertise

A principal expert for pension plan is an actuary. The actuary brings in an actuarial control cycle, which is a key governance tool for the actuary, the sponsor, and the administrator. In the international context, good professional governance means self-governance, individual responsibility, enforceable standards, and effective discipline. The professional must also comply with national law and the requirement should be responsive to the public interest and supportive of the supervisory and regulatory framework. Professionals can make risk-based supervision much more efficient. The sponsor and administrator are responsible to select and verify qualifications, monitor good professional governance, and use of best expertise of all providers. It does not mean that the sponsor or the administrator need to re-do calculations, but may compare and if necessary ask for a second opinion. It is not good governance to take the answer from an actuary as something that cannot be discussed or challenged. Challenging will help the administrator better understand the recommendation.

Good governance also means that the actuary is always responsible for the methodology and the accuracy of the calculations in accordance with sound actuarial principles. This responsibility cannot be transferred to the sponsor or the administrator.

The only exception to this responsibility is when applying mandated methods or assumptions, for example in accounting for pension expenses, fully responsible for using methods and


assumptions appropriate for the purpose and consistent with the public interest. However, it is not forbidden, on the contrary, it is recommended, that the actuary takes into account the business plan of the sponsor, the investment guidelines and the investment strategy of the administrator to the extent deemed appropriate. An actuary may look at the investment policy and past performance and have a best estimate for the future.

Actuaries play multiple roles and good governance needs to ensure there is no conflict of interest between different roles.

Statutory reporting of costs and liabilities Expense reporting and financial condition Consulting advice Program design Risks management Financing path Performance of program

The actuarial report is a principal product of the actuary used by the administrator that will go to the sponsor and used by the supervisory board. The actuarial report is supposed to contain sufficient information so that another actuary can re-produce the result and provide the employer and the reader of the report with the essential information and justification for the assumptions made in the selected methods. There is a need for quality, consistency, objectivity, and independence. The report should be based on discounted projections of future benefits payments and contribution flows. Best practice is to present not only the static view of current costs and liabilities but also a range for the projected results over a number of years.

The sponsor and the administrator are responsible for ensuring that the actuarial report complies with good professional governance and provides information for the management and good governance of the plan.

Actuarial Control Cycle

Actuaries offer a unique combination of mathematical, statistical, demographic, economic, financial, analytical and modelling skills. Actuarial studies, reports, and analyses can play a vital role in the control of risks. It is a part of the work of an actuary to accumulate information, study the experience, and therefore be able to adjust the parameters that are being used. Experience studies, gain and loss analysis and projections can detect errors, provide a basis to quantify risks, determine sensitivity of results to risks, and send early warning signals. Good communications between the actuary, risk manager, administrator, and sponsor are essential to ensure that the assumptions reflect facts and best-known information. Actuaries can provide guidance on the optimization of the financing path for mitigating volatility within regulatory constraints.

Graphically, this concept is represented as a feedback cycle (see figure 104). There is risk analysis through financial projection, and then the actuary adjusts parameters, monitors performance, and collects new data and revises the design and the model parameters and starts over again.


Figure 104: The actuarial control cycle – A basic governance tool

Financial ProjectionsRisk analysis

Revise design and modelparameters Monitor

PerformanceCollect data

AdjustOperation

parameters

This is the basic tool for the actuary but it is also the basic tool for the governance of the pension plan, and the sponsor and the administrator can benefit a lot from this approach, which gives feedback on the result.

Proposed roles of responsibility amongst parties

The sponsor may appoint the supervisory board but the appointee should not be on the board of directors of the sponsor. This would avoid a conflict of interest.

It is important to understand the distinction between the role of the administrator and the role of the supervisory board. The supervisory board, also called the advisory board, does not have any powers but plays the role of a watchdog and a whistle blower. To play this role with a certain amount of objectivity and independence, the board has to be far from the management to maintain neutrality. However, it is important that the responsibility between the administrator of the pension plan and the supervisory board is not split. The administrator has full responsibility under law. This is the difference between a pension plan and a corporation. The corporation has a board of commissary and a board of directors and both are a part of the authority on the corporation. This is not the case in a pension plan. The full responsibility is with the administrator, and good governance demands that the line of responsibility is not fuzzy. Therefore, the supervisory board should stay away from taking on the role and responsibility of management of the pension plan and far away from the management of the employer as well. The responsibility of the sponsor is to divide this power and to ensure that there is no influence on the management of the pension fund. This can be a complicated issue in companies.

Issue of independence of the pension plan

The pension plan is created by the employer for employees and, to that extent, it is not independent. But the sponsor cannot interfere with the administration of the pension plan. Therefore, the plan design is the responsibility of the sponsor and once the rules and benefits are decided, they need to be adhered to. But the sponsor has full authority to determine the benefit, which must be done in an official, neutral, and objective fashion. A sponsor has the independence to create investment guidelines but once these guidelines are created any interference is forbidden.


Investing Insurance and Pension Assets


Dr. K. Ravindran President

Consolidated Risk Management Solutions

How do traditional liabilities differ between insurance companies and pension plans? A life insurance company’s liabilities are long-term and involve “guarantees” at time of death. The insured pays a premium for life and, at the time of death, gets the insured amount. It is a straightforward liability. From the insurer’s point of view, the company is exposed to mortality risk and lapsation risk. If the policy lapses, then there may be insufficient funds to pay for future claims.

On the pension front end, the norm was defined benefit plans some years ago. The employee contributed some amount at regular frequencies and, at retirement, receives a lump sum payment. Liabilities involved converting contributions into living benefits at retirement. In both concepts, there is a measure of risk, element of risks, and an element of guarantees.

The landscape has changed drastically in the past decade. There is an increasing sophistication of individual investors and a convergence of financial and insurance markets. It is common to have products that have both insurance and financial market segments. There is an increasing amount of innovation by product providers (taking advantage of tax breaks). Companies now invest in mutual funds and equity markets. Insurance companies now offer products that include financial market risks. Pension plans now transfer risks from plan sponsors to plan owners (employees).

