Chapter 2

Business Models in Takaful and Regulatory Implications

Simon Archer, Rifaat Ahmed Abdel Karim, and Volker Nienhaus

2.1 INTRODUCTION

Conventional insurance is based on an exchange of premium payments now for future indemnities in case of specified events. Such an exchange (sale) contract would not be valid under Shari'ah law due to the uncertainty (gharar) of the value of the future indemnities. The Shari'ah view on conventional insurance and the basics of an Islamic alternative are outlined in Chapter 3. Shari'ah scholars accept uncertainty in contracts for one-sided transfers (tabarru') such as endowments or donations. Therefore, they base takaful schemes as the Islamic alternative to insurance on the concept of “donations” (voluntary individual contributions) to a risk pool out of which indemnities are paid to other contributors. The term “donation” may be somewhat misleading because there is no recipient who can dispose of the donated funds at his will, and the motive of the donor is not altruism or the well-being of others but a claim to benefits for himself in case of damage. The result is a “conditional donation,” which is in conformity with Shari'ah: takaful participants donate a sum of money to a risk pool (the takaful fund) subject to the condition that they will receive compensation from the pool for specified types of losses suffered by them.

An important question remains; namely, whether the compensation for damages will be in full or only partial. It cannot be ruled out that, in a certain period, the total amount of all claims exceeds the funds in the risk pool. If no further resources are available, claims cannot be compensated in full. This would not happen in conventional insurance where the insurance company has to fill any gap. Seemingly, in takaful, a partial compensation is also not envisaged: both takaful practitioners as well as Shari'ah scholars accept the possibility that the risk pool can run into a deficit. A deficit implies that the value of indemnities is determined only with respect to the financial damage caused by a specified event and irrespective of the financial position of the risk pool. Given predetermined claims of participants, the crucial question is who will cover the deficit in a takaful scheme. Only two options are at hand: either the shareholders of the company that manages the takaful scheme (the takaful operator) or the takaful participants. Conceptually, it must not be the takaful operator (although factually this may be the case, see below), so it has to be the participants. They can make up a deficit only out of future contributions.1

The obligation to cover deficits implies that a second condition is tied to takaful “donations”; namely, the commitment to pay further contributions if the initial ones are insufficient to cover the total claims of the members of the risk pool. It seems that Shari'ah scholars have not dealt with this feature explicitly, which is hard to reconcile with the common understanding of a voluntary “donation.” Because of this shortcoming, the elaborate juristic views of Shari'ah scholars do not offer an easy access to the economics of takaful. To understand takaful business models and regulatory issues, another approach can be taken which underlines the structural similarities of takaful and conventional insurance schemes based on the principle of mutuality: similar to the participants in a takaful scheme, the members of a mutual insurance do not purchase a risk cover from or transfer their risks to another party; instead, they form a solidarity group whose members take mutually binding promises to compensate all damages that occur within this group. They also accept the obligation to pay further contributions, if necessary. Mutual insurance is taken as the point of reference in Chapter 4 where the need for and scope of takaful regulations are explicated. The same perspective prevails in this chapter which will (a) give a systematic overview of the basic business models and their major variants as applied today by takaful undertakings (explicitly excluding retakaful schemes) and (b) summarize regulatory implications for the protection of the interests of takaful participants.

Other chapters of this book will broaden the perspective and include shareholders and other stakeholders. They will also dig deeper into some issues that are touched on here only on the surface, such as capital adequacy and solvency, corporate governance structures, transparency, and market discipline.

2.2 BUSINESS MODELS

2.2.1 Basic Structure

Takaful participants (TPs) are individuals (or institutions) who enter into a Shari'ah-compliant scheme of mutual risk cover. In contrast to the emergence of conventional mutual insurance since the 18th century, the Islamic solidarity arrangements of today are initiated and managed by takaful operators (TOs) which are commercial corporations (joint stock companies). Thus, the takaful business (risk cover and investment) is executed in takaful undertakings with a hybrid structure, consisting of a commercial management company (the TO) and a separate risk fund or underwriting pool, the participants' takaful fund (PTF).

The TPs pay contributions to the PTF from which compensations and operating expenses have to be financed. The contributions of each TP are contractually fixed and recorded in the participants' risk accounts (PRAs; in Malaysia: participants' special accounts, PSAs). The takaful contracts also specify the (monetary value of) claims in cases of damage. While conventional insurance policyholders buy a risk cover from and transfer the “ownership” of the money they pay to the insurance company, the TPs remain the owners of the PTF. In takaful, it is not an insurance company but the TPs themselves who provide mutual risk cover out of their PTF. The TO only manages the underwriting and investments on behalf of the TPs. Underwriting surpluses and investment profits belong to the TPs, who also should bear deficits and losses (except for cases of misconduct and negligence of the TO). In practice, however, TOs are forced by law in many countries to provide an interest-free loan (qard hasan) if the underwriting leads to a deficit in the PTF. This loan is to be recovered from future underwriting surpluses. The mandatory qard facility requires sufficient shareholders' funds (SHF) of the TO.

