Reinsurance and Retakaful
The takaful market has been showing tremendous growth since the first takaful company was established in Sudan in 1979. It is estimated that the total global takaful contribution (equivalent to premium income in conventional insurance) will double from US$5.5 billion in 2005 to at least US$11 billion by 2010. Estimates vary depending on the underlying assumptions; however, what is not in doubt is the double-digit growth the takaful industry is experiencing. In 2007, the number of takaful players stood at around 140 operating in 20 countries, and there were 12 retakaful operators worldwide (either fully-fledged or having a window operation) to support the growth of the takaful industry.
To gain an appreciation of the subject matter, this chapter will outline the concepts pertaining to conventional reinsurance, followed by an introduction to the basic concepts of takaful. Retakaful and various operational models will then be explained, to enable the reader to gain an understanding of how the mechanics of conventional reinsurance have been used to fit the unique concept of takaful.
When talking about insurance or reinsurance, one cannot avoid mentioning the word “risk,” as it is at the very center of the concept of insurance. Within the insurance context, risk is defined as “the uncertainty of loss.”1 Uncertainty is considered in two dimensions—that is, frequency and severity of the occurrence—while a loss is measured in financial terms. When the combination of frequency and severity in terms of risk leads to a financial loss at a level that one is no longer able to bear, something must be done to manage and mitigate it. Insurance has been an important mechanism for managing such risks.
Under the conventional concept of insurance, an insured transfers risk to an insurer, in exchange for a certain amount of money called a premium. The premium is determined based on the nature (represented by the frequency and severity of the risk) and also the quantity of risk being transferred, which is usually expressed as the “sum insured.” The premium amount should be affordable relative to the sum insured; otherwise, the insurance mechanism will not be a viable proposition from the insured's point of view, as in that case, the insured would rather retain the risk itself or consider another, more cost-effective, means of risk control.
By effecting insurance against the adverse economic impact of certain events, the insured enjoys greater security and peace of mind by being able to replace variable costs by a fixed cost. In this context, variable costs are represented by unpredictable time and magnitude of loss, while the fixed cost is the insurance premium.
The insurance company faces issues similar to those faced by an individual insured—that is, determining which probable claims cost will arise from the collection of risks received from the insured. The total aggregate of probable claims the insurer may incur can be much higher than the total amount of premiums collected plus investment income on insurance fund assets.
Furthermore, not all the amount of these premiums is available to pay claims. A portion of it has to be spent on other expenses such as acquisition costs, staff salaries, operational expenses, and other fixed costs. Even though the probability that all individual risks in the insurer's portfolio will give rise to claims in the financial year is quite small, the possibility of the aggregate claims exceeding the total premiums collected is not. Just as the individual policyholder wants to protect itself by taking out insurance against the unforeseeable economic consequences of certain events, the insurer who has taken over a magnitude of such risks also has the need to replace some of the variable costs created in this way by fixed costs. Thus, the insurer needs to insure itself with other risk carriers. This leads to the concept of reinsurance.
Reinsurance can simply be defined as “insurance of insurance.” Reinsurance is insurance taken out by an insurance company.
A more descriptive definition is given by Robert Kiln and Stephen Kiln in their book Reinsurance in Practice, as follows:
- the business of insuring an insurance company or underwriter against suffering too great a loss from their insurance operations; and
- allowing an insurance company or underwriter to lay off or pass on part of their liability to another insurer on a given insurance which they have accepted.
The direct insurance company that is being protected by reinsurance is called the “reinsured,” and the company that insures it is called the “reinsurer.”
From an insurance company's perspective, there are at least four fundamental functions provided by reinsurance:
1. Reinsurance is an effective and convenient way to spread the insurance company's risk portfolio over different risk carriers as well as territories.
2. Reinsurance provides underwriting capacity to the insurance market, enabling it to fulfill the needs of the public—in particular, the insurance of large industrial and mega risks.
3. Reinsurance acts as a back-up to the insurance market against the risk of ruin arising out of any catastrophic event.
4. Reinsurance is a cost-effective substitute for capital.
Reinsurance coverage can be granted on either a “facultative” or an “obligatory” basis. Facultative reinsurance is arranged separately for each single risk, and the reinsurer has the choice of accepting or rejecting the risk being offered by the reinsured. The terms and conditions of the cover will generally follow the original policy.
Under obligatory reinsurance, the coverage provided by the reinsurer is for all policies/risks within a given portfolio. Its obligatory nature stems from the fact that the reinsurer is not able to reject giving cover on specific risks in the portfolio. On the other hand, the reinsured cannot exclude certain risks from the reinsurance cover. The reinsurance furthermore need not necessarily follow the same terms as the original policies. Original policies may have wider coverage than the “obligatory” reinsurance that protects them. In these cases, the reinsured has either to resort to protecting the uncovered part with other reinsurance or to retain the risk itself. Obligatory types of reinsurance are better known as “treaty reinsurance.”
