Chapter 10

Solvency and Capital Adequacy in Takaful

James Smith1

10.1 INTRODUCTION

Insurance prudential regulation, including that of takaful, is in a state of change. Many jurisdictions, including some in which takaful is strongly represented, are in the process of moving from traditional solvency approaches to more sophisticated methods based on risk rather than ratios.

This chapter starts from the premise that takaful is appropriately considered a part of the insurance sector, and that solvency rules for takaful operations should follow the same principles as for conventional insurers. Identical principles do not necessarily mean identical detailed rules. The treatment should be fair to both takaful and conventional insurers, as in most markets, they will compete. This goal of following the same principles may be becoming easier to attain. In recent decades, a great deal of work has gone into attempting to rectify the perceived deficiencies of traditional solvency systems, and into developing “risk-based capital” (RBC) solvency requirements responding to the individual characteristics of the insurers that are to comply with them. This new conceptual framework for insurance solvency opens the way for solvency requirements for takaful operations to be customized not only for the characteristics of takaful operators as a class but also for the characteristics of individual takaful operators.

Taking a risk-based approach to solvency allows a neutral approach to the debate as to whether one type of operating model for takaful should be favored over another. That issue is not within the author's competence and it is not the intention of this chapter to enter into that debate. One strength of the risk-based approach is that—in theory, at least—it responds to what the operating model is, rather than assuming that it is one particular model.

In addition, if a risk-based approach is taken to capital adequacy of all forms of insurance, some debates can be resolved. In particular, it may sometimes be argued that takaful operations should have lower solvency requirements because underwriting surpluses and deficits belong to their participants. By identifying capital and risks on a basis that is conceptually consistent, a solution may be available whereby capital requirements properly reflect risk. Whether the solution necessarily meets the expectations of current proponents in the debate might, of course, be a different matter, but at least the result will be reasoned rather than arbitrary.

Solvency (or capital adequacy—the terms are used interchangeably in this chapter)2 systems have typically been developed in environments dominated by conventional insurance. Some features of the profile of takaful operations will not have been contemplated before by many regulators.3

This chapter does not set out to provide a survey of solvency requirements for takaful entities. There are many regulatory regimes governing takaful companies in different countries, and since insurance regulation is in a state of change, any such survey would rapidly become out of date. It would also be very complicated, since not all extant operational models for takaful are permissible in every relevant jurisdiction. The aim of this chapter is rather to identify some issues and suggest possible ways forward that may be helpful to policy makers, to regulators, to takaful operators, and to those contemplating the establishment of takaful operations.4

10.2 THE NEED FOR SOLVENCY

Most commercial enterprises are not subject to solvency margin requirements, other than a general requirement to cease trading if they are unable to pay their debts. Financial institutions are subject to tougher requirements. This is related to the role and position of the financial sector, including insurance, in facilitating economic activity:

• Effective mobilization of funds and risk intermediation requires trust on the part of those paying over their savings and taking the economic risks that they could not take without insurance.
• Financial institutions tend to be large, with many retail and commercial customers and creditors financially dependent on them either directly or indirectly, or on the occurrence of an insured event. The failure of a major bank or insurer can bring down other enterprises as well, with destabilizing consequences.
• Retail financial markets involve a massive imbalance of economic power and information between the consumer on the one hand and the financial institution on the other. Solvency requirements are one tool that is used to help redress this imbalance by reassuring consumers that financial institutions are safe to entrust their assets to.
• Finally, a solvency margin buys time. Financial products have a comparatively long life cycle, so that the true economic impact of transactions may emerge sometimes years after the product was initially sold.5 The presence of a solvency requirement provides some comfort to the company's various stakeholders that commercial difficulties can be dealt with in an orderly fashion.

How does takaful fit into this picture? At a general level, one can say that the same underlying principles apply, even if one does not accept that takaful is insurance in the conventional sense.6 The sector still acts to pool and deploy finance and risk, and it can be a major focus for financial activity such that governments have a strong interest in its stability.

10.3 THE PRINCIPLE OF SOLVENCY

Solvency, or capital adequacy, is only one form of prudential regulation, the general term for regulation aimed at ensuring that regulated entities operate safely and soundly. Other aspects of prudential regulation include requirements for minimum risk management standards, requirements for fitness and propriety of managers and owners, and requirements for sensitivity analysis to forecast the effect of plausible scenarios. As will be seen, the line between solvency regulation and these other forms of prudential regulation is becoming blurred.

Solvency tests are becoming increasingly sophisticated, but the essence of such a test is a comparison between an institution's capital—the excess of its assets over its liabilities—and a required minimum amount. The assets and liabilities are measured according to prescribed valuation rules, which may not be the same as the accounting rules used for the institution's statutory reporting under companies legislation. Usually, some assets are excluded as inadmissible for solvency purposes (typically, intangible assets and others that could not be realized for value in a crisis). To reconcile from surplus under statutory reporting to surplus under regulatory reporting, a process along the lines shown in Figure 10.1 is required.

In this example, the usual financial reporting under company legislation would show that shareholders enjoyed a comfortable surplus of assets over liabilities. However, from the regulatory viewpoint, it is likely that some assets would be excluded or revalued downwards for solvency purposes, reducing the amount of surplus available, and the true regulatory surplus would be only the amount by which the available excess of assets over liabilities exceeded the required margin of solvency or regulatory capital requirement—a much lower amount, in this example, than the shareholders' equity under normal company reporting rules.