The structure outlined so far was for general takaful—that is, for the Shari'ah-compliant alternative to non-life insurance. For the alternative to life insurance—called family takaful—the participants' investment fund (PIF) has to be added. Family takaful contributions comprise, in addition to the risk component, a savings and investment component which is credited to the individual participants' investment accounts (PIAs) (see Figure 2.1). This portion of the contribution is not part of the mutual risk cover. It is invested in order to build up wealth for the participant in case of survival or for the beneficiaries in case of death. The TO is responsible for the profitable investment of this part of the takaful contribution.

For third parties, a takaful undertaking seems to be identical with the TO who enters into contractual relations with them. The PTF is a distinct entity only in the internal setting (relevant for the relations between the TO and the participants) but does not have a separate legal personality (relevant for relations with third parties). A different arrangement is possible only in Pakistan, where the shareholders of the TO have the option to dedicate capital to the formation of a waqf which transforms the PTF into a separate legal entity. The implications of this option will be discussed later.

The TO can decide freely how to fulfill its contractual duties toward the takaful participants. For example, the TO has the right to enter into retakaful (or even conventional reinsurance) arrangements. It is reported that some TOs have ceded up to two-thirds of their underwriting to reinsurance companies. This implies that most of the risk management is not done by the TO. It can also be questioned whether such a practice is compatible with the idea of a well-defined solidarity group formed by the participants of a specific takaful fund.

The participants' contributions are factually merged with others in a wider risk pool on the retakaful or reinsurance level. Another example of the outsourcing of duties is the asset management (especially for the savings part of family takaful contributions). This can be transferred explicitly or implicitly to an independent asset manager: explicitly, if this task is contractually assigned to another company; implicitly, if the TO places substantial parts of participants' funds in investment accounts with Islamic banks. Although there are no legal objections against such practices, it is difficult to reconcile them with the concepts of mutuality, donation and participants' ownership of takaful contributions, and they raise corporate governance issues that are mentioned below and discussed at greater length in Chapter 4 of this book.

2.2.2 Standard Models and Variants

The basic structure of a takaful undertaking is designed by the TO. From a regulatory perspective, a major concern is how the TO is remunerated for its services. Two standard models have emerged (which allow for variations in details)—the wakalah (agency) model and the mudarabah (profit-sharing) model. Variants are the wakalah model with performance fees and the modified mudarabah model.

In practice, a combination of these two standard models is widely applied: the wakalah mudarabah model. This model applies wakalah principles to the underwriting (PTF) and mudarabah principles to the investment business (with respect both to reserves and excess resources in the PTF and to participants' contributions to the PIF). An even more specific arrangement is the wakalah mudarabah waqf model, which is permissible and applied in Pakistan.

2.2.2.1 Wakalah Model

In the wakalah model, all relations between the TO and the participants are based on an agency contract: the TO is the wakeel (agent) who acts on behalf of the participants (principal) both in underwriting and investment. The wakeel's services in both fields are remunerated by fees, which are contractually specified either as an absolute amount or as a percentage of the turnover (that is, the volume of contributions or of invested funds), but not as a percentage of the profit of the undertaking. The fees must cover all management costs (not including claims and direct costs of claim handling) plus the profit for the shareholders.

Wakalah Model with Performance Fees

Turnover-related fees imply incentives for profit-oriented TOs to enhance the volume of contributions and invested funds while the performance in underwriting and investment does not have a direct impact on the income. This cannot be in the interests of the takaful participants. Therefore, fees sometimes include “performance” elements, where performance is measured in relation to the underwriting surplus or the investment profit. This changes the incentive structure and governance problems considerably and brings them close to those of the mudarabah model (see below). This becomes a problem especially if the performance element is strong and if higher underwriting surpluses lead to higher fees.

2.2.2.2 Mudarabah Model

In a mudarabah contract, one party (rabb al maal) provides the capital (the participants) and the other party (mudarib) provides the entrepreneurial skills to manage the capital (the TO). Both parties share the profit generated from the employment of the capital in a pre-agreed ratio, while a loss has to be borne by the capital-providing party alone. In case of a loss, the entrepreneurial efforts of the mudarib are not remunerated. In a pure mudarabah model, the TO has to cover all its costs out of its profit share and must not charge additional fees. Proponents of the mudarabah model initially subsumed under profit both the underwriting surplus and the investment profit. However, Shari'ah scholars clarified that the underwriting surplus is not a profit that can be shared between the TO and the participants (see below). This restriction makes the pure mudarabah model factually useless for general takaful, where only relatively small amounts (reserves and temporary excess liquidity of the risk pool) are at hand for investments on a profit-sharing basis.

