Operational and Actuarial Aspects of Takaful Emerging Issues in Takaful.

Operational and Actuarial Aspects of TakafulEmerging Issues in Takaful

Sub TopicsTakaful v Insurance: RecapRisk assumption & transferAccounting recognitionImplicit guaranteesLiberalized marketRisk based capital (RBC) issuesTaxation of takaful funds/ operatorsRetakaful

Differences between Takaful and InsuranceTakaful Insurance Area

Based on mutual cooperation and ‘Tabarru’

Based solely on commercial factors

Contract

Profit sharing between the individual participants and the pool of participants in the Takaful

Exchange of contract between policyholder and the insurance company

Contract

Participants own the Takaful funds and managed by the operator. Participants give up individual rights to gain collective rights over contribution and benefits.

Insurance is a buy-sale contract. In which policies are sold and the policy-holders are the buyers

Contract

Contracts of Agency between the participants and the Takaful operator to manage the fund

The fund belongs to the insurance company

Contract

Participants make contributions to the scheme

Policyholders pay the premiums to the insurance company

Contract

Free from ‘riba’, ‘gharar’ and ‘maisir’.

Presence of ‘riba’, ‘gharar’, and ‘maisir’.

Principles of the contract

Profit may be shared among operator (company) and participant on Mudharabah basis or Performance Investment Fee on Wakalah.

Underwriting profits belongs to the Company.In life insurance, only participating policyholders will received share of surpluses.

Contract of Musarakah

Depending on the Biz Model and line of biz, contributions may be split in the PIA or wholly credited to the PSA. For general Takaful, usually credited to the Tabarru’ Fund (PSA).In Family usually credited into the PIA then ‘dripped’ into the PSA

In general insurances premium credited into the general insurance account.

In life insurance policy similarly, the collected premiums are credited into the life insurance account or fund

Contractual relationship

Differences between Takaful and Insurance

Shariah Perspective on Risk TransferThe transfer of risk from one person to

another is allowed in Islam. Can be inferred from acceptable contracts such as kafalah, dhaman and hiwalah.

However, the scholars are not in agreement whether assuming a risk by charging a fee is permissible. Many scholars are of the opinion that in order to avoid doubts, there should not be any fee involved.

Shariah Perspective on Risk Transfer In the case of conventional insurance however, most scholars are of the

opinion that it is haram (prohibited); the reasons usually quoted are gharar, maisir and riba.

To render insurance permissible, Sheikh Yusuf Al-Qaradawi put forth the following conditions ( which insurance companies do not satisfy) :

1. “Every member who pays his allotted share of money pays it as tabarru’ in the spirit of brotherhood. From this pool, help is given to those who are in need.

2. If any part of this money is to be invested, it should be invested in halal business only.

3. It is not permitted to the member to donate his share on the condition that he will receive a pre-determined amount in the event of an unforeseen calamity. Rather, he will be paid an amount which will compensate his loss or part of it, depending on the resources of the group, from the pooled moneys.

4. What has been tabarru’ is a gift (hibah) from the donor and the taking of it back is haram.”

Shariah Perspective on Risk TransferThe underlying philosophy for the

prohibition of insurance is that the insurer assumes the risk for a fee; and the insurance contract can be analogous to a contract of exchange, which itself is deduced from a sale contract. The transfer of risk from the insured to the insurer and the assumption of the risk by the insurer for a fee is akin to the contract of exchange. Under a contract of exchange, one of the conditions of the subject matter is that there should not be any gharar.

Shariah Perspective on Risk TransferThe prohibition of charging a fee for an

assumption of risk can also be seen from the civil laws of some Muslim countries that derive from Islamic jurisprudence. For example, item number 1098 of the civil transaction laws of the United Arab Emirates states that, “It is not permitted for the guarantor to charge a fee for his guarantee.” Scholars from this school of thought only allow charging of fees to cover costs and expenses for the assumption of risk, but not to profit from it.

Shariah Perspective on Risk TransferHence, rather than the takaful operator

the participants themselves should share the risk and the opertaor is just the manager of the takaful fund.

The contract between the takaful operator and the participants can be one of the acceptable contracts such as musharakah, mudharabah or wakalah whilst the principle underlying the relationship among themselves may be one of tabarru’at or tanahud

Shariah Perspective on Risk Transfer – Tabarru’ is Hibah?If tabarru’ is hibah, why is it that the takaful

operator determines the amount of hibah? Should not the participants who decide how much to give?

If the amount of tabarru’ is decided by participants, the takaful system breaks down as there is a large probability that the takaful fund may not be enough, at least for some classes.

If it is (straightforward) hibah, how does one reconcile the condition for compensation? It then becomes conditional hibah as mentioned above and this would render it non permissible according to some scholars.