There is also a type of reinsurance called “facultative/obligatory reinsurance,” which is a hybrid of the two general types—that is, facultative and treaty. It gives the direct insurer the ability to offer the reinsurer certain selected risks which the latter is obliged to accept under the terms and conditions stipulated at the outset of the contract. The basic range of reinsurance types is reflected in Figure 8.1.
Figure 8.1 Types and methods of reinsurance
Leaving facultative/obligatory reinsurance aside as a special form, as shown in Figure 8.1, each type can be further split by the method of reinsurance, which is either proportional or non-proportional. The two types and two methods of reinsurance then give us four combinations:
1. proportional facultative;
2. non-proportional facultative;
3. proportional treaty; and
4. non-proportional treaty.
Proportional treaties sector is further split into quota share and surplus treaties; while the non-proportional sector has two main forms: excess of loss and stop loss treaties.
The basic idea of proportional reinsurance, either treaty or facultative, is that each risk is being proportionally shared between the direct insurer (the retention proportion) and the reinsurer (the cession proportion). The gross premium and all individual claims are then distributed following the proportion of risk distribution agreed at the outset.
Take an example of a property with a total sum insured of US$10 million. The cedant (that is, the reinsured) retains 40 percent of the risk and cedes the rest, being 60 percent, to the reinsurer or a group of reinsurers. Assuming a premium rate of 0.1 percent, this translates into a gross premium for the whole risk of US$10,000. This premium is then distributed in the same proportion of 40:60 percent (Figure 8.2).
Figure 8.2 Risk and premium distribution under proportional reinsurance
By ceding a part of the risk to the reinsurer, the cedant is entitled to receive a reinsurance commission to cover its own operating costs. The purpose of the commission is to reimburse the cost incurred in procuring the business (the acquisition cost) in proportion to the premium ceded, and to make some contribution toward expenses for servicing the business. This is logical since the reinsurer receives a share of the all-inclusive direct premium, which includes the pure risk premium, acquisition costs, and overheads. The reinsurer, therefore, returns to the ceding company by way of reinsurance commission a part of the premium, expressed in an all-embracing percentage of the premium, as compensation for expenses incurred. The level of reinsurance commission is determined by considering factors such as loss cost, profitability, investment income prospects, original pricing, and the impact of competition in the market.
On the basis of a reinsurance commission of, say, 30 percent, the premium flows from the cedant to the reinsurer are shown in Figure 8.3. The reinsurer has to return 30 percent of its gross reinsurance premium (US$1,800) to the cedant as reinsurance commission, leaving a net reinsurance premium of 70 percent of the gross reinsurance premium (US$4,200) for the reinsurer.
Figure 8.3 Premium flow of proportional reinsurance
Under proportional treaty reinsurance arrangements, the reinsurer does not generally retain control over the adequacy of the direct premiums charged by the cedant to its policyholders, which will ultimately affect the performance or profitability of the treaty. However, the reinsurer is able to set and vary the level of commission on the basis of the probable result of the treaty and past performance. It may grant generous commission levels for excellent performance or penal levels when the business performance is poor.
Should a loss of US$6 million occur, once again the same proportion applies in the distribution of the amount to the cedant's retention and the reinsurer's share. This is shown in Figure 8.4.
Figure 8.4 Loss distribution under proportional reinsurance
8.6 NON-PROPORTIONAL REINSURANCE
Under non-proportional reinsurance (also known as “excess of loss business”), no risk and premium distribution is effected at the beginning of the year. Instead, it operates on quantum of actual loss, not on size of risk. Non-proportional reinsurance is structured in layers, as shown in Figure 8.5. The direct insurer will pay any loss up to a certain limit, called the “priority” or “deductible,” represented by the lowest block in the figure. All layers above the priority form the protection provided by reinsurers.
Figure 8.5 Structure and loss allocation of non-proportional reinsurance
One reinsurer may either participate in all layers or select certain layers and avoid others. The number of layers, the monetary size of each layer, and the priority level are pretty much a combination of the direct insurer's requirements and its appetite for risk, and the nature and profile of the risk or portfolio being protected. The price to be paid by the reinsured will be computed by the reinsurer applying actuarial and risk models.
The reinsured will participate in each and every loss, but the maximum amount is limited to the priority. Reinsurers of the first layer will only be liable if the loss exceeds the priority, for the amount above the priority up to the upper limit of the layer. The second layer will only respond if the loss exceeds the upper limit of the first layer, and so on. For example, the reinsured has to pay the whole of Loss 1 shown in Figure 8.5, as it is within the priority. For Loss 2, the priority and first layer have to pay up to their maximum liability, but the second layer is only partially affected. The third layer and all other layers above it will not have any involvement for this particular loss.
For each layer, there is no proportional relationship between premium amounts paid by the reinsured and the size of a certain layer in relation to the total protection of all layers. Instead, it is determined by the probability of each layer being affected by losses, based on factors such as frequency, severity, and exposure at risk.
Normally, excess of loss premium is expressed as a percentage of the premium income received by the insurer on the protected portfolio. The reinsurers set the premiums at an adequate level to cover their expected claims, expenses, and margin. They do not take any portion of expenses incurred by the reinsured; therefore, no reinsurance commission is returned.