Modified Mudarabah Model

Especially in early years when reserves have not yet been built up in the PTF, the pure mudarabah model implies a high risk for the TO: if claims exceed contributions—that is, when the underwriting leads to a deficit—the TO will not only receive no remuneration for its services but must also provide a qard hasan to keep the PTF solvent. This may threaten the existence of the TO itself, especially if such a situation occurs in more than one year. Therefore, some takaful arrangements allow the TO to charge not only the direct costs of claims handling but also all management expenses to the PTF before the underwriting surplus or deficit is calculated. Although the Shari'ah compliance of the modified mudarabah model is questionable, it is applied in practice and is also applicable to general takaful. For the underwriting part, its incentive structures (and governance problems) are very similar to a wakalah model with performance fees. Therefore, it is possible to transform a modified mudarabah arrangement into a commercially equivalent wakalah model with performance fees in order to avoid debates about the Shari'ah qualities.2

The authorities in Malaysia have permitted the mudarabah model for underwriting, but it is seriously challenged in most other countries. The main legal argument is that the underwriting surplus is not a profit that could be shared between the participants and the TO. It is the excess of participants' funds contributed for the specific purpose of mutual help, and any excess not needed for this purpose belongs exclusively to the participants and must not be shared with the TO. There is also an economic argument against surplus sharing: if the TO receives a share of the underwriting surplus, its remuneration increases with the size of the surplus (as in the mudarabah model and in wakalah models with performance fees tied to the size of the surplus). The TO then has an incentive to maximize the surplus. However, from the perspective of the participants, the optimal underwriting surplus would be (close to) zero (provided sufficient reserves have been built up). Any systematically higher surplus means that their contributions would exceed the risk-equivalent level as determined by actuarial calculations.

2.2.2.3 Wakalah Mudarabah Model

The wakalah mudarabah model seems to have become the most widely applied arrangement for takaful. It combines the wakalah model (with performance fees) for underwriting with the mudarabah model for investment (in general and family takaful). From a TO's perspective, this model avoids the Shari'ah disputes on modified mudarabah in underwriting but allows for equivalent commercial results. It has the potential to combine the advantages of both standard arrangements for TOs. The flip side of this coin is that it also has the potential to maximize the governance issues from the participants' perspective.

2.2.2.4 Wakalah Mudarabah Waqf Model

The structural difference between the wakalah mudarabah and wakala mudarabah waqf models is that the PTF gets the legal personality of a waqf. The waqf comes into existence by a waqf deed. The initiators of the takaful scheme (that is, the shareholders of the TO) provide the initial capital of the waqf, which can be nominal. The purpose of this capital is not to ensure the solvency of the takaful undertaking but only to establish the waqf as a legal personality. The funds needed for its operation are provided by the participants, and the solvency has to be backed up—as in the other models—by a qard facility.

The purpose of the waqf is to support the beneficiaries in cases of damages and financial losses. Takaful participants donate their contributions to the waqf and become its beneficiaries for the period specified in their donation contracts.

The waqf model has provoked an ongoing debate among Shari'ah scholars. The majority is particularly skeptical with regard both to the permissibility of a waqf with a nominal capital that is insufficient to support any beneficiary, and to temporary memberships based on term contracts. In addition to Shari'ah arguments, the legal specificities lead to economic differences between the waqf model and the other models with far-reaching conceptual implications. An essential feature of the waqf model is that the ownership of the donated funds is transferred from the participants to the waqf. This establishes claims of the participants against the waqf, while they lose those rights that are substantiated by their ownership of funds in the other takaful models. For example, the participants do not have any rights to the underwriting surplus. The surplus remains within the waqf, and decisions on its appropriation are at the full discretion of the TO managing the waqf. But participants also lose some obligations. In a conventional mutual insurance, participants have—at least conceptually—an obligation to make further contributions (that is, pay calls) when the risk pool runs into a deficit. Conceptually, takaful participants have similar obligations.

However, this obligation may not become fully effective: the obligation to make further contributions is cushioned in takaful insofar as the shareholders of the TO are obliged to provide a qard hasan. In theory, the same takaful participants who benefited from this loan should also repay the qard so that they bear the deficit. In practice, the payback of a qard cannot take place in the same period as when the deficit occurred, but only later. Then most probably the composition of the solidarity group has changed, implying that those who benefited from the qard and those who are burdened with the payback are not fully identical. Therefore, it is not the obligation of each participant individually3 but of the PTF as such to repay the qard. In the worst case, it may not be possible to recover the qard if potential participants shy away from a PTF that is burdened by the need to recover a former deficit. Then in the last instance, the shareholders of the TO bear the deficit.4 The waqf model is clearer with respect to obligations in the case of an underwriting deficit: the PTF is established as a separate legal entity that receives and has to pay back the qard. But this legal precision does not change any of the underlying economic relations: not the waqf (with nominal capital) but only future participants can repay a qard, or the TO's shareholders will suffer a loss.