Regulatory adjustments are not always negative. Some assets may be worth more for regulatory purposes than the amount at which they are recognized in the insurer's accounts. Also, the accounts may treat as liabilities some items that the regulator is prepared to consider as capital. We consider this situation below.

Figure 10.1 represents a simple situation where the institution is unitary. It is readily adaptable to situations where, as in a takaful organization, the institution may be subdivided into different funds or accounts between which cross-subsidy may be restricted or forbidden. The principle of separate fund solvency is widely used for life insurance business and sometimes also for non-life. Separate solvency rules may apply for individual funds and for the operation as a whole, and the insurer has to comply with both.

Solvency regulation has largely superseded some earlier forms of prudential measures, such as minimum paid-up capital requirements and statutory deposits, though these requirements still exist in many jurisdictions as a back-up. Neither was sensitive to the amount of capital that an institution required for its business, and in the case of statutory deposits, the inflexibility that it imposed on institutions might even increase the risk of failure. However, minimum paid-up capital requirements do have the merit that they require those proposing to set up a financial institution to show they are serious in their intention, by putting up a significant initial stake.

A final principle of solvency is that it is a continuous requirement. It is not practicable to calculate a solvency requirement at every moment. However, it is generally accepted that an insurer must always have funds in excess of its most recently calculated solvency requirement. It would make little sense for a regulatory framework to measure solvency only once a year, and then to permit an insurer to make a distribution in between that put the insurer into an insolvent situation.

10.4 TRADITIONAL APPROACHES TO INSURANCE SOLVENCY

Requirements for capital and solvency have evolved over the years. From minimum levels of paid-up capital to required minimum solvency margins based on simple percentages of metrics, the world's more advanced financial services regulators now require operators to maintain capital according to individualized risk profiles. The International Association of Insurance Supervisors, to which most insurance regulators now belong, has endorsed this approach in the Principles that its members are supposed to follow.7 The use of internal capital models, pioneered by major groups, ratings agencies, and banking regulators, is now being adopted by insurance regulators. These features of insurance regulation are described further below.

In practice, insurance regulation in many countries still uses methods whereby the required minimum solvency margin for general insurance is calculated on the basis of ratios of premiums, claims, or liabilities. These methods have the advantage of being relatively straightforward and reproducible from reported (and often audited) data, but they have several deficiencies in terms of effectiveness.

Typically, the requirement based on premiums is of the order of 15–20 percent of net premiums, sometimes with a limitation on the adjustment for reinsurance. Requirements based on claims are more variable as some are based on claims incurred and some on the recorded claims liability.

Although requirements on a simple ratio basis do vary according to the level of business carried on, they are necessarily arbitrary and rarely give weight to the differences in volatility between the different classes of business. Some classes of business (for example, motor damage) have relatively predictable outcomes that are determined relatively soon. In other classes, such as liability, losses may emerge long after a contract has been completed, and may be individually very large. This is particularly true of matters involving latent diseases or injury, or environmental pollution. To provide the same level of confidence of financial adequacy, an insurer writing such “long-tail” business, or business involving infrequent, severe losses, needs more capital than an insurer writing business involving frequent and less severe losses.8

Ratio-based solvency requirements can also have the unwanted effect of rewarding high-risk behavior by individual insurers. If solvency requirements are based on premiums, an insurer that takes extra risk by undercutting the market is subject to a lower solvency requirement, which surely is the opposite of what should happen. If the solvency requirements are based on outstanding claims provisions, an insurer that maintains prudent levels of provisions is penalized by having to retain more capital.

Ratio-based solvency requirements also cannot capture other forms of risk, such as exchange rate mismatch risk, credit risk, and exposure to investment market fluctuations. As mentioned above, some high-level adjustments are made—assets deemed unsuitable for solvency purposes are excluded, as also may be concentrations in excess of prescribed limits for exposure to individual counterparties, or for particular types of asset. However, they are not fine-tuned for individual cases, and could also discriminate against whole classes of insurer—takaful being an obvious example, since the investment “universe” for takaful providers may be limited.

Traditional approaches to solvency regulation for life insurance have typically placed great reliance on the conservative judgment of an actuary, who was expected to build conservatism into the valuation of a portfolio of life insurance contracts and the assets backing them. This is still the case in several jurisdictions where life insurance solvency regulation is otherwise undeveloped. Even elsewhere, actuaries retain an important role in life insurance and increasingly in non-life insurance as well, but a trend toward transparency means that explicit solvency regulation has overtaken the implicit. Greater concentration is now seen on the role of the actuary as expert opining as to whether insurance liabilities are correctly valued, and on qualitative matters such as the insurer's asset–liability management.

Explicit solvency requirements for life insurance are complicated by the fact that this class of business commonly combines a protection element and a savings element, and that the contracts are long-term, such that the premiums or claims in a year provide very little indication of the risk to which the entity is exposed. The European Union's current approach, which has been emulated in other jurisdictions, attempts to treat investment contracts (where they can be isolated) separately, and to apply a percentage of the value at risk in respect of the protection element, as well as applying an overall 4 percent margin to the assets covering the protection element and the mixed element. Since every contract “in force” is taken into account, the calculation is closely allied to the actuarial valuation.