The reinsurance industry plays a vital role in the global economy in providing risk protection across continents. Most of the leading reinsurers are global companies writing business in many geographical regions. The volume of reinsurance premiums written by the 10 largest global reinsurers in 2006 is set out in Table 8.1.
Table 8.1 Written Premiums of the 10 Largest Global Reinsurers, 2006
| Ranking | Group name | Gross premium (US$ million) |
| 1 | Munich Re | 26,482 |
| 2 | Swiss Re Group | 23,151 |
| 3 | Berkshire Hathaway Group | 12,486 |
| 4 | Hannover Re | 11,452 |
| 5 | Lloyd's of London | 9,053 |
| 6 | GE Global Ins Holdings (2) | 8,565 |
| 7 | XL Capital | 5,686 |
| 8 | London Reins Group | 4,243 |
| 9 | RGA Reins Co | 4,222 |
| 10 | Everest Re Group | 4,109 |
Source: Best's Review
The action of taking precautionary measures, or “ikhtiar,” against possible danger and its consequences is among the teachings of Islam. As a concept, mutual insurance actually does not conflict with the teachings of Islam, as it is a method by which funds are pooled in order to help the needy.
However, handling risks through risk transfer on a contract of exchange, as in conventional insurance, is not in compliance with Shari'ah principles, according to scholars of Shari'ah. Although conventional insurance operates on the basis of a common pool, where the fortunate many will pay for the unfortunate few, its transaction today is based on a contract of exchange whereby the insured pays a premium in exchange for a promise by the insurer to pay financial compensation should a loss as defined in the policy occur. Through insurance, the insured is able to transfer its risk to the insurance company. The insured replaces uncertainty with certainty at the amount of the premium paid. This is the financial security provided by conventional insurance.
Conventional mutual insurance is closer to the ideal of takaful, as the insureds transfer their risks to a pool that they own, and not to a proprietary insurance company. However, in addition to the avoidance of riba, other modifications need to be made to the juristic basis of insurance in order to achieve compliance with the Shari'ah principles, notably the payment of contributions on the basis of tabarru' rather than premiums in the conventional sense.
Transferring risk to another party in return for a premium is challenged because it brings at least three forbidden elements to the contract—namely, gharar (uncertainty), maisir (speculation), and riba (usury). Under Islamic law, any contract of exchange involving gharar (al bai' al gharar) is prohibited. The risk, defined as uncertainty of loss, is indeed a kind of gharar by nature. Therefore, putting risk as the subject matter of a contract of exchange (insurance) is prohibited. The insurance company that receives the premium and agrees to bear the risk is regarded as basing its fortune on good or bad luck of others; therefore, it falls under the definition of maisir (speculation).
Shari'ah scholars view insurance contracts as a transaction where money is being exchanged for money, as two parties to the contract are basically exchanging the premiums for claims, both in monetary terms. Exchanging money for money itself is not a problem per se as long as there is no difference in the amount or time involved. However, under conventional insurance transactions, the premiums and claims being exchanged are different and take place at different times. This brings about the problem of riba (usury). Furthermore, riba in the investment activities of the insurance companies is another element that makes conventional insurance unacceptable from a Shari'ah perspective.
It is furthermore important to understand that Islam is not inherently opposed to the idea of insurance, but most scholars are of the view that the conventional insurance contract does suffer from certain weaknesses in implementing the basic idea. Thus, an alternative mechanism for dealing with risk had to be developed to replace prohibited conventional insurance.
To bring insurance in line with Islamic principles, most Shari'ah scholars suggest the concept of takaful (solidarity, or guaranteeing one other). Instead of transferring their risks to insurance companies, individuals or organizations that carry the same or similar risks make a collective commitment to help one other by pooling their risks. Each participant will bring its risk into the pool and pay a certain amount commensurate with the risk. The money payable to the pool is not a premium in the conventional sense, as it is not a price for transferring risk. That money is a contribution or donation to the pool on the basis of tabarru' (doing good deeds to one other) or takaful (guaranteeing one another). For the sake of fairness, which is one of the most important fundamentals of Islam, the amount of contribution to the pool must represent the quality and quantity of the risk introduced, so that no one commits dhulum (injustice) to others.
Under takaful, the role of the insurance company has principally changed from the party who bears the risk to one who manages portfolios of risks. Such companies are no longer entitled to earn all the amounts paid by the participants, as they take no underwriting risk and retain no obligation to pay claims. In fact, the created pool now has the liability to pay for the claim and the insurance company works on remuneration paid by the pool. Various operational models of takaful in the market differ fundamentally only in the manner in which the company is being remunerated. However, the same basic idea of tabarru' is adopted whatever operational model is being used. All operational models are in absolute agreement on the relationship among the pool participants and differ only in defining the relationship between the pool (participants) and the company.
Takaful is not considered as a contract of exchange. Instead of buying a promise based on an event that may or may not occur, takaful customers make a contribution to a common pool on the basis of tabarru' (donation), with the intention (niah) to participate in a mutual aid scheme.