While the participants' obligation to make further contributions in the case of an underwriting deficit does exist—although somewhat blurred—in the standard models, such an obligation does not exist in the waqf model where the waqf is a legal personality that benefits from and has to repay the qard. This eliminates the essential feature of mutuality in risk protection and raises the question: What is the basic conceptual difference between takaful based on waqf and conventional insurance? If policyholders or participants are not locked into long-term insurance or takaful contracts but do have periodic choices to change their insurance or takaful providers and products, it is highly probable that in a competitive environment underwriting deficits cannot be recovered from future premiums or contributions. If reserves are not available, and if the theoretical recourse to the previous policyholders or participants is ruled out by the waqf construction, then deficits must ultimately be borne by the shareholders of the TO. This is the same as in a conventional proprietary insurance. Thus, no substantial economic differences remain in the underwriting business between conventional insurance and a waqf-based takaful scheme.5 The waqf model looks and feels as if participants were not members of a solidarity group based on the principle of mutuality, but as if they just purchased a risk cover policy from a legal person without any further individual obligations and rights.

The waqf model is permissible and practiced in Pakistan. However, the practice differs between the existing takaful undertakings, and the conceptual debate has not yet come to a final conclusion—although it seems that a majority of Shari'ah experts tends to reject the model.

2.2.2.5 Bancatakaful

The bancatakaful business model is not fundamentally different from the previous models at the core, but is distinct in the combination of features with governance implications. TOs utilize different channels for the selling of their takaful products—for example: employed sales personnel, independent brokers, or telecommunication tools (internet). A distribution channel that is becoming increasingly more popular in conventional insurance as well as in takaful is the branch network of banks (conventional or Islamic). This distribution channel offers benefits to TOs, banks, and customers.

• Customers increasingly look for comprehensive financial services at one point of sale (for example, money transfer, house financing, insurance/takaful products, savings schemes, wealth management, and so on). A convenient point of sale can be (the branch of) a bank.
• Banks meeting such customer expectations by selling takaful products not only contribute to customer satisfaction but also open up new sources of revenues (mainly from fees and commissions).
• TOs get access to a large pool of potential participants and benefit from the reputation and knowledge of a bank as distribution partner.

In practice, three bancatakaful arrangements are applied which differ with respect to the relation between the bank and the TO:

• The Islamic bank sells takaful products of independent third party TOs under the brand names of these TOs. It is apparent to the customers that the bank acts only as a broker for these takaful products.
• The Islamic bank sells takaful products under its own brand name. The first variant is that the bank provides takaful services through a TO that is its own subsidiary. Even if this TO is legally and commercially independent from the bank (which is a regulatory requirement in most jurisdictions), the bank—or, more precisely, the shareholders of the bank—can determine the business of the TO. This justifies the expectation of customers that the bank and the TO operate on the basis of a consistent set of management rules, disclosure policies, reporting standards, Shari'ah interpretations, business ethics, governance procedures, and so on.
• The Islamic bank sells takaful products under its own brand name. The second variant is the distribution of takaful contracts that are produced by an independent TO in cooperation with a white label service provider (WLSP, see below). For the customer, the difference between the first and second variant is hard or even impossible to recognize, and he or she may have the same expectations regarding consistency of basic principles and procedures. However, these expectations are much harder to satisfy because the views of three legally and commercially independent partners with different shareholders have to be reconciled.

Although the white label bancatakaful model does not induce fundamentally new governance issues, its complexity and the coordination needs are much higher than in the other business models. A distinctive feature of white label bancatakaful is that an Islamic bank sells under its own brand name a takaful product that combines basic administrative services of a local TO and conceptual and managerial services provided by an independent financial service provider, the WLSP. More specifically:

• The Islamic bank does not only sell the white label takaful product through its own personnel and other channels (telephone, internet) but can also influence the investment portfolio (for example, by including its own mutual funds into the funds selection model of the WLSP), and it is the custodian of the participants' assets.
• The local TO holds the license needed to create the takaful product for the Islamic bank by complementing the services of the WLSP with its own input, which includes the processing of customer applications, the administration of the product in accordance with local regulatory requirements (including accounting and reporting), and the valuation and handling of claims. The basic structure can be a wakalah or a mudarabah model. If the local TO is an independent company (as it actually is in most cases), it can also offer takaful products on its own (under its own brand name).
• The services of the WLSP are essential and include the design of the product, the assurance of its Shari'ah compliance, the risk assessment, and the provision of a powerful tool for the asset management (such as a dynamic funds selection and allocation model), which can be customized to specifications of the Islamic bank. The WLSP may also provide additional services such as a web-based point of sale application processing tool with immediate individual risk assessment or customer data access facilities. Further, the WLSP can negotiate retakaful arrangements.

A WLSP usually cooperates with only one Islamic bank and one TO per jurisdiction, but in several jurisdictions. In this respect, the WLSP is a global player. White label bancatakaful is established in family takaful—that is, in takaful contracts with a savings component (and with unit-linked investments).