Risks Underlying Pensions

Defined Benefits

Plan sponsors need to have enough investments in the plan to ensure sufficient returns to meet promises made to plan owners (employees). Plan sponsors that invest in equity markets need to generate enough returns to meet the obligation of a fixed stream of cash flows, which are not related to equity markets. It is common to see sponsors struggling to generate returns to pay off guaranteed claims. The question is – is there anything wrong with this approach? The answer is yes.

Take the derivatives business, for example. Hedging currency or stocks means actually buying that asset to mitigate the risk. If selling a derivative on the price of oil, for example, one needs to buy futures and options on oil to hedge the risk. The fundamental philosophy in the derivative market is being able to replicate your risk using the underlying instrument that creates the value of derivative.

If one applies this philosophy to the pension world and talks of defined benefits, the employer is often faced with a catch 22 situation. To fund future cash flows, is it prudent to invest in an equity fund or an investment option that is interest rate sensitive? An interest rate sensitive investment option may not appreciate enough to fund the liabilities. Therefore, the option must have consistency of liability models and inputs with capital markets. How do you actually value these liabilities? These liabilities cannot be valued in a vacuum. Valuation in a vacuum can lead to undervaluation and fund bankruptcy. Second, purchase assets that are highly co-related with liabilities. Thirdly, manage risks inherent with liabilities in a manner consistent with the approach for derivative products.


Defined Contributions

Plan members need to have sufficient return on the investments in the plan to ensure a sufficient amount to meet their lifestyle needs upon retirement. Yet, individuals tend to be naïve and could end up putting their money into a highly volatile fund. This problem can be fixed through investment guidelines for plan owners (employees). Policy guidelines should be a function of age. This is developed using risk-management techniques that dictate frequency of re-allocation of portfolios and information on liquidity of local and foreign capital markets.

Secondly, it is important to educate plan owners (employees) on risks and rewards. This is lacking in most pension funds.

Thirdly, it is necessary to ensure that the incentives of financial institutions and brokers do not conflict with needs of plan members. For example, it is important that brokers are not being paid for trade churning. Otherwise, brokers tend to ask individuals to switch to schemes that pay better commission. It would also be good to have some kind of principal guarantee. Products such as the 401K in the US offer principal guarantees to certain companies if required.

Risks Underlying Insurance

In traditional life insurance products, policyholders pay premiums so that beneficiaries do not have to face financial hardship after the death of the policyholder. To manage this risk the insurance company reinsures the lapse and mortality risk. The company manages the non-reinsured risks using assets, typically corporate bonds with low credit ratings and equities. Once again, there is a problem with this approach.

The solution is to have many highly correlated assets. There have been many insurance companies that went bankrupt due to funds being invested in high-yielding corporate bonds or volatile equities. The insurance company can ensure that the price of the policy is not established using unrealistic assumptions. There will be problems of mismanagement if the pricing assumptions are not realistic or practical. Equally important is the whole concept of managing counter party risk, credit risk, and rural area risk.

In equity-based guarantee products policyholders pay premiums towards some fund that is either fully transparent (e.g. unit-linked products) or not transparent (e.g. with-profits products) so that beneficiaries do not have to face financial hardships after death of policyholder. Recently, there has been a debacle in the U.K with a profit-based product and regulators are insisting on increased transparency on how the profit is earned. Insurance companies manage the risk of these products by reinsuring some amount of mortality and lapse risks and sometimes market risks. Typically, they manage investment market-related risks by holding capital. In practice, this does not work out very well since the capital is based on the best estimate of the risk today and this may not be enough. Setting aside capital is not the best answer to the problem but somewhat acceptable. Once again, insurance companies can manage this risk better by using highly correlated assets, ensuring that the policy is not priced using unrealistic assumptions and understanding that mortality and financial market risks are embedded and therefore it is difficult to split risks. Insurance companies also need to manage and understand counterparty risks, rollover risks, and interest rate risks in these products.

Role of Capital Markets

Hedging is synonymous with risk management for both insurance and pension products and requires a strong capital market. A liquid capital market is required to manage long-term risks efficiently. This means having access to different liquid market products, such as bonds, especially when these liabilities are long term. Trying to re-invest repeatedly in short-term assets


in the hope that it will work out in the long-term is the worst strategy since every rollover exposes the investor. The ideal scenario is to buy into long-term assets but this may not be practical. The market simply may not have liquid products extending beyond a particular tenure, such as ten or twenty years.

This situation is when derivatives can play a key role. Accounting regulations should encourage use of derivatives as form of risk-management tools (e.g. moving to mark-to market valuation as opposed to using book value for liabilities). Insurance companies tend to be wary of derivatives for risk-management without realizing that, by offering policyholders options on the policy, they are using a form of derivatives. In the US, for example, if the insurer uses a derivate for hedging, their financial statement tends to be volatile. The asset is marked to market but not the liabilities and this makes the earnings volatile. So in a sense, the company is penalized for using derivatives. This is a discouragement for managing risk actively since every public company wants to look good for investors and stakeholders.

In the absence of liquid capital markets, the investor needs access to foreign capital markets. Unfortunately, some countries forbid this. This kind of policy is self-destructing. Investors cannot hedge risks internally since the assets are not sufficiently long-term and they cannot invest overseas if the regulation forbids it.

Lastly, there should be capital relief for companies managing risks effectively. This has been adopted in the US and Canada. It is important to ensure that liability pricing is consistent with capital markets if planning to manage risks actively.

Conclusion

What are the issues that regulators should think off when trying to regulate the pension market and the insurance market? One of the initial issues to understand is that financial market risks cannot be diversified across policyholders buying the same product. This means if a policyholder buys a particular insurance product, linked to a financial market of a particular fund and another policyholder buys a similar type of product and the financial market crashes then it is going to affect everyone. Thus, regulators need to ask the following questions:

How realistic are financial market assumptions relative to what is inherent in capital markets?