How well a particular solvency framework accommodates takaful will depend, to a large extent, upon whether takaful was contemplated (and if so, what structural model of takaful) when the framework was developed. As noted in the joint IAIS/IFSB paper referred to above, “it is necessary to conduct a detailed review of the specific capital regime under consideration, in the light of the specific structure of a specific takaful operator in order to determine if any modification is required.”

Where an aspect of the framework fails to acknowledge aspects of takaful, and the difficulty is one of structure rather than principle, it is necessary for takaful operators either to accept a disadvantage compared to conventional insurance, or to seek a dispensation. The first option may limit the activity of the takaful sector; the second has practical difficulties. Regulators are rightly reluctant to grant dispensations, even where they have the power to do so. They prefer to err on the side of prudence. In addition, giving a dispensation to takaful companies could expose the regulator to complaints from conventional insurers that takaful companies are being given favorable treatment. Regulators must also have regard to the political environment in which they operate. A regulator whose operational independence is guaranteed by the law is in a stronger position to do what it believes is justified than is a regulator who is directly answerable to the executive government.

Consequently, it is better for takaful if the regulatory framework contains flexibility that can accommodate takaful and arrive at the “right” answer for both takaful and conventional insurance, rather than requiring special dispensation for one or the other. Principles-based approaches, therefore, seem to have an advantage, in that they would be more able to accommodate different takaful structures, and less likely to require modification, than traditional ratio-based methods.

10.5 RISK-BASED CAPITAL

Regulators have long recognized that the arbitrary nature of ratio-based solvency requirements made them unreliable as measures of the appropriate level of capital that should be held by a particular insurer. This perception has led to informal measures such as rules of thumb set higher than the statutory requirement, and flexibility given only when the regulator was satisfied that it was warranted in the case of an individual insurer. However, informal rules of this nature are difficult to sustain.

Risk-based approaches have been used for some time by private-sector agencies rating insurers on financial stability or claims-paying ability. (The global organizations Standard & Poor's, AM Best, Moody's, and Fitch are probably the best known, though there are other agencies some of which specialize in providing information for retail customers.) Ratings depend on the rating agency's assessment of the insurer's capital adequacy on a risk-adjusted basis, and in order to retain the higher ratings insurance organizations have often needed to maintain significantly more capital than the regulators require. Although this may give regulators additional comfort as to the financial stability of the larger insurers, it also calls into question the adequacy of regulatory solvency requirements for other insurers.

In a number of jurisdictions, regulators have set out to develop more robust approaches that could be applied across the market. This is an ongoing process and few, if any, regulators could claim to have completed the journey. Ratio-based solvency requirements and risk-based capital are not discrete approaches but lie on a continuum, with crude ratios at one end, and fully-integrated, entity-specific capital models at the other. In between lie various possible approaches that combine elements of the two. Standard risk weighting models are increasingly frequent. For example, the U.K. currently applies a more complicated ratio analysis to the assets and insurance metrics of general insurance companies, and refers to the result as the “Enhanced Capital Requirement,” which it uses as the starting point for its assessment of the insurer's more comprehensive (but still informal) RBC calculation, the Individual Capital Assessment. The Monetary Authority of Singapore has an approach of this nature. Examination of the rulebooks of the Central Bank of Bahrain and the Dubai Financial Services Authority also shows risk weighting factors applied to different types of business and to different assets, including for takaful.

The task for insurance regulators in attempting to develop new standards for risk-responsive solvency requirements for the sector was, to some extent, simplified by the trail blazed in the banking sector by the Basel Committee for Banking Supervision. The “Basel Accords” incorporate a conceptual framework for supervision of banks. Key elements of this framework include:

• the classification of capital into “tiers” of different quality;
• consistent rules on valuation of assets and liabilities;
• the identification of different classes of risk;
• the setting of capital requirements based on a defined probability of failure;
• the possibility of using internally developed capital models, rather than a standard approach; and
• an active role for the regulator in assessing risk management and, if necessary, penalizing poor risk management by imposing additional capital requirements.

The IAIS has reflected the case for RBC in its pronouncements, and although it does not yet promote a specific model, it has an ongoing project9 based on several agreed “cornerstones” including the principle of explicit and transparent sensitivity to risks, supervisory review of risk management, and the potential use of internal capital models. The project has already resulted in the adoption of a number of Guidance Papers in this area which, like the organization's Principles and Standards, may be obtained from the IAIS website.10

The European Union has followed the Basel framework in developing its solvency revision project, Solvency II11 (a piece of work in progress that is likely to come into force across the European Union after 2012). The European RBC model currently under development is likely to be extremely influential in the development of RBC approaches in the forum of the IAIS and in other jurisdictions, though it is far from being the first such. The United States has had a risk-based capital model, endorsed by the National Association of Insurance Commissioners, for some years; the United Kingdom has foreshadowed the European approach with its own, introduced in 2004; Australia was seen as a regional pioneer; and RBC is either in place or on the agenda in Asian countries as varied as Singapore, Korea, Japan, Malaysia, and Indonesia.

