ISLAMIC ECONOMICS & FINANCIAL ISSUES FROM ISLAMIC PERSPECTIVES

ISLAMIC ECONOMICS & FINANCIAL

ISSUES FROM ISLAMIC PERSPECTIVES

ECON 6864

GROUP PAPER:

SHARI’AH & FINANCIAL ISSUES OF TAKAFUL

SEMESTER: SEM 1 2013/2014

STUDENT:ISHAM SHAFARIN BIN ISHAK (G1128403)

MOHAMAD HAIDIR HASHIM (G1116671)

MOHD ASHRAF BAHARIN (G1212709)

ROBIATUL ADAWIYAH SAFRUDDIN (G1312514)

EXAMINER: DR. MUSTAFA OMAR MOHAMMED

TABLE OF CONTENTS

CHAPTER ONE: INTRODUCTION / BACKGROUND...................3

CHAPTER TWO: LITERATURE REVIEW...........................5

CHAPTER THREE: TYPE AND STRUCTURE OF TAKAFUL.............8

CHAPTER FOUR: SHARI’AH & FINANCIAL ISSUES OF TAKAFUL....12

CHAPTER FIVE: CONCLUSIONS / RECOMMENDATIONS.............20

BIBLIOGRAPHY............................................22

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CHAPTER ONE:

INTRODUCTION / BACKGROUND

Contemporary takaful is a combination of a social security

system and a risk management. It draws inspirations from two

concepts from Islamic heritage; the Islamic brotherhood and

the risk management in Islam. In the time of the Prophet and

His Companions, due to the strength of the Islamic

brotherhood, the social security was very strong in the

community. Back then, should one fall sick or face hardship,

his neighbours and other Muslim brothers would surely offer

their assistance; be it in monetary, food, physical effort or

others. Muslims do this out of their piety and love to each

other. This is due to the teaching of Islam that enjoins

Muslims to help each other in times of difficulty. This spirit

is gloriously enshrined in both Quran and the Prophetic

traditions. As narrated in one hadith:

“He who relieves the hardship of a believer in this world, Allah will relieve his

hardship on the Day of Judgment. He who makes easy what is difficult, Allah

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will make it easy for him in the world and the Hereafter. He who conceals the

faults of a Muslim, Allah will conceal his faults in the world and the

Hereafter, for Allah helps the servant so long as he helps his brother. He who

travels a path in search of knowledge, Allah will make easy a path to

Paradise, for a people do not gather together in the houses of Allah, reciting

the Book of Allah and studying together, except that tranquility will descend

upon them, mercy will cover them, angels will surround them, and Allah will

mention them to those with Him; and he who is slow to good deeds will not

be hastened by his lineage.”(Sahih Muslim)

With regard to risk management, until now, it is a common

belief to some Muslims that it is not allowed to mitigate risk

hence all type insurances are impermissible. This is due to

their confusion and lack of knowledge on the concept of

predestination and the concept of risk in Islam. However, one

only needs to look to the following hadith to know that

managing risk has been allowed if not encouraged by the

Prophet himself:

Prophet Muhammad (s.a.w) asked a Bedouin who had left his camel untied,

“Why do not tie your camel?” the Bedouin answered, “I put my trust in Allah”

the Prophet then said, “Tie up your camel first then put your trust in Allah”

(Tirmidhi)

From these two evidences, we can conclude that Islam not only

encourages Muslims to help each other and do charity but also

to manage their risks. Thus, modern Takaful was born from the

applications of these two concepts. The most common form of

takaful in the market currently are two; Mudarabah and Wakalah

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contracts. In the Mudarabah contract the takaful operator

establishes an investment partnership with the takaful

policyholders and works as their mudarib (operator) to manage

the investment. In the second model, the takaful policyholders

are the owner of the pooled fund and appoint a takaful operator

as a wakil (representative) to manage their fund at a fee. In

short, the working principle of takaful is not far off from

the principle of mutual funds, which we will discuss further,

in subsequent chapters. Although it seems that Muslims have

been very receptive and supportive of the application of risk

management via takaful, there are still issues and challenges

about it, whether from the viewpoints of Shari’ah or financial.

Therefore, in this study we attempt to identify and discuss

the issues of the existing practice of takaful in the market.