How much capital should companies set aside for the risks undertaken? How should the required capital be reduced to reward a company for deploying sound risk-

management practices? Regulators need to understand actuarial risks. Very often insurers sell products where the policyholder behavior assumption was incorrect but is approved by the regulator.

Mortality Risks can be diversified across policies unless it is integrated with financial market risks.

Validity of lapse and dynamic lapse behavioral assumptions. Validity of other types of policyholder behavioral risks.

Regulators often forget to look at operational risks. It is important to check whether operational and legal systems are in place for hedging risks.

Key man risks Systems and data risks Counterparty risks Legal risks arising from misrepresentation to policyholders.


Dr. R Kannan President

the Actuarial Society of India

Principal Issues in the Pension Market

There are a number of key issues driving change in the pension markets:

The shift from defined benefit to defined contribution schemes as companies are finding it difficult to meet liabilities.

Individuals are shifting from non-unitized funds to unitized funds where the entire investment risk is borne by the policyholders or the contributors to the pension funds.

These issues create many asset-liability management issues. There is a need for a transparent procedure and educating the contributors.

Financial stability is the responsibility of the industry, making public accountability and a transparent process very important. Japan is one country where principal guarantees have played havoc (see figure 105).

Figure 105: Interest rate guarantees in the Japanese market

3

Policy issue year Policy durationFund yield

< 10 years 10 < . < 20 years 20 years < .

Up to 1952 3,0%Actual fund yields in this period usually in

excess of guarantees

1952 – 1974 4,0%

1974 – 1976 4,5%

1976 – 1981 5,5% 5,5% 5,0%

1981 – 1985 6,0% 5,5% 5,0%

1985 – 1990 6,3% 6,0% 5,5%

1990 – 1993 5,8% 5,5% 5,5%Actual fund yields in

this period often below guarantees

1993 – 1994 4,8%

1994 – 1996 3,8%

1996 – 1999 2,8%

1999 – 2001 2,0%

2001 to date 1,5%

Prior to 1990, the yield on funds was in excess of the guarantees offered by products. After 1990, and particularly from 1996 onwards, the actual yield on the funds is far below the guaranteed returns. Eight companies became insolvent between the years 2000 to 2004, and ten million guaranteed policies were cancelled. Three companies levied additional surrender penalties. As a result, twenty-five percent of assets in a portfolio became non-performing or of low value. The Japanese fiasco raises many issues in risk management.

Financial Bankruptcy. In the case of insolvency risk, the result of guarantees, the value of liabilities is more than the assets.

Fraud Risk is an operational risk due to bad management and the lack of internal control.


Inflation risk occurred in France in the late eighties. Due to inflation, the value of the benefit

guaranteed became lower than what the policyholder expected when starting contributions. Short-term market risk is the erosion in market value in the short run. Long-term market risk – it can take the market a long time to come back to the previous level

before a short term fall. Longevity risk. Balance-sheet risk.

Highlights of the OECD guidelines

Appropriate legal and governance structures. Accountability, integrity, and professionalism. Transparency. The enforcement of actuarial certification.

Product Design

The potential duration of a pension product is forty years or longer. Whereas, the potential duration of an insurance product is twenty-five to thirty years. Therefore, the asset-liability management is very important. In the figure 106, the Defined Benefit example is based on the percentage of final salary. The mortality rate and the technical rate are fixed. The second one (pink) is the defined contribution product where the investment is unit linked. There is no commitment on the mortality table.

Figure 106: “Products Design

Payments Premium Commitment Benefits Death cover Financial type

Employer Annuities Defined technical rate (whole term)

Compulsory Defined benefits

Face amount

Employee Choice Defined rate (limited period)

Non compulsory

Defined contributions

Reserves

Both Lump sum No guarantee

If you develop various scenarios for these products and examine various risk factors then in product one the longevity risk, inflation risk and the market risk is highly pronounced. In product two, these risks are not prevalent but the product offers insurance along with a pension and as a result the insurance product carries some risk (see figure 107).


Figure 107: Comparison of the two pension funds according to the three main risk factors Product 1 Product 2

Insured Pension funds Insured Pension funds

Longevity risk 0 +++ ++ +

Inflation 0 ++ ++ 0

Market risks 0 +++ +++ 0

There can be mechanisms to mitigate insurance risk if the pension and life cover is offered together. The relevant period in the figure is 1952 to 2001 and there are different blocks of five, ten, fifteen, and twenty years. There are twenty-one years where the stock index performance was very big, eleven years where the government security bond market was at the peak level. Nine years where the money market instruments had a maximum return, and six years when inflation was at the peak level (see figure 108).

Figure 108: Best Asset by Period Duration

Period (between 1950 and 2001)

Stock Bonds Monetary Inflation

5 years (47 ) 21 11 9 6

10 years (42 ) 20 8 8 6

15 years (37 ) 16 10 11 0

20 years (32 ) 11 12 9 0

Diversification is required when investing in bonds and equities. There is a model that discusses certain probabilities to demonstrate that diversification of a portfolio is necessary (see figure 109). The model looks at the probability of the assets dropping below liabilities in twenty-five years i.e. the probability of under funding. If the money is in government securities, the risk is low. With local stocks the risk increases beyond a particular point. The higher the diversification in the portfolio, the lower the risk of under funding.


Figure 109: Example of Concrete Asset Liability Management

Performance of investments net of inflation

Probability of underfunding once in the next 25 years Local stock

World stock index

Monetary

Local bonds

World bonds

It is important to consider the average age of policyholders so as to determine the duration of the combined liabilities. The following figure takes into account the mathematical reserves of a man aged 50 years, and the woman aged 35 years (see figure 110).

Figure 110: Mathematical Reserves

0

2000

4000

6000

8000

10000

12000

14000

16000

18000

20000

0 5 10 15 20 25 30

Man 50Woman 35

It is important to interject here that the perception that unit-linked investments are not good for developing countries, is incorrect. It works if you take care of your investment pattern and are careful in portfolio allocation. If the average length of investments is more than twenty-five years, then the portfolio should have a higher level of equities and start reducing that component as you move closer to retirement.