RBC requirements are still a relatively recent innovation; many countries do not have them, and face a challenge in implementing them due to their complexity and the levels of judgment that are required. Particular difficulties to be surmounted include:

• Skilled resources for the creation and assessment of capital models are scarce in many jurisdictions and take time to train—one cannot just conjure actuaries out of thin air—and as a result command high rewards. In an era of increasing mobility, it is easier than ever for a person with scarce skills to move to a country where rewards are greater.
• Insurance often operates on tight margins, so spending money on capital models is a difficult business decision, and regulators too are restricted in their budgets and are simply unable to offer the levels of remuneration that would be necessary to attract and retain the relevant resources.
• The existing insurance sector may be dominated by a large number of small companies, competing intensely and inefficiently, but without the resources to improve their risk management and capital resources. The sudden introduction of RBC requirements in such an environment could close down a large part of the industry.

It is sometimes necessary to move slowly, and the political will may not be there to move at all. Indonesia provides an example of a jurisdiction where RBC was phased in and synchronized with initiatives to build insurance technical capabilities in the country.

RBC presupposes organizations with the resources to develop and implement capital models. Some insurance regulation has historically looked more leniently on small insurance organizations,12 and some takaful operations may start off as too small to cause regulators great concern. However, the growth experienced to date and predicted in the takaful sector suggests that regulators should be planning for the future, not the present, and with takaful in the mainstream, not at the fringes.

Any capital adequacy regime hinges upon the comparison of two key metrics: the capital for regulatory purposes, and the capital adequacy requirement (though the two interact with each other, as will be seen). We turn now to examine these two items. The following observations are generic and do not reflect any single existing RBC regime. They may help regulators and takaful operators to identify suitable approaches for takaful within an existing regime, or when planning reforms to a regime.

10.5.1 The Nature of Capital

In accounting theory, capital is a residue—it represents the excess of the assets of an entity over its liabilities.13 The residue, or balance, may in the case of insurers include not only the equity attributable to the shareholders of the business but also any element of equity that is attributable to the policyholders. This arises where policyholders are entitled to the profits of the business or a part of it, as in the case of a mutual, a life insurer offering “participating” (with-profits) products or a takaful undertaking. In these cases, underwriting or other surpluses attributable to policyholders, but retained in reserves rather than allocated for distribution, form part of equity. Regulators, like accountants, draw a distinction between amounts that are available to “absorb” losses, and amounts that have been “appropriated” as bonuses, dividends, or other profit shares, and have thus been converted into liabilities even though they may not yet have been paid out.

Whereas traditional solvency regimes for insurance have generally14 regarded capital as a single item (the excess of admissible assets over liabilities), RBC approaches seek to recognize that eligible capital can encompass a range of items, and to recognize the differential ability of those items to absorb losses. Some items of capital may well not qualify as “capital” for accounting purposes and must be shown as liabilities in financial statements.15 Others may not even qualify under accounting rules to be shown on the balance sheet at all. It is possible for the “regulatory capital” to exceed the owners' and policyholders' equity shown in the financial statements.

Depending on how it is structured, a takaful operation may involve potential capital “instruments” that do not have an exact equivalent in a conventional insurer. However, consistent principles may be applied when determining their status. Consider, for example, a simple takaful operation that consists of two funds—an operator's (or shareholders') fund, and a risk fund—in a jurisdiction that assesses the risk fund separately, as well as the company as a whole, for capital adequacy purposes.16 The takaful model allows for capital to be contributed to the risk fund in the form of a “qard hasan” benevolent loan. From the point of view of the risk fund, since there is a separation between the operator's fund and risk fund, qard hasan received might be viewed as capital in the risk fund, provided that it is appropriately subordinated to the need to meet claims and can only be repaid out of future surplus. To avoid so-called “double-gearing” (using the same capital to cover two different risks), if qard hasan represented capital in the risk fund it could not also be recorded as an asset in the operator's fund, even though it is expected to be repaid. Under these circumstances, the regulatory capital of the operation might have a profile along the lines shown in Figure 10.2.

For clarity, the example in Figure 10.2 assumes that there are no regulatory adjustments to values of assets and liabilities. In this example, a qard hasan benevolent loan has been paid to the risk fund so that the risk fund “owes” it to the operators' fund. Initially, it represents an asset of the operator's fund and a liability of the risk fund. However, by recognizing the qard hasan as capital of the fund rather than a liability, the initial deficit in the fund is wiped out and the fund has a small surplus of regulatory capital.

In the example shown in Figure 10.2, the risk fund is still, after taking the qard hasan into account, quite thinly capitalized. Its surplus might not be sufficient to meet the capital requirement. In this case, it might be necessary to consider another form of capital that is not recognized under accounting practice but which is still capable, to some extent, of absorbing losses.

