Takaful or Islamic insurance is a booming industry around the world. In fact, many Western insurance companies already engage in the takaful business in the Middle East and Malaysia, including AIG and Lloyd’s. I believe that takaful can be launched as a major insurance product in the West, as cooperative insurance is not a new or foreign concept in Western countries. In fact, Westerners are excited about the takaful concept, which includes return on investment and the return of the premiums at the end of the policy.
Takaful is almost the same concept as conventional mutual insurance, except that the operator can inject an interest-free loan called qard hassan into the fund in the event of insolvency. Islamic insurance is based on cooperative risk sharing and joint-guarantee, which is a concept already widely used in the West and favoured by ethical people, Christians, Muslims, and Jews. Takaful can be considered a form of investment insurance with coverage and is a valuable financial tool for people seeking coverage, investment returns, diversification of portfolios, wealth management, and innovative retirement plans. It is also quite useful and widely used by people of all faiths, nationalities and backgrounds in international trade finance. If marketed properly, takaful can become a wildly popular mass consumer product in the West and the world. This article aims to describe the takaful concept and give an overview of the business while addressing the treatment of qard hassan in the operation of a takaful fund.
A conventional insurance company speculates on the risk by making an assessment of the risk and then pre-determining profit based on the estimated payout versus the premium. It is in a sense gambling. Proprietary insurance is concerned with risk transfer, insured risks being transferred from the insured to the insurer in return for a premium. Takaful is concerned with risk-pooling, whereby the policyholders (takaful participants) mutually insure one another in a common risk pool financed by their contributions (premium payments). Takaful, or Islamic insurance, is a cooperative scheme, where in which the participants pay a premium in the form of donation or tabarru in a common pool in return for the ability to draw upon that pool upon a valid claim.
The word takaful originates from the Arabic world kafalah, which means “guaranteeing each other” or “joint-guarantee.” Takaful is essentially a concept where the participant is both the insurer and the insured.
In a takaful fund, the participants may get a return on investment plus the premiums returned at the end of the policy. The funds remaining in the takaful fund on maturity of the policy are distributed back to the participants after deduction of the charges due to the operator and according to the type of takaful management model utilised by the fund. In a situation where the fund is not able to meet its current and future obligations, the operation will be deemed insolvent (i.e. the fund has less assets than liabilities).
The term solvency means the financial ability to pay debts when they become due. The fund’s inability to pay claims is contrary to the intent of the participants in joining the scheme and hence, a primary objective of everyone concerned is to ensure that fund solvency is maintained at all times. The operator plays an important role that the management of a conventional mutual does not play in the event of a periodic deficit in a fund that exceeds the reserves of the fund, thereby making it potentially insolvent. In this case, the operator acts as a lender of last resort by providing a qard hassan or interest-free loan to the fund. Such a loan will be repaid out of future underwriting surpluses.
However, the terms and conditions of repayment are often unclear and sometimes not stipulated. In the event of non-recovery of a qard hassan, is the operator willing to write it off as the deficit increases? What will happen to the qard hassan in the event of insolvency? From the operator’s perspective, the qard hassan is a temporary injection of operator capital into the risk fund and is a particular use of the operator’s capital (which ultimately comes from the shareholders of the operator). There is an opportunity cost for the operator when the operator’s capital is used for qard hassan. It is the availability of affordable capital (either for the operator to inject into the fund as qard hassan or as the surplus available in the fund, which is not locked up to ensure continuing solvency) that determines the speed at which a business can grow. Thus, the use of the qard hassan may stifle profitability, growth, and/or expansion of the business.
The operator grants a qard or interest-free loan in the event of a deficit in the fund (in contrast to mutual insurance). The operator is expected to offer a qard loan facility, which can be drawn down if the fund is unable to meet its obligations (because of a deficit or lack of liquidity). The loan does not remove a deficit, as it increases the fund’s liabilities simultaneously with the assets, but provides liquidity to enable the fund’s obligations to be met. The loan should be recoverable by the operator through future underwriting surpluses. As a qard hassan is considered a loan injection into the fund, repayment of such loans should take precedence over surplus distribution to participants. Considering that the fund is under the direct management of the operator, such a loan may fall under the broader context of ‘related party’.