Asset Liability Management Issues (ALM)

ALM issues are important to ensure meeting payments of a pension fund at the time of the member’s retirement. A pension fund has a longer duration than an insurance product and deals with different profiles, uncertainties of life expectancy and heterogeneity of contribution between members. ALM issues are dependent on two factors. First, the individual’s characteristics on which the average duration and the type of portfolio is based. Most developing countries tend to invest heavilly in government securities and are nervous about investing in equities even though returns are higher. However, with equity the risks and the volatility also increases and one needs to determine the optimal combination taking into account risk tolerance and yields (see figure 111).

Figure 111: Returns and Risks

Equity 0 5 10 15Equity 0 5 10 15Return 6 9 15 21Return 6 9 15 21Volatility 5 7 11 23Volatility 5 7 11 23

In India, the regulator allows the pension, the general annuity business, and the unit-linked insurance business to invest not less than fifty percent in government securities or other approved securities, and not less than fifteen percent in infrastructure and the social sector and thirty-five percent in other exposures to be specially governed. The Indian regulatory body has provided for adequate freedom for pension funds.

In the insurance business, twenty percent can be invested in government securities, and the others, including state government investment should be not less than forty percent and the balance in approved investments (not exceeding sixty percent). Over the past year, the regulators have allowed investments in derivatives, not exceeding five percent.

Key factors to be considered while formulating investment strategy

Total return (net of taxes and expenses); Nature of liabilities. How much is real in nature and how much is nominal, the structure and

tenure of liabilities. Term of the liabilities. Currency of the liabilities Evolving nature of the fund, to avoid liquidity problems. Active versus Passive. Passive investments track the index fund but require full replication,

stratified sampling, optimization, synthetic funds.

The move towards defined contribution requires attention to fund management. If outsourcing fund management, these are the factors that need to be considered –

The size of the funds under management. Number of personnel in key investment management. Number of clients. Investment process in areas of asset allocation and portfolio construction. Performance records. Risk adjusted returns. Fee structure. If the fund is small then the cost of outsourcing might be expensive. Communication and reporting schedule. Portfolio guidelines and restrictions.



The aim of a pension fund is to provide retirement income and it is almost a failure of fiduciary duty to not invest in the best assets.

Asset allocation is the key to good pension and insurance management. In my opinion, Indonesian pension funds should hold a diversified portfolio with more external assets than Indonesian assets. Insurance companies and pension funds in Indonesia are doing the exact opposite. Almost a hundred percent of the portfolio is invested domestically, possibly due to political constraints.

Merrill Lynch released a report about Iceland and the incestuous relationships between the banks and insurance companies. The money was just circulating within Iceland. Therefore, it is possible that these situations can be politically motivated.

External investment has to take into account the exchange rate risk. It is also important to take into account the fee paid to the external advisor. If the amount of the fee accounts for a large part of the yield earned from overseas investments then it is not a sustainable solution.

A guideline for optimal asset diversification is to consider the age of the policyholders. If the average age of the contributors is thirty-five and the retirement age is sixty, the fund has a twenty-five year time horizon for investment and should include more equities. Money market instruments would be more appropriate if the average age is close to retirement. This basic guideline reduces the volatility of payments when it is time to make them.

In Argentina, the government had an increasing amount of government debt. The ultimate downfall of these plans suggests that completely liberalizing investments, subject to prudential norms, is a perfectly reasonable answer.

In conclusion, it all comes down to managing various risks, such as currency risks, liquidity issues in different countries and ensuring that the assets purchased are co-related to the liabilities.

Appropriate benchmarking mechanism

The benchmark for defined contribution schemes is extremely standardized. It has to be pegged to consumer pre-index increases. Generally, the rough rule is to take fifteen or thirty-year government securities and generate a return over that. The yield difference between corporate bonds of a similar duration will be 100 to 150 basis points. This kind of return required is possible only by including equities in the portfolio.

That is, the proportion of equity is designed from the base of the average duration. So, I have 250 basis points to add to that particular yield, and that particular benchmark will take care of your consumer pressure for pension performance also. Unless there is a very specific situation, for example the oil price increases are totally outside your control and that fuel price inflation may be difficult to predict. In the normal circumstances it is the choice of benchmark that we need to think about. You raised a very interesting question that is a basic reason that is fundamental when you decide the base an insurance product on a 2% technical rate or a 3% technical rate. This kind of product is not likely to be saleable to many in the low income group, because of competition from bank deposits. For example in India, the same bank account will pitch 4% whereas if you price your product at 3% I don’t think the consumer is being benefited by buying the insurance product. So you must to price at least 100 basis point above the 3% floor rate which is available in the economy.


In an attempt to mathematically source certain things, it is easy to embark into a journey of complexity and get completely lost. Tools like the concept of inflation through the consumer price index are all important tools but it is important not to get lost in the complexity of it all because it will be impossible to practice in reality. Having said that, when pricing pension products it is important to be consistent with the capital market.

It is also not advisable to keep the pricing constant for too long if the capital market has changed. This is a common phenomenon in some countries where there is a tremendous reluctance to change anything even if the markets have moved and the liquidity position has changed. It is important to keep in mind the notion of adaptability occasionally.

One of the key issues in benchmark design is the fact that the benchmark should be available for investment in practical terms. If the benchmark is not available for investment, then it is not a valid benchmark. Therefore, when talking of a benchmark, one should take into account the investability of the assets and construct something that managers can actually use and invest in. The fundamental test of a benchmark is replicability.

Benchmarking is not possible if the market has not reached maturity. In very illiquid markets and if the market is at an infant stage it is difficult to develop a benchmark – instruments and institutions are not developed. Then there is the question of what is going to be benchmarked. This depends on what point in the market benchmarking comes in? Over the past fifteen years, people have been talking of benchmarking of the consumer rate of interest. Now India is talking of the debt market. Benchmarking in the initial stage is difficult and generally countries choose index tracking. Once the economy matures and there is a reasonable amount of instruments and market debt available, a more sophisticated benchmark can be created.