Although it is normally a condition of recognizing capital that the amounts concerned have already been paid in, RBC principles may recognize, though generally only to a limited extent, capital that is not paid in. Takaful operations may be able to consider the following items as falling within this category:

• Capital in the operator's fund that is available for transfer as qard hasan but has not actually been transferred. Depending on the structure of the company, the operator's fund might be obliged to make a transfer, or it might be discretionary. An obligation to provide funding would be more likely to receive regulatory approval for recognition as contingent capital than just a discretionary ability to do so. Clearly, the capital needs to be present in the operator's fund. If it is eroded by operating losses, or distributed by dividend, it would no longer be available and could not, therefore, count as contingent capital of the risk fund.
• Calls on participants for additional contributions. A takaful operation may be founded on a strict principle of deficit sharing, which would mean that if the pooled risks result in a deficit over and above the accumulated contributions, the participants are liable to pay additional contributions to defray the deficit.17 Clearly, it is only appropriate to recognize calls on participants as capital to the extent that they are expected to be received; however, if calls can be made with a realistic prospect of receiving them, it would appear appropriate to recognize the possibility in the capital calculation.

In the second case, in particular, the onus would normally be on the takaful provider to demonstrate to the regulator that the item claimed as capital was genuinely available to meet the deficits. There is a precedent in regulation of conventional insurance, in that some jurisdictions allow capital credit for uncalled contributions of mutuals or unpaid share capital. A particularly relevant example is that of the so-called Protection & Indemnity Clubs in the marine insurance market, whose participants commit themselves to making additional contributions if called upon to do so, and which under European solvency rules can count such amounts as regulatory capital to a limited extent.

A takaful provider whose policy was to reclaim deficits through future pricing increases might argue that this too constituted capital. The author feels that this would be a step too far, given that participants would presumably be at liberty not to renew their policies, and to take new and cheaper insurance with another takaful provider that did not carry a burden of deficits to be recouped. Consumers may agree in principle with the concept of intergenerational equity, but may be reluctant to practice it when it operates to their detriment. The proposal also does not deal with the possibility that next year might show a deficit too, and the one after that. There is a clear difference between a call that one can make on identified participants, and a refund that is contingent on future surplus. In addition, if one allowed the possibility of future surpluses to be considered as capital, the same privilege would have to be extended to all financial institutions.

The above examples indicate how a takaful operation might be assessed in terms of identifying the components of its eligible capital. If the regulatory framework permits and requires conventional insurers to identify and categorize their capital, the same process can be applied to takaful.

The question of regulatory adjustments to values of assets and liabilities (other than reclassifications between liabilities and equities) has been largely left aside in the above discussion. Any regulatory regime that tries to achieve a level playing field must adjust for differences in valuation and differences in quality of assets in some way. The approach that is being taken by the European Solvency II project is to use market-consistent values for assets and liabilities, including where there are no market estimates that incorporate a risk margin. This approach has the advantage that international accounting practice is also moving toward a standardized approach, such that increasingly, an insurer's own financial statements should provide a consistent basis for determining regulatory capital. It is unfortunate that the key matter of valuation of insurance technical provisions remains as yet under debate in international accounting circles. The resolution of this debate may assist alignment of regulatory valuation with accounting.

For assets (for example, intangibles) that regulators currently regard as unsuitable for counting for solvency purposes, a theoretical choice remains; they can be deducted from capital, or they can be added to the capital requirement. The resultant solvency ratio is affected, but the effect on regulatory surplus is otherwise identical.18

10.5.2 Different Tiers of Capital

The Basel Committee has established the convention that capital is divided into “tiers” based on quality, ranging from the top quality of capital, which is in the possession of the insurer and carries no obligation to repay it or to make distributions on it, down to capital that can be called upon if the insurer requires it and is, therefore, less certain to be available when it is needed. Although it is not the author's intention here to describe in full the Basel designations of tier one, tier two, and tier three capital, and the sub-divisions within them, the recognition of different types of capital raises clear opportunities for characteristics of takaful operations to be recognized in an RBC model for insurance.

The different qualities of different tiers of capital are reflected in an RBC model by setting limits on the extent to which capital of lower quality can be taken into account for solvency purposes. Typically, the top quality of capital represents the equity of ordinary shareholders—paid-up share capital, plus any premium, plus cumulative retained earnings. In a mutual company, the equivalent would be any initially contributed capital plus cumulative unallocated underwriting surpluses and other earnings. Similar analogies may be drawn for a takaful company, recognizing separately the capital attributable to the operator and that attributable to the participants (policyholders).19 A bedrock of top-quality capital is usually required—an insurer would not normally be allowed to operate if its tier one capital had been eroded by trading losses to below a prescribed level. Lower-quality capital would include (for a conventional insurer) items such as preference shares and subordinated debt instruments. For a takaful operation, as mentioned above, potential qard hasan and the ability to make calls might equate to lower-quality capital in the fund. The limits on the use of lower-quality capital might be expressed as percentages of the total amount of capital, or of the required solvency margin, or in some other way. For example, in a simple model where only two tiers of capital were recognized (tier one, the higher quality; and tier two, the lower quality), the rule might be that at least half of total capital had to be tier one. If its tier two capital was over the limit, excess tier two capital would be treated as a liability rather than capital. For every unit of tier one capital the insurer raised (by retaining profits or issuing new shares), it would also be allowed to recognize an additional unit of tier two (for example, by receiving subordinated debt; or, if it had excess tier two capital recognized as liabilities, by reclassifying some of it from liabilities into regulatory capital).