2.3 BUSINESS STRUCTURES AND REGULATORY IMPLICATIONS

The focus of this chapter is on the relations between the TOs and the participants in different business models and the respective regulatory concerns.6 Regulation may become necessary where market discipline cannot bring forth an effective protection of the consumers—that is, the takaful participants. It is assumed that takaful participants are interested in:

• the financial solidity and solvency of their takaful scheme;
• contributions that are risk equivalent (based on actuarial calculations) and allow for a reasonable build-up of reserves;
• an underwriting performance that does not deteriorate the quality of the risk pool (by adding poorer risks to the solidarity group for the sake of higher fees or larger underwriting surpluses); and
• adequate information about other financial institutions and service providers that contribute essential components to their takaful product.

2.3.1 Capital Adequacy and Solvency

The concept of takaful implies that all claims are settled out of the participants' contributions. Thus, it should be the participants who take measures to ensure the solvency of the risk pool. This could be achieved either by the participants accepting limits to their claims (determined by the sum total of contributions in the respective period) or by an obligation to pay additional contributions in case of need (or a combination of both). If these options are not appealing, an alternative for the participants is to pay regularly somewhat more than what is needed for the anticipated compensations in a given period and use the extra to build up reserves as back-up capital for extraordinary damages (with high losses but a low probability).7

Suppose there is a desired (or required) level for this back-up capital based on actuarial calculations for irregular events with low probabilities and high losses. As long as the reserves have not reached this level, especially in the early years of a takaful scheme, they are too small to cover such irregular losses. If claims are not to be limited, additional payments are the only way out. For many practical reasons, these additional payments can only come from future contributions. This creates the need for bridging finance, and it is consistent for regulators to require this—in the form of a qard hasan—from the TO.

For each period, the solvency of the PTF should be guaranteed by the reserves and the qard facility. If a risk pool in deficit is not in a position to get Shari'ah-compliant bridging finance from the capital market or from an Islamic financial institution, then the equity of the TO must be sufficiently large and invested in assets that allow the provision of the qard. As a consequence, regulators should set capital adequacy standards accordingly.

• It is appropriate that the TO's shareholders expect some remuneration for the provision of back-up capital for emergencies. It should be noted, however, that an increase in reserves implies a decrease in the need for the TO's equity as back-up capital. In the extreme, the TO's equity could be released completely from being back-up capital once the reserves have reached the desired (or prescribed) level.
• If the participants participate not just in one takaful scheme for one specific type of risk, but in several schemes for different and uncorrelated risks, it would be possible to pool reserves and achieve the same back-up level with less funds compared to segregated reserves of isolated PTFs.8 If a TO manages separate risk pools in such a way that synergies can be realized and reserves are used more efficiently (without a transfer of regular risks between the different PTFs), this is a service of the TO that deserves some remuneration.

It is debatable whether and how these features should be reflected in the remuneration structure of the TO. In any case, disclosure rules should induce the dissemination of information on the remuneration structure of TOs (in a format comparable between TOs and comprehensible to takaful participants) in order to stimulate competition.

2.3.2 Transparency and Disclosure

Transparency and disclosure provisions serve two purposes. On the one hand, they are a prerequisite for comparisons of products and services and they facilitate informed choices of consumers. On the other hand, they are needed for a better understanding of the functioning and the systemic qualities of takaful business models as alternatives to conventional insurance. Both dimensions have regulatory implications.

2.3.2.1 Multiple Fees and Charges

A takaful contract of a TO in the Gulf region serves in the following as a concrete example for a contract allowing for a multitude of fees which all together constitute strong incentives to expand the number of participants and the volume of contributions. The TO benefits from a high volume of underwriting, due to:

• an upfront payment in the first year, calculated as a percentage (30–60 percent) of the first year's contribution;
• annual fund management charges of 1.5 percent of the value of the funds under management; and
• contract administration charges of 0.25 percent of the fund value.

Further, an increasing volume of underwriting implies an increase in the volume of contributions to the risk pool (PTF), which are the basis for the calculation of the periodical wakalah fee of 25 percent of the risk charges (contributions to the PTF). If the management feels the need to increase the risk charge element of the contributions for whatever reason without altering the percentage for the wakalah fee, the TO benefits from this increase—irrespective of whether or not management expenses have also increased.

Finally, the TO receives a share of 30 percent of the profits earned by the investment of the PTF. The remaining portion of the investment profit belongs to the participants, but is not paid out to them; instead, it is retained in the PTF until the event of death, surrender, or maturity. These retained profits can be invested again with a profit share for the TO.

Most components of the remuneration of the TO are directly proportionate to the volume of takaful contributions collected from the participants. TOs, with such a remuneration structure, have strong incentives to increase the volume of contributions—both by an increase in the number of participants as well as by fixing contributions above the risk adequate level.