The problem is that, as the market develops, it changes every few years. There is a new participant every few years. It is important to ensure that the benchmark does not change every few years. A frequently-changing benchmark is worse than no benchmark.


The Way Forward


Developing Pensions and Insurance Markets – The Indonesian Challenge in Global Context

Michael Pomerleano

Lead Financial Specialist the World Bank

P.S. Srinivas

Lead Financial Economist the World Bank Indonesia office

Sectoral Findings

The World Bank has an ongoing study called “Unlocking Domestic Financial Resources for Development: The Role of Non-Bank Financial Institutions”. These are some conclusions from the study in Indonesia.

Equity: The market is small, highly-concentrated, and relatively illiquid due to low equity mobilization and weak governance. It accounts for twenty four to twenty six percent of GDP, compared to a 150 percent in Malaysia and seventy percent in Thailand. It is also highly concentrated – the top ten listed stocks account for almost eight percent of market capitalization. It is illiquid with very little free float. On an average, the free float of the top twenty companies is 34 percent. There was a spurt in equity mobilization post-crisis but it has withered away. A robust market should mobilize fresh capital in the range of seven to eight percent of market capitalization. Not many emerging markets fulfill this mission but countries like Korea and Brazil are improving. Equity mobilization was nine percent of market capitalization in Brazil.

The finance business, at the end of the day, is not about dollars and offices but about how people conduct themselves. A senior Citibank official used to say that the assets of the bank go down in the elevator at night and return in the morning. It ultimately comes down to capacity, skills, and moral conduct of the people. It is about governance – and the concept cannot be emphasized enough. The root of everything in finance is confidence, something that good governance generates.

Government bonds: There has been considerable progress following the recapitalization of the banks but much more needs to be done.

Corporate bonds: Issuance has been limited because of remaining developmental challenges. The market still suffers from low credit ratings.

Mutual funds: The industry suffered a massive blow in 2005 due to unsustainable net asset values (NAVs). Regulation and supervision needs strengthening, NAV reporting needs enforcement. Better disclosure of risks and improved sales practices are necessary.

Leasing: The industry can be a major source of financing for the small and medium enterprise sector but distortionary taxation hinders the growth of this sector.

Consumer finance: There is rapid growth but a credit information system is urgently needed. Korea suffered due to a similar problem. There was rapid consumer lending growth without credit information systems. As a result, there were massive losses in the banking system. The Koreans learned the hard way and are now implementing credit information systems. Indonesia is struggling with getting a credit information system going.


Venture capital: The industry is still embryonic and essentially founded on subsidies masquerading as venture capital. It requires an improvement in the investment climate and development of entrepreneurship.

Worldwide, leasing prospers in industries where taxation is neutral. The reason to get into the industry is to preserve the benefit of depreciation. India also destroyed a vibrant leasing industry. Indian leasing companies needed a forty to fifty percent rate of return to be profitable. The companies were denying depreciation in terms of keeping tax and neutrality but also including sales tax on the transfers.

Thematic Findings

Regulatory settings are broadly reasonable, but implementation is invariably delayed. Therefore, passing new laws and regulations is not the priority but implementation of the existing framework is important.

Supervisory capacity is in short supply and therefore enforcement is inadequate. There is a need to further strengthen the regulator to take a more activist and developmental role. The classic example is with respect to the mutual fund sector. The industry lacked the tutoring, the reporting and the capacity of the regulator to enforce rules on the industry. Essentially the mutual fund industry requires enforcement capacity and skills.

OJK will be established by 2010, consistent with the global trend towards integrated financial authorities. It is a good idea to have everything under one umbrella but it needs to be done correctly. This action should not be seen as a quick fix. If this is to be implemented, full-fledged preparation should start right away. It is important that capacities and skills need to be strengthened in every area of expertise – pensions, insurance, securities – with the goal of having an integrated supervisor. The BAPEPAM-LK merger needs to be speedily completed. It is important that the government approach this step with caution or it can be disastrous for the financial system.

Simply changing the structure of the supervisory system will not correct the problems with prudential and market conduct standards, surveillance, and enforcement. It is more important that, even as separate institutions, the capacity of Bank Indonesia and BAPEPAM-LK be strengthened in their respective areas. The important economic issue is to ensure sound regulation and development; whether it is one or two institutions is a quasi-political decision.

The major driver of future market development will be investor and consumer education Financial sector governance is weak and needs substantial strengthening. Ultimately, a

financial system is only as good as the people working in that system. In Indonesia, there is a dire need for professionals in every segment. For example, the actuarial profession is virtually non-existent. There are 328 actuaries in a country of 260 million people. That is a per-capita density of one for a million people. The US has 18,000 per million people. India has 200 currently but needs 8,000. However, if a country does not have actuaries, there cannot be a viable pension and insurance industry. The only answer is to open up. Indonesia needs to stop looking at this in terms of a shrinking pie for the domestic industry and rapidly absorb foreign expertise.

The role of industry associations and bona-fide self-regulatory organizations (SROs) in market development should increase. Consider the SRO industry association. Genuine SRO discipline is about members educating other members, certify, and re-validating professional criteria. Despite the fact that SROs still maintain an industry association, they still have to earn for themselves a genuine SRO role. This is a two-way street: The SROs and associations should come-up with genuine market development and “vested-interest-free” solutions and the government needs to have a forum to consider these in policymaking.


A financial system is not just made up of the private sector or the public sector but the

regulator and industry together working for mutual good. Industry associations, such as the actuarial association, need to step up and consider what is best for the industry and take action consistent with a developmental role.

As the following figure indicates, the Indonesian financial system is not in the best of health. There are several areas of concern (see figure 112).