10.5.3 Solvency Requirements

The traditional approach to solvency requirements, based on percentages of premiums or claims or of life insurance liabilities, was discussed earlier in this chapter. This section concentrates on RBC approaches to solvency requirements, and considerations for takaful providers. Because the European Union's developing Solvency II project provides a ready example of an RBC regime that is likely to have wide influence, including within the IAIS, reference will be made to its approach as an example.

The basic premise of an RBC system is that the capital requirement is determined based on the risk profile of the insurer. To achieve this goal requires a benchmark and a risk analysis.

The benchmark needs to be defined in terms of a probability of ruin (that is, inability to pay debts) over a given time scale. The benchmark is arbitrary; it is a matter of policy for the regulator to decide what probability of failure is acceptable. There is an incentive for insurance regulators to choose similar benchmarks, since the probability chosen affects the amount of capital required. A regulator that chooses a higher benchmark than most others may find that insurers prefer to operate in other territories. The benchmark currently proposed under the European Union's Solvency II project is 0.5 percent probability of ruin over a one-year time scale. The solvency requirement is then the value at risk corresponding to that probability of ruin. Put another way, the insurer must have enough capital to enable it to survive a one-in-200-year event. The time horizon requires the insurer to consider its capital over that period and to take into account matters such as distributions.

In the discussion of traditional approaches above, it was noted that regulators sometimes set formal or informal levels above the statutory minimum solvency requirement, which operated as intervention points. These are also a feature of risk-based models, including the Solvency II model, which will technically adopt a statutory minimum of less than the 99.5 percent confidence level referred to above. The 99.5 percent confidence level will represent a formal trigger point for regulatory intervention. The purpose of such “control” levels of capital is to enable the regulator to take action before an insurer's capital approaches the statutory minimum, to compel the insurer to take action to restore its solvency situation. It avoids the situation where a regulator is unable to take formal action before matters have deteriorated to the point that its only option is to withdraw the insurer's license.

The process of risk analysis requires scenario analysis and modeling the impact of extreme but plausible scenarios on the capital of the company. The process is not foolproof and an insurer may, in practice, be caught out by a scenario that it had not contemplated but which nonetheless occurs. In addition, it builds estimation upon estimation; insurance deals in uncertainty and matters such as future mortality trends and the frequency and severity of natural disasters are difficult to quantify. Nonetheless, a rigorously reasoned capital model that is constantly under review and has its predictive capability constantly tested in real-world conditions is generally considered a more responsible approach than trusting to luck and expectations.

An insurer has to examine all of its significant risks to determine its risk-based capital, not only insurance-related events. Risks can be categorized in different ways. The IAIS has, in its “Cornerstones” project referred to above, adopted the categorization of risk into five types: underwriting risk, credit risk, market risk, liquidity risk, and operational risk, a grouping which is closely aligned to that adopted by the Basel Committee. Underwriting risk represents the risk that the premiums charged will prove inadequate to meet the insurance liabilities undertaken. Credit risk is linked to failure of counterparties to meet obligations. Market risk represents the risk of assets failing to realize the values that have been assigned to them. Liquidity risk relates to the risk of an institution being solvent but being unable to mobilize liquidity when it is required. Operational risk is less easy to define; the Basel Committee defines it as “risk of loss resulting from inadequate or failed internal processes, people and systems or from external events.”20 The Basel definition includes legal risk but excludes strategic and reputational risk. For a takaful operation, other classifications may also need to be included, notably the risk (in the operator's fund) that fees received for managing the operation are less than the actual expenses of management.

Capital may be of limited effectiveness in protecting against some types of risk. This is the case for some forms of operational risk, and for liquidity risk. One can hold additional capital to cover the risk of market losses and creditor insolvency; however, for liquidity risk and operational risk, contingency plans and robust internal controls are likely to be far more effective. It is, therefore, important that an insurer's assessment of its risk profile takes into account its management practices and internal controls.21 It is for this reason, too, that in RBC models the quantitative aspect—calculating the capital requirement—is only part of the process, and there is a major role for the regulator in reviewing and evaluating the process by which the calculated capital requirement was arrived at, and imposing additional capital “add-ons” if the regulator is not satisfied with the insurer's risk management. Thus, RBC systems provide an incentive for insurers to adopt effective risk management systems.

The insurer determines its minimum capital requirement by applying risk factors to each of the identified risk components, reducing the resultant amounts by identified risk mitigants, and aggregating the results. Some further reductions may be possible by identifying diversification effects, though on the other hand the regulator may impose add-ons as described above. The process is summarized in Figure 10.3. (Figure 10.4 provides a live example drawn from the documentation of the European Union's Solvency II project.)

One area where takaful operations may face particular regulatory difficulties is that of the market risk and credit risk components of solvency requirements. As was mentioned above, the investment universe for takaful operators is more restricted than that for conventional insurers. With the growth of Islamic finance providers and the expansion of products such as sukuk, the options available to takaful operators are becoming broader; however, inability to invest in conventional fixed-interest securities may represent a significant restriction, as standard models tend to assign lower asset risk weightings to fixed-interest securities with high credit ratings. Takaful operators may be comparatively overweight in assets such as equities and land, which tend to be more volatile and/or less liquid, and hence, attract higher risk weightings.