It is worth noting that a takaful could, in principle, be organized in a manner similar to a conventional mutual company, with a management employed by the participants rather than a separate management company. The mutual insurance company takes a cooperative form, such as a company limited by guarantee. However, such forms of company are not legally recognized in a number of countries. In addition, a newly founded mutual company may face severe problems of capital adequacy (see Chapter 6 in this volume). As a result, the management of a takaful undertaking is normally undertaken by a management company (the takaful operator) with its own share capital and reserves.
As mentioned earlier, reinsurance is simply defined as insurance of insurance. From a legal perspective, a contract of reinsurance is basically a contract of insurance. All doctrines that apply to insurance also apply to reinsurance.
Adopting the same logic facilitates the description of what retakaful actually is. Retakaful can simply be defined as “takaful of takaful.” The retakaful contract is essentially a contract of takaful, so that all the basic principles of takaful must also be followed.
While the definition of retakaful as the “takaful of takaful” is simple, it does bring with it an in-depth meaning and consequences. The takaful pool of risks being managed by a takaful operator is a translation of the principle of tabarru'/takaful among individual participants. Similarly, a retakaful pool of risks, which is managed by a retakaful operator, is a real implementation of tabarru'/solidarity among takaful pools of risk.
Taking the view from a different angle, retakaful is actually a means of widening the spectrum of the principle of solidarity or mutual help. Without retakaful, implementation of the principle of tabarrru' is limited within the boundary of a single takaful pool being managed by a takaful operator. However, through retakaful, a participant in one takaful pool essentially helps or is being helped by other participants in the other takaful pools. This concept is a unique dimension of retakaful that is not to be found in conventional reinsurance.
The technical functions of conventional reinsurance as discussed previously also apply to retakaful. As with conventional reinsurance, retakaful plays the role of spreading risks from one pool to others, and at the same time of providing underwriting capacity to the takaful pool. Using the appropriate techniques, retakaful will also be able to protect a pool from the effects of a catastrophic event.
The capacity provided by the retakaful industry will allow takaful operators to underwrite large industrial and mega risks, and hence, to be in a position to compete with established conventional insurers, while reducing the need to raise huge amounts of capital. Retakaful is an effective and convenient way of spreading the risk portfolio over different takaful pools as well as territories. It also reduces the probability of the risk of ruin for the industry when large catastrophic losses, either natural or man-made, occur.
From the takaful operator's perspective, retakaful is a cost-effective substitute for capital. While not assuming the risk, takaful operators remain obliged to set aside capital to support the pool under their management through the mechanism of qard (benevolent loan) in the case of a deficit in the pool.
Considering the high rate of growth of the global takaful industry, it is, therefore, equally important for the industry to reflect long-term sustainability. The existence of an adequate and financially strong retakaful industry is an essential factor for sustainability. No insurance market, globally, is able to flourish and sustain itself on a long-term basis in the absence of the support of reinsurance, and takaful is no exception.
The retakaful industry is in the development stage. In 2007, there were six fully-fledged retakaful operators and seven retakaful windows in the market. Estimates indicate that retakaful contributions amounted to US$570 million in 2006, and this figure is projected to double by around 2010. Not all this volume is absorbed by retakaful operators as, for historical and capacity reasons, many takaful operators reinsure their portfolio with conventional reinsurers.
In principle, takaful operators are not permitted to reinsure with a conventional reinsurer, as reinsuring with a conventional reinsurer impairs full compliance with Shari'ah principles which is of crucial importance in takaful. However, in the absence of capacity and of financially strong retakaful undertakings in the market, Shari'ah scholars do grant temporary permission to reinsure with conventional reinsurers as a matter of dharuraa (necessity). As the takaful industry continues its rapid growth, the need for adequate and financially strong retakaful capacity becomes more evident.
8.10.1 Takaful Models in the Market
Having recognized the importance of retakaful to the takaful industry, a significant issue is to determine how retakaful is to be modeled in order to effectively play its role of supporting the industry while complying with Shari'ah principles. There are at least three operational models of takaful that are prevalent in the market—namely, the mudarabah, the wakalah, and the waqf.
The basic features of the models are as follows:
Mudarabah model
- The mudarabah model was introduced in the Malaysian market in 1984.2
- The participants' role is as the rabb al maal (capital provider).
- The operator's role is as the mudarib (entrepreneur).
- The takaful (tabarru') fund belongs to the participants.
- Profit is being shared between the participants and the operator in a pre-agreed proportion.
Wakalah model
- This model began its development in Sudan and the Middle East.
- The takaful operator is compensated by a pre-agreed fee.
- The participants' role is as the principal.
- The operator's role is as the wakeel (agent).
- The takaful (tabarru') fund belongs to the participants.
- The operator does not share in the underwriting surplus, but instead is compensated by a fee deducted from the contribution at the outset of each contract.
Waqf model
- The waqf model that emerged and is being used in Pakistan has a number of similarities with the wakalah model.