• In conventional insurance, sub-marginal risks (when expected future claims exceed cumulated premiums) have a negative impact on the long-term income of the insurance company. In a takaful scheme, this long-term effect burdens not the TO but the participants (especially if they are factually locked in by contracts). As a consequence and for identical risk populations, the number of takaful participants accepted and the total amount of contributions paid will, other things being equal, exceed the number of conventional policyholders and the total amount of insurance premiums.9
• The fixing of contributions above the risk equivalent makes sense for the TO even if an “excess” (underwriting surplus) will be returned to the participants. (1) All the multiple fees and charges are levied on the basis of the contributions, including the excess, and they are final and will not be corrected at the end of the period when an excess is refunded. (2) If there is a performance fee that is related to the underwriting surplus, this fee will further reduce the amount available for refund. (3) The participants will forgo that share of profits from the investment of the excess that is due to the TO as fund manager. If this share is high, or if the investment is less profitable than alternative investments, the participants forgo returns that they might have achieved if they invested the excess on their own.

It can be questioned whether specific regulatory action is justified: if competition were effective in the takaful market, excessive underwriting and overcharging would not be sustainable. However, as long as transparency is generally low, consumers are lacking in education in and experience with insurance products, information asymmetries prevail, and the number of TOs is very limited, at least some milder forms of regulation (for example, disclosure requirements) could be considered.

2.3.2.2 Commissions (in Family Takaful)

In family takaful, the commission to be paid to the distribution partner poses a major problem. The commission is generally calculated as a percentage of the underwritten amount, including the savings component of a contract. For long-term contracts, this commission is usually paid upfront after the contract has become effective. The commission payment may well exceed the total amount of the participant's contributions in the first year(s). As a result, the surrender value of conventional life insurance policies is very low or even zero in the early years. Unlike in conventional insurance, the savings element of the contributions of a takaful contract cannot be used for commission payments. If the commission has to be paid out of the underwriting element only, even a fee that absorbs fully this part of the contributions of the first year(s)—and therefore looks excessive from the participants' perspective—may not be sufficient to cover what is due to the distribution partner. This problem of an excessive absorption of risk contributions by commissions could be mitigated by a participation of the TO in the underwriting surplus (and in the profits of the short-term investment of the surplus funds). Against this background, it is not surprising that the (modified) mudarabah model is most popular with TOs mainly engaged in family takaful (as in Malaysia), and that a high underwriting surplus is desirable for these TOs. But this does not invalidate the Shari'ah critique of surplus sharing, nor does it consider the long-term interests of the participants. They will benefit neither from risk contributions far above the risk equivalent, nor from a membership that goes well beyond the optimal size.

An alternative to surplus sharing could be to pay the commission not upfront but pro rata over the term of the contract. But if takaful products compete with conventional insurance policies for the support of distribution partners, and if conventional insurers pay commissions upfront, TOs would be at a serious disadvantage. To overcome this problem, initiatives are being launched to develop a Shari'ah-compliant scheme for the transformation of future pro rata payments into an upfront lump sum payment.

2.3.2.3 Complexity of Structures

The white label bancatakaful model is the best illustration of the possible complexity of the construction of takaful products. If a product is sold under a specific brand name, the buyers should get at least some basic information on essential contributions from other parties. If their reputation is as good as that of the selling bank, such a disclosure could even be used for marketing purposes by the bank itself. But if this is not the case, or if some components are contributed by providers that have a good reputation within the industry but are hardly known to anybody else, disclosure regulations may be needed to create a minimum of transparency. This is also true for less complex but equally opaque relations between the original TO and reinsurance or retakaful companies (and their respective business models).

Transparency of complex structures is a precondition for an assessment of the systemic (and ideological) qualities of a takaful system. It is clear that the modern takaful system with multiple actors and anonymous markets is moving away from the ideal of traditional (Islamic) solidarity in small communities, and also presents differences from solidarity or mutuality in underwriting as understood in conventional mutual insurance. For the hybrid takaful undertakings, regulatory standards are still in the formative stage.

2.3.3 Embodiment of Participants' Interests in the Governance Structure

Corporate governance problems of conventional insurance are not solved in takaful, and the need for regulation is no less here than in conventional insurance. The ideological dimension of takaful even adds some governance issues that do not exist in conventional insurance: the participants are the owners of the funds that the TO manages on their behalf. Compared to conventional insurance companies and mutuals, the risk–reward and control structure in takaful undertakings is heavily biased against the takaful participants (as ultimate risk bearers and owners of the PTF) and in favor of the shareholders and managers of the TO:10