In the case of a family (life) takaful operation structured such that investment risk is primarily borne by its policyholders (similarly to an investment-linked conventional life insurance operation), the market risk associated with its investments is at least partially mitigated as the asset risk and the liability risk are matched and (barring events such as unit pricing error or fraud) cancel each other out.22

Takaful operations may also find that their ability to hedge insurance risk is limited, unless they rely upon the doctrine of necessity to make use of conventional reinsurance, since the retakaful industry is as yet relatively undeveloped. However, the capacity of the retakaful industry does appear to be expanding, increasing the possibility for pooling of insurance risks with other takaful operations in diversified locations.

An RBC approach, depending on its flexibility, may allow the insurer a choice between the use of a standard capital calculation determined by the regulator, which while being based on risk still applies a standard and intentionally prudent approach, and an internal capital model developed by the insurer itself. There are several advantages to the insurer of adopting the latter approach:

• The internal capital model can be structured in the way that the insurer is organized, which should make it easier for management information to be incorporated in the model.
• Non-standard features of the insurer can be given particular effect.
• Realistic management responses can be built into the analysis.
• It is easier to integrate predicted solvency into the company's strategic plans.

Nonetheless, the internal capital model is not an easy option. Its construction, testing, and implementation require skilled resources, and the regulator will examine it critically before approving it for use.

A standard model will not necessarily be simple to calculate, either. The current proposal for the standard calculation of the solvency capital requirement under Solvency II, based on aggregation of different risk components, is illustrated in Figure 10.4. It is not proposed to explain the different items (the full explanation may be found in the Technical Specifications of the fourth round of Quantitative Impact Studies for Solvency II, published by the Committee of European Insurance and Occupational Pensions Supervisors23). This shows how risks are addressed at a granular level; it also shows that risk-mitigating impacts, including future profit sharing, are built into the risk model, a matter of particular relevance for takaful. It is interesting to note that the model does not at the current stage of development recognize an explicit profit-sharing element in the non-life insurance elements (those marked as NL), though this would, of course, be the case to some extent for most takaful models.

Whether the standard model or an internal model is used, insurers need to deal with practical issues, including the following.

• Because different forms of risk interact, determining the capital requirement for a 99.5 percent confidence of adequacy for a particular risk is a complicated process. For example, an insurer may be satisfied that it has sufficient capital to withstand the bankruptcy of a major counterparty, but fail to realize that this event would also cause a fall in the value of investments in other parties who relied upon the same counterparty. An insurer may model a major natural disaster and be confident that its capital and reinsurance together will ensure its financial survival, but not factor in possible correlated events, such as a fall in the local currency driving up the cost of imported components, and hence, the insurer's cost of claims, or the increased probability of bad debts from reinsurers of lower credit ratings.24
• It is also, of course, possible for scenarios to have inversely correlated effects on different risks of insurers. For example, a property insurer that has investments in the building trade may expect that property catastrophes will cause a boom in the building industry, increasing the value of its investments. It is also reasonable for an insurer with a diverse insurance portfolio to take account of geographical diversification when modeling the impact of scenarios. However, regulators may be skeptical about claims for such diversification benefits when examining internal models.
• Further complicating the matter, an insurer needs to consider where in its operation various different types of risk will have their impact. Some forms of capital may have the ability to absorb losses on some but not all forms of risk, and positive impacts of scenarios in one part of the organization may be unable to offset negative effects in another part due to requirements to segregate funds. The ability to make calls on participants, for example, might protect a takaful operation in the case of insurance losses (underwriting deficits), but not necessarily in the case of a credit, market, or operational risk loss. There is an interaction between the types of capital available, the structure of the company, and the risk scenarios tested. It becomes less and less possible to determine a single “solvency requirement” figure to compare to a single figure of available capital. Solvency assessment is certainly moving far from the days when 20 percent of net premium was considered the benchmark. However, as the description above may indicate, the aim of RBC to reflect the individual characteristics of insurers provides the flexibility that is necessary to accommodate not only conventional insurance but also takaful.

If an internal capital model is accepted by a regulator for solvency purposes, capital adequacy measurement seems to blur into the insurer's own internal capital management processes, and indeed this is part of the intention of advanced regulators in pursuing this line. Whether the regulator accepts the internal capital model for solvency evaluation purposes depends not only on the adequacy of the model but also on the so-called use test; whether the capital model is actively used in the management of the business.

Acceptance of internal models for capital adequacy is doubtless far off for insurers, including takaful operations, so far as many jurisdictions are concerned. Consequently, there will for a long time (and probably indefinitely, as a baseline) remain standard capital models that insurers and regulators will use to assess capital adequacy.

10.6 SUMMARY

Insurance regulation involves solvency requirements, because of the importance of the insurance sector in the broader economy. The same principles apply to takaful, although, because solvency requirements have tended to be developed in jurisdictions without a tradition of takaful and then replicated across the world, applying those principles to takaful requires modification if neither takaful nor conventional insurance is to be treated unfairly.

Traditional, ratio-based methods of solvency regulation have limited flexibility and it can be difficult to accommodate them to the different structures adopted by takaful operations, and to the different risk profiles that takaful operations present. This inflexibility may disadvantage takaful operations and limit their ability to develop this section of the market. Consequently, the development of risk-based capital regulation for insurance is of considerable interest, as this offers the potential for flexible application of principles that are equally valid for takaful and for conventional insurance, rather than rigidly applying prescriptive rules that may not be.