- The tabarru' fund is viewed as a social-governmental-owned enterprise that operates on a non-profit basis (a public foundation).
- The tabarru' fund belongs to no one in particular, neither the participants nor the operator.
- The operator is compensated by a fee.
- Distribution of surplus among participants or to the operator is not possible.
8.10.2 Basic Model of Retakaful
The basic model of retakaful is as shown in Figure 8.6. The figure shows how the principle of mutual help within the takaful pool is extended to the retakaful pool. No part of the risk is being shifted to the retakaful operator as a company, which acts as the manager of the retakaful pool. The role of the retakaful operator is similar to that played by the takaful operator to the takaful pool. The retakaful operator cannot claim all of the contributions payable from the takaful pool to the retakaful pool as its income. In fact, its income is limited to the fee (wakalah) and/or profit sharing (mudarabah).
Figure 8.6 Basic model of retakaful
Once participants decide to join a takaful pool, they pay a certain amount of contribution to the takaful fund for the risk they place into the pool. This contribution is used mainly to pay claims and all other expenses arising out of the management activities of the takaful operator, such as acquisition costs and administration costs. The takaful operator is also entitled to receive a portion of this contribution as its fee. This fee is income for the operator and is credited to its account. All claims made by the participants will be paid out of the takaful fund.
As manager of the takaful fund, the takaful operator is obliged to take all reasonable measures to ensure that the takaful mechanism among the participants is managed in a sound and professional manner for the benefit of the participants. It must exercise prudent underwriting so that the quality of the portfolio being managed remains sound. It also has to invest the funds in Shari'ah-compliant investment instruments and earn a reasonable investment yield at acceptable levels of risk and diversification.
The takaful operator has to monitor the health and robustness of the takaful fund in relation to the liabilities attached to it. If, in its professional judgment, the assets available in the takaful fund are likely to be inadequate to pay expected claims, the operator has an obligation to take proper and corrective action to resolve the issue. Retakaful is one of the mechanisms the takaful operator will use to manage this situation. In this way, retakaful mitigates problems of capital adequacy of takaful funds, which may be particularly troublesome in the case of a new takaful fund that has not had time to build up prudential reserves to provide a solvency margin. The use of retakaful also reduces the potential dependence of a takaful fund on a qard facility from its operator (see below).
When arranging retakaful, the takaful operator basically shifts a part of the liability assumed by the takaful fund to the other fund—namely, the retakaful fund. Although retakaful contracts are concluded and signed between the takaful operator and the retakaful operator, it is fundamentally a contract between the takaful fund and the retakaful fund. In this contract, both takaful and retakaful operators are acting on behalf of their respective funds.
By shifting liability to the retakaful fund, the takaful fund must transfer a part of its fund, as a contribution to the retakaful operator. Expenses that relate to all retakaful activities, such as claims, acquisition costs, and administration costs, are paid out of the retakaful contribution received. The retakaful operator will also receive its fee or profit sharing from the retakaful contribution. The percentage or amount of contribution to be allowed for the retakaful operator's fee should be agreed at the inception of the contract between the takaful operator and the retakaful operator.
Shifting partial liabilities by using retakaful means reduces the possibility of the takaful fund experiencing a deficit that may lead to the takaful operator triggering the qard facility, a benevolent loan that is granted by the takaful operator to the takaful fund in case the fund is unable to meet its obligations. Retakaful, therefore, protects the takaful fund as well as the capital of the takaful operator.
The retakaful pool has the same characteristics as the takaful pool. Given that the takaful pool is built on the basis of tabarru' among the participants, the retakaful pool will follow this. The retakaful pool widens the spectrum of mutual help by combining participants of many different takaful pools, which are managed by different takaful operators. Through its global nature, retakaful reduces the risk volatility across geographical boundaries.
The retakaful operator plays an important role as a manager of the retakaful pool, similar to the takaful operator (cedant) who is the manager for the takaful pool. In this role, the retakaful operator is entitled to be remunerated. The remuneration is dependent on the model adopted in the underlying retakaful contract. If the mudarabah concept is applied, then the retakaful operator's remuneration will be based on profit sharing. Under the wakalah or the waqf model, the retakaful operator will receive an agreed fee, regardless of the result of the pool. A combination of models is possible—in particular, the wakalah model for the pool underwriting management contract and the mudarabah for managing the fund investments.
Should the retakaful fund experience a deficit, then the retakaful operator is responsible and duty bound to grant a qard to secure claimants' rights to payment of claims. It is to be noted that a retakaful operator has no obligation to support a deficit of the original takaful pool via a qard facility, as this obligation falls under the takaful operator's responsibility as its manager. Similarly, the takaful operator will not be called upon to make a qard to a retakaful fund to which it has ceded business in the case of a deficit arising in that retakaful fund.
8.10.3 Compatibility and Other Principles
Bearing in mind the limited resources of retakaful available and the fact that there are several operational models being used by cedants, it is vital to have retakaful models that are compatible with any underlying models used by takaful operators. The situation of a retakaful contract not being concluded solely because of model incompatibility should be avoided as far as possible. Otherwise, the retakaful industry would not be able to maximize its role in supporting the growth of takaful, and the development of the retakaful industry itself will be slowed.