Related party transactions must be publicly disclosed and only carried out on an arm’s-length basis without any unduly favorable terms. In some jurisdictions, independent valuations and appraisals are required before the regulatory authorities will allow substantial related-party transactions to take place. This is in order to avoid the directors and management of the company manipulating the movement of funds or assets of the company in favour of certain parties who are related to or favoured by them.
Should the requirement to publicly disclose the qard facility be similarly imposed on takaful operators on the basis that it is a related-party transaction? Should the existence of the facility be disclosed or only the loan if the facility is actually drawn down? While it would seem desirable to disclose the existence and amount of the facility, transparency would also require disclosure of the draw-down amount when made.
Furthermore, certain safeguards may also be required in order to ensure that the qard is not employed in a manner that favors certain pools among the many pools of funds under the management of an operator. In countries such as Malaysia, operators are obliged to give an undertaking to the regulator to provide a qard facility to be drawn down in the event of a deficit of a fund. Without proper regulation of the industry, there is room for nepotism like behaviour, corruption, and non-transparent, inadequate, and inaccurate financial reporting, which may result with the financial collapse and bankruptcy of many companies and the reputation risk of takaful and the Islamic finance industry as a whole.
As only three countries — Malaysia, Brunei and Pakistan — possess comprehensive takaful legislation, the global takaful industry is heavily under-regulated as well as lacks a proper dispute resolution mechanism. A unique and harmonised regulatory and reporting regime is required for takaful for many reasons, including the two-tier structure of companies, which includes shareholder and policyholder funds. Shareholder and policyholder funds are managed separately and capital may not be fungible or transferable between the two separate accounts. Furthermore, funds have unique policyholder entitlements and rights, different structures, and face different risks compared to conventional insurance. One of the main differences between conventional and Islamic insurers lies in the fact that in Islamic finance, the assets underlying the underwriting pools are owned by the policyholders whereas assets in conventional proprietary insurance companies are owned by the shareholders and must at all times be sufficient to cover their obligations to the policyholders. Accordingly, in contrast to conventional insurance companies, takaful companies must make disclosures about the underwriting pools and underlying assets.
The AAOIFI regulations FAS 12 General Presentation and Disclosure in the Financial Statements of Islamic Insurance Companies and FAS 13 Disclosure of Bases for Determining and Allocating Surplus or Deficit in Islamic Insurance Companies address many of these issues. The AAOIFI standards require disclosures on policyholders’ funds and the determination and allocation of surplus and financing of deficits. However, the requirements in respect of movements between the funds should be enhanced and the individual rights of the policyholders should be clearly stated in the financial statements. There is also a lack of transparency in the financial statements of some companies in regards to undistributed fund balances.
Overall, the current financial reporting practices of takaful companies do not provide adequate information regarding the company’s investment strategy, funds allocation, and revenue and expenses accruing to their particular investment funds. Exacerbating the situation, companies have not yet adopted a single framework for financial reporting and this has resulted in the lack of transparency and comparability of financial statements.
In many jurisdictions, solvency and capital requirements for companies remain simple. However, several countries, including Malaysia, Indonesia and certain GCC countries, are moving towards risk-based capital (“RBC”) regulation. In terms of capital adequacy regulation, it may be difficult to apply ratio-based methods as it can be difficult to accommodate them to the different structures adopted by takaful operations and their different risk profiles. For this and other reasons, it is more advantageous to develop risk-based capital regulation (RBC) for the takaful industry.