For the ease of reading, this paper will be organized into

five (5) chapters. The first chapter is the introduction and

background of takaful. The second chapter is the literature

review where we will summarize some articles and literatures

produced by others on takaful or Islamic risk management. The

third one will discuss on the type and structure of existing

takaful in the market. Next, we will move to the main body of

this paper discussing the point that we have identified as

Shari’ah and financial issues of takaful. And last but not least,

is our conclusions and recommendations out of this study.

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CHAPTER TWO:

LITERATURE REVIEW

There is a lot of literature focusing on risk management,

takaful and objectives Shari’ah. Most of the articles discuss and

analyse either all of the aforementioned topics separately

emphasizing on a particular issue pertaining major topic,

either they talk about risk management in takaful, or risk

management and Maqasid al-Shari’ah or takaful and objectives Shari’ah.

For proper literature review, we categorize the literature

into the following themes:

risk and risk management,

takaful and insurance

takaful and Maqasid al-Shari’ah,

takaful, risk and risk management,

2.1 RISKS AND RISK MANAGEMENT

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Papers pertaining aforementioned topic such as “Risk

Management: An analysis of issues in Islamic Financial

Industry” (Khan & Ahmed, 2001), “Risk Management and

Mitigation Techniques in Islamic Finance A conceptual

framework” (Kumaran, 2012) and “Risks in Islamic banks:

description and analysis” (Meshaal, 2013) provide overview of

risks and risk management in Islamic financial industry, most

fully emphasizing on Islamic banks only. “Enterprise Risk

Management (ERM) Practices Among Government-Linked Companies

(GLCs) in Malaysia” (Yazid, Wan Daud, & Hussin, 2008)

discusses relatively new phenomenon of ERM. Again, all of

these articles do not mention takaful at all or mention only in

passing.

2.2 TAKAFUL AND INSURANCE

First of all, there are reports about takaful industry.

“International Takaful Report 2012-2013: Shari’ah and Legal

Analysis” (Khan & Hasan, 2013) presents takaful from Shari’ah and

legal regulatory considerations in the Gulf Cooperation

Council countries. “The World Takaful Report” (A MEGA Brand,

2012) and “Takaful Review” (A.M.Best, 2011) provide global

report of Islamic insurance industry, showing financial

strengths of the companies as well as discussing issues

pertaining industry. Books such as “Essential Guide to Takaful

(Islamic Insurance)” (Engku Ali, Odierno, & Ismail, 2008),

“Takaful and Retakaful: Advanced Principles and Practices” (Frenz

& Soualhi, 2010), “Insurance and Takaful” (Salleh, 2010),

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“Fundamentals of Takaful” (Yusof, Wan Ismail, & Abdullah, 2011)

generally review takaful, also the subjects related to Islamic

insurance starting with explanation of Islam, Islamic finance

and Islamic financial contracts; covering such topics as takaful

operations and models, markets, retakaful as well as risks in

takaful. However, they are silent on objectives of Shari’ah topic.

“Islamic Financial System: Principles & Operations” (ISRA,

2012), in its turn, provide overview of Islamic finance and

its operations, taking into account all the main topics

regarding it as well as risk management, takaful and objectives

Shari’ah.

However, these topics are discussed separately and in general

manner. “The Concept and Challenges of Takaful Investment in

Malaysia” (Abdullah, Laldin, Ali, Ahmad, Abdullah, & Zuki,

2013) and “A Shari’ah Compliance Review On Investment Linked

Takaful In Malaysia” (Noor, 2009) articles discuss mainly issues

regarding investment activities of Islamic insurance companies

in Malaysia. Other articles such as “Problems and Prospects of

Islamic Banking: a case Study of Takaful” (Ahmad, Masood, &

Khan, 2010), “Takaful: An Innovative Approach To Insurance And

Islamic Finance” (Masud, 2011), “Islamic Insurance and

Reinsurance: Theory and Practice” (Mulhim & Sabbagh), “Takaful

Models and Global Practices” (Akhter, 2010b) and “The concept

of takaful” (DarAlTakaful, 2013) have a broader coverage, but

again it is general review of and retakaful without referring to

risk management and objectives of Shari’ah. “Insurance Solvency

Supervision, European Regulation And Takaful Products” (Dreassi,

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2009) and “Solvency of Takāful Fund: A Case of Subordinated

Qard” (Onagun, 2010) talk about solvency of Islamic insurance

companies.