Figure 112: Summary of Sectoral and Thematic Findings

7

Access

Developing investor base and investor

education

Competition landscape

Taxes

Skills

Regulation and Enforcement

Market Development

Venturecapital

LeasingInsurance PensionFunds

MutualFunds

CapitalMarketsTaxonomy

Good PoorConcerns

The country needs the public and private sector to collaborate to develop non-bank financial institutions. The private sector can provide institutional and market infrastructure. The public sector provides regulation and supervision. It is difficult to garner data on the capacity of the private and public sector in Indonesia. The country is not under the National Association of Pretrial Service Agencies (NAPSA6) and is less transparent. The New-York based NAPSA is a global organization that tracks compliance with standards and codes. Standards and codes, such as the AIS principles and the Basel core principles are like an international highway of international best practices that countries abide with (see figure 113).

Indonesia rates at zero in insolvency, ten in accounting, ten in auditing, and money laundering is at sixty and payment settlement at thirty. The Hong-Kong based Asian Corporate Governance Association7 puts a lot of energy in tracking governance in the region (see figure 114). The association ranked Indonesia at thirty-two in 2003 and thirty-seven in 2005. Poor governance is the reason why, despite a legal framework that is reasonably strong, enforcement remains the key issue in Indonesian corporate governance.

6 For more information on this organization, see their web site at www.napsa.org 7 For more information on this organization see www.acga-asia.org


Figure 113: Standards and Codes: Institutional and Market Infrastructure Scores

8030301060Poland

3060101030Colombia

060303060Chile

6060301060Turkey

6060103010Russia

3080303060Mexico

608001060Brazil

060603060Argentina

806003030Thailand

8060103030Korea, Rep. of

060103030Malaysia

306010100Indonesia

Payment andSettlementSystems

MoneyLaundering Auditing Accounting Insolvency

Note: Data as of December 1, 2005. Source: eStandardsForum, www.estandardsforum.com

Figure 114: Corporate Governance Scores

3732Indonesia

4637Philippines

4443China

5046Thailand

5655Malaysia

5055Korea, Rep. of

5258Taiwan (China)

6166India

6973Hong Kong (China)

7077Singapore

20052003Economy

Source: Asian Corporate Governance Association www.acga-asia.org/

“While the legal framework looks reasonably strong, enforcement remains the key issue in Indonesian corporate governance. There were few, if any, changes in the regulatory

environment in 2005, and the lack of progress is disappointing.”

“While the legal framework looks reasonably strong, enforcement remains the key issue in Indonesian corporate governance. There were few, if any, changes in the regulatory

environment in 2005, and the lack of progress is disappointing.”

Under the heading of financial regulation and supervision, banking is rated at eighty. Security and insurance supervision are zero (see figure 115).


Figure 115: Financial Regulation and Supervision

308080Poland

06030Colombia

606080Chile

06030Turkey

603060Russia

606030Mexico

0080Brazil

60600Argentina

0600Thailand

808060Korea, Rep. of

3000Malaysia

0080Indonesia

InsuranceSupervision

SecuritiesRegulation

Banking Supervision

Note: Data as of December 1, 2005. Source: eStandardsForum www.estandardsforum.com/

Low ratings are partly about poor performance. But they are also about poor communication to the world about the positive elements of the economy. To paraphrase a Harvard professor: “Pick three important things and do them well and communicate, and let the world know.” Silence is probably dangerous.

Figure 116: Enforcement Scores

68302933Indonesia

82502253Philippines

68504043China

73504058Thailand

75604959Malaysia

82434051Korea

59654953Taiwan

75655666India

91785864Hong Kong

95735674Singapore

Accountingand

Auditing

EnvironmentEnforcementRules andRegulations

Economy

Note: Data as of 2005. Source: Asian Corporate Governance Association www.acga-asia.org/


Indonesia – not unique

Often countries, including Indonesia, have the refrain that our problems are unique and therefore the solutions must be unique. This is not entirely true. Many countries face the same problems and Indonesia is not unique. Clearly, every country is different and solutions may need to be tailored but the fact is that the alternatives are available.

There is a new momentum in Indonesia. Until very recently government and regulatory energy was involved in reforming the banking sector, as it was at the core of the crisis. However, now there is an opportunity to focus on new reforms in the insurance and pension industry.

Broadly, in developing countries, regulation and supervision of the banking and securities industry is in place. With some exceptions, insurance regulation tends to be weak (India is an exception) and pension regulation tends to be non-existent. The conclusion from a study done on sixty developing countries is that it is rare to find a coherent regulatory framework for non-banking financial institutions.

Pension Fund Problems

Public pension funds dominate in most countries. These funds have virtually non-existent regulation and supervision. Coverage is low, typically

less than ten percent of the workforce. The funds have high administrative expenses. This is relative to pension funds globally. For

pension funds that are investing either in bank deposits or in government bonds, administrative expenses should be close to zero.

Public pension fund investment performance trails private pension fund investment performance (see figure 117). It is usually about ten percent lower than private plans. There are some measurement issues across different countries and different regimes but the data overall makes a point that public pension funds do not do as well as private funds globally.

Figure 117: Performance of Public Pension Funds

-6.7%Average public schemes

-44.0%1981-87Peru-33.1%1986-94Uganda-28.5%1980-91Zambia-15.3%1979-89Venezuela-11.2%1986-96Tanzania-9.3%1980-87Ecuador-9.1%1981-95Egypt-5.0%1980-96Costa Rica-4.9%1985-95Guatemala-4.5%1979-86Jamaica-3.9%1978-90Kenya-0.3%1960-97Sri Lanka0.8%1978-91Philippines1.4%1970-94Japan1.5%1961-95Singapore1.6%1977-97India1.8%1971-89Canada2.0%1955-96US2.1%1961-95Sweden2.3%1985-96Morocco3.2%1958-96Malaysia5.4%1988-97Korea

Compounded Real Annual

ReturnPeriodCountry

4.1%Average private schemes

-0.3%1970-90Switzerland

0.9%1970-87Japan

1.7%1970-90United States

1.7%1975-89Canada

2.1%1970-88Denmark

2.2%1983-96Hong Kong2.3%1970-90Netherlands

3.3%1984-93Japan

3.3%1984-96Switzerland

3.9%1984-96Denmark

3.9%1987-94Australia

4.0%1970-90United Kingdom

4.4%1984-93Spain

5.9%1984-96Netherlands

6.1%1984-96Ireland

7.0%1981-96Chile

7.2%1984-96Belgium

7.2%1984-96United States

7.3%1984-93Sweden

7.9%1984-96United Kingdom

Compounded Real Annual

ReturnPeriodCountry


Investment returns are weak or negative for a number of reasons:

Government directed investments. Illiquid real-estate investments. Maturity mismatches. Absence of international portfolio diversification. Lack of investment opportunities and investments, particularly in countries like Indonesia.