• It is not the participants but the management of the TO that have taken the initiative to establish the system. It was not a group of participants who searched for managers for an existing solidarity fund; it was the managers who looked for participants to create a new solidarity fund.
• All crucial decisions—such as the establishment and design of the takaful scheme, the choice of the business model and risk strategy, the determination of the takaful “donation” (premium contribution), the asset management, and the allocation of surpluses and profits—are taken by the managers of the TO.
• It is not the takaful participants but the shareholders of the TO who appoint and dismiss the TO's managers, define the performance criteria for them, and reward or sanction management decisions.
• Because of the separation of the takaful fund from those of the TO, the participants do not have any institutionalized influence on even the most crucial decisions of the TO. In the terminology of the principal–agent theory: the participants only have (at best) an “exit” but no “voice” option. The corporate structure of the takaful system does not reflect the ownership of the participants in any significant way.11

This would not constitute a serious problem if the incentive structure were such that the TO is factually forced by its self-interest to act in the interest of the participants. Since this is not the case, regulations should require a more balanced representation of the interests of takaful participants in the governance bodies of takaful undertakings. The practice in Sudan may serve as an example. Modifications of the institutional setting—which are not specific to a particular business model—are discussed by the industry and regulatory bodies. Several proposals have been made on how to implant participants' interests into the governance structure:

• The role and autonomy of the actuary in the determination of risk-adequate contributions, the desirable level of reserves, and so on, should be strengthened. Actuarial recommendations should get a more binding character. However, independent external actuaries are in short supply and their services are rather costly. This can impede takaful undertakings in the competition with conventional insurers. Issues of confidentiality of relevant information will complicate the setting further. If, therefore, only employed actuaries are available, conflicts of interest are inevitable and a formally strengthened autonomy is, by no means, a guarantee for a more balanced consideration of participants' interests in management decisions.
• Another proposal is to extend the mandate of the Shari'ah board and to assign to it the role of a custodian of participants' interests. This proposal not only suffers from the shortage of Shari'ah scholars and their high fees; but also further assumes an acquaintance of experts in Islamic law with commercial strategies and procedures that cannot be taken for granted.
• The most promising suggestion is that the board of directors (BoD) should set up a Governance Committee (GC) to give policyholders' interests more consideration in management decisions as is proposed by the IFSB.12 The GC should comprise at least three people, including an independent non-executive director who should act as a kind of advocate for the takaful participants. It is debatable whether this director should be a takaful participant or not, and if not, whether a representative of the takaful participants should be added to the GC (with a status different from that of a director). A direct representation of the participants in the GC would be difficult to organize—it requires not only participants with specific expertise but also a selection mechanism by which suitable candidates would be chosen by a kind of (annual?) general assembly of participants. The GC should oversee the implementation of a governance policy framework and monitor the financial management of the takaful undertaking (including the fee structure, reserve policy, risk and asset management, and surplus and profit sharing).

The character of takaful undertakings as hybrids induces additional and more complex governance issues compared to conventional insurance. These issues should not be ignored by regulatory authorities, but procedural and structural rules and regulations specific to takaful are still rare exceptions. In most jurisdictions, the same legal requirements with only minor adjustments are applied to both takaful and conventional insurance. This must not be the last word, because competition can hardly be considered effective while a rapid expansion of the industry is anticipated. Under such circumstances, consumer protection should not be left to market forces alone.

2.4 REGULATORY PERSPECTIVES

Irrespective of the specific business model, takaful undertakings differ from conventional insurance companies by the contractual exclusion of the risk transfer from the participants to the TO. Regulators need to require, for solvency purposes, that in the case of an underwriting deficiency, the TO will provide a qard to the PTF. Since the qard shall be recovered from future contributions, the participants should be informed about this obligation. They should know not only the amount of the deficiency they have to recover, but also the planned recovery strategy of the TO (especially the envisaged time frame and the portion of contributions used for the qard recovery). Based on such information, participants can assess changes in their future “value for money (= contributions)” resulting from the underwriting deficiency, and they can decide whether to continue their contracts with the same TO or seek other options.

Contrary to the clear formal demarcation, the factual differences between takaful and conventional insurance are somewhat less clear with regard to risk transfer and the final risk bearer. It is by no means the intention of an insurance company to absorb underwriting losses ultimately out of its own resources (and thus diminish its capital). Just like a TO, a conventional insurance company also intends to provide capital only temporarily and to recover underwriting deficits in one period from future premiums. But because policyholders do not have a formal obligation to repay the bridge financing provided by the insurer, there is no conceptual need to disclose the underwriting deficiency to the policyholders. If policyholders are not aware of a deficiency (and of recovery strategies of the insurer), they have no incentive to question the future value of their premium payments or to consider a switch to another insurer.

This asymmetry with possible adverse competitive effects for takaful undertakings with (temporary) underwriting deficiencies has to be taken into consideration by regulators when defining disclosure rules. In the interest of a level playing field and systemic stability of the takaful industry, rules that have a potential to distort competition between the Islamic and the conventional segment of the insurance industry must be avoided.