2.3 TAKAFUL AND MAQASID AL-SHARI’AH

“Fulfilment of Maqasid al-Shari’ah via Takaful” (Abdul Aziz &

Mohamad, 2013) and “Takaful From A Maqasid Al-Shari’ah Perspective”

(Abdullah S. , 2012b) are one of the rare articles discussing

takaful and Maqasid al-Shari’ah. However, all discussion concludes

that Islamic insurance concept is in line with Maqasid al-

Shari’ah, without referring to the techniques of risk management

in and them being in line with Shari’ah objectives.

2.4 TAKAFUL, RISK AND RISK MANAGEMENT

“The Parameter Of Permissible Risks In Takaful” (Ahmad & Hashim,

2011), “Risk Management in Takāful” (Akhter, 2010a), “Risk and

Risk Management of Takaful Industry” (Aris, Tapsir, & Abu Talib,

2012), “Takaful and Mutual Insurance: Alternative Approaches to

Managing Risks” (Gönülal, 2013) and “Risk management

efficiency of conventional life insurers and Takaful operators”

(Yusop, Radam, Ismail, & Yakob, 2011) cover risk and risk

management aspect of takaful industry. Although these articles

and books analyse methods and techniques of risk management in

Islamic insurance industry as well as the efficiency of the

companies unlike the articles from previous section they are

silent about Maqasid al-Shari’ah. It is obvious from literature

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review that there is no literature that discusses all three

aspects, namely risk management, takaful and objectives Shari’ah

together, except “Risk Management via Takaful from a Perspective

of Maqasid of Shari’ah” (Abdullah S. , 2012a). Nonetheless, even

this article just shows that risk management is a concept that

lies within the spirit of Shari’ah in general and in takaful in

particular. Therefore there is a gap in research, which this

paper will cover. To be more precise, there is no literature

that discusses aspects of risk management in takaful from Shari’ah

objectives perspective, in other words are the techniques and

concepts used by takaful operators in harmony with the concept

of objectives of Shari’ah?

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CHAPTER THREE:

TYPE AND STRUCTURE OF TAKAFUL

There are two major model of takaful currently in practice in

the market, Mudarabah & Wakalah.

3.1 Mudarabah Model

Mudarabah originates in Malaysia, first by Syarikat Takaful

Malaysia (STM) in 1984. In short, the policyholder and the

shareholder operate on a joint venture basis. Both the

policyholder and the shareholder share the direct investment

income, in term of percentage. The policies separate a

proportion of the premiums paid into tabarru’ (donation) account

for the risk coverage and the investment account. The tabarru’

account generally under the jurisdiction of the shareholder.

The sum assured depends on the amount of the tabarru’ account,

and the performance of the investment fund. The shareholder

only shares in the investment return, to incentivize them to

search for better investment opportunity. In the event of a

loss, the shareholder has to top up the fun. The mudarabah

contract is cancellable, and upon cancellation, all cumulative

capital plus profit must be returned to the capital provider

less administrative expenses. Consent must be granted by the

policyholder to the shareholder for investing on the Shari’ah

compliant instruments.

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Many Shari’ah scholars have concern on the risk contract in

which the underwriting surplus being treated as mudarabah

profits. Contribution to the tabarru’ fund is considered as a

one-way transaction in which the contributor has no right to

take any benefits from it. Tabarru’ fund is reserved for any

participants who face financial difficulties or losses within

the time period in the insurance policy. There are a few

concerns from Shari’ah perspective on this practice:

1. There is concern that effectively the policyholder

contributes their premium directly to the shareholder

because it is the shareholder who controls the usage of

the fund.

2. Technically the contributions in tabarru’ (donation) and it

is not mudarabah (profit sharing). Thus the takaful should

not be called mudarabah contract since a portion of it is

donation.

3. In mudarabah contract generally, distribution of profit

is via investment profit. This profit is not the same as

surplus (excess of premiums over claims, reserves, and

expenses)

4. The practice of top-up interest free capital which is

called qard al-hasan is not in line with the mudarabah

concept.

3.2 Wakalah Model

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This model is commonly applied in gulf countries. Wakalah is a

contract of agency. Basically the policyholder appoints a

company owned by shareholders to manage his affairs. In takaful

operation, the shareholders are appointed as a representative

by the policyholders, to manage the takaful fund for a defined

fee. Under this model, the ownership of the takaful fund remains

with the policyholder. The shareholders, will deduct the fund

from its operating expenses which include the management fee,

claim reserves, technical reserves, retakaful etc. The balance

or normally known as underwriting surplus, will be used for

investments and distributions among the policyholders. There

are a few concerns from Shari’ah perspective on this practice

1. Same with mudarabah, in wakalah model, a percentage share

of the underwriting surplus is paid as a performance

incentive for the operator. This might lead to taking

advantage of the lack of information from policyholder

perspective to mislead them to pay a higher premium in

return of lesser coverage & benefits.