Pension funds that do want to invest in long-term assets often find them to be unavailable. The available investment opportunity also determines the performance of these funds.

Insurance Sector Problems in Developing Countries

Insurance penetration tends to be low (one to three percent)8. Again, this problem is not unique to Indonesia.

Insurance penetration is dominated by insurance segments that are mandated by the government, like third party auto insurance for example.

Weak confirmation infrastructure is another problem. There are countries, with a GDP many times that of Indonesia, that use the 1960 US mortality data. Fresh mortality data is difficult to come by and as a result, the industry cannot price products appropriately to reflect risk.

Many countries have public sector ownership or de-facto public sector ownership of insurance enterprises. Unfortunately, public ownership leads to poor performance. This is true across financial institutions like banks, insurance firms, and pension funds. There are very few exceptions to this rule.

Controls on premiums, investments, and reinsurance have hindered development. In several markets there is a high concentration where a few firms control the majority of the

market. On the other hand, many countries including Indonesia have too many small insurance companies. Most of them are under-reserved with high expense ratios but survive due to poor regulation and supervision or enforcement action. This situation tends to hamper the development of the rest of the industry. Industry consolidation is an urgent issue in these countries and it comes back to the enforcement of regulation.

Regulation and supervision is often weak or virtually non-existent due to the lack of an independent supervisor.

Enforcement is a major problem in many developing countries.

Typical Pension Sector Reforms in Developing Countries

Countries that start on pension reform do so from a similar or the same base. There is a fundamental overhaul of public systems.

Global move from defined benefit to defined contribution systems. Fiscal difficulties are driving reform. Budgets can no longer bear public pension payments and reform ensures long-term sustainability. In some cases, this is helped by the fact that the credibility of the government is low. People do not believe the government can honor pension promises and move voluntarily.

There is a greater move towards private provision of pensions. In some countries, the private sector collects the contributions, manages the assets, and pays the benefits. In other countries, some tasks, such as asset management, are allocated to the private sector. The government often manages the contribution collection process and makes it more efficient than retail collection.

Most countries have focused on strengthening regulation and supervision.

8 Insurance penetration is defined as the insurance premium as a percentage of GDP.


There is a concerted attempt to eliminate political interference as it was the main cause of

problems in these funds. There is also a focus on improving infrastructure required to improve the performance of the

pension and insurance sector. There is a move towards improved professionalism and upgrading the skills of auditors, actuaries, experienced asset managers, and accountants.

Have a look at the range of investments allowed. Limit government debt, and allow equities and diversify into international assets.

Insurance Sector Reforms

There is a fundamental restructuring of the sector. State-controlled companies are being privatized or marginalized on a gradual basis in several countries. In some countries, it is not politically viable to privatize the monopoly service-provider or the largest provider so the marginalization strategy works best.

Promote industry consolidation where appropriate by increasing the minimum capital requirement, implement a suitable capital regime, and tighten licensing requirements. Close weak companies, which are unable to implement time-bound remedial action plans.

Lift unnecessary controls on premiums, investments, and re-insurance. Strengthen regulation and supervision under an independent supervisory authority.

Interestingly, this has moved ahead where banking is concerned in some countries as opposed to insurance and pension. The OJK is being established in Indonesia and there is a good case for merging institutions into one consolidated authority. However, whether a new institution is established or not, it is important that the existing supervisory and regulatory framework and institutions are strengthened.

Pension Reforms Required in Indonesia

Regulatory The law creating a National Social Security System (SJSN Law no. 40) prescribes mandatory

contributions and participation in five programs. However, the law is vague on details regarding benefits, contribution rates, major strategic policy options, and financing. Implementing regulations have not been completed.

Half of the pension assets do not produce retirement income as they are payable as a lump sum at retirement or earlier.

Ambiguity in the laws and regulations discourage the creation of occupational pension plans: employers comply with mandatory programs before contributing to a voluntary program.

Pension funds are not allowed to invest in foreign assets. This is likely to have a fundamental impact on the industry, as employers are more likely to

implement mandatory actions before they do anything of a voluntary nature. Therefore, this law needs to be clarified to promote growth in the pension industry.

Enforcement The capacity of supervision is inadequate due to poor skills. Enforcement of mandatory contributions is lax. The annuities market in Indonesia is not attractive due to the tax structure. Skills PAI (Persatuan Actuaris Indonesia) has issued a standard on pension work, but standards

need to be improved. Actuarial reports are generally of a low professional quality. Notably, the lack of management experience and knowledge, failure to use modern

technologies, weak systems of registering and recording benefits, and absence of investment monitoring systems is a problem.


Taxes A harmonized tax policy is needed covering all types of retirement savings. Pension funds do offer some tax incentives, but EET treatment is has not been fully

implemented. For instance, the tax on capital transferred from a registered pension fund to an insurance company to purchase an annuity makes annuities unattractive.