Shariah Perspective on Risk Transfer - TanahudPrinciple of tanahud is based on the hadith

narrated by Imam Bukhari and Muslim with respect of the ‘Ash’ariyun.

But an analogy cannot be made between the hadith and the fees and/or profits charged under the wakalah or mudharabah contracts.

In the hadith, the contributions differ but the wealth is distributed evenly whereas in takaful practice the contributions match the compensation.

The practice of sharing of surplus is also strictly not in line with the hadith

Shariah Perspective on Risk Transfer – Surplus Sharing AAOIFI recommends that the takaful operator should not

participate in the surplus. It is valid ruling as surplus sharing would effectively mean that risk, at least in part, has been assumed by the operator which they do not. Takaful operators should not be like conventional insurer where sharing of the underwriting surplus is key.

But takaful operators may lack sufficient financial incentive to operate the business, especially for non-tariff general takaful business. Does AAOIFI ruling, puts the takaful operator in a position of disadvantage and inhibit the growth of takaful?

The same impact may not be felt as much in life (family) takaful business since other factors are involved and that in many cases and jurisdictions, conventional insurers are also required to give back a large proportion of surplus to policyholders. In this respect most jurisdictions only allow conventional life insurers to take up between 10% to 20% of the life fund surplus only.

Shariah Perspective on Risk Transfer – Surplus SharingThe issue of assumption of risk by the takaful

operators still exists as statutory provisions in almost all jurisdictions demands that takaful operators assume the risk in the event of inadequate contributions to operate the takaful fund (providing a qardhal hasan facility) !

Shariah Perspective on Risk Transfer – Capital AdequacyAny regime must recognized differences

between a Takaful operator and an insurerNeed to take account of the conceptual

separation between policyholders’ and shareholders’ funds

The asset profile of a Takaful operator (General or Family), is likely to be very different from an insurer. Hence, risk weights for Islamic instruments should be different under a RBC regime.

Different contractual models gives rise to different treatment to capital adequacy

Accounting IssuesCurrently, the accounting treatment for

premiums (contributions) and other income is based on the accrual concept as required by most insurance/takaful regulators in the different countries.

For a takaful operator it was argued that there is an issue of gharar if the accrual method is used. Also, one cannot distribute the surplus from the unpaid contributions since we are not sure whether these contributions will be received.

On the other hand, most operators have used the accrual basis.

Accounting IssuesThe accrual basis of accounting extends to

other income such as investment income and rental income. In this respect investments of a Takaful operator are to be shown in the balance sheet at their “current value” implying "market value”.

Market value at an earlier date is permitted in the case of land and buildings, provided that they are properly valued at least once every five years and account is taken of any diminution in value since the last valuation.

Accounting IssuesFor debt securities the market value is, by

implication, to be a “clean” value, excluding the value of any accrued interest, since such interest must be shown separately on the face of the balance sheet.

An alternative treatment is permitted for fixed-income securities. A company may amortise the difference between the purchase price and the amount payable on the redemption of the security over the period to the redemption date instead of marking it to market.

Accounting IssuesThe use of the amortised cost basis is appropriate

for redeemable fixed income securities (intended to be held on an ongoing basis) but is inappropriate for irredeemable fixed interest stocks and accordingly these should be accounted for at current value.

This method give rise to first, use of conventional interest and second, the issue of unrealized profit which has attracted debates amongst scholars. Scholars may not allow its amortisation due to the perceived “gharar” element.

Accounting IssuesHowever, many scholars allow income to

be recognised on an accrual basis if they can be reliably estimated. Use of estimates has been allowed by the tradition of the Prophet and salafi scholars such as Ibn Musayyab. Otherwise, income is recognised on actual distribution.

Rental income, on the other hand, is recognised on an accrual basis.

Implicit GuaranteesThe issue of implicit guarantees may be seen in

two areas. One is the guarantees that may be implied in the

marketing process which gives rise to expectations in the mind of the participant as to the benefits that will be payable (concept of PRE).

The other aspect of implied guarantees relates to the pricing product process. Does the operator has a fiduciary responsibility for guaranteeing the set of assumptions which is considered reasonable and prudent at the time of product pricing?

Implicit GuaranteesA takaful contract, unlike the conventional

insurance policy, places a greater burden on participants collectively to absorb fund insufficiencies due to the principle of mutual indemnity, but regulators could place financial responsibility and take action against operators for such fund deficiencies, especially if they are found to be willfully negligent in their role as takaful fiduciaries.