2. In a typical wakalah, tabarru (donation) remains under the

property of the policyholder. This might be giving

problems and issues such as inheritance and zakat in

which it is not possible to calculate the share of the

surplus in the pool at time of death.

3. Another generational issue is the compulsory qard al-hasan

for the shareholder in the case of deficit in the Tabarru

fund. This contribution supposed to be returned by the

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future generations, but the future generations are not

the one who has given rise to the deficit.

3.3 Mutual Insurance & Takaful

Mutual insurance is the oldest from of insurance that still

exists until today. According to Wikipedia, a mutual insurance

company is an insurance company owned entirely by its policyholder. Any profit

earned by a mutual insurance company is rebated to policyholders in the form of

dividend distributions or reduced future premiums. Mutual Insurance Company

operates by the principle that the monetary loss per member is

smaller, the larger the company is. In other words, mutual

insurance is a ‘not for profit’ company in which collects monthly

premium in exchange for protection against risk for all its

members. It target is not making money, but rather service and

affordability were the main concerns.

The best way to explain mutual insurance is by looking at the

real life example. One of the best-run mutual insurance

companies is Folksam in Sweeden. As its website puts it,

“Folksam is a mutual company, meaning our customers are also our owners. The

profit doesn’t go to shareholders, it stays within the company and benefits us all …

Our vision [is] that People should feel secure in a sustainable world.” Folksam was

founded in 1908, in its own words, as “a response to great

injustices”—the inability of ordinary people on low incomes to

be able to obtain the sort of insurance protection relevant

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for them. Until today, it is closely connected to

the cooperative and trade union organizations in Sweden.

Rather than just concentrating on insurance, Folksam has also

taken a few significant initiatives that are very successful

in bettering the life of its policyholders. For example, they

have put effort in the last 30 years to reduce the number of

road accidents by investing in road safety research. The date

that they have collected also enable Folksam to identify most

safe and environmentally friendly car, and they use this data

to give incentive in term of lower insurance premiums for the

car owners. Besides road safety, Folksam also takes

initiatives in various fields such as engagement with the

companies whose share it holds to influence the companies to

do ethical business and reduce environment unfriendly

activities. They also push for gender equality remuneration

policies and equal presence on the board level.

Takaful was conceived in the late 1970s out of the need for

Islamic banks to have insurance coverage consistent with

Muslim principles. According to Wikipedia, ‘takaful  is a co-operative

system of reimbursement in case of loss, paid to people and companies concerned

about hazards, compensated out of a fund to which they agree to donate small

regular contributions managed on behalf by a Takaful operator’. By its

definition, Takaful should be run like a mutual insurance in

which its main objective is the security and benefits to its

members. But in its current structure and manifestation, Takaful

operators run takaful for profits and its objective is to

provide a good return of investment to its shareholders.

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This situation arises because of several factors. In the today

world, the minimum size requirements and regulations in

minimum capital for insurance-based company including takaful

requires takaful companies to seek investors to provide for the

initial funds. These investors surely require return for the

capital that they have putted in. It would be almost

impossible for a truly mutual insurance to be set up with the

current requirements and regulations still in place. Also

sometimes difference interpretation of sharia law and the lack

of global standards at how sharia applies to takaful resulting

in the difference of practices between jurisdictions. For

example, sharia scholars may differ in opinion on the

following:

1. Whether the takaful shareholders are entitled to a share of

any underwriting profits

2. How any surplus on a winding up of a takaful fund(s) should

be allocated

3. Whether the tabarru’ (risk premiums) should be paid into

a waqf (trust fund)

Thus it is very hard to agree on the most rightful

implementation of takaful in the modern times. Thus we believe

that the most easiest way out for takaful operators is to follow

mostly the conventional way of running insurance with a few

exceptions to ensure Shari’ah compliance. This will surely

implies that takaful will be closer to stock insurance rather

than mutual.

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CHAPTER FOUR:

SHARI’AH & FINANCIAL ISSUES OF TAKAFUL

4.1 Principal-Agent Issue

In economics theory and real life situation, agents will try

to maximize their fee income. In the current wakalah structure,

income is defined as a percentage of premium income collected.