Competition Landscape There is little room for the participation of the private sector or regional governments in the

five mandatory programs. Indonesia prohibits pension funds from investing in foreign assets limiting the variety of

instruments available, the sharing of expertise, and the diversification of risk. Voluntary plans have to compete with many more immediate needs, with mandatory

programs, and with individual myopia. Access The coverage of mandatory plans is low. In 2003, coverage was 6.9 million or twenty-one

percent of the private sector formal workforce. The coverage of private pension funds is also low, with 338 funds covering 2.6 million people

in 2003. Developing Investor Education Companies regard pension plans as an expense rather than as a HR benefit and component

of compensation. Individuals prefer cash and short-term rewards. Neither workers nor employers are educated about the need for financial security in

retirement and the advantages of building income-generating assets early in their career. The country needs to improve investor education. The layman is not well versed with the need

for financial security in retirement.

Insurance Reforms Required

Regulatory A policyholder protection guarantee fund is eventually needed, but currently premature Indonesia should first focus on restructuring the sector and then put in place a guarantee

fund. The World Bank agrees with the view that this move is beneficial for the market but questions whether this is the right time. There are issues regarding the structure of the industry that need to be resolved first before such a move can be put in place.

Enforcement Supervision capacity needs to be improved. There are adequate powers available to the Indonesian authorities to intervene. However, the

enforcement of these powers has been weak. Regulation of industry participants is uneven. Minimum capital requirements and risk-based

capital requirements were introduced but are not enforced adequately, protecting companies from normal market discipline. For instance, the response to insolvencies is inadequate.

Enforcement of tax law policy is unreliable and unpredictable. Skills Actuarial skills are short supply. PAI should make more effort to open membership and

upgrade skills (see figure 118).


Figure 118: Indonesian Insurance Sector – Actuarial Skills

4,76479.75United Kingdom

14,96853.16United States

34548.05Switzerland

19929.27Hong Kong, China

24627.74Sweden

1,28221.78France

8220.41Singapore

1,66120.22Germany

9718.73Finland

12912.87Hungary

8536.73Japan

1684.54Argentina

4082.40Brazil

1911.95Mexico

680.90Philippines

110.23Korea, Rep. of

130.21Thailand

1110.11India

40.10Poland

140.10Pakistan

3281.51Indonesia

80.01China

Number of actuariesNumber of actuaries per million populationEconomy

There are 328 fellow actuary and 132 associate actuary members of the Indonesian Actuary AssociationThere are 328 fellow actuary and 132 associate actuary members of the Indonesian Actuary Association

Taxes Annuities are not attractive because single premiums paid out of a private pension fund to

purchase a life annuity at retirement are taxable, ending the tax shelter. Non-life companies are penalized more than life companies by the absence of deductibility of

IBNR reserves - forty percent of non-life liabilities. Competition Landscape The insurance industry is highly concentrated, with five insurers serving forty eight percent of

the market. There is a convergence of products between banks, insurance companies, and mutual funds. Access Insurance penetration in Indonesia is low, with premiums equal to 1.49 percent of GDP

(versus the ASEAN average of 3.35 percent). Developing Investor Base and Investor Education. Transparency: private sector ratings of insurance companies are not available. Indonesia has

a long way to go where this is concerned. It would be useful for the regulator to publish the RBC ratings. This will create the additional momentum and pressure in the industry.

A sustained campaign is needed to educate and promote the benefits of the insurance industry and its products.

Clearly, Indonesia has tremendous potential and scope. An integrated and coherent policy and regulatory approach conducive to the development of pensions and insurance sectors is needed. There should be increased public and private effort to support building capacity and to implement pension and insurance reforms. Every problem that exists in Indonesia can pick from solutions that are being experimented with in many countries. These solutions can be tailored to Indonesia’s needs.



In the nineties, the focus was obviously on banking sector restructuring. It has been eight years since the crisis and clearly, Indonesia could have achieved much more. Progress has undoubtedly been slow in many markets. Investment in the equity markets and the corporate bond markets has been very low. Fixed investment has started recovering only in the past two years. The year 2004 was a better year than 2005.

The difference in Indonesia now compared to previous years is that there is an economics minister and president who are willing to communicate on behalf of the industry. Hopefully, progress will be faster. For example, the Indonesian government recently granted a license to an institute of risk management. The institute, STIMRA, has been operational since April 2006 and Indonesian students can obtain a bachelors degree in risk management.

Once the government decides what tax regime to adopt (EET, TEE, EEE) institutions such as the World Bank need to give advice to the tax department on implementation of this policy. The government and the tax department need a thorough understanding of the infrastructure required for implementation.

It has been observed that the privatization of any industry results in efficiency, in better delivery and in customer satisfaction. It is not the responsibility of government agencies to look after the masses. This is the responsibility of the citizens of the country. The private sector in developing nations should try to ensure that insurance and pension products are not available to just one strata of society but are available to the masses.

On paper, Indonesia is very well organized. There is a reasonable framework for the pension fund and insurance sectors. But there are a few examples of Indonesia shooting itself in the foot. Destroying the leasing industry through the taxation framework was one such example. The other is Law 40. Yet, these are isolated events and the basic framework is sound.

The biggest flaw in Indonesia continues to be enforcement. Generally, Indonesian contracts are not perceived to be subject to the rule of law, affecting confidence that a contract is enforceable. Individuals do not have confidence that if savings are made today they will see them at retirement. This is a hindrance for insurance and pension products.

The other factor is that the distribution of income is not favorable. In a country of 230 million people and a labor force of over 100 million, only 30 million are in the formal sector. A great proportion of these are at minimum wage.

There are also cultural problems such as the reliance on family. This is positive culturally but from an economic point of view it is a problem. There is also a lack of faith in the currency. All these factors are responsible for weak demand.

Better investor education can help to some extent. There is not enough publicity and communication in the industry. This is like throwing seeds on the land but the land must be fertile for the seeds to grow. The government needs to establish more confidence in the enforceability of contracts, in the stability of the currency, and more confidence in the capacity for individuals to influence their own destiny.

The labor law allows a very generous termination pay. In Taiwan (China), this payment is transferred to the pension scheme. This could be a way out for Indonesia. Any attempt to revise the labor law will be met with resistance but the current law is not the best thing for investors. If the employer funds the pension scheme, it could be a win-win solution for the government.

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