Importantly, all three models of takaful operate on the basis of tabarru', particularly in defining the relationships among participants of the pool. What makes them different from one another is the relationship between the takaful operators and the participants, which then leads to the question of how to remunerate the takaful operators. Under the mudarabah model, the relationship is defined as between investor (rabb al maal) and entrepeneur (mudarib) and the remuneration of the operator is paid from its agreed share of profit. Under the wakalah and waqf models, the takaful operator acts as the agent or representative of the participants and is remunerated by a pre-determined fee.
In addition to compatibility, the following basic principles should be fulfilled by retakaful in order to be Shari'ah compliant:
- There should be no element of risk transfer from the pool/participants to the retakaful operator.
- The retakaful pool must operate on a basis of tabarru' (doing good deeds) among the participants.
- None of the prohibited elements under Islamic Shari'ah law should manifest itself in the retakaful model, such as riba, dhuluum (injustice), concealment, and so on.
8.10.4 Example
As an example of a retakaful mechanism, take a property with a total sum insured of US$10 million, as was cited earlier. The takaful pool retains 40 percent of the risk and cedes the remaining 60 percent to the retakaful pool. Assuming a contribution rate of 0.1 percent results in a gross contribution for the whole risk of US$10,000, risk and loss allocation will remain the same as in conventional reinsurance, as shown in Figures 8.2 and 8.4, respectively. However, there may be a slight adjustment in terms of the flow of the contribution/premium as a consequence of changing the basic concept from conventional risk transfer to tabarru' risk sharing.
As mentioned earlier, retakaful is a contract among pools, and both takaful and retakaful operators act on behalf of their pools and are entitled to a certain fee for services rendered to the pool. Assuming that the takaful and retakaful operators' fee is 5 percent each and the retakaful commission is 25 percent, contribution (premium) flow is shown by Figure 8.7. This is not yet an established and agreed standard mechanism used by the takaful industry, but is a likely possible structure that will fit the wakalah model for both takaful and retakaful.
Figure 8.7 Possible flow of premium (contributions) under the wakalah model of retakaful
The concept of ceding commission is still appropriate under retakaful in order to reimburse the expenses incurred by the takaful pool (including the remuneration of the takaful operator). Some contracts use the term “retakaful incentive” for this item. Unlike reinsurance commission, which is paid by the reinsurer to the cedant, the retakaful commission is paid by the retakaful pool to the takaful pool. As the takaful operator has already taken its fee at the outset, the cedant's profit margin is no longer considered in determining the level of commission. As with conventional reinsurance, the retakaful operator can vary the level of commission to reduce the unfavorable impact of an inadequate level of contribution charged by the takaful operator. Similarly, the retakaful operator is entitled to receive a fee from the retakaful pool.
One may argue that this possible structure looks a bit more complicated than the conventional one, owing to the segregation of assets between the participants and the operator. But it is also beneficial because it is in line with the principle of transparency and is considered as a way to achieve fairness among the parties involved in the transaction. Fairness is one of the most important aims of any muamalat (transaction) activity.
8.11 MAIN ISSUES RAISED BY RETAKAFUL
Islamic finance, in general, continues to face challenges in trying to match the requirements of a conventional regulatory framework, while attempting to uphold the principles of Shari'ah. The following are some of the issues that need to be addressed by the industry, practitioners, and interested parties in relation to retakaful.
8.11.1 Full Shari'ah Compliance
To enable the takaful operator to declare that its products are fully Shari'ah compliant, it has to reinsure with Shari'ah-compliant reinsurers (retakaful). However, owing to the lack of retakaful capacity in the market, Shari'ah scholars have granted temporary permission, allowing takaful operators to reinsure with conventional reinsurers on the basis of dharuura (necessity).
With a considerable number of new retakaful companies having been established and now entering the market, many of which are global reinsurance players such as the writer's own company Hannover Retakaful, this exemption will come under close review from scholars. Enhanced participation by retakaful operators will ensure the Shari'ah compliance of all aspects of takaful. However, the issue of dharuura needs to be considered in relation to the soundness and security of the retakaful operator, in order to ensure the long-term sustainability and robustness of the industry.
8.11.2 Global Standard of Retakaful
At the time of writing there is not yet an established standard for the concept and mechanism of retakaful. Most of the retakaful contracts in operation are still based on the mechanism and wordings applicable to conventional reinsurance. These wordings are unsuitable for takaful. The basic principle of tabarru', or mutual help, among participants, is not clearly defined in such contracts, nor is the segregation of the retakaful (participants') fund and the retakaful operator's fund defined. Although the contract is being concluded between takaful and retakaful operators, using a conventional mechanism and wording does provide challenges to ensure the Shari'ah compliance of retakaful.
To respond to the need to provide reinsurance protection that complies with Shari'ah, it is important for the retakaful industry to develop a globally accepted standard mechanism for retakaful. By having standard concepts, the slowing-down effect arising from the use of different terminology and interpretations will be removed. The standard retakaful concept and practice will also address the issues of transparency within the takaful industry.