In such case, it is arguable that agent will be incentivize to

increase turnover through poor underwritings and improper

premiums. This might lead to insufficient portion of the

contribution to the claim in the situation of a crisis or bad

situation, for example when a major disaster like tsunami and

typhoon affects a majority of the policyholders. Furthermore,

the agent or the operator in such bad situation in which the

fund allocated for claim is insufficient; is not liable to

provide the extra fund for the claim. This is also true for

mudarabah based takaful.

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Operator of takaful in the current structure also has a share in

the profit of surplus, but not in the loss. Normally surplus

is invested in Shari’ah compliance investment products. Without

proper control, the operator will be has an incentive to

invest in a high return, high-risk investment. In a bear

market condition, this investment might turn out to be bad and

depleted the policyholder fund. But then also, the operator

will not be penalized for this. In term of Shari’ah community is

also divided; some sees it as contrary to the concept of

mutuality. It is also not fully in accordance to the wakalah or

agency contract in which the agent is entitle to a

predetermined & quantifiable fee. Some scholars see it as

permissible as an incentive for good performances.

Another difference between mutual the takaful is that in mutual,

it is expected that the focus is on customer service rather

than profits alone. In an agent-principal relationship such in

takaful, the operator as the agent may seek to maximize profit

by minimizing expenses, which inadvertently can affect service

to the policyholders.

The fees structure also favors operator since the participants

has no say, other than comparing with a few operators. Surplus

distribution also determined by the operators. This is not

easily monitored, thus corporate governance is an important

issues in takaful. The surplus is also has to be invested in a

proper way in a Shari’ah compliance companies. This is supposed

to be advised and monitored by a Shari’ah board. However, sharia

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scholars are rarely versed in the technicalities of insurance,

and some decisions that they made is arguable.

For example, one disagreement is in the application of tabarru’,

which literally means ("to donate, contribute, or give away").

According to Wikipedia, tabarru’ means participant agrees to relinquish a

certain proportion of his takaful installments that he agrees or undertakes to pay,

should any of his fellow participants suffer a defined loss.  The issue relates

to the finality of donations: specifically, once an amount has

been donated, the donor loses all rights to the donation. This

is the principal reason why participants in takaful do not have

equity in the risk pool, unlike policyholders of mutual

insurers. When a surplus transpires, the participants will not

a refund of part of their contributions because they have

given up their equity.

4.2 The Driver of Takaful Operator: Profit

The main objective of takaful is to share risks among

participants and it is one of the available ways of managing

risk. Indeed, the word Takaful originates from the Arabic word

of Kafalah which means “guaranteeing each other” or “joint guarantee”.

The purpose of this concept is not to generate profit but to

uphold the principle of “bear ye one another’s burden”1 or to help

each others. However, how far does the contemporary takaful

activity really meet the main objective? Similar to Islamic

banking system, in their early days, from providing

alternatives for banking activities for Muslims, has switch to

1 Galatians 6:2 (King James Version)

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quest for profits. Indeed, in takaful business, there will be

surplus in terms of investment and underwriting. As sharing

the investment surplus or profits between participants and

takaful operators is a non-issue, the sharing of underwriting

surplus is debatable. It is acceptable in Malaysia to share

underwriting surplus, however, it is considered unacceptable

in Islamic point of view in the other part of the world. In

the previous era, takaful operators were first developed in the

Middle East, out of the desire of banks to obtain insurance

that are in accordance to Shari’ah law.

As profit was not a prime consideration, takaful operators were

set up on pure cooperative principles. All surpluses remained

in the fund, and actual expenses were charged to the risk

fund. Profit for the operator was purely on investment income

generated by capital. On the other hand, the first takaful

operator in Malaysia (Syarikat Takaful Malaysia) was established

in 1984 to support the operations of the owner that is Bank

Islam Malaysia2. In the beginning, Syarikat Takaful Malaysia

used a mudarabah model for its family takaful (life insurance)

operations, in which the operator and the participants shared

the profit from investments of capital (operator only) or

policyholder funds (operator and participants). Management

expenses were paid out of the profits shared with the

operator. Then, as general takaful and yearly group takaful

developed, underwriting surplus was also shared. This was a

practical consideration, as investment income for such plans

was insufficient to cover expenses, and thus surplus was2 Malaysian Takaful Industry 1984-2004, Bank Negara Malaysia

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treated as “profit” under the mudarabah model. The

distribution of underwriting surplus under Mudarabah model has

brought the criticisms from Shari’ah scholars. Mudarabah model

is an equity contract in which the profit will be distributed

proportionately while the loss will be born solely by the

capital provider. The most important part is that, the

remaining principal capital, both under profitable or losing

conditions, must be return back to the capital provider.