Liberalized MarketA liberalized market means the removal of obstacles to

market access particularly in the areas of : Government intervention in the domestic financial

system Capital controls and restrictions on the convertibility of

the currencyDiscriminatory treatment between foreign and domestic

companies and cross-border provision of financial services

Liberalization can have the following positive impact: Promotes efficiency Promotes financial depth Supports business Enhances financial systems

Liberalized MarketIn the takaful industry protective barriers

have been gradually removed and international players have made their presence felt in several Muslim countries through the setting up of takaful windows or separate subsidiaries.

International players can own up to 50% of the takaful operation and at least one country has allowed majority foreign ownership.

International players provide new capital, technical expertise, extensive distribution experience and other resources.

Liberalized MarketShariah scholars have not disagreed with

the participation of international non-shariah compliant companies in the industry.

These international players have also established their own shariah committees, in line with expected requirements of the regulators such as Bank Negara Malaysia.

Is the entrance of international players a positive move for the industry??

Risk Base CapitalRBC reflects the risk tolerance of the company

and the way management gauges risk. Risk-based capital is used to set capital requirements considering the size and degree of risk taken by the insurer.

It is the capital required to cover the risk the company takes. It is derived from the evaluation of the different risks. It is the virtual amount of capital that needs to be covered by the asset side of the balance sheet.

RBC methods used by different regulators could be slightly different from one another.

Risk Base CapitalThe theory behind RBC is as follows:- assess the level of security of a company; - determine the rate at which profits are

expected to become distributable for the purposes of calculating the Embedded Value;

- assess the volatility of the company profits;

- determine the discount rate to be applied to expected future profits

Risk Base CapitalIn RBC a Risk-Based Capital is determined, which

is the amount of capital (assets minus liabilities) an insurance company must have as a basis of support for the degree of risk associated with its company operations and investments.

A RBC ratio is developed by dividing the company's capital by the minimum amount of capital that the regulatory authorities feel is necessary to support the insurance operations. A ratio of 1.00 or greater may be set to be satisfactory.

This standard can be used to identify inadequately capitalized companies, thereby enabling regulatory authorities to intervene before a company becomes insolvent.

Risk Base Capital In US four major categories of risk must be measured to

arrive at an overall risk-based capital amount. These categories are:

1. Asset Risk- a measure of an asset's default of principal or interest or fluctuation in market value as a result of changes in the market.

2. Credit Risk- a measure of the default risk on amounts that are due from policyholders, reinsurers or creditors.

3. Underwriting Risk - a measure of the risk that arises from under-estimating the liabilities from business already written or inadequately pricing current or prospective business.

4. Off-Balance Sheet Risk - a measure of risk due to excessive rates of growth, contingent liabilities or other items not reflected on the balance sheet.

Taxation Issues In some countries, the tax laws have not have considered

the peculiar nature of takaful contracts have put the takaful operators in a disadvantage vis a vis conventional insurers. This is especially true for general takaful business .

For example, the insurance/takaful regulator may require that takaful operators in their jurisdiction comply with reporting revenue on a given statutory basis which may result in the operator being liable to tax which it would not otherwise have been subject to had the reporting been on a different basis.

An additional tax liability by the takaful operator may also be due to some other reason not necessarily due to regulatory requirements. An example would be if the shariah council require the takaful company to follow a certain basis of reporting.

Taxation IssuesAnother issue with respect to taxation is the

payment of zakat. Many contemporary scholars advocate the payment of zakat by takaful operators, including the operators’ shariah council.

In some countries where zakat is not a rebate against tax or even tax-deductible. This problem is compounded by the fact some shariah council require that the zakat payable be based on net current assets and not on profits; discriminating the takaful company further especially in the early years.

Retakaful IssuesRetakaful has the following uses:

The takaful operator or cedant, can take on more risk in areas where the rewards may be higher, effectively creating value.

As a source of Capital for developing and expanding other areas of business

Help takaful operators in their risk management (underwriting and claims administration) of the takaful fund

Retakaful IssuesRetakaful operators are generally lowly

capitalized and therefore takaful operators would then need reinsurance from conventional reinsurers.

In this respect the Accounting and Auditing Organisation of Islamic Financial Institutions (AAOIFI) has put limits on purchases of conventional reinsurance cover up to 45% of the total retakaful contributions ceded out.

Many takaful operators argue that conventional reinsurance is preferred over retakaful as conventional reinsurers are better rated.

Retakaful IssuesFinancial Retakaful may be advantageous in the

short term but adverse effects may result in higher cost of retakaful in the future. For family retakaful, specifically term, it is generally best to set the retention at the lowest level as the difference in the mortality pricing assumption and retakaful cost for mortality may vary by a huge margin.

The other issue, as has been mentioned briefly above, is the balance between reinsurance and retakaful. Almost always, it has been argued that reinsurance is cheaper than retakaful and therefore more capital can be released through purchasing reinsurance than retakaful.