In the RBC, calculating the capital requirement is combined with evaluating management practices and internal controls. In this process, there is a major role for the regulator in reviewing and evaluating the process by which the calculated capital requirement was arrived at and imposing additional capital add-ons if the regulator is not satisfied with the insurer’s risk management. The insurer determines its minimum capital requirements by applying risk factors to each of the identified risk components, reducing the resultant amounts by identified risk mitigants and aggregating the results. Some further reductions may be possible by identifying diversification effects, though on the other hand the regulator may impose add-ons. Takaful operators may be comparatively overweight in assets such as equities and real estate, which tend to be more volatile and/or less liquid, thereby attracting higher risk weightings.
In Malaysia, a RBC framework has been implemented in the conventional insurance industry since 2009. A similar framework for takaful was intended to be implemented in 2012/2013. It would apply to all takaful and re-takaful operators registered under the Takaful Act 1984. It requires the maintenance of adequate capital at levels commensurate with the risk profile of the operations to act as a financial buffer against any exposure to risks. It is the operator’s fiduciary duty to manage the capital and risks prudently, and in line with the objectives of shari’ah as well as to maximize profit for the shareholders. Thus, an RBC framework is required, which takes into account the different risks of takaful structures and Islamic finance. In addition, for this reason, proper regulation, financial dispute resolution, and financial reporting must be implemented by the operators and industry.
In takaful, the concept of RBC is applied on the understanding that it is the risk fund (representing all participants as a single collective fund) that needs to have sufficient assets to meet minimum solvency or RBC requirements. Under the new framework, the regulators, based on their assessment of a takaful product design or features, may require operators to establish other funds to clearly reflect the specific nature, purpose, or risk of a component of the contribution or other elements of the product. This is intended to protect the interest of the participants, the soundness of the funds and where appropriate, to reflect shari’ah requirements. Given the requirement for the operator to extend a qard hassan in the event of a fund in financial distress, the framework is designed to ensure that the operator has the appropriate amount of capital to meet the qard obligation as well as to support its business operations. Each operator is therefore required to maintain adequate capital in its shareholders’ fund to support its business. For this purpose, the capital available in the fund will be recognised in the capital adequacy measurement of risk by the operator to the extent that this is consistent with the underlying responsibility and ownership of the various funds in the business. To this effect, the framework provides incentive for the operator to build a strong risk fund, thus reducing the amount of capital needed to be held by shareholders to support potential qard hassan obligations.
In the case of a takaful business, the capital adequacy ratio (“CAR”) measures the adequacy of the capital in the shareholders’ and funds to support the total capital required for the business. The CAR is the ratio of the business’s capital to its risks. Capital adequacy is the key indicator of the operator’s financial resilience and may be used to determine the appropriate level of supervisory interventions by the regulatory authorities.
CAR =Total Capital Available (TCA) x 100%
Total Capital Required (TCR)
The Malaysian regulators’ approach of pre-emptive intervention means that supervisory action is taken in the early stages of an operator’s financial difficulties. To do this, they have set a supervisory target capital level of 130%, below which supervisory actions of increasing intensity will be taken to resolve the financial problems of the operator. The operator is then required to establish a higher internal individual target capital level. The regulator will assess whether this target capital level is appropriate for the operator’s risk profile and risk management practices; if it is not, the operator will be required to make adjustments. An operator will not pay shareholders dividends if its CAR position is less than its individual target capital level or if the payment of dividend will impair its CAR position to below its individual target capital level.
Although takaful has been witnessing an approximately 20% per annum growth rate, much needs to be done in terms of regulation, legislation, and a dispute resolution framework for the global industry. The future of the global takaful industry is vibrant and robust similar to the Islamic finance industry as long as we can ensure investor confidence and reputation through implementing a proper regulatory and accounting framework, regulation including capital adequacy regulation, legislation, proper financial reporting, and effective adjudication of disputes. The capital adequacy regulation and requirements for the industry are insufficient and bare minimal at the most.
Takaful is faced with various other challenges, including scarcity of suitable shariáh compliant investments and very few re-takaful or reinsurance operators in the world today. These shortages can lead to concentration of risks or lower quality assets than desired by the business. Furthermore, there is a limited availability of risk management tools for takaful similar to Islamic finance and more attention needs to be paid to product design, IT and control processes.