Please refer the diagram below to have a clear flow of how

takaful operates on Mudarabah concept:

Family Takaful based on Mudarabah concept

*source : Takaful Ikhlas

According to the diagram above, participant is the capital

provider while the Takaful operator is the trustee. Based on the

model, the Takaful contribution made by a participant will go to

Taawuni Account Pool and Investment Account. If there is any

surplus out of Taawuni Account Pool, it will be credited as

surplus. Later, the surplus, either profitable or not, will be

Net Surplus

NetInvestme

ntIncome

Investment Fund

Personal Investment Account

Personal Risk Investment

AccountGeneral Risk Investment Account

Participant’s contribution

ion

Surplus

Taawuni Account Pool

Balance

If risk fund is insufficie

Surplusadministra

tion

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distributed between the participant account and the operator.

The operator’s portion is called SAC (Surplus Administration

Charge). The issue here is about the definition of the

surplus. Under mudarabah contract, surplus should be profit,

and not the principal. Thus, the operator is entitled for the

profit but not the remaining principal. The current practice

is that, the surplus is anything left after the total risk

fund is deducted with claims, and it includes the balance

principal. Admittedly that the basis for takaful, clarified by

the Islamic Fiqh Academy, emanating from a meeting of the

Organization of the Islamic Conference in Jeddah in December

1985, resolved that there are three main principals to be met

for takaful operators to be considered Islamic, which are:

I. In accordance to Shari’ah ruling

II. Charitable Donation (tabarru’)

III. Cooperative principles

The discussion did not mention about whether any underwriting

surplus can be shared between the participant and the operator

or whether it should be distributed solely to the participants

or be used for some other purpose, that is, as reserves or

charitable donations3. However, as mentioned before, the

definition of surplus in mudarabah is the profit not the

principal. Thus, takaful operators could operate based on other

concepts such as wakalah- jua’lah model, which possess lesser

Shari’ah-compliance risk. Under wakalah-jua’lah model, a Takaful

operator is entitled for a wakalah fee (i.e. Expense Fund) and3 Taylor, Dawood. n.d. “To Be or Not to Be (Takaful), That Is the Question.”

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later also entitled for jua’lah fee if there is any surplus.

jua’lah is a fee imposed on performance basis. Nonetheless,

whichever model is used, generally, in contemporary Islamic

finance environment, takaful operations has been slightly

slipped from its initial objective that is to help each other

against possible losses.

We are of the view that profit seeking is not immoral;

however, it can be so if profit was to be the main goal. The

markets for takaful are growing and interest continues to grow

mainly in line with the development of Islamic banking in many

Muslim-majority countries and Muslim-minority countries. The

growing interests is surely attractive for profit-seekers, and

in some markets, competition has been aggressive with respect

to fees, charges, and profits. The takaful operator sets up a

takaful fund, which is put together for groups of participants

to assist each other in times of need. The direct link between

contributors and those in need is not present. There is less

focus on religion and religious observance, although a sharia

council carefully reviews the practices of these firms to

ensure compliance. Therefore, takaful can be considered a mutual

insurance hybrid, operating in a new segment of the universe

of insurance models. Takaful is similar in structure to a mutual

insurance company, which is run by a stock insurer for a fixed

fee, but also to a faith-based insurance company, which needs

to comply with religious principles4.

4 Hybrid Insurance Structures: Reciprocals, Hybrid Mutual Insurers and Takaful – Zainal Abidin, Hassan Scott, Sabbir Patel.

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4.3 Underwriting and Liability Risk Issue

The liability risk could be lower than for conventional

insurance if the takaful operator stays away from providing

contribution guarantees, especially for long term family takaful

business. On the other hand, operators are faced with a

potentially more volatile and less diversified portfolio in

view of the small market place. However, this could easily be

managed through an appropriate retakaful arrangement. Strong

competition, together with lower economies of scale and lower

investment returns, could result in mispricing or under-

pricing and premium insufficiency. The lack of clams

experience data poses a challenge when it comes to

establishing loss reserves. In the absence of credible

experience data, more conservative assumptions need to be used

for reserving (Frenz & Soualhi, 2010).