Achieving consensus on a standard retakaful contract at this stage of the development of the industry is also important. With a number of retakaful operators belonging to groups that have operated in the conventional reinsurance market for quite some time, they should be able to deploy their expertise in producing a reliable concept for retakaful. Furthermore, the fact that the retakaful concept can be derived from established conventional techniques will ease the effort. Certainly, cooperation with regulators and global organizations such as the Islamic Finance Services Board or the Accounting and Auditing Organization for Islamic Financial Institutions will enhance the acceptability of the concept.
8.11.3 Capital Requirements
The issue of the requirement that the retakaful operator provide a qard facility (benevolent loan) to the retakaful fund in case of a deficit emphasizes the relevance of capital, although fundamentally, the retakaful operator is not directly assuming the risk exposure.3 What constitutes acceptable assets for calculation of capital requirements and solvency does remain an open issue. A number of models that are used by regulators for calculating capital requirements rely on the use of rating criteria for asset classification as well as for investment volatility purposes. As many Islamic investment instruments are not rated, these investments do not get due recognition, and therefore, may be categorized inappropriately.
Of particular significance also is the ability of the takaful undertaking to raise new capital to counter any capital erosion in times of strain. A conventional insurance company generally retains a significant proportion of its profits and can also raise additional capital from external sources. While a takaful entity may have access to similar capital-raising solutions, nevertheless, the effectiveness of some of the capital supporting the venture may need to be verified for its robustness, such as the commitment of the capital for the longer term and the ability of the capital providers to respond to large loss scenarios.
The development of takaful goes hand in hand with that of other types of innovative Shari'ah-compliant financial products provided by Islamic banks and Islamic capital markets. Access to Islamic financial products is very important for takaful to build a non-riba asset base without exposure to excessive risk, as would be the case (if riba was avoided) by allocating a large portion of the portfolio to equities and/or real estate.4
8.11.4 Rating
Security ratings awarded by independent rating agencies for retakaful companies are very important in order to demonstrate the robustness of the industry. Having awarded a rating to the retakaful operator, the rating agency will continuously monitor the performance of the company for a possible upgrade or downgrade. The pressure to maintain an acceptable rating level will be a motivator for companies to prudently manage the pools.
8.11.5 Asset-Management Capabilities
It is essential that shareholders' and policyholders' funds be invested in Shari'ah-compliant investment instruments. As a custodian of policyholders' funds, the retakaful operator must also ensure that the funds are soundly managed to instill confidence among the increasingly sophisticated public, also in terms of delivering returns. At the same time, compliance with AAOIFI standards is also essential, particularly with regard to the elimination of prohibited income.
8.11.6 Building the Retakaful Pool
To be Shari'ah compliant, as previously mentioned, the retakaful should operate on the basis of risk sharing via a retakaful pool that consist of risks being brought from many takaful pools by many takaful operators. From a technical and application perspective, this certainly poses some challenges. The retakaful operators will receive risks from different takaful pools comprising different classes of business. As a result, the retakaful operator has to manage the retakaful pool, which is heterogeneous in nature in terms of risk categories, classes of business, catastrophe exposure, and geographical scope. This leads to the question of whether the retakaful operator should maintain a single pool for all the businesses, or segregate the pools according to certain conditions, such as classes of business, geographical distribution, or type of retakaful.
The single pool option will allow cross-subsidization among classes or types of retakaful, and the retakaful operator will provide the qard facility only when the whole fund has been exhausted. However, this may be considered an unfair proposition, as good-quality risks may be subsidizing the hazardous or sub-standard risks. From the operator's point of view, a huge single bulk pool is likely to be more difficult to manage due to high variance, volatility, and instability within the portfolio.
Segregation of the pool into several and more homogeneous pools is perhaps an efficient way to manage the portfolio. The entire portfolio can be split based on the classes of business, so that the retakaful operator may have, for example, a property retakaful fund, a casualty retakaful fund, an engineering retakaful fund, and so on.
Furthermore, the nature of the retakaful contracts also needs to be considered. Proportional treaties may result in a better-balanced portfolio than non-proportional treaties. Similarly, facultative and catastrophe business is considered to produce a volatile portfolio. In this situation, it would be sensible for a retakaful operator to split its pool based on parameters such as business classes and type of retakaful. Each of these separate pools will have different actuarial evaluations for the reserve requirement, since frequency, severity, and the nature of the portfolio needs to be considered.
As far as solvency is concerned, the retakaful operator may be obliged to maintain the solvency of the whole portfolio. Alternatively, it may have to ensure that each individual pool is also solvent. Once any individual pool is in deficit or is insolvent, the retakaful operator will have to extend a qard facility to that particular pool. This clearly puts more strain on the operator's shareholders' capital, and there is more pressure on the operator to manage the portfolio in a more disciplined manner.
This issue needs to be addressed by the retakaful industry in cooperation with regulators and prudential standard-setting bodies, such as the IFSB, to ensure the soundness and stability of the industry.