The evolution of solvency requirements for insurance is still continuing at the present time and there is not yet such a thing as a global standard in the sense that the Basel Accords have provided one for banks. Attention in this regard is focused on Europe, which has little tradition of takaful, because of the size of the European economy and its influence in organizations such as the IAIS and the IASB. It remains the case that in some jurisdictions with a takaful tradition, solvency and capital requirements remain relatively simple. However, the countries that are moving along the path toward RBC include several where takaful is in the mainstream, including Malaysia, Indonesia, and certain Gulf Co-Operation Council countries.

 

 

Notes

1 The author is not a Muslim and claims no personal expertise in the field of Shari'ah interpretation. This chapter is written from the standpoint of his experience in the field of insurance, and in particular in insurance prudential regulation. All views expressed are the author's own and are not held out to be those of Ernst & Young.

2 Some would maintain that “solvency” is a measurement at a point in time, while “capital adequacy” is a judgment more forward looking, but for present purposes the author feels it is unnecessary to distinguish.

3 The International Association of Insurance Supervisors and the Islamic Financial Services Board have already commenced the process of examining some of the challenges that this poses, publishing jointly in 2006 a paper on Issues in Regulation and Supervision of Takaful (Islamic Insurance).

4 Editors' note: The IFSB is in the process of preparing a standard on the solvency of takaful companies.

5 Liability law and warranty arrangements create extended rights for consumers of other goods and services, too, increasing the working capital requirements of other forms of enterprise and creating a market for insurance of such risks.

6 Takaful is in principle more closely related to conventional mutual (or cooperative) insurance than to conventional proprietary insurance. The word “takaful” in Arabic signifies solidarity (see Chapter 1).

7 “Capital adequacy and solvency regimes have to be sensitive to risk,” (Principle 6, Principles on Capital Adequacy and Solvency, adopted by the IAIS in 2002.) This point is also referred to in the joint IAIS/IFSB paper referred to above: “The solvency regime needs to reflect the location of risk.”

8 The European Union has recognized this by adding a 50 percent loading to the liability insurance metrics used in its minimum solvency test for insurers.

9 “Common structure and common standards for the assessment of insurer solvency.”

10 www.iaisweb.org.

11 There was also a “Solvency I,” but that was an interim measure, updating the ratio-based requirements that had been in place since the 1970s.

12 For example, small mutual insurers may go “below the radar” of the regulatory system and thus not be subject to the regulatory capital requirements. The European Directives on insurance exempt certain small mutuals, though it is open to member states of the European Union to regulate them anyway.

13 See the definition of equity at paragraph 49(c), Framework for the Preparation and Presentation of Financial Statements, issued by the International Accounting Standards Committee and subsequently adopted by the International Accounting Standards Board (IASB). Participants have no immediate right to withdraw equity, whereas a liability represents an existing claim on the economic resources of the entity. Liabilities must be settled first, and only then can capital—whatever is left—be distributed.

14 But not exclusively. Some regimes, such as that set out in European Directives, which is predominantly a “traditional” ratio-based regime, contain some elements of discretion for regulators.

15 See International Accounting Standard (IAS) 32, Financial Statements—Presentation for accounting considerations as to whether an item is a liability or equity for accounting purposes.

16 This is, of course, a simplification for ease of illustration. In practice, a takaful operation may have several separate participants' funds or accounts. The structure of takaful operations is dealt with in other chapters.

17 If a retail takaful operation sought to use this mechanism, it would be necessary to ensure that members were well aware of the risk of having to make extra contributions, to avoid allegations of mis-selling. Generally, insurance is bought by those seeking to cap their exposure, and the possibility of having to make further contributions might not be attractive to consumers. In practice, this form of capital might be available only to retakaful operations or to specialist corporate lines.

18 The author's personal preference is to make all such adjustments through the capital requirement, which may reflect a preference for accounting tidiness. However, in practice, regulators do make deductions from regulatory capital, even where an RBC approach is used for determining the capital requirement.

19 It would appear necessary to regard qard hasan transferred into a takaful fund as top-quality capital of the fund, since a takaful fund does not have the option of issuing equity instruments and otherwise an underwriting deficit would immediately render the fund insolvent. Similarly, in a conventional insurer a transfer from the shareholders' fund into a life insurance fund, although not qard hasan, becomes capital of the fund.

20 Paragraph 644, Basel Accord (Comprehensive compiled version, June 2005).

21 This is a requirement on U.K. insurers (rule INSPRU 7.1.15R in the U.K. Financial Services Authority's Handbook of Rules and Guidance).

22 As was noted above, retail financial markets are vulnerable to accusations of mis-selling, and the insurance industry has experienced several cases of alleged mis-selling where customers misunderstood or overestimated the security of the investments that they were purchasing. Regulators would need to be satisfied that the consumers were indeed accepting the investment risk, before allowing this mechanism as a risk mitigant.

23 This is a committee made up of national regulators of the EU member states, which has the task of advising the European Commission on insurance regulatory matters, including proposals for Solvency II.

24 One need only consider the impact of the global financial crisis that intensified in late 2008, for examples of how failures in one part of the financial system have knock-on effects across the financial sector and indeed the wider economy.