Moreover, takaful operators having Shari’ah Supervisory Board have

higher financial expenses comparing to conventional

counterparts, which do not need this board. Eventually, Shari’ah

compliance together with the salaries of Shari’ah Supervisory

Board reduces the income of takaful operators. The takaful

operator as an investor faces a challenge in matching assets

to liabilities. Though long-term investment is potentially

more profitable than short-term investment, the takaful operator

has to maintain a sufficient amount of liquid assets in the

takaful funds to be able to pay out arising claims. The problem

with fully liquid assets is that they are not invested and,

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therefore, do not earn profits. Conventional insurance

companies have access to a wider array of highly liquid

assets, such as bonds, that can be sold on short notice in the

secondary market. Malaysian takaful companies have access to a

fairly well developed sukuk market, which allows them similar

facilities, but takaful companies outside Malaysia are

handicapped in this regard (Abdullah, Laldin, Ali, Ahmad,

Abdullah, & Zuki, 2013).

“The Guidelines on Takāful Operational Framework” (BNM, 2012a)

emphasizes that takaful operators must formulate policies for

prudent fund management in order to avoid any adverse impact.

To do so, they need to take into account the amounts and

timings of the takaful liabilities and, based on that, choose

investments commensurate with the particular fund’s tolerance

of risks (BNM, 2012a). Having realized the importance of

proper asset-liability management in a financial institution,

the study views this duty as very challenging to the takaful

operator. It not only needs to manage the shareholders’ fund,

but also the takaful fund, a separate entity from the company’s

fund. Therefore, the takaful operator must ensure transparent

reporting in the asset and liability management that ensures

segregation of the two funds.

4.4 Operational Risk Issue

Operational risk is all risks other than market, credit and

underwriting risks. With takaful being at a young stage, it is

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naturally subject to higher operational risks for various

reasons:

• Evolving takaful regulations and accounting standards

resulting in uncertainty and potentially additional

compliance costs, e.g. changes expected in:

o valuation requirements and RBC,

o regulations detailing how to ensure

intergenerational equity in surplus sharing, which

is currently at the discretion of the operator or

appointed actuary,

o and potential conflicts due to dual supervision by

both regulator and Shari’ah board.

• Potential mismanagement:

o Conflict between Shari’ah compliance and professional

risk management might result in sacrificing one for

the other.

o Lack of takaful professionals and Shari’ah scholars is

a natural source of mismanagement.

• In dual markets, there is fierce competition with

conventional insurers for market share. However, takaful

operators are often less well capitalised, and enjoy

lower economies of scale and potentially lower

investment returns. This could result in;

o under-pricing or expense overrun;

o failure to adhere to underwriting and claims

guidelines for the sake of increasing the top line.

• Risk of mis-selling:

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o Although transparency is an objective of takaful, it

is often lacking in takaful contracts,

o There is also a general lack of takaful understanding

amongst agents and the public. The perception is

often that takaful is the same as insurance, which is

clearly not the case.

As mentioned above, IT framework used by Islamic insurance

companies is still the same that used by conventional

insurers. It calls to develop own IT framework, which will

take into account features pertaining takaful business (Frenz &

Soualhi, 2010). Not only that, the lack of any control

mechanism for the funds invested by the fund manager. This is

due to the fact that most of the investment activities are

assigned to an external fund manager whose activities are

governed by the operator’s outsourcing service policies. To

date, there is no standardized parameter regulating the

policy, except a general provision in the “BNM Shari’ah Standard

on Mudarabah”, which gives an option to the mudarib to assign

the capital under his management to another mudarib or another

manager (as agent), subject to the conditions agreed to by the

capital provider (BNM, 2012b).

Among the most important duties of the fund manager appointed

as a sub-investment manager is to stay updated on the Shari’ah

compliant investment avenues, particularly securities, which

are continuously reviewed by the respective authorities such

as the Securities Commission. The proper and continuous

27

mechanism of control is important to ensure that all funds are

invested in a Shari’ah compliant manner and Shari’ah compliant

instruments. The issue becomes potentially critical in a

subsidiary structure where the investment duties are

outsourced to the parent or to other companies in the same

group or to a third-party fund manager against an agreed fee.

The shared-service practice or outsourcing will result in a

Shari’ah non-compliance issue if the outsourced investment

activities involve non-permissible investment avenues. This

study is of the view that the outsourcing service policy

adopted by the operators with their fund managers must clearly

spell out the nature of the contract between them, either

mudarabah (al-mudarib yudarib, i.e., a sub-investment manager), or

wakalah (investment agent), or ijarah ‘ala al-‘amal (a hire of

service) and their respective rights and obligations as

reflected by the unique principles of the defined contract

(Abdullah, Laldin, Ali, Ahmad, Abdullah, & Zuki, 2013).