8.11.7 Handling High-Severity, Low-Frequency Risks
The mechanism of mutual help, whereby the fortunate many agree to compensate the unfortunate few, may work perfectly on the portfolio that consists of “high-frequency, low-severity loss scenarios” or a homogeneous portfolio. Unfortunately, this concept poses a challenge when one is dealing with risks that are exposed to catastrophic or high severity but low frequency losses. These kinds of risks have been a problem for risk management in general, not only for takaful and retakaful.
These types of risks need specific attention; otherwise, the entire treaty portfolio may be ruined by one single big loss. These risks can be handled through facultative or non-proportional reinsurance, where the retakaful operator has access to all relevant details of the risks and can set the terms and conditions accordingly. One single loss may exhaust all the contributions collected during a 10- or 20-year period. This is one of the reasons why the facultative portfolio tends to have more volatility.
Clearly, these types of extraneous risks place a particularly harsh strain on the capital of the shareholders. Alternative techniques of retakaful may be required to deal with this problem, especially to release the retakaful operator from heavy pressure on its own capital and to maintain the principle of risk sharing between participants. Should the risk-sharing concept be considered unable to address this issue, at least in the development stage of takaful, some form of risk transfer to the retakaful operator might have to be considered.
8.11.8 Computing the Solvency of Retakaful Undertakings
Under conventional (re)insurance, solvency is calculated by comparing the admitted assets of the (re)insurance company to the total liabilities that they assume and other related risks attached to their business operation. The liabilities coming from risks they underwrite clearly become the most important part of their entire risk.
This issue becomes more complicated when it comes to (re)takaful, as now the main part of the liabilities is being taken away from the company and the (re)takaful fund is now the entity that carries the risks. This basic difference requires a different approach to measure solvency.
The main question is that of identifying the assets to which the liabilities should be compared; should it be to the retakaful fund assets only, or to both the retakaful fund and the retakaful operator's shareholders' funds?
As the entity that bears the risks, there is no doubt that the (re)takaful fund needs to be solvent. On the other hand, while the (re)takaful operator is not the direct risk carrier, it is exposed to the underlying risks assumed by the (re)takaful fund through the mechanism of the qard facility that it provides. It also faces operational risks in taking on business that may negatively affect the managed fund and participants. This may lead to a requirement that the solvency regime be applied to (re)takaful operators to some extent.
8.11.9 Retrotakaful
Retakaful pools face a risk similar to that of takaful pools—that is, that the fund may be consumed by excessive claims. Therefore, they need to limit their own exposure by spreading the risks to other pools through a mechanism called “retrotakaful.” On the conventional side, this type of contract is known as “retrocession.”
Normally, a retrotakaful contract is signed among retakaful operators. Any one of the forms of retakaful can be used for the purpose of retrotakaful. Facultative retrotakaful can also be negotiated on large acceptances. Quota share and surplus contracts can also be set up. An excess of loss contract may be arranged to protect against an accumulation of losses arising out of one event.
The retrotakaful should be an integral part of the retakaful system. It is an instrument for spreading risks effectively across the worldwide (re)takaful industry and helps in providing coverage for mega risks. At this stage of development of the industry, there is a limited amount of retrotakaful capacity available. The retakaful operators may still have to cede their exposures to conventional risk carriers, again on the basis of dharuura (necessity).
Currently, takaful has been showing tremendous growth together with the boom in other Islamic financial services. In order to have stable and sustainable growth, the takaful industry needs the support of retakaful. Despite the limited number of retakaful players hitherto, some global reinsurance groups have now shown the interest and commitment to develop the untapped potential of the takaful market.
However, as a newly emerging industry, retakaful does face several challenges, such as the lack of a globally accepted standard for a retakaful model, capital requirements, solvency, rating, asset management, and the scarcity of retrotakaful capacity.
To address these challenges, the retakaful industry needs to intensify technical discussions in deploying their know-how and expertise in enhancing both retakaful concepts and business models and the scale of the market. Close cooperation with regulators, Shari'ah scholars, and other global or regional related bodies is important in order to achieve convergence and to increase the effectiveness of the industry.
Notes
1 By contrast, in finance, risk is normally defined as the dispersion of the distribution of possible outcomes about the expected mean outcome, and is often measured by the standard deviation of the distribution.
2 The doubts about the Shari'ah compliance of the operator sharing in an underwriting surplus in the mudarabah model in direct takaful, to which reference was made in Chapter 6, also apply to this model in retakaful. There is no objection to the use of mudarabah for the operator's management of the fund assets.
3 This requirement cannot be included in the contractual obligations of the takaful operator to the participants, as according to Shari'ah principles, a benevolent loan cannot be a contractual obligation. Any such requirement must, therefore, be imposed by law or regulation as having the force of law.
4 As may be seen from the analysis in Chapter 11, substantial use is made of these asset classes by takaful operators in the GCC (Gulf Cooperation Council) countries and Malaysia, but there is also considerable use of investment accounts with Islamic banks.