Mutuality in the risk pool is a constitutive concept for takaful. The hybrid nature of takaful undertakings implies complex principal–agent problems: the management of the TO is the agent of two principals, namely the takaful participants and the shareholders of the TO. This gives rise to a multitude of conflicts of interest. Although governance structures are mainly determined by the corporate laws of a country and do not fall into the competence of insurance and takaful regulators, the regulators should give serious consideration to the idea of providing an institutionalized degree of influence of participants' interests, albeit at a minimum level (for example, through a Governance Committee of the BoD). Participants are conceptually the owners of the risk fund and the ultimate risk bearers, and as such, should potentially be more involved in the takaful management than policyholders of conventional proprietary insurance companies. Participants should be better informed (and more concerned) about the financial situation of the risk pool and the performance of the TO management than policyholders in conventional proprietary insurers. If there is no institutionalized voice of participants' interests and their views on management strategies, they can only express discontent by use of the “exit option” in the short-term or terminable takaful contracts: the result would be that the better information on performance and risk differences may lead to considerably more shifts and switches between TOs than in conventional insurance markets, and this may induce more instability or volatility in the takaful sector. Systemic stability and fair competition, however, should be major concerns to regulators.

The task of finding an adequate institutionalized form for the “voice” of participants becomes even more complex when due account is taken of retakaful and bankatakaful. At present, many TOs cede a very high percentage of the risk of their takaful contracts to retakaful (or reinsurance) companies. By this, the factual risk position of the individual takaful participant changes (both with respect to the risk exposure and the risk-covering “solidarity group”). In bankatakaful arrangements, the number of involved parties increases and the web of contracts as well as the potential for conflict or interest expand considerably.

In the long run, takaful risk pools should become self-sufficient with respect to capital requirements. But until adequate reserves have been built up, the qard facility of the TO is indispensable to ensure the solvency of the takaful fund. Although the idea of a qard is that it will be repaid out of future contributions, it cannot be taken for granted that this can always be realized. For example, competitive pressure could limit the portion of contributions that a TO can take to recover the qard, or unfavorable events may cause deficits in one or more consecutive years. In the early years of a newly established takaful undertaking, regulators have to focus primarily on the—temporary as well as final—loss absorption capacities of the TO's capital. For a mature takaful undertaking, the volume and loss absorptive qualities of the assets representing the reserves will become more relevant. A problem with the reserves is their legal status. Conceptually, they are “owned” by the participants as a group. However, this collective group neither has a distinct legal personality, nor institutions to formulate and express a will. The reserves are managed by the TO who is the de facto owner. Regulators have to form an opinion on the treatment of reserves, especially if they apply risk-based models for the calculation of capital adequacy and solvency requirements. They must also decide whether (and how) the build-up of reserves shall allow the release of some of the TO's equity as solvency capital.

These are only a few of the regulatory implications of the different business models of takaful. The following chapters in this volume will deal with several regulatory topics in more detail. In some cases, questions have been asked, but only preliminary answers could be provided. Thus, priority areas both for further research and for regulatory action can be identified. Due to the rapid expansion of the industry and the large potential for innovative business models (with respect to risk and asset management, distribution channels and marketing strategies, corporate structures and contract design, and so on), it is safe to predict that further regulatory issues will turn up which have not been mentioned (let alone been covered) in this book.

 

 

Notes

1 As a kind of emergency measure to keep the takaful scheme solvent and alive, a temporary interest free loan can be provided by the shareholders of the TO (or another third party). This loan has to be repaid from future contributions.

2 Without going into any detail, it should be noted that despite the use of Arabic names of traditional contracts, none of the contracts applied in modern takaful meet all the criteria and conditions of the classical contracts as developed by the early Islamic jurists. All are modern adaptations, and the fundamental question is how far modern adaptations can deviate from classical constructs and still claim Shari'ah compatibility derived from contracts of classical Islamic law.

3 The participants may not even have an explicit clause in their contracts regarding additional contributions in the case of an underwriting deficit.

4 This looks reasonable if the deficit is not due to adverse market trends or an unforeseeable general increase of damages, but to the poor management of the TO.

5 Differences in substance may be found with respect to the asset management, which has to observe criteria of Shari'ah compliance in takaful. But for the claim that takaful is fundamentally different from insurance, this is only of limited relevance.

6 Other chapters of this book will widen the perspective and include shareholders and other stakeholders.

7 The reserves could be built up by not returning an underwriting surplus (and profits from the investment of risk pool funds) to the participants in full, but retaining and transferring part or all thereof to the reserve. This is common practice in conventional mutual insurance.

8 This also implies that each fund requires less equity, or that a TO can operate more PTFs with the same amount of equity.

9 It is assumed that the individual payments for the risk cover are identical for takaful and conventional insurance.

10 Corporate governance issues and stakeholder rights are dealt with more extensively in Chapter 4.

11 It seems that the Sudanese model, which is discussed in Chapter 4, is the only exception to such a structure.

12 See Islamic Financial Services Board (2008).