The outsourcing service agreement should also clearly define

the method of fee calculation, which must be consistent with

the type of contract adopted. The outsourcer (takaful company)

should also have ways to review and examine the investment

undertaken by the subcontractor (fund manager) so as to ensure

that such activities do not involve prohibited transactions

which may taint the company’s halal income. The takaful operator

can provide the requirements on the screening, purification

and remedial processes in the outsourcing policy and the

agreement with the fund manager. In addition to the Risk Fund

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surplus, prudent management of the Investment Fund in a way

that accumulates profits is another indicator of a solvent

takaful operator. The issue, which needs serious investigation is

how surplus and profit are each defined in the surplus and

profit management policy and, consequently, how they are

recorded in the financial report.

A close scrutiny of the internal surplus and profit management

policy in various takaful operators may reveal that, in many

instances, the two are referred to as the same item and the

terms are used interchangeably. While ‘profit’ may also be

referred to, linguistically, as a ‘surplus’, in the context of

takaful, each results from a different fund, and they may be

managed under different contracts that impose different rights

and liabilities upon the takaful operator as the party managing

the funds. As such, the financial report should separately

disclose the profit from the Investment Fund (PIF) and the

underwriting surplus from the Risk Fund (PRF) in detail before

the Shari’ah committee and the board for their further

deliberation. Even if the Risk Fund is invested, its profit

portion must be separately reported from that of the

Investment Fund. Therefore, constant Shari’ah review of the

Surplus and Profit Management Policy and the Annual Financial

Report must be carried out to ensure continuous

standardization and transparency in the takaful operator’s

reporting.

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CHAPTER FIVE:

CONCLUSIONS / RECOMMENDATIONS

The takaful industry, with its rapidly evolving landscape, is

currently facing numerous regulatory and technical challenges.

The industry is constantly seeking improvements in its effort

to improve competitiveness and to meet Shari’ah requirements as

well as treating policyholders and takaful operators fairly,

which is in line with Maqasid al-Shari‘ah. It must also survive

side-by-side with the conventional insurance industry. The

lack of suitable human resources means that actuaries can add

significant value to assist takaful operators in tackling these

current issues faced by the industry.

Mutuality or cooperative is a concept that has existed for

centuries in the insurance world. Actuarial expertise and

knowledge in the management of mutual insurance business can

be adopted within takaful to enhance its success. The takaful

industry is continuously striving to develop best practices in

the management and valuation of the business. Actuarial

principles and practices in the conventional insurance context

such as embedded value calculations, asset liability

management, enterprise risk management, capital management,

surplus determination, and distribution methodologies have

direct application to the takaful industry, sometimes

compromising Maqasid al-Shari’ah. In addition to technical

30

challenges, there are also regulatory challenges within the

industry. Due to the varying degrees of Shari’ah interpretation,

there are difficulties in developing global takaful standards or

regulations, although the IFSB has issued takaful consultation

papers in an attempt to achieve some consistency in the

industry. Actuaries can work closely with the regulators to

develop a framework that is appropriate and relevant to takaful.

With the conventional insurance industry moving towards a

risk-based capital assessment regime, and with the current

changes in the global accounting standards, considerations

need to be given to their application to takaful.

The problems of development of new prospects of Islamic

finance at the conceptual and practical levels still exist.

There are three main points that should be kept in mind to

develop Islamic finance: formal issues related to appropriate

products and instruments to serve the goals, the human capital

involved in the industry and the systemic matters of concept,

paradigm, goals, structure and directions of an Islamic

financial system. Obviously, substantial works should be

employed not only in the foundational area of takaful but also

in the operational area. As a result, takaful will be able to

provide genuine Islamic alternatives to contemporary insurance

practices. For this purpose, a clear and coherent

philosophical foundation that originates from an Islamic

worldview is required. The study is limited to general

overview, in other words the paper describes concepts and

practices in general without going deep into details. Still,

31

there are more researches can be done in the future covering

each aspect of risk management in takaful from both theoretical

and practical aspects. This, however, calls for closer

collaboration of academicians with the industry, which merely

was achieved during this research, because of lack of

willingness of the people from industry to help the